Dr. Clifford S. Asness is founding principal of AQR Capital Management, a highly regarded, top performing quantitative hedge fund. Prior to forming AQR, Cliff was at Goldman, Sachs & Co. where he was Director of Quantitative Research for the Asset Management Division.

Cliff has authored articles on many financial topics including multiple publications in the Journal of Portfolio Management and the Financial Analysts Journal. He has received the best paper award from the Journal of Portfolio Management twice (2001, 2003). From the Financial Analysts Journal he has received the Graham and Dodd Award for the year’s best paper (2003), a Graham and Dodd Excellence Award (2000), the award for the best perspectives piece (2004), and the Graham & Dodd Readers’ Choice Award (2005), as well as the CFA Institute James R. Vertin Award, given to individuals who have produced a body of research notable for its relevance and enduring value to investment professionals.

~~~

Keep the Casinos Open
by Clifford S. Asness, Ph.D.
Preliminary version Last updated: April 26, 2010

In the storm of politician and pundit pique over financial regulatory reform, brought to a crescendo by conveniently-timed SEC charges against Goldman Sachs1, one refrain is repeated again and again in different forms. Paraphrasing a few:

• Wall Street is just a casino.

• Over-the-Counter derivatives like the Goldman Sachs’ CDOs are just “side bets” and should be banned, or at the very least we should regulate the bejesus out of them.

• These “bets” aren’t “real investments”.

• We should not let people “gamble” in this manner.

However ubiquitous, and now verging on the conventional wisdom, this is still just silly talk.

First, almost all derivatives are side bets. Even the exchange-traded, clearinghouse-blessed plain vanilla ones that the love-to-regulate crowd supports are still side bets. The simplest S&P 500 futures contract is a bet between the long investor and the short investor that is settled up without any stocks changing hands. Even contracts that, in theory, have physical delivery at their end almost never do, and even if they did are still a side bet between the long party and the short party. So, unless you’re planning to ban all derivatives, including these plain vanilla exchange-traded clearing-housed beauties, please don’t complain about side bets and casinos.2, 3

OK, now why are these side bets good for the world? Well, first, I don’t think I need to prove that. To “ban” something (a word statists really love), you need to show it does a lot of harm to those that are not a party to the transaction. Otherwise, again, be quiet and let free people transact (including betting) with each other as they see fit. But, luckily, I don’t need to rely on just my fellow Americans’ love of liberty here. These side bets are indeed generally good for the world.4, 5

This is all fairly standard economics so I won’t spend much time on it. Any time you have a transaction, including a side bet, which both sides enter into voluntarily, both sides must think they are being made better off. In the case where one side is a speculator and the other a hedger (or better, two offsetting hedgers) both can be made better off before and after the fact. The speculator, by making money, the hedger by reducing a risk he feared (e.g., if you buy fire insurance on your home you are not made worse off by your home not burning down). The tough case seems to be speculator-on-speculator side bets. In this case somebody will win and somebody will lose. First, I appeal again for the rights of free people to put their money where their opinions lie. Just because somebody will be wrong doesn’t reduce this right. But, second, this activity still makes society itself better off. If these “side bets” encourage more research, more time and energy, into figuring out whether the current price is too high or too low, they themselves can make prices more accurate.

Consider of course the case of John Paulson and the now infamous Goldman Abacus deal. Now imagine that instead of just John Paulson and only a few others, many people realized how ugly the real estate bubble was going to be, and realized it a few years earlier than when it was actually experienced. If they all tried to put on “side bets” that real estate would fall (and mortgages would default), they would have moved prices. They would have had to entice people to take the other side. The way this enticement works in a free market is by prices changing. In other words, if more people tried to do this earlier, real estate prices never would’ve gotten so high, and mortgage yields never so low. Put simply, a more vigorous, more liquid, more active market for “side bets” like John Paulson’s would likely have made the real estate / credit bubble a less, not more, dangerous event.

Consider the recommendations of Professor Robert Shiller, famed for predicting both the technology stock and real estate bubbles. Shiller has long advocated a futures market on economic news. These derivatives would give us the ability to bet on how strong GDP will be, how high or low unemployment comes out, whether inflation is climbing back, etc. Furthermore, every one of these is a “side bet”. He doesn’t advocate these side bets as he cruelly wants to feed people’s gambling obsessions, or wants to create a new vehicle on which Wall Street can charge commissions. He advocates for these contracts because he knows that legitimate hedgers and speculators, facing economic risk themselves and wanting to reduce it (hedgers), or holding economic opinions and wishing to profit from them if correct (speculators), will use the contracts to make their worlds, and the World, a better place. Risk would be reduced for those who wish it, and through the research of speculators we would gain valuable insight into where the economy is heading (I promise no forecast will be as good as the net of those betting their own money). The “side bets” Shiller advocates here are worthwhile, but no more so than “side bets” on the state of the real estate and mortgage world back in 2007. And they are all worthwhile for the same reasons.

Of course, another knock on complex OTC derivatives is that they threaten the world’s stability through a giant web of “interconnectedness.” This is certainly possible, though I tend to think this worry is considerably overdone, particularly if some very reasonable small steps are taken. A combination of reducing the pernicious application of too-big-to-fail, the root of so many of our problems, increasing demands that securities be marked-to-market, and simply focusing more energy on the before-the-fact mechanics of unwinding a large derivatives trader in bankruptcy, should suffice to make the system far more robust. If you still worry about disaster, then advocate all you want for exchange trading and clearinghouses. Again, that is a separate issue from the demonization of “betting”, the topic I address here.6

A lot of the moralistic yelling against casino-like “side bets” is simply the old prejudice against short-selling rising up again in slightly altered form. 7

These “side bets” I defend have both a long investor and a short investor, and thus presuppose the legitimacy of going short. Of course, short-selling is actually a very good thing. Since asset prices rise over the long-term, unless short-sellers are right unusually often, on average the shorts are doing the rest of the world a favor by losing money so we can all be a little more net long. And, from the tech bubble to Enron et al, to the real estate / credit crisis, the shorts help (if obviously insufficiently) to rein in bubbles. So, logically we should all embrace short-sellers, and establish rules to make their activities cheap and easy, as they are either transferring money to the rest of us, making our prices more accurate, or both. But, through an almost atavistic prejudice we just hate their guts. When you hear someone ranting about the Wall Street “casino” it’s a good bet that misguided bias against short-sellers is behind it.

