Inequality

[crazy canuck]

There are different types of derivatives, and some can get complex, but I don't think that led to any problem (credit default swaps aren't conceptual complex either, but seem to have caused some trouble).

You are ingoring the problem Alfred.  You might be able to create a derivative that is easy to understand.  But that doesnt address the issue that actual derivatives are complex instruments that few actually understand.  From just one of many articles on the subject.
http://www.ft.com/cms/s/0/833a0994-6e32-11df-ab79-00144feabdc0.html#ixzz1u0hPZpnf

For banks, the Dr.Jekyll of derivative trading is the revenues generated. The Dr. Hyde is the risks in derivative trading, generally deferred into a Panglossian future "neverland" using complex models, based on arcane mathematics and confidence that only willful ignorance can support.

The complexity of modern derivatives has little to do with risk transfer and everything to do with profits. As new products are immediately copied by competitors, traders must "innovate" to maintain revenue by increasing volumes or creating new structures. Complexity delays competition, prevents clients from unbundling products and generally reduces transparency. Frequently, the models used to price, hedge and determine the profitability also manage to confuse managers and controllers within banks themselves allowing traders to book large fictitious "profits" that their bonuses are based on. In Warren Buffet's words this allows the dealer to see "... where the arrow of performance lands and then [paint] the bull's eye around it".

[DGuller]

I do.    It was mainly in articles predicting the financial meltdown (I refuse to call it a subprime meltdown, because it deliberately marginalizes the true nature of the meltdown).

It's interesting that people were able to predict the meltdown without knowing how the instruments worked.

You didn't have to really know exactly how they worked.  All you had to know is that none of the people knew how they worked, that they had a lot of hidden leverage, and that their volume was enormous.

[crazy canuck]

What I meant by lack of accountability is at its most basic sense: giving accounts of what you do - and this happens when you are forced to explain things to people from "outside" the system, because sometimes you realize you are also explaining them to yourself. Deregulation removed one incentive from that kind of rendering accounts. The very, *very* closed society of high flying managers with few incentives to explain what they are doing is another. The bureaucratization of both firms, and accounting bureaus is yet another (and, again, by that I don't mean evil bad government, but the increasingly routine, increasingly compartimentalized structure of financial institutions). And perhaps the financiarization of the economy in general with its dissolution of shareholders into faceless forces might be another.

Even if Oex was sitting in a board room in the 90s and his task in a compensation committee was to determine the appropriate compensation for an executive I daresay even Oex would look at what the competition was doing.  Also, even Oex would feel the pressure of the shareholders to make sure the best executive talent was retained. I dont think even Oex would have been the lone voice in the wilderness saying the world was flat.  Remember this was a time when secretaries on the bus were talking about what stocks to trade.  And Oex is no high flyer.


It is easy in hindsight to point and think about how stupid it all was.  But that is just hindsight.  Its like Alfred trying to claim after the fact that derivatives really are not that complex - even though the complexity of the instruments fooled most people.

[DGuller]

And, by how they worked, I mean the distribution of outcomes, and their probabilities, as well as what impact counterparty risk would have on other business.  Some common derivatives may not have been all that complex by themselves, but that's just part of the picture.  Another part of the pictures is knowing what happens even with simple derivatives during the tail events, and any derivative can add to the contagion.

[crazy canuck]

I do.    It was mainly in articles predicting the financial meltdown (I refuse to call it a subprime meltdown, because it deliberately marginalizes the true nature of the meltdown).

It's interesting that people were able to predict the meltdown without knowing how the instruments worked.

You didn't have to really know exactly how they worked.  All you had to know is that none of the people knew how they worked, that they had a lot of hidden leverage, and that their volume was enormous.

Exactly, that is why there was a push to try to regulate them.  Something Greenspan firmly opposed.  He won.  We lost.

[alfred russel]

You are ingoring the problem Alfred.  You might be able to create a derivative that is easy to understand.  But that doesnt address the issue that actual derivatives are complex instruments that few actually understand.  From just one of many articles on the subject.
http://www.ft.com/cms/s/0/833a0994-6e32-11df-ab79-00144feabdc0.html#ixzz1u0hPZpnf

That is a standard and very common type of derivative. I've worked with derivatives at a number of companies and with the exception that multiple derivaties (including options) are sometimes in a single contract, that is usually as complex as they get.

[alfred russel]

And, by how they worked, I mean the distribution of outcomes, and their probabilities, as well as what impact counterparty risk would have on other business.  Some common derivatives may not have been all that complex by themselves, but that's just part of the picture.  Another part of the pictures is knowing what happens even with simple derivatives during the tail events, and any derivative can add to the contagion.

As I posted yesterday:

"Where there is complexity is with counterparty risk."

