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You’ve probably heard of derivatives. In 2021, they were reportedly worth $600 trillion in face value. Some critics say it was only $12.4 trillion if you count only the money “netted.” By comparison, the entire U.S. national budget in 2021 totaled $6.8 trillion.
If your own work were described as derivative, it would not be a compliment. Derivative as an adjective means to be hackneyed and stale, or even plagiarized or stolen. So how can a small group of Wall Street banks, hedge funds, private equity and investment firms make trillions selling and trading in derivatives, and not necessarily the stuff they’re derived from? What are they exactly?
Farmers and merchants began trading the first U.S. derivative called futures, at the Chicago Board of Trade, founded in 1848. Their futures were contracted bets, called long and short, on future prices of crops and commodities. Since money wasn’t exchanged until crops were delivered, their bets weren’t the point; a reasonable price for dependable delivery of goods was the goal.
The federal government began regulating these in the 1920s, but the Commodities Futures Trading Commission (CFTC), a small federal bureau, wasn’t created until 1974, when futures expanded to include international exports of corn and soybeans. The Reagan administration’s CFTC expanded traditional agricultural markets to international markets for silver and gold, oil and energy—and then into more and more abstract markets like foreign currencies, global prices and interest rates, stock indices, and sovereign debts of nations.
The biggest Wall Street banks sold most of these complicated derivative contracts around the world called options, swaps, forwards and futures. If these names make your eyes cross, don’t worry—no one can claim to understand all their details, and the playing field for these contracts is limited to “accredited” investors with a spare liquid million bucks. Few on Wall Street really understood derivatives derived from mortgages that, along with other derivatives, brought us the 2008 global financial crash.
The most radical new idea was derivative bets on bank credit. In 1989, young traders at Wall Street’s biggest banks came up with something they called “credit default swaps.” A credit isn’t exactly a loan until you use it, like your credit card. And like your credit card, there’s fine print in the contract.
A young J.P. Morgan trader engineered the first credit-default swap to protect her bank employer. Exxon had just gotten a big line of credit from J.P. Morgan to cover lawsuits from the Exxon Valdez oil spill. Bank regulations required it to reserve enough capital to cover possible defaults. What if something more went wrong?
The bank’s exposure was huge, and so was the drain on their available capital if they went by the rules. This new credit default swap quietly slid the risk off J.P. Morgan’s books to a counterparty, another big bank in Europe, in an opaque and private contract.
Most importantly, the contract freed J.P. Morgan’s capital from reserve requirements. They could then use it to take more risks.
Few on Wall Street really understood derivatives derived from mortgages that, along with other derivatives, brought us the 2008 global financial crash.
The swap idea exploded, and more exotic derivative types were developed, promising investors a risk-free financial system in more and more markets, with more and more complex contracts that few really understood. Dennis Kelleher, founder of Better Markets, described the nature of derivatives in a 2012 Frontline episode on “Money, Power and Wall Street“:
“It’s an insurance product designed not to be regulated as an insurance product and designed to avoid regulation at all. And one thing we do know is that when a product of any type is designed with minimal regulation, capital and activity moves into that area and it expands dramatically.”
Most derivatives are still traded “over the counter” as private deals, not on a public market or exchange like the New York Stock Exchange. Amounts traded that way can only be estimated, based on Wall Street reports. It is widely known, however, that many are highly “leveraged”—a fancy way of saying investors used credit or borrowed money, Wall Street’s specialty. These new unregulated financial tools launched what is now called “shadow banking.”
Today, just three CEOs with three boards of just three shadowy investment firms—BlackRock, Vanguard and State Street—manage $20.7 trillion in assets. This small group’s unregulated decisions move the whole world’s economy. Sen. Bernie Sanders named it an “oligarchy” just this year, a form of outsized ruling power.
It’s not as if we didn’t have warnings that this was dangerous. In the ’90s, fraud cases began to surface at the CFTC, and yet more derivative types were permitted. Among them was Enron’s “energy swaps” and “hybrid futures.”
By 1996, the CFTC’s newly appointed head, Brooksley Born, challenged the danger of so many privately traded options, swaps, futures and forwards, grown increasingly complicated. She said it represented unparalleled risk to people whose livelihoods might be affected if the market took a downturn. Why? Billionaire Warren Buffett once described market risk and leverage this way: “Until the tide goes out, you can’t know who’s swimming naked.”
