Political Economics Prof

Tag: Finance

  • The Economics of Financial Markets

    The Economics of Financial Markets

    THE ECONOMICS OF FINANCIAL MARKETS

    MARKET-MAKERS, BIASED INFORMATION, AND FORECASTS

    This tutorial will look at financial markets and how they actually function. 

    There are two general theories about how financial markets work. The first is the Efficient Market Theory, which assumes all decision-makers are rational – they have access to information, can analyze it, and make investment decisions. Strangely, a major conclusion is that investors cannot predict stock price movements, which are random. The second is Behavioral Finance, which assumes that investors are irrational – they have a number of biases and are influenced by the markets’ past behavior.

    Both theories based on this supposed distinction that “explain” financial price behavior are irrelevant.

    What is left out of theoretical models of financial markets is how financial markets actually operate. Between buyers (investors) and sellers (including issuers of new securities), there are market makers like brokerage firms, managed funds, hedge funds and investment banks. It is in their interest to get investors to invest in financial assets rather than other types of assets, to trade often, to buy riskier securities and derivatives. All these strategies generate more revenue for them. 

    It is also in their interest to convince investors to pay large fees for supposedly superior information or analytical skill, that is, to ignore the Efficient Market Hypothesis. And investors, including large pension funds, often do.

    The primary selling tools are financial information, analysis of the information, and forecasts. It is the self-interest of all market-makers to present biased information and optimistic forecasts. For market-makers, financial information and forecasts are marketing data.

    What is financial information? First, the current earnings of companies. The problem is politely phrased “quality of earnings.” Earnings, and earnings per share (EPS), are routinely managed by corporate accountants to show steady or exponential earnings growth. This increases the share price as EPS goes up and, if earnings rise by a high or increasing percent every quarter, by increasing the price/earnings (P/E) ratio of the stock. 

    Since top management now receives much of its compensation from stock options and bonuses based on earnings growth, they have a personal reason to see that earnings are managed.

    Even a casual reading of the financial press or case studies on corporate finance reveal the numerous ways reported earnings per share can be increased when there is no increase in operating earnings or even a decrease. The simplest way is to increase financial leverage. The current version is to borrow money to finance share buybacks. This increases earnings per share since there are fewer shares outstanding.  

    For a sample of corporate accounting frauds, see http://www.accounting-degree.org/scandals/. Also see the entertaining film The Smartest Guys in the Room for the massive accounting fraud that bankrupted Enron.

    Then analysts who work for market-makers spin the earnings. They invent plausible reasons for the steady or accelerating increase in EPS and P/E ratios. Assuming these reasons will continue if not accelerate, they make optimistic forecasts of future earnings. Since the stock market is “forward-looking,” these biased forecasts are important pieces of “information” that investors use to make decisions. Analysts (and CNBC) become cheerleaders for the industries and companies they study, especially if they work for a financial institution that competes for investment banking business. Often analysts will hype a company that they privately know is a dog.

    Analysts overwhelming issue buy or hold recommendations and very seldom issue sell recommendations.

    The worse scenario for an investor is an industry with new technology. Analysts are free to make whatever predictions they want, no matter how improbable. A good story sells. In the decades I’ve followed the stock market, I’ve never heard an analyst tell the simple truth:  Almost all the companies trying to develop a new technology will go bankrupt and it is impossible to tell which few will be big winners (if any). Think about the biotech, dotcom and “clean energy” booms. I think it is fair to include the clever innovations that made the subprime mortgage and derivative boom possible.

    Investors are buying the future. Even stock index funds, which are weighted averages of the market value of the underlying stocks, go up mostly because of the more rapid than average increase in the hot stocks and hot industries. 

    This game comes to a temporary reversal when there is an “external shock” such as a recession. The phrase indicates important events than cannot be forecasted. Then there are the inevitable losses, “restatement of earnings,” “extraordinary losses” and “write-down of assets.” Hyped new technology companies go bankrupt. Hot stocks and industries driving the market get clobbered and indexes go down. Often a lot. 

    Besides reducing past earnings, companies will also take a “big bath” write-off of assets and anticipated future expenses. It is common practice to overestimate future expenses and losses. Then when actual expenses are incurred, they are smaller than announced and earnings are higher. This is one reason for the apparent paradox that a company’s stock price often goes up when the company announces a large loss and a large write-off of assets. 

