10/19/2008 Debt leveraging, not the use of derivatives, is the real culprit.

It is debt leveraging, not derivatives, that caused the boom and bust in our financial markets.

In time of financial crisis, socialism could be an easy answer to sell by the politicians, under some other occasions, an idea out of desperation or simply due to the unawareness of some free market alternatives available. Capitalism always survives its own crises and abuses based on repeated innovations. This time around it could be no different. Some innovations may indeed lead to abuse but innovation itself is not the one to be blamed. Drawing on the analogy used repeatedly before again, it is drunk driving, not the car, that is to be blamed for an auto accident.

We have seen many renewed derivatives bashing these days by those who usually do not have adequate insider knowledge about how these financial markets function. We may have had some serious abuse problems of derivatives again in our capitalism system, as demonstrated by the recent financial market turmoils. The problem is not with the tools which derivatives really are. The real culprit is again, the simple concept of debt leveraging, or explained differently, the abusive exploitation of OPM (Other People’s Money) again. The use (or abuse) of derivatives is simply one of the many ways to facilitate the debt leveraging. Restricted from high leveraging abuse, many derivative concepts are actually benign and pervasive in many existing consumer financial products already. They will not go away. People who made comments that they wanted to call for a ban on derivatives are as naive as if they want to ban mortgages or loans all together in our economy, simply because we have been experiencing some human abuse again.

Greedy folks used high leveraging, with small own money up-front and high OPM for irresponsible investment opportunities. Wall Street investment banks, major commercial banks and mortgage lenders all did it. But if you think a leveraging of 30 or 60 times is high, try to think about what average American homeowners were doing again. With 100% LTV it is really an extreme infinity leveraging with no money down at all. Furthermore, how do you even calculate the leveraging of a cash-out refinance with a 120% LTV?

So financial disasters were created by uncontrolled high debt leveraging. When times were good, everybody made money much faster, got carried away and went into extremes by innovating further ways to leverage, Wall Street firms and homeowners alike. When the time turned sour, the reverse should understandably have been equally true and that had led to our financial market bust.

If the inability to control the high debt leveraging is the first blunder by the Administration, the wisdom (or a simply careless mistake) of the fact that Federal Reserve abruptly raised the short term interest rates which had caused the collapse, knowing very well we already had an inflated bubble is really the second major blunder. Without using other ways such as shared appreciation or shared equity concepts to deflate the bubble into a soft landing for our economy, piercing a needle through the bubble was really a foolish thing to do.

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