Consumer Protection: Reverse Convertibles

Since we’ve already run new stress tests out of this webpage, I’m going to go ahead and run the Consumer Protection Agency out of the Rortybomb Blog while President Obama and team continue to get the legislation worked out. So welcome to the RCFPA – Rortybomb’s Consumer Financial Protection Agency. Today we also have the responsibility of the Financial Product Safety Commission. Let’s see what the thought process of such a government agency might look like. Our principles for consumers interacting with financial innovation:

1 – Markets Work; No Free Lunch
We trust that prices that undergo more market interactions reflect more information. If you are earning extra money on your investments, barring very clear reasons why markets have failed, it is because you are taking on more risk.

2 – Reduce Transaction Costs
Transaction Costs are wasteful and destructive to capital, and should always be avoided whenever possible.

3 – People are Poor with Estimating Tail Risk; They Underestimate it
People should be discouraged, though not prevented, from profiting by taking on excessive tail risk. If they do want it, they should be made very aware of what they are doing.

4 – People are Poor at Understanding Embedded Options
When embedded options are hidden inside financial products, they should be made very clear, and if reasonable, broken out into another product.

That’s a good start. Following these guidelines for consumer interaction with financial innovation will make the financial system stronger, more equitable and more stable. And I don’t find any of those four controversial.

So our first case at the RCFPA comes from Felix Salmon – Reverse Convertible Bonds, which the WSJ just called a nest-egg slasher. This bounced around the blogosphere yesterday. Here’s James Kwak on the instrument:

In a reverse convertible, you give $100 to a bank for some period, like a year; it pays you a relatively high rate of interest, say 10%. The $100 is virtually invested (no one actually has to buy the stock) in some underlying stock, like Apple. If at the end of the period the stock is above a threshold, like $80, you get your $100 back; if it is below the threshold, you get the stock instead. (The terms can depend on whether the stock ever went below the threshold and where it is at the end of the period, which makes the deal worse for the investor, but that’s the basic idea.)

The Wall Street Journal article follows the story of a radiologist who buys the instrument expecting to get a safe bond plus a free stock if things go bad and is surprised that he was written out of the money put options on stocks.

Our verdict at the RCFPA: FAIL. This instrument should not be allowed to retail investors, or perhaps not at all.

Hey! I’m a radiologist who wants to buy this instruments. What makes you want to nanny-state over me?

First off this is really selling people an embedded put option but calling it a bond. FAIL Rule #4. I’m mad he beat me to it, and so well, but here’s Nemo nailing this out of the park in comments:

As jck points out below, this is actually a naked put. (Same risk/return as a covered call, but a simpler and more accurate description when you do not already own the stock.) Since markets are efficient — at least in this sense! — there is no possible advantage whatsoever to anybody, except the bank, who is ripping people off. If you tried to use these things in volume, you absolutely would move the stock, just as if you sold lots of puts. And if these gadgets were more cost-effective than simply selling puts, somebody would arbitrage the difference away.

Therefore, this is simply a way to convince naïve investor to sell puts, but with the extra risk of the bank as a counterparty and with the extra friction of having the bank as an intermediary.

So it also involves taking on extra transaction costs when they could be avoided by just buying a put option. Rule #2 FAIL. Indeed this strikes me as more destructive of capital than breaking it down into components.

It also is FAIL on the crucial Rule #1 – It believes that the market price of a put is somehow inefficient. This is all I can read where its defenders, such as Nick Schulz say: “They are cash-secured put options.” Asking Nick if he doesn’t believes in markets is almost akin to asking him if he doesn’t believe in America and Apple Pie, but I need to ask – does he not believe in markets? Does he, and people like Daniel Indiviglio, believe there is a Free Lunch to be had by structuring cash and a put option this way?

