Big Bank Time Bomb Ticking

What is so abundantly clear is that the lack of transparency in derivatives trading, and the sheer complexity that is a by-product of that lack of transparency, really can make them "financial weapons of mass destruction."
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Haven't we had this discussion before?

And maybe I said "I told you so" then? Forgive me. But we still haven't gotten to the point where we actually do something about federally insured big banks gambling with derivatives.

Investopedia defines a derivative:

... a security whose price is dependent upon or derived from one or more underlying assets. The derivative itself is merely a contract between two or more parties. Its value is determined by fluctuations in the underlying asset. The most common underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes. Most derivatives are characterized by high leverage.

Got that? I prefer Warren Buffett's more succinct definition: "I view derivatives as time bombs, both for the parties that deal in them and the economic system; derivatives are financial weapons of mass destruction."

Certainly Buffett's definition better explains the news report that JPMorgan Chase, the nation's largest and most profitable bank, confirmed on May 10 that it had suffered a $2 billion loss on credit derivative bets, mainly by a trader colorfully named the "London Whale" in its Chief Investment Office. This was less than a month after Chase CEO Jamie Dimon had branded a Bloomberg News report that there was a major problem with derivatives in his London Office as "a complete tempest in a tea pot." After the announcement of the gigantic loss, Dimon said, "in hindsight, the new strategy was flawed, complex, poorly reviewed, poorly executed and poorly monitored."

Uh-huh. And haven't we heard that before? This was just the latest example of the high profile financial disasters caused by the use and promotion of derivatives. Remember when the very prosperous Orange County of California decided to dabble in derivatives and ended up in bankruptcy in 1994? Or when a derivatives trader at Barings, the oldest merchant bank in London, ran up $1.3 billion in losses in 1995 and put the 200-year-old firm out of business? And of course you remember when Long Term Capital Management had to be bailed out by the Federal Reserve in 1998 after $ 3.5 billion in bad derivative bets.

I could easily cite others, but let's jump to 2008 when derivatives hit the really big time and were complicit in the failures of Bear Stearns, Lehman Brothers and AIG, claimed their first country -- Iceland -- as a victim, and very nearly brought down all of the world's financial markets.

Derivatives are involved in the present Greek economic crisis, a crisis that once again threatens the world's economy. Last February, German Chancellor Angela Merkel talked about the use of credit default swap derivatives by the Greek government to hide its deteriorating economic situation from the rest of the Eurozone. "Credit-default swaps," she said, "where you insure your neighbor's house just to destroy it and make money from it, that's exactly what we have to curb." "Surely," said former Fed chair Paul Volcker, "the recent revelations about the use (and abuse) of complex derivatives in obscuring the extent of Greek financial obligations reinforces the need for greater transparency and less complexity."

That's exactly right. No one is calling for a ban on derivatives trading. Even Warren Buffett's companies use derivatives. They have legitimate uses in risk management. What is so abundantly clear is that the lack of transparency in derivatives trading, and the sheer complexity that is a by-product of that lack of transparency, really can make them "financial weapons of mass destruction."

Volcker, of course, is the author of the Volcker Rule in the 2010 Dodd Frank Wall Street Reform Act, which would restrict trading by federally insured banks for their own accounts, called proprietary trading. But the Dodd Frank legislation, now 22 months old, kicked the can down the road to regulatory agencies on hundreds of issues involving its implementation. And, as always, the devil is in the details.G iven the intensity of Wall Street lobbying to stop regulation, it is no surprise that rules are being postponed. A September 2011 study by Duke Law School professor Kimberly Krawiec found that 93 percent of the meetings with the regulatory agencies responsible for implementing the Volcker Rule were with representatives of financial institutions. If anything, that percentage has become higher since last September. Want to bet on a really effective interpretation of the Volcker Rule?

Here's a depressingly ironic coincidence: On the same day JPMorgan Chase announced its derivatives loss, the Commodities Future Trading Commission announced that, after almost two years of study, it was going to have to postpone a decision on derivatives until Dec. 31, 2012.

Believe me. I'm not looking forward to my next "I told you so" column.

Ted Kaufman is a former U.S. Senator from Delaware. Please visit for more information. This piece first appeared in the Wilmington News Journal.

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