Wednesday, August 22, 2007

Financial Engineering: Money Maker and Credit Cruncher

In these times of market turmoil, it's natural to obsess over the market's daily bungee jump and wonder whether or not the rope will hold. With things momentarily calmer the last two days, we should take a brief step back to think about how we got here, and what we might learn from the events of the last few months.

Financial engineering--the design and construction of new financial contracts--has been a part of the financial system since, metaphorically speaking, the days of Romeo and Juliet, when bankers in northern Italy developed the notion of the check as means of financing trade in wool and other products made in northwestern Europe. Over the centuries, financiers have continuously developed new ways of attracting capital and investing it. The corporation, with its innovative limitation of the liability of shareholders to the amount of their investments, was much less risky than a general partnership, which placed unlimited personal liability on partners, or traditional insurance syndicates (such as Lloyds of London as it existed in the 1980s), which placed unlimited personal liability on the persons assuming the insurance risk (called the "names"). Consequently, the corporate form of business facilitated the aggregation of the enormous amounts of capital needed for an industrialized society and came to predominate.

Financial innovation can be highly remunerative. Forty years ago, mutual funds were a small sector of the financial services sector. However, with the bear market of the 1970s, the advantages of providing small investors a highly diversified and liquid investment that might be less volatile than individual stocks made mutual funds--and especially the index fund--a winner. The shareholders of mutual fund management companies such as Fidelity and Vanguard profited greatly.

Another innovation that has enjoyed increasing popularity is the Exchange Traded Fund (or ETF). Fifteen years ago, the ETF was a tiny blip on investors' screens. Today, it is a commonplace investment. There are advantages and disadvantages to investing in ETFs, as we discuss in Whatever they mean for the individual investors, they mean big bucks for the firms that developed them.

And then, there are derivatives. While some kinds of derivatives have existed for centuries (such as the commodities futures contract), today's financial markets are distinguished by the proliferation of financial derivatives. The credit markets--including commercial lending, the bond market, the mortgage market, and the consumer credit market--have to a large degree been transformed into derivatives markets. Banks are no longer the ultimate lenders much of the time. Investors who purchase derivatives of these extensions of credit are often the true lenders. The stock markets are shadowed, and perhaps overshadowed, by the derivatives contracts that institutional investors can purchase as proxies for equity investments. One can fairly debate whether price movements in the S&P 500 stocks drive market activity in the S&P 500 futures contracts or vice versa.

Gargantuan amounts of money have been made on Wall Street by firms offering and trading in financial derivatives contracts. Because these financial products are mostly traded by telephone or by appointment (in much the same way that over-the-counter stocks were traded in the 1920s), the firms that deal in them can charge large markups on sales and large discounts on purchases. There is usually no exchange or electronic trading system that displays prices of these contracts, even though such a system would promote competition. The dealers have the upper hand.

The enormous profit potential of financial derivatives has fueled innovation. The CDO, a financial instrument which will live in infamy, has been around in its current iteration for only a few years. The rate of innovation in financial engineering has accelerated to such a degree that simple processes like recordkeeping for transactions hasn't kept pace. See In plain English, what this means is that some derivatives contracts may be based on nothing more than a phone call. There isn't even a handshake to seal the deal. In cases like this, if one side of the contract goes into a tailspin, do we think the losing party might deny any recollection of the phone call?

Notwithstanding the current market mess, financial innovation will surely continue apace. As new financial instruments proliferate, the ability of everyone in the traditional financial sector--bankers, investors, and regulators--to keep track of what's going on is greatly diminished. Derivatives trade in largely unregulated markets, that have no central repositories for market data. As the derivatives markets grow larger and larger, and the exposures they create spread farther and farther, no one can figure out where all the tentacles go. And when the yogurt hits the fan, it splatters all over and no one has a good idea of how to clean it up.

