Financial Engineering – the Good and the Bad

            Right now we are in one of the worst times for financial institutions. A perfect storm has come about leading to a precarious situation for most banks and investment firms. While much has been said about the sub-prime market and the precipitous rise in interest rates, little is remembered of one of the first events that marked the beginning of the end—the Structured investment vehicles. The CDO and CLO markets also saw downturns at about this time.

 

            Structured investments were one of the biggest sources of debt financing. These items were modeled after the mortgage backed securities and were an extension of financial theory that had moved its way through the markets over time. Mortgages were one of the first extensions of an academic view that all investment opportunities could be analyzed as a risk vrs. Reward prospect. In this case for the debt issuers, the goal was to minimize risk with respects to a fixed reward. The long standing idea was that these debt obligations could be packaged together into a larger group of which pieces of that group could be sold. While I might not be able to give my neighbor 500,000 dollars loan for his house, I could own a piece of his mortgage and 30 other guys that fit his profile.

 

            Interestingly enough, many people didn’t mind being far removed from the actuality of their investment and liked the ability to easily understand the analytics of what they owned. At the same time, the glut of liquidity in the markets caused people to be less risk averse and offer more supply for some of the riskiest securities. The problem, however, came with the amount of abstraction done concerning the mortgages. While banks and sellers of mortgages had an obligation to pass through the important information concerning the mortgages, they increasingly had less incentive to insure that the little information they did give out was accurate.

 

            One thing that is interesting is how the debt markets here diverged strongly from the equity markets. While these two markets have different outlooks and security, the changes taking place between the two accentuate why the SIVs and debt markets would see a huge change. It would seem incredibly odd for banks to try this with equities. In this case, they would package together these “stock portfolios” that grouped together a certain set of companies with similar risk profiles. While this might sound like a mutual fund, it differs in one key aspect—similarity of risk. While a mutual fund will spread themselves amongst a set of stocks with different risk profiles, SIVs and debt markets would create smaller portfolios of similar profiles which meant that diversification was not really occurring. At the same time, the debt portfolios had less oversight into what they actually owned, while stock portfolios will pay close attention to the items within the portfolio.

 

            The important thing is where things will go into the future. The SIVs and debt markets are an important source of liquidity for businesses. While debt was too freely given before, it is now unrealistically hard to get. SIVs typically were using short term payments to cover more long term investments which was probably a poor choice in terms of liquidity since they would have to pay back money far in advance of making it back on the investments they would have to sell. While financial engineering has helped us to understand that all securities are similar in key respects such as risk and return, they have often blinded us to the reality that truly good investment comes from the intangibles. If we only analyzed companies as cash in/cash out vehicles with differing volatilities of earnings, it would be hard to determine which ones held true value. While debt is more secure than equity, it does not mean that diligence is not as important for the investor. Sometimes we underestimate a person or companies willingness to file bankruptcy.