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Keynes, probability, asset pricing and the great clusterfuck

by Migeru Tue Jul 17th, 2012 at 07:01:15 PM EST

A long time ago, in a galaxy far away, Drew gave me his copy of Keynes' Treatise on Probability, which he had acquired at some point thinking it would be relevant to his economist education but which might be more profitable to me, who had an academic interest in probability theory and had read a number of classic works already. The book languished on my shelf (and travelled in a box, and was stacked on another shelf where it languished, and so on through three separate moves) until one day last week I decided to finally read it (in fact encouraged by a conversation I had with another participant in the Minsky Seminar last month). I think it was worth it, but then again I have weird tastes in reading material.

To Keynes, probability is a branch of logic: the theory of rational thought under uncertainty. Ordinary logic is just the subset of rational thought dealing with certain (or certainly false) propositions. I think this is a really interesting approach. Probability to Keynes is relative but not subjective. That is, probability is always relative to some data (or hypotheses), and so it is in a way subjective since each of us has different data/knowledge/experience, even different mental acuity. However, Keynes' probability is not subjective in the sense that a correctly formed probabilistic reasoning, being enunciated relative to explicit hypotheses, should be valid independently. Keynes writes at length about the problem of induction (reasoning from particular, though possibly numerous, observations to general statements) and he stresses that, contrary to what has been asserted by philosophers in the past, the fact that an inductive conclusion turns out to be false does not invalidate the inductive reasoning relative to the information available at the time the conclusion was formulated.

Anyway, back in 2009 in the context of a discussion of a journalistic piece about David Li's killer formula (the gaussian copula approach to CDS pricing) I said I should probably write a diary about the arbitrage pricing theory that underlies a lot of the ongoing Global Clusterfuck. At the time I was probably thinking that I might use the preface of a popular book on derivative pricing, Financial Calculus by Baxter and Rennie. They begin their book with a parable of the bookmakers intended to disabuse the reader from the get-go that market prices are expected future values. That's right: market prices are not average values as normally understood. However, after having read Keynes on Probability I don't have to infringe Baxter and Rennie's copyright or even retype their text from my hardcopy of the derivatives book, because I can simply lift a section from the Project Gutenberg version of Keynes...


Reading Keynes' ideas on probability, it is absolutely not surprising that he takes the position he does on the role of uncertainty and expectations in The General Theory. Also it helps to understand how all the "deviations from rationality" that neoclassicals like to talk about can actually be rational behaviour under uncertainty form a Keynesian point of view.

4. If we pass from the opinions of theorists to the experience of practical men, it might perhaps be held that a presumption in favour of the numerical valuation of all probabilities can be based on the practice of underwriters and the willingness of Lloyd's to insure against practically any risk. Underwriters are actually willing, it might be urged, to name a numerical measure in every case, and to back their opinion with money. But this practice shows no more than that many probabilities are greater or less than some numerical measure, not that they themselves are numerically definite. It is sufficient for the underwriter if the premium he names exceeds the probable risk. But, apart from this, I doubt whether in extreme cases the process of thought, through which he goes before naming a premium, is wholly rational and determinate; or that two equally intelligent brokers acting on the same evidence would always arrive at the same result. In the case, for instance, of insurances effected before a Budget, the figures quoted must be partly arbitrary. There is in them an element of caprice, and the broker's state of mind, when he quotes a figure, is like a bookmaker's when he names odds. Whilst he may be able to make sure of a profit, on the principles of the bookmaker, yet the individual figures that make up the book are, within certain limits, arbitrary.
There are two arguments here. The first is that the insurer, if he's effectively making a bet, will want to name favourable odds, and that the fact that insurers are willing to name odds and clients are willing to "overpay" for insurance doesn't mean that the probability has a definite value, just that some upper bound to it can be estimated. Later in the paragraph Keynes argues that merchants will be willing to overpay for insurance just because the insured loss would be crippling to them and they want to be sure to avoid ruin.
... These merchants, moreover, may be wise to insure even if the quotations are partly arbitrary; for they may run the risk of insolvency unless their possible loss is thus limited. That the transaction is in principle one of bookmaking is shown by the fact that, if there is a specially large demand for insurance against one of the possibilities, the rate rises;--the probability has not changed, but the "book" is in danger of being upset.
The second argument is based on bookmaking, when the insurer or bookmaker is not actually making any bets, but quoting odds that add up to more than 100% and pocketing the difference. The quoted odds may change with time in response to "market" demand for insurance against the various events, in order to ensure that the bookmaker does not lose money in any event.
... Subsequent modifications of these terms would largely depend upon the number of applicants for each kind of policy. Is it possible to maintain that these figures in any way represent reasoned numerical estimates of probability?

In some insurances the arbitrary element seems even greater. ... In fact underwriters themselves distinguish between risks which are properly insurable, either because their probability can be estimated between comparatively narrow numerical limits or because it is possible to make a "book" which covers all possibilities, and other risks which cannot be dealt with in this way and which cannot form the basis of a regular business of insurance,--although an occasional gamble may be indulged in. I believe, therefore, that the practice of underwriters weakens rather than supports the contention that all probabilities can be measured and estimated numerically.

(Ch. III, The measurement of probability)

(My emphasis)

So, what happens in financial markets is that assets whose actual value depends on future contingencies are given market values on the basis of little more than the bookmaking principle: if there is a certain demand to buy/sell a given asset, a market-maker can set a bid/offer spread such that the demand for sales or purchases of the asset at those prices approximately balance each other and the market-maker pockets the difference as a profit. Similarly, in derivatives trading banks will be willing to take a position with a client by selling them a derivative and then they will turn around and attempt to take an offsetting position (a 'hedge') against another client. Prices will be attempted to be adjusted in order to ensure that the bookmaking principle is kept and the book makes money in any event. With financial derivatives things are a little more complicated than with ordinary bets, as with the passage of time a book can get out of kelter and require additional hedging without the need for more clients coming and asking to trade. This is because of the nonlinearity of payoffs.

But, anyway, the fact that financial asset prices are normally determined by bookmaking considerations implies that, while prices do have something to do with supply and demand (of nothing necessarily more tangible than bets, though), they have nothing to do with probabilities of future events, necessarily. Keynes saw this clearly as per the previous quotation. But the conceptual confusion arises because of what has the characteristics of a mathematical representation theorem, namely that any collection of prices can be represented as a collection of mathematical expectations over a certain probability distribution. Let's be clear here: a probability distribution is constructed (not inferred) out of the market prices, not the market prices calculated out of an estimated future probability distribution. In quant parlance, this is known as the market measure. Then, the market measure constructed from "vanilla" (liquid) derivative prices is fed into models which output the prices of "exotic" (therefore illiquid) derivatives. The whole theory is an exercise in the construction of a self-consistent collection of prices, "calibrated" to some observed market prices determined by supply and demand of liquid assets. At no point does an estimation of the "actual"/"physical" future probabilities of payoffs come into the picture.

To put it slightly differently, (and in fact closer to the spirit in which the mathematical theory of financial asset prices was developed, at least according to the entertaining read Capital Ideas by Bernstein), financial asset pricing theory attempts to answer the question: given this set of observed (quoted) asset prices, can we find a general equilibrium to infer from it the "fair" (but unobserved) prices of these other illiquid assets? Naturally, the resulting theory has nothing whatsoever to say about asset price dynamics. Even the "time" dimension that appears in the sophisticated stochastic processes used to price derivatives is an artifact of the "representation theorem". It is not "physical time" even though it is labelled according to the time span between a derivative's inception and maturity.

Nor does the pricing theory really need to concern itself with "physical" time or dynamics, given that market makers' books are supposed to be hedged (hedging is the basis of the assumed enforcing of arbitrage pricing). Then again, the hedges normally need to be constantly rebalanced, so hedging assumes liquidity; and sometimes liquidity evaporates from markets, leaving books unhedged un unhedgeable, and institutions insolvent and unsalvageable... except by massive infusions of central bank liquidity.

