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Financial Carcinoma -- Denninger: Did You Need a PhD For That?

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January 06, 2010 – Comments (1)

Like I have said most recently here (Financially My Dear I Don't Give a XLF), I am very bearish on finanicals, calling them the cancer of the economy

I am very vocally bearish on financials for the long term. I think they are the cancer of the US economy. Monetary policy over the last 20 years have allowed for, encouraged in fact, the economy to become financially top heavy. I could go on a rant (and have many times in the past regarding financials) but I will not. I am very long term bearish, and I will leave it at that for the moment.

But just to clarify my stance, I am not bearish just for a sake of being a bear. I do not want to be down on the economy. I mostly an optimistic guy and would rather be positive on the economic outlook.

Financials are not, at their core, bad businesses. They do perform a very vital role of facilitating the dispersion of resources. It it not productive, so there is a loss of efficiency, but there is an overall economic good that comes out of it.

But today, financials comprise a disproportionate size of the economy to the amount of economic usefulness they perform. This non-productive garbage has to be cleaned out, just like cancer. This is precisely why I call financials the cancer of the economy. They are a huge drain that transfers the economy's money (the wealth of the productive part of society), largely between each other, collecting fees for their "work".

Karl Denninger wrote a post that perfectly captures this charade and points at the most malignant form of financial activity

Karl Denninger - Did You Need a PhD For That?

[excerpt]

Again, back to basic laws of business balance:

   1.      Nobody works for free.  Ever.

   2.      The risk-adjusted return available on any lending transaction is a fact and not subject to "massage."  While default on any single loan is binary (it either does or doesn't) default on a sufficiently-large and diverse group of loans with a known set of characteristics is a statistical function.

   3.      Each person who touches such a transaction or group of transactions, therefore, must inevitably reduce the total amount of return below the risk-adjusted amount, and the more people who touch it - that is, the more complex it is - the more the total return must inevitably be BELOW the risk-adjusted amount.

   4.      The less transparency in a given set of transactions the more "spread" or "vig" those who process the transaction are able to retain for themselves through the obstruction of price discovery.

This leads to axiom #1:

    IN EACH AND EVERY CASE OF FINANCIAL INNOVATION THE RETURN PAID TO INVESTORS MUST ALWAYS BE LESS THAN THE RISK-ADJUSTED RETURN.  THAT IS THE MORE COMPLEX THE INSTRUMENT THE WORSE INVESTORS GET SCREWED.

We then add to the first axoim the following:

   1. For each alleged means of "hedging risk" the person offering the hedge must also get paid.

   2. The parallel with fire insurance is clear: If you own one house you buy fire insurance because you cannot afford the damage a fire may cause, even though a fire is improbable.  But if you own 100,000 houses spread across the entire nation you're an idiot to buy fire insurance since the insurance company must either charge you more than the actual loss expected across those 100,000 houses or they will be unable to pay when the fires occur.

   3. As a direct consequence of (1) and (2) it is not possible to buy both a security and insurance against it defaulting and have the total blended return be greater than a risk-free security.  Either (1) the return will be lower or (2) the seller of the insurance will not be able to pay.

This leads to axiom #2:

    ANY REPRESENTATION THAT ONE CAN CONSTRUCT A SYNTHETIC "RISK FREE" DEBT INSTRUMENT BY PURCHASING BOTH A RISKIER INSTRUMENT AND INSURANCE AGAINST IT DEFAULTING THAT WILL RETURN MORE THAN THE RISK-FREE INSTRUMENT IS FRAUDULENT.  EITHER THE SELLER OF THE INSURANCE WILL BE UNABLE TO PAY OR THE RETURN WILL BE LESS THAN IF YOU HAD SIMPLY BOUGHT THE RISK-FREE INSTRUMENT.

This is the essence of "financial innovation" folks: IT IS A SCAM.


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1 Comments – Post Your Own

#1) On January 06, 2010 at 11:51 PM, Option1307 (29.92) wrote:

ANY REPRESENTATION THAT ONE CAN CONSTRUCT A SYNTHETIC "RISK FREE" DEBT INSTRUMENT BY PURCHASING BOTH A RISKIER INSTRUMENT AND INSURANCE AGAINST IT DEFAULTING THAT WILL RETURN MORE THAN THE RISK-FREE INSTRUMENT IS FRAUDULENT. 

Well now you tell me!

Ha jk, but it seems so simply and straight forward when it's broken down like that. I agree, financials are the plague of the 21st century...

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