Editorializing From The Financial Capital Of The World

Although headquartered in the financial capital of the world, the NY Times editors apparently do not believe they need to understand the first thing about finance.  Here they go again, bleating about the civil suit against Goldman Sachs and comparing derivatives to casino gambling:

What all those proposals don’t address is whether the type of derivative Goldman was selling should even be allowed to exist. The Goldman deal was nothing more than a bet on the mortgage market, in which one side was destined to win and the other to lose, without “investing” anything in the real economy. The C.D.O. did not hold actual mortgage-related bonds, but rather allowed the participants to stake a position on whether bonds owned by others would perform well, or tank. And that helped to further inflate the housing bubble.

That is not investing. It is gambling, and it is abusive. It has no place in banks that can bring down the system if they fail.

Hmm - empowering sellers by creating synthetic mortgages that let sellers absorb the demand created by buyers inflated the housing market?  Would it really be a better world if the German money manager on the losing side of the controversial Goldman deal had used his money to fund more construction of new homes?

I will say this - it appears, after the fact, that the overall effect of making housing-related financing more liquid was not helpful.  Had it been harder for people to finance and re-finance their homes the housing bubble would surely have been smaller.  There are lots of ways the government could intervene to make the mortgage market grind more slowly.  They could start with reining in Fannie Mae and Freddie Mac, move on the imposing more stringent mortgage origination criteria (that would have a disparate impact on minorities, women, and immigrants), limit mortgage securitization by requiring originators to retain a portion of their product, and eventually work up the food chain to derivatives.

But even though derivatives are so unfashionable that a NY Times columnist can boast about her ignorance, the Times really needs to crack open a basic economic textbook to help them distinguish between gambling and speculation.

Gambling can be thought of as the creation and transfer of risk for entertainment's sake; the resulting prices and risk transfers don't guide any useful economic activity.  A bet on whether my next toss of the dice will result in a seven does not guide any real economic activity, other than baby getting a new pair of shoes.  Or not.

Speculation, by way of contrast, can provide socially useful prices and the opportunity for risk transfers.  For example, speculators routinely buy and sell futures contracts on corn, even though they have no interest whatsoever in growing, storing, milling, or selling corn.  Why is that not just gambling?  Because the speculators, through their participation in the market, help guide the behavior of people who do have to make a living growing and handling corn.

Kelloggs will be making a lot of corn flakes next December - should they fill their corn silos now to assure their supply of corn, or wait until the next harvest?  A "bet" with a speculator may simplify their planning.

A farmer has to decide whether to plant more corn, leave a field fallow, or plant something else.  What will corn be worth come harvest time?  The existence of speculative derivative contracts on corn helps provide an answer to that question and an opportunity for a farmer to assure his price today.

The Goldman deal looks like socially useful speculation.  Should mortgage originators push even more money out the door to create more supply for the securitization chain?  There were a lot of buyers lined up saying "Yes!"  However, the use of synthetic CDOs allowed sellers to show up shouting "No."  That price discovery can be socially useful, as the Times editors ought to understand.

I QUIBBLE WITH MYSELF:  What about betting on which teams will go the the World Series next fall - is that socially useful?  I would not dismiss the question out of hand - the mayors and police chiefs of Atlanta, Philadelphia, and St Louis (not to mention New York and Boston) might like to know what October will bring; event planners and convention organizers might like to know whether there will be plenty of hotel rooms, or whether their event will be over-run by a baseball crowd.  That is a thin thread, but it takes us to the gray line between gambling and prediction markets.

Comments

[Melinda Romanoff]

Understood.

But what tripped up LTCM was the belief that Russia would pay it's debts. It was outside their statistical models, and what the difference between Poisson and Gaussian statistical models mean. One is finite in its horizon, the other, infinite.

So when calculating the probability of an event, how far out do you go with your sigmas? In the case of LTCM, not far enough.

