Derivatives are a hotbed of abuses and bailouts, why are taxpayers footing the bill?

By Zach Carter at AlterNet

For the Wall Street reform package currently making its way through Congress to work , it has to accomplish two broad goals: It must take a huge bite out of banking profits and end the too-big-to-fail oligopoly that encourages megabanks to take megarisks and stick taxpayers with the tab. Neither of these goals can be accomplished without taking on derivatives — the wild, unregulated market that brought down AIG. Right now, the U.S. government pays big banks for operating derivatives casinos. If we’re going to clean up the derivatives mess, we have to move taxpayer money out of the market.

“The dirty little secret here is that the American government has been subsidizing the derivatives market through the Fed and other avenues since its inception,” says Adam White, director of research for White Knight Research and Trading. “That’s crazy.”

What kind of business is the American taxpayer subsidizing? One with a history of deception and abuse that dates back to its earliest years. Back in 1993 when derivatives casino was first getting off the ground, a Wall Street titan called Bankers Trust Co. sold a derivatives package to drug and chemical giant Procter & Gamble. At the time, Bankers Trust was a powerful, well-respected financial player, which was how it scored big-time clients like P&G. But P&G ultimately took a huge loss on the deal with Bankers Trust, and took the bank to court, where it obtained more than 6,500 tape recordings of horrific derivatives strategizing.

The public release of those tapes was not enough to compel Congress to actually do anything as a matter of public policy, but it was more than sufficient to utterly ruin Bankers Trust. One quote from the tapes, in particular, has become infamous among the nation’s financial establishment, but remains obscure to the general public. It’s a Bankers Trust salesman, describing the Procter & Gamble deal:

“Funny business you know? Lure people into that calm and then just totally fuck ’em.”

To this day, such techniques remain a central part of the derivatives business, as the SEC’s recent fraud suit against Goldman Sachs has made clear. These operations are ugly enough as purely private-sector enterprises. But the real disgrace is that ordinary taxpayers are actually helping to fund it. That taxpayer payout, in turn, creates market distortions that encourage fraud, abuse and bailouts.

“In the fall of 2008, when the derivatives market-making of the five big banks lead to a systemic catastrophe, the banks all proudly walked back to the Fed window to get assistance to prop up their derivatives market-making,” says Michael Greenberger, who served as the chief deputy to Commodity Futures Trading Commissioner Brooksley Born during her unsuccessful attempt to rein in the derivatives market in 1998. “The central question is whether we want this to be part of the basic business of derivatives. That seems insane.”

As the Wall Street reform bill moves into its final stage of negotiations, the only proposal still on the table that would actually move taxpayer money out of the derivatives sinkhole comes from the unlikely source of Sen. Blanche Lincoln, D-Ark., a career corporatist who has never shown much interest in regulating anything. But it’s a whopper of a proposal, one that comes free of any loopholes and goes straight to the heart of Wall Street’s bubble machine.

The plan is simple: If you want to be dealing the crazy, complex financial products that toppled AIG, Enron and Long-Term Capital Management, then you can’t receive any funding from the Federal Reserve. No bank can operate without access to the Federal Reserve’s money supply, so the five megabanks would have to choose — do they want to be derivatives houses or do they want to be banks? If they want to be banks, they have to move all of their derivatives operations to an independently capitalized subsidiary — a company that raises money on its own and has no access to taxpayer perks.

While several policymakers close to the financial industry like Fed Chairman Ben Bernanke and Treasury Secretary Timothy Geithner oppose the Lincoln language — known on Capitol Hill as “Section 716”– many top economists agree that getting taxpayers out of the derivatives business is the most important Wall Street reform still on the table for 2010.

“To me, preserving section 716 is really the critical issue,” Nobel Laureate economist Joseph Stiglitz said on a June 9 conference call with reporters. “It protects the taxpayer.” Top economic thinkers like Nouriel Roubini, former IMF chief economist Simon Johnson, Dean Baker and Jane D’Arista have also offered support for the measure.

If banks can’t pump taxpayer money into the derivatives machine, that machine becomes much less profitable. Instead of booking fictitious profits based on perpetual government aid, derivatives dealers will have to price their risks as they exist in the real world. Market forces would shrink the casino, putting the entire economy in a better place.

Most followers of the Wall Street collapse know that derivatives are dangerous — but even some dedicated reformers can find themselves wondering just what the hell a derivative actually is. The answer: just about anything a banker wants it to be. Derivatives are used to for everything from straightforward insurance to outrageous accounting fraud. Any financial contract whose value is derived from some other asset can be classified as a derivative. They can be derived from just about any asset imaginable, which is why derivatives scandals are so diverse in nature. Enron used derivatives to loot the California electricity market. AIG used them to loot the U.S. mortgage market, J.P. Morgan Chase used them to loot Jefferson County, Alabama and Goldman Sachs used them to loot the European Union.

