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Why are investment banks casinos? what's so terrible about derivatives? They're not "pseudo" products, or any more "dangerous" than say a stock. Firstly deriva

by retube 13y ago

Why are investment banks casinos? what's so terrible about derivatives? They're not "pseudo" products, or any more "dangerous" than say a stock. Firstly derivatives have been in use for thusands of years - first employed to lock in prices for future crop harvests. Now millions of businesses rely on derivatives to manage fx exposures, commodity exposures, interest rate exposures and so on. Without recourse to such products companies future cash flows would be much less predictable and expose companies to material risks. Contrary to what you might hear, derivatives ARE socially useful (e.g think the S.Korean business who hedges his USD-denominated payroll liabilities). Secondly, IBs are not casinos. They take risks, but so do retail banks (they borrow short and lend long so you have a duration mis-match leading to credit, liquidity and interest rate exposures). The financial crisis was born out of over-enthusiastic mortgage lending - i.e your basic retail product. Even lehman brothers, a classic IB, went down due to it's large commercial property portfolio which tanked in the crisis (again, nothing to do with derivatives). In all crises governments and the media need someone to blame. IBs are the scape goat this time. But the reality is a heck of a lot more complex than a simplistic "greedy IB assholes running amoke and stealing the world's wealth with nasty derivatives". Indeed all the regulation that's now been implemented is incredibly counter-productive. It doesn't make banks safer (people can and will always make stupid business decisions no matter how much regulation you deploy), it increases costs and restricts lending - the very opposite of what's needed to finance a return to, or increase in growth.

marcosdumay 13y ago
> Secondly, IBs are not casinos. They take risks, but so do retail banks They are different things. Retail banks take risks with their money (if a lend doesn't pay off, they are the ones that pay for it), IBs take risks with other people's money. In principle, there is nothing wrong with that, but IBs get money when they get positive returns for your investment, but don't suffer when the return is negative. That, again, is not a problem by itself, but it's an incentive for the IBs to assume the highest risks they can find around. And if left unchecked, they do become casinos.
- onebaddude 13y ago
  >They are different things. Retail banks take risks with their money (if a lend doesn't pay off, they are the ones that pay for it), IBs take risks with other people's money. When I buy stock in, say, Google or General Motors, whose money are they taking risks with? I didn't tell Google that I wanted them to put money into Uber, nor do I think it's a great idea. Too bad for me I guess. And what do you mean "they pay for it"? Do you think when Joe Public defaults on his mortgage it comes out of the broker's bonus? No, the default risk is priced into every transaction the bank does. You and I and every other shareholder or bondholder pay for it. Investing is investing.
- retube 13y ago
  > Retail banks take risks with their money Huh? No! They are taking risks with YOUR money. When they lend on a mortgage, or make a corporate loan to a business they're doing that with YOUR deposits. This is how a savings account pays interest. They take your money, lend it at some interest rate and pay you a slightly lesser one. If the bank goes bust it's YOUR money which is lost: and this is why in most countries there are Federal Deposit Guarantees (i.e the govt will cover you up to some level if a retail bank goes bust) Ironically this is precisely the OPPOSITE of the IB business model. They are NOT taking risks with your money: they fund in the money and debt markets, i.e they borrow the money to fund their activities.
digitalengineer 13y ago
In my country borrowing for your company became incredibly difficult (if not outright impossible) if you didn't 'hedge' yourself using derivatives. None of the (AAA) banks like Rabobank explained what the risks of using these products were. They were sold as 'safe' interest-fixed products. Apart from that most were locked at the Euribor rate. You know, the one they forged...
- retube 13y ago
  Mis-selling of swaps and attempts at libor fixing are completely seperate issues. They have nothing to with, or precipitating, the financial crisis.
  - digitalengineer 13y ago
    You ask 'what's so terrible about derivatives? ' well their very non-transparant nature and lack of regulation and registration.
    - 001sky 13y ago
      I'm not one to apologise for the post glass-stegal investment banks, but your're comment is confusing. Are you saying the banks tied the interest rtates on basic loans to companies purchases of other banking products? As a general rule, the financial crisis was caused by <loans that were too cheap>. Not by derivatives. The issue of derivitives is a more incidental role in the whole story. To use an analogy, something else caused the accident. Derivatives were like the airbag not deploying. Still a problem, but not in the way you are implying. It is also arguably the case that loans were too cheap because the banks were like a supermarket selling one product at a loss (debt) to get customers in the store (so called "loss-leader" product). And then they took advantage of the less educated consumers (ie, selling derivatives to people that should have known better). This is of course, why glass-stegal was in fact originally law. To prevent ths type of bundling. One thing this article fails to point out, though, is that the clinton administration got this model by copying it from the brits and europeans who long favoured the so-called "universal banking" model. so in that sense, its dis-ingenous to imply the usa was imposing or exporting this model via the WTO (it was the staus quo in Asia, too). For historical reasons, the continentals (eg, Germany), the Japaneese and others, never split off teh i-banks from the lending banks [1,2]. As a rsult, the CEOs of those combined banks were paid more than their US counterparts. This whole fiasco was driven by the US ceo's of the debt banks who were missing out on the windfalls accorded to the Investment Bank CEOs during internet 1.0 bubble. If you look at the history, the banks bought up the i-banks (as they had much larger balance sheets) and the CEO pay skyrocketed. [1] https://en.wikipedia.org/wiki/Universal_bank https://en.wikipedia.org/wiki/Universal_bank [2] https://en.wikipedia.org/wiki/Keiretsu https://en.wikipedia.org/wiki/Keiretsu
b1daly 13y ago
>The financial crisis was born out of over-enthusiastic mortgage lending - i.e your basic retail product. Even lehman brothers, a classic IB, went down due to it's large commercial property portfolio which tanked in the crisis (again, nothing to do with derivatives). How can you possibly say this? It was mortgage backed securities (derivatives) and collateralized debt obligations (derivatives of derivatives) that were the main product that allowed excessive lending, by obscuring the true risks. It was the markets for these securities that froze, causing the liquidity crisis that drove the financial crisis.
- retube 13y ago
  An MBS is NOT a derivative. It's a cash product. Either way you're missing the point. Securitisation is just a way of funding lending. Whether you use deposits, borrow from the money markets, or securitise loans, the money to make those loans has to come from somewhere. Ultimately it was mortgage brokers and the retail banks (or retail arms of universal banks) that sanctioned these mortgages and lent money to highly unsuitable people. Yes they were securitised and sold on but as I say above this is just a funding mechanism. Yes the IBs have some responsibility for not checking the quality of the loans but then there's an argument that should have been done already by the retail side. And of course no-one imagined that default rates would ever get as high as they did - which did wipe out some MBS and CDO tranches resulting in large losses for the holders. As an indication these types of issuance were typically stressed at default rates of 10% - and that was considered extremely conservative. What actually happened was some of these mortgage pools were so crappy default rates hit 80% or 90%.
  - redblacktree 13y ago
    Why would a mortgage broker care to do his due diligence, if he knows he'll sell the loan tomorrow, and take none of the risk of default? This is about incentives. Incentives that were bound to lead to excessive risk taking and an inevitable crash.
  - nissimk 13y ago
    Derivative does not equal swap. MBS is definitely a derivative. It's a bond whose price and cash flow is based on an underlying pool of loans. The mortgage loans themselves are not derivatives, but mbs are. Stock options are cash products and they are most certainly derivatives.
danmaz74 13y ago
Over-enthusiastic mortgage lending was fueled by the securitisation of that debt through CMOs, which create this situation in which those who work in mortgages retail couldn't care less if the mortgage is ever repaid - all they need is to find someone who will buy the security. Who created CMOs? Who made billions from them - until the collapse? Who was opposed to any form of regulation in financial markets?

