Writing naked puts and how the financial sector makes so much money

In part the financial sector does the equivalent of writing "naked puts," namely taking risks which usually yield extra income but occasionally blow up and bring large losses, part of which are socialized.  Lending money to homeowners under relatively loose terms is one way of taking such a position but of course trading strategies can replicate related risk positions.

H. Peyton Young just wrote me that he and Dean Foster have a piece in the latest QJE on a closely related logic; I have yet to read it closely but it strikes me as a very very important article.

The key problem underlying all of this is we don't know how to punish people in a manner consistent with the rising size of absolute rewards.  As I wrote:

Another root cause of growing inequality is that the modern world, by so limiting our downside risk, makes extreme risk-taking all too comfortable and easy. More risk-taking will mean more inequality, sooner or later, because winners always emerge from risk-taking. Yet bankers who take bad risks (provided those risks are legal) simply do not end up with bad outcomes in any absolute sense. They still have millions in the bank, lots of human capital and plenty of social status. We’re not going to bring back torture, trial by ordeal or debtors’ prisons, nor should we. Yet the threat of impoverishment and disgrace no longer looms the way it once did, so we no longer can constrain excess financial risk-taking. It’s too soft and cushy a world.

That’s an underappreciated way to think about our modern, wealthy economy: Smart people have greater reach than ever before, and nothing really can go so wrong for them. As a broad-based portrait of the new world, that sounds pretty good, and usually it is. Just keep in mind that every now and then those smart people will be making—collectively—some pretty big mistakes.

Matt is correct that the argument doesn't require bailouts, although bailouts make the problem much worse, by neutering creditors as a risk-reducing force.

Most likely, shareholders favor some but not all of these "going short on volatility" risks.  To some extent they are ripping off the creditors by taking such risks, to some extent they are ripping off the public sector through an expected bailout (not true for most non-financial firms, of course), and to some extent the managers are pushing the risk beyond the point shareholders would desire, if they understood what was going on.  Keep in mind that shareholders and bondholders are also potential market competitors, so the firm's trading book can't be completely open to even the owners of the firm (a neglected point, in my view).

One question, raised by Robin Hanson, is why everyone doesn't write these naked puts.  You can introduce the "not everyone can expect a bailout" point here and it works fine.  But there are other reasons too:

1. Large-scale banking involves economies of scale (after the few biggest U.S. banks, size drops off dramatically).  You don't have to think these economies are socially productive; the point remains that Goldman can take positions which my local bank will not or cannot with equal facility, for a mix of institutional and expertise reasons.  The prospect of bailouts, of course, cements concentration in the sector because everyone wants to lend to "Too Big to Fail."

2. Arguably every bank does write the equivalent of naked puts to a socially non-optimal degree.  It is often homeowners on the other side of the market, arguably to an irrational degree.  In any case the resulting price of the put can be actuarially fair and the basic mechanism still operates.  If you play this strategy, you can expect (the mode) a bunch of years of multi-million returns, followed by an eventual unceremonious firing (if that) and life in the Hamptons.  If you follow an efficient markets strategy, you can expect the going rate of return on the diversified market portoflio.  Which sounds better?

Soon I'll write a post on whether vigilant creditors can neuter this risk-taking, so please hold off on that question for now.

Addendum: This "going short on volatility" risk strategy is receiving a good deal of attention from commentators on my piece, but I actually think "arriving there first with a good asset purchase," as I discuss in the article, is a somewhat more important mechanism for increasing income inequality among the top one percent.  A lot of the rise in income inequality has come outside the financial sector narrowly construed, though it still is related to the existence of relatively open capital markets.