It would be one thing if the only victims of the current mortgage market mess were rich people who were forced to bypass the Bentley dealer and crawl into a Lexus dealership with their tails between their legs. However, the credit crunch has cut a much wider swath of victims--uninformed adjustable rate, no doc mortgage borrowers, laid-off mortgage company employees, everyone who owns stocks or bonds, and overextended home equity borrowers who thought their equity was real, among others.

Most of the discussion today of governmental action revolves around the question of a Federal Reserve cut in the target fed funds rate. That, however, is debating whether we administer CPR or use a defibrillator. Perhaps we should also think about diet, exercise, stress control and other preventative measures. Here are a few points to consider.

1. Hedge Fund Registration. It's important to know who is out there, and which individuals are in charge. Little things like the hedge fund's address, telephone number and e-mail address may make a lot of difference in an emergency. Basic information about structure and investment philosophies could be valuable.

2. Recordkeeping Requirements. Uniform recordkeeping requirements would greatly facilitate the task of figuring out where the bodies are buried when hurricanes reach the shoreline. Markets can become pretty dysfunctional when the only record of a trade is one witness' recollection that is contradicted by another witness.

3. Settlement and Clearance. Trades should be settled and cleared by a third party. This is what happens in the stock and bond markets, where trades are reconciled by independent corporations that seek to confirm what the buyer and seller claim. With major losses accumulating in the derivatives markets today, we will surely see a lot of market players try to walk away from trades where they hold the short end of the stick. If the trade hasn't clearly been settled, they may succeed. Many lawyers will cover their children's college expenses and then some from the litigation that is in the offing. But these windfalls for lawyers could be avoided with a good third party settlement and clearance process.

4. Margin Authority. As we have discussed before, derivatives contracts were usually developed as ways to hedge or lay off risk, but can easily be turned into instruments for speculation. See The recent easy availability of credit to transact in derivatives greatly increased the potential for speculation. That's what about 3,000 hedge funds founded in the last 4 years did. They used mountains of credit to invest in CDOs composed of subprime mortgages. They didn't buy CDO tranches to transfer risk or hedge exposures. They were speculating.

Most of the collateral damage from the mortgage market mess resulted from the credit gluttony of hedge funds and other speculators. If these players had invested only their paid-in capital and not deployed borrowed money, they would have bought much less risk. And when losses occurred, they would have fallen on the hedge funds' investors, but not a lot of other people who never agreed to speculate with them in subprime mortgages.

Because the use of leverage has caused so much collateral damage, it's fairly nominated a candidate for regulation. An appropriate independent agency--most likely the Fed--should have the authority to impose limitations on the use of credit to transact in derivatives contracts. This authority should cover not only hedge funds, but all financial market participants who want to play with these matches. The Fed got the authority to regulate margin used to buy stocks after the 1929 stock market crash (much of which resulted from leveraged speculation in common stocks). It's logical to extend that authority now to derivatives.

5. Examination Authority. The feds--SEC and Federal Reserve--need to be able to find out what the heck those hedge funds are up to. Both regulatory agencies should have the authority to demand information from the hedge funds, and to have staff go on site to look at their records. Right now, the Fed is struggling to figure out who's got exposure to whom for what, when and for how much. It has no systematic way of getting this information, and what it's getting may or may not be comprehensive. Information is crucial to effective government action in a crisis. We have a crisis now, but the availability of information is not up to snuff.

Banks and brokerage firms face regulation regimes that are much more stringent than these few measures. Yet they've managed to thrive. Perhaps many in the hedge fund community react viscerally against the idea of regulation. They should consider the visceral reactions of their investors who are now seeking to withdraw their funds asap. Having the confidence of one's investors is crucial to success in the financial markets, and confidence in hedge funds is receding. The SEC recently attempted to adopt a regulation calling for hedge fund registration, but was shot down a federal appeals court. Perhaps Congress needs to take action to make clear the SEC's authority in this area. Whatever the legal issues, the economic case for hedge fund regulation increases with every point lost in the Dow.

Food News: some people really like chicken wings.

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