Too Bad Not to Fail

Just what are derivatives, and how much more damage can they do?

New York Stock Exchange Advanced Trading Floor, New York, 2001 (Eduard Hueber, courtesy Asymptote Architecture)
New York Stock Exchange Advanced Trading Floor, New York, 2001 (Eduard Hueber, courtesy Asymptote Architecture)

In “Babylon Revisited,” F. Scott Fitzgerald’s 1931 short story about the aftermath of the 1929 Wall Street crash, Fitzgerald makes the point that such collapses are slips in morality as much as financial failures. Charlie Wales, the story’s emotionally fragile hero, returns to Paris in a desperate effort to regain custody of his nine-year-old daughter. “I heard that you lost a lot in the crash,” says the Ritz bartender. Implying his moral lapses, Charlie replies that yes, he did, “but I lost everything I wanted in the boom.” In fact, upper-middle-class people like Charlie hesitated during the first months of the market’s run-up—until early in 1928. That was when they joined the gambling frenzy, and that was when, as John Kenneth Galbraith wrote in The Great Crash, 1929, the “mass escape into make-believe, so much a part of the true speculative orgy, started in earnest.”

Eight decades later, stock-market investors like Charlie had no role in bringing on or profiting from the 2008 financial crisis. This time they stood on the sideline as major financial institutions engaged in a speculative orgy. Guided by no moral compass, the most sophisticated financial players in the world were betting big with one another about interest rates, commodity prices, and whether companies or governments would default.

Until the 1990s, investment banks—the institutions that help corporations and governments raise capital by underwriting and issuing securities—were organized as partnerships. Under that setup, the general partners risked their personal net worth on the solvency of their firms and regulated the bank’s activities with the knowledge that they were liable for any losses. When almost all the partnerships reorganized into corporations, investment banks became, in effect, liability casinos operated by croupiers unbridled by long-term financial responsibilities. The sole object was to maximize day-to-day profits.

Bankers bought and sold something few Americans had heard of before: derivatives. These instruments were hard to define, we were told, yet they were heralded as financial “innovations” designed to minimize risk and were reassuringly referred to as “insurance,” “protection,” or “hedging.” Other strange terms—“tranches,” “mezzanine,” “regulatory arbitrage,” and “repos”—surfaced at the same time.

What are derivatives? They are financial contracts whose value is derived from a security such as a stock or bond, an asset such as a commodity (crude oil, sugar, copper, etc.), or a market index. Derivative is used to cover contracts of many different kinds, some dating back hundreds of years; others, until the 1990s, were unknown to man. Midwestern grain farmers, in the early 19th century, sometimes sold their crops while they were still growing. That is a futures contract, a kind of derivative, the likes of which have been traded on the Chicago exchanges since Civil War times. They are helpful to all parties. Southwest Airlines, for an­other instance, can assure itself the price of jet fuel in the future by entering into a contract—a derivative.

A synthetic collateralized debt obligation (CDO), the subject of the Security and Exchange Commission’s lawsuit against Goldman Sachs this April, is also a derivative. But before you can have a “synthetic” CDO, you have to have an actual CDO. What’s that? Say that a person who is a poor credit risk takes out a mortgage he can’t afford. Thousands of such mortgages are collected into a security—a mortgage-backed bond. Then a number of those bonds are collected into another security. This is a CDO that is sold to investors. A “synthetic” CDO refers to an actual CDO with no underlying asset, meaning, in this case, no mortgages. It is essentially a wager, and, like any bet, it requires two sides: a “long,” who is betting that housing prices will go up, and a “short,” who is betting that housing prices will decline. The short bettor, by means of a credit default swap (CDS), agrees to pay the interest owed to the long bettor. In return, the long bettor agrees to pay the principal of the CDO if it defaults. Goldman was the bookie who put the bets together; Rube Goldberg would have blanched at such a grotesque contraption.

