Wednesday, March 25, 2009

Pushing Paper

Hernando De Soto, author of such brilliant books as The Other Path and The Mystery of Capital (Amazon) has an interesting op-ed today in the WSJ on what he sees as the underlying problem in this crisis: that the paper being traded has lost its linkage to the underlying assets they represent. He argues in the WSJ:

These derivatives are the root of the credit crunch. Why? Unlike all other property paper, derivatives are not required by law to be recorded, continually tracked and tied to the assets they represent. Nobody knows precisely how many there are, where they are, and who is finally accountable for them. Thus, there is widespread fear that potential borrowers and recipients of capital with too many nonperforming derivatives will be unable to repay their loans. As trust in property paper breaks down it sets off a chain reaction, paralyzing credit and investment, which shrinks transactions and leads to a catastrophic drop in employment and in the value of everyone's property.
Though I'm not entirely sold on the idea that it's the problem of derivatives themselves, the fact that there's a lack of transparency to the point that there are doubts as to whether a financial institution is solvent is clearly a problem. He makes a number of important points though:
  • "Every financial deal must be firmly tethered to the real performance of the asset from which it originated. By aligning debts to assets, we can create simple and understandable benchmarks for quickly detecting whether a financial transaction has been created to help production or to bet on the performance of distant "underlying assets.""

  • "Governments should never forget that production always takes priority over finance. As Adam Smith and Karl Marx both recognized, finance supports wealth creation, but in itself creates no value."

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