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"Lure People Into That Calm and Then Just Totally F--k 'Em": How All of Us Pay for the Derivatives Market

Derivatives are a hotbed of abuses and bailouts. So why are taxpayers footing the bill?

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While several policymakers close to the financial industry like Fed Chairman Ben Bernanke and Treasury Secretary Timothy Geithner oppose the Lincoln language -- known on Capitol Hill as "Section 716"-- many top economists agree that getting taxpayers out of the derivatives business is the most important Wall Street reform still on the table for 2010.

"To me, preserving section 716 is really the critical issue," Nobel laureate economist Joseph Stiglitz said on a June 9 conference call with reporters. "It protects the taxpayer." Top economic thinkers like Nouriel Roubini, former IMF chief economist Simon Johnson, Dean Baker and Jane D'Arista have also offered support for the measure.

If banks can't pump taxpayer money into the derivatives machine, that machine becomes much less profitable. Instead of booking fictitious profits based on perpetual government aid, derivatives dealers will have to price their risks as they exist in the real world. Market forces would shrink the casino, putting the entire economy in a better place.

Most followers of the Wall Street collapse know that derivatives are dangerous -- but even some dedicated reformers can find themselves wondering just what the hell a derivative actually is. The answer: just about anything a banker wants it to be. Derivatives are used to for everything from straightforward insurance to outrageous accounting fraud. Any financial contract whose value is derived from some other asset can be classified as a derivative. They can be derived from just about any asset imaginable, which is why derivatives scandals are so diverse in nature. Enron used derivatives to loot the California electricity market. AIG used them to loot the U.S. mortgage market, J.P. Morgan Chase used them to loot Jefferson County, Alabama and Goldman Sachs used them to loot the European Union.

"You can use derivatives to get into any business you want," says Michael Masters, an incredibly successful hedge fund manager who has worked closely with White on derivatives reform proposals. "If a bank wants to get into the iron ore business, they can do that. They can get into the coal transportation business. You can say, 'I'm going to be in the shoe business now,' and concoct some derivatives based on shoes, and all of a sudden, you come to dominate the shoe industry. Banks are supposed to be banks. They're supposed to facilitate commercial activity, not directly compete with commercial enterprises. That taxpayer subsidy gives them a leg up on every other industry, financial or otherwise, when they can deploy it on derivatives."

A bloated financial sector is bad for the economy. Instead of acting as a catalyst for broader economic growth, oversized financial sectors actually devour other productive activity. By 2007, finance accounted for about 40 percent of corporate profits, according to the Bureau of Labor Statistics. After taking a dive during the crash of 2008, finance was back to 36 percent of profits by the end of 2009, almost all of that rebound carried by derivatives operations. If we cannot shrink bank profits, our economic recovery is going to be unnecessarily weak. The rest of the economy will be suffering at the expense of our financiers.

But the very fact that most people need to ask the question -- what is a derivative? -- is part of this market's profit magic. By injecting needless complexity into otherwise straightforward financial transactions, banks can game their balance sheets, deceive investors and defraud their own clients. The recent examples are nauseating -- Goldman Sachs setting up its own customers to fail and then betting against them; Lehman Brothers using derivatives to hide mountains of debt from its own investors; and on and on.