The problems with derivatives are abundant and far-reaching:

  • There are no caps on the numbers, which generally are immense—big enough to bring down world markets. The derivatives market is $600–800 trillion—about 10 times the $70-trillion output of the world economy.
  • The terms are so complex that they are only dimly understood by the parties entering into them as well as by the regulators who are supposed to police them; in fact, no one knows how to regulate them.
  • By putting the economies of U.S. allies in jeopardy, they can too easily undermine American national interests.

September 2008 was when we learned that the big banks were earning most of their profits from dealing in derivatives and, by the way, that the financial statements they were issuing were worthless because derivatives were extensively used to evade accounting, legal, and regulatory requirements. The air of mystery and impenetrable lingo were no help when the banks went bust and put the real economy at so dangerous a risk that the U.S. government committed $23.7 trillion in cash and commitments to bail them out. The bailout was outrageous on its face, even before details about what the banks were doing were made public. Then we learned that the Federal Reserve and the Treasury Department, which are charged with regulating U.S. currency, and the Securities and Exchange Commission (SEC), whose mission is to protect investors and maintain fair, orderly, and efficient markets, hadn’t adequately scrutinized the banks or their derivatives.

That September the Treasury also put $85 billion into AIG, the world’s largest private insurance company, supposedly to save it from bankruptcy. Five months later, the administration disclosed under intense congressional pressure that $13 billion had gone to pay 100 cents on the dollar on some of Goldman Sachs’s derivative bets, a payout that Neil M. Barofsky, the Special Inspector General for the Troubled Asset Relief Program (TARP) called a “back door bailout” for Goldman.

There was more to come. Last December the public learned that the Goldman Sachs bet that the Treasury had bailed out was one Gold­man made against a mortgage-backed security it had created and sold to custo­mers. “The simultaneous selling of securities to customers and shorting them because they believed they were going to default is the most cynical use of credit information I have ever seen,” Sylvain R. Ranes, an authority on structured finance, told The New York Times. “The woeful performance of some CDOs issued by Goldman made them ideal for betting against,” the Times reported.

Why were the Goldman Sachs CDOs performing so badly? The SEC alleged that Goldman’s motivation was to defraud. The bank, according to the civil complaint, had colluded with a hedge-fund operator who wanted to short the housing market. The hedge fund purchased CDSs that would pay off if the mortgage-backed securities failed. The investors were unaware that the hedge fund, with economic interests directly adverse to the investors, then played a significant role in the selection process. The hedge fund had an incentive to choose the worst of the mortgage-backed securities to include in the portfolio. The SEC said that Goldman made more than $15 million from the CDOs. European banks, including the German state bank, bought the securities from Goldman, which neglected to tell the Europeans that the mortgages were selected on the basis of probable failure, according to the SEC. Within nine months of their creation, 99 percent of the CDOs were downgraded. The European banks lost $1 billion, the hedge-fund operator made $1 billion, and British Prime Minister Gordon Brown called Goldman morally bankrupt. Derivatives had created a culture in which morality was unimportant.

From the time of the investment-bank conversions in the 1990s until the 2008 crash, Wall Street depended on short-term financing to an extent previously unknown in the world. The customary vehicle for borrowing was the repurchase agreement or “repo.” Repos are contracts for the sale and future repurchase of a financial asset, and overnight is the most common duration of a repo agreement. Similar to an overnight secured loan, the buyer receives the securities as collateral against default and the seller raises capital.

William Cohan writes in House of Cards that Bear Stearns employees manning the repo desk would for a couple of hours each morning phone overnight lenders in order to raise perhaps $75 billion daily. In turn, the overnight lenders would secure their loans with Bear Stearns’s U.S. Treasury securities. “It’s of course insane,” former Bear Stearns executive Paul Friedman admitted to Cohan. “In the normal world it would be insane, and in this world it’s really insane.” It also was a business model that no general partnership would ever consider. The daily funding drama collapsed after Lehman’s bankruptcy in September 2008, because the overnight lenders stopped lending and the banks were left holding their toxic—worthless—assets. Lehman failed when it no longer could balance its books. Bear Stearns’s last president, Alan Schwartz, testified this May to the Financial Crisis Inquiry Commission that Bear had U.S. Treasuries to secure the overnight repos but the lenders would not take them because of doubts about the solvency of Bear. ”You have to understand the overnight lender makes a very small profit,” Schwartz said, “so while he is fully protected legally—he can sell the Treasuries, pay himself, and send any surplus to Bear—you might decide you don’t want to.”

