November 10, 2009

Pointless Arbitrage

Banks are special: the Fed pumps them with money because they are supposed to be the smartest lenders. The decisions of the local bank loan officer drive the engine of capitalism.

Unfortunately, the big money is no longer in writing the loans. The big money is in arbitrage.

And that is why our economy is in trouble today.

Reversi Arbitrage

The pointlessness of arbitrage is obvious after you play a couple short games of Reversi.

On the left, play as Black. On the right, play as White.

Either game is challenging to win on its own.

However, if you play both games at once, replaying Black's moves against White and vice-versa, then you are guaranteed to win one game with no effort and no skill.

Even if you are a terrible player, you can rack up a 50% record with this strategy.

And there is money to be made on a 50% record. You can offer to bet $100 for every game played, and you will never lose any money. If you put on a good suit and print some business cards, you could surely collect a few pennies of fees for each game and turn this two-faced game-playing technique into a profitable business. Or make a computer program that plays this way, plug it directly into the markets, and make a killing.

The problem is this: you might be rich, but you would still be a terrible player.

Arbitrage Is Not Banking

And that is the problem with arbitrage.

Banks are no longer playing the loan-officer game. They do not need to know how to recognize a bad loan. They just need to know how to package it up to be resold to a different investor. Maybe the investor is being dumb, or maybe the borrower is being dumb - the banks don't care because they just pass the game through to the other side.

That is the norm in banking today. It is a blind, stupid business and it adds nothing to the economy.

Banks have long argued that the derivatives they write increase the efficiency of the capital markets, but the more you really understand derivatives, the more you realize that they are simply a way for banks to duck out of their responsibility of actually playing the role of a bank.

We need banks to get back to the business of making real decisions and taking on real risks.

Banks Need To Take Risks

Banks should not be allowed to securitize loans, write derivatives contracts, buy insurance against defaults, or transfer risk to other investors in any way.

The role of banks should be to take risks and absorb risk. Banks are insured by the FDIC and have access to the Fed discount window. They should not be allowed to have these advantages while passing their risks on to others. Arbitrage and banking should be separated.

Banks need to have skin in the game.

Posted by David at November 10, 2009 10:45 PM

Based on the Wikipedia definition, I think "arbitrage" is the wrong term.

What you are describing is "hedging" where one risk is offset by another.

Posted by: Roger at November 17, 2009 12:03 PM
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