    But memories are short, hope springs eternal and there is always a new story to tell – a new hot industry, new hot companies, especially if in a new technology. And the game moves to a different location.

    The main point here is that even if investors “rationally” analyze the biased information and forecasts, their subsequent behavior will not be any different than “irrational” investors who follow trends created by the biases and asymmetries of the financial information.

    UNDERPRICING RISK AND FAULTY MARKETS

    An important part of the information used to make investment decisions is forecasts. Yet the analytical tools used to forecast, and also price financial instruments, are defective. They are mostly based on a normal distribution of price movements and related linear regression models. Normal distribution models underestimate the probability of a large downward movement in stock prices. The market has much more risk (volatility) than the models indicate. Some of the studies and statistics are summarized in Benoit Mandelbrot, The (Mis)Behavior of Markets. This conclusion has been popularized in the best-seller, Nassim Taleb’s Fooled by Randomness.

    A recent example was the credit default swap market. The pricing of credit default swaps in the 2000s was based on a correlation model that assumed away the possibility of defaults! Since AIG thought there was no risk of actually paying off for defaults, it underpriced the credit swaps and could not afford to hedge its positions. The resulting defaults of derivatives and investment companies led to the bankruptcy of the largest insurance company in the world.

    There are some markets that cannot be forecasted. The bond market is bigger than the stock market. Yet economists cannot forecast interest rates and thus the movement of bond prices. The mortgage market cannot be forecasted. The future cash flows of variable rate mortgages are highly uncertain and fixed rate mortgages can be refinanced. Thus the future cash flows of mortgage-backed securities cannot be forecasted. Uncertainty is compounded by leverage in buying mortgage-backed securities  (MBSs), the creation of derivatives based on MBSs, and default risk.

    INDEX FUNDS VERSUS MANAGED FUNDS AND PICKING STOCKS:  INFORMATION AND IGNORANCE

    Financial markets are information rich. According to economic theory, prices should reflect this information. The pricing mechanism should be very efficient, summarizing the analysis of the large amount of data. But most individual investors and many institutional investors such as pension fund trustees are totally ignorant of financial markets and incapable of interpreting and analyzing financial data. What to do?

    1) Pay someone else to analyze data and pick stocks. (Managed funds)

    2) Buy index funds and index ETFs.

    An index fund like the S&P 500 ignores the problem of picking good stocks and buys the entire stock market. Stocks in the index are weighted by their total market value (in the jargon, called “market cap,” short for market capitalization). So the index buys 10 times as much of a stock with a market cap of $100 billion than another stock with a market cap of $10 billion. The index has to adjust the weights as the relative market caps change.

    Indexes tend to be dominated by very large companies and rapidly growing technology companies with high and rising P/E ratios. Before the 2008-2009 crash, indexes were dominated by financial companies. Six of the top ten market cap companies in the S&P 500 are tech companies. Currently (2018), the eight companies in the world with the highest market cap are all information technology companies.

    “Buying the market” (index funds) rather than individual stocks is a strategy for totally ignorant investors. Much of the increase in money going into the stock market after the 2008-2009 crash has gone into index funds and index ETFs. All that investors have to assume (believe) is that the real economy will grow, total profits and earnings per share (EPS) will thus increase, and that most if not all stock prices will rise as a consequence. Investors can ignore the competitive strategies and financial performance of individual companies, industry analysis, monetary and fiscal policies, and global and macroeconomic trends.

    And total ignorance works. A great deal of statistical evidence indicates that index funds outperform over 90% of managed funds over long periods of time. They also have lower costs – no expensive analysis costs. Managed fund managers also tend to take greater risks and create leverage (invest with borrowed funds in additional to investors’ money) to offset higher costs and achieve higher rates of return than index funds. Because of greater leverage, greater risk, and high costs, managed funds tend to do poorly in stock market downturns. Many “blow up” (go out of business).

    Index funds work because in the long run the economy does grow, total profits of public companies rise, and most stock prices go up. As more money goes into index funds, the funds must buy more of all of the stocks in the fund. The whole market goes up and the index funds prosper. 

