By Arnold Kling
These derivatives are the root of the credit crunch. Why? Unlike all other property paper, derivatives are not required by law to be recorded, continually tracked and tied to the assets they represent. Nobody knows precisely how many there are, where they are, and who is finally accountable for them. Thus, there is widespread fear that potential borrowers and recipients of capital with too many nonperforming derivatives will be unable to repay their loans. As trust in property paper breaks down it sets off a chain reaction, paralyzing credit and investment, which shrinks transactions and leads to a catastrophic drop in employment and in the value of everyone’s property.
I don’t think this generalization works. Credit default swaps may be poorly documented. However, mortgage-backed securities (which de Soto includes as derivatives) are as well documented as bonds and other securities. The international currency markets are filled with derivative transactions, and those markets are not malfunctioning. Readers of this blog know that I am a fan of de Soto and I am not a fan of credit default swaps, but this article did not persuade me.
Second, we have Michael J. Roberts.
Expected returns of the underlying asset go down with risk. Expected returns for the taxpayer would be somewhat less than that of the underlying asset since the investor gets 10% in expectation. A seriously raw deal for the taxpayer kicks in around an SD of 15% of the purchase price.
I don’t know how much uncertainty there is. But my guess is it’s less than an SD of 15%.
I have not checked Roberts’ analytics. However, if he is correct that the standard deviation on the “toxic assets” has to be 15 percent or more to shaft taxpayers, then my guess is that taxpayers are shafted. I think of the typical toxic asset as being not a bond, which might have a reasonably low standard deviation. I think of it as a put option that is just barely out of the money, so that it has a huge standard deviation.
Finally, David Leonhardt writes,
The car rental industry’s original sin isn’t so different from the economy’s. It took on too much debt.
The point of the article (I think) is that if a company’s fundamentals are not good, tight credit is not really the issue.
I would go beyond that and restate my point that instead of worrying about making our banking system hard to break we should try to make our economy easy to fix. Our economy would be easier to fix if we did not encourage so much debt finance. Having corporate tax laws that punish equity and reward debt is an issue. Encouraging home ownership by subsidizing mortgage indebtedness is another issue.