The terrible cost the U.S. pays for derivatives

April 16, 2012: 10:53 AM ET

Whether they understand them or not, all taxpayers have been sucked into the derivatives virtual reality game, and at great cost.

By Eleanor Bloxham, CEO of The Value Alliance and Corporate Governance Alliance

FORTUNE -- It's tax time -- and if you are like many people, you may spend a moment contemplating all the benefits your tax dollars bring. But amid all of those benefits, your money is also propping up the proliferation of derivatives in our economic system. Now isn't that something to be proud of?

"Derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal," Warren Buffett wrote in 2002. Boy was he right, in more ways than one.

In practice, they're destructive in three killer ways. Strike one: Unbridled manufacture of and investment in them continues to lead to bubbles, an erosion of trust in the capital markets, and they fueled our most recent financial crisis. Strike two: Used in compensation, they encourage risky behavior and economic instability. Strike three: Rather than going to other, useful causes, tax dollars are instead subsidizing both the corporations that dole out derivatives as compensation and the profits of the financial institutions that create them.

Derivatives aren't real in any natural sense, like iron or coal or water. They are a manufactured investment product that is supposed to have a relationship to something that is more real, like a stock, a bond, a mortgage, or a commodity -- but that relationship is sometimes tenuous at best. Whether they understand them or not, all taxpayers have been sucked into this virtual reality game, and at great cost.

Still crazy, after all these years

Many of us are aware that the securitization of loans and the manufacture of CDOs (collateralized debt obligations) contributed to the recent financial crisis. In Economic Value Management, a book I published decade ago, I explained how securitizations enrich investment banks, which garner fees for arranging them, and usually destroy value for the commercial banks that use them to offload subprime mortgage and credit card loans. Nevertheless, securitizations continued to proliferate, and along with derivatives, encouraged fraudulent loan transactions, the housing and securities bubbles, and the biggest financial crisis since the Great Depression.

But we haven't changed our stripes yet. Unbridled creation of these little monsters continues to be great sport for the investment banks -- and there still isn't effective regulatory control over the sale of these products, or the companies that manufacture them.

Consider the recent case of Credit Suisse's (CSvelocity exchange traded notes. The bank apparently controlled the market for this investment product and, according to Bloomberg, stopped issuing the notes in February and didn't resume until late March, drying up supply and driving up the price by 90%. The bubble burst and the notes' price fell by 50% in just two days, according to Barron's. (Other exchange traded notes have not fared well either. Barron's calls Barclay's S&P 500 futures exchange traded note "treacherous" for long-term investors, "down more than 90% over its lifetime.")

Consider also recent reports on derivative investment practices at J.P. Morgan (JPM). The Financial Times recently reported that "JPMorgan had amassed a big position in an index of credit default swaps, sufficient in size to move the market" and Bloomberg reported last week that J.P. Morgan trader "Bruno Iksil's outsized bets in credit derivatives are … fueling a debate over whether banks are taking excessive risks with federally insured and subsidized money."

Clearly, we not only need the Volcker rule to curb proprietary trading, we need to make sure investment manager fiduciaries stay away from these instruments so our pension funds, 401k plans, and mutual funds don't continue to bleed like they did during the financial crisis.

An executive pay infection

But this isn't just an investment and capital markets problem. CEOs who receive stock options and restricted stock pay grants, which "are nothing more than long term options" to the executives who receive them, benefit from volatility and are prone to take risky actions that result in "economic instability," a December New York Fed staff report concluded.

Based on a review of large company filings this proxy season, derivatives in the form of stock options and restricted stock grants constitute the bulk of most executives' pay, from 75% to 99% for the CEOs of companies like Bank of America (BAC) and Apple (AAPL). (Buffett is a noticeable exception and receives no derivative-based pay.)

Uncle Sam helps to subsidize the proliferation of derivatives by providing low-rate funding to the banks that manufacture and control markets in these ticking time bombs. Meanwhile, your check to the government subsidizes the corporations that use stock options and restricted stock to take huge tax write-offs for pay. When stock options are in play, the amounts these companies deduct in taxes far exceed what is recorded on their books. These tax deductions are partly based on the false notion that this pay is for performance and is therefore not subject to the $1 million cap on salary deductions.

But this theory on performance-based pay doesn't match reality. For starters, options and stock grants are often explicitly not based on performance. This is no secret. Last month, over lunch, a board director at a well-known insurance company animatedly sketched what happens on a napkin. To match previous dollar values, boards often hand out the largest awards when stock prices are low (to achieve a  certain dollar value) even if the price has gone down on the executive's watch. By using derivatives in this way, stock price volatility, rather than stock price, becomes the real driver of pay.

Even if some shares and options are awarded at higher prices, momentary blips in stock price can be great times to cash out. Most top executives, unlike middle managers, time their stock sales carefully. They often hold out for long periods, waiting for just the right moment to cash in, according to Ted Allen, governance counsel at proxy advisory firm Institutional Shareholder Services.

Reform in the wings?

In February, Senator Carl Levin proposed the Cut Unjustifed Tax Loopholes Act. The bill, as currently written, would change tax deduction rules for stock options and would bring them in under the million-dollar pay cap (although, in its current form, the bill does not address restricted stock or other forms of pay). Based on current law, Facebook will have "a tax break of up to $3 billion" and may not have to pay a single cent in federal income taxes for years, Levin said. Putting it into perspective, Levin said that "in 2009, the most recent year for which IRS data is available, taxpayers from 11 states in our union sent less than $3 billion in individual income tax revenue to the treasury."

Facebook isn't alone. In total, options tax breaks cost the government tens of billions of dollars every year, according to several estimates. A report released last week by Citizens for Tax Justice outlines the extent to which taxpayers are subsidizing these behaviors. While tax subsidies that produce jobs and strengthen the economy may be worthwhile, it does not make sense to encourage pay that leads to economic weakness.

A decade ago, we received strong warnings about the effects of derivatives on our capital and labor markets -- and we chose to ignore them. The subsequent effects on the federal deficit were real. While the advice may be old, how many more tax seasons are we willing to let this go? And how many more crises are we willing to suffer through?

Eleanor Bloxham is CEO of The Value Alliance and Corporate Governance Alliance (http://thevaluealliance.com), a board advisory firm.

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About This Author
Eleanor Bloxham
Eleanor Bloxham
Contributor, Fortune

Eleanor Bloxham, an authority on governance and valuation, is CEO of The Value Alliance and Corporate Governance Alliance, an independent board and executive educational and advisory firm she founded in 1999. She is author of the books Value Led Organizations and Economic Value Management: Applications and Techniques, and publisher of the Corporate Governance Alliance Digest and her blog The Bloxham Voice.

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