
The Profit Motive Behind Financial Complexity - chollida1
https://www.bloomberg.com/view/articles/2016-07-12/the-profit-motive-behind-financial-complexity
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Animats
There was a time when the US Congress tried to prevent complexity in financial
products. The Utility Holding Company Act limited utility ownership to a tree
depth of 3. This was in response to a mess created by Samuel Insull in the
1920s. The Glass-Stegall Act kept banks and brokerages separate. All that
ended in the 1990s, because the banking industry managed to convince or pay
off enough legislators to get the idea accepted that risk was now
quantifiable.

Economists fell for the myth of Black–Scholes. This is a neat way of
quantifying risk, but it assumes that risk has a Gaussian distribution.
Sometimes it doesn't.

~~~
alexbeloi
>Economists fell for the myth of Black–Scholes. This is a neat way of
quantifying risk, but it assumes that risk has a Gaussian distribution.
Sometimes it doesn't.

Maybe you're being loose with your terminology, but there is no such
assumption. The simplest versions of Black-Scholes does assume that stock
price is a lognormal process with constant variance/volatility, which
empirically it isn't.

The point of Black-Scholes is to price derivatives not quantify risk, but the
price also has an empirical market price. Just as you can use the 'assumed'
variance/volatility to try to compute the derivative price (according to B-S),
you can use the market price of the derivative to compute the 'implied'
variance/volatility.

If you look at the options page for AAPL on yahoo finance[0], you'll see a
column for implied volatility, the above method is precisely how it is
calculated.

[0][https://finance.yahoo.com/quote/AAPL/options?p=AAPL](https://finance.yahoo.com/quote/AAPL/options?p=AAPL)

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bradleyjg
The same thing applies at the consumer level. A standard immediate annuity is
a relatively simple product — a consumer pays a lump sum up front and gets
back a stream of payments for the rest of his life. Ditto for standard term
life insurance — consumer pays a premium and he dies his estate gets a payout.
Both of these markets are competitive, products from different sellers can be
directly compared, and margins are relatively tight.

But as you add more and more riders, variants, bells, and whistles the
products become less comoditized and more profitable for companies that issue
them. Their profit is your cost.

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WalterBright
There's an enormous amount of deception going on by politicians and how
government operates, too. I wouldn't single out libertarians as particularly
naive - the people who believe in government solutions to every economic issue
are equally or worse naive. Governments regularly use accounting methods that
would land any private company in jail, for example.

~~~
GeneralTspoon
> Governments regularly use accounting methods that would land any private
> company in jail, for example.

Genuinely curious, could you give examples of these? Maybe it's time to start
a country for tax reasons :)

~~~
WalterBright
The social security trust fund was spent. The government replaced the funds
with an IOU, and treats it as an asset. No company could get away with that.

~~~
toomuchtodo
The IOUs are backed by US treasuries, the safest, most reliable investment
product in the world. Of course a company can’t get away with that, it has no
ability to tax a populace, which guarantees the revenue stream.

Now of course there’s the argument that the US government borrows too much:
totally true. Someone has to jump on the grenade and cut military spending
(the greatest discretionary income spend) and raise taxes (they’re at the
lowest levels in US history, and must go up), but that’s a bitter pill to
swallow.

~~~
WalterBright
The IOUs are "invested" in a special type of bond only issued to and
redeemable by the SSA. It's clear by accounting laws that calling a debt an
"asset" is illegal. There is no money in the SSA trust fund.

As for reliability, consider the gold bonds the government used to issue. They
guaranteed repayment in gold, and hence sold at a premium. In the 1930s,
Roosevelt repudiated them, paid them off in dollars, and pocketed the
difference.

The government can, and has, simply printed money and forced people to accept
that as payment of debt.

~~~
millstone
Of course the SSA's bonds are assets. If you lend yourself money, you create
an asset and a debt (else where does the money go?) The debt is on the
Treasury's books already; the Treasury bonds held by the SSA are the other
half required to balance the books, and reflect actual payroll taxes. If we
called those treasuries debts, we would be double - actually triple - counting
debt.

This is an extremely mild accounting practice compared to what private
companies routinely engage in. Not all of Google's IP actually originates from
an Irish-owned company headquartered in Bermuda.

"Reliable" gold with its 30% annual price swings - well, enough said on that.

> The government can, and has, simply printed money and forced people to
> accept that as payment of debt.

Forced who - investors who willingly buy Treasuries, understanding full well
how the dollar works?

Or did you mean 1930s investors who got fiat instead of gold-backed dollars?
There were rather more significant victims of the Depression.

~~~
WalterBright
> Of course the SSA's bonds are assets. If you lend yourself money, you create
> an asset and a debt (else where does the money go?)

And when you spend the money (the asset), you're left with just debt.

> This is an extremely mild accounting practice

Spending trillions, and then still calling it an asset?

> Forced who - investors who willingly buy Treasuries, understanding full well
> how the dollar works?

The US government gold bonds promised to pay in gold. That's why they sold at
a premium. Are you arguing that the bondholders shouldn't have trusted the
government to keep its word?

> There were rather more significant victims of the Depression.

The topic is how government bonds are "the safest, most reliable investment
product in the world", not who is the bigger victim.

~~~
Terr_
Regarding SS funds, this "it's all one big government" view muddles more than
it clarifies.

Instead, consider a 3-node chain, where the US government discretionary budget
has debts coming due to the SS budget, and the SS budget has obligations to
the public.

When demagogues claim the SS fund is empty, they are actually trying to trick
the public into _writing off_ that debt, instead of going after the upstream
debtors... Which is basically Congress.

