and Greenspan
have gotten all the press, but my nomination for book of the year in the finance/economics
space (with the important proviso that I haven’t got very far into it yet) is
of the Fortune Tellers" by Riccardo Rebonato. Like Paul
Kedrosky, I’ll come back to this later, once I’ve finished it. But it seems
to me that Rebonato’s book is a constructive and very important way of changing
the way that we look at risk in the financial world.
While Paul and I are still working our way through this book, Arnold Kling
has already finished it, and Rebonato seems to have sparked some extremely interesting
ideas about the relationship
between liquidity and transparency. I’m not at all sure that these are Rebonato’s
ideas, but they’re fascinating all the same: Kling’s big thesis is basically
that the two generally work against each other.
Kling explains:
Financial intermediation is about enticing investors to buy securities backed
by investments whose risks the investors cannot fully evaluate. The intermediary,
such as a bank, hedge fund, or ordinary corporation, specializes in evaluating
risk. The investor who buys securities from the intermediary looks to the
past performance of the intermediary as well as to concise summaries of the
risk of those securities. The ratings of "AA" or "A+"
by bond rating agencies are just one example of these concise risk summaries.
Modern financial intermediation is multi-layered. The mortgage broker knows
the specific characteristics of the house being purchased, as well as the
borrower’s financial data and credit history. Mortgage funders funnel funds
through brokers, using only summary statistics such as the borrower’s credit
score, the ratio of the loan amount to the appraised value (LTV), and the
broker’s historical performance with the funding agency. Funders then pool
loans together. Firms that buy the pools know only the general characteristics
of the pool — the rangeof credit scores, the range of LTV’s, and so on. These
pools may befurther carved up into "tranches," so that if loans
start to default, some investors will take an immediate loss while others
continue to receive full principal and interest.
At each step in the layering process, some of the detailed information about
the underlying risk is ignored. Instead, investors rely on summary information.
It is this use of summary information that makes these investments liquid
— that is, it enables them to be bought and sold by many investors. As an
intermediary layer is added, while the amount of detailed risk information
is going down, liquidity is going up.
I think this is true, and something that Wall Street is loathe to admit. Much
of finance is predicated on the idea that investors, in aggregate, are in possession
of all the relevant information they need to make investment decisions –
and that therefore since that information is alread "priced in", there’s
often little point in reinventing the wheel and going out and getting all that
information ourselves.
But by the time that structured products go through two or three iterations
of tranching and reconfiguring, there’s really no one who has a clue what the
underlying risk is or how to measure it. Investors in such products are buying
the reputation and history of the entity which structured the product as much
as they’re buying any particular risk. They also tend to place a lot of faith
in statistical models which might not bear as much relation to reality as they
think.
When I raised
questions about the use of Value-at-Risk as a risk management tool, a commenter
replied with the utmost faith in Wall Street:
I presume that [Morgan Stanley], like other investment banks, has other,
more sophisticated, risk controls, but are reluctant to release detail to
the public, because it is part of their IP.
Me, I presume no such thing. Morgan Stanley may or may not have other risk
controls; those controls may or may not be more "sophisticated" than
VaR; and that sophistication may or may not make those controls more useful
as a risk management tool. But my gut feeling is that you don’t have sophisticated
risk managers running around Morgan Stanley telling people to take less risk:
rather you have John Mack, at the top of Morgan Stanley, giving strict instructions
to his bankers to take on more risk, and firing them if they don’t.
There is no shortage of mathematical prowess at all levels of Morgan Stanley,
I’m sure. But a lot of that is devoted to looking at securities pricing, as
opposed to real-world sources of potential systemic disruption like the chance
that house prices will fall by 10%. And so securities get built on top of other
securities, which are built on models rather than reality. And liquidity goes
up, and everybody makes lots of money, and no one, really, has the slightest
clue what they’re buying.