The Financial Market Parallel Universe

The Financial Market Parallel Universe

This article was written in June 2008, prior to the financial crisis occurring in the fall of 2008. Looking at the market in general, what has changed and what has stayed the same?

By Allen Elstein

Weekends get me into a lot of trouble. This is especially true since a new candy store opened near my home. Well, to be more accurate, a new bookstore–one with those comfortable wooden chairs and an in-house cafe. Now, I like to read sports biographies, but to get to them I have to get past the sales books and the business books.

These days the business books describe postmodern Wall Street. When you get past the jargon, the message is often the same. The inner belly of the new investment world is very different from what the better-educated laypeople, politicians and regulators think it is ... and potentially far more dangerous.

Within the new financial inner circle there are a surprisingly small number of big players–a few global banks, seven or eight investment banks (fewer by the day) and the furtive hedge funds. They are all in cahoots, heavily leveraged and trading chips in the shrouded world of counterparty transactions, not the open market. These transactions are often in made-up, synthetic securities and derivatives, a world removed from real, tangible assets–with surprisingly little regulation.

Long gone are the days when the investment banks primarily did IPOs and created simple debt instruments. Today, it seems that they have a poker hand in every game from creating synthetic investments to derivatives on both sides of the fence. And it's the Wild West, as far as them being the least regulated player–rules or capital requirements ... who cares? They argue they are the ones best able to set the "right" amounts and capital for themselves. And in recent years, this principle-based system has largely replaced what regulatory rules supposedly held them down. After all, we do not want redundant capital tied up.

Now, maybe, when investment banks are playing bookie and taking risk off your table, you might want to do some thinking. Said differently, what your investment bank counterparty is going to do when there is a crunching sound in the economy may be something to lose sleep over. Ph.D.s in physics, with little day-to-day investment time, running investment models on products so complex not 100 people in the country understand them, and with no history. Leverage everywhere. Not a time for you to take a Rip Van Winkle nap and assume when you awake, all of your assets will be protected. Just who are the investment banks and other players now? Perhaps, the insiders will now tell all.

But it is more than derivatives and the need for counterparties. Investment banks and others are in the thick of making new higher-yield products that finance and insurance companies thirst for in this super-competitive world. Why? Many insurance products today are like commodities. They are called spread products. Companies bid against themselves and the winner has to pay the highest rate of return to the customer. What the company profits is dependent on the amount it can earn over what it pays the so-called spread. Here, investment banks get them the juice, but at the price of little understood features (hidden risk?). Money market funds bulk up on securities lending and structured investment vehicles. Insurance companies make their bottom line with collateralized debt obligations (CDOs) and asset backed securities.

As you can guess, there is no free lunch. The price for yield is often things like liquidity and volatility. Liquidity is a double dip. The securities can be volatile and hard to sell. And second, if leverage is involved, not only can the investment go to zero, there may be margin requirements. Further, to the extent that slicing and dicing goes on, often the only ones who want to provide money for the garbage (equity) tranche for a CDO type investment are the hedge funds. Presto, the investment banks need the hedge funds as much as the hedge funds rely on the investment banks ... a witch's brew of a marriage.

Maybe the prophets of doom, who thought for the risks involved, the investment banks needed many times the capital they had, were not so far off. And all that has happened is the investment bank equity tanks have been refilled to one-quarter full.

Recently, with the Bear Stearns related credit crunch, a book written in 2006 has reappeared. I can't remember its name or the author. Likely, the book by Stephen Leeb.1 Resurrected in 2008 at 75 percent off, with a title that suggested that it predicted the oil crisis and the pickle that the Federal Reserve (Fed) has now with the housing and subprime crisis. The book stated oil would go to $100 a barrel by 2008 and maybe $200 a barrel by 2010 or so, and the housing bubble would cause the Fed to not be able to tighten money and correct the easy money, low-interest rates that helped cause the bubble. This, of course, would cause a crisis of confidence abroad on the dollar, given all the printing of money and inflation pressures. Where was Paul Volker when we needed him? Two cents shy of $6 for this gem of a book was a bargain. It just sat on the shelf, except for a few curiosity seekers like myself.

