The consequences of being “addicted to complexity”

John Gapper in the FT has an interesting piece on how financial institutions got “addicted to complexity” over the last years in their pursuit of profits, and how regulators explicitly rejected regulation of the credit default swaps that are a large element of the current financial crisis:

AIG…had been writing credit default swaps (CDS), which are a form of derivative allowing one financial institution to pass the risk of a bond defaulting on to another. It sold them to banks wanting to protect themselves against defaults on collateralised debt obligations (CDOs), built from sub-prime mortgages. When these CDS plunged in value because the market stopped trusting what they were worth, AIG came close to bankruptcy and was bailed out by the US Treasury.

With hindsight, this bizarre degree of complexity in financial markets was bound to lead to trouble, and some people had warned that it would. But the dicing up of cashflows and risk has been a growing part of markets since Fischer Black, Myron Scholes and Robert Merton, three US academics, devised a way to value options in 1973. Over the ensuing three decades, banks and insurance companies got addicted to complexity.

One reason for this is that it skews the odds in favour of those who hold the technology. Trading in markets is essentially a zero sum game, in which you have an equal chance of winning or losing. But banks have been able to shift the odds by using computer models that others lack, to trade in volatility, for example.

A second is that structured finance –- the practice of using the cashflows from stocks and bonds to create other securities -– has been a huge money-spinner. Every institution involved in creating and selling structured bonds, from banks to ratings agencies to insurance companies, gained a big fee every time such a bond was issued.

A third is that complexity produced yield. In an era of low interest rates, pension funds and insurance companies found it hard to earn much money from cash. So any instrument that appeared safe but paid a higher interest rate than Treasury bonds, which mortgage-backed securities did, found ready buyers. Of course, again with hindsight, the problem was that these securities paid a higher yield than other triple A rated paper precisely because they were complex. Investors got paid more to hold them because they were so difficult to understand.

Last, and most perilously, structured finance gave banks and others more chances to take on “tail risk”. This is an insurance-like trading strategy: one institution writes swaps or options that provide it with regular payments in exchange for taking another’s risk of default. In most cases, this produces profits, but occasionally it is disastrous

The biggest regulatory gap involves over-the-counter (OTC) derivatives, the contracts traded among banks and insurance companies that lie at the heart of the financial crisis. These are not regulated at all in the US since they were excluded by the federal government from Commodities Futures Trading Commission oversight eight years ago.

Alan Greenspan, the former chairman of the Federal Reserve, was a strong advocate of freeing OTC derivatives from regulation. He told Congress that “the professional counterparties that use OTC derivatives do not require the protections [needed by] retail investors” in futures. He missed the point. OTC derivatives dealers should have been sophisticated enough to judge the risks in trading with each other, but in practice they were not.

So CDS’s were swell and needed no regulation in 2000, but now they are said by the SEC to be “ripe for fraud and manipulation.” Uh oh.

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