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Keynes, probability, asset pricing and the great clusterfuck | 157 comments (157 topical, editorial, 0 hidden)
Re: What now? (none / 1)
Santiago, have you seen this elsewhere in this thread, or this interactive map of derivatives sold to entities in the French private sector?

Often banks suggest that buying a derivative on the side is a condition for access to funding or credit. In fact, often the banks will encourage that the client sell the bank an option. That's not how insurance works.

If you are not convinced, try it on someone who has not been entirely debauched by economics. — Piero Sraffa

by Carrie (migeru at eurotrib dot com) on Mon Jul 23rd, 2012 at 01:58:18 AM EST
[ Parent ]
Re: What now? (none / 0)
That's interesting.  No, I didn't see that thread.  But I disagree.  That is exactly how insurance works in banking. Mortgage insurance, crop insurance, and risk management strategies including derivatives make sense for a lender to require in many, if not most, lending situations.

That doesn't mean that there aren't any shenanigans going on that need correction, banning, or even prosecution.  But the concept of requiring insurance, of which derivatives are a subset, is a pretty reasonable practice and generally a good idea.

by santiago on Mon Jul 23rd, 2012 at 09:42:05 AM EST
[ Parent ]
Re: What now? (4.00 / 2)
Mortgage insurance, crop insurance, and risk management strategies including derivatives make sense for a lender to require in many, if not most, lending situations.

It makes sense for banks to require counterparties to take on derivatives to reduce the counterparty's exposure. This means the bank sells protection to the nonfinancial counterparty, and it's the bank's job to hedge, distribute, the resulting risk in the financial markets. That's not what has been done. Counterparties have been encouraged to sell protection to the bank, or equivelently, to take on additional risks in order to reduce the headline borrowing costs, often with assurances of the kind of "what can possibly go wrong?".

If you are not convinced, try it on someone who has not been entirely debauched by economics. — Piero Sraffa

by Carrie (migeru at eurotrib dot com) on Mon Jul 23rd, 2012 at 10:04:25 AM EST
[ Parent ]
Re: What now? (none / 0)
No, except in a few cases, the borrowers' derivative or other insurance strategies protect the borrowers' ability to repay loans, which is never consistent with anything that would incur more risk for them. Where things have gone wrong lies in speculative play by insurers, not borrowers.  It's the insurers -- big banks and insurance firms -- who have been unable to pay out to insurees when they were supposed to that has caused all the problems because they -- the insurers -- didn't understand the true risks involved in their increasingly complex and fee generating derivatives strategies.
by santiago on Tue Jul 24th, 2012 at 02:35:22 PM EST
[ Parent ]
Re: What now? (none / 0)
Sorry, no
"It's a joke that we're in markets like this," said [Saint Etienne municipal finance director Cedric] Grail, 38, from the 19th-century city hall fronted by an arched facade and the words Liberte, Egalite, Fraternite. "We're playing the dollar against the Swiss franc until 2042."
And overwhelmingly these derivative plays with public sector entities are favourable to the banks.

If you are not convinced, try it on someone who has not been entirely debauched by economics. — Piero Sraffa
by Carrie (migeru at eurotrib dot com) on Tue Jul 24th, 2012 at 02:43:24 PM EST
[ Parent ]
Re: What now? (none / 0)
Of course their favorable to banks, because banks are accepting increased risk for increased profits, which insurance strategies using derivatives legally allow them to do (and should be the focus of reform), but this isn't something where borrowers are forced to take on higher risk outside of that.  The only additional risk in the derivatives that borrowers might be asked to participate in is the counter-party risk that their insurer won't be able to pay up. Otherewise, the borrowers derivatives really are good hedges unless something criminal is going on according to current laws and regs.
by santiago on Tue Jul 24th, 2012 at 03:28:34 PM EST
[ Parent ]
Re: What now? (none / 0)
Of course their favorable to banks, because banks are accepting increased risk for increased profits

But they are not: banks were buying exotic options from nonfinancial counterparties in exchange for lowering the headline borrowing costs of the counterparties by a few basis points. As you know, the seller of an option (in this case, not the bank) overwhelmingly bears the risk.

We're not talking about vanilla interest rate swaps here.

If you are not convinced, try it on someone who has not been entirely debauched by economics. — Piero Sraffa

by Carrie (migeru at eurotrib dot com) on Tue Jul 24th, 2012 at 03:38:23 PM EST
[ Parent ]
Re: What now? (none / 0)
What are some examples of that that don't have to do with big-time rich people on both ends?  I'm still skeptical that there is any systematic attempt to force average average or typical borrowers into anything like this.  Rather, these are capital market activities within and among the investment class that have to do with financing banks as much as borrowing from them.
by santiago on Tue Jul 24th, 2012 at 05:28:47 PM EST
[ Parent ]
Re: What now? (none / 1)
Hmm, how do you classify deals between banks and corporations or public sector entities like local or regional governments, school districts, hospitals, etc?

