I have play a lot of poker in my day...a whole lot. I used to sit around and watch the World Series of Poker on ESPN when I didn't have a game going. I marveled at the skill of the poker pros, the ones who made it time and time again to the final table. They carried an enormous amount of respect from the growing number of amateurs who found their way into the tournament. The commentators would profile the pros, tell us why they were so good at the game. Some of them were mathematical geniuses, they told us. They could figure the odds of winning at the drop of a hat. Some of them had an uncanny ability to see into the thoughts of their opponent, reading the twitch of an eye, or betting patterns, or some ephemeral glow about them that told the pro exactly what that person was holding.
I too once suffered from the hubris of believing myself to be a good player. I approached the table with an air of confidence, pushed more and more money into the pot until I came out ahead. But over time I learned something about poker. Players have varying degrees of skill that allow them to gain certain advantages, but ultimately, to win you have to have the cards.
Let's shift gears for a moment. The gambler's fallacy is the false belief that as a certain result occurs more and more over time, the gambler believes that the probability of that event happening again rises. The classic example is the coin flip. If I flip a coin 20 times and it comes up heads twenty times then, if I fall prey to the gambler's fallacy, I begin to believe that the probability that the coin will land on heads again is greater than 50%. The problem is that no matter if I flip a coin every minute until the day I die and it always lands on heads, the probability of it landing on heads never rises above 50%. However, my confidence that it will land on heads goes up each time, causing me to believe more and more that the coin is destined to land on heads no matter what.
It's the same thing with derivatives. The contracts were structured in such a way as to allow for such a small probability that their inherent risks would manifest themselves that the people engaging in these agreements began to fall prey to the gambler's fallacy. The problem with derivatives is the same problem with any investment: greater risk = greater (possible) reward. Thus, the companies entering into derivative contracts made enormous profits from them and managed to avoid the risk factors. But then home prices began to decline and the risk reared its ugly head.
We can only hope that our government learns that if it looks like a security, and quacks like a security, then it needs to be regulated like a security. There is a reason that the SEC was formed in the 1930s. There is a reason that we still abide by the Securities Act of 1933 and 1934. We learned a lot about the pitfalls of unconstrained finance in those years. Let's not forget those lessons.
3 comments:
Boo, you can't assume all derivatives are the same thing. For example, puts and calls are stock derivatives that are indeed regulated by the SEC. Credit default swaps (CDS) and collateralized debt obligations (CDOs) are totally different beasts.
First, on the CDS. Credit default swaps are basically private insurance contracts on debt. I sell you insurance against a credit event against debt, say a default. You pay me a down payment and the yearly fee (say 300 basis points) for that insurance; if the credit event occurs, then I pay you the nominal price of the bonds. Strangely, there is no obligation that you're even entitled to the debt to begin with. Essentially, an insurer or an investment bank would write the CDS at some value and then hedge against with another CDS contract from another counterparty but at lower rate. If I insure at 300 bps but coverage only cost 100 bps, then the I make 200 bps for doing nothing. This layer-upon-layer of CDS coverage makes the notational amount of the CDS somewhat less ominous.
Legally, blaming the SEC for failure to regulate the CDS is somewhat baseless. Because the transaction at hand is essentially a private contract between two parties, federal regulation of the CDS is a bitch; requirements for jurisdiction requires things like public offering, etc. Furthermore, because the CDS is an insurance contract, regulation is expressly left to the states under the McCarron-Ferguson Act. Although it's undeniable that the federal government could regulate the CDS, it's kind of murky exactly who should regulate it. The FDIC could regulate it, but then insurance companies (e.g. AIG) and investment banks (Goldman) wouldn't be regulated. The SEC really doesn't have the expertise; plus, they're jurisdictionally limited. The Federal Reserve is trying to take the lead, but once again, state-chartered banks would be exempted.
Like the CDS, the basis for regulating the CDO without express Congressional authority is somewhat cloudy. Hell, just describing the CDO is tough.
Mortgages/car loans/etc --> Bank [sells the loans to] --> Special investment vehicle [who then issues bonds secured by the payment stream of the mortgages/car loans] --> fixed-income investors
The problem that we're in is that our economy over the last 40 years requires the cycling of credit, and the CDO and CDS, unfortunately, are instrumental to that process. Any de-acceleration of this process necessarily leads to deflation. That is the Federal Reserve's greatest fear, and hence the truly messy situation that we're in...
Interesting times.
Ok, you caught me oversimplifying. But I'll say that I wasn't blaming the SEC for the problem. You're right to point out that states are the chosen vehicles to regulate insurance contracts. You're also right to point out that we don't have a great structure to regulate CDS's and CDO's.
What you describe as our dependency on credit cycling, I would describe as robbing Peter to pay Paul, in a sense. And I think that's the fundamental problem with our "service-based" economy. We have not been creating enough value in the overall economy to keep up with consumption. If that's the case, the deflation is the answer, albeit a scary one.
My prediction is an extended recession and then one of two things: commodities drop in price enough to grease the consumption wheels enough for us to start "cycling credit" again and forget that we have a fundamentally flawed system; or we experience a major downward adjustment in our collective quality of life and, over time, begin doing things like manufacturing that add real value to our economy.
Interesting times indeed.
Credit swaps aren't insurance because they don't protect against a casualty, necessarily.
They definitely aren't securities.
Thus, they aren't "like" private contracts, they are private contracts.
But hell, at least someone has bothered reading an article or two.
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