Inventor of the "Swap" Blames Regulators for Financial Crisis
David Swensen discusses the current state of the market and derivatives trading
The Wall Street trader who invented the swap says he's dismayed by how other traders have so abused his invention and the "complete and utter failure" of regulators to prevent the abuse that led to the current financial meltdown.
David Swensen, now the legendary manager of Yale University's endowment funds, says swaps and other financial derivatives ought to be traded on an exchange and hedge funds that get big enough to pose risks to the financial system should be regulated.
"I don't think it is the tool that is the problem," he says of swaps. "I think it is the fact that our regulatory authorities aren't doing their jobs" that allowed derivative trading to balloon dangerously. The bursting of that balloon is one of the main reasons for the Wall Street credit crunch.
In the late 1970s, David Swensen took his new Yale doctorate in economics to Wall Street. While working for Salomon Bros. in the early 1980s, he figured out a way for IBM and the World Bank to trade, or swap, payments in different currencies. It was a key development in a larger Wall Street trend to create and trade new financial "derivatives"--or instruments whose value is derived from an underlying asset or income stream. As a part of this trend, musician David Bowie found investors willing to pay him upfront cash in return for the right to collect future earnings on his hit songs, for example. And an entire industry arose to create and trade derivatives based on the mortgage payments of homeowners.
"Like a lot of good things, [the swap] morphed into something way beyond" what its inventor intended, Swensen says.
The credit markets are dysfunctional now because "disclosure is inadequate and understanding of what disclosures there are is inadequate. It has been a complete and utter failure on the part of regulatory authorities to not even measure what is out there," he says.
Now, Swensen supports requiring swaps and other derivatives to be traded openly on an exchange--a proposal that was torpedoed by both the Clinton and Bush administrations. "Having a clearinghouse is a fabulous idea. It reduces risks," he says.
If it is such a good idea, why hasn't it happened? "Financial institutions that deal in these things have resisted that because it would make the market more transparent and less profitable," Swensen believes.
In addition, he says, politicians haven't been forced to make changes because past crises, such as the market crash of 1987, were so short-lived. "If there is a quick snap back, people will forget about it and go on their merry way and wait until the next crisis, which will be worse," he says.
Swensen, who describes himself as a "very idealistic" Midwesterner, says the failure of political leaders and regulators has made him "very cynical about how our political system works." Now, although he says he signs that "we might be moving in the right direction," he's worried that "the only circumstance under which we would get serious regulatory reform would be if this crisis persists."
Swensen is a notoriously reticent investment manager. But he is speaking to the press now about the latest edition of his book Pioneering Portfolio Management, which argues that individual investors, and most professional managers, don't have the time, information, or expertise to beat the overall market or to profit from the kind of long-term alternative investments that have turbocharged Yale's endowment. But his book does note that frequent--even daily--rebalancing of a portfolio to maintain a preset ratio of assets such as stocks, can prove profitable over the long term. That would imply that Yale has been buying into the current bear stock market.
Related content:
advertisement
