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A Sure Way To Solve America's $200 Trillion Derivatives Problem

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America's banks hold derivatives valued at more than $200 trillion, about a third of the world total.

Hopefully Wall Street has it figured out just right and there won't be any major losses. After all, when has Wall Street ever been wrong about financial instruments?

"Derivatives are dangerous," says Warren Buffett. "They have dramatically increased the leverage and risks in our financial system. They have made it almost impossible for investors to understand and analyze our largest commercial banks and investment banks."

While many in Washington would like to limit derivatives trading, make such trades open to public scrutiny or both, Wall Street is vehemently against regulation.

In fact, there's a simple way to resolve derivative worries. Allow unlimited derivatives trading -- but only by individuals and partnerships willing to personally take the risk of profits and losses.

What's A Derivative?

In basic terms a derivative is a bet tied to the movement of anything that can be valued. We could have a derivative bet which says the price of a mortgage-backed security (MBS), Hungarian currency or lemonade indexes will go up or down by a certain date.

Notice, however, that derivatives are not like stocks or bonds.

First, there's no limit to the size of the derivative marketplace because none of the bettors actually have to own the underlying asset.

Second, there's huge leverage because not much cash is needed to enter into a derivative agreement.

Third, if you bet on a derivative you typically make an off-setting bet to limit risk.

Fourth, your bet assumes that a specific counter-party can pay if you win.

$605 Trillion

According to the Bank for International Settlements (BIS), the notational value of derivatives at the end of June 2009 was $605 trillion.

The gross credit exposure from these securities was believed to be $3.7 trillion according to the BIS -- that's down from $4.5 trillion at the end of 2008.

Do taxpayers have any exposure? You bet. According to the FDIC, at the end of 2009 U.S. depository institutions held derivatives with a notational value of $213.568 trillion. However, such bets are not spread across the entire banking system. Banks with at least $10 billion in assets hold virtually all derivatives, securities with a notational value of $213.474 trillion. While the FDIC insures deposits in some 8,000 banks and savings associations, only 85 FDIC-insured institutions have deposits of more than $10 billion. Your little community bank, savings association or credit union has no derivatives department.

Social Benefit

Derivatives are simply bets. They finance no factories, no research, no colleges, no homes and no cars. Any jobs they produce are incidental and inconsequential relative to the potential risk they represent, the risk that credit exposure has been incorrectly figured by hundreds of billions of dollars if not more. Since big banks hold virtually all derivatives, and since taxpayers can face massive costs if big banks fail, it follows that something should be done to limit taxpayer risk.

"In banking," said Buffett in 2003, "the recognition of a 'linkage' problem was one of the reasons for the formation of the Federal Reserve System. Before the Fed was established, the failure of weak banks would sometimes put sudden and unanticipated liquidity demands on previously-strong banks, causing them to fail in turn. The Fed now insulates the strong from the troubles of the weak. But there is no central bank assigned to the job of preventing the dominoes toppling in insurance or derivatives. In these industries, firms that are fundamentally solid can become troubled simply because of the travails of other firms further down the chain. When a 'chain reaction' threat exists within an industry, it pays to minimize links of any kind."

How can we control derivative worries? If they're so necessary and safe, let bankers and traders take the risk. Personally.

This can be done with regulations which restrict the ownership of derivatives and derivative interests to individuals and partnerships. Federally-regulated banks, savings associations, credit unions as well as their subsidiaries and partnership both in the US and abroad would be prohibited from originating, buying, selling, brokering, owning, trading, holding or financing derivative interests, directly and indirectly -- for themselves or for another party. The regulations would also apply to financial products which fit within the definition of a derivative, even if called something else.

Under this system, derivative profits would be owned entirely by individuals and partnerships. And derivative losses? They too would be owned entirely by individuals and partnerships. No longer could taxpayers be forced to pick up the pieces if something goes wrong.

Conservatives, Republicans and Wall Street say they're big believers in personal responsibility so here's an idea they can instantly support. Isn't that right?

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Peter G. Miller is the author of The Quick & Dirty Guide To Successful Mortgage Modifications. For more real estate news and commentary, please visit OurBroker.com.