So, then, what about Li's gaussian copula and the Great Clusterfuck? In the thread linked above the fold I claimed

Anyway, Li's formula doesn't systematise or quantify the risk. It prices it. And, under arbitrage pricing, the price of a credit instrument has nothing to do with the "actual" probability of default but is just related to a "market implied" probability of default.
to which Drew reacted with
In other words, they were pricing these things based upon magic?
The magic of arbitrage pricing, yes.

For instance, under arbitrage pricing the price of a futures contract depends only on the spot price and the interest rates, not on the probability distribution of future price movements. Which explains why "financial futures" prices are, empirically, bad predictors of future "spot" prices.

"Arbitrage pricing" being the same as "risk-neutral pricing" or "bookmaking prices". Then I said
I recently read an article (it may have been Mark Taibbi's in Rolling Stone which, unfortunately, is no longer available in full online) which explained (like the wired.com one) that CDOs are priced using Li's formula and CDS price correlation data and therefore (and this is the important part) without Li's formula or CDS prices the Bank's toxic assets cannot be priced.

Also, CDO (or CDS) prices have nothing (a priori) to do with actual default probability.

prompting ATinNM to react with
WTF, over?

Cannot be priced?  Are we talking "physically impossible in this Universe" or "we're too stupid to figure-out what the price is without a bogus mathematical statement to play with"?

To which I replied
I think the answer is "impossible in this universe" because CDOs were constructed to take advantage of Li's formula:
The effect on the securitization market was electric. Armed with Li's formula, Wall Street's quants saw a new world of possibilities. And the first thing they did was start creating a huge number of brand-new triple-A securities. Using Li's copula approach meant that ratings agencies like Moody's--or anybody wanting to model the risk of a tranche--no longer needed to puzzle over the underlying securities. All they needed was that correlation number, and out would come a rating telling them how safe or risky the tranche was.
That is, the price and creditworthiness of a CDO has precious little to do with the underlying securities.
As a result, just about anything could be bundled and turned into a triple-A bond--corporate bonds, bank loans, mortgage-backed securities, whatever you liked. The consequent pools were often known as collateralized debt obligations, or CDOs. You could tranche that pool and create a triple-A security even if none of the components were themselves triple-A. You could even take lower-rated tranches of other CDOs, put them in a pool, and tranche them--an instrument known as a CDO-squared, which at that point was so far removed from any actual underlying bond or loan or mortgage that no one really had a clue what it included. But it didn't matter. All you needed was Li's copula function.

The CDS and CDO markets grew together, feeding on each other. At the end of 2001, there was $920 billion in credit default swaps outstanding. By the end of 2007, that number had skyrocketed to more than $62 trillion. The CDO market, which stood at $275 billion in 2000, grew to $4.7 trillion by 2006.

And, by construction, without a liquid CDS market you cannot price CDOs. The information to do it simply is not available, assuming you could coerce a rating out of the information if you had it, which is unlikely.
The context of the document is that a professional credit rater has told his superiors that he needs to examine the mortgage loan files to evaluate the risk of a complex financial derivative whose risk and market value depend on the credit quality of the nonprime mortgages "underlying" the derivative. A senior manager sends a blistering reply with this forceful punctuation:
Any request for loan level tapes is TOTALLY UNREASONABLE!!! Most investors don't have it and can't provide it. [W]e MUST produce a credit estimate. It is your responsibility to provide those credit estimates and your responsibility to devise some method for doing so.
Back to Drew:
In other words, they have nothing to do with supply and demand and probability theory.  They're just garbage built to a model that, as is the case with all models, does not fully explain reality.
And my reply:
It has everything to do with supply and demand and nothing to do with an intuitive understanding of probability and risk. But the language of probability theory is used. The model describes not actual risk but the market pricing of it. When dealing with default probabilities is is probably a fatal mistake to ignore the distinction.

Drew J Jones:

I've heard of creating markets, but this is ridiculous, no?
The financial sector was itching to securitise its mortgages to evade capital adecuacy requirements, but there was not a liquid market for the securitised assets because they could not be priced. Li's formula, by enabling pricing, made the market possible.

"Expected value" pricing is exceedingly difficult. "Arbitrage pricing" much less so. A similar phenomenon occurred with "vanilla" derivatives (such as ordinary call options) - before Black-Scholes-Merton pricing was "expected value pricing" and people had to carefully consider the actual probabilities of future stock price movements. After Black-Scholes-Merton pricing became decoupled from market forecasting and the market for "vanilla" derivatives exploded.

But vanilla equity derivatives are continuously hedgeable in a way that credit derivatives are not. What happened with CDS and CDO was qualitatively (and now visibly in their consequences) very different.

And, in a parallel subthread with ARGeezer
It seems likely that [Li's] model was misused and misunderstood, especially in that nobody cared to protect themselves against the possibility that the correlation parameter in his model changed.

Hedging against changes in the implied volatility of options is standard fare in options trading. Why not hedging against changes in the correlation given by CDS prices?

Then again, it is possible that credit risk cannot be hedged but only insured...

I think that ATinNM best summarised the situation, incidentally in the spirit of Keynes' scepticism of frequentist/Laplacian probability methods:
The unfortunate truth is:

  • Mathematics has no empirical content
  • Thus, a mathematical formula has no empirical content
  • Thus, a mathematical formula of correlation has no empirical content
  • Thus, a mathematical formula of correlation of disparate events has no empirical content
  • Thus, and I don't care how many fucking epicycles Li came up with, he was blowing it out his ass.

I'm beginning to wonder if economists, financial economists in particular, could all be replaced by a spreadsheet.  They certainly don't seem to understand the mathematics they toss around so glibly.

Display:
I apologise for any exploding heads...

If you are not convinced, try it on someone who has not been entirely debauched by economics. — Piero Sraffa
by Migeru (migeru at eurotrib dot com) on Tue Jul 17th, 2012 at 07:10:33 PM EST
There was nothing left of mine after the quote on dactyls in the Virgilian line. I thought I'd made good my escape from that forty years ago.
by afew (afew(a in a circle)eurotrib_dot_com) on Wed Jul 18th, 2012 at 01:11:23 AM EST
[ Parent ]
Good old Francis Ysidro Edgeworth:
If we could imagine dactyls and spondees to be mixed up in the poet's brain in the proportion of 16 to 24 and shaken out at random
Keynes:
indicates, if I do not misapprehend [him], that th[is] authorit[y] [is] at fault in the principles, if not of Probability, of Poetry


If you are not convinced, try it on someone who has not been entirely debauched by economics. — Piero Sraffa
by Migeru (migeru at eurotrib dot com) on Wed Jul 18th, 2012 at 01:33:16 AM EST
[ Parent ]
Seems to me that the old investor rule of thumb still applies: if you don't understand what you're buying, don't buy it.

Of course, this changes completely when you introduce the agent-principal problem. Suddenly it might be a good idea for you to do or buy stuff, even if it's bad for your employer or employers (such as the people who's money you are managing). This means extremely tough regulation is required to deal with this problem.

But regulations are communism, dontcherknow?

Peak oil is not an energy crisis. It is a liquid fuel crisis.

by Starvid on Wed Jul 18th, 2012 at 04:07:03 PM EST
[ Parent ]
Um, the principals set the skewed incentives that encouraged agents to misbehave.

If you are not convinced, try it on someone who has not been entirely debauched by economics. — Piero Sraffa
by Migeru (migeru at eurotrib dot com) on Wed Jul 18th, 2012 at 04:24:19 PM EST
[ Parent ]
Only in a very indirect way, by voting for politicians who refrained from implementing the required regulations.

Peak oil is not an energy crisis. It is a liquid fuel crisis.
by Starvid on Wed Jul 18th, 2012 at 04:26:37 PM EST
[ Parent ]
That's a cop-out, we're talking about principals and agents of private entities.

If you are not convinced, try it on someone who has not been entirely debauched by economics. — Piero Sraffa
by Migeru (migeru at eurotrib dot com) on Wed Jul 18th, 2012 at 04:45:57 PM EST
[ Parent ]
Well, alright then, but I still don't see how shareholders/pension(or mutual) fund investors set the skewed incentives which allowed managers and executives etc to misbehave. The politicians, or the agents themselves, design the constraints, or rather the lack of them.

