Small towns are losing millions of dollars on derivatives bets just when they can least afford to lose money. Why are we surprised?

The municipalities have to pay up because they used derivatives to try to manage their interest-rate risk.

“Local officials say they were not told, or did not understand, that interest rates could go much higher if economic conditions worsened — which, of course, they did,” requiring much higher payments, often immediately, just as tax revenues are sinking, the Times reports today.

Municipal distress triggered by derivatives were supposed to be a thing of the past.

Fifteen years ago, Orange County’s bankruptcy, the biggest in municipal history, shocked the bond world.

Orange County got in so much trouble because its investment manager, advised by Merrill Lynch, had used cheap financing to make irresponsible one-way bets on interest rates.

Such investments are far riskier than straight-up investments in stocks and bonds, in which you can only lose the money you paid for the initial investment. Said the Times about such exotic bets back then, “derivatives can result in losses that investors may never had imagined.”

Orange County wasn’t alone in 1994. The same year, Procter & Gamble and Gibson Greetings sued Bankers Trust over huge derivatives losses, claiming that they hadn’t understood the risks. Eventually, Merrill and Bankers Trust would pay hundreds of millions in fines, to the municipalities and companies they advised and to the Securities and Exchange Commission.

So why are we right back there?

After circa-1994 derivatives blow-ups, regulators and elected officials learned the wrong lesson. It was easy for politicians and regulators to blame individual misjudgment and misbehavior for unfortunate incidents, rather than see that bad behavior in the context of a slow regulatory breakdown.

When Bankers Trust and Merrill did bad things by selling bad derivatives to dumb people, it was thought, the banks needed one-off punishment as deterrence. The market, in general, didn’t need consistent securities regulations to protect customers and the banks in the future.

“Investigations of Orange County and, later Sumitomo and Barings — two other institutions caught up in derivatives messes — “turned up more signs of old-fashioned moral decrepitude and management negligence than of the need for green-eye-shade supervision, the Wall Street Journal editorialized in 1997.*

Just as important, it was thought that derivatives’ supposed victims — from the lax left-coast county to the greeting-card guys — were victims because of their lack of sophistication. It followed, then, that more sophisticated investors could handle the complex risks posed by complex derivatives just fine. “You don’t put an average pilot in an F-15 fighter,” Harvard prof Andrew Perold said at the time.

And who was more sophisticated than a big bank?

Few politicians or regulators stopped to wonder if a big, sophisticated bank — or a big insurance company like AIG — might blow itself up, someday with derivatives, rather than just blow up its customers.

So five separate bills to regulate derivatives like we regulate other securities reached Congress, but none was passed. “So far, so good,” Alan Greenspan told British bankers about the increasingly engorged derivatives market in 2002.

And by the time of the new millennium, banks and their customers seemed to think that they had worked out the kinks. Hedges would work. Counterparties, insurers, and other investment partners would always do what they were supposed to do. No reason to worry. Except …

Hedges don’t work just when you need them to — leaving only that open-ended bet.

Investing in a derivative, then, often means getting paid a modest amount a few years in exchange for giving someone else the right to hit you over the head with a baseball bat whenever he feels like it, usually just when you don’t want to be hit in the head with a baseball bat because you have the flu.

So. Now we have no (non-government-guaranteed) sophisticated banks.

But not only that, we have the same problem supposedly solved with punishment in 1994: cities and towns dabbling in things that can pose great risk at times of stress — just when you don’t want them to — and suffering for it.

Maybe this time, we’ll learn the right lesson: any big, unregulated financial market will eventually destroy itself — and a bunch of other stuff, too.

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