Like contagious diseases, derivatives travel freely across national borders. After bringing down our system, they are now undermining the euro, the currency of the world’s second largest economy. Greek Prime Minister George Papandreou equated them to buying fire insurance on your neighbor’s house.

Greece, in 2001, sought to enter the euro zone but learned that it had too little revenue and too much debt to meet the European central bank’s standards. The Greek government turned to Goldman Sachs, paying the firm $300 million to fix the books. Goldman provided cash up front in return for mortgaging Greece’s airport fees and lottery proceeds until 2019; the loans were called sales, a classification that camouflaged the debt. Based on Goldman’s cooked books, Greece was admitted to the euro zone, and then Goldman began betting against its own client and the euro. “By enabling politicians to mask additional borrowing,” Michael Fallon, a member of the British Parliament, admonished the managing director of Goldman Sachs during hearings this year: “Banks like yours have, in fact, accentuated the sovereign risk of these countries which the markets are now focusing on.” Edward Gerald Corrigan of Goldman replied, “With the benefit of hindsight . . . the standards of transparency could have been and probably should have been higher.”


Based on Greece’s status as a euro-zone member presumed to be adhering to euro-zone standards, European banks bought lots of Greek debt. Now Europe can’t easily let Greece go, given the present global sovereign (meaning government-backed) debt crisis. “The fear that began in Athens, raced through Europe, and finally shook the stock market in the United States is now affecting the broader global economy,” the Times reported.

In May, the European Finance Ministers announced a $1 trillion rescue plan to set up a special-purpose facility, funded with taxpayer money from the International Monetary Fund and the European governments, to buy euro bonds from the banks. The result, much like America’s TARP, is to shift the loss from the banks to the taxpayers. German voters, unwilling to bail out Greece, took away Prime Minister Angela Merkel’s legislative majority. Once again, Goldman had designed something to fail and positioned itself to profit from the failure.

Like the irresponsible millionaires Tom and Daisy Buchanan in The Great Gatsby, Goldman left a mess in its wake. As Fitzgerald wrote, “They were careless people, Tom and Daisy—they smashed up things and creatures and then retreated back into their money or their vast carelessness, or whatever it was that kept them together, and let other people clean up the mess they had made.”

Greece was not American banks’ first foray into foreign-policy territory. The bankers also sold complex derivatives to Italian cities like Milan as well as to smaller municipalities such as the Umbrian hilltop town of Baschi, population 2,713. As detailed in the Financial Times, the Italian central bank reports that between 2001 and 2008, 525 local Italian authorities entered into 1,000 interest-rate swaps with an aggregate value of $50 billion—one-third of all local Italian debt. Baschi thought it could get a lower interest rate if it entered into a swap, and the bankers offered $40,000 in cash to entice the town into the deal. Baschi exchanged its fixed-rate lending on $4 million for a variable rate with the bankers. The small print of the contract was so unfavorable to the town that it lost both ways. Interest rates rose and the village lost; interest rates fell and the village still lost. The town’s treasurer, Antonietta Dominici, says derivatives should be banned. Meanwhile, Americans would do well to question whether American banks should be destabilizing Italian cities and hilltop villages.

Credit default swaps “grow like mushrooms in the dark,” Grigori Marchenko, governor of Kazakhstan’s central bank, told the Financial Times. He is concerned about CDSs because they are dragging down the country’s two major banks. Between 2004 and 2007, Western banks rushed to provide financing to Kazakh banks to fund Kazakhstan’s building boom. Some, including Morgan Stanley, purchased CDSs to protect themselves against potential losses on the outstanding Kazakh loans. And some, again including Morgan Stanley, may have bought more swaps than they had loans outstanding—meaning they would benefit if the Kazakh banks defaulted. Kazakh­stan is now trying desperately to restructure its banking system but suspects that the Western banks may be betting against them. “I don’t think anyone was prepared for what has happened here,” says Marchenko. “There is a new class of financial institutions now who are speculating that BTA [the largest Kazakh bank] will go into a default . . . rather than in keeping the bank as a going concern.” Goldman Sachs was an adviser to the Kazakhstan government but resigned for reasons the Financial Times calls unclear.

