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Dan Radmacher, Published November 01 2009

Dorgan called it in 1994

The problem with prophets is it’s so difficult to tell who the genuine ones are until after the fact. Sen. Byron Dorgan, D-N.D., for instance, turned out to be a genuine prophet in an article he wrote back in 1994. The problem was that no one realized it until the global financial system teetered on the brink of collapse 14 years later.

In that 1994 article in Washington Monthly, Dorgan warned that the trading of new, complex financial instruments called derivatives could lead to a “real financial conflagration – one that would make us nostalgic for the days of the $500 billion savings-and-loan collapse.”

Back then, derivatives represented a $35 trillion market. Now these financial instruments, which are so complex they defy a simple definition, have a paper value of nearly $600 trillion – or about 10 times the gross domestic product of the entire planet.

So, what are derivatives, and how could they be worth 10 times more than the entire planet produces in a year?

Dorgan wrote, “Derivatives may well be the most complicated financial device ever – contracts based on mathematical formulas, involving multiple and interwoven bets on currency and interest rates in an ever-expanding galaxy of permutation.” (See what I mean about defying simple definitions?)

Even more dangerous than their complexity, though, Dorgan warned, is the lack of transparency. Derivatives are not sold on open exchanges like stocks and futures. They involve contracts between corporations that are often off the books. They are inaccessible to regulators and others interested in the worth and stability of mammoth financial institutions such as Lehman Brothers and American International Group.

In this article – which was, don’t forget, written in 1994 – Dorgan explained how such contracts, especially as banks enter into offsetting contracts to spread and attempt to manage risk, could taint the entire financial system. The scenario he describes is essentially what played out in 2008:

“So now a default by X could create a domino effect: X could not pay its bank, and its bank therefore couldn’t make the payments on its offsetting contract, and so on until the chain of losses enters the exchange, where the originally esoteric bet can hurt real businesses.”

The only protections against such a catastrophe, Dorgan wrote, are “guardians of the banking system in Washington.” Obviously, that didn’t work out. As Dorgan said back then, and as remains distressingly true today, exotic derivatives “just don’t fit within the existing scheme of federal finance regulation. It’s a little like asking traffic cops to stop the nation’s computer crime.”

Dorgan has been right about this issue since at least 1994.

The nation would do well to listen to him now – before he is proven right again.


Radmacher is the editorial page editor of The Roanoke (Va.) Times.