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Being skeptical of financial innovation: The derivatives case study

derivativesotcchart.png

Ryan Avent wants more skepticism of the merits of financial innovation, and I'm happy to oblige. Lately, when I think about this, I think about over-the-counter derivatives. They're the customizable, opaque suckers that juice bank profits and confuse regulators and created the situation where everyone owed tons of money to everyone else, but few knew who owed what to whom, or who could pay what they owed, and so the market panicked.

And yet with clockwork regularity, there are op-eds defending this state of affairs. In today's Wall Street Journal, for instance, Mark Brickrell argues that if companies have to set aside the money needed to pay off their derivative bets, then that will mean they "set aside billions of dollars that would no longer be available, as 3M testified last year, to build more factories or create new jobs." Similarly, if I have to set aside enough money to pay my rent each month, I will have less money to purchase consumer goods that will stimulate my local economy! But I still have to do it.

My real skepticism, however, comes from the graph above. These derivative products barely exist in the 1990s. They become bigger in the early-Aughts. Then they explode after the 2005 Bankruptcy Bill gives them favorable treatment in bankruptcy proceedings. So we've got a pretty good natural experiment here: Has the post-2005 economy been much better and more stable than the pre-2005 economy? Or has the Aughts economy vastly outpaced the '90s economy?

Of course not. And nor have there been massive technological or sectoral changes that make these economies so different that entirely new financial instruments are needed to survive them. Instead, it seems pretty clear that banks developed a new product that increased their profits, government was lobbied to give it favorable treatment, and then it took off like gangbusters.

Now people are trying to justify the product's importance to the economy. But there's little evidence of its importance to the economy, as opposed to its importance to bank profits and certain schemes to make balance sheets look better and certain efforts for corporations to hedge slightly more risk in a slightly more elegant way than they could've otherwise. And given the dangers of customizable derivatives, it's hard to say those marginal benefits outweigh the dangers of this opaque market. Innovation is great and all, but as entrepreneurs know, new ideas have a pretty high failure rate.

By Ezra Klein  |  May 14, 2010; 10:32 AM ET
Categories:  Financial Regulation  
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Comments

"set aside billions of dollars that would no longer be available, as 3M testified last year, to build more factories or create new jobs."

And what happens with those new factories and new jobs when the derivatives markets crash? And drag down everything with them?

We've got 10% unemployment. The job creation potential of derivatives is not a good defense. It's a spectacularly tone-deaf defense.

"But there's little evidence of its importance to the economy,"

There's also little evidence that opacity in "financial innovation" is a good thing. The derivatives were attractive not so much for what they were intrinsically, but because of their opacity. Just demanding and derivatives be traded on open exchanges with full disclosure makes them much less attractive, because then they can't be used to hide losses, hide risks, and snow investors.

Posted by: Kevin_Willis | May 14, 2010 11:17 AM | Report abuse

Its nothing but a computer driven casino where the govt backs all of the gambling (speculation). If congress can't or won't regulate the derivatives market, make it transparent, eliminate OTC trading of derivatives by creating a public exchange, we are doomed for more massive bailouts that simply enrich the obscenely wealthy at the expense of seniors (medicare and social security) children (education cuts), and the general economy (just look around). Someow we had financial markets before widespread derivatives trading was introduced. We need to drastically rein in the financial sector or the general economy will suffer. Derivatives taxes (esp on naked or synthetic derivatives trades) now!

Posted by: srw3 | May 14, 2010 11:21 AM | Report abuse

So, when a large group of end users with disparate interests (America’s Natural Gas Alliance, American Exploration and Production Council, American Gas
Association, American Public Gas Association, American Public Power Association, Edison
Electric Institute, Electric Power Supply Association, Independent Petroleum Association of
America, Interstate Natural Gas Supply Association, Large Public Power Council, National Rural
Electric Cooperative Association, Natural Gas Supply Association, and U.S. Oil & Gas
Association) jointly write a letter stating that "we oppose mandates
that all derivatives transactions be centrally cleared or executed on exchanges," you would answer them with a graph showing excessive growth in the total volume of derivatives? Why, that's very wonky of you! Of course, they have no idea what their real interests are. It's good of you to set them straight.

