Robert Shiller: Capitalism and Financial Innovation

At the 2012 CFA Institute Financial Analysts Seminar, Yale professor Robert Shiller laid out his views on capitalism and financial innovation.

Professor Shiller channeled his inner Gary Gorton, another Yale Professor whose work on informationally insensitive debt and safe assets your humble blogger has previously debunked, and talked about the benefits of financial innovation, in particular securitization.

According to Professor Shiller,

The ideas I posit are basically an appreciation of financial innovation. Today, cynicism and skepticism regarding financial innovation abound.

Your humble blogger is neither a cynic or a skeptic.  I simply subscribe to Yves Smith's maxim:  nobody on Wall Street is compensated for creating low margin, transparent products.

Financial innovation is primarily about how to create opacity so that the bankers can extract excess rent from investors who are gambling on the value of the opaque innovation rather than investing in a transparent investment.

Even former Fed chairman Paul Volcker contributes to these views. A couple years ago, he famously said that he couldn’t think of any useful financial innovation within recent memory besides ATMs. 

What Volcker says gets a big audience, but I couldn’t disagree with him more.

Which puts the burden on Professor Shiller to show a financial innovation that is actually useful for something other than extracting excess rent from investors (we'll get to that when he talks about securitization).

Our civilization is built on financial innovation. Finance begets and supports almost all activities; it makes the world turn in a modern and civilized way. 

Innovation is necessary if finance is to remain relevant as a means of achieving society’s goals. Perhaps what I have to say will help the finance community defend itself better and encourage finance professionals to assume personal responsibility for their role in making markets more efficient....

This is quite a statement as most people would think that it is the real economy and its inventions that built our civilization.

Finance certainly has a role in supporting the real economy, but it is not at all clear that it is financial innovation that lead the real economy and its inventions and built our civilization.

Securitization was an innovation that blew up in the latest crisis because the process was fraught with errors. 

The most notable error in securitization was in real estate—the subprime loan securitization, which blew up because people didn’t appreciate the risk that home prices would fall. 

It is misleading to say that people didn't appreciate the risk that home prices would fall as a drop in home prices is not what caused the losses on these securities.

What caused the losses was that the borrowers were not making payments on their mortgages.

Since the value of these securities is based on the ongoing payments on the mortgages, so long as the borrowers are paying on their mortgages, the security is performing regardless of what is happening to the price of the house the mortgage is secured against.

Perhaps Professor Shiller never heard the expression "opaque, toxic sub-prime mortgage-backed securities".


What made these securities so dangerous to investors' wealth was that opacity hid their true toxicity.

Specifically, the lack of observable event based reporting on all activities like a payment or delinquency on the underlying collateral before the beginning of the next business day made it impossible for market participants to know what they were buying or know what they owned.

Your humble blogger has demonstrated this numerous times using a Brown Paper Bag to represent a security using current industry disclosure practices and a Clear Plastic Bag to represent a security using observable event based reporting.

As a concept, however, securitization will survive because it is a means through which a large number of people benefit.

I happen to agree with Professor Shiller that securitization will survive.  The question is whether it will survive in its current opaque form that allows bankers to extract excess rent from investors or in a transparent form where it supports society.

Securitization is an innovation designed to solve an asymmetric information problem.

Actually, as Wall Street uses securitization, it is an innovation designed to create an asymmetric information problem.

The asymmetry is that Wall Street has the information on the current performance of the underlying collateral (they see these securities as if they are Clear Plastic Bags) and the rest of the market place has out of date performance information (they see these securities as they truly are, Brown Paper Bags).

This information asymmetry effectively lets Wall Street trade on tomorrow's news today.

As the financial crisis showed, Wall Street is more than willing to take advantage of this information asymmetry at the expense of the investors.

In the case of the mortgage market, mortgages and thus mortgage-backed bonds require a lot of analysis that many investors are unable to do, so without securitization, those investors would forgo investing in this market.

By securitizing mortgages, tranches of similar credit quality are created, allowing a large swath of the general investing population to buy mortgage-backed bonds that they otherwise would not buy. 