I think I was confusing a few months ago when I said that believing in efficient markets should cause us to doubt most financial innovation. This is exactly what I mean. I believe the best price of a put option on a stock is going to the market and getting the price of a put option. I believe that the implied price of a put option, married with odd extra risks and transaction costs, in this reverse convertible bond instrument is a worse price for the put option than the market one, because I believe the more markets vet prices the better they are. Nemo’s point is absolutely correct – if they were much different, the market would be arbitraging them away.

And if you got a better deal taking this reverse convertible bond instead of just a market put, which I highly doubt but let’s assume, is it because there was a market failure that had been innovated away, thus increasing value? Or have you simply just piled into a new risk factor that you are being compensated for? Again, if you believe in markets the only sensible thing to do is assume the later until it a very clear argument has been made for the former.

Hey! Maybe I want to take on those extra risk factors so I can be compensated for them.

Really?

Yes. What are they?

Well, as Nemo said, you’ve taken on counterparty risk. If you bought, say, a Morgan Stanley Reverse Convertible Bond on AT&T (SEC – html), if Morgan Stanley isn’t around you aren’t getting anything. If you bought a put option and secured cash, you wouldn’t have that to the same degree. In so much as that is hidden tail risk, it violates #3. If you want to bet that Morgan Stanley is going to be around in a year, and be compensated for that, there are other options available that directly do this that are traded with more information.

If you dig in that SEC document there’s a bunch of risks with stock-splits and extra dividends and accerlations if AT&T goes bankrupt. Fine print risk.

There’s also that knock-in portion, of which Felix says “pricing these things is pretty much impossible.” Here’s a screen shot from Wilmott’s intro guide of just part of the equations you’d have to solve to estimate its value:

knockin

The answer to the value doesn’t have a closed-form solution, so you’ll need to set up computers to iterate simulations to solve it. At Morgan Stanley there’s a room full of Math PhDs who instead of developing solar energy are spending their hours trying to rip off radiologists using math. Buying this instrument is a bet that you can solve those equations better than them. Good luck. In practice, it means more hidden tail risk in the form of another embedded option, so FAIL #3 and #4.

Ha! I fooled you all. I’m actually a very sophisticated investor, and Felix, James, Nemo and you were wrong to be looking at this by charting the stock price. I’m actually betting that the volatility of this stock has been overrated, and am betting it will come down.

That’s very sophisticated for a radiologist who just wanted to buy a bond.

I know. Thank you. Now take your laws off my bong, man.

Hey, I’m not at all against you make esoteric bets with options. If you, Mr. Radiologist, wake up in a cold sweat after having dreams that the market is overestimating the term structure of the second moment of AT&T stock, go ahead and place a bet (I have those same dreams myself). Go short a straddle. Just sell the put option. There are baskets of derivatives that can handle this. The RCFPA should help you achieve your dreams.

What I do want though, as Chief of an imaginary government agency, is for you to make that statement in the positive. I want you to say clearly “I am selling a put option on AT&T” or “I am betting that the vol numbers will decrease.” I don’t want you buying what you believe is a magic bond only to realize later you’ve taken a large position in tail risk.

What should be our next case?

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34 Responses to Consumer Protection: Reverse Convertibles

  1. chrismealy says:

    Those transaction costs you’re reducing are also known as financial industry profits. Good luck with that!

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  3. q says:

    are these a real problem? how big is the market in these? why are they the hot topic all of the sudden? who in their right mind would buy one — they sound like a real ripoff.

    but trying to ban something because it is STUPID — especially something which is so transparently dumb as this — if people are stupid, and don’t do their homework, SOMEONE will find a legal way to rip them off. if you make this product go away, you won’t stop them from getting ripped off. you’ll just shift the problem from one con artist to another.

  4. Mike says:

    Chris – exactly! Here’s one source of where your inflated banking sector profits come from – by purposefully introducing frictions and transaction costs into the market.

    q – I don’t follow. On a long enough timeline, all of our survival rates drop to zero. Should murder be legal?

    It is transparently dumb because I took the time to break it down and build it back up. I’m a professional at this stuff though. A financial advisor, who may not even understand it himself, telling his client about a great deal with a bond that gives you a stock as a backup, may not. And those marketing teams are pretty brilliant.

