Is there a social benefit from complicated/risky financial schemes/products?

I’m currently reading Michael Lewis’ Boomerang, discussing how banks and governments got themselves into trouble in the oughts. One passage succinctly said something I have long believed:

“The global financial system may exist to bring borrowers and lenders together, but, over the past few decades, it has become something else, too; a tool for maximizing the number of encounters between the strong and the weak, so that the one might exploit the other. … [I]nvestment banks devise deeply unfair, diabolically complicated bets, and then … scour the world for some idiot who will take the other side of those bets.”

That pretty concisely sums up how I feel about a lot of what I hear about high level finance - although I admit my incredible ignorance of the subject. It very frequently impresses me that entities are trying to maximize their gains, while shifting the risk of losses onto someone else. It doesn’t get any more blatant than the bankers in 08 who admitted they were selling “shit.”

Why is the industry not regulated more strictly? Why do governments allow entities to get “too big to fail”, and then why do governments bail them out?

Yeah, I know I should take some finance courses. But I was hoping some of you smarter than I could point me in the direction of some resources. Gotta admit - even a book like this, which is written for a general audience, pretty much makes my head spin.

Because lobbyists for the industry write the laws that “regulate” them (this is a no-shit truth, look it up) and every goddamned presidential Cabinet is stuffed with ex-Citibank and other Wall Street assholes who pretty carefully steer the old ship of state in the direction Wall Street prefers, while all that financial sector cash goes into the pockets of the congresscritters to keep them with their noses firmly in the gravy trough. And so it goes.

Yeah - that’s pretty much my cynical impression, but - like I said - the whole concept makes my head spin. My understanding is that the financial industry has far greater resources than the regulators, and often seek provisional approval when they push the boundaries of what is allowed.

This is not solely a US/Congress issue. The book I’m reading discusses Iceland, Greece, Ireland, and even Germany.

As a general matter, I’ve got little issue w/ institutions taking advantage of each other - so long as the losing party bears the losses.

I am NOT disagreeing with SmartAleq, but if you want a less cynical answer, I’d say that the industry is regulated pretty strictly already. But the industry is understandably profit-motivated, and is in a constant struggle to find ways to maximize those profits.

The title of the thread specifically asks about “social benefit”. I suppose there are some companies that put such things high on their list of priorities, but there seem to be more companies that prioritize the profits, and care about legalities and ethics to a lesser degree.

Similar tactics can be found in many industries. Consider, for example, a company that has a gazillion franchises, and cares more about how much money they can squeeze out of the franchise owners, and not so much about whether those owners will still be in business two years from now.

There are two kinds of capitalists in this world: those who make things and those who make only money. The financial wizzards who buy and sell securities, change money, invent CDOs and the like get very wealthy, while their contribution to the general welfare is negative. Bill Gates made things. Sergey Brin and Larry Page provided a useful service. Even Warren Buffett helped the companies he bought operate better. But a hedge fund manager, a day trader, etc. is just siphoning off money from the rest of us.

Stocks started out as a way for businesses to raise money. To operate, buy input goods, expand, whatever. So if you invest in a stock, you are helping to grow the economy. But a day trader? He isn’t investing, he is just hoping the stock will go up within 24 hours. And for such a bet to make sense, he probably has (or thinks he has) some inside information. For an amateur like me, investing in securities is a mug’s game.

I am an American working in “high finance” in Europe. My previous background included financial audits and Sarbanes-Oxley compliance.

Investment markets here are regulated much, much more rigorously than back in the US. I am involved with several American based companies with European asset management arms. They generally firewall their local operations because the procedural rules are vastly more strict and because many American investment products are simply not legal here.

The quote in the OP is correct. The overwhelming majority of profits in the investment space are not earned by finding and supporting healthy and successful, but undervalued, companies, as the ideological vision of capitalism would hold. It is much more profitable to find comparatively ignorant people and separate them from their money.

I admit to uncertainty as to how to phrase the title. I’m not expecting the firms to be altruistic. But the same way governments (hopefully) protect their citizens from pollution, why aren’t stricter steps taken to - at the very least - have the big money players bear their own risks?

I guess what I was thinking is that there seem to have been very clear “harms” to society as the result of financial “overreach.” It would seems to me that some clear benefit would exist to make the risk of such harms tolerable.

So why do governments back their positions/insure their losses?

Have things changed since 2011 - when the book was written? Because it sure makes Ireland, Greece, and even aspects of German banking sound pretty fucked up?

Some of the more straightforward derivatives serve a useful purpose. Futures markets allow participants in the productive part of the economy to hedge risk, and futures promote rapid and transparent price discovery. And there are straightforward products like vanilla interest rate swaps that can facilitate access to capital markets.

