Someone needs to explain how markets work to the WSJ

Today’s WSJ op-ed page has a curious defense of keeping more-complex derivatives off exchanges. It goes like this: when someone (like John Paulson) takes a short position on a derivative (like a synthetic CDO), that’s really important information for the market to have since it signifies John Paulson’s opinion that the thing tied to the derivative (like the U.S. housing market) is due for a tumble. Therefore, derivatives should remain opaque, private contracts.

In other words, who is doing what with derivatives is so important that we should only let a small club of financially interested players get a view.

Kind of nonsensical, right?

The alternative is what Congress is currently attempting to legislate: putting derivatives on exchanges so that trades are visible, and using a central clearinghouse so that folks have to prove that they’re good for the bets they’re making. Call me naive, but it seems like that set-up would go a lot further in spreading the word that people are betting against a particular asset class.

L. Gordon Crovitz, who penned the WSJ op-ed, doesn’t specifically say why the information contained in Paulson’s bet wouldn’t translate to an exchange/clearinghouse, but (if I’m connecting the dots correctly) he feels that if synthetic CDOs had to be traded on an exchange then they wouldn’t exist in such a robust way because it would take longer to come up with standardized contracts and there wouldn’t be as much profit to collect since the whole system would be more transparent and efficient. Considering that Paulson made $1 billion on his bet, I’m guessing that he would have found a way to make it, with or without an exchange.

More broadly, though, Crovitz is probably right—an exchange would dampen the speculative trading of synthetic CDOs and their ilk. But would we be losing more in terms of market information than we would be gaining in terms of market stability?

I doubt it. Consider the recent housing bubble. How many investors decided to get out because they knew someone was taking short positions against house-related synthetic CDOs? I can’t put a number to that, but the answer is definitely many fewer than were getting in because of the false promise of low risk and high return.

Point of fact is, in advance of the financial meltdown there were plenty of Cassandras for anyone willing to listen. The real problem is that no one did. So should we err on the side of market information or market stability? I say stability.

deconstructiva

Thanks, Barbara, good post. If we had open derivatives mkts. in the ‘90’s would we have avoided the Long-Term Capr. Mgmt. fiasco since some traders and analysts would’ve seen someone (LTCM) load up on swaps and equity volatility? And either point it out or take opposite bets to neutralize this (and profit if bets pay off) …similar to today’s mortgage-based crap? At least AIG shareholders (let alone banks) could’ve received warnings about what their company was up to. Thanks for your thoughts.
volkerh

I don’t get the both of you, Barbara and Gordon Crovitz.

The way I understand it, the whole point of markets is that they aggregate the opinion of the players as expressed by their trading. The hope is that that sum of all that knowledge is a reasonable estimate of some security’s worth.

So, the fact that someone thinks (and expresses by trading) that a certain market is going to go down, doesn’t lose information, it would add information, making markets more efficient.

Am I missing anything obvious here?
Barbara Kiviat

Exactly. Which is why I think this trading should happen on an exchange that anyone can see, and not through a serious of private contracts.
http://rodgermmitchell.wordpress.com Rodger Malcolm Mitchell

For a paper devoted to finance, the WSJ has become remarkably clueless about . . . finance. One of many examples: A recent editorial about a “welfare-entitlement state” ( Editorial ) was so out of touch with reality, one wonders whether the recession has forced them to hire high school students as editors.

Rodger Malcolm Mitchell
http://bankergolfer.wordpress.com bankergolfer

I sincerely hope that you’re not surprised by an article like this showing up in the Wall Street Journal, of all places.

The Journal is a financial rag that will do anything it can to ingratiate itself to those working on Wall Street in an attempt to be the first to bring the latest financial gossip.

In return, Wall Street calls up the Journal and says “Blue Horseshoe loves Anacott Steel”….

As a result, I expect nothing less than the Journal’s bias to show up in its articles.

Real financiers read the Investors Business Daily (IBD). All others read (or pretend to read) the Journal….
tpmcd1

This is more of a question. Does Goldman Sachs and others borrow money from the Fed and then use it to gamble on CDOs. If so I think the Govt should exercise more control on how they use our money.
pneogy

“So should we err on the side of market information or market stability? I say stability.”

I don’t think it is a matter of information versus stability. What Paulson appears to have had was privileged or asymmetric information. What he did (quite legally) would be considered insider trading in a regulated market – something that people have gone to jail for. By removing asymmetric information, as you say, markets will be more efficient and more stable.
Barbara Kiviat

I like your framing.