If you are not convinced, try it on someone who has not been entirely debauched by economics. — Piero Sraffa
by Carrie (migeru at eurotrib dot com) on Tue Jul 24th, 2012 at 06:46:33 PM EST
[ Parent ]
Re: What now? (none / 0)
Good example.
by santiago on Wed Jul 25th, 2012 at 10:38:24 AM EST
[ Parent ]
Re: What now? (none / 0)
Same example we've been discussing for, I don't know, a dozen comments now.

If you are not convinced, try it on someone who has not been entirely debauched by economics. — Piero Sraffa
by Carrie (migeru at eurotrib dot com) on Wed Jul 25th, 2012 at 05:03:29 PM EST
[ Parent ]
Re: What now? (none / 0)
So it was. But that brings up something else -- the fact the it's government entities that are getting bilked by banks.  Are there similar non-government examples? (I suspect there must be if the problem really is derivatives.) But bilking government and taxpayers, aka corruption, isn't anything new, and it isn't peculiar to derivatives.  It's a function of problems inherent in the principal-agent relationships between government officials and their constituents and information asymmetry.  So are derivatives really the problem or is this just today's manifestation of the age-old game of finding ways to steal money from the public purse.  
by santiago on Thu Jul 26th, 2012 at 12:58:42 PM EST
[ Parent ]
Re: What now? (none / 0)
Derivatives are the problem because it is not a matter of derivatives being mispriced, per se, but the offer of "I can save you a little bit in your borrowing costs if you sell me this exotic option - don't worry, nothing can go wrong on it".

If you are not convinced, try it on someone who has not been entirely debauched by economics. — Piero Sraffa
by Carrie (migeru at eurotrib dot com) on Thu Jul 26th, 2012 at 01:17:30 PM EST
[ Parent ]
Re: What now? (none / 0)
But that's an argument for why derivatives aren't the problem.  Insurance scams are as old as insurance, but that doesn't mean that insurance is bad.  The fact that some people are using derivatives for evil instead of good doesn't mean that it's a good idea to ban them and think you've solved the problem of insurance scams.
by santiago on Sun Jul 29th, 2012 at 08:45:49 PM EST
[ Parent ]
Re: What now? (none / 0)
Any contract that an untrained but reasonably intelligent intern does not understand has a high probability of being a scam.

Most "exotic" derivatives fall into this category.

- Jake

Friends come and go. Enemies accumulate.

by JakeS (JangoSierra 'at' gmail 'dot' com) on Mon Jul 30th, 2012 at 04:24:49 AM EST
[ Parent ]
Re: What now? (none / 0)
Cue in my proposal for Central Bank collateral eligibility criteria: if an untrained intern cannot figure out the product, it's not eligible.

If you are not convinced, try it on someone who has not been entirely debauched by economics. — Piero Sraffa
by Carrie (migeru at eurotrib dot com) on Mon Jul 30th, 2012 at 09:57:43 AM EST
[ Parent ]
Re: What now? (none / 1)
Your argument - as usual - is pure sophistry and misdirection.

Most derivatives are simple gambling - and clearly so. There is no upside, and no 'good' there.

Bankrupt and publicly humiliate anyone who works in finance and is found guilty of scamming of any kind.

Set up stocks in front of Canary Wharf. Give the public an opportunity to tell scammers and corrupt bankers what they think of them.

by ThatBritGuy (thatbritguy (at) googlemail.com) on Mon Jul 30th, 2012 at 05:24:03 AM EST
[ Parent ]
Re: What now? (none / 0)
No, a few derivatives are simply gambling, but it is you who engaging in the sophistry of making broad generalizations about things that have very little to do with how they are actually practiced in the real world.

Most derivatives are simply contracts between counter-parties that control for risk.  Such contracts benefit from the liquidity provided by the development of a market for risk-taking speculators, but such speculation is only problematic where people are dishonestly engaged in classic insurance scams, which means that it is the dishonesty that is the problem, not the practice of insuring oneself in financial contracts.

by santiago on Mon Jul 30th, 2012 at 03:49:43 PM EST
[ Parent ]
Re: What now? (none / 0)
Most derivatives are simply contracts between counter-parties that control for risk.

Nonsense.

And clearly nonsense.

