Wednesday, January 28, 2009

Are Derivatives the Problem?

Bob Shiller, the Yale economist, has gotten a lot of press in recent days supporting the use of derivatives and arguing against the use of the efficient markets model in understanding financial (and non-financial) markets. I am supportive of what he is trying to say. In this post I present my reasoning for this support…you can go to Bob’s articles in the Wall Street Journal and elsewhere and his upcoming book (along with his many other books) to get his view.

First, human beings are innovators. They are problem solvers and are constantly pushing the edge trying to come up with something new that makes things better.

The problem we are dealing with here is risk. People, investors, don’t like risk. They are constantly trying to reduce risk in their lives…and they are willing to pay to reduce risk.

And, this is the essence of derivatives. Derivatives are risk reducing tools that can be used to hedge cash flows and thereby protect individuals from assuming more risk than they would like. People will pay for this…derivatives will get invented.

Answer me this…will a large number of people pay someone to invent a tool for increasing risk? The answer to this is no! People don’t pay people to build speculative instruments. The expected return to speculation is zero or less. Now how much will you pay for someone to create a tool that can provide you with an expected return of zero or less? Right…nothing!

People will pay innovators to build instruments that help to reduce risk because they are receiving value by being able to reduce the risk. Now this does not mean that people will not use these risk reducing instruments to speculate with. Hedging is providing a cash flow to offset the movements of all or part of another uncertain cash flow. Speculation means that you are taking an uncovered position…that is, you are working with only one of the cash flows.

So, like other innovations, derivatives have been created for a positive reason…but can be used in ways that increase risk. Like cars…or drugs…or nuclear energy plants. All these can be used in positive ways…but they can also be used in other ways as well.

Conclusion: derivatives will continue to be used, created, and, at times, misused. Financial innovation is with us and will continue with us. My experience supports the view that only a minimal amount of regulation will be effective to control the use of derivatives because part of innovation…is to get around the rules. That’s life!

My second point has to do with the efficient market hypothesis. People who support the efficient market hypothesis argue that market prices reflect all the information that is available to the market at a particular time. That is, market prices are correct. In essence, everyone in the market knows what information is available, what that information means, and how that information is translated into market prices…for all time. At least, there is a well informed group of arbitragers that know these things so that “on the margin” market prices can be made “right”.

In the world I live in, individuals have to deal with incomplete information…especially about the future. That is why uncertainty exists and why people have created probability theory as a way to deal with incomplete information and the resulting uncertainty. For prices to be “correct” and for markets to be “efficient” we need complete information which means no probability distributions for we will have certainty. I can’t believe that everyone in the market, given what information is available, knows what the price of every stock will be at every period of time in the future.

When we have incomplete information markets cannot be efficient because we don’t know the exact models to forecast the future with and we don’t know the appropriate probability distributions that surround our forecasts. As a consequence, our risk management models, as well as our risk management controls, have been inadequate. As such, our hedges have contained more risk in them than we had anticipated and our speculative positions have provided way more risk that we had assumed. Thus, our financial structure has been out-of-line with where we thought we were and our financial system has been more fragile than we thought.

My third point concerns the incentives present in an economy. People will use the instruments that are available to them in ways that are consistent with the incentives that exist within the economy at a given time. For example, in the past, the price of a house may have appreciated over time but this was not the real value of the house. The real value of the house was the flow of services that people received over time…it was this which made the house a home. What people acquired was the flow of housing services…not the stock…not the house itself. This was because the house was not going to be sold…at least not for a long time into the future. In this sense the price of the house was only important at the time of purchase.

What changed? In recent years in too many cases the price of the house became more important than the flow of services. Why? Because in many cases, houses were “sold” every two or three years. People with teaser interest rates, or whatever, that reset every three years, “sold” their house to themselves because the game was to refinance the house using the inflated house price to get a better mortgage rate. Living in the home was not the essence of the deal…speculation on the house price was the focus…and this was seen explicitly in the many “speculative” deals that arose at this time. And this was the essence of the asset-based securities used to support these transactions.

Also, remind me sometime to tell you about my friend that ran a mutual fund who avoided moving into stocks until the year before the stock market bubble burst. He did not move into these securities until he saw that too much money was leaving his fund…going into funds showing better results because they had invested in stocks. And he made the front page of the Wall Street Journal when the bubble burst and his “late-in-the-day” bets…collapsed.

Finally, my last issue has to do with the government. Unfortunately, in many cases, government policies can dominate the economy; government policies can create the incentives that people respond to. And, although the government may not mean to, it can create incentives that are detrimental, at least over the longer run, to the health of the economy.

If you have read many of my posts, you know that I believe that the Bush43 tax cuts, the war on terror along with other events that inflated the spending of the government, and the Greenspan “low interest rate” policy set the scene for the bubble in the housing market, the exponential increase in credit over the past eight years, and the overwhelming increase in leverage. The incentives that were created during this time put more and more pressure on business executives to take speculative positions and finance these positions with more and more leverage.

Who was responsible for the behavior of these business executives? Like my friend that ran the mutual fund…even those that were relatively conservative in their business decisions…ultimately found themselves forced into positions where they had to take on more risk than they would like. Competitive pressures “forced” decision makers to respond to the current environment that existed in the market place. After-the-fact they seem to have been overly greedy. After-the-fact they appear to have been insensitive to the risk they were taking…careless even. And now, people and politicians have dumped on them for their mis-guided behavior. The politicians that created the environment many years ago…although they might have lost the election…walk away defending their legacy in other areas. This is one of the difficult things about economics…results often trail, by many, many years, those policies and programs that were their cause.

Yes, I agree with Shiller that derivatives are here to stay. And, I agree with Shiller that many new kinds of derivative securities will be invented in the future. I just wish that we could invent a derivative that would allow us to hedge against bad policy making in Washington, D. C.

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