  5. Chris says:

    a bond that gives you a stock as a backup

    Unless I’m misunderstanding your description, it gives you the stock only when giving you the stock is a loss for you. Some backup! Even unlevered you could lose the whole investment if the stock is, say, Bear Stearns.

    Anyway, I’d like to controvert (or at least examine) your uncontroversial principle #2. Transaction costs make the market slower to adjust to changing conditions, which is bad. But they also make the market slower to “adjust” to fads and animal spirits, which is good. Anyone who has ever tried to walk on ice knows that friction is important to stability. In the wake of the destruction of large sections of not just our financial markets but our actual economy by financial instability, how can you defend low transaction costs when they lead to high volatility?

    In particular, one idea that has come up in the wake of the current crisis is a financial transaction tax – i.e. a deliberately introduced transaction cost. The revenue so raised would go partly toward paying for very expensive government rescues of the financial sector, partly toward paying for moderately expensive government oversight of the financial sector, and maybe partly towards other public ends – and it’s sometimes claimed that the tax is Pigouvian because volatility is a public hazard (people occasionally stumble into it and destroy their pensions, home equity, etc.) and therefore a modest amount of friction-stabilization of the markets would actually be beneficial.

    Do you think that transaction costs don’t damp instability, or that damping instability isn’t actually desirable, or that the dead weight of damping rational movement is always worse than the benefit of damping irrational movement, or something else?

  6. Mike says:

    Chris –

    I should emphasize that this is a kind of principles for retail/small/consumer investors dealing with the financial market, as opposed to the financial market policy as a whole. Which would probably have some different principles. I’m trying to flesh out what I think a consumer financial product group should look like, what it should deal with and how.

    So by transaction costs here I mean transaction costs faced directly by consumers that are ‘charged’ by intermediaries. A transaction tax, with I am sympathetic to though haven’t followed it all that closely, would be all right by these principles since it is faced by everyone, including those intermediaries. It’s not a fee the financial sector charges consumers as a rent to get access. The transaction fee of buying this instrument instead of the put is not meant to slow the turnover in the rate of financial instrument. Nor is it in exchange for a service I can identify. Or so I could read it and square the two thoughts and be ok with it.

    Larry Summers wrote a paper in support of increasingly (because we have a very small one already) transaction tax in the late 1980s. I assume he’s still not behind it.

  7. Kid Dynamite says:

    Chris – I disagree with your base claim that lower transactions costs lead to higher volatility. Lower transactions costs –> easier to transact –> more liquidity –> LOWER volatility.

    -KD

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  9. James Kwak says:

    Great post. I like your insight that applying efficient markets thinking undermines the reason for existence for these products. And thanks for saving me the trouble of responding to those people arguing with my post.

  10. Pingback: Reverse Converts Ignites the Blogosphere | OneMint

  11. Terry Ivanauskas says:

    Great post. I also agree that we should give the real names to the instruments. It is the same with medicines. Why should we permit fantastic fictional names in drugs with the same active principle? If that doesn’t make sense in health care, that shouldn’t make sense in financial care. And normal people shouldn’t be obligate to be financial experts as they are not required to be doctors in pharmaceuticals.

    I was also wondering after reading your text if the financial innovations of an unregulated financial market are really always beneficial. Take these reverse convertibles for example. Banks are supposedly better investor than normal people like housewives or blue collars. In the old times, housewives and blue collars would buy ordinary pre-fixed bonds and the bank would have the problem to find an investment that could beat the pre-fixed interest rate. They would have to be efficient searching for investments. Now we have banks passing ahead tail risks to housewives and blue collars (probably without telling them that). “What’s the problem if the stock where we invested the client’s money just became crap?” a bank would ask, “let’s just give it to the client!”

    Terry

  12. Chris says:

    So by transaction costs here I mean transaction costs faced directly by consumers that are ‘charged’ by intermediaries.