The truth - as you well know, and everyone here knows - is that the true purpose of most financial instruments is either simple gambling or dishonest risk camouflage.

The reality is that risk remains resolutely uncontrolled, and ultimately - so we're told - is so uncontrolled it has to be back-stopped by governments.

 

by ThatBritGuy (thatbritguy (at) googlemail.com) on Mon Jul 30th, 2012 at 04:02:35 PM EST
[ Parent ]
Re: What now? (none / 0)
It's the whiff of brimstone that removes any rational doubt from the mind that what you said is the naked truth.
Time to call a spade a spade, damn the torpedoes.
Or something.
;)

'The history of public debt is full of irony. It rarely follows our ideas of order and justice.' Thomas Piketty
by melo (melometa4(at)gmail.com) on Mon Jul 30th, 2012 at 05:53:20 PM EST
[ Parent ]
Re: What now? (none / 0)
I'm glad you are such an expert on derivatives, tbg, that you can make such broad claims about things with which you have little, if any, experience.  Would that we could all be as smart as you.
by santiago on Thu Aug 2nd, 2012 at 12:33:00 PM EST
[ Parent ]
Re: What now? (none / 0)
Finally out of allegedly substantive points? Can't answer Mig's and Jake's facts?

Reduced to dull old Internet ad hominems, eh? Excellent.

Incidentally, you're quite wrong if you really think I have no knowledge of CFDs or derivatives from the consumer side.

But - whatever.

by ThatBritGuy (thatbritguy (at) googlemail.com) on Thu Aug 2nd, 2012 at 01:28:36 PM EST
[ Parent ]
Re: What now? (none / 0)
If you have specific knowledge of consumer derivatives then just present it. I'm not making any points here, just questioning the unwarranted assertions made by some, and agreeing with others that have been warranted.
by santiago on Fri Aug 3rd, 2012 at 12:39:47 PM EST
[ Parent ]
Re: What now? (none / 0)
"In the real world" I've seen enough monsters to suspect that the monsters are not anomalies, even if infrequent.

If you are not convinced, try it on someone who has not been entirely debauched by economics. — Piero Sraffa
by Carrie (migeru at eurotrib dot com) on Mon Jul 30th, 2012 at 06:36:50 PM EST
[ Parent ]
Re: What now? (none / 1)
If after all this discussion you still can't see why it is backwards (and wrong) that financial institutions offload market and credit risk on non-financial institutions through complex derivatives, or that the nonfinancial counterparties sell insurance to the financials, then I truly cannot help you.

If you are not convinced, try it on someone who has not been entirely debauched by economics. — Piero Sraffa
by Carrie (migeru at eurotrib dot com) on Mon Jul 30th, 2012 at 09:56:26 AM EST
[ Parent ]
Re: What now? (none / 0)
I do see where such a practice is wrong.  What I don't see is that such a thing is very prevalent in derivatives use today, or ever.  Most derivatives are between financial counter-parties, and those that are not should be investigated under the broad category of insurance scams, not derivatives problems.
by santiago on Mon Jul 30th, 2012 at 03:52:23 PM EST
[ Parent ]
Re: What now? (none / 0)
Most derivatives are between financial counter-parties

Do you have statistics on that? Most of the derivatives I see "in the real world" are with between a financial and a nonfinacial. Or things like a financial getting in between a financial and a nonfinancial to take over the financial's credit risk exposure to the nonfinancial from an existing derivative contract.

If you are not convinced, try it on someone who has not been entirely debauched by economics. — Piero Sraffa

by Carrie (migeru at eurotrib dot com) on Mon Jul 30th, 2012 at 06:40:06 PM EST
[ Parent ]
Re: What now? (none / 0)
No, I don't have statistics.  Do you?
by santiago on Tue Jul 31st, 2012 at 02:21:20 AM EST
[ Parent ]
Re: What now? (none / 0)
Most derivatives are between financial counter-parties, and those that are not should be investigated under the broad category of insurance scams, not derivatives problems.

What would you call derivatives marketed to retail banking customers? Investment products, insurance, or scams?

If you are not convinced, try it on someone who has not been entirely debauched by economics. — Piero Sraffa

by Carrie (migeru at eurotrib dot com) on Mon Jul 30th, 2012 at 06:45:01 PM EST
[ Parent ]
Re: What now? (none / 0)
"Retail banking customers" usually means small loans to individuals or small businesses.  Loans to local governments are very large bonds and are not generally in the category of retail but are instead usually categorized as "capital market" lending. Mortgage insurance is an example of a form of insurance marketed to retail borrowers that is paid for by borrowers but really just insures the lender and its investors. Default derivatives are in the same category of loan insurance but in a form appropriate for large loans and bonds.  

