Customs Street Advisors is a full service investor relations firm based in Lagos, Nigeria.

Killers, not Guns, Pull Triggers: Financial Innovation Must not Die

This week in Street Talking on NEXT, I argue that in spite of all the bad rep it has been receiving from politicians and commentators lately, products of financial innovation including derivatives, remain vital for global economic efficiency.

We all know the doomed legend of Icarus. The youth’s father, Daedalus, had fashioned wings made with feathers and wax for their getaway from King Minos of Crete’s prison. Before their ascent, Daedalus warned his son not to fly too close to the sun or the sea. Alas! Icarus flew too close to the sun and came crashing down to the sea below. No one disputes that Icarus, not his father, and certainly not flying, wax or feathers caused his death. After all, Daedalus, a pioneer of aviation, escaped to freedom.

Somehow, it would appear that while we applaud ingenuity in certain human endeavours, we vilify it in others. For instance, take financial innovation, which I define as the creation of tradeable second- and third- order contractual instruments whose values are determined by changes in underlying revenues, cash flows, prices and credit ratings. Lately, it has become the fugitive in the manhunt for the Single Simplistic Cause of the Economic Meltdown. I think that is wrong, very wrong.

A day does not go by without a politician or commentator coming on TV to ascribe Faustian amorality to the alchemists of Wall Street for trying to rewrite the hallowed rules of finance, in the same way Daedalus attempted to do with the human anatomy.

The talking heads zero in on isolated sound bites like those of Blythe Masters of JP Morgan as further evidence of their usurpation of the gods’ prerogative. Masters, who played a major role in the creation of credit default swaps (CDS), explained that:

Doing so would overturn one of the fundamental rules of banking: that default risk is an inevitable liability of the business. . . .For the first time in history, banks would be able to make loans without carrying all, or perhaps even any, of the risk involved themselves.

Ironically, that goal of helping banks to serve Main Street better through credit expansion is now forgotten.

Last week’s revelation that the US Securities and Exchange Commission (SEC) had filed  civil charges against Goldman Sachs for ‘making material misstatements and omissions in connection with a synthetic collateralized debt obligation (CDO),’ has provided more grist to their mill. Did Warren Buffett himself not denounce derivatives as weapons of financial mass destruction? Everything and anything that smacks of derivatives – that awful D-word – must be bad, mad, and dangerous. For this crew, it is no coincidence that ‘D’ is for demonic, devil and diabolical.

At the slightest provocation, they reel out a litany of accidents caused by derivatives: the collapse of Barings, the implosion of Long-Term Capital Management, the rogue trading scandal at Société Générale, etc. What they fail to admit is that it was poor risk management, porous back office operations, leaky models and perverted incentives that inflicted these losses and not the instruments by themselves. After all, in each case, counter-parties on the other side of the trade made money. Again, just like Daedalus’ flight to safety but Icarus’ demise.

The antagonists conveniently draw a phantom Maginot Line between ‘good’ finance – making loans to businesses and trading in stocks and bonds – and ‘evil’ finance – anything beyond first-order instruments. They blur out the pension funds which could use them to hedge investments for retirees’ futures, developing country governments that need them to shield their foreign exchange earnings from wild swings in commodity prices and high street banks which use them to defend against sudden changes in interest rates and borrower defaults. Only the greedy investment bankers are allowed in this jaundiced picture.

These critics plainly refuse to acknowledge that the distinction between their self-acclaimed ‘good’ finance and its sinister doppelganger is a myth. The fallacy reminds me of the scene in The Devil wears Prada when Miranda Priestley, so memorably played by Meryl Streep, tears into Andrea Sachs, her assistant, for fawning aloofness from the so-called vanity of haute couture.

Miranda Priestly: This… ’stuff’? Oh… ok. I see, you think this has nothing to do with you. You go to your closet and you select out, oh I don’t know, that lumpy blue sweater, for instance, because you’re trying to tell the world that you take yourself too seriously to care about what you put on your back.

But what you don’t know is that that sweater is not just blue, it’s not turquoise, it’s not lapis, it’s actually cerulean. You’re also blithely unaware of the fact that in 2002, Oscar De La Renta did a collection of cerulean gowns. And then I think it was Yves St Laurent, wasn’t it, who showed cerulean military jackets? I think we need a jacket here.

And then cerulean quickly showed up in the collections of 8 different designers. Then it filtered down through the department stores and then trickled on down into some tragic casual corner where you, no doubt, fished it out of some clearance bin.

However, that blue represents millions of dollars and countless jobs and so it’s sort of comical how you think that you’ve made a choice that exempts you from the fashion industry when, in fact, you’re wearing the sweater that was selected for you by the people in this room. From a pile of stuff.

The point is that the products of financial innovation are everywhere we look.

Related posts:

1. SEC’s Appeal – Will the Regulator ever get its mojo back? The Securities and Exchange Commission (SEC) has been in the...
2. Rebel Yodel: Shareholders’ rallying cry in 2010 As the year draws to an end, it is tempting...
3. Fending for Themselves: Who’s Looking out for Shareholders? In his immensely entertaining account of the global economic meltdown,...
4. Lost in translation, apples and oranges, or tomahto to tomayto?: The need for companies on the Nigerian Stock Exchange to carry the investment community along in the transition to International Financial Reporting Standards (IFRS). On April Fool’s Day, First Bank, a foremost Nigerian bank,...
5. This is a medical exam not a striptease: Transparency and access are a must for companies and not a favour to investors I distaste buzzwords. The ease with which they roll off...