Since the United States economy nearly collapsed in 2008, economics and finance have become a hobby of mine (if you’re interested, Frontline offers a good explanation of how the economy fell apart, here, and This American Life has an amazing story about what led up to the breaking point, here.)
In studying what happened, I’ve become increasingly interested in the role derivatives play in the world of finance. Since I live in New York, I’m acquainted with a few people who work in the financial sector, and I know one person in particular who is employed by an investment bank that deals in derivatives.
Through some conversations I’ve had with him, I’ve reached two conclusions: (1) Derivatives, like novels, can help or hurt people’s lives, (2) Derivatives are a form of legalized gambling and should be regulated accordingly.
I know what you’re thinking: “Black Beard, isn’t it hyperbole to label a widely practiced legitimate form of business gambling?” No. My finance-friend explained one of the varieties of deals he works on this way: a company wants to take out a big loan (hundreds of millions of dollars) with a variable interest rate, and they’ve found a lender, but the lending bank is worried that if interest rates begin to rise the borrower will default on the loan. So the borrower contacts the bank where my friend works and enters into a contract where the borrower pays his bank a fee for the promise that his bank will pay the interest on the loan if rates go above a certain number. In other words, my friend’s bank is betting that interest rates will stay below that number. If they do, his bank will receive a lot of money for basically nothing, and if they don’t, they will lose money.
On a similar note, I made a bet with another guy I know that the Colts will beat the Jets by seven points this weekend. If they do, he’ll pay me $100, and if they don’t, I have to pay him. The question I ask you is how this is any different from the bank deal above?
Now, I know the official argument is that derivatives allow companies to hedge their investments and protect themselves from risk. However, it seems to me that if I borrowed a big chunk of money from a bank and they told me they were afraid I wouldn’t be able to pay them back, then perhaps I should reconsider the amount I was borrowing, or whether it is a good idea to take on any debt in the first place.
This is just one example. There are other derivatives that are much worse (Collateralized Debt Obligations, for example) which offer no value tangible benefit for society. That being said, I’ll be the first person to admit that art should be classified under the heading “no tangible benefit for society.” I love Ulysses, as you may or may not know, but I’m not foolish enough to believe the novel has done anything to combat human suffering caused by disease or poverty. It’s a fascinating piece of text, but nothing more (in fact, for the vast majority of people who walk the Earth, it’s not even that). But at the same time, a lot of people write a lot of bad novels and correct me if I’m wrong, the world’s economy has never been pushed to the brink of collapse by the accumulated effect of bad art.
Compare this to derivatives. They’re esoteric instruments that really only a small group of people are concerned with (I would estimate slightly fewer people than have read Ulysses). Like a novel, if a derivative like, say, the aforementioned CDO (again, if you do nothing else today, listen to this episode of This American Life) is successful then it makes the person who created it happy (and by happy I mean rich) and gives the people who were fans of it pleasure (by fans I mean investors and by pleasure I mean money). If, however, that CDO is unsuccessful the effect is much more far reaching than a bad novel. We can’t outlaw everything with negative side effects (or else alcohol would still be illegal, along with Wes Anderson movies), but if Ulysses could be banned from the United States on the charge of obscenity, I think we can afford to ban the very thing that has brought about our current recession. At least until I earn enough money to start investing in them.
