Tag Archives: finance

How Much Does the Financial Sector Cost?

Benjamin Friedman, in the Financial Times (hat tip Yves Smith), questions the high cost (read: compensation) of our financial sector. But he does not simply say that huge bonuses for bankers are unfair. Instead, he says that the costs of financial services need to be balanced against their benefits.

The discussion of the costs associated with our financial system has mostly focused on the paper value of its recent mistakes and what taxpayers have had to put up to supply first aid. The estimated $4,000bn of losses in US mortgage-related securities are just the surface of the story. Beneath those losses are real economic costs due to wasted resources: mortgage mis-pricing led the US to build far too many houses. Similar pricing errors in the telecoms bubble a decade ago led to millions of miles of unused fibre-optic cable being laid.

The misused resources and the output foregone due to the recession are still part of the calculation of how (in)efficient our financial system is. What has somehow escaped attention is the cost of running the system.

In particular, Friedman wonders at the relationship between the value provided by financial services and the opportunity cost involved: “Perversely, the largest individual returns seem to flow to those whose job is to ensure that microscopically small deviations from observable regularities in asset price relationships persist for only one millisecond instead of three. These talented and energetic young citizens could surely be doing something more useful.”

This reminds me of something Felix Salmon wrote about a while back: If profits and compensation in the financial sector go up and keep going up, that’s a priori evidence of inefficiency, not efficiency. Those higher profits mean that customers are paying more for their financial services over time, not less, which means that financial services are imposing a larger and larger tax on the economy. Now, it is possible that they are also increasing in value fast enough to cover the tax, but that is something to be proven.

By James Kwak

More and Better

After the wholesale discrediting of the strong form of the efficient markets hypothesis, Robert Shiller may be the most respected financial economist in the world at the moment. This is what he has to say on the last page of Justin Fox’s The Myth of the Rational Market:

Finance is a huge net positive for the economy. The countries that have better-developed financial markets really do better. . . . I think that we’re less than halfway through the development of financial markets. Maybe there’s no end to it.

I think Shiller’s first and second sentences are almost certainly true. There is a strong correlation between having a high material standard of living and having a relatively sophisticated financial system; think of the United States, Japan, and Germany as opposed to Zimbabwe, for example.  But you can’t infer that more financial market “development” is always better. (I’m not saying that Shiller necessarily believes that, but most of the defenders of financial innovation take it for granted.)

Just because something is good, it doesn’t necessarily follow that more of it is better. Take food, for example. It’s pretty obvious that over a wide range – say from 0 to 1500 calories per day – more food is better for you. For most people that range probably extends up to 2000 calories or a little more. After that, not so much.

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The View from the Top

One of our longtime readers recommended “The Death of Kings,” Nick Paumgarten’s “notes from a meltdown” in The New Yorker (subscription required, or $5 for this issue alone) a few weeks back. The article is mainly color rather than analysis; it’s a series of portraits of people on “Wall Street,” ranging from the merely rich to the astoundingly rich, and what they think of the crisis. Paumgarten paints a picture of people who know that we are all screwed but regard the phenomenon with a mix of intellectual superiority, self-righteousness, and resignation. The vignettes are certainly not representative; I’m sure most bankers and traders, though perhaps not working quite as hard as in 2005, are still scrambling to make the next killing. But they are still a window into a world most of us will never see.

There are two passages in the article I thought were particularly . . . “insightful” isn’t the quite word . . . maybe “poetic” is better. The first is a quotation from Colin Negrych, a successful money manager and the article’s Voice of Wisdom:

“What constituency is there for pessimism? People believe optimism is necessary, an American right. The presumption of optimism is the problem. That’s what creates the debt we have now.” 

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Option Pricing for Beginners

For a complete list of Beginners articles, see Financial Crisis for Beginners.

I’ve had two posts so far on the terms under which Treasury sold back to Old National the warrants on Old National stock that Treasury got in exchange for its TARP investment, so I thought it was time for an introduction to warrant/option pricing.

The warrants received by Treasury give Treasury the right to buy common stock in the issuing bank under predefined terms. Buying the stock is called exercising the warrant. The warrant specifies how many shares Treasury can buy; the price that it must pay to buy them (the exercise price); and the term of the warrant, meaning how long Treasury has to decide whether or not it wants to exercise the warrant. If Treasury never exercises the warrant, then it expires and nothing happens. For our purposes, a warrant is the same as a call option; there are some differences I will ignore, which are outlined here.

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Structured Finance for Beginners

For a complete list of Beginners posts, see Financial Crisis for Beginners.

This is more of an advanced beginners topic – I already covered CDOs (collateralized debt obligations) in my first Beginners article – but I imagine that most of our readers are already familiar with structured products. At least, many people know that first a bunch of securities are pooled together, and then they are “sliced and diced,” in the common media parlance I find incredibly annoying. But Joshua Coval, Jakub Jurek, and Erik Stafford have a new paper, “The Economics of Structured Finance,” which does a brilliantly clear job of describing what these securities are and why they were so widely misunderstood, with the results we all know.

The paper is 27 pages long, not counting references, tables, and figures, and if you are comfortable with probabilities and follow it carefully you can understand everything in it. I will provide a summary to whet your appetite. I am not going to use numerical examples because the examples they use throughout their paper are so good.

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