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Derivatives!

By Peter Morici
web posted April 26, 2010

Derivatives are as ancient as civilization.

Greek famers insured crops with investors prepared to speculate on the weather, just as life insurers hedge mortgage-backed securities by purchasing credit default swaps.

When written against real assets—farmers' crops or homes--derivatives spread risk, lower capital costs and foster growth.

Like any other financial contract, derivatives can be abused, and the big bonus culture on Wall Street has given us some high profile shenanigans.

How derivatives are regulated or overregulated is central not just to curbing excess, but to ensuring that farmers can plant, home buyers can borrow, and businesses can invest.

Controversy about reform centers around three issues. Creating a platform similar to commodities future exchanges to push some 95 percent of trading from the over-the-counter market into those exchanges; banning banks—institutions taking government guaranteed deposits—from running trading desks and holding positions; and limiting synthetic securities.

Derivatives often have specialized purposes. For example, chemical manufacturers and life insurers have exposures to energy prices and interest rate movements that vary a lot, and these companies need specialized hedges. Pushing virtually all transactions through standardized contracts on public platforms will work poorly, concentrate risks and lower economic growth.

Virtually all of the 200 banks that failed over the last two years had no trading desk. Most failed making lousy loans and investing in poor commercial mortgage backed securities. Now, investment banking activities—yes trading—is helping to redeem Citigroup.

Banning banks from derivatives makes little sense, unless we bring back Glass Steagall by restricting banks to taking deposits, making loans and holding government debt. Congress has no stomach for that.

Banks provide trust services and make markets in municipal and state bonds—both vital services. Banks need to hedge positions, and the recent financial crisis would not have been averted had J.P. Morgan, Citigroup and other big banks been banned from derivatives trading.

Estimates of the SWAPs market range from $450 to $600 trillion in a global economy less than one-fifth that size. The market is so large, because speculators are writing synthetic securities— positions on securities that neither party owns. It's like buying insurance on a North Carolina beach house you don't own.

The scale of those markets can instigate financial calamity when underlying asset prices abruptly move—for example, housing prices after 2006—and synthetic securities do little to mitigate risk and aid investment and growth in the real economy.

Arbitrary limits won't work. Derivatives are simple contracts among consenting adults, and we know how laws to enforce private morality work—they don't!

We can require banks, licensed securities dealers and the like to only sell contracts when the originating party posts adequate resources to pay if prices drop abruptly on underlying assets. That was missing at AIG when its house of cards collapsed and would limit the scale of the market.

The rest that is being proposed is Washington excess. Fixing what is not broke and breaking what is running better than we now recognize. ESR

Peter Morici is a professor at the Smith School of Business, University of Maryland School, and former Chief Economist at the U.S. International Trade Commission.

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