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How to Understand Derivatives Like A Billionaire, Banker, or Politician-- And Fight the Great Recession On Layman' s Terms

First, don't be scared by all this talk about DERIVATIVES. The word itself is horrifying, like something out of your high school trigonometry class. The thing is, you're not supposed to understand the world of derivatives---even Wall St. pros don't understand them--which, of course,is part of the problem.

But there are some facets of the derivatives world that, upon examination, we can understand: 1) parties to derivatives contracts make ungodly sums of money; 2) the derivatives market is worth over $770 trillion (yes TRILLION); 3)the derivatives market is UNREGULATED, meaning there is no government oversight over the parties (think of the Wild West with saloons and gunfights); 4) ALL players--Republican, Democrat, big banks, Wall Street, politicians, Alan Greenspan-- agree that the cause of the Great Recession was an out-of-control derivatives market.

This article will explain the "derivatives issue" to you in layman's t erms. You will be able to speak intelligently about the market, and the need for reform.

And, no doubt, you'll be angry when you find out simple facts like this: the Health Care Plan (whether the Republican or Democratic sponsored plan) is going to cost roughly $900 billion over ten years. And the big argument is that we--as a nation--can't afford it. Yet, each and every single derivatives transaction (again, totalling over $770 TRILLION)--goes untaxed.

Meaning trillions of tax dollars are left on the table, a simple tax that could pay for: universal health care coverage, every senior prescription, every student loan past, present and future, both wars (Iraq and Afghanistan), AND giving each taxpayer back an additional, and substantial refund.

The refund alone would help generate savings WHILE giving consumers funds to shop, giving the economy an enormous, and well needed, jolt of energy.

This is a lot, yes...but not in the world of deri vatives.

If this has your attention, please read on:

A Call For Transparency?
A Call For Transparency?

What to do: regulate or deregulate, tax or leave alone?

You tell me. Or better yet, tell Congress.

Derivatives can be based on different types of assets such as commodities, equities (stocks), residential mortgages, commercial real estate loans, bonds, interest rates, exchange rates, or indices (such as a stock market index, the consumer price index (CPI), or even an index of weather conditions). And, in addition, credit derivatives have become an increasingly large part of the $770 Trillion derivatives market.

Right now, the transactions are--get this--UNTAXED.

You can't even buy a pair of socks without paying a tax. And you pay the tax each and every time you buy a pair of socks.

Yet, the billionaires, and millionaires, and banks and financial institutions of the world pay NO tax on the billions of lucrative derivative transactions they make each year. Even a miniscule tax on derivative transactions would lead to thr ee immediate benefits: 1) it would require transparency in the market place; 2) it would pay for not just a health care plan, but a UNIVERSAL health care plan; 3) it would help pay off the deficit, leading to tax refunds which would, in turn, lead to consumer spending, which would kick start the economy.

Regulate Wall Street?
Regulate Wall Street?

Second, did anyone forsee the impending crisis?

Brooksley Born figured that out, well over ten years ago. Her stance, that the derivatives market ought to be regulated, made her the subject of scorn and ridicule, not only by the Wall Street elite, but by Congress, the White House and members of the Federal Reserve.

So -- who is Brooksley Born?

Brooksley Born was chairperson of the Commodity Futures Trading Commission (CFTC)in the late 1990's, the federal agency which oversees the futures and commodity options markets. At that point, it came to Born's attention that there was no federal law (or regulations) governing the $770 TRILLION derivatives market.

Born sought "comments" (a form of federal regulation) on the need to regulate derivatives, specifically the swaps that are traded at no central exchange.

These trades are made in what is known as the "dark market", called so because there was no tra nsparency (no paperwork, no computer files, no governmental reporting) to trades (except as to the two counter-parties directly involved).

Born completed a financial analysis which led to the anticipation of a serious financial crisis, stemming from the unregulated derivatives market-place. In other words, what happened in the Fall of 2008, was called by Born---get this--nearly TEN years ago.

Of course, Born's request for "comments" was vehemently opposed by the Federal Reserve chairman Alan Greenspan, Treasury Secretaries Robert Rubin and Lawrence Summers and SEC Chairman Arthur Levitt.