    OK, but then aren’t those necessary for the intermediaries to even exist (pay for their offices and employees and lobbying against regulation of the financial sector etc.), let alone make a profit as chrismealy implies? If the intermediaries could survive just by making the investments themselves, they would do so; they need to profit from bringing the investor and the investment together.

    If the intermediaries gambled, they might lose, and be destroyed. They have to take a casino/bookie position of letting others gamble for a fee, because it’s the only way to get a revenue source stable enough to maintain their existence.

    Ideally, because the investments are investments in businesses some of which produce value in the real economy (even though no one knows in advance which ones will produce value and which will fail), the game is positive-sum; but even so, the house has to skim off some of the value created by the successful businesses before passing the remainder along to the successful investors.

    What am I missing here?

  13. bh says:

    I would think that the real question here is the transaction costs of selling a put and buying the bond versus the transactions costs of the instrument.

    I find it hard to believe that you will have any luck banning these things and not some how entrenching a different intermediary–the options exchange or options dealers at the same time. But its an empirical issue…

  14. Another Mike says:

    Chris,

    I can’t speak for Mike, but I’m going to try anyway.

    I think he’s not calling to eliminate transaction costs but to limit them to what economists would call “normal” profits. This is is the level that same assets, otherwise invested, would realize the same return. They’re pretty much assumed away in conventional economic analysis as a “cost” of production, much like the cost of raw materials.

    The opposite is called a “rent.” Rents can be achieved in good and bad ways–examples of each would include a new innovation that yields above-market returns and a revenue stream that comes from lobbying the government. Defenders of financial institutions would argue that they earned these supernormal profits from developing new products. Mike is arguing (I think) that many of these innovations amount to little more than rents reaped by hoodwinking uninformed consumers or investors.

    And you’re right–Mike’s ideas would shrink the financial sector and its revenue. In recent years, finance has come to account for something like 40 percent of all corporate profits, up from around 20 percent a few years ago. Many people are arguing that a healthy economy should not look like this, that finance should only serve only to support other industries and activities.

    If I can go a bit further, I would say that Mike wants to reduce all consumer financial services to commodities, products whose features are indistinguishable from each other. In economics, all (supernormal) profits from commodities get competed away, since anybody can enter the market and capture that last penny of excess profit that others are earning simply by charging one cent less.

  15. q says:

    one thing i find rather amusing in this discussion is that nobody has brought up numbers as to whether people buy these things and how much they cost relative to their ‘efficient’ price. anyone have numbers on this, or are ye all just blowing smoke?

    • Another Mike says:

      Reverse converts were used as an example to illustrate how abstract principles would apply to a real-life instrument. If you want examples of broad-based abuses, read the entries on prepayment penalties or credit cards.

      Where does your libertarianism end? Do you believe that everyone should become experts on every product they ever buy? You sound like Greenspan when he said that laws against fraud were unnecessary because the fraudsters would soon go out of business. Are the first few children who die of lead poisoning the necessary sacrifice we have to make for an efficient market in toys? Or should everybody own a lead-testing kit, just in case?

      • Another Mike says:

        Reading this over again, it sounds more hostile than I intended. It’s hard to get such things right on the Internet. **shrugs**

        In any case, my point is that you seem to be asking a lot of people. Am I wrong? Do you draw a line anywhere?

      • q says:

        i think that you are imputing some things beyond what i am suggesting. i don’t take any offense though. i have been on-line for a couple decades and know it is difficult to judge intent behind words.

        and i think you have my intent wrong. that’s my fault as much as anything.

        my larger point is ‘why are you picking on this product when this is probably small potatoes’.

        i am generally in favor of stronger consumer protection in finance even though i disagree with much of the reasoning i find here. reverse convertibles are something i would probably ban, although i don’t see that they are a big enough problem to get excited about.

        for two more examples of things i would at least consider banning: i’d think about banning hedge fund replication products (probably, though it’s really the marketing that i would ban — there’s no way or reason to stop people from trying to replicate HF indices and selling that) and double short ETFs.