One closely related canard is used to target credit default swaps (CDS) particularly. Countless commentators have informed us that you should not be allowed to purchase CDS as a “bet” against a company, unless you have an insurable interest (money at risk if the company defaults) in that firm. Each and every one of these geniuses have quite independently made the analogy to existing law stopping you from purchasing fire insurance on your neighbor’s house but only allowing it on your own. We are supposed to nod at the deftness of this analogy and “ban” yet another thing that people who like banning things want us to ban (ok, I’m not proud of that sentence). In this case, we’re supposed to ban CDS unless you already own the company’s bonds, in which case the CDS is near useless as you probably should just sell some of the bonds.

The problem is that the fire insurance analogy for CDS is a terrible one. The reason you are prohibited from purchasing fire insurance on your neighbor’s house is not that there is anything inherently wrong with “betting” on such a thing as a bystander. The problem instead is that if you bet on such a thing you would have too much incentive to light the fire yourself. We prevent this type of bet because it introduces a drastic and clear incentive to work actively towards burning your neighbor’s house down. Now, there are indeed tales of “bear raids” by short-sellers and purchasers of CDS — active attempts of short-sellers to bring companies down for profit. The difficulty is that these are just tales. Nobody has ever come close to proving any large bear-raid conspiracies, let alone showing that they are any more prevalent than the possible fraud and intentional rumor-mill that may occur on the “long” side.8

Like in our other examples, giving investors incentive to root out companies whose credit is worse than it appears, by allowing them to profit, or lose if they are wrong, from this bet is a worthwhile economic activity. If the short-sellers (CDS purchasers) are right the problems really exist, and it’s always better to discover problems now, not later.

Stepping back, nowadays the popular narrative is that this economic crisis was caused by Wall Street and derivatives. It was not. It was a real estate bubble caused by government, countless individual people, indeed Wall Street, and a bevy of other economic agents like mortgage and real estate brokers and a government-created oligopoly of underperforming rating agencies. Government was a prime culprit through the creation of disastrous GSEs, implementing politically correct social policy that warped the housing market, enacting land use restrictions in the bubble’s worst epicenters and, of course, promoting 20+ years of too-big-too-fail when it was not at all needed, including pursuing exceptionally easy monetary policy for years after the “dot com” bubble. Individuals contributed mightily through a get-rich-quick mentality (who doesn’t know somebody who quit a real job to flip houses?), over-spending, and short-sightedness. Financial firms of all types clearly pitched in as they tried to ride the bubble until it burst all over them.

Had Wall Street acted more soberly we would still have had a bubble (but maybe a smaller one, which I agree would’ve been better!). But had government not built a bonfire and thrown gasoline on it, I’m not sure we’d have had any problem at all. This can be argued in a circle forever and, admittedly, rational people can disagree how to apportion blame. But, to solely blame Wall Street, as has become the popular narrative, and use that as an excuse to bring yet more of the economy under the federal thumb, is sordid.9 Government is using a disaster it had a primary role in creating as cover for further takeovers in a cloud of class warfare and lies. That just sounds wrong to me

To review, government, including many of the same legislators who brought us Fannie Mae and took VIP loans from Countrywide, is pinning the full blame for this mess on Wall Street, and concluding we should give government much more power going forward. Its idea of reform is not to commit to ending too-big-to-fail, but to plan for it in perpetuity. Its idea of reform is to give government unspecified but exceptionally puissant abilities to prevent and to fix all problems in the future through bureaucrat-determined arbitrary taxes, open-ended takeover powers, and unprecedented resolution powers that ignore a century of well-developed bankruptcy law (making the corruption carried out in the Chrysler bankruptcy now the law of the land). I’ve exhausted even my ability to be sarcastic here. Please ridicule government amongst yourselves.

OK, back to the point. All derivative contracts are side bets. They serve a useful economic purpose and our base case should be to let free people who want to make contracts with each other do so. The reviled Goldman transactions did not cause, or even inflate, the real estate bubble, it just made one financial institutional (Paulson) a bigger winner, and another a bigger loser. It was a bet each wanted to make, and was by definition considered a fair one by each party at the time. How do we know this? Easy, it was voluntary.10 Now government wants to rewrite history and say that this type of fair bet caused all our problems, and they’ll never bother us again if we just give them much more power, again. Do you believe them?

_________________________________________
Footnotes:

1 At no point in this essay do I address the question of whether Goldman perpetrated a fraud in this transaction by not disclosing material information. That is a completely separate issue from whether we should listen to the hysterical mass of punditry and politicians and ban what they consider to be “gambling.” Believers in limited government like myself believe civil courts adjudicating fraud are one of the few proper functions of government (as opposed to, say, taxing soft drinks to pay for “cash-for-clunkers”).

2 One prominent legislative proposal would ban all OTC derivatives, save those issued by Native Americans. Yep, if you’re 1/16th Chippewa you can issue customized, naked CDS without requiring margin.

3 I made up the prior footnote. I know you were 95% sure of that, but isn’t it a little scary that you were even 5% unsure?

4 By the way, and for the record, government loves betting, it just doesn’t love free people betting amongst themselves without government wetting its beak. Government loves Powerball. Government loves OTB. Government loves legalized casinos that pay big taxes. So please, don’t tell me it’s a moral thing about gambling, or about government protecting us from ourselves. It’s a power and revenue thing where the government wants it all.

5 For fun, let’s talk about Powerball some more. Government monopolizes and promotes about the most regressive scheme in history (let’s make a giant number of poor people a little poorer to make one poor person super-rich) and this causes them no shame whatsoever. But, at least after selecting each Powerball winner the government has one new “fat cat not doing his fair share” to demonize.

6 Irrespective of government action, I’d be shocked if more or most derivatives did not move to exchanges and clearinghouses naturally. Both business and government can and do make horrible mistakes. But, businesses really do learn from their errors. Government promotes theirs to higher office.

