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Depression Solution Part 2: Derivatives and Financial Innovation

pic by Muddy Funkster@ Flickr creative commons

We looked at one depression solution last week: lower or suspend capital gains tax.

The common thinking about the recent economic collapse is that financial instruments, like derivatives and quantification formulas, were the reason for the collapse. This might be like blaming the fuel tank for running out of gas.

To solve our economic malaise, we need more financial innovation, not less.

Derivatives are powerful financial instruments. When used incorrectly, they can cause trouble. Certainly, dozens of hedge funds collapsed because of improper use of derivatives. Lehman Brothers is the poster child for the improper use of derivatives.

But human error doesn’t mean the instrument itself isn’t valuable or effective. It also doesn’t recognize the good that the derivative market does. They help businesses manage risk and maximize profits. They open up new markets. A long stretch of economic expansion was aided by derivatives.

With all due respect to Warren Buffett, if derivatives are tools of economic mass destruction, they are amazing tools of economic construction.

(It’s also important to note that Buffett uses derivatives all the time in his business. registration required for link.)

Quant traders are also blamed for a lot of the volatility. It’s probably true that computer trading did contribute to the mass sell-0ff. But where would science and technology be if there wasn’t some degree of experimentation and refinement? Experiment absolutely requires failure.

The solution to economic expansion isn’t less financial experimentation, it’s more.

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  1. July 6th, 2010 at 14:49 | #1

    I disagree wholeheartedly.

    The notional amount of derivatives volume vastly exceeds what is necessary for legitimate uses, such as commodities futures and position hedging. They are basically being used for gambling with catastrophic results. Even worse, are the new vehicles, such as synthetic CDOs and Credit Default Swaps, in which the issuer bets against their customer. The final attrocity is that these derivatives are largely unregulated and traded in secret.

    None of this is good for our country, our markets or the economy. In fact, I would say it is grossly irrersponsible how our government has allowed this and the finance idustry has abused it. And, it has cost taxpayers a trillion dollars in bailouts and millions of jobs.

    Our government should move immediately to reinstate the Glass-Steagall Act, limit derivatives to legitimate uses and require all trades to take place on regulated exchanges. Anything less is simply gambling with our economy, with taxpayers being the losers.

  2. July 7th, 2010 at 01:21 | #2

    Thanks for your reply Bret.
    I appreciate the alternative viewpoint.
    Wouldn’t it be difficult to separate bad derivatives from position hedging, though? Technically CDOs and swaps are used as position hedging.

  3. July 7th, 2010 at 19:31 | #3

    @matt
    Matt,

    You are right, that regulation is a slippery slope and it’s tough to enforce. But, completely unregulated derivitives trading has been a complete disaster, that put the world’s financial systems at risk.

    It’s tough to draw a clear line, but here is my opinion:

    1. By reinstating Glass-Steagall you would re-separate investment banks from commercial banks. This is a huge safeguard for depositors and it was gutted by Phil Graham and President Clinton, so Citibank could merge. The consequence is that banks can pretty much do whatever they want now. For example, investment banks reformulated into bank holding companies to just collect TARP money. This is a no-brainer to put an end to this.

    2. Limiting dervivatives to legitimate uses is harder to pin down. If you ask Goldman Sachs and the hedge funds, all the derivatives are necessary, but this is B.S. They just want unregulated profit potential and they have proven to be irresponsible. I am at the edge of my knowledge on this subject, but a couple of things are obvious. For starters, the purchasers should be required to have funds to cover their positions, unlike AIG. And, leverage should be limited to a reasonable multiple, unlike the Russian bonds purchased by LTCM. This is required of retail investors and it makes sense for investment banks and hedge funds as well. Finally, investments with unlimited loss potential, such as naked shorts, should be banned completely.

    3. Trading on regulated exchanges is another no-brainer. There is no good reason for all of these trades to be conducted in secret, except they wouldn’t pass the smell test. If they are above board and necessary, they can be conducted on a regulated exchange.

    I’m sorry for the long response, but it’s a complex subject.

