Financial Regulation

Time To Hate On Derivatives?

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David Frum thinks there ought to be less opposition to derivatives regulation. The real problem with financial regulation, he argues, is the creation of the Consumer Financial Protection Agency. As Reason's Katherine Mangu-Ward has frequently noted, there's plenty to dislike about the CFPA. But do derivatives—financial products in which the value is pegged to another variable—make a good bad guy? I'm not so sure.

Not so much like this.

Derivatives are often described as bets, and that's not inaccurate. But without context, that terminology can give the impression that using derivatives is the Wall Street equivalent of a drunken Las Vegas dice game. But in many instances, the truth looks a lot less like playing a wild casino game and lot more like adjusting cells inside a spreadsheet.

The first thing to remember is that, despite derivatives' reputation for causing chaos, they have, for decades (at least), helped a variety of basic, boring businesses—from farming to airlines—safely manage their risk. Here's a simple example from the Congressional Research Service:

A firm can protect itself against increases in the price of a commodity that it uses in production by entering into a derivative contract that will gain value if the price of the commodity rises. A notable instance of this type of hedging strategy was Southwest Airlines' derivatives position that allowed it to buy jet fuel at a low fixed price in 2008 when energy prices reached record highs. When used to hedge risk, derivatives can protect businesses (and sometimes their customers as well) from unfavorable price shocks.

The benefits of this kind of risk management, which allows businesses to lock in prices for crucial resources in volatile markets, are widely recognized, even by derivatives scaremongers. Warren Buffett, for example, has referred to derivatives as "financial weapons of mass destruction," but he is invested in them to the tune of about $63 billion through Berkshire Hathaway. (Which explains why he called for a regulatory exemption on the derivatives he already owns.)

More like this.

More broadly, derivatives can be used to speed up the identification large-scale risk—and perhaps even the "systemic risk" that's been the subject of so much recent debate. This is when they start looking a little more like bets. One type of derivative known as a credit default swap is essentially an informed wager that a firm or investment will default on its obligations. The side benefit here is that, because informed individuals are putting money on their guesses, they can serve as prediction markets.

And those predictions could be used to ring warning bells about the state of the financial system. In the most recent issue of National Affairs, Harvard's Oliver Hart and the University of Chicago's Luigi Zingales proposed using CDS prices as early warning signals to let us know when big financial firms may be nearing failure.

If one had to predict in August 2007 the five institutions that would go under first on the basis of their CDS rates, one would be correct in four out of five cases. By the end of 2007, the data showed a decisive worsening of the situations of the investment banks and Washington Mutual. In late December, the market put the probability of Washington Mutual's defaulting within a year at 10%. By March 2008, that estimate had risen to 30%—and yet the regulator waited until September 25 to take over the bank.

Derivatives can be quite complex, but it's easy to see how they can serve as checks on the market. As Gordon Crovitz wrote yesterday, "Reducing the opportunity for traders to take advantage of better information means slowing the pace at which better information enters the market." Derivatives, in other words, give us more information, and thus hasten price discovery. There are certainly risks involved in using them, but, in general, the more restrictions we place on their use, the less we're likely to know about what's actually going on in the market.

In 2004, Gene Callahan and Greg Kaza wrote in defense of derivatives.

NEXT: GM's Phony Bailout Payback

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  1. In the second picture, look where the dude’s right hand is. He totally fell asleep while ‘batin’, didn’t he.

    1. You obviously know nothing about a modern office environment. If you are going to sleep at your desk, you have to protect your junk. It’s just common sense.

      1. To quote the immortal Episiarch:
        “If you don’t like getting kicked in the balls, you can just move somewhere where they don’t kick people in the balls.”

    2. So he works at the SEC?

  2. The problem with many of the derivative contracts that cratered Lehman and are still poisoning the balance sheets of many firms is that they are one-off, specifically-enforcable contracts. They are not comparable one to another; not fungible; in a word (well, two), not exchange-traded.

    This means that their value as pricing signals is severely compromised. And their ability to fuck up the financial system is magnified.

    I think. I’m hoping domo is around today to give us his take, since he knows more about high finance than the rest of us rolled into a ball.

    1. The other problem with these exotic OTC derivatives is the significant exposure to counter-party risk that you’re left with. A bets that B and C won’t go bankrupt, and then B bets with A that C won’t go bankrupt, and then C bets with D that A and B won’t go bankrupt, and then D bets with A that B won’t go bankrupt, &c. As long as the system is intact, everything’s kosher. However, once someone goes bust and those bets are reliant on capital from one of the busted guys, it spreads like wildfire. Add in the fact that they’re non-standard, so these derivatives sitting on the balance sheet can’t be easily liquidated and you have a shit storm on your hands, especially when these things are levered 30x.

