What do you make of this scenario? Mr You-and-me invests his hard-earned pension contributions in “Trust-Me” pension fund which, in turn, invests the same in high-yielding “Complexity Bonds”, rated AAA by “Safe Track” credit rating agency. But unknown to our protagonist and his pension fund, the high-profile “Securitization Bank”, which peddled these “Complexity Bonds”, was also shorting the same.
Then one day disaster strikes, the markets crash, and the hard- earned pension savings disappear, while the “Securitization Bank” makes a windfall.
Welcome to the spectacular world of modern financial markets, with its alphabet soup of exotic financial instruments, Nobel laureates, mathematicians and financial whizkids, and those wonderfully versatile off-balance sheet entities called structured investment vehicles.
Two rapidly emerging trends from the global financial markets are a cause for deep concern—a widening returns gap between categories of investors, and increasing difficulty in locating and pricing risk.
The extensive application of information and communication technology and the resultant integration of global financial markets have helped ordinary investors access real-time market information. With all available information being increasingly reflected in the prices of financial instruments, the major sources of profits are only twofold—arbitrage opportunities across markets and instruments; and multiplication of small margins by trading in volumes.
Such efficient markets trade away all the easy and obvious arbitrage options, leaving only the more latent and complex opportunities. Taking advantage of these fleeting profit opportunities requires deploying a battery of mathematics and finance wizards, armed with sophisticated software programs based on complex financial models and access to real-time information. And profiting from margin multiplication requires large investments, from either personal capital or debt.
All this is beyond the reach of ordinary investors. High net- worth individuals, hedge funds and private equity firms, being better positioned to locate and price risk, therefore tend to corner the lion’s share of profit opportunities, leaving but crumbs for small investors. With credit ratings providing inadequate and often misleading information about the levels of risk embedded in various financial instruments, and the price itself hardly revealing the inherent risks, ordinary investors are left vulnerable to be feasted on by larger investors.
Now let us explore the second trend. It has been claimed that two products of modern financial theory—portfolio diversification and securitization of liabilities— have helped diversify and transfer risk to make the financial system safe.
Securitization helps banks and other lending institutions pool their loans into asset-backed securities (ABSs), with or without structured tranches, so as to raise money in the capital markets for further lending, and also transfer credit risk from their books. It allows them to remain in the mortgage business as originators and intermediaries without taking too much of the interest rate, term and liquidity risks on to their own highly leveraged books.
But the reality has been somewhat different. Recent events have clearly shown that the complex ABSs have been “sold off by people who know best how to evaluate it, to people who don’t know what they’re in for.”
This turn of events can be traced back to a failure to address the two fundamental concerns that remain despite all the financial innovation of recent years— the quality of the underlying loan collateral and the pricing of its risk. Unlike in the past when the extent of risk and its bearer was easy to identify, complex financial instruments such as collateralized debt obligations have dispersed risk deep and across the system, making identification and pricing difficult.
Further, the commonly used risk pricing models such as the value at risk contain the usual flaws and discrepancies, which get ignored or glossed over despite numerous bitter experiences to the contrary. The regular suspects of bell curve and capital asset pricing model apart, risk rating models assume that any credit defaults are independent of each other, thereby permitting the use of the “Law of Large Numbers”, to discount the probability of default of more than 20% of the principal. In the absence of any acceptable liquidity valuation method, the risk pricing models do not account for the risks associated with market liquidity. From hindsight, we realize that these omissions have been at great cost.
The complexity and sophistication of financial instruments has often been a convenient shield for skirting laws and accounting rules, besides obscuring risk and confusing unsuspecting investors. Besides, it also increases the difficulty of restructuring or rescheduling debt, thereby restricting one of the main levers of managing financial meltdowns.
There are numerous examples from the recent subprime mortgage crisis of how modern financial engineering actually gave only an illusion of risk transfer. The complex inter-relationship between hedge funds and others and the Wall Street banks often meant that the former borrowed money from the same banks that they were insuring against bond default by selling credit derivatives.
For the bigger investors, it is “heads I win, tails you lose!” For the rest of us, a blunt but accurate description of most of what passes on as financial innovation would be—gambling!
Gulzar Natrajan is a civil servant. These are his personal views. Comments are welcome at email@example.com