Where they are marketed without equal understanding of the risks and true costs among all counter-parties, the possibility of scams occurs and should be guarded against by regulation targeting such activity, like all other forms of insurance fraud that is already supposed to be policed.

by santiago on Tue Jul 31st, 2012 at 02:31:50 AM EST
[ Parent ]
Re: What now? (none / 0)
"Retail banking customers" usually means small loans to individuals or small businesses.  Loans to local governments are very large bonds and are not generally in the category of retail but are instead usually categorized as "capital market" lending.

Yes, and in this instance I'm talking about "retail banking customers", not about the public sector "toxic loans" referred to above.

If you are not convinced, try it on someone who has not been entirely debauched by economics. — Piero Sraffa

by Carrie (migeru at eurotrib dot com) on Tue Jul 31st, 2012 at 03:44:09 AM EST
[ Parent ]
Re: What now? (none / 0)
I can't think of any reasonable reason for a retail lending customer to have to buy a derivative in order to get a loan.  Such practices, if they occur, and I'm not sure they do yet. should obviously be banned, just like other forms of insurance scams.
by santiago on Tue Jul 31st, 2012 at 06:37:25 AM EST
[ Parent ]
Re: What now? (4.00 / 2)
<sigh>

Just google "retail structured product distribution" and weep...

This one from 2003: Retail derivatives made simple

Fashion has hemlines, ecology has climate, finance has derivatives. In each case eminent industry participants form time to time rail against the evil inherent in the present state of the relevant topic. In the case of derivatives, these tirades are usually delivered by eminent, albeit senior, members of the finance community ...
These all geezers don't understand the brave new world
These outpourings do not create the ideal environment in which to advocate the widespread distribution of derivatives to retail investors...
They say it as if the widespread distribution of derivatives to retail investors were a good idea...

This one from just this year: Why structured products might benefit from the FSA's Retail Distribution Review (Risk.net, 15 May 2012)

Implementation of the UK Financial Services Authority's Retail Distribution Review (RDR) will be costly for independent financial advisers (IFAs) but will make structured products more attractive to investors, according to market participants.

...

"The shape of business is going to change, but from a client perspective it will make products more attractive," says Adrian Neave, managing director at distributor Gilliat Financial Solutions in London. "The 3% usually paid for commission will now be used to increase the coupon on products."

...

"More IFAs have been asking us for training in structures that they are less familiar or comfortable with, which should only serve to increase their confidence in recommending them. We have seen some advisers who hadn't previously used structured products starting to use them in client portfolios after having training, which allayed their concerns or filled gaps in their knowledge," he says.

Hey, look, it will now cost people zero up-front to go into a retail derivative contract. They will pay the fee in the form of coupons over the life of the deal... And we're going to force financial advisors to sell products they are "not comfortable" with. What's not to like? From late last year: UK distributors to adopt discretionary model in response to Retail Distribution Review (Risk.net, 12 Dec 2011)
"The FSA has proposed the question as: 'Is it better to receive bad advice or no advice?' and it has decided it is best to receive no advice," says Simon Gleeson, partner at law firm Clifford Chance in London.
 The RDR will cut the majority of the UK market from financial advice of any kind, says Gleeson. "Distributors are looking to change the regulatory classification of their activity from advice to discretion. At that point, it becomes possible to invest in products that you wouldn't be able to invest in under RDR," says Gleeson.
 On the basis that discretionary managers do not have to comply with the regulatory framework set out in RDR, some of them will be able to take investor funds without disclosing the type of structures that the investors would be exposed to.
Wheee!

Now, why would the Belgian regulator have imposed a moratorium on retail structured products, if they hadn't been abused in the past? Belgium's moratorium on retail structured products dissected (Risk.net, 29 Aug 2011)

When Belgian regulator the Financial Services and Markets Authority's (FSMA) issued its moratorium on the distribution of `needlessly complex' products in June, it came as little surprise to market participants, many of whom see the moratorium as broadly replicating the stringent regulatory measures being applied elsewhere in Europe.

"The moratorium has definitely been inspired by regulation in other countries, especially France," says Benedict Peeters, founding partner at Finvex, a structured products research boutique in Brussels. But while French regulation excludes capital-protected products, the Belgian moratorium includes protected solutions, says Peeters. The fact that most structured products offered in Belgium include capital protection means "it is ultimately those investors that the moratorium is trying to protect," he says.

