During Steve Kroft’s interview with Frank Partnoy, a law professor at the University of San Diego, Partnoy said, “A derivative is a financial instrument whose value is based on something else.”
“It’s basically a side bet,” he said. “Think of it for a moment as a football game. We don’t own the teams. But we have a bet based on the outcome. And a lot of derivatives are bets based on the outcome of games of a sort. Not football games, but games in the markets.”
A hundred years ago, Congress passed a law that made such financial instruments illegal. That is, until Congress repealed the law without public fanfare in 2000 A.D.
After that, for lack of a better description, it became legalized gambling of gigantic proportions. Not to mention, the firms taking the bets remained unregulated and thus were not required to keep any money in reserve, to guarantee payment should the outcome go against their bet.
Additionally, none of the investment banking firms ever thought they would have to pay out any claims.
Within this regulatory vacuum, investment banks created and expanded the sub-prime mortgage market.
Contrary to popular opinion, this program was hardly altruistic by nature. The marketing strategy clearly promoted the long-term profitability of the program to investors, promising a high rate of return as the mortgages matured beyond the first stages when higher interest rates would kick in.
When the interest rate hikes did materialize, the mortgage payments were unsustainable, at best, pushing homeowners toward default on their loans.
This became the unexpected long shot bet against the house of cards—against the seller of derivatives, or side bets, if you will—that demanded a payout.
John Paulson’s Credit Opportunities Fund reaped a bonanza totaling in the billions, with Paulson personally collecting a reported $3.7 billion.
In addition to the investment banking collapse, this crisis threatens to consume the resources of an estimated 5 million households as defaulted mortgages advance toward foreclosure. At last count, more than 1 million homes are already in foreclosure with more than 85,000 additional homeowners facing foreclosure every month.
Dare one say the era of the unregulated, free-market economy is over? Perhaps it is. Even former chairman of the Federal Reserve Alan Greenspan, a long term advocate of the libertarian philosophy and influential proponent of deregulation, admits in his testimony before the Congress: “I made a mistake in presuming that the self-interests of organizations, specifically banks and others, were such as that they were best capable of protecting their own shareholders and their equity in the firms.”
That mistake cost the American taxpayer trillions of dollars in lost pensions and investments that may never be recovered. The taxpayer has a right to ask Mr. Greenspan, “Where do you suggest we send the bill?”
I believe the free-market economy is the best economic system we have, to date. Having said that, financial entities should never be trusted to self regulate, as has been proven with dramatic clarity in the last decade. In the interests of the greater good of all people, there must be a moral hand that guides the affairs of all institutions.
Even wealthy financier George Soros agrees. In an interview on Bill Moyer’s “Home Journal” program, he said, “Capitalism is a false ideology…much like communism and socialism.”
Though Soros prefers the free-market system to the other systems, he, too, advocates the use of a moral hand to protect all citizens from adverse behavior of other people or institutions.
Trust is the primary ingredient that is essential for the successful management of all financial institutions within an open society. Without it, people will not have faith in any banking institution nor will they permit access to their resources to manage in a responsible and prudent manner, which ultimately benefits all citizens.
The nation’s investment bankers have squandered and abused the trust of the American taxpayer, perhaps more than any other private institution in the history of this nation.
As the American taxpayer has involuntarily come to the rescue to bail out the private institutions who are responsible for this financial crisis, the issue before our representatives of government and these wayward institutions is whether they can restore the public trust.
To do that, Congress must re-establish effective regulatory oversight to assure the taxpayers and citizens of this land that this trust will never be abused or taken for granted again.