“You can use derivatives to get into any business you want,” says Michael Masters, an incredibly successful hedge fund manager who has worked closely with White on derivatives reform proposals. “If a bank wants to get into the iron ore business, they can do that. They can get into the coal transportation business. You can say, ‘I’m going to be in the shoe business now,’ and concoct some derivatives based on shoes, and all of a sudden, you come to dominate the shoe industry. Banks are supposed to be banks. They’re supposed to facilitate commercial activity, not directly compete with commercial enterprises. That taxpayer subsidy gives them a leg up on every other industry, financial or otherwise, when they can deploy it on derivatives.”

A bloated financial sector is bad for the economy. Instead of acting as a catalyst for broader economic growth, oversized financial sectors actually devour other productive activity. By 2007, finance accounted for about 40 percent of corporate profits, according to the Bureau of Labor Statistics. After taking a dive during the crash of 2008, finance was back to 36 percent of profits by the end of 2009, almost all of that rebound carried by derivatives operations. If we cannot shrink bank profits, our economic recovery is going to be unnecessarily weak. The rest of the economy will be suffering at the expense of our financiers.

But the very fact that most people need to ask the question — what is a derivative? — is part of this market’s profit magic. By injecting needless complexity into otherwise straightforward financial transactions, banks can game their balance sheets, deceive investors and defraud their own clients. The recent examples are nauseating—Goldman Sachs setting up its own customers to fail and then betting against them; Lehman Brothers using derivatives to hide mountains of debt from its own investors; and on and on.

Taxpayers have subsidized banking since the 1930s by providing both deposit insurance from the FDIC and cheap emergency lending from the Fed. There’s a damn good reason for providing this aid: If a bank fails, its depositors don’t lose their savings. This keeps ordinary people from being directly wiped out by a financial crisis, and it also makes financial crises less likely by preventing bank runs.

These guarantees also help banks. Since there is no risk of loss, banks do not have to pay depositors very much to win their money. That makes financing the everyday operations of the bank very cheap, and allows the bank to book bigger profits. So the flip-side of that subsidy is regulation. Up until the 1990s, that regulation meant that banks couldn’t do any risky securities trading while receiving taxpayer perks. By 1999, Congress and regulators had ripped away all of those restrictions.

But the explosion of the derivatives market in the 1990s may have been even more significant than the repeal of the Depression-era restrictions on what banks could do. Derivatives did not become a significant part of the banking business until the 1990s. At the end of 1992, at the dawn of the Clinton administration, the total face value of the derivatives market was $12.1 trillion, according to the Government Accountability Office. That sounds like a lot, and it is, but by the end of George W. Bush’s reign in 2008, the derivatives market had exploded to $683 trillion, according to the Bank for International Settlements. In today’s banking industry, just five U.S. banks control nearly $300 trillion of that international market: Goldman Sachs, J.P. Morgan Chase, Citigroup, Bank of America and Morgan Stanley.

This explosion didn’t happen by accident. The surest way to feed a destructive market in anything — finance, oil, junk food, whatever — is to deregulate it, and then subsidize it. Fraudsters love to specialize in products the government doesn’t scrutinize, and everybody likes free money from Uncle Sam. The Bankers Trust scandal was a major event in financial circles, but it didn’t spark a systemic freak-out. But in 1998, one of the world’s largest hedge funds, Long-Term Capital Management, found itself on the brink of collapse after getting in way over its head on derivatives. The scare was so severe that the Federal Reserve orchestrated a bailout for the hedge fund, albeit one financed by the private sector rather than taxpayers. Brooksley Born took that collapse to heart and pushed to regulate derivatives, but was blocked by a coalition of Alan Greenspan, Robert Rubin and Lawrence Summers. In 2000, a Republican Congress passed legislation that further deregulated the market with the blessing of both Clinton and Summers. Suddenly, bankers had carte blanche to do whatever they wanted with derivatives, and get subsidized by the American public.

Derivatives are a fundamentally risky business, much more so than lending. Loans provide a much more direct economic function, their risk is much more easily ascertained, and they can be put to productive uses — buying a home, investing in new inventory, whatever.

“The whole point of government guarantees is to avoid bank runs and establish confidence so that they can lend money out,” says White. “You don’t want to give your money to a bank and have them stick it in the mattress. They’re not lending it out any more. These days, every time they get a dollar from the Fed, they have to make a choice: Are we going to make a loan, are we going to conduct derivatives trades, or are we use it to do proprietary trading. Generally, making a loan is third on that list.”

Even when they are not fraudulent or abusive, derivatives are usually purely speculative instruments. They often do not serve any productive economic function, but instead allow clever opportunists to cash in on some economic event (say, the collapse of the subprime mortgage market). That doesn’t actually help anybody create jobs or bring a great new product into the economy—it just lets somebody get rich at the economy’s expense.

