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Guilty Bystander
04-07-2009, 10:47 AM
Near the end he opines that derivatives had little to do with the rise and collapse of housing prices. I'm wondering what other AOers think about that. It seems to me that CDOs and CDOs-squared played a big part in the subprime problem. So, the issue becomes, I think, how large an affect the subprime market had on the housing market overall. Easy credit fostered by the transfer of (obfuscated) risk was a (the?) problem.




OPINION APRIL 6, 2009, 10:38 P.M. ET In Defense of Derivatives and How to Regulate Them

The much-maligned financial instruments have legitimate uses.

By RENé M. STULZ
The dictionary defines a derivative in the field of chemistry as "a substance that can be made from another substance." Derivatives in finance work on the same principle. But if you read the headlines these days, you might think derivatives were made from arsenic by Wall Street institutions bent on causing financial destruction.

There are two sides to derivatives -- one positive and beneficial, one exploitive and negative. Of the latter, the most visible example today comes to us courtesy of the American International Group (AIG) and reveals what happens when a lightly regulated but highly interconnected financial institution ends up positioned in a way that it cannot survive a housing crash and then such a crash occurs.

The other side of derivatives, however, involves the less-publicized but widespread use of these financial instruments in ways that benefit companies. Derivatives have been immensely valuable tools and will be instrumental in providing the liquidity needed to jump-start the economy. Derivatives are used by a vast number of U.S. companies, both small and large, to manage various risks that arise in connection with their businesses.

From the perspective of Main Street companies, derivatives are not just about high finance, quants and politics, but about investing in America's core industries, jobs and economic recovery. Companies find that over-the-counter derivatives are essential to their day-to-day operations. Derivatives help insulate them from risk, which allows them to borrow capital at better prices than they would otherwise. And derivatives are more useful than ever in these days of unusual volatility in financial markets.

For example, not being able to hedge currency risk through the use of a derivative can leave a company exposed to fluctuations in currency markets. Without derivatives companies could see movements in exchange rates turn a profitable export contract into a money-losing agreement.

In its current annual report, Caterpillar Inc. makes the case for why it relies on derivatives: "Our risk management policy . . . allows for the use of derivative financial instruments to prudently manage foreign currency exchange rate, interest rate, commodity price and Caterpillar stock price exposures."

For those unfamiliar with market jargon, credit default swaps, which are most often in the news, are simply financial contracts between two parties. If, for example, you own bonds in a company and are worried that the company will default, you can manage your risk and protect your holdings with a credit default swap. Under it, you would make regular payments to maintain the contract. If the company does not default, you're out-of-pocket the payments. But if the company does default, the swap serves as a form of insurance by giving you the right to exchange the questionable bonds for the principal amount, or to be reimbursed in other ways. There's nothing exotic or complex about these contracts. They can be highly valuable for Main Street firms, because they enable them to protect themselves against the failure of large customers.

However, Main Street firms cannot afford derivatives unless there is a competitive market for them with participants willing to take the opposite position. Restricting access to derivative markets, which is being proposed by some in Congress as well as by some regulators, would make the costs of derivatives prohibitively expensive and eliminate liquidity.

That derivatives benefit our financial system and our national economy is well established. Twenty-nine of the 30 companies that make up the Dow Jones Industrial Average use derivatives. According to data from Greenwich Associates, two-thirds of large companies (those that have sales of more than $2 billion) use over-the-counter derivatives and more than half of all mid-size companies (those that have sales between $500 million and $2 billion) are very active in derivatives markets. Derivatives are necessary and helpful tools for companies seeking to manage financial risk.

The most important benefit of derivatives is that they allow businesses to hedge risks that otherwise could not be hedged. This does a number of positive things. It transfers risk, allowing firms to guard against being forced into financial distress. It also frees lenders to offer credit on better terms, giving companies access to funds that they can use to keep their doors open, lights on and, even, invest in new technologies, build new plants, or hire new employees.

It's important for regulators not to overreact by pushing for counterproductive new rules. The regulators, after all, were no better at foreseeing the current crisis than the private sector, proving that regulation has obvious limits and cannot replace efforts by financial institutions to devise risk-management approaches that enable them to cope with crises in the financial markets of the 21st century.

At the same time, some sensible regulations are in order. With the interconnectedness of markets today and the systemic problems facing the world's economies, there is a lot that can be done to limit systemic risks. One beneficial step would be for Congress to adopt some version of a systemic-risk regulator that would place every participant in the financial markets that poses a systemic risk, including derivatives traders, under federal regulatory oversight.