Peak oil is not an energy crisis. It is a liquid fuel crisis.
by Starvid on Wed Jul 18th, 2012 at 04:55:02 PM EST
[ Parent ]
I'm considering the Management the principals in this case.

If you are not convinced, try it on someone who has not been entirely debauched by economics. — Piero Sraffa
by Migeru (migeru at eurotrib dot com) on Wed Jul 18th, 2012 at 04:58:18 PM EST
[ Parent ]
I'm considering the Management the principals in this case.

De facto that is the case. But there is a quaint time or yore, often invoked by certain folks, when management were the agents of the owners. But, with diffused ownership of publicly held corporations, management has been able to seize control - even of who is on the board of directors in many cases - so now they are, indeed, the principals and the stock holders can go pound sand.

"It is not necessary to have hope in order to persevere."
by ARGeezer (ARGeezer a in a circle eurotrib daught com) on Wed Jul 18th, 2012 at 07:48:37 PM EST
[ Parent ]
As JK Galbraith discusses in The New Industrial State, that was only the case in closely held corporations, before WWII.

If you are not convinced, try it on someone who has not been entirely debauched by economics. — Piero Sraffa
by Migeru (migeru at eurotrib dot com) on Thu Jul 19th, 2012 at 01:43:49 AM EST
[ Parent ]
Galbraight did actually refer to this problem in the New Industrial State IIRC, in that way. That is, how management (agents) have taken the power from the shareholders (principals), and that they are working for their own interests rather than for the owners.

Peak oil is not an energy crisis. It is a liquid fuel crisis.
by Starvid on Thu Jul 19th, 2012 at 10:33:39 AM EST
[ Parent ]
Do you think managers understood anything about derivatives? In that respect, the principal/agent problem is between the bank management (as principals) and the quants/traders/portfolio managers (as agents).

Once the management takes over from the owners they're the ones that set the skewed incentives for the staff.

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

by Migeru (migeru at eurotrib dot com) on Thu Jul 19th, 2012 at 10:46:51 AM EST
[ Parent ]
Certainly a lot of bank managers have plead "I didn't know" in various inquiries since 2008.

"It is not necessary to have hope in order to persevere."
by ARGeezer (ARGeezer a in a circle eurotrib daught com) on Thu Jul 19th, 2012 at 11:02:57 AM EST
[ Parent ]
Being a manager means you are accountable. If your staff make crazy bets, then it's not really their fault. It is your fault, because as a manager, everything that happens is your responsibility.

Peak oil is not an energy crisis. It is a liquid fuel crisis.
by Starvid on Thu Jul 19th, 2012 at 11:09:32 AM EST
[ Parent ]
In theory.

"It is not necessary to have hope in order to persevere."
by ARGeezer (ARGeezer a in a circle eurotrib daught com) on Thu Jul 19th, 2012 at 01:25:35 PM EST
[ Parent ]
Wasn' t one of the big reasons for the appearance of CDOs and CDO² the regulatory need for many institutional investors to buy AAA stuff ?

So regulations can blow things up too !

Un roi sans divertissement est un homme plein de misères

by linca (antonin POINT lucas AROBASE gmail.com) on Thu Jul 19th, 2012 at 05:40:32 PM EST
[ Parent ]
Not exploding.  You might to check London Banker's comments on price discovery here.
by rifek on Sat Jul 21st, 2012 at 09:57:53 PM EST
[ Parent ]
That's an excellent post by London Banker.
by afew (afew(a in a circle)eurotrib_dot_com) on Sun Jul 22nd, 2012 at 03:24:41 AM EST
[ Parent ]
Very nice.

OTC ("over-the-counter", bespoke transactions between two named counterparties as opposed to anonymous standarised transactions on an exchage) is not going away. Instead, clearing houses are being set up as "central counterparties" to mutualise credit risk while the casino roars on. Other than that, full cash collateralisation is becoming the norm, and giving rise to a black hole that will suck all the liquidity that Central Banks care to throw at the banking sector.

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

by Migeru (migeru at eurotrib dot com) on Sun Jul 22nd, 2012 at 08:52:03 AM EST
[ Parent ]
In other words, they were pricing these things based upon magic?

No, they're pricing these things based upon faith.

Markets quantify collective faith in the future. That's all they do.

They also reward the faithful and those who inspire faith, and punish those who are deemed to be destroyers of financial faith.

The whole thing is really quite medieval - which is why there's no point expecting it to make rational sense.

by ThatBritGuy (thatbritguy (at) googlemail.com) on Tue Jul 17th, 2012 at 08:49:49 PM EST
Financial engineering turns out to be most profitable when it's used to obfuscate ("extend and pretend"). A perfect example is the way the EU has attempted to obfuscate the Euro crisis with their EFSFs and ESMs and Greek collaterals. The EU's misfortune is that their attempts at obfuscating are pretty transparent. That's why the half-life of dead-cat market bounces after each Eurogroup summit keeps getting shorter.

If you are not convinced, try it on someone who has not been entirely debauched by economics. — Piero Sraffa
by Migeru (migeru at eurotrib dot com) on Wed Jul 18th, 2012 at 01:45:52 AM EST
[ Parent ]
the half-life of dead-cat market bounces

Oh so the cat is radioactive? Schrödinger's? So can you be sure it's dead?

It is rightly acknowledged that people of faith have no monopoly of virtue - Queen Elizabeth II

by eurogreen on Wed Jul 18th, 2012 at 08:45:11 AM EST
[ Parent ]
Look in the dead cat box.

"It is not necessary to have hope in order to persevere."
by ARGeezer (ARGeezer a in a circle eurotrib daught com) on Wed Jul 18th, 2012 at 09:21:49 AM EST
[ Parent ]
If you can stop it moving.
by ThatBritGuy (thatbritguy (at) googlemail.com) on Wed Jul 18th, 2012 at 10:09:50 AM EST
[ Parent ]
That's a different box ~ the dead cat box stops moving not long after it hits bottom.

I've been accused of being a Marxist, yet while Harpo's my favourite, it's Groucho I'm always quoting. Odd, that.
by BruceMcF (agila61 at netscape dot net) on Wed Jul 18th, 2012 at 06:59:05 PM EST
[ Parent ]
And still be able to figure out where it is.

- Jake

Friends come and go. Enemies accumulate.

by JakeS (JangoSierra 'at' gmail 'dot' com) on Mon Jul 23rd, 2012 at 09:15:14 AM EST
[ Parent ]
So  for several years the growth in the world economy was entirely made of bets on imaginary finance. It truly is the Wylie E Coyote school of finance isn't it, and we're past the point where he realises that he can't feel anything solid under his feet.  The current economic expansion is now the point where he's halfway towards the canyon bottom, and he's madly flapping his arms in the vain hope that he can actually fly.

Any idiot can face a crisis - it's day to day living that wears you out.
by ceebs (ceebs (at) eurotrib (dot) com) on Tue Jul 17th, 2012 at 09:46:30 PM EST
It was a classic case of "A man hears what he wants to hear and disregards the rest", (apologies to Paul Simon). There was a powerful incentive to find a way to price some of these derivatives. A possibly questionable method of so doing appears and senior managers realize how much money can be made by applying this. Rewards in the form immediate business with fees and profits from participation and bonuses at year end are evident. Risks are unknown but more distant. And if they make a big enough mess, others will be forced to help clean it up to prevent crashing the whole system. Their response to any objections from the quants would be along the line:
...a professional credit rater has told his superiors that he needs to examine the mortgage loan files to evaluate the risk of a complex financial derivative whose risk and market value depend on the credit quality of the nonprime mortgages "underlying" the derivative. A senior manager sends a blistering reply with this forceful punctuation:

   Any request for loan level tapes is TOTALLY UNREASONABLE!!! Most investors don't have it and can't provide it. [W]e MUST produce a credit estimate. It is your responsibility to provide those credit estimates and your responsibility to devise some method for doing so.


Want to keep your job? Either use the questionable method or demonstrate quickly and conclusively that using that method will lead to massive and certain short term losses. After all, the very idea that derivatives needed to be regulated had been shot down in 1999 when Brooksly Borne tried to do so. The odds of stopping a feeding frenzy with sharks were higher than those for successfully objecting to using Li's formula under those circumstances.

