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fransgeraedts (99.92)

Financial Disarmament

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August 12, 2010 – Comments (2) | RELATED TICKERS: SKF , FAZ , FAS

Should we not simply prohibit the use of the more complex derivatives?Should we not simply prohibit trading techniques like HFT? Should we not simply prohibit every institution that manages other peoples money to trade on the financial markets for its own account? Should we not simply prohibit the use of commodity futures except for producers and users? Should we not simply prohibit the trading of any financial instrument outside regulated markets? Should we not simply prohibit banks do do any transaction or hold any instrument "of the books"? 

This train of thought started when i began to read about the causes of the flash crash. (Do read those analyses for your self  ..they are illuminating.) But around that irritant other older worries ruminations and thoughts coalesced. Warren Buffet calling complex derivatives weapons of mass financial destruction. George Soros insistment that trading should always be on a regulated exchange -but no longer was. Roubinhi bringing to our attention the enormous amount of capital moving through the shadowbanking system. The way GS with (almost total) impunity betted against its own clients. Investment professionals openly declaring that they did not understand the instruments they bought or sold . The financial crisis revealing that the risk assumptions underlying many instruments were completely wrong. The total failure of the ratingsystem.

Let me add three observations. (1)Humanity always innovates blindly: we cannot know the unintended consequences. Therefore we always have to master the forces we called after the fact.(2) The last twenty years have seen a much higher speed of financial innovation then usual. (3) The idea that markets selfregulate has led to a hesitation to use the power of the state to prohibite.

Could it be that underlying quiet a few of the innovations is an idea about riskmanagement that is fundamentally flawed? In shorthand: the instruments in question spread risk. The idea is that spreading risk means lowering the risk. That is false. Spreading risk means exactly what it says. The total amount of risk stays the same.  But if we add behavorial aspects to it could it not be that spreading the risk even means that the total risk rises? Because if the risk is spread over more agencies the tendency for all individual agencies could be to take on more risk? And the agregate would thus rise? The illusion that spreading risk lowers risk strengthens that  tendency. Just as the possibility for originators to defer the risk further down the chain does.

I believe it is time for a resolute pruning of the financial system, its instruments, its tradingpractices, its strategies. A pruning along the lines of the rethorical questions i started this post with.

I believe that the first question we should ask is wether an instrument or trading practice contributes significantly to the efficient allocating of capital. If it does not we should get rid of it. The second is wether it heightens in practice the systemic risks siginificantly. If it does we should get rid of it. I believe many of our recent innovations do not contribute to an efficient allocation and in practice raise risklevels in the financials system.

If Buffet's metaphore is fitting, they are like wmfd's, should we not urgently begin disarmament talks?

I imagine that a very large consensus could be constructed around such actions. Democrats and republicans, keynesian and classical economists, even libertarians?, working class americans, middle class americans, businesses and entrepeneurs, institutional investors with a conservative outlook, the (large) part of wall street  that caters to individual investors. Buffet Soros and others demonstrate that there are even among the class of professional large scale investors and speculators those that would prefer to create practices that are more fair and more efficient. 

Caps could be one of the grass roots of such a movement for "financial disarmament". A first step would be to create a list of instruments and practices we should get rid of. Suggestions anyone? 

fransgeraedts

  

 

2 Comments – Post Your Own

#1) On August 12, 2010 at 1:42 PM, binve (< 20) wrote:

Hey fransgeraedts!

Excellent post!  I am in agreement. I wrote this post that had very many similar observations (risk, dervatives, crises, etc.): Of Modeling, Risk, Financial Innovation, and Liquidity Crises - http://caps.fool.com/Blogs/of-modeling-risk-financial/344745.

Regarding what to get rid of? The very first thing on my list would be Credit Default Swaps with no exposure to the underlying debt: http://caps.fool.com/Blogs/psw-the-fed-cds-development/340700

It is most important to understand that most of the "financial innovation" in these instruments is fradulent to begin with!! This post goes through a step-by-step reasoning as to why: http://caps.fool.com/Blogs/financial-carcinoma-/322718

Thanks!..

 

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#2) On August 12, 2010 at 7:25 PM, guiron (20.22) wrote:

S&L banks should not be engaged in any off the books activity or off-exchange derivatives. Hedging might be OK but only up to certain risk levels.

Consumer housing loans should not be securitized AT ALL. The loan should be held on the books by the originator until paid off or written off, so that the risk is clearly understood by both parties. Commercial loans might have different restrictions, but the housing market should not be leveraged and obfuscated to the level it was - causes way too much damage when it turns down, and nobody can tell who owns a loan after the bank sold it, making short-sales and refinancing difficult or impossible in many cases. Nobody wants to write off defaulted loans when it's part of a security - they just let it fester with the other bad loans until the hole gets too big and it collapses. Who cares? Not the bank - not their problem anymore. No, it's just the rest of us who get stuck with the problem of an oversold, overleveraged housing market in a bubble that burst, when we all just want a place to live.

Could it be that underlying quiet a few of the innovations is an idea about riskmanagement that is fundamentally flawed? In shorthand: the instruments in question spread risk. The idea is that spreading risk means lowering the risk. That is false. Spreading risk means exactly what it says. The total amount of risk stays the same.  But if we add behavorial aspects to it could it not be that spreading the risk even means that the total risk rises?

Yes, people are often not rational actors, and when risk is spread through securitization, it makes sense mathematically, but psychologically it's different. There is no originator involved anymore, and the risk of each loan is difficult to distinguish, if possible at all. There is no need to see the loan through with a refi when things go south, because it's all about how the risk is managed, as purely an aggregate balance sheet and not individual parties. There is no one party to negotiate the terms anymore, because the loan has been sliced up into smaller pieces of risk. It makes what should be a simple financial arrangement into something incredibly complex, to the point where even proving the housing market was in trouble in 2006 took a lot of digging - try figuring out what a loan is worth after it's been securitized.

Investment banks should not be engaged in any off the books activity or off-exchange derivatives. Hedging is OK up to a higher risk level than a S&L bank but still must maintain adequate risk levels as well as capital.S&L banks should be separated from investment banks.

In other words, no financial institution should be engaged in off the books activity or off-exchange derivatives, and banking and loans should be a separate activity than investing, in separate businesses. We did it that way for a long time, because we've been through this before. Every time, given enough time, people forget and start to let those old regulations go. And every time, this is what happens.

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