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

Great Debates
21

I’m not saying this benefit doesn’t exist, or that we should ban all forms of these loans. I’m just saying that just because you’re averaging out your risk doesn’t mean you’ve eliminated it.

Yes, there is a social good to giving people access to cars and houses through loans. But making these loans too accessible or safe (for example by making them nondischargeable) can lead to inflating costs - if it is super easy to get a loan to pay for something, lots of people will, and the price will go up. A situation similar to the college loan crisis would not be in the social good if it happened to cars - IE if it was very easy to get a low interest car loan, but cars cost 10 times what they do today as a result.

It’s all a balancing act.

22

This is true.

Like I said, I tried to illustrate a social benefit from a complicated and risky financial product. If the OP has others in mind, I’m happy to try to address that one as well.

Here’s another example – futures contracts. They’re pretty complicated (ever tried to follow the action at the end of Trading Places?). Basically, they’re standardized forward contract and a forward contract is an agreement to buy or sell some product in the future at a price agreed to today. So, I tell you I will pay $60 to buy a barrel of oil in 3 months or 6 months or whatever. You and I can enter into this agreement with no intent ever to buy or sell the actual oil – I can sell the contract before it comes due or I could just settle with you on the difference between the $60 I promised to pay and whatever oil is worth today. A futures contract is the same thing, but traded in standard form on an exchange.

Pretty complicated and rife for speculation/betting. However, if I’m an actual oil producer and I know I can be profitable if I sell oil for $60/barrel but unprofitable if it falls to $40, I can protect myself – I’ll sell you oil in 6 months at $60/barrel regardless of where the price goes, and you promise to buy it. So, I know I’ll make a profit.

If the price rises to $80/barrel, I’ve missed out on that gain – I could have been more profitable. But, I’ve protected myself from the downside that it falls to $40/barrel, which would have made me lose money or go bankrupt. Missing out on the gains is worth it to avoid the losses.

Farmers do the same thing with grain, cattle, etc., and orange juice (from Trading Places).

Complicated and easy to abuse, but the social good is that actual producers can hedge themselves and avoid losses and bankruptcy, gain stability.

23

I see it a little differently. Yes, I totally agree that the best route (as you concluded) is to do business only with highly ethical people. The tricky part is figuring out who is ethical and who isn’t.

Madoff is a great example. But I don’t think people imagined that “he’s my crook, therefore he is scamming someone other than me.” Rather, what they said to themselves was that “he’s my guy, my friend, I know him, and I can’t imagine that he’d do something wrong.” Even when they suspected something was indeed wrong, their reaction was, “This is complicated stuff, but Madoff understands it better than I do, and if he is doing it, it must be okay.”

24

Madoff hit up Jewish centers because the people there were naturally inclined to trust a fellow Jewish person (related to that other thread – I think it would be OK to say “a fellow Jew” in this case – thoughts?). It’s called Affinity Fraud.

25

I dunno. I think some people, at least–the more savvy ones–had to wonder how he was out performing the market over and over and over again, and thought he must have inside information or something. Something gray. But they had plausible deniability. It’s like deciding to just trust your friend when he says he’s fine to drive you home. You trust him enough to know he’s not “drunk drunk” and you’d rather not do the investigating to see if he really stopped at one, an hour ago, or if he maybe pushed it to a point where you, personally, wouldn’t drive, but where maybe someone else would. You know, a zone where ethically you aren’t comfortable going, but what you are willing to tolerate in others. I think a lot of otherwise upstanding people use that zone to rationalize stuff.

26

2 factors. Lobbyist influence and regulatory capture. Obviously the people who have the most money are going to throw more money at politicians to sway them toward more permissive ways of making money. Also, over time, industries tend to get so complex that only industry insiders understand it very well, so there’s more hiring demand for insiders in regulatory agencies. That’s called regulatory capture.

2 things about it. First, on the topic of “too big to fail”, there’s a reason we use the term “pump priming” so frequently when we talk about the financial system. For a water pump, the system cannot draw water until the pump itself is full enough to transmit the suction to the intake. If the pump is newly built or repaired, external water needs to be injected. The financial system is also like that. The water is credit. If everyone is too spooked to lend, or if their capital has depreciated so badly that they can no longer lend, we have a halted financial system that won’t start until cash is injected. Some banks are so big that they would need to be re-primed with more money than the government can mobilize, so they get bailed out before that happens.

As to why the government allows that to happen, I point you back to regulatory capture and the demand for risk. One basic principle of stable banking is the fractional reserve system… people put their money in banks because they’re not using it, so banks should be able to loan out more money than they have on hand. That’s one of the oldest beneficial technologies of society. Bankers can tweak their capital ratio upward or downward depending on the risk climate. Unfortunately, having all these levers at their disposal is also a tremendous temptation to put extra money into speculative risk.

That’s not to say this is the one simple explanation of the phenomenon. But as you are educating yourself, look for this repetitive tug-of-war pattern between people who are trying to maintain a healthy fractional banking system for the public good, and those who want to make huge selfish bets with the public bearing the risk. That’s why huge financial legislative packages are frequently seen either putting up these firewalls between banking and investing, or tearing them down.

