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Wednesday, May 13, 2009

The CW Fallacy of Regulation

Today, President Obama continued to show just how little he understands about the problem.




The Obama administration yesterday unveiled a plan to regulate a vast market of exotic financial instruments known as derivatives, which fueled the global economic crisis and wounded some of the biggest names on Wall Street.

As the administration's first step to overhaul financial regulations, the proposal calls on Congress to establish rules that would restrict the banks, hedge funds and other investors who trade derivatives on what have been called "dark markets" for their lack of oversight.


Like most politicians, especially on the left, President Obama mistakens that the root of the crisis was caused by a lack of regulation rather than enforcement. Think about the dozens of regulations that are involved in real estate finance. Anyone who has closed a loan knows just how many regulations there are because the closing documents are over a hundred pages. Despite having all of these regulations, on a mass scale people lied on their applications. That's a lack of enforcement of the most basic regulation, fraud.



In the case of derivatives, the reality is that there aren't any problems in most derivatives. Derivatives are financial instruments that DERIVE their value from another security. For instance, stock options and commodity futures are derivatives. A lack of regulation hasn't necessarily affected those markets.




It's only Credit Default Swaps specifically that were affected. So, what happened in that particular market. The first characteristic was actually pointed out in Wikipedia.
The buyer of a CDS does not need to own the underlying security or other form of credit exposure; in fact the buyer does not even have to suffer a loss from the default event.[2][3][4] By contrast, to purchase insurance the insured is generally expected to have an insurable interest such as owning a debt.


With ALL derivatives, besides CDS, is the ability to turn the derivative into the underlying instrument.In other words, if I have a call stock option on Microsoft, the actual stock is available to me in case I convert it at the underlying terms. In this case, that isn't the case in all. Unlimited number of bets can be made on the same security. That's simply not how a derivative is supposed to work. Now, if you say that having a derivative work like a derivative is supposed to work is a regulation, so be it, however I don't think the president needs anymore power to demand this.



Second, AIG dominated this market. That's called a MONOPOLY. That's what we have the Sherman Anti Trust for. There's no new regulation necessary.



Instead of simply focusing on this, President Obama wants to create a whole new framework. Of course, this new framework is like to adversely affect options and futures . It's all because he falls for the CW fallacy.

1 comment:

Anonymous said...

Indeed. Lack of enforcement of existing regulations seems to have been a recurring issue for the Bush and Clinton Administrations. And considering how Obama's stuffed his Cabinet with Clinton retreads I don't this problem will soon be rectified.