"It is not necessary to have hope in order to persevere."
by ARGeezer (ARGeezer a in a circle eurotrib daught com) on Tue Jul 17th, 2012 at 10:33:59 PM EST
[ Parent ]
And even demonstrating conclusively that the proposed method would quickly lead to large losses would immediately be seen as shooting Santa Clause and job tenure would be jeopardized, at the minimum.

"It is not necessary to have hope in order to persevere."
by ARGeezer (ARGeezer a in a circle eurotrib daught com) on Tue Jul 17th, 2012 at 10:38:54 PM EST
[ Parent ]
Of course it was. How could it be otherwise when:

When the economy is in an overall Ponzi Finance position, faith is required to make it keep going a little bit longer before the bubble bursts.

I've been accused of being a Marxist, yet while Harpo's my favourite, it's Groucho I'm always quoting. Odd, that.

by BruceMcF (agila61 at netscape dot net) on Tue Jul 17th, 2012 at 10:44:18 PM EST
[ Parent ]
I was going to make some comment along the lines of it is not really all about derivatives, there are macroeconomic fundamentals (Bruce's chart of private debt is not about derivatives), yatta yatta... and then I realised that it's probably actually about financial engineering anyway, and I already had the quote in the diary
The financial sector was itching to securitise its mortgages to evade capital adecuacy requirements, but there was not a liquid market for the securitised assets because they could not be priced. Li's formula, by enabling pricing, made the market possible.


If you are not convinced, try it on someone who has not been entirely debauched by economics. — Piero Sraffa
by Migeru (migeru at eurotrib dot com) on Wed Jul 18th, 2012 at 01:43:32 AM EST
[ Parent ]
Yes, the specifics about why it was a rort are about the specific instruments used in the rort, but the general picture is they couldn't gain the unsustainable debt-leverage growth that they were accustomed to without inventing a whole new layer of lies to go further beyond the edge of financial prudence than they had already gone.

And once you are over the edge of financial prudence, there's plenty of immediate pain if you listen to critics who call for a return to financial prudence. Shying away from that immediate pain then stores up pain to be experienced in the future ~ with interest.

I've been accused of being a Marxist, yet while Harpo's my favourite, it's Groucho I'm always quoting. Odd, that.

by BruceMcF (agila61 at netscape dot net) on Wed Jul 18th, 2012 at 04:16:36 PM EST
[ Parent ]
So  for several years the growth in the world economy was entirely made of bets on imaginary finance.

Not entirely. Lots of houses, machines, installations and so on were actually created. Not in the most optimal way perhaps, but they were created. The problem now is that we for some reason feel we must punish ourselves for the previous madness by idling a considerable fraction of our productive capacity, possibly to make people feel  better, or something.

Peak oil is not an energy crisis. It is a liquid fuel crisis.

by Starvid on Wed Jul 18th, 2012 at 04:11:11 PM EST
[ Parent ]
The problem now is that we for some reason feel we must punish ourselves for the previous madness...

'some reason' goes back to the late '60s when wealthy conservative libertarians vastly scaled up their funding of 'think tanks' and leveraged their influence over the media to make their bogus 'economics' and politics the default mode. They have, in effect, re-defined the parameters of reality to their advantage. That is what must be undone if we are to be able to pursue a sane policy.

"It is not necessary to have hope in order to persevere."
by ARGeezer (ARGeezer a in a circle eurotrib daught com) on Wed Jul 18th, 2012 at 07:59:15 PM EST
[ Parent ]
No reason to invoke conspiracy theories:
The hangover theory, then, turns out to be intellectually incoherent; nobody has managed to explain why bad investments in the past require the unemployment of good workers in the present. Yet the theory has powerful emotional appeal. Usually that appeal is strongest for conservatives, who can't stand the thought that positive action by governments (let alone--horrors!--printing money) can ever be a good idea. Some libertarians extol the Austrian theory, not because they have really thought that theory through, but because they feel the need for some prestigious alternative to the perceived statist implications of Keynesianism. And some people probably are attracted to Austrianism because they imagine that it devalues the intellectual pretensions of economics professors. But moderates and liberals are not immune to the theory's seductive charms--especially when it gives them a chance to lecture others on their failings.


If you are not convinced, try it on someone who has not been entirely debauched by economics. — Piero Sraffa
by Migeru (migeru at eurotrib dot com) on Thu Jul 19th, 2012 at 01:46:12 AM EST
[ Parent ]
But the project of the right is not a conspiracy theory, it's a documented fact, with money flows, new institutions and chairs in universities all created by it...
by Metatone (metatone [a|t] gmail (dot) com) on Thu Jul 19th, 2012 at 05:25:30 AM EST
[ Parent ]
And it may or may not have involved some degree of direct coordination between wealth holders personally, or, more likely, between the agents of those wealth holders and the beneficiaries. But 'monkey see, monkey do' alone provides a quite sufficient explanation.

"It is not necessary to have hope in order to persevere."
by ARGeezer (ARGeezer a in a circle eurotrib daught com) on Thu Jul 19th, 2012 at 08:07:27 AM EST
[ Parent ]
It's also a question of class consciousness. The moneyed perceive themselves as advancing the interests of their class at the expense of commons. The commons generally do not have a sense of class identity and are regularly shafted in the  process.

It's one of the pitfalls of the equality myth which has it that we are all equal and therefore belong to a classless society.

by de Gondi (publiobestia aaaatttthotmaildaughtusual) on Thu Jul 19th, 2012 at 04:12:05 PM EST
[ Parent ]
I can understand that insurance creates value.

Derivatives, I have been told, are a form of insurance. Ever since I understood that there existed derivatives that are too complex to be understood intuitively (late 90s?) I postulated that they couldn't be creating value. This was merely intuitive, but now I think I understand why this is true.

Insofar as insurance is a matter of paying a more or less arbitrary price to hedge a specific risk, complex derivatives are not insurance, but a form of gambling : about as economically useful as Chinese people gambling on the outcome of third-division European football matches. i.e. useful to the bookmaker, and/or those who are in a position to fix the outcome.

It is rightly acknowledged that people of faith have no monopoly of virtue - Queen Elizabeth II

by eurogreen on Wed Jul 18th, 2012 at 08:55:17 AM EST
useful to the bookmaker, and/or those who are in a position to fix the outcome.

Many of those in such a position are just now on prominent display courtesy of the Libor scandal.  

"It is not necessary to have hope in order to persevere."
by ARGeezer (ARGeezer a in a circle eurotrib daught com) on Wed Jul 18th, 2012 at 09:27:25 AM EST
[ Parent ]
Bloomberg: Saint-Etienne Swaps Explode as Financial Weapons Ambush Europe (April 15, 2010)
"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."

...

"This is speculating in the hopes of gain," said Peter Shapiro, managing director at Swap Financial Group LLC, in South Orange, New Jersey, an adviser to companies and governments. "The investor is taking a chance in hopes of a high return. It has nothing to do with hedging."

...

"These municipal swaps are the same thing as Greece," said [Saint-Germain-en-Laye city council member Emmanuel] Fruchard, a former banker at Credit Lyonnais, now a unit of Credit Agricole SA, who designed swaps in the early 1990s. "It's all trying to dress up your accounts."

...

"It's like Easter eggs," said [Pforzheim's former budget director] Weishaar, 45, who holds a degree in math and economics from the University of Ulm. "You want to buy one and somebody sells you a painted hand grenade instead."



If you are not convinced, try it on someone who has not been entirely debauched by economics. — Piero Sraffa
by Migeru (migeru at eurotrib dot com) on Wed Jul 18th, 2012 at 09:49:47 AM EST
[ Parent ]
nsofar as insurance is a matter of paying a more or less arbitrary price to hedge a specific risk, complex derivatives are not insurance, but a form of gambling : about as economically useful as Chinese people gambling on the outcome of third-division European football matches. i.e. useful to the bookmaker, and/or those who are in a position to fix the outcome.

