It was pretty funny. I got a good laugh, but its a good illustration of something I've been thinking about since all of this began.
Its dangerous to compare the profits of someone like Henry Ford with someone like Richard Fuld. I'm afraid the subtlety might be lost on both politicians and the general public. There's a difference between someone who becomes rich by making things and someone who does it with "derivatives". One creates wealth. One just "makes money".
I cringe every time I hear some highbrow use the word "wealth" as just a more sophisticated-sounding way to say "money", oblivious to the difference.
If, in our zeal, we demonize the Henry Fords along with the Richard Fulds, we'll create a perfect regulatory environment to ensure that we never get another of either.
Edit: I put "derivatives" in quotes partly because I didn't want to bleat "derivatives bad" as if it should be promptly followed up by a statement of the goodness of quadrapedality, and partly because "gaming the system in order to distort the reality of risk and thereby extract unearned profits for the unaffected mitigation thereof" didn't exactly flow. I was promptly and correctly called out for it. Bummer.
There's a difference between someone who becomes rich by making things and someone who does it with "derivatives". One creates wealth. One just "makes money".
I respectfully disagree. Bashing derivatives used to be a fad. Now it's the norm. Not all derivatives were created equal. And, contrary to popular belief, some derivatives actually do create wealth.
For instance, suppose I am a corn farmer in Iowa. Derivatives allow me to buy the option of selling X bushels of corn at a specified price Y, on day Z. Hence, I have a guaranteed revenue at some point in the future. If for some reason, the demand for corn is really low this year, I don't care because the counterparty will have to buy my corn at the specified price. Derivatives provide me insurance against price fluctuations. Thus, I can allocate my capital more efficiently because uncertanty has been reduced. Wealth is created.
Of course, some will parrot that "Buffett said that derivatives are financial weapons of mass destruction" even though they don't really understand what that means. Buffett is not a derivatives trader. Period. Derivatives have existed since ancient times (the Greeks and the Phoenicians used them already). If some financial products survive over 2000 years, it's because they have some value.
Services create wealth too. Derivatives provide insurance, and that is a valuable service.
This is true. But the traditional understanding of derivatives and what went down in the past decade might be whole different animals. (The math and logic used to turn subprime loan bundles into AAA's is still somewhat opaque to me.)
The argument might be broadened to include the traditional "financial grease" that the markets provided. As you said, bashing derivatives has become the norm, but even Henry had to raise capital.
It will be extremely difficult to recover from the damage done in public opinion to financial instruments in general. "Yes, Ma'am, I know you lost all of your money on those investments, but these are good derivatives. Scouts Honor! "
I'm still not exactly sure how they managed to turn subprimes into AAAs either but from what I've been able to understand the rating isn't determined by the type or amount of the loans but the perceived risk in it. It's like your credit rating. It doesn't matter how much you have out in credit but how you are determined as a risk. Someone with 10k in debt but a credit score of 780 is going to find it much easier than someone with no debt and no credit score. You are a known quantity, there is a number slapped on your file. The other guy is an unknown quantity, he doesn't have a history of payments so they perceive him as a lot riskier.
The mortgage bundles work the same way. The banks told the agencies that there are a certain quantity of A loans, B loans, and C loans. Based on that information the bundles were given a rating.
Well what happened is those A loans turned into D loans when they were unable to make payments. Then as the investors started asking for more information they found some people weren't being honest. Now the bank is stuck with these shitty assets and they are unable to lend money because it's tied up in junk.
All of this is just my opinion as a financial outsider.
I agree. I would like to say that I honestly believe that the way the masses perceive the markets is completely and deeply flawed.
For instance, if you build a new super high-tech cruise ship which ends up sinking during its inaugural voyage, then people will perceive that failure as a design problem, and they will blame the naval engineers who designed and built the ship. Only a crackpot would claim that one should ban all ships because they're dangerous.
If you create a new market and that markets fails, people will claim that it's a dangerous market and that it should be banned. No one will think that the market might have been poorly designed. When it comes to markets, moral issues such as "right" and "wrong" trump everything else. Emotion defeats reason. That's intriguing, isn't it?
> For instance, suppose I am a corn farmer in Iowa. Derivatives allow me to buy the option of selling X bushels of corn at a specified price Y, on day Z. Hence, I have a guaranteed revenue at some point in the future.
Hm. Firstly, I do not think that is what "derivative" means, leastwise in common economic parlance. Derivatives would be products to other parties based on the various futures/options/insurances/promises-to-buy schemes.
> Thus, I can allocate my capital more efficiently because uncertanty has been reduced. Wealth is created.
Well, no, you have successfully severed your production from even that most tenuous of connections to reality which is supply and demand, and created money where none should exist (naturally it is arguable that the s&d ratio would be different and there would exist wealth if the financial sector was not mired in these schemes to begin with.)
