Post #36 – Why We Should Ban Credit Derivatives

I think we should ban credit derivates. In fact, on one occasion they nearly got me killed. But just what are derivates, and why are they so bad? Well… I’ll get to that in a minute.

To keep this post as deriveting (ha!) as possible, I’m going to adopt at least one more bad pun and pop culture references to illustrate my point. I believe there are six major reasons we need to ban credit derivates – and those points are as follows:

  1. The first is the obvious detriment of counter-party risks.
  2. The second is that they are a sneaky way to hide credit risks from the markets.
  3. The third argument will revolve around regulation being good-for-nothing.
  4. The forth will be an examination of morals (i.e. that thing bankers don’t have) and how credit derivatives play to our worst characteristics.
  5. My fifth point will focus on how these ‘weapons of mass destruction’ as Warren Buffett refers to them – play a major role in the financialisation of labour and the further commodification of the working class.
  6. Last but not least… payback. The conglomerates involved in credit derivatives, and let’s look at the big picture here – there are only a few major players in the game – refused.sensible regulation by the American Commodities Futures Trading Commission back in 1998. They lobbied hard to fight regulation; therefore I think they should reap what they sow. If you can’t play nice, you don’t deserve to play at all. By the end of this post, not only will you agree with me, but you might not have fallen asleep in the process.

To understand why they should be banned I’m gunna give you a brief history of derivatives and how they gotten to the position where, eight years after the crash that nearly destroyed the global economy, we’re still debating what to do with the damn things. Beginning in the 1990’s, deregulation and advances in technology led to an explosion of complex financial products called derivatives. Economists and bankers claimed they made markets safer, but instead they actually made them unstable, for example the Global Financial Crisis (GFC). Using derivatives, bankers can gamble (and I deliberately use that word gamble, because that’s what it is) on virtually anything – the rise or fall of oil prices, the bankruptcy of a company, even the weather. By the 1990’s, this bad boy was a $50 trillion dollar unregulated market. Brushing off multiple attempts at regulation the parties involved in credit derivatives drove the world economy off a cliff in 2007 when the music stopped and the system fell apart. To illustrate my point I’m going to read you a quote referring to that period of time:

It wasn’t real profits, it wasn’t real income – it was just money that was being created by this system and booked as income. Two-three years down the road, there’s a default, it’s all wiped out. I think it was, in fact, in retrospect, a great big national, and not just national, but international, Ponzi scheme

Now these aren’t the words of some harebrained conspiracy theorist, this is a quote from Martin Wolf, the Chief Economics commentator at the Financial Times. So following on from that quote, lets address my first argument.

1) It was the argument revolving around ‘counter-party risk’, and by that I mean, in the particular instance of derivatives, that you can’t always guarantee that the other party will pay up. You can’t have your cake and eat it – you can’t argue for a deregulated market revolving around credit derivatives and then cry foul when the other party doesn’t – as the Americans’ say – ‘play ball’. In the Economist article titled ‘The Great Untangling’, the argument is put forth that the root cause of the crisis was bad mortgage lending – not credit derivatives. But there was more at play here – this argument misses why these dodgy sub-prime loans were approved in the first place. Because credit derivatives essentially mean that the risk can be passed onto someone else.

Credit derivatives create an environment where risky financial deals are encouraged because the risk is externalised – suddenly bad deals make economic sense, you get to worry about the repercussions later. At present, there’s no way of settling credit derivatives, or more specifically credit default swaps (CDS), in the case of a default. That’s why, for example, despite the idiotic actions of the financial giant AIG, the U.S government had to bail them out – the alternative was too extreme to even contemplate. That is why nothing less than a ban can suffice in cancelling out the very real danger of counter-party default.

2) My second point is that credit derivates are so complex that they can actually harbour fugitives. What I mean by this is that these financial products can be used to hide credit risk from the markets. This was demonstrated by the rating agencies brandishing everything AAA – even though they contained things like sub-prime mortgages and dodgy credit-card debt within them. We also know from the events that unfolded in the crisis that AIG, J.P Morgan and all the rest of them were using mathematically elaborate management tools based on empirically false assumptions about the frequency and severity of bad events and the correlations between them. When a product is so complex that the government – the regulators – the financial institutions – the investors and the market overall don’t understand the risks involved… it should be banned, or at least a moratorium on their use until we can truly get our heads around how we should be using these financial tools.