Unbelievably, the arm of AIG that dealt with derivative products was not subject to serious scrutiny by a federal agency with relevant experience. A systemic-risk regulator, or markets-stability regulator, should oversee every kind of financial institution that is found to be systemically important, including banks, broker-dealers, insurance companies, hedge funds, private equity funds and others. That regulator should have the authority to ensure that such financial institutions have sufficient capital to reduce the risks they pose to the financial system, to examine parent companies and subsidiaries, and to bring enforcement actions.

Additionally, a clearinghouse for standardized credit default swaps was launched in March, and other competitor clearinghouses are under construction. Clearinghouses clear and settle trades and limit the risk to the larger financial system if any one dealer, like AIG, fails to meet its obligations. A clearinghouse also allows regulators to monitor the exposure firms have to these products, while simultaneously ensuring that each firm posts the necessary collateral to cover its obligations under its trades.

However, clearinghouses should be reserved for established and standardized derivatives, leaving participants in capital markets free to engage in bilateral contracts for derivatives that fulfill specific needs as well as for new products. Further, use of a clearinghouse should not be compulsory, but capital-requirement regulations should recognize that derivatives positions that are not put through a clearinghouse may pose greater systemic risks than those that are.

The subprime mess triggered one of the most destructive financial crises in decades. It's not surprising, then, that the hunt is on for culprits. But derivatives are not the culprit. They had little to do with the rise and collapse of housing prices. Wider availability of housing derivatives would have actually reduced the impact of the collapse of housing prices if homeowners had been able to hedge against possible decreases in home values.

Our businesses need derivatives. Most of us choose to drive cars even though they sometimes crash. But we also insist that cars are made as safe as it makes economic sense for them to be, and that speed limits and other rules of the road are enforced. The same logic should apply to derivatives.

Mr. Stulz is a professor of finance at the Fisher College of The Ohio State University.

Will Durant
04-07-2009, 11:40 AM
1) Derivatives have legitimate uses
2) CDOs and CDOs-squared didn't played a big part in the subprime problem

Both of those statements can be (and are) simultaneosly true. Because CDOs were mispriced (by assuming real estate prices ricing forever and by misundertsanding the correlations between the underlying mortgages and underestimating how bad some of the underlying mortgages really were) doesn't mean CDOs don't have a legitimate purpose in a portfolio.

Just beware the financial alchemy.

Guilty Bystander
04-07-2009, 12:04 PM
I don't disagree with the assertion that derivatives have legitimate uses.

I think my response to WD's #2 is to imagine the last several years without CDOs and CDOs squared. I don't think the crisis is anywhere near what it is. Perhaps I have to also include CDSs to make that last sentence true.

Stulz states that, "derivatives are not the culprit." Perhaps not the culprit, per se, but if derivatives don't share a large part of the blame for either the "subprime mess" or "the most destructive financial crises in decades", then why even suggest any regulation besides what existed prior and during the financial meltdown?

JMO
04-07-2009, 12:32 PM
George Bernard Shaw wrote an essay called "The Vice of Gambling and the Virtue of Insurance." I think that a similar situation is involved here. Derivatives are not the problem. They can and often are appropriately used for hedging - a form or insurance. The problem was the result of gambling with derivatives - or in other words, speculating. Leverage played a role too, but that just allowed for much bigger gambles. JMO, as they say.

WWSituation
04-07-2009, 12:49 PM
Bravo Mr. Stulz. That was a very good piece.

Dr T Non-Fan
04-07-2009, 01:29 PM
The existence of derivatives created an incentive for commissioned folks (and their bonus-incentivated managers) to create mortgages where they otherwise wouldn't have. Easy, low-cost mortgages --> housing demand --> higher housing prices --> more houses built --> .....

An artificially high market will eventually collapse. A leak occurs -- the first sign that mortgages were oversold to people who could not afford them, at least not forever -- when the default rate rises a bit.

I wrote someplace around here that the term "toxic asset" is a misnomer, but got no comment on it. They should be called "toxic liabilities." Is that more accurate, as they are obligations to pay contingent on events?

exactuary
04-07-2009, 03:35 PM
Bravo Mr. Stulz. That was a very good piece.That's Prof. Stulz, Mr. Situation.

Attached is seminal risk management paper in finance.

Third Eye
04-07-2009, 03:47 PM
Of course he's technically correct. WMDs don't kill people. People kill people.

JMO
04-08-2009, 07:19 AM
I wrote someplace around here that the term "toxic asset" is a misnomer, but got no comment on it. They should be called "toxic liabilities." Is that more accurate, as they are obligations to pay contingent on events?