        as for your question about ‘do i believe that everyone should become experts on every product they buy’ i think that the answer for financial products is ‘yes’. if you don’t, you stand a good chance of being legally ripped off.

        in any case the principal-agent problem is not something that you can completely solve — if you delegate investment decisions to someone else (who may be working for many, many other people besides himself), that person is not always going to be working in your interest. that’s the core problem and it’s inherently not solvable. you can go after its various manifestations ex-ante, but you will still end up with new ones that come up in new situations.

        btw, i could make the same ‘ripoff’ allegation against my index fund mutual fund. they have no information that i couldn’t buy cheaply, so i should be able to do what they do without paying their fee. i even have the technical skill to do it. am i getting ripped off? in some sense i am. why don’t i do it myself?

        for non-financial products the ideal answer would be yes but it’s not practical. i can’t practically check the milk i put into my coffee at every client meeting.

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  17. Mike says:

    Q: Obviously we aren’t making specific policy. But I am interested in the principles that might motivate a financial consumer protection agency, and taking those principles and throwing them at whatever the financial/economics blogs are talking about at this time. There are obviously lower-hanging fruit for the real guys to go after. Numbers and size aside, I do feel that this approach online is adding more light than heat, especially when everyone is trying to figure out what might motivate an agency like this.

    In term of a good question – ‘should everyone become experts on every product they buy’ I agree people should do research but I think there are practical limits. I mean, do we believe that I should become an expert in medical surgery if I under go surgery?If the doctor turned out to make the wrong call, and I undergoing surgery was a bad decision, is “well you could have easily been a surgeon too and researched all this” a strong defense?

    Another Mike: Good call on rents. I am a little uncomfortable using that word because I’m not sure on everything it implies and its full definition, but it sounds like what I’m getting at.

    And indeed, transaction costs here is something that needs a better definition. Not being able to raid your 401(k) is a big transaction cost, but I think that’s a great thing.

  18. Chris says:

    Defenders of financial institutions would argue that they earned these supernormal profits from developing new products. Mike is arguing (I think) that many of these innovations amount to little more than rents reaped by hoodwinking uninformed consumers or investors.

    That sounds to me less like an argument than like two different ways of saying the same thing. The financial sector can’t make profits by building a better mousetrap because it doesn’t build any mousetraps. It makes (economic) profits by building a better investortrap. The more efficiently you intermediate the smaller a financial sector you need *for intermediation* – and with modern information technology that should be quite small indeed. The rest is glorified bookies and greater-fool hunters.

  19. q says:

    ok, another question.

    fact of investor psychology: everyone wants to maximize yield and minimize risk.
    most ‘financial innovation’ is geared toward this goal.
    however, there is always leftover ‘tail risk’ — either risk that the model is wrong or that asset values will fall broadly. or, what is a good definition of ‘tail risk’?

    who should own tail risk?

    not consumers (rortybomb’s argument)
    not banks (buildup of tail risk => systemic risk)
    not insurers (they already take the real economy’s tail risk; plus systemic risk see AIGFP)
    not the government (promotes moral hazard)

  20. winstongator says:

    As the husband of a young radiologist these types of ‘investments’ make me wake up in cold sweats. Aren’t doctors notorious marks for the shittiest investments? Lots of income, no real business savvy, and not a whole lot of time to research.

    OTOH, if my wife wants to put 400k into something, I’ll ask her what it is and see if she understands it. There are lots of people who thought C, or BAC were staid banking stocks, and ENRN was a good energy company.

    I would add to #2 a transaction tax. It would kill short term trading, but do little to affect real market impacts on companies. It wasn’t traders that discovered Enron or Lehman’s bk’s, and short term investments didn’t realize the true value of the stocks any quicker than anyone else.

  21. Pingback: Mother, I Thought We Went Over This Already «  Modeled Behavior

  22. Another Mike says:

    Chris and q,

    I’m not sure I understand everything you’ve asked, which probably means I wasn’t very clear in the first place. I’ll try to explain myself. Some of this may be repetitive, and some may be so simple as to insult your intelligence. But, as I said earlier, these things are hard to get right over the Internet.

