Arnold re-asks Kevin Drum's question.

But this is mysterious. After all, not everyone is going short on volatility. In fact, by definition, only half of the punters on Wall Street are doing it. The other half are taking the other side of the bet.

A bank makes a mortgage to a potentially dubious borrower with little or no money down.  The bank receives an upfront fee, and holds a potentially profitable loan, but accepts the obligation to buy the house at a forty or so percent discount to market value, should the borrower decide to, or have to, stop mortgage payments, thus inducing foreclosure.  In the short run, the borrower is long volatility.  A strong economy means "end up owning the house," while a very weak economy means "mail in the keys," no damage no harm.

In lots of world-states the buyers are better off and that is why it is politically popular to allow and indeed encourage banks to take on this kind of net position, however dangerous it may be in the longer run.  The real scorpion's tail to this financial trick is that both special interests and populism will favor it, politically.  Politicians, like banks, also prefer to go short on volatility and embrace the ticking time bomb.  As with bankers, there is no "boil in oil" penalty worse than dismissal and the cost of that penalty does not vary much with the badness of the crisis.

The synthesis of CDOs out of tranches makes this basic logic much more intense, in a non-transparent way; read this post on the entire logic.

Of course this mechanism interacts with the real economy to (sometimes) help feed or encourage a real estate bubble, thus boosting systemic risk.  This individual home buyer position, done collectively and in sufficiently large numbers, damages the interest of the buyers by inducing macroeconomic volatility and thus altering the distribution of their job market and equity market returns (note that in simple options pricing the overall distribution of returns is taken for granted). 

It is appropriate to observe that many buyers are failing to cash in on the value of their "mail in the keys" option, perhaps for reasons of custom and conscience.

When various banks hedged their risk with AIG, they shifted some of the risk but most or all of them remained with net exposure to the real estate market and net exposure to volatility.  AIG nonetheless played the same strategy as the banks did.

This piece builds a new impression with each paragraph:

It's cheap at the price — for 14 euros, a Ukrainian firm hires out drinking buddies to help while away the evenings in the industrial town of Dniprodzerzhynsk. The service is proving very popular.

A firm in eastern Ukraine has come up with a promising business idea — hiring out drinking buddies with whom clients can shoot the breeze on long evenings out in the industrial town of Dniprodzerzhynsk, presumably over a bottle or two of vodka.

For a fee of around €14 ($18), a company called "Kind Fairy" provides "a pleasant companion who can enliven a boring evening," manager Yulia Peyeva told AFP.

Dniprodzerzhynsk on the river Dnieper is known for its heavy industry and named after the founder of the Bolshevik secret police, Felix Dzerzhynsky.

"Virtually all of our people are talented. They can play guitar, sing or recite poetry. Today you may want to talk about art and tomorrow to read Faust," said Peyeva, adding that the firm does not encourage binge drinking.

She said the service is enjoying strong demand, and that the firm employs a number of psychologists among its staff of boozing partners.

For the pointer I thank Brian Wheeler and also Allison Kasic.

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.

Earlier this year, in the wake of several studies, including one conducted by the Swiss government, that found that young teenagers had trouble finding suitably sized condoms, a company called Lamprecht AG started selling the Hotshot, a smaller-than-usual condom marketed to 13- to-15-year-olds.

The link is here and it leads you to the latest and 10th annual NYT Year in Ideas, a superb series from the beginning.

The excellent Michael Mandel writes:

Over the past 10-15 years, the strengthening of information flows into developing countries meant that knowledge capital was being distributed much more quickly around the world.  As a result, the normal process of knowledge capital depreciation greatly accelerated in the U.S. and Europe–beneath the radar screen, because no statistical agency constructs a set of knowledge capital accounts.  

I agree with the conclusion but I am not sure that globalization was the mechanism.  I sometimes think of an imaginary economy with two sectors: music and bathtubs.  I believe that my bathtub is over thirty years old, yet for me it works fine and I have no desire to buy a new one.  When it comes to music, most people want to listen to what is new and hot, not Bach's B Minor Mass.  Furthermore, even within the music sector, acts seem to have declining longevity, in part due to the decline of the iconic album, the rise of the iTunes single, the fall of entry barriers, and the proliferation of genres.  The Rolling Stones are still around, or U2, but more rapid turnover is the trend. 

A while ago I read a good article about how few people on Netflix rent or stream the indie movies from the 1980s or 90s.

The more that your economy "looks like" the music sector, the more rapid the rate of depreciation for production capital and knowledge capital.  This means we may be overestimating our national wealth.

Here is Michael on our aging capital stock.