The black box economy
Behind the recent bad news lurks a much deeper concern: The world economy is now being driven by a vast, secretive web of investments that might be out of anyone's control.
By Stephen Mihm January 27, 2008
THE PAST YEAR has been a harrowing one for the world's financial markets, shaken by subprime crises, credit crunches, and other ills. Things have only gotten stranger in the past week, with stock prices swinging wildly in every major market - drastically down, then back up.
Last week the Federal Reserve announced the biggest cut in overnight lending rates in more than two decades. Congress, not to be outdone, is slapping together a massive deficit spending package aimed at giving the economy an emergency booster shot.
Despite the anxiety, nobody is stockpiling canned goods just yet. The prevailing assumption in today's economy is that recessions and bear markets come and go, and that things will work out in the end, much as they have since the Great Depression. That's because there's a collective confidence that the market is strong enough to correct itself, and that experts in charge of the financial system will understand how to mount a vigorous defense.
Should we be so confident this time? A handful of financial theorists and thinkers are now saying we shouldn't. The drumbeat of bad news over the past year, they say, is only a symptom of something new and unsettling - a deeper change in the financial system that may leave regulators, and even Congress, powerless when they try to wield their usual tools.
That something is the immense shadow economy of novel and poorly understood financial instruments created by hedge funds and investment banks over the past decade - a web of extraordinarily complex securities and wagers that has made the world's financial system so opaque and entangled that even many experts confess that they no longer understand how it works.
Unlike the building blocks of the conventional economy - factories and firms, widgets and workers, stocks and bonds - these new financial arrangements are difficult to value, much less analyze. The money caught up in this web is now many times larger than the world's gross domestic product, and much of it exists outside the purview of regulators.
Some of these new-generation investments have been in the news, such as the securities implicated in the mortgage crisis that is still shaking the housing market. Others, involving auto loans, credit card debt, and corporate debt, are lurking in the shadows.
The scale and complexity of these new investments means that they don't just defy traditional economic rules, they may change the rules. So much of the world's capital is now tied up in this shadow economy that the traditional tools for fixing an economic downturn - moves that have averted serious disasters in the recent past - may not work as expected.
In tell-all books, financial blogs, and small-circulation newsletters, a handful of insiders have begun to sound the alarm, warning that governments and top bankers may simply no longer understand the financial system well enough to do anything about it.
"Central banks have only two tools," says Satyajit Das, author of "Traders, Guns and Money: Knowns and Unknowns in the Dazzling World of Derivatives," who has emerged as a voice of concern. "They can cut interest rates or they can regulate banks. But these are very old-fashioned tools, and are completely inadequate to the problems now confronting them."
Since the last financial crisis that genuinely threatened the fabric of our society, the Great Depression, the United States has built a system of regulatory checks and balances that has, for the most part, worked. The system has worked because the new regulations enforced some semblance of transparency. Companies abide by an extensive set of rules and file information on their profits, losses, and assets.
Obviously, there are limits to transparency: Without withholding some information from public view, it would be hard for companies to take advantage of opportunities in the marketplace. But a modicum of transparency can go a long way, enabling both regulators and investors to make informed decisions. The advantages of the system are many; the costs of even a single case of nontransparency, as with Enron, can be high.
But when the mortgage crisis broke last summer, it opened a window on something else: The existence of a huge wilderness of investments in the financial sector that are nearly impossible to track or measure, and which operate out of the view of both investors and regulators. It emerged that investment banks, hedge funds, and other financial players had issued, bought, and sold hundreds of billions of dollars' worth of esoteric securities backed in part by other securities, which in turn were backed by payments on high-risk mortgages.
When borrowers began defaulting on their loans, two things happened. One, banks, pension funds, and other institutional investors began revealing that they owned huge quantities of these unusual new securities, called collateralized debt obligations, or CDOs. The banks began writing them off, causing the massive losses that have buffeted the country's best-known financial companies. And two, without a market for these securities, brokers stopped wanting to issue risky mortgages to new home buyers. Home values began their plunge.
