The story started here at Baseline Scenario, where I waded thru the hot debate and steaming comments on “reverse convertibles.”
“New financial instruments are like designer drugs and should be regulated when they are created,” growled Min.
These are a “sophisticated instrument,” argued Cafecb750. “Financial services companies cannot simply develop products that make no economic sense for the investor.”
“What planet are you from?” Bond Girl snapped at Cafecb750.
Then I came across this jewel:
“As many have noted here, this is simply a way for banks to offer unsophisticated customers a product that looks a lot like a covered call (or naked put, it’s the same thing) and to pocket some fees in the process. I’m 100% certain that the banks won’t take the risk to their balance sheet, but will arbitrage it away in the options market. So any reasoning that this would somehow be useful for thinly traded options doesn’t stand: the bank still needs to dabble in the options market to offset the trade. … In short, you end up hiring a very expensive broker or market maker to write a naked short.
My eyes glazed over.
I was clueless. But I did get the drift. (Reverse convertibles are a scam.) I could pick out bits of vernacular speech: gambling, banks, Wall Street casinos, Las Vegas casinos, designer drugs …
So I decided to have some fun …
University researchers have created the world’s first animal laboratory that models human gambling addiction.
The Novel Rat Gaming Task has found that rodents can “play the odds” and demonstrate lower risk-taking behaviour when given the right incentives. If the rats won the game, they received the associated reward (sugar pellets). But if they lost, they experienced timeout during which reward could not be earned. High-risk options offered more potential sugar pellets, but also greater risk for more frequent and longer timeouts. Rats learned to “play the odds” by optimizing risk and reward to maximize their sugar pellet profits.
Now those are AAA-rated rats.
The study on rats makes sense. Suppression of serotonin leads to an increase in impulsive behaviour and higher risk-taking. Suppression of dopamine leads to decreased pleasure and lower risk-taking. “The neurobiological basis for gambling is still poorly understood,” said lead researcher Dr. Catharine WinStanley. “It brings us a step closer to drug-based treatments for people suffering from gambling disorders.”
The advance will help scientists develop new treatments for gambling addiction, a devastating condition that affects millions worldwide.
Let’s apply this to the casinos on Wall Street.
Brave New World revisited: Big Pharma could design a drug for gambling addicts on Wall Street. The indications would be an optimal level of risk-taking (serontonin) and reward (dopamine) for a balanced approach to profit-taking. Certainly DNA testing might help. But that would be a violation of civil liberties.
Here’s the scoop. Reforming compensation might create a similar outcome. Here’s another scoop. The casino industry is regulated. But not apparently Wall Street.
The last word goes to MK:
“If banks (and insurance companies) actually ran like casinos we wouldn’t be in this mess. Casinos are regulated, the odds have to be within certain parameters, games have to be true ‘games of chance’ so some people have to be allowed to win, and most importantly all casinos have to have enough money to cover the bets on the casino floor. If AIG had enough money to cover the losses in it’s credit default swaps or Lehman had enough money to cover losses in it’s CDO portfolio there would be no problems, and change in the regulations allowing leverage to go from 12:1 to 40:1 was a big player in the collapse.
Dr. Winstanley’s webpage
Her press release
Her study: (No I didn’t read it.) Serotonergic and Dopaminergic Modulation of Gambling Behavior as Assessed Using a Novel Rat Gambling Task.
Bond Girl’s website
© July 2009