Real Problems, No Easy Solutions

On Monday I wrote a post criticizing the sloppy way that Robert Shiller argued for financial innovation, which focused primarily on the use of metaphor and secondarily on the use of a valid example (people are overly cautious about some financial products) to make an invalid general point (people are overly cautious about all financial products. Then I threw in a sloppy paragraph, because I wanted to get to the end of a long post:

“From there, the article actually gets better, because Shiller gives us examples of areas where he thinks financial innovation would be good. And here I don’t really disagree with him that much. I agree with him that reliance on housing as an investment vehicle is bad. I don’t really agree that target-date mutual funds are such a good idea (since as far as I can tell the conventional wisdom about switching from stocks to bonds as you age is the equivalent of an old wives’ tale), but they are probably better than many of the things people are currently invested in. Retirement annuities, another thing he recommends, would definitely be useful if you could get them at a decent price. (I believe now they suffer from a significant adverse selection problem.)

“For the sake of argument, I am willing to concede that these are useful innovations that would make people better off.”

Felix Salmon rightly points out that I shouldn’t have conceded it for the sake of argument. Really, what I should have said was that I agreed with Shiller that people face real problems — relying on housing for investment is bad, and it “would definitely be useful” if you could get inflation-adjusted annuities for retirement. (I don’t like target-date funds, and I said so.) But since I had already made my main point (the one about metaphor), I didn’t look into the specific innovations that Shiller was proposing to solve these problems. Salmon points out accurately that the proposed solutions rely on embedded options that ordinary consumers are likely to get screwed by. I recommend reading his post.

By James Kwak

19 responses to “Real Problems, No Easy Solutions

  1. I can’t believe James Kwak used the word “screwed”. My degenerate posts are finally rubbing off on him.

  2. I read Salmon’s post. What seems to be strangely missing is all aspects of this interchange of ideas is who supplies, hence owns, the underlying value that supports vehicles like derivatives. Every fellow building contractor I know knew the mortgage scheme was going to go bust as early as 2002. What we didn’t know was how the scheme was being pulled off.

    I finally took the time to follow the underlying madness. The issue familiar to building contracts asks, “Where is the value that will support the sale price, in order to repay the debt?”

    This question seems to be lost on economists. I would love to be corrected if I am wrong.

  3. Also, James, in regard to the difference between simile and metaphor. Since I have taken double-entry book-keeping apart in its every detail, and that its language is grammatical, I suggest this definition: a simile is to the subject|predicate relation in a sentence as metaphor is to the group of sentences that report a story’s object.

  4. > relying on housing for investment is bad

    i’m really not sure why you think this. can you elucidate?

    of course we just went through a housing bubble and that was a bad thing, but that doesn’t invalidate the basic principle.

    do you think it’s better for people (en masse) to rent housing and own separate inflation-linked annuities?

    one thing to keep in mind is that there is no free lunch here. ultra-safe investment positions (such as an inflation linked annuity) do not reduce aggregate risk. they move risk from one party to another.

  5. This is a key issue.

    A big problem with derivatives is that they blur the connection between risk and return.

    Making derivatives like inflation-linked annuities, where you promise good risk free returns to one party, pervasive has the problem that, in order to keep all other things equal, someone else has to take on all the risk, and if the economy fails to deliver strong returns, that other party will be wiped out. In other words, if you create one class of low-risk investors, you necessarily increase leverage of other parties.

    Being highly levered is a good thing if your underlier is doing well.

  6. Even a plain vanilla mortgage contains an embedded option, which I imagine most borrowers find very useful. In fact, much of the demand for interest rate derivatives stems from lenders’ need to manage the duration risk associated with this option.

    If I recall correctly, what we have come to know as a plain vanilla mortgage was a financial innovation introduced following the Great Depression; prior to the Great Depression, mortgages typically had much higher required downpayments, shorter terms, and were structured to include a balloon payment. The products we are familiar with now probably took some getting used to at one point in history. And the optionality involved is now widely understood and accepted.

  7. Have you called Phil Gramm about that job as a bank lobbyist yet???

  8. Bond Girl,
    Between the end of the Great Depression to the early 1980s swaps did not exist. Also during that time there were very very few banks that went insolvent. Could you explain to us how it is that very few banks went insolvent when there were no swaps to help with interest rate risk???

  9. good points, bond girl.

  10. Interest rates were relatively stable until the 70s – early 80s. That period was pretty instructive on the need to manage interest rate risk.

    And yes, many institutions have failed because of interest rate risk. Remember S&Ls?

  11. S&Ls began to fail well into the 1980s.

  12. The failures accelerated well into the 1980s due to the Tax Reform Act of 1986. I do not think you have much of an argument if you think interest rate risk was not driving it, however.

    It is not an accident that interest rate derivatives started to gain in popularity in the 1980s.

  13. Bond Girl,
    Your knowledge is lacking in some areas of economic history. Lincoln Savings and Loan collapsed in 1989, not in the 70s. S&Ls failed due to DEREGULATION. 747 S&L associations failed during this time. Savings and Loan associations could choose which charter they were under, state charter or federal charter. S&Ls chose federal charters in states like California and Texas because the federal charters had less strict regulations.

    You can ask ask John McCain about that. He was part of a group named “The Keating Five” that was very friendly with a man named Charles Keating. Charles Keating was Chairman of the Lincoln Savings And Loan Association and served 5 years in prison for corruption.
    http://en.wikipedia.org/wiki/Keating_5

  14. Here is a good historical overview of interest rate and credit risk management in the (modern) mortgage market from Arnold Kling to give you some background. It addresses how various market participants have been affected by risk and innovations over time, including S&Ls, agencies, and private market participants. Likely not sufficiently politically biased for your tastes, but at least I tried.

    http://www.finreg21.com/lombard-street/should-mortgages-be-securitized

  15. Also, a note to StatsGuy, if you are reading this —

    Kling’s argument about what would be necessary to return to the S&L model is interesting. Perhaps NGDP or CPI futures targeting (a la Sumnner) could help us return to boring banking?

  16. Bond Girl,
    Yes, I know Wikipedia is so well known for their “political bias”. I’m so sorry those FACTS aren’t useful to you and the bank lobbyists.

  17. bond girl, speaking of arnold kling, here’s his paper on the roots of the financial crisis. it’s a very interesting read.

    http://www.mercatus.org/PublicationDetails.aspx?id=28118

  18. Many thanks, q!

  19. I read the following on a sports website (http://www.footballoutsiders.com/walkthrough/2009/walkthrough-ramblin-gamblin-man), and thought it would be of interest in one of the financial innovation discussions here:

    “In Delaware, you aren’t allowed to bet single games. Instead, you bet parlay cards, choosing a minimum of three games. The Half-Point Parlay cards are based on the true Vegas lines for the game, although some are moved a half point to avoid pushes. The Teaser Cards have modified lines for favorites and underdogs; for the Ravens game, I could take the Ravens minus-8.5 or get the Browns plus-20.5 instead of the regular 12.5 point line. The catch, of course, is that payoffs aren’t as good on the Teaser Cards: a three-game winner pays at 13-to-5 as opposed to 5-to-1 for a half-point parlay. There’s also a Super Teaser card, which lowers the payoffs further but warps the spreads past the point of logic: the Chiefs +27, while it seemed like a safe play, was just too much to wrap my brain around.”

    How similar does that sound to financial innovation, where the goal is also to relieve the innumerate of their cash?