Professor Shiller's observation about the need for analysis reminds me of Professor Gorton's theory on informationally insensitive debt.

Professor Gorton cited bank deposits as an example of informationally insensitive debt.  There is one small problem with this example.  Bank deposits are insured and depositors are very sensitive to this fact.  Confirmation of this can be seen in Greece and Spain where doubts have arisen about whether deposit insurance will be honored and depositors have pulled their money.

Regular readers know that our financial system is based on the FDR Framework under which the government is responsible for ensuring that all useful, relevant information is disclosed in an appropriate, timely manner and investors are given the incentive to use this information as they are responsible for all losses on their investments.

Investors know this.  As a result, if investors cannot assess the information on the mortgages themselves, rather than forgo making an investment they simply engage third party experts who can assess the information.

Individuals hire portfolio managers.  Portfolio managers, if they or their organization cannot do the analysis themselves, hire third party experts.

The simple point is that if there is transparency and all the useful, relevant information is disclosed in an appropriate, timely manner, it is used by investors so they can make a fully informed investment decision for any type of investment.

Unfortunately, current securitizations are opaque and there is no information for investors to analyze.  As a result, buying or selling these securities is nothing more than gambling on the contents of a Brown Paper Bag.

Thus, mortgage securitization creates a financial market that allows many people to buy homes that they otherwise might not be able to buy, and it also lowers mortgage rates. 

Isn't one of the problems we have is that people bought houses that they couldn't afford?

The theory of finance involves asymmetric information as one of the elements that financial professionals have to engineer and design around. 

Please re-read the highlighted text again as Professor Shiller has effectively praised Wall Street for creating high margin, opaque products where Wall Street has an asymmetric information advantage.

What is good for society is when financial products are designed to eliminate asymmetric information.

Like bankers everywhere else, Chinese bankers find way around regulations

Reuters reports that Chinese banks are providing local government bonds 'liquidity support' to get around a ban on guaranteeing these bonds.

This simply confirms that Chinese bankers are like bankers everywhere else.  They will create a financial innovation to get around any regulation that interferes with their ability to make money.

One of the reasons that your humble blogger has pushed for requiring banks to provide ultra transparency and disclose on an on-going basis their current asset, liability and off-balance sheet exposure details is it captures the exposure regardless of how the bankers package it.

Chinese banks are providing de facto guarantees to bonds issued by local government financing platforms, official media reported on Friday, raising new concerns about the risk of local government debt threatening the health of China's banking system. 

Direct guarantees of corporate bonds by commercial banks was once common practice, but was banned from 2008 in an effort to avoid excessive concentration of risk in the banking system. 

Recently, however, fundraising prospectuses for bond issuances by city investment companies frequently boast of so-called "liquidity support" from commercial banks, the official Shanghai Securities News reported. 

Such support is effectively a guarantee by a different name designed to circumvent the ban, the paper quoted industry sources as saying, enabling local governments to pay lower interest rates on the debt.... 

Concerns have risen since 2010, however, that such investments may fail to yield the cash flows necessary to service the debt, leading to a potential rise in bad loans that could threaten the health of the banking system.

US banks say they have little exposure to Europe, MF Global and its derivative bet indicate otherwise

Gretchen Morgenson had a very interesting column on how Europe's problems are likely to be problems for US banks.

The column discusses the simple fact that because of a lack of disclosure market participants do not know what any individual firm's exposure to derivatives is.  Without this information, it is impossible to assess the risk of any firm.

As a result, the markets are dependent on the financial regulators to properly analyze the risk of each firm's derivative exposure.  However, what MF Global suggests, is that the regulators are not up to the task.

WHO are you going to believe — me, or your own lying eyes? 

That old line from the Marx Brothers came to mind last week as MF Global, the brokerage firm run by Jon S. Corzine, was felled by over-the-top leverage and bad derivative bets on debt-weakened European countries. 

Suddenly, all of those claims that American financial institutions have little to no exposure to Europe rang hollow. 

You can understand why Wall Street wants to play down the threats from Europe....

If market participants actually knew their exposures, they would not be able to gamble with derivatives.

Market participants would exert market discipline by increasing the banks' cost of funds and decreasing their access to funds to dissuade banks from taking on excessive risk.

But MF Global provides two lessons. The first is that our financial institutions are not impervious to Euro-shocks. The second is that when those problems reach our shores, they usually ride in on a wave of derivatives. 

“The problems that we’ve had since the inception of the credit derivatives market have never been solved in any meaningful way,” said Janet Tavakoli, president of Tavakoli Structured Finance and an authority on these instruments. “How many times do we want to live through this?” 

MF Global’s debacle was a result of complex swaps deals it had struck with trading partners. 

While those partners owned the underlying assets — in this case, government debt — MF Global held the risk relating to both market price and default. 

These arrangements at MF Global underscore two big problems in the credit derivatives market: risks that can be hidden from view, and risks that are not backed by adequate postings of collateral....

Both of these problems are cured with detailed disclosure.

Detailed disclosure eliminates the ability to hide risks from view.

Market discipline, which results from being able to see the risks being taken, works to prevent financial firms from taking on more risk than they can absorb.

Consider an investment vehicle known as a credit-linked note. In these deals, investors buy a note issued by a special-purpose vehicle that contains a credit default swap referencing a debt issuer, like a government. That swap provides credit insurance to the party buying the protection, meaning that the holder of the note is responsible for losses in a so-called credit event, like a default. 

Credit-linked notes are very popular and have been issued extensively by European banks. Many are governed by I.S.D.A. contracts, which define the terms of a credit event and require a ruling by the association on whether such an event has occurred. 

But some deals have different definitions or contractual language overriding the I.S.D.A. agreement. 

“The people writing these contracts may say, ‘I would like to be paid if there is a voluntary restructuring of debt, or if Greece goes back to the drachma, or if Greece goes to war with Cyprus,’ ” Ms. Tavakoli said. “I can declare a credit event where I am entitled to get paid if any of those events happen.” 

Cash calls can also be generated by declines in the market price of the notes or increases in the cost of insuring the underlying sovereign debt issue, according to credit-linked note prospectuses. 

The other party has to agree to these terms up front. 

But, given the nature of these so-called bespoke deals, we don’t know the full extent of the insurance that investors have written on troubled nations or the circumstances under which the insurance must be paid. Neither do we know who may be facing severe collateral calls or demands for termination payments on the contracts. 

When those collateral calls start coming, market values assigned to the securities that have been provided as backup can decline significantly. And when a company’s credit rating is downgraded, as MF Global’s was in late October, cash demands from skittish trading partners become even greater. 

“At this late date we still don’t know the risks that are out there,” Ms. Tavakoli said. “This market is opaque, bespoke, and the regulators don’t know what they’re doing.” 

At least regulators didn’t deem MF Global too big to fail. That’s a plus. But given the billions at stake in these markets, more transparency is needed about market participants, their financial soundness and their ability to withstand liquidity crises like the one that wiped out MF Global.

ECB's ABS Data Warehouse and Citigroup's CDO related fraud settlement

For everyone who thought that the ECB and its economists would be deterred in their pursuit of the ABS data warehouse, a Bloomberg article confirms they are still pushing ahead.

Not only are they pushing ahead, but

The European Central Bank is considering lending more money against asset-backed securities where issuers provide additional information about the loans securing the bonds, said a person familiar with the matter.... 

The bank’s Eurosystem Risk Management Committee is discussing lowering the reduction on asset-backed bonds from the 16 percent levied now....

The proposed change is part of a broader ECB initiative to encourage banks to improve transparency in asset-backed bonds they sell to investors and boost confidence in a market blamed for worsening the credit crisis in 2007 ....

“The ECB loan-level data project will enhance transparency and standardization on the collateral, so that’s welcome,” said Paolo Binarelli, a fund manager at P&G SGR Alternative Investments SpA in Rome, which oversees 1 billion euros ($1.4 billion) of assets. “The key point is that the cost of disclosing that information mustn’t be too high”...