But derivatives have become more and more complex, and any potential benefit for “clients” (corporates, pension funds etc.) in customized or complex products is more than offset by the negatives:
(a) the professionals are far more competent at valuing them, enabling them to rip of clients more easily;
(b) the complexity often introduces more risk, both individually for clients who don’t fully understand them, and systemically by hiding huge concentrated chunks of risk in unexpected places, sometimes opaque to regulators, only exposed when Black Swan market events lead to catastrophe.

An opportunity was missed in the aftermath of the 2008 crisis. You can’t tell people to stop trying to make money - that’s the fundamental incentive of capitalism. But you can just outlaw useless and dangerous products. The regulators should have just introduced sweeping reforms to make the great majority of derivatives illegal, especially the most complex and opaque over-the-counter products. They serve absolutely no useful purpose. But in the financial markets you really need to do this everywhere around the globe for it to work. The will might have been there to do this in a coordinated global regulatory move post-2008, but it never happened.

Yes, dramatically. The PRIIPs regulatory regime (that stands for Packaged Retail and Insurance-Based Investment Products) was negotiated from 2014 and came into full force in 2018. There’s still an exception for UCITS funds (basically, what Americans would call mutual funds, more or less), which have been regulated under a separate framework since the mid 80s. However, the UCITS framework has itself been frequently updated, with a major overhaul about five years ago, around the same time as PRIIPs passed. And the UCITS exception under PRIIPs is set to expire at the end of 2021, though that may be extended, because UCITS is working well, and PRIIPs is much more complex.

As to the regulatory strategy behind these two programs…

The European approach, historically, has not been to flat-out ban categories of investment products. There are a few broad prohibitions, yes. But in general, the preferred strategy has been to mandate significant levels of disclosure, and allow the market to work.

Basically, under UCITS, and expanded under PRIIPs, the idea is to clearly define various performance, cost, and risk metrics: what they mean, how the figures are collected and calculated, and where and how often they are published. With those characteristics exposed, the high-risk, low-value products become broadly undesirable, and fail in the marketplace (give or take a few adrenaline-junkie speculators). The typical retail investor will read through a formal Key Information Document, see the “Risk=7” indicator (which represents historical volatility plus credit risk, with 7 being the highest value) next to the array of fixed costs and an incomprehensible statement of investment strategy, and decline to invest.

Many asset management companies complain bitterly about how the required metrics are defined, saying that compliance is difficult and the results make their products unmarketable. The regulators listen and nod and pretend to care, because driving those products out of the market is precisely the aim. (Edit to add: This is why many American investment products cannot be offered for sale in Europe; their makers cannot comply with the disclosure regime.)

The US could learn a lot from the European approach. It’s not perfect. But it’s a damn-sight better than the offshore casino of the American market.

Another less cynical thought. The United States has always been big on the idea of a freedom or liberty to contract. While we don’t want libertarian laisse faire allowing charlatans to run amuck, we want to balance that with the idea that people should be free to make poor choices, or that in some circumstances, the decision between a poor choice and no choice is just plain no choice at all.

Suppose I have below average credit, but need a car to go to work. The best deal I can get is 13% interest. Many people would say that is terrible that some “shady” car dealer is using my already shaky financial skills against me. But if I want to do the deal, I’m a free grown man so why should a committee of my betters prevent me from doing the deal? What if the only alternative after your protection is that nobody will sell me a car under any terms which are legal and which are enacted into law to “protect” me from myself? I can’t go to work. I am on the public dole.

We’ve ran that balancing test throughout our history and have swung back and forth between the most important thing we want to protect, but we’ve always been skittish about going too far.

That’s always been one of my biggest problems with our kind of capitalism: we tend to privatize profit and socialize loss.

Yep. The greedy and the ignorant. A tale as old as time itself.

This is a separate question with an easy answer.

Governments bail out the banking sector because it’s an important part of public infrastructure. Like water or electricity.

And the banks are “too big to fail” because the banking regulations are designed to fix the failure of the previous system, where you had lots lots of little banks that needed to be bailed out when there was a banking sector crash.

There’s some technical arguments about how bail outs should work, and how regulation should work, that go alongside the moral arguments, and are, arguably, trumped by the political arguments.

Regarding the title question: when I was peripheral to the finance sector, before the crash, the general view was that complicated products had no general redeeming value, and were designed to separate suckers from their cash.

My understanding of the 2008 crisis is that the “idiots who took the other side of the bets” were the ones who were bailed out. Which means those idiots weren’t really betting on the financial instruments in question. What they were betting on is whether or not they would get bailed out by the taxpayers when the shit hit the fan. They guessed correctly on that bet.

You say that like it’s not kind of the fundamental goal of pretty much any business entity. I think what you’re getting at is that there are derivatives that are composed of other securities, like the infamous mortgage-backed securities of the 2008 financial crash, and that the whole thing is kind of a rickety house of cards often built on shaky foundations because the underlying mortgages were shit to begin with.

But in large part, it’s not individual middle-class investors buying these derivatives with their pinched pennies, it’s other financial institutions and types, who should know better. They get greedy and effectively see getting something for nothing, and jump at the chance. Or at worst, they can’t/don’t suss out what’s actually backing them and/or how sound they are.

