Many factors contributed to the 2008 financial crisis. Among them were collateralized debt obligations, CDO’s, and over the counter derivatives, OTC's. CDO’s are collections of many different types of bonds, which can consist of AAA-rated bonds, to junk bonds. When many different bonds are put into a larger portfolio they can be labeled as less-risky and sold at a price that reflects the risk. OTC derivatives are derivatives traded outside of listed exchanges, like NYSE or NASDAQ; so, it is possible only the two parties involved in the trade are aware it ever happened. Back in 2002, Warren Buffett went as far as to call derivatives, “ticking time bombs,” and “financial weapons of mass destruction.”
After the financial crisis, the Dodd-Frank Act was passed in an effort to promote financial stability by improving transparency and accountability in financial markets. To achieve this, many financial practices were regulated, including OTC’s, and oversight was increased for institutions that posed a “significant systemic risk.” James Glattfelder gives an interesting Ted talk about the highly centralized nature of the global financial system, which leads to increased systemic risk.
In an effort to circumvent new regulation some banks are turning to a new technique called collateral transformation, which is essentially a process where you give the bank low-quality bonds, pay a fee, and get high-quality bonds in return. Kyle Spencer, a writer for the blog, seeking alfa, claims this will create additional systemic risk. A recent article in the Financial Times half-jokingly compares the practice to ancient alchemists trying to make gold.
“It’s not a new idea, it’s a new way of packaging” Jamie Lake – Former Goldman Sachs collateral manager
So why does all this matter? Some estimates put the size of the world derivative markets in excess of 600 trillion dollars, which is around 9 times the world GDP. New regulations, like the Dodd-Frank act, are intended to prevent these huge markets from getting out of hand, again. However, if ways around this legislation are found, there could be another financial crisis on the horizon.
I'm glad that there has been some much needed reform in regards to regulations in the financial market. However, as was eluded to in the last paragraphs, it is just another solution package. I believe that the real solution lies in reforming the way that reforms are made. I.E. we cannot continue to allow huge financial institutions to have such financial contributions in political elections, as to sway policy their way. If we keep allowing financiers and the current top shelf men to keep writing their own policies, they will surely always advantage the growth of the financial sector, weather it increase public good in the LONG RUN or not.
ReplyDeleteWe of course have laws in place to minimize the size of donations from single donors, intended to prevent large companies for disproportionately controlling elections, however, we have seen super PACS undermine these measures. I agree that in an idyllic society and government large corporations would not have influence, only individual citizens should be able to influence democratic elections. This is mute point though, because we do not live in an idyllic world and as long as there is money there will be power dynamics, and as longs as there ate power dynamics those with the most power will wield the level of influence they choose, even under the purview of good regulation. The question and debate then becomes, if we cannot stop power relations, if we cannot stop private or derivative trading, if we cannot stop corporation special interest, how do we change the discussion and s that corporations and financiers interests more with the best interest of the population as a whole. We do this by providing tax breaks for corporations with financial and corporate transparency as well as incentives for environmental initiatives and better healthcare for employees. Maybe this seems unreasonable to some, but i think in the Long Run, it will be the most prudent choice.
ReplyDeleteIn an economy where finance innovation is valued extremely high, we tend to give financiers of all of the power in institution construction. Until markets place value over sectors like labor, where the financiers aren't the end all solution to everything I think we'll see a shift in compensation and increased regulation initiatives to curb such an abundance of wealth.
ReplyDeleteI agree with Paige that in the long run implementing collateral techniques is the most valid option considering large corporations do currently have strong influences on domestic politics. I find it interesting that some financial advisors view these new collateral techniques as a tool to agree with new emerging political policies. Viewing the process as involving banks helping funds pledge their illiquid securities, in exchange for more liquid collateral, which then in turn can be funneled to back derivatives trades. The Wall Street Journal notes that collateral issues emerge when banks manipulate their regulatory capital requirements to undertake the activity profitably. This could mean they are not well insulated if markets crashed, which like this post notes , could lead to another financial crisis in the future.
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