10 ms·

The Profit Motive Behind Financial Complexity

110 points by chollida1 9y ago

vostok 9y ago
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 9y ago
  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.
  - vostok 9y ago
    > You certainly can witness that with municipalities that are close to going bankrupt because they bought instruments that backfired on them. That seems to be a story about corrupt hiring practices at municipalities. Maybe they should look into hiring the kid with the foreign name and funny accent instead of their high school buddy's kid. I'm sure they got screwed on all sorts of construction contracts too.
    - maxxxxx 9y ago
      Maybe the bankers could stop selling things to people that don't understand them?
      - vostok 9y ago
        First, I don't see how they (arguably more like a trader or a sales person than a banker) can possibly determine whether or not you understand the product. You don't generally expect car sales people to determine whether or not you really need a Ferrari or if a Toyota will do. Second, we all buy financial products that we don't understand and we generally benefit from them. Many people use fixed rate mortgages to buy homes and index funds to invest. I'd argue that they probably don't understand those products as they're relatively complex underneath the surface. This isn't financial advice, but I'd argue that they do benefit from using them.
        uiri 9y ago
        Neither fixed rate mortgages nor index funds are particularly complex. The idea behind an index fund is that it invests in the components of an index. Generally, that is a specific basket of stocks or bonds. Stocks are perhaps the most straightforward financial instrument: pieces of ownership of a company. Bonds are a bit more complex, but they're just the right to repayment of a loan (principal plus interest). Complexity arises if the fund can't directly invest in the components of the index and most replicate it with other things instead but that's an implementation detail and an individual is perfectly capable of buying the individual components themselves if they're worried about that. A fixed rate mortgage is a loan with a fixed, compounding interest rate and a fixed term. The mortgage payment is determined based on an amortization schedule but that's an implementation detail - it could just as easily be monthly interest plus a fixed portion of the principal or something else.
        vostok 9y ago
        By your standards, MBS are also not particularly complex. They're not that different from pools of mortgages. In fact they have a lot of similarities with index funds and tranches are similar to options on the index. The complexity is precisely in the details. How much is the pre-payment option on your fixed rate mortgage worth? How much is the embedded interest rate swap that differentiates a fixed rate mortgage from a floating rate mortgage worth?
      - 9y ago
  - WalterBright 9y ago
    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 9y ago
      People have a very good understanding of a car's risks. Same for computers.
      - tedunangst 9y ago
        That's a very questionable assertion.
        meesterdude 9y ago
        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.
    - sah2ed 9y ago
      Cars and certain investment products are complex, yes but that's where the similarity ends. People don't generally buy cars with the expectation of a return like is typical for investments. The article was complaining about how complexity can impede sussing out how much risk a sufficiently informed investor might be exposed to from owning a complex security, this is a different kind of risk from not being sufficiently informed while actively using a complex product (like your car example).
bradleyjg 9y ago
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.
pessimizer 9y ago
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 9y ago
  >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!
clairity 9y ago
> "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 9y ago
  > 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 9y ago
    > 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__ 9y ago
      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
WalterBright 9y ago
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 9y ago
  > 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 9y ago
    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 9y ago
      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 9y ago
        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.
Animats 9y ago
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.
- RA_Fisher 9y ago
  Gaussian? Risk is asymmetric, so I'm sure they use something more like an extreme value model.
- alexbeloi 9y ago
  >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
yuhong 9y ago
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.
rumcajz 9y ago
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 9y ago
  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.

110 points by chollida1 9y ago

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 9y ago
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.
- vostok 9y ago
  > You certainly can witness that with municipalities that are close to going bankrupt because they bought instruments that backfired on them. That seems to be a story about corrupt hiring practices at municipalities. Maybe they should look into hiring the kid with the foreign name and funny accent instead of their high school buddy's kid. I'm sure they got screwed on all sorts of construction contracts too.
  - maxxxxx 9y ago
    Maybe the bankers could stop selling things to people that don't understand them?
    - vostok 9y ago
      First, I don't see how they (arguably more like a trader or a sales person than a banker) can possibly determine whether or not you understand the product. You don't generally expect car sales people to determine whether or not you really need a Ferrari or if a Toyota will do. Second, we all buy financial products that we don't understand and we generally benefit from them. Many people use fixed rate mortgages to buy homes and index funds to invest. I'd argue that they probably don't understand those products as they're relatively complex underneath the surface. This isn't financial advice, but I'd argue that they do benefit from using them.
      - uiri 9y ago
        Neither fixed rate mortgages nor index funds are particularly complex. The idea behind an index fund is that it invests in the components of an index. Generally, that is a specific basket of stocks or bonds. Stocks are perhaps the most straightforward financial instrument: pieces of ownership of a company. Bonds are a bit more complex, but they're just the right to repayment of a loan (principal plus interest). Complexity arises if the fund can't directly invest in the components of the index and most replicate it with other things instead but that's an implementation detail and an individual is perfectly capable of buying the individual components themselves if they're worried about that. A fixed rate mortgage is a loan with a fixed, compounding interest rate and a fixed term. The mortgage payment is determined based on an amortization schedule but that's an implementation detail - it could just as easily be monthly interest plus a fixed portion of the principal or something else.
        vostok 9y ago
        By your standards, MBS are also not particularly complex. They're not that different from pools of mortgages. In fact they have a lot of similarities with index funds and tranches are similar to options on the index. The complexity is precisely in the details. How much is the pre-payment option on your fixed rate mortgage worth? How much is the embedded interest rate swap that differentiates a fixed rate mortgage from a floating rate mortgage worth?
    - 9y ago
- WalterBright 9y ago
  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 9y ago
    People have a very good understanding of a car's risks. Same for computers.
    - tedunangst 9y ago
      That's a very questionable assertion.
      - meesterdude 9y ago
        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.
  - sah2ed 9y ago
    Cars and certain investment products are complex, yes but that's where the similarity ends. People don't generally buy cars with the expectation of a return like is typical for investments. The article was complaining about how complexity can impede sussing out how much risk a sufficiently informed investor might be exposed to from owning a complex security, this is a different kind of risk from not being sufficiently informed while actively using a complex product (like your car example).

bradleyjg 9y ago

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.

pessimizer 9y ago

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 9y ago
>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!

clairity 9y ago

> "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 9y ago
> 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 9y ago
  > 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__ 9y ago
    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

WalterBright 9y ago

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 9y ago
> 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 9y ago
  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 9y ago
    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 9y ago
      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.

Animats 9y ago

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.

RA_Fisher 9y ago
Gaussian? Risk is asymmetric, so I'm sure they use something more like an extreme value model.
alexbeloi 9y ago
>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

yuhong 9y ago

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.

rumcajz 9y ago

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 9y ago
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.