That said, I’m with @Riemann; the dangerous and useless ones (i.e. the ones intended to be obfuscatory) should either be banned outright or highly regulated.

The way I understood it was that it wasn’t that everyone understood how shady the instruments prior to 2008 were, it’s that everything was going great guns and nobody worried about it, right up until something happened (subprime mortgage/housing bubble collapse) that kicked out the support to the house of cards and it all fell down around an unprepared financial industry.

Basically everyone kind of looked the other way as long as they were making money. But it ended up being something as mundane as lenders making poor loans to subprime mortgage customers who couldn’t pay to send the whole thing crashing down, much to many (most?) people’s surprise.

It might be helpful to pull some examples of

I have the book sitting around somewhere and can try to dig something up if folks don’t have anything immediately in mind.

This well is pretty poisoned, but I’ll try and explain the social benefit from at least one complicated financial product. If the OP wants to supply an example of another complicated financial scheme/product, I’ll see if I can suss out a social benefit.

There’s something called an auto loan securitization. It’s definitely complicated, but here’s a simplified explanation. You take a bunch of auto loans, let’s say $100 million worth of loans, and you create new securities out of them. The loans are to individuals, and each person has some probability of defaulting on the loan (it will vary depending on the borrower (the person who got the loan), and is roughly measured by their FICO score). Out of that huge number of loans, you create (for example) $80 million of AAA-rated bonds, $10 million of BBB-rated bonds, and $10 million of total junk. Typically, the company who issued the loans in the first place (often, the car company) will hang onto the total junk.

Why does this work? Well, each loan has some probability of defaulting, and chances are the $10 million at the bottom will take losses. The chance that more than $10 million in loans will default is much lower than the first $10 million, so the BBB bonds are much safer. And, the chance that more than $20 million will default is very, very low, so the AAA bonds are very safe.

What’s the social benefit? Well, assuming people having access to an automobile at a pretty low interest rate is a social good, these securitizations allow the car companies to raise money from a variety of investors. Some investors only want very safe investments, and contribute the $80 million. Without these instruments, the auto company would have to raise the $100 million itself, and that would be much more expensive, driving loan rates much higher and cutting off lower rated buyers from credit. The car company would lose a good chunk of the bottom $10 million either way, so hanging onto that bottom tier is not much different than they would have anyway, but now they only have $10 million out the door instead of $100 million. So, they can continue to lend money and sell cars, and individuals can continue to get relatively cheap credit and buy cars.

Because Governments don’t really care about the will of the people, contrary to popular belief. They are formed of individuals who respond to incentives, and unfortunately in our society the rich get to pretty much freely set the incentives of elected officials. You need lots of money to get elected; these big companies have lots of money that they’re willing to donate to your campaign if you act in their best interest. 2+2=4.

These last twenty years have weirdly made me so cynical that I’ve somehow come out the other side: one thing I think we’ve seen, over and over and over, is that you should never overlook a crook because you think he’s your crook. Madoff is a really good simple example of this: lots and lots of people suspected something fishy was going on, but since they were all making money, they didn’t look into it: they assumed he was scamming someone else, not them, so that was okay. And they weren’t culpable because they didn’t do it. It’s similar to offloading risk, but it’s offloading sin: you find someone else to do the dirty work and tell yourself your hands are clean (and, of course, lots of people Madoff scammed didn’t know and weren’t suspicious. But some were. Those numbers were too good).

Trump is the same thing: lots of his supporters know he’s a terrible, unethical asshole, but they think it’s okay because he’s their terrible, unethical asshole.

So yes, conservative, boring financial institutions bought this sus securities from flashy institutions, or allowed their own quants to sell them on ideas they didn’t really understand because they assumed that while these instruments might be ethically gray, they were on the winning side of the con, so it was okay.

So yeah. I feel like one of the great values of the past was to always do business with only highly ethical people. Not for the sake of morality or idealism, but because if they will screw anyone, they are 100% going to screw you.

This only works if you assume that the odds of any given loan defaulting is independent of the other loans. But as we saw in 2008, this is a faulty assumption, because in fact the whole economy is linked.

The models assume some amount of correlation between borrowers. As long as that correlation is less than 100%, you get some benefit from securitization.

The problem with many of the bonds that failed back in 2008 is that they were securitizations of securitzations. If you take a bunch of AAA-rated securitizations (the $80 million from my example above) and try and securitize those, you’re right – AAA-rated securitizations are very highly correlated and if one defaults, chances are they’re all having problems, so a AAA-bond issued from a securitization of securitizations is crap. The rating agencies and regulators have caught on to this fact and those kinds of instruments basically don’t exist anymore.

AAA-rated auto loan bonds did just fine through the 2008 crisis. And, your comment doesn’t address the social good of cheaper and more widely available credit for car buyers. I’m trying to address the OP’s question.