NationStates Jolt Archive

I just got sent this, and thought it had to be worth a mention here.

http://mitworld.mit.edu/video/659
There will be a time “beyond crisis,” asserts Robert C. Merton (http://en.wikipedia.org/wiki/Robert_C._Merton), who delves into the dense science of derivatives -- a field he has fundamentally shaped -- to explain how the vast global economic collapse has come about, and how financial innovations at the heart of the collapse could also be tools for reconstruction.

Merton uses deceptively simple graphs to show how risk propagated rapidly across financial networks, bringing down financial institutions. While he admits the crisis “is very big and complicated,” Merton boils a piece of it down to the use of put options, a derivative contract that’s been around since the 17th century. This asset-value insurance contract, a guarantee of debt, is the basis for the credit default swaps widely adopted by financial giants in the last few years -- now widely regarded as a primary cause of the meltdown. It turns out, says Merton, that the put “makes risky debt very complicated, and treacherous…”

In these puts, if the value of assets goes down, the guarantee value goes up, so the value of the written insurance is worth more. The value of this guarantee is very sensitive to the movement of the underlying asset. When dealing with puts on the local level, this movement can be tracked and managed more easily. But when financial institutions manipulate bundles of assets (for instance, mortgage-backed securities), the increase in risk proves non-linear. Add some volatility, like the jolts posed by widespread drops in housing prices, and the difference between the decline in asset value and the value of the guarantee becomes enormous -- leading to mountains of debt and felling behemoths like AIG (insurer to lenders).

Yet, Merton counsels not to blame the current crisis on put options, or too much complexity, but rather on incomplete understanding of the models of risk involved. It’s not “bad and incompetent people” who have brought this about (although he admits there are plenty of those) but “a structural issue between financial innovation and crisis.” We’ve essentially built a high speed train for which there’s not yet an appropriate track. We’ve created instruments for manipulating financial risk without a thorough understanding of the underlying engineering.

Derivatives are not going away, says Merton. We need regulators who understand these instruments, and perhaps a sovereign wealth fund intended to “maximize the expected return for risk for people of the U.S.” Merton concludes with “something positive” -- a model of how to “weaken the tradeoff between pursuing comparative advantage vs. efficient risk,” applied to the nation of Taiwan.

So there we go. A high-speed train without the appropriate tracks. The question is: what is the appropriate response? There are many merits to the use of derivatives: they are excellent hedges for many producers of real, physical things, they create liquidity and thus improve the price determination in financial markets and ultimately they can serve to reduce the cost of funding to physical producers and to more efficiently allocate capital to where it is needed. There are also obvious risks, primarily because beyond a certain level of complexity you get to a "monkeys with guns" situation where most of the people doing the trading themselves don't properly understand the underlying intuition, mathematics and even philosophy of these valuation models.

So just outlaw the things? What is the best way to treat derivatives going forward?

I just got sent this, and thought it had to be worth a mention here.

http://mitworld.mit.edu/video/659


So there we go. A high-speed train without the appropriate tracks. The question is: what is the appropriate response? There are many merits to the use of derivatives: they are excellent hedges for many producers of real, physical things, they create liquidity and thus improve the price determination in financial markets and ultimately they can serve to reduce the cost of funding to physical producers and to more efficiently allocate capital to where it is needed. There are also obvious risks, primarily because beyond a certain level of complexity you get to a "monkeys with guns" situation where most of the people doing the trading themselves don't properly understand the underlying intuition, mathematics and even philosophy of these valuation models.

So just outlaw the things? What is the best way to treat derivatives going forward?

Not sure if outright outlawing them is needed. However I like the "Monkeys with Guns" analogy because it fits the situation. I say put them on the back burner for now until appropriate systems are set up where it wont collapse the economy. In other words for right now "keep it simple stupid".

I'm not going to pretend that I know in any detail how derivatives work, as I understand it they are a means of spreading risk such that more risky debt it made "safer" by bundling it up with less risky debt. So if I'm vaguely right the following should make some sense.

Well certainly Derivatives need to be better regulated. The Cause of the current crisis was not simply the use of derivatives, but an unrealistic assesment of the long term performance of those things against which debt is secured, Including house prices. While house prices are rising, defaults by "risky" debtors don't matter, the asset still exists and is worth more than the value of the debt. The problem occurs when prices start to fall, now the debt is worth more than the assets, and so banks may stand to lose alot of money if defaults start increasing (which they did).

This then caused a lack of confidence, and banks stopped lending to each other. Problems were also caused by stockmarkets and commodities being significantly over valued.

So were does this leave derivatives... Well obviously having regulators who understand them would be a start, and if they are going to be used, then their use should reflect the fact that markets are cylical, and so banks should not expand risk during bubbles as this leaves huge problems when those bubbles burst.

Perhaps a system which instead reflects better long term trends, and makes provisions for downturns, whilst not overheating during bubbles would be a more stable foundation for market capitalism, clearly though the banks won't do this for themselves (particularly if they feel confident of receiving a bail-out when things go wrong) and so stronger regulations are needed to provide this more stable future.

