Government needs to regulate derivative markets

May 22, 2010|By TIM ROWLAND

"There were more morons than crooks, but the crooks were higher up."

- A Wall Street insider, quoted in Michael Lewis' new book "The Big Short"

When Congress was talking recently about capping the multimillion-dollar bonuses of Wall Street executives, we were treated to a collective shriek of protest and a line of defense that went almost exactly like this:

"We captains of finance are brilliant men whose keen minds transgress those of you mere mortals. If you cap our pay, there will be a 'flight of talent' away from the big investment banks, leaving no one behind capable of steering the ship."

But my, oh my, how a few criminal charges change things.

Facing potential jail time, the tune of the executives has gone from "we are all-knowing gods" to "we were too dumb to know and/or understand what was going on in our own shops."


It's pretty clear it's been the latter all along. The investment banks were not populated with talented men of genius, but with two-bit hucksters who threw the dice again and again until a game they failed to grasp almost brought down the entire world economy.

The power of money, virtually uncountable oceans of money, is such that it blinded these financial wizards to a rather fundamental truth: People without incomes are unlikely to repay home loans.

But amazingly, according to Lewis' book, virtually no Wall Street insider worried about whether or not a Mexican tomato picker with a $750,000 mortgage or a Las Vegas stripper with five rental properties (true stories) would ever be able to repay their notes. They just knew they needed to make more and more loans, even as there were fewer and fewer people in America who could afford them.

Even so, we might have escaped relatively unharmed had just these subprime mortgages gone south. But to generate more cash to loan to deadbeats, bankers weren't content to trade the mortgage-backed bonds alone.

So they created, out of whole cloth, Lewis writes, investments that were not mortgage-backed bonds in fact, but mirrored the movement of mortgage bonds as they rose and fell.

Now it would stand to reason that as the housing loans got riskier, they would be rated lower by Moody's and Standard and Poor's, the houses that judge the quality of a bond.

But this didn't suit the banks, which wanted to be able to dupe investors into thinking that the housing bonds were a safe bet. So they bundled the worst of the worst bonds into big packages and presented the whole stinking package to the ratings agencies.

The agencies operated on the customary logic that maybe the top third of these loans had to be good, so plenty of bonds that had no chance of survival wound up with Triple A ratings - and were peddled as such to innocent investors.

And then the capper. A very, very few hedge fund managers - those who actually bothered to read a prospectus and actually were talented - figured out that the whole house of cards was ripe for collapse.

Incredibly, they were able to talk the investment houses - always looking for a side bet - into selling insurance on these bonds (the infamous credit default swaps) to those who wanted to bet against the whole system.

These hedge fund managers couldn't believe their luck and couldn't believe that anyone would be that stupid.

It was like being able to buy life insurance for someone who was in the final stages of lung cancer.

It gets worse. The people with limited, if any, incomes who received these housing loans had scant chance to repay under the best of terms. But the low-cost teaser rates they received would only last two or three years and then adjust to rates and payments far beyond the means of the borrower - it was a subprime time bomb that went off when everyone's rate adjusted and everyone consequently defaulted.

There could have been no other outcome, and anyone with a brain who studied the matter in any depth should have seen it coming.

The legal question is whether bankers set up these bonds to fail, sold them to their clients by telling them it was a good investment and then placed rich side bets that would pay off if the bonds tanked, as a few bankers knew they ultimately would.

On that matter, who knows? And at this point, who cares?

What we do know is this: For those of us who believe strongly in capitalism and free markets, this is a betrayal of trust. It is why the government has no choice but to step in and regulate a segment of the capital markets, which ideally should be left alone.

Say what you will about Big Oil and Big Tobacco, but at least they produce something. The derivative markets produce nothing but numbers on a ledger. It's not capitalism. It's gambling, pure and simple. Which would be fine if only the gamblers stood to lose.

But as we've seen, the gamblers, win or lose, all walk away rich. It's the rest of us who have to pay. And if it takes government intervention to put an end to this financially sociopathic behavior, then so be it.

Tim Rowland is a Herald-Mail columnist. He can be reached at 301-733-5131, ext. 2324, or by e-mail at"> Tune in to the Rowland Rant video under">, on or on Antietam Cable's WCL-TV Channel 30 at 6:30 p.m. New episodes are released every Wednesday.

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