3) This leads into my third argument though – regulation doesn’t really work on credit derivatives. The CFTC, the regulatory body I was referring to earlier, tried to regulate credit derivatives and were slapped down. Fast-forward to today and the crisis has made the players involved in the CDS market even more concentrated than before the crisis. No amount of regulation will be able to stop the credit derivatives market manipulating a situation to create a sense of panic – and therefore exploit that sense of panic. By banning credit derivatives we don’t have to worry about regulation not doing it’s job – or being circumvented – or being watered down due to lobbying in the future. This is turn leads me to my next point – human behaviour.

4) I think credit derivatives should be banned because they prey on our worst attributes as human beings’, and for obvious reasons this shouldn’t be encouraged. As I just noted, credit derivates can be used to not only create but exploit a sense of panic, for example leading up to the crisis the credit default obligations being held by investors were going bad, which meant that AIG as their insurer was on the hook – much to the delight of speculators. A perfect analogy of how this particular market works is in this quote from financial expert Satyajit Das who says:

In insurance you can only insure something you own – let’s say you and I own property – I own a house, I can only insure that house once. In the derivatives universe, it essentially enables anybody to actually insure that house. So you could insure that, somebody else could do that, fifty people might insure my house. So what happens is, if my house burns down, the number of losses in the system becomes proportionately larger

That, in a nutshell is why AIG went bankrupt. Quite simply, the holders of credit default swaps have an incentive to push companies into bankruptcy. When the tools of capitalism are being used to cannibalise other functionaries of capitalism you know it’s a good time to step in and say ‘enough’s enough’. In regards to the role of credit derivatives in the GFC, let’s look at Goldman Sach’s pre-GFC. Goldman Sach’s didn’t just sell toxic crappy collateralised securities; it started actively betting against them at the same time it was telling customers that they were high quality investments. So by purchasing credit default swaps from AIG, Goldman Sachs’ could deliver the ultimate sack-wack by betting against CDO’s it didn’t own, and get paid big bucks when the CDO’s failed. Ultimately, they must’ve known it was all going to end in tears, but the incentive was too great to resist. This is why credit derivatives must be banned – to take away the temptation from an industry that does not quite understand the concept of limitations.

5) I’m going to briefly go off on a tangent here and talk to you about an event I’m sure you all remember – the Egyptian Revolution?

Well, I was in Egypt when that happened and to be specific, I was actually in Cairo about 3 weeks before the revolution too, so I personally witnessed the gradual build-up of discontent in the capital. When I first arrived in Cairo and I was exploring the city I noticed long lines of people, predominantly in the poorer areas, waiting to get something – I didn’t know what this was, so I asked. What I found out was that the government was handing out loaves of bread and portions of flour, because many people simply could not afford to purchase the basic staples they depended on anymore. What I wasn’t aware of at the time was that the Worldwide Food Price Index was the highest it had ever been, and this was partially the result of a speculative derivatives market fluctuating prices.

It was widely reported after the revolution that, particularly by Harper’s Magazines’ economist Fred Kaufman that the Middle East revolutions were partly caused by what he calls ‘food derivatives’. Now, Egyptians are particularly vulnerable to increases in food prices because they spend an unusually high proportion of their income on food – about 40% on average. So about three weeks after witnessing these scenes I also got to witness a Cairo on fire and what it felt like to have an AK-47 pointed at me – so take heed people, the derivatives market, especially when applied to food prices, can sometimes have pretty bad repercussions. That’s what happens when you gamble with people’s basic food supply!

6) Lastly, I want to look at the fascinating argument that credit derivatives ensure an environment where betting on the misery of others ultimately becomes the misery of all. We shouldn’t see the derivates market as some pathological growth – like a tumour, on capitalism – but rather see credit derivatives as an integral part of the modern capitalistic apparatus. Credit derivatives need to be seen in their wider context, in that the derivatives market is a further attempt to commodify labour and financialise all aspects of life. Credit derivatives, by their very nature, see the labouring class also as an ‘asset class’. To provide an analogy, this class would be a piñata that the financial industry can whack to get more capital, but in hindsight it’s a piñata they whacked a little too hard leading up to 2007. A ban on credit derivatives would allow us to draw a line in the sand, put on our best Gandalf voice and say: “You shall not pass!”

To sum up, the risks associated with a counter-party in a credit derivative transactions, the secrecy and complexity associated with the product, the industry’s disdain for meaningful regulation, it’s ability to utilise mans’ worst traits – and increasingly credit derivatives role in the ensuing commodification of the commons – all point towards a total ban as the answer. Credit derivatives should be banned so the industry gets a taste of the potency of labour – and so the financial industry knows that it is us, not them, that are the true creators of wealth and stability in society.


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