Paper by Sanjeev Arora , Boaz Barak, Markus Brunnermeier, and Rong Ge
Traditional economics argues that financial derivatives, like CDOs and CDSs, ameliorate the negative costs imposed by asymmetric information. This is because securitization via derivatives allows the informed party to find buyers for less information-sensitive part of the cash flow stream of an asset (e.g., a mortgage) and retain the remainder. In this paper we show that this viewpoint may need to be revised once computational complexity is brought into the picture. Using methods from theoretical computer science this paper shows that derivatives can actually amplify the costs of asymmetric information instead of reducing them. Note that computational complexity is only a small departure from full rationality since even highly sophisticated investors are boundedly rational due to a lack of requisite computational resources.
The whole scheme, and indeed it is a scheme, is nothing more than a circuitous, convolute Ponzi-tontine operation. It was done by design, not by “accident,” as all those of the Wall Street criminal class so claim.
The same rubes that yell “free market” when discussing the preferential trade the ruling elites promote with China, believed the criminals instead of the obvious.
“..Can actuall amplify costs..” is such a self-evident and absurdist notion without even realizing that the wrong maths were used together with severely limited variables.
One cannot base a model on newly created loans, having no history, yet claim historical data to support said models!
Just the knowledge that an unlimited number of credit default swaps can be written against one borrower or entity is explanation enough for anyone with an IQ above a door knob!
I think the paper understates the complexity, at least when they use factoring a given four digit number as an example. The complexity is only relevant when an investor questions the number the issuer comes up with. Doing the reverse engeneering in such a conflict is unfortunatly not regulated by precise mathematical rules, but by the legal interpretation of a six hundred pages long contract (give or take some hundreds) which tries to spell out an agreed mathematical formula for the value of the investment. I rather take on factoring with pen and paper than try to predict in advance the number which may come out from such a legal battle.
i believe that “traditional” “classical” or any other recognized bit of economics would not argue in favor of a technology that increases transaction costs, decreases market transparency and increases speculation. Due to the over the counter nature of these swaps and structured finance vehicles a responsive markets structure is not existent and as such would not obey any notion of the laws that govern supply and demand analysis. The inherent complexity in these instruments is not an accident of their existence. Just as humans walk upright for a multitude of reasons so to are these abomination complex for a number of reasons. Chief of among the complexity necessity is that those with 3+ years of calculus and a knowledge of finance cannot parse them apart just as people walk upright because it is more efficient. If no one but Janet Tavakoli and the quant masters at Ren-Tec can decipher what you are selling they assume that you are smarter than them and have invented a truly foolproof scheme. “This guy went to “blah-blah” school and has done this for years and is rich. We are all so human.
That’s fine, you make good points. The reason many people call CDOs derivatives is that the tranches price as derivatives and many books on the subject will jump from CDSs to CDOs as derivatives for that reason, same models, copulas.. et al.
Actually, after having a quick read of the paper I would propose the authors to rephrase certain things.
For instance:
“Traditional economics argues that embedded derivatives in securities, like CDOs, ameliorate the negative costs imposed by asymmetric information. ”
And to define a financial derivative as “a contract entered between two parties” does not make things very clear. If a security contains an embedded derivative, that derivative is not a contract between two parties, as anyone (licensed) can buy and sell the security. So the derivative is only the second part of the definition, a stream of payments based on the performance or events relating to one or more underlying assets.
Sorry rambling on…
CDOs aren’t securities either, they are structures with assets and liabilities and one side liabilities i.e. tranches are derivatives and sometimes part or all of the assets side are also derivatives (for synthetics). this is not a legalistic view but recognition of the fact that tranches are priced using the same technique as CDSs or CDSs baskets/indices.
CDOs are not financial derivatives, but securities. However, there is a financial derivative embedded in the security. CDSs are financial derivatives. (as per Economics of Contempt). To quote John Jansen: if they can`t get the little details right, how can we trust them on the big things?
Don`t take me to seriously though … it was not meant to be