In other words, a staggeringly complex financial instrument that most Americans had never heard of, and which many financial writers still don't fully understand, became in a matter of months the most important influence on home values in America. That's not how the economy is supposed to work - or at least that's not what they teach students in Economics 101.
The reason this had been happening totally out of sight is not difficult to understand. Banks of all stripes chafe against the restraints that federal and state regulators place on their ability to make money. By cleverly exploiting regulatory loopholes, investment banks created new types of high-risk investments that did not appear on their balance sheets. Safe from the prying eyes of regulators, they allowed banks to dodge the requirement that they keep a certain amount of money in reserve. These reserves are a crucial safety net, but also began to seem like a drag to financiers, money that was just sitting on the sidelines.
"A lot of financial innovation is designed to get around regulation," says Richard Sylla, professor of economics and financial history at NYU's Stern School of Business. "The goal is to make more money, and you can make more money if you don't have to keep capital to back up your investments."
The hiding places for these financial instruments are called conduits. They go by various names - the SIV, or structured investment vehicle, is one that's been in the news a great deal the past few months. These conduits and the various esoteric investments they harbor constitute what Bill Gross, manager of the world's largest bond mutual fund, called a "Frankensteinian levered body of shadow banks" in his January newsletter.
"Our modern shadow banking system," Gross writes, "craftily dodges the reserve requirements of traditional institutions and promotes a chain letter, pyramid scheme of leverage, based in many cases on no reserve cushion whatsoever."
The mortgage-driven securities that have been making headlines are but the tip of a much larger iceberg. Far larger categories of investment have sprung up, with just as much secrecy, and even less clarity into who holds them and how much they are truly worth.
Many of these began as conventional instruments of finance. For instance, derivatives - the broad category of investments whose value is somehow based on other assets, whether a stock, commodity, debt, or currency - have been traded for more than a century as a form of insurance, helping stabilize otherwise volatile markets.
But today, increasingly, a new generation of derivatives doesn't trade on markets at all. These so-called over-the-counter derivatives are highly customized agreements struck in private between two parties. No one else necessarily knows about such investments because they exist off the books, and don't show up in the reports or balance sheets of the parties who signed them.
As the derivatives business has grown more complex, it has also ballooned in scale. Broadly speaking, Das - author of a leading textbook on derivatives and complex securities - estimates that investors worldwide hold more than $500 trillion worth of derivatives. This number now dwarfs the global GDP, which tops out around $60 trillion.
Essentially unregulated and all but invisible, over-the-counter derivatives comprise a huge web of bets, touching every sector of the world economy, that entangles a massive amount of money. If they start to look shaky - or if investors need to start selling them to cover other losses - that value could vanish, with catastrophic results to the owner and unpredictable effects on financial markets.
Derivatives can ripple through the market and link players that might not otherwise be connected. With some types of new investments, that fusion takes place within the security itself.
For instance, some financial instruments are built of two or more different types of assets, linking together sectors of the economy that aren't supposed to move in tandem. In the name of transferring risk - and in the interest of creating an appealing new product to sell to aggressive investors seeking higher returns - a bank could create a CDO, for instance, that packaged subprime mortgages together with corporate bonds. An economist would expect those to move independently, but thanks to a large - and unseen - investment in such a linked package, problems with one could drive down the other. A bad apple can ruin an entire barrel of fruit.
Again, it's not as though anyone necessarily knows the composition of these structured securities. Nor do they know who has invested in them, thanks to the fact that they have not, until recently, counted as conventional assets subject to the normal rules of accounting. And because they don't trade on open markets, their values are essentially guesses, calculated by computer algorithms.
Das disparages much of this as the product of bankers creating "complexity for the sake of complexity," trying to wow their clients by inventing more sophisticated-seeming investments. "Financial innovation is a magical catch phrase," he explains. "It's very sophisticated and chi-chi."
"Investment bankers want to make them more complex, so that they won't be copied, and so that their clients won't understand them," he says. "When they ask whether they're paying the right amount, they won't know."
But when reality comes home to roost, things can get ugly pretty quickly: If an investor is forced to sell a CDO, the onetime price realized on the open market may bear no relationship to the theoretical value generated by a computer formula. That means that everyone holding CDOs can no longer sleep well at night: the same thing can happen to them.
