Friday, June 24, 2011

When growth stops.... Why the CDS trade is a symptom of catabolism

An interesting point about the CDS trade occurs to me.

As you know, you don’t have to actually have exposure to Greek debt to buy a CDS to protect against a Greek “credit event”. The trade in derivatives of this kind leads to correlated systemic risk (a well-known issue). However there is another, less obvious and more philosophical problem:

It favours destruction over creation.

Once you buy a CDS on Greek failure it is in your interest to trigger the failure, so you short the currency, spread rumours of defaults, etc.

Philosophically it is probably true to say that over the last 3 decades the focus of the financial sector has moved increasingly away from its roots – moving from fostering productivity to embracing and creating destruction. I haven’t seen this stated elsewhere, so here is my suggested progression and timeline:

1. Early 1700s to early 1980s. Emphasis on using capital to foster growth (lending money to build businesses, commerce, transport, etc.).

2. Late 1980s, 1990s, early 2000s. A move by financial institutes away from using capital to support the creation of physical product to investing capital in markets that are increasingly detached from real, tangible products. Emphasis on “synthetic products” such as CDOs SIVs etc, where the emphasis was on “using money to make money” with little actual connection between these “sliced and diced” products and any real creation of physical products. The underlying physical objects that “collateralised” these synthetic products weren’t in any way changed in value by the slicing and dicing, yet the resulting products were inexplicably increased in value by the slicing and dicing process.

3. Early 2000s to now. Increased use of “Derivatives”. Essentially placing bets. No physical production or real creation here – it is worse than a zero-sum game because the house takes a percentage. Succeeding in a derivative bet usually requires something to go wrong or fail – and increasingly it turns out that the entity placing the bet had a hand in the failure. The size of the derivative market is many times the size of the real economy, so it is now quite obvious that derivatives market is completely unrelated to real productivity – the focus is instead on negative events and ways to identify, predict or create them.

If our financial institutions are a reflection of the allocation of our efforts, then we have progressed from a long period (centuries) of physical production, through a period of unproductive resource allocation (which mainly served to enrich the financial markets at the expense of the “margins” in productive growth), to a period with a destructive focus that is several sizes larger than the regular, productive portion of the economy. This destructive focus tends to destroy production-oriented entities in order to enrich financial entities.

So the CDS derivative is more than just a new financial product, it is a symptom of something. There is an underlying problem. If the markets could be productive I believe they would be. Catabolism is an ongoing process, even in healthy organisms. But when catabolism exceeds anabolism it is a sign of either starvation (no inputs) or sickness (no ability to process the inputs). I believe that our society can still process inputs, so we are left with the alternative… there aren't enough inputs.

...And we are back to my point about diminishing returns from declining resource quality.