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More Derivatives Needed Now. Seriously.

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But risk must be priced appropriately.

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I haven't heard the interview with Minnesota congressman Collin Peterson about his new credit-default-swap bill, or seen a transcript. But what I read in a recent article disturbed me.

Here's what Representative Peterson apparently said: "If you allow the naked short-selling in CDS when you have a ban on selling stock, you are exposing people to a situation where they can't protect themselves. It would blink on and off based on what the SEC does."

Say what?

Maybe it's just me, but I'm really not sure Representative Peterson is clear on how CDSs work. (Of course, that could also probably be said about a lot of people who've sold them in recent years). If the SEC is imposing certain requirements for short sellers -- to have established locates in a stock, for example -- Representative Peterson wants to allow only holders of the company's debt to buy credit protection on it.

The 2 don't really match up the way Representative Peterson seems to think. The SEC rules don't prohibit short selling - they just make it more difficult for traders to get in and out of short positions quickly. But the CDS restriction would greatly inhibit an important pricing source. The CDS market has caused trouble not because of the buyers -- who were trying to sound the alarm that credit risk was being ignored -- but because of the sellers. By taking a big group of buyers out of the market, we are running the risk that we may start pricing risk too cheaply again, with disastrous results.

Right now it's very easy to make populist arguments against Wall Street, against bonuses, against derivatives. And, frankly, I agree with some of them. But we need to be very careful. Yale's Robert Shiller, known for his warnings about market excesses, is featured in an article on derivatives in Newsweek's February 2nd edition. He argues that we actually need more, not fewer, derivatives right now.

Derivatives, such as CDSs, are all about pricing risk and putting it into the hands best equipped to bear it. Let's not kid ourselves - derivatives are also about making big trading profits for Wall Street firms. But they couldn't have been as successful as they've been if there hadn't been at least some degree of merit to them.

One of the biggest problems, which I believe is being ignored, is a lack of understanding as to why credit risk was priced too cheaply. I don't claim to have all the answers - but I do have a couple. Credit spreads had widened significantly in the period between the bursting of the dot-com bubble in 2000-2001 and the invasion of Iraq in the spring of 2003, with the 9/11 attacks and an economic slowdown occurring in between.

When credit began to rally in 2003, many of the asset allocators (funds of hedge funds, in many cases) began to move away from strategies seeking to profit from market volatility and toward ones that would benefit in an improving economy.

The initial thrust of this re-allocation probably made a lot of sense. The trouble is that many asset allocators tend to skate toward where the puck is, not where it's going. It's much easier when defending one's choices to go this way: Everyone can see where the puck is, and it's anyone's guess as to where it might be going.

So these allocators, over a period of years, continue to follow the herd toward taking more credit risk. As long as the trade was working, they stayed with it, even though the mathematics insisted that the only way to generate acceptable returns was to add leverage. But these allocators jeopardized their careers if they failed to follow a popular trade, so they continued to endorse selling CDSs despite an increasingly unfavorable risk-reward skew.

We need to institute policies that reward long-term, forward, skeptical, creative thinking. It won't sound popular right now, but buying cheap disaster protection when everyone is trading as if disasters can't happen is just one example of that kind of thinking. We need to hear those voices. It's next to impossible to manage money in strategies that typically make small losses but occasionally generate huge profits - the Nassim Nicholas Taleb approach.

The problem is this: Investors love steady profits and hate losses. The love of steady profits, however unrealistic they may be, is what allows a Bernie Madoff happen

We need our markets to be forums where dissenting opinions can be expressed. Representative Peterson's bill, as I understand it, does exactly the opposite. By all means, let's improve transparency, and let's establish clearinghouses that keep risk shared and in the open.

But let's stop trying to shoot the messengers we need to hear.
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