Is complexity outpacing the ability to manage risk?
Email has become a curse for bankers. Last week, Citi, Merrill Lynch and UBS agreed to pay nine-digit fines each to the US authorities, and agreed to buy back about $40 billion of “auction rate securities” sold to individual investors on dubious promises. (Auction rate securities are supposedly liquid long-term bonds with interest rate re-set every 7, 14 or 35 days in auctions.) It may be recalled that email evidence was also helpful in nabbing US bankers who had mis-sold highly over-priced equities in the dotcom boom in the late 1990s.
The Financial Times (August 2) quotes an email sent by a Merrill executive in November last year: “(The auction rate securities) market is collapsing. No more $2k dinners at CRU!” In February this year, Merrill was still selling the same securities describing them as “a good, conservative, reasonable, investment” to individual investors. As the market had collapsed, investors who had put money assuming the investments to be short-term and liquid were stuck with the securities — hence the buyback enforced on the three banks mentioned above.
Bankers are by no means the only culprits: Rating companies are not far behind. To quote an email from a rating company analyst: “Let’s hope we are all wealthy and retired by the time this house of cards falters”. The mail is of December 2006: For quite some time thereafter investments linked to sub-prime mortgages continued to be assigned AAA ratings. A report by the US Securities and Exchange Commission, from which the quote is taken, accuses rating companies of flouting conflict of interest norms and fudging ratings. Another analyst quoted in the SEC report wrote in April 2007 that “It could be structured by cows and we would rate it”; that she had measured only half the risk before she was forced to provide a rating! The fees were too juicy?
It may be mentioned that institutional investors are not covered by the buybacks referred to at the beginning of the article — and there are any number of unsophisticated institutional investors sitting on losses on investments they thought were as safe as a treasury bill. Local authorities, school boards in Florida and Australia and many others were sold securities by blue chip banks, only to see them default in a matter of months after purchase. As can be expected in a litigious society like the United States, lawyers are having a field day as banks face a “tsunami” of suits involving billions of dollars and accusing banks of providing false and misleading information to investors. In too many cases, the unsophisticated end-user finds himself without a chair when the music stops.
One other interesting feature to come out of these “mature” financial markets and “sophisticated” accounting systems is that accountants are singing off on different values of the same security for different clients! In a way, this is not very surprising. In the absence of an active and liquid market, accounting rules allow investors to mark the investments to (mathematical) models. In the case of complex, structured products there is no single mathematical model universally accepted for valuing them. One imagines that, if auditors did not find anything grossly illogical in the model being used by the investor in a consistent fashion, they would accept the valuation — and hence perhaps the variations. (There is of course yet another variation of MTM — mark-to-myth a stratagem used extensively by corporations, like Enron, to hide losses.)
The problem, of course, is the ever greater complexity of derivative products: The objective of structuring them is not to meet any genuine hedging need or investor demand as to hide pricing margin and risks. As markets in vanilla products become more efficient, dealer profitability, and bonuses, suffer and hence the attractions of promoting complex, structured products. As James Tobin, the Nobel Laureate, said back in 1984: “I confess to an uneasy...suspicion, perhaps unbecoming in an academic, that we are throwing more and more of our resources, including the cream of our youth, into financial activities remote from the production of goods and services.....I suspect that the immense power of the computer is being harnessed to this ‘ paper economy’, not to do the same transactions more economically but to balloon the quantity and variety of financial exchanges” for the benefit of the structures. The problem, of course, is that knowledge asymmetry means risk often finally lands on the shoulders of those least able to appreciate, let alone price, it. But not always, as banks have discovered while writing off $500 billion in subprime mortgage-based securities. Is complexity outpacing the ability of even the most sophisticated players to measure, manage and price risk? As Satyajit Das argued in his “Traders, Guns and Money”: “Too large a proportion of recent mathematical economics are concoctions, as imprecise as the initial assumption they rest on, which allow the author to lose sight of the complexities and interdependencies of the real world in a maze of pretentious and unhelpful symbols.”