Another factor as you alluded is the complexity of various financial instruments and ventures. To play the devil’s advocate, a well-designed financial instrument contributes to a more perfect market where we understand more about scarcity and where to put our capital. But you’re right, some of these are contrived one-sided bets, and some of them end up in value webs that are so complex that nobody can predict the contingencies in the case of a market crash.

If you’ve heard of the 2008 stress tests, it aims to add some regulatory oversight to those complex instruments. Banks will run certain simulations where it wipes out the values of certain holdings to see if the bank is overall resiliant. As one might expect, these measures are opposed by those who are wealthy enough to survive a financial collapse, and they are only supported by the government when it’s acting on behalf of people who aren’t that wealthy. There’s always a big outcry for more regulation after a financial crash, and a big outcry for deregulation as more people arrive to the party and want the same spiked punch that the early guests all got.

27

You’re describing an extremely straightforward arrangement; in no way is that complicated, which is what the OP was talking about. A car loan at any interest rate is right out in the open. 13% might be really usurious for a car loan, but you know precisely what you’re getting into. No one’s fooling anyone.

The 2008 fiscal crisis was caused in part because of deception.

28

This is common in multi-national businesses for trading currency. Sure, you may do better just getting the market exchange rate whenever you need it, but if you know you’re going to need a steady supply of Mexican pesos for payroll, locking those in pulls a lot of uncertainty out of your projections. And having a liquid market means you don’t have to one-for-one match up your needs with sellers.

I’m not sure this counts as a “complicated/risky financial scheme/product” though.

29

I’ll leave that for the OP to decide. I think forward contracts and futures are pretty complicated for the average layman. And, I think they were blamed for some oil price volatility or something in the past, so one could ask what good are they.

30

Thank you for your detailed responses.

The example you offer of the auto loans makes sense. As does the problems with the securitization of securitizations. I’m glad to hear they no longer exist.

This one book described various other examples - from Iceland, Ireland, and Greece, in which banks were essentially borrowing money with no apparent idea of ever being able to repay, and based on little other than an unrealistically optimistic hope for neverending prosperity and growth.

I guess it is hard to expect governments to require responsibility from banks, when they exercise so little responsibility themselves. The final chapter in this book addressed state/municipal insolvency - something my state of IL is going to have to figure out sometime soon.

So why was it appropriate to bail out the banks in the US (as well as Ireland, Iceland, Greece)? Wouldn’t it be preferable to limit the size or breadth of the hugest institutions just to ensure that they are not too big to fail?

Yeah - A LOT of finance exceeds my ken. But it seems as tho a lot of such instruments are pretty complicated for the purported experts.

31

This seems like a hijack, but it’s your thread, so I’ll do my best.

First, sometimes an institution becomes too big to fail without people noticing, and by the time you see it, it’s too late. You can try and break it up, but you don’t want to do that in the middle of a crisis. Second, sometimes having a few giant institutions is better than a thousand little ones – back in the late 80s (early 90s?), there was the S&L crisis, and it mostly affected smaller banks, but it was hard to manage because there were so many of them, so banks were encouraged to merge together. In Canada, there are only 6 banks, and each is really too big to fail, but the Canadian government is tougher on them in terms of regulations so it may be more stable than the US with lots of little banks and a few big TBTF ones.

So, that’s how you get there. In the US, post-2008, any bank that’s considered systemically important (too big to fail) has to hold extra capital and has extra regulation. GE broke up and sold off GE Capital because the regulations were so onerous, and GE Capital was considered systemically important.

As to why you bail them out, if an institution is really too big to fail, if you don’t bail them out, the institution can take down the economy with it. If Wells Fargo failed, not only would it really strain the FDIC that guarantees all the depositors, it would also strain the other institutions it did business with, putting more strain on the FDIC and other counterparties, etc. When Lehman wasn’t bailed out, it led to the whole financial system almost breaking. Lehman was a bad actor, but the effect on the economy was worse than the punishment of letting Lehman fail.

32

Eons ago, I worked in mortgage banking. In the boom cycle that led up to the 2007/8 bust, I remember being in a conversation with an ardent Bush supporter, where he touted the record-high minority home ownership rates.

Which was true, and essentially good.

But, I remarked, since the passage of Gramm-Leach-Bliley that basically reversed Glass-Steagall, a significant amount of effort had been applied toward loosening lending requirements.

I inquired of my friend as to how many of these newly-minted homeowners should ever have qualified for these mortgages in the first place.

I think we found out.

The “liar loans” were legendary. While many of the borrowers should have arguably known that they couldn’t afford the loans they were taking (based on the promise of ever-increasing real estate prices), those on the lending side knew or should have known.

The (ridiculously) greedy and the (at least a little greedy but probably a lot) ignorant.

What they did with putting mountains of bad loans into a Cuisinart in order to put lipstick on a pig, package these basically poor-quality loans as AAA, and then spin them off in the secondary market was also criminal.

Or should have been.

