Greenspan was right, derivatives do spread risk… but they don’t cap it.

September 19, 2008

I’m sure you have often heard the saying “if it ain’t broke, don’t fix it” — something similar should have been said many years ago about the complicated financial derivatives causing so many problems today. The risk associated with mortgages didn’t need to be spread out across the entire industry, the only result such a goal could ever have accomplished is to generate huge profits for massive risk takers abusing the system of “spreading risk” by dumping their crap on everyone else.

The end result of this stupidity is that a problem which could have been isolated to a few adventurous mortgage lenders has contaminated the balance sheets of almost every player in the industry. Spreading the risk worsened the problem by lengthening the amount of time it took for these irresponsible brokers to go bankrupt, and greatly increasing the amount of toxic paper in circulation. Instead of one or two institutions going under quickly, they will all suffer for a long time.

Imagine that you’re a basketball scout getting paid per signed athlete and every team has promised to accept any player above 7 feet tall. Would you go out of your way at great cost to find the best players? Of course not, you would probably hack into the health insurance company database and grab any giant you can find regardless of their abilities. Why do you care? The risk associated with finding these people has been spread out across the entire industry, you can’t lose. They get hundreds of mostly worthless athletes and you get rich.

Risk is good, not bad. It shouldn’t be spread, it should be isolated. Everyone should have clarity and a full understanding of the risks associated with their investments. How else could anyone possibly make intelligent and informed decisions?