Weapons of mass destruction are most often chemical, biological and nuclear weapons. The fears and a need for regulation could also be said for derivatives, which, according to Warren Buffett, are “weapons of financial mass destruction.”
Put simply, a derivative is a bet or a contract that obtains its value from the performance of something else. It could be a stock, a bond, a currency, a commodity, an interest rate, an asset, etc. This market is massive and estimated to be as large as $1.5 quadrillion, which is more than 20 times larger than the entire world’s GDP. The exact number of derivatives out there is unknown.
For a market this large and risky, a reasonable person may expect it to be regulated, but it isn’t. The only law on the books that partially regulates derivatives is the Dodd–Frank Wall Street Reform and Consumer Protection Act, which hasn’t been implemented yet.
Students are already part of this market. Most of our student loans, car loans, credit card debt and mortgages go through the securitization food chain; and when we pay our monthly bills, it goes to investors all over the world. As strange as this sounds, this is the world of modern financial innovation.
Thirty years ago if you wanted to take out a mortgage to buy a home, lenders were cautious because they expected to be paid back.
Today, that lender-borrower model doesn’t exactly apply because of the securitization food chain. After the bank sells you the mortgage, it will then turn around and sell the mortgage to an investment bank on Wall Street. The investment bank on Wall Street in turn takes that mortgage and bundles it up with all other kinds of debts including credit card debt, car loans, student loans, commercial mortgages and mortgages of other people. They then package it into a new product called collateralized debt obligation, or CDO. Wall Street then sells these CDOs to investors all over the world.
The securitization food chain increased the level of interconnectedness and risk taking, leading up to the financial crisis in 2008. The derivative-driven financial crisis ended up costing the U.S. economy $11 trillion and more than 9 million jobs. Two of the biggest culprits of mortgage fraud and bad derivative trading were JP Morgan Chase and Bank of America.
Recently JP Morgan Chase had its first quarterly loss in a decade because it set aside $23 billion for litigations. Federal prosecutors have charged JP Morgan Chase with selling faulty mortgages to Fannie Mae and Freddy Mac. The settlement had been agreed at $13 billion, an all-time record, shattering the previous record set by BP’s Gulf of Mexico Oil Spill at $4.5 billion.
Fannie Mae and Freddy Mac were also sold fraudulent mortgages by Countrywide, now owned by Bank of America. Federal prosecuters and Bank of America have recently reached a $848 million settlement over the issue.
Finally, after five years, there has been some justice done to hold Wall Street firms accountable.
As students entering the workplace, it is important to know that we are all entangled into the financial system through the securitization of our debts which has made the financial markets larger, more complex and unstable.
The legal settlements of JP Morgan Chase and Bank of America represent the root causes of the financial crisis, and if there isn’t serious financial reforms to address the derivative market, another financial crisis will be inevitable.
These derivatives, though highly profitable for the few on Wall Street, are risky and dangerous to the overall economy. Washington has been unable and unwilling to regulate derivatives, which caused the greatest financial crisis in our lifetimes.
We students need to be prepared to live through another financial crisis, which may hit within the next few years because Washington, as usual, will be unwilling to act in time.