In all the blame concerning our latest plunge into recession, financial derivatives have come in for a hefty, and somewhat justifiable share. They also have been accused for initiating every downturn since the crash of 1987.
In theory, derivatives provide a really sweet method of risk sharing in the market. You own a stock or commodity on which you are willing to take a ride for a nice predictable profit. Another investor, who is more of a wild-eyed risk taker, is willing to help you keep that ride safer by transferring part of the risk to himself for a fee. If the share price goes above or below certain agreed-upon numbers, our wild-eyed risk-taker takes the excess profit, or loss. Both derivatives’ popularity and instruments, from standard S&P 500 Index Futures to exotic credit default swaps (CDS), have grown exponentially in the last decade.
The trouble is that derivatives are merely a crap shoot. You’re not investing in an actual entity, like a corporation that produces software. You’re simply betting on tomorrow’s roll of the market dice.
To provide a truly expert view of what part derivatives (and many other factors) have played in our latest recession, Princeton University’s Woodrow Wilson School of Public and International Affairs will present “Derivatives: Weapons of Mass Destruction or Generators of Market Stability?” on Monday, October 11, at 4:30 p.m. at Dodds Auditorium. This free panel discussion features speakers #b#Roger Lowenstein#/b#, prominent business author and journalist for the Wall Street Journal and New York Times; #b#Gillian Tett#/b#, British journalist for the Financial Times, and author of “Fools Gold;” and former governor and Goldman Sachs CEO #b#Jon Corzine#/b#. Visit www.princeton.edu/events.
“People often say that I was following in my father’s footsteps” says Loswenstein, “but that’s not at all the way it happened. He (Louis Lowenstein) was a corporate lawyer who, by a circuitous path, found his way into becoming a Columbia law professor. I, as a reporter, found my own circuitous path into the Wall Street Journal.”
Lowenstein’s path included initial jobs with two newspapers — one in Virginia, another in Caracas, Venezuela. In 1979 he joined the Wall Street Journal. By 1989 he had begun his stock market column, “Heard on the Street,” which he continued for more than a decade. He has also written countless articles for the New York Times, Bloomberg Wire Service, and the New Republic.
Lowenstein has written five books including “When Genius Failed: The Rise and Fall of Long-Term Capital Management,” in which Jon Corzine is a major character. Lowenstein’s latest, “The End of Wall Street,” analyzes the history and causes of our most recent recession.
#b#The road astray#/b#. “This recession is the latest in an ever-escalating series of economic crises,” says Lowenstein, “and when I began researching its history, I was surprised how far back I had to go.” In all the three decades of previous crashes, he points out, we were able to slough them off and keep going. Like the 2000 dotcom crash, the downturns were localized, striking a specific sector of the economy. But this current bubble and meltdown took an a much broader scope.
The pathway down. This latest recession sprang from the greatest possible numbers of society and involved the very core of our economic functions. An estimated one in six businesses are dependent on housing and construction. In 2008 more than two thirds of American families owned their own home. Further entangling the process, those home mortgages engaged every level of economic institution, from local community banks to the nation’s largest brokerage houses.
“The real problem is an age old one,” insists Lowenstein. “There was just too much credit leveraged out there. Too much money being used by people that was not their own.” Certainly, many economists have likened the dangerous 1920s stock market practice of allowing investors 10 percent margin (the other 90 percent being borrowed) to 2008’s no-money-down home purchasing.
A small part of the recession blame may be laid at the homebuyers’ doors. Consumers did, with great encouragement, over-reach their prudent purchasing capacity. “But it is the bank’s job to screen out bad loans,” says Lowenstein. “When you entice a borrower to purchase a 100 percent mortgage, give him a pass on the interest for a year, then ignore the documentation, what can you expect?”
The damage might have been contained to this individual buyer level had it not been for the delusion that any problem could be passed on. Borrowers believed in the tradition that banks always hated to foreclose and that they could always borrow more.
Banks, which were getting paper cuts as mortgages profitably passed from themselves to brokers like Countrywide Inc., felt that a poor loan could be mended by its purchaser. Brokers, in turn, felt that good and bad loans could be evened out by loan bundlers, like Merrill Lynch and Lehman Brothers. These big institutions merely saw their loan bundles as an attractive, high-yield package, desired by any large investor. Finally, the investors themselves saw the whole proposition as liquid income that could be recouped at the slightest sign of instability. All of this “letting the next guy fix it” proved horrifyingly wrong.
#b#The return road#/b#. Winching ourselves back on track is, as Lowenstein puts it, “a very delicate task. The problem is, we’ve got to get our economy up and the institutions self-functioning again.”
But every move holds a counter caveat. We’ve got to get the government out of the business of resuscitating our economy — but at a sensible schedule, weaning our financial institutions at a rate that will allow them to stand profitably on their own.
LIkewise, to achieve fiscal health, interest rates must be raised, but at the same time, we must keep our rates low until we achieve substantial employment growth. Consumers need more than confidence to buy, they need paychecks.
“Finally, we, as a nation, must address the budget deficit” says Lowenstein. And that means taxes.” Could the U.S. emulate the popular European model and raise its tax rates 50 percent, thus cutting many of our current living costs? “No, definitely not 50 percent,” says Lowenstein. “But I would absolutely undo all the Bush tax cuts, and consider an overall raise for all but the poorest sectors.”
The current view that any and all taxes are destructive, Lowenstein points out, is harmfully short sighted. On the local level, many municipalities have saved their taxpaying residents $25 a month by dropping garbage pickup from their list of services. Now the homeowner pays $130 to privately contract for that service. And despite the $105 increased cost, many folks still rejoice at this municipal spending cut as long overdue.
One thing is sure — knee-jerk responses like total regulation or free-range capitalism do not hold the answer. Timing and amount are everything. Could too much regulation spoil the derivatives market? Yes, and that would cripple much of the vigorous investment growth that has coincided with the derivatives proliferation. Should derivatives be allowed to run free as a backroom gambling den, sullying the security of solid market investment which contributes vitally to business growth? Probably not.
Somewhere lies a careful, middle ground that may be found after all the political footballing and outright greed have been cleared away. It is there. But it will demand an unprecedented amount of cooperation and far-sighted compromise to make it all work.