DeLong Smackdown Watch: Sources of Social Surplus from Finance Edition

Hoisted from Comments: Robert Waldmann:

Throat-Clearing on the SEC's Goldman Sachs Case: Ahem. Your fourth win-win "Information:" is not like the others. You redefined win-win to mean "socially desirable" and decide that, if a third party wins, it is a win-win. Also, as you understood when you were in high school and Grossman and Hart figured out when you were in college, information does not explain trading. If the only differences across people were that they had different information then trades couldn't be win-wins. If it were common knowledge that everyone is rational then trades couldn't occur. It is not unusual for someone in a type 4 trade to think they are in some other sort of trade. In theory there are no type 4 trades which are known to be type 4 trades. Obviously in reality there are such trades....

Obviously not everyone is rational (who ever thought everyone was?). In particular, there is a group which keeps writing papers which correspond to actual financial markets and keeps being ignored. I forget who they are, but they have created a subfield of Lake Wobegone finance in which everyone thinks they are relatively more informed than they are. Obviously this is what's normally happening -- traders think their trades are profitable, because they think the traders on the other side are irrational.... It is obvious that the synthetic CDO market was type 4 Wobegone finance. The Case-Shiller assets are better for hedging of all risk except specifically for RMBS default risk which can be completely hedged with only non-synthetic CDOs. Basically ACA had to know that their counterparties were someone like Paulson. Now there was fraud all right. ACA didn't know that their counterparty was uhm helping them choose underlying assets for the synthetic CDO. However, if they thought they were selling insurance, then they were such dangerous fools that taking their money is a public service...