Americans, meanwhile, would do well to wonder if U.S.-chartered banks should be undermining the banks of a strategic U.S. ally. Dollar Diplomacy, as designed 100 years ago by Theodore Roosevelt and William Howard Taft, used American business to achieve national policy objectives, primarily to stabilize Latin America and discourage European meddling in our back yard—such as Vladimir Putin’s recent visit to Hugo Chávez’s Venezuela. The new Goldman Sachs version of Dollar Diplomacy is, of course, not intended to advance the national interest but to profit the company. Profit opportunities are advanced by volatility not stability.

Governments large and small normally issue fixed-rate debt rather than variable-rate debt because they need to know their future liability. Los Angeles, in 2006, issued $317 million in variable-interest bonds to build sewers and then swapped them with Goldman Sachs and other banks for the city’s promise to pay a fixed-interest rate. The city made money in the first few years, but now variable-interest rates have dropped to near zero and the city’s fixed-interest obligation far exceeds the rate it is receiving. Call provisions in fixed-rate bonds allow cities to avoid such losses from large interest-rate shifts if interest rates drop. Municipalities can pay off the outstanding bonds and issue new low-interest bonds. But L.A., by entering into the swaps agreement, gave up its right to call its bonds, and the swaps don’t expire until 2028. The banks will let the city out of the contracts for $26 million.

It’s irrational to assume that you will win a bet with Goldman Sachs or Morgan Stanley, and the village of Baschi and the city of Los Angeles should have known better. But it is also immoral to take advantage of people who may not be as clever as you. Whether those deals are legal remains to be seen.

The president of Harvard University is no doubt better advised than the treasurer of an Italian hill town, but the university’s experience with derivatives is even worse. In 2006, Lawrence Summers, shortly after a five-year term as Harvard president, told The New York Times: “There is a temptation to go for what is comfortable, but this would be a mistake. The universities have matchless resources that demand that they seize the moment.” As recounted in a Vanity Fair article last August, Summers sought “to lead (or force) the university into a glorious renaissance.” And so, in 2005, Harvard entered into a deal involving $3.7 billion of interest-rate swaps to hedge against rising interest cost. But interest rates plunged, and the losses piled up—$1.8 billion and still counting. The university’s financial report for fiscal year 2009 notes that the “unprecedented” fall in interest rates caused Harvard’s swap agreements “to incur sudden and precipitous declines in value which in turn led to significant increases in associated collateral pledged to counterparties, creating liquidity pressures on the University.” Summers told a former colleague, “I held out the hope that Boston would be to this century what Florence was to the 15th century.”

When the crisis struck, the toxic assets made it appear as if most or all of our big banks were bust. No one knew who owed what to whom. “In a just world,” financial journalist Michael Lewis told television host Charlie Rose this past March, “all . . . the failed firms would have failed.” Instead, Lewis said, for the last year and a half “the government has subsidized the banks, gifting them out of their problems.” Liquidity is not the problem, according to Anna Schwartz, co-author with Milton Friedman of A Monetary History of the United States, 1867 to 1960. The problem is insolvency and the fear of insolvency, aggravated by the secrecy of the over-the-counter derivatives market. “The real problem was that because of the mysterious new instruments that investors had acquired, no one knew which firms were solvent or what their assets were worth,” Schwartz wrote in the Times. In May, the former Treasury secretary and Goldman Sachs CEO Henry Paulson put his spin on derivatives. “They didn’t create the crisis, but they magnified it. They exacerbated it,” he testified at a Financial Crisis Inquiry Commission hearing.