T
hese risks are magnified, as they were during the stock bubble of the 1920s, by the fact that many of these assets are owned by investors who borrowed money to make the investments in the first place. When a market shock like the subprime crisis hits, it can send tremors through the system with incredible speed.
If the contagion spreads, the conventional wisdom holds that the Federal Reserve and other central banks around the world can step into the breach caused when consumers and investors start to lose their confidence. But what happens when all these complicated financial arrangements and instruments start to unravel? The market for one product alone - the credit default swap, or CDS - dwarfs this country's economy. The Fed has an uphill battle, made harder by the fact that it is grappling, to a large extent, with unseen forces.
In theory, additional regulation may help with this. The Financial Accounting Standards Board, which establishes corporate accounting procedures and guidelines, took a first step in that direction this past November, ordering investment banks and anyone else holding complicated securities to assign market values to so-called Level 3 assets - a fancy name for assets for which there is no prevailing market price. This meant assigning a market value to all those CDOs.
Banks promptly began writing down tens of billions of dollars of assets, and their investors are still trying to sort through the results. It's still too early to tell whether or not the effort will work, or whether the "market prices" that get reported are anything more than figments of in-house accountants' imaginations. For his part, Das is skeptical. "It will help that people will know the poison they're drinking," he says. "Whether it will help stabilize the system is another question."
It would be ideal if the financial markets became a bit less opaque and intelligible before that happens. That would be the job of regulators, but Das isn't sure that regulators have the intellectual horsepower to figure out what they need to do. "If you're bright and you can make $5 million a year on Wall Street," he asks, "why would you settle for making 50K as a regulator?"
And in any case, transparency isn't really what the denizens of Wall Street want, Das observes. "The regulators keep espousing things like clarity and transparency, but it's in the investment bankers' interest to keep things opaque." Das pauses for a moment.
"It's like a butcher. He doesn't want the buyer to know what goes into making the sausage." He chuckles, noting that it's the same with financiers. "That's what they're all about and always have been."
Behind the recent bad news lurks a much deeper concern: The world economy is now being driven by a vast, secretive web of investments that might be out of anyone's control.
By Stephen Mihm January 27, 2008
THE PAST YEAR has been a harrowing one for the world's financial markets, shaken by subprime crises, credit crunches, and other ills. Things have only gotten stranger in the past week, with stock prices swinging wildly in every major market - drastically down, then back up.
Last week the Federal Reserve announced the biggest cut in overnight lending rates in more than two decades. Congress, not to be outdone, is slapping together a massive deficit spending package aimed at giving the economy an emergency booster shot.
Despite the anxiety, nobody is stockpiling canned goods just yet. The prevailing assumption in today's economy is that recessions and bear markets come and go, and that things will work out in the end, much as they have since the Great Depression. That's because there's a collective confidence that the market is strong enough to correct itself, and that experts in charge of the financial system will understand how to mount a vigorous defense.
Should we be so confident this time? A handful of financial theorists and thinkers are now saying we shouldn't. The drumbeat of bad news over the past year, they say, is only a symptom of something new and unsettling - a deeper change in the financial system that may leave regulators, and even Congress, powerless when they try to wield their usual tools.
That something is the immense shadow economy of novel and poorly understood financial instruments created by hedge funds and investment banks over the past decade - a web of extraordinarily complex securities and wagers that has made the world's financial system so opaque and entangled that even many experts confess that they no longer understand how it works.
Unlike the building blocks of the conventional economy - factories and firms, widgets and workers, stocks and bonds - these new financial arrangements are difficult to value, much less analyze. The money caught up in this web is now many times larger than the world's gross domestic product, and much of it exists outside the purview of regulators.
Some of these new-generation investments have been in the news, such as the securities implicated in the mortgage crisis that is still shaking the housing market. Others, involving auto loans, credit card debt, and corporate debt, are lurking in the shadows.
The scale and complexity of these new investments means that they don't just defy traditional economic rules, they may change the rules. So much of the world's capital is now tied up in this shadow economy that the traditional tools for fixing an economic downturn - moves that have averted serious disasters in the recent past - may not work as expected.
