The same types of derivatives that caused the Great Recession could sink our financial system again. By Steven Goldberg, Contributing Columnist November 16, 2011 Just three years after the worst financial crisis since the 1930s drove us to the brink of another Great Depression, the Wall Street bankers who caused the catastrophe again threaten the global economy. What's more, they're doing it by making almost the exact same mistakes that triggered the earlier meltdown. SEE ALSO: Our Special Report on Investing in Volatile Markets This time, instead of gross negligence with securities and derivatives based on rotten U.S. mortgages, the big bankers have tied us to shaky debt and derivatives in Europe. Specifically, it’s the financial web that surrounds Portugal, Ireland, Italy, Greece and Spain. The PIIGS are at the center of a toxic mix of bonds and of credit default swaps -- derivatives that are supposed to protect bondholders from default. These supposedly brilliant bankers don’t seem to remember that credit default swaps were at the heart of the 2008 financial catastrophe. The problem: When many of the mortgage securities soured, the banks and insurance companies that had sold the credit default swaps couldn’t afford to pay them off and collapsed. Advertisement Now consider that European banks are, if anything, less well regulated than U.S. banks. So no one knows how much in PIIGS bonds each of the European banks holds. Nor do we know how much these banks hold in credit default swaps, or how much of these swaps they have issued to other banks, in Europe and the U.S. So bankers are afraid to lend one another money, even overnight. Liquidity, the ability to buy and sell bonds without driving their prices violently up or down, is as bad as it has ever been except for the worst weeks of the 2008 crisis, says Dan Fuss, co-manager of Loomis Sayles Bond fund (symbol LSBRX) and a man with more than 50 years of experience in the bond investing business. Unfortunately, bankers are scared for good reason. Buried in the footnotes of their third-quarter earnings reports, U.S. banks revealed how much they own in derivatives, such as credit default swaps. The numbers: Bank of America (BAC), $2.17 trillion; Citigroup (C), $1.1 trillion; and JP Morgan Chase (JPM), $2.04 trillion. The total from just these three banks equals about one-third of U.S. gross domestic product! These are gross numbers, the bankers correctly note. In other words, this is what the banks would be on the hook for if every conceivable thing went wrong. And most of these obligations are hedged with other securities or other derivatives. But what happens if we have a rerun of 2008, and some of the banks can’t make good on their obligations to other banks? They could fall like dominos. Advertisement The collapse of a big European bank is the nightmare scenario. It’s not clear that some of the European governments would or could come up with the cash to bail out their biggest banks. And the whole global banking system is inextricably linked through a bigger web of credit default swaps and other derivatives. If one bank fails, the whole web could unravel. What’s the solution? To start with, break the big banks up into much smaller banks. This was persuasively argued by Simon Johnson, former chief economist of the International Monetary Fund, in his 2010 book, 13 Bankers: The Wall Street Takeover and the Next Financial Meltdown. Smaller banks means any bank could fail without threatening the entire financial system. Next, bring back the Glass-Steagall Act. This Depression-era law separated commercial banking (banks that take deposits and make loans) from investment banking (banks that provide assistance and financing to companies in going public and mergers and acquisitions.) It was repealed in 1999 in the misguided belief that big banks could safely mix those businesses. Depending on how the rules are written and enforced, the Dodd-Frank financial reform law may accomplish some of these things -- but not nearly enough, thanks to the lobbying efforts of the banks and their friends in Congress. Fortunately, we can count on Dodd-Frank to make it harder for banks to trade for their own accounts -- that is, make big wagers with bank money. And, thankfully, it will raise the amount of capital that banks have to hold on their balance sheets so they can cover losses when their gambles go awry. Advertisement The big banks need still more regulation -- which they fight at every turn. Unfortunately, it doesn’t look like they’ll get the regulation needed to protect us from their recklessness. To start with, the banks need more transparency, lower leverage limits and restrictions against buying and selling derivatives, such as credit default swaps. Alas, there is zero evidence that these bankers learn anything from their mistakes. Steven T. Goldberg (bio) is an investment adviser in the Washington, D.C. area.