    Bret

  4. July 8th, 2010 at 15:13 | #4

    I see what you’re saying and you bring up some good ideas that should be considered.
    But regulating a few organizations with one organization (the government) will likely lead to poor regulation and a chilling effect on finances. Money will probably move overseas and into other markets and schemes. Financial innovation will be stifled.
    I don’t have the link, but I did come across a stat of how many homes owned by good, paying owners were backed by swaps and similar derivative products that would have never sold without these risk-management tools. It’s probably safe to say I’m living in one.
    I’d be much more in favor of transparency and stricter punishments.

  5. July 8th, 2010 at 16:49 | #5

    Matt, you seem like a pretty sharp guy. But, I am going to have to respectfully disagree with you.

    The government has been norotiously defficient at regulatory enforcement and that is a problem for our markets. For example, the SEC investigated Bernie Madhoff four times based on five complaints and they never cracked his books open once. Fail! We’ll see if they have improved when the Goldman Sachs investigation happens.

    As for stiffling innovation and money moving oveseas, it’s a red-herring. I heard the same argument when they instituted Sarbanes-Oxley after the fall of Enron and it hasn’t affected market registrations one bit. It’s considerably more important to have markets with integrity in the U.S. than it is to retain entities with questionable business practices. I say, let them go register with Hong Kong or Singapore and screw up their markets. If we lose the ability to raise capital because people lose faith in our markets, our economy, our currency and all of our investments are toast. This isn’t something we can afford to screw up.

    I’m glad you got a house, but subprime ARMS (like in CDOs) represented 6% of loans but 39% of foreclosures. CDOs were a disaster for America and the entire world. First, they overinflated real estate prices, by flooding the market with non-conforming loans. Then, they caused the Financial Crisis of 2008 by seizing up the credit markets. That’s why they were called “toxic assets”. CDOs aren’t a risk-management tool. They were a shell-game con to unload AAA rated garbage onto unsuspecting investors. They cost American taxpayers a trillion dollar bail out and deflated our stock markets by 40%.

    I’m not against derivitives. I am against the irresponsible use of derivitives. I’m not a big fan of regulation. But, regulation is very necessary at this point. Otherwise, we will be doing this all over again during the next economic cycle.

  6. July 9th, 2010 at 04:25 | #6

    Hi Bret–
    I think we’re in agreement. “The government has been notoriously deficient in regulatory enforcement.”
    I just read in RealClearMarkets that part of the new financial regulations includes gender and racial quotas… This is what regulation looks like.
    Also: “I’m not against derivatives. I am against the irresponsible use of derivatives.” Exactly how I feel. Derivatives had nothing to do with a former associate who bought a home for $350,000 and thought he could sell it for $700 grand the following year. That’s plain old human idiocy.
    I just believe that you learn from your failures and create better financial innovations and smarter safeguards. I’m not sure we need a bunch of bureaucrats dictating that.
    I’m with you: we need smart regulation. But we have a stupid government.

  7. July 9th, 2010 at 09:08 | #7

    @matt
    “… we need smart regulation. But we have a stupid government.”

    Well said Matt.

    I have been following financial regulation on my blog for years and it is very frustrating. The biggest problem, besides the inneptitude of our bureacrats, is that special insterest sneak in a bunch of weasel clauses to water down enforcement. That’s why the CARD Act and Overdraft Reform only addressed half of the problems. And, there will be a continuous effort to undermine them, now that they have become law.

    One more point I want to make and then we can give it a rest. None of this regulation would be necessary if financial institutions acted responsibly and with integrity. They could make a ton of money with standard banking opportunities. Instead, they are acting like the robber-barrons of the 1800s. Between the dirty credit card tricks, overdraft scams and all of the derivitives gambling, they are out of control. And, they have to be reeled back in for the security of our nation.

  8. July 9th, 2010 at 11:21 | #8

    Well said.
    Greed is actually limited thinking.
    I appreciate your insights and I think I learned a lot.

  1. July 20th, 2010 at 16:23 | #1