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An explanation of derivatives for the average citizen, and solutions to prevent another derivatives crisis

Lynn Stout specializes in securities law and is widely recognized as an expert on the role derivatives played in the 2008 financial crisis. She's written a relatively short article on the subject and it's easy to understand, even if you don't have knowledge of financial markets. She explains how a centuries old common law rule called "the rule against difference contracts", successfully kept speculation in check until the Commodity Futures Modernization Act (CFMA) deregulated derivatives in 2000. The repeal of Glass Steagall in 1999 and the implementation of the CFMA were major contributors to the financial crisis. Glass Steagall should be reinstated and CFMA should be repealed.

It's important for average citizens to understand the role derivatives played in the last crisis, and what can be done to prevent another derivatives related crisis. So please take the time to read Stout's article and email it to friends, business associates and elected officials. Here's the link to her article:

http://blogs.law.harvard.edu/corpgov/2009/07/21/how-deregula...

Michael Greenberger is a former director of the Commodity Futures Trading Commission (CFTC), which had authority to regulate derivatives until the Clinton administration took its authority away. In this 90 second video, Greenberger illustrates the common law regulation of derivatives (like Credit Default Swaps) that had existed for centuries. If you've read Lynn Stout's article, Greenberger's comments will be an eye opener.

http://www.youtube.com/watch?v=dry053_-M4E

To understand the threat posed by banks with highly leveraged derivative positions, check out this link:

http://theeconomiccollapseblog.com/archives/the-coming-deriv...

When the Clinton administration stripped the CFTC of its authority to regulate derivatives, Michael Greenberger was working there under director Brooksley Born. Ms. Born warned Clinton that derivatives would cause a financial crisis but his economic advisors "shut her up and shut her down". PBS Frontline did a documentary called "The Warning", which chronicles Born's struggle to regulate derivatives and demonstrates Clinton's role in causing the financial crisis. I highly recommend watching it.

http://video.pbs.org/video/1302794657/

In addition to reinstating Glass Steagall and repealing CFMA, there needs to be criminal prosecution of Wall Street executives. In the following radio interview, former prosecutor William Black lays out compelling evidence for prosecuting Wall Street titans. At least listen to the first few minutes. The second link is Kansas City Fed President Tom Hoenig making a case for reinstating Glass Steagall. We need to need to pressure law enforcement and elected officials to act. If citizens would email these links/post to local attorneys, Sheriffs, prosecutors, State Attorneys General, U.S. Attorneys and elected officials, it would make a difference. Thank you.

http://onpoint.wbur.org/2011/10/18/prosecuting-wall-street/p...
http://www.c-spanvideo.org/clip/3343244

For more info check out my website:
http://www.standupforyourrights.me/?p=1047

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Question About Rehypothecation

I found this article on zerohedge.com (see: http://www.zerohedge.com/news/shadow-rehypothecation-infinte... ).

It seems to me that rehypothecation is a form of derivative that banks use to pledge collateralized debt as their own collateral for speculative investment. Is this correct or am I off base?

That's right.

Assets have been rehypothecated multiple times. That is a major reason the derivative bubble is so big.

Each vaulted ounce of gold could have many owners. Mortgages too.

Does this mean thaT more

Does this mean thaT more regulation would be better for the economy and might have prevented the 2008 crisis?

If you read...

Lynn Stout's article referenced in the post, you'll see that a return to common law regulation is the opposite of heavy handed gov't regulation as the former requires Wall Street gamblers to be responsible for their own losses. This facilitates self regulation.

http://www.dailypaul.com/277342 (Rand Paul: One person can make a difference)
http://www.StandUpForYourRights.me/?p=1264 (Fast and Furious hearing)

Bookmarked for later reading

Thanks for posting!

I think you are a bit late.

There is no way to unwind the current mess without a complete collapse.

Here is a better solution. Get rid of the monopoly on currency.

http://www.ronpaul.com/2009-12-10/break-the-monopoly-ron-pau...

Ron Paul's Free Competition in Currency Act would repeal legal tender laws, voiding the Fed monopoly, and allowing folks to transact in gold, silver, or whatever. There would be no bank runs if banks did not lend out more than they owned. No need for all the complication. No one would chose a depository institution practicing fractional banking over one that does not without serious compensation.

