Financial Derivatives: Coming from Foolishness, Fallacies, or Fraud?

Derivatives are a hot topic today. There are various groups assembling to defend the purpose and value of derivatives in the financial markets, others who decry their abusive and destructive nature, those who want to regulate them, some who want to constrain where and to what they can apply, and certainly other interests that have their own particular bent on derivatives. And of course there are the Congressional hearings on the Financial markets collapse and on the Financial Reform effort to address regulatory needs, if any, that the government should establish.

Derivatives are not a new financial concept they have existed in different forms for centuries if not millennia. The derivatives that were created in conjunction with the housing mortgage bubble and other financial bubbles that have contributed to the devastating financial markets’ near collapse were perhaps more ‘complex’ instruments but they were based on the same financial principles that derivatives have always been created upon. And if regardless of what Congress decides to do in terms of regulating, restricting, or intervening on with respect to derivatives; they will not change the need for nor the availability of some financial instrument that will function to the same purpose as derivatives. So the question is will Congress recognize what the real issue is that they need to address?

Where derivatives foolish investments? No, some derivatives did very well for those who invested in them. In fact, they made literal fortunes. Of course others got wiped out. So they were not foolish investments unless you had misjudged the situation that they related to, or you invested in them without any understanding of what the risk was versus the reward potential that they offered. There does appear to be a foolishness factor with some of the investors in the derivatives like the collateralized debt obligations. Even big, smart, sophisticated, and “best and brightest” financial institutions got sucked into buying derivatives that they did not understand or have any means of properly evaluating. And on the other side of the equation, there were those putting together derivative packages that they may have not understood.

But foolishness alone is not the story. Did anyone make plain and simple mistakes or base their actions on false assumptions? Yes. There were fallacies aplenty. People used information given to them about derivatives without any attempt to verify it, to assess it, or to apply the information that the derivative was formulated on to how it affected or influenced the value or risk of their other investments. The derivatives were being treated by many individuals/entities as if they were independent of other financial consequences in the market. So fallacy played its own contributory role in the melt-down.

Now for the last factor: Fraud. Was fraud involved in the derivatives? Yes it was, but don’t assume that it was strictly and exclusively only the banks and financial institutions. Fraud was probably present in every layer and part of the process that created not only the derivative instruments, but that was involved in the underlying investments that seeded the housing mortgage bubble. And fraud was an essential component in the marketing of the derivatives and in the underlying investments. Both instruments were not marketed in the same context, to the same customers and with the same disclosure information.

The issue that Congress, the financial industry, the investment community and the public need to focus on and demand be addressed by way of business, government and societal reform is the very principle that capitalism is based upon: an open market place where everyone has access to the same information and has the same opportunity to compete. This is where the derivatives market went woefully wrong. Deals were made behind closed doors, information was kept for some groups and provided to others, and false and misleading information was used to mislead some investors for the benefit of others.

If Congress is to succeed in protecting the country, the pubic and the free democratic system that they are sworn to serve then Congress is going to have to see beyond the special interests, beyond the public outrage, and beyond the political opportunity and perceive the valid principles of American capitalism.