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Financial Derivatives Market

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BlackNumero posted on Thu, Dec 18 2008 12:49 PM

When I talk to this one guy on a forum (I reffered to him earlier about his other posts), he says that the cause of this current crisis has nothing to do with the Federal Reserve or Banking but with the derivatives market. I tell him that bad loans were made because of the money supply increase, but he says that the problem is from deregulation. I keep trying to talk to him about it, but he doesn't listen.

Can anyone help me explain how the derivatives market (use company examples if you want) were created from the Federal inability or Fractional Reserve Banking in general?

Thanks alot.

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Suggested by Pyramid

I may be wrong but you and your friend are both explaining the problem just at different points.  Your argument stems from the Federal Reserve which is true, you're just looking farther up the stream.   Eventually, most of our economic problems stem from the source of our money which is the FED.  However, there were two factors also contributed to the crisis of financial derivatives.  One is deregulation on the Repub side, who championed free market ideology and that regulation doesn't belong in capitalism.  I agree with this to a point; capitalism doesn't need regulation but the greed of capitalists do.  On the dem side, was the Community Reinvestment Act (CRA) which forced banks to loan money to those with bad credit creating toxic assets which were bundeled as derivative packages and sold to other banks.  The combination of both policies and ultimately the FED created this crisis in the derivatives market.

 

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I thought it would be nice to post his response.

 

Originally Posted by rofl
So what happened in the past eightish years? The Federal Reserve tried to get us out of a recession by creating a bubble and lowering rates dramatically (now we can't even do that, the Federal Funds Rate right now is skinnier than Nicole Richie). Businesses take this money to finance new projects, and people take this money to make investments for newly purchases houses (to try and resell later for a higher price). Banks start lending wildly to everyone, and everyone spends or invests money crazily.

OK, for the last time: that's not the disaster we're dealing with.

That's another, smaller, mess. Another example of "free market" ideology gone goofy.

That isn't important to the market whose crash just wiped us out. It helped, but it made more or less the same contribution to the problem that the current Fed manipulations are making to the solution.

That little scene had almost nothing to do with the derivatives market, and the derivatives market is what crashed.

AIG, for example, not a bank, was not using newly or wildly lent money to make credit default swaps and deal in credit default obligations - they were leveraging existing financial products, money already lent, just once, not necessarily wildly, maybe years ago, maybe backed by the Fed somehow or maybe not, for something (not necessarily a mortgage) no longer relevant.

The market was dealing in CDOs and CDS's backed not by new loans, more wild lending created by the Fed, but by past CDOs and CDS's. These things were being bought by "money" leveraged originally from the entire US real estate market and more besides. (I would like to find one particular number, just for entertainment: what was the highest level attained before the crash? That is, what was the financial instrument furthest removed from one of its content original loans in the US market? These trades were being generated by computer, and marketed electronically - that level could be in the hundreds).

They were creating their own money, in your sense, independently of the Fed. The only reason people are even mentioning the Fed is that the Fed was supposed to keep an eye on the banks, especially the big ones, and the larger banks had jumped into this market with both feet.

That used to be illegal, for banks. The Government used to meddle in the free marketing of such financial instruments, and prevent banks from dealing in them. No more.

The model here is not a Federal Reserve bubble - there was one of those going on, but as a minor factor compared with this mess - the model here is something like the recent collapse of Albania's newly-emerged economy. In Albania, the whole country invested its savings in a few Ponzi schemes, and the whole country was wiped out. Their central bank was a bystander. Here: http://www.crimes-of-persuasion.com/...ania_ponzi.htm Notice: no central bank miscreance or other government meddling involved. Free market at work.

Nobody is denying that the Fed created a bubble or two recently, or that the recent one in housing was a bad scene. But that was peanuts compared with this crash. Trivial. Maybe a tenth the size? A twentieth?

Quote:
Originally Posted by valurean
PS if you look up Federal Reserve on Wiki, you get a really nifty graph on how our inflation rate exponentially increased starting from the year of it's unconstitutional founding.

It was founded in the Great Depression. An inflation rate of 0 would have been an "exponential" (your sense, meaning: large) increase.

 

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First of all, the root of this crisis was not the various financial instruments.  If the housing bubble never popped, these instruments would have had at least close to a correct rating, most everyone would have been paid, and no one would be complaining.  Calling for deregulation is as plain as stating, "I don't understand the financials market, so it must be hiding something dark."

