Monday, April 26

Mission possible

It’s virtually impossible to adequately price risk when one is unaware of pertinent information and when rating agencies assign AAA credit ratings to securities that were in effect the equivalent of junk Bonds. The logical prudent action is to avoid investing where there is a lack of information but what we saw at the frenzied height of activity just prior to the Global Financial Crisis was the abandonment of any form of formalised risk assessment practices. Firms and investors and even government agencies consumed by greed threw caution to the wind as successive ‘Collateralized Debt Obligations’ were sliced into so many sub categories that millions of pages of text would need to be read to satisfactorily understand the underlying risk.

Many of these instruments traded such as the so called ‘Synthetic Collateralized Debt Obligations’ were extremely complex and offered investors a share in the issuance proceeds of credit default swaps which resemble a form of Insurance. How they worked was to distribute to eager investors the proceeds from issue whilst investors remained liable for any subsequent losses or defaults in the underlying securities. This was roughly the equivalent to an underwriter in insurance providing cover in exchange for receiving a premium within varying risk rated tranches.

There were many large players and one notable insurer engaged in this practice, with just a select few in the know whilst others remained permanently in the dark. Overall it is fair to say there was no free market where information was available to make any rational decisions or to attempt to adequately price risk. Many analogies have been attempted to explain the position, likening it to selling someone a house whilst conspiring to cause arson, or selling cars with faulty brakes whilst inviting others to underwrite insurance on their roadworthiness against having an accident.

The opportunity for conflicts of interest and or fraud under such an opaque system are all too obvious and especially prevalent when a firm chooses to simultaneously engage in proprietary trading (in house) in relation to those same securities – in the recent case with Goldman Sachs it is alleged by the SEC that Goldman deliberately either betted against those securities sold or knew of others so engaged (Hedge Funds) whilst continuing to sell large amounts to uninformed buyers. It is surprising there are not many more actions like this undertaken by the SEC by now, considering the sheer volume of short selling and the value of synthetics actively traded, which grossly exceeded the world’s gross national product. I understand there are about 50 probes still under consideration.

But understandably there has been a reluctance to use the word fraud and deception and instead make reference to oblique innocuous suggestions about inappropriate gearing and market exuberance. It is also interesting to note the SEC commissioners only narrowly voted 3 to 2 in favour of the lawsuit proceeding, with the 2 Republican commissioners voting against. Let’s hope this ushers in a new era where fraud is no longer tolerated and recognised readily for what it is. But that will be cold comfort for the many sophisticated Investors such as pension funds, insurance companies and large banks who suddenly lost more than $1.8 trillion dollars as a consequence of the worst economic crisis since WW I1.

The popular idea 'caveat emptor' applies is also deservedly losing creditability as it was not only investors who lost large sums of money but substantial sums were also contributed from taxpayers’ funds. The SEC for the past several decades has preferred ‘settled’ cases which have avoided what might otherwise be a prolonged lawsuit against the big Wall Street investment banks, that have moved on after paying penalties and managed to avoid damaging bad publicity. Hopefully those days are past and we see a re-energised regulator capable of instilling more confidence into a fully transparent system.

That system has been far too highly incentivised to become too reliant on short term trading gains. Some good people can become part of a corrupted system to the extent they fail to exercise sufficient resolve to ensure integrity is maintained and pretend ‘caveat emptor’ is perfectly okay within the market place. There is nothing new in the idea of a group of people making unethical decisions under the “psychological umbrella” of a peer pressure group, particularly when those actions are either sanctioned or given the seal of approval by a charismatic leader.

The fact is the whole system was out of kilter and a blight by any measure on good governance and corporate social responsibility. The original concepts involved issuance of securities that were imbedded with CDS’s so that the issuer profited from both the issue and their subsequent demise for two bites of the cherry. What was entertained from their very first embryonic creation might have been clever but ultimately was representative of the brainchild of those who were oblivious to any sense of corporate social responsibility.

The rules of engagement need a very thorough revision. I might add that those who defend proprietary trading are starting to look less and less credible. But central to all of this is the notion that the GFC arose because of a lack of integrity and trading designed to profit the few who were in the know about future catastrophic losses.

Probably the most important but least afforded attention for the current administration contemplating financial reform packages concerns transparency. You can’t legislate morality but you can make it obligatory for a seller to disclose all pertinent information. That sort of principle has long been embedded to determine a price for risk – otherwise it is mission impossible.

This brings me back to the heading “mission possible” and what positive aspects can we assert going forward for a post-GFC world in the provision of financial services. Future success rests on two important planks; to ensure a degree of transparency so that derivatives are traded on a recognised market and that there is obligation to provide all available information pertaining to those securities, including any commissions or interests declared by the seller in such instruments. That might sound all rather simplistic but all busts and fraudulent intent are best thwarted by an open and transparent system.

