Financial Res Ipsa Loquitur

Comparing Guns, Credit Derivatives

Guns don't kill people, people kill people.

--NRA bumper sticker

Credit derivatives don't blow up financial systems, people do.

--Wall Street mantra du jour

Despite the incalculable harm wrought by credit derivatives on the U.S. -- and global -- financial system the past two years, Wall Street is clearly resistant to the idea that credit derivatives are a destructive force that need to be reined in. Or simply banned.

Wall Street's argument?

Using credit derivatives to hedge risk is a legitimate financial function. Things go awry when credit derivatives are misused.

In the words of Jerry Webman, Oppenheimer's chief economist, credit derivatives are no different than gasoline. The same gasoline that powers your lawn mower can just as easily blow up a Molotov cocktail.

Examples of legitimate uses of derivatives include airlines that need to hedge their fuel cost; farmers who need to lock in the price of their harvests; and oil producers who need to sell their output.

Flaws in the Argument

The problem with the foregoing argument is that it ignores reality -- recent, catastrophic financial reality.

Imagine hearing the dirigible industry defending hydrogen as an inert gas, safely used with the right precautions . . . the day after the Hindenburg blew up.

The public wouldn't buy it.

So why, in the aftermath of AIG, Lehman Brothers, Bear Stearns, etc. isn't there a massive public groundswell demanding regulation of credit derivatives? Why hasn't Congress taken action?

Two reasons stand out: 1) credit derivatives aren't well understood outside Wall Street (and perhaps, inside as well); 2) Congress isn't protecting the public, but rather the financial industry.

Financial Res Ipsa Loquitur

When a patient emerges from surgery with a scalpel left in their back, they don't need to prove negligence because of a legal principle called "res ipsa loquitur" -- the thing speaks for itself.

In practice, res ipsa loquiter shifts the burden of proof from the patient, who normally must prove that the surgeon was negligent, to the surgeon, who must now prove that he wasn't.

Something similar is now needed to weigh the utility of credit derivatives. In this case, the surgeon is Wall Street; the patient would be . . . us (as in savers, investors, and taxpayers).

Society doesn't allow assault weapons on school playgrounds.

There's no reason to permit what Warren Buffett famously labeled "financial weapons of mass destruction" to wreak havoc on our financial markets ever again.