With the credit crunch, a new book with a catchy title magically appeared this April. About 200 pages, priced at about $22. Brilliantly written. Also seems to sit around. Written in Readers Digest style, but probably requires an MBA in finance to fully appreciate. The book is titled, "The Trillion Dollar Meltdown," by Charles R. Morris.2 Subtitled: "Easy Money, High Rollers and the Great Credit Crash." Written in the summer of 2007 and rushed to market.

What makes this book so interesting is not that Morris states the world is awash with dollars, that foreign countries that may not have our best interest in mind have many of those dollars, or that the Fed, in combating recession, now may recreate the stagflation of the 1970s. Nor the implied criticism Alan Greenspan may not have been all that brilliant in keeping consumer inflation in tow, if he allowed housing inflation, and the gross inflation of financial assets, and the proliferation of arcane derivatives (which might not create more liquidity if there are too many).

What makes this book unique are the pages that describe just how concentrated and below the surface our financial system really is. The book also highlights the relationships between the investment banking universe, the banking universe and the hedge fund industry–and how leveraged all of those organizations are.

Before discussing these relationships, it is necessary to understand how financial markets have changed. While overly simplified, the savings and loan crisis of the 1970s created a situation whereby regulators attempted to create a larger capital requirement for banks. This could have restrained growth except for the fact that banks and investment banks soon found out that they did not have to have capital if they could bifurcate their activities and become originators. They might have some temporary inventory, but then with securitization and trusts, the risks could be off the books. Of course, off the books did not always mean off the books, if, like Bear Stearns funds, there was some implicit guarantee to provide cover.

Insurance companies also found they could do the dance of getting capital requirements and reserves off the books. They could find thinly capitalized reinsurers, and if they were offshore, all the better. All they needed was a letter of credit. Unfortunately, these liabilities could return if the reinsurer failed at about the time the letter of credit did not renew.

Now let us turn to some interesting statistics from the Morris book (pages 134-135): In the midst of all of this, global financial assets have grown from about world gross domestic product to about 3.7 times as much. Now, either investors have bid up the value of these assets or there are more of them. One would think that this might imply some speculation, and when it ends, lower returns. Moreover, derivatives, much of it running through investment banks, are notionally bigger by a factor some say is three times the size of financial assets. Now, that size of derivatives implies that more is going on than just makes the financial market work more efficiently. Also, guess who the prime brokers for hedge funds are. If you guessed the investment banks, you get the prize. And the investment banks get 20-30 percent of their profits from the hedge funds (page 110).

More from the Morris book (page 125): The primary sellers of swaps such as credit default swaps are banks and hedge funds. Banks are on the hook to make good on $18.2 trillion of portfolios, while credit hedge funds have $14.5 trillion. Such positions are generally uncollateralized. Credit hedge funds are reputed to account for about one-third of hedge fund equity. They could not likely withstand even a tiny payoff due in major part to the leverage they employ to get such large exposure. Yet, for the most part, their financials do not show any reserves put aside.Now, credit default swaps, like everything else, can be both good and bad. If you have too much exposure to Ford bonds and want to lay off some risk, buying Ford credit default swaps (CDS) makes sense. However, if due to credit default swaps, synthetically there are 10 times as many imitation Ford bonds out there as real ones, strange things can happen, especially when some of the players are leveraged hedge funds that can create or be caught in a squeeze.

And finally from the Morris book (page 108-109): A large segment of hedge fund concentration is in CDOs and CDS. These hedge funds account for about 60 percent of all CDS trading and about one-third of all CDO trading. Much of the trading is in the riskiest of the CDOs. CDOs are also a favorite alternate investment for life insurance companies. This should make some portfolio managers a bit sleepless.So what do we see here? We see a small number of players who are not tightly regulated: mainly the investment banks, the global banks, and the hedge funds, all interdependent and not operating in a transparent market. Counterparties, margin calls, and difficult to understand instruments have, to a material extent, replaced the semi-transparent bond market we used to know. Derivatives do not complement the market. They are so large that they can cause major disruptions in the market.

And on a simpler level, can arcane products designed by somewhat inexperienced physics and math whizzes, who have little practical investment experience, be expected to behave well? Maybe not.

