Summary:
John Gapper explains why banks and insurance companies got addicted to complexity, through the practice of dicing up cashflows and risk. Origin of practice traces back to Black, Scholes and Merton, 1973. The appeal to financial institutions derives from four reasons: it skews the odds in favour of those who hold the technology; structured finance has been a huge money-spinner; complexity produced yield; and, most perilously, structured finance gave banks and others more chances to take on "tail risk." The future of finance and regulations now looks very uncertain. The crisis has exposed gaping holes in the US regulatory structure. The current system is outdated (devices in the 1930s). The biggest regulatory gap involves over-the-counter (OTC) derivatives. (Published: 19/09/08)
Notes:
- worst financial crisis in US markets since 1929
- the investment banks and insurers that caused the problem did so by taking mortgages and first packaging and repackaging them into bizarrely complex securities, and then topping them off with derivatives
- e.g. AIG had been writing credit default swaps (CDS)
- a form of derivative allowing one financial institution to pass the risk of a bond defaulting on to another
- sold them to banks wanting to protect themselves against defaults on collateralised debt obligations (CDOs), built from sub-prime mortgages
- when these CDS plunged in value because the market stopped trusting what they were worth, AIG came close to bankruptcy and was bailed out by the US Treasury
- dicing up of cashflows and risk
- has been a growing part of markets since Fischer Black, Myron Scholes and Robert Merton, three US academics, devised a way to value options in 1973
- over the ensuing three decades, banks and insurance companies got addicted to complexity
- four reasons
- it skews the odds in favour of those who hold the technology
- rading in markets is essentially a zero sum game, in which you have an equal chance of winning or losing
- but: banks have been able to shift the odds by using computer models that others lack, to trade in volatility, for example
- structured finance has been a huge money-spinner
- i.e. the practice of using the cashflows from stocks and bonds to create other securities
- every institution involved in creating and selling structured bonds, from banks to ratings agencies to insurance companies, gained a big fee every time such a bond was issued
- complexity produced yield
- in an era of low interest rates, pension funds and insurance companies found it hard to earn much money from cash
- so any instrument that appeared safe but paid a higher interest rate than Treasury bonds, which mortgage-backed securities did, found ready buyers
- the problem was that these securities paid a higher yield than other triple A rated paper precisely because they were complex
- investors got paid more to hold them because they were so difficult to understand
- structured finance gave banks and others more chances to take on "tail risk"
- this is an insurance-like trading strategy:
- one institution writes swaps or options that provide it with regular payments in exchange for taking another's risk of default
- in most cases, this produces profits, but occasionally it is disastrous
- huge uncertainty over the future of finance and of regulation
- risks of financial institutions devoting themselves to the underwriting and sale of complex securities have become abundantly clear
- complexity is a good way to make money, but it also causes bank runs
- crisis has exposed gaping holes in the US regulatory structure
- largely devised in the 1930s and is outdated
- the supervision of banks and investment banks is done by different bodies while insurers are regulated by US states
- biggest regulatory gap involves over-the-counter (OTC) derivatives
- the contracts traded among banks and insurance companies that lie at the heart of the financial crisis
- not regulated at all in the US since they were excluded by the federal government from Commodities Futures Trading Commission oversight eight years ago
