Goldman Sachs and Derivatives

In October 2009, Robert Johnson, Director of Financial Reform for the Roosevelt Institute submitted testimony to the House Committee on Financial Services regarding the over-the-counter derivatives market and the role they played in the financial meltdown of 2008.  He was only given five minutes to make his presentation and, therefore, had to resort to presenting a written document.  His testimony did not get as much publicity as it deserves.

His text was about the role of derivatives in causing and aggravating the financial crisis for which the taxpayer had to bail out the banks in order to prevent another Great Depression.  We have read many commentators say that the five largest US banks are insolvent but becasue of opaque OTC derivatives the truth of that statement cannot be ascertained.  It is worthwhile reading what Johnson has to say about the danger of unregulated derivatives and he suggests that derivatives should be treated as exchange-based trading rather than in clearinghouses.

Johnson used the metaphor of a fault line which undergoes great pressure until it erupts into a deadly earthquake to describe the present danger of derivatives in the financial system. 

Below are excerpts from Robert Johnson's testimony:

Testimony of Robert A Johnson. . . Before the US House of Representatives Committee on Financial Services. . .October 7, 2009
. . . .

CDS buyers in the so-called shadow banking system felt that their purchased protection was a substitute for bank shareholder capital. Yet the writers of the CDS protection, in the case of AIG, did not appear to, and were not required to, set aside adequate capital. As a result, the taxpayer’s capital was extracted to support the counterparties of AIG such as Goldman Sachs and a number of foreign banks who did not pay into any kind of guarantee pool for insurance. This web of connections was considered too dangerous to let fail and it was an example of the hazards of unregulated OTC derivative market breakdown. . . .

Most importantly, the institutions that were at the core of the crisis and controversial bailouts in the fall of 2008 are at the same time the dominant institutions in the OTC derivatives market. In fact, according to the Office of the Comptroller of the Currency, the Top 5 institutions in terms of derivatives exposure, Citigroup, J.P. Morgan/Chase, Bank of America, Morgan Stanley and Goldman Sachs hold over 95 percent of derivatives exposure of the top 25 Bank Holding Companies, of which 90 percent is OTC. This is why I call this the financial equivalent of the San Andreas Fault. Our Too Big to Fail Institutions, the same ones that have relied on the support of the public treasury in the crisis, are the dominant market participants in the OTC derivatives market. As a result, U.S. taxpayers have a very strong and direct interest in how the derivatives markets are structured and regulated.

Read the rest of the testimony here