I recently took a walk to the bank. Our bank has a reading section. Sure enough, a cute headline about LIBOR–articles on this subject have appeared in several papers and Internet sites, including the Financial Times and Bloomberg. One of the articles was about a large, but not that large, trading volume of securities that are rated about AA–mainly the rate at which various British banks can borrow. It would not be of much interest except that many times the trading volume is tied up in mortgages tied to LIBOR, as well as other debts that the London banks may have. It seems that certain banks may have been under-reporting aspects of the rate or volume in order to keep the rate from rising more rapidly than it already was due to recent liquidity and credit crunch. So, we have an index that might be manipulated, and it is controlling the mortgage rates of millions of people. Even if not manipulated, what kinds of problems can occur if someone's borrowing rate is not tied to some broad, short-term rate, but rather to a rate for inter-bank borrowing? Are there unintended consequences to tying up rates on a large amount of assets to a smaller borrowing base? Food for thought.

The bank also had an old Wall Street Journal. Seems that everyone wants to create Exchange Traded Funds (ETFs). But what to do if there are not enough securities to go around? Voilà, the Exchange Traded Note (ETN). It seems an investment bank has come up with an exchange traded note that follows some market basket of agriculture futures that it may or may not own. No basket of goodies to back it up. ETNs have introduced counterparty risk to the masses. And if agriculture futures are easier to buy through such notes, does this artificially increase the price and the volatility of wheat? Interesting.

Lest you think it is only in the world of the sophisticated investor that change has occurred, you need look no further than the once frumpy money market fund. Long an alternative to low bank interest rates, the annual reports of these funds used to be boring. But now, strange things appear, as fund companies stretch for yield, such as master notes from investment banks, securities lending, and spiced-up variations of commercial paper. Not too dissimilar to the stuff in a few municipal bond funds a few years back that were difficult to sell and caused asset valuations to go down when withdrawals occurred. And with institutional investors as heavy users of some money market funds, withdrawals can happen quickly.

Finally, here's a story that may be apocryphal, but seems real: A hedge fund had a need for a loan from an investment bank to cover a margin call. The investment bank had some hard-to-value assets that seemed to have gone down in value since the last trade. The deal: The investment bank would make the $300 million loan to the hedge fund, if the hedge fund would buy $50 million of the asset labeled a "dog" at the last known market price. Result. No reason for the investment bank to worry when its auditors questioned whether it was marking this asset to market.

It is hard to come to conclusions, but we can say some things. We have a very complicated new world of financial instruments and derivatives. They are not valued in an open market, and the small number of very large players make money on hard-to-understand deals. Much of the extra revenue seen in investment banks thus does not come through the tried and true channels of bringing securities to market the old fashioned way. Trading desks get involved. And leverage can affect all of these players on the way down, since there are not tight capital requirements. Hedge funds, global banks and investments banks, saved for the moment, but strategies on cruise control and without a strong push for regulation. As long as there are not strong capital requirements for these players, a control on leverage, and a reining in of derivative volume, can we just expect more of the same?

As far as insurance companies go, is it a witch's brew to lower capital requirements by moving to other entities and off-shore? And is it smart to stretch too much for yield in the newly created investment (CDOs, etc.) where liquidity and market value are interrelated?And should the regulators be so fast in introducing market-to-market valuing of debt securities, following the Basel II initiative? Or, for that matter, long-term insurance liabilities? After all, don't we want an accounting system that prevents companies from going down, instead of adding to it? Said simply, do we need to mark everything to the last sale or market value for a security or product, when nothing is being bought or sold today? Do we need all those accounting fluctuations, or is some form of long-term economic value and smoothing the ups and downs more sensible than so-called fair value? Especially in illiquid markets where there is little dollar activity, and what there is may be at bargain basement values. Accounting valuation systems that make sense in normal, robust times may not work in markets frozen under stress.

Crises can occur at any point, with forks in the road if the Fed has to tighten money to control inflation or stabilize the dollar. Time to wind down? Time to worry? Time to read old issues of Mad magazine?

Allen Elstein, FSA, MAAA, is a life and health actuary at the Department of Insurance, State of Connecticut, Hartford. The views expressed in this article are solely those of the author and do not represent the express or implied opinion of the Connecticut Insurance Department. This article was written in June 2008, prior to the financial crisis occurring in the fall of 2008.