Financial Reform and Straw Cattle (er, Men)

WSJ: 'Financial Reform Hurts Farmers'

"Finance Overhaul Casts Long Shadow on the Plains"

--Headline, The Wall Street Journal (7/14/2010)

So, according to The Wall Street Journal, regulating derivatives -- as the financial reform bill before Congress weakly proposes to do -- will in fact hurt Midwestern farmers.

That's because it will cost them more to hedge the sale of their crops, livestock, etc.

There are only two problems with that argument:

One. It's far from clear that regulating derivatives will make them more expensive.

In fact, buried in the Journal's own article are quotes from several experts who argue that better regulation and more transparent trading will make derivatives less expensive.

Two. The cost of not regulating derivatives (just so far) has come to trillions in new federal debt, a crashed financial system, and a nasty, ongoing recession.

Not exactly good for farmers -- or anyone else!

P.S.: my alternative -- and more correct -- headline: 'Finance Overhaul Lifts Long Shadow Over the Plains.'

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.

China, cont.

"Geithner Says China Has Faith in U.S."
--headline, The New York Times (6/3/09)

[Editor's Note: Sorry, I'm on a China kick -- just one more in that vein. And yes, it does bear on real estate. In fact, whether China keeps buying U.S. debt -- and therefore whether mortgage rates stay low -- is probably the single biggest variable affecting U.S. housing prices right now.]

Just two thoughts on the above headline:

One. Wouldn't it be more reassuring if it read, "China says China Has Faith in U.S."??

Two. Actions speak louder than words.

Some of the most flattering things you'll ever hear about a publicly-traded company are analysts and major stockholders praising it as they seek cover to dump their shares (or recommend same). Or buy credit derivatives that appreciate as company shares tank, which is effectively the same thing.

You'd think that the Securities and Exchange Commission ("SEC) would police that (and a lot of other things), but there's plenty of evidence that they don't.

"Over a Barrel"

So here's what you're left with: don't listen to what Chinese leaders say, watch what they do.

Of late, they've been pushing to have their own currency, the renminbi, included in a basket of world currencies to serve as a meta "reserve currency." That's significant because it would supplant the U.S. dollar as the de facto world reserve currency.

Why does that matter?

A key difference between, say, Albania, and the U.S., is that the latter's debts are denominated in its own currency. If the U.S. debt becomes unmanageably large -- one of the big concerns at the moment -- it always has the option of printing more money. For now, at least.

One last quote regarding China, which already owns a trillion-plus in U.S. debt: 'if you owe your bank $1,000, they've got you over a barrel; if you owe them a couple trillion, you've got them over a barrel.'

Unfortunately, there's a crucial difference between dumping what you already have -- and buying more.