    To start off, let’s compare finance with a different service: medicine. It’s relatively easy to understand what kind of service doctors provide; they help us become healthier. Finance is a little more opaque.

    There are several types of contributions financial institutions can make to the economy. One is to get money into the hands of people who can best use it. Financiers match up savers, who have money but don’t have profitable opportunities, with investors, who have profitable opportunities but no money.

    Another function is to spread risk. Some people may have a productive activity in which they want to engage but are afraid that some random event will wipe them out. Others are willing to take on this risk in exchange for a fee. This obviously describes insurance, but there are other products that fit this description, such as commodity futures (which I’ll explain below).

    There are more types of services that financial institutions provide, but I’m not trying to be comprehensive here. One theme that you may have already noticed is that they are enabling specialization. In both of these examples, there are two parties who have different but complementary abilities. Finance allows each of them to concentrate on what they do best. Specialization makes the economy more efficient and therefore more productive. Everybody wins.

    (This, by the way, is why I do not consider mutual funds to be exploitative. You or I may be able to do the same thing ourselves, but it would be much better for the economy if each of us could just focus on what we do best. We delegate these decisions to an expert, the mutual fund manager, because he makes the decisions more efficiently, especially if he’s making the same decisions for a pool of funds from lots of investors.)

    (Specialization also gives us an idea of who should bear risk. Wealthy people and institutions–pension funds, university endowments, Warren Buffett–have enough money to diversify their exposure across many types of risk and have long time horizons. So long as their failure does not bring down other institutions–that is, so long as they are not insanely leveraged–we don’t worry too much about them losing 30 percent of their value in one year. They’re still rich, and their investments will recover when the economy bounces back.)

    Financial institutions provide a service not only by bringing different people together, but by administering the relationship to minimize the risk of one party screwing over the other. They do this through financial innovations, contractual structures such as collaterized loans or insurance policies.

    An example of a good innovation is commodity futures. When the farmer plants his crop, he doesn’t want to do an econometric analysis of what wheat prices will be in six months. So he contacts his futures trader, who does this kind of thing all of the time, and agrees to sell his crop to him in advance for a prespecified price.

    The first person to offer futures probably earned what economists call a rent. This is the profit one earns on an asset above and beyond what it would earn in any other use. The idea is that competition reduces the income on any investment strategy to a single rate, the “market” rate. Innovators earn rents because they have a virtual monopoly on their market–that is, until others figure out how to copy him (or his patent runs out).

    Now, one can also earn supernormal profits in unproductive ways. People can lobby the government for special privileges, for example, or by repackage snake oil as medicine. These are “bad” rents. They do not improve efficiency in the economy. In fact, they actually harm it, because people are devoting their efforts to activities that transfer wealth instead of creating it.

    We want an economy in which people do not earn rents from bad financial innovations. One method of doing that is caveat emptor–everyone must remain vigilant against bad financial innovations. But this is inefficient because it asks a lot of people who are not good at finance to invest resources in learning it. It would be much better if we had a smaller group of people who could specialize in evaluating financial innovations and prevent bad ones from reaching the marketplace in the first place. Only the government has the coercive power to accomplish the second part of that proposition. (There are other methods, such as having professional organizations license practitioners, but so far this hasn’t seemed to work very well. I’d love to hear about other alternatives, as my preferred strategy is to have markets govern economic activity. Also, there should be limits to government oversight. The range of goods and services that the government regulates should be limited to only the most important and complex.)

    However, we don’t want to stifle good financial innovations. And innovative people are not going to invest their efforts in designing new products unless they have some idea ahead of time that they’re not going to get shot down by some arbitrary and capricious government agency. So we ought to specify principles that will bind the decisions of this agency.