This seems a very good way of looking at it to me. As Migeru has noted, the big impetus for a lot of this was to get around capital adequacy requirements. i.e. The bookmaker (bank) gained from having the bets occur - the outcome was almost irrelevant - except that things in the economy reached the point where the "book" blew up and what was a "house wins either way as well as doing business" turned into a "house loss."

by Metatone (metatone [a|t] gmail (dot) com) on Wed Jul 18th, 2012 at 03:05:01 PM EST
[ Parent ]
That's because derivatives were priced as if there were no credit risk...

If you are not convinced, try it on someone who has not been entirely debauched by economics. — Piero Sraffa
by Migeru (migeru at eurotrib dot com) on Wed Jul 18th, 2012 at 03:39:57 PM EST
[ Parent ]
Was there a way to price them in the margins allowed for transactions costs that would have taken credit risk into account?

Assuming credit risk away is a tremendous reduction in information processing overhead ~ just as tossing away the video part of a Youtube clip is a tremendous reduction in the information load of processing a Youtube stream.

I've been accused of being a Marxist, yet while Harpo's my favourite, it's Groucho I'm always quoting. Odd, that.

by BruceMcF (agila61 at netscape dot net) on Wed Jul 18th, 2012 at 04:20:26 PM EST
[ Parent ]
No, there was not, because you cannot hedge credit risk. Only move it to someone else's balance sheet, and take out a new credit risk against them in the process.

Therefore, you cannot have liquid markets or tracking portfolios for credit risk.

- Jake

Friends come and go. Enemies accumulate.

by JakeS (JangoSierra 'at' gmail 'dot' com) on Mon Jul 23rd, 2012 at 09:24:24 AM EST
[ Parent ]
Derivitives - should they be legal in any form?

Securitization - should it be legal in any form?

And speaking of the agent/principal problem, should professional managers of other people's money be allowed to exist?  If they're just going to invent stuff, counterfeit, swindle and defraud their clients and the public without endless supervision and consistently inadequate regulation, why not just ban the profession entirely?

by Zwackus on Thu Jul 19th, 2012 at 07:05:53 AM EST
What you're getting at is, to what extent should the freedom to contract and the enforceability of contracts be limited?

And, as we know from historical experience with the imaginative ways to evade usury bans, just making these things illegal doesn't mean they will go away. That's, after all, what the shadow banking system is. And it hasn't gone away.

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

by Migeru (migeru at eurotrib dot com) on Thu Jul 19th, 2012 at 09:16:54 AM EST
[ Parent ]
Yes, I suppose I am getting to limitations on contract.  But such limitations already exist.  A contract which specifies illegal activity is not legal, to the best of my knowledge.  

That is, if I make a contract with a professional assassin to kill someone I don't like, and said assassin fails to perform, I don't think I can take them to court and sue them for breach of contract.

I suppose what I'm trying to get at with that question is, what positive case can be made for derivatives and securities?  Do the positive goods that they provide to society outweigh the various troubles, mischiefs, and economic destruction that they create?  And such, are they worth keeping around?

What would a world without them look like, and in what ways would that world be better, or worse?

I think of it in a similar manner to nuclear power.  There are benefits to be had, costs to be paid, and risks of catastrophic disaster.  Do the risks of catastrophic disaster render the entire activity more of a bother than its worth?

by Zwackus on Thu Jul 19th, 2012 at 08:54:31 PM EST
[ Parent ]
This is an excellent point - making something illegal is no guarantee of it going away, but by removing the safety of court enforcement you change the calculus of how often it gets used.
by Metatone (metatone [a|t] gmail (dot) com) on Fri Jul 20th, 2012 at 11:35:07 AM EST
[ Parent ]
It does more than change the calculus.  It changes who has more power in the relationship at hand, as well as other related relationships. For example, the fact that gay people are not provided the legal device of marriage in most parts of the world has never prevented gay people from forming romantic or domestic relationships.  However, when disputes or ruptures in such relationships occur, the most capable member of such a soured relationship, such as the smarter one, the meaner one, the healthier one, etc., finds him or herself with enormous benefits for getting what one wants compared to the less capable member.  Allowing the larger community to participate in the power struggles of a gay couple through the institution of marriage helps to equalize the power between them when disputes occur.
by santiago on Fri Jul 20th, 2012 at 03:08:51 PM EST
[ Parent ]
Other examples: the "war on drugs" makes drug cartels incredibly wealthy; "usury laws" throw poor people in the hands of loan sharks.

If you are not convinced, try it on someone who has not been entirely debauched by economics. — Piero Sraffa
by Migeru (migeru at eurotrib dot com) on Fri Jul 20th, 2012 at 04:02:43 PM EST
[ Parent ]
So, which group, exactly, would suffer from the prohibition of securities and derivatives?  Let's imagine that they are prohibited by law, and that individuals or corporations found to have purchased or sold such forbidden financial items would be liable for fines, corporate dissolution, felonies, and imprisonment.

Who buys these things, how much are they really going to risk to buy them, and how capable are they of defending themselves given the lack of state support?  What classes of poor and disenfranchised people would truly suffer from a prohibition on securities and derivatives?

In my uninformed opinion, these are the playthings of the rich, and the rich have a lot to lose.  As such, they tend to steer clear of seriously illegal activities.  Who faces a truly compelling need to purchase a CDO, such that they would turn to the mob-brokers to buy one?

by Zwackus on Fri Jul 20th, 2012 at 09:37:58 PM EST
[ Parent ]
First, let's make sure we know what we're all discussing when we're talking about derivatives and banning. Derivatives are just a boring insurance policies, nothing more and nothing less -- a contract between private individuals that commits one party to something for other under various circumstances.  

The fact that some economists have been able to publish a lot of papers about some of the interesting mathematical qualities regarding the parameters of these otherwise boring contracts does not change the fact that derivatives are just insurance policies and if some of the parameters in such contracts were forbidden by law, other legal language would soon evolve to provide the same guarantees to each counter-party that they have been able to get from the language in today's so-called derivatives contracts.

The insurance industry is heavily regulated already because ripoffs can occur so easily, but no one has ever suggested banning it because risk mitigation through private insurance contracts really is valuable to people -- income smoothing is really helpful in a multitude of circumstances and that is all that derivatives do regardless of the fact that sometimes insurers get too speculative on their end and run into trouble.  

Now, the real question is whether there are some parameters in current derivatives contracts that are so beneficial that we wouldn't want to change that, and the answer is, yes, just like there are benefits to people to securitizing the shares of private firms to allow them to be sold to others.  The benefit comes largely in the form of increased transparency, which prevents people from ripping each other off by benefiting from what economists call information asymmetry. Markets do that -- or, rather, the set of rules that allows markets to exist do that.  So it just makes more sense to fix a few of the rules in a way that resolves some of the problems in insurance contracting and accounting that allow for scams and catastrophes of the kind we've recently seen.