"I do not think that is what "derivative" means, leastwise in common economic parlance."
Last time I checked, put options were considered derivatives. After all, a put option is basically a contract whose value is derived from the price of a certain security / commodity (in this case corn) at a certain point in the future. Depending on the price of corn, the buyer of the option will choose whether or not to exercize the right to sell the agreed ammount of corn.
"and created money where none should exist"
None should exist? Why not? If I know I will earn Y dollars on day Z, I can plan my investments better. Instead of delaying the purchase of a new tractor, I can buy it at the most appropriate time because I don't need a money cushion to damp any effects a falling price might have on my business.
One of the biggest challenges of running a business is forecasting demand. Using derivatives, you can at least guarantee a revenue stream and transfer market risk to whoever is more qualified to handle it.
Some derivatives might help brick-and-mortar production happen but a look at the details of the financial crisis will reveal that the majority of derivative investments have involved a casino-like approach to investment which bred exponentially increasing systemic risk. Some derivatives can be a necessary part of healthy economic activity but that doesn't justify the most recent approaches any more than the fact that some hospitals stock heroin justifies becoming a junkie.
On the other hand, it is too glib to say that the activity of getting rich with a brick-and-mortar factory is fundamentally different from getting rich with derivatives. Factory managers and hedge fund managers each manager people and risks. Bioinformationists and quants each manage complex formulas. I mean, you can dig a hole to lay a foundation for a new factory, you can dig a hole to cover it back up again or you can dig a hole to bury some bodies. The activity of digging the hole itself isn't that different.
There is some "service" production that differs only from the production of material things by its immateriality. There is also the production of wholly useless good or goods intended to cause harm to someone, like land mines.
In the derivative mess, there are ways that our society, as a whole, allowed resources to be channeled into detrimental uses. Those who profited from this weren't necessarily subjectively different from those who built railroads in earlier times. Indeed, a lot of useless tracks were laid in the 19th century as an adjunct to a lot of dirty dealing.
Hey, no conclusion but keep these points in mind...
"Some derivatives might help brick-and-mortar production happen but a look at the details of the financial crisis will reveal that the majority of derivative investments have involved a casino-like approach to investment which bred exponentially increasing systemic risk. Some derivatives can be a necessary part of healthy economic activity but that doesn't justify the most recent approaches any more than the fact that some hospitals stock heroin justifies becoming a junkie."
What could be the solution? If one destroys a market, one creates a black-market (quoting Churchill). If one imposes heavier and stricter regulation, there's really no guarantee that it will be enforced. There will always be loopholes to be exploited. The one solution would be economic totalitarianism (?)
What could be the solution? If one destroys a market, one creates a black-market (quoting Churchill).
I know I started the heroin-derivatives comparison but continuing it in this direction is fallacious. Speculative derivative contracts are like heroin in the sense of being socially destructive but they aren't like heroin, cigarettes or cocaine in the sense that they can be traded on street corners if they are not sold in corner stores.
Derivative markets depend on the legality of the contracts which are written, indeed they depend on large, public entities guaranteeing them. Consider: it is no longer legal to take out a large life insurance policy on someone you have no other relationship with - the murders got to be a bit annoying. There is no noticeable black market in such insurance policies either. Yet insurance for those who can show a need for it is still legal and available.
Regulating speculative derivatives would have relatively simple mechanics. However, it would also require that this society adopt a different regulatory paradigm than the present belief that Casino-like-speculation benefits the economy and society as a whole. This dovetails into the things Paul Krugman said recently.
Have you read the text? Is there any politics in there? Even the most die-hard Ayn Rand fanboy should laugh at it. It's hilarious.
Of course satire and politics are NOT mutually exclusive. To keep you happy, Rod should have written "it's satire, NOT politics, and NOT (satire AND politics)" ;-)
Its dangerous to compare the profits of someone like Henry Ford with someone like Richard Fuld. I'm afraid the subtlety might be lost on both politicians and the general public. There's a difference between someone who becomes rich by making things and someone who does it with "derivatives". One creates wealth. One just "makes money".
I cringe every time I hear some highbrow use the word "wealth" as just a more sophisticated-sounding way to say "money", oblivious to the difference.
If, in our zeal, we demonize the Henry Fords along with the Richard Fulds, we'll create a perfect regulatory environment to ensure that we never get another of either.
Edit: I put "derivatives" in quotes partly because I didn't want to bleat "derivatives bad" as if it should be promptly followed up by a statement of the goodness of quadrapedality, and partly because "gaming the system in order to distort the reality of risk and thereby extract unearned profits for the unaffected mitigation thereof" didn't exactly flow. I was promptly and correctly called out for it. Bummer.