7 Holman Jenkins writing in the Wall Street Journal on 4/21/10 in “The War on Shorts, Cont.” makes this point well.

8 Remember, in both the long and short cases we can and should prosecute fraud.

9 The political reasons for this narrative seem clear. Those in government can either blame themselves, those who vote for them, villainous bankers, or the most accurate, some combination of the three. Which would you guess they’d choose?

10 Unless, of course, as the SEC alleges, one side’s consent was obtained via fraud. In that case, as a fraud, it is covered under existing law. We don’t need new laws to prevent it but simply enforcement of the existing ones.

Category: Derivatives, Regulation, Think Tank

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

52 Responses to “Keep the Casinos Open”

  1. wally says:

    “First, almost all derivatives are side bets.”
    Oh, it’s all so innocent. Not side bets where the table is tilted the dice are loaded or the cards are stacked?
    Point is, they weren’t just side bets. They moved events and they affected people other than just the bettors – people who didn’t want to play games with their savings and retirement but who now are forced to.

  2. gloppie says:

    “OK, now why are these side bets good for the world? Well, first, I don’t think I need to prove that.”

    that’s where I stopped reading, you arrogant prick.

    Here, read Matt Taibbi’s last piece, so as to enlighten you on where the average “sheeple” or J6P as we’re called, stand.

    http://www.alternet.org/story/146611/taibbi%3A_the_lunatics_who_made_a_religion_out_of_greed_and_wrecked_the_economy__/?page=entire

  3. super_trooper says:

    “OK, now why are these side bets good for the world? Well, first, I don’t think I need to prove that. ”
    That’s childish. If you’re not going to prove it, why state a question and then follow it by that statement?
    Besides, we have lived in a world where 1+1=3 => anything is true.

  4. beaufou says:

    Goldman helps inflate the bubble – Goldman goes short and creates shitty CDOs – “clients” such as Royal Bank of Scotland buy into this shit, then lose $840million – British Government buys 85% of RBS with taxpayer money after the bubble bursts – Paulson walks away with the dough.
    AIG – Citibank etc…taxpayer money.

    You know where you can put those “good for the world” side bets.

  5. jnutley says:

    What the hell is a CDS? It’s one of several games used to obscure the risk on questionable investments. It takes bullshit and helps turn it into a AAA paper for the big institutions. It is one of several devices invented to let finance companies lie to each other. (Barry’s book spells this out in detail)

    If the boys on Wall Street are so smart and so sharp, why can’t they work with straight up mortgages, leases, business plans and contracts? They could investigate an opportunity, perform due diligence on the specifics, put money on the likely winners and let the losers go. This process, connecting money with what look like good ideas, is what ordinary folk imagine “investment” is.

    Your long post tells us we should continue to pay these folks to invent amazing lies to sell to each other. With the TARP and it’s follow-ons, ordinary taxpayers are paying for Wall Street to continue, not just watching raptly from distant flatlands anymore. Why shouldn’t we get real value for our money?

  6. Mike in Nola says:

    It’s always good to see an unbiased opinion from someone who hasn’t been making a sh*tload of money from gimmicks and has no connection with the Vampire Squid.

    http://www.aqrcapital.com/cliff.htm

    And we know how well all those models he built worked.

  7. Florida says:

    Hey Asness, maybe if you spent more time looking for ways to not lose your hedge fund clients’ money and less time typing up screeds defending your former bosses at Goldman, both you and your clients would be better off, you clown.

  8. zzzalpo says:

    Whether or not derivatives exist is not the problem. The problem is that they exist in private where the rest of the world has no idea what the bets are. Opening up the market so that investors have enough information to know who is betting against them would solve a lot of these problems.

  9. Econskeptic says:

    Wow, that’s a seriously crappy post, and I’m gonna blame Barry for doing a poor job vetting this one. I’ll just point to a Delong-Waldman exchange here: http://delong.typepad.com/sdj/2010/04/delong-smackdown-watch-goldman-sachs-and-abacus.html, which has a lot more substance in a lot fewer lines.

  10. I have found many of Clifford Asness’s prior works to be extremely insightful.

    He is an original thinker, who looks at the world in a unique way.

    Before you dismiss his comments — not all of which I agree with — I suggest you read them carefully first.

  11. thedude says:

    Wow, the comments here really shed light on the lack of level headed thinking by readers of this blog. This was a very salient piece that many of you just flat out ignored the merits of because of your inherent cognitive biases and prejudices.

    Everything is “DERIVATIVES! OMG! THEY ARE TO BLAME FOR ALL OUR WOES! REGULATE! BAN OR SOCIALIZE EVERYTHING IN SIGHT!”

    How about we address Asness’s statements on government’s major role in creating a housing bust/boom? Or his comments on how two faced the government is with regard to allowing other types of gambling , particularly the very regressive tax oriented Powerball? Oh, that would mean putting down the pitchforks so I guess that’s out of the question. You all make me sick.

  12. Haigh says:

    If only he would have taken the next step: Take the brain power going into the pricing of Credit Default Swaps and channel that into a new bond rating business model, putting Moody’s etc out of business.

  13. Brendan says:

    This post just makes me want this crap banned even more. If his goal was to convince me that these financial instruments should be kept around, he failed miserably.

    The author basically says, “this has no value, and too bad if you don’t like it; it’s a vehicle for me to make money and how dare you take away ones liberty to confuse people and take their money. It’s their fault that they entered into a bad deal without knowing it. Swindling is the American way.” If financial transactions do not serve the economy, then the government (or appropriate currency regulator) damn well has the right to regulate the hell out of it. He might as well be saying, “yeah, I’m printing fake money, but it doesn’t hurt anyone. Look, it’s obviously fake, anyone (and by anyone I mean a small group of highly trained people like myself) could tell that. You’re taking away my liberty to print what I want.” Wahhh! Freedom of the press! Freedom of the press! Oh my liberties.

    Oh please, this has nothing to do with freedom, and everything to do with greed.