I suppose what I'm saying is that we shouldn't throw the baby out with the bath water (but there is a lot of bath water to throw out)

And here I thought we were going to have a maths thread . . . :(

So he's saying a CDS isn't a complicated derivative? Sure, but it doesn't matter how simple the insurance on a CDO is if a CDO is too complicated for anyone to correctly price. He's not really addressing the problem, imo. Outlawing CDSs isn't going to do any good if you don't regulate CDOs. I would agree with that. The problem is, it's notoriously difficult to see a derivative making you and everyone else money and say, "hey maybe I don't fully understand what I'm doing here."

I don't know, I guess I just don't fully understand how what Merton is proposing is fundamentally different from what we had before or how it's going to prevent the next crisis. I'll have to watch the full video when I get home.

Integrate the derivatives. ;)

and here i thought we were going to have a maths thread . . . :(

!

:(

I do not think that derivatives should be outlawed. I think that is a ridiculous intrusion into economic freedom. However, I never use derivatives because they are complicated and I do not really understand them. I am a firm believer in only investing in something that I understand.

I have heard secondhand that derivatives are a lot more risky than ordinary investing.

Just give me control of all Us money and you wont have to worry about it anymore.

I saw this on the bumper of a car:

"Don't drink and derive!"

It was for math, but I think it still applies. -_-

The financial crisis could not have been anticipated? I don't think so. Wasn't anticipated? Absolutely.
The financial crisis is too complicated to assign blame? BS. I don't believe that for a second.
I would listen to what Alan Greenspan says about it in a Brookings Institute talk. (http://rapidshare.com/files/224260339/Brookings.mp3.html)


I think his comparison between the complexity of a derivative like a CDO and an investment like sock in a corporation is too flawed to even be reasonable. For one thing, management of a corporation is (theoretically) there to protect the interests of shareholders. The SEC is there to regulate public corporations. People who securitze mortgages and debt have no such obligation and no such regulation. Not to mention that you can look at a corporation, look at it's financial statements, look at it's position, and make some judgment about its value. When you buy a CDO, you have no idea what's in there. Some trader at Lehman told you what was in there, so there's no transparency. That's exactly what made CDOs too complicated to price. And of course, if you can't price a CDO, obviously you can't price a CDS.

It also seems odd to me that he can declare that the liquidity crisis hasn't led to assets being undervalued. He thinks that they're at the appropriate level right now. I have no idea how he can make this assertion. If you look at stocks, first of all, everything's too volatile to make that kind of statement. Second, everyone started selling their stocks because they got scared. They wanted liquidity and they wanted security. They didn't sell their investments because they thought the companies performance was going to go down so drastically. It just happens to be that stocks landed at their right values?


He also quipped about 10 sigma events. He dismissed those criticisms by claiming, oh, the standard deviation was obviously much large than we thought, they're probably more like 2 sigma events. We just have to adjust our models. He never even considers that maybe you can't use a Gaussian model to predict reality. Maybe the models don't work at all. Let's say you're using your black-scholes-merton model to price your derivatives and for a long time you're making money for many years. But all the sudden there's a whole bunch of 10 sigma events in just 6 months. So now you want to correctly model for the so-called 10 sigma events by making sigma much larger. OK, now you're overpricing the risk for all the derivatives for the years in which you were making all that money. I just don't see how it can work.


P.S. bleh, I spent so much time watching this and typing up this post that I missed the Daily Show.

I think his comparison between the complexity of a derivative like a CDO and an investment like sock in a corporation is too flawed to even be reasonable. For one thing, management of a corporation is (theoretically) there to protect the interests of shareholders. The SEC is there to regulate public corporations. People who securitze mortgages and debt have no such obligation and no such regulation. Not to mention that you can look at a corporation, look at it's financial statements, look at it's position, and make some judgment about its value. When you buy a CDO, you have no idea what's in there. Some trader at Lehman told you what was in there, so there's no transparency. That's exactly what made CDOs too complicated to price. And of course, if you can't price a CDO, obviously you can't price a CDS.

I think his point was that conceptually CDOs are no more difficult to value than an equity though. And he's sort of right about that. Theoretically, you are supposed to know what is in them - or at least ultimately that sort of thing should be capable of being found out. So it really should be just a boring exercise to actually figure out what the things are worth.

Though I'd agree that it's not a great comparison, given you have different buyers for each and that a lot of these things were deliberately structured to be opaque. And there is a lot of fraud hidden there too.

I guess he's just trying to point out that there is nothing theoretically wrong with collateralized structures in principle. And in that sense I sort of agree. I just don't believe there would ever be a market for them if they were priced properly.

I thought his discussion about CDS losses was interesting. Though I think he overstates the actual implications. I would have thought in a collateralized situation the losses to the writer would be figured on the value at exercise, so I'm not sure why he made such a deal about the curve in pricing.

