Complex financial products: caveat emptor: technical perspective

the fLoW of capital in the financial industry relies on the packaging of assets into products that can be reliably valued and then sold to global investors. For example, many home mortgages were packaged into products known as Col-lateralized Debt Obligations (CDOs) in the run-up to the sub-prime mortgage crisis of 2007. An investor in a CDO buys the rights to a share of the principal and interest payments collected from home-owners. By pooling assets and promising to pass along payments before making payments to other investors, new financial products offering lower risk than the underlying assets can be constructed. CDOs are examples of financial derivatives , with a value that depends on the underlying assets—mortgages in this case—with which they are linked. These kinds of complex financial products are the cause célèbre of the financial crisis, and many have called for their regulation or even elimination. In the following paper, Arora, Barak, Brunnermeier, and Ge provide new insight into the problem: a complexity-theoretic explanation for how sellers can hide bad assets in these derivatives. Even when buyers are fully informed, with correct beliefs about the probability with which underlying mortgages are likely to default, sellers can package a disproportionate number of bad assets into some products, and do so without detection. The reason is the in-tractability of checking whether or not this manipulation has occurred. By fo-cusing on this missing angle of computational complexity, this paper starts to bridge the gap between the common view that derivatives can be rigged and a viewpoint from economics that this is impossible when buyers are fully informed. Computationally bounded buyers may end up significantly over-paying, and a trustworthy seller cannot even prove that financial products have not been rigged. To understand the reason to sell derivatives in the first place, we can consider Akerlof's famous " lemons problem. " Suppose that 80% of secondhand cars are good, and worth $1,000 to buyers, while the rest are lemons and worth $0. Without the ability for a seller to credibly signal the quality of a car, buyers will only pay $800 and trades of good cars by sellers with values in the range [$800, $1,000] are forfeited. If all sellers of good cars want close to $1,000 then the effect of information asymmetry between buyers and sellers is much worse—only lemons remain in the market and there is complete market collapse! Still, a seller …