"From the preparatory work, it became clear that it should be possible to impose restrictive conditions on certain products, particularly where their complexity renders them unsuited to the average retail investor," says an FSMA spokesperson in Brussels. The moratorium constitutes the first step in a process intended to "increase the traceability" of retail investment products, he says.

The whole category of "capital protected" products is interesting, because that's usually the hook that's used to sell to retail customers. "Don't worry, in the worst case you won't lose your capital".

If you are not convinced, try it on someone who has not been entirely debauched by economics. — Piero Sraffa
by Carrie (migeru at eurotrib dot com) on Tue Jul 31st, 2012 at 08:48:30 AM EST
[ Parent ]
Re: What now? (none / 0)
It still doesn't say these are very common, but if so, I agree, the practice should be prohibited, butfor the same reason that many other forms of insuring consumer debt repayment should be prohibited. (The banks should be taking the risk on such loans and pricing them according because they have more information than consumers do.)

Most European countries' laws do not provide consumers with the extensive kinds of protections from debt collection that consumers enjoy in the US, so care should be taken to enhance such protections in order to replace the perceived value consumers may be finding in such derivative products, if they are in fact so common.

by santiago on Fri Aug 3rd, 2012 at 12:55:15 PM EST
[ Parent ]
Re: What now? (4.00 / 3)
It's not the same thing, but in principle, I'm reminded of the "payment protection insurance" scam that credit card companies try to run, where they ask borrowers to take out insurance to cover their own risk of becoming unable to continue repayment on their credit cards.
by Zwackus on Wed Jul 25th, 2012 at 06:32:34 AM EST
[ Parent ]
Re: What now? (none / 0)
That's not really a derivative specifically, but it is an example of the same sort of thing in a different type of insurance contract.
by santiago on Wed Jul 25th, 2012 at 03:32:07 PM EST
[ Parent ]
Re: What now? (none / 0)
Credit risk isn't an insurable sort of risk.

AIG provided an instructive case in point.

- Jake

Friends come and go. Enemies accumulate.

by JakeS (JangoSierra 'at' gmail 'dot' com) on Thu Jul 26th, 2012 at 02:57:18 PM EST
[ Parent ]
Re: What now? (none / 0)
Yes, it is. Just like lifespans are.
by santiago on Sun Jul 29th, 2012 at 08:47:04 PM EST
[ Parent ]
Re: What now? (4.00 / 4)
  1. Deaths are not autocorrelated, except under force majeure conditions.

  2. Insuring against the risk of death does not increase the insurer's risk of death.

  3. Defaults are always autocorrelated.

  4. Insuring against default increases the insurer's risk of default.

  5. Screws up your efforts to create an actuarial model.

  6. Means, when combined with (1), that when you attempt to insure yourself against default, you are only interposing the insurer between yourself and the downward leg of the business cycle.

There is precisely one insurer in each jurisdiction who can stare down the downward leg of the business cycle and win. And the default insurance that the government sells is a lot less subtle than a credit default swap.

- Jake

Friends come and go. Enemies accumulate.

by JakeS (JangoSierra 'at' gmail 'dot' com) on Mon Jul 30th, 2012 at 04:22:49 AM EST
[ Parent ]
Re: What now? (4.00 / 2)
There is preciselyat most one insurer in each jurisdiction who can stare down the downward leg of the business cycle and win.

When you let neoliberal or Austrian ideologues or common sense conservatives or gold bugs write your laws, you may end up with no insurer of last resort. On which, see the Eurozone.

If you are not convinced, try it on someone who has not been entirely debauched by economics. — Piero Sraffa

by Carrie (migeru at eurotrib dot com) on Mon Jul 30th, 2012 at 09:59:55 AM EST
[ Parent ]
Re: What now? (none / 0)
Insuring against default does not automatically increase the probability of default, and even where it does, the increase is usually small. And this is especially true in the case of derivatives where the counter-parties are often between investors in the loan and not related to the borrower at all.

While adverse selection is indeed a non-trivial problem in credit risk and actuarial models of default, the statistical evidence is quite strong that the correlation between insurance and defaults is sufficiently weak to allow for gains by insuring against default.  

