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.

Firms aren't too big to fail, the sector is

When the financial crisis first started, I had a front row sit. As an investment analyst with a small financial advisor, it was my job (among many others) to keep an eye on the financial new and keep everyone appraised of what they had already read on Bloomberg. So when Bear Stern started giving signs of fading, (by which I mean screamed in agony) and JPMorgan started salivating at the smell of juicy interest obligations with low risk thanks to the Fed decided to altruistically help the Fed in rescuing the economy, I was able to start pondering the concept of "too big to fail."

My first reaction was: "Let them burn." Those were actually my words. I am a little bit of a libertarian and I tend to think that if a firm makes poor decisions over and over again, it should fail and allow other better firms to take over. At the very least, a lesson would be learned. I held on to that belief for quite a while and have not completely given up on it, but as times past by, I realized that 1) despite my grumbling, tax dollars were going to rescue those big banks and 2) I did not really want another Great Depression just to teach those guys a lesson.

Having given up on my insignificant campaign in the comments of financial blogs to advocate letting banks fail, I started joining the ranks of those who believed that at the very least, if you are too big to fail and you get rescued, part of the deal should be to make you small enough to fail next time. That felt very clever, but those words always left me with a bad after-taste which I ignored for quite some time.

Recently, I started thinking about the concept of too-big-to-fail within the context of the systemic risks and factors central to this crisis. (Now, many people will try to tell you that the crisis was due to greed, Clinton or Bush. Don't listen to them. In fact, if anyone claims to explain this financial crisis in less than a 10 page essay, they are either summarizing a very intelligent argument, an idiot or lying. Most likely, it is not the first.) The big culprits were poor loan origination practices which were focused on closing a deal no matter what the deal was and the lack of understanding of many mortgage-backed securities. (I refuse to say "lack of clarity". Those securities were very clear, they were just complicated requiring something beyond cursory examination to understand. If you bought a computer without reading the specs and it failed to do what you wanted, you would not call the computer obscure. You would call your buying process uninformed.) The combination of these two factors created a huge understatement of systemic risks throughout the financial system. That understatement lead to an over-evaluation of those securities which gave us the crisis when that stopped being the case.

Now, if instead of having a couple of very big banks, we had many small banks, the differences would have been quasi-nil. I spoke some time ago with an executive at a firm which hired loan officers. Now, when you meet a loan officer, you may feel that you are talking to a perhaps eager, but level-headed guy pretty low on the totem pole. The truth is, the best ones among them were rock stars. If you can originate enough loans, banks will offer anything to bring you on-board. That created a competition where tying compensation to repayment of the loan quasi-impossible. Because if you try to better align your loan officer's compensation to your firm's interest, he'll go find a job with another firm. And if that happens, your competitors will eat you up and you will not last long enough to see your smart long-term planning vindicated. By having more smaller firms with less market power you would have even more competition for those star underwriters further exaggerating that tendency to short-term thinking. When it comes to the wide-spread use of these over-priced securities, it does not matter whether the firms are big or small. Everyone was using them from pension funds in Sweden to the big firms on Wall Street. Breaking up Citibank into 50 small banks would have done nothing to prevent the crisis.

The truth is, it was not those big firms that were in difficulty and too big to fail. It was the entire financial services industry. And so concentrating on making sure Citibank is not "too big" or ensuring Goldman Sachs cannot topple the world economy will solve no problem. The waves of failures of hundreds of small banks would have pulled us into a Great Depression just as surely. In fact, the size of those big banks and the industry concentration allowed the government to more efficiently use its resources. When Bear Stern was failing, Ben Bernanke had their executives in his office within hours and a plan could be hammered over the week-end. Can you imagine the government having to negotiate a rescue plan for hundreds of small failing banks simultaneously? It would take months and chances are that by the time the government acted, it would be too late.