The Senator Who Saw This Coming

Newsweek has a great article in the April 13th edition called, “The Senator Who Saw This Coming.” It is a brief interview with North Dakota Senator Byron Dorgan, about his effort to regulate exotic derivatives back in 1994.

I met with one of Senator Dorgan’s key staffers on a trip to Washington, DC in February. I had found through my research in the Congressional Record that Dorgan had tried to pass legislation that in my view would have preventing the global financial meltdown by preventing the massive credit and derivatives bubble that caused it. So I asked his legislative specialist, “why isn’t Senator Dorgan calling attention to all his earlier efforts and saying, ‘see, I told you so?'”

I found the answer tonight in this Newsweek article, “There’s very little solace in being right, given the carnage,” said Dorgan. “This is one of the most expensive lessons in American history.”

Senator Dorgan is a great America, representing a great state whose old fashioned values and conservative banking practices we can learn something from.

Recent news stories indicate that North Dakota is largely escaping the recession, because of its conservative banking practices and “midwest… sensibilities.” Large banks there apparently avoided sub-prime lending. There are almost no foreclosures and there is full employment still.

I started a citizen journalism effort several months ago called Crashopedia–an effort to document the root causes of the global financial meltdown and the key players in that story. I found that Senator Dorgan was on the right side every step of the way. But it was like David fighting a hundred Wall Street Goliaths–the most effective financial lobby in the history of the world–and we know who prevailed.

I was so impressed with his 1994 article in Washington Monthly Magazine called “Very Risky Business – Derivatives” that we made it the first link on the entire Crashopedia web site.

Dorgan tried from 1994-1999 to restrict the financial industry from selling exotic instruments. But the financial lobby prevailed. Since then, derivative bets first generated hundreds of billions of dollars of profits (and billions of dollars in bonuses for those who waged them) and hundreds of billions in toxic liabilities when the bets turned sour.

As the derivative industry started churning out hundreds of trillions of dollars in derivatives contracts, our whole economic picture turned bizarre.

I read one study that said that in the early 80s the financial sector generated about 8% of the total profits from the S&P 500. That’s a pretty understandable level. By 2006 it had jumped to nearly 40%. That’s insane! 40% of our profits in the S&P 500 (which represents 75% of the market capitalization of US companies) coming from banks? Banks hardly create wealth–entrepreneurs and businesses do–unless you count balance sheet wealth or insurance premiums from derivatives contracts (with no risk, of course) as reported by the financial geniuses running these companies.

It’s no wonder that Warren Buffett called derivatives “financial weapons of mass destruction” in his letter to shareholders in 2002. But amazingly Byron Dorgan saw this train-wreck coming 8 years before that letter, and more than 10 years before Buffett’s partner Charlie Munger said he’d be shocked if there wasn’t a massive derivatives blow-up in the next 5-10 years.

Perhaps if Newsweek and enough others tell the story of Dorgan’s attempts to restrict the financial industry from selling these very exotic instruments that generate huge reported profits in boom times but massive losses when they crash, maybe there will be a sequel–David and Goliath Round II.

And maybe this time, we’ll learn from our past mistakes, and back Dorgan in his efforts to make sure the 21st century banking industry returns to old fashioned values, where reserve assets are strong, leverage is small, and profits are lean.

Let’s put a rock in the head of the Wall Street casino that Dorgan warned us about where “quants” (Ph.D’s in mathematics) develop wild mathematical models that allow twenty-something traders to make millions in bonuses by selling seemingly low-risk derivatives instruments with higher than average yields to bankers all over the world. (See the March 2009 Wired Magazine article titled, “Recipe for Disaster: The Formula That Killed Wall Street.”)

I say lets rally behind Dorgan, and cheer him on in this second round of battles that still seem impossible to win, in part because the financial lobby seems to control so many seats in Congress and in part because the revolving door between Goldman Sachs and the Treasury Department and the Federal Reserve itself has kept the bad guys in charge even now.

At this point, we are still in big trouble, because creating and selling toxic and exotic derivative instruments is still as legal (and as unregulated) as it was a year or two ago, and bankers will create them once again (with a whole slew of new clever names and models) as soon as there is a market for them again.

As if to facilitate more of the same, the President and the Treasury Secretary are proposing (as Bush and Paulson did before them) to buy up to $2 trillion of these bad derivatives and get these “toxic assets” off the balance sheets of the largest banks.

It may be too late to punish the perpetrators of the scheme that has allowed the derivatives industry to pillage our economy for all these years and now harm our prosperity and threaten our very way of life, but it may not be too late to stand with Dorgan and make sure that it never happens again.