Beyond Thunderdome

Out of the ruins
Out from the wreckage
Can't make the same mistake this time
--Tina Turner

Carol Loomis is one of the most talented reporters of the financial industry. Her capacity for describing important people and actions in this industry is nearly unparalleled.

Like many 'journalists,' however, she frequently slides down the slope from description to analysis and, sadly, to editorial. When she assumes these latter roles, it appears to me that her diagnosis frequently misses the mark, and reveals bias toward 'big bad business' and desire for increased government control.

In her recent Fortune article on derivatives, for example, Ms Loomis advances the typically Leftist argument that derivative markets require more regulation because they threaten the financial system. Without more oversight, buyers and sellers of these instruments, whom to Ms Looomis appear incapable of understanding the complexity of these instruments and/or managing their risk, will create a situation that will ultimately bring down large institutions or perhaps the entire system. In fact, that situation may be upon us currently, with the world wide notional value of derivatives standing at nearly $600T (yep, that T stands for trillion).

Let's for a second assume that the root cause behind all of this is just greed-driven miscalcuation of risk by the buyers and sellers of these instruments. Sellers of these instruments underestimated the probability that the events they were insuring would come to fruition, and buyers overestimated the counterparty's capacity to make good on the terms of the derivative contract.

Were we to stop right there and assume we're at the root cause of the problem, then regulation makes little sense. The way that markets drive improvement of such situations is to have buyers and sellers learn from their mistakes--in the form of losses. The bigger the losses, the more future market participants will change their behavior to get risk:reward into better balance.

Regulating markets, almost by definition, mitigates lessons learned and squelches learning and improvement.

More importantly, however, by assigning the blame to 'excessive greed' and 'lack of understanding,' Ms Loomis' superficial level of analysis does little to explore real root causes of this situation.

Valuable analysis would employ more reason. First, we might begin by observing that the derivative market is way out of balance. We would then reason that markets do not get way out of balance on their own, because markets seek balance between risk and reward. To get this far out of whack, there has likely been intervention that has skewed the risk:reward calcuation.

Why did sellers of credit default swaps misjudge tail risk so badly? Why did buyers of derivatives fail to accurately assess counter party risk? What situation(s) suddenly created such huge demand for these derivative products? 'Greed' alone can't explain this, because under free market situations 'fear' checks greed.

Instead, a salient question here seems to be: What interventions distorted the risk:reward dynamic, and threw the derivative market way out of balance?

Rather than blindly assigning a cause of 'excessive market freedom,' prudent analysts would be wise to investigate the interference that threw the system out of balance, and not settle for superficial analysis that pins the blame on excessive market freedom.