I think we're within spitting distance of an understanding of the GS and reform stuff, but what gets me is giving the White House unlimited authority over all businesses and their potential viability. A lot of room for political whimsy, if you ask me, and plenty of opportunity to insert some permanent campaign contribution channels, a la Chicago.

[anduril]

But what tripped up LTCM was the belief that Russia would pay it's debts. It was outside their statistical models...

Russia defaulting was an event in the real world. Unfortunately for LTCM, and taxpayers, LTCM's investments were also events in the real world. In the ideal world (in the Platonic sense) of their statistical models LTCM was fabulously wealthy, but in the real world in which they invested they went belly up. Statistical models are wonderful tools for dealing with the real world, but they are not mirror images of reality (cf. Heisenberg, Werner). Nor does it take much sophistication to realize, at least in a general way, the limits of statistical models. Yet these highly educated and experienced guys, who were considered by one and all at the time to be the ultimate in sophisticated investors, couldn't grok the difference between their models and the real world. Sooooo, if you go down a few rungs to people who are smart but greedy or lazy or have minds addled by porn (cf. SEC), imagine what the results could be like! Well, I guess we've seen it, but it could be even worse next time. Of course all this also has implications for the "sophisticated investors" defense, as also for the important question of what is a material misrepresentation or a failure to disclose material information.

I think we're within spitting distance of an understanding of the GS and reform stuff, but what gets me is giving the White House unlimited authority over all businesses and their potential viability.

I never supposed we were outside spitting distance of that. The fact that I assign a fair share of the blame for our current mess to the Bush administration doesn't mean that I'm a socialist, nor even a garden variety Democrat--I have, in fact, never voted for a Democrat. But if you want to imagine the ultimate in campaign contribution channels, just think about Cap 'n' Trade for a bit.

[Melinda Romanoff]

Oh, but statistics is where LTCM thought they excelled, in their VAR analysis. They thought they were "sucking up nickels" using multiples of leverage (sound familiar?). They sold deep, out-of-the-money, puts, thereby collecting premiums

They also traded using leveraging no one had ever used for trading, twenty and thirty to one dollar of cash, and higher depending on the trade, to ramp up returns.

More specifically, David Kaminsky, Jimmy Cayne, and other Wall Street wizards, committed their firms' respective retirement funds, management only (thank you) into LTCM, and then lent them money for the order flow to their firms.

Yes, Russia's default was real world, but they were betting that it was returning to the real world and would honor their debts.

Ooops.

I know the strategies of LTCM thoroughly, and their respective faults.

More later, dinner.

And we should pick a shorter thread before it's clock runs out, if that's OK with you.

Back later.

[anduril]

Oh, but statistics is where LTCM thought they excelled...

Any thread. But statistics weren't going to tell them how Russia would react--that was a unique event. That was a dumb bet made by very "sophisticated" guys. Put it this way: it was more like a gamble than a calculated risk. Stats can help you with risk management, but not in a one-off situation. What did they know about the variables that went into Russia's decision? Clearly not enough, and I'll bet very little beforehand.

[nathan hale]

Wasn't the Russian default, triggered by the Asian collapse, which in turn was provoked by
Soros's playing the renimbi and the baht like
dominoes

[Melinda Romanoff]

I'll make my "aside" tomorrow, using the word "aside".

LTCM was making the bet that Russia was going to allow their short term rates to go only so high, leaving off the table that they might even consider walking away. The Russians walked away instead. This, by the way of Russia, is the flawed underlying economic principle to the Cloward/Piven strategy, ultimate power will draw all the money towards it.

LTCM was something a bit different than portrayed by Lewis, for a reason, for a lot of people.

Have a good night, I'm beat, and I have some larger installs to accomplish tomorrow. As well as catching up on two whole days of earnings releases.

And, yes, I go through each and every one that is publicly traded in the US.

[anduril]

Well, Bush certainly played right into Cloward/Piven.

[nathan hale]

That's more likely a 50/50 proposition, he did embrace 'the home ownership revolution' but he did call attention to the subprime
menagerie and was stalled by the usual suspects