Most often the complaint is about synethetic CDO's based upon credit default swaps, rather than actual mortgages or mortgage-backed securities.  Yes, these are riskier investments and should have been rated better.  However, without the bursting of the housing bubble, there would be less defaults, which means the CDS's would have kept receiving funding without having to pay out on defaults.  The holders of the synethetic CDO's would have been paid.

Calling for regulation here essentially means that the government must regulate risk in general.  This is like asking the government to fix prices in their proper places.  It has always been the case that private business handles risk/prices better than government planning.

Indeed, the big investment banks put themselves under way too much risk.  But why?  One reason is hopes of a government bailout in case the bets go sour, which was already historically the case.  This is called moral hazard.  The free market seeks to eliminate moral hazard by tying negative outcomes to bad choices.

Another reason is the FED's credit creation somehow fooled the rating agencies' models.  This makes sense - essentially this is the root of all business cycles.  The objective data on interest rates, inflation, etc. hide the truth about what the market would naturally look like.  This leads to massive errors.

Finally, regulation of derivatives would have only popped the bubble earlier.  Liberals should ask why there was a bubble to begin with.  They'll answer some vague quality like greed, but I provide an objective list of things below that contribute to the bubble.  It's easy to prevent a bust by outright prohibition.  We could prevent further stock market crashes by simply having the government buy shares in any corporation whose stock trades at a lower value than it is already at.  Or we could simply ban all forms of exchange.  This doesn't solve our economic problems; it just creates new ones.

 

My breakdown of the financial crisis is as follows: around 1994-1997, the FED started the printing presses, which led directly to the dot-com boom/bust.  In 1997, Clinton and co eliminated capital gains taxes up to $500,000 for owner-occupied real estate.  The housing bubble started then.  The easy money policy of the FED from 1997 - 2006 fueled this trend.

While the CRA had effects, they did not cause the crisis.  This makes sense.  The CRA has been around forever.  The CRA's negative effects on banks' risk taking were amplified by the housing boom, however.

While Fannie and Freddie also gave implicit government backing to their mortgage securities, it was not the primary cause.  Before Fannie and Freddie bought the majority of the nation's mortgages, the savings and loans did.  These entities also had implicit government backing, and that became explicit in 1989.  Again, the GSE's added to the fuel, but did not start it.

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BlackNumero:
AIG, for example, not a bank, was not using newly or wildly lent money to make credit default swaps

AIG is an insurance company.  CDS's are a form of insurance.  This guy is suggesting that insurance companies not be able to sell insurance policies, because that would put the insurance company under too much risk.

BlackNumero:
The market was dealing in CDOs and CDS's backed not by new loans, more wild lending created by the Fed, but by past CDOs and CDS's.

That they did that was not stupid, looking solely at derivatives-creation methods.  When you understand how they re-tranche the things and look at the cash flows and predicted default rates, they make sense and the credit ratings should be relatively accurate, so long as the underlying mortgages had an accurate rating.  The problem was that the underlying assets were in a giant bubble.  They were horribly inaccurately rated.  If these CDO's were made on car loans or CDS's on car loans, which weren't in a bubble, these derivatives wouldn't have collapsed.

In any case, why shouldn't a company be able to leverage itself or an investor take risk?  The ones who take bad risks fail and thus have less influence over the market in the future.  These are all the people the government is trying to save: sub-prime borrowers, the investment banks, etc.  If our normal state of affairs is bailouts for market losers, then we already have economic central planning, and the government should indeed be the one determining what financial instruments can and will be produced.  We reject all regulation because we realize that solving said regulation's problems will only require more regulation for more problems...and so on and so on until we're all socialists.

What this person fails to realize is that the entire bailout mentality right now isn't based upon saving the financial system.  It's based upon preventing further market corrections to the housing bubble.  In other words, banks allied with government still have too much bad debt on their balance sheets, and the government is trying to prevent the market from discovering its true value.  That's why they abandoned the TARP plan.  It would partially reveal how bad these banks are.

BlackNumero:
They were creating their own money, in your sense, independently of the Fed.

No.  Money is a medium of exchange.  No one can trade a CDO for bread.  And they also failed as a store of value.  Most Austrians don't even consider MMMF's as money although they fit a much better description of it than CDO's.  A better question than why the investment banks sought to create so many of these is why investors were so quick to buy them up.  They were the speculators fueling the bubble.  Why not let them pay for it?

