Financial Markets 101 and the Current Financial Crisis
I've been asked to define some financial terms and comment on the current financial crisis and coming recession.
-Financial institution (is it any bank or stock broker?)
-Investment bank ( I never understood why Goldman Sachs was considered a kind of bank)
-Systemic risk
-Counter party risk
-Mortgage backed securities vs. mortgages (does a mortgage become a security when it's bunched up with a lot of other mortgages so a person can invest in the whole bunch?)
-Hedgefund
-Relationship between hedge funds, short selling and credit default swaps.
Financial Institution - any company that deals in finance - money, credit, stocks, insurance. It could be a bank, stockbroker, insurance company, hedge fund, credit card company, mutual fund company, etc. Even half of GE is a financial company.
Investment bank. In 1934, the U.S. government passed a law dividing banks into commercial banks and investment banks. That law has since been repealed so there is a lot of overlap now. Big commercial banks usually have investment bank subsidiaries. Some of the big hedge funds are evolving into investment banks.
So, what is an investment bank? Unlike a commercial bank or savings bank, an investment could not take in private deposits (think checking accounts). Until the revolution in banking that began in the 1970s, investment banks mostly did underwriting (floated new stock and bonds of big companies), arranged financing for mergers and acquisitions, dealt in government bonds, sometimes investing their own money. But with the explosion of new kinds of financial instruments and markets, especially derivatives, investment banks greatly expanded their business, both as brokers (bringing buyer and seller together for a fee) and dealers (taking a position with their own or borrowed money). They also entered into complicated relationships with hedge funds and private equity funds.
Goldman Sachs was always an investment bank. Like a lot of old-line investment banks, they also had ties with banks in Europe. So advising foreign banks on U.S. investments and handling their investments was a part of their business.
Systemic risk. The big change in financial markets in the last 35 years (beginning in 1973) has been the pricing of risk, starting with the Black-Scholes equation that priced options. New financial instruments (products) were invented to let individuals and companies either hedge against risk (similar to buying an insurance policy) or speculate (take on risk hoping to make a big profit). There is nothing new about this - it's just the huge size and sophistication of the markets that's new. Now, any one company can hedge against risk or lots of types of risk (changes in the value of foreign currencies, changes in interest rates, changes in the price of raw materials, even changes in the weather). But there is a big question of whether or not this reduces the overall risk in the global economy. No one knows. This overall risk is called systemic risk, or the risk in the entire financial system.
My personal feeling is that systemic risk is much higher because of the complexity and interconnections of financial markets. Which gets us to counterparties.
Counterparty. Generally, it just means someone on the other side of a financial contract. So, if you have a mortgage, you and your bank are counterparties. But the term usually has a more limited meaning to describe the two parties to a private contract involving some type of derivative. The main risk is that the counterparty won't be able to pay up if it owes you money in the future. So you really have to trust the other party, which is why most counterparty contracts were between the biggest and most secure financial institutions. Until recently, when companies like hedge funds became major players in these markets. So, counterparty risk mostly means the risk of the other guy not being able to pay up during or at the end of the contract.
Mortgage-back securities vs. mortgages. Generally, yes. Banks generate mortgages. They then sell some of them to companies like investment banks or Fannie Mae. Then the income from the mortgages (the monthly mortgage payments) of a bunch of them are sold as a bundle to other investors. How? But creating (selling) a mortgage-backed security. Think of a mortage-backed security as nothing more than a bond backed by the cash flow of the bunch of mortgages. That's the easy part. Then the mortgage-backed securities can be sliced and diced into lots of pieces, sometimes called collateralized mortgage obligations (CMOs) or "tranches". There were typically six tranches. The lowest one, the one with the highest risk, was so risky the issuers of the CMOs (often investment banks) kept it. These were the parts of mortgage-backed securities that were called "toxic waste." Investors could pick which combination of risk and return they want.
That's the easy part. The "toxic waste" tranches were then bundled and sliced up again. Incredibly, the "best" of these "toxic waste" securities were often rate AAA. True alchemy - buffalo chips had been turned into gold.
But wait! There's more! The buyer of a CMO or some other security might enter into a contract to hedge some of the risk. The counterparty might enter into a second contract on the other side to offset its position in the first contract. Some other institution that bought a mortgage-backed security or a CMO might decide to arbitrage the difference between changes in interest rates on mortgages and interest rates on some other debt instrument, typically U.S. Treasuries. And on and on it goes.
