Recklessness on Wall Street

Given the role that Wall Street's reckless use of derivatives played in causing the recession, I can understand the desire for new ways to regulate financial instruments.

For example, on March 31 Gretchen Morgenson of the New York Times advocated creating a federal agency to test new financial products in the same way the Food and Drug Administration tests pharmaceuticals before they are allowed onto the market — "an agency that examined new financial instruments and ensured that they were safe and benefited society, not just bankers."

The idea was not her own, although she thought it a good one. Morgenson properly credited an academic paper by two University of Chicago professors — Eric A. Posner, who teaches law, and Glen Weyl, an assistant professor in economics — who had a Bloomberg View op-ed article on the subject the following day.

The professors argue that the dangers of new, untested financial products "seem at least as extreme as the dangers of medicines," but insist that their proposed agency would not compete with the new Consumer Financial Protection Bureau.

"It is not the main purpose of our proposal to protect consumers and other unsophisticated investors from shady practices or their own ignorance," they wrote. "Our goal is rather to deter financial speculation because it is welfare-reducing and contributes to systemic risk."

Not cancer cures

With all due respect to Posner and Weyl — whom I do not know — and to Morgenson, for whom I have much respect, the idea of testing new financial products in a government laboratory as if they were potential cures for cancer is one of the sillier ideas to come down the pike since the onset of the financial crisis five years ago.

Set aside the fact that the efficacy of a new fin-ancial product cannot be judged in the same way as a new drug or consumer electronic — there is no on-off switch on a new financial product, and no empirical way to tell if it will cause good or harm other than to see it in action.

The biggest drawback is that any agency with a bias toward deterring "financial speculation" because it "contributes to systemic risk" would have quickly doomed any number of invaluable financial innovations Wall Street has created in the past few decades.

For instance, would such an agency have allowed junk bonds, the innovative financing mechanism that Michael Milken and his firm, Drexel Burnham Lambert, pioneered in the 1980s as a way to give access to lower-cost capital to companies that otherwise would have been shut out of the capital markets? Would a financial-product protection bureau of the early 1970s have allowed Salomon Brothers' Lew Ranieri to take streams of cash flow that derive from mortgage, car and credit-card payments and turn them into securities that can be bought and sold the world over? There is no question that Ranieri's innovation led to lower mortgage costs for homeowners, gave access to credit cards to hundreds of millions of Americans and allowed millions of others to get a car loan.

Beyond ridiculous

Ah, I can hear you scream, didn't Milken's junk-bond monsters bring about the stock market crash of 1987, when the Dow Jones Industrial Average lost 22.6 per cent in one day, leading to the credit crunch that engulfed the economy from 1989 to 1993? And didn't Ranieri's little devils lead to the current financial crisis when one mortgage-backed security after another went into a tailspin? Wouldn't an FDA-type agency, like the "pre-cogs" in the 2002 movie Minority Report, have seen these two train wrecks coming and prevented them?

This is beyond ridiculous, for the simple reason that there is no way to deconstruct a financial product before it goes to market to determine whether it will end up doing more harm than good. Yes, the excesses in Milken's junk-bond market helped cause the speculation in the stock market that led to the Crash of 1987.

But both before the crash and most certainly for the last 25 years the junk-bond market has been robust and vital, allowing thousands of companies access to capital while also providing investors with the sorts of risk-adjusted yields they most certainly cannot find in the overinflated Treasury market.

— Bloomberg