Perspective on Derivatives
What Went Wrong and Why
By Wayne Pearson
We have all heard about the problems our economy is experiencing as a result of the
financial collapse of such Wall Street investment bankers as Bear Stearns, Lehman
Brothers and the various and sundry mergers to save such financial firms as Morgan
Stanley. Many of us have had personal experiences with the results of the problem
including a precipitous fall in the value of assets such as retirement savings, funds set
aside for college and the value of homes. This financial debacle has caused the US
government to infuse billions of dollars of monies into the financial institutions to keep
them afloat. These so-called “bail out” funds came from the US Treasury, or in other
words, from the taxpayers, namely you.
The question we have is why did this happen? Let’s begin our investigation by trying to
understand just what it was and still is that these financial institutions are engaged in that
caused the problem.
We all know regular banks; the kind that we grew up with and placed our allowances or
earned money into as kids. We later learned about the Federal Deposit Insurance
Corporation, F.D.I.C. which protected our savings in the event of the failure of the bank.
The F.D.I.C. was put in place in the 1930’s after the massive run on the banks during the
recession. My own parents lost all of their savings as a result of that bank crash. Today
these traditional banks are highly regulated to minimize the possibility of failure, and in
the event of such as catastrophic event, your and my savings are protected.
Starting in the 1990s, other financial institutions were permitted to enter the banking
business. These firms had plenty of excess cash from their main activities and could now
use that cash for financial activities outside the primary mission of their enterprise. These
firms included insurance companies, and investment bankers. Most of the investment
banker’s headquarters are on Wall Street in New York City. We can more or less
understand what insurance companies do, but what does a Wall Street investment banker
do? Mostly, they deal in “financial derivatives”. So, this raises the question:” What is a
“financial derivative”? Let’s start with Webster’s dictionary definition:
“Derivatives is the collective name used for a broad class of financial instruments that
derive their value from other financial instruments events or conditions”
OK, so a derivative is a financial instrument derived from an underlying asset such as
stocks, currency, mortgages, etc. Derivatives allow holders to speculate on price
movements of the underlying asset without actually owning the asset concerned.
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Derivatives are traded for two main reasons:
1. To allow holders to hedge a position, that is to reduce the risk inherent in their
basic position;
2. To allow speculators to profit from correctly anticipating movements in price
either up or down...
Investment bankers’ profits derive from the premiums paid by the hedgers for reducing
their risks. And you can bet on anything from a financial asset to no asset at all. There is
no type of debt that cannot be sold. Examples include student loans, home equity loans,
credit card balances, auto notes, buying up and life and/or health insurance policies and
as we have seen, home mortgages. The carbon credits from cap and trade will be ideal
new derivatives. Moreover, all of these derivatives can be bundled which makes it more
difficult to ascertain the true value of these financial instruments.
The current sub-prime mortgage is a classic example. First, the lendee provided little or
no down payment and secondly, there was little or no evidence that the lendee could
repay the loan. The banks then sold these mortgages to the investment banks who
bundled them, sometimes 4000 or more in a bundle, and sold them to whomever wanted
to trade in these risky assets.
If this sounds a little like a Las Vegas casino to you where you place bets, you are
thinking correctly.
With the Internet and the worldwide web that reaches everyone on the planet who has
access to it, these financial instrument bundlers can deal with anyone in the world who
wishs to gamble on whatever bet these characters are promoting. The new information
technology coupled with the fact that all transactions can be global today, complicates
this issue by several orders of magnatude. Moreover, these companies do not have to
operate from Wall Street in New York City. They can locate anywhere on the planet that
they please.
Now that you have some idea of the length and breadth of the possiblilities, it should
occur to you that it would be extremely difficult for our or any government to regulate
this activity short of shutting it down altogether. This might require a Constitutional
amendment like the eighteenth amendment which attempted to prohibit alcohol
consumption. We know how well that worked. We learned the hard way that that
approach drove the use underground with the concomitant rise in the Mafia.
What should be done? And can it be done? These are the key questions.