Some of the assets* are toxic, and there are also some toxic liabilities. In the case of a "monoline" such as AIG, I think it was a liability, because they promised to pay in the even of a default or credit downgrade.


* All those CDOs, especially the multiply layered ones, :shake: became toxic when it was realized that they had been priced on bad assumptions, but nobody knew what the right assumptions were. The race to the bottom was exacerbated by the same "mark to market" rules that had fed the bubble in the first place.

Jack
04-08-2009, 08:09 AM
Eric Dinallo argued in his OP-Ed piece in the FT is that instruments like CDS were deliberately exempted from old bucket shop laws. So instruments that have legitimate uses has hedges were used for speculation.

http://www.ins.state.ny.us/press/misc/op_ed_03302009.htm

Jeremy Gold
04-09-2009, 08:34 PM
That's Prof. Stulz, Mr. Situation.

Attached is seminal risk management paper in finance.This is a very important paper in corporate risk management. I see that at least 16 people have viewed it. Have some of you read it? Would you like to discuss it?

campbell
04-10-2009, 08:05 AM
This is a very important paper in corporate risk management. I see that at least 16 people have viewed it. Have some of you read it? Would you like to discuss it?

I'm reading it now, but I've already read derivative (sorry.... [no, I'm not]) works, as these concepts are in a couple readings on the AFE exam syllabus. Most specifically, these results (and concrete examples) show up in study note FE-C117-07: Doherty, Integrated Risk Management, Ch 1, Ch 7, Ch 8

What I would be interested in are more references to empirical studies of these concepts. Just as with utility maximization theory, one often finds that real-world behavior deviates quite a bit from that predicted by theory. And an overdose of theory has been a problem with the derivatives market, I think.

Eimon Gnome
04-10-2009, 11:07 AM
That's Prof. Stulz, Mr. Situation.

Attached is seminal risk management paper in finance.

Good reading. Thanks for the link!

Dr T Non-Fan
04-10-2009, 01:02 PM
This is a very important paper in corporate risk management. I see that at least 16 people have viewed it. Have some of you read it? Would you like to discuss it?
I would not like to discuss it. I'd like to read your opinion on this whole mess.
Not sure if I am worthy of posting in the same thread. Snarkiness and asking stupid questions are my forté.

Jeremy Gold
04-10-2009, 02:13 PM
Neil Doherty taught this paper to me. Neil and the paper have influenced me a lot.

Mary Pat, I don't think that empirical testing of this paper is how it should be measured. We all know that companies behave as though they were risk-averse (how skillfully they do so may be another matter). This paper, and others like it, provide a theoretical basis for the observed behavior. The interesting empirical issue is whether this theory (which is consistent with the maximization of shareholder value) or alternative theories based on self-serving managerial misbehavior (agency costs) better explain the observation.

I have used the favorable theory here:

http://www.pensionfinance.org/papers/TheIntersectionofPensionsandEnterpriseRiskManageme nt.pdf

and in an unpublished version which needs the help of a good applied mathematician.

And DTNF, after 33,000 posts I have never found you to be snarky or stupid-questioning. Of course I have probably read only 30,000 of them and who knows what hell you have unleashed in the other 3,000.

Which whole mess? We have so many today.

Dr T Non-Fan
04-10-2009, 02:29 PM
And DTNF, after 33,000 posts I have never found you to be snarky or stupid-questioning. Of course I have probably read only 30,000 of them and who knows what hell you have unleashed in the other 3,000.

Which whole mess? We have so many today.
You're too kind.

The messes: economic meltdown, for starters, and the various proposals for cleaning it up. Any ideas you have, or others' you prefer?

This op-ed piece defends the existence of derivatives in their proper use. A snarky analogy might be debating the existence of a wood-chipper. Sure, it chips wood and tosses the chips into a truck. Very convenient and efficient.



Then, there's "Fargo."

Wag, the Dog
04-11-2009, 05:55 AM
Sure, it chips wood and tosses the chips into a truck. Very convenient and efficient.



Then, there's "Fargo."Still very convenient and efficient.

campbell
04-11-2009, 10:47 AM
Mary Pat, I don't think that empirical testing of this paper is how it should be measured. We all know that companies behave as though they were risk-averse (how skillfully they do so may be another matter). This paper, and others like it, provide a theoretical basis for the observed behavior. The interesting empirical issue is whether this theory (which is consistent with the maximization of shareholder value) or alternative theories based on self-serving managerial misbehavior (agency costs) better explain the observation.

