The Nuclear Option
Unless you’ve been living under a rock, you know that a housing boom enhanced by risky leverage has caused an implosion within our very financial system. What was first contained to the real estate and financial markets has now quickly spread into mainstream job losses.
While the panic may have subsided, the pain that people continue to feel is very real. Businesses continue to fail and the very health of some of the largest financial institutions still remains in doubt. There have been a lot of solutions proposed for getting ourselves out of this debt ridden mess, but most agree that it’s going to take some kind of investment to break the vicious downward spiral. Some argue that this investment should come from the government through stimulus spending, while others have argued that we need tax breaks and incentives for the market to properly function. Some say we should do nothing and let the market figure it out. There are even those who argue that the tax revenue from legalizing marijuana could be the solution to our problems.
While every argument has it’s pros and cons, even at $3 trillion dollars, I can’t help but wonder if these solutions aren’t radical enough. Now bear with me, because I’m still trying to flesh out the impact that this kind of idea would have on the financial markets, but here is my own proposal for an economic recovery plan.
Eliminate the creation of any new derivative investment.
When you look at the cause of the financial crisis, it’s easy to blame real estate, but the reality is that it was over leverage that created the tsunami after the quake. Because of the lax regulation surrounding CDOs and other leveraged investments, banks and institutional investors were able to create a side market where they could bet on the success or failure of the marketplace.
From 02′ – 07′ the derivative market grew from $100 trillion to $516 trillion in size. When the bubble burst, this side market took the real market down with it. Considering that it was leverage that led us into this, forgive me if I can’t help but wonder how beneficial this stuff really is.
While derivatives do allow for businesses to hedge risks that they’ve taken, they are also used to speculate on everything from the price of gold to the weather in New York city. The problem is, that I don’t think they actually create jobs, at least not directly.
If a company wants to raise money so that they can hire staff, expand their business or just stay alive, they’ll typically either borrow the money (debt) or will sell off ownership in their company (equity). While there are many other ways to raise money, the important point is that the debt or equity that is created goes towards helping the business succeed.
When a big bank writes an option contract or an interest rate swap and links it to the price of something else, none of the money goes to the business or underying asset that investors are betting on (or against for that matter.) Instead the money raised is passed between investors and financiers depending upon the final result.
So what would happen, if the captains of industry weren’t allowed to underwrite derivatives any longer? This $500 trillion market would be forced to find other investments. Instead of being able to borrow money and make 10 – 1 long shots, they’d have to invest in the real assets or buy that debt and equity off of the open market. Instead of a $3 trillion injection, we would see $500 trillion redistributed to businesses as more and more contracts expired.
Now I’ll be the first to admit that there are some serious risks to my proposal and that such a drastic action could potentially cause an even greater collapse. I’ll also concede that any possible attempts at banning derivatives would have so many loopholes that it wouldn’t be effective. I won’t even pretend to know how the financial behemoths would react if they lost access to these types of investments. Certainly a few of them would likely go under. I’m also not sure what type of contraction effect something like this could have on the money supply. The last thing we’d want is for people to have to pay back $500,000 mortgages earning 1980′s level wages. Yet despite all these misgivings, I can’t help but wonder how important this extra layer of investment really is. By not allowing derivative investments, it would remove a middleman from the finance system and allow private money to go directly to job creation.
The cure may end up being worse then the disease, but if we end up finding ourselves in the great depression 2.0, I think that the nuclear option should be left on the table.
Posted on February 11th, 2009 by Davis
Filed under: SA
With all the credit default crap, I’d forgotten about the derivative portion. I remember it making the latent conspiracy portion of my brain tingly. I’m not really that person, but when you can take an insurance policy out on something you don’t even own. The mind wanders.
It is even more scary when the insurance policy is ten times the value of the underlying asset. It gives people too much of an incentive to make sure something succeeds or fails. Buffet was right when he called them financial weapons of mass destruction. When they’ve imploded the results have been very unpredictable.