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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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Taxpayers have subsidized banking since the 1930s by providing both deposit insurance from the FDIC and cheap emergency lending from the Fed. There's a damn good reason for providing this aid: If a bank fails, its depositors don't lose their savings. This keeps ordinary people from being directly wiped out by a financial crisis, and it also makes financial crises less likely by preventing bank runs.

These guarantees also help banks. Since there is no risk of loss, banks do not have to pay depositors very much to win their money. That makes financing the everyday operations of the bank very cheap, and allows the bank to book bigger profits. So the flip side of that subsidy is regulation. Up until the 1990s, that regulation meant that banks couldn't do any risky securities trading while receiving taxpayer perks. By 1999, Congress and regulators had ripped away all of those restrictions.

But the explosion of the derivatives market in the 1990s may have been even more significant than the repeal of the Depression-era restrictions on what banks could do. Derivatives did not become a significant part of the banking business until the 1990s. At the end of 1992, at the dawn of the Clinton administration, the total face value of the derivatives market was $12.1 trillion, according to the Government Accountability Office. That sounds like a lot, and it is, but by the end of George W. Bush's reign in 2008, the derivatives market had exploded to $683 trillion, according to the Bank for International Settlements. In today's banking industry, just five U.S. banks control nearly $300 trillion of that international market: Goldman Sachs, J.P. Morgan Chase, Citigroup, Bank of America and Morgan Stanley.

This explosion didn't happen by accident. The surest way to feed a destructive market in anything -- finance, oil, junk food, whatever -- is to deregulate it, and then subsidize it. Fraudsters love to specialize in products the government doesn't scrutinize, and everybody likes free money from Uncle Sam. The Bankers Trust scandal was a major event in financial circles, but it didn't spark a systemic freak-out. But in 1998, one of the world's largest hedge funds, Long-Term Capital Management, found itself on the brink of collapse after getting in way over its head on derivatives. The scare was so severe that the Federal Reserve orchestrated a bailout for the hedge fund, albeit one financed by the private sector rather than taxpayers. Brooksley Born, already targeting strengthened regulations after the Bankers Trust fiasco, took the Long-Term Capital Management collapse to heart and pushed to rein in derivatives, but was blocked by a coalition of Alan Greenspan, Robert Rubin and Lawrence Summers. In 2000, a Republican Congress passed legislation that further deregulated the market with the blessing of both Clinton and Summers. Suddenly, bankers had carte blanche to do whatever they wanted with derivatives, and get subsidized by the American public.

Derivatives are a fundamentally risky business, much more so than lending. Loans provide a much more direct economic function, their risk is much more easily ascertained, and they can be put to productive uses -- buying a home, investing in new inventory, whatever.

"The whole point of government guarantees is to avoid bank runs and establish confidence so that they can lend money out," says White. "You don't want to give your money to a bank and have them stick it in the mattress. They're not lending it out any more. These days, every time they get a dollar from the Fed, they have to make a choice: Are we going to make a loan, are we going to conduct derivatives trades, or are we use it to do proprietary trading. Generally, making a loan is third on that list."