Sunday, February 28, 2010

Derivative Financial Instruments

The Office of the Comptroller of the Currency reports that U.S. financial institutions held $13 trillion in credit derivatives in Q3 of 2009.  Derivative instruments such as credit default swaps (tradable insurance policies against borrower default on commercial and real estate debt) have been blamed for the widespread failure of banks and the speed at which such failures rippled across the world.

Congress and even some economists have called for a halt to the use of such instruments. Such a solution would limit market liquidity without lowering structural risks. Instead, it would introduce operational risks to commercial enterprises that do not have the capacity or capability to self-insure.

Derivatives are perfectly fine devices for managing risks when the contracts are backed by the appropriate reserves. Counterparties simply need to demonstrate their capacity to meet the obligations of their contracts in the event of reversal. 

The real problem is an interventionist government that has repudiated free market principles. Based on the paradigm that some banks are simply 'too big to fail', TARP sent the message that the U.S. government, through its taxpayers, was willing to be the lender of last resort.  Risk disappeared from the system.  'Too big to fail' is a belief based on another (self-serving) belief that government must fix everything. It is not a statement about how free markets actually work.  In free markets, nothing is too small to succeed nor too big to fail.

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