The Senate paved the way for a final vote on financial reform. As the final vote comes closer we will likely hear populist arguments that derivatives caused the financial crisis, that they aren’t real investments, and that they have no societal benefit.
In Washington, there is a bevy of politicians looking for someone to blame for the housing crisis. Many blame exotic, esoteric derivatives for the collapse in the housing market. While many of these investment vehicles are undoubtedly esoteric, derivatives did not cause the housing crisis—reckless behavior on the part of the governmental sponsored enterprises (GSE’s), ratings agencies, and countless individuals were the prime culprits. Derivatives provided people like hedge fund king Jon Paulson, the ability to bet against the real-estate market. Had more people made similar bets on the real estate market falling, prices would have moved, and the real estate bubble would not have been as disastrous as it turned out to be.
So how are derivatives possibly good for the world? First, the purchase of a derivative is a transaction, and people should be free to transact as they see fit. These derivatives are good for the world because whenever you have a transaction, two sides enter into an agreement. In order for two parties to transact, they must both think they are being made better off. Take, for example a hedger and a speculator. The speculator becomes better off by making money, and the hedger is better off because she mitigated risk.
In the event there is a speculator-on-speculator side bet, someone will invariably lose money. You might ask, “How is this possibly good for society?” First, I would argue that people should be able to invest their hard earned capital as they please. But, back to the point, this is beneficial for society because it will lead to greater market research, which will allow the financial markets to better gauge whether prices are too high or too low.
To review, the same government that brought us GSE’s such as Fannie Mae and took subpar loans from the likes of Countrywide Financial is now trying to pin the blame for the financial crisis on derivatives. The fact is that these financial instruments are beneficial for society, and are valuable indicators of the quality of investments. Allowing investors to profit by exposing companies with miscalculated credit ratings is an economically beneficial activity and we should do all we can to encourage this type of investment activity.
-Andrew Thappa is a second-year student