Who's More to Blame: Derivatives or the Glass-Steagall Repeal?

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Join the Fool as we assess blame for this financial meltdown -- March Madness bracket style! Below is one of four second-round matchups you can vote on … enjoy!

The case for derivatives, by Dan Caplinger
Having already made the general case for why derivatives are most to blame for the financial crisis, I wanted to share some thoughts from a well-respected analyst on the subject:

  • In correctly predicting last July that Wachovia would burn your portfolio, he cited accounting practices that "disguise the true extent of derivatives losses" as a primary factor for his winning call. The stock's price fell from $17 when he made this call to below $1 before Wells Fargo (NYSE: WFC  ) grabbed the bank out from under Citigroup's (NYSE: C  ) nose for $7.
  • A year ago, he pointed out how the crisis would spread to Europe, noting that "toxic securitized debt instruments and deleveraging derivatives may be among the leading exports from the U.S. for a while."
  • One oft-cited factor in his bullish calls for gold stocks like Yamana Gold (NYSE: AUY  ) is how "[c]redit markets remain effectively dysfunctional, and the multi-trillion-dollar derivatives market appears set to continue de-leveraging."

Who's this prescient analyst? None other than Christopher Barker, my esteemed opponent, who finds himself somewhat awkwardly on the other side of the argument in this debate.

Admittedly, I can see how the repeal of Glass-Steagall could seem like a tempting scapegoat for the crisis. Combining banks with securities firms carries the potential for huge conflicts of interest. But it fails to explain a number of things:

  • How did banks and other lenders that didn't even have securities businesses, such as Countrywide Financial, Washington Mutual, and IndyMac, manage to set in motion the cycle of toxic mortgages that got us in this mess in the first place?
  • How did securities firms that until recently had absolutely no banking exposure, including Goldman Sachs (NYSE: GS  ) and Morgan Stanley (NYSE: MS  ) , get to the point of needing capital infusions in order to survive?

The answer to those questions is the proliferation of derivatives. That's why I believe derivatives deserve more of the blame.

The case for the repeal of the Glass-Steagall Act, by Christopher Barker
I'm proud of you, Fools!

Alan Greenspan certainly helped set the stage for this crisis by fostering excessive liquidity in the credit markets. Ben Bernanke is presently dumping indebtedness upon unborn generations of Americans in what I consider a fatally flawed response strategy.

Nonetheless, you well-informed Fools peered beyond those alluring scapegoats and voiced your greater discontent with the fateful extinguishing of Glass-Steagall and the creation of those convoluted instruments called derivatives. By selecting these factors over Greenspan and Bernanke, you exhibit a keen understanding of the historic events now unfolding.

You can't have a chicken without first having an egg. The relaxing of Glass-Steagall back in the 1980s -- which permitted the predecessors of JPMorgan Chase (NYSE: JPM  ) , Citigroup, and others to deal in instruments like mortgage-backed securities and commercial paper -- was the rotten egg which eventually hatched into the present derivatives debacle. The failure to heed the lessons of history permitted history to repeat itself.

Derivatives became the scourge of the Earth only after flourishing in a sea of deregulation. Indeed, the unchecked expansion of derivatives in recent years formed a key foundation for my reluctant bearishness toward the U.S. dollar. Since 2002, when Warren Buffett called derivatives "financial weapons of mass destruction" in a letter to Berkshire Hathaway (NYSE: BRK-B  ) shareholders, the global derivatives market has ballooned from $100 trillion to at least $684 trillion. Jim Sinclair, chairman and CEO of Tanzanian Royalty Exploration, estimates a notional value of well over $1 quadrillion (that's 1,000 of these!).

The unwinding of these instruments may indeed yield shock and awe, but the mess could never have been made with those Depression-era regulations intact. If you select the Glass-Steagall repealers on the basis of this argument, I will highlight the significant role of derivatives in subsequent rounds.

Check out the Fool’s entire 2009 March Madness bracket here.

Fool contributor Christopher Barker thinks March Madness would be a great name for Bernanke's quantitative easing initiative. He can be found blogging actively and acting Foolishly within the CAPS community under the username TMFSinchiruna. He owns shares in Yamana Gold. Fool contributor Dan Caplinger owns shares of Berkshire Hathaway. JPMorgan Chase is a former Motley Fool Income Investor selection. Berkshire Hathaway is a Motley Fool Inside Value and Motley Fool Stock Advisor recommendation. The Fool owns shares of Berkshire Hathaway.  The Motley Fool's disclosure policy carries zero counterparty risk.

Read/Post Comments (3) | Recommend This Article (26)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On March 24, 2009, at 7:30 PM, kelly347 wrote:

    Here's something you may have missed-- the repeal of Glass-Stegal did not only allow for banks to employ brokerages, but it took away the threat of personal liability lawsuits for the CEOs & Board of Directors who are now for the most part the fox in the hen house & are in bed together playing let's make a deal that is great for us..This didn't just happen, it has been wearing down the quality of our money with all the bank defaults in the 80's & 90's and the whole deterioration of 'white collar crime' that was declared not to be prosecuted over 15yrs ago. Those with the leaning to live high on the hog have done exactly that, while us others have been paying for it over & over...Look at our politicians & what they are giving's a joke...they need to reinstate the Glass-Stegal act for corporate accountability, & then hopefully political accountability will follow the lack of can be done!

  • Report this Comment On March 24, 2009, at 9:36 PM, jerryguru69 wrote:

    IIRC, Glass-Steagall was originally repealed at the behest of C, who had acquired Travelers and saw a cash cow. I remember reading stories about TransAmerica Insurance who had to spin off BA; why not the other way around? Because the insurance company made much more money, now I think because it was more highly leveraged. However, if the Commodities Future Exchange Board (or whoever) had not changed the rule about who could buy a CDS during the Clinton Administration, there would not be $10T’s of these things poisoning the well, and we would never have heard of “leverage”. You can (and they did) create an infinite number of CDS, but RMBS are limited by the number of mortgages that exist. The value of CDS is orders of magnitude greater than RMBS.

  • Report this Comment On February 22, 2010, at 2:46 PM, hende1964 wrote:

    Ok, I think well agree sooner or later we have to pay the piper?

    My bet is the Euro/Dollar zone will continue to erode against the Dollar to levels we have not seen for awhile. My thinking is that this will be like a double dip! Or a dip/dip/rise……..

    I’m thinking to trade from the Canadian Dollar in metals and other emerging markets in ASIA. My thoughts are that if the dollar keep improving China will likely continue to liquidate about 50% of Treasuries, such an event coupled with a leveling of EUR/DOLLAR could cause the dollar gain on EURO and fall against a basket of many other currencies? Such Canadian Dollar and the Swiss Frank?

    My thinking is that this mass exoduses from the EURO will push many into commodities that are under priced like oil, away from what appears to a evlavated stock market, thus providing additional hedge that the Canadian Dollar could reach 1.20+ against the dollar, this should allow for a double gain and also provide a better level of security if China dumps a large block of Treasuries.

    Your thoughs?

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