Posted by: ostap666 | May 14, 2010 12:03 PM | Report abuse

What I want to know about derivatives and financial innovation is this: Do these derivatives create massive profits because they
A) Create wealth
B) Siphon wealth out of other sectors of the economy, or
C) Create the illusory wealth, which can be traded around the economy in exchange for actual wealth until the illusion breaks, leaving the people who trade real wealth for fake wealth holding the bag.

There's probably some of each, but I fear that it's mostly C, and I would love to hear somebody with real knowledge about the situation explain. Certainly in the case of selling mortgages to people who can't really pay, what you have is a systematic manufacture of imaginary wealth, but the mortgages themselves weren't derivatives. Did the credit default swap market create even more fake wealth on top of the bad mortgage fake wealth?

Posted by: GalenHBrown | May 14, 2010 12:30 PM | Report abuse

@Galen,

probably visionbrkr can explain this better, but here's how I see it.

A) They don't really create wealth, given that they exist to hedge risk. So basically they allow the risk of certain activities (say, mortgage lending) to be passed on to those investors willing to take it. But they also allow farmers to lock in known prices so they can plan which crops to grow, and for General Mills to lock in known prices so the price of Cheerios doesn't bounce around every week.

B) Plenty of this, which I'll elaborate.

C) Plenty of this also. Between Wall Street, Fannie, and Freddie, the packaging of these derivatives reduces the cost of mortgages to the buyers. More & bigger houses sold, more refi's (more fees!), more lines of credit to buy big screen TVs. Can that create wealth? Maybe. Can it make us feel more wealthy? Yep.

Item B) applies especially to the OTC derivatives. Corn futures trade on the CME Group (and several smaller exchanges), so everyone who is interested knows what the legitimate price is. The CDS and CDO markets made by Wall Street have very opaque value. Nobody really knows what they are worth. This is one reason that the bank collapse took so long after the forclosure boom started. Basically the price of the private CDO changes when the holder (ie, the banks in Sep 08) admits to it.

Recently, the CEO of Morgan Stanley (I think, though it could have been JP Morgan) said bringing derivatives into the open would cost his firm $2 Billion per year in profits. This tells us a few things:
A) Private derivatives markets mean opaque pricing, which means:
B) The bank making the market gets to essentially set the price, which means:
C) The bank charges the buyer more and pays the seller less than would happen on the open market, allowing:
D) Morgan Stanley to bilk $2 Billion annually from its customers.

Posted by: J-NC | May 14, 2010 2:21 PM | Report abuse

"Item B) applies especially to the OTC derivatives. Corn futures trade on the CME Group (and several smaller exchanges), so everyone who is interested knows what the legitimate price is. The CDS and CDO markets made by Wall Street have very opaque value. Nobody really knows what they are worth. This is one reason that the bank collapse took so long after the forclosure boom started. Basically the price of the private CDO changes when the holder (ie, the banks in Sep 08) admits to it."

Yes! I actually understand this now! I think.

Posted by: slag | May 14, 2010 4:40 PM | Report abuse

I don't get it. How can the derivatives market be 700 TRILLION dollars. There isn't that much money in the world. If the US GDP is about 15 trillion, does that mean the financial companies making the derivatives are leverages at about 47 to 1? Seems risky.

Posted by: gaaallen | May 14, 2010 7:21 PM | Report abuse

That really ought to be done on a log scale, where a constant rate of growth looks like a straight line. There's still substantial growth happening, but it's not quite as crazy as it looks.

Posted by: NomadHomebody | May 15, 2010 5:25 PM | Report abuse

I would disagree with the assessment that the market exploded in 2005 - I did a fit to the data and overlaid it on the graph:

http://www.flickr.com/photos/44803970@N04/4612762856/

The exploding exponential growth is (technically) happening even before the derivatives market has been deregulated (although given the uncertainty, it is plausible it only really gets going after deregulation). But the growth is at the same exponential rate from 1999 until the crash.

I'd put it more like this: the finance industry saw the potential for making money with these instruments (because they were already making exponential money) and decided to lobby for deregulation so that it wouldn't get in the way when the market got big enough for the SEC to put under the microscope. The 2005 bankruptcy bill could have been just another obstacle that they moved before it became a problem. It was like breaking down dams before the rush of the flood made it to them. It didn't have any discernible effect on the rate.

ps Also, for NomadHomebody I put a version of the fit with a log scale in the photostream.

Posted by: JasonFromSeattle | May 16, 2010 4:00 PM | Report abuse

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