CBS News Investigative Unit's Kim Lengle wrote this story for CBSNews.com.
"This bill will, in my judgment, raise the likelihood of future massive taxpayer bailouts. …if you want to gamble, go to Las Vegas. If you want to trade in derivatives, God bless you."
That was North Dakota Senator Byron Dorgan's statement on the floor of the Senate - not this week or last, or even during the last six months as Wall Street collapsed - but back in 1999.
Four years later in a letter to shareholders, billionaire investor Warren Buffett followed with his own warning, calling derivatives "weapons of financial mass destruction" controlled by "madmen."
While financial experts were concerned with the housing bubble and mortgage-backed securities, Dorgan and Buffett were focused on what many now believe may be the next big shoe to drop - the credit derivatives market, better known as credit default swaps.
What worries financial insiders most is the $54.6 trillion of risky credit derivatives concentrated among the few banks left standing.
Credit default swaps (CDS) are the cornerstone of the credit derivatives market accounting for more than 98 percent of all credit derivatives. They are difficult to understand, ignored by regulators and poorly reported on balance sheets. In simplest terms, CDS are insurance policies on things like bonds, loans and corporate debt. But there are two big differences: the seller of a CDS doesn't need to have the money to cover losses if the security defaults, and the buyer doesn't need to own the asset it wants to protect.
It's as if hundreds of people could buy insurance policies on houses they didn't own yet still collect the full value if it burns down.
The danger comes when the company defaults and the seller - because he's not required to - doesn't have the money to pay out on the default.
Investment firms that traded various derivatives, such as CDS, collected an average of $2 billion in fees each quarter over the past two years. And traders who spoke to CBS News said these transactions were the largest cash cows on Wall Street, even more profitable than mortgages. The newfangled transactions were seen as easy money and many traders had the attitude that when it blows up, it's someone else's problem.
Today, the same commercial banking heavyweights thought to be the most safe, JPMorgan, Citigroup Inc. and Bank of America, hold 92 percent of all the disclosed credit derivative contracts, according to the Office of the Comptroller of the Currency.
But that number is merely an estimate because the overwhelming majority of these contracts are unregulated - private, mostly undisclosed and difficult to measure.
"There is no question we are at the edge of the cliff and someone is going to fall off," said Weil, Gotshal & Manges Senior Partner Harvey Miller who is currently overseeing the Lehman Brothers bankruptcy.
Back in 1999 when the legislation was being debated Senator Dorgan opposed the consolidation of commercial and investment banks. In fact, he sponsored two amendments to prohibit these new mega-banks from …investing in derivatives.
Today, Dorgan apparently feels the same way. He was one of 25 senators who voted no on the recent $700 billion bailout.
"No one knows where [the credit derivatives] are, whose balance sheets they may threaten, or how much additional risk they pose to financial firms. Yet, I was told this plan could not require regulation and transparency of these financial markets because there was opposition in Congress and the White House," Dorgan said in a statement explaining why he didn't vote for the bailout.
With banks already suffering losses from the subprime fiasco, many now believe they face chain reaction failures from the credit derivatives market.
"If the market keeps going in the direction it's been going, you're going to have lots of defaults which are dangerous things," said Miller.
Some economic analysts predict even more panic over next few months. As more corporations default and banks find out they can't make good on their contracts, a new round of losses for funds and financial firms could result and make the recent losses in mortgage-backed securities seem miniscule by comparison.
By Kim Lengle
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