Look on my Financial Engineering, ye Mighty.

Felix responds to my previous post about 401(k)s and still believes his “thesis that financial innovation over the past couple of decades has been, on net, a bad thing.” Felix isn’t necessarily looking for a specific instrument that has been good but is making a more general indictment of the financialization of the economy, but I’m going to throw one out. I suppose this depends on where you draw the line, but I’ll suggest the Interest Rate Swap market as a piece of positive financial innovation from the 1980s. Many noise traders have blown up otherwise good portfolios with them no doubt, but on average I think they have been a win, for specific reasons.

As opposed to monstrosities like reverse convertibles, it is very clear what one is getting, and isn’t designed to trick people from their money. It is one item that adjusts one series of cash flows. We have good reason to believe the interest rate yield curve is rationally priced, and with a quick excel check you can figure out a fair value for an interest rate swap. Retail investors should never be allowed near one, of course, but for informed investors they aren’t trying to figure out the likelihood of events deep in the tail like a CDS, or something that is opaque, hidden, and not necessarily subject to arbitrage forces downward, like how housing will do in the next 5 years. They are easy to get out of, and they can actually hedge, or speculate on, a real risk easily. I’d like to see fewer school boards take large positions in this market, but on average I think it has been a win.

Is there anything to salvage in the last 60 years of financial innovation post-crisis? There are three waves of financial innovation:

1950s-1970, Portfolio Selection: This is your CAPM, mean-variance analysis, diversification arguments and index funds. This sets up future stock price movements to be the results of correlations, and where you get your heavy asset allocation statisticians. It is also why when you look at stock information, say at Wolfram Alpha, there’s a mess of correlation charts and data. Beta is more or less dead now, having been performed so hard by market participates that it has lost its ability to predict what it was intended, and is now replaced with factor models and momentum effects.

Asset allocation has taken it on the chin lately but I don’t think it will go away. I don’t have a lot of opinion on equity allocation, not having to deal with it directly, but I’d like to say that we are exposed to a lot of systematic risk in the market lately, and that the theory was exactly that you couldn’t diversify away from this aggregate market risk, just the idiosyncratic risk of individual firms.

1970s: Black-Scholes. Call and put option pricing. Binomial models to supplement Black-Scholes to non-constant volatility and correlation models. I think the bevy of call and put options available on exchanges have been a net win. It gives us more information on the evolution of prices in stock in a medium term period, and allows people to hedge, or speculate, on the evolution of a stock.

1980s-on: Here I’m mostly in agreement with Felix, though I think it is important to view the changes in the context of the larger change towards a capital markets banking system, and the instruments that were needed to start up this system and keep it running after the wave of late 1990s deregulation kicked in. I’m not sure if we can go back easily, though repealing a fair amount of the banking deregulation would be a start.

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7 Responses to Look on my Financial Engineering, ye Mighty.

  1. Pingback: Wednesday links: earnings vs. revenues Abnormal Returns

  2. guy says:

    Securitization has likely had benefits – for example, being able to buy more precisely the risk you want, borrowers become less captive to local lending conditions (e.g., if California banks are hunkering down, you might pay twice what a borrower would pay in Virginia, where banks are flush). Of course, it got a little out of hand, but securitization does have its benefits.

  3. Mike says:

    I do think keep securitization is a very good idea; agreed it’s just a matter that we don’t try to force to to become the entire banking sector.

  4. Milton Recht says:

    The 1980′s changes to the banking system are the results of the 1970s inflationary economic environment. Fed Res Reg Q capped interest rates on deposits at banks well below the inflation rate and banks gave toasters to attempt to attract deposits. Consumers removed banking deposits and put them into money market mutual funds, which paid a higher rate than banks. Banks lost their cheap, stable funding source. The Fed modified Req Q to allow market rates on deposits. Banks then had higher funding costs, which pushed them into higher rate lending, which attracts riskier borrowers. It also made alternatives to deposits less comparatively expensive. Additionally, the higher costs pushed banks to a more efficient use of funds through loan participations and securitizations. With more price sensitive deposits, depositors sought better rates and they became less geographically restricted. With a more volatile, less stable, less inertial deposit base, there came the need for geographical diversification of banking deposit gathering. Banks merged and expanded across the US.

    By the 1980s, large US companies had easy access to the capital markets for equity and debt. They had very little need to borrow from banks. Banks targeted middle market companies, but the public debt and equity markets opened to these companies also. Banks lost commercial lending market share. Banks pushed into credit cards, leverage buyout financings and increased their share of commercial and residential real estate lending to develop interest income and fees to pay the banks’ higher deposit gathering interest rates and expenses. Banks tried to eliminate branches to cut costs, but found deposit gathering needed a branch system.

    Financial innovation, whatever that undefined concept means, is a continuation by banks to use their resources efficiently to generate income to offset their needs to offset their higher expenses of operation in a modern environment. Modern financial innovation is about lowering the costs of raising funds, investing, and lending.

    As soon as short-term rates rise again, banks will find deposit gathering difficult unless their rates are competitive to alternatives. Any repeal of rules to a previous form of bank operations, such as caps on credit card fees and interest rates, limits on securitizations, limits on types of lending, increasing capital, etc., will lower a bank’s potential revenue. Less income will force banks to lower their expenses, including lowering interest rates paid on deposits and merging into larger institutions to achieve economies of scale. As soon as market interest rates rise, banks will again face disintermediation as they did in the late 1970s and early 1980s. Banks will face either a funding crisis or stop lending at a time when the economy is rebounding and there is demand for commercial and consumer lending. Either will force Congress to undo its restrictions.