BlackNumero:
That used to be illegal, for banks. The Government used to meddle in the free marketing of such financial instruments, and prevent banks from dealing in them. No more.

This guy would be surprised to learn that banks have historically existed almost exclusively to provide the market with money substitutes, many of which were backed by risky loans.  Austrians are the only economic school to seek a system where money substitutes must be strongly backed by assets, namely the commodity money they serve to replace.  The differences in reserves held against liabilities under decentralized quasi-free banking systems were much higher than we have currently or under any central banking regime.  Even further Rothbardians demand a regulated 100% reserve, treating demand deposits and bank notes as claim transactions rather than credit, which would effectively turn banks into commodity warehouses.

Without government intervention, whether it's bailouts, artificial credit, or banking regulation, these risk errors would disappear.

BlackNumero:
Nobody is denying that the Fed created a bubble or two recently, or that the recent one in housing was a bad scene. But that was peanuts compared with this crash. Trivial. Maybe a tenth the size? A twentieth?

Then let the people who perpetrated it fail.  Let the credit based upon bad debts get wiped out the system.  No one is claiming these people are free market geniuses.  Apparently, however, they are mixed economy wizards.  They milked the boom for every penny, and now they're asking for the tax-payers to continue to fund them during the bust.  We have not had a free market in a long time.  If this guy believes all private market participants are solely trying to get rich without government intervention, he is living in a dream world.  This goes back to the 19th century "robber barrons".

BlackNumero:
It was founded in the Great Depression. An inflation rate of 0 would have been an "exponential" (your sense, meaning: large) increase.

Federal Reserve was founded in 1913.  Indeed, a price inflation rate of 0 would probably indicate that new money is being created.  The natural order for consumer goods' prices under a static money supply is to fall as production expands and becomes more efficient.  Any money substitute not backed by commodity loaned into existence lowers the interest rate artificially and creates malinvestment.

What this guy doesn't realize is that if the system has too much bad debt, wiping it out will appear as a recession.  Look here.  The only times M' stops growing or experiences negative growth are 1989, 1995, 2001, and 2007; and these are brief adventures.  This means that there is a ton of bad debt in the system, much more than the housing and dot-com bubbles have shown.  The recessions and crashes are the corrections.

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Given that Albania is part of the interconnected, global US financial empire, how does he reason that, exactly? By pulling it out of his ass? One must wonder...

Freedom of markets is positively correlated with the degree of evolution in any society...

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Read the ponzi scheme thing.  here's a quote:

We were promising to double investors' money in two months and were depositing it in banks paying maybe 25% a year

So it's fraud.  That's not part of the free market.  Fraud is equivalent to theft.

Look at this quote from wikipedia on Albania:

Following the signing of the Stabilisation and Association Agreement in June/July 2006, EU ministers urged Albania to push ahead with reforms, focusing on freedom of press, property rights, institution building, respect for ethnic minorities and observing international standards in municipal elections.

So freedom of the press and property rights were apparently not around in 2006, far beyond the 1997 date of the scheme.

Let's see what wikipedia says specifically about this incident:

In the mid-1990s, Albania was becoming a liberalized economy after years under acontrolled economy; the rudimentary financial system became dominated by Ponzi schemes, and government officials endorsed a series of pyramid investment funds. Many Albanians, approximately two-thirds of the population, invested in them. By 1997 the inevitable end came, and the people of Albania, who had lost $1.2 billion (out of a small population of 3 million), took their protest to the streets where uncontained rioting, fueled by their discontent at the state's failure to protect them from the fraud, led to the toppling of the government and the country descended into anarchy in which some 2,000 people were killed.[3]

Market failure or government failure...you be the judge.

I would also like to add that when you forcefully prevent a market economy from functioning for a long time, you should expect investors to make foolish descisions for a while.  There are no pre-existing prices balancing risk and returns.  I bet a modern-day Albanian can spot a ponzi scheme pretty well.

Also, look at Madoff.  The SEC didn't protect investors.  Investors have to protect themselves.  That's why smart ones hire due-diligence firms when they are promised extra-ordinary returns.  This is in a country that supposedly has significant public financial regulation and fraud protection.

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