Credit Default Swaps and Mortgage Backed Securities: a Primer.

I’ve previously noticed Mark Labaton’s writing. Labaton is a lawyer in LA, and he writes with the kind of clarity and precision that is crucial to effective lawyering. In the most recent issue of LA Lawyer (pdf), he applies those writing skills — in the article entitled “Swap Meet” — to explaining “derivatives,” those financial instruments central to our current economic disaster. I’ve tried to do a similar thing here a few times (here, for example), but Labaton’s account is much more comprehensive. It’s an important piece. I can’t say enough to my students that they have to reject any idea that the stuff they have to face is too complicated for them to understand. We were told again and again that credit default swaps were too complicated to understand (see below, from a CNBC Telecast in November 2006). That’s hogwash. Accepting the myth our financial markets were dealing with risks too complicated for anyone to understand (even the most active participants in the markets!) put us in this mess an is keeping us from getting out of it as quickly or effectively as we might. Labaton not only understands this point, he also provides a very useful explanation for the rest of us.

We mere humans have let the financial geniuses down.

There’s nothing original in my critique of Alan Greenspan’s thinking, but it boggles my mind that a man who has been considered the financial genius of our recent times could engage in reasoning as fallacious as that described in the review of his legacy written on October 8 in the New York Times (emphasis added):

Chairman Alan Greenspan has fiercely objected whenever derivatives have come under scrutiny in Congress or on Wall Street. “What we have found over the years in the marketplace is that derivatives have been an extraordinarily useful vehicle to transfer risk from those who shouldn’t be taking it to those who are willing to and are capable of doing so,” Mr. Greenspan told the Senate Banking Committee in 2003. “We think it would be a mistake” to more deeply regulate the contracts, he added.

Today, with the world caught in an economic tempest that Mr. Greenspan recently described as “the type of wrenching financial crisis that comes along only once in a century,” his faith in derivatives remains unshaken.

The problem is not that the contracts failed, he says. Rather, the people using them got greedy. A lack of integrity spawned the crisis, he argued in a speech a week ago at Georgetown University, intimating that those peddling derivatives were not as reliable as “the pharmacist who fills the prescription ordered by our physician.”

How can anyone, much less one considered a genius, design systems intended to govern human behavior and fail in doing so to account for inevitable human weaknesses? And how can such purported geniuses persist in the face of overwhelming evidence of their failings as Greenspan has?  Yesterday, he told the House Committee on Oversight and Government Reform that

“Those of us who have looked to the self-interest of lending institutions to protect shareholders’ equity, myself included, are in a state of shocked disbelief.”

I’m no genius, purported or otherwise, but I do remember back in the 80s, as I witnessed from up very close the demise of a financial institution that many believed had created a new market immune to every market’s eventual downward turns. It was then that I realized that at least some of the investment bankers with whom I was dealing were a different species of animal than I. I had the firm belief their visual fields, like the Terminator’s, provided continual digital readouts of relevant financial information about anything and everything they glanced at. Unlike the Terminator’s data streams, however, the digital readouts in the visual fields of the Financial Geniuses provided a continual updating of the price per share of whatever it was they happened to be looking at. Thus, for example, they could glance at the disclosures set forth in a bond offering and instantly calculate the impact those disclosure would have on the issuing company’s price per share. Worse, however, I was convinced they could look at me and instantly read their estimates of my own value. And believe me, that value was, at best, de minimis.