We have learned, painfully, of the damage derivatives can do to an economy in a financial crisis. But derivatives are hurting the economy even on its best days, according to a new study.
In the crisis, derivatives exposures brought down giant financial institutions and markets, leading to the worst recession since the Great Depression. But derivatives are also weapons of slower, more insidious destruction: They drain cash away from productive segments of the economy into the financial sector, according to a new study by the progressive think tank Demos.
Derivatives can be opaque and confusing to even sophisticated investors, and the market for them is dominated by just a few of the biggest, savviest investors in the world. This combination allows banks to routinely overcharge their customers for the "innovation" of credit derivatives.
"Innovation has become a means to extract value from the markets," writes Demos fellow Wallace Turbeville, the paper's author and a former Goldman Sachs banker. This, he suggests, is sapping the economy's strength.
"Inefficiencies that transfer earnings to the financial sector are like a tax that redistributes wealth upward," he later adds. "This system cannot persist."
Financial derivatives are regularly touted as ways for banks, hedge funds and other investors to shed the risks they take on when they lend money, or gamble on corn futures or whatever. Through the magic of derivatives, these banks and investors have more money freed up to lend and gamble and otherwise just build a brighter tomorrow for us all.
In reality, though, the financial crisis showed that derivatives make the system way more dangerous by encouraging these banks and investors to pile up more and more risk. Their risk hasn't gone away; it has just been disguised.
But when they're not blowing up the economy, derivatives are also a nifty way for banks to funnel a constant stream of cash from their ill-informed customers. This business is dominated by four ginormous U.S. banks: JPMorgan Chase, Citigroup, Bank of America and Goldman Sachs, which together control more than 93 percent of the U.S. banking industry's derivatives market.
It may perhaps surprise you to learn that these banks are not charities! Instead, they extract a fee from the hedge funds or pension funds or other banks that seek the privilege of a derivatives contract for hedging risks or making fat stacks or whatever. What is this fee? Why, it's whatever these four big banks that dominate the market say it is, that's what. And if you don't like it, you can go on down to Mom & Pop & Toaster Savings & Loan and ask them for a derivatives contract and see how far you get.
Actually, this shouldn't surprise you at all. Banks charge interest for loans, so it only makes sense for them to charge a little something for a derivative, which is essentially another form of credit. A derivative contract loses or adds value as the price it tracks changes. When it loses enough value, then the bank will demand that you pony up some money -- the dreaded "margin call" -- just as it does with a regular loan. This was exactly what nearly brought down AIG and the, whaddya call it, global economy.
So far, no big deal: Banks charge interest for loans, and they charge something like interest for derivatives. What's the problem?
The problem is that banks regularly charge up to 10 times as much in rent for derivatives as they do other forms of credit, the Demos paper suggests.
"Because the pricing of derivatives was so complex, customers almost never understood how much a bank charged for entering into the derivative," Turbeville writes. "This constitutes a massive distortion of the credit markets."
Demos sadly does not try to put a dollar amount on how much banks are draining from the economy with their derivatives business. "Many, many billions" seems like a safe guess. The paper cites a study by independent researcher Andrew Kalotay, who found that state and local governments had been overcharged $20 billion by banks between 2005 and 2010 alone. And that's just state and local governments, like the Denver Public Schools and Jefferson County, Alabama, two infamous municipalities that ended up as derivative roadkill. This estimate does not include the many, many other users of derivatives, from hedge funds to pension funds to other banks.
No wonder banks love derivatives so much and have fought so hard to keep them from being regulated. The Dodd-Frank financial-reform act tried to price derivatives more clearly, but banks have lobbied for and won so many exemptions that the law is pretty much useless, Turbeville writes.
He recommends closing the Dodd-Frank loopholes and setting up some other safeguards, including stricter accounting rules and maybe a new federal agency to keep an eye on how banks are fleecing state and local governments with derivatives. Probably none of these things will happen, at least until after the next crisis. In the meantime, the economy will continue to pay the price.