Affordable Housing Institute : US

 

As the world continues sloshing around in excess liquidity, where will it go? I’ve previously posted that, whereas capital is fickle — the wind blows where it will — property is stodgy: you can’t move it (duh), you can’t change it, and the measure of its physical change is the half-decade or longer. In that light, the Economist recently published a terrific special section devoted to global capital finance, chock-filled with insights about capital’s dynamics.

Better insights a millionaire’s blogger won’t post

Today’s capital markets are in a state I’ve never seen before, positively vibrating with excitement at the prospect of finding credible income streams of meaningful scale. Since most of the world’s wealth reposes in real estate, and most of its real estate wealth is in residential property, naturally a lot of capital is looking at a lot of variations of residential income.

 

The extent and taste of capital’s appetite is, therefore, of critical interest to housing policy. While in the long run housing affordability is all about earning power and land-use restrictions, in the short run housing affordability depends on interest rates. Here in America, interest rates depend increasingly on the world’s availability of capital, and that capital’s interest in US assets.

 

I have always depended on the kindness of Treasury note buyers!

(Besides, this post is your one-minute, impress-your-cocktail-party-friends, MBA-in structured-finance.)

 

But Tad, if I read the AHI blog posts, I’ll understand what you’re saying

Let’s start, paradoxically, with where the Economist ends up, quoting Francis Bacon in its essay Spreading the muck:

“MONEY is like muck,” wrote Francis Bacon in 1625. “Not good except it be spread.” Today’s pin-striped philosophers might swap the word “money” for “risk”.

 

Plenty of opportunity here

Hold credit risk too long, Wall Street wisdom has it, and it may eventually reek to high heaven. Spread it about, and a hundred flowers of finance will bloom.

In mathematical terms, risk is volatility of return. In normal human terms, it’s uncertainty about the future. About the only thing certain about the long run, as Maynard Keynes famously observed, is that we are all dead. In the meantime, risk is what motivates human achievement, so like other intoxicants, a little is good for you … but not too much. As the Economist’s piece, Eggheads and long tails, puts it, the question is not how you take zero risk, but which risks you choose to take:

 

In a report last year Moody’s looked at Goldman Sachs, the most profitable investment bank and, in many respects, the envy of its peers. Describing its risk philosophy, Moody’s said Goldman saw risk not only as the counterpart to revenues or profit, but as “the source of profit”.

 

You sure there’s profit at the end?

According to Moody’s, “most firms might ask themselves if they are taking too much risk; Goldman Sachs’s most senior management—more aggressively than others—constantly asks the question, ‘are we taking too little?’ and ‘are we taking the right kind of risks?’”

If risk is essential, indeed to be sought, how can we be smart about seeking it?

 

It is at least 20 years since such theories began to take root in the world of banking, and there are good reasons why commercial banks that make loans, and investment banks that transform them into securities, have embraced them. Regulation allows banks to hold less capital if they lend to sound and diverse borrowers, so better to sell off the dodgier stuff if they can.

 

That can be said in a less cynical way — risk, if disaggregated, can be distributed, and its distribution, as we have seen in the subprime story, means that more stakeholders are motivated to mitigate risk. That’s good for the ecosystem because it means more people are trying to alleviate risk, and the more people motivated to help, the better our chances for emerging intact.

 

Oh, and let’s not forget the profit motive:

 

First of all, we’ll change its name to ‘profit-oriented’

The more of their lumpish loans that are converted into liquid securities, the higher the profits that accrue to the middlemen, the investment banks. And regulators too are happier if the banks whose depositors they are meant to be safeguarding have less toxic matter on their books.

But where does that risk end up?

 

Don’t want to get stuck with the Risk card

As the Economist points out, in Alchemists of Finance, another article from the same collection, it’s distilled into risk moonshine:

At the same time the search for yield, as investors seek to compensate for low returns in high-quality markets such as government bonds, has increased demand for instruments of greater complexity, such as credit-default swaps (CDSs), collateralised debt obligations (CDOs) and other derivatives.

 

Complexity is itself a form of risk, for it is the risk that the buyer does not understand what he is buying:

 

There are known unknowns, and unknown unknowns: and some are really little

That has pushed down implied volatilities to multi-year lows, arguably making the assets appear more reassuring than they actually are.

 

Don’t worry about those signs, folks, there’s plenty of risk for all of you!

Regulation has helped, too. Under the Basel 2 banking accord, whose trickier provisions are due to come into force in the European Union next January and in America starting a year later, capital will be allocated according to the riskiness of assets.

This, to be sure, is fundamentally sound.

 

That has encouraged banks to make more use of credit derivatives to diversify their credit portfolios, and to sell more assets into the capital markets to be repackaged into debt securities.

 

All this packaging and repackaging ought to shift who holds the risk, but in the end, does it really reduce risk?

And might some of [the risk] be going undetected on the books of investment banks, the most complex institutions at the centre of the finely spun web of global finance? This survey has sought to test the nuts and bolts of their risk-management machinery to see how solid they are. What it has found is partially reassuring. The top firms […] are taking more risk, but then risk is their business. Earnings and capital have risen even faster.

 

Hey, cher, you wan’ some moah risk, darlin’?

And they are trying to expect the unexpected, aware of the inherent flaws in the models they use to measure their increasingly complex exposures.

Just how sexy are these models?

 

Come back tomorrow and I’ll show you my algorithms

[Continued tomorrow in Part 2.]

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