I think his point was that conceptually CDOs are no more difficult to value than an equity though. And he's sort of right about that. Theoretically, you are supposed to know what is in them - or at least ultimately that sort of thing should be capable of being found out. So it really should be just a boring exercise to actually figure out what the things are worth.

Though I'd agree that it's not a great comparison, given you have different buyers for each and that a lot of these things were deliberately structured to be opaque. And there is a lot of fraud hidden there too.

I guess he's just trying to point out that there is nothing theoretically wrong with collateralized structures in principle. And in that sense I sort of agree. I just don't believe there would ever be a market for them if they were priced properly. I would agree with that.

I thought his discussion about CDS losses was interesting. Though I think he overstates the actual implications. I would have thought in a collateralized situation the losses to the writer would be figured on the value at exercise, so I'm not sure why he made such a deal about the curve in pricing.

What do you mean?

It seems strange to me that people are allowed to sell debts owed to them in the first place.

It seems strange to me that people are allowed to sell debts owed to them in the first place.

I dont see anything strange about this.

I dont see anything strange about this.If I borrow money from Bank A, my contract is with Bank A. If Bank A sells its debt to Bank B, this wouldn't (in and of itself) change my contract to Bank B.

What is the best way to treat derivatives going forward?

Well, we could take another derivative to see the zeroes in the graph...;)

(urgh, sorry, no good math joke came to me, so I had that bad one. Also was contemplating a Latin pun, but couldn't think of a good one there, either)

What do you mean?

At exercise the P/L for a put is on a straight line, because there is no volatility. If you are the writer you take the loss at exercise not before, so the whole discussion about where you are on the curve doesn't make sense to me, because to the party bearing the loss it should be a straight line.

If I borrow money from Bank A, my contract is with Bank A. If Bank A sells its debt to Bank B, this wouldn't (in and of itself) change my contract to Bank B.

I think you'll find that most loan contracts where this happens have language in them saying they can do that.

Even then, unless there was wording explicitly preventing it, what would be the problem? As long as paying bank B was no different to paying bank A (more or less) there shouldn't be any problem in bank A assigning the interest.

I think you'll find that most loan contracts where this happens have language in them saying they can do that.I suppose they'd have to, but I'm unsure.

Even then, unless there was wording explicitly preventing it, what would be the problem? As long as paying bank B was no different to paying bank A (more or less) there shouldn't be any problem in bank A assigning the interest.I didn't contract with Bank B. Perhaps I did this because I disagree with Bank B's business practices.

I didn't contract with Bank B. Perhaps I did this because I disagree with Bank B's business practices.

Well then, you can pay off the loan.

I can see your point that you went to A specifically to avoid B, and so the transfer is injurious. But I don't think it would be recognized that way by a court.

Loans have to be salable because otherwise the banking system wouldn't work. What happens, for example, if a bank goes out of business; the loan has to go somewhere.

Well then, you can pay off the loan.

I can see your point that you went to A specifically to avoid B, and so the transfer is injurious. But I don't think it would be recognized that way by a court.

Loans have to be salable because otherwise the banking system wouldn't work. What happens, for example, if a bank goes out of business; the loan has to go somewhere.Why does the loan have to go somewhere?

Why does the loan have to go somewhere?

Because banks don't go out of business because they decide banking is boring and they want to convert to being a taco shop. They go out of business when the value of their assets (yours and others loans/mortgages) becomes less valuable than their liabilities (money lent to them, deposits, etc.) and they can't dig themselves out of the hole. So when a bank goes out of business and files for bankruptcy, the assets get sold off and the money from the sale gets distributed to the banks debtors. I mean, do you expect them to just let you have a free house because they're a shitty bank?

I just got sent this, and thought it had to be worth a mention here.

http://mitworld.mit.edu/video/659


So there we go. A high-speed train without the appropriate tracks. The question is: what is the appropriate response? There are many merits to the use of derivatives: they are excellent hedges for many producers of real, physical things, they create liquidity and thus improve the price determination in financial markets and ultimately they can serve to reduce the cost of funding to physical producers and to more efficiently allocate capital to where it is needed. There are also obvious risks, primarily because beyond a certain level of complexity you get to a "monkeys with guns" situation where most of the people doing the trading themselves don't properly understand the underlying intuition, mathematics and even philosophy of these valuation models.

So just outlaw the things? What is the best way to treat derivatives going forward?

Awww. I thought this was about mathematical derivatives. :(

Because banks don't go out of business because they decide banking is boring and they want to convert to being a taco shop. They go out of business when the value of their assets (yours and others loans/mortgages) becomes less valuable than their liabilities (money lent to them, deposits, etc.) and they can't dig themselves out of the hole. So when a bank goes out of business and files for bankruptcy, the assets get sold off and the money from the sale gets distributed to the banks debtors. I mean, do you expect them to just let you have a free house because they're a shitty bank?Yes.
The entity I borrowed money from to no longer exists.

Yes.
The entity I borrowed money from to no longer exists.

