"Any losses [AIG1] may realize ... under these derivatives will not be material."

-- AIG, Feb. 12, 2008

We all remember how in late 2008, staggering losses on risky derivatives nearly brought down our entire financial system.

With 43 members of the House and the Senate hammering out a final version of the financial-reform bill, one of the biggest contentions remains what to do about the mind-boggling, vast, and opaque derivatives market owned by the nation's too-big-to-fail megabanks.

The problem is getting worse. Notional amounts of derivatives held by federally insured banks have risen to more than $200 trillion.

Graph

Source: Office of the Comptroller of Currency as of Dec. 31, 2009.

The blue line you see is the huge profit center of derivatives casinos and squeezing customers. The yellow one is mostly naked credit default swaps, the same instruments for gambling on the bankruptcy of other companies that blew up AIG (NYSE: AIG). Green is what banks use to actually hedge their risk.

Granted, many of these positions cancel each other out, but even assuming the "netting" works, we're still talking more than $20 trillion.

No matter how you measure it, this is a ton of risk, and it's concentrated in five hands: JPMorgan Chase (NYSE: JPM), Bank of America (NYSE: BAC), Goldman Sachs (NYSE: GS), Citigroup (NYSE: C), and Wells Fargo (NYSE: WFC).

Graph

Source: Office of the Comptroller of Currency as of Dec. 31, 2009.

There are at least three problems with this picture:

1. This is crazy.
At 14 times the size of the U.S.'s gross domestic product, if even a fraction of these opaque and convoluted instruments blow up, as they did in 1998 and again in 2008, it would be bad news bears for everyone who doesn't live on roots and berries.

2. They're too big to fail.
The chief selling point of the financial-overhaul bill is that it somehow reduces the problem of too big to fail. Whether or not you believe that it does (it does not), one thing is for certain: The liquidation authority that is supposed to restore discipline and end moral hazard in financial markets is unlikely to work so long as derivatives traders continue to use American families' deposits as human shields. Derivatives collateral gets paid out before deposits, so the next time a megabank melts down, the Federal Deposit Insurance Corp. could be left holding the bag in liquidation.

3. We're subsidizing them.
Market-making can sometimes be socially useful, while gambling billions of dollars on interest-rate movements is probably less so, and given the dangers, may be socially detrimental. But none of these risky activities needs to be subsidized by our FDIC-insured deposits, 0% Federal Reserve liquidity guarantees, and the prospect of future bailouts. Continuing to do so will only encourage the market to grow larger and more dangerous, and siphon capital away from more legitimate activities like, say, lending money to support an economic recovery.

JPMorgan Chase, the largest dealer, borrowed at an average rate of 0.08% in the fourth quarter of 2009 thanks to the aforementioned subsidies, which it has been using to pile up derivatives with a notional value nearing 50 times that of its assets. Ever wonder what banks are doing with all that cheap capital the Federal Reserve provides them in lieu of small business lending? Look no further.

The purpose of FDIC insurance and the Fed discount window is to allow us to know that our deposits are safe, so that banks can convert those savings into loans for businesses and families -- not so they can use our savings as a cheap source of funding for derivatives casinos.

What you can do about it
One section of the financial-reform bill being debated now would end subsidies for derivatives trading.

Section 716, "Prohibition Against Federal Bailouts of Swaps Entities," is a flat ban on federal assistance to derivatives casinos. Banks could still use derivatives to hedge their own risk, but they would have to fund derivatives trading operations with their own money instead of ours.

Wall Street is furious. It apparently feels entitled to gamble with our savings.

Because Section 716 is one of the truly meaningful parts of the reform bill, everyone expected it to be defeated. But so far Congress has been too afraid to go along. It's an election year, and members of Congress are feeling pressure from the electorate to get it right this time.

As the conference committee finalizes legislation designed to prevent the next financial meltdown, we should tell the conferees to end subsidies and bailouts for the very same derivatives that led to the last one. If they don't do so, it's likely we'll get the same result.

The fate of section 716 will be decided in just days, and it could really go either way. If you want to end subsidies for derivatives casinos, click here to sign the petition or use the widget below. 

Once you're done, you can amplify your voice by calling one of the critical members of Congress listed underneath the petition.

 

Petitions by Change.org|Start a Petition »

 

Thanks! Now, do you have a minute to call one or two of these numbers? Just tell the person who answers the phone that you're calling to comment on the financial reform bill, and that you need the representative or senator to oppose attempts to weaken Section 716 of the Senate derivatives chapter that ends subsidies and bailouts for derivatives casinos.

Rep. Barney Frank                                                          (202) 225-5931

Sen. Chris Dodd                                                               (202) 224-2823

Rep. Paul Kanjorski                                                         (202) 225-6511

Sen. Jack Reed                                                                 (202) 224-4642

Sen. Blanche Lincoln (tell her to stand strong)             (202) 224-4843