I have used the favorable theory here:

http://www.pensionfinance.org/papers/TheIntersectionofPensionsandEnterpriseRiskManageme nt.pdf

and in an unpublished version which needs the help of a good applied mathematician.


I'll read your paper later - I remember talking with you about the economic value added perspective for pensions before.

By "empirically test" the theory, I'm not exactly saying that we should be proving that firms are optimizing in exactly this way... we already know that just from human fallibility alone, people and groups of people do not optimize even to strongly held targets even when they've got a lot of information. What I mean by this is that it would be interesting to compare what the theory would show as an optimal solution and what firms actually do - and then look into either what is causing these disparities, or if certain things would make behavior more in line with what "should" happen [depending on people's own ideas of "should"].

I got interested in behavioral finance [which is usually meant to explain human deviation from optimal theory] when I worked at TIAA-CREF, as one might say there have been natural experiments on their policyholders, and there have been several papers published based on TIAA-CREF's own experience with financial education, etc. The empirical aspect I'm interested in has to do with designing programs, incentives, and the like to nudge people in the direction so that optimal results occur [such as the ideas in Thaler & Sunstein's book =Nudge=, and other books I've come across such as Cialdini's =Persuasion= and a diet research book I can't remember the title of now, so I've got to check my bookshelves later... but dealt with ways people's diets are unconsciously altered].

I think I'll stop here because I'm getting a little far afield. Anyway, what I meant by "empirically test" has nothing to do with whether the theory is "true" but how much firms deviate from optimal, and why, and how to fix it (and if we should fix it).

Plant Food
04-14-2009, 09:14 AM
There are two sides to derivatives -- one positive and beneficial, one exploitive and negative. Of the latter, the most visible example today comes to us courtesy of the American International Group (AIG) and reveals what happens when a lightly regulated but highly interconnected financial institution ends up positioned in a way that it cannot survive a housing crash and then such a crash occurs. (emphasis added)

snip

It's important for regulators not to overreact by pushing for counterproductive new rules. The regulators, after all, were no better at foreseeing the current crisis than the private sector, proving that regulation has obvious limits and cannot replace efforts by financial institutions to devise risk-management approaches that enable them to cope with crises in the financial markets of the 21st century.



This article is nothing more than a plea to ignore the past and continue letting the financial sector do what it wants. In a lightly regulated environment bad things happened. He then argues that we need to keep that regulatory model, in spite of the empirical evidence.


The other side of derivatives, however, involves the less-publicized but widespread use of these financial instruments in ways that benefit companies. Derivatives have been immensely valuable tools and will be instrumental in providing the liquidity needed to jump-start the economy. Derivatives are used by a vast number of U.S. companies, both small and large, to manage various risks that arise in connection with their businesses.

From the perspective of Main Street companies, derivatives are not just about high finance, quants and politics, but about investing in America's core industries, jobs and economic recovery. Companies find that over-the-counter derivatives are essential to their day-to-day operations. Derivatives help insulate them from risk, which allows them to borrow capital at better prices than they would otherwise. And derivatives are more useful than ever in these days of unusual volatility in financial markets.



He might have a point here if there wasn't evidence to the contrary in one of his papers (on the CAS8 syllabus, BTW), "Rethinking Risk Management" from The New Corporate Finance: Where Theory meets Practice (3rd edition), by DH Chew (editor), McGraw-Hill/Irwin, 2001, 411-427.

... most corporate derivatives users appear to allow their views of future interest rates, exchange rates, and commodity prices to influence their hedge ratios. Such a practice appears inconsistent with modern risk theory, or at least the theory that has been presented thus far.



Wider availability of housing derivatives would have actually reduced the impact of the collapse of housing prices if homeowners had been able to hedge against possible decreases in home values.


This is idiotic. He's suggesting that homeowners replace the risk of a decline in housing values with counterparty risk. If those products existed (I don't know if they do or not), the risk would get bundled and end up within one institution or a group of institutions and we have the same type of sytematic risk we've got today. What would happen is that a new class of retail financial products that homeowners don't understand would be pushed on them at closing by lenders/brokers with the corresponding fees and limited recourse for fraud (i.e. mandatory arbitration) that the financial sector is famous for. It's just another attempt by Wall Street to reach into Main Street's pocket.

Mr. Stulz is a professor of finance at the Fisher College of The Ohio State University.