When the fed quits printing interest rates will begin their ascent, the derivative bubble will come unraveled, sovereigns will default, and confidence will be lost in fiat. Downgrades of govt. bonds could be the other catalyst. Either way, the system will come unglued.

More fatalistic anarcho-drivel

I'm sure many said the same thing after the market crash in 1929. But Glass Steagall was enacted and it kept Wall Street speculation in check for seventy years. We can do the same again.

http://www.dailypaul.com/277342 (Rand Paul: One person can make a difference)
http://www.StandUpForYourRights.me/?p=1264 (Fast and Furious hearing)

Exactly. It led to the

Exactly. It led to the longest sustained propserty in American (if not World) history.

Plan for eliminating the national debt in 10-20 years:

Overview: http://rolexian.wordpress.com/2010/09/12/my-plan-for-reducin...

Specific cuts; defense spending: http://rolexian.wordpress.com/2011/01/03/more-detailed-look-a

I see only two problems

1) FDIC insurance. With such government insurance banks cannot even theoretically go under, they can only merge or split.

2) Government keeping pension funds in stokes. Same thing.

Whining about Wall Street or derivatives is like whining about speculation. If you do not want to lose, you do not play. Economy cannot suffer from speculation - for every loser there is a winner. A bancrupt company would just get a new owner who would rehire most of the employees (since such a new owner would got it on the cheap.) But for that to work, freedom from wise central planners is needed.

You're denying the fact that FDIC insurance

worked well for seventy years by protecting deposits. The current problem is Dodd-Frank has expanded the FDIC safety net to include the high risk gambling activities of investment banks. Listen to Rep. Sherman and libertarian economist Jeffrey Miron's comments on Dodd-Frank's Resolution Authority.

http://www.c-spanvideo.org/clip/3343222
http://www.c-spanvideo.org/clip/3343218

Regarding derivatives, for centuries common law made a distinction between purely speculative derivatives that exponentially increase the risk of asset bubbles and derivatives used to legitimately hedge against risk, for example, taking out fire insurance on a home you don't own (speculation) and taking out fire insurance on a home you do own (hedging). In 2000, this distinction was removed by the CFMA. I suggest you take the time to read the short article on this subject by Lynn Stout. The link is in the post.

http://www.dailypaul.com/277342 (Rand Paul: One person can make a difference)
http://www.StandUpForYourRights.me/?p=1264 (Fast and Furious hearing)

oh com'on guys lets keep playing around....bout half looped here

but i think i can still out smart the two of you,,,,,i'll for first...i am a secessfull option trader and din't even go to college.......come on guy....tell me i am wrong.....glass stragel was like closing the barn door after all the cows got out.

In today's Orwellian world, smart is not smart

You'll have to try your disinformation on someone else, we're not in the market for options on BS. But thanks for trying, it keeps us sharp.

http://www.dailypaul.com/277342 (Rand Paul: One person can make a difference)
http://www.StandUpForYourRights.me/?p=1264 (Fast and Furious hearing)

not disinformation

it's dis-intermediation.........

The repeal of the

The repeal of the Glass-Steagall Act is what gave us this derivatives mess.

http://dealbook.nytimes.com/2009/11/12/10-years-later-lookin...

"Ten years ago to the day, the government reversed one of the key elements of the Depression-era banking laws, knocking down the firewall between commercial banks, which take deposits and make loans, and investment banks, which underwrite securities. The repeal of the Glass-Steagall Act of 1933 was seen at the time as a way to help American banks grow larger and better compete on the world stage."

Thanks Bill Clinton.

Never be afraid to ask simple questions.

Good point, I forgot to mention it in my post

I added a video of Kansas City Fed President Tom Hoenig who is calling for reinstatement of Glass Steagall, I think you would like it. I also added an interview with law professor William Black who is pushing for criminal prosecution of Wall Street execs. These are an important part of solutions to prevent another financial crisis. Thanks for your input.

http://www.dailypaul.com/277342 (Rand Paul: One person can make a difference)
http://www.StandUpForYourRights.me/?p=1264 (Fast and Furious hearing)

Glass Steagall is half the story

Glass Steagall removed the firewall between commercial banks and high risk investment banks. The legislation called Gramm-Leach-Bliley (GLB) repealed Glass Steagall in 1999. Here's a short article on GLB and Glass Steagall.

http://westlawinsider.com/?s=gramm-leach-bliley&submit.x=8&s...

