Warren E. Buffett, America’s foremost investor, warned in 2002 that derivatives are “financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.” Felix G. Rohatyn, the investment banker who saved New York from financial disaster in the 1970s, called them “hydrogen bombs.” George Soros, another major financier, wouldn’t use them “because we don’t really understand how they work.”
But Alan Greenspan, who as Federal Reserve chairman monitored the U.S. economy for more than a decade, through the heady financial bubble that burst and landed us in the worst recession since the 1930s, fought off efforts to regulate them. He testified in 2003 that “derivatives have been an extraordinarily useful vehicle to transfer risk from those who shouldn’t be taking it to those who are willing to and capable of doing so.”
Who was right? Just ask the people who have lost their fortunes when the whole economy sank and is still sinking.
Mr. Buffett said this year that derivatives are too dangerous and complex for auditors to audit them and regulators to regulate them.
What exactly are derivatives? They are bundles of other investments — such as home mortgages, credit card debt — with sound and unsound stuff mashed together and sliced into marketable segments as side bets on the market. The big rating agencies classed many of them as AAA, regardless of the subprime mortgages embedded in them.
A leading Scottish economist, John Kay, used to teach, as did Mr. Greenspan and many other economists, that derivatives allowed risks to be transferred to those better able to bear them. But, as reported by Floyd Norris in The New York Times, Mr. Kay now knows he was wrong. He now teaches that derivatives allow risk to be shifted from those who understand it a little to those who don’t understand it at all. Mr. Norris quotes another financial specialist, Richard Bookstaber, as calling derivatives “the weapon of choice for gaming the system.” He told a Senate subcommittee: “Derivatives provide a means for obtaining a leveraged position without financing or explicit capital outlay and for taking risk off-balance sheet, where it is not as readily observed and monitored.”
President Obama last month proposed a “sweeping overhaul of the financial regulatory system,” but it is up to Congress to enact the details. Derivatives will be at the center of a struggle as to whether and how far to regulate them.
Many of the big banking institutions want to keep profiting from dealing in derivatives instead of returning to easily understood “plain vanilla” banking, where the lender knows the identity and the soundness of the borrower. Morgan Stanley, in an analysis of the pending reform package, attributes much media criticism to “a poor understanding of the products and the benefits derivatives provide for American businesses.”
Maybe derivatives are beneficial for some businesses, but they have proved disastrous for the system as a whole. Derivatives need, at minimum, closer scrutiny and regulation.