  14. gloppie says:

    Here is a simple question; “if side bets are good for the world,” why is the majority (80%) of the World’s population living on 20% of the World’s resources, while we, the affluent few, (20%) enjoy the benefits of %80 of the resources? We do have the technology to feed everybody.

    Then, Clifford wrote in one of his previous pieces (Appalled in Greenwich)
    “Another thing to note is that this is now called a financial or banking crisis. This is true without being right (which is a difference with a distinction). Our current economic pain, the high unemployment, the disappointing economic growth, has deep and varied roots. For years, some things were unsustainably high and growing: housing prices, the trade deficit, consumer debt and more recently government debt; while other things were unsustainably low and falling: credit spreads, inflation rates and savings. While people differ on which were the causes and which were the effects, and who was to blame, few believed things could have continued indefinitely (while again, calling the top a very dangerous game to hold the bankers to getting precisely right). Some dramatic change was inevitable, and it was equally inevitable that it would be painful. Perhaps wiser and less greedy bankers would have given us an earlier and gentler wake-up call, but the same is true of wiser and less greedy politicians, central-bankers, non-financial companies and individuals, many of them with more latitude to step off the gas than bankers with shareholders. The economy crashed, not just the banks. It was caused by the entire economy, not just the banks. It’s the economy that has to be fixed, not just the banks.”

    Now, take a good look at any average size town, around 10.000 souls, and tell me what you see in the downtown area: A couple of towering banks surrounded by empty CRE. I agree the Economy in general has to be fixed.
    Because for the last 30+ years our Credit based banking system has sucked the life out of the economy.
    Look at any chart comparing Financials with the rest of the industry over 30 years, and just tell me that it is a linear progression. For Pete’s sake, go read Karl Denninger. WE CAN’T SERVICE MORE DEBT. It does not matter how much paper you push around on your desk, you are not adding one single cent of wealth anywhere.
    You put money in your pocket, and in your client’s pockets too. But you PRODUCE nothing. Nada. Zilch.
    Where is the Money coming from then. Debasing. Everybody else gets less for their work. Especially in China and other emerging or 3rd world countries.
    You can keep on thinking it will never end. It will, trust me.

  15. Sunny129 says:

    BR:I have found many of Clifford Asness’s prior works to be extremely insightful.

    I do appreciate his ‘out of the box’ view on the issue. But ABACUS kind of deal was made in ‘secret’ with an asymmetric information between the parties. There is definite tilt of success or failure (favoring one another) from the very beginning!

    Without transparency and symmetric information, human tendency is take the’ short cut’ to winning with no scruples but claim ‘caveat emperor’ as a defense!

  16. thedude says:

    Sunny, what the heck are you talking about? ACA picked the very collateral that created the Abacus deal! The composition of the assets was not secret to them. No one owes them a duty to tell them who is on the other side of the transaction. If you go buy MSFT shares, does your broker tell you who the seller is? The seller could be Fidelity, it could Joe Blow, it could Joe Blow selling borrowed shares even (shorting, imagine that).

  17. drummist says:

    Thanks for the post, Barry. Nice that Asness can think outside the box and give one fresh ideas, but he is way inside the box on this one. This post gave me the idea to remember that: the best swindlers always mix a little truth in with their pitch. By the way, we’re not discussing “banning” derivatives. We need transparency and oversight. HIs seeming lack of any shred of interest in our society is, while not unheard of, pathetic.

    Many derivatives, such as S&P contracts, are often not “side bets” but are offset by positions in the market (currencies, equities, etc.). It’s called hedging. Isn’t that why LTCM was bailed out? Where has he been?

    Overleveraging these “side bets” has it’s own inflated effect on markets. Quite risky, too (see Lehman, Bear Sterns, AIG, et al).

    Slicing/dicing mortgages, a practice pushed to the limit to create fees for Wall Street firms and lenders alike, has now left many homeowners unable to locate who services their mortgage. This has caused much hardship for many. The ratings agencies were complicit in this scam along with many lenders and firms on the Street. It was fraudulent. THAT is the point.

    It is all the Government’s fault. But “Had Wall Street acted more soberly we still would have had a bubble (but maybe a smaller one, which I agree would have been better!)” …..and the inevitable contraction in housing would not have necessarily happened so sharply and tanked the global economy. Nor would we have had the massive sub-prime lending fraud, due to the existence of CMOs for generating of fees. I’ll just ignore on his ass-covering comment.

    Government did not:
    1. Give AAA ratings to sub-prime crap.
    2. Slice up mortgages to flog to “savvy investors” after engineering those ratings.
    3. Leave homeowners unable to talk to their lender in a crisis by creating CMOs.
    4. Crash the global economy by overleveraging and fraud.
    5. Stop any of the above from happening by properly overseeing Wall Street.

    Let’s be honest. We know that politicians are in the Street’s pocket to some degree. That is, they are doing Wall Street’s bidding. His blaming Government is like hiring a hit man and then saying you are not responsible for the hit.

    Indeed, government needs to act “more soberly” and fulfill a duty of proper oversight of Wall Street to prevent the kind of devastation that has happened to millions of Americans through unemployment and wealth destruction in their pensions.

    His take on short-sellers is, uh, a bit blinkered and overly-simplistic, IMHO. “It is always best to discover the problems now, not later.” Not in the manner of crashing the global economy, Clifford.

    Oh, and bear raids are a myth (see Jesse Livermore).

  18. [...] savvy quant and all around sharp cookie Clifford Asness has a very provocative post, titled Keep the Casinos Open. Cliff has amassed an outstanding track record, and is extremely knowledgeable about the mechanics [...]

  19. nhr_215 says:

    Dr. Assness conveniently completely fails to address the embedded moral hazard in the current status quo. Certainly I expect an ulta-freemarketeer who has made his entire living on absolute free-market capitalism to take this position. However, I would also expect even a cursory mention of the conflict of interest, the moral hazard, the assymetric information embedded in the current investment banking-facilitated derivatives system. Lets not even discuss the corruption involved in government-facilitated bailouts of various derivative-related financial collapses (tequila crisis, current economy crisis, LTCM, etc.) when those making the decisions are former CEOs and managing directors of the firms benefiting from the bailout (i.e. Robert Rubin, Hank Paulson, etc.).