by retube 13y ago

marcosdumay 13y ago

> Secondly, IBs are not casinos. They take risks, but so do retail banks They are different things. Retail banks take risks with their money (if a lend doesn't pay off, they are the ones that pay for it), IBs take risks with other people's money. In principle, there is nothing wrong with that, but IBs get money when they get positive returns for your investment, but don't suffer when the return is negative. That, again, is not a problem by itself, but it's an incentive for the IBs to assume the highest risks they can find around. And if left unchecked, they do become casinos.

onebaddude 13y ago
>They are different things. Retail banks take risks with their money (if a lend doesn't pay off, they are the ones that pay for it), IBs take risks with other people's money. When I buy stock in, say, Google or General Motors, whose money are they taking risks with? I didn't tell Google that I wanted them to put money into Uber, nor do I think it's a great idea. Too bad for me I guess. And what do you mean "they pay for it"? Do you think when Joe Public defaults on his mortgage it comes out of the broker's bonus? No, the default risk is priced into every transaction the bank does. You and I and every other shareholder or bondholder pay for it. Investing is investing.
retube 13y ago
> Retail banks take risks with their money Huh? No! They are taking risks with YOUR money. When they lend on a mortgage, or make a corporate loan to a business they're doing that with YOUR deposits. This is how a savings account pays interest. They take your money, lend it at some interest rate and pay you a slightly lesser one. If the bank goes bust it's YOUR money which is lost: and this is why in most countries there are Federal Deposit Guarantees (i.e the govt will cover you up to some level if a retail bank goes bust) Ironically this is precisely the OPPOSITE of the IB business model. They are NOT taking risks with your money: they fund in the money and debt markets, i.e they borrow the money to fund their activities.

