Financial Weapons of Mass Destruction

More than 5 years ago, Warren Buffett warned of the dangers of what he called "financial weapons of mass destruction" that could damage our entire economic system. Buffet was speaking of derivatives, such as futures, options and swaps. There's a reason he's called the "Oracle of Omaha" and renowned as the world's greatest investor.

As it turns out, one type of derivative, Credit Default Swaps (CDS) are especially toxic, and in a world where financial risks are magnified and government oversight is non-existent they have caused exactly the kind of economic crisis Buffett predicted.

According to Fortune magazine, CDS's "...played a critical role in the unfolding financial crisis.... by ostensibly providing 'insurance' on risky mortgage bonds, they encouraged and enabled reckless behavior during the housing bubble...."

In addition, "...terror at the potential for a financial Ebola virus radiating out from a failing institution and infecting dozens or hundreds of other companies - all linked to one another by CDS and other instruments - was a major reason that regulators stepped in to bail out Bear Stearns and buy out AIG, whose calamitous descent itself was triggered by losses on its CDS contracts."

Michael Greenberger, a University of Maryland law professor and former director of trading and markets at the Commodity Futures Trading Commission (CFTC) explains:

"If CDS had been taken out of play, companies would've said, 'I can't get this [risk] off my books. If they couldn't keep passing the risk down the line, those guys would've been stopped in their tracks. The ultimate assurance for issuing all this stuff was, 'It's insured.'"

In testimony before the Senate last month, SEC Chairman Chris Cox pointed to the dangers we face:

The failure of the Gramm-Leach-Bliley Act to give regulatory authority over investment bank holding companies to any agency of government was, based on the experience of the last several months, a costly mistake. There is another similar regulatory hole that must be immediately addressed to avoid similar consequences. The $58 trillion notional market in credit default swaps — double the amount outstanding in 2006 — is regulated by no one. Neither the SEC nor any regulator has authority over the CDS market, even to require minimal disclosure to the market.

It's not encouraging to think that there's an even greater danger looming than the disaster created by the Gramm-Leach-Bliley Act. How can it be that a $58 trillion market (almost four times the value of the entire U.S. stock market) is not regulated? Who caused this? Is Chairman Cox simply making excuses after having "betrayed the public's trust," as John McCain has suggested?

I agree that Chairman Cox should be fired, but in fairness, the SEC can't regulate credit default swaps, nor can the Commodity Futures Trading Commission (CFTC). They are prohibited from doing so by a law.

The CDS market was never been well regulated, and attempts by the CFTC in the late 1990's to increase regulation were met with stiff opposition. More regulation was clearly needed for what was a very rapidly growing market. But even the possibility of increased regulation was too much for the "deregulators," who wanted absolutely no oversight whatsoever.

So the Commodity Futures Modernization Act of 2000 (CFMA) was born. It included numerous provisions, such as the infamous "Enron Loophole." The far more destructive impact, however, was that it eliminated any existing regulation over CDS's, and specifically banned regulation of CDS's by any federal agency.

Too bad the bill's cosponsor, Sen. Phil Gramm, didn't have Buffet's crystal ball before he claimed the CFMA "protects financial institutions from over-regulation ... and it guarantees that the United States will maintain its global dominance of financial markets."

Apparently, McCain's economic advisor and (former) campaign co-chair believed he was elected to "protect financial institutions from over-regulation."

And that's a big part of the problem.