Sunday, September 27, 2009

Using Derivatives for Good Instead of Evil

This excerpt Robert Pozen's "Too Big to Save? How to fix the US Financial System" points to a good use for derivatives (HT: Marginal Revolution):
The Danish model has another critical and innovative feature.  Holders can retire their own mortgages by purchasing the same face amount of mortgage bonds at the prevailing market price.  To prepay a mortgage by purchasing bonds, the home owner must give advance notice of several weeks to the MCI [mortgage credit institutions], which designates by lottery the specific bonds to be purchased.  Thus, if rising interest rates or other factors cause mortgage bonds to trade at a discount, home owners can reduce the principal or retire the whole mortgage by purchasing an appropriate mortgage bond at a discount.
This is an example of innovation that would make markets more robust help prevent foreclosures, rather than the types of innovations we've seen in the US, which are mostly meant to subvert regulations. The fact that this has not evolved in the US makes me think two things: One, that the balance of power IS tilted in favor of banks and against the consumer (maybe due to lobbying power, which Adam Smith and other "classical" market economists warned against); and two, that the regulatory framework has created some degree of moral hazard and/or regulatory capture (i.e. banks are taking risks and doing things way beyond what they would normally do because they do not face consequences from the market, i.e. bailouts, or the regulators, i.e. bureaucratic corruption) over the last 30 years.

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