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"Much of what investment bankers do is socially worthless" watch

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    Banks are the bureaucracy of the free market - alternatives simply aren't there.
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    (Original post by simontinsley)
    The market will quickly converge to the consensus price, and then investors will buy if they deem it under-valued or sell if they deem is over-valued. I wouldn't so much call that mis-pricing (perhaps it is, but only if the consensus is wrong), but rather the difference between an individual's expectations and the market is what allows investment. I think that's what he was getting it, but I could be wrong.
    I'm not sure if this has exactly to do with his thesis, but I should point out that, with bubbles, there is largely a different mentality. To paraphrase from A random walk down wall street, the mentality is that "the market may be overpriced, but it's growing, so I can make profit if I buy and sell out before the other guy does". Investors, in this case, are not looking for fundamental value, but are speculating that the bubble would not collapse before they pull out. The skewed incentive here is to buy not what is underpriced, but what is overpriced.

    For this particular case, however, I think the issue has more to do with information. Let's say you knew that housing would eventually go bust, but it's very pricey now. You could then stick a partial investment of housing inside a financial instrument, significantly increasing the value of that instrument, and convince consumers that your instruments are well-cushioned because of that housing thing. The consumers don't know your stuff is going bust, because you've made the instrument excessively complicated and they don't really get the damn thing; it's your firm's reputation that is getting them to buy. This is, at least from a social perspective, a form of fraud and what the author calls "rent seeking". What's the social value in making all these complicated instruments, aside from tricking consumers? I think something like this is Cassidy's point.
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    (Original post by Saichu)
    Hang on, here; are you sure that what you're saying is actually a good thing? There was a housing bubble, after all, and there is a natural problem in using an overpriced market, like the instruments did, as backup. Yes, the instruments might have, as a side-note, allowed more homeowners to be funded, but if anything, that only represents a failure in allocation - the mortgages should never actually had been made, as the foreclosures caused by the post-bubble prices revealed. Perhaps I am misunderstanding you, but I don't think a misallocation of resources is considered a social good.
    Why shouldn't the mortgages have been made? If banks had maintained enough capital on their balance sheets there'd be no problem. House prices are dictated by supply/demand so naturally there is no misallocation. It's only when you look back in hindsight and see the correct allocation facilitated the recession that you consider them misallocated - but actually the recession was caused by more than just allocation of loans.

    The housing market only collapsed because people were allowed to walk away from their homes/mortgage payments when they realised their homes were in negative equity. There are lots of financial instruments that exist - whether they're used in a good social way or a bad social way depends on how/why the person is using them (e.g. Enron).
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    (Original post by Saichu)
    I'm not sure if this has exactly to do with his thesis, but I should point out that, with bubbles, there is largely a different mentality. To paraphrase from A random walk down wall street, the mentality is that "the market may be overpriced, but it's growing, so I can make profit if I buy and sell out before the other guy does". Investors, in this case, are not looking for fundamental value, but are speculating that the bubble would not collapse before they pull out. The skewed incentive here is to buy not what is underpriced, but what is overpriced.

    For this particular case, however, I think the issue has more to do with information. Let's say you knew that housing would eventually go bust, but it's very pricey now. You could then stick a partial investment of housing inside a financial instrument, significantly increasing the value of that instrument, and convince consumers that your instruments are well-cushioned because of that housing thing. The consumers don't know your stuff is going bust, because you've made the instrument excessively complicated and they don't really get the damn thing; it's your firm's reputation that is getting them to buy. This is, at least from a social perspective, a form of fraud and what the author calls "rent seeking". What's the social value in making all these complicated instruments, aside from tricking consumers? I think something like this is Cassidy's point.
    Likewise, you can blame the banks but they're only made because there is demand for them from investors. Investors should know what they're doing - most don't realise it for example but financial statements are created for an audience of people who have a knowledge of accounting already.
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    Please tell me if I'm missing something important, as there were some statements you made which I honestly couldn't see how they fit into the debate.

    (Original post by Altruistic1)
    Why shouldn't the mortgages have been made?...The housing market only collapsed because people were allowed to walk away from their homes/mortgage payments when they realised their homes were in negative equity.
    You seem to have answered your own question. They shouldn't have been made because of the high risk that people would walk away after the housing bubble burst. This risk was hidden (when packaged for the consumer) by what was essentially the investment bank's reputations, combined with the complexity of financial instruments.

