What do you make of this scenario? Imagine this middle class employee, who has invested his hard earned pension contributions in a Pension Fund, which in turn invests the same in complex and high yielding financial instruments, rated AAA+ by the major credit rating agencies. But unknown to the employee and the Pension Fund, the high profile investment bank which peddled those instruments, was also shorting the same instruments. Then one day disaster strikes, the markets crash, and his hard earned pension savings disappear.
Ladies and gentlemen, welcome to the spectacular world of modern financial markets, with its alphabet soup of exotic financial instruments, assortment of Nobel laureates, mathematicians and financial whizkids, and those wonderfully versatile off-balance sheet entities called Special Investment Vehicles (SIVs). Move over Harry Potter. Read on.
There are two observations on the recent trend in global financial markets that are a cause for concern. They relate to who are the major beneficiaries of financial innovation and how risks get transferred.
Thanks to the financial innovation of the last few years and the broadening and deepening due to integration of global markets, it is now widely acknowledged that markets are becoming more and more efficient. All the information available in the markets is increasingly being reflected in the prices of financial instruments. In the circumstances, the major source of profits are just two:
1. Arbitrage opportunities across time, areas, and instruments.
2. Multiplication of small margins by trading in volumes.
In an increasingly efficient market, all the easy and obvious arbitrage options get quickly traded away, and only the more latent and complex opportunities remain. Taking advantage of these fleeting profit opportunities requires complex financial models and an assortment of PhDs and MBAs, armed with sophisticated software programs based on models devised by Nobel Prize-winning theoreticians. This only the high net worth individuals and their hedge fund and private equity The later requires large investment requirements, either own capital or debt. Both these requirements are beyond the reach of the regular investors.
It is claimed that the complex products of financial engineering have helped diversify risk and make the financial system safe. It was hoped that securitization of liabilities would help take out and disseminate risks across a large number of investors, who are best suited to bear it. Asset Backed Securities (ABS) like Credit Derivatives, CDOs, CMOs, CDS etc and off-balance sheet entities like SPVs and SIVs have emerged with the objective of transferring and diverisfying risks.
But the reality has been somewhat different. The most fundamental principle of risk management is that risks have to be allocated in such a manner that they are borne by those best able to bear it. But recent events have clearly shown that the complex ABS have been "sold off by people who know best how to evaluate it, to people who don't know what they're in for." By being able to transfer their loans and receivables through securitization, lenders suddenly realized that they no longer had to be concerned with the quality of the loans. This moral hazard led them to maximize their loans by lending to anybody willing, and even some unwilling, to borrow.
Further, as Frank Partnoy has shown in his insightful book, Infectious Greed: How Deceit and Risk Corrupted the Financial Markets, "complex financial instruments are designed not so much for the purpose of reducing risk as for skirting laws or accounting rules and providing a source of windfall profits to Wall Street's traders and brokers.". Complexity and sophistication of financial instruments has been a convenient shield for obscuring risk and confusing unsuspecting investors.
Standard financial theory claims that risk and return have a directly proportional relationship. These complex securities help high risk investors take positions that offer the potential of very high returns. But it also creates distortions like low risk investors ending up with very high risk securities. (Standard & Poor's downgraded credit rating for the bond insurer ACA Financial Guaranty Corp from Aaa to CCC "junk" status in December 2007)
In this context, it is also important to note that risk itself needs to be re-defined. The levels of risk assumed for identical investment positions, varies for different categories of investors. What is very risky for one category of investors may not be so for another group. Unlike the small investors, the hedge fund and private equity firms, supported their battery of mathematical and financial wizards and number crunching supercomputers with access to real time information, are better able to locate and price risk.
With the credit ratings providing inadequate, even misleading, information about the levels of risk embedded in various financial instruments, and the price itself not fully reflecting the inherent risks, the small and regular investors were left with no means of identifying risk. This market failure was exacerbated by the absence of adequate regulatory controls to locate and price securitization risks.
The risk pricing models used contained the usual flaws and discrepancies, which continues to get ignored or glossed over depsite numerous bitter experiences. The regular suspects of Bell curve and CAPM apart, risk rating models assumed that mortgage 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. Further, in the absence of any acceptable liquidity valuation method, the risk pricing models did not account for the risks associated with market liquidity.
For the high net worth investors, hedge funds and private equity firms, it is "heads I win, tails you lose"! A blunt, but more accurate description of most of what pases on as financial innovation, would be cheating!
No comments:
Post a Comment