Financial Engineering: Butter Knife or Cleaver?

January 8, 2010 at 12:08 am 4 comments

Recently, former Federal Reserve Board Chairman Paul Volcker blasted the banking industry for innefectual derivative producs (i.e., credit default swaps [CDS] and collateralized debt obligations [CDOs]) and a lack of true innovation outside of the ATM machine, which was introduced some 40 years ago. In my opinion, the opposing views pitting the cowboy Wall Street bankers versus conservative policy hawks parallels the relative utility question of a butter knife versus a cleaver. Like knives, derivatives come in all shapes and sizes. Most Americans responsibly butter their toast and cut their steaks, nonetheless if put in the wrong hands, knives can lead to minor cuts, lost fingers, or even severed arteries.

That reckless behavior was clearly evident in the unregulated CDS market, which AIG alone, through its Financial Products unit in the U.K., grew its exposure to a mind boggling level of $2.7 trillion in notional value, according to Andrew Ross Sorkin’s book Too Big to Fail. The subprime market was a big driver for irresponsible CDO creation too. In The Greatest Trade Ever, Gregory Zuckerman highlights the ballooning nature of the $1.2 trillion subprime loan market (about 10% of the overall 2006 mortgage market) , which exploded to $5 trillion in value thanks to the help of CDOs.

Derivatives History

However, many derivative products like options, futures, and swaps have served a usefull purpose for decades, if not centuries. As I chronicled in the Investing Caffeine David Einhorn piece, derivative trading goes as far back as Greek and Roman times when derivative-like contracts were used for crop insurance and shipping purposes. In the U.S., options derivatives became legitimized under the Investment Act of 1934 before subsequently being introduced on the Chicago Board Options Exchange in 1973. Since then, the investment banks and other financial players have created other standardized derivative products like futures, and interest rate swaps.

Volcker Expands on Financial Engineering Innovation

In his comments, former Chairman Volcker specifically targets CDSs and CDOs. Volcker does not mince words when it comes to sharing his feelings about derivatives innovation:

“I hear about these wonderful innovations in the financial markets, and they sure as hell need a lot of innovation. I can tell you of two—credit-default swaps and collateralized debt obligations—which took us right to the brink of disaster…I wish that somebody would give me some shred of neutral evidence about the relationship between financial innovation recently and the growth of the economy, just one shred of information.”

 

When Volcker was challenged about his skeptical position on banking innovation, he retorted:

“All I know is that the economy was rising very nicely in the 1950s and 1960s without all of these innovations. Indeed, it was quite good in the 1980s without credit-default swaps and without securitization and without CDOs.”

 

Cutting through Financial Engineering

The witch-hunt is on for a financial crisis scapegoat, and financial engineering is at the center of the pursuit. Certainly regulation, standardized derivative contracts, trading exchanges, and increased capital requirements should all be factors integrated into new regulation. Curbs can even be put in place to minimize leveraged speculation. But the baby should not be thrown out with the bathwater. CDSs, CDOs, securitization and other derivative products serve a healthy and useful purpose towards the aim of creating more efficient financial markets – especially when it comes to hedging. For the majority of our daily requirements, I advocate putting away the dangerous cleaver, and sticking with the dependable butter knife. On special occasions, like birthday steak dinners, I’ll make sure to invite someone responsible, like Paul Volcker, to cut my meat with a steak knife.

Read Full WSJ Article with Paul Volcker Q&A

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper. 

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at time of publishing had no direct position in any company mentioned in this article, including AIG. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.

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4 Comments Add your own

  • […] like virtually all derivatives, can either be used to speculate or hedge (see also, Einhorn CDS and Financial Engineering articles), so the existence of strange noises does not necessarily indicate foul play or that any […]

    Reply
  • […] like virtually all derivatives, can either be used to speculate or hedge (see also, Einhorn CDS and Financial Engineering articles), so the existence of strange noises does not necessarily indicate foul play or that any […]

    Reply
  • […] trading desks, the need for new reforms becomes even more evident. Derivatives are not evil (see Financial Engineering), but like a gun or knife, if misused these instruments can become extremely dangerous…as we have […]

    Reply
  • […] In addition to including a controversial government-led rating agency selection process, the transforming regulatory reform bill also includes a dramatic change to ban “naked” credit default swaps (CDS). As I’ve written in the past, derivatives of all types can be used to hedge (protect) or speculate (e.g., naked CDS).  Singling out a specific derivative product and strategy like naked CDSs is like banning all Browning 9x19mm Hi-Power pistols, but allowing hundreds of other gun-types to be sold and used. Conceptually, proper use of a naked CDS by a trader is the same as the proper use of a gun by a recreational hunter (see my derivatives article). […]

    Reply

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