by santiago on Sun Jul 22nd, 2012 at 08:09:04 PM EST
[ Parent ]
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 Migeru (migeru at eurotrib dot com) on Mon Jul 23rd, 2012 at 01:58:18 AM EST
[ Parent ]
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 ]
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 Migeru (migeru at eurotrib dot com) on Mon Jul 23rd, 2012 at 10:04:25 AM EST
[ Parent ]
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 ]
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 Migeru (migeru at eurotrib dot com) on Tue Jul 24th, 2012 at 02:43:24 PM EST
[ Parent ]
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 ]
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 Migeru (migeru at eurotrib dot com) on Tue Jul 24th, 2012 at 03:38:23 PM EST
[ Parent ]
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 ]
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 Migeru (migeru at eurotrib dot com) on Tue Jul 24th, 2012 at 06:46:33 PM EST
[ Parent ]
Good example.
by santiago on Wed Jul 25th, 2012 at 10:38:24 AM EST
[ Parent ]
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 Migeru (migeru at eurotrib dot com) on Wed Jul 25th, 2012 at 05:03:29 PM EST
[ Parent ]
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 ]
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 Migeru (migeru at eurotrib dot com) on Thu Jul 26th, 2012 at 01:17:30 PM EST
[ Parent ]
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 ]
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 ]
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 Migeru (migeru at eurotrib dot com) on Mon Jul 30th, 2012 at 09:57:43 AM EST
[ Parent ]
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 ]
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 ]
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 ]
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 ]
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 ]
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 ]
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 ]
"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 Migeru (migeru at eurotrib dot com) on Mon Jul 30th, 2012 at 06:36:50 PM EST
[ Parent ]
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 Migeru (migeru at eurotrib dot com) on Mon Jul 30th, 2012 at 09:56:26 AM EST
[ Parent ]
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 ]
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 Migeru (migeru at eurotrib dot com) on Mon Jul 30th, 2012 at 06:40:06 PM EST
[ Parent ]
No, I don't have statistics.  Do you?
by santiago on Tue Jul 31st, 2012 at 02:21:20 AM EST
[ Parent ]
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 Migeru (migeru at eurotrib dot com) on Mon Jul 30th, 2012 at 06:45:01 PM EST
[ Parent ]
"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 ]
"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 Migeru (migeru at eurotrib dot com) on Tue Jul 31st, 2012 at 03:44:09 AM EST
[ Parent ]
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 ]
<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 Migeru (migeru at eurotrib dot com) on Tue Jul 31st, 2012 at 08:48:30 AM EST
[ Parent ]
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 ]
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 ]
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 ]
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 ]
Yes, it is. Just like lifespans are.
by santiago on Sun Jul 29th, 2012 at 08:47:04 PM EST
[ Parent ]
  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 ]
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 Migeru (migeru at eurotrib dot com) on Mon Jul 30th, 2012 at 09:59:55 AM EST
[ Parent ]
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 ]


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 ]
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 ]
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 ]
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 ]
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 ]
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 ]
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 Migeru (migeru at eurotrib dot com) on Mon Aug 6th, 2012 at 03:59:32 AM EST
[ Parent ]
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 ]
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 Migeru (migeru at eurotrib dot com) on Mon Aug 6th, 2012 at 11:11:55 AM EST
[ Parent ]
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 ]
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 Migeru (migeru at eurotrib dot com) on Mon Aug 6th, 2012 at 12:41:23 PM EST
[ Parent ]
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
[ Parent ]
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 Migeru (migeru at eurotrib dot com) on Mon Aug 6th, 2012 at 01:00:48 PM EST
[ Parent ]
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 Migeru (migeru at eurotrib dot com) on Mon Aug 6th, 2012 at 11:17:57 AM EST
[ Parent ]
Agreed.
by santiago on Mon Aug 6th, 2012 at 12:04:25 PM EST
[ Parent ]
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 Migeru (migeru at eurotrib dot com) on Mon Aug 6th, 2012 at 11:21:03 AM EST
[ Parent ]
If limited to those cases, I agree.
by santiago on Mon Aug 6th, 2012 at 12:18:38 PM EST
[ Parent ]
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 Migeru (migeru at eurotrib dot com) on Mon Aug 6th, 2012 at 12:27:12 PM EST
[ Parent ]
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
[ Parent ]
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 Migeru (migeru at eurotrib dot com) on Mon Aug 6th, 2012 at 06:49:56 PM EST
[ Parent ]
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 ]
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
[ Parent ]
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 Migeru (migeru at eurotrib dot com) on Mon Aug 6th, 2012 at 12:26:07 PM EST
[ Parent ]
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 ]
The problem is not derivatives as contracts. If things were so boring as your nice textbook account of why derivatives exist, we wouldn't have had have several multiples of world GDP in credit derivative notionals.

In my opinion the attraction of derivatives is that it allows everyone to play fast and loose with statutory solvency rules. For debtors, derivatives are non-debt funding (which is why municipalities and hospitals find themselves in the red over derivatives now - what the press has taken to callin "toxic loans"). Since Eurostat doesn't consider derivatives as debt, Greece was able to get around debt limits by entering into derivatives transactions with investment banks.

The real problem is the accounting of contingent liabilities (and assets), and the very existence of off-balance-sheet accounting. The problem is that derivatives make accountants' heads asplode, and therefore "Generally Accepted Accounting Practice" basically ignores derivatives. This means derivatives result in grossly undercapitalised positions, and therefore there's lots of money to be made by inflating derivative books.

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

by Migeru (migeru at eurotrib dot com) on Mon Jul 23rd, 2012 at 04:20:41 AM EST
[ Parent ]
Case in point:
Firms issue innovative securities for many reasons, but two of the most important are to escape the bite of taxes and regulation.

(2004) Grinblatt, Mark & Titman, Sheridan
Corporate Finance and Incentives
McGrav Hill, Singapore, ISBN 007-229433-7
pp. 51

That work being mainly concerned with fixed income securities rather than derivatives pricing, the "innovative securities" mentioned are junk bonds, camouflaged foreign currency bonds and their sundry relatives. But the same basic criminal intent is obvious in exotic derivatives as well.

- Jake

Friends come and go. Enemies accumulate.

by JakeS (JangoSierra 'at' gmail 'dot' com) on Mon Jul 23rd, 2012 at 09:37:33 AM EST
[ Parent ]
I agree.  The problem with derivatives is precisely that accounting practices don't adequately account for them.
by santiago on Mon Jul 23rd, 2012 at 09:43:41 AM EST
[ Parent ]
The corollary to that is that any derivative for which one cannot properly account should be out of bounds for any entity which has a legal obligation to present not-misleading accounts.

- Jake

Friends come and go. Enemies accumulate.

by JakeS (JangoSierra 'at' gmail 'dot' com) on Mon Jul 23rd, 2012 at 09:51:13 AM EST
[ Parent ]
That would be a good start.
by santiago on Mon Jul 23rd, 2012 at 09:58:23 AM EST
[ Parent ]
Another corollary is that any derivative which cannot be readily understood by an untrained intern is unsuitable as collateral for loans.

- Jake

Friends come and go. Enemies accumulate.

by JakeS (JangoSierra 'at' gmail 'dot' com) on Mon Jul 23rd, 2012 at 10:02:26 AM EST
[ Parent ]
Derivatives are just a boring insurance policies, nothing more and nothing less -- a contract between private individuals that commits one party to something for other under various circumstances.

Insurance contracts are not necessarily boring. Taking out life insurance on a romantic rival is one of the more, uh, interesting uses of such instruments. At least judging by the mileage Agathe Christie and her colleagues have gotten out of that particular trope.

- Jake

Friends come and go. Enemies accumulate.

by JakeS (JangoSierra 'at' gmail 'dot' com) on Mon Jul 23rd, 2012 at 09:30:58 AM EST
[ Parent ]
By the way, santiago, we missed your central banker insight in this discussion.

If you are not convinced, try it on someone who has not been entirely debauched by economics. — Piero Sraffa
by Migeru (migeru at eurotrib dot com) on Mon Jul 23rd, 2012 at 04:27:13 AM EST
[ Parent ]
Also, too.

If you are not convinced, try it on someone who has not been entirely debauched by economics. — Piero Sraffa
by Migeru (migeru at eurotrib dot com) on Mon Jul 23rd, 2012 at 04:36:23 AM EST
[ Parent ]
Yeah, I read those when you posted them and was writing something up but didn't send it, and now have to go back and rewrite something.
by santiago on Tue Jul 24th, 2012 at 03:32:50 PM EST
[ Parent ]
Quite, but unlike payday loans, insurance and cohabitation arrangements, exotic derivatives serve no useful purpose, so nobody actually needs to gamble on them.

And the extent of my sympathy for suckers who decide to do so anyway is decidedly limited. Suckers will be separated from their money whatever legal protections you care to dream up.

- Jake

Friends come and go. Enemies accumulate.

by JakeS (JangoSierra 'at' gmail 'dot' com) on Mon Jul 23rd, 2012 at 09:27:05 AM EST
[ Parent ]
The point is that derivatives and securities will exist regardless of whether a state permits them to or not because people will continue to make over-the-counter deals to hedge against risk whether or not there is any governmental regulation or blessing for such relationships between people. So the question is not whether or not there are social benefits or costs to derivatives or securities, but whether there are benefits or costs to regulating them.  Banning them is the same as deregulating them entirely; it does not mean getting rid of them.
by santiago on Fri Jul 20th, 2012 at 03:18:03 PM EST
[ Parent ]
To paraphrase and mangle  Arthur C Clarke - any sufficiently stringent regulation is the equivalent of a ban.