Uhuh. But the money they were lending wasn't theirs. They got it by borrowing from others. Those others still exist. And so you have to keep paying so they can get paid back, even though the intermediary ceased to exist.

So that's what happens when a bank gets wound up. The assets (like your loan) and the liabilities (the money the bank borrowed) get transferred to another institution.

There's really nothing unfair about it.

And all these banks are sort of interrelated anyway. So if you chose one bank over the other because you had a moral objection to their behavior and don't want to give them money, then you had pretty well just not go to a bank and look for a hard money lender instead. (Where presumably you can insist upon a deal that would extinguish your loan in the event it ceased to exist).

Yes.
The entity I borrowed money from to no longer exists.
that's like saying that cause the mate you borrowed money has died, you're under no obligation to repay that debt to his widow.

Uhuh. But the money they were lending wasn't theirs. They got it by borrowing from others. Those others still exist. And so you have to keep paying so they can get paid back, even though the intermediary ceased to exist. Why? The entity that they lent money to no longer exists. Their money is (or should be) gone.

So that's what happens when a bank gets wound up. The assets (like your loan) and the liabilities (the money the bank borrowed) get transferred to another institution.

There's really nothing unfair about it. I understand this is how the financial system works, but it seems strange to me that it is so.

that's like saying that cause the mate you borrowed money has died, you're under no obligation to repay that debt to his widow.Sort of. It's possible that the money he lent me was both of theirs, in which case she still exists as a lender and therefore a claimant.
But if the money wasn't hers, I shouldn't be obligated to pay her back (though I probably would).

Yes.
The entity I borrowed money from to no longer exists.

Well, then demand a mortgage that can't be sold to another institution. Good luck finding a bank willing to write that mortgage.

I can sit here and demand jalapeno flavored fritos because I think they would be delicious. That doesn't mean the frito company is under any obligation to offer me jalapeno flavored fritos.

Why? The entity that they lent money to no longer exists. Their money is (or should be) gone.


The assets haven't ceased to exist though. They are still there. Their loan to the bank (in whatever form it took) was made contingent upon having a claim to whatever remained in the wound up bank's estate.

It wouldn't really work otherwise. You'd end up with no intermediaries, so banking and all sorts of other things would cease to exist.

Why? The entity that they lent money to no longer exists. Their money is (or should be) gone.
It would be much easier if you looked at banks the way (theoretical) economists do: as legal structures housing coalitions of lenders who try and optimise liquidity and returns with their savings. Just like the word says: Intermediaries.

They're just conduits, and if the conduit happens to break, the people whose money it ultimately is (like me, putting money in a savings account) are justified in pursuing whatever means we have to not only get the money back, but hopefully even continue the lending relationship using some other conduit.

Well, then demand a mortgage that can't be sold to another institution. Good luck finding a bank willing to write that mortgage.Or, alternatively, demand that the law be changed to say that the mortgage can't be sold to another institution.

The assets haven't ceased to exist though. They are still there. Their loan to the bank (in whatever form it took) was made contingent upon having a claim to whatever remained in the wound up bank's estate.

It wouldn't really work otherwise. You'd end up with no intermediaries, so banking and all sorts of other things would cease to exist.Why would it be contigent upon that claim? I mean, why couldn't the loan be made purely for the potential interest to be made?

It would be much easier if you looked at banks the way (theoretical) economists do: as legal structures housing coalitions of lenders who try and optimise liquidity and returns with their savings. Just like the word says: Intermediaries.

They're just conduits, and if the conduit happens to break, the people whose money it ultimately is (like me, putting money in a savings account) are justified in pursuing whatever means we have to not only get the money back, but hopefully even continue the lending relationship using some other conduit.I don't agree that they are justified in doing so. I would say that that is the risk of lending somebody money - that they might be unable to pay you back.
(I would also say that this was the purpose of FDIC insurance, to pay back people's deposits in the event of a bank failure. In this case, they would not be getting their deposits back from the bank, but from the insurance company.)

Why would it be contigent upon that claim? I mean, why couldn't the loan be made purely for the potential interest to be made?


It could be. But it would make lending money to the bank so unreasonably risky that the interest rate the bank would have to pay would be enormous. And so, the amount of interest charged on any loan made by the bank would be even greater. You'd also lose all the really risk averse capital because money would go into the mattress. There would therefore be a huge shortage of credit, and the standard of living would plummet. I mean, the nightmare caused in food production alone would be epic. Consider the amount of a monthly household budget that is spent on food in places where there is no fully developed system and farmers don't have easy access to credit. (Modern farming being extremely capital intensive).

Also, if a bank elected to do this, it would be quickly driven out of business by banks that don't (because everyone would use the banks that don't). So you'd have to pass a law making it so.

I think the bottom line is that when someone signs a promissory note - or similar - they are undertaking to pay back the loan, not pay back a person or entity.

It's not unreasonable to require that certain obligations survive the entity that makes them. Pensions for employees for example.