    Of course Dr. Asness does not complain about the government intervention in the markets when it benefits him or his associates. This is typical of the faux-free-marketeer in this day and age. They decry government
    intervention when it cuts profits and beg for it when it saves profits. As such, his one sided argument rings not only hollow but self-servingly inconsistent and dare I say hypocritical.

    To argue that no regulation is needed flies in the face of not only history but common sense. On the other hand, I completely agree that the extremely loose monetary policy facilitated and catalyzed the bubble, much like it is doing today in the stock market.

  20. JustinTheSkeptic says:

    “Consider the recommendations of Professor Robert Shiller, famed for predicting both the technology stock and real estate bubbles. Shiller has long advocated a futures market on economic news. These derivatives would give us the ability to bet on how strong GDP will be, how high or low unemployment comes out, whether inflation is climbing back, etc.”

    Could it be that using, “put protection,” actually supports a market at higher levels and therefore distorts the price seeking mechinism of the market? But no one cares when it supports the market do they????????????

  21. Invictus says:

    OK, now why are these side bets good for the world?

    Yes, Cliff, when I think of things that are “good for the world,” I usually list derivatives right behind Jonas Salk’s discovery of a vaccine for polio. Seriously. Get a grip and, as BR might say, have a nice tall glass of STFU. It was virtually impossible to read beyond that line.

  22. davver1 says:

    “Investors” didn’t enter into these “side bets”. Agents acting on behalf of investors entered into these agreements. Thus, even if the two parties: the agent (long) and the speculator (short) can enter into a voluntary transaction that benefits the both of them without benefiting the investor. Thus the agent buys a crappy CDO because a few years of earning a little extra yield earns him a bonus for beating his benchmark, while the ultimate losses will be born by the investor, not the agent, if there is a blow up somewhere down the road. And even if there is a blow up we all know financial professionals tend to land on their feet as long as “everyone was doing it”.

    The reason we like to ban complex transactions of this nature is because they make it very easy for the agent to screw over the investor, either by accident or purpose. It makes it very difficult for the investor to keep tabs on the agent and understand what he is doing. Transparent, uniform, simple investment instruments mitigate the principal agent problem.

  23. davver1 says:

    Adding to the above.

    Financial trading in and off itself involves a great deal of friction costs and volatility. Thus, it is not desirable in and of itself. It is only desirable in so much as it provides capital for the necessary entrepreneurship of our economy.

    Gambling like the lottery is different. When someone gambles they WANT volatility and they expect to lose in the long run. The act of gambling is a consumer service, not related at all to investing.

  24. ChrisH says:

    When you cut through all of the sarcastic commentary, the argument that’s being made here is very elegant in theory, assuming, of course, we’re all symmetrically informed, rational and there are no negative externalities. For example, it’s easy to make the decision to take your side of the bet when there’s an “unbiased” AAA rating involved and markets are completely efficient. The game envisioned here may be elegant with minimal rules, but is that the game we want to play? To use an Einsteinian cliche, “Everything should be made as simple as possible, but not simpler.”

  25. alfred e says:

    WOW! Think Tank is normally sleeperville.

    Invictus? Dude!

    Yeah. And when carbon cap and trade gets forced down our throats and oil goes to $200 by the big-boy speculators we can all remember how Assness said it was a good thing for the world.

    Hey Guy, get a real job.

  26. well, personally, I think Asness is pointing out, what used to be, ‘Truisms’.

    People should be allowed to do as they please, along as they’re not harming anyone else–if they are, there are Courts, for equity..

    and, in so many words, if peep don’t want to have their t*ts sucked dry, keep’em in a brasseire.

    Past that, the combination of Ignorance+State Proscription has led nowhere, anyone wants to travel.

    the idea, obviously, well-loved by many, of “the beneficent State” is one that will cost far more than your Wealth, it will, left unchecked, cost you Everything.

  27. Mbuna says:

    First off Barry, I have to agree with gloppie- arrogant prick is an apt description for the attitude of Dr. Asness. Now let’s get into a few details.

    “So, unless you’re planning to ban all derivatives, including these plain vanilla exchange-traded clearing-housed beauties, please don’t complain about side bets and casinos.2, 3 …These side bets are indeed generally good for the world.4, 5″ There is no logic to this apparent justification of derivatives, only pure junior high attitude here. WTF does powerball have to to with justifying derivatives are good for the world? Yes you can say both are gambling and sanctioned by government but powerball will not bring the world financial system to its knees. This is simply asinine- my grandson could do better.

    The next 3 paragraphs are spent talking about how usefull derivatives are for Hedge funds and speculators, as if that somehow benefits us all and the world!?!? Mr Assness lives in the bubble created by having his head up his “Assness” so to speak. Wall St. is clearly his idea of the real world and nothing else counts. His suggestions for controlling derivatives and too big to fail only make sense inside the bubble that is Wall St. They fail to address all the other human issues at stake here that come into play as result of Wall St’s gambling, and that is why they will never, ever work the way he suggests.

    Dr Asness then goes on to talk about the “bad analogy” of buying fire insurance on your neighbors house and how the stories of bear raids out there are just “tales”. Are you fucking kidding me? Just look at what is going on with European bonds today, all the result of the collusion between crooked bankers and crooked politicians. Clearly from Dr. Asness’ point of view neither crooked bankers or crooked politicians exist in the first place, this is all fine and above board.

    “Like in our other examples, giving investors incentive to root out companies whose credit is worse than it appears, by allowing them to profit, or lose if they are wrong, from this bet is a worthwhile economic activity. If the short-sellers (CDS purchasers) are right the problems really exist, and it’s always better to discover problems now, not later.” The problem with this paragraph is illustrated in my previous paragraph. You have banksters colluding with politicians which then enable a country like Greece to get into real debt problems via crooked accounting and derivatives and then from his point of view the bond vigilantes coming in are a “worthwhile economic activity”!?! WTF! Someone get a grip here, this is pure insanity.

    Barry, what am I missing here?

