One striking aspect of the public debate about the future of derivatives – and how best to regulate them – is that almost all the available experts work for one of the major broker-dealers.
There are a couple of prominent and credible voices among people who used to work in the industry, including Frank Partnoy and Satyajit Das. And there are a number of top academics, but if they help run trading operations they are often unwilling to go on-the-record and if they don’t trade, they lack legitimacy on Capitol Hill and in the media.
The Obama administration is criticized from various angles – including by me and, even more pointedly, by Matt Taibbi – for employing so many people from the finance sector in prominent policy positions. But, the administration pushes back: Where else can we find people with sufficient expertise?
The defense sector faced a similar problem after World War II. The rising importance of technology in combat meant that the military needed specialized suppliers who would invest large amounts of private capital in developing tanks, airplanes, radar, and other types of equipment. But there was – and still is – a real danger that these companies would capture the Defense Department and push it to buy overly expensive and ineffective technologies (or worse).
President Eisenhower famously warned in 1960, as he was leaving office, about the military-industrial complex. His concise remarks were brilliant – look at the text or YouTube versions. And C. Wright Mills’ influential The Power Elite, published in 1956, put weapons suppliers at the center of our national power structure. (link: ; but this may be copyright violation.)
Constraining the power of defense contractors is a hard problem – and you might say that we have not completely succeeded, depending on your view of Vietnam, Iraq, and Afghanistan.
But, at least in terms of weapons design and procurement, we have made some progress in developing a set of highly skilled independent engineers – as argued by Larry Candell in the latest issue of Harvard Business Review (now on-line, but there’s an awkward page break; here’s an alternative link – look for idea #3).
Larry is an interested party – from a leadership role at Lincoln Labs, he explains that this organization provides an independent design and evaluation capability that is not government bureaucracy and definitely not a profit-oriented defense contractor. (Disclosure: Lincoln is part of MIT, where I work.)
Irrespective of what you think about the defense business, Larry’s proposal vis-à-vis finance is intriguing. He thinks the government should set up its own arms-length labs (or sponsor nonprofit research organizations to do the same) that would concentrate on testing financial derivative products in test bed-type settings.
This would not, of course, be the same as trading in real markets. But with today’s computer resources and plenty of unemployed finance talent at hand, it should be possible to develop individual people and a broader organizational capacity able to test the effects of various kinds of derivatives on customers, as well as on overall financial system stability.
The proposed National Institute of Finance (NIF) would have similar broad goals – and the National Institutes of Health is an appealing model – but as NIF is currently proceeding with industry-backing (e.g., Morgan Stanley, Bank of America), we should be skeptical.
We definitely need independent derivatives experts who can be called to testify before Congress or work in an administration. They must have a deep understanding of financial markets, as well as hands-on experience with products that are dangerous to our economic health.
It would be great if people from hedge funds or other financial institutions were willing to step forward and play this role – many of our best experts don’t actually work for the big banks. But while these independent people criticize eloquently the major broker-dealers in private, very few of them are willing to step forward in public.
Initial responses (e.g., by Stefan Stern, writing in the Financial Times) suggest that Larry’s idea may get some traction.
By Simon Johnson
This piece appeared, in an edited form, earlier today on the NYT’s Economix; it is used here with permission. If you wish to reproduce the entire post, please contact the New York Times.
The Baseline Scenario 
This strikes me as backwards. We do not need government to hire a bunch of PhDs so that it can have independent “expertise” on complex financial instruments. What we need is to ban all financial instruments complex enough to require a PhD to understand.
As far as I can tell, the sole purpose of complex financial instruments is to deceive investors and evade regulators. We should simply recognize that the complexity itself is not worth it and make it illegal.
Show me any evidence that a CDO^2 ever did any good for anybody other than the leeches and parasites on Wall Street, and I might change my mind.
And here’s a sadly resistible quote from that same speech by Ike:
“Another factor in maintaining balance involves the element of time. As we peer into society’s future, we — you and I, and our government — must avoid the impulse to live only for today, plundering, for our own ease and convenience, the precious resources of tomorrow. We cannot mortgage the material assets of our grandchildren without risking the loss also of their political and spiritual heritage. We want democracy to survive for all generations to come, not to become the insolvent phantom of tomorrow. ”
Go tell it to the Boomers, babe.
