Although headquartered in the financial capital of the world, the NY Times editors apparently do not believe they need to understand the first thing about finance. Here they go again, bleating about the civil suit against Goldman Sachs and comparing derivatives to casino gambling:
What all those proposals don’t address is whether the type of derivative Goldman was selling should even be allowed to exist. The Goldman deal was nothing more than a bet on the mortgage market, in which one side was destined to win and the other to lose, without “investing” anything in the real economy. The C.D.O. did not hold actual mortgage-related bonds, but rather allowed the participants to stake a position on whether bonds owned by others would perform well, or tank. And that helped to further inflate the housing bubble.
That is not investing. It is gambling, and it is abusive. It has no place in banks that can bring down the system if they fail.
Hmm - empowering sellers by creating synthetic mortgages that let sellers absorb the demand created by buyers inflated the housing market? Would it really be a better world if the German money manager on the losing side of the controversial Goldman deal had used his money to fund more construction of new homes?
I will say this - it appears, after the fact, that the overall effect of making housing-related financing more liquid was not helpful. Had it been harder for people to finance and re-finance their homes the housing bubble would surely have been smaller. There are lots of ways the government could intervene to make the mortgage market grind more slowly. They could start with reining in Fannie Mae and Freddie Mac, move on the imposing more stringent mortgage origination criteria (that would have a disparate impact on minorities, women, and immigrants), limit mortgage securitization by requiring originators to retain a portion of their product, and eventually work up the food chain to derivatives.
But even though derivatives are so unfashionable that a NY Times columnist can boast about her ignorance, the Times really needs to crack open a basic economic textbook to help them distinguish between gambling and speculation.
Gambling can be thought of as the creation and transfer of risk for entertainment's sake; the resulting prices and risk transfers don't guide any useful economic activity. A bet on whether my next toss of the dice will result in a seven does not guide any real economic activity, other than baby getting a new pair of shoes. Or not.
Speculation, by way of contrast, can provide socially useful prices and the opportunity for risk transfers. For example, speculators routinely buy and sell futures contracts on corn, even though they have no interest whatsoever in growing, storing, milling, or selling corn. Why is that not just gambling? Because the speculators, through their participation in the market, help guide the behavior of people who do have to make a living growing and handling corn.
Kelloggs will be making a lot of corn flakes next December - should they fill their corn silos now to assure their supply of corn, or wait until the next harvest? A "bet" with a speculator may simplify their planning.
A farmer has to decide whether to plant more corn, leave a field fallow, or plant something else. What will corn be worth come harvest time? The existence of speculative derivative contracts on corn helps provide an answer to that question and an opportunity for a farmer to assure his price today.
The Goldman deal looks like socially useful speculation. Should mortgage originators push even more money out the door to create more supply for the securitization chain? There were a lot of buyers lined up saying "Yes!" However, the use of synthetic CDOs allowed sellers to show up shouting "No." That price discovery can be socially useful, as the Times editors ought to understand.
I QUIBBLE WITH MYSELF: What about betting on which teams will go the the World Series next fall - is that socially useful? I would not dismiss the question out of hand - the mayors and police chiefs of Atlanta, Philadelphia, and St Louis (not to mention New York and Boston) might like to know what October will bring; event planners and convention organizers might like to know whether there will be plenty of hotel rooms, or whether their event will be over-run by a baseball crowd. That is a thin thread, but it takes us to the gray line between gambling and prediction markets.