Indeed, at this writing, 19 months after the bailouts, the banks still hold the toxic assets and we still don’t know what they are worth. But the solution, if Schwartz is right, didn’t require money; it only required transparency. What if the five big banks—JPMorgan Chase, Bank of America, Citi­group, Wells Fargo, and Goldman Sachs—were collectively invited to the Fed or the Treasury and asked to disclose their derivative liabilities to one another? Some deals could be canceled. At least investors, and other banks, could see what bets had been made and which banks were solvent. The failed banks could be shut. (A similar approach was taken by the New York Federal Reserve Bank in 1998 to pressure the creditor banks to keep Long Term Capital Management from bankruptcy. LTCM was the hedge fund exposed on $1.25 trillion of interest-rate and foreign-exchange derivatives that it could not pay. The intervention prevented bankruptcy without any taxpayer dollars.) The troubling point, according to Michael Lewis, is that the federal government never considered alternative solutions to subsidizing the banks.

The government told the public that the bank bailout was necessary and that the bailout dollars would be multiplied as the banks made business loans. But the plan didn’t succeed because it was based on an outdated analysis of what the banks were doing. The Banking Act of 1933, commonly called the Glass-Steagall Act, separated commercial banks from investment banks and gave us a stable financial environment. But half a century later the traditional banking system, although it raised and allocated capital efficiently, proved insufficiently flush to fund the huge salaries that became common on Wall Street. Commercial banks reorganized into investment banks to escape Glass-Steagall and become derivatives dealers—for their own and their customers’ accounts. The comptroller of the currency reports that banks, for 2009, reported record derivatives-trading revenues of $22.6 billion. The five big banks hold 97 percent of all derivatives.

Of course, advising customers at the same time you are buying for your own book is a conflict of interest. “People who know the industry and know Goldman Sachs know that it is a giant hedge fund, but it’s wrapped in an investment banking wrapper,” says Professor Samuel Hayes of Harvard Business School. He believes, as do others, that the public “would be horrified to think that their tax dollars [in the bailout] were going to a hedge fund.” In 2009, Goldman Sachs made more than $100 million a day on 131 out of a total of 263 trading days. In December 2009 Lloyd Blankfein, Goldman’s CEO, maintained in The Sunday Times of London that Goldman “was doing God’s work.” Consistent daily returns of $100 million did seem miraculous. Gambling is a zero-sum game; each day that Goldman won $100 million, the other bettors lost.

The problem is that the banks, while discarding their socially useful functions, retained taxpayer subsidies designed to support those functions. They held on to federal deposit insurance and benefited from an implied taxpayer guarantee under the “Too Big to Fail” doctrine and practice. They could borrow at lower rates because of the implied taxpayer guarantee. But the way the banks work now, no valid theory entitles them to any taxpayer subsidy. The taxpayer, under the rules, can only lose.


Before the banks could turn into casinos, they had to repeal Glass-Steagall, the laws already in place to prevent the banks from becoming hedge funds. Congress did so in a bipartisan effort, and President Bill Clinton signed the Financial Services Modernization Act of 1999. Senator Byron Dorgan (D-ND), knew the bill would pass but nonetheless spoke against it:

Does anybody here think this makes any sense, that we have banks involved in derivatives, trading on their own proprietary accounts? Does anybody think it makes any sense to have hedge funds out there with trillions of dollars of derivatives, losing billions of dollars and then being bailed out by a Federal Reserve–led bailout because their failure would be so catastrophic to the rest of the market that we cannot allow them to fail?

Senator Phil Gramm (R-TX) spoke for the repeal in glowing terms of Republican orthodoxy: “We are here today to repeal Glass-Steagall because we have learned that government is not the answer. We have learned that freedom and competition are the answers.”

Democratic President Clinton said, “It is true that the Glass-Steagall law is no longer appropriate for the economy in which we live. It worked pretty well for the industrial economy, which was highly localized, much more centralized, and much more nationalized than the one in which we operate today. But the world is very different.” He congratulated Congress:

So I think you should all be exceedingly proud of yourselves, including being proud of your differences and how you tried to reconcile them. Over the past seven years, we have tried to modernize the economy. And today what we’re doing is modernizing the financial services industry, tearing down these antiquated laws, and granting banks significant new authority.