In tell-all books, financial blogs, and small-circulation newsletters, a handful of insiders have begun to sound the alarm, warning that governments and top bankers may simply no longer understand the financial system well enough to do anything about it.
"Central banks have only two tools," says Satyajit Das, author of "Traders, Guns and Money: Knowns and Unknowns in the Dazzling World of Derivatives," who has emerged as a voice of concern. "They can cut interest rates or they can regulate banks. But these are very old-fashioned tools, and are completely inadequate to the problems now confronting them."
Since the last financial crisis that genuinely threatened the fabric of our society, the Great Depression, the United States has built a system of regulatory checks and balances that has, for the most part, worked. The system has worked because the new regulations enforced some semblance of transparency. Companies abide by an extensive set of rules and file information on their profits, losses, and assets.
Obviously, there are limits to transparency: Without withholding some information from public view, it would be hard for companies to take advantage of opportunities in the marketplace. But a modicum of transparency can go a long way, enabling both regulators and investors to make informed decisions. The advantages of the system are many; the costs of even a single case of nontransparency, as with Enron, can be high.
But when the mortgage crisis broke last summer, it opened a window on something else: The existence of a huge wilderness of investments in the financial sector that are nearly impossible to track or measure, and which operate out of the view of both investors and regulators. It emerged that investment banks, hedge funds, and other financial players had issued, bought, and sold hundreds of billions of dollars' worth of esoteric securities backed in part by other securities, which in turn were backed by payments on high-risk mortgages.
When borrowers began defaulting on their loans, two things happened. One, banks, pension funds, and other institutional investors began revealing that they owned huge quantities of these unusual new securities, called collateralized debt obligations, or CDOs. The banks began writing them off, causing the massive losses that have buffeted the country's best-known financial companies. And two, without a market for these securities, brokers stopped wanting to issue risky mortgages to new home buyers. Home values began their plunge.
In other words, a staggeringly complex financial instrument that most Americans had never heard of, and which many financial writers still don't fully understand, became in a matter of months the most important influence on home values in America. That's not how the economy is supposed to work - or at least that's not what they teach students in Economics 101.
The reason this had been happening totally out of sight is not difficult to understand. Banks of all stripes chafe against the restraints that federal and state regulators place on their ability to make money. By cleverly exploiting regulatory loopholes, investment banks created new types of high-risk investments that did not appear on their balance sheets. Safe from the prying eyes of regulators, they allowed banks to dodge the requirement that they keep a certain amount of money in reserve. These reserves are a crucial safety net, but also began to seem like a drag to financiers, money that was just sitting on the sidelines.
"A lot of financial innovation is designed to get around regulation," says Richard Sylla, professor of economics and financial history at NYU's Stern School of Business. "The goal is to make more money, and you can make more money if you don't have to keep capital to back up your investments."
The hiding places for these financial instruments are called conduits. They go by various names - the SIV, or structured investment vehicle, is one that's been in the news a great deal the past few months. These conduits and the various esoteric investments they harbor constitute what Bill Gross, manager of the world's largest bond mutual fund, called a "Frankensteinian levered body of shadow banks" in his January newsletter.
"Our modern shadow banking system," Gross writes, "craftily dodges the reserve requirements of traditional institutions and promotes a chain letter, pyramid scheme of leverage, based in many cases on no reserve cushion whatsoever."
The mortgage-driven securities that have been making headlines are but the tip of a much larger iceberg. Far larger categories of investment have sprung up, with just as much secrecy, and even less clarity into who holds them and how much they are truly worth.
Many of these began as conventional instruments of finance. For instance, derivatives - the broad category of investments whose value is somehow based on other assets, whether a stock, commodity, debt, or currency - have been traded for more than a century as a form of insurance, helping stabilize otherwise volatile markets.
But today, increasingly, a new generation of derivatives doesn't trade on markets at all. These so-called over-the-counter derivatives are highly customized agreements struck in private between two parties. No one else necessarily knows about such investments because they exist off the books, and don't show up in the reports or balance sheets of the parties who signed them.