(I would also say that this was the purpose of FDIC insurance, to pay back people's deposits in the event of a bank failure. In this case, they would not be getting their deposits back from the bank, but from the insurance company.)

The FDIC, which really isn't insurance, operates under the assumption that assets and liabilities of wound up institutions and institutions in receivership can be used to offset one another before a single penny of the trust fund is used. Under you system the FDIC wouldn't be able to function.

Edit: Yeah, and under your proposed system, forget 99% of the population ever getting a mortgage. There's be such a shortage of credit it would only go to the most excellent debtors. AA corporations and extremely well collateralized individuals. Also, the potential for fraud would be epic. It's just inviting bad behavior. For example, if enough of the banks debtors got together and decided to default it would basically wipe out the bank discharging their liability, so it basically rewards bad behavior - taking loans that were never intended to be repaid.

If I borrow money from Bank A, my contract is with Bank A. If Bank A sells its debt to Bank B, this wouldn't (in and of itself) change my contract to Bank B.

I think you'll find that most loan contracts where this happens have language in them saying they can do that.

Even then, unless there was wording explicitly preventing it, what would be the problem? As long as paying bank B was no different to paying bank A (more or less) there shouldn't be any problem in bank A assigning the interest.

I suppose they'd have to, but I'm unsure.

I didn't contract with Bank B. Perhaps I did this because I disagree with Bank B's business practices.

Well then, you can pay off the loan.

I can see your point that you went to A specifically to avoid B, and so the transfer is injurious. But I don't think it would be recognized that way by a court.

Loans have to be salable because otherwise the banking system wouldn't work. What happens, for example, if a bank goes out of business; the loan has to go somewhere.

Why does the loan have to go somewhere?

Yes.
The entity I borrowed money from to no longer exists.

Why? The entity that they lent money to no longer exists. Their money is (or should be) gone.

I understand this is how the financial system works, but it seems strange to me that it is so.

Sort of. It's possible that the money he lent me was both of theirs, in which case she still exists as a lender and therefore a claimant.
But if the money wasn't hers, I shouldn't be obligated to pay her back (though I probably would).

Or, alternatively, demand that the law be changed to say that the mortgage can't be sold to another institution.

Why would it be contigent upon that claim? I mean, why couldn't the loan be made purely for the potential interest to be made?

I don't agree that they are justified in doing so. I would say that that is the risk of lending somebody money - that they might be unable to pay you back.
(I would also say that this was the purpose of FDIC insurance, to pay back people's deposits in the event of a bank failure. In this case, they would not be getting their deposits back from the bank, but from the insurance company.)

Jello Biafra, I really do not see what your problem is with the assignment of a debt from one bank to another. First, I am 99.9999% sure that when you contracted with Bank A, one of the provisions of your contract permitted the assignment of loans to third parties.

The government hopefully creates laws to deal with some sort of evil. I have no clue what the evil is that you are concerned with. First, you consented to the assignment of your loan to third parties. Second, there is really no problem with assets such as accounts receivable having a high degree of liquidity. Assets are not typically made worse by being more liquid.

You seem to apply that FDIC insurance is somehow free. It is not. My bank went from having premiums of about $30,000 per year to like $600,000 last year! The thing of it is is that my bank pays has such a good financial situation that it has the lowest premiums and it is still wacked hard by the premiums. Anything we can do to keep FDIC insurance low is going to help the banking industry.

Sorry, I hope this is not trolling or flaming or whatever it is called but it sounds like you want to weasel out of your loan commitments.

Or, alternatively, demand that the law be changed to say that the mortgage can't be sold to another institution.
Ok, now we're getting to the real meat of the issue. There's nothing inherently wrong with selling a mortgage from one institution to another. The small community banks are doing just fine for themselves, it's the big financial institutions that are really screwed right now. They're doing fine because, surprise, they were being regulated. They looked at peoples credit history and income to determine whether or not they were good for a loan.

The problems are coming from the institutions which weren't regulated. They made loans to people who couldn't pay them back, then they sold them off to big financial institutions. So there are two problems there, the people who hold the mortgages can't pay them back, and the people buying up those mortgages don't know how likely they are to default and they have no idea what's inside of those CDOs.

So why did they make the loans? Because their intention the whole time was to close the deal and sell it off as quick as possible. Maybe we just need to regulate the institutions who make those loans and force them to retain at least some of the risk of default.

I think the bottom line is that when someone signs a promissory note - or similar - they are undertaking to pay back the loan, not pay back a person or entity.

It's not unreasonable to require that certain obligations survive the entity that makes them. Pensions for employees for example.I suppose it should depend on what the entity is, and the conditions of the deal that's being made.

(I cut out the rest about the banking system itself, not because it isn't relevant, but because my response to it would begin a whole new argument which isn't the point of the thread.)