    The next 3 paragraphs are spent blaming government instead of Wall St. My problem with this line of reasoning is that the 2 are now so interconnected I tend to think of them as 2 arms of the same problem. I don’t buy his argument one bit- he is just talking his book here as any Wall St. minion would.

    Barry I am still wondering, as I was from the outset, if this was like some big April Fool’s joke or something. I fail to see any useful insight in this article whatsoever. To me this article is pure Wall St meth junkie talk and nothing more.

  28. alfred e says:

    @MEH: Cool. So what does that have to do with the house controlling the odds and the prices?

    “as long as they’re not harming anyone else”.

    So, did $140 oil harm anyone???????

  29. stevesliva says:

    I give his conservative statements higher points that usual because this is at least relatively nonpartisan and doesn’t try the blame the CRA:

    “Stepping back, nowadays the popular narrative is that this economic crisis was caused by Wall Street and derivatives. It was not. It was a real estate bubble caused by government, countless individual people, indeed Wall Street, and a bevy of other economic agents like mortgage and real estate brokers and a government-created oligopoly of underperforming rating agencies. Government was a prime culprit through the creation of disastrous GSEs, implementing politically correct social policy that warped the housing market… including pursuing exceptionally easy monetary policy for years …”

    That’s true. We can’t blame the GSE bailout on anyone but the feds. But let’s not pretend the other bailouts aren’t Wall Street’s fault. If the feds created the bubble, all these “sophisticated investors” still don’t deserve bailouts for riding the wave.

  30. R. Cain says:

    i read the whole thing
    with due respect (before i go and throw up):

    1/ had to stop and check whether i was reading a Goldman press release
    (not kidding)

    2/ ‘To “ban” something …, you need to show it does a lot of harm to those that are not a party to the transaction.’
    hint: taxpayers (e.g. AIG)

    3/ ‘ … and through the research [sic] of speculators we would gain valuable insight into where the economy is heading (I promise no forecast will be as good as the net of those betting their own money).’
    see: stock market

    4/ ‘Of course, another knock on complex OTC derivatives is that they threaten the world’s stability through a giant web of “interconnectedness.” … A combination of reducing the pernicious application of too-big-to-fail, …, increasing demands that securities be marked-to-market, and simply focusing more energy on the before-the-fact mechanics of unwinding a large derivatives trader in bankruptcy, should suffice to make the system far more robust. ‘
    sounds good in theory
    if my aunt …

    5/ 6/ 7/ 8/ sorry out of time

  31. hammerandtong2001 says:

    With all due respect, and deserved acknowledgement of the considerable brainpower behind Dr. Asness’ opinion…

    I am all for two parties doing business together in any manner that suits their interests, presuming it’s inherent legality. And this business would of course not involve or affect me, or any others so uninvolved.

    But in the matter at hand — the financial collapse — the parties who did transact business using complex derivatives DID affect me. These parties also affected millions of other essentially uninvolved people as well. By shutting down credit, by disrupting normal business activity, by throwing the country into a deep and lasting recession, by throwing many millions of people out of work.

    Not only that, my unborn grandchildren –and everyone else’s too — are now to be saddled with a debtload our governemnt required to bail some of these “willing parties” out of their disastrous business decisions.

    So, quite logically, I — personally — have a stake in this mess.

    The essential “FREE” of the free market, which lies at the basis of the above argument, requires the qualification that FREE is just that, and it includes that the uninvolved are FREE from any consequences flowing from poor decisions made by business hungry parties.

    And that simply is NOT the case here.

    .

  32. Mannwich says:

    Yawn. Talk your book much? These “side bets” serve no greater social benefit to the real economy. Gamble all you want with your own capital. Just don’t take the rest of us down with you when you fuck up and ask for a red cent from Main Street in the form of bailouts. Deal?

  33. Mannwich says:

    @Mbuna: Well put. I’m actually perplexed as well as to why Barry would post this garbage.

  34. DisparityFlux says:

    What supercomputer is being used to run simulations of reality in order to determine the “real” value of 600 trillion in “notional” value OTC derivatives already created?

  35. greenback says:

    “Now, there are indeed tales of “bear raids” by short-sellers and purchasers of CDS — active attempts of short-sellers to bring companies down for profit. The difficulty is that these are just tales. Nobody has ever come close to proving any large bear-raid conspiracies, let alone showing that they are any more prevalent than the possible fraud and intentional rumor-mill that may occur on the “long” side.”

    So I’m wondering, by this same standard is there any proof that short sellers have shut down anything then?

    I’ve read much better versions of this same libertarian screed. Little things like the aforementioned “I don’t have to prove it” and the use of “statist” telegraph the greater agenda.

  36. alfred e,

    see: “Consider of course the case of John Paulson and the now infamous Goldman Abacus deal. Now imagine that instead of just John Paulson and only a few others, many people realized how ugly the real estate bubble was going to be, and realized it a few years earlier than when it was actually experienced. If they all tried to put on “side bets” that real estate would fall (and mortgages would default), they would have moved prices. They would have had to entice people to take the other side. The way this enticement works in a free market is by prices changing. In other words, if more people tried to do this earlier, real estate prices never would’ve gotten so high, and mortgage yields never so low. Put simply, a more vigorous, more liquid, more active market for “side bets” like John Paulson’s would likely have made the real estate / credit bubble a less, not more, dangerous event…”

    similiar, would have worked in your “Oil” example..

    simply, if more people/organizations, actually, believed they were exposed to the ‘Market’-price of Oil, they would have, like the, now, famous example of LUV, hedged their exposures..

    think about how cripplingly stoopid it is to hear org.s, like the USPS, or, even, UPS, tell you that ~”We have to raise Postage Prices, due to higher Oil costs..”

    or, maybe, better, your DOT tell you ~”We have to suspend Road repairs, b/c of ‘unforeseen’ increases in the cost of Oil..”

    like these People, supposed ‘Professionals’, didn’t know that they had future Demand for those Inputs?

    Riight..

    those ‘Pros’ didn’t ‘give a s***’, b/c they knew they wouldn’t be held accountable/they had someone to pass the buck to/scapegoat..

