Very Risky Business

Ken AshfordEconomy & Jobs & DeficitLeave a Comment

In the Washington Monthly, Senator Byron L. Dorgan — I'll only include snippets:

Last spring, when the stock market took its hair-raising ride, in one corner of Wall Street there was more than the usual anxiety. In fact, there was stockbrokers-looking-for-upper-floor-windows kind of fright. In April, clients of the giant Bankers Trust New York Inc.–including Procter & Gamble–took multimillion dollar losses on a kind of trading most Americans had never even heard of, called "derivatives." A rumor went around the Street: Maybe something truly sinister was brewing. Maybe this was a … derivatives collapse.


More trouble comes from exotic new derivatives called "swaps." Say Company A has borrowed money at a floating interest rate but is worried that rates might rise. It wants to lock in the rates at the lower level. So it calls a derivatives dealer–often a major bank–to find another company, call it B, which is willing to bet that the floating rates will be more favorable than the set rate. A swap results: Company A will pay a fixed rate of interest to Company B, which will pay a floating market rate to Company A. The risk to Company A is that rates will fall but A will be obligated to pay the higher, fixed rate. The risk to Company B is that B will end up paying higher rates than the fixed rate it receives from A. If you had trouble following that, then you are starting to get the idea. And all of this can be done without anyone even knowing, since such transactions can be done "off book"–effectively concealing them from stockholders and employees. Procter & Gamble bought a floating rate deal like this from Bankers Trust, losing a reported $157 million in the process.


But the truly scary thing is how losses like these could spread through the entire banking system. Suppose X, our film company, had entered into a swap with a New York bank. That bank in turn might then enter an offsetting contract with another bank which in turn might continue to pass along that risk on and on and on, perhaps using exchange-traded futures. So now a default by X could create a domino effect: X could not pay its bank, and its bank therefore couldn't make the payments on its offsetting contract, and so on until the chain of losses enters the exchange, where the originally esoteric bet can hurt real businesses. This is not mere fantasy.


All that stands between the public and a financial disaster of this sort is the guardians of the banking system in Washington. Regrettably, they are outgunned by the derivatives dealers in several ways. For one, there are fewer examiners than dealers, and many examiners are young and inexperienced. Worse, exotic derivatives–the stuff the big boys are doing–just don't fit within the existing scheme of federal finance regulation. It's a little like asking traffic cops to stop the nation's computer crime.

You get the idea.

But here's the thing: this was written in 1994.

And he proposed a solution back then, too:

The threat is not from foreign competition, or Government deficits or regulation. It is from Wall Street, and a new form of sophisticated financial bingo called derivatives. Even Fortune magazine–hardly a carping business critic–is warning that derivatives could swamp our economy in a sea of red ink.

Fortune estimates the new derivatives game at some $16 trillion, which is more than twice our Nation's total economic output. A single default, the magazine said, could ignite a chain reaction that runs rampant through the financial markets. `Inevitably, that would put deposit insurance funds, and the taxpayers behind it, at risk.'

That is a risk that Congress must not permit. Already the taxpayers of this country are footing the bill for the $500 billion bailout of the savings and loan industry. A gang of financial high-fliers tried to get rich quick on junk bonds and inflated real estate loans, and the taxpayers had to clean up the mess. Congress learned a lesson, or should have, at least.

That is why I am introducing today a bill to protect the taxpayers of this country from a replay of the savings and loan fiasco. Specifically, my bill would prevent banks and other institutions with Federal insurance from playing roulette in the derivatives market. If an institution has deposits insured by the Federal Government, it should not be involved in trading risky derivatives for its own account. Such proprietary trading involves a degree of risk that is totally out of step with safe and sound banking practices. It will not occur if my bill is enacted.

Perhaps we should have listened to him.