Note that it is the lender, and the lender's investors, who are insuring against default, not the borrower.  This is even the case where a lender requires the borrower to effectively insure oneself against one's own default because a borrower bears no risk of loss in case of default: The borrower already received the benefits when the loan was disbursed, so only the lender bears the risk of loss from the point the loan was made until it is repaid.

by santiago on Mon Jul 30th, 2012 at 03:43:48 PM EST
[ Parent ]
That's what AIG thought (n/t) (none / 0)


Friends come and go. Enemies accumulate.
by JakeS (JangoSierra 'at' gmail 'dot' com) on Mon Jul 30th, 2012 at 06:36:53 PM EST
[ Parent ]
Re: That's what AIG thought (n/t) (none / 0)
AIG made the same mistake that lots of insurance companies have made throughout history have made -- they overextended the protection they could provide customers because of inadequate appreciation of the risks involved. The problem was not that they were insuring against defaults, but that they did too much of it relative to their capacity to pay out on their commitments in the event of loss. They wrote too many derivatives, but the problem was 'too many' not 'derivatives.'
by santiago on Tue Jul 31st, 2012 at 02:37:23 AM EST
[ Parent ]
Re: That's what AIG thought (n/t) (4.00 / 2)
The problem was derivatives, because the derivatives in question had been specifically designed and marketed as ways to break the law.

There hasn't been a "financial innovation" since the ATM which hasn't been about finding technically legal ways to skirt prudential regulation. The technicalities really don't matter - being engaged in "financial innovation" is prima facie evidence of conspiracy to defraud the public.

- Jake

Friends come and go. Enemies accumulate.

by JakeS (JangoSierra 'at' gmail 'dot' com) on Tue Jul 31st, 2012 at 05:15:50 AM EST
[ Parent ]
Re: That's what AIG thought (n/t) (none / 0)
No. The problem is trying to break the spirit of laws and the misuse of financial derivatives, a form of insurance contract, is the mere manifestation of the problem at the present time. Tomorrow it will be something else.
by santiago on Fri Aug 3rd, 2012 at 11:56:05 PM EST
[ Parent ]
Re: That's what AIG thought (n/t) (4.00 / 3)
Doesn't change the fact that there hasn't been a useful financial innovation since the ATM.

Which means that simply making a - very short - whitelist of stuff banks are allowed to do would make it vastly more difficult to scam people, at no loss of anything important. Drowning the mark in impenetrable bafflegab that make the salesman look smart is a staple of confidence scams, and there is no good reason to give conmen in business suits that option.

- Jake

Friends come and go. Enemies accumulate.

by JakeS (JangoSierra 'at' gmail 'dot' com) on Sun Aug 5th, 2012 at 07:55:04 AM EST
[ Parent ]
Re: That's what AIG thought (n/t) (none / 0)
I'm not disputing that point.

I just don't think derivatives really fall into the category of financial innovation.  Derivatives are merely particular specifications of insurance, which has been around a lot longer than ATMs, and there is nothing fundamentally wrong, or right, about derivatives that warrant them being treated any differently than the way insurance is already treated.  Insurance fraud should be prohibited and policed, and the same standards for determining fraudulent practices versus legitimate practice should be applied to derivatives as well.  

by santiago on Sun Aug 5th, 2012 at 10:16:35 PM EST
[ Parent ]
Re: That's what AIG thought (n/t) (4.00 / 2)
Derivatives are not insurance, because no insurable interest is required to enter into a derivatives transaction.

Derivatives are gambling.

For evidence that derivatives are gambling and not insurance, consider the fact that insurance is priced on actuarial principles on the basis of physical probabilities, whereas derivatives are priced on bookmaking principles on the basis of market probabilities. As discussed in the diary, incidentally. Maybe the diary is not too clear on this point, which would be a Fail™.

If a risk is not actuarial it's not insurable.

If you are not convinced, try it on someone who has not been entirely debauched by economics. — Piero Sraffa

by Carrie (migeru at eurotrib dot com) on Mon Aug 6th, 2012 at 03:59:32 AM EST
[ Parent ]
Re: That's what AIG thought (n/t) (none / 0)
For the insurer, no insurable interest is required either.  For the insuring party, insurance is gambling.  That's what actuarial tables are -- odds-making, based on physical as well as other probabilities.  

What you are arguing is that some things are legitimately insurable -- such as life expectancy -- and some things aren't, such as market price outcomes, which is an interesting argument, but not a convincing one.  Probabilities are probabilities, so why shouldn't people who face costly market volatility risks be able to transfer, for a price, those risks on to gamblers who are willing to accept it?    

by santiago on Mon Aug 6th, 2012 at 10:55:56 AM EST
[ Parent ]
Re: That's what AIG thought (n/t) (none / 1)
Normally the insurer is the wealthier party to the transaction (there's even a calculation dating back to Daniel Bernoulli in the early 1700's showing that under logarithmic utility there's a wealth level below which it makes sense to buy insurance and a wealth level above which it makes sense to sell insurance). Or, in any case, at least one of the two parties to an insurance transaction (the buyer of insurance) has an insurable interest. In the case of derivatives, there are various problems: first, often none of the two parties has an insurable interest; second, in some cases (the ones under discussion in this thread) the market-maker does not provide insurance but buys insurance from a less wealthy counterparty which is not in the business of selling insurance on a wide array of financial events so as to diversify away the downside risk; it is a common practice to offer improved borrowing terms in exchange for a sold option and the downside risk is not understood by the counterparty.

