Thursday, June 24, 2010

Derivatives

FLG largely agrees with the NYTimes editorial on derivatives regulation. He can't really disagree with this part:
The largely unregulated, multitrillion-dollar market in derivatives fed the bubble, intensified the bust and led to the bailouts. Unreformed, it will do so again.

And the recommended solution is reasonable in FLG's eyes as well:
The final bill must ensure that derivatives are traded on transparent exchanges and processed through third-party clearinghouses to guarantee payment in case of default.

The problem FLG has with the NYTimes' analysis is this -- they're looking at derivatives as super complicated instruments that 1) allow banks to make huge profits by pulling stuff over on customers or making risky bets and 2) largely divorced from the real economy.
That would end the opacity that masks the size and risk of derivatives deals, like those that caused the bailout of the American International Group.

For FLG, the issue, and he's said this over and over again, is leverage. Pure and simple. The unregulated, opaque market allowed companies to overleverage. That's where the systematic risk is. The whole "it's a complicated casino with no real benefit to the economy" stuff that so many people seem to believe leads them into the wrong direction.

This is where FLG gets concerned, and also where he thinks viewing derivatives as a casino misleads many people:
Finally, lawmakers must find a way to separate banks’ derivatives dealing from federally insured deposits. Ideally, that would involve spinning off derivatives businesses into separate entities. A lite version of reform would involve setting up a separate derivatives affiliate within the bank holding company. What is crucial is that derivatives operations are supported by adequate capital of their own, and that there are no loopholes allowing federally backed banks to keep dealing in derivatives.

The problem is, for the gazillionth time, leverage. The exchange/clearinghouse solution makes the leverage rather explicit. Moreover, the Times is okay with the exception to allow "commercial businesses [to] use [derivatives] to hedge legitimate risks." The big question for FLG is whether commercial banks could use derivatives to hedge legitimate risks? His guess is that the Times would call that a "loophole." Also, who is defining legitimate?

The point of all this is that systematic financial risk comes from leverage. Derivatives aren't risky; overleverage is. We can regulate the amount of leverage that banks take on without getting into rules banning banks dealing in derivatives. Broad-based capital requirements at the firm level and collateral requirements on the exchanges inhibit leverage. It makes much more sense to simply deal with leverage than to have somebody making value judgments about what is and is not legitimate.

FLG's sense is, however, that the NYTimes and other people of the Left don't simply want to prevent another crisis, but also, in fact, do want to make value judgments about and have some control over financial transactions and how capital is allocated. Indeed, there is a long history on the Left of viewing the financial economy as morally inferior to the real economy. But FLG thinks he's mentioned all this before.

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