Primer for the day

Let’s do a little primer.
Let’s bracket the idea, for a moment, that collateralizing securities and layering contractual bets on these securities – derivatives – only exist as rentseeking instruments, ie, have no productive economic use. What, then, is the justification for them? The only possible justification is that they ameliorated risk, so that lenders, who would otherwise not be able to afford more hazardous loans, are able to make them. And what is the signal for the lenders that the risk is well spread? The signal is prices. So, the only justification for the derivative market, and for the off the books market in collateralized securities, is that they can smooth out the price of risk.

Given this, ask yourself: why, then, does it turn out that nobody can price out these instruments?

The answer is that this is an institutional failure. Unlike the stock exchange, which transparently represents the price of stocks for all buyers and sellers to see, the pricing system for risk and “insurance” on risk, bizarrely, is institutionally dispersed, and thus systematically opaque.

If – as with a heavy heart, LI thinks will be the case – some type of bailout is attempted that doesn’t address the institutional failure, we will simply watch the greatest disappearing act ever performed, dwarfing Houdini’s legendary vanishing elephant routine.

So, congress should insist that any bailout bill carries with it mandatory institutional reforms. The two things can’t be disconnected. That the Treasury, absurdly, proposes to price the securities “by hand” tells us all we need to know about the ridiculousness of the current system. The OTC system is in ruins. There must be an open and instituted exchange through which all instruments must pass. There could even be more than one. But to pass this bill and continue the OTC system is utter folly. This “crisis” is much like the gold ring crisis of 1876, except that the corrupt officials in Grant’s administration were violating the law, while this bold faced robbery sticks up the nation and demands to be legalized. The least we can demand is that the pricing system be radically revamped.