Harkin on financial derivatives

From the office of Sen. Tom Harkin from today's Senate Ag Hearing exploring the role of financial derivatives:

“We are holding this hearing in the midst of the deepest and most far-reaching financial crisis in nearly 80 years. Major U.S. financial institutions which were thought to be rock-solid are now in bankruptcy, have been sold for pennies on the dollar, or are on life-support from U.S. taxpayers. Money and capital are not flowing, families and businesses cannot get the credit they need, and our already weak economy has sunk further into recession. U.S. economic growth is flat to negative, jobs are being lost and unemployment is climbing. Though stock prices rose yesterday, at the end of last week the Dow-Jones Average had fallen 40 percent in the preceding year and stocks in the Wilshire 5000 Index lost $8.4 trillion in value in the same period. And farm commodity prices have fallen dramatically.

“We all understand the urgent and critical need to revive the financial markets and return them to functioning. We in Congress went along with a modified version of the administration’s rescue plan because the stakes are so high. We hope some of those outlays, which will likely well exceed $700 billion, will come back to the Treasury, but there is no assurance of that. How will it be paid for? By borrowing; by adding to the national debt. That means our children and grandchildren will be paying for it. What’s more, saving the financial sector makes it all that much harder to pay for our nation’s other needs and to fund genuine investments in the future such as education, a better health care system, medical and other research, or renewable energy.

“If we are going to borrow against the future to save the financial sector, then we had better make sure that money is well spent. If Wall Street is an emergency room patient, we cannot just give a big blood transfusion without stanching the bleeding – without attacking ails the patient. We have to get to the root of how our nation’s financial system has fallen into this crisis, then fix the problems in order to restore and rebuild fundamental soundness, confidence, and integrity to those markets and our overall economy.

“We have all heard much about the impact of nonperforming real estate loans. Real estate mortgages were packaged, and then securities backed by those mortgages were sold to investors. But far too many of the securities sold to investors were risky – certainly riskier than their ratings indicated – because the underlying mortgages were risky – toxic is the word now used. Now we are learning about another layer of risk that was added on top of the risk from junk securities.

“We now know this financial crisis and the collapse of key financial institutions owe a great deal to the extensive commerce in credit default swaps and similar contracts. Credit-default swap contracts were written and sold to pay out in case of loss on a variety of securities and financial obligations – including securities backed by unsound mortgages. In other words, credit-default swaps were issued and used in ways that made highly risky investments seem sound. Now, as the losses mount on the securities and other obligations, those responsible under the credit-default swaps are having to pay up – in amounts that greatly exceed anything the issuers and sellers of the swaps expected and anything the financial sector could withstand.

“The total outstanding notional, or face, value of credit-default swaps exploded to a high of some $62 trillion worldwide last year, according to the International Swaps and Derivatives Association. That roughly equals the gross domestic product of the entire world for 2008. And the total face value of all types of financial swaps was some $587 trillion worldwide at the end of last year. So the market in swaps is vastly greater than the value of any underlying assets – in part because an investor can enter the swaps market without owning a bond or any other interest at risk. This huge multiplication of leveraging with the help of credit-default swaps has now come home to roost with a terrible vengeance. That is why Warren Buffett called derivatives “financial weapons of mass destruction.”

“Credit-default swap contracts function somewhat akin to insurance, but are purposely not written like insurance and thus avoid the safeguards of insurance policies. Swaps contracts also function much like futures contracts, but they are not regulated as futures contracts because of a statutory exclusion from the authority of the Commodity Futures Trading Commission. So they need not be traded on open, transparent exchanges, and as a result, it is nearly impossible to know whether swaps are being traded at fair value or whether institutions trading them are becoming overly leveraged or dangerously overextended.

“We are told that the traders and institutions involved in financial derivatives are highly capitalized and sophisticated. They can look after themselves. The credit-default swaps and derivatives have been put together by mathematics and physics geniuses, but carried out without an understanding of human behavior and market behavior. What they thought were tools to manage and limit risk have turned out to magnify and amplify risk. Yes, these derivatives may be devised and traded by sophisticated parties, and I am not worried about them. The problem is that their miscalculations and blunders have put our national economy on the precipice.

“We cannot simply condone anything and everything done in the financial markets in pursuit of huge profits. What is good for Wall Street banks and money managers is not necessarily what is good for our economy and society. We have seen that time and again. We also we must question the soundness of our economy’s ever-greater dependence upon the financial sector. In 1948, 56 percent of the profits of U.S. companies were in manufacturing while 8.3 percent were in the financial sector. But in 2007, only 19 percent of profits were from manufacturing, while 26 percent were from the financial sector.

“I am a firm believer in capitalism, in markets, and in financial sector innovation. What I am not in favor of is what has come to be known as market fundamentalism – the idea that the market knows best and must be allowed freely to make and correct its errors. Recent events have once again shown that the stakes are too high for our entire economy to follow this sort of rigid ideology. Regulations must be reasonable and allow financial markets to function effectively and efficiently to move capital and credit to where they are needed in our economy. Yet we must have regulations that will protect the rest of our economy from the excesses in the financial markets – to protect all Americans from collateral damage when the financial sector makes a blunder.

“In my mind there is no question that we must adopt a stronger system of regulation and oversight for over-the-counter swaps and derivatives. It is hard for me to see how we are going to put our financial sector and our economy back on a sound footing unless we do so. I welcome our witnesses and look forward to hearing from them.”