Were the barriers “antiquated”? The country had no serious commercial bank failures while they were in place, and no financial crisis infected the real economy.

Bucket shops were once operated in many large American cities. Outfitted with a New York Stock Exchange ticker, each shop would post quotations as they came in. Customers, rather than buy stocks, would bet on the tape—for example, 20 shares of sugar at $100—and the shop would take a commission. If the stock went down, the customer lost. Customers could also short a stock. Edwin Lefèvre’s 1923 book, Reminiscences of a Stock Operator, vividly describes the turn-of-the-century bucket shop. They were partially blamed for the Panic of 1907, and states outlawed them soon after that. The New York Stock Exchange, where customers bought the underlying assets, continued to be legal.

The “synthetic” collateralized debt obligation is a revival, 100 years later, of the bucket shop. Could anyone defend the return of gambling shops? Well, yes, President Obama’s principal economic adviser, Lawrence Summers, did. In July 1998, as deputy treasury secretary in the Clinton administration, he explained to Congress that the derivative market “in just a few short years” had become “highly lucrative” and a “magnet for derivative business from around the world.” The market, Summers continued, is developed “on the basis of complex and fragile legal and legislative understandings.” It was true, he said, that “questions have been raised as to whether the derivatives market could exacerbate a large, sudden market decline.” But he didn’t think so, noting that the derivatives supported “higher investment and growth in living standards in the United States and around the world.” There was no reason for concern, he said, since:

the parties to these kinds of contracts are largely sophisticated financial institutions that would appear to be eminently capable of protecting themselves from fraud and counterparty insolvencies and most of which are already subject to basic safety and soundness regulation under existing banking and securities laws.

Summers explained that the market was based on an “implicit consensus that the OTC [over the counter] derivatives market should be allowed to grow and evolve without deciding” the legal issues—i.e., whether derivatives violated laws prohibiting bucket shops, gambling, and trading in unregistered securities, not to mention doing so outside the regulated options exchanges, such as the Chicago Mercantile Exchange. “At the heart of that consensus has been a recognition that ‘swap’ transactions should not be regulated . . . whether or not a plausible legal argument could be made” that the contracts are “illegal and unenforceable,” Summers said.

The Commodity Futures Modernization Act of 2000, 262 pages in length, passed both houses of Congress without debate the day after it was introduced. The President’s Working Group on Financial Markets, led by Summers and Federal Reserve Chairman Alan Greenspan, wrote to Congress that it “strongly supports” the bill, which would maintain the U.S. “competitive position in the over-the-counter derivative markets by providing legal certainty and promoting innovation, transparency and efficiency in our financial markets.” Section 117 of the bill stated: “This Act shall supersede and preempt the application of any State or local law that prohibits or regulates gaming or the operation of bucket shops.”

The U.S. economy prospered without derivatives and has not prospered since they were legalized in 2000. Paul Volcker, who preceded Greenspan as chairman of the Federal Reserve, recently said:

I have found very little evidence that vast amounts of innovation in financial markets in recent years have had a visible effect on the productivity of the economy. Maybe you can show me that I am wrong. All I know is that the economy was rising very nicely in the 1950s and 1960s without all of these innovations. Indeed, it was quite good in the 1980s without credit-default swaps and without securitization and without CDOs.

I do not know if something happened that suddenly made these innovations essential for growth. In fact, we had greater speed of growth and particularly did not put the whole economy at risk of collapse. That is the main concern that I think we all need to have.

Any reasonable reform of our financial system has to start with the repeal of the 1999 and 2000 acts that provide legal immunity to derivatives dealers. Restoration of Glass-Steagall would return our banks to taking deposits and making loans, thus reducing their size and getting them into safer activities. Derivatives, without their federal immunity, can be tested against state gambling and anti–bucket shop laws. The synthetic collateralized debt obligation, which is a pure bet, would fall. Volcker proposed a ban on proprietary trading by a bank. The so-called Volcker rule almost amounts to a return of Glass-Steagall, but it is doubtful that Congress will include it in the current reform bill.