digitalengineer 13y ago

In my country borrowing for your company became incredibly difficult (if not outright impossible) if you didn't 'hedge' yourself using derivatives. None of the (AAA) banks like Rabobank explained what the risks of using these products were. They were sold as 'safe' interest-fixed products. Apart from that most were locked at the Euribor rate. You know, the one they forged...

retube 13y ago
Mis-selling of swaps and attempts at libor fixing are completely seperate issues. They have nothing to with, or precipitating, the financial crisis.
- digitalengineer 13y ago
  You ask 'what's so terrible about derivatives? ' well their very non-transparant nature and lack of regulation and registration.
  - 001sky 13y ago
    I'm not one to apologise for the post glass-stegal investment banks, but your're comment is confusing. Are you saying the banks tied the interest rtates on basic loans to companies purchases of other banking products? As a general rule, the financial crisis was caused by <loans that were too cheap>. Not by derivatives. The issue of derivitives is a more incidental role in the whole story. To use an analogy, something else caused the accident. Derivatives were like the airbag not deploying. Still a problem, but not in the way you are implying. It is also arguably the case that loans were too cheap because the banks were like a supermarket selling one product at a loss (debt) to get customers in the store (so called "loss-leader" product). And then they took advantage of the less educated consumers (ie, selling derivatives to people that should have known better). This is of course, why glass-stegal was in fact originally law. To prevent ths type of bundling. One thing this article fails to point out, though, is that the clinton administration got this model by copying it from the brits and europeans who long favoured the so-called "universal banking" model. so in that sense, its dis-ingenous to imply the usa was imposing or exporting this model via the WTO (it was the staus quo in Asia, too). For historical reasons, the continentals (eg, Germany), the Japaneese and others, never split off teh i-banks from the lending banks [1,2]. As a rsult, the CEOs of those combined banks were paid more than their US counterparts. This whole fiasco was driven by the US ceo's of the debt banks who were missing out on the windfalls accorded to the Investment Bank CEOs during internet 1.0 bubble. If you look at the history, the banks bought up the i-banks (as they had much larger balance sheets) and the CEO pay skyrocketed. [1] https://en.wikipedia.org/wiki/Universal_bank https://en.wikipedia.org/wiki/Universal_bank [2] https://en.wikipedia.org/wiki/Keiretsu https://en.wikipedia.org/wiki/Keiretsu

b1daly 13y ago

>The financial crisis was born out of over-enthusiastic mortgage lending - i.e your basic retail product. Even lehman brothers, a classic IB, went down due to it's large commercial property portfolio which tanked in the crisis (again, nothing to do with derivatives). How can you possibly say this? It was mortgage backed securities (derivatives) and collateralized debt obligations (derivatives of derivatives) that were the main product that allowed excessive lending, by obscuring the true risks. It was the markets for these securities that froze, causing the liquidity crisis that drove the financial crisis.

retube 13y ago
An MBS is NOT a derivative. It's a cash product. Either way you're missing the point. Securitisation is just a way of funding lending. Whether you use deposits, borrow from the money markets, or securitise loans, the money to make those loans has to come from somewhere. Ultimately it was mortgage brokers and the retail banks (or retail arms of universal banks) that sanctioned these mortgages and lent money to highly unsuitable people. Yes they were securitised and sold on but as I say above this is just a funding mechanism. Yes the IBs have some responsibility for not checking the quality of the loans but then there's an argument that should have been done already by the retail side. And of course no-one imagined that default rates would ever get as high as they did - which did wipe out some MBS and CDO tranches resulting in large losses for the holders. As an indication these types of issuance were typically stressed at default rates of 10% - and that was considered extremely conservative. What actually happened was some of these mortgage pools were so crappy default rates hit 80% or 90%.
- redblacktree 13y ago
  Why would a mortgage broker care to do his due diligence, if he knows he'll sell the loan tomorrow, and take none of the risk of default? This is about incentives. Incentives that were bound to lead to excessive risk taking and an inevitable crash.
- nissimk 13y ago
  Derivative does not equal swap. MBS is definitely a derivative. It's a bond whose price and cash flow is based on an underlying pool of loans. The mortgage loans themselves are not derivatives, but mbs are. Stock options are cash products and they are most certainly derivatives.

danmaz74 13y ago

Over-enthusiastic mortgage lending was fueled by the securitisation of that debt through CMOs, which create this situation in which those who work in mortgages retail couldn't care less if the mortgage is ever repaid - all they need is to find someone who will buy the security. Who created CMOs? Who made billions from them - until the collapse? Who was opposed to any form of regulation in financial markets?