Learning the Right Lessons

As I mentioned on Monday, I'm looking for some good stories related to derivatives that will help people understand the hubbub over them a little better.

Fareed Zakaria's column on Goldman Sachs is a good place to start.  As you've no doubt heard by now, Goldman has been sued civilly by the SEC and its executive were grilled by the Senate Permanent Subcommittee on Investigations in the past couple of weeks.

Zakaria demonstrates that one doesn't have to opposed derivatives regulation to understand the dangers, however, inherent when one firm is made a scapegoat for an industry:

the rage surrounding the Goldman case can cloud our perspective and distort public policy. We're going through a familiar part of America's boom-and-bust cycle. Having been mesmerized during the go-go years, having unduly lionized and feted industries, firms, and people as they rode the wave, we now want to throw these people to the wolves. We need to step back for a moment and try to understand what happened and learn the right lessons.

Whether new regulations are warranted is best left to a blog dedicated to studying financial issues, but making sure our processes and methods of oversight are calibrated to learning the right lessons is of vital importance to all fans of good government.

The Congressional Debate Over Derivatives

I recall Congress debating derivatives several years ago.  Listening to members talk about them was painful.  One member even discussed them as if Congress was discussing mathematical derivatives (such as that above) and asked why Congress thought it could regulate mathematics.  Needless to say, nothing was done at the time.

With the financial crisis and the role that derivatives well publicized (if not totally agreed upon), it appears Congress is now ready to tackle them.

Derivatives (as in the financial type - no the mathematical) are simply agreements for party A to pay party B some money if something else happens (interest rates go up, the price of wheat falls, the dollar rises against the ruble).  For many parties, such as farmers and manufactures, its a useful tool to "hedge" against a risk that party doesn't want to bear.  In current parlance, hedgers are known as "end users" and are generally thought to be ok sorts of folks.  The other guys are the "speculators" or those who create them to speculate rather than hedge any risk that derives from their business operations.  These are mainly Wall Street types.

The main questions being debated: to what extent must derivatives be standardized and traded through exchanges (with the exchange serving as a middleman) rather than customized and traded "over the counter" directly between two parties?  Next, to what extend should financial institutions need to segregate their derivatives trading from other financial activities?

These topics are way to complex to do justice to them in a blog, but I'll try to post some links to useful sources for those who want to learn more soon.