Friday, December 31, 2010

Market Pipeline: The Dark Side of Financial Innovation

When I keep going back to a particular post, eventually I have to talk about it.

[LINK to the Market Pipeline post]

Cormick Grimshaw of the Pipeline posts an abstract of a paper by Brian J. Henderson and Neil D. Pearson. I reduced the abstract until it made sense to me:

The offering prices... of a popular... structured equity product were... almost 8% greater than... the products’ fair market values....

Under reasonable assumptions... the mean expected return... is slightly below zero.

The products do not provide tax, liquidity, or other benefits, and it is difficult to rationalize their purchase by informed rational investors.

So, somebody's getting ripped off. I think a lot of people get a lot more upset about that kind of thing than I do. Don't get upset about it. Bear with me.

The last part of the abstract is presented complete, below:

Our findings are, however, consistent with the recent hypothesis that issuing firms might shroud some aspects of innovative securities or introduce complexity to exploit uninformed investors.

In other words, the issuing firms are putting extra nicotine in their cigarettes to get you to keep smoking them.

The best way to get back at those companies is to make people want to stop buying their product. And you know what? People already want to stop buying their product. At least, people want to reduce their debt. When people succeed, finance will become a smaller business in this country. Lenders will have less raw material to work with, from which to create "structured" products and other derivatives.

The best way to get back at those finance companies is to depend less on finance. Just remember, the necessary step is to change economic policy.

Related Links:

  • The SSRN page identifies the "structured equity product" as SPARQS.
  • What is SPARQS? An interest-paying note built on equity (stocks); a derivative.

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