Monday, March 5, 2012

Must Read: A Smart Takedown of Economist's Cheerleading on Financial Innovation

Recently the Economist had a terrible report on the benefits of financial innovation. I read only part of it, but the jejune, spirited prose suggested an earnest college student who has discovered all he thinks he needs to know about the free market and economics via a couple of high-level courses.

I was pleased afterwards to read this smart, extremely thorough takedown by frequent guest poster at Naked Capitalism, Satyajit Das. It's a great piece (though has Das's singular failing -- he can't write a shopping list in less than 500 words ;)). Everyone should read Das on financial "innovation" to learn how the Economist comes up woefully, naively short in its analysis.

A few highlights I plucked out are below.

First, Das has a terrific section on risk transference (my bold):
Securitisation for the last 15-20 years entailed shifting assets from banks to structure[s] which reduced the amount of capital required, arbitraging regulatory capital requirements.

If a bank already held a loan funded with deposits, then in aggregate by selling the loan to the same depositors does not increase the supply of credit. The increase in credit is a function of the several things: (1) shifting risk into the shadow banking system; (2) alchemy (tranching) to create highly rated securities (AAA or AA) which acts as collateral to allow further re-leveraging; and (3) the ability to re-hypothecate the collateral over and over again, such as in re-securitisation.

The process increased leverage (crudely the capital against risk in reduced), model risk, liquidity risk, complexity and linkages via counterparty risk. It also moves risk from somewhere where it is highly visible to where it is less visible. In cutting and dicing risk, it encourages mis-pricing.
Das also includes quotes from Fabrice Tourre of Goldman Sachs, whose candid e-mails captured the arrogance and reckless complexity of the industry:
“More and more leverage in the system. The whole building is about to collapse anytime now?.?.?.? Only potential survivor, the fabulous Fab[rice Tourre] standing in the middle of all these complex, highly leveraged, exotic trades he created without necessarily understanding all of the implications of those monstrosities!!!”

“Anyway, not feeling too guilty about this, the real purpose of my job is to make capital markets more efficient and ultimately provide the U.S. consumer with more efficient ways to leverage and finance himself, so there is a humble, noble, and ethical reason for my job :) amazing how good I am in convincing myself!!!"
Finally, Das concludes with this withering paragraph:
Information on the issues is all in the public domain. There are a plethora of reports, such as Financial Crisis Inquiry Commission Report, the Turner Report etc, which explore financial innovation and the financial crisis. There is also, I understand, a relatively new innovative Internet-based tool – the “search engine” – with could have been used by The Economist to check and research such facts.