If you need an example, as cigarettes and tobacco are increasingly regulated and taxed in the UK, so the volume of smuggling cigarettes and tobacco in from France has gone up.

So - people are always going to do hedging deal - delineate very simple hedges in regulated exchanges. For the rest, just remove court enforceability and FDIC backing etc. Let there be no question that if you invest in an institution that engages in complex derivatives, you will never be bailed out if they lose their shirt.

by Metatone (metatone [a|t] gmail (dot) com) on Sat Jul 21st, 2012 at 05:03:52 AM EST
[ Parent ]
Metatone:
as cigarettes and tobacco are increasingly regulated and taxed in the UK, so the volume of smuggling cigarettes and tobacco in from France has gone up

As cigarettes and tobacco are increasingly regulated and taxed in France, so the volume of smuggling cigarettes and tobacco in from Belgium, Italy, Spain has gone up.

That's "competitiveness" for you...

by afew (afew(a in a circle)eurotrib_dot_com) on Sat Jul 21st, 2012 at 07:40:50 AM EST
[ Parent ]
That's essentially what the Dodd-Frank act did in the US.  Formerly OTC hedging is now required to be done in official, directly regulated exchanges, with very limited parameters, if they want the protection of law.
by santiago on Sun Jul 22nd, 2012 at 01:47:55 PM EST
[ Parent ]
That's not the issue so much as should financial institutions and other companies be allowed to carry them on their books as anything other than illiquid assets, and if so, specifically what kind and specifically why?

You can securitize all you want, but if the result is not a security grade asset, and insurance companies and pension funds cannot by them, why bother?

The defense from smoke and mirrors and "the smartest men in the room" effect is simple rules. Simple rules like, no CDO based on derivatives can be rated as better than junk, and for CDO's composed entirely of original assets, the weighted average of the rating of the tiers of the CDO cannot be greater than the weighted average of the rating of the original assets generating its income.


I've been accused of being a Marxist, yet while Harpo's my favourite, it's Groucho I'm always quoting. Odd, that.

by BruceMcF (agila61 at netscape dot net) on Thu Jul 19th, 2012 at 09:57:00 AM EST
[ Parent ]
That would be a good start, but I don't think it would solve the problem.

Remember, these variations were cooked up to slap virgin white paint on rotting and worthless debt.

They're only one possible way to do that. You can be sure that if you close one loophole the self-styled 'smartest men in the room' will start creating others.

A further step would be to require regulatory approval and oversight of all financial innovations.

But you're then back to the lobbyist and ownership problem, where the industry can divert huge sums of cash to buying legislation and keep regulation ineffective.

The best effective solution is to place a ceiling on income spreads and personal wealth. No one individual actually needs to own a billion dollars of personal cash.

You don't necessarily have to tax it - although that might not be a bad idea. But you could mandate that income and assets over a certain amount must be spent on useful things in the real economy, and that only a certain relatively small fixed amount can ever be used for gambling.

You still have the problem of getting from here to there, and I can't see how that's going to happen without either controlled or uncontrolled demolition of the shitpile.

But it's important to start getting new ideas out there now. The implosion of the shitpile is going to be the perfect moment to push things in a saner direction.

by ThatBritGuy (thatbritguy (at) googlemail.com) on Thu Jul 19th, 2012 at 10:25:24 AM EST
[ Parent ]
As far as wealth, a big problem is the freedom to pass on a self-sustaining pile of wealth. That is, odds are that over half of the 196 individuals financing 80% of the US Presidential race inherited the bulk of their wealth.

Avoiding the establishment of perpetual fortunes involves taxing total lifetime gifts. Say, 0% rate up through 50x median annual income, 25% from 50x to 100x, 50% for 100x to 150x, 75% at 150x to 200x, and 100% above 200x median income. So if median annual income is $40,000, a billionaire can avoid inheritance taxes entirely if they divide it up into $2m pieces, or can leave $5m pieces if they are willing to pay $3m in gift taxes per piece.

I've been accused of being a Marxist, yet while Harpo's my favourite, it's Groucho I'm always quoting. Odd, that.

by BruceMcF (agila61 at netscape dot net) on Thu Jul 19th, 2012 at 01:23:17 PM EST
[ Parent ]
I've always favored an exponencial rate, indexed on minimum income possibly.

res humà m'és aliè
by Antoni Jaume on Thu Jul 19th, 2012 at 02:53:20 PM EST
[ Parent ]
I adopted the rates from How Rich is Too Rich, Inhaber & Carroll, the indexing from what was required to get to about US$2m per step, which is roughly their step converting from mid-90's to 2012 dollars.

Its indexed to median incomes mostly for political messaging purposes. People lose track of big numbers, but I reckon "tax free up to 50 years worth of regular income, then raise the tax rate by 25% for each extra 50 years worth of income" is clear enough.

I've been accused of being a Marxist, yet while Harpo's my favourite, it's Groucho I'm always quoting. Odd, that.

by BruceMcF (agila61 at netscape dot net) on Thu Jul 19th, 2012 at 03:19:24 PM EST
[ Parent ]
Then again, my penniless mother is seriously concerned about having to pay a death tax. The mere comprehensibility of a rational policy does not mean it will be understood rationally.
by Zwackus on Mon Jul 23rd, 2012 at 05:30:31 AM EST
[ Parent ]
There are lots of simple derivatives which are very useful and make perfect sense. Options, futures and so on. Securitization makes sense in basic forms as well, just think of stocks and bonds.

Simple=good, complex=bad.

Why not ban money management? Because of specialisation. Not everyone saver can or want to spend the time to manage her savings. If she wants to pay someone else to do it for her, fine. But strict regulation is needed, far stricter than we have today. The fraud that is "actively" managed mutual or pension funds must be banned for example. If they look like index funds, smell like index funds and behave like index funds, they should not be allowed to trick people into paying higher fees than what index funds usually demand (max 0.5% per annum).  

Peak oil is not an energy crisis. It is a liquid fuel crisis.

by Starvid on Thu Jul 19th, 2012 at 10:45:11 AM EST
[ Parent ]
Still, can't one claim that market/futures prices actually do tell us something about the future? Maybe not something by the future per se, but rather they show the average belief/bet of all those who bet on what the future will be like?

Peak oil is not an energy crisis. It is a liquid fuel crisis.
by Starvid on Thu Jul 19th, 2012 at 11:06:55 AM EST
One can claim that the market reveals useful information. I can't see how one could back up such a claim in the case of derivatives which are too complex to understand. Miguel has demonstrated that you can't price this shit rationally.

The only thing the pre-2008 derivatives pricing revealed is that a lot of people expected to keep making money on bonds. That turned out to be not very useful information, because they were wrong.

It is rightly acknowledged that people of faith have no monopoly of virtue - Queen Elizabeth II

by eurogreen on Thu Jul 19th, 2012 at 11:19:25 AM EST
[ Parent ]
Well, the complex stuff I agree with, sure. But say, oil futures?

Now, oil futures have no predicitve power anyways, because since maybe 2003 5 year oil futures have roughly identical as the spot price, which only tells us no one has any clue what the future price might be. But before 2003, the 5 year oil futures always traded around $20 per barrel, as this was considered the marginal price of new production.

Ok, so oil is a bad example. But wheat futures, or sugar futures, or gold futures?

Peak oil is not an energy crisis. It is a liquid fuel crisis.

by Starvid on Thu Jul 19th, 2012 at 11:24:10 AM EST
[ Parent ]
One word: margin requirements.

With low enough margin requirements, hedgers will be swamped by speculators and the market will become useless.

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

by Migeru (migeru at eurotrib dot com) on Thu Jul 19th, 2012 at 11:28:08 AM EST
[ Parent ]
I don't see the problem? Speculators also trade on their beliefs, and hence take part in creating the aggregate market view. Now, this view does not tell us anything about the future, but it does tell us what the aggregate view of the market participants about future prices is.