Since most of this activity is done in private, unregulated markets with no reporting of positions, no one really knows the whole picture. Most of this is done with borrowed money - leverage. Systemic risk again. We are now seeing what happens when everyone tries to "deleverage," a large part of which is no longer knowing which counterparty to trust, unwinding positions and paying back loans. Result - markets freeze up, no one wants to lend or take a position, assets like mortgage-backed securities can't be sold and so no one knows what their market price is. Uncertainty and lack of liquidity (inability to sell an asset) are the worst things that can happen to financial markets. This is what's happening right now and why the only lender or investor left in many countries is governments. Very ironic.
Hedge fund. Basically, any unregulated investment company that can do whatever it wants. There are about 7,000 or so in the U.S. They pursue many different strategies. They control about $2 trillion (less this month) and are often highly leveraged, meaning they borrow a large multiple of their capital. So most of them pursue high-risk strategies that make them a lot of money (high return) most of the time. But in a downturn, they lose lots of money and many go out of business.
I'm going to fudge a little on your last question because it covers a lot ground.
Short selling. This means a bet that something, usually a stock price, is going to go down in price. If it happens, the short seller makes money. One way to do this is to use put options. Anyone can do this, not just hedge funds.
Credit default swaps. These are like insurance policies. This started out as a rather conservative way to insure against a counterparty or some other financial institution going bankrupt. For example, say you owned bonds issued by Lehman Brothers and started to get worried about Lehman's solvency. You might buy, for a fee, a credit default swap. If Lehman goes bankrupt, some of their bonds might only be worth 9% of their face value. The seller of the credit default swap then has to pay you some or all of the difference, depending on how the swap was written. This actually happened this week. What's funny about this example is that Lehman Brothers was a major writer of credit default swaps.
But, as usual, some smart guys saw these as a way to speculate. Leaving aside the details (rather messy), more and more credit default swaps became a bet on the probability a company would go bankrupt.
AIG was a big seller of credit default swaps. It looked like a safe way to earn the equivalent of insurance premiums. Until this fall. It's like what happens to an insurance company when a large hurricane like Katrina hits. The probability is low but when it happens, the losses are huge. In this case, so big it brought down the company.
Recommended reading. Taleb, Fooled by Randomness. A rather philosophical musing about the role of risk in finance and life. Written by a former derivatives trader.
FINANCIAL CRISIS
I always thought, and said so many times in class over the years, the Alan Greenspan and the Fed were mostly smoke and mirrors. For twenty years, everything broke right for the economy. The Fed did more harm than good but basically nothing much until after 9/11. Then, to set negative real interest rates for three years as a massive subsidy to the banks, see the housing bubble coming as early as 2004 (I found an old article), and do nothing about it because of "ideology" is moral cowardice or stupidity (take your choice). Also, the whole question of deregulating parts of the financial market is mostly a non-issue. Huge parts are private and/or unregulated anyway (hedge funds, private-equity firms, investment banks) and even the regulated part has figured out how to get around the rules (SIVs, something right out of Enron). AIG was one of the most highly regulated firms in finance. Also, I don't think anyone thought through the systemic risk of the proliferation and rapid growth of layers of derivatives financed by debt.
Most investment advice doesn't work in a big market downturn. Especially "diversify." Everything goes down. Past patterns that are the basis of arbitrage break down (hello LTCM). And the risks are far higher than the models indicate, as Taleb argues.
There is also a long-run problem. The Dow and S&P are back to where they were in 1996. So if you had put money into your 401K every month for the last 13 years, you would have had a negative rate of return. My back of the envelop guess is that the total real return on stock index funds in this period -after inflation and fees - has been about a negative 50-60%. No wonder investors put their money into houses.
There's some really scary stuff out there already. If the auto industry and their suppliers go bankrupt, they could dump their entire pension expenses on the U.S. government. Could be higher than $20 billion a year. The huge California pension fund (Calpers) has been very aggressive in the past and earned above average rates of return, So far this year they're down $40 billion and that's without taking a markdown on their big investments with hedge funds and private equity funds. (What the hell are pension funds doing investing billions in hedge funds?) I would guess that most public pension funds are now underfunded, certainly true in New Jersey.
So we go into this recession with a $1 trillion budget deficit, a $600 billion trade deficit, one million foreclosures, five million mortgages underwater, and a financial system that can't even price debt instruments. At some point, foreign savings will stop financing all of this. Already, around the world, a lot of capital is "coming home," causing problems in Eastern Europe and other emerging economies' financial markets.
I hope I'm wrong but I think this recession is going to be really nasty.
-Financial institution (is it any bank or stock broker?)
-Investment bank ( I never understood why Goldman Sachs was considered a kind of bank)
-Systemic risk
-Counter party risk
-Mortgage backed securities vs. mortgages (does a mortgage become a security when it's bunched up with a lot of other mortgages so a person can invest in the whole bunch?)
-Hedgefund
-Relationship between hedge funds, short selling and credit default swaps.
Financial Institution - any company that deals in finance - money, credit, stocks, insurance. It could be a bank, stockbroker, insurance company, hedge fund, credit card company, mutual fund company, etc. Even half of GE is a financial company.
Investment bank. In 1934, the U.S. government passed a law dividing banks into commercial banks and investment banks. That law has since been repealed so there is a lot of overlap now. Big commercial banks usually have investment bank subsidiaries. Some of the big hedge funds are evolving into investment banks.
So, what is an investment bank? Unlike a commercial bank or savings bank, an investment could not take in private deposits (think checking accounts). Until the revolution in banking that began in the 1970s, investment banks mostly did underwriting (floated new stock and bonds of big companies), arranged financing for mergers and acquisitions, dealt in government bonds, sometimes investing their own money. But with the explosion of new kinds of financial instruments and markets, especially derivatives, investment banks greatly expanded their business, both as brokers (bringing buyer and seller together for a fee) and dealers (taking a position with their own or borrowed money). They also entered into complicated relationships with hedge funds and private equity funds.
Goldman Sachs was always an investment bank. Like a lot of old-line investment banks, they also had ties with banks in Europe. So advising foreign banks on U.S. investments and handling their investments was a part of their business.
Systemic risk. The big change in financial markets in the last 35 years (beginning in 1973) has been the pricing of risk, starting with the Black-Scholes equation that priced options. New financial instruments (products) were invented to let individuals and companies either hedge against risk (similar to buying an insurance policy) or speculate (take on risk hoping to make a big profit). There is nothing new about this - it's just the huge size and sophistication of the markets that's new. Now, any one company can hedge against risk or lots of types of risk (changes in the value of foreign currencies, changes in interest rates, changes in the price of raw materials, even changes in the weather). But there is a big question of whether or not this reduces the overall risk in the global economy. No one knows. This overall risk is called systemic risk, or the risk in the entire financial system.
My personal feeling is that systemic risk is much higher because of the complexity and interconnections of financial markets. Which gets us to counterparties.
Counterparty. Generally, it just means someone on the other side of a financial contract. So, if you have a mortgage, you and your bank are counterparties. But the term usually has a more limited meaning to describe the two parties to a private contract involving some type of derivative. The main risk is that the counterparty won't be able to pay up if it owes you money in the future. So you really have to trust the other party, which is why most counterparty contracts were between the biggest and most secure financial institutions. Until recently, when companies like hedge funds became major players in these markets. So, counterparty risk mostly means the risk of the other guy not being able to pay up during or at the end of the contract.
Mortgage-back securities vs. mortgages. Generally, yes. Banks generate mortgages. They then sell some of them to companies like investment banks or Fannie Mae. Then the income from the mortgages (the monthly mortgage payments) of a bunch of them are sold as a bundle to other investors. How? But creating (selling) a mortgage-backed security. Think of a mortage-backed security as nothing more than a bond backed by the cash flow of the bunch of mortgages. That's the easy part. Then the mortgage-backed securities can be sliced and diced into lots of pieces, sometimes called collateralized mortgage obligations (CMOs) or "tranches". There were typically six tranches. The lowest one, the one with the highest risk, was so risky the issuers of the CMOs (often investment banks) kept it. These were the parts of mortgage-backed securities that were called "toxic waste." Investors could pick which combination of risk and return they want.
That's the easy part. The "toxic waste" tranches were then bundled and sliced up again. Incredibly, the "best" of these "toxic waste" securities were often rate AAA. True alchemy - buffalo chips had been turned into gold.
But wait! There's more! The buyer of a CMO or some other security might enter into a contract to hedge some of the risk. The counterparty might enter into a second contract on the other side to offset its position in the first contract. Some other institution that bought a mortgage-backed security or a CMO might decide to arbitrage the difference between changes in interest rates on mortgages and interest rates on some other debt instrument, typically U.S. Treasuries. And on and on it goes.
