Tuesday, April 27, 2010

Why we're running out of zeroes...

When I read the article below, I thought about a truly clever short story written by Steve Martin which contained no periods. It could be the world will run out of zeroes if financiers continue their invention of derivatives.

Consider these sobering words from Hernando de Soto, who wrote one of the best books on property rights and finance I have read:
Today's global crisis -- a loss on paper of more than $50 trillion in stocks, real estate, commodities and operational earnings within 15 months -- cannot be explained only by the default on a meager 7% of subprime mortgages (worth probably no more than $1 trillion) that triggered it. The real villain is the lack of trust in the paper on which they -- and all other assets -- are printed. If we don't restore trust in paper, the next default -- on credit cards or student loans -- will trigger another collapse in paper and bring the world economy to its knees.
If you think about it, everything of value we own travels on property paper. At the beginning of the decade there was about $100 trillion worth of property paper representing tangible goods such as land, buildings, and patents world-wide, and some $170 trillion representing ownership over such semiliquid assets as mortgages, stocks and bonds. Since then, however, aggressive financiers have manufactured what the Bank for International Settlements estimates to be $1 quadrillion worth of new derivatives (mortgage-backed securities, collateralized debt obligations, and credit default swaps) that have flooded the market.
These derivatives are the root of the credit crunch. Why? Unlike all other property paper, derivatives are not required by law to be recorded, continually tracked and tied to the assets they represent. Nobody knows precisely how many there are, where they are, and who is finally accountable for them. Thus, there is widespread fear that potential borrowers and recipients of capital with too many nonperforming derivatives will be unable to repay their loans. As trust in property paper breaks down it sets off a chain reaction, paralyzing credit and investment, which shrinks transactions and leads to a catastrophic drop in employment and in the value of everyone's property. [More][My emphasis]
This is, I believe the crucial issue at the center of the storm over financial regulation changes. While I have trouble wrapping my mind around the amount of money looking for investment plays, and the leverage they can obtain from such instruments, it seems clear to me, as well as others, these products are time bombs being foisted from fool to fool.
The purpose of financial reform is to, at the very least, take a first pass at re-regulating markets and behaviours that have caused untold hardship and suffering. Derivatives trading was, in many ways, at the heart of that suffering. And while the Lincoln bill might not have best dealt with actions by banks like Lehman Brothers, Bear Sterns, Merrill Lynch, AIG and Fannie/Freddie, it is the banks like Goldman Sacks and JP Morgan Chase who got away with the risks they took and are primed to inflict more harm — at no cost to themselves — that are the even greater worry. [More]
Getting back to the pure arithmetic, I am aware the nominal value of derivatives can be misleading. As farmers know, options - a form of derivatives - can simply disappear at a given date as they expire unexercised. But the sheer size of the bets being made (a quadrillion is 15 zeroes, folks!) sorta hints at the range of catastrophe possible when the black swan paddles into view.
Policing derivatives. Importance: High. Derivatives are invented securities such as futures contracts, collateralized debt obligations, and credit-default swaps that are related to real assets or events but have no inherent value of their own. They have legitimate uses, such as allowing airlines to hedge against wild swings in energy prices, so they can better control costs. But derivatives are also unregulated, which allows speculators to place huge bets on various parts of the economy in secret, which can amplify real problems and occasionally produce disastrous results. Congressional reform proposals call for regulating derivatives on exchanges, the way stocks and commodities are regulated. Hedge funds and financial firms oppose this, because it would shine light on one of the shadiest parts of the financial system and cut into profits for the most privileged firms. But it's hard to argue against transparency, which is why some regulation of derivatives looks likely. [More]
Coping with the astonishing amount of wealth in the world and its ability to move at the speed of light compounds our economic problems by exceeding our instinctive grasp of quantity and consequence. Any trivial mistake multiplied by a quadrillion is a disaster, and forcing these transaction into a marketplace open to public scrutiny would not be an unwarranted burden for an industry already capturing most of the profits in the US.

Finance is supposed to be how we allocate capital to useful purposes, but seems to have become an end unto itself. To be sure, folks with big money have the right to make whatever investments/bets they wish, but what has been demonstrated is their mistakes have external costs far beyond their own yacht.

Regulating this shadow economy is not just prudent, I think, but urgent as our global economy continues to defy prediction for intricacy and risk innovation. If you don't buy that idea, name all the things you now keep an eye on that you didn't care diddly about 10 years ago.

1 comment:

Anonymous said...

Money (read finance), makes a fair servant and a very poor master.