      Without the leverage, it’s a few bad bets with a short hangover, akin to the tech bubble. Add in significant leverage and you get systemic problems.

      The first thing to remember is that, despite derivatives’ reputation for causing chaos, they have, for decades (at least), helped a variety of basic, boring businesses?from farming to airlines?safely manage their risk.

      By lauding those sorts of derivatives, you basically support Frum’s POV. Those derivatives are mostly exchange traded derivatives (ETD) that are exchanged in places like the CME. The advantage of these derivatives is that the counter-party risk is largely eliminated because there are standard terms and they are netted out at a central location. One goal of the bill is to make the more exotic derivatives exchange traded and provide greater visibility in them akin to the TRACE system implemented for the bond market.

      This reform could be made a lot simpler and more effective with just the derivatives exchange portion and limitations on hyper-leverage.

  3. Hedging against risk with derivatives is a good thing. But derivatives can be extraordinarily complex, and they–as R C Dean notes–can be surprisingly different and difficult to bundle into generally tradable commodities.

    Failure to properly hedge against interest-rate risk was one of the major problems that analysts report WaMu had.

  4. There is broad support for a centralized derivatives clearing house for products that are currently traded OTC.

    I have a friend who’s worked on a matching engine for CDOs. It is possible to create a much more transparent marketplace than what exists now. It’s the opacity of the current marketplace that continues to put the fright into Wall Streeters and regulators alike.

    If Dodd’s bill was focused on this, it would attract broad bi-partisan support. But Dodd’s bill is your typical mish-mash of good intentions larded with special interest crap. It’s a disaster and should be put down.

  5. I don’t hate derivatives, or any gambling by wall street. I hate the idea that the taxpayer covers their losses. That’s something that the current president and congress just doesn’t seem to understand.

    1. Nor the last President and Congress

  6. Off topic:
    I just got an e-mail from the Democratic Senate Campaign Committee leading with this:

    Rand Paul “holds an unacceptable view of civil rights, saying that ? private business people should be able to decide whether they want to serve black people, or gays, or any other minority group.” -Louisville Courier Journal

    Dear (CITIZEN NOTHING),

    Kentucky’s Rand Paul thinks businesses shouldn’t have to serve African Americans. Arizona’s J.D. Hayworth thinks his state’s new “birther bill” – designed to question President Obama’s legitimacy – doesn’t go far enough. At least five other Republican Senate candidates are unwilling to recognize that President Obama is an American citizen…

    1. As bad as the CJ comment was, ellipsing it even made it worse.

      BTW, that comment was made as part of their endorsement in the Senate primary – they are endorsing neither Republican. Apparently, Paul’s views on civil rights arent bad enough for them to support Grayson.

    2. He may not been born in the US, he born in Kenya. He also is Muslim, which means he ca’nt be president.

      1. He also is Muslim, which means he ca’nt be president.

        I missed the part of the Constitution where it says Muslims can’t be president.

        1. He not born in US. Constitution says US born only to be president.

          1. Then why have “which means he ca’nt be president” as the dependent clause to “He also is Muslim”. It’s not my fault you don’t understand basic sentence structure.

            1. He not born here so ca’nt be president.

            2. I think by this time it’s obvious we’re feeding a troll.

          2. best sockpuppet ever!

            1. I think Bob is the lion in Pearls Before Swine.

  7. Did you know Rand Paul believes that private businesses should be able to decide if they want to serve Christians, whites and straight people?
    Wake up, America!

  8. Presumbably he also believes that private businessmen should be free to not serve heterosexuals, whites, men, sports fans, beer drinkers, non-union members, and right wing radio listeners.

    1. They shouldn’t have to, those are not protected groups that get special rights. They are part of the patriarchy and need to pay back their debt to womyn.

    2. I should have the right not to serve anyone I don’t want. I am not a slave.

      1. You’re gonna have to serve somebody.

  9. Arizona’s J.D. Hayworth thinks his state’s new “birther bill” – designed to question President Obama’s legitimacy – doesn’t go far enough.

    The bill is actually shockingly reasonable – Arizona wants to require that all candidates for President demonstrate that they meet the rather minimal Constitutional requirements for the office before they are put on Arizona’s ballot.

    Its like requiring photo ID for voting – so reasonable that you have to wonder what the opposition is afraid of.

