Melamine on Wall Street

There are some odd parallels between America's financial crisis and the tainted milk scandal in China. In each case greed, combined with a lack of proper governance, caused the crisis. In each case there were laws, bank oversight and credit evaluation standards, or food purity regulations, that should have prevented the crises.

A Chinese milk farmer who was arrested for adding melamine said he knew the chemical is not human food, and his family doesn't drink his adulterated milk. However he had no idea of the actual consequences, and never thought about it. For him, adding melamine was another investment risk necessary for doing business. The vaguer knowledge of the consequences, the fewer qualms he felt. But the ignorance did not prevent him from being arrested. To him the whole concept of his actions causing kidney failure in infants was as baffling as, say, a mortgage backed derivative.

One would think Harvard educated Robert Rubin, Treasury Secretary for Clinton administration and economic advisor for Obama's Transition, would know a lot more than an uneducated Chinese farmer. Yet it was this Robert Rubin who saw no red flags as he led Citigroup to make bold bets, who pushed for a more aggressive approach toward risk-taking that eventually resulted in Citi's demise.

I can see how those traders on the financial front lines selling mortgage backed derivatives and inflating credit ratings probably did not understand exactly what they were doing. They may have known something was wrong. They may also have shied away from their own creations when building their personal portfolios. But they did not see the consequences. They were just taking necessary risks to further business goals.

But for an economic expert like Robert Rubin? Either he, like the farmer, was blinded by greed, or the financial system he believes in has something inherently wrong. Or both.

The financial crisis has upset Americans for many of the same reasons the tainted milk upset the Chinese. The difference is, while what the Chinese milk farmer did was illegal, what the traders and companies in the US did is legal, and a lack of understanding actually prevents the guilty from being arrested.

What the poor Chinese farmer did was to make one gallon of milk look like two gallons and still pass the nutrition test. Buying melamine was cheaper than producing real milk. He had discovered his way to wealth through leverage. Had he lived in the US, he needn't bother with melamine, because he could get a lot bigger leverage LEGALLY.

Leverage, of course, is fabulously effective way to make amazing amounts of money. Homes could be bought with no money down, stocks bought with the slimmest of margins, and derivatives could be created without constraints from their underlying basis. Who would have thought it was leading to the credit collapse and market meltdown?

True, without the leverage a lot less "wealth" might have been generated. House prices would never have gone as high. The stock market would not have seen the gains it had. But what do the high-leverage derivatives do, really? Do the fortunes thus created actually create goods and services? Do they stimulate healthy productivity growth, or simply feed the greed and increase market volatility? Do we get more milk, or just milk that tastes different and make us sick?

The tainted derivatives are the melamine on the market. Yet Americans aren't shying away from them. Instead they are treated as an advantage of the financial system. As a Chinese saying goes, "The biting dog does not bark." The unseen poisons of derivatives are more damaging than melamine.

Worse yet, now the concept of derivatives is likely to be imported into China's financial market. Some insiders are hoping China will begin to trade derivatives next year. That is, China's financial system is poised to follow in America's steps.

I remember in 2000, before the tech bubble burst, one day at a Chinese neighbor's party I heard the host explaining the concept of derivative trading to a man visiting from China. The visitor, who had never heard such a concept before, was in awe and became visibly excited, arms dancing and eyes shining, in the hope one day China would also be trading such "advanced" novelties. Well, his dream may soon be realized. When that happens, Chinese people will not be so lucky to escape the damage the way Americans skipped melamine tainted Chinese milk. I just hope the stewardship of China's financial system falls to someone wiser than Robert Rubin and such a calamity can be avoided. It's not too late to stop introducing derivatives trading into China's financial market.

One final note: apparently, milk tainted with melamine is causing a new problem in China. There is too much of it; the cost of disposing is too high; dumping it into rivers increases toxicity. Now a food safety official in Canton has found a solution: burning the bad milk to make nice bricks.

With tainted derivatives, however, there will be no such clever way to "turn a bad thing into good." The only thing they will be burning is money. Tax payers' money.

(image from ChinaDaily.com)