1 Boring Old Man

House Panel Clears Derivatives Bill, Debates Plan for Consumer Agency
By Zachary A. Goldfarb
Washington Post
October 16, 2009

The Obama administration won its first major victory Thursday in its effort to overhaul the nation’s financial system as a key House committee passed a bill to regulate exotic financial instruments known as derivatives. Trading in derivatives – contracts used to bet on the movement of stocks, bonds, commodities and other things – magnified last year’s financial crisis by forcing companies to record bigger losses as markets collapsed. But for years policymakers had rejected regulating the derivatives market, worried about stifling financial innovation.

The vote Thursday by the House Financial Services Committee, largely along party lines, endorsed a central plank of the administration’s plan for new regulations aimed at preventing another financial calamity. But the measure still faces a long road. The House Agriculture Committee, which also has oversight of derivatives, will vote on and quite possibly amend the proposal, and the full House and Senate must act, too.

The regulators that would be in charge of policing the derivatives market – the Securities and Exchange Commission and the Commodity Futures Trading Commission – hailed the passage of the legislation even as agency officials continued to voice concerns about whether it goes far enough. "Substantive challenges remain," CFTC Chairman Gary Gensler said in a statement, adding that he intends to work with Congress to design a bill that "covers the entire marketplace without exception" and "to ensure that regulators have appropriate authorities to protect the public"…

If you haven’t yet tried to understand Financial Derivatives, Wikipedia has a surprisingly clear description. But it still has the jargon of Wall Street. So, I’m going to have a slight shot at things, using the jargon of something else – Calculus. I’m aware that the mere mention of the word sends shivers through many who survived the Calculus-Hell that had to be traversed to get the grades to go to college. For others, it was a fascinating thing that was conceptually challenging, but has little direct application in adult life [For me, it was the last time that the universe seemed sensible and orderly].

After a couple of years of Algebra studying equations and graphs of the relationship between variables, you moves to the world of Calculus where you meets derivatives. A derivative is another equation that tells something about the first equation. In the example on the right, the second equation gives the slope [rate of change] of the first equation at a given point in time – something about the first equation.

Well, that’s what a Financial Derivative is too. It’s not a Security [a share of some actual entity like a Company]. It’s not a Commodity [a real thing like Soy Beans]. It’s something about the real things. So people buy and sell contracts based on which way the Dow Jones average goes, or what happens with the weather. For example, Financial Derivatives are used as insurance to hedge investments. I buy a futures contract on Soy Beans for my Soy Bean Processing Plant. But if there’s a Drought, I lose my shirt – so I buy a contract betting on bad weather. Why would someone sell me such a contract? It’s because bad weather is very unlikely and most of the time, there’s no payoff.

Such Casino-like transactions seem benign on first hearing, but they’re malignant because they’re unregulated. A.I.G. sold Derivatives on Mortgage Backed Securities – packaged Real Estate Loans that only had value if the borrowers paid off their loans. When the Housing Bubble burst and people began to default on their loans in record numbers, A.I.G. didn’t have the capital to pay off their derivative contracts [credit default swaps]. You know the rest of the story. The risk had moved up the chain to a megalithic Financial Institution that almost went under because a small unit in London went from a Cash Cow to a deal-breaking liability in a very short time.