As the derivatives business has grown more complex, it has also ballooned in scale. Broadly speaking, Das - author of a leading textbook on derivatives and complex securities - estimates that investors worldwide hold more than $500 trillion worth of derivatives. This number now dwarfs the global GDP, which tops out around $60 trillion.
Essentially unregulated and all but invisible, over-the-counter derivatives comprise a huge web of bets, touching every sector of the world economy, that entangles a massive amount of money. If they start to look shaky - or if investors need to start selling them to cover other losses - that value could vanish, with catastrophic results to the owner and unpredictable effects on financial markets.
Derivatives can ripple through the market and link players that might not otherwise be connected. With some types of new investments, that fusion takes place within the security itself.
For instance, some financial instruments are built of two or more different types of assets, linking together sectors of the economy that aren't supposed to move in tandem. In the name of transferring risk - and in the interest of creating an appealing new product to sell to aggressive investors seeking higher returns - a bank could create a CDO, for instance, that packaged subprime mortgages together with corporate bonds. An economist would expect those to move independently, but thanks to a large - and unseen - investment in such a linked package, problems with one could drive down the other. A bad apple can ruin an entire barrel of fruit.
Again, it's not as though anyone necessarily knows the composition of these structured securities. Nor do they know who has invested in them, thanks to the fact that they have not, until recently, counted as conventional assets subject to the normal rules of accounting. And because they don't trade on open markets, their values are essentially guesses, calculated by computer algorithms.
Das disparages much of this as the product of bankers creating "complexity for the sake of complexity," trying to wow their clients by inventing more sophisticated-seeming investments. "Financial innovation is a magical catch phrase," he explains. "It's very sophisticated and chi-chi."
"Investment bankers want to make them more complex, so that they won't be copied, and so that their clients won't understand them," he says. "When they ask whether they're paying the right amount, they won't know."
But when reality comes home to roost, things can get ugly pretty quickly: If an investor is forced to sell a CDO, the onetime price realized on the open market may bear no relationship to the theoretical value generated by a computer formula. That means that everyone holding CDOs can no longer sleep well at night: the same thing can happen to them.
T
hese risks are magnified, as they were during the stock bubble of the 1920s, by the fact that many of these assets are owned by investors who borrowed money to make the investments in the first place. When a market shock like the subprime crisis hits, it can send tremors through the system with incredible speed.
If the contagion spreads, the conventional wisdom holds that the Federal Reserve and other central banks around the world can step into the breach caused when consumers and investors start to lose their confidence. But what happens when all these complicated financial arrangements and instruments start to unravel? The market for one product alone - the credit default swap, or CDS - dwarfs this country's economy. The Fed has an uphill battle, made harder by the fact that it is grappling, to a large extent, with unseen forces.
In theory, additional regulation may help with this. The Financial Accounting Standards Board, which establishes corporate accounting procedures and guidelines, took a first step in that direction this past November, ordering investment banks and anyone else holding complicated securities to assign market values to so-called Level 3 assets - a fancy name for assets for which there is no prevailing market price. This meant assigning a market value to all those CDOs.
Banks promptly began writing down tens of billions of dollars of assets, and their investors are still trying to sort through the results. It's still too early to tell whether or not the effort will work, or whether the "market prices" that get reported are anything more than figments of in-house accountants' imaginations. For his part, Das is skeptical. "It will help that people will know the poison they're drinking," he says. "Whether it will help stabilize the system is another question."
It would be ideal if the financial markets became a bit less opaque and intelligible before that happens. That would be the job of regulators, but Das isn't sure that regulators have the intellectual horsepower to figure out what they need to do. "If you're bright and you can make $5 million a year on Wall Street," he asks, "why would you settle for making 50K as a regulator?"
And in any case, transparency isn't really what the denizens of Wall Street want, Das observes. "The regulators keep espousing things like clarity and transparency, but it's in the investment bankers' interest to keep things opaque." Das pauses for a moment.
"It's like a butcher. He doesn't want the buyer to know what goes into making the sausage." He chuckles, noting that it's the same with financiers. "That's what they're all about and always have been."
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