The concept itself is quite old. Would we be looking at an Underwriters Laboratory of finance? The Harvard Business Review Seal of Good Finance?
Is not the ultimate product problem securitization depersonalization? Down to earth, does the debtor have a moral obligation to a trust where 5000 mortgages feed in and the trust spews out the cash flow of the mass in pieces to thousands of recipients? In essence, does the mark have a moral obligation to the grifter? Then there is grifter versus grifter as in much of the present organization of finance.
A government owned UL is rather humorus. Still, it might work for a considerable time if it were made up of hellions of finance. Wild and crazy guys that could pound the daylights out of the products tested. One status level would literally be ” Only a moron buys this product, are you a moron?” Another would be ” Figures don’t lie but liars do figure and the liars win here”. Tester organizations can no longer be mundane bureaucrats like the monolines. These people must be very well paid too!
With respect to mortgage backed securities, the proper experts to evaluate their true value are traditional bankers and lenders who have used and continue to use successfully the traditional, time-proven ways of approving and valuing mortgages based on the cost of the home, the actual verified income of the borrower, the credit history of the borrower and so forth. To do this, the mortgage backed security must be untangled and the value of the underlying mortgages evaluated. The Wall Street “experts” probably lack this critical expertise and this should be pointed out.
Secondly, there are many mathematical experts in other fields such as physics with detailed knowledge of fitting mathematical models to data. There are standard tests and methods for determining the goodness of fit. These experts can almost certainly demonstrate that the specific mathematical models used to value mortgage backed securities (and most other derivatives) are seriously flawed (falsified!).
What we have is an example of widespread adoption of an unproven new technology that has proven to have serious flaws. In this case, the adopters of the new technology are compromised since they made a mistake. There are many historical examples of widespread adoption of a new technology that failed: the widespread use of the Kudzu plant in the southern United States, lethal vitamin deficiency diseases caused or greatly increased by the adoption of new food processing techniques in the late 19th century that removed vitamins from bread, milk, and other common foods. It would be appropriate to call on experts in the history of science and technology to testify regarding these historical cases as well.
Sincerely,
John
There is the usual increased liquidity decreased risk argument.
“But, the administration pushes back: Where else can we find people with sufficient expertise?
“The defense sector faced a similar problem after World War II.”
That reminded me of a problem the U. S. faced in WWII, breaking enemy codes. After WWI the government had dismantled the U. S. code breaking apparatus. President Wilson said, “Gentlemen do not read other gentlemen’s mail.”
The solution? Enlist the Army Band to learn codebreaking.
It would not surprise me if talented musicians could learn financial derivatives well enough to regulate them in short order. :) Or how about talented computer programmers? You do not have to mine the industry for the requisite skills, surely.
The trouble with this type of thing is that there is so much disagreement. It isn’t a matter of one person being an expert and the other not knowing what they are talking about. Intelligent, experienced and disinterested economists come to radically different conclusions based on exactly the same data (and how the weight or discount parts of the data set). We can typically explain the diverge with ideology, but the fundamental problem remaining is that there is no way of knowing which is correct. It’s no different with finance.
“Secondly, there are many mathematical experts in other fields such as physics with detailed knowledge of fitting mathematical models to data. There are standard tests and methods for determining the goodness of fit. These experts can almost certainly demonstrate that the specific mathematical models used to value mortgage backed securities (and most other derivatives) are seriously flawed (falsified!).”
Did you miss the last decade? These were the people designing the more complex structures.
Or bridge players (Jimmy Cayne, anyone?), poker players, chess players, go players?
“Did you miss the last decade? These were the people designing the more complex structures.”
That’s the point, isn’t it? People with the skills to design those structures can also analyze them. And they are not necessarily within the financial industry.
All claims regarding the usefulness of OTC derivatives are addressed to the ignorant. That is how PR works. The arguments SOUND reasonable, because the ignorant have no idea what is really going on.
Do you distinguish the Boomers from the Hippies? Weren’t the Hippies against the Military-Industrial Complex (in a non-violent way, of course)? Weren’t they about living in harmony with the environment, not about squandering resources, even as they were about living in the here-and-now?