The Senate just passed a bill intended to massively overhaul the banking and related
investment industries. In essence the bill:
· Calls for new ways to watch for risks in the financial system
· Makes it esier to liquidate large failing financial firms
· Writes new rules for complex securities,i.e., derivatives
· Creates a new consumer protection agency
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If passed and signed into law, this doubtless goes too far, especially the new consumer
procection agency which could regulate industries far beyond the financial ones. The
only law that is needed is one that separates the regular banking industry that is regulated
by the F.D.I C. from the Wall Street financial institutions that deal in deratives. It is a
joke to think that the Federal Governement can effectively regulate investment
organizations who create and package hard-to-define securities and sell them off to
unknowedgable and unsuspecting purchasers.
What is needed is a mechanism to build a moral compass in the minds of the workers
in these institutions. That compass is commonly and historically known as a
conscience. This cannot be regulated by law!
In the Senate’s investigation of the Wall Street investment bankers, it is interesting that
Senator Carl Levin quizzed the Goldman Saks management with the phrase: “Didn’t
you know these were shitty” deals.” Then he used that adjective 12 times. From the look
on the faces of the CEOs of the investment bankers, one could deduce that they wondered
where he had been. Had he never heard of Hedge Funds?
Carl is about 73 years old and has been in the Senate for 32 years. He is a graduate of
Harvand Law School and has never worked in private enterprise save for a short stint in
private law practice. So, where was Carl during the past 32 years? Hadn’t he noticed that
growing number of young persons who seen not to know the difference between right and
wrong? In fact, as a liberal, I suspect he contributed to the demise of the system that used
to be in place to install moral compasses in our children, and I suspect that he contributed
to what has made our society so litigious.
The thirty something persons at these financial institutions who are creatively
formulating these “bets” are the product of the abandoment of the principles and
institutions that used to build consiences in children so that when they became adults they
would know the difference between what was a “shitty” deal and what was not. In those
halcion days of long ago a hand shake would suffice to seal a deal because a man’s word
was his bond. The deals were transparent and rarely “shitty”.
Well, then, what is a conscience? A definition that applys here is that it means “a person
who has a conscience is aware of wrong doing” .Nearly everyone has had experience
with newly born animals and realizes that they need to be trained to behave in the mannor
that society deems acceptable. We house train our pets and teach horses to do incredible
tricks, but we know that left alone without teaching or training the pet will be no
different than a wild animal. The human animal is no different, because it is an animal.
However, the difference between a human animal and other animals is that the human’s
brain can be taught the difference between right and wrong, where right or wrong
conform to some standard that society has established. But it must be taught!
The old adage, “You can’t teach an old dog new tricks” is very applicable here. Recently
we have been told that our most prestigious business schools such as Wharton and
Harvard, have decided to add an “ethics” course into their curriculum.
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This would be laughable if this issue were’t so serious. We have news for these schools:
this is too late by twenty years! The teaching must begin as early as possible, and the
teaching must be constant and continuous until the conscience is fully imbedded and truly
functional on its own. Moreover, this task must be completed by the time the child is
eighteen years of age. This is hard work for the parent and for society, but it must be
undertaken and with dedication.
Forty years ago our society had four pillars to support a parent in their task of turning a
human from birth into a reliable and honest citizen who would be an asset to society.
These four pillars were:
1. The parent who knew and accepted responsibility for leading the task of inserting
a “moral compass” in its offspring.
2. The neighbor who felt comfortable and even responsible for assisting the parent in
the task.
3. The school system who knew and accepted their responsibility to assist the
parent.
4. The Sunday School who knew and accepted their responsibility for integrating the
child into the community of persons who, following the teaching of Christ would
“Love their neighbor as they would love themselves”
For the most part, it is all gone. What happened in these past forty years to cause us to
decide it was not necessary to build moral compasses, e.g. consciences, in our children?
How did this happen in a mere 40 years when it was so solidly integrated for centuries?
Was it Spock and the consept of building Self-Esteem? Was it the ACLU? Was it the
ease of Family Break-up via no-fault divorce? Was it the number of illegitamite children
who were being raised without the presence of both parents, with usually the father in
absence? Was it the huge and growing numbers of lawyers we graduated without visible
means of income, so that they had to make jobs by creating our Litigious Society?
Actully, it was all of those things!!
