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October 20, 2008

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Curmudgeon

A means to guide bond-related financial innovation without paternalism might be for regulators to deem that all new innovative bonds and bond derivatives carry a risk rating of junk for 24 months after introduction. This cooling off period would enable a greater degree of experience in pricing and rating new products before systemically important firms could get neck deep in things no one understood.

If a financial innovation was useful, it would survive a two year cooling period handily. If the innovation was toxic, the cooling period would provide a disincentive to people building bubbles on garbage.

Per Kurowski

The financial engineering bubble!

Give home buyer Joe a 300.000 dollar mortgage at 11 percent for 30 years.

Place that mortgage with other similar in a structured security able to argue itself to a triple-A rating.

Convince investor Fred that the security that includes the mortgage to Joe, as it has a triple-A rating, is at a rate of only 6 percent, a good financial investment.

And then you can sell to Fred the 300.00 dollar mortgage to Joe for 510.000 dollars

As you see, after all is sliced and diced, the 210.000 dollar profit had little to do with easy money or a house bubble, and all to do with the wizardry of financial engineering bubble based on the venom of ratings.

And now we have Joe, with a real liability of a mortgage of 300.000 dollar guaranteed with a house that might o might not be worth it, and Fred, with a 510.000 dollar investment in the willingness of Joe to service his original mortgage at 11 percent for 30 year.

How do we sort this one out?

Cheers

Daniel Clarke

Good financial innovations:
1. Annuities: You can cheaply protect yourself against outliving your assets. I suspect they have substantially improved the lives of the elderly (at ages with mortality, say 5% p.a. - in the west, ~ age 75). 2. Life insurance: A breadwinner can protect dependents from the possibility of untimely death.
3. Inflation indexed-linked bonds (see http://en.wikipedia.org/wiki/Inflation-indexed_bond): Without such instruments it is very difficult for financial institutions to offer inflation-linked products (as opposed to production-linked products). Governments effectively act as market makers.

bg

Although I believe that role of regulation (informal and formal) is critical to a well functioning financial system, I feel that those focused on the mechanics tend to avoid looking at the cyclical nature of economics, and those that look at this big picture tend to gloss over the the reality.

So to complement Nassim Talebs view, let me propose the following:

Humans are social creatures, and that a million cassandra's could not have convinced the government, home buyers, banks and hedge funds from stopping the lovely bubble. (Remember Isaac Newton lost a fortune on the South Sea bubble)

After bubble comes deflating the bubble. If the bubble is big enough a million politicians cannot stop assets from deflating eventually. Deflation pushes capital to the sideline - necessarily.

Two generations pass, and we learn the benefits of cocaine again. And nothing can stop it again.

And just like winter (a highly undesirable and unstoppable cycle) - It serves a purpose.

Without booms and busts would there be Google and Microsoft? A computer? A city? A family?

There is the type of regulation that lasts (democracy, protestantism, capitalism) and that which does not (margin requirements, collateral requirements, risk adversion).

We need to learn what distinguishes these, and learn to promote virtues between them.

Simon Thum

I too think boom & bust are human, or even natural. Still MS and, to a lesser extent, Google would probably just have taken other forms without the boom. But I digress.

We should tame the cycles. Here in germany, anit-cyclic fiscal policy is part of the constitution. But actual policy makes a joke of that.

As a result, the crisis was reinforced by government following close to bank's wishes - with the US serving as a precedent to lobbyists.

I think this is a prime example where protection of the people (against bank practices) could have served protection of the society as a whole.

My conclusion is that we need more democracy on the long term.

So how does that relate to the question?

It provides us a stability indicator. Would product x have been legal 5, 15 and 40 years ago? If no, why not?

The nice thing is that it applies to a broad range of innovations and the knowledge to perform assessment is established.

Not that law obedience is inherently 'good', but the view this indicator provides might hold people from buying into anything well-lobbied. The good of that can't be overestimated.

Sprizouse

Financial Engineering instruments are simply tools. They're neither good, nor evil. When I use my FE toolbag I can structure payments and cash flows from any investment in any way imaginable.

But (as the good finance profs teach), all financial engineering relies on prior assumptions about the underlying investment. If your assumptions are wrong, then your FE instruments won't matter in the least (and might actually exacerbate your problems).

Financial Engineering in its (relatively) short rise to popularity, has instilled a lot of false confidence in the investors who have used them. First it was Salomon in the '80s, the LTCM in the '90s and then EVERYONE in the 2000s.

All these people, at some point in their use of FE instruments, either believed they had successfully engineered their way out of danger, or FE'd their way into magical profits. They all forgot (or didn't care) that if the assumptions about the underlying investment are wrong, then all the FE instruments in the world won't matter in the least when the piper comes calling.

Now, if you want to say FE instruments have no value because accurate predictions about the future of any investment are a crap shoot at best... well that's another matter.

But I believe the right question isn't whether financial innovation is good or bad, just as nobody asked whether airplanes were good or bad after 9/11. The right question is how to stop the bad stuff (meaning bad habits, the tendencies to trust financial engineering, the tendency to exploit financial innovation for profit rather than to hedge against uncertainty) from happening.

Whether the answer to that is regulation, abolishment or something else, doesn't really matter. Making sure financial innovation is used properly in the future is the only thing that matters... and if we can't stop people from profiteering through the use of financial engineering then that says more about human beings (especially the smart MBA math whizzes on Wall Street) than it does about the instruments themselves.

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The choice is clear here. Either we put our faith in some Basel or other international process that will deliver global convergence on standards and on how to deal with systemic risk issues. Or else we go the national route, and ensure that national financial systems are ring-fenced and protected against regulatory arbitrage and contagion.

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