“This strikes me as backwards. We do not need government to hire a bunch of PhDs so that it can have independent “expertise” on complex financial instruments. What we need is to ban all financial instruments complex enough to require a PhD to understand.”
Good point! :)
“Decreased risk”? You mean like we have seen in action for the past two years?
One lesson of this crisis is that these fancy instruments do not decrease risk at all; they hide risk and create perverse incentives. For example, lenders do not care whether a borrower will ever repay as long as they can “hedge their exposure”. This is a bug in our system, not a feature.
As for “liquidity”, I have heard no compelling argument for why it is desirable to anybody other than speculators, but I know quite a few arguments for why it is harmful. Steve Waldman said it better than I ever could, but briefly… I believe we want investors to have difficulty entering and exiting positions, because then maybe they will actually bother to consider what they are buying instead of programming their supercomputers to dodge in and out of positions thousands of times per second. But then, I believe one of these is a good thing for the financial sector to do, while the other is a bad thing for the financial sector to do. I consider this to be self-evident, which is why I ask for evidence to the contrary.
Huh? One symptom of the cause of the bubble was excessive faith in the abilities of mathematical models to accurately describe financial markets. The models got developed by bringing in experts in fields such as physics (and math), who were really good at applying standard tests and methods for determining the goodness of fit. These experts certainly demonstrated that the specific mathematical models used to value mortgage backed securities were robust and not seriously flawed. Until they were proved wrong.
Whether you want to describe it as Soros’s “reflexivity” or something else, human behavior and common sense (or lack there of) are not easily captures in mathematical models, which is why the million that the financial sector spent on financial models didn’t save them.
In other words, I don’t think the failure had much to do with not having enough math talent around. I think it had much more to do with a failure of common sense and bubble psychology.
So your belief is that the hedge funds, banks, insurance companies and other financial institutions that use OTC derivatives are merely ignorant? Or they wish to deceive the public so that they do what, exactly?
The fact that these things exist suggests that someone believes that they have value. Those people may be misguided, or may be poor evaluators of risk (aren’t we all?), but that doesn’t make them necessarily deceitful.
I would love to see Simon do a piece on this. I have been doing a lot of research to understand the value of these instruments and to understand why we need them and I cannot find anything out there that convinces me these instruments are needed or are in any way desirable to the economy at large.
Well, yes, you would *think* the experts had carefully applied standard tests and verified that the models worked.
However, see for example Nassim Nicholas Taleb’s writing on this very issue:
http://www.edge.org/3rd_culture/taleb08/taleb08_index.html
in particular the technical appendix which argues that most financial assets have a kurtosis inconsistent with Gaussian statistics.
There is a good non-technical discussion of these issues in When Genius Failed by Roger Lowenstein about the Long Term Capital Markets (LTCM) failure, which is very similar to the current fiasco, involving many of the same players.
John
If you want people who can look at things from a different view point look to your IT systems trouble shooters. Among these folks you will find the best problem solvers who also have an innate understanding of how systems work and who are quick learners capable of understanding systems content. They have the advantage of not being blinded by being experts in “content” and understand that nothing is above being questioned when systems need stabilizing. They would, however, need access to subject matter experts.
In this matter, simple solutions are the best: outright ban.
Nobody should be wasting mental energy figuring out complex financial “products” that bring no benefits to society. Whenever finance becomes rocket science, somebody is about to be conned. And thanks to the government that somebody is us.
Perhaps more relevant to this issue (including a proposed National Institute of Finance) is a later, less well known part of Eisenhower’s farewell address:
Akin to, and largely responsible for the sweeping changes in our industrial-military posture, has been the technological revolution during recent decades.
In this revolution, research has become central, it also becomes more formalized, complex, and costly. A steadily increasing share is conducted for, by, or at the direction of, the Federal government.
Today, the solitary inventor, tinkering in his shop, has been overshadowed by task forces of scientists in laboratories and testing fields. In the same fashion, the free university, historically the fountainhead of free ideas and scientific discovery, has experienced a revolution in the conduct of research. Partly because of the huge costs involved, a government contract becomes virtually a substitute for intellectual curiosity. For every old blackboard there are now hundreds of new electronic computers.