    (Original post by Altruistic1)
    House prices are dictated by supply/demand so naturally there is no misallocation.
    Only if the supply/demand accurately reflect the utility achieved by society, which, judging by the extreme collapse afterwards, is probably not so (unless people suddenly started hated houses just that much :p:).

    (Original post by Altruistic1)
    Likewise, you can blame the banks but they're only made because there is demand for them from investors. Investors should know what they're doing
    In an ideal world, perhaps. In the real world, it is evidently not the case, and this gives a very real chance for banks to seek rents (the socially worthless activity we were talking about).
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    (Original post by Saichu)
    They shouldn't have been made because of the high risk that people would walk away after the housing bubble burst.
    Yes, there was risk... but investors know there is risk. They expect a risk premium (higher risk = higher expected return). You're saying this is "bad" but, actually, this is the whole point of the market - why investors bother investing. Everyone knows they could lose their principal investment, especially if they're taking on highly levered positions. You're saying this shows banks shouldn't have given too many loans - on the other hand, why didn't legislation stop homeowners walking away so easily? why isn't this question about politicians being socially useless? Likewise, what makes you think this risk is 'hidden'? If an investor fully understands the contract they've entered into then there is no hidden risk. You seem to be saying that banks are at fault because investors don't understand what they're doing. And to that I replied they are expected to - financial statement analysis requires accounting knowledge.

    Only if the supply/demand accurately reflect the utility achieved by society, which, judging by the extreme collapse afterwards, is probably not so (unless people suddenly started hated houses just that much :p:).
    I'm not sure what you mean. If I have a house worth $200,000 and try to sell it for $250,000 then certainly one person might buy it (happiness premium) but on a consistent basis across the country people wouldn't buy into that. As a similar notion, if I have a lottery with an expected return of £100, it doesn't mean that I'll expect £100 if I play it, it just means I'll get £100 on average if I play it on a consistent basis (i.e. many times).


    In an ideal world, perhaps. In the real world, it is evidently not the case, and this gives a very real chance for banks to seek rents (the socially worthless activity we were talking about).
    Certain things are complex by nature. We don't stop people selling gas ovens just because they could potentially blow up if you don't know how to install and use them properly. There's demand so there ought to be supply, the markets are driven by product knowledge and info release (or lack of it).
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    (Original post by Altruistic1)
    Yes, there was risk... but investors know there is risk.
    Please be less one-track about what you say; I have already pointed out that they didn't. The bankers knew of the risk, and essentially "tricked" the investors with their companies' reputations, thereby gaining significant short-term rents.

    See here for a summary and here for a more detailed discussion.

    (Original post by Altruistic1)
    why didn't legislation stop homeowners walking away so easily? why isn't this question about politicians being socially useless?
    An interesting turnaround; a possible answer involves precisely your own observations. Investors are, as you say, supposed to be able to evaluate the risks; they are (and indeed, you personally have indicated you expect them to be) responsible for any potential losses. If you truly believe this, there is nothing wrong with the political scheme.

    Rather, what is wrong is when overtly complicated instruments, as well as reputation, prevent the investors from understanding risks. There is nothing socially beneficial about this.

    (Original post by Altruistic1)
    I'm not sure what you mean. If I have a house worth $200,000 and try to sell it for $250,000 then certainly one person might buy it (happiness premium) but on a consistent basis across the country people wouldn't buy into that.
    This is naive; people will buy houses for higher and higher prices if they believe that they can sell it for even higher prices to a greater fool (before, of course, prices finally collapse).

    (Original post by Altruistic1)
    Certain things are complex by nature. We don't stop people selling gas ovens just because they could potentially blow up if you don't know how to install and use them properly. There's demand so there ought to be supply, the markets are driven by product knowledge and info release (or lack of it).
    If there's a gas oven that's so complicated that the number of accidents is comparable to the number of investors affected, rest assured there would be investigation. So why hasn't there been investigation in this case?
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    investment bankers are in essence just financial intermediates trying to make markets efficient there undertaking a common task which is necessary for the efficiency of the market. Giving you the best deals. You could argue shareholders/corporations are socially worthless (i'd agree). Every industry will have a negative externality in someway or another bankers have just been put in the limelight i could name a few others.
 
 
 
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