Further Reflections on Module 1 - Sub-Prime Shakeout

Financial innovation and the Global Liquidity Factory

Lets just raise the following: 1) When it is stated that derivative structures are “…virtual and not real” what does this suggest about the value of financial innovation, broadly defined as “…the act of creating and then popularizing new financial instruments as well as new financial technologies, institutions and markets” (Peter Tufano, Financial Innovation 2002 at http://www.people.hbs.edu/ptufano/fininnov_tufano_june2002.pdf).
2) Following up on the article (“Are we headed for an epic bear market?” at http://articles.moneycentral.msn.com/Investing/SuperModels/AreWeHeadedForAnEpicBearMarket.aspx?page=1) that states While you might think that the U.S. Federal Reserve can help prevent disaster by lowering interest rates dramatically, as they did Wednesday, the evidence is not at all clear. The problem, after all, is not the amount of money in the system but the fact that buyers are in the process of rejecting the entire new risk-transfer model and its associated leverage and counterparty risks.

Two questions on the claims about a global liquidity factory:

I. What does the class think of this article’s claims?
A) Completely right
B) Somewhat right
C) Too pessimistic
D) Don’t know and II.

Based on your answer to the above, how should you allocate your assets?

Articles

Peter Tufano link . Below is another link to his paper + another one on the subject.

http://www.people.hbs.edu/ptufano/fininnov_tufano_june2002.pdf

http://www.hbs.edu/research/pdf/07-082.pdf

http://www.nyabe.org/fergusonspeech.pdf

http://hbswk.hbs.edu/item/5745.html

Comments and Reflections

Interesting comments and articles, so knowing what I know now – where would I place my assets? I think Mark hit it pretty close. Precious metals (gold) are not really one place where I would put any money. This is based on history. Even though the price of gold is high right now, it really just getting back to the 1980 price after a decline for many years. But commodities are probably a great place. Now we all know that past performance does not predict future performance, but wheat has more than doubled, oil continues to increase – as well as corn and sugar. But I also know these markets are better left to the experts and I am not an expert on the commodity markets. So that being said, I would keep my liquid assets in short-term Treasuries and long-term investment in large to mid-cap value companies like GE, PEP, MMM, GLW, MSFT, and stocks like this have low betas, low to zero debt and lots of cash. Currencies would have been a good investment, but the chances that there would collaboration among global banks are probably pretty good. Also cooperation and collaboration among government, the Federal Reserve, regulatory agencies, and financial institutions will have to work together to sift through this mess and minimize the global damage. I still think the stock market is solid for the most part, but growth stocks are in potential trouble – due to the credit crunch. Problems will probably loom for 10 years. The S&P Case-Schiller Home Prices Indexes predict falling house prices in certain markets for the next five years and these devaluations are 15 to 20% - not 1 to 5%.

All of these financial innovations or derivatives started in 1986. Numerous new derivatives products were placed in the market. This is probably why many people did not understand them exactly. Derivative had been around a long time and people understood them. My guess is that they all assumed that the new derivatives were just improvements on the older ones – more efficient, etc. The financial engineers knew that the sum of the pieces were greater than the value of the whole in tact. This was proven by the corporate raiders, etc. These financial innovators just had to figure a way around the laws and regulations in order to create this value. Getting around taxes and regulations has been the single greatest motivator for these financial innovations. Turning short-term gains into long-term gains to avoid paying higher taxes or basically greed was involved to increase their profitability and cash flows. Greenspan’s dropping the federal fund rate lead to a large amount of liquidity injected into the market. These financial innovations just applied a multiplier to this existing liquidity, which allowed to easy money. Everyone seemed to forget that derivatives were created to transfer credit risk – diversify the risk – and not to create virtual money and earn high interest rates. Mortgage rates where at the lowest rate in like 30 years. Loan originators were all making in excess of $100,000/year and brokers were probably in excess of $500,000/year. All of these people work basically on commission – no loans no paycheck. If the employees were making this kind of cash (you may have 10 to 15 LOs in one office) how much do you think the financial institutions were making? Also we can all see the motivation was not to be ethical or to work on the fine line of legal and ethical boundaries in order to close the most loans. A high risk – low credit score – so what just charge them 50 to 100 bps more, the interest is still low. Also this greed lead to the ARMS, etc. mortgage product innovations, which further aggravated this entire sub prime issue. This all lead to an explosion in the M3 money supply.

M3 – includes all of the time deposits, money fund balances, Eurodollars, and repos. All basically due to the “financial innovations” of derivatives by the financial engineers. Then the Fed decided to stop tracking and monitoring the M3 money supply in March of 2006. This seems to have left the system unchecked by anyone. Why did the Fed decide to stop monitoring M3? If they stopped tracking it because they could not get their arms around it, then they just decided to stick their heads in the sand and hope for the best.

Financial institutions could use the advances in technology to improve process and system efficiencies or use technology for product innovations and marketing schemes. It is obvious that is was easier to create money through product innovations and clever marketing and packaging schemes than it was to change their operations. The short-term immediate gain without any regard to consequences was chosen instead of a more long-term approach of improving processes and systems to control and eliminate risks.