The prospect of domination of the nation’s scholars by Federal employment, project allocations, and the power of money is ever present – and is gravely to be regarded.
Yet, in holding scientific research and discovery in respect, as we should, we must also be alert to the equal and opposite danger that public policy could itself become the captive of a scientific-technological elite.
John
“Well, yes, you would *think* the experts had carefully applied standard tests and verified that the models worked.
However, see for example Nassim Nicholas Taleb’s writing on this very issue:
http://www.edge.org/3rd_culture/taleb08/taleb08_index.html
in particular the technical appendix which argues that most financial assets have a kurtosis inconsistent with Gaussian statistics.
There is a good non-technical discussion of these issues in When Genius Failed by Roger Lowenstein about the Long Term Capital Markets (LTCM) failure, which is very similar to the current fiasco, involving many of the same players.
John”
Oddly enough, it was exactly Taleb’s criticism (among others) that I had in mind. But unless I am misunderstanding him (always a possibility), he isn’t saying just that the models in use were not “verified,” but also that they cannot be verified.
My point, however, was more limited. The people designing the models thought they worked. Bringing a team of new quants to do new models likely only generates the same result. The quants will think their model works until they learn otherwise.
If you have never used the financial products in question, and never had a need for them, are you really in a position to say that they have no value to society? Isn’t it at least possible that there might be realms of usefulness (1) beyond your personal experience, and (2) beyond your ability to project?
Perhaps the risks outweight the benefits, but let’s not pretend that someone doesn’t (or didn’t) value the instruments you seek so quickly to dismiss.
Well, I can see how the mission of the National Institutes of Health relates to, say, the “promote the general welfare” clause in the Constitution.
How exactly would a National Institutes of Finance relate to the objectives of our government? Would it seek to identify and help eradicate financial products and services that are a pox on the general welfare?
I believe Taleb’s criticism is more pointed. The kurtosis figures are intended to show that the financial assets do not follow the Gaussian statistics assumed in many popular valuation models such as the original Black-Scholes option pricing model. So he is saying the models are demonstrably false.
In less technical terms, most financial assets exhibit rare sharp jumps, usually corresponding to market crashes, that do not follow the Gaussian/Normal/Bell Curve distribution as well as many models used in pricing derivative securities. The financial assets also occasionally exhibit extreme deviations from assumptions such as that different assets are uncorrelated and so forth.
Truly independent experts whose salaries/bonuses/etc. do not depend on the derivatives business can probably demonstrate this yet again rigorously.
It is difficult to get a man to understand something when his job depends on not understanding it.
Upton Sinclair
John
Many of us that spent our lives in a corporate bureaucracy long understood the requirement of pretending not to understand if understanding is deleterious to our paychecks. In a corporate or state bureaucracy this is the first rule of survival. You excercise what you understand as apart from what you pretend only when it is politically required for your personal survival and increased emoluments. Bridging the gap in understandings from a failed understanding to a workable understanding reqires great skill that takes a long time to master. Princes are touchy.
Every so often circumstances allow you to present your real understanding of the problem or issue at hand. At that point you must be very adept at integrating your real understanding with the cultural view of the particular prince or princes of the moment.You do this or become the prince yourself . If you move and fail you move elsewhere.
The problem of disguised better understanding has been with bureaucrats since the very beginning of complex organizations. The problem is eternal. Yet, I often wonder if the acme of the problem might not be in operation with present US elites. US elites base claim to their position resides in their degreed knowledge which is mostly theory and compatible ideology. Mess with their theory understandings and you put down the very knowledge that underpins their eliteness. To the last person, elites understand that once they ” buy into” a concept it must be defended vigorusly in network with those of similar view.
These understandings worked for me. I worked in the corporate world for 52 years and never ever had the need to file for unemployment. On top of that, I only worked for three companies after public accounting. I did have one caveat though. I never, by choice, ever worked for a company that was more than nominally publically held and the last 25 years for a purely private company.
Independent evaluation organizations must work within the framework of bureaucracy to minimize their becoming bureaucratically moribund. That has always been a tall order because ineptitude is only held at bay by vigorus structures that require participants go on the record. Any financial evaluations probably should be one persons call and goes out under that person’s name. Soon enough the expert will have a following or will be disregarded.
