Rethinking the Goals of Finance, Cont'd

Some Letters to the Editor

The article Rethinking the Goals of Finance: Lessons from the Amherst Arbitrage proved controversial. Below are a couple emailed responses Political Animal recieved on the topic:

Dangerous Derivatives?

I particularly enjoyed the case example of Amherst Holdings versus the banks. Indeed, the use of financial derivatives was a superbly brilliant strategy by Amherst to protect itself against financial loss and importantly provided a social good to the community whereby none of the homeowners lost their houses.

That said, this essay should have ended in the second paragraph with the authors’ assertion that “there is nothing inherently problematic with finance……financial practices are troubling because of their execution, not because finance is itself problematic.” As with many things in life, including finance, poor execution can typically lead to unfortunate and unintended outcomes. For example, owning a car is considered a valuable and useful asset, but poor execution (reckless driving) may very well lead to catastrophic consequences.

The article connotes a very negative view of derivative instruments, which I find troubling because derivative usage–contrary to the authors’ implications–does not typically result in “dangerous concentrations of risk.”

Derivatives are an excellent tool that have been used since ancient times to prudently manage risk in financial and investment portfolios. There is no way to prevent a rogue trader or poorly managed firms from misusing any instrument, including a derivative and when that happens the individuals and the companies that they work for (assuming the companies did not have adequate risk controls in place) should be held accountable and punished severely, including possible jail sentences.

The authors make their case using the sub-prime mortgage crisis–which many would refer to as an outlier or 100 year event–caused by one specific financial derivative, a credit default swap, which is a just a tiny part of the massive $1.0 quadrillion global derivatives market. To the continue the motor vehicle vs. financial vehicle analogy, this is akin to focusing on a small subset of dangerous drivers and critiquing the entire transportation network on that basis.

The sub-prime mortgage crisis proved that many firms were “driving” dangerously in their usage of credit default swaps. But it does not show that the credit default swap themselves are inherently risky, or that the overall financial derivatives market is prone to dangerous concentrations of risk.

-ZA

Social Investing Overlooked

This article builds up to the claim that “our financial system advances without a well-defined real social goal.” I find it strange, therefore, that it does not even mention the growth of socially responsible investing.

The idea of using finance and investing as a tool to promote social good has been around for some time gaining attention in the 1970’s when investors avoided investing in South Africa in an attempt to end apartheid. Then in 2006, the United Nations launched its six Principles for Responsible Investing with a mission to promote a financial system “that will reward long-term, responsible investment and benefit the environment and society as a whole.” Many financial institutions globally, including banks, investment firms and multi-billion dollar pension funds have become signatories to this initiative with a resulting growth in socially responsible investing since 2006, much earlier than the 2008 mortgage crisis.

Socially responsible investing is not an underlying rule of finance, of course, but that is the nature of the free market.

The primary goal of investors is to maximize the rate of return on their investment portfolios, whereas the goal of social investing is to make life better for other people while still earning a healthy rate of return. Sometimes the two goals are in sync, but oftentimes they diverge. Although the evidence is murky, many investors would argue that investing with a social conscience is detrimental to investment performance. In a capitalist society, the decision to invest with social goals in mind cannot and should not be mandated, but should rest with each individual investor. It involves a choice between following one’s pocketbook and following one’s social conscience.

-AA