Understanding “poor” financial contracts
Here is an article from one of my favorite blogs, Interfluidity. Steve Waldman really contributes an enormous amount of insight and clear thinking on today’s financial issues. If your interested in a concise, informative, and fascinating opinion piece read-on. Click Here To Skip The Introduction & Read The Full Article On Financial Contracts Their Use & Abuse
Article Introduction (Interfluidity)
Despite all that’s gone down over the last few years, I’m an enthusiast of “financial innovation”. I think it essential that we remake our financial system into something so different from what it has been that we would hardly recognize it. Doing so will require a lot of innovation.
But there’s no question that the current financial crisis was abetted and largely enabled by many of the “innovations” that became ubiquitous in the financial sector earlier this decade — CDOs, SIVs, (arguably) CDSs, etc. To square the circle, I resorted to an old cop-out: the revolution hasn’t been tried. There’s good innovation and there’s bad innovation. The stuff that didn’t work was the bad stuff. Lame as that may be, it is what I think, and I did try to put some flesh on how we could distinguish good from bad going forward.
Article Excerpts (Via Intefluidity)
“A contract is “structurally” transparent if, conditional on any set of observable real economic outcomes, it is clear what cash flows are compelled of all parties.”
“A contract is “substantively” transparent if the economic outcomes that determine the cash flows are themselves susceptible to analysis. A mortgage-backed security, for example, might be structurally transparent but substantively opaque”
“I think a strong case can be made for regulatory promotion of structural transparency. Contracts can be made arbitrarily complex, and there is little reason to think that skill at crafting and understanding challenging legal documents overlaps with peoples’ ability to evaluate economic risks and outcomes.”
Conclusion (Via Interfluidity)
Fundamentally, the agency problems associated with financial intermediation are deep, and it will take a lot of reform — and innovation — to find good solutions. Regulation to promote structural clarity in investment contracts and manage leverage and counterparty risk may help limit the damage, but won’t be nearly enough. I think we need a fairly wholesale restructuring of financial intermediation, one that limits the scale and leverage of intermediaries, segregates transactional balances and noninformational savings from informational risk investment, and ensures that those who do manage large quantities of wealth land in penury or in prison before the taxpayers are on the hook to make private losses whole. But having regulators review and restrict the substantive terms of financial contracts strikes me as a bad idea.
Click Here To Read The Full Article On Financial Contracts Their Use & Abuse