Access to capital fuels economic growth. But many capitalists are like people in maximum security prisons, serving life sentences: they have nothing to do All Day Long but figure out how to escape. In the case of many capitalists, it’s more about understand the laws and how to get around them while reaping nearly unimaginable profits.

Steal a TV – go to jail.

Tank a global economy – profit beyond most people’s wildest dreams and retire to an island that you bought in the Caribbean.

And leave the taxpayers and the world to subsidize and clean up your mess.

Oh, and let’s not forget that these same capitalists who ruined the housing and real estate markets also snatched up a huge amount of those properties at the bottom, in part explaining why the overwhelming portion of the recovery $ went to the wealthiest Americans.

It’s a marionette thing. Maybe more like a yo-yo: they make money on the way up and on the way down.

And the carnage that it creates ? The lives it ruins ? Pfffft.

#Murica

33

You example is very illustrative, but naturally not all encompassing. Most of these things start out making sense and serving a larger public good. Take your example of turning car loans into a type of bond (collateralized debt obligations or CDOs). This makes sense in a lot of ways. It allows more people to get cars. On paper, even the riskiest debts have some safety in the collateral. But it never stops at the most rational and beneficial level, because someone is always looking for ways to squeeze out some extra money.
Car loans are the third wave of financial product that may screw us over that I am aware of. The first was credit cards. When banks started selling credit card debt, it drove a frenzy of easy credit. When the defaults started happening, the card companies that were so eager to hand out cards to anyone lobbied hard to “reform” bankruptcy laws. I don’t really need to go into the housing crisis. That has been mentioned multiple times in this thread. Now we have the car loan boom.
As mentioned, it makes sense to get people in needed transportation. But it is never that easy. This seemed safer than the housing boom because a lot of the lenders are ok with the risk of the lowest tier in theory because their business model is not really a financial institute, but a car company. If they make less money on the financial side it is fine as long as it increases income on the sales side. But will they be happy with that? What is stopping them from offloading that lowest tranche of loans to a institution who will remix and retranche, just like the real estate backed CDOs of 15 years ago? I have seen nothing that says that is banned now.
Also, we now have a subprime auto loan industry that sells used cars to desperate people. In most cases the car sales themselves never really pay off. Instead, they work by selling and repossessing the same cars over and over and collecting months of payment each time. Invest 10k in a car and sell it 10 times for an average of 1k in down payments and 1k of collected payments each time. If the initial loans are packaged and resold has high interest bonds, this model can spread out even farther and ruin even more people.

34

Yeah - this book refers to the different way the responsible bankers - or even folk filing for bankruptcy - are treated in US vs Germany.

I guess I shouldn’t expect an explanation other than that I do not understand/appreciate the desirability of having financial services comprise such a significant portion of our economy, or a society in which the esoteric manipulation of balance sheets is a path to greater wealth than actually providing more tangible products/services.

I remember back in law school when a lot of folk got upset over one fellow defining capitalism as the right of each individual being allowed to take advantage of each other individual to the extent permitted by law. In the following 35 years, I’m not sure I heard it defined more accurately/succinctly.

35

Because their failure would harm the economy. They are too big to be allowed to fail. The government should bail them and take them over or at least take a huge equity share in them. But they add nothing to the actual economy. The only thing they make is money.

36

I think the real problem is if the car sales guy sells cars to everyone, regardless of risk and then demands that the city cover the unpaid debts because car sales are essential to the community.

37

I guess I’d be interested in a cite that this is actually occurring. Selling a car and trying to get payments and then repossessing it all take time and money. I don’t see how this would really be profitable.

Anyway, if the OP has other complicated/risky financial schemes and products to see where they may have a social benefit, I’ll do my best, but all of these complaints about the financial industry in general seem pretty off-topic and I’m not all that interested in defending the financial industry or capitalism overall.

38

Dated, light on nationwide statistics, and heavy on anecdotes, but here are at least some examples:

39

The one that irritates me the most, even those it has a fairly low risk of destroying the economy, is high frequency trading. There is absolutely no reason for it to exist. Its justification is to lower the bid ask spread, but it does that by putting a middle buy sell in between. It just lets already wealthy groups extract a little off the top from everyone else. An insurance retirement fund wants to purchase 100,000 shares of X company and are willing to buy at $92 a share? HFT computers see that before the rest of the market and can then find sellers who may be willing to sell for 91.98 a share. .2 seconds later they have made $2,000 dollars. If they could do that consistently, they make $31 million a year just by inserting themselves in as an unnecessary middle man.

40

Here is where I first heard about the details of the subprime auto loan world:

UNIDENTIFIED PERSON #2: Credit Acceptance is looking at it as, how can I put this customer in a position where, should they default, I have the largest amount of money to collect via alternate collection routes like the court system?

KAMAT: And this money doesn’t just add to Credit Acceptance’s profits; it’s also going to their backers on Wall Street. That includes their investors, their bondholders and banks, like Wells Fargo. Credit Acceptance has issued over $6 billion in subprime, automobile asset-backed securities - basically bonds backed by pools of subprime auto loans. Their bonds are highly rated by the ratings agencies and offer returns of as much as 4%.