    All of this also benefits managed funds. Experienced fund managers with access to all past and current financial and economic data, data and trend analysis programs, and proprietary models should be able to outperform the market in such an environment. But they do not. Why?

    They are making decisions based on biased and misleading information.

    There is a problem of too much information that is hard to analyze. For example, many companies no longer release an annual report. Instead, they send their stockholders (and analysts) their 10-k, which is the annual report they have to file with the government’s Securities and Exchange Commission (the SEC). These are incredibly detailed reports with small type that go on typically for 100-150 pages. Most of the content is unimportant or irrelevant. (This is the mushroom effect. How do you raise mushrooms?  Keep them in the dark and pile manure on them.) 

    They tend to buy companies with rapidly rising sales and profits. These companies also have high and rising P/E ratios during the innovative, rapid growth phase, increasing the rise in the stock price. As these innovative companies mature, their growth slows down. Profit growth also slows down or stops. P/E ratios fall. The result is a drop in their stock price, often large, followed by mediocre stock performance. Many of these companies are attacked by smaller companies developing or using newer technology.

    Companies like IBM, Microsoft, Intel, and Oracle were innovative growth companies, are now large and profitable, but have been lousy stock investments for a long time. The large percentage increase in their stock prices in 2017 and early 2018 looks similar to the large runup in their prices in 1999, just before the dotcom market crash of 2000-2002.

    Professional investors cannot predict “phase transitions” in industry technology or organization, or in the underlying economy. Just as it is difficult to predict the winners developing a new technology, it is difficult to predict the losers they will replace. It is the winners, not the losers, that make it into the indexes.

    Managed funds do a lot of trading – buying and selling stocks in their portfolio. They try to time their trades with major moves in the stock market. This is difficult to do. Very few investment professionals ever predict market downturns.

    Some managed funds buy a subset of large, mature companies. A diversified portfolio of about 30 stocks reduces risk almost as much as a total market index. Their economic performance as a group will be about the same as the large, mature companies in the index funds. With about the same sales and profit growth over time, the subsets in the managed funds should have long-term stock price increases about the same as the market. But at a higher cost.

    On average, about 60-70% of an individual stock’s price movement will be correlated to the price movement of the whole market. So, much of the movement of stocks in a managed funds will move with the market, especially a managed fund dominated by large companies with large market capitalization.

    Some large cap companies are so diversified that they are a diversified portfolio in themselves. Johnson & Johnson could represent much of the pharmaceutical and health care industry. Parker Hannifin could be a proxy for investing in cyclical industrial companies. Companies like Google and Celgene buy or invest in new and small technology companies in their industries, almost like a venture capital company. Many large companies not only have a diversified business but are also multinational corporations, a proxy for investing outside the United States.

    Some managed funds concentrate on innovative companies. The problem is that many new tech and startup companies fail; their stock prices will go to zero. Many did in the 2000-2002 dotcom market downturn. They took a lot of managed funds down with them.

    As discussed throughout these tutorials, an important factor for the success of a startup is the drive, determination, focus, and strategy of the founders/entrepreneurs. It is hard for an outsider like an investment manager to evaluate the intelligence, dedication, and personality of the founders.

    Outside analysts and investors do not have the key information they need to evaluate a company – the internal detailed proprietary knowledge responsible for the competitive advantage causing sales and profit growth.

    Most stocks, including those of the large, mature companies that tend to dominate index funds tend to go up and down (are correlated) with the overall market. There may be individual exceptions because of company-specific events but as a group they heavily influence (account for) overall stock market changes. There is no need to try to pick individual stocks among this group. 

    Often, one sector drives the market – IT and Internet stocks in the 1990s, finance in the 2000s, and technology in the 2010s. It is hard to pick winners early and the timing of the downturn is also unpredictable. Index funds ride through the downturn and are there for the next upturn fueled by innovative companies in new sectors and industries.

    There are internal dynamics of the stock market. Companies increase dividends, buy back their stock, and do mergers and acquisitions. All these moves can increase the price of an individual stock; collectively, they increase the value of the entire stock market. Index funds automatically benefit. Managed funds often do not.

    Picking stocks to outperform the market critically depends on predicting growth rates in expected EPS for years into the future. Any forecast will be highly uncertain and subject to large errors.

