Affordable Housing Institute : US

[Continued from yesterday’s Part 1.]

 

Yesterday we saw that advances in computing technology have moved in parallel with advances in financial technology — complex financial structuring, securitization, and more.

 

My dear sir, if it were easy, everyone would be doing it

As it writes in Black Boxes, the Economist is a tad skeptical:

Advances in technology and information have always been good for capital markets. Richard Sylla of New York University’s Stern School of Business argues that financial globalisation started earlier than previously thought, around 1816. At that time packet sailing ships began to make regular scheduled crossings between New York and British ports, cutting the average time it took for mail—and information about securities prices—to cross the Atlantic. Later that century the telegraphic transatlantic cable, along with steam shipping, heralded the huge growth of global markets between 1870 and 1914.

The computer is the cable of our age, and it has turned investment banks into hothouses of financial innovation. The financial principles are not new: parallels have been drawn between the spectacular growth of credit derivatives in recent years and the introduction of wheat futures in America in the mid-19th century.

 

 

The Chicago Board of Trade: the house that risk built

But thanks to computing power the products have become infinitely more malleable. They are designed to appear complex and impenetrable.

‘Designed’ to appear impenetrable? Perhaps they are in fact complex and impenetrable.

 

But they are not patented, and staff turnover across the investment-banking industry is estimated to be up to 20%, so ideas travel quickly.

In capital markets, they always do.

 

 

Matt King, a credit strategist at Citigroup, says that demand for CDOs has lately been stimulated by the approaching implementation of the Basel 2 capital accord, which encourages banks to swap risky loans on their books for CDO tranches to avoid high capital charges.

 

 

If we swap, we both win!

This has been helped by the increasing willingness of banks to sell loans into the capital markets in order to diversify their portfolios. Huw van Steenis of Morgan Stanley estimates that some 78% of senior secured loans in America have now been sold in this way, compared with 29% in 1995.

Pause for a moment on that statistic — the share of loans securitized has tripled in a dozen years. That, my friends, is a revolution.

 

 

Aux barricades! Aux derivatifs!

The second concern is the possible need to pay out on CDSs if a wave of defaults were to hit. The attraction for the CDS seller, as with any insurance contract, is receiving a steady stream of payments for a risk it hopes will not occur. If its calculations are wrong, the result can be devastating. The BIS says the best way to gauge the total volume of CDS exposures is by their gross market value, which was $294 billion last June. That is a small fraction of the $20 trillion in notional amounts outstanding, and the whole lot would never blow up at once. But there would still be tidy sums involved if the sellers—including investment banks—ever had to pay up.

 

 

Don’t the banks take risk? The Economist suggests, in Capital spenders, that they are deft in not doing so:

Investment bankers would hate to admit it, but traditionally they have borne some resemblance to estate agents, matching buyers and sellers of financial assets instead of houses and land and taking a fee on the transaction.

 

 

You callin’ me a broker? You sayin’ broker to me? ‘

Cause I don’t see any brokers here.

Yet investment banks have recently changed out of all recognition. These days, if they were estate agents they would:

· Not only suggest a suitable property to buy and offer to handle the transaction, but also

· Propose a loan

· Come up with sophisticated products to offset the risk of rising rates

· Provide help with the down-payment

· Sell you funky insurance products and

· If they decided the property was a bargain, even buy it from under your nose.

In short, investment banking has migrated from an agency model towards a principal one.

 

 

Have you boys been trading securities for your own account again?

It’s a different poker game when you’re playing with your own chips — and, in most relevant ways, a better one:

The industry is not just offering its clients a growing array of products to buy and sell; it is making bigger bets with its own capital, too. According to Merrill Lynch, in 2005 one-third of the industry’s revenues came from principal trading of debt and equity and only 15% from the commissions business, once the industry’s bread and butter.

 

Yet, if I both sell you products, and compete with you in buying them, isn’t that a conflict of interest?

 

 

I’m not conflicted! I’m interested!

 

As suggested by the Economist’s feature Merchants of Boom, the answer is — well, yes!

 

 

Oh, be-have

Yet investment banks serve so many masters at the same time that sometimes they cannot avoid ruffling feathers. Goldman, along with other banks, has appointed senior people to prevent this happening or at least minimise the effects. “We can’t avoid conflicts,” says the firm’s Mr [David] Viniar. “We have to manage them.”

 

 

“No conflict, no interest,” as one of my colleagues likes to chant.

As in other parts of the debt markets, the liquidity has been fed by the large number of investors willing to buy tranches of collateralised debt obligations or, in the case of leveraged lending, collateralised loan obligations (CLO’s), a market which has rallied since 2002. Once bankers have underwritten the loans, they can sell them on to CLO funds rather than keeping them on their books, which may help to explain their willingness to take greater credit risks than before.

But hey, markets are smart, aren’t they? Isn’t that the key premise — that all those independent actors, making independent decisions, are a cellular automaton smarter and quicker than any individual? That’s true enough in the normal situation, but sometimes things go abnormal, as the Economist observes in The Wobble Factor:

 

 

Only the most abby normal brains here

 

 

In 2005 participants at the Kansas City Fed’s annual shindig in Jackson Hole, Wyoming, were reminded of a sunny day in London in June 2000 when the queen opened the new Millennium Bridge. Thousands of people flocked to take part in the spectacle, but no sooner had they stepped on to the bridge than it started shaking violently, forcing them to hold on to the handrails. The bridge was immediately closed again and remained so for 18 months.

The speaker at Jackson Hole, Hyun Song Shin, a professor of economics at Princeton University, used that embarrassing wobble as a metaphor for potential instability in financial markets. He was discussing a paper entitled “Has Financial Development Made the World Riskier?”, and he equated the pedestrians on the bridge to people in financial markets, and the bridge itself to movements in prices.

 

 

 

Buy, sell/ buy, sell/ buy, sell

As Mr Shin observed, soldiers are trained to break step before crossing bridges. The footfall of thousands of individuals should be entirely random in the first place. “Here is the catch,” he said. “When the bridge moves, everyone adjusts his or her stance at the same time. This synchronised movement pushes the bridge that the people are standing on, and makes it move even more. This, in turn, makes the people adjust their stance more drastically, and so on. In other words, the wobble of the bridge feeds on itself.”

 

 

When I was kid, we used to wonder what would happen if everyone in America flushed their toilets at once, or if all the Chinese jumped up and down at the same time.

 

 

The face of cataclysm?

Something of that kind evidently happens in financial crises — everybody comes to the same realization simultaneously, which is where stampedes come from.

 

 

“Risk! Risk!”

Fears of a self-reinforcing downward spiral in prices have been around for as long as financial markets have, but regulators and central bankers are becoming more vocal about the danger.

 

 

Many have argued that the enormous difference in consequences of the 1929 stock market crash and the 1987 trader’s meltdown (or, for that matter, 1998’s Long-Term Capital Management implosion) is due to smarter monetary policy, all learned the hard way, to counteract people’s normal credit-shrinking instincts.

The proliferation of new instruments, such as credit derivatives, and new market participants, such as hedge funds, intermediated by a small number of large global investment banks, poses new questions about financial stability.

 

Any time we built a complex system we don’t understand, weird secondary effects show up.

 

 

 

 

We’ll make you queen of the obscure risks

[Concluded tomorrow in Part 3.]

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