Corruption always flourishes given excessive secrecy to benefit the few and generally is accompanied by misallocations and poor economic performance. Citizen’s would like to think their savings channeled into investments would reap better returns than bank interest , but this decade has been one of the worst since WW 2.

But the future is not mission impossible, since already there are encouraging signs with the percentage of private savings increasing and consumption falling away markedly. I think there is good chance countries like the United States and other debtor countries will continue to save more, import less and export more than would otherwise be the case. If this favorable trend continues – notwithstanding the extreme misery of current record unemployment - there is no reason why the next decades could be significantly better economically and socially than the last decade. Already instead of 47% of the brightest students electing to try their hand at the business related courses we have less than 20% so that maybe we are already seeing the beginnings in a change in culture.

A turnaround in fortunes towards a more equitable society is a mission possible for the next decade.


Mercutio said...

It seems as if there are philosophical underpinnings which are part of a larger movement at play, with regulation in general being vilified.

I suppose the new laws for credit cards were the first in the new push for regulation.
It just seems as if any new regulation enacts a few noteworthy rules, but fail to address the underlying issues.
And I have to wonder about the enforcement and oversight end of things. Without adequate enforcement, there are no laws.
I think something will come of it, but I'm not overly hopeful.

gfid said...

once again, you filter the murk from the waters, o wise one. it even makes sense to my weary brain. autumn blessings to you and yourn in Oz.

lindsaylobe said...

Hi Mercutio
Thanks for your interest in this post
I noticed your senate so far has refused to allow any debate on regulatory overhaul proposals for Wall Street aimed at avoiding another financial meltdown.
Although you can’t effectively legislate morality you can impose obligatory rules which ensure a transparent market which currently does not exist for derivatives.
I watched on TV at length when Goldman Sachs senior employees were questioned by senators and what was clear is the assertion that the so called ‘market-makers’ feel they have no obligation to inform their clients about their own position which may include significant shorting positions in those same securities sold.
The assertion is it would be both impractical and awkward to inform clients of the ‘market makers’ position at the time and in the future if that position changes. This raises the question as whether or not you act in your client’s best interests at all times or not. That is not the case in relation to the activities of ‘market makers’.
I see no reason (in the light of modern technology) for positions taken by a ‘market makers ‘to be transparent or easily made known to those intending buyers of securities. This goes to the very heart of the matter as to whether or not you wish to have a fair, transparent and truthful system or not for parties to make informed decisions. You don’t need a huge volume of legislature to do that and enforcement is very straightforward. Nor do you need to separate out those activities into separate entities.

That is the essence of the philosophical viewpoint of my post for transparency and so far I have not heard anyone argue effectively against that view.
Best wishes

lindsaylobe said...

Hi Gfid -thanks for your words and the best wishes to you and yours in the more meaningful world of the Res store – which is a long way away from betting billions on failures to those few well chosen fruitful investmnts in a much brighter future.

susan said...

We've been following the Senate hearings fairly closely but up to now there have been no serious proposals or drawing of lines by those who should be in position to do so. Unfortunately, the enormous sums of money these people have co-opted have been used most successfully to line their own pockets and to add to the campaign finance coffers of those who won't legislate against their greed.

lindsaylobe said...

Hi Susan
Yes –and also a smart beneficiary previously able to earn a few million regularly each week under a opaque system may not be the best candidate to champion transparency.

Best wishes

Seraphine said...

i don't think there was an "abandonment of formalised risk assessment practices" so much as a failure to model "the worst that can happen."
improbable is different than impossible, but it was fatally priced on par with impossible by many people who should have known better.
prospectuses and disclosures are almost useless because they are filled with "boiler plate" language dictated by attorneys. they don't give proper *weight* to the real risks in any investment.
so here is a general tool to use when considering an investment: the bigger the prospectus, the bigger the risk.
bravo, lindsay, on your thoughtful discussion. i agree with you wholeheartedly.
thoughtful long term investments that openly benefit business and society at large should be promoted over secrecy and short term profits.
the worst that can happen shouldn't happen.

lindsaylobe said...

Thoghtful and good points you have made Sera - you could say it was all due to a mispricing of risk but that was due in turn in no small part as your no doubt aware to their complexity,

You have the CDO squared or cubed where the securities were from pools of CDO’s rather than from a pool of debt instruments – so you have a CDO of CDO’s of CDO’s meaning millions of pages would need to be read to claim any understanding of the underlying risk which of course was an impossible task.

Best wishes

財榮 said...


lindsaylobe said...

Hi 財榮
(your previous coomment translated- Great article ~ thanks!!.)

Thanks also for confirming your interest - Best wishes

感謝您的興趣也確認 - 最良好的祝愿