    pick a side: Integrity/Accountability & Liberty or Slavery, as it stands, it’s, only, our Ignorance that binds us..

  37. Invictus says:

    And, before I forget, how’d all those innocuous “side bets” (a synthetic rate swap) work out for Jefferson County, Alabama? Not so well, methinks.

  38. alw1066 says:

    Rather pie-in-the-sky. When is Stephen Friedman going to get prosecuted for insider trading? How do I avoid
    buying stock in Goldman if I have a 401K at Vanguard? As a mute and unwitting shareholder in GS through my
    Vanguard 401K index funds, how do I avoid getting fleeced by GS management? How do I buy tulip bulbs for
    the garden if speculators have bid them up?

  39. beaufou says:

    thedude
    “Wow, the comments here really shed light on the lack of level headed thinking by readers of this blog. This was a very salient piece that many of you just flat out ignored the merits of because of your inherent cognitive biases and prejudices.”

    Wow, makes me wonder how the world ever progressed without all this supa-dupa exotic stuff.
    Level headed? why don’t you take your head out of your ass for a start.

  40. F. Horne says:

    The reason many people want the casinos managed is because the US taxpayer just had to make good on all the bets. Specifically, to take just one example, to settle AIG’s gambling debts, the taxpayer has made good to the tune of 100 cents on the dollar–no haircuts, no nothing–to not only Goldman Sachs and US banks, but also to a number of European banks. If the taxpayer is forced to pay the defaulted gambling debts because the casino is too big to fail, then the casino needs to be regulated more tightly, or shut down.

    The casinos then took the bailout money, as though it was no more than their due, and paid their normal bonuses with it! Now they’re fighting like dogs to maintain the status quo. Who can blame them? They’re in casino nirvana–the taxpayer is guaranteeing their bets and their bonuses!

    We’re frigging fed up. Your insane argument is more evidence, just as GS’s showing in Congress yesterday, that Wall Street money doesn’t get it. People don’t understand your business, but they understand too-big-to-fail, they understand fraud, and they understand that conflict-of-interest which rises to the level of fraud, has become the cornerstone of Wall Street’s business model.

  41. gasman says:

    mark e hoffer,

    if i am reading your post properly, you are saying USPS and DOT should have hedged their oil exposure? really? so you want them to hedge their input (oil) even though they cannot hedge their output (whatever they produce/provide)?

    any company that hedges only one side is a speculator. an airline that “hedges” long-dated oil exposure without having already sold the appropriate amount of tickets over the same time frame is actually a speculator. a power generator that already has long term fuel contracts in place and sells power futures is an actual hedger. make sense? sounds like you want DOT to be an oil speculator…. interesting.

    As for Asness, he pretty much fails. Completely. He is going to brush off the differences between opaque CDS or synthetic mortgage securities and plain vanilla exchange-traded futures? Can I go the route of Asness and say I shouldn’t have to explain what’s so different because it is so obvious? clearly, having proper margin for all these instruments and not having huge concentrated bets couldn’t have been avoided by changing the way they were regulated. Riiiiiiiiiiight.

  42. alfred e says:

    @MEH/Beaufou: Agree. Except the little guy with some common sense does not get to be a player.

    Businesses should be best and prosper at what they do best, not hedging their input resources. Leave that to producer and manufacturer. Not Wall Street.

    The commodities market has been controlled and dirty for decades. Fat cats getting fatter. And the little guy pays.

    There are some few exceptions that make sense but not many. And none of them reside on Wall Street.

    I think real businesses do something more productive than “enticing others to take the side bet”.

  43. chwee says:

    Actually the author was too dogmatic in the assumption that as long as there’s 2 sides to a bet, it’s all good. That violates the first principle of insurance, or hedging => if you don’t own a property, you can’t buy fire insurance on it else you will be incentivised to do some arson. That’s exactly what happened with John Paulson and Abacus.

    So yes, you can have CDS, but the only folks who should be allowed to buy the CDS are the ones who bought chunks of the CDO, just to hedge their exposure. Not to buy 10X their initial exposure and thereby open the floodgates to creating junk CDOs again.

    All these are basic commonsense rules to actually pool risks in a proper manner to prevent destructive gaming of the system.

  44. WaltFrench says:

    I believe most BP readers recognize the concept of the “Greenspan put.” But the moral hazard associated with it actually originated centuries ago with the Limited Liability public corporation. For $50 to Delaware’s Dept of State, a corporation can buy the right to incur liabilities, and there may not be enough money in the pot to pay everybody back in the event of bankruptcy.

    A company can borrow money, defer paying taxes, promise pension funding downstream, and gamble/invest the cash flow in high-risk, high-return opportunities. If the bet works out, pay out dividends or otherwise extract the fruits of your genius. Great work! Repeat it. If not, well, the owner only loses the stake not yet taken back out; somebody else loses the rest.

    In Modigliani-Miller theory of the firm, no problem: lenders and other creditors will examine the books and monitor the activities of the firm and charge higher rates of interest on high-risk strategies, stripping out the benefit of gambling with Other People’s Money.

    Cliff knows that (a) Modigliani-Miller is useful only as a rough approximation of the principle of risk, helpful only for finance students who can not yet handle solid food, and (b) the remedy of suit for fraud is inadequate for the very reason that there is no money left in the corporation.

    Prospective harm to others is endemic to corporations and the lawsuit remedy is inadequate. Interestingly, the investment banking industry has moved in the last couple of decades from a partnership model to a corporate model, for the very reason that it allows bankers to more highly leverage their personal wealth, to borrow on a scale that a handful of three-piece-suit types could never dream of.

    Misplaced leverage, and the inability to repay lenders, need not be venal behavior; it can be simply mistaken assumptions about how one’s model will perform. Happens to us all. But our society should work to build firewalls so that my self-rated genius, hard work, foolishness, over-ambition or little white lies do not have the potential to create more harm than good. For small firms, even such as Mr. Asness’s, some FDIC-type insurance/tax on systemic risk factors should suffice to protect society. For TBTF firms, well, they’re too big to fail. If they could fail in a way that the public could not be protected from, then fairness demands that the public also has full right to the upside, too.

