Say it with a sneer: "derivatives traders"

Credit default swaps were supposed to make the world safer. At AIG, they did the exact opposite. That kind of work deserves a million dollar bonus, doesn't it?

Published March 17, 2009 10:10PM (EDT)

Reading the text of Obama's statement directing his Treasury Department to "pursue every legal avenue" to block the now notorious AIG bonuses fails to deliver the same impact as hearing the president deliver the words, something I did not realize until watching the cable news shows Monday evening. When Obama said "it's hard to understand how derivative traders at AIG warranted any bonuses," he gave the words derivative traders a subtle, yet masterful, twist of the knife that does not translate well to the static page.

Of all the people struggling through the recession, he intimated, the last people deserving a reward are the traders in complex financial products who helped create our global-economy-consuming debacle. You could hear an unmistakable echo of the sneer in press secretary Robert Gibbs' "derivative trader" slam aimed at CNBC loudmouth Rick Santelli a few weeks earlier. Whether focus grouped or not, the White House has come to a clear conclusion. Derivatives traders are now about as esteemed in the United States as steroid-using baseball sluggers or refugees from 80's hair metal bands. Ridicule them as you please.

And why not? The Financial Times' Gillian Tett wrote on Monday that one of the striking things we have learned from the AIG debacle is that the whole thesis of why credit derivatives were supposed to be a good idea in the first place has been turned completely upside down. (Thanks to Brad Setser for the link.)

After all, during the past decade, the theory behind modern financial innovation was that it was spreading credit risk round the system instead of just leaving it concentrated on the balance sheets of banks.

But the AIG list shows what the fatal flaw in that rhetoric was. On paper, banks ranging from Deutsche Bank to Societe Generale to Merrill Lynch have been shedding credit risks on mortgage loans, and much else.

Unfortunately, most of those banks have been shedding risks in almost the same way -- namely by dumping large chunks on to AIG. Or, to put it another way, what AIG has essentially been doing in the past decade is writing the same type of insurance contract, over and over again, for almost every other player on the street.

Far from promoting "dispersion" or "diversification," innovation has ended up producing concentrations of risk, plagued with deadly correlations, too. Hence AIG's inability to honor its insurance deals to the rest of the financial system, until it was bailed out by US taxpayers.

The most prominent critique of the risk "diversification" theory held that the job of judging risk had migrated from those with the necessary skills to evaluate the credit-worthiness of loans -- i.e. banks -- and been put into the hands of those who didn't have that expertise -- hedge funds, pension funds, small towns in Norway. What nobody suspected was something much, much worse! Risk wasn't being diversified at all -- it was being concentrated in discrete toxic landfills, waiting for a random trigger to be pulled before blowing up the universe. One unfortunate consequence of this concentration: The absolute requirement to keep AIG afloat, lest everybody else go down with it.

We have seen some contrarian defenses of why bonuses should be paid as promised to AIG's derivatives traders. Basically, they boil down to the theory that not paying the bonuses will drive away the "good" traders who might be able to clean up the mess that they created.

This is unconvincing. For years, "derivatives traders" and their apologists told us how the miracle of unfettered markets and financial innovation was making the world a safer place. I have been on the receiving end of no small dumploads of arrogance when asking my own questions on this topic over the years. Those of us who dissented were dismissed as naive and foolish.

I will grant that there are undoubtedly domains -- straightforward commodity trading, for example, under close government oversight -- where derivatives are extremely useful in smoothing out market swings and providing stability to farmers and other raw material producers.

But in the case of credit derivatives as practiced by AIG traders? Few participants in capitalism have ever been proved as spectacularly wrongheaded. And these are the people we expect to be able to fix their own mess, with the help of million-dollar retention bonuses? Excuse me for my naivete, but somehow, I'm skeptical.

By Andrew Leonard

Andrew Leonard is a staff writer at Salon. On Twitter, @koxinga21.

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