Derivatives are not evil

I am quite annoyed and tired of people acting like sheep when it comes to analysing the financial crisis. I just got finished watching a Daily Show episode where some guy named Scott Patterson explained to everyone how quants on Wall Street were all just making models with no relation whatsoever to real asset valuation and creating swaps: "these really toxic assets."

The first part where this is wrong is that asset valuation models were not unrelated to actual assets. A lot of those models actually included real economic indicators and real financial data regarding the health of those companies. Secondly, basing a model on past returns does not mean that you are completely disconnected from the asset. It just means that you trust pricing mechanisms to give you information instead of going to collect the information directly. Is that always a good idea? No! Is it always a bad idea? No!

The second error is referring to all derivatives as though they were these evil monstrous things. Derivatives were used for a lot of different things. Currency swaps are used by companies who export or import to limit their exposure to foreign exchange. In other words, they are using swaps to NOT gamble on foreign exchange rates. Futures are used by companies to ensure that the price they pay for their raw materials will be constant for a certain period of time. Airlines use options on oil to limit their exposure to short term fluctuations on the oil market. These are specifically examples of companies using derivatives to NOT make bets. And yes, unless there is a speculator on the other side to take the risk off your hands, very often that transaction won't be able to happen.

Third, I would like to address the issue of "swaps these really toxic assets." I assume the guy was talking about Credit Default Swaps. Those turned out to be a huge problem for a simple reason: They were heavily traded amongst financial institutions and they were over the counter. What that means is that instead of being bought and sold, positions were closed by writing a new CDS. So let's say Bank A sells a CDS to Bank B. Now Bank B doesn't want a CDS, but it can't sell the one it has. So it writes a new one and sells it to Bank C and so on an so forth. Normally, it works great. Except that if suddenly it's time for Bank A to pay Bank B and Bank A doesn't have the money, Bank A fails. And if Bank B was counting on Bank A's money to pay Bank C, well Bank B might fail too and so on and so forth. And the problem was, nobody knew who owed what to whom. Which meant that there was a lot of fear that maybe the bank you do business with usually might fail despite looking healthy because the people it bought a CDS from can't pay. It's called counterparty risk. It's not that CDS were "really toxic assets." It's that there was a lack of information and a lot of paranoia.

Fourth and last, I want to advise anyone listening to the show to listen to the part when Patterson starts talking about what quants did that was risky. Apparently "hedging" made the list. Hedging is a strategy which consists in... reducing your risk! What part of reducing your risk is really risky? Oh sure, when done improperly, it can blow up in your face, but hedging is by definition NOT risky.

I am to be honest sick and tired of the approximations that people make about the financial crisis. Not everyone has to be a brilliant economist like yours truely, but instead of following everyone like a sheep, think for yourself for a little bit. Find information. You think that derivatives destroyed the world? Look up what derivatives are and learn how they were used. You'll find out that there was a lot of stuff going on and that while some was not prudent by a long shot, a lot of it was quite frankly not a bad idea for the people without the benefit of 20/20 hindsight. It's really easy to point the finger at someone and lynch them with everyone else. It's much harder to try to figure out what complex set of circumstances led to the current situation. And honestly, the comments that guy is making are not encouraging much thought.