The evaluation organization should therefore be quite loose. The opinion writer on a product should get the bulk of the fee.
Isn’t it odd to hear a lot of pro market economists want to test something outside of the market. That strikes me as a negation of their theory. Instead of abandoning the concept of markets-as-gods they find it easier to ask for testing of products before the market gets a say. What would saint Milton Friedman say?
As for the comments above about the math: it was not the abundance of math talent that caused the melt down. It was that they used the wrong math. It was a case of being stupid in a really clever way. And that’s the worst kind of stupid.
I’ve studied all this long enough that I can confidently say if there were a legitimate use for these things I would’ve heard of it, and if there were people engaged in worthwhile actions I would’ve heard of them.
There definitely is not and there are not. Just cons and criminals.
Somehow, I have questions about your objectivity.
Since everyone really knows that derivatives are completely useless and extraordinarily dangerous, and I don’t mean vanilla stuff like straightforward futures, options, etc. but the CDOs, CDSs that nearly and may still destroy the world economy, it’s very dismaying to see Mr. Johnson temporize on this topic.
I agree with Nemo: no experts, financial or otherwise, are needed. The products should be banned forthwith. We need people like Mr. Johnson to issue clarion calls for this to happen, along with indefinite extensions to Federal UI, and a new stimulus package.
When Mr. Johnson, Mr. Kwok et al. act less like Robert Skidelsky and more like Paul Krugman, the world moves closer to the second Great Depression that we’ve so far managed to avoid, just barely.
This was the original idea behind certified public accountants. They would be able to examine a companies books, analyze the value of all its assets, including financial assets and place some value on them. Part of the problem is that accountants developed various conflicts of interest which made this difficult and part of the problem is that practices in accounting did not keep up with the changing world of finance.
Just kill the Mortgage Interest Tax Deduction. It’s the root cause of 30-year toxic MBOs. Why? The tax deduction creates cheap money that can be borrowed for a long time. And that results in 30-year securities that are impossible to value.
Also we need to stop bailing out banks that get burned by derivatives. If they are taking risks, at least let them do it with their own money.
I think America just needs to get used to smaller houses.
Start by taxing all derivatives while looking for clever individuals to dream up regulations. I’ve yet to hear any remotely sound argument against a small stamp duty tax. In early 2008 the City of London claimed it was creating $600bn of OTC derivatives contracts per day (approximately 40% of the worldwide market).
A 0.5% tax (stamp duty) giving $3bn per day to the UK treasury might become an irresistible proposition to any UK Chancellor, let alone politically popular with the majority of main street voters. Is $1 trillion per annum chicken feed to the US treasury?
If necessary point out the level of income tax rises needed on the higher paid to generate the same cash or how many dollars extra on gasoline tax. A 20% Federal VAT (common in Europe) may be another option to consider.
Maybe call it temporary – like income tax:-) The UK and Europe want to introduce such a tax, but Tim Geithner says it’s too easily avoided. Perhaps he would like to share his expertise on tax evasion in more detail?
What is certain is that treasuries in US, UK and EUR desperately need more revenues and most other forms of taxation would not be as hugely popular. Europe might go ahead anyway which could have the effect of pushing the business (and any attendant financial risk – but no tax revenue) to New York.
I believe that I can state the solution quite succcinctly: (1) require that all derivatives be traded publicly and tranparently, or (2) outlaw all of them. Why are they really necessary, except to allow the financial giants to confuse and deceive investors and the public. The only real benefited parties are the dealers and creators so far as I can tell. And obviously they create far more risk than benefit under present conditions. But, that said, I realize that I am spitting into the gale, and this makes Larry’s proposal at least mildly interesting. Sorry, ever the skeptic me.
The Mortgage Interest Tax deduction was killed off years ago in the UK, but had no braking effect on the housing price bubble. Maybe a 6% stamp duty as in France and CGT even on primary residences might be more use. In fact French house prices have gone up (and down) hugely too but loans (LTV) were far more conservative, so far fewer people are underwater.