Jello Biafra, I really do not see what your problem is with the assignment of a debt from one bank to another. First, I am 99.9999% sure that when you contracted with Bank A, one of the provisions of your contract permitted the assignment of loans to third parties.I'm not talking about a specific loan I've taken out. I have no idea what would be in a loan contract. I would assume that such a contract would have to, but the selling of loans to third parties is legal, so I'm unsure if the legality of it is contingent upon the existence of a clause in the loan contract. If there is no such clause, then I would not have consented to such a thing.

So why did they make the loans? Because their intention the whole time was to close the deal and sell it off as quick as possible. Maybe we just need to regulate the institutions who make those loans and force them to retain at least some of the risk of default.Yes, that is part of the problem with the idea of selling loans off - that it reduces the risk of default and allows more bad loans to be made.

OK, but that still has nothing to do with, "If the bank goes out of business, I should get a free house."


btw, I'm about to start reading Financial Shock by Mark Zandi, fun stuff.

I do not think that derivatives should be outlawed. I think that is a ridiculous intrusion into economic freedom. However, I never use derivatives because they are complicated and I do not really understand them. I am a firm believer in only investing in something that I understand.

I have heard secondhand that derivatives are a lot more risky than ordinary investing.

Derivatives derive their value from an underlying security and often are used to reduce risk. Or transfer risk to someone else. They should not be outlawed. Regulations should be in place on their use, such as capital requirements.

Anything that is a pain in math should not be in finance

I don't agree that they are justified in doing so. I would say that that is the risk of lending somebody money - that they might be unable to pay you back.
Yeah, but I'm saying it would help you if you stopped thinking about the bank as an entity that is separate from those who fund it. If you drop the distinction, you see that since you are still able to pay back that money, default risk should not be an issue for your lenders. It's merely a reorganisation of their internal structure, really of no concern to you.

I'm not talking about a specific loan I've taken out. I have no idea what would be in a loan contract. I would assume that such a contract would have to, but the selling of loans to third parties is legal, so I'm unsure if the legality of it is contingent upon the existence of a clause in the loan contract. If there is no such clause, then I would not have consented to such a thing.


This is an interesting point. Assignment of interests is usually covered in most contracts. I bet that the question of a default policy for contracts that are silent on assignment rights could go either way. I sort of like the idea of a default position of alienability to encourage the liquidity of assets but some good points have been raised on limiting assignment in order to keep the original lender on the hook in case they lended money in a stupid manner.

OK, but that still has nothing to do with, "If the bank goes out of business, I should get a free house."How else would you ensure the bank assumed all of the risk of the loan unless they risk losing the money they lend?

Yeah, but I'm saying it would help you if you stopped thinking about the bank as an entity that is separate from those who fund it. If you drop the distinction, you see that since you are still able to pay back that money, default risk should not be an issue for your lenders. It's merely a reorganisation of their internal structure, really of no concern to you.So you're saying that instead of having separate banks, we really have one gigantic one?

This is an interesting point. Assignment of interests is usually covered in most contracts. I bet that the question of a default policy for contracts that are silent on assignment rights could go either way. I sort of like the idea of a default position of alienability to encourage the liquidity of assets but some good points have been raised on limiting assignment in order to keep the original lender on the hook in case they lended money in a stupid manner.And what would be the consequences to the original lender who is still on the hook?

How else would you ensure the bank assumed all of the risk of the loan unless they risk losing the money they lend? There are pretty much 2 things you can do. Force them to retain some of the risk of default whenever they securitize a loan, and regulate who they make loans to. If you actually make sure the person you're lending to can actually pay the loan back beforehand, then there is nothing wrong with that mortgage. It doesn't matter whether you keep it or sell it off, as long as the mortgage itself is good. Like I said, the community banks, who are regulated, are doing fine right now. It's the institutions who bought mortgages from the unregulated brokers who are in trouble. Surprisingly, regulation actually does work.

Think of it this way. You're thinking about lending money to a bank. If that bank goes out of business, you have zero chance of getting any of your money back because they aren't allowed to sell off their assets during bankruptcy as you propose. That means that it's a much more dangerous investment than lending money to any other business. So there are fewer lenders to banks, and those who do charge a much higher interest rate. The bank, in turn, charges you a much higher interest rate on your loan and now only the super rich can even afford to buy a house because credit is so expensive. Welcome to Argentina.

So you're saying that instead of having separate banks, we really have one gigantic one?That's not what he's saying. It's like a retail clothes store. They buy their clothes from China for cheap, then sell it to you for a higher price to make a profit. They didn't actually DO anything to the clothes, they are just conduits, middlemen, they move stuff around so the manufacturer in China doesn't have to worry about it. Banks (coincidentally, also using funds from China) take money from investors and debtors in exchange for an agreed upon interest rate, and they sell you a mortgage. They're just selling you money for an agreed upon interest rate which is higher than the one their debtors charged them. They didn't do anything to the money, they just moved it around.

And what would be the consequences to the original lender who is still on the hook?[/QUOTE]
What do you mean the original lender?

