Type four win-win trading
by Robert Waldmann
Brad DeLong clears his throat. I throw a cow.
The win-win benefits of trading money for money–where are they? It turns out that they are there. There are, actually, four:
1. Trading money now for money later: people who want to save now and spend later can make win-win trades with people who want to spend now and save later.
2. Risk: people who are unusually averse to risk in general can make win-win trades by trading off some of the risks that they are bearing to people who are unusually tolerant of risk in general.
3. Insurance: people who are holding a lot of one big risk can reduce the risk of catastrophic loss by paying a great many others to each take a small piece of that risk.
4. Information: people who have information that prices are going to rise can make win-win deals with people who have information that prices are going to fall–although here the win-win is not for the participants in the trade: for them it is zero-sum, and the winners are those others who observe the market price at which the trades occur.
Ahem. Your fourth win-win “Information:” is not like the others. You redefined win-win to mean “socially desirable” and decide that, if a third party wins, it is a win-win. Also, as you understood when you were in high school and Grossman and Hart figured out when you were in college, information does not explain trading. If the only differences across people were that they had different information then trades couldn’t be win-wins. If it were common knowledge that everyone is rational then trades couldn’t occur. It is not unusual for someone in a type 4 trade to think they are in some other sort of trade. In *theory* there are no type 4 trades which are known to be type 4 trades. Obviously in reality there are such trades.
Now, obviously, trading volumes can not be explained by trades of types 1 through 3. Similarly the amount of CDSs written can’t be explained that way, since it is vastly greater than the amount of assets on which CDSs were written.. I think actually that this is a highly relevant problem. I’m not sure that you can explain the existence synthetic CDOs without type 4 trading which is known to be type 4 trading.
Obviously not everyone is rational (who ever thought everyone was). In particular, there is a group which keeps writing papers which correspond to actual financial markets and keeps being ignored. I forget who they are, but they have created a subfield of Lake Wobegone finance in which everyone thinks they are relatively more informed than they are. Obviously this is what’s normally happening — traders think their trades are profitable, because they think the traders on the other side are irrational.
Goldman Sachs claim that people always know there is a short seller in “such trades” refers to synthetic CDOs not all CDOs. One case of someone with exposure to mortgage default risk who wants to shed it is that someone owns an RMBS and wants to insure it. That agent could just buy Treasuries and sell the RMBS to form a normal non synthetic CDO. I can imagine other people trying to shed a correlated risk — construction firms and construction workers should have bought RMBS-CDSs to hedge against the bubble bursting — but do you really think that ACA and the German bank thought their counterparties wore hard hats to work ? No they thought that their counterparties were irrational type 4 traders.
It is obvious that the synthetic CDO market was type 4 Wobegone finance. The Case-Shiller assets are better for hedging of all risk except specifically for RMBS default risk which can be completely hedged with only non-synthetic CDOs. Basically ACA had to know that their counterparties were someone like Paulson.
Now there was fraud all right. ACA didn’t know that their counterparty was uhm helping them choose underlying assets for the synthetic CDO. However, if they thought they were selling insurance, then they were dangerous fools such that taking their money is a public service.
In fact, I think the fraud was a public service. If people who think they are smarter than average decide that maybe Goldman-Sachs is defrauding them, then there will be less speculation. I think that would be a very good thing. The reason is that I think type 4 trading reduces the valuable information in prices. The trades can’t exist in Nash equilibrium. Therefore finance theorists assume that there are some irrational traders. Then finance theorists (except for DeLong et al) assume that the volume of irrational trade is exogenous. They conclude that anything which causes high trading volume causes prices to be closer to fundamental values. That’s a pretty direct passage from an unjustified assumption to a conclusion. I think it is obvious that higher trading volume causes greater price volatility and that this volatility is always vastly greater than the volatility of fundamental values. So I think that, aside from not being an argument that type 4 trades are win-wins, your argument has it backwards. I think that real world type 4 trading reduces the information content of prices — because it is fundamentally irrational. So less of it would be better.
Goldman Sachs has damaged its reputation as a fair broker with this scam. I think that is an excellent thing, because that reputation caused people to trade if they thought they were smarter than average. Fear of being cheated by Goldman Sachs makes up for irrational over confidence and will lead the economy towards where it would be if everyone were rational. To put it briefly, what’s bad for Goldman Sachs is good for the world.
Question 1: What’s “winning”? Is it:
. increasing the objective probability/magnitude of a positive result?
. decreasing the objective probability/magnitude of a negative result?
. increasing the subjective probability/magnitude of a positive result?
. decreasing the subjective probability/magnitude of a negative result?