The real issue is Too Big to Fail. There are two parts to the practice: the “Too Big” part and the “to Fail” part. The “Too Big” part holds the most promise. If we can limit financial institutions to a size we are willing to let fail without a blink, the problem is solved. But Congress has been unwilling to do so.

Volcker recently asked, “Can we reasonably continue with a financial system that, implicitly or explicitly, relies on a firmly held expectation that major financial institutions will be protected from failure in the face of financial crisis?” The banks generally threaten to move most of their operations overseas if Congress passes laws unfavorable to their interests. But the European countries, since the Greek affair, have probably also had enough of the new bankers. They would very likely agree to treaties with the United States that would regulate financial institutions.

The courts, too, may be helpful. Legal processes are slow but relentless. Judges do, after a fashion, reflect popular opinion. In Baschi, town treasurer Dominici has filed a lawsuit against the banks. In Milan, four banks face criminal charges for aggravated fraud in connection with a 2005 $2.3-billion bond and swap deal. Dario Loiacono, an Italian lawyer connected with the case, said, “It is clear that the municipalities did not understand the risks and costs they were taking on. This case will clarify who has responsibility for that.” The mayor of Milan, Letizia Moratti, on the eve of the criminal trial, said the bankers must change their behavior. She singled out Goldman Sachs, although it is not one of the defendant banks. Milan, she said, was not lacking in financial sophistication but was duped: “It is because we had a false letter from the banks stating that the derivatives were economically positive for us when they weren’t. It is not that we didn’t understand English.”

These days Americans may feel a bit like Charlie Wales as Fitzgerald described him in the conclusion of “Babylon Revisited”: “He wasn’t young any more, with a lot of nice thoughts and dreams to have by himself.” But we also can take solace in the glimmer of hope that Fitzgerald held out for Charlie: “He would come back some day; they couldn’t make him pay forever.”

An Update, September 8, 2010:

The Compromised Response by Congress

“Because of this law, the American people will never again be asked to foot the bill for Wall Street’s mistakes. There will be no more taxpayer funded bailouts. Period.” President Obama made this assertion July 21 when he signed the Dodd-Frank Wall Street Reform and Consumer Protection Act, Congress’s response to the 2008 stock market crash.

But derivatives, the unregulated financial contracts that set off the crash and that have cost U.S. taxpayers $3.7 trillion so far, have been largely undisturbed by the new law. The derivatives business is concentrated in the big banks–90 percent is conducted by the 10 biggest banks–and they produce $60 billion a year. Because of them, no one knew who owed what to whom, and they are the reason banks stopped dealing with one other.

What should Congress have done with derivatives, considering the fact that no one knows how to regulate them? The synthetic Collateralized Debt Obligations and other exotic inventions that are collectively known as derivatives simply should have been banned. Congress, however, did not seriously consider that, although it did try to bring them out of the shadow world of unregulated trading. Drafts of the bill proposed that derivatives be traded on exchanges so the public and regulators would at least know they exist and their pricing. But the bankers’ lobbyists beat back that modest effort at reform in the last days before the law passed.

Meanwhile, derivatives continue as the favorite betting vehicle in the casino called Wall Street. Less than a month after the new law was signed, bankers were taking huge bets on deflation: For $15,000, the bankers will cover any drop in the consumer price index up to $1 million for the next 10 years. One bettor has put down $174 million in hopes of winning $9 billion, a 20 to 1 return, The Wall Street Journal reported in late August.

Does anyone think whether or not we are going into another Depression is predictable enough to bet on? Would you bet the farm on it? Do you like bankers betting your farm on it? The banks say they have hedged their bets by buying derivatives from other banks. The hedges will be as good as long as the other banks are solvent–the same disastrous cycle we went through with AIG in 2008.

Is this what banks are supposed to be doing? “Never again” could be next week.

Permission required for reprinting, reproducing, or other uses.

William J. Quirk was a professor at the University of South Carolina School of Law and a former contributing editor of The New Republic. He died in September 2014.


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