There are pretty much 2 things you can do. Force them to retain some of the risk of default whenever they securitize a loan, and regulate who they make loans to. If you actually make sure the person you're lending to can actually pay the loan back beforehand, then there is nothing wrong with that mortgage. It doesn't matter whether you keep it or sell it off, as long as the mortgage itself is good. Like I said, the community banks, who are regulated, are doing fine right now. It's the institutions who bought mortgages from the unregulated brokers who are in trouble. Surprisingly, regulation actually does work.So, hypothetically speaking, if there was a bank that made a bunch of bad loans to people who can't or aren't paying them back (but only one, so not like the current situation), what should happen to that bank?

That's not what he's saying. It's like a retail clothes store. They buy their clothes from China for cheap, then sell it to you for a higher price to make a profit. They didn't actually DO anything to the clothes, they are just conduits, middlemen, they move stuff around so the manufacturer in China doesn't have to worry about it. Banks (coincidentally, also using funds from China) take money from investors and debtors in exchange for an agreed upon interest rate, and they sell you a mortgage. They're just selling you money for an agreed upon interest rate which is higher than the one their debtors charged them. They didn't do anything to the money, they just moved it around.I get the purpose of a conduit, but it seemed as though Neu Leonstein was saying something to the effect of there was no distinction between the people who invest in the store and the store itself.

However, using this analogy, let's say that you ordered 10,000 shirts from the store, and agreed to a payment plan with the store to pay off the shirts. The store then, for whatever reason, sold your payment plan to someone else, and is now saying you have to pay that someone else. That would be the same thing as banks selling debts to one another.

What do you mean the original lender?In this case, it would be the bank who made a risky loan to somebody, then sold that loan to another bank (or some other financial firm).

So, hypothetically speaking, if there was a bank that made a bunch of bad loans to people who can't or aren't paying them back (but only one, so not like the current situation), what should happen to that bank?A community bank? They would take a loss. If enough people default, they would become insolvent and the FDIC would come in and sell off all the assets (the mortgages) to other banks. If there were enough money from the sales, they would pay back the depositors and then the debtors of the bank. If there were not enough money, the FDIC would guarantee the depositors up to $100,000 each.

What would happen to an unregulated mortgage broker? Nothing, they would go swimming in their piles of money because they didn't retain any of the risk. 80% of subprime mortgages came from these guys, that's why we have a problem right now.

I get the purpose of a conduit, but it seemed as though Neu Leonstein was saying something to the effect of there was no distinction between the people who invest in the store and the store itself.Well there isn't really. If I buy a share of stock in Wal-Mart, I literally own a piece of Wal-Mart. My future wealth is entirely dependent on the success of Wal-Mart and I (theoretically) have some say in how the company is run.

However, using this analogy, let's say that you ordered 10,000 shirts from the store, and agreed to a payment plan with the store to pay off the shirts. The store then, for whatever reason, sold your payment plan to someone else, and is now saying you have to pay that someone else. That would be the same thing as banks selling debts to one another.Correct, that's effectively what happens whenever you use a credit card.

So you're saying that instead of having separate banks, we really have one gigantic one?
Well, if you look at the early theoretical papers outlining why a banking system exists in the first place, ie where it fits into GE theory and the like, the distinctions between banks aren't really important, because there exists an interbank market for funds which distributes savings and money for investments efficiently.

And that's similar to real life (well, without the "efficiently" part, anyways...that's where my thesis comes in). You're giving your money to a bank for a savings account, but really that money just goes into a giant pool of Fed Funds and is freely exchanged throughout the system. Your counterparty is really the FDIC-insured banking system as a whole. And ultimately it's the same with your loans. People aren't really fussed about their deposits being lent to other banks overnight or over longer maturities as part of everyday business, and they're not too upset if the FDIC organises those deposits to be transferred to another bank should yours croak. Loans are just reverse deposits, so I don't see the difference conceptually or otherwise.

However, using this analogy, let's say that you ordered 10,000 shirts from the store, and agreed to a payment plan with the store to pay off the shirts. The store then, for whatever reason, sold your payment plan to someone else, and is now saying you have to pay that someone else. That would be the same thing as banks selling debts to one another.


Yes it would. And it happens all the time. Receivables are used as collateral in order to roll commercial paper. Which lets them pay their staff, so commerce can be conducted.

Hell, back before america was even america, notes could be discounted and used in trade. It's how commerce works.

I suspect you actually know all this and are trying to prove some point about how being a hunter gatherer would be better. And maybe it would. The sticking point in this, however, is the vast majority disagrees with your optimal lifestyle choice.

I suspect you actually know all this and are trying to prove some point about how being a hunter gatherer would be better. And maybe it would. The sticking point in this, however, is the vast majority disagrees with your optimal lifestyle choice.

I read some Henry David Thoreau, and it was boring as hell.

A community bank? They would take a loss. If enough people default, they would become insolvent and the FDIC would come in and sell off all the assets (the mortgages) to other banks. If there were enough money from the sales, they would pay back the depositors and then the debtors of the bank. If there were not enough money, the FDIC would guarantee the depositors up to $100,000 each.Oh, so nothing different than how the system works now (in theory).