Hopefully the ECB and its economists have found solutions to the obstacles to the successful implementation of the ABS data warehouse that have been highlighted on this blog.

One of those obstacles, was the timing of the disclosure of the loan-level data for the loans that back the ABS securities.  Leading up to the crisis, this data was disclosed once-per-month after the end of the month.  As originally conceived by the ECB and the Market Group, its chosen agent to implement the ABS data warehouse, this was also the frequency with which the data warehouse would collect and disseminate information.

There is only one small problem with this frequency.  It is not frequent enough so that buyers, including most institutional investors in Europe, of ABS securities under Europe's Capital Requirement Directive 122a can know what they own.

This is not my opinion, but rather the opinion of Moody's and S&P.  Both of these rating agencies told the US Congress in the fall of 2007 that data released with this frequency was inadequate for making timely changes to ratings (a form of valuation).  If you cannot value a security, how can you claim you know what you own?

The SEC has also confirmed that once-per-month after the end of the month is not frequent enough.

The reason I focused on the frequency problem is a NY Times article that reported on Citigroup's settlement of a fraud complaint based on a CDO it sold.  According to the article,

As the housing market began its collapse, Wall Street firms and sophisticated investors searched for ways to profit. Some of them found an easy method: Stuff a portfolio with risky mortgage-related investments, sell it to unsuspecting customers and bet against it. 

Citigroup on Wednesday agreed to pay $285 million to settle a civil complaint by the Securities and Exchange Commission that it had defrauded investors who bought just such a deal. The transaction involved a $1 billion portfolio of mortgage-related investments, many of which were handpicked for the portfolio by Citigroup without telling investors of its role or that it had made bets that the investments would fall in value....

If investors could not value these mortgage-related securities before the crisis because they received information once-per-month after the end of the month, why should they be able to value these securities now with the proposed ABS data warehouse?

The answer is that without addressing the frequency problem, investors cannot do a better job of valuing these securities using the data in the ABS data warehouse.

Since I have written extensively on this problem, I assume that the ECB, its economists and the Market Group have adopted a new disclosure frequency.  Specifically, I assume that the ABS data warehouse will provide performance information on the underlying loans which is current as of the close of business yesterday.  This is the data investors need if they are going to know what they own.

If they have adopted this frequency, this is also very good news for your humble blogger as it suggests that the ABS data warehouse is going to license my patent on an ABS data warehouse which provides current performance information on the underlying loans.

Opaque structured finance products allow Wall Street to 'swizz' market participants according to George Osborne's private secretary

As defined in the Oxford Dictionary, a swizz is something that represents a mild swindle.

The Telegraph carried a must read article on a structured product being offered by Barclays to its retail clients.

Since before the financial crisis began on August 9, 2007, your humble blogger has been advocating for disclosure.  One area I have focused on is disclosure of all the useful, relevant information in an appropriate, timely manner so that market participants could value structured finance products.

The reason it is important that market participants can value a security is that it is only with the ability to value a security that the market participant knows if the price that Wall Street is offering for the security is too high, what it should be, or a bargain.

Without the ability to value a security, Wall Street is in a position to take advantage of market participants through their marketing (think brokers...).  This situation is what the UK's George Osborne's aide would call a "swizz" and wonders why financial regulators would allow it to occur.

Please note that the same thing occurs with structured finance products sold to sophisticated investors. Examples of this include CDOs, subprime mortgage backed securities and interest rate swaps (think Jefferson County Alabama).

In short, the idea of a swizz applies to every opaque product created by Wall Street.

The only way to end this swizz is for global policymakers and financial regulators to adopt and fully implement the FDR Framework.  Under this framework, no financial product can be sold where all the useful, relevant information is not available in an appropriate, timely manner so that market participants can independently assess the risk of and value the product.

Greg Hands, personal private secretary to George Osborne and a junior member of the Treasury, said he had been offered the structured bond from Barclays as he was a customer of their stockbroking division. He said the complicated nature of the product revealed that banks still had a long way to go to make their offers transparent and suitable for investors. 

