FRIDAY APRIL 30, 2010

In Praise of Derivatives

Following the the Congressional bluster coming out of the Goldman Sachs testimony this week, a politician is now calling for the ban of all derivatives.  In a incredible demonstration of ignorance, derivatives are said to provide "no social benefit."  What a stunningly stupid statement.

When it comes to derivatives, the National Rifle Association's "it's not the gun, it is the user" line is appropriate.  There is no doubt that these instruments can be and were used to make leveraged bets on the markets, particularly the housing market.  That said, derivatives most certainly provide social benefit.  These instruments create liquidity in the market places which in turn reduces the cost of capital for the economy.  They also allow for the dispersion of risk across many avenues which not only reduces the cost of capital but reduces cyclically of the economy.  These wonderful benefits allow for more job creation.  Farmer's can hedge the price of their crops.  Airlines can hedge the volatility of jet fuel prices.  And yes, Goldman Sachs can hedge its mortgage exposure by going "short" the American dream of homeownership.  Indeed, the presence of large institutional players in the markets provide the "grease" that make the markets go.  Banning the use of derivatives would result in less liquid, more volatile markets.  Is that what we really want?

Maybe we should be thanking the users of derivatives for blowing up the mortgage market.  Yes, the Great Recession caused by a subprime housing bubble was painful.  But does anyone believe that everything would be copacetic if we just let the housing bubble inflate even more.  The longer a bubble is allowed to persist, the greater economic carnage that follows.   As scary as it sounds, it could have been worse, much worse!  Thankfully, the use of derivatives allowed many a financial company to survive this economic storm.  Just don't hold your breath waiting for a Member of Congress to say so.

POSTED AT 1899-12-30 10:26:00.0

KEN ENTENMANN, CFA
SENIOR VICE PRESIDENT AND
THE DIRECTOR OF INVESTMENT MANAGEMENT SERVICES

Ken is a Senior Vice President and the Director of the Trust and Investment Services at Alliance Bank, N.A. He has 23 years of investment experience and oversees the management of assets totaling $1 billion. He holds a B.S. in Applied Economics and Business Management from Cornell University and an M.B.A. from the William E. Simon Graduate School of Business Administration at the University of Rochester. He has also earned his Chartered Financial Analyst designation. He is a member of the Executive Committee of the Trust Division of the New York Banker's Association. He is also a director of the Central New York Community Foundation.

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