Obama & Derivatives: Stiffening Backbone?

Good news is hard to find, but there's a little in Washington this week and on the critical issue of (sorry!) derivatives. So I'll report it...

Health care reform was a great win for Obama; a small step forward for the American people. International relations to date has been a disaster both for Obama and for those hoping for a peaceful world (witness the collapse of efforts to resolve the Palestinian-Israeli conflict, the carnage in Afghanistan, and the failure to engage Iran). Finance policy has been a complete sell-out to Wall Street so far, but this may be about to change. Might the health care victory give Obama the guts to support actual reform rather than trying to “achieve” a lowest-common denominator back-room deal with Republican diehards? Standing firm on derivatives regulation and winning could just possibly turn Obama into a real leader. Then, his best move would be to read his own campaign promises.

If you don’t know anything about the intentionally mysterious Wall Street invention called “derivatives,” here is Derivatives 101, from Time’s Swampland Blog, 4/14/10:

Everyone agrees that new derivatives regulations are needed to head off another financial implosion, but there is huge disagreement about which derivatives should be regulated and how.

Complicating things further is the fact that the five largest banks--Goldman Sachs, Citibank, J.P. Morgan, Morgan Stanley, Bank of America--control the vast majority of the derivatives market, and make a mint doing it. As it now stands, derivatives are largely traded over the counter, meaning they are private arrangements between two or more parties. Without a transparent market, banks are able to take a significant cut off of each trade, yielding roughly $20 billion in profits last year. The problem is that this same system conceals risk. Without transparency, regulators cannot know for sure whether banks or other parties in derivatives transactions actually have the ability to pay off their bets if things go bad. The system functions very much like a dimly lit casino, but in this casino some people bet with far more money than they have or can get. When the dice come up box cars, taxpayers must come to the rescue, or watch the markets freeze in fear.

A more authoritative bottom-line assessment was provided by economist Joseph Stiglitz last fall [Bloomberg, 10/12/09]:

Large banks should be banned from trading derivatives including credit default swaps, said Joseph Stiglitz, the Nobel prize-winning economist. 

The CDS positions held by the five largest banks posed “significant risk” to the financial system, Stiglitz said at a press conference in Brussels. Big banks should have extra restrictions placed on them, including a ban on derivative trading, because of the risk that they would need government money if they fail, he said in a speech today.

“We will have another armed robbery unless we prevent the banks, the banks that are too big to fail,” Stiglitz said. “We should say that if you’re too big to fail then you are too big to be. They need more restrictions, such as no derivative trading.”

My pulse is quickening, but I will really believe that Obama is serious about financial reform when he advocates that derivative trades be taxed.

My personal bottom line is simple: let the rich trade derivatives all they want, but with as much transparency as we demand from Iran on nukes and with taxation of the profits at a rate at least equal to the taxation of honest labor. 

If you thought the ideas of compromise as the route to peace and health care as a right rather than a cookie crumb trickling down from insurance company profit-making were hard concepts to understand, the legitimate use of derivatives in a democratic society will really curl your hair. But try: this issue is important.