    In conclusion, the stock market is not a random walk (impossible to forecast) or the result of irrational, emotional behavior by investors and money managers. Professional money managers seldom “beat the market” because of uncertain forecasts, the domination of mature companies, the difficulty of outsiders to pick innovative winners, and incomplete and misleading data. 

    I recommend reading Burton Malkiel, A Random Walk Down Wall Street. Revised and Updated Edition, 2007. Professor Malkiel was associated with Vanguard for a long time. Earlier editions of this book were an argument for the index fund approach to investing made popular by Vanguard. This edition gives a more balanced approach than earlier editions.


    INSIDER INFORMATION:  PROFITING FROM ASYMMETRIC INFORMATION

    Financial markets are rife with insider information. Inside information is a classic example of asymmetrical information, where insiders can profit at the benefit of investors not yet knowing the information. Sometimes insiders use their information and position to manipulate prices, such as the massive LIBOR price-fixing scandal. 

    Many foreign markets are insider markets, where locals can conspire to manipulate and fix prices, especially at the expense of foreign investors. This is similar to what U.S. markets were like before the reforms of the 1930s.

    FINANCIAL MARKETS AND MORAL HAZARD

    Conservatives argue that deregulation of financial markets leads to innovation and more efficient markets. The first part is true; many new financial instruments and new types of financial companies have been created. The implication of the second part is that because of more competition prices in financial markets quickly adjust to something approaching “fundamental value” or, in economic jargon, equilibrium. The basic problem is that the first effect works against the second effect.

    The problem is moral hazard, an idea that says that individuals like managers and owners of financial institutions will take more risk if someone else (the U.S. government and taxpayers) pays the price of failure. 

    This happened in the savings and loan crisis of the late 1980s. The industry was deregulated so that S&L managers could make riskier loans at higher interest rates but deposits were still federally insured. So the more aggressive banks offered higher interest rates on deposits, took in a lot of money, and made a lot of high-risk bets, including illegal loans to insiders. They lost. Half of the S&Ls went bankrupt and it cost U.S. taxpayers over $130 billion in losses on bad loans.

    Deposit insurance is one source of moral hazard. Another is that the two largest players in the mortgage market, Fannie Mae and Freddie Mac, had the implicit guarantee of the government. A third source is the “too big to fail” doctrine, already invoked in a big bank rescue in the 1980s. Combined with that is the idea of “systemic risk,” which implies that if a financial institution failed, even if it wasn’t a bank or “too big to fail,” it might set off a chain reaction that would threaten the collapse of the entire financial system. This is what happened with the failure of Long-Term Capital Management in 1998. 

    EXTREME RISK AND TOO BIG TO FAIL:  LONG-TERM CAPITAL MANAGEMENT (LTCM)

    In the 1990s, the company with the most sophisticated models and trading strategies was Long-Term Capital Management. Its partners included the former head of bond trading at Solomon and two Nobel Prize winners for their work in financial models (Myron Scholes and Robert Merton). Its strategy was based on reversion to the mean of the difference in the prices of a large number of supposedly unrelated financial instruments, another correlation model. But in the global financial crisis environment of 1998, the difference in prices moved in the opposite direction of historical behavior partly because of a “run to safety” in buying U.S. Treasuries. Spreads between Treasuries and other instruments increased instead of the expected decrease. This, plus enormous leverage based on underestimating risk, led to a massive bankruptcy. Only a huge infusion of capital from other firms, made under pressure from the Fed, averted a financial crisis.

    LTCM was a hedge fund so the government had no legal obligation to intervene. It also wasn’t that large in terms of capital invested. But it was very highly leveraged, meaning it had borrowed a huge amount of money (about 30 times its invested capital) and had over $100 billion of assets and liabilities on its balance sheet. If it failed, its lenders and counterparties to financial contracts would take a huge hit; it was believed that some credit markets might even freeze up (become illiquid). The Fed decided that this was too big a risk to take and forced nine major banks to chip in over $3 billion to carry the assets. LTCM was liquidated and its positions were eventually sold. But it established a precedent that a threat to financial markets, not necessarily the size of the company or the legal obligation of the government, might be a reason for the government to bailout a company. And the threat to financial markets was rapidly increasing as all large financial institutions increased their leverage in the 1990s and 2000s, many to the 30-1 ratio of LTCM. They were using borrowed funds to buy and trade inherently risky mortgage-based bonds and derivatives.