As to:

Probabilities are probabilities
You either have not read the diary, have not understood it, or completely disagree with the meat of it.

If you are not convinced, try it on someone who has not been entirely debauched by economics. — Piero Sraffa
by Carrie (migeru at eurotrib dot com) on Mon Aug 6th, 2012 at 11:11:55 AM EST
[ Parent ]
Re: That's what AIG thought (n/t) (none / 0)
On the last point, no, I do not agree with point the diary is making, to the extent I understand it correctly.

Regardless of whether risk can be reduced for all parties or even estimated correctly, it can still be reduced for one party by being transferred to another who is willing to accept the much higher chance of loss, even a loss that effectively means accepting a negative expected return -- gambling.  If this wasn't the case, it would be mathematically impossible for casinos to remain profitable, would it not?

In such cases, yes, the wealth of the gambler must be high enough to be able to cover the event of loss without being catastrophic to the system, and that was not the case at the beginning of the credit crisis. In other words, the CDO market in 2007 didn't have an enforcer capable of kneecapping AIG and its investors to cover the losses, due to poor oversight by financial authorities.  But that doesn't mean it can't work if such oversight and enforcement exists.

by santiago on Mon Aug 6th, 2012 at 12:33:04 PM EST
[ Parent ]
Re: That's what AIG thought (n/t) (none / 1)
I recently read a quip that there's no gambling analogue of futures and options, because casinos would consider them too reckless as bets.

In addition, casino bets have limited downside and are skewed to the upside (for the players). In other words, you bet a given amount in hopes of a larger payoff. Or, in a more precise gambling analogy, you're required to post 100% margin (you have to put down your maximum loss for the current round of betting). Unregulated casinos where people can bet their house or can even make bets without having the money at the table are the stuff of mafia stories.

If you are not convinced, try it on someone who has not been entirely debauched by economics. — Piero Sraffa

by Carrie (migeru at eurotrib dot com) on Mon Aug 6th, 2012 at 12:41:23 PM EST
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Re: That's what AIG thought (n/t) (none / 0)
And where derivatives markets are regulated, as in the US now with the recent legislation that banks opposed so much, the same conditions now exist as in the casinos as you describe -- you have to be able to cover your bets with 100% of the margin, just like futures and options in regulated commodities markets. If you're arguing that Europe should adopt similar regulations, I agree.
by santiago on Mon Aug 6th, 2012 at 12:52:03 PM EST
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Re: That's what AIG thought (n/t) (none / 1)
you have to be able to cover your bets with 100% of the margin, just like futures and options in regulated commodities markets

Put that way, it should kill the retail derivatives market stone dead.

If you are not convinced, try it on someone who has not been entirely debauched by economics. — Piero Sraffa

by Carrie (migeru at eurotrib dot com) on Mon Aug 6th, 2012 at 01:00:48 PM EST
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Re: That's what AIG thought (n/t) (none / 1)
What you are arguing is that some things are legitimately insurable -- such as life expectancy -- and some things aren't, such as market price outcomes, which is an interesting argument, but not a convincing one.

I'm not saying that market price outcomes are not legitimately insurable. I'm saying that when neither party to a derivative contract has an exposure to the relevant market price outcome (that is, when both parties increase their exposure by entering the transaction) then it is not insurance. A case in point is the proposal to allow cashing of CDS payouts only on delivery of a defaulted bond. That allows people to gamble on CDS prices, but it only allows one to call it insurance if the CDS is actually buying protection against default.

If you are not convinced, try it on someone who has not been entirely debauched by economics. — Piero Sraffa

by Carrie (migeru at eurotrib dot com) on Mon Aug 6th, 2012 at 11:17:57 AM EST
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Re: That's what AIG thought (n/t) (none / 0)
Agreed.
by santiago on Mon Aug 6th, 2012 at 12:04:25 PM EST
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Re: That's what AIG thought (n/t) (none / 0)
why shouldn't people who face costly market volatility risks be able to transfer, for a price, those risks on to gamblers who are willing to accept it?

That's not what I'm talking about. I'm talking about lenders buying exotic derivatives from nonfinancial counterparties, which increases the exposure of the borrower to financial price risk.