A year later the Commodity Futures Modernization Act (CFMA) deregulated derivatives and the combination of GLB and CFMA caused the current mess. A link explaining the CFMA is in the original post.

Also, in 2004, the SEC essentially removed all capital requirements for large financial institutions.

For more info: http://www.standupforyourrights.me/?p=1047

http://www.dailypaul.com/277342 (Rand Paul: One person can make a difference)
http://www.StandUpForYourRights.me/?p=1264 (Fast and Furious hearing)

Comment out of sequence

The comment below titled "I got your points" is out of sequence. It was meant as a reply to "You seem to be confusing your opinion with fact".

http://www.dailypaul.com/277342 (Rand Paul: One person can make a difference)
http://www.StandUpForYourRights.me/?p=1264 (Fast and Furious hearing)

I got your points

on derivatives and A credit default swap is not the same type of derivative as an Interest rate swap or currency swap......sorry they are just not the same. A credit default swap was a disguised insurance product and should have been regulated by the State's Insurance Regulator. But to claim the risk is the same for "interest rates & currency" swaps is ignorance of the products, plain and simple.

I have read some of the Financial Crisis Inquiry Commission and found it to be no more of a credible source then the Warren Commission on the Kennedy Assassination. You don't believe in Arlen Specter Magic Bullet Theory do you? Come on man....how do you know the government is lying to you.....Because their lips are moving.

As far as "where I am getting my information from" here is a link to an article from the New York Times on a , like I said, April 28 2004 SEC meeting about the "changing of net capital rules" Although the article states that the "investment banks requested" the change in Net Capital Rules.......as someone who knows......An investment bank would have never made such a request, because it signals to the market that "IT NEEDS" a change in the Net Capital Rules......and that signal would have been a death nail to ANY investment bank, esp.…… one that is highly leveraged. A little mosaic theory would tell you "WHAT" was going on at the time.......like I said “FANNIE AND FREDDIE'S accounting scandal" and the worry of bailing them out. So who had the "STREET CRED" to call all the investment banks in and push them to "leverage up even more and push the change in NET CAPITAL RULES ON THEM.....the USG and this version is verified in the movie" INSIDE JOB"......But I came up with it first once I read that article in 2004. Just like I am the only one you will hear about blaming the 2008 financial crisis on the repeal of the dis-intermediation laws during the financial de-regulation in the early 1980's. You cannot deregulate a CARTEL…….ie the Federal Reserve System. It is an oxymoron to de-regulate inside a cartel.

http://www.stockbrokerfraudblog.com/2008/10/2004_sec_vote_th...

I don't think you got my points

First of all, if you want to reply to a comment, click on reply, don't click on "new comment" because your reply will be out of sequence. For those just tuning in, the "I got your points" comment was intended as a reply to "You seem to be confusing your opinion with fact".

As you know, a number of top officers from Wall Street banks testified before the Financial Crisis Inquiry Commission. If the gov't had "forced" them to buy and securitize subprime loans, they would've provided proof of this. And if they were able to prove that the gov't had forced them to create fraudulent securities, they wouldn't be facing billions of dollars of lawsuits from public and private organizations. Futhermore, the same banks you claim were forced by the gov't to engage in fraud, have gladly paid hundreds of millions in fines to settle the suits against them.

