Sunday, April 25, 2010

Bling Bling

I dislike when people wade into subjects they almost passably understand and make definitive comment (think Peace Corps volunteers who know everything about fixing developing nations because they spent two years teaching English somewhere or TFA volunteers who could fix education if just given the reins). I'm also gonna do it right now; prepare to learn why hedging in the stock market is bull, and doesn't help America.

We open the prosecution by calling on Adam Smith. In his famous work The Wealth of Nations, he identifies land, labor, and capital as the three factors of production and the major contributors to a nation's wealth. The stock market hinges on liquidity, and isn't involved in rapid land transactions. It also doesn't deal labor (unconstitutional). Therefore, if we are to assume the body contributes to our national economy, it must be through an infusion of capital.

I buy this to an extent. When a corporation goes public, it allows investors to purchase a portion. The arrangement provides an infusion of cash, allows for the purchase of capital goods and becomes an economic driver. (A simplistic take, but generally correct.) What's problematic is when we treat subprime deals and subsequent betting with equal deference.

Two factors should determine how a loan is calculated: level of risk and transaction costs (operating costs of the lender captured here). Now in our system you can lower your level of risk by taking out insurance on the loan, effectively betting against it (when you're dishonest about it, Goldman Sachs can get in trouble). This decreases the cost of the loan, undervaluing the inherent level of risk. I don't think this is good for America.

An argument exists for supporting this hedging. Economic undertakings are risky, and demand an infusion of capital that isn't guaranteed to pay off. A business start-up that may never have gotten off the ground can be given the chance to flourish because, at the margin, hedging insurance makes the loan just cost-effective enough to work. We all profit as the next Berkshire Hathaway is born.

This fantasy of some economic boon facilitated by lending on the margins is fantasy. Loan fees should reflect the full risk of investment - if the risk of default is too great to grant without insurance, it's probably not a good loan to be making. There's an argument that when you bundle multiple loans and hedges, you can come out ahead (more loans are repaid than default) while capital is still generated. I say even more capital and profits are generated by encouraging safer loans.

The solution must consider who you want to shoulder the burden of the default. AIG obviously failed when everyone started going under and collecting their insurance payments. A bank forced to keep enough in reserves won't have this problem: you can eat the bankruptcy with your reserves! Of course, AIG could've also been forced to keep enough reserves to cover payouts, but not even China has that much money.

I actually wouldn't oppose the idea of hedging with insurance in moderation, much like I support acts of vigilantism on a limited basis. Unfortunately, we both know it's unrealistic to believe moderation would ever be observed if allowed. Limiting bank size is a smart, essential policy. Limiting market insurance of subprime lenders is even more important. At the minimum, it needs to get spread around more. A limit on market share or some other mechanism would be excellent. Would economies of scale make this unreasonable because smaller insurance companies can't shoulder bets on defaults? All the better. Our unemployment rate is still above 10%, and I graduate in less than a week without a job. If a trade-off must occur, you can bet I think growth should've been tempered in favor of sustainability.

1 comment:

  1. Update: Levin moving to make betting against customers illegal: