I posted this last week on Google+ at https://plus.google.com/u/0/114613808538621741268/posts/13tBzre1nRa. Given market drops since then, I'm reposting it in a more public forum.
How could our next financial crisis start? I was in an interesting discussion about this last night. I'd give better than even odds that it will be ugly before Christmas. Here are some of the possibilities to watch.
- General economic slowdown. The economy seems to be slowing. Plus there are all of the other stresses I'll discuss, all of which are likely to make it slow more. But it seems implausible that a general slowdown will happen suddenly enough to precipitate a full-blown crisis. Though it sure provides stress that could cause something else to happen.
- European sovereign debt issues. We all have heard about Greece. Italy is in the news. But the really scary quantities of debt are in Spain. And Europe has proven to have no political appetite for having meaningful bailouts of one country by another. Either the prospect of the EMU (European Monetary Union) dissolving, or a liquidity crisis caused by a large default (even if it doesn't get called a default) is a likely bet.
- US sovereign debt issue. We dodged the debt ceiling debate. 2 of the 3 rating agencies have left the USA at AAA, but on a negative watch. (Meaning better than even odds of a downgrade within a year.) The third, S&P, based on past guidance is likely to downgrade the USA this month. Though they could do what the other two did. The next test is what the super committee comes up with for the second half of the cuts that are in the debt ceiling deal. That's expected around Thanksgiving. Whether that triggers a crisis depends on what is cut. But a crisis is unlikely. The bigger problem is that people have been backed into a political corner where the US government will be unable to intervene if something else goes south.
- Residential mortgages. The current expectation in the industry is a 3-6% drop next year, with 15% as a worst case scenario. However if the mortgage tax deduction were to be yanked (for instance as part of deficit reduction), much worse changes are possible. (And, of course, another financial crisis would take all bets off of the table.)
- Commercial mortgages. Everyone is aware that commercial mortgages are in a world of pain. However servicers have been very forgiving. They really don't want to force bankruptcies which are in nobody's best interest, so they restructure deals, collect as much blood as they can, then limp along. (A clear case of, "If you owe $100,000, you have a problem. If you owe $100,000,000 the bank has a problem.") However the sector is still under stress. And last month the delinquency rate spiked to the highest rate on record. There could still be trouble there. Particularly if a slowing economy reduces how much money is available to pay back debt.
- Private equity. There is a world of pain coming here as deals struck in 2006 and 2007 (2007 had a lot more) see principal payments come due this year and next. Based on the experience with commercial mortgages, I would expect the banks to be unusually forgiving. But the question is whether they have sufficient liquidity to be forgiving enough. (As much as the banks may want to make deals, they have a real problem if nobody pays them back.) Borders just went bankrupt, how many more companies will follow in the next year?
- Municipal debt. Meredith Whitney has been crying wolf on this for some time, but she has a real point. There are trillions of dollars of debt issued by municipal governments who are under stress. In the first half of this year they got unexpected revenue increases. However a slowing economy could cause them to get back in trouble. And their budget cuts to deal with financial pain could slow the economy. To add salt to the wound, most have large investments in pension plans that is budgeted to get 8% annual growth. Those rates are hard to reach in today's economy, so a lot of that money is in risky asset classes like investments in private equity. It is very likely that those assets will under perform, adding to budget holes. Central Falls, Rhode Island just filed for bankruptcy. How many more will follow in the next year?
- Chinese asset bubble pops. I know little about what is going on there. They do have a big asset bubble. History says that it will pop eventually. Nobody knows when, or what the fallout will be. However my impression is that when it happens, the pain will be mostly felt in China.
- External shocks. You name it. Successful terrorist attack. (The 10'th anniversary of 9/11 is coming up...) Unrest in the Middle East triggers oil spike. An unexpected major earthquake. (For instance the Cascadia fault slips, leaving over 100K dead in Seattle, Vancouver and Victoria.) These are all unlikely, but possible.
Showing posts with label financial collapse. Show all posts
Showing posts with label financial collapse. Show all posts
Monday, August 8, 2011
Thursday, November 5, 2009
Is the financial crisis really over?
I recently asked a friend who works on Wall St about whether these warnings about the municipal bond market were accurate. He gave me a detailed response, and gave me permission to repeat the comments but without his name or company attached. This is very reasonable given his current position, so I won't say anything more detailed than that he is in a good position to know what is happening in the credit markets, and I trust his opinion far more than any of the talking heads you see on TV.
Here is what he said:
Reading this I am strongly reminded of what I saw predicted in Wealth and Democracy several years ago. The book is a long read, but buried in it were a list of parallels between the USA circa 2000 and the last 3 great world empires shortly before their collapse. In all 3 cases shortly after a boom caused by financial speculation there was a financial crisis, which they recovered from fairly fast at the same time that they launched a military adventure that was expected to be a quick, successful war. The war dragged on and cost far more than expected. Then public mood turned against the war around the time that a more serious financial collapse hit. After a series of subsequent financial collapses there was political unrest leading to civil war 15 years after the peak in 2 out of 3 cases. (The exception was England, which got involved in WW I before the civil unrest could become worse.)
When I first read this I thought, "Interesting, and Kevin Phillips does have a track record of making apparently absurd predictions that came true, but I'm not overly concerned." I still believe that the prospect of expressing ourselves through democracy can head off the possibility of civil war, but it has been scary watching the timeline unfold like clockwork.
Here is what he said:
Well, more than remotely accurate....
We have 3+1/2 more disasters to go in this crisis:
- Resi: this is the 1/2 disaster, as we're a little more than half way through the resi correction; unfortunately, we still have a long ways to go!
- Commercial real estate lending / CMBS: 4th Q retail will likely be a disaster, and commercial real estate has had as much or more price explosion as resi; already we are seeing soaring bankruptcies, etc. Many shopping center tenants have 'go dark' provisions (no rent due if >x% of the mall is dark), which are coming close to exercise. Banks and insurance companies are hugely exposed here; could make subprime look like a walk in the park.
- Credit card debt: even though the pace of job destruction has slowed, we are still in job destruction mode; consumers are increasingly falling behind on all debt payments. People are (wisely) looking to save rather than pay down debt (treating the debt as a lost cause)....
- Muni. As an example, tax revenue in your golden state is down 40%, and this story is repeated all over the country at all levels of government. So far, the Fed government has kicked a huge amount of money down the muni chain, which has kept the problems largely at bay; however, this process is nearing an end. The fact is that the entire country is massively leveraged: consumers, local government, state government, and the federal government. In the boom years, governments piled on debt and hugely increased their services, and most also hugely grew employment as well as entitlements (health care and pensions for muni employees). Now, they are facing revenue shortfalls but have great difficulties cutting services (often mandated by law), cutting staff (administration is opposed), cutting capital expenses (again, mandated by law). Default is in the cards for a lot of them, as federal money runs out.
Given the way the administration handled the automakers, I expect the muni bond holders to get hurt while the pension plans are made whole. I don't know what government does to avoid massive service cuts, though! It has seemed to me that one of the motivations for doing federal health care now is actually to ease up on state medicare spending (that's why your Governator has been making pro-health care reform statements).
So far, managing the crisis has relied on using the remaining credit of the borrower of last resort (the US). And while lots of reports have shown that govie debt is low relative to GDP on a historic max basis, these reports have completely overlooked the net debt position of both government and consumers. It is of course difficult to tease it all out (lots of munis fund housing projects), but personally I feel that we really can't have much debt ceiling left. Particularly if you consider that current/recent levels of GDP require a level of corp credit, but we now have vastly less corp credit available: without more corp credit availability, GDP must continue to slide, which implies debt-to-GDP continues to rise even without more borrowing.
An economist friend of mine (who lived through Argentina) and I both believe that the only real outcome of the whole crisis is that the Fed will manage a graceful and slow dollar dilution, so that we see a huge inflation but over a long enough stretch of time so as to not be unduly destabilizing. This process would basically inflate away our debt as it revives the domestic economy. Unfortunately, so far as I know, no country has ever achieved economic success via a weakening currency!
Anyway, yes, this is all really bad, and still has a ways to go!
Reading this I am strongly reminded of what I saw predicted in Wealth and Democracy several years ago. The book is a long read, but buried in it were a list of parallels between the USA circa 2000 and the last 3 great world empires shortly before their collapse. In all 3 cases shortly after a boom caused by financial speculation there was a financial crisis, which they recovered from fairly fast at the same time that they launched a military adventure that was expected to be a quick, successful war. The war dragged on and cost far more than expected. Then public mood turned against the war around the time that a more serious financial collapse hit. After a series of subsequent financial collapses there was political unrest leading to civil war 15 years after the peak in 2 out of 3 cases. (The exception was England, which got involved in WW I before the civil unrest could become worse.)
When I first read this I thought, "Interesting, and Kevin Phillips does have a track record of making apparently absurd predictions that came true, but I'm not overly concerned." I still believe that the prospect of expressing ourselves through democracy can head off the possibility of civil war, but it has been scary watching the timeline unfold like clockwork.
Monday, October 26, 2009
What are financial derivatives?
This weekend my wife convinced me to see Michael Moore's movie about Capitalism. It had its good points, its bad points, and its silly points. One of the silly points was multiple purportedly smart people finding that they couldn't explain what a financial derivative was.
So I decided to see if I could come up with an easy to understand explanation. And then explain the risks and benefits in (hopefully) common sense terms.
A financial derivative is a contract that has value based on what some other thing might do.
Let me illustrate with a concrete example. A put is a binding contract saying that person A can sell person B something at a fixed price on a fixed date. There is no obligation to sell. But if A wants to sell, B has to buy at that price. No matter what the current price happens to be.
Why would someone buy or sell one of these? Well suppose I bought some stock whose price I think will fluctuate, but which I think will wind up higher. So I think I'll make money, but just in case I can buy puts at somewhat below the current stock price as insurance. If the stock goes down I can sell the stock at the pre-agreed price, and I limit my losses. Conversely the person who sells me the put doesn't think the price will go down either, which is why they are happy to sell me my insurance.
Please note this carefully. Neither the buyer nor seller here believes the put will be used. Therefore it can be purchased cheaply. (This is why it makes a good insurance policy.) Yet the put has value to the buyer and risk to the seller, and therefore money has to trade hands for the contract to be worthwhile to both.
The next thing to notice is that virtually any type of contract you can dream up can be made into a derivative. For instance if you want you can do the reverse of a put. Rather than saying that B has to buy from A at a fixed price, you can say that B has to sell to A at that price. Those actually more popular and are called calls.
Both puts and calls are called options because they give someone the option (but not obligation) to do something at some point in the future. In fact the options that are given to employees are almost always calls. (Almost, but not actually always. One job rewarded me with a contract that was carefully constructed to legally be a bond, and not a call. That was done for tax reasons.)
Now a warning about derivatives. In theory derivatives can be used to limit and manage risk. Supporters generally introduce derivatives by illustrating how all parties to them can use them to manage risks. However they can also be used to create and concentrate risk very rapidly. For instance if you sell many puts very cheaply and then the price of the stock falls, you can quickly be out an insane amount of money. This is not a hypothetical risk. Every so often a rogue trader will accidentally destroy a bank or other large financial institution by making big options trades that go sour. A good example is Barings Bank. Let me stress that this typically happens by accident, not intent. (Usually, as with that case, someone does something stupid, loses money, then keeps doubling up their bet hoping to get out of trouble. If the string of bad bets goes long enough, the company goes broke. Which makes me wonder how many mistakes are made then are successfully corrected without anyone being the wiser...)
So derivatives are contracts. People can buy and sell them. But how should you price them? Well the standard answer for puts and calls is to apply the Black-Scholes pricing model. I won't go into the math, but here is the idea. What they do is construct a portfolio that, managed very carefully, will in the end come to the same effect as a put or call. The price of this portfolio is theoretically the price of the option. Why? Well if the portfolio is less than the option, then you can buy the portfolio and sell the option, manage the portfolio, and you make a guaranteed profit. (Making some combination of trades with guaranteed profit is called arbitrage, and people on Wall St are very, very interested in finding opportunities to do this because arbitrage is free money.) Conversely if the portfolio costs more than the option you can buy the option, sell the portfolio, manage the portfolio and again make money. So in an efficient market the prices have to match.
OK, this is all well and good. Now let's move on to something more fun. Given that the complexity of derivatives are only limited by the imagination of the people writing the contract, here is no shortage of interesting possibilities. Let us focus on swaps.
A swap is just an agreement for two parties to trade things of equal, or close to equal, value at the time of the trade. There are many kinds of swaps traded today. Some are traded with insane volumes. For instance foreign exchange swaps trade money between currencies today in return for a reverse trade tomorrow. This is done to the estimated tune of $1.7 trillion (USD) per day! (The primary purpose is to transfer money at close of business from traders in New York to Tokyo, then from Tokyo to England, then back to New York. That way money can be used to make money 24 hours a day.) But let's take something different. I'll look at an example of two companies swapping mortgages.
Our scenario is that a US company is building a skyscraper in Japan. At the same time a Japanese company is building a skyscraper in the USA for approximately the same price. Neither has sufficient cash on hand to fund this, so each needs a mortgage. (This would likely be done with bonds, but let's not worry about that detail.) But rather than each taking out a mortgage in the other currency, let's say that they enter into a contract to swap the financial obligations - the US company pays the mortgage on the US building, while the Japanese company pays the mortgage on the Japanese building. That's a swap.
Well they certainly swapped something. But what is the point?
The point is that neither wants to have to worry about exchange rates. The mortgage on the Japanese building will be in yen. The mortgage on the US building will be in dollars. The US company has a reliable stream of dollars coming in in their future, but doesn't know how much to set aside to meet an obligation priced in yen. The Japanese company has the reverse situation. It is easier for each to budget and plan for an expense in their own currency, and so they'd each prefer to pay the other's mortgage.
It is important to stress that this is not just a convenience. When the companies go to the banks, the banks will recognize the exchange rate risk and that will affect the rates the companies can get. A US company can therefore get a loan in US dollars at a better interest rate than the Japanese company can. Conversely the Japanese company can get a loan in yen at a better interest rate than a US company can. So after the companies swap mortgages, each gets a better interest rate than they could otherwise get. And since both save on their interest payments, both write down immediate profits from making that swap.
This is one of the most important and counter-intuitive points to understand about financial derivatives. Two companies entered into a contract, and both wrote down an immediate profit. Nothing is faked here. Real money is saved in their monthly bills. That saving can be calculated, and as a result the company is better off. Over time the exchange rates will likely move and as a result one probably makes money and the other eventually loses on the deal. But on day 1, both marked down a profit and the profit is real.
Now if there is one thing that gets the attention of people in finance, it is the ability to manufacture money out of thin air. That apparently happened here. It is therefore worth repeating that this example has been studied to death and generally accepted accounting rules agree that both companies get to write down immediate profits in this case.
Of course you can only set this up if the conditions are just right. These profits aren't particularly easy to find. But once you've seen a way to do it, people can set them up over and over again. And over time the financial wizards found cases where companies could write private contracts and claim an immediate profit. As with the swap described there was inevitably long-term risk associated. But who wants to turn down free profits?
Now here we have a critical danger. With many financial derivatives people enter into complex contracts which, based on some complex theory, they think entitles them to write down a profit. However the investments take time to pan out, and come with significant risks. Worse yet there is the very real possibility that people will write down profits that aren't real due to honest mistakes. And if someone honestly overvalues the value of a particular kind of contract, they will enter into that kind of contract over and over again, writing down fake profits each time. (And getting paid correspondingly large bonuses for finding such great deals!) As a result in the end even the smartest people in the world can find themselves unable to truly measure the risks a given company is taking.
If you think I am exaggerating, go read what one of the greatest investors ever has to say about financial derivatives. There is a section about derivatives that starts on page 14 of this PDF from Berkshire-Hathaway. When Warren Buffett wanted to talk about financial derivatives in 2002, the first point he made was, Charlie and I are of one mind in how we feel about derivatives and the trading activities that go with them: We view them as time bombs, both for the parties that deal in them and the economic system. He then goes on to explain many of the same points that I have. His common sense comments are well worth reading by anyone who wishes to make sense of the recent financial crisis.
Now let's move on to securitization. Securitization starts with a bunch of things with promised future payments that may or may not materialize. The things could be loans on houses, credit card debt, student loans, risky bonds - as long as it is a stream of future payments it is meat for the grinder. Typically each thing is a stream of relatively small payments that lasts for a long time. An issuer takes a whole bunch of these, and puts them together in a deal. A deal likely will have a long stream of big payments. Technically a deal is a very carefully set up corporation whose assets are the things that go into the deal, and whose likely future revenue is used to issue a series of bonds. Each bond is a stream of payments that ends once a particular amount of money has been delivered. The first bonds issued are very likely to be worth full face value, and the last ones are unlikely to make much money. For technical reasons the different kinds of bonds are of interest to different investors.
A financial security is any financial instrument that can be traded. The loans etc that go into a deal can't be traded in any kind of open market. The bonds that come out of the deal can. Therefore this process creates securities out of debt, hence the name securitization.
When the deal is set up right, the loans, etc that go into the deal can be purchased for less than the bonds sell for, and the issuer gets to write down an immediate profit. If the deal is correctly modeled, every purchaser gets a known amount of possible future profit with a clearly understood associated risk. Everyone wins.
Given recent bad press it is worth pointing out that securitization has been around for a while and until recently it worked out well for most of us. Whether or not we were aware of it.
Securitization is really a mechanism for diversifying risk. Before securitization took hold, mortgages would be held by the local issuing bank. This meant that if a local area's economy took a nose dive, the local banks would get seriously hurt and sometimes got wiped out. This would restrict the availability of credit for a long time following, and made eventual economic recovery much, much slower.
Since the 80s things have been very different. Banks now sell their loans on to Wall St, which turns them into securities. This means that if a local economy collapses, like Pittsburgh's when the steel industry left or Michigan's with the auto industry troubles, local banks are much less likely to collapse with it. And they can continue to offer credit, which makes it much easier to recover down the road. Therefore securitization has made local economies much more resilient than they otherwise would be.
But, as we all know, there is a fly in the ointment. In the case of sub-prime mortgages we had bad risk models. Thanks to those risk models companies could write down easy profits while not understanding the size of the risks they were taking on. And in their pursuit of profit, they repeated the mistake over and over again. As a result widespread acceptance of securitization wound up replacing the risk of fairly frequent nasty local economic collapses with the risk of relatively rare nasty global collapses. Luckily with the last one having been averted. (So far, anyways.)
So there we have it. Financial derivatives are just contracts. People enter into them for all sorts of reasons. They are traded in large volumes. They can be arbitrarily complex. They can mitigate or create risk. We have theories on how to price them. When financial derivatives are set up correctly, apparently free money is created. This money comes with associated risk. Honest mistakes about the pricing or risks can lead to disaster. Warren Buffett has written on this topic with extreme warnings about this exact issue. Securitization is a way of bundling lots of little streams of cash into nice bonds. Securitization brought us increased local financial stability, which has been to our general benefit. But systemic mistakes in securitization also brought us a real risk of global collapse.
If you understood that then you likely understand financial derivatives better than half the talking heads you see on TV. And you definitely understand them better than Michael Moore appeared to in his movie.
So I decided to see if I could come up with an easy to understand explanation. And then explain the risks and benefits in (hopefully) common sense terms.
A financial derivative is a contract that has value based on what some other thing might do.
Let me illustrate with a concrete example. A put is a binding contract saying that person A can sell person B something at a fixed price on a fixed date. There is no obligation to sell. But if A wants to sell, B has to buy at that price. No matter what the current price happens to be.
Why would someone buy or sell one of these? Well suppose I bought some stock whose price I think will fluctuate, but which I think will wind up higher. So I think I'll make money, but just in case I can buy puts at somewhat below the current stock price as insurance. If the stock goes down I can sell the stock at the pre-agreed price, and I limit my losses. Conversely the person who sells me the put doesn't think the price will go down either, which is why they are happy to sell me my insurance.
Please note this carefully. Neither the buyer nor seller here believes the put will be used. Therefore it can be purchased cheaply. (This is why it makes a good insurance policy.) Yet the put has value to the buyer and risk to the seller, and therefore money has to trade hands for the contract to be worthwhile to both.
The next thing to notice is that virtually any type of contract you can dream up can be made into a derivative. For instance if you want you can do the reverse of a put. Rather than saying that B has to buy from A at a fixed price, you can say that B has to sell to A at that price. Those actually more popular and are called calls.
Both puts and calls are called options because they give someone the option (but not obligation) to do something at some point in the future. In fact the options that are given to employees are almost always calls. (Almost, but not actually always. One job rewarded me with a contract that was carefully constructed to legally be a bond, and not a call. That was done for tax reasons.)
Now a warning about derivatives. In theory derivatives can be used to limit and manage risk. Supporters generally introduce derivatives by illustrating how all parties to them can use them to manage risks. However they can also be used to create and concentrate risk very rapidly. For instance if you sell many puts very cheaply and then the price of the stock falls, you can quickly be out an insane amount of money. This is not a hypothetical risk. Every so often a rogue trader will accidentally destroy a bank or other large financial institution by making big options trades that go sour. A good example is Barings Bank. Let me stress that this typically happens by accident, not intent. (Usually, as with that case, someone does something stupid, loses money, then keeps doubling up their bet hoping to get out of trouble. If the string of bad bets goes long enough, the company goes broke. Which makes me wonder how many mistakes are made then are successfully corrected without anyone being the wiser...)
So derivatives are contracts. People can buy and sell them. But how should you price them? Well the standard answer for puts and calls is to apply the Black-Scholes pricing model. I won't go into the math, but here is the idea. What they do is construct a portfolio that, managed very carefully, will in the end come to the same effect as a put or call. The price of this portfolio is theoretically the price of the option. Why? Well if the portfolio is less than the option, then you can buy the portfolio and sell the option, manage the portfolio, and you make a guaranteed profit. (Making some combination of trades with guaranteed profit is called arbitrage, and people on Wall St are very, very interested in finding opportunities to do this because arbitrage is free money.) Conversely if the portfolio costs more than the option you can buy the option, sell the portfolio, manage the portfolio and again make money. So in an efficient market the prices have to match.
OK, this is all well and good. Now let's move on to something more fun. Given that the complexity of derivatives are only limited by the imagination of the people writing the contract, here is no shortage of interesting possibilities. Let us focus on swaps.
A swap is just an agreement for two parties to trade things of equal, or close to equal, value at the time of the trade. There are many kinds of swaps traded today. Some are traded with insane volumes. For instance foreign exchange swaps trade money between currencies today in return for a reverse trade tomorrow. This is done to the estimated tune of $1.7 trillion (USD) per day! (The primary purpose is to transfer money at close of business from traders in New York to Tokyo, then from Tokyo to England, then back to New York. That way money can be used to make money 24 hours a day.) But let's take something different. I'll look at an example of two companies swapping mortgages.
Our scenario is that a US company is building a skyscraper in Japan. At the same time a Japanese company is building a skyscraper in the USA for approximately the same price. Neither has sufficient cash on hand to fund this, so each needs a mortgage. (This would likely be done with bonds, but let's not worry about that detail.) But rather than each taking out a mortgage in the other currency, let's say that they enter into a contract to swap the financial obligations - the US company pays the mortgage on the US building, while the Japanese company pays the mortgage on the Japanese building. That's a swap.
Well they certainly swapped something. But what is the point?
The point is that neither wants to have to worry about exchange rates. The mortgage on the Japanese building will be in yen. The mortgage on the US building will be in dollars. The US company has a reliable stream of dollars coming in in their future, but doesn't know how much to set aside to meet an obligation priced in yen. The Japanese company has the reverse situation. It is easier for each to budget and plan for an expense in their own currency, and so they'd each prefer to pay the other's mortgage.
It is important to stress that this is not just a convenience. When the companies go to the banks, the banks will recognize the exchange rate risk and that will affect the rates the companies can get. A US company can therefore get a loan in US dollars at a better interest rate than the Japanese company can. Conversely the Japanese company can get a loan in yen at a better interest rate than a US company can. So after the companies swap mortgages, each gets a better interest rate than they could otherwise get. And since both save on their interest payments, both write down immediate profits from making that swap.
This is one of the most important and counter-intuitive points to understand about financial derivatives. Two companies entered into a contract, and both wrote down an immediate profit. Nothing is faked here. Real money is saved in their monthly bills. That saving can be calculated, and as a result the company is better off. Over time the exchange rates will likely move and as a result one probably makes money and the other eventually loses on the deal. But on day 1, both marked down a profit and the profit is real.
Now if there is one thing that gets the attention of people in finance, it is the ability to manufacture money out of thin air. That apparently happened here. It is therefore worth repeating that this example has been studied to death and generally accepted accounting rules agree that both companies get to write down immediate profits in this case.
Of course you can only set this up if the conditions are just right. These profits aren't particularly easy to find. But once you've seen a way to do it, people can set them up over and over again. And over time the financial wizards found cases where companies could write private contracts and claim an immediate profit. As with the swap described there was inevitably long-term risk associated. But who wants to turn down free profits?