    1. Oboma not born hear, so ca’nt be president, that is they afraid of.

  10. Again, I’m flummoxed–FLUMMOXED!–to see it suggested that other people’s behavior needs to be justified as being in the best interests of society generally…especially if it’s coming from libertarians.

    …and especially considering other legislation that’s now on the table.

    “The real problem with financial regulation, he argues, is the creation of the Consumer Financial Protection Agency.”

    The only reason anyone would call the CFPA problem “real” and the other not is because CFPA would effect more people directly.

    …again, we’re trying to justify this in terms of whether other people’s sacrifices are good for society generally, and that leads to all manner of evil.

    Exhibit A for manner of evil being a misdirection of responsibility…

    Ultimately, the reason Barak Obama and Congress squandered $350 billion of our future earnings to bail out Wall Street investors wasn’t because of any derivatives contract…

    It was because Barak Obama and Congress decided to squander $350 billion of our future earnings to bail out Wall Street investors.

    Talk about dodging responsibility for the decisions he made! What is Barak Obama doing to make sure he never squanders our hard earned future paychecks again? Anything?

    …because squashing derivatives activity has nothing to do with the decisions Barak Obama made–that’s a character flaw of Barak Obama’s, and no further Wall Street regulation can ever fix that.

  11. watching the goldman hearings…Claire McCaskill understands nothing about finance or markets. But let’s have people like her regulate finance by all means.

    1. Boy, that’s just racist. Why don’t you join the Klan. Knowledge, facts, reasoning ability, understanding – all racist code words.

  12. The free market way of regulating markets is to eliminate all government transfers of liability and let those who control the assets and make the decisions responsible for the results of those decisions.

    If you buy too much house and can’t afford it then you lose

    If you buy too much derivatives and bet wrong then you lose.

    Buying either too much house or too much derivatives and not being able to pay is thievery and fraud and off to jail you go.

    Once people start losing their money and freedom for thievery and fraud then much of the problem will end. There will always be some who don’t learn the lesson but that is what prison is for

    1. They got rid of debtors prisons some time ago.

      1. Obviously a mistake since the debtors are now using the government to take my money to pay their debts.

  13. Derivitives are used by the evil corporations to steal mone from poor people.

      1. We can’t even afford the “e” in money — or in “womyn.”

  14. …the “y” in mone — or the e in “womyn.”
    Damn it!

  15. If Sugarfree and Episiarch want to wager on whether Steve Smith will rape the redhead or the blonde (or the golden retriever) first. I have no problem with that. If Epi bets a “million, trillion” dollars, and loses, and Sugarfree wants to cut off his ears as payment, I have no problem with that.

    If Sugarfree comes to collect the money from me, I have a problem.

    1. “It’s not like I have a bucket of women’s ears back at my flat.”

  16. The term “derivative” is too broad.

    Futures contracts have existed for some time. They are traded on organized exchanges. I don’t think they were closely related to crisis.

    Credit default swaps are one type of derivative that perhaps was involved in the recent financial crisis.

    My view is that the relationship works like this. AIG wrote lots of credit default swaps to Goldman Sach’s. Goldman Sach’s bought them because they were expected a mass default and knew perfectly well that AIG couldn’t pay off. However, they had good friends at the Fed and the Treasury. So, they paint scary pictures of the consequences of AIG not paying off this unregulated uncontrolled thing with 60 trillion in notional value. And so, the Fed and Treasury lends (gives) money to AIG. AIG can pay off as promised to Goldman Sachs. And Goldman Sachs has avoided losses on all the bad mortgage backed securities they held.

    This was big money. And so the stories aimed at getting money to Goldman Sachs turn into the credit default swaps were the source of the problem.

    Really, the source of the problem was people lending into a speculative bubble in housing. They didn’t need credit default swaps to do it. And all the credit default swaps do is shift the losses.

  17. I always preferred integrals.

  18. There are a few regulations on derivatives that I think make sense, like requirements they be exchange traded. It seems to me that the main problem wasn’t the derivatives themselves, but the fact large players were able to hide various conflicts of interest due to the fact no one could tell how many derivatives existed and who was buying them.

  19. As stated above the problem is that things like the mortgage CDO’s are traded OTC. How can these instruments signal the market when it’s all done in secret? No one knows what anyone elses position is. Plus you have the collusion of the rating agencies giving this crap triple A ratings. Then you have institutions selling swaps who do not adhere to any of the requirements to sell insurance. The credit default swap market is estimated to be 600 trillion dollars worldwide. That’s a hundred times the world GDP. It’s a disaster waiting to happen.

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