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Information loss

December 29, 2011

When people ask me why the financial system is so complicated, I always say the same thing: because it benefits the insiders of the financial system to make it that way. The more complicated and opaque something is, the more opportunities to extract fees and withhold information. Or rather, to withhold information in order to extract fees.

In some sense you can think of the financial system as a huge “information loss” system, where people get paid based on how much more information they know than you do. Incidentally, this theory flies in the face of most economic assumptions of transparency, and explains the origin of the phrase “dumb money.” And it’s not my idea, it’s kind of an elemental fact for insiders; I’m bringing it up because I want to make sure people are aware of it.

As an analogy, think of the situation when you buy a used car from someone. They tell you some things, like its make and model, and they may let you test drive it, but you end up not knowing how many accidents it’s been in, and stuff like that. Your partial information in general lets them make money.

It’s kind of understandable why there’s so much insider trading going on. Insider trading is the ultimate and most efficient way to profit from information.

Another good example of information loss is with mortgages, and mortgage-backed securities. The original idea behind securitizing mortgages was that investors get to buy pieces of pools of mortgages, which “behave better” than individual mortgages: whereas an individual can refinance (and often does, when interest rates go down) or default, it’s less likely that a majority of the people in a pool refinance or default.

[Let’s ignore for now the issue that the banks got so high on the profits of securitization that the assumption of better behavior of pools got thrown out the window as the underlying mortgages became worse and worse – a gleaming example of information loss.]

In selling these pools, the banks were charging fees so that you, the investor, wouldn’t have to “deal with the details” of all of the individual mortgages in the pool. This is one way that people withhold information and charge a fee for it, by calling it a chore.

And it is a chore, if you actually do it. However, in the case of mortgages, lots of banks charged that fee for that chore and then never actually did the chore– they kept terrible accounts of the mortgages, and when they started to default in large numbers, started illegally pretending their papers were in order, through “robo-signing,” in order to foreclose quickly.

Here’s something you can do if you have a mortgage. Demand to see your mortgage note. It turns out there’s a legal way for you to ask your bank to trace the ownership of your mortgage through the securitization system, and you can do it for fun, you don’t need to be late on your mortgage payments or anything.

There does seem to be a risk associated with asking to see your note, however, namely to your credit score, which is bullshit. There’s also a form letter of complaint if your bank somehow doesn’t come up with the answer.

Categories: #OWS, finance
  1. Constantine Costes
    December 29, 2011 at 10:21 am

    I agree with a lot of reasoning in this piece. One issue that it touches on is intentionality; is the financial system deliberately constructed to confuse or obfuscate? You seem to suggest that it does, and I think that is sometimes the case. But I think more often, it is a case of incentives (especially in systems where authority is not highly centralized, so there is no single decision-maker, in which case it may not be deliberately constructed at all). Suppose someone makes a discovery in finance; given the choice between revealing/advertising it (so as to educate others and thereby even the playing field) or exploiting it (for a profit), what is going to happen? That is one reason that education/training is such a low priority in finance and why most financial knowledge is commonly understood to have an associated time frame; once everyone knows about it, it is no longer valuable: hence, the ubiquitous secrecy in the field.

    This discussion ties in with another aspect of financial culture that initially surprised me: everyone understands most trends to be ephemeral and is (usually privately, sometimes publicly) estimating when reversals will occur. The waiting period is often measured in years; for example, I can think of a number of people who had been waiting for the housing market to collapse for years before it actually did and were only focusing on getting the timing right. So people become used to the idea of working in a field that they know cannot go on forever, so the focus tends to be short-term, since there is not much point in devoting resources to building anything lasting. Only property is seen to be a permanent resource.


  2. Aaron
    December 30, 2011 at 12:45 am

    I recently had a discussion with someone whose job was to inspect the mortgages in preparation for them to be securitized, claiming he went so far as to personally inspect each property, in addition to the financials of every mortgage holder. His opinion was that one should have a caveat emptor attitude in the stock market, and that anybody who buys anything without knowing exactly what they are buying gets exactly what they deserve. My pleas that it was prohibitively difficult, if not impossible, for most people to personally do though research on everything they would want to have in a balanced portfolio seemed to fall on deaf ears. We disagreed on the extent it is fraudulent to withhold information on a financial product you are selling (e.g. intentionally suppressing information that would make an investment appear more risky).

    Is there any general consensus on the matter? What constitutes due diligence on the part of a buyer? If you are paying a fee for someone to have done research, to what extent should you be able to trust the results? If someone creates a financial instrument, what obligations do they have to disclose what they know about the instrument? What obligations should they have? If the market is filled with bad actors, and if nobody can be implicitly trusted to provide honest and thorough information about investments, then to what extent is it dubious that we encourage lay people to invest in the stock market (e.g. through 401(k) plans)?


  3. Michael C
    December 30, 2011 at 1:31 am

    Once I used to review new products at one of the large Int’l banks. The first and last question the head of risk management would ask about the new twist was, “Where’s the arbitrage here?”, If there was none he’d reject the idea. If there was one it got the OK.

    Translation, there’s nothing new under the sun in banking, Unless you have an information advantage you can exploit, there’s no ‘new’ in ‘financial product’.

    Simple as that.


  4. Constantine Costes
    December 30, 2011 at 9:43 am

    Michael C, thanks for your comment, which is both illuminating and consistent with what I saw while working in finance.


  5. Bindicap
    December 31, 2011 at 1:58 am

    I don’t think the glib answer about why things become complex is very helpful. Leases and other legal agreements, computer code and car engines have all become more complicated to address incremental needs over time. Often both parties are just customizing or incorporating lessons learned into their relationship, but there are of course cases of very one-sided relationships — ridiculous EULAs are a good example.

    I also don’t really see the point of the Where’s the Note campaign you are endorsing at the bottom or how it is connected to your theme. It seems to be trying to manufacture pointless conflict. Afaik, you can inquire to see your note and the servicer can just respond sorry, no.

    Where problems happen is if your inquiry appears to repudiate your debt or threaten continued payment — I think this was justifying negative reports to credit bureaus. The form letter on the WTN site is intentionally walking up to the line here: “If you fail to produce a mortgage note proving that you have a right to collect my mortgage payments, I will be forced to consider all options available to me to ensure that my family and my home are protected.” If the communication goes as planned, you get to vent a bit, cause work for someone at the servicer and then the attorney general, but why? Are any people actually getting appointments to come in and see their original notes in a file, and how do they then benefit?


  1. December 30, 2011 at 7:38 am
  2. January 29, 2012 at 7:56 am
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