Peak oil is not an energy crisis. It is a liquid fuel crisis.
by Starvid on Thu Jul 19th, 2012 at 11:38:19 AM EST
[ Parent ]
yes, but the speculators aren't interested parties, so their opinion about future prices have no value. They are along for the ride.
Actors who actually need to hedge future prices are likely to have an informed view; so a market that excluded speculators might reveal useful information.

It is rightly acknowledged that people of faith have no monopoly of virtue - Queen Elizabeth II
by eurogreen on Thu Jul 19th, 2012 at 12:24:38 PM EST
[ Parent ]
Speculators speculate that prices will rise or fall for a reason, unless they are chartists or astrologists.

Peak oil is not an energy crisis. It is a liquid fuel crisis.
by Starvid on Thu Jul 19th, 2012 at 12:50:10 PM EST
[ Parent ]
Or they are caught in a bubble.

If you are not convinced, try it on someone who has not been entirely debauched by economics. — Piero Sraffa
by Migeru (migeru at eurotrib dot com) on Thu Jul 19th, 2012 at 12:52:18 PM EST
[ Parent ]
Of course. Such is life.

Peak oil is not an energy crisis. It is a liquid fuel crisis.
by Starvid on Thu Jul 19th, 2012 at 12:57:34 PM EST
[ Parent ]
You know, there's a faux-Nobel prize in Economics just waiting for someone to take on this particular piece of Hayekian folk-wisdom.

If only I had the leisure.

Short version:

Collapsing n-dimensional motivational imperatives into a single dimension called price reveals far less information than Hayek liked to believe.

The number and weighting of motivational imperatives for "real goods" (e.g. iron ore) kind of works on Hayekian lines, because the labour/energy involved in digging it and transporting it outweigh other motivations quite strongly, most of the time.

Ramp up to the other end of the spectrum - informational goods (including iron ore futures) and the dimensions get more and more equal in weight, because the production of informational goods is virtually costless and frictionless. Once you have equality between the dimensions you are collapsing into one, it's never possible to know which dimension has given you the information that you now hold. There's a word for this kind of thing - it's noise.

by Metatone (metatone [a|t] gmail (dot) com) on Thu Jul 19th, 2012 at 05:09:35 PM EST
[ Parent ]
No. They tell you the present cost to hedge a future exposure. Nothing more, nothing less.

If you are not convinced, try it on someone who has not been entirely debauched by economics. — Piero Sraffa
by Migeru (migeru at eurotrib dot com) on Thu Jul 19th, 2012 at 11:56:49 AM EST
[ Parent ]
And the present cost to hedge a future exposure, depends on the view of the market on what the future will be like.

Peak oil is not an energy crisis. It is a liquid fuel crisis.
by Starvid on Thu Jul 19th, 2012 at 12:01:03 PM EST
[ Parent ]
For a very special value of "view". (Refer to the diary for details)

If you are not convinced, try it on someone who has not been entirely debauched by economics. — Piero Sraffa
by Migeru (migeru at eurotrib dot com) on Thu Jul 19th, 2012 at 12:10:15 PM EST
[ Parent ]
The point is ---and Jerome can speak to this better than I can--- that if you have to do financial planning for a long-term project you can do two thing. You can assume that future prices are those implied by futures prices (ahem), and explicitly hedge the risk that prices will be different by including futures contracts in your financial planning... or you can take your best estimate of future prices and then you'll have to defend your estimate against the scepticism of any of the rest of the parties to the project, who will ask you how in the world you're going to hedge your price risk when the market is pricing risk differently than your assumptions.

If you are not convinced, try it on someone who has not been entirely debauched by economics. — Piero Sraffa
by Migeru (migeru at eurotrib dot com) on Sat Jul 21st, 2012 at 04:02:40 PM EST
[ Parent ]
  Though I don't understand these arcane theories about probability, I've recently been reading a fascinating book which in part, as a necessary prelude to discussion of other matters in biology, touches very practically on the uses and abuses of thinking about probability.

   I recommend it to you---

   L'Origine des individus, KUPIEC, Jean-Jacques, Le Temps des Sciences, Paris, Fayard, 2008.

  Trad. angl. The Origin of Individuals, World Scientific, 2009.

 I think he's on his way to becoming as famous and important for his work as is Charles Darwin for his and is perhaps rightly to be seen as the contemporary who has best understood (and restored) a proper grasp of Darwin's place and importance.

  Here is some of what I can follow as to his views on probability--in part, they contradict what we're offered in

The unfortunate truth is:

    * Mathematics has no empirical content
    * Thus, a mathematical formula has no empirical content
    * Thus, a mathematical formula of correlation has no empirical content
    * Thus, a mathematical formula of correlation of disparate events has no empirical content
    * Thus, and I don't care how many fucking epicycles Li came up with, he was blowing it out his ass.

  or, mathematics is not properly speaking, a "science," which requires that theories be testable and verifiable in experiential, experimental, conditions.  That is one thing.  It's very much something else to go on to assert that there neither is nor can be any nexus at all between mathematical theory and certain examples in physical phenomena.  

  ---

  the following comes from chapter 2, "Qu'est-ce qu'un processus probabiliste?" ("What is a probabilistic process?") pages 35 to 55 in the french edition.

  Kupiec points out that, in sum,

  There is no qualitative difference between determinism and probabilism.  (P. 36)

Or, an event with a probabilty of "1" is qualitatively a probabilistic event in exactly the same sense as an event with a probabilty of greater than zero but less than one.

  Regarding some common misconceptions about probability, he writes,

  Probability does not negate causality.  (p. 39)

  Hence, it's a mistake to put probable events down to something called "accident".

 ' The word cause designates the conditions, in the large sense of the term, of random events.'

    Probability is not incompatible with reproducibility (i.e. as in experimentation's reproduction of predicted phenomena).  (p. 40)

   "Probability, accident, contingence, are not synonyms." (p. 43)

   "The word accidental is often used in the place of probabilistic.  This is an approximation which leads to a counter-sense."

   (which often springs from  a conscious or unconscious acceptance of "essentialism")

   "Probabilty is not 'noise'."

   some links/

   http://www.dailymotion.com/video/xe4kid_l-origine-des-individus_news

  http://fr.wikipedia.org/wiki/Jean-Jacques_Kupiec

 

"In such an environment it is not surprising that the ills of technology should seem curable only through the application of more technology..." John W Aldridge

by proximity1 on Mon Jul 23rd, 2012 at 01:47:14 PM EST
Though I don't understand these arcane theories about probability
Well, which part of the following is so difficult to understand? I thought you were big on phlosophy
To Keynes, probability is a branch of logic: the theory of rational thought under uncertainty. Ordinary logic is just the subset of rational thought dealing with certain (or certainly false) propositions. I think this is a really interesting approach. Probability to Keynes is relative but not subjective. That is, probability is always relative to some data (or hypotheses), and so it is in a way subjective since each of us has different data/knowledge/experience, even different mental acuity. However, Keynes' probability is not subjective in the sense that a correctly formed probabilistic reasoning, being enunciated relative to explicit hypotheses, should be valid independently. Keynes writes at length about the problem of induction (reasoning from particular, though possibly numerous, observations to general statements) and he stresses that, contrary to what has been asseted by philosophers in the past, the fact that an inductive conclusion turns out to be false does not invalidate the inductive reasoning relative to the information available at the time the conclusion was formulated.
That's all the diary says about Keynes' theory of probability. The rest is not about probability proper.
Kupiec points out that, in sum,

There is no qualitative difference between determinism and probabilism.  (P. 36)

Or, an event with a probabilty of "1" is qualitatively a probabilistic event in exactly the same sense as an event with a probabilty of greater than zero but less than one.

I also don't know how that contradicts Keynes, though I insist I have not gone into any detail into the details of what Keynes said.

As to the rest, extraordinary claims require extraordinary evidence

I think he's on his way to becoming as famous and important for his work as is Charles Darwin for his and is perhaps rightly to be seen as the contemporary who has best understood (and restored) a proper grasp of Darwin's place and importance.


If you are not convinced, try it on someone who has not been entirely debauched by economics. — Piero Sraffa
by Migeru (migeru at eurotrib dot com) on Mon Jul 23rd, 2012 at 03:51:07 PM EST
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