After all, every dollar that isn't being spent servicing the debt to SS is a
dollar that can be used in tax cuts for the wealthy...

~~~
toomuchtodo
So strange this is downvoted when it’s fact.

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pessimizer
The case that people can be easily conned into believing risks are lower than
they are for endeavors that have elements that they don't understand is
sensible, but I think that it leaves out an argument of why people would
choose a product that they don't understand over a product that they do.

I'd argue that 1) there are more opportunities for graft in more complex
products because a cut can be taken at every layer of indirection, so
therefore amongst salespeople confusing multiply layered products will crowd
out simpler products with fewer levels of commission and kickback, and

2) Making uncommon choices is a sign of expertise, because one has to be
somewhat more knowledgeable about a domain to know of the existence of
uncommon choices. This makes those choices easier to sell through flattery
and/or the appeal of being an insider and getting a special deal. An example
of where looking like an expert is an appeal that allows people to be suckered
is the fact that the best odds at a craps table are on pass/don't pass, and
every other bet is far worse, going from doubling the house edge to nearly
multiplying it 10x.

[http://www.crapsage.com/craps_payouts.php](http://www.crapsage.com/craps_payouts.php)

~~~
tormeh
>Making uncommon choices is a sign of expertise, because one has to be
somewhat more knowledgeable about a domain to know of the existence of
uncommon choices. This makes those choices easier to sell through flattery
and/or the appeal of being an insider and getting a special deal.

That's a very insightful observation. Thanks!

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rumcajz
I really think economists should get mandatory training in evolutionary
biology to get a feeling of how even the smallest glitches in the system,
loopholes so small as not to be visible even under detailed scrutiny are
unavoidably exploited by opportunistic organisms. Alternatively, some
practical work in computer security may help to get the same point across.

~~~
Nomentatus
Economists were captured long ago, to tell pleasing lies to power; I
originally wanted to go into economics, but I knew too much about computer
programming - it was too obvious economists had become mere computer
fetishists, to me.

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vostok
I agree that customers generally get worse pricing on more complex products,
but I don't think this is necessarily bad for the customer. To use a simple
example, the market for on the run treasuries is much more liquid than the
market for off the run.

If I need to take an old long bond off my books that has 10 years left until
maturity then it might better to just sell it instead of going short the on
the run 10 year even though the on the run has better pricing.

Dealers are just better equipped to handle the complexity so the higher profit
margin on more complex products doesn't necessarily lead to a worse result for
the customer.

~~~
maxxxxx
I think the complaint of the article is that complex products are being sold
to customers who don't understand them. You certainly can witness that with
municipalities that are close to going bankrupt because they bought
instruments that backfired on them. The while financial crisis of 2008 was
pretty much about people buying things where they couldn't assess the risks.

~~~
WalterBright
People don't understand how cars work, but that doesn't stop them from buying
them and benefiting. Occasionally, not understanding cars gets people in
trouble. In fact, very few of the things we deal with every day are generally
understood - like the computer you're reading this on.

~~~
maxxxxx
People have a very good understanding of a car's risks. Same for computers.

~~~
tedunangst
That's a very questionable assertion.

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meesterdude
uh - no its not. It's near common sense the things that can go wrong with
owning and operating a car. that doesn't help people mitigate the risks
themselves, but they are so prevalent you need to take a test that covers them
before you can get a license to operate one.

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yuhong
I think the problem now is that all the complexity is to take advantage of the
current debt-based economy. For example, I suspect that better returns on
stocks than bonds contributed to the Glass-Stegaall repeal.

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clairity
> "That might not come as a shock to most people, but to economists of the
> libertarian, free-market bent, it’s tantamount to heresy. Tricksters and con
> men, they say, will be weeded out of the market by their bad reputations.
> That’s a pretty big assumption, and might rightfully strike most non-
> economists as wishful thinking. But if you look at economic models, you’ll
> find that few of them include successful fraud and deception as a
> possibility. Modern econ relies so heavily on the assumption of rationality
> that there’s just not much room for tricks and scams. Obviously these models
> are far removed from most people’s experience of real markets, in which
> deception is common."

this is the achille's heal of libertarianism. it simply leans too heavily on
the rationality assumption, while also ignoring many things of value in our
lives like love, empathy, conversations, the future (unknowable) value of
natural resources, homemaking activities, etc. it's political use (in the
_mano a mano_ sense, not in the government sense) is as a rationalization to
be a jerk to your neighbor.

complex financial instruments are simply a manifestation of that mindset.

~~~
WalterBright
> leans too heavily on the rationality assumption, while also ignoring many
> things of value in our lives like love, empathy, conversations, the future
> (unknowable) value of natural resources, homemaking activities, etc.

I don't see any justification for that assessment. How does libertarianism
overlook empathy, for example?

> it's political use (in the mano a mano sense, not in the government sense)
> is as a rationalization to be a jerk to your neighbor.

That's not remotely true.

~~~
bittercynic
> That's not remotely true.

I've witnessed self-described libertarians doing exactly that. It usually goes
along with a lack of understanding of the power they have over someone far
less economically fortunate.

~~~
__blockcipher__
It seems quite silly to argue against a viewpoint by citing that you've met
some douchebags who follow that philosophy.

I'm met plenty of republicans who lack understanding of the power they have
over the less fortunate. I've also met many liberals who can't comprehend why
someone would want to own a gun, or who constantly look for any excuse to peg
someone as racist/sexist/classist/etc. (Obviously these are all United States-
centric examples since I've spent most of my life here)

To me it seems far more productive to examine the "best form" of each
philosophy rather than the worst

~~~
bittercynic
I don't think any reasonable person could disagree with either of your first
two paragraphs. On the third, though, I think it is worthwhile to examine the
good, bad, and ugly of each viewpoint.

I only meant to point out an example of ugliness that sometimes falls out of
libertarianism.