But here is an unattractive question that I have heard come up, including before the crash: "Who cares?" If your counterparty is a large institutional, it isn't going to fail unless the market collapses in an unprecedented fashion, and is such an event worth planning for?

[crazy canuck]

You are ingoring the problem Alfred.  You might be able to create a derivative that is easy to understand.  But that doesnt address the issue that actual derivatives are complex instruments that few actually understand.  From just one of many articles on the subject.
http://www.ft.com/cms/s/0/833a0994-6e32-11df-ab79-00144feabdc0.html#ixzz1u0hPZpnf

That is a standard and very common type of derivative. I've worked with derivatives at a number of companies and with the exception that multiple derivaties (including options) are sometimes in a single contract, that is usually as complex as they get.

Ok Alfred, you are the smartest guy in the room.

http://en.wikipedia.org/wiki/Enron:_The_Smartest_Guys_in_the_Room



But you are seriously missing the point.  It is not that derivatives could be created in a simple straight forward manner so that they are transparent and everyone on both sides of the deal fully understands the risk.  It is that they are not created that way more often than not.

[crazy canuck]

But here is an unattractive question that I have heard come up, including before the crash: "Who cares?" If your counterparty is a large institutional, it isn't going to fail unless the market collapses in an unprecedented fashion, and is such an event worth planning for?

If people dont understand what they are bargaining for then there is no problem?

[DGuller]

As I posted yesterday:

"Where there is complexity is with counterparty risk."

But here is an unattractive question that I have heard come up, including before the crash: "Who cares?" If your counterparty is a large institutional, it isn't going to fail unless the market collapses in an unprecedented fashion, and is such an event worth planning for?

The problem in finance is that if you discount the possibility of a nuclear event, because you can't really protect yourself against it anyway, your consequent actions are skewing the probabilities in such a way that makes the nuclear event more likely.

[The Brain]

 

[Oexmelin]

Even if Oex was sitting in a board room in the 90s...

Why are you writing in such belittling way?

I am not saying the way people acted is stupid, or horrible. I don't know why you insist into attributing aggressive value-judgement on my part on what I aim to describe.

I am trying to complicate the picture by saying economic is also social behaviour, and that therefore, it might make sense to think on how people get their information, are being positively reinforced by a group of identifiable peers, and modify their behaviour according to some organizational principles that are not market-driven.

In other words, I will assume for the sake of argument everything you wrote is true. My point was simply that:

Also, even Oex would feel the pressure of the shareholders to make sure the best executive talent was retained.

might warrant an examination of at least four things (I can think of more).

How is the shareholder pressure expressed and conveyed?
Who represents the "desire" of the shareholders? Who interprets them for any sort of compensation committee / board ?
How is "best executive talent" evaluated?
And who gets to judge this?

Now, you might answer to these questions that the market takes care of it all, but that is in the end saying very little about decision-making process.

You might answer - perhaps like JR - that we should bracket these issues away for intelligibility's sake, while we review what current economic thought has to say about it. Fair enough.

But maybe, we can briefly do the reverse as a thought experiment, and bracket the market away and try to understand what kinds of social (rather than strictly methodologically individualistic) forces make people take the decisions they took.

[alfred russel]

Ok Alfred, you are the smartest guy in the room.

http://en.wikipedia.org/wiki/Enron:_The_Smartest_Guys_in_the_Room



But you are seriously missing the point.  It is not that derivatives could be created in a simple straight forward manner so that they are transparent and everyone on both sides of the deal fully understands the risk.  It is that they are not created that way more often than not.

I'm not the smartest guy in the room, which is a part of the point here. Almost anyone who has been in a professional finance or accounting role at companies large enough to be publicly traded will have the experience because derivatives are very common. Your larger multinationals probably have thousands of contracts outstanding.

These are contractual relationships between large organizations where both sides should have professionals that know what they are doing.

[alfred russel]

The problem in finance is that if you discount the possibility of a nuclear event, because you can't really protect yourself against it anyway, your consequent actions are skewing the probabilities in such a way that makes the nuclear event more likely.

Sounds like a macroeconomic problem. I don't see why an individual company would care (at least when contemplating its own actions).

[alfred russel]

CC--I don't know what you are trying to say.

Derivatives used by large companies are either to hedge risk or (less often) to speculate: either way they aren't naive consumers. These are strategies they seek to employ.

Derivatives are also used in speculation, often by hedge funds. I again doubt that they don't understand the risks (and have limited sympathy if they don't). Derivatives are a convenient way to replicate the effects of significant leverage.

Maybe you have some concerns that mortgage backed securities were packaged in securities with derivatives embedded. In some cases these received solid ratings and were sold to institutionals who apparently were satisfied with the ratings. The issue here seems to be a problem with a lack of transparency in the securitization process combined with a lack of investigation on the part of consumers. I don't see a reason to think derivatives were the key to misleading the purchasers of the products.