Well there isn't really. If I buy a share of stock in Wal-Mart, I literally own a piece of Wal-Mart. My future wealth is entirely dependent on the success of Wal-Mart and I (theoretically) have some say in how the company is run.Sure, but you and the Wal-Mart would be separate entities. If Wal-Mart breaks the law and is fined, it's not the same thing as fining you personally.

Correct, that's effectively what happens whenever you use a credit card.I thought the idea was that I contracted with the credit card company for them to pay the store and then I paid the credit card. Not the store contracting with someone else.

Well, if you look at the early theoretical papers outlining why a banking system exists in the first place, ie where it fits into GE theory and the like, the distinctions between banks aren't really important, because there exists an interbank market for funds which distributes savings and money for investments efficiently.

And that's similar to real life (well, without the "efficiently" part, anyways...that's where my thesis comes in). You're giving your money to a bank for a savings account, but really that money just goes into a giant pool of Fed Funds and is freely exchanged throughout the system. Your counterparty is really the FDIC-insured banking system as a whole. And ultimately it's the same with your loans. People aren't really fussed about their deposits being lent to other banks overnight or over longer maturities as part of everyday business, and they're not too upset if the FDIC organises those deposits to be transferred to another bank should yours croak. Loans are just reverse deposits, so I don't see the difference conceptually or otherwise.I do. The reason a person would deposit money into a bank is for the interest, and they know that in order to get the interest, the bank has to lend money to people.
The reason people take loans is not so the bank can sell that loan to another bank.

Yes it would. And it happens all the time. Receivables are used as collateral in order to roll commercial paper. Which lets them pay their staff, so commerce can be conducted.

Hell, back before america was even america, notes could be discounted and used in trade. It's how commerce works.That's appalling.

I suspect you actually know all this and are trying to prove some point about how being a hunter gatherer would be better. And maybe it would. The sticking point in this, however, is the vast majority disagrees with your optimal lifestyle choice.No, I didn't know any of that.
Nonetheless, there's a massive number of alternatives between the current system and the hunter-gatherer system.

Oh, so nothing different than how the system works now (in theory).What's wrong with the FDIC system we have in place now? I think it works pretty well in times of crisis.
2:00 http://www.youtube.com/watch?v=-xKPcyvlfnc

Sure, but you and the Wal-Mart would be separate entities. If Wal-Mart breaks the law and is fined, it's not the same thing as fining you personally.Actually, it kind of is. True, I have no criminal liability as a shareholder, but the value of my stock goes down when the company loses money, therefore I lose money. Let's say it was discovered that Wal-Mart was polluting the environment, the executives who Okayed the practice won't get fined, the company will and my stock will suffer.

I thought the idea was that I contracted with the credit card company for them to pay the store and then I paid the credit card. Not the store contracting with someone else.Yeah, but the end result is the same. The credit card company assumes the risk of default and the responsibility of collecting the debt. This allows the store to sell stuff to people on credit without worrying about every single transaction.

I do. The reason a person would deposit money into a bank is for the interest, and they know that in order to get the interest, the bank has to lend money to people.
The reason people take loans is not so the bank can sell that loan to another bank.

That's appalling.

No, I didn't know any of that.
Nonetheless, there's a massive number of alternatives between the current system and the hunter-gatherer system.

Welcome to Argentina. There are clearly problems with our credit system and our financial system in this country, and regulation needs to change. But really, what you're asking for is to shut down pretty much everything. I don't think that's the right solution.

And here I thought we were going to have a maths thread . . . :(
So did I. In fact, I think I'm going to pretend it is, as I'm more familiar with math(s) than finance.

Solving the derivative problem is simple: just integrate them and you should get the original function. I grant you, it is trickier than it sounds, especially with partial derivatives, but in theory at least, not complicated.

What's wrong with the FDIC system we have in place now? I think it works pretty well in times of crisis.The consideration of money owed as an asset that can be sold.

Actually, it kind of is. True, I have no criminal liability as a shareholder, but the value of my stock goes down when the company loses money, therefore I lose money. Let's say it was discovered that Wal-Mart was polluting the environment, the executives who Okayed the practice won't get fined, the company will and my stock will suffer.Right, which means that while there is a relationship between you, the executives, and the company, they aren't the same thing.

Yeah, but the end result is the same. The credit card company assumes the risk of default and the responsibility of collecting the debt. This allows the store to sell stuff to people on credit without worrying about every single transaction.True, but the process of achieving this end result is different.

Welcome to Argentina. There are clearly problems with our credit system and our financial system in this country, and regulation needs to change. But really, what you're asking for is to shut down pretty much everything. I don't think that's the right solution.Heh. Well, there are plenty of good reasons to shut the banking system down other than this, but they are outside of the scope of this thread.

And what would be the consequences to the original lender who is still on the hook?

The consequences are that the original lender would still be subject to the ordinary lenders' risks at least in proportion to the amount of the debt that it still retains.