Your point that derivatives have different functions doesn't relate to what I've said in my post or what Lynn Stout said in her article. My point is, all derivative contracts/wagers can be used for hedging or speculation. The Commodity Futures Modernization Act (CFMA) eliminated that legal distinction and as a result, taxpayers are backstopping the high risk gambling activities of Too Big To Fail banks. That's why the CFMA needs to be repealed and the rule against difference contracts reinstated. FYI, the CBO says it will cost taxpayers 8.6 Trillion to prop up failing banks, and that doesn't include the short term liability represented by another financial crisis, which is equal to 40% of GDP (5.6 Trillion). Here are the links to Senator Brown citing the CBO report and Simon Johnson on the cost of another financial crisis.

http://www.c-spanvideo.org/clip/3343308
http://www.c-spanvideo.org/clip/3343395

http://www.dailypaul.com/277342 (Rand Paul: One person can make a difference)
http://www.StandUpForYourRights.me/?p=1264 (Fast and Furious hearing)

The inside Job

Don’t really want to disagree with what you have said here because the premise is correct. If you had said that you “cannot deregulate a system inside a cartel” it may be more correct. I.E. you cannot deregulate the creation of money and credit inside the Federal Reserve System because the system is a privatization of profit with the socialization of losses…..But the responsibility clearly lies at the feet of the United States Government. Their reason for the system is because it allows the USG to live beyond it means through the taxation of inflation and crony capitalization for which gives the politicians access to enrich themselves.

The definition of Corruption is
“The intrusion in to the free market through government regulation”

A couple of things I will take issue with ……one is this statement from the article from the link to your website.

It’s also important to remember that nobody forced Wall Street to BUY worthless subprime loans, securitize them, leverage them 50 to 1, put fraudulent triple A ratings on them, and sell them around the world.

Actually there was “someone” that forced the Banks to do this……it was the USG. There was meeting on April 28, 2004 where the USG brought all the Banks together and basically told them to “leverage up their balance sheets” because Fannie and Freddie where just opening up about their accounting scandals and the USG knew they were going to have to bail them out and without Fannie and Freddie (Qusi-central banks) in the market place they had to find others to keep the economy going.

If you want the most accurate picture of what caused the financial crisis the movie “Inside Job” got the closest aleast of the public information. But that really is only a study of the “System” mentioned earlier. The only real way to prevent a crisis is to “never let it develop” in the first place and never let the system to be created, the “free market” and private money is the only real answer.

http://www.youtube.com/watch?v=TlIqHlJ9ZSw&feature=related

Another thing is not derivatives are created equal. The notional values of credit and currencies derivatives are not the same as the insurance products of credit default swaps, not to mention the illegal aspect of insuring someone else’s property which the USG encouraged.

As far as de-regulation of derivatives not being a good idea i would agree but it's not the linch-pin, the real problem developed in the early 1980’s when they de-regulated the securitization process. It made way for the shadow banking system and the loss of control in credit creation……which was huge inflation.

You seem to be confusing your opinion with fact

I thank you for your interest in this subject. But the fact is, derivatives have existed for centuries and as Lynn Stout points out in her article, the centuries old common law "rule against difference contracts" kept speculation in check by declaring purely speculative derivative contracts to be legally unenforceable wagers. Stout explains this as follows:

"The rule against difference contracts did not stop you from wagering on anything you liked: sporting contests, wheat prices, interest rates. But if you wanted to go to a court to have your wager enforced, you had to demonstrate to a judge's satisfaction that at least one of the parties to the wager had a real economic interest in the underlying and was using the derivative contract to hedge against a risk to that interest."

An example of a legally enforceable wager (derivative contract) being used as a hedge against risk is buying fire insurance on your home. A legally unenforceable wager/derivative contract would be buying fire insurance on a home you did not own, i.e., you do not have an economic interest in the underlying asset, in this case, the home.

If you watch the 90 second video of Michael Greenberger, the difference between a hedge and a purely speculative bet will be perfectly clear. This legal distinction between hedging and bets was removed in 2000 by the Commodity Futures Modernization Act, which is why Wall Street speculation is now backstopped by the Federal safety net (FDIC).

Also, you incorrectly believe that Wall Street banks were forced to buy subprime loans on the secondary mortgage market. I don't know where you're getting that information but I suggest you check out the Financial Crisis Inquiry Commission hearings (FCIC). You'll hear sworn testimony from top officers of Wall Street banks, ratings agencies, Fannie and Freddie, and gov't regulators, none of whom say that banks were forced to buy and securitize subprime loans. Here's the link to the FCIC.

http://fcic.law.stanford.edu/hearings

http://www.dailypaul.com/277342 (Rand Paul: One person can make a difference)
http://www.StandUpForYourRights.me/?p=1264 (Fast and Furious hearing)