    BIASED INFORMATION, FRAUD, EXTREME RISK, AND TOO BIG TO FAIL:  THE SUBPRIME MORTGAGE MARKET CRASH OF 2007-2009

    After the Dotcom market bust of 2000-2002, the market continued upward, fueled by tremendous gains in the financial markets. Financial firms had found a great new business – securitizing mortgages and other debt instruments and selling bonds and other derivatives based on the cash flow of the underlying assets. At the foundation of this was a huge increase in subprime mortgages and mortgage refinancing. Many of the subprime mortgages were blatantly fraudulent or certain to go into default. But banks and other financial institutions were able to sell pyramids of derivatives many times greater, and more profitable, than the original issuance of mortgages. These markets were totally unregulated. (To understand how all this happened, see the movie The Big Short and read Explaining Derivatives – An Analogy after this essay.)

    The subprime mortgage business was a con game from the start. Mortgage brokers and loan officers at sketchy banks used deceptive and often fraudulent methods to originate subprime loans. Mortgage and mortgage-baked securities (MBSs) risk analysts at some banks and investment banks, the credit rating agencies, and Fannie Mae knew that there would be a high rate of default after the low “teaser” rates ran out. In loftier language, Alan Greenspan warned in 1994 that there was a good possibility of a housing bubble and massive defaults of mortgages.

    The problem was how to sell these “junk” mortgages. In a rational market, investors in subprime mortgages and their MBSs should have received high rates of return to balance the high risks of default. Not to be. If banks kept the mortgages, they could be financed by low-cost short-term borrowing. Why low cost? Because throughout most of the 2000s, the Fed kept short-term interest rates low. The prime rate was below 2% for three years.

    But banks sold most of subprime mortgages to other financial institutions that would securitize the mortgages into bonds backed by the monthly payments of the mortgage holders. The bonds should have paid a high rate of return. But they didn’t. The reason was that these mortgages and their derivatives were laundered. The financial industry, with the connivance of credit rating agencies that were paid by the banks, turned bundles of high-risk mortgages into bundles of investment-grade (low-risk) bonds. Then the riskier parts of these bundles were turned into new derivatives that were also rated as investment grade. By labeling these securities as investment grade, this greatly increased the pool of potential institutional buyers such as pension funds. Mortgage origination fees, underwriting fees, selling fees and trading commissions were enormous.

    But who bought these instruments? At the height of the subprime boom, large purchasers were Fannie Mae and Freddie Mac. In the past, both companies would have automatically rejected subprime mortgages. They didn’t even have models to evaluate these types of mortgages. As companies with de facto government guarantees, they were obligated to only buy and securitize high quality, low-risk mortgages. But under political and industry pressure, and loss of market share, they became major buyers of subprimes and sold mortgage-backed bonds at rates slightly higher than U.S. government bonds. Massive defaults led to the bankruptcy of both companies, which were taken over by the federal government. For political reasons, most of the losses were not borne by the bondholders such as the Chinese government but by U.S. taxpayers.

    So the consequence of deregulation was not diversifying risk and self-equilibrating financial markets but accelerating systemic risk underwritten by moral hazard. How could it be otherwise? Selling greater volumes of increasingly riskier assets meant huge increases in salaries and bonuses. What did mortgage originators and managers of banks, investment banks and hedge funds care if they were creating higher levels of risk that could bring down their companies or the entire financial system? Increased leverage meant increased profits and increased bonuses. Fraud was rampant. Regulators were either clueless (SEC) or ignored their feelings that a crash was coming (Greenspan). Most deals were private so that even the hope of “free market discipline” was missing. Best of all, there were huge pools of funds run by unsophisticated trustees (asymmetric information) to finance the whole thing. Wall Street’s attitude was nicely summarized in a line from the movie The Magnificent Seven, “If God didn’t want them sheared, He wouldn’t have made them sheep.”

