Did You Need a PhD For That?



Denninger, Jan 6, 2010:



.....

Stiglitz said the idea that record banking profits were warranted because of a large degree of "financial innovation" was plainly wrong.

MIT's Johnson went further. What he calls the "mythology of financial innovation" was really "a way to extract rents out of consumers."

That's overly-complex.

Here's reality and a much-more succinct view: These "financial innovations" were and are a raw fraud.

Again, back to basic laws of business balance:

  1. Nobody works for free.  Ever.

  2. The risk-adjusted return available on any lending transaction is a fact and not subject to "massage."  While default on any single loan is binary (it either does or doesn't) default on a sufficiently-large and diverse group of loans with a known set of characteristics is a statistical function.

  3. Each person who touches such a transaction or group of transactions, therefore, must inevitably reduce the total amount of return below the risk-adjusted amount, and the more people who touch it - that is, the more complex it is - the more the total return must inevitably be BELOW the risk-adjusted amount. 

  4. The less transparency in a given set of transactions the more "spread" or "vig" those who process the transaction are able to retain for themselves through the obstruction of price discovery.

This leads to axiom #1:

IN EACH AND EVERY CASE OF FINANCIAL INNOVATION THE RETURN PAID TO INVESTORS MUST ALWAYS BE LESS THAN THE RISK-ADJUSTED RETURN.  THAT IS THE MORE COMPLEX THE INSTRUMENT THE WORSE INVESTORS GET SCREWED.

We then add to the first axoim the following:

  1. For each alleged means of "hedging risk" the person offering the hedge must also get paid.

  2. The parallel with fire insurance is clear: If you own one house you buy fire insurance because you cannot afford the damage a fire may cause, even though a fire is improbable.  But if you own 100,000 houses spread across the entire nation you're an idiot to buy fire insurance since the insurance company must either charge you more than the actual loss expected across those 100,000 houses or they will be unable to pay when the fires occur.

  3. As a direct consequence of (1) and (2) it is not possible to buy both a security and insurance against it defaulting and have the total blended return be greater than a risk-free security.  Either (1) the return will be lower or (2) the seller of the insurance will not be able to pay.

This leads to axiom #2:

ANY REPRESENTATION THAT ONE CAN CONSTRUCT A SYNTHETIC "RISK FREE" DEBT INSTRUMENT BY PURCHASING BOTH A RISKIER INSTRUMENT AND INSURANCE AGAINST IT DEFAULTING THAT WILL RETURN MORE THAN THE RISK-FREE INSTRUMENT IS FRAUDULENT.  EITHER THE SELLER OF THE INSURANCE WILL BE UNABLE TO PAY OR THE RETURN WILL BE LESS THAN IF YOU HAD SIMPLY BOUGHT THE RISK-FREE INSTRUMENT.

This is the essence of "financial innovation" folks: IT IS A SCAM.

I can make a crapload of money selling you "auto insurance" for $100 a year.  If I was to do so I would probably make $100 million dollars in three months!  My initial books would look great - only a few of you would have accidents immediately and so long as I kept selling policies faster than people crashed everything would be fine.

But this does not change the fact that over the course of the year there is no chance I would be able to pay off on the claims.  It is mathematically impossible for the full term of those contracts to be honored.

This is what the so-called "financial innovation" was, in point of fact.  It was nothing more complicated than a Ponzi Scheme that INEVITABLY had to fail.

The bad news is that we have NOT removed the Ponzi - indeed, we are once again seeing things like PIK/Toggle bonds and the CDS monster has not been neutered.

As a consequence of these facts it is inevitable that a second crash will occur, as we have not learned a damn thing.  We have not locked up those who made mathematically-impossible claims of performance and we have not barred them from doing so now and in the future.  We have instead bailed out the mathematically impossible - this time - while allowing the scam to continue and in fact increase in intensity, which guarantees not only a second crash but a worse one.

This outcome is assured folks.  It is simply the math of the matter - 2 + 2 cannot equal 6, no matter how many times someone tries to claim it does.