After the dust begins to settle following some economic calamity we all look for reasons. Many of us look to the abstruse and technical aspects only to discover that people forgot (or ignored) the basics. This time many of us are censuring derivatives when we should be examining the human dilemma.
Derivatives are insurance contracts. When rightly used, they reduce the dangers of currency fluctuations, credit defaults, and other business perils by spreading the risk widely. The insurance basic here is diversification—not putting all your eggs in one basket. To the company using derivatives, the lower risk may make it attractive to invest in more job-creating activities to serve more people. If there is an active market for derivatives, it is that much easier to obtain the insurance. This is the social value of derivatives and derivatives markets.
A derivatives market has to follow two basic and simple rules to work effectively. First, there must be many customers to pool the risk. In the recent past customers have been plentiful. Second, the real assets must be reasonably valued and the people involved must be reasonably credit worthy. It’s the second rule that was violated—violated from bottom to top by diverse people who had little in common but their human natures.
Looking back a few years starting at the beginning of the chain of transactions that led to the crisis here are some questions. Why would loan applicants have worried too much about the second rule when credit was readily available, they could pay the initial teaser rates, and they wanted so much to have the American Dream? Next, why would mortgage brokers have done thorough due diligence and insisted upon sensible lending rules when the financial institutions just wanted the business? The market was hot and profitable and Congress was urging loans to less affluent people.
Why would those in financial institutions have carefully checked when their bonuses (or jobs) depended upon high turnover, the next quarter’s earnings results would be published shortly, and the loans would be packaged, sold, and resold to others? And why should they have worried too much when other organizations were willing to insure the loan package anyway? Actually, why worry much at all if rating agencies were not too concerned? Why would governmental bodies rigorously police markets that were successful and generating economic growth and voter approval? Survival and prosperity push hard against morality and the tough questions in this environment.
Almost everyone was happy—homebuyers with marginal creditworthiness, bankers of all kinds, investors, members of Congress. Warren Buffett and a few others were voices crying in the wilderness but even the Oracle of Omaha was surprised by the downturn. When things fell apart one of the most respected economists in the world, Ex Fed Chairman Alan Greenspan, told Congress in October 2008: "Those of us who have looked to the self-interest of lending institutions to protect shareholder's equity—myself especially—are in a state of shocked disbelief."
Why are we surprised when most of us learned, either in Economics 1 or on the street, that no industry will police itself effectively? The answer is that we are human; we forget. We often forget because it is convenient to do so. Pogo Possum in the old comic strip had it right: “WE HAVE MET THE ENEMY AND HE IS US.” How do we deal with such an enemy?
Regulation is certainly one answer, and regulation is on the way. But legislation regulating the economy has been passed after nearly every major cyclical downturn since 1907. sharpening our forecasting skills will help although it seems extremely difficult if not impossible to predict a business cycle with much accuracy. Despite their limitations, working on these defenses is a good way to use our heads to combat the crisis.
However, we will not be able to claim lasting victory with our heads alone because the enemy is not to be found there. It lives in our hearts. It is greed and envy and pride that make war against our better natures and distorts our minds. It is there that change must happen.
I suspect that it is not possible for us to bring about a worldwide change of heart on our own although education along the lines of our school’s Another Way of Doing Business will have a positive impact. The full renewal of our hearts must come from God for with God nothing is impossible. And so we pray, use our heads, remain watchful, and keep our companies agile.
Dr. Herb Kierulff is professor of finance and entrepreneurship at Seattle Pacific University. He has consulted in the fields of new venture development, turnaround management and curriculum development for a variety of public and private organizations since 1968. Herb’s life changed dramatically in his early 30’s when a series of spiritual experiences rocked his understanding of who he was, his goals in life, and his relationship to God. And he has been on an exciting journey ever since.