Ballooning Finance: How Financial Innovation Produces Overgrowth and Busts
Via Naked Capitalism:
Ballooning Finance: How Financial Innovation Produces Overgrowth and Busts
Yves here. It’s a welcome surprise to see economists devise a model that delivers generally sensible results. Here, three economists looked at how financial innovation leads to an bloated financial sector as well as greatly increasing the risk of meltdown.
One quibble is that they characterize financial innovation as a benign process at the outset that is all too quickly abused, particularly when the authors assume information asymmetries (as in the investors don’t fully understand what they are buying). One of their examples, collateralized debt obligations for subprime securitizations, disproves the thesis.
The writers miss that an earlier version of this type of asset-backed CDO also existed in the 1990s, and as in its 2000 reincarnation, was critical to keeping subprime mortgage securitizations going. As we discussed long form in ECONNED, the ability to sell these deals was constrained by the difficulty of placing the least attractive tranche, the BBB slice. Those (along with more attractive financial sausage constituent parts) were rolled into CDOs, which were tranched just as the original mortgage backed securities has been.
Now astute students of finance know that pretty much any product defect can be solved by price. That means those deemed-to-be-drecky BBB tranches could have sold if they had had higher interest rates. Of course, that would have meant some combination of higher interest rates on the underlying mortgages (as in less product to sell, since fewer people can afford payments on more costly mortgages) and/or lower fees to the deal participants. So these CDOs, which proved to be a Ponzi scheme in both their 1990s and 2000s versions, were a “financial innovation” created to get around the need to price RMBS more realistically. And the result in both cases was too much subprime origination and a CDO crash.
Dan here: See Vox post:
By Bruno Biais and Jean-Charles Rochet, professors at the Toulouse School of Economics, and Paul Woolley, Senior Fellow at the London School of Economics. Originally published at VoxEU
The problem for banks was not that they could not package or sell the stuff. The problem is that finance was and still is trying to be something they can not possibly be: a prime producer of wealth. Finance can not grow in a sustainable way with substance to their existence outside of or without a production economy. Though that is what they keep trying to do. And that is what keeps putting economies into major crisis such as the “Great Depression” and this “Great Recession”.
It is the problem for those who try to explain our economy based on what the Fed can or can not do. Zero lower bound, monetary policy quantitative easing etc, etc, etc.
But hey, we can keep moving money around the planet and everyone booking the same dollar counting it as a new additional dollar to the pot.
There is the fundamental issue of “knowledgeable folks” not walking away if they don’t understand what they are buying. It appears that this happens both to the “knowledgeable folks” as well as to folks less knowledgeable. The thing that surprising is that the folks buying the junk did not know it was junk, or was it you had to make the next quarters returns, or you were out the door, and damn the long term all that matters is the next quarter. It seems that folks are unwilling to admit they don’t understand something, by just saying no, and would rather appear clued in and buy the trash the salestypes peddle.
Modern financial innovation serves to increase obfuscation.
In 1995 Gibson Greetings and Procter & Gamble successfully sued Bankers Trust, asserting that they had not been informed of the risks or had been unable to understand the risks involved in the derivatives which they had been sold. There were tape recordings of Bankers Trust OTC personnel laughing at Proctor and Gamble’s failure to understand the bad deal they were getting.
See: http://en.wikipedia.org/wiki/Bankers_Trust
http://www.pbs.org/wgbh/pages/frontline/warning/interviews/born.html
In 1998 Long Term Capital Management had equity of $4.72Billion, owed $124.5Billion, and had assets of $129Billion. (Debt to equity ratio of about 25 to 1) It had off balance sheet derivative positions of $1.25Trillion. After it lost the capability to raise money, the Federal Reserve Bank of New York organized a bailout. It is difficult to believe that LTCM’s customers understood that LTCM was that highly leveraged. Wasn’t this like buying life insurance from a homeless person.
See: http://en.wikipedia.org/wiki/Long-Term_Capital_Management
Yet in 2000, the Congress passed the Commodity Futures Modernization Act of 2000. The primary purpose of the law was to make absolutely sure that neither the CFTC (federal) nor the states could legally regulate derivatives.
