Streetwise Professor

November 21, 2008

Just as I Suspected

Filed under: Derivatives,Economics,Exchanges,Politics — The Professor @ 3:45 pm

My post yesterday on Senator Harkin’s derivatives bill was based on the WSJ report. Michael Giberson at Knowledge Problem kindly provides a link to Harkin’s full statement (and even more kindly links to SWP.) And wouldn’t you know, as I suspected, Harkin indeed quoted the Sage of Omaha’s “Weapons of Financial Mass Destruction” yadda yadda, and adds some hyperventilating of his very own:

My bill will end the unregulated ‘casino capitalism’ that has turned the swaps industry into a ticking timebomb. And it will bring these transactions out into the sunlight where they can be monitored and appropriately regulated.

“Casino capitalism.” “Ticking timebomb.” “Bring these transactions out into the sunlight.” How trite: that scores very low on the originality scale, senator. Like a zero.

How about a serious comparative analysis of the costs and benefits of alternative trading mechanisms for different instruments? How about at least a moment of silence to ponder the questions: “Why have these markets evolved in this fashion, with a diversity of trading methods for a variety of different products?” and “What makes me so much smarter than the market?” and “What specific market failure (externality, collective action problem, etc.) is at work here, and how does forcing everything onto an exchange fix it?” and “Gee, we tried this before, and it created all sorts of problems, so why should we expect it to work any better now?” How about a recognition that market participants with very high powered incentives in fact spend a great deal of effort and money to monitor counterparty risks?

The issues here are very, very, very complicated. There are myriad moving pieces. I certainly disclaim any divine insights as to what the best way to organize derivatives markets. But I can make a plausible case based on a comparative analysis grounded in an understanding of basic economic considerations that there are very good reasons for trading some things on exchanges subject to centralized clearing, and to trade other things on bilateral OTC markets without clearing. A debate over the appropriate regulatory framework should focus on these kinds of considerations. Maybe such a debate will lead me–and others–to conclude that there are remediable problems in the way that markets are organized, and to identify the most efficient fixes. One thing for sure, however, is that cheap, lazy, hackneyed, grandstanding, and fact-free bloviations about “casinos” and “timebombs” are hardly the basis for re-engineering markets involving billions and perhaps trillions of dollars.

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1 Comment »

  1. I couldn’t agree more but worry about the likely success of this and similar proposals in the current political and media environment where “regulating” is equated with “doing something.” I think that the current financial crisis was, in part, due to the same kind of thinking, namely regulatory and politically-attractive mandates “encouraging” unprofitable lending by banks and mortgage brokers who then turned around and offloaded them (i.e., “sold” them) to Fannie Mae and similar GSEs which manufactured a market for these instruments because of the mandates. This is a classic case of the conflict between political and economic incentives, of overestimating the benefits of regulations by underestimating or simply not anticipating the myriad side-effects and unintended consequences of non-market solutions.

    These groups then mispriced the risks of the pooled and stripped assets by underestimating the positive correlation between housing-related macro-level assets….i.e., by overestimating the value of so-called diversification of pooled assets.

    But we — the market participants, researchers, and academics — only see this in hindsight…and the market is at this very moment learning how to better price these complex derivative securities that are traded in local markets but have significant “global equilibrium” risk factors as well…The idea of a “systematic risk regulator” being touted by Washington and media is nothing more than “feel good legislation” that would transfer the pricing of financial assets out of the hands of the economic actors who can best internalize the marginal costs and benefits of the transaction and who now have even more heightened incentives to improve the transactions and pricing models going forward.

    I just don’t know how we, as economists and teachers, can stem the tide of the “do something, do anything” psychology that seems to be winning the day.

    Comment by Sherry Jarrell — November 28, 2008 @ 1:35 pm

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