    As I read it, that’s what this post was about. It was a preliminary stab at what those principles might be. For the purposes of the discussion, it doesn’t matter if the example (reverse converts) is common or rare or even exists. Even a hypothetical example would be fine because the purpose of the example is only to illustrate the application of the principles.

    (If you managed to read this entire post, I am grateful for your patience.)

    • q says:

      i managed to get to the end! (your comment is a lot shorter than most of mike’s posts anyway.)

      with respect to the consumer space, revolving credit is a lot more troublesome than reverse convertibles. i think mike did a good job covering that. on one hand, i think it makes sense to rein the card companies in, perhaps through a cap on how much they can increase interest on existing balances. on the other hand, if we limit consumer credit, it means people will buy and spend less. as to how to balance that, i don’t know — i think it is well and good for a bunch of overeducated people who don’t rely on revolving credit (and i am in this set of people) to talk about what makes sense for the others, but it’s only one side of the story.

      btw, there’s an agency that does similar things to what you are talking about in another arena: the fda.

      regarding retail sales of investment products like reverse convertibles, i think they are a small problem. there’s no evidence that these are a big enough issue to create systemic risk; these products are designed to distribute risk away from the financial system and toward the consumer. most of these products do not employ much internal leverage. in terms of tail risk, i’m not convinced by mike’s graphs that there is more tail risk than holding the stocks outright. so the only issue for me is marketing. do people understand what they are getting? (again, taking the fda example, a lot of what the fda does is regulate drug marketing.)

      in terms of the discussion of ‘rents’, i am not an economist so i don’t know the terminology. looking at the commodity future example, which i think is very close to what most banking does, i wonder how you would figure out what an ‘acceptable’ rent is. over the long term the entity that writes the commodity futures contract needs to ensure that it is solvent, so it has to collect enough ‘rent’ (i hope i am using the word correctly) to cover losses plus costs. however, the losses aren’t known up front, and the contract writer needs to ensure that he is solvent with very high probability all the time (ie not just on average and not just at the end of the contract), so on average banks should be very profitable. how does emergent market theory handle this?

      as for ‘who holds the risk’ that’s another question, but there’s good reason to believe that at least one of the main reasons for the crisis was that many large holders of dollars (namely emerging economies) weren’t willing to take risks. (the argument is that this pushed down interest rates for ‘safe’ debt, including government debt and GSE debt, leading to increased government spending and lower mortgage rates; lower mortgage rates were one factor in the house price bubble. meanwhile americans, unconvinced by low interest rates for safe debt, chose either consumption (spend it now) or risky investments.) i think that creating a class of restricted investors _could_ have the same effect — lowering returns for those investors while concentrating risks on those allowed to take them. so you have to be careful.

      (if you got to the end of this, grateful for your patience.)

      • q says:

        i meant ‘efficient market theory’, not ‘emergent market theory’, duh. i was watching sanford of south carolina make a fool of himself on tv while writing this, so i was a little distracted.

  23. Chris says:

    We delegate these decisions to an expert, the mutual fund manager, because he makes the decisions more efficiently, especially if he’s making the same decisions for a pool of funds from lots of investors.

    This approach may gain in efficiency, but it also introduces principal-agent risk (which, AFAIK, the mutual-fund investor is not typically rewarded for bearing). All those people who delegated their investment decisions to Bernard Madoff aren’t too happy with their savings in time and effort.

    A system that only works when all participants are honest is a system not suitable for use by humans.

    Financial institutions provide a service not only by bringing different people together, but by administering the relationship to minimize the risk of one party screwing over the other.

    Hmm. That doesn’t seem to actually be the case in this example. The financial institution is not just organizing the transaction, they are a party to the transaction. And therefore they have no interest at all in minimizing the risk of *that* party screwing over the other party.

    Put simply, their incentives are not aligned with the investor’s. This seems to bring us back to caveat emptor – or if the bank can’t be trusted to offer you an investment deal that is good for you, then you need an expert to examine your deal with the bank.