If you are not convinced, try it on someone who has not been entirely debauched by economics. — Piero Sraffa

by Carrie (migeru at eurotrib dot com) on Mon Aug 6th, 2012 at 11:21:03 AM EST
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Re: That's what AIG thought (n/t) (none / 0)
If limited to those cases, I agree.
by santiago on Mon Aug 6th, 2012 at 12:18:38 PM EST
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Re: That's what AIG thought (n/t) (none / 0)
Derivatives makes it very easy to separate fools from their money.

If you are not convinced, try it on someone who has not been entirely debauched by economics. — Piero Sraffa
by Carrie (migeru at eurotrib dot com) on Mon Aug 6th, 2012 at 12:27:12 PM EST
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Re: That's what AIG thought (n/t) (none / 0)
The problem with derivatives is that they made it easy for really smart people to be separated from their money too.
by santiago on Mon Aug 6th, 2012 at 05:21:01 PM EST
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Re: That's what AIG thought (n/t) (4.00 / 2)
People who think they're smarter than they are count as fools in this game.

If you are not convinced, try it on someone who has not been entirely debauched by economics. — Piero Sraffa
by Carrie (migeru at eurotrib dot com) on Mon Aug 6th, 2012 at 06:49:56 PM EST
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Re: That's what AIG thought (n/t) (none / 0)
Probabilities are probabilities, so why shouldn't people who face costly market volatility risks be able to transfer, for a price, those risks on to gamblers who are willing to accept it?

Because that's not how people actually use those types of contract.

You don't need exotic derivatives to do that - you can do it with plain old forward contracts. What you need exotic derivatives for is turning credit risk into market risk, so you can hedge it. Which you should not do, because,

  • Credit risks are correlated and pro-cyclical, which creates a structural bias for undercapitalized insurance salesmen.

  • Insuring credit risk lets lenders outsource due diligence to insurance companies, which is never a good idea.

- Jake

Friends come and go. Enemies accumulate.

by JakeS (JangoSierra 'at' gmail 'dot' com) on Mon Aug 6th, 2012 at 11:46:15 AM EST
[ Parent ]
Re: That's what AIG thought (n/t) (none / 0)
Don't disagree in general with either point.  

However, keep in mind that "exotic" just means customized, over the counter contract specific to a particular case. You often need them for the same reason that many other kinds of insurance contracts are specific to individual cases.  

Credit risks are really only weakly correlated.  Even in the worst of the current credit crisis, most loans are not being defaulted. Therefore they are easily insurable.

Last point I agree completely. This is the principal-agent problem, and it is aggravated by the fact, alluded to by Migeru, above, that lenders usually have better information than insurers and borrowers in these cases.

However, default derivatives, CDOs, are really only a very small part of the derivatives being done by financial organizations, and even less so today. Most of them are interest-rate derivatives unrelated to default, where risk is traded for interest payments and these have none of the problems you associate with default speculation.  

by santiago on Mon Aug 6th, 2012 at 12:17:54 PM EST
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Re: That's what AIG thought (n/t) (none / 0)
However, keep in mind that "exotic" just means customized, over the counter contract specific to a particular case. You often need them for the same reason that many other kinds of insurance contracts are specific to individual cases.  
Um, in real life "exotic" means it has a high "WTF!?" factor, it is highly nonlinear or is outright explosive when certain market events happen, it is highly leveraged, and/or has no obvious economic purpose.

I admit many "exotic" deals are simply bespoke non-toxic derivatives, but there are enough painted hand grenades out there masquerading as swaps. Sometimes an overexcited young heir fresh out of business school asks for a painted hand grenade suppository, too.

If you are not convinced, try it on someone who has not been entirely debauched by economics. — Piero Sraffa

by Carrie (migeru at eurotrib dot com) on Mon Aug 6th, 2012 at 12:26:07 PM EST
[ Parent ]
Re: That's what AIG thought (n/t) (4.00 / 2)
Credit risks are really only weakly correlated.  Even in the worst of the current credit crisis, most loans are not being defaulted.

OK, time to break out the Statistics 201 book here. 100 % correlation does not require that all loans default, only that all those loans which do default do so at the same time. If all loans go from having 1 % default risk to having 5 % default risk at precisely the same time, then the correlation is one, and the insurer who is capitalized on the basis of a 1 % default risk goes bust.

- Jake

Friends come and go. Enemies accumulate.

by JakeS (JangoSierra 'at' gmail 'dot' com) on Mon Aug 6th, 2012 at 01:15:55 PM EST
[ Parent ]

Keynes, probability, asset pricing and the great clusterfuck | 157 comments (157 topical, 0 editorial, 0 hidden)
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