January 25, 2010

THE REASON YOU GET PAID TO LEND MONEY IS BECAUSE YOU ASSUME CERTAIN RISKS:

At SEC, a Scholar Who Saw It Coming (KARA SCANNELL, 1/25/10, WSJ)

To help with the task, Mr. Hu brought in another well-known critic of financial innovation, Richard Bookstaber. The former risk manager for large hedge funds is focusing on how to better train SEC staff and marshal the data the agency collects.

Mr. Bookstaber, whose 2007 book warned of a looming financial crisis, told Congress that derivatives are "vehicles for gambling," and he has urged a "flight to simplicity" in financial products. [...]

The Taipei-born 53-year-old studied biochemistry at Yale, worked as a deal lawyer, and then spent 20 years at the University of Texas in Austin, delving into the hard-to-understand products that define modern finance. He acts more like an enthusiastic professor than a jaded Washington bureaucrat, waving his arms and emphasizing points with "boy" and "wouldn't that be neat."

In his 1993 article "Misunderstood Derivatives: The Causes of Informational Failure and the Promise of Regulatory Incrementalism," Mr. Hu described how financial innovation could lead Wall Street astray. When financiers dream up new products, he wrote, they have an incentive to downplay the risks and use them to generate short-term profits—as well as big bonuses.

In particular, he warned about what he called low-probability catastrophic events. That was a premonition of AIG's near-collapse in 2008, triggered partly by the firm's use of certain types of derivatives that were tied to mortgages. Financial institutions such as AIG hadn't predicted credit and liquidity for the products would dry up so fast.

"He's been a Cassandra," said federal judge Patrick Higginbotham in Dallas, a former boss.

Mr. Hu and a colleague have written about a scenario in which a bank lends money to a company but uses derivatives to eliminate any exposure if the company goes bankrupt. Mr. Hu calls the bank in such a case an "empty creditor," and says it is dangerous because it undermines a basic assumption in financial markets: that creditors act in the interests of the debtor's survival.

In a Wall Street Journal opinion article in April 2009—which Ms. Schapiro says prompted the job offer from the SEC—Mr. Hu suggested Goldman Sachs Group Inc. used a kind of derivative called a credit default swap to turn itself into an empty creditor of AIG. He wrote that this may have encouraged Goldman to push for extra collateral from AIG, even when that threatened AIG's existence.

Posted by Orrin Judd at January 25, 2010 11:31 AM
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