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Derivatives’ Nostradumus Recommends Regulation for Derivatives

The least complex explanation for derivatives, and particularly the credit default swaps that drove this financial crisis, is that they are a form of unregulated insurance — they are designed to insure investors against risk by guaranteeing a payout in exchange for premium-like payments. But the lack of regulation of derivatives led to the need to bail out AIG, among other companies, and drove America to the brink of financial collapse.

Martin Mayer predicted all of that in his book “The Danger of Derivatives” in 1999, and in an interview with Gretchen Morgenson of The New York Times, he offers some solutions the government could — but probably won’t — put into effect to stop a repeat of this crisis.

To prevent the regular insurance industry from taking customers’ premiums and then being unable to pay out claims, the industry is regulated. The states and federal government require that insurance companies keep significant capital around so that if there are a number of simultaneous claims, they can be paid without bankrupting the company. Insurance giants like AIG liked derivatives because it allowed them, for a time, to make money without having to comply with the capital requirements of regular insurance.

The banks that use derivatives like them, too, as they are able to take risky bets without assuming all of the risk. And, as Mayer points out, in the wake of the bailout, they continue to make risky investments, now that they know full well the government (and taxpayers, by proxy) won’t allow them to fail. Mayer recommends that derivatives be regulated like the insurance products they are and traded on the open market because it requires more transparency in terms of accounting and risk, and that taxpayer-insured banks (i.e., commercial bans) be barred from using them because of the risk.

Of course, Mayer doesn’t believe that will happen, in no small part because too many in Congress don’t understand derivatives and are more than happy to allow financial industry lobbyists to argue that they aren’t really insurance and aren’t really that risky, and that to regulate them will mean stifling innovation. Of course, this “innovation” is simply a way to insure some and then make money off of the failure of others — quite the innovation.

But the financial industry ought to be happy that Mayer is just calling for oversight and regulation — Financial Times columnist Wolfgang Munchau called this weekend for an outright ban on credit default swaps, and he’s hardly the first. They might end up stuck between the proverbial rock and hard place — but without the sweet lubrication of taxpayer dollars to bail them out again.

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