    Will it happen again? Of course. The financial reform bill is a joke, nothing more than a political CYA crafted by the same politicians that helped create the mess. But the Congressional hearings were good theater as every member of Congress repeated a variation of the cynical line from the movie Casablanca, “I am shocked, shocked, to find out that gambling is going on in here!”

    As part of its attempt to save the financial industry from imploding, the government brokered a number of “shotgun” mergers between large financial institutions. A small number of banks are now much larger than before the bailouts. They really are “too big to fail.” They are more dominant, gaining market share. They are also closely tied to the large hedge funds and private equity firms, which gives these private, unregulated companies some government protection. And, in a delicious irony, Goldman Sachs, a major private derivatives and trading investment bank, has applied to become a commercial bank so that FDIC can protect some of their creditors. The idea that American taxpayers are providing insurance to Goldman Sachs’ creditors, which include hedge funds, is moral hazard with a vengeance.

    Government bailouts went way beyond the usual targets, to include insurance companies, General Motors’ and Chrysler’s financial arms, and GE Capital. There is delicious irony in the bailout of GE Capital. GE Capital is part of General Electric (GE), one of the largest corporations in the world. For many years, GE has paid no U.S. corporate income tax.

    A last, major example of moral hazard. Public and private pension funds have made risky investments and lost. So what? The public pension funds must have a certain level of assets in the future. So future taxpayers will pay more in taxes and receive fewer services. And $60 billion of unfunded liabilities in private pension funds are guaranteed by the government.

    Large financial firms can expect public bailouts and subsidies when they “blow-up” but investors cannot. So financial firms can take excessive risks with investors’ money to earn large fees. It is only when they start to believe their own propaganda that the financial instruments they sell are really not as risky as they are, and begin holding the securities in their own portfolios, that financial institutions risk bankruptcy.

    What this means is that in the future just about any company remotely related to finance can expect a bailout. There are no market restraints on risk left. The U.S. government is now underwriting the entire financial industry, no matter how reckless. And every risk-taking gunslinger in the future knows it.

    CONCLUSIONS

    Analytical tools and analysts are biased producing biased information and forecasts.

    Statistical models underestimate risk. Risk is underpriced and uncertainty cannot be modeled. Combined with the upward bias in public information, this creates higher percent growth of financial prices in “normal” times followed by periodic “blow-ups” in financial markets.

    Moral hazard allows investment managers to take great risks since they know that the government or taxpayers will underwrite large losses.
    The information and knowledge that most professionals possess does not give them an advantage over the total ignorance of investing in passive index funds. They cannot “beat the market.”

    ===============================================

    EXPLAINING DERIVATIVES – AN ANALOGY

    You go around to farmers with cows. You buy all the cows and pay the farmers a small fee to milk the cows and sell the milk. You pay for the cows with ass(et)-backed securities called MBSs (Milked Bovine Securities) that you tell investors are udderly safe. But some of the cows don’t give enough milk (cow flow problem) or give no milk at all. You take some of the asset-backed securities, say they’re backed by the subprime cows, and use them as collateral to sell another set of securities called CMOs (Cow Milk Obligations). Then you buy CDSs (Cow Dried-up Swaps) from AIG (Angus Insurance Company) to insure the CMOs when the cows stopped giving milk. If you work it right, you collect more on the CDSs than you pay out to retire the CMOs. The money you get from selling the dead cows go to pay the CLOs (cow leather obligations).

    You could also sell CDOs (cow dung obligations) that depend on how much cow dung is produced. This is a typical Wall Street product – turning shit into gold. 

  • Financial Markets 101 and the Current Financial Crisis


    I’ve been asked to define some financial terms and comment on the current financial crisis and coming recession.

    -Financial institution (is it any bank or stock broker?)

    -Investment bank ( I never understood why Goldman Sachs was considered a kind of bank)

    -Systemic risk

    -Counter party risk

    -Mortgage backed securities vs. mortgages (does a mortgage become a security when it’s bunched up with a lot of other mortgages so a person can invest in the whole bunch?)

    -Hedgefund

    -Relationship between hedge funds, short selling and credit default swaps.

    Financial Institution – any company that deals in finance – money, credit, stocks, insurance. It could be a bank, stockbroker, insurance company, hedge fund, credit card company, mutual fund company, etc. Even half of GE is a financial company.

