Regulating Derivatives

           by Drew Benson, ITR economist

 Many commentators are determined to blame the “financial crisis” on derivatives.  They suggest that reckless financial innovation exacerbated by greed ultimately induced the “Great Recession of 2008-09.” This ad hominem attack has failed to get at the crux of the issue, “Why did people make such outrageous bets on derivatives?”

            To suggest that derivatives are inherently dangerous and that they played a key role in causing the financial crisis is like blaming a car, and not the driver, for an auto collision.  The excessive risk taking that occurred through financial derivatives was not the byproduct of the intrinsic volatility of derivatives themselves but a byproduct of the perverted incentives of the game.  In other words, the government created a cozy environment for Bear Stearns, AIG, Bank of America, Chase, Lehman Brothers, Fannie Mae, Freddie Mac, and many others to engage in irresponsible risk-taking and leveraging.

            Take for example a situation where the government concluded that no person should have to bear the expenses of a car crash.  What would ensue?  People would have an incentive to drive recklessly, making car crashes more frequent.  Therefore, the only way to contain the increased danger of the roads would be to institute harsher traffic laws.

            When the Federal Reserve bailed-out Long Term Capital Management (LTCM), the highly leveraged hedge fund that went bust in 1998, they sent a message to the rest of the financial community that they would cover their future losses from excessive risk taking as long as they were “too big to fail.”  This bailout precedent had been ongoing since the Franklin D. Roosevelt Administration, but the LTCM rescue validated greedy behavior on Wall Street.

            A person engages in greater risk because of the upside potential, but the downside losses that occur in a free market naturally causes prudent behavior.  The Federal Reserve and Congress essentially removed downside losses when they started rescuing insolvent companies.  As the downside losses disappeared, financial CEO’s had every incentive to throw prudence out the window.  By changing the rules of the game and by moving further away from the free market, the U.S. Federal Government removed market discipline.  Hence, the large financial companies engaged in unsustainable bets on derivatives.

            In an attempt to deal with the excessive risk-taking, Congress recently passed the massive financial overhaul bill.  The bill will substantially increase regulation in the financial markets, and it takes particular aim at derivates.  The increased Wall Street rules are as absurd as strict traffic laws in a society where people do not bear the costs of an auto crash.  The new financial regulation is merely covering years of ill conceived government policy and it is a move in the opposite direct of where the industry should go.  This bill is going to increase the size of the financial bureaucracy (i.e. the Federal Reserve, Treasury, and SEC) which will impose increased constraints on the federal budget and the taxpayer.  Further, as almost all regulation does, it will increase the cost of doing business which will harm both the producer and the consumer.

            Derivates trading needs a dose of the free market, not heightened regulation.  If financial companies overexpose and over-leverage themselves going forward, the federal government should let them fail, no matter how big they are.  This will inject prudence and market discipline without the increasing the leviathan state. 

            Mankind did not become inherently greedier in the twenty-first century, public policy become inherently more intrusive.