High levels of household debt and investments in unsuitable and complicated products was seen as one of the reasons for the financial crisis. 

Mr Hands, who worked in derivatives for eight years before becoming an MP, said the bond was almost impossible to price. "I do sometimes wonder about some of our banks and others with the marketing of their financial products," he said at a fringe meeting at the Conservative Party conference last week. 

No need to wonder Mr. Hands.  Yves Smith would tell you that the reason this product is being marketed is because no one on Wall Street is highly compensated for developing low margin, transparent products.

"I am a client of Barclays stockbrokers and I am amazed at some of the stuff they are putting out to purely retail individual investors, not high net worth clients." 

At the event organised by the Social Market Foundation Mr Hands then referred to the recent offer he had received from Barclays: "This is an exclusive offer until the 28 September," he said the offer document explained, before continuing: "It is a very complicated product that is a bond linked to the level of the FTSE. 

I used to price some of these products and it was not possible to price this product. I'm not saying Barclays is exceptional in this, I believe other banks are likely to be similar. But there are a very complicated set of options embedded in this product which are called in the world of derivatives an American style set of binary options where basically your capital is at risk if at any point during the next five or six years the FTSE falls below a certain level. 

"You could end up losing a considerable part of your capital which I don't think is particularly explicit in this product." 

There is no reason to believe that high net worth or sophisticated investors would be able to do a better job of pricing this product than an individual with experience like Mr. Hands.  The same lack of transparency into the true risk of the product would also be a barrier to their investment advisors in evaluating the product.

Mr Hands said that only at the bottom was there a suggestion that "structured products are not for everyone" or investors should "seek independent advice". He said many retail investors did not have access to suitable advice. "This is basically what you would call on the street a swizz....

Last night, a spokesman for Barclays said: "Barclays Stockbrokers provides a service through which clients can trade a wide range of securities. We make available from time to time structured products which enable sophisticated investors to express a view on the market. The literature complies with FSA guidelines and makes it clear investors' capital is at risk."

The problem currently is and has been since well before the beginning of the financial crisis that disclosure is inadequate.

UK Chancellor looking to by-pass the banks to get credit to small businesses

According to a Telegraph article, George Osborne, the UK's Chancellor, has directed the UK's Treasury to look into how the government could directly lend money to small businesses and then package these loans so they could be sold in the capital markets.

The UK government would not need to do this if the securitization markets were functioning.  If they were, there would be private firms that would make the loans and sell them into the capital markets.

Regular readers know that the securitization market is not functioning because the buyers are on strike.  They went on strike at the beginning of the credit crisis and are not coming back until they have access to current performance information on the underlying assets.

The UK government could restart loans flowing to small business simply by requiring current performance disclosure on the underlying assets.

Of course, the UK government could also elect to retain the credit risk of the loans as an enticement to attract buyers.  But by doing so, it is no longer really "selling" the loans.  Instead, it is setting up the equivalent of Fannie Mae and Freddie Mac in the US - an agency where private investors do well and taxpayers are stuck with the losses.

George Osborne used his speech at the Conservative Party Conference to announce plans for "credit easing" - which is a form of quantitative easing for businesses. 

The Chancellor said: "I have set the Treasury to work on ways to inject money directly into parts of the economy that need it such as small business. It is known as credit easing. It is another form of monetary activism," he said. "It is similar to the national loan guarantee scheme we talked about in opposition." ...

However the Government could deploy public to buy corporate bonds either directly through the Treasury or via the Bank of England's asset purchase facility. This facility was set up in 2009 during the apex of the financial crisis but has hardly been used since. 

The Treasury wants to create packages of small business loans that could then be traded. 

In this way the Government support would not add to the national debt for accounting purposes because they would be a tradable asset. 

The plans also include setting up a Small Business Bank that could handle the new policy. At the Liberal Democrat Conference two weeks ago, Vince Cable used his speech to back plans for a new state-backed bank as a way of tackling the failure of banks to lend to small firms.... 

