Go easy on the Wall Street whiz kids
Thursday, February 12, 2009 at 2:36AM FEATURE: "The Case for Derivatives: Economist Robert Shiller believes they could help solve the crisis," by Zachary Karabell, Newsweek, 2 February 2009.
The bonus thing is driving Washington and the populace rather nutty, and it should. Bubble earnings through the first three quarters were effectively erased by the disastrous fourth quarter, so yeah, you eat what you kill but you suffer the outcomes your tribe as a whole delivered.
But I remain totally serious in Great Powers when I say, "thank God for those whiz kids on Wall Street." Developing ever more complex and sophisticated risk instruments is a very good thing for this massive entity we call the global economy, and if America isn't taking that lead, who will?
Do we make mistakes along the way? Geez, that's the entire history of finance in America--finding new ways to create bubbles amid real booms by working around the rules already in place. You want advance? Then live with experimentation.
So right now there's a lot of toss-the-baby-out-with-the-bathwater thinking regarding derivatives, but that's a mistake, says Mr. Irrational Exuberance himself, Robert Shiller (Yale economist):
Derivatives, says Shiller, are merely a risk-management tool the same way insurance is. "You pay a premium and if an event happens, you get a payment." That tool can be used well or, as happened recently, used badly. Shiller warns that banishing the tool gets us nowhere. Instead, he envisions a world where derivatives become as common as cash.
What separates Shiller from the majority of economists is his lack of faith in the "efficient-market hypothesis," That belief, which also guides the hand of most money managers, holds that the market will price assets according to their fundamental value and that those prices reflect all pertinent information. Shiller instead follows those, like John Kenneth Galbraith, who hold that market prices reflect "animal spirits" and popular passions, not perfect information. That is why bubbles form, and that, for Shiller, is why financial innovation, and not just government regulation, is imperative.
Smart stuff.
To me, innovations don't go away. They just get better regulated. Investment banks are a good example: we lose all the biggies in the crash but that doesn't equal the end of investment banking--just those behemoths. Already you see all sorts of smart money articles about the coming rise of "boutique investment houses."
In many ways, what Enterra's doing in Kurdish Iraq is acting like an investment bank--a very specific version of a boutique firm. You look at globalization's continued advance into new regions, and you have to come to the conclusion that this function is now needed more than ever, no matter what the Wall Street Five did to end their own historic run there.
Reader Comments (8)
The key quote within the key quote: "Derivatives, says Shiller, are merely a risk-management tool the same way insurance is." Insurance, however, is highly regulated, and one of the key regulations prevents speculation: you cannot insure something (life, house, car, etc.) for multiples of it's worth.
Derivatives, of course, were very purposely utilized precisely for speculation. Call it a "CDO" instead of "Mortgage Insurance," evade regulation, and place your bet to the tune of many, many multiples of the value of underlying the mortgages. Thus a (comparatively) low mortgage default rate has been sufficient to virtually wreck the entire financial system, and possibly the global economy as a whole.
Instead of outlawing derivatives, could we please outlaw deregulation?
^ I don’t necessarily agree with your prognosis, but most of what you said is accurate. Except that, in general, CDOs have nothing to do with derivatives or value multipliers. CDOs are simply managed pools of collateralized debt, tranched and sold to various investors. I suppose that a CDO pool could contain derivatives, but I’ve never seen one that does.
NOTABLE QUOTES FROM ADAM SMITH
ON INVESTMENT RISK
"The ordinary rate of profit rises more or less with risk. It does not, however, seem to rise in proportion to it, or so to compensate it completely. Bankruptcies are more frequent in the most hazardous trades ... The presumptuous hope of success seems to act here as upon all occasions, and to entice so many adventurers into these hazardous trades, that their competition reduces the profit below what is sufficient to compensate for the risk.
ON BUSINESSMEN AND MERCHANTS
This group has a different interest than the general interest of society. Those who constantly employ capital are smarter than country gentlemen (legislators). Their candor is rare, and always biased. Their advantage is understanding their own interests better than other groups ... (They) delude country gentlemen that ... (their) interest is the public interest."
We had a system where the people who reaped the rewards were isolated from the risks that they took. That kind of system with Heads they win and become rich as George Soros, Tails we (the rubes, you know, you and me) lose and get stuck with trillions of dollars of destroyed wealth, a damaged economy and years to recover is an inherently flawed rule set.
My modest proposal would be to improve the connection between risks and rewards by coordinating our financial system more closely with China. Financial whiz kids who committed the fraud of convincing others that CDS was insurance should be extradited to China where they will be tried for fraud, convicted, shot in the head, their internal organs auctioned off for transplants and a bill for the bullet sent to their relatives.
And, as we have seen, circumstances (or bubbles) sometimes catch us in the 'tween!