GFC confusion, part 4: blame derivatives

One of the loudest critics of liberal capitalism in Australia, Robert Manne, has blamed derivatives for the crisis. In this he is not alone. In America another prominent anti-capitalist crusader Richard Katz has also pointed the finger at “the explosion of unregulated derivatives in the United Stats and globally” building on the housing bubble.

This is the perfect enemy for the anti-capitalists because the cause of the problem was the financial market itself. Boo. Hiss.

But, like the “blame savings” thesis, the “blame derivatives” thesis fails to explain the main problem.

The idea is that the markets packaged bad home loans into new financial vehicles and these were widely traded around the world. Derivatives are a financial asset that gain their value by leveraging to real underlying asset. They enable people to shift risk to people who are most able or willing to accept the risk. They also allow people to take a more nuanced position in any market. With home loans, the original writers of the debt were able to sell the risk as a derivative, and as home loans have gone bad these derivative holders have faced losses.

But this answer fails to address the initial problem – which is the existence of the bad home loans in the first place. Derivatives don’t create the underlying asset. They are an add-on to any pre-existing asset. Further, derivatives don’t increase the risk or the loss. They simply allow the risk to be traded.

If it was the existence of derivatives that is the main problem, then all derivatives should have the problem and not only those derivatives related to home loans. But that isn’t the case.

True, people wrongly assessed the riskiness of the property-based derivatives. But that isn’t the fault of the derivatives. The real questions that need to be answered are (1) why did people over-invest in property; and (2) why did people incorrectly assess the risk of those loans? The existence of derivatives doesn’t answer either of these questions and so leaves us none the wiser.

(Previous articles in this series are about Lehmann collapse, greed & the savings glut).

8 thoughts on “GFC confusion, part 4: blame derivatives

  1. I thought the main reason for those dodgy loans was because of american laws forcing lenders to give loans to people who normally wouldn’t qualify, under the guise of equality?

  2. That was one reason, though probably not the main one. Quasi-government agencies Freddie Mac & Fannie Mae probably played a bigger role. As did the moral hazard built up in the system via implicit government backing of the banking system.

    And of course some market players simply made mistakes… backed up by rating agencies that also made mistakes. But even then, it can be argued that the government distorted the market for rating agencies.

  3. We already have an array of regulatory agencies and extensive political tampering with financial markets not to mention the fact that globally, for multiple decades, we have slipped into a monetary environment without real market commodity foundations.

    Excessive financial engineering (the derivative bubble) is only a byproduct of arbitrary political tampering with interest rates and the political and arbitrary production of national currencies engendered by state owned/affiliated central banks.

    The only ‘regulation’ required is the rule of individual property rights and contract. The derivative situation can only be properly rectified by removing all the regulatory tampering that is inconsistent with individual property and contract law principles.

    The socialist/fascist regulation crowd have no coherent, logical explanations of exactly what principles, or exactly how it can be that tax eating bureaucrats will incorruptibly, impartially co-exists with the financial community and wisely foresee the disasters coming that they fantasize are inherent in markets trading absent their bureaucratic tampering.

    Anyone who can’t delve into the foundations of money and banking can not be taken seriously on these types of issues.
    Parroting dis proven socialist ideology and dressing it up with some numbers and statistics or maybe saying the word Reagan and de-regulation a few times just doesn’t cut it.

  4. Chris – yes that was a primary cause of the bad debt in the first place. But it’s been quickly hushed up, as that would detract from the nice convenient conclusion that greed and neo-liberalism is the scapegoat. I’m not sure what’s ‘greedy’ about lending money to people who won’t be able to pay it back, but anyway I digress.

    JH you’re correct – derivatives did not cause the underlying problem – IMHO it was the ‘social justice’ laws (specifically the Community Reinvestment Act, which sounds exactly like a Wesley Mouch directive from Atlas Shrugged) plus the moral hazard of an implicit government bailout, especially since the biggest mortgage aggregators (the bizzarrely named Freddie Mac and Fannie May) were quasi-governmental.

    But there is an argumant that derivatives exacerbated the problem – mainly because they got so complex that no-one really understood the total picture. It’s possible, but I don’t think that’s a reason for banning them.

  5. I agree with John Humphreys in the sense that one of the root causes of GFC was not directly the mere existense of mortgage related derivatives etc, including reinsurance taken out on these derivatives or financial obligations. However, as Papachango stated above – did not the existense of these financial instruments exaceberate an otherwise natural business cycles – i.e. When markets left to themselves go through phases of growth, exuberence (bubbles) and an inevitable correction.

    In the absense of these financial instruments the correction would have been localised – however the existense of certain finacial instruments made it inevitable that the correction would flow through to other regions/industries and markets – GFC.

    I am not saying that we should ban derivatives or that a greater regulatory regime may have avoided the GFC – but as I understand it, the mortgage based derivatives market definitely had a hand in the rapid deterioation and the extent in the damage caused. Saying that it was not the root cause is fine, but absolving these instruments as a significant factor would be short-sighted. Hopefully, once burnt institutions/individuals will price in the risk better in the future, that will moderate market corrections.

    If the wind blows over a pyramid stacked with cards, yeah sure the root cause is not the weak link between the cards themselves, but to take an approach where one completely blames the wind and avoid the role of the cards would be incorrect.

  6. If you make a few bad loans but then figure out that you can profitably get away with onselling the loans via slicing and dicing then you have a decent incentive to make more bad loans. Whilst I think blaming derivatives for the GFC is like blaming guns for murders there does seem little doubt that many buyers of derivative based products failed in fundamental ways to understand what they were buying. It won’t be the last time this happens but perhaps it will now be less common for a while at least.

  7. No one should be bailed out – even if this means people loose their savings account, as it bails out a bank who was absolutely clueless and irresponsible.

    Think about it. A bank holds a huge number of CDO’s and miss-manages the risk about holding them. They buy the CDO’s with peoples deposited money. The CDO’s fall over. They now cry that their depositors will those all their money if they are not bailed out. Sorry but the depositors DESERVE to loose all their money for letting a useless bank hold it. Instead we bail out the bank, and these banks are *still* allowed to run as if nothing happened, as if they didn’t make just about worst financial decisions in history.

    No one learns from this. People still have their money in bailed-out banks even when they know the bank still balances its books with ‘CDOs’ listed as an asset.

    If would have been great if there was no bail out. The banks would have fallen over. The depositors would loose all their money. From then on everyone else would be extremely careful about how a bank used their money to gain interest. We would see banks having to carefully discolose what they were actually doing with people money. We would see far less derivaties and less leveraging and far more reserve and gold holdings. We would see far less profit for banks. Which is the real reason for the bail-outs.

  8. MikeO – i believe what you’re describing there is precisely a “moral hazard” – the banks have no motivation to act wisely when bailouts are there for the taking. Similarly to GM and Chrysler – why build decent cars and manage your finances when the taxpayer can pick up the bill?
    The shame of it all is that banks who are prudent, miss out on the higher profits that could have been had by taking the riskier positions. The bailouts are rewarding foolishness, and punishing prudence.
    What about a compromise? Let those banks fall over and those foolish fund managers join the dole queue, and the mums and dads who had their money invested, give them 75% back as a bailout? I think that way, the lessons would be learnt, and innocent investors wouldn’t be burnt too much.

Comments are closed.