    Maybe we need a category of investment fiduciary who is banned by the standards of his profession from advising you to invest in deals to which he is a party. (Banks clearly don’t hesitate to engage in exactly that sort of self-dealing, which probably means it’s not illegal for them.) Presumably, such fiduciaries would advise their clients to avoid the instrument described in this post for the same reasons Mike describes. If they cut deals under the table with specific financial organizations to steer clients in their direction or something like that, they could be expelled from the profession and/or sued for breach of fiduciary duty.

    (To say nothing of the ratings agencies; what happened with them seems very like a used car dealer bribing all the local mechanics to say that cars from his dealership are in perfect condition, even when they’re not. Investors thought they were hiring expertise to work for them, but were unaware that those same experts had already been hired to lie.)

  24. Another Mike says:

    I’m very tired, so I won’t answer your comments except to say that they are very good. I especially like the points about China and the investment fiduciary. Chris’s point about the principal-agent problem (“not just organizing the transaction, they are a party to the transaction”) points to an important weakness in my argument, I think, although I’d have to ruminate about it a little more to be sure. All I can say for now is that I don’t see this as a matter of eliminating principal-agent problems, which would be impossible, but of moderating them to acceptable levels. Institutions, whether government (e.g., the FDA) or private (professional organizations) can mitigate agency problems. At the same time, they impose costs, so there’s a balancing question involved. Without hard data that measures the effectiveness of various methods and their costs, it’s going to be difficult to resolve the issues we’re talking about.

  25. Chris says:

    It seems to me that both mortgage brokering and bond ratings agencies were very severely affected by principal-agent problems in the current crisis (or would you call it ordinary fraud? I think the agent/contractor distinction has been intentionally obscured in some cases), and so moving in the direction of more supervision is probably the right thing compared to our ca. 2005 institutions.

    But maybe I have an unrepresentative view, or something. It certainly bears looking at.

    In any case, I think the financial consumer protection agency should not just look at investment. It should look at consumer debt, and how it is incurred, structured, and secured. Everything from paycheck cashing to option ARMs.

  26. Mike says:

    This whole discussion in the comments has been fantastic – thanks for working out these issues. I’m going to reflect on them and probably post again next week (finishing up vacation). Thanks for reading and discussing all!

  27. Pingback: Financial Innovation, Once More Into the Breach « The Enterprise Blog

  28. Walt French says:

    Great topic; fine example.

    However, I’m wondering where the Rortybomb CFPA might draw the line that separates “the pit” from “the slippery slope. I have a real-life example:

    My wife, as trustee for her out-of-the-country father, was asked to buy a CD with one that matured. The banker, noting that 4-year CDs were only paying 3.X%, proposed a 3+ yr note linked to the S&P– if the S&P ever crossed over a level about 50% higher than its value at purchase(~12%pa), zero interest. If the S&P had declined by maturity, zero interest. In between, the S&P return.

    I SWAGged the expected return at about 50 bps below the vanilla CD, with the spread paying for the fine services of the engineers who would lay off ANY AND ALL bank risk with options and the bankster who patiently explained that the S&P couldn’t possibly go down from its then low levels, so forget that clause; hence the expected rate was rather closer to halfway between zero and the cap rate. And it’s FDIC insured!

    (I did not have her ask him, since she wasn’t in a game-playing mood, whether he would separately sell us the put for a nominal fee, since it obviously wasn’t worth anything.)

    Now, the questions: would such a complicated (and so, easily mis-represented) note be disallowed under the RCFPA? Or would you come up with ways of correcting the informational asymmetry? How about the proposed FSA model, where anybody “advising” clients has a fiduciary standard, and cannot receive commissions for moving product? Would you propose a disclosure such as, “we provide transactional services for a fee and make no representation that any contract will have any value?” How about all products being standardized, and through that, require a third-party risk/valuation review paid for by the bank but with the reviewing agency selected by the Feds (sorta like might help the rating agency shopping)?

  29. Pingback: Financial Innovation I, Two Problems and TRACE « Rortybomb

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