Speculation in small amounts is not an economic disaster. Indeed, some degree of speculation is necessary for a financial system to function at all. But when speculation is subsidized by the government, the rewards offered by raw gambling very easily outweigh the risks. Subsidizing speculators results in way too much speculation in the economy, and puts the economy at large in serious danger.

This is essentially what happened in the subprime mortgage market. As Nomi Prins has detailed, only about $1.4 trillion in subprime mortgages were issued between 2002 and 2008, while about $14 trillion in securitized bets were derived from these mortgages. When the subprime market cratered, the economy’s problem was several trillion dollars larger than it needed to be thanks to derivatives.

The derivatives dealing problem is different from the matter of proprietary trading—banks simply gambling for their own accounts. By dealing derivatives, banks act as a go-between for other speculators. The bank is not betting for its own account, but the taxpayer subsidies for the operation make acting as this go-between much more profitable, and, as a result, speculation throughout the entire financial system becomes cheap and rampant. A strong Volcker Rule — something not yet included in the Wall Street reform package — would end the subsidies for prop trading. But we shouldn’t be subsidizing speculation anywhere, and so long as banks are allowed to deal derivatives, that’s exactly what we’ll be doing.

“They should be seen as complementary,” Stiglitz said. “What is obviously clear is that the current Volcker Rule needs to be strengthened, but even after it’s strengthened…the two are dealing for the most part with different issues, different kinds of activities, different risks, different distortions.”

But there is another still deeper problem in derivatives beyond the subsidization of recklessness, abuse and speculation. By allowing derivatives dealers to operate within the commercial banking system, taxpayers are directly subsidizing too-big-to-fail. Banks deliberately wrap themselves in extremely complex webs of derivatives trades in an effort to insulate themselves from regulatory scrutiny. The current Wall Street reform package tries to end too-big-to-fail by giving regulators new powers to shut down failing financial behemoths. But if banks can still deal derivatives, those powers are likely to prove meaningless. As a subsidized derivatives dealer, a bank can conduct millions of dollars worth of derivatives trades every day, making it impossible for regulators to predict the fallout from shutting the bank down. When push comes to shove, the regulator won’t shut down the bank—it will just bail it out.

“Without OTC derivatives reform enhanced resolution powers for dealing with insolvent institutions could well be rendered impotent and future crises in the credit allocation system will likely be longer and deeper than is necessary,” former Senate Banking Committee economist Robert Johnson told the Houses Financial Services Committee in November 2009.

Everybody in Washington who has bothered to be educated in derivatives knows that banks use derivatives to make themselves too-big-to-fail, and key politicians have taken direct steps to prevent the public from getting the message. When Johnson testified in November 2009, he was cut off early by Rep. Melissa Bean, D-Ill., and Congress refused to post his testimony online until outrage from the financial blogosphere reached a fever-pitch several weeks later. The House was in the middle of a plan to gut the already timid derivatives reforms offered by the administration of President Barack Obama, and the House ultimately offered an incredibly weak plan to cope with the catastrophe.

But the overarching lesson is clear: you cannot end too-big-to-fail without divorcing taxpayer subsidies for derivatives from the banking industry. Insane profitability carries with it extreme political power. Every other aspect of Wall Street reform hinges on the willingness of Congress to defuse derivatives profits. So long as megabanks can rake it in on derivatives, it will be extremely difficult to rein in other aspects of their business, regardless of what rules are actually on the books.

Fortunately, the political winds are shifting. Kansas City Federal Reserve President Thomas Hoenig offered strong support for the plan to end derivatives subsidies in a June 10 letter to Sen. Blanche Lincoln. Lincoln herself decided to run with the derivatives crackdown when she realized that her primary challenger Bill Halter had both the funding and the support from progressives to unseat her. While Obama remains opposed to the Lincoln proposal, Lincoln’s sudden ferocity on derivatives was championed by both Obama and former President Bill Clinton as reasons for her relevance in the November elections, and this support led Lincoln to a narrow victory in the Democratic primary last week. After watching so-called “moderate” Democrats spend a full year watering down reforms to please their Wall Street backers, at least one Blue Dog finally realized that Americans want real reform, and that real political gain could be realized by providing it.

Organized labor, major boosters of financial reform, poured $10 million into Halter’s campaign against Lincoln. Even though Halter didn’t win, this investment is beginning to look like one of the greatest in history. J.P. Morgan Chase CEO Jamie Dimon expects the current derivatives language to cost his company $2 billion a year in profits. Multiply that figure by the number of major dealer-banks, and it comes to $10 billion a year. Over the course of a decade, $100 billion in Wall Street profits will remain in the real economy instead of being distributed as dividends and bonuses. Score $100 billion for the economy on a $10 million investment is a return of 1,000,000 percent—easily the greatest single trade in history.

Forcing banks out of the derivatives business is by no means a done deal. Only continued public pressure can keep politicians from selling out to Wall Street (again).

Call Congress today and tell them you’re sick of seeing your money go to financial predators.