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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. More

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