Another member of the bewildering zoo of derivative products dreamed up and sold by Wall Street ? this time a constant proportion debt obligation (CPDO) named Rembrandt ? has imploded wiping out unsuspecting investors, according to a June 21 article on Bllomberg.com by Christine Harper, Shannon D. Harrington and James Sterngold, titled “Failed AAA Rated Rembrandt on Wall Street Spurs Opacity Outcry.” As the title says, Rembrandt was an opaque “black box” whose inner workings could only be modeled by computers, and so, of course, was given the highest investment grade rating of AAA. Rembrandt was reportedly linked to credit-default swaps on investment-grade companies, and lost 93 percent of its value in two years.
“Wall Street’s penchant for concocting opaque products — investments that lacked real-time pricing data and were so complex they could only be created and analyzed using computer models — played an important role in the worst financial crisis since the Great Depression,” the authors noted.
Wall Street counters that it is just satisfying investor demand for higher returns in a low interest rate environment, as it should. But many informed critics disagree. “I don’t think it’s the job of the financial community to bewilder its clients,” Nicholas Brady, former U.S. Treasury Secretary, was quoted as saying. “They were making so much money they just wanted to keep the bewilderment machine churning,” he added.
Alan Greenspan testified to Congress in 1998 that “regulation of derivatives transactions that are privately negotiated by professionals is unnecessary.” But that statement is belied by the fact that Citigroup Inc. and American International Group Inc., had to be bailed out of bad bets on contracts whose risks they underestimated or ignored.
Furthermore, these structured products are sold to people who have no idea what they are getting into, and who rely on Wall Street’s representations and professed expertise, as Wall Street encourages them to do.
Part of the financial reform being considered by Congress, and opposed by Wall Street, would require that these complex products be sold on exchanges which are supposed to provide current pricing information. In addition, banks would be required hold reserves to cover losses, and limits would be placed on speculation by banks whose failures would damage the economy.
Wall Street is opposing reform because its profit growth in recent times has been derived from sales of these exotic financial instruments ? often as a counterparty betting against deals it created and sold to investors.
“The more complex, generally speaking, the more profit there’s going to be for the derivatives dealer,” Warren Buffett reportedly told the Financial Crisis Inquiry Commission on June 2. As contracts like interest-rate swaps became commonplace and profit margins eroded, banks “embedded more exotic instruments, and that’s where the money was,” Buffett said.
Does such “financial innovation” really benefit investors, as Wall Street claims? Absolutely not, says John C. Bogle, the founder of the Vanguard Group of mutual funds. Bogle is in favor of tougher financial oversight and says that investors have been fooled into believing they benefit from Wall Street innovations rather than bear the cost. “The financial system subtracts value from society,” Bogle was quoted as saying. “Wall Street represents a cost that takes away from the proven long-term returns available in the market. That’s the reality.”