Note that win-win is a lot easier to achieve if you deal in subjective results.
And a quibble. 3 is a genuine item, but it’s not how insurance usually works. Conventionally, insurance happens when a group of people with a large, low probability risks decide to pool their risky ventures and pay enough into the pool to cover the occasional failures. And note that if you deal in objective rather than subjective perceptions, insurance summed over an entire pool must always be a losing propositon for one or both parties because of overhead/transaction costs.
I’m not sure that you can explain the existence synthetic CDOs without type 4 trading which is known to be type 4 trading.
Synthetic CDOs are “re-CDOing” a tranche of an existing CDO, thereby changing the timing and preference of cash flows of the subject tranche. Types 1-3 are applicable here.
Goldman should have put the following in its offer documents (and if there why did they not say it) “Goldman may take a long or short position on this security or buy CDS’s against it and may change its position at any time. Also have their salesmen give that disclaimer. Then the conflict is exposed. Of course Fabrice in one of his emails described the synthetic CDO as a form of self pleasure and that likley true. I just suggest moving synthetic CDO’s to the Casino, and let the Nevada Gaming commission regulate them move that part of the business to Las Vegas, there is clearly sufficient housing in that town to hold the new people moving there.
You mean disclosure like this:
“Goldman Sachs does not make any representation, recommendation or warranty, express or implied, regarding the accuracy, adequacy, reasonableness or completeness of the information contained herein or in any further information, notice or other document which may at any time be supplied in connection with the Transaction and accepts no responsibility or liability therefore. Goldman Sachs is currently and may be from time to time in the future an active participant on both sides of the market and have long or short positions in, or buy and sell, securities, commodities, futures, options or other derivatives identical or related to those mentioned herein. Goldman Sachs may have potential conflicts of interest due to present or future relationships between Goldman Sachs and any Collateral, the issuer thereof, any Reference Entity or any obligation of any Reference Entity.”
If thats there why did the people yesterday not point it out. I would have whipped this back to the senators, when the questioned the issues. Blankfein must have some pretty poor advisors to have not pointed this out. Every add you see for a security says read the prosepetus, if the sophisticated investors did not read the document then it is their tough luck. (It appears that Goldman management did not read it either) Why Goldman did not publicize this is unclear, because it says we may have a conflict and you should be aware of it. So this is now a case of dumb pr/legal counsel for Blankfein and others.
The Senate hearings were theater designed to drum op support for a heavily democrat version of a finance bill. By the time the trial is done the Senate bill will be long gone and decided one way or another. I cut and pasted from the actual complaint against Goldman Sachs so there is no question if its there or not. I’m not trying to say anything definitive but it looks to me like it was a “shitty” hearing over a bogus issue.
On blankfein’s testimony he’s the CEO of American’s premier investment bank so I don’t see him making a lawyers argument. That’s what the firm pays their lawyers to do and a senate hearing is not a court of law and it’s the home court for a hostile committee chairman.
Well its actually not a technical legal issue, but lies at the heart of the basic idea of the 1933 and 1934 acts. Transparency fixes all issues. If they had said to those who raised the issue, we disclosed that there could be a conflict, and the parties could decide if they wanted to live with it it changes the tone. But the senate hearing was in the court of public opinion, and they did not point it out there. In this case the court of public opinion is the critical one, because the conflict of interest issue was not brought up by the SEC, because they knew it was a bogus issue because they had read the document. While it could still have been called a legal technicality it would have been easier to defend.
But reading the big short its apparent that a lot of sophisticated investors don’t read the documents either, just like how many read every document presented for signing at a real estate closing.
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Yes and every piece of software I ever bought made my acknowledge I read and agreed to the License, which for even the simplest utility or game might be dozens or more pages of legalese.
Prospectuses and software licenses are not written to be understood or for that matter read but are in 99% of cases simple CYA exercises.
Really unless you make it a point to scour every word of every product warranty or actually clicked through to the language of that software license before clicking ‘Agree’ you have no grounds for criticizing investors who despite whatever is written down expect some semblance of a client relationship in regards to their broker.
I mean have you ever been to a real estate signing? There is literally no time to read through all the disclosures without inconveniencing that nice lady escrow officer (and they are mostly women) with questions she might not actually be prepared to answer (licensed or not). This is by design and for the same reason why your car salesman has to ‘talk to my manager’, they want you to think the person handing you the pen is just trying to make a buck or at least is on your side. When mostly you only have the first half right.
Sorry ‘should have read the prospectus’ may be a sound legal defense, but it doesn’t necessarily elevate the entire transaction out of moral fraud territory.