Making finance safe for our children

If you read the business press carefully, you already know that the global financial market is crumbling. Serious? Yeah, dead serious.

To be sure, it will take a while. But just recently the world's biggest bank, Citibank, announced a US$24 billion write-off, and estimated it will lay off up to 24,000 employees. This is another episode in a series of such news since August last year.

Citibank is one among many that have taken a blow as a result of the meltdown of their "subprime" mortgage deals and other credit-related losses. There is much more to come.

We need people in finance, in banking, and in business generally, who
work for nobler motives and out of a desire to serve their fellowmen.
The truest purpose of any kind of honest business is not profit, but

I will explain in a minute the nature of the beast. But first let me emphasize that the real question is neither whether we are entering a financial crisis, nor how big it will be (my idea is, pretty big). The question is what next? As the events unfold, people will ask who and what on earth caused it, and what we can do to protect ourselves against similar catastrophes in the future.

Credit, risk and derivatives

We are dealing with three things: credit, risk and derivatives. Credit and risk require no in-depth explanation - they are the bread and butter of financial markets. Finance is all about lending and borrowing money or other assets, and risk is inherent to such business.

Derivatives are a tad more complex. Yet on the basic level they are straightforward: Financial derivatives are contracts that allow parties to trade risks that derive from some underlying assets. An agricultural producer can, for example, buy a futures contract in wheat or coffee, whereby he locks into a specific sale price in the future, thereby eliminating the risk of price changes during the production period. Another well-known derivative is the stock option, which is often used as an incentive device for top employees (sometimes it may even work).

However, derivatives can do more than that. From the 1980s onwards, banks have been developing increasingly complex products and structures. Some of them are good, while others have turned out to be more dubious.

One issue with derivatives is that they can be employed to circumvent regulations. This has happened time and time again. Because they are complex and innovative, their regulation lags behind new developments. One of the foremost supporters of financial derivatives, Merton Miller, of the University of Chicago, rested his case on this very attribute. Clearly, he was no friend of silly regulations.

But there are silly laws and sound laws. If the rules of the game are useful and necessary, they can prevent derivatives from creating a mess. For example, some regulations are there to protect shareholders and final investors against excessive risk-taking and gambling by corporate treasurers and fund managers.

A crumbling house of cards

Among the fiendishly complex derivatives are so-called credit derivatives. They became a big market just a couple of years ago, and have grown to a truly global trade. Their key idea is simple: to allow lenders (for example, banks) to transfer their credit risks (for example, default of mortgagees or corporations) to outside investors. Thus banks can do more business.

It can be very profitable to banks to do this. But why would anyone participate? Because that can be profitable too - as long as it works. Credit derivatives such as credit default swaps (CDS) can provide participating investors with inordinately large returns to their investment.

The trouble is that it may not work out as planned. What happened during the last couple of years was the typical artificial boom: too much money flowing into certain investments, giving rise to a lot of credit and risk. The housing markets around the world have been hot for many years in a row, with many people getting mortgages on flimsy grounds and hoping that prices would go up indefinitely.

The imprudent behavior of house buyers was one thing. The other was the conduct of the lenders, who neglected ordinary risk measures, as the idea was to sell the risks to someone else. The latter -hedge funds, pension funds and so on - seemingly did not always quite grasp what they entered into; perhaps the coupon just looked too yummy to say no to. Risk rating agencies had their role in the story too, as they gave too good marks to products bearing seeds of destruction.

It all started as an attractive new trade in which many people wanted to participate, but it grew into a global house of cards that was hard to sustain. Somewhere down the line, US consumers had not enough money to maintain their excessive living and spending habits, so that an increasing number of mortgagees defaulted on their loans. This caused a downward spiral, in which foreclosures and sales shot the property market down, thereby eroding collateral value and reinforcing the negative cycle.

Instruments of fraud

So far we have seen the meltdown of mortgage-related credit derivatives, where rising default rates have turned the brave new products sour. We have yet to see the same effect in other asset classes, such as car loans, credit cards and corporate debt. Other houses of cards rest on these shaky foundations.