The chancellor also repeated that he would give the Bank of England the green light to engage in further quantitative easing if it decided to go for more asset purchases. 

John walker, National Chairman, Federation of Small Businesses, said: We also welcome steps to help inject money into small firms, but need to see more detail so look forward to working with the Government on this."

Disclosure and the hunt for yield

A Telegraph article reported on the Bank of England's Paul Fisher's speech in which he discussed the implications for financial market stability from investors hunting for yield in a low rate environment.

As predicted under the FDR Framework, investors are crowding into those assets where they have access to all the useful, relevant information in an appropriate, timely manner.  Included in these assets are debt with government guarantees and high grade corporate bonds.

Mr. Fisher is concerned that as spreads on these assets tighten to pre-credit crisis levels, investors will turn to securities they do not understand to pick up additional yield and this will in turn create financial instability in the future.

This is ironic.

At least in the US, it is an explicit goal of zero interest rate policies to force investors into riskier assets.  The Fed has gone so far as to reduce the supply of risk-free assets by purchasing treasury securities.  By doing so, they have artificially depressed the yield across the entire treasury yield curve.

This mis-pricing of the risk-free rate carries over to all other debt securities.  As the spreads over treasuries on these other debt securities return to their pre-credit crisis level, this is an indicator that these debt securities are over-priced.

Why?

Because the mis-pricing of the risk-free securities is now embedded in the pricing of the other debt securities.  For example, say that under the Fed's policy the risk-free securities are trading for 0.25% less than they would without Fed intervention.  This same 0.25% is now embedded in the pricing of the other debt securities when their spreads return to pre-credit crisis levels (otherwise the spreads would be 0.25% higher than pre-credit crisis levels).

It appears that Mr. Fisher is making an artificial distinction by focusing only on those debt securities for which investors do not understand what they are betting on when the largest categories of debt securities are mis-priced too.

"Investors know – and must remember – that there is no such thing as a free lunch, and that additional return involves additional risk," said Mr Fisher, the Bank's executive director of markets and a member of its interim Financial Policy Committee. 

Intelligence gathered by the Bank has flagged up a "number of pockets of increasing risk appetite and a few specific markets which have been showing signs of excess," he said, with the trend most marked in the US. 

Investors are on the hunt for higher yields, or returns, against the backdrop of the massive emergency injection of liquidity into the financial system by the world's central banks. They [central banks] bought up government bonds in vast quantities, which pushed down the yields from these "safe" assets and encouraged investors to look elsewhere. 

The worry is that the lower yields on these traditionally low-risk assets is now coinciding with an apparent shortage of high-quality assets, therefore prompting investors to move into products where the risks are not so understood, Mr Fisher said in a speech to institutional investors released yesterday. 

Mr. Fisher's statement suggests that the stated intent of Fed policy poses risks to financial stability.  Having identified the risks, the question becomes what is the appropriate response by policy makers.  The choices include:

• The Fed stops pursuing zero interest rate policies and the purchase of risk-free debt securities.  This will increase the supply to the market and ease the pressure to move into products where the risks are not understood.

• Governments actually making sure that market participants have access to all the useful, relevant information in an appropriate, timely manner.

• Reminding investors that the last time they purchased debt securities they did not understand, think sub-prime mortgage backed CDOs, they lost a bundle.

Mr. Fisher opts for reminding investors.

... "The combination of portfolio rebalancing and this reported shortage of specific high-quality assets might have wider implications for financial stability if it encourages investors to look for additional yield by moving into more illiquid products ... or into more complex products (which they might not fully understand)," Mr Fisher said. 

He highlighted exchange traded funds (ETFs), which are traded like shares. Their rapid growth has been characterised by "increasing complexity, opacity and interconnectedness, and ... if left unchecked, could grow to pose risks to the stability of the financial system", he said. 

It is not surprising that ETFs are becoming increasingly complex and opaque.  Wall Street is engineering them this way because they know that the regulators are not requiring that all the useful, relevant information be disclosed in an appropriate, timely manner.

However, the most immediate threat to markets was seen as problems around governments' debt and the potential impact on European banks.