Lynn Stout, How Dereulgating Derivatives Led to Disaster and Why Re-regulating Them Can Prevent Another, is worth a read. As I've been saying for some time, she notes that Phil Gramm's coup with the Commodities Futures Modernization Act deregulating credit derivatives permitted banks to do the speculative betting that brought the system down. She has a novel solution--go back to the pre-2000 system where courts wouldn't enforce speculative derivative contracts. Not sure I think that's enough, at this stage, but it would be better by far than what we have now (still no regulation of derivatives).
Hedges are real positions that offset real positions. Derivatives --and in particular, credit default swaps--allow parties to take raw bets on whether an issuer will default (including a variety of small-scale technical defaults) on a bond obligation. Here's Stout's language describing derivatives.
Finance economists and Wall Street traders like to surround derivatives with confusing jargon. Nevertheless, the idea behind a derivative contract is quite simple. Derivatives are not really “products” and they are not really “traded.” They are simple bets on the future—nothing less, and nothing more. Just as you might bet on which horse you expect to win a horse race and call your betting ticket your “derivative contract,” you can bet on whether interest rates on bank deposits will rise or fall by entering an interest rate swap contract, or bet on whether a bond issuer will repay its bonds by entering a credit default swap contract. After the 2000 coup, the derivatives market expanded explosively. According to a Newsweek article, there was about $600 TRILLION in derivatives outstanding in late 2008 (including about $60 trillion in credit default swaps protecting against only about $15 trillion in bond principal!). That was mostly raw betting (and a little bit of fancy financial instruments that facilitated tax shelter deals) rather than the genuninely useful hedging that provides insurance if a future event destroys value. As Stout says: Speculation is the attempt to profit not from producing something, or even from providing investment funds to someone else who is producing something, but from predicting the future better than others predict it.4 A speculator might, for example, try to make money predicting wildfires by buying home insurance on houses in Southern California without actually buying the houses themselves. Similarly, a speculator might hope to make money betting on a company’s fortunes by buying CDS on the company’s bonds without buying the bonds themselves. Unlike hedging, which reduces risk, speculation increases a speculator’s risk in the much same way that betting at the track increases a gambler’s risk. Highly‐speculative markets are also historically associated with asset price bubbles, reduced returns, pricemanipulation schemes, and other economic ills. So after 2000 we had a lot of big banks doing a lot of risky speculation --raw betting--with very little regulation (deregulation by legislation of derivatives, and deregulation by lax enforcement along every other angle by the Bush Administration). AIG was a significant counterparty to bets and counterbets in the financial system, so when it went down, all bets were off (excuse the pun) about who would come out ahead once the smoke cleared. Stout describes this problem as rampant throughout the markets, not just the case of a "rogue" AIG insurer giving in to the gambling bug. Given the stigma attached to speculation, it’s not surprising that most parties to derivatives contracts claim, at least in public, that they use derivatives for hedging and not for speculation. In some cases this seems a rather transparent attempt at deception. (Hedge funds, for example, should really call themselves “speculation funds,’ as it is quite clear they are using derivatives to try to reap profits at the other traders’ expense.) Perhaps more often, derivatives traders incorrectly describe themselves as “hedging” when they use derivatives to offset some of the risk associated with taking a speculative position. This is much the same as a racetrack gambler claiming she is “hedging” because, in addition to betting on a particular horse to win, she also buys a betting ticket for the horse to show. *** When the notional value of a derivatives market is more than four times larger than the market for the underlying, it is a mathematical certainty that most derivatives trading is speculation, not hedging. And business history—including very recent history—shows derivatives speculation increases systemic risk. So when Goldman claims that it was fully hedged and therefore was correct in not having to take a discounted payment on its counterparty claims against AIG, is that right? Probably not. First, Goldman's counterparties on its hedges against its bets with AIG were probably also involved in swaps with AIG. If AIG didn't pay, they wouldn't pay. So Goldman and the counterparties were all being bailed out when the government provided the funds for AIG to pay 100% on Goldman's and the others' claims. (Does that mean that Goldman may have gotten some preferential handling from Treasury's Paulson (and old Goldman hand) in the waning days of 2008? You decide.)
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