Investor Warren Buffett once called credit derivatives "financial weapons of mass destruction". What he was referring to was the potential of these complex products to send entire economies off the rails. By hiding risks in complex financial structures - frequently offshore legal entities called Special Purpose Vehicles (SPVs) - credit derivatives created a speculative bubble, which cannot burst without wreaking havoc on the global economy.

There is no doubt that they can be used properly and for good cause too - but not when people are ruled by greed rather than love of neighbour. One could point to many dubious practices in relation to these complex financial derivatives, such as off-balance-sheet accounting, over-the-counter deals, and marking-to-model practices. These have enabled hedge fund managers and other participants to hide the risks from the ultimate stakeholders.

Those practices are still, broadly speaking, legal. But word is going around that there may have been outright misinformation and fraud in the origination process of mortgage derivatives. Wait for the f-word to come out into the open: fraud. It means big bucks for the lawyers and nightmares for the banks, entirely regardless of whether the rumours are correct.

False diagnosis, false solution

Let me make my prediction of what happens next. It will probably take some months for the situation to become clear and the other categories of credit derivatives begin to melt down. Once we are at that stage, the discussion, blaming and policy planning starts. It will be all over the place in major media. The bottom line will be this: "We need more global coordination and regulation of financial markets and economies, for that is the only way to protect ourselves from greedy hedge fund managers and rogue derivatives traders."

Unfortunately, this solution will be mistaken, because it rests on a three-fold misdiagnosis of the illness.

Firstly, while is true that we have a regulatory issue with derivatives, that is nothing new, for it was discussed extensively in the USA in 1994-95 after a smaller derivatives crisis. Heavier regulation was also seen as the solution to the collapse of Enron in 2002 -- a collapse mainly caused by the abuse of financial derivatives by the company. The result was the infamous Sarbanes-Oxley Act which, apart from creating headaches for businesses and more business for lawyers, has done nothing to prevent the ongoing derivatives crisis.

What went wrong in 1995 and 2002 was that the resulting regulation failed to tackle the real issues, such as the reporting of off-balance-sheet items. We need less and simpler regulation; regulation of the right kind.

Secondly, it is not a question of regulatory powers, but of how these are employed - and by whom. Often, regulators are two or three steps behind financial innovators, and making everything more global and coordinated will probably make things slower and more bureaucratic.

More critical than the nature of the regulatory regime is the issue of control. In his book, Infectious Greed, law professor and former derivatives broker Frank Partnoy demonstrates how banking interests indirectly control the regulatory bodies such as the US Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC). Through their powerful lobbying efforts, bankers in 1995 were able to divert and water down the correct legislative agenda, thereby permitting and encouraging dubious practices. More centralized regulation and control will not solve this challenge, but may in fact make regulatory capture easier than before.

Conversion in demand

Thirdly, this is not a legal issue first and foremost. It is a moral issue. Financial derivatives are not evil per se, but only when used for wrongful purposes by imprudent persons. Laws will accomplish little if there is not a critical mass of men and women who seek the good because it is good, and not because deviations are penalised.

This is not to say that all finance professionals are morally bad. There are many good people out there. But, unfortunately, greed may have become more ordinary in banking and finance than in many other sectors. An inordinate desire for material wealth and profit is reflected in the culture and the incentive structures which feed it, and they attract individuals who are more inclined to greed. There are no easy solutions to this moral challenge; governments are practically powerless before it.

There is only one solution, and it is very simple. It is called conversion -- conversion of heart.

We need people in finance, in banking, and in business generally, who work for nobler motives and out of a desire to serve their fellowmen. The truest purpose of any kind of honest business is not profit, but service. If the atmosphere is demanding, we may even need martyrs - not ones that are fed to lions, but ordinary people who accept the humiliations and ill-treatment that follow from their refusal to conform to morally questionable practices.

All this may sound idealistic and off-topic. It is neither. It is the heart of the matter, and it is realistic. History is not driven by material conditions, but by the spiritual side of man. As the movie Amazing Grace reminds us, true men of the spirit have always been at the forefront of socio-cultural transformation. Through their words and example these spiritual innovators set the model and standard for others to follow, and those who follow are not just many. They are legion.

Trained in economics and law, Oskari Juurikkala works in mining and finance. He is also consultant with Ansgar Economics and founding editor of, the leading precious metals website in Finland.


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