Since most of this activity is done in private, unregulated markets with no reporting of positions, no one really knows the whole picture. Most of this is done with borrowed money - leverage. Systemic risk again. We are now seeing what happens when everyone tries to "deleverage," a large part of which is no longer knowing which counterparty to trust, unwinding positions and paying back loans. Result - markets freeze up, no one wants to lend or take a position, assets like mortgage-backed securities can't be sold and so no one knows what their market price is. Uncertainty and lack of liquidity (inability to sell an asset) are the worst things that can happen to financial markets. This is what's happening right now and why the only lender or investor left in many countries is governments. Very ironic.
Hedge fund. Basically, any unregulated investment company that can do whatever it wants. There are about 7,000 or so in the U.S. They pursue many different strategies. They control about $2 trillion (less this month) and are often highly leveraged, meaning they borrow a large multiple of their capital. So most of them pursue high-risk strategies that make them a lot of money (high return) most of the time. But in a downturn, they lose lots of money and many go out of business.
I'm going to fudge a little on your last question because it covers a lot ground.
Short selling. This means a bet that something, usually a stock price, is going to go down in price. If it happens, the short seller makes money. One way to do this is to use put options. Anyone can do this, not just hedge funds.
Credit default swaps. These are like insurance policies. This started out as a rather conservative way to insure against a counterparty or some other financial institution going bankrupt. For example, say you owned bonds issued by Lehman Brothers and started to get worried about Lehman's solvency. You might buy, for a fee, a credit default swap. If Lehman goes bankrupt, some of their bonds might only be worth 9% of their face value. The seller of the credit default swap then has to pay you some or all of the difference, depending on how the swap was written. This actually happened this week. What's funny about this example is that Lehman Brothers was a major writer of credit default swaps.
But, as usual, some smart guys saw these as a way to speculate. Leaving aside the details (rather messy), more and more credit default swaps became a bet on the probability a company would go bankrupt.
AIG was a big seller of credit default swaps. It looked like a safe way to earn the equivalent of insurance premiums. Until this fall. It's like what happens to an insurance company when a large hurricane like Katrina hits. The probability is low but when it happens, the losses are huge. In this case, so big it brought down the company.
Recommended reading. Taleb, Fooled by Randomness. A rather philosophical musing about the role of risk in finance and life. Written by a former derivatives trader.
FINANCIAL CRISIS
I always thought, and said so many times in class over the years, the Alan Greenspan and the Fed were mostly smoke and mirrors. For twenty years, everything broke right for the economy. The Fed did more harm than good but basically nothing much until after 9/11. Then, to set negative real interest rates for three years as a massive subsidy to the banks, see the housing bubble coming as early as 2004 (I found an old article), and do nothing about it because of "ideology" is moral cowardice or stupidity (take your choice). Also, the whole question of deregulating parts of the financial market is mostly a non-issue. Huge parts are private and/or unregulated anyway (hedge funds, private-equity firms, investment banks) and even the regulated part has figured out how to get around the rules (SIVs, something right out of Enron). AIG was one of the most highly regulated firms in finance. Also, I don't think anyone thought through the systemic risk of the proliferation and rapid growth of layers of derivatives financed by debt.
Most investment advice doesn't work in a big market downturn. Especially "diversify." Everything goes down. Past patterns that are the basis of arbitrage break down (hello LTCM). And the risks are far higher than the models indicate, as Taleb argues.
There is also a long-run problem. The Dow and S&P are back to where they were in 1996. So if you had put money into your 401K every month for the last 13 years, you would have had a negative rate of return. My back of the envelop guess is that the total real return on stock index funds in this period -after inflation and fees - has been about a negative 50-60%. No wonder investors put their money into houses.
There's some really scary stuff out there already. If the auto industry and their suppliers go bankrupt, they could dump their entire pension expenses on the U.S. government. Could be higher than $20 billion a year. The huge California pension fund (Calpers) has been very aggressive in the past and earned above average rates of return, So far this year they're down $40 billion and that's without taking a markdown on their big investments with hedge funds and private equity funds. (What the hell are pension funds doing investing billions in hedge funds?) I would guess that most public pension funds are now underfunded, certainly true in New Jersey.
So we go into this recession with a $1 trillion budget deficit, a $600 billion trade deficit, one million foreclosures, five million mortgages underwater, and a financial system that can't even price debt instruments. At some point, foreign savings will stop financing all of this. Already, around the world, a lot of capital is "coming home," causing problems in Eastern Europe and other emerging economies' financial markets.
I hope I'm wrong but I think this recession is going to be really nasty.
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