Now here we have a critical danger. With many financial derivatives people enter into complex contracts which, based on some complex theory, they think entitles them to write down a profit. However the investments take time to pan out, and come with significant risks. Worse yet there is the very real possibility that people will write down profits that aren't real due to honest mistakes. And if someone honestly overvalues the value of a particular kind of contract, they will enter into that kind of contract over and over again, writing down fake profits each time. (And getting paid correspondingly large bonuses for finding such great deals!) As a result in the end even the smartest people in the world can find themselves unable to truly measure the risks a given company is taking.
If you think I am exaggerating, go read what one of the greatest investors ever has to say about financial derivatives. There is a section about derivatives that starts on page 14 of this PDF from Berkshire-Hathaway. When Warren Buffett wanted to talk about financial derivatives in 2002, the first point he made was, Charlie and I are of one mind in how we feel about derivatives and the trading activities that go with them: We view them as time bombs, both for the parties that deal in them and the economic system. He then goes on to explain many of the same points that I have. His common sense comments are well worth reading by anyone who wishes to make sense of the recent financial crisis.
Now let's move on to securitization. Securitization starts with a bunch of things with promised future payments that may or may not materialize. The things could be loans on houses, credit card debt, student loans, risky bonds - as long as it is a stream of future payments it is meat for the grinder. Typically each thing is a stream of relatively small payments that lasts for a long time. An issuer takes a whole bunch of these, and puts them together in a deal. A deal likely will have a long stream of big payments. Technically a deal is a very carefully set up corporation whose assets are the things that go into the deal, and whose likely future revenue is used to issue a series of bonds. Each bond is a stream of payments that ends once a particular amount of money has been delivered. The first bonds issued are very likely to be worth full face value, and the last ones are unlikely to make much money. For technical reasons the different kinds of bonds are of interest to different investors.
A financial security is any financial instrument that can be traded. The loans etc that go into a deal can't be traded in any kind of open market. The bonds that come out of the deal can. Therefore this process creates securities out of debt, hence the name securitization.
When the deal is set up right, the loans, etc that go into the deal can be purchased for less than the bonds sell for, and the issuer gets to write down an immediate profit. If the deal is correctly modeled, every purchaser gets a known amount of possible future profit with a clearly understood associated risk. Everyone wins.
Given recent bad press it is worth pointing out that securitization has been around for a while and until recently it worked out well for most of us. Whether or not we were aware of it.
Securitization is really a mechanism for diversifying risk. Before securitization took hold, mortgages would be held by the local issuing bank. This meant that if a local area's economy took a nose dive, the local banks would get seriously hurt and sometimes got wiped out. This would restrict the availability of credit for a long time following, and made eventual economic recovery much, much slower.
Since the 80s things have been very different. Banks now sell their loans on to Wall St, which turns them into securities. This means that if a local economy collapses, like Pittsburgh's when the steel industry left or Michigan's with the auto industry troubles, local banks are much less likely to collapse with it. And they can continue to offer credit, which makes it much easier to recover down the road. Therefore securitization has made local economies much more resilient than they otherwise would be.
But, as we all know, there is a fly in the ointment. In the case of sub-prime mortgages we had bad risk models. Thanks to those risk models companies could write down easy profits while not understanding the size of the risks they were taking on. And in their pursuit of profit, they repeated the mistake over and over again. As a result widespread acceptance of securitization wound up replacing the risk of fairly frequent nasty local economic collapses with the risk of relatively rare nasty global collapses. Luckily with the last one having been averted. (So far, anyways.)
So there we have it. Financial derivatives are just contracts. People enter into them for all sorts of reasons. They are traded in large volumes. They can be arbitrarily complex. They can mitigate or create risk. We have theories on how to price them. When financial derivatives are set up correctly, apparently free money is created. This money comes with associated risk. Honest mistakes about the pricing or risks can lead to disaster. Warren Buffett has written on this topic with extreme warnings about this exact issue. Securitization is a way of bundling lots of little streams of cash into nice bonds. Securitization brought us increased local financial stability, which has been to our general benefit. But systemic mistakes in securitization also brought us a real risk of global collapse.
If you understood that then you likely understand financial derivatives better than half the talking heads you see on TV. And you definitely understand them better than Michael Moore appeared to in his movie.
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