(In) Securitization

The meltdown in the alphabet soup of the derivatives market—from ABCP and CDOs to RMBS and CDS—has given rise to concerns that the problem is systemic to these kinds of financial products. No less than Warren Buffet, one of the most successful investors of our generation has called derivatives “financial weapons of mass destruction”. Given the events of the past month or so, Buffet’s view may strike a more responsive chord than it did when first articulated four years ago. Yet, despite the financial losses borne by the innocent and guilty alike, the view is as wrong today as it was then.

One characteristic of financial crises is that it compresses the time horizon of many market participants. There is a great sense of urgency and immediacy as the leveraging and extensive risk-taking unwinds. These developments obscure our vision. The near-term outlook becomes increasingly less certain. However, to appreciate the significance of what is taking place and why this is not the end of the evolution of the capital markets one needs to understand the bigger picture.

Big Picture
Of the 35 years from 1865-1900, half were characterized by panics, crisis and depressions. There were two significant and inter-related responses. First, there was a merger wave that involved a greater share of the US GDP than subsequent waves, including the present, as businesses sought to rationalize production. Second, the federal government created a number of new institutions that would help regulate the new national economy, including the re-establishment of a central bank.

These measures failed to stabilize the economy. The Great Depression and its aftermath made it painfully clear that the vagaries of the business cycle, if not tamed, could undermine democracy and capitalism. Policy makers of various ideological stripes embraced the counter-cyclical function of the state associated with Keynesianism, perhaps culminating in Richard Nixon’s early 1970s admission that “we are all Keynesians now.” Consider that the world’s biggest economy has experienced only five contracting quarters since 1990 and a total of seven in the past quarter century.

The development of the capital markets was understood to be integral to the stabilization of the business cycle after the ruinous inflation of the 1970s. The price of financial assets, like stocks, bonds and currencies, would adjust and act like shock absorbers so the real economy could adjust more slowly with less dislocations. Volatility would be transferred from the economy to the financial markets, where it could be managed.

Credit Cycle
However, one of the lessons of the 1997-1998 financial crisis was that the volatility of the capital markets themselves could in effect create a feedback loop and again threaten the real economies. In several countries, the crisis helped topple governments and some countries, like Malaysia opted out of the system. Other countries in Asia considered launching their own Asian Monetary Fund, like the IMF, without what were often seen as onerous demands and conditionality.

At the heart of it, was that although the business cycle had been smoothed out, the credit cycle remained troublesome. The end of credit cycles frequently caused economic strains and dislocations. The further development of the capital markets was embraced in part because it had the potential of flattening out and lengthening the credit cycle.

Businesses could reduce their exposure to the Federal Reserve’s monetary policy utilizing such financial innovations as asset-backed securities. For example, corporations issued asset-backed IOUs (bills and bonds) and paid a lower rate than a conventional debt security. Local governments often did the same thing, like a bond backed by parking meter receipts. For households, the development of various mortgage products, like adjustable rate mortgages or interest only payment schedules, as well as home equity loans, allowed the expanding of their credit cycles.

From another vantage point, what we are discussing is part of the process of what economists call disintermediation. Previously, banks had a near monopoly on the distribution of capital. They would grant credit and remain the actual holders. This would lead to episodic crisis of overexposure to one sector or another (e.g., Latin America, the oil patch, commercial real estate) and cripple or paralyze the banking system. As was made clear in Japan’s experience through the 1990s and the early part of this decade, a hobbled banking system deters robust growth and paralyzes an important conduit of monetary policy.

The de-regulation of the capital markets and financial innovation, coupled with an expansion strategy of large money center banks opened up the distribution of capital. It broadened and diversified the sources of liquidity. Bank-centric capitalism was transformed in the US, and to a lesser extent, in other Anglo-American economies into market-centric capitalism.

In the popular press this is partly experienced as banks becoming more fee-based rather than interest rate-driven. But the underlying process by which this was achieved was securitization. Assets and liabilities were in effect converted into claims that could be traded, bundled, and deconstructed. Credit itself became product that could be traded.

What is to be Done?
The recent turmoil shows how far we have come in this process, but also how far the process still has to go before this attempt to smooth out the credit cycle can be fairly evaluated.

First, the process of disintermediation has not progressed as much as it had appeared. Some investment banks re-capitalized related hedge funds even though they stood at arms length. Banks still bear the risks associated with underwriting and now banks are holding a few hundred billion dollars worth of bonds that they cannot yet sell. Banks also provide the backup credit facility behind much of the commercial paper, if it cannot be rolled.

Second, the market for much of these high-end financial products, like collateralized debt obligations, are not actively traded, which means they are not subject to the price discovery process and lack transparency. The solution is not to end financial innovation and unilaterally disarm “the financial weapons of mass destruction”, but to bring more market forces to bear. Recall the history of high yield corporate bonds. When they operated chiefly out of one man’s desk it was not a real market. But now, with greater transparency and liquidity, they have become a genuine asset class.

Nobel-prize winning economist Edmund Phelps argued along these lines recently, identifying the lack of transparency as a critical failing. He suggested the need for a new type of rating agency that focused less on the probability of default and more on providing investors with more information about the securities that they purchase.

Third, it needs to be more fully appreciated that markets are prone to overshoot. The late Rudiger Dornbusch showed more than 30-years ago why an overshoot in the foreign exchange market was rational. There has been much ink spilt over the years on what the literature call “rational bubbles”. The popularity of books such as Nassim Taleb’s “The Black Swan” should be a timely reminder that the multi-sigma event is considerably more likely than traditional approaches allow.

Financial derivatives need not be any more financial weapons of mass destruction than other market instruments. And what is the alternative? Not develop risk management tools and breaking risks down to more palatable sizes, in an almost homeopathic approach? How is the credit cycle to be flattened, lengthened and smoothed out?

What makes America great is not the flexibility of the labor markets, which in practice amount to little more than hiring and firing at will, occasional downward pressure on real wages, and a shift in the burden of pension from the company (defined benefits) to the employees (defined contribution). Rather, the source of America’s economic prowess is the flexibility of its capital markets.

The disintermediation of banks can be understood in part as the democratization of the distribution of capital. The capital markets typically have money for any one—bankrupt businesses, sovereigns that recently defaulted, and even bank-creditworthy households who want to buy a house. Some 3.2 mln US households acquired homes through sub-prime and ninja loans (no documentation of income, job or assets) that were later sold and packaged and taken apart and re-packaged. Moody’s Economy.Com estimates that some 1.7 mln households may lose their homes. This is a tragedy indeed, but that means that 1.5 mln households will now be home owners that otherwise would still be renters.

It seems that having once bitten from the Tree of Knowledge, there is little choice but to keep eating. It makes no sense to close up shop. A deepening and broadening of the capital markets, increased transparency, and stronger regulation and better risk management tools will likely result from the current market turmoil.