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Derivatives and Greed: a Dangerous Combination

March 15, 2012

I have written many times and for many years about my extremely strong concerns regarding derivatives. Yesterday, an executive for Goldman Sachs wrote an editorial piece for the New York Times that confirms my concerns. Mr. Greg Smith’s article, “Why I am Leaving Goldman Sachs” tells us what we should already know. If we trust large Wall Street financial firms, we are suckers. And more, if we trust derivatives, we are suckers. And finally, if we don’t think we are being played as suckers, we are suckers.

I might differ with Mr. Smith’s opinion that his firm has changed over the period he has been at Goldman Sachs, which is about 10 years. I think what happened in Mr. Smith’s case is that 10 years was enough time to have the veil removed from his eyes. The real changes to Wall Street firms occurred when they went from being privately held companies to publicly held companies. This change resulted in a culture of focusing on short-term profit and a bonus-driven mentality at the sacrifice of what is in the long-term interest of the firm (and their clients). Regardless, I think Mr. Smith is absolutely correct in his findings that large financial investment firms view investors as pawns they can use to get  the most profit off  their clients (my words not his).    

These firms live under the motto, “A fool and his money are quickly parted.” While I do not like the idea of these “too big to fail bankers” taking advantage of naïve investors, there is an even bigger problem that exists here. Mr. Smith observed that derivatives were being used to bilk their clients. He also observed that meetings always centered on how much money the firm was making and never considered how the client was doing. I would note that derivatives-investing is not your average investor’s chosen investment tool. Therefore, I would be willing to bet (or take out a derivative contract…ha ha) that most of you reading this blog are not sitting on the edge of your seat wondering what might be happening with your personal derivative investments. Derivative contracts are extremely complex contracts that act much like an insurance policy and a casino bet all at the same time. The growth of derivatives has been beyond astronomical over the past two decades and the reason their growth is so extreme is that it is an instrument from which Wall Street makes gobs of money. It is the tool of choice for the ‘fool and his money’ motto.

So, you may ask, if derivatives are not a financial instrument the average investor can get sucked into, why should I be concerned? The reason I am concerned is that derivatives are the instrument being sold to big and ‘sophisticated’ investors, including pension plans. In addition, you do not have to be buying derivatives directly to be a participant in the “bet.” There is the flip side of the bet that derivative contracts are betting against. In the case of credit default swaps, the bet is often against  traditionally safe investment instruments like mortgages, or countries’ sovereign debt (bonds). The bottom line is that derivatives can be very bad news even if you don’t believe you are directly invested in them. And there is absolutely no justification for having a derivatives market that now exceeds $700 trillion! There are two reasons derivatives have grown so exponentially: their growth has been pushed by those who make exorbitant fees from selling these instruments and they have been pushed by those who want to bet against traditional investments that have unknowingly become a ticking time-bomb (like what is happening in Europe with nations’ debts, or what happened in the mortgage market not so long ago). Either way, the motive behind these complex investments is often greed.  

For greed to flourish, there must be suckers. Institutional investors must say they are not willing to invest in products that don’t make sense, or are overly complicated and therefore open to manipulation, or wrongly motivated profiteers. What we do NOT need is our government or central bankers bailing out the financial institutions who view their clients as “Muppets.”

I congratulate Mr. Smith for his decision to leave Goldman Sachs and I pray that more employees who work for firms like his choose to listen to their conscience!

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