Self Esteem:The worst idea of all was the concept of how one achieves self-esteem. In
the old days, one earned self-esteem. Today, it is assigned. All children must suceed, and
they must be coddled and protected to assure that their self-esteem is not harmed. It has
gone so far that the modern parent believes he or she needs to be the pal of the child , a
buddy so to speak. How many of us who grew up with the old ways have heard our
children admonish us for trying to get a grandchild to stop misbehaving and being told
by our child, now the parent, to quit that because we would destroy the grandchild’s self
esteem? After all, if grandparent’s generation doesn’t know how to program a VCR,
what would it know about raising children? Whatever happened to the motto that a child
should be “seen and not heard.” Today, a child’s behavior in public is most likely to be
“obsceen and absurd”.
The ACLU: This organization methodically tries, and with much success, to get the
principles promulgated by the church out of our schools. The Bible is no longer read,
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there are no prayers said before classes, and there are no Bacculariat services at
graduation.
Family Break-up: The research is in. A child will be better educated, will be more
wealthy, more healthy and live longer and be happier when raised with both the father
and mother present in their lives. The marriage vows no longer mean anything, legally or
other wise. As a result the number of single parents is increasing. This makes it easier for
the child to manipulate the single parent into doing what the child wants. All any child
wants is to test the boundries and keep pushing them as far as possible. The research
shows that the child is happier and behaves better when it is certain where the boundries
are and they remain firmly in place.
Litigious Society: When one can be sued for the slightest real or imagined infraction,
one becames very cautious about entering into any activity or behavior which might bring
on a law suite. Whether one wins or loses a law suite, the cost can become so high that it
prohibits the pursuit of the case. Consider the school Principal who is confronted with
having a Christmas Tree or anything smacking of Christmas celebration in or on his
school property. The ACLU is very likely to sue. Consequently, the School Board will
have to come up with the funds to fight the case or pay off the complainer; and the
Principal will be blamed and perhaps punished for not foreseeing this event. School
Principals are not stupid. The pragmatic course for any Principal is to avoid having any
symbal of Christmas within miles of his juristiction. So, he or she prohibits it.
Likewise the neighbor who might have grabbed your child and removed him or her from
a dangerous situation is unlikely to do so for fear of being chewed out at the least and
sued at the most. In the old days , the parent would thank the neighbor for saving and
even repromanding the child. Subsequent to that, the parent would speak firmly to the
child and that would be that!
Ethics:
It used to be that nearly everyone went to church on Sunday, and the children went to
Sunday school. There the students were taught the story of Jesus and the many lessons he
taught via parables. They learned the Ten Commandments, four of which dealt with how
one should relate to God; the other six dealt with how one should relate to another human
being. The second six are secular and deal with ethics. Next to the parent, the church was
the main place where ethics were taught in an organized fashion. The schools supported
this by permitting readings from the Bible each day and by their rules for exacting
discipline. “Ethics” could be taught in an atheist society, but with the panic about
separation of church and state, these six commandments are treated as religion not ethics
or rules to live by. Consequently, they are forbidden to be mentioned in schools.
The question here is why are the children not going to church? Well, if one watched the
modern parent with these children during the past 30 or so years, we noted these
situations:
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· As soon as the child could sit up, it was placed on a high chair in front of the TV
and given food which it ate alone.
· As soon as the child could sit at the table, if it refused the fare that the mother had
prepared, the mother would get up from the table and prepare what the little
darling wanted, while everyone else either waited for the mother to return to the
table or else went on to finish their meals, while the conversation focused on what
that child wanted.
Now, if or when a parent stated that the plan was to go to Sunday school, guess what the
child’s reaction was? Right, he or she stated emphatically that they did not want to go,
and they did not go, because it was already established that the child would have the say
about what he or she wanted. Therefore, the child did not and does not go to church.
If one believes in the old-time farming principle that “what you sow you will reap” which
is also in the Bible, “so you sow, so you reap”, why are we surprised that the thirty
something Wall Street kids who have created the derivatives don’t know the difference
between a truthful, honest transparent deal versus one, to use the Senator from Michigan,
Carl Levin’s term, “shitty”?
In conclusion, we have thrown the baby out with the bath water, and the derivatives
scandal is the product we are reaping. Our next Blog will attempt to outline what our
society can do to rescue the baby!