    That’s a rather different solution than Cliff proposes.

    A few more notes: “fractional reserve banking,” the kind practiced by every bank in the US, has ALWAYS had the problem that ordinary noise in people’s needs to borrow or save, could cause runs on banks, and banks were often unable to line up lenders to meet the runs in time. Prior to the Federal Reserve, this was an intrinsic problem for banking, and the economic growth of the United States. The wild-west no-regulation approach meant frequent currency crises, and losses by depositors who could never have foreseen liquidity crises against which no bank could protect itself with 100% certainty. Any decent US economic history should document this in spades. In addition to the information asymmetry issues, there is the issue of randomness and how it can rocket around the globe, picking up steam like Plutonium going critical. Mr. Asness does not mention the long history of successful bank regulation in the 20th century, weakened and almost abandoned towards the end of it.

    I confess to thinking that I am strongly pro-capitalist. I try to watch whether risk management cuts back on the opportunity to succeed. But because there are real problems in knowing how well a counterparty can honor its obligations, and because markets are dynamic, I cannot see how capitalism can survive without government being the lender-of-last-resort, and bringing in strong regulations for behavior and information that will minimize the concomitant moral hazards.

    Finally, I find it interesting that in the last couple of decades, investment banking has moved from a relatively fluid, free-market set of partnerships to a handful of mega-corporations, ones where Capital, in the persons of the Boards of Directors, are utterly incapable of understanding the basic business of the firm. Leveraged risk, and the false appearance of profitability that it creates, has swollen during this era, as has the danger to society.

  45. shivasquest says:

    FYI…

    a matrix from the Bank of International Settlement that included the $605 as the total of the ‘over-the-counter’ derivatives market; the matrix showed an additional $600+ Trillion in ‘registered’ derivatives. Not a problem?

  46. victorberry says:

    What if the U.S. government had not bailed out AIG? Then all those clever side bets which relied on CDS protection from AIG would not have paid 100 cents on the dollar. Consequently, John Paulson might have grossed only $80M instead of $1B. I wonder if every man, woman, and child in America realizes that Uncle Sam took $3 out their pockets and gave it to John Paulson?

    As an aside, it seems to me that the AAA rating on the ABACUS bonds was essential for Paulson’s purposes. This improved his chances that there would eventually be a ratings downgrade sufficient to trigger the CDS payout. I really doubt the ABACUS bonds had to become totally worthless before Paulson’s CDS protection kicked in.

    And one more thing. Goldman Sachs may not have made a dime of profit from the AIG bailout and the TARP fund infusion, but it sure kept GS from having to declare real and immediate losses of billions of dollars.

  47. FrancoisT says:

    @Barry
    “Before you dismiss his comments — not all of which I agree with — I suggest you read them carefully first.”

    It is precisely my careful reading that compels me to dismiss his comment altogether. This is sophistry laced in half-truths (comparing Powerball with CDS..WTF??) seasoned with “Fuck You Tyrone, I’ve Got Mine” spice blend.

    Yes! The dear doctor may be a very smart cookie, but brilliant people do very stupid things sometimes. Writing this post was one of those instances.

  48. gasman,

    the USPS, and the DOT, are set up as ‘going concerns’, no?

    with that, in order to execute their Business Plans, they have some idea of the Inputs they’re fixin’ to consume, yes?

    w/ the USPS, the ‘miles travelled’ is pretty knowable, so, yes, they could ‘hedge’ their inputs..

    similiar, w/the DOTs–they plan their construction projects years out, they have a good idea of the materials needed to complete the Projects–so, yes, they could ‘hedge’ their inputs..

    what you are calling ‘speculation’ can, actually, be seen as a conservative Project Management/Supply Chain Management approach..
    ~~
    alfred e,

    w/this: “Except the little guy with some common sense does not get to be a player.”

    I hear you, though, Demand Aggregation can provide the, necessary, ballast, to counteract this “The commodities market has been controlled and dirty for decades. Fat cats getting fatter. And the little guy pays.”-phenomena..

    People should learn that “Choice” is expensive, not only to themselves, but for the Producers.
    Forecasting Demand, into the Markets, not only makes the Costs ‘knowable’, for the Purchaser, but also, from the Producers’ side, the Revenue..

    That, additional, Information, makes Planning easier, and, over time, would serve to smooth Prices..

    As it stands, far, too many predictable Demand Streams are left to be filled ‘at Spot’–and People wonder why they’re getting their heads caved-in..

  49. goodrich4bk says:

    Thank you to all who took the time to rebut this post. My initial thoughts were very dark, and left me with terrible sinking feeling in the pit of my stomach, particularly after reading this:

    “I don’t think I need to prove that. To “ban” something (a word statists really love), you need to show it does a lot of harm to those that are not a party to the transaction. Otherwise, again, be quiet and let free people transact (including betting) with each other as they see fit.”

    The arrogance of that statement was astounding. The overwhelming reply was heartening.

    And, for the record, I thoroughly agree that free people should be able to bet WITH THEIR OWN MONEY as they see fit. As others have pointed out, that is not at all what occurs between agents in today’s financial casino. Hence, the post’s entire premise is false and not worthy of further analysis.

  50. slackful says:

    What a coinkidink! I had the same feeling (terrible sinking feeling in the pit of my stomach) after reading all the “overwhelming, heartening replies”. For the love of god, never have I read such a pile of uninformed, unscientific groupthink all in one place. I think I read most of these opinions in “A Tale of Two Cities”. Oh well, wtf. Off with their heads, what’s the worst that can happen?

    Clifford, gravity pulls up. And there’s nothing you can say that will convince some people otherwise. Your papers, your awards, your success at navigating the real world of trading and finance in its natural element through understanding…means nothing. You could have saved yourself a lot of time and effort and thinking by just waiting for and then memorizing repetitive blogspeak to inform you of financial reality, it’s so much easier that way.

  51. [...] safer. “Consider the case of John Paulson and the now infamous Goldman Abacus deal,” Asness wrote on the popular financial blog, The Big Picture. The tough case seems to be speculator-on-speculator side bets. In this case somebody will win and [...]