Comments on: Managing Financial Innovation

By: jonathan

jonathan — Fri, 19 Dec 2008 23:07:36 +0000

There are two fairly apparent mechanisms.

1. Pools that operate as a brake. When the big deregulation bill was passed in the late 90′s, Gramm did not put in what Treasury wanted, which was a coverage or insurance pool funded by market participants for certain derivative instruments. Note that AIG has now become infamous for writing instruments based on its credit and then not setting aside reserves because their models showed no or negligible default risk.

2. Decouple bonuses from the present. This is simple and obvious. The incentive has always been to cobble together deals, get the bonus and then maybe even be elsewhere when the deal fell apart. This got out of hand over the last decade and so individuals made many millions on deals that then destroyed their companies (and many lives and the entire financial system). If you don’t get paid today, then people aren’t rewarded for selling crap today. The mechanisms for doing this are simple in this computerized age.

By: Mark Foley

Mark Foley — Fri, 19 Dec 2008 20:37:10 +0000

Without mathematical models of high sophistication banks would be unable to generate level 3 assets which can be valued against ‘unobservable’ inputs.

The major banks cannot run without these sophisticated models because they have riffed all the middle-management folks that used to follow and understand the individual businesses and positions with sophisticated human judgment.

By: engineer27

engineer27 — Fri, 19 Dec 2008 16:39:06 +0000

Also noteworthy:
“Today no major financial institution … can function without the computer-based mathematical models … based typically on the Black-Scholes option pricing methodology.”

The Mandelbrotians have been saying for years that Black-Scholes is based on a faulty premise (that markets follow Gaussian laws). Yet even after this unprecedented failure of the models there has been no wholesale reexamination of the theory, least of all by Merton (as evidenced by his comments on the panel hosted by Harvard two months ago).

Isn’t it about time to stop tweaking the faulty models and start over?

By: engineer27

engineer27 — Fri, 19 Dec 2008 15:25:47 +0000

This statement grabbed my attention:
“Derivative securities … function as adapters among … incompatible domestic systems …. widespread use of derivatives … provided an effective offset to dysfunctional country-specific institutional rigidities.”

It reminds me of Michael Lewis’ description of the synthetic CDO, that via deriviatives new homeowners were being fabricated “from whole cloth.”

So, if you don’t want to deal with Hugo Chavez, you can just create a shadow Venezuela out of derivatives, that behaves (financially speaking) just like the real one, and trade with the shadow nation. In fact, why stop with just one, when you can create an unlimited number of Venezuelas?

Financial engineering, indeed.