Mr. Stulz is a bag man for the financial industry. He's the guy Ronald Ferguson hired to try to convince the judge that, even if he'd committed fraud, the AIG stockholders weren't harmed. http://www.bloomberg.com/apps/news?pid=20601087&sid=aKWBPXav91No&refer=home Not only does he drink the kool-aid, he invents new flavors of kool-aid.

campbell
04-26-2009, 10:41 AM
I feel like I should create some "generic statements on financial crisis thread" but whatever. Here's a WSJ opinion piece from L. Gordon Crovitz
http://online.wsj.com/article/SB124018430498933171.html

In Finance, Too, Learning Entails Risk
What if other innovators had given up?

Modern cities were built through trial and error. As architects reached upward, there was the trial of inventing a safe elevator so that buildings could become skyscrapers. Early contraptions were used in factories and mines, but when cables broke they plummeted to the bottom of the shaft. In the 1850s, Elisha Graves Otis developed a safety device to keep elevators from falling, eventually giving people the confidence to use them.

Our era may be losing the tolerance for the trial and error needed to make innovations successful. Consider the financial engineers whose mistakes led to today's financially led recession. They thought they were creating a more stable economy by applying mathematical models to markets, using new technologies of computing power and global trading. Even having lost fortunes, today they and their financial institutions are pariahs, subject to media frenzy and government regulation.
....
Mr. [Robert] Merton gave a fascinating lecture at MIT last month that deserves wider attention (the video can be viewed via The Business Insider Web site at http://bit.ly/MertonatMIT).
....
It's easy to forget that financial derivatives have real value when applied with judgment. Businesses use them to hedge risks, from currency to the chances of a counterparty going out of business. Lenders can offer better terms by minimizing their risks, freeing up capital to support investment and economic growth. When the system seizes up, as we now see, pain spreads well beyond financial markets.

In a paper for the scientific journal of the Royal Society back in 1994, Mr. Merton warned that "any virtue can become a vice if taken to extreme, and just so with the application of mathematical models in finance practice." We know even better now that some risks can be calculated and thus reduced, while some unknowns cannot be turned into probabilities. "The mathematics of the models are precise, but the models are not, being only approximations to the complex, real world."

Dr T Non-Fan
04-27-2009, 12:35 PM
I think the "Cat in The Hat Comes Back" explanation works great:
The Cat makes a mess (or, a risk is created).
Cat takes Cat A out of his hat (insurance against risk) to clean mess. Moves mess (risk) to some other part of house.
Cat takes Cat B (slightly smaller than Cat A) out of Cat A's hat to clean up Cat A's mess (shift risk somewhere else).
...
...
...
Cat Z (infinitessimally small) cleans it all up, somehow.

Question: in our financial mess, what does Cat Z represent?

campbell
04-27-2009, 12:54 PM
and does Cat Z have a VOOM! in his hat?

Dr T Non-Fan
04-27-2009, 01:02 PM
and does Cat Z have a VOOM! in his hat?
I'm not even sure what Cat Z was supposed to represent in the book. Faith? Magic? The Impossible? The Truth (all prior cats were taking a dirty lie and spreading it around, making it worse and worser)?

I seem to recall that The Cat took a bath and left a ring. Hilarity ensued.

Maybe Non-Act Cyberchat has an answer.

campbell
04-27-2009, 01:04 PM
As I've got the book pretty much memorized at this point [having 3 kids under age 6], I think the main point of the book is to review the alphabet.

And maybe look at cause and effect.

Dr T Non-Fan
04-27-2009, 01:34 PM
As I've got the book pretty much memorized at this point [having 3 kids under age 6], I think the main point of the book is to review the alphabet.

And maybe look at cause and effect.
Surely there is a subversive message in there somewhere?

JMO
04-27-2009, 02:24 PM
Surely there is a subversive message in there somewhere?
The letters S, E and X are in there, I suppose.

Guilty Bystander
04-27-2009, 02:40 PM
Pretty sure Cat(s) Z are the millions of individual taxpayers.

campbell
04-27-2009, 03:21 PM
...what I want to know is where Dad got those $10 shoes....

Dr T Non-Fan
04-27-2009, 04:06 PM
...what I want to know is where Dad got those $10 shoes....
Wow, I thought I was well-versed on this....

In short: there is always someone better to come along and clean up whatever mess you've made. So enjoy your mess while it lasts.

WWSituation
04-27-2009, 04:41 PM
MPC - I second your idea to start a new thread to discuss RM disasters (not unlike the public pension thread)

campbell
04-27-2009, 04:58 PM
MPC - I second your idea to start a new thread to discuss RM disasters (not unlike the public pension thread)

Done and done.

http://www.actuarialoutpost.com/actuarial_discussion_forum/showthread.php?p=3607915#post3607915

Which reminds me, I need to refresh the public pension thread.