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What's really burning down the financial house

Derivatives are out of control. Time for adult supervision.

By Mark Lange / November 5, 2008

San Francisco

The most pressing business for the presidential transition team? Forget the customary interlude measuring the White House for drapes. Make it flights to Washington to meet with Treasury and Federal Reserve leadership, to begin restoring confidence in the financial system.

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This can't wait. It begins with the recognition that, behind all of the explanations and recriminations, what ultimately brought down the financial house were volatile investments known as "derivatives" – idiosyncratic and inscrutable securities "derived" from other securities, such as bundles of home mortgages. If we fail to regulate them, we will continue to invite the financial equivalent of arson.

The value of these financial abstractions has grown fivefold since 2002, to at least $531 trillion today. That's nearly 10 times the total output of all of the goods and services the entire world produced last year.

Think of derivatives as computer-generated casino wagers. Upper-class slot machines, video games played by Wall Street's Masters of the Universe, they amount to bets placed on the future direction of interest rates, stocks, commodities – any asset or investment. Their aim is to cover losses, or reap gains from the bad bets of others.

In the case of housing, that meant shaky mortgages bundled up and priced based on guesstimated odds of being repaid, at exorbitant interest rates and dismal (or fictitious) credit ratings.

At best, derivatives can insulate against investment risk. But because they're entirely unregulated and trade on no public exchanges, their originators can deliberately hide their vulnerabilities. So anyone buying them risks burning down the house.

The most explosive derivatives? Credit default swaps – contracts sold to banks eager to insure themselves against default on the bad debt they knew they were issuing. These fake insurance policies sever the link between bank risk and borrower responsibility. Investment bankers lined up to bet on mortgage bankers' not being paid back – wagering teetering piles of borrowed money on capital bases only 1/20th to 1/30th the size of the bets they'd placed.

Follow the dollars, and the housing boom wasn't a creature of Main Street. It was demand for these derivatives, including "securitized" mortgages, which led to loose lending and pumped up home prices. So when the banks' exposure (first at Bear Stearns, and fatally at Lehman Brothers) finally became obvious, their stocks cratered, and what meager capital coverage they had was burned up.

And there is still $62 trillion in these bets on the balance sheets of banks and insurers. Wall Street's high finance has amounted to magical, money-for-nothing thinking. No wonder taxpayers are infuriated by the idea of paying the people who got us into this mess to get us out of it.

This was more than a matter of low rates, loose credit, and lax regulation, as former Federal Reserve Chairman Alan Greenspan almost alluded to last month. We got into this mess through a deliberate obstruction of regulation – a dogmatic dereliction of duty on the part of the Fed.