    Investment bank. In 1934, the U.S. government passed a law dividing banks into commercial banks and investment banks. That law has since been repealed so there is a lot of overlap now. Big commercial banks usually have investment bank subsidiaries. Some of the big hedge funds are evolving into investment banks.

    So, what is an investment bank? Unlike a commercial bank or savings bank, an investment could not take in private deposits (think checking accounts). Until the revolution in banking that began in the 1970s, investment banks mostly did underwriting (floated new stock and bonds of big companies), arranged financing for mergers and acquisitions, dealt in government bonds, sometimes investing their own money. But with the explosion of new kinds of financial instruments and markets, especially derivatives, investment banks greatly expanded their business, both as brokers (bringing buyer and seller together for a fee) and dealers (taking a position with their own or borrowed money). They also entered into complicated relationships with hedge funds and private equity funds.

    Goldman Sachs was always an investment bank. Like a lot of old-line investment banks, they also had ties with banks in Europe. So advising foreign banks on U.S. investments and handling their investments was a part of their business.

    Systemic risk. The big change in financial markets in the last 35 years (beginning in 1973) has been the pricing of risk, starting with the Black-Scholes equation that priced options. New financial instruments (products) were invented to let individuals and companies either hedge against risk (similar to buying an insurance policy) or speculate (take on risk hoping to make a big profit). There is nothing new about this – it’s just the huge size and sophistication of the markets that’s new. Now, any one company can hedge against risk or lots of types of risk (changes in the value of foreign currencies, changes in interest rates, changes in the price of raw materials, even changes in the weather). But there is a big question of whether or not this reduces the overall risk in the global economy. No one knows. This overall risk is called systemic risk, or the risk in the entire financial system.

    My personal feeling is that systemic risk is much higher because of the complexity and interconnections of financial markets. Which gets us to counterparties.

    Counterparty. Generally, it just means someone on the other side of a financial contract. So, if you have a mortgage, you and your bank are counterparties. But the term usually has a more limited meaning to describe the two parties to a private contract involving some type of derivative. The main risk is that the counterparty won’t be able to pay up if it owes you money in the future. So you really have to trust the other party, which is why most counterparty contracts were between the biggest and most secure financial institutions. Until recently, when companies like hedge funds became major players in these markets. So, counterparty risk mostly means the risk of the other guy not being able to pay up during or at the end of the contract.

    Mortgage-back securities vs. mortgages. Generally, yes. Banks generate mortgages. They then sell some of them to companies like investment banks or Fannie Mae. Then the income from the mortgages (the monthly mortgage payments) of a bunch of them are sold as a bundle to other investors. How? But creating (selling) a mortgage-backed security. Think of a mortage-backed security as nothing more than a bond backed by the cash flow of the bunch of mortgages. That’s the easy part. Then the mortgage-backed securities can be sliced and diced into lots of pieces, sometimes called collateralized mortgage obligations (CMOs) or “tranches”. There were typically six tranches. The lowest one, the one with the highest risk, was so risky the issuers of the CMOs (often investment banks) kept it. These were the parts of mortgage-backed securities that were called “toxic waste.” Investors could pick which combination of risk and return they want.

    That’s the easy part. The “toxic waste” tranches were then bundled and sliced up again. Incredibly, the “best” of these “toxic waste” securities were often rate AAA. True alchemy – buffalo chips had been turned into gold.

    But wait! There’s more! The buyer of a CMO or some other security might enter into a contract to hedge some of the risk. The counterparty might enter into a second contract on the other side to offset its position in the first contract. Some other institution that bought a mortgage-backed security or a CMO might decide to arbitrage the difference between changes in interest rates on mortgages and interest rates on some other debt instrument, typically U.S. Treasuries. And on and on it goes.

    Since most of this activity is done in private, unregulated markets with no reporting of positions, no one really knows the whole picture. Most of this is done with borrowed money – leverage. Systemic risk again. We are now seeing what happens when everyone tries to “deleverage,” a large part of which is no longer knowing which counterparty to trust, unwinding positions and paying back loans. Result – markets freeze up, no one wants to lend or take a position, assets like mortgage-backed securities can’t be sold and so no one knows what their market price is. Uncertainty and lack of liquidity (inability to sell an asset) are the worst things that can happen to financial markets. This is what’s happening right now and why the only lender or investor left in many countries is governments. Very ironic.