Word Nemo and Russ!! We either recognize the grotesque injustice, the crimes committed and the very real suffering of the people on one hand, and the otherwordly government largess and wealth of the predatorclass on the other, – or we don’t. If we do, then predatorclass heads will roll. If not, – then we are a criminal nation owned and controlled by predatorclass criminal oligarchs and syndicates and gangs, and what are we then as a nation or a people???
FAILED insitutions, and FAILED management pimping and bruting FAILED models and “innovative products” must be held accountable for thier FAILURE!!!! Shadowing or cloaking these crimes and failures is a ruthless attack on every principle America was founded upon, and the core values we send our young daughters and sons to defend.
Have you no shame gentlemen? Have you no shame?! Crimes were committed, and crimes are being committed now. Criminals must be held accountable for crimes. Or – in effect – there are no laws. Where are no laws, – there are no laws for anyone predatorclass biiiiaaatches!
This also sounds reasonable. To see why it isn’t read a little Satyajit Das or Frank Partnoy. Don’t expect to be educated in a sound bite.
There is no disagreement among people who both understand how these instruments work and have no personal interest in cashing in on them (or corrupt interest in enabling those who do).
As for ‘disinterested economists’, every ‘economist’ makes his career on the back of a model which ignores reality. Why not canvas disinterested alchemists?
Try to understand that rational approaches to markets are always wrong because of the overriding influence of leverage; therefore, you must try to create the least potentially damaging model. Otherwise, you end up where we are, sooner or later.
Soros explains this very well in The Crash of 2008.
We have now all been used by them to the tune of fourteen trillion and counting. Are you a Congressman or a lobbyist?
Since when is failure a crime?
hmmm. yet the hippie culture faded out. it couldn’t compete with the dominant culture, which completely ignored Ike’s good advice.
When failure is executed by someone who takes a great deal of money out of the failure, it begins to look more like fraud.
AJ,
Jake and others are completely right: S. Das, derivatives expert, has explained time and again that CDS can NOT work as advertised.
Now BIS and FDIC are VERY worried that interest rate derivatives may blow up. Please, please realize that about 85% of derivatives are interest rate swaps. We’re talking about some $ 400 trillion (!!!). Imagine what might happen when rates change all of sudden. They are financial weapons of mass destruction (source: Buffett).
Or listen to Adair Turner, chairman FSA, London:
““Some financial activities which proliferated over the last 10 years were socially useless, and some parts of the system were swollen beyond their optimal size,” he told the gathering.
…..
Turner is mostly unrepentant. While his words may have been imperfect, he now says, he stands by the sentiments behind them. “I wish I had said ‘economically useless’ rather than ‘socially useless,’ as it would have been more precise,” he says.
http://www.bloomberg.com/apps/news?pid=20601109&sid=aKeO6gsaeQ_M&pos=11
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Yeah, but that argument’s bogus and untrue. “Decreased risk” was blown out of the water in 2008 — complex products inherently increase risk because the risks of nontransparency are many times every other sort of risk.
“Increased liquidity” of what? The ‘toxic assets’ were illiquid because they couldn’t be unwound properly, and this is typical of complicated structured products: they’re too complicated to unwind, which creates illiquidity of the underlying assets.
Increased liquidity of the synthetic derivatives has no function: it’s fundamentally just an increase in the supply of money, but this is undesirable as money supply should be left under the control of Treasury and the Fed.
The incentives are structured so that the people running the banks (etc) generally get paid whether or not they bankrupt their companies. The OTC derivatives are often quite good for getting those people paid — but not good for the banks and other companies as institutions.
In some other cases, the derivatives *are* good for the deceitful criminals on one side of the operation, and the people on the other side are suckers.
The Hippie culture never faded out really. Why do you think we have strong support for sex ed, drug legalization, and of course environmental protection? Those used to be *marginal, unpopular* views.
The Hippies are slowly but surely winning. They’re just wearing suits from 9-5 now. :-)
I can tell you exactly which financial “derivatives” are useful:
(1) plain vanilla options
(2) plain vanilla futures
on (A) stock, (B) commodities, and (C) currency (only futures not options)
(3) insurance, governed by insurance regulations
Everything else is unnecessary and dangerous. Any legitimate use of anything else can be restructured into the simple components above.