    The economic forces pushing banks into higher risk lending and efficient use of capital will not disappear because Congress is upset about the current banking crisis. Imposing restrictions on banks, such as increasing capital and restricting activities, fees and interest rates, is an implied recognition that banking is passé. It will force alternatives to our current banking system, such as private equity, to develop and mature much faster. Whether that is good or bad, better or worse than what we currently have, will unfold over the next decade or two. However, the underlying economic forces affecting banking will not abate because some of the outcomes trouble some people.

  5. Felix Salmon says:

    Orange County? Harvard? I think the problem is that reasonably sophisticated real-money investors overestimate their ability to manage the risks in the rate market. Plus, like any derivatives market, you can quite easily make the following argument:

    (1) The market, as a whole, is zero-sum.
    (2) The sell-side investment banks, as a group, have made billions of dollars out of it.
    (3) Therefore, real-money institutions have *lost* billions of dollars on it.

    Now, were those billions of dollars a reasonable price to pay for being able to lock in fixed interest rates? I can’t see it, myself.

  6. Milton Recht says:

    The market, as a whole, is not is not zero sum. Derivatives markets are, but equity markets are not.

  7. The article: Ben “Systemic Risk” Bernanke proves that Bernanke knowingly maintained a strict monetary policy long after he knew of the sub prime problem.

    It shows that it was the only cause of the “Depression”.

    And that he probably engineered it on purpose!

    If you want to sleep tonight, Don’t Read It!

    “In contradiction to the prevalent view of the time, that money and monetary policy played at most a purely passive role in the Depression, Friedman and Schwartz argued that “the [economic] contraction is in fact a tragic testimonial to the importance of monetary forces” (Friedman and Schwartz, 1963, p. 300).

    To support their view that monetary forces caused the Great Depression, Friedman and Schwartz revisited the historical record and identified a series of errors–errors of both commission and omission–made by the Federal Reserve in the late 1920s and early 1930s.

    According to Friedman and Schwartz, each of these policy mistakes led to an undesirable tightening of monetary policy, as reflected in sharp declines in the money supply. Drawing on their historical evidence about the effects of money on the economy, Friedman and Schwartz argued that the declines in the money stock generated by Fed actions-or inactions–could account for the drops in prices and output that subsequently occurred.

    Friedman and Schwartz emphasized at least four major errors by U.S. monetary policy-makers.
    The Fed’s first grave mistake, in their view, was the tightening of monetary policy that began in the spring of 1928 and continued until the stock market crash of October 1929 (see Hamilton, 1987, or Bernanke, 2002a, for further discussion).

    This tightening of monetary policy in 1928 did not seem particularly justified by the macroeconomic environment:
    The economy was only just emerging from a recession, commodity prices were declining sharply, and there was little hint of inflation.
    Why then did the Federal Reserve raise interest rates in 1928? The principal reason was the Fed’s ongoing concern about speculation on Wall Street.

    Fed policy-makers drew a sharp distinction between “productive” (that is, good) and “speculative” (bad) uses of credit, and they were concerned that bank lending to brokers and investors was fuelling a speculative wave in the stock market. When the Fed’s attempts to persuade banks not to lend for speculative purposes proved ineffective, Fed officials decided to dissuade lending directly by raising the policy interest rate.

    The market crash of October 1929 showed, if anyone doubted it, that a concerted effort by the Fed can bring down stock prices. But the cost of this “victory” was very high. According to Friedman and Schwartz, the Fed’s tight-money policies led to the onset of a recession in August 1929, according to the official dating by the National Bureau of Economic Research.

    The slowdown in economic activity, together with high interest rates, was in all likelihood the most important source of the stock market crash that followed in October.

    In other words, the market crash, rather than being the cause of the Depression, as popular legend has it, was in fact largely the result of an economic slowdown and the inappropriate monetary policies that preceded it.

    Of course, the stock market crash only worsened the economic situation, hurting consumer and business confidence and contributing to a still deeper downturn in 1930.”

    Governor Ben S. Bernanke
    Money, Gold, and the Great Depression.
    At the H. Parker Willis Lecture in Economic Policy, Washington and Lee University,
    Lexington, Virginia.
    March 2nd, 2004

    You can read also: Preparing for the Crash, The Age of Turbulence Update: 22/07/09.|

    “Much as we might wish otherwise, policy-makers cannot reliably anticipate financial or economic shocks or the consequences of economic imbalances. Financial crises are characterised by discontinuous breaks in market pricing the timing of which by definition must be unanticipated – if people see them coming, then the markets arbitrage them away.

    …..

    That is mission impossible. Indeed, the international financial community has made numerous efforts in recent years to establish such oversight, but none prevented or ameliorated the crisis that began last summer. Much as we might wish otherwise, policy makers cannot reliably anticipate financial or economic shocks or the consequences of economic imbalances. Financial crises are characterised by discontinuous breaks in market pricing the timing of which by definition must be unanticipated – if people see them coming, then the markets arbitrage them away.”

    Alan Greenspan
    The Age of Turbulence: Adventures in a New World [Economic Order?].

    Plea for a New World Economic Order.

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