    Hedge fund. Basically, any unregulated investment company that can do whatever it wants. There are about 7,000 or so in the U.S. They pursue many different strategies. They control about $2 trillion (less this month) and are often highly leveraged, meaning they borrow a large multiple of their capital. So most of them pursue high-risk strategies that make them a lot of money (high return) most of the time. But in a downturn, they lose lots of money and many go out of business.

    I’m going to fudge a little on your last question because it covers a lot ground.

    Short selling. This means a bet that something, usually a stock price, is going to go down in price. If it happens, the short seller makes money. One way to do this is to use put options. Anyone can do this, not just hedge funds.

    Credit default swaps. These are like insurance policies. This started out as a rather conservative way to insure against a counterparty or some other financial institution going bankrupt. For example, say you owned bonds issued by Lehman Brothers and started to get worried about Lehman’s solvency. You might buy, for a fee, a credit default swap. If Lehman goes bankrupt, some of their bonds might only be worth 9% of their face value. The seller of the credit default swap then has to pay you some or all of the difference, depending on how the swap was written. This actually happened this week. What’s funny about this example is that Lehman Brothers was a major writer of credit default swaps.

    But, as usual, some smart guys saw these as a way to speculate. Leaving aside the details (rather messy), more and more credit default swaps became a bet on the probability a company would go bankrupt.

    AIG was a big seller of credit default swaps. It looked like a safe way to earn the equivalent of insurance premiums. Until this fall. It’s like what happens to an insurance company when a large hurricane like Katrina hits. The probability is low but when it happens, the losses are huge. In this case, so big it brought down the company.

    Recommended reading. Taleb, Fooled by Randomness. A rather philosophical musing about the role of risk in finance and life. Written by a former derivatives trader.

    FINANCIAL CRISIS

    I always thought, and said so many times in class over the years, the Alan Greenspan and the Fed were mostly smoke and mirrors. For twenty years, everything broke right for the economy. The Fed did more harm than good but basically nothing much until after 9/11. Then, to set negative real interest rates for three years as a massive subsidy to the banks, see the housing bubble coming as early as 2004 (I found an old article), and do nothing about it because of “ideology” is moral cowardice or stupidity (take your choice). Also, the whole question of deregulating parts of the financial market is mostly a non-issue. Huge parts are private and/or unregulated anyway (hedge funds, private-equity firms, investment banks) and even the regulated part has figured out how to get around the rules (SIVs, something right out of Enron). AIG was one of the most highly regulated firms in finance. Also, I don’t think anyone thought through the systemic risk of the proliferation and rapid growth of layers of derivatives financed by debt.



    Most investment advice doesn’t work in a big market downturn. Especially “diversify.” Everything goes down. Past patterns that are the basis of arbitrage break down (hello LTCM). And the risks are far higher than the models indicate, as Taleb argues.



    There is also a long-run problem. The Dow and S&P are back to where they were in 1996. So if you had put money into your 401K every month for the last 13 years, you would have had a negative rate of return. My back of the envelop guess is that the total real return on stock index funds in this period -after inflation and fees – has been about a negative 50-60%. No wonder investors put their money into houses.



    There’s some really scary stuff out there already. If the auto industry and their suppliers go bankrupt, they could dump their entire pension expenses on the U.S. government. Could be higher than $20 billion a year. The huge California pension fund (Calpers) has been very aggressive in the past and earned above average rates of return, So far this year they’re down $40 billion and that’s without taking a markdown on their big investments with hedge funds and private equity funds. (What the hell are pension funds doing investing billions in hedge funds?) I would guess that most public pension funds are now underfunded, certainly true in New Jersey.



    So we go into this recession with a $1 trillion budget deficit, a $600 billion trade deficit, one million foreclosures, five million mortgages underwater, and a financial system that can’t even price debt instruments. At some point, foreign savings will stop financing all of this. Already, around the world, a lot of capital is “coming home,” causing problems in Eastern Europe and other emerging economies’ financial markets. 



    I hope I’m wrong but I think this recession is going to be really nasty.