It will take several more readings to metabolize it all, but on a first pass through, it is a classical greek tragedy. The roots of its tragic end are apparent as the story builds. The financial industry feels constrained by the restrictions of the rules and regulations left over from Roosevelt’s New Deal. The regulations that saved the day and restored the market begin to be eroded and are gradually portrayed as unnecessary fetters standing in the way of growth and prosperity "in the emerging global market." The regulatory agencies are seen as excessively stern fathers unwilling to allow the young turks their time in the sun. And as each chunk is removed from the regulatory structure, it is heralded as a breakthrough – and the prosperity is palpable.
The Over-the-Counter OTC Derivative model gains a foothold in the early 1990’s when the outgoing Commodity Futures Trade Commission casually allows some OTC derivative trading. As that market blossoms, unobserved by any regulatory agency, various people warn that it is dangerous and may lead to collapse, but others in higher places seem assured that things will be fine. This trading blossoms and the big financiers join in this market [which amounts to little more than a Casino]. The temperatures rises, but the reassurances keep coming that things are fine. Financial bubbles come and go, and the instances of fraud increase.
Pundits who should know better begin to say things like "the fundamentals are strong" and "the economy is robust" or "resilient," while traders become increasingly adept at heavy leveraging, hedging, and risk taking. Until the eleventh hour, government officials and most of the financial sector continues to be reassuring. Like the Ponzi Schemes, everything works fine so long as the markets are booming. Capital is replaced with paper based on mortgages and unsecured insurance in the form of other Derivatives. Since Derivatives are not really based on anything real, the day comes when one too many investors in this virtual economy balks and tries to collect real assets from the system, and down comes the whole house of cards.
August 11, 1987 – Alan Greenspan was sworn in as Chairman of the Federal Reserve. As reported recently in the NYT:
“Proposals to bring even minimalist regulation were basically rebuffed by Greenspan and various people in the Treasury,” recalled Alan S. Blinder, a former Federal Reserve board member and an economist at Princeton University. “I think of him as consistently cheerleading on derivatives.”
Arthur Levitt Jr., a former chairman of the Securities and Exchange Commission, says Mr. Greenspan opposes regulating derivatives because of a fundamental disdain for government.
For more than a decade, the former Federal Reserve Chairman Alan Greenspan has fiercely objected whenever derivatives have come under scrutiny in Congress or on Wall Street. “What we have found over the years in the marketplace is that derivatives have been an extraordinarily useful vehicle to transfer risk from those who shouldn’t be taking it to those who are willing to and are capable of doing so,” Mr. Greenspan told the Senate Banking Committee in 2003. “We think it would be a mistake” to more deeply regulate the contracts, he added.
On top of everything else we’re have to metabolize about this economic disaster is the realization that the supposedly best financial minds of our generation were so stupid — or blind — or greedy — or . . . something bad.
We entrusted our financial future to people who had no common sense and could not look at the signs that would have alerted any kitchen table, household budget maker.
No wonder trust in the system is gone.
Greenspan’s statement seems absurd. They apparently mistook this risk-spreading scheme for the basic concept of insurance. The difference is that with flood insurance on your home, everybody pays a small premium so that there will be money to cover the large loss that a few people have.
The difference is that insurance is regulated, and companies are required to keep a reserve fund to pay off the damages. The derivatives market was not regulated and there was no fund — only a balloon full of hot air.