See: http://en.wikipedia.org/wiki/Commodity_Futures_Modernization_Act_of_2000
From Forbes 30 April 2014: http://www.forbes.com/sites/robertlenzner/2014/04/30/seking-shelter-warren-buffett-limits-receivables-from-major-banks/
“Warren Buffett is well known for his famous warning about derivatives as “weapons of mass destruction.” Well, recently he went much further with Forbes Magazine, flatly prognosticating someday (he doesn’t known when) a massive financial “discontinuity,” which the dictionary refers to as an “ending, expiration, halt, lapse, a shutdown, a stoppage,” that could very well be worse than 2008. What terribly worries him is that he simply doesn’t understand the massive derivatives position on the balance sheet of J.P. Morgan Chase .” Like many other financial experts Buffett can’t really figure out the financial health of JPM’s derivatives. It is impossible for anyone to divine the extent that JPM is profiting or losing money or the risks entailed in the identity of counterparties, the quality of the collateral used, and the amount of leverage employed.”
Once upon a time it was accepted law that the basis for a contract was a ‘meeting of the minds’! But today we have contracts riddled with “Gotcha” clauses and the courts enforce them, understood or not.
Derivatives are no different. And without derivatives, how could the lowest tranches of mortgages or CDOs be sold as AAA investments? Without the AAA rating the number of buyers would have been much more limited. Without a market for the lowest tranches the entire securitization scheme is in trouble.
Derivatives should be regulated right out of existence. Any benefit is far outweighed by the increased risk. That was obvious by September 2008 when Hank Paulson needed a bazooka or the world as we knew it would end.
JimH
People are going to forget that history and revise it to suit their needs. It is important that we can recite it to give people an understanding of what actually happened. Even now people let Greenspan off the hook. It is important to remember Booksley Born, Senator Dorgan, Iris Mack, etc the people who attempted to shine a light on the issues.
http://www.freedom4um.com/cgi-bin/readart.cgi?ArtNum=74200
By why do the experts at the lesser knowledge place let themselves be suckered in? Is it because to not understand could result in being laughed at and that is a form of adult bullying? Perhaps we need to take the drug campaigns just say no campaign, and teach it to all financial professionals. It is clearly a failing of folks who work in the finance industries to understand. Perhaps it is the push for volume that means that they can’t possibly take the time to understand something. All regulations will mean is that a new form will be evolved to take advantage of the suckers, always has been. Recall that it is said in a finance meeting look around and see who the sucker is if you can’t see her then its you.
Don’t forget the impact of the ratings agencies who simply lied about the quality of the underlying mortgages.
Let’s put the blame where it belongs. On that community that says it understand economics. Economist if there were of any value would long ago proved that unregulated markets do not work, that the Federal Reserve was the greatest rip off in the nations history, and last do not even understand secular stagnation.
The above can be blamed on the ignorance of the people and politicians.
For those who do not think there are answers the economic questions. I offer the book below written by someone who helped many administration
OTHER PEOPLE’S MONEY by Louis D. Brandeis
http://www.law.louisville.edu/library/collections/brandeis/node/191
JackD
“Don’t forget the impact of the ratings agencies who simply lied about the quality of the underlying mortgages.”
And there is the key. As the article states, any financial boob can write a matrix, price it correctly, and sell it. You can even do it where the matrix is all back end loaded.
They key is money supply. The vast amount of money supply in the world is restricted to AAA rated investments. So the key to the entire fraud was not finding buyers for these loans, but finding investors for these loans.
And the rating agencies supplied them.
Then too there were the credit default swaps which allowed players with no ownership interest at all to bet on the success or failure of securitized mortgages sold to other players. This is what caused the losses in the market to multiply many times beyond the actual securities that were failing. They might as well have been betting on sports events with institutional money. Bizarre!
Then too there were the credit default swaps which allowed players with no ownership interest at all to bet on the success or failure of securitized mortgages sold to other players. This is what caused the losses in the market to multiply many times beyond the actual securities that were failing. They might as well have been betting on sports events with institutional money. Bizarre!
Plenty of blame to go around but…Those BBB tranches were based on a pool of mortgages that was already diversified..(indeed the goal is to make the pools big enough to extract the maximum benefit of diversificatin before tranching them).Why would ANYBODY believe that pooling BBB tranches from a variety of RMBSs would be trancheable? The pools were made from similar mortgages, the tranching conditions were similar, so they were all highly correlated, and therefore they either all went bad (if there was a mild national RE downturn) or they all paid off. Any body with any experience with the actual underlying mortgages instead of just mathematical models should not have been fooled.