In a well known meeting of the President's Working Group, Treasury Secretary Rubin and Federal Reserve Board Chairman Greenspan clearly objected to the issuance of the CFTC's "concept release". They argued that the markets--and Wall Street--were fully capable of regulating themselves.

They---Greenspan, Summers, Rubin and Levitt-- c laimed potential turmoil created by the report and raised concerns that the imposition of new regulatory costs would have immediately stifled innovation, imperiled the booming economy, and caused such transactions to be pushed offshore. (Not to mention the hurt it would put on the pocketbooks of their boys on Wall Street.

They were wrong. With a lack of transparency, a small fraction of the derivatives market crashed in the Fall of 2008, causing the Great Recession.

Make Changes We Can Believe In
Make Changes We Can Believe In

Last, there must be a call for transparency in the derivatives marketplace.

Alan Greenspan--before Congress, in 2009-- and Arthur Levitt have since stated that Brooksley Born was absolutely correct, and that the U.S. government should have regulated derivatives and the dark market all along.

It has not happened. As of October 2009, the $770+ derivatives market is still unregulated and untaxed. The President, the Congress, and BOTH the Republican and Democratic Parties appear to be held at hostage by the overwhelming influential Wall Street lobbyists.

Without federal oversight --and laws--protecting the economy and consumers, the derivative problems brought to light in this past financial crisis will likely repeat themselves, perhaps even faster, perhaps eve more violently. Do you really expect Wall Street--and the financial markets---to self regulate these contracts? And should we really give the financiers a tax-free ride to even more money and more power?

Lawmakers are afraid to cast their vote against the titans of Wall Street. But nothing frightens politicians more than a fired-up electorate.

Demand transparency and a tax on all derivative transactions---now THAT'S a change we can believe in.

Just remember, derivatives are contracts which, when broken, are not enforceable by governing law. There are over $770 TRILLION in derivative contracts in existence---do you really think one will never be breached or broken just because Wall Street says so?

And if one falls, leading others to fall, it could lead to a domino effect, causing the world economy to crash in a manner never seen before in history.

Promises To Pay
Promises To Pay

First, exactly what are DERIVATIVES?

At their core, derivatives are contracts--and contracts are, in turn, as any first year law student can tell you, PROMISES. In law, enforceable contracts are defined as a promise, or a set of promises, for the breach of which the law provides a remedy.

The problem with derivatives is, while they are contracts, they are UNREGULATED contracts. There is no federal statute that applies to the conduct of the parties, no standard for record keeping, and no standard by which to settle disputes. Thus, without adequate record keeping, how can these promises--these derivative contracts--- be enforceable?.

So what's the problem?

OK, the derivative contract is basically a promise to pay at some future date. Specifically, (OK--this is the boring part, but you'll get the ever important gist) they are financial instruments whose values depend on the value of other underlying financial instruments. (The ma in types of derivatives are futures, forwards, options and swaps.)

The main use of derivatives is to reduce risk for one party. (Example: A contract may state "I promise to cover your $10 million investment if this particular market bottoms out..").

In turn, THAT contract is sold to another party. And then the third party sells it to a fourth party, etc. Often, these contracts are bundled and sold as a group (which was a common theme in the residential mortgage market). And everyone makes money on these transactions UNLESS --or until---that particular market crashes, or bottoms out.

And when that happens? Some party is--you guessed it--- stuck with the debt. And they want their $10 million dollars back. And that's when the fights start. And catastrophes. And bankruptcies. (Ask Lehman Brothers.) And, in perfect mixed metaphor, the merry-go round continues as the dominoes begin to fall...

So, at their core, derivatives are contra cts---regulated by no one. (And now back to the interesting part). So basically, the world is subject to $770 TRILLION worth of unregulated contracts valued at a whole lot less than--you guessed it--$770 TRILLION.

Here's the kicker. All the big players are subject to the cause or effect of derivatives, including, but not limited to: HSBC, Bank of America, Wells Fargo, Santander, ICBC, Ameican Express, Citibank, BNP Paribas, China Construction Bank, Chase, J.P. Morgan, Banco Bradesco, Credit Suisse Group, and Goldman Sachs, just to name a few.

Difficulty: Easy

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