In chapter seven of Jobenomics, the author provides a layman’s explanation of just how derivatives evolved, what role derivatives played in the sub-prime mortgage crisis, and how derivatives are impacting the American recovery process.
It started when lenders spread the risk to investors by packaging sub-prime loans into asset-backed securities, and selling these securities on the secondary market with US government backing.
Much in the same way, credit derivatives provide insurance regarding defaults on loans, credit cards, mortgages and like credit products. Underlying assets include mortgages, equities (stocks), commodities (corn, gold, and oil), loans, bonds, interest rates, exchange rates, and even more unusual items like the weather.
During the boom years in the early 2000s, derivatives created hundreds of trillions of dollars worth of new wealth based on bets on the bountiful real estate market.
The CEOs of these real estate markets were give incentives by Congress to sell more housing derivatives, under the assumption that home ownership would give citizens a larger stake in the American dream.
In trying to figure out where to place blame, the acrimony against Wall Street was too high in Main Street and Washington to make reasoned judgments. A lot of money was made by numerous people from the merchant, ethanol, underwriter, trader, global warming group, pension fund, and arbitration groups. Making matters worse, the government created a legal special purpose entity, that was also separate from the government, which could own and trade a set or pool of mortgages. Then the bubble broke, just like other over-inflated real estate asset bubbles, such as the Japanese real estate bubble collapse in the 1990s.
Chapter seven of Jobenomics comes to the difficult to admit, but reasonable conclusion: reform, transparency, oversight and regulation of derivatives are clearly needed. The financial sector, as well that the US government, needs to set a proper course of action and restructuring. Sadly, the chapter concludes that such reforms may not happen right away. Quite simply, the American government is in on the blame game. It is much easier for Washington to point to Wall Street, as opposed to looking at its own role in the derivatives market. Second, Washington is locked in a “capitalism versus socialism” debate, which preempts any forward movement on how to oversee and regulate the financial industry. Third, few understand the shadowy nature of the derivatives. For example, AIG is still trying to untie the Gordian Knot of credit default swaps. Government pressure and threats from private citizens are causing professionals who understand the subtleties of derivatives to quit and transfer to other jobs. Finally, the future impact on the economy of derivatives is yet to be seen. This leads into the next chapter of Jobenomics, which examines what to do next. As chapter seven outlined, unchecked capitalism proved to be unworkable, but unchecked intervention by the government might be even worse.
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