Born knew market dishonesty did tangible harm, having investigated a fraud with silver derivatives. She urged greater public market transparency of derivative trades, which her fellow regulators, Securities Exchange Commission (SEC) chair Arthur Levitt, Federal Reserve chair Alan Greenspan, Secretary of the Treasury Robert Rubin and his deputy Larry Summers, all pooh-poohed, preferring the markets’ supposedly sophisticated self-regulation.
When she didn’t back down, the same guys convinced Congress to strip the CFTC of its regulatory power. Testifying against her proposal for rules and a public derivative market, they effectively ran her out of town in 1999. That same year President Clinton signed a bill to “modernize” finance by freeing Wall Street investment banks to use federally insured depositor’s money for their gambles.
By 2000, Enron—a Wall Street sweetheart success story reportedly worth $10 billion—came crashing down. Its 29,000 employees lost jobs, paychecks and pensions, and its top executives went to jail, its accounting firm ruined. This was followed by a string of corporate corruption and fraud cases: Tyco, HealthSouth, WorldCom and WireCard.
Yet none of that stopped Wall Street from creating new mortgage-backed securities, derived from U.S. mortgage loans, considered the safest.
How did they do it? Paul LeBlanc, with the Aspen Institute put it this way:
“You would buy these big pools of mortgages, and these credit default swaps enabled you to bundle all this stuff together, bring it in-house, in order to get it ready to put through the sausage-making machine and create these securities.”
Credit default swaps around the world are now measured in trillions of dollars. Author of Infectious Greed, Frank Partnoy, told Frontline that the banks don’t want to have to quantify the risk they are taking on their balance sheets. They want to be able to push it off and hide it—”and that was why they lobbied so hard to make sure swaps and derivatives would be treated differently from other kinds of financial products,” he said.
How does one know about, or demonstrate against, an unlisted virtual, offshore corporation that operates in an unregulated electronic space using a secret proprietary trading strategy to buy and sell arcane financial instruments?
Edward LiPuma and Benjamin Lee
The latest new repackaged sausages are derivatives called CMBS, or commercial mortgage-backed securities. Empty downtown office buildings without renters because of the pandemic and telecommuting now threaten “a storm is brewing.” Don’t take it from me—that’s Warren Buffett again. This month for the first time in its history, the Federal Reserve is reporting billions in losses, while it continues to pay high-interest income to the biggest banks on Wall Street. You know, the ones considered “too big to fail.” Again?
Headlines this month from Jamie Dimon, executive director of J.P. Morgan, warned of “unsettling pressures,” saying the bank’s indicators were consistently at odds with “heady financial markets.”
When economic catastrophe unrolls around us in slow motion, it’s harder to name. “Financialization” and “privatization” mask a much deadlier trend on a changing planet in crisis. Most Americans today believe their families are less secure than their parents and grandparents, despite recent rosy reports on jobs and wages. The growing prices of basic needs, like food, housing and healthcare, mean more Americans are whipping out their credit cards.
Economists Edward LiPuma and Benjamin Lee are among those trying to decode a financialized and very privately controlled economy that no one fully understands, except that its rigged. Their tome, Financial Derivatives and the Globalization of Risk, has 58 references to violence—an abstract violence of intention much harder to see and understand.
They warn this new explosion in derivatives has created a culture that sees itself as superior, the “cutting edge,” as if money alone creates value. It appears indifferent to widespread poverty, job loss and climate ruin—which LiPuma and Lee think helps explain a global rise in nostalgia for strong-man political authoritarianism. They suspect people are longing for old regime certainties of everyday life, a vanished “foundational logic that once seemed to bind work to wealth, virtue to value, and production to place.”
Abstract is intangible; it’s not concrete reality. How can people protest, LiPuma and Lee ask, when this power “offer[s] up no address or even an identifiable object? How does one know about, or demonstrate against, an unlisted virtual, offshore corporation that operates in an unregulated electronic space using a secret proprietary trading strategy to buy and sell arcane financial instruments?”
Insurance for a world full of risks is valuable, and so is its oversight by a government protecting people from fraud and fraudsters. We feminists already know too well how cruel dominators demand their secrets be kept, enforced by threats and real violence. As Sen. Sanders says in his book, It’s Okay to Be Angry About Capitalism, our turbulent times demand fundamental changes. That requires we keep on learning and keep on working, out in public in plain sight, for a tangible future that’s no secret and derived from people and the planet, our real source of value.
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