Sunday, November 29, 2009

Kling and Schultz on Financial Intermediation

I read an interesting book this weekend by Nick Schultz and Arnold Kling: From Poverty to Prosperity. It's a nice exposition of how life has changed over the past 100 years (mainly for the good), interviews with top economists, and provides food for thought on many issues.

In the last section of the book, however, I found their general description of finance to have a misleading emphasis. There was an exposition where assets have risk characteristics that are obscured as they are passed up a food chain, until finally there is greater liquidity, but less information available. Risk is transferred, but because of the lack of transparency, it actually increases.

Clearly, there is transferral of risk in finance, but I think this is not the essence of finance. Finance is intermediation, taking money from savers and giving to people who want to use that money. They, in turn, promise to pay it back. The process generates prices that act as signals to inform those borrowers and savers how best to borrow or save.

Yet, fundamentally, much finance can be considered one of five forms: marketmaking, clearing, originating, servicing, and warehousing. These specializations make for different focus by various firms, so that things important to one set of financial institutions are often irrelevant for another, and 'risk' means different things to different parties, because the risk they retain have different characteristics.

Investment banks, NYSE members, and venture capitalists, often make markets for those wishing to buy or sell. If they merely help connect two parties, like, they are brokers. If they have an inventory, like Nevada's Bunny Ranch, they are dealers. This activity is primarily about pricing. Risks are mainly about not having a correct hedge.

Clearing transactions such as checks or sales of stocks, is a valuable service, because one needs to know funds actually get from one party to another. For example, it an escrow account, both parties are sure to get their interests prior to losing control of what they are exchanging. Risks are operational, due to fraud or incorrect documentation.

Lenders originate loans or investments via their connections or brand name. This gives money to those who want to buy houses, set up a company, or finance their receivables. It involves marketing, designing products with attractive features, and doing the initial credit evaluation of the borrower and collateral check (underwriting).Risks here involve making 'innovations' to the product that are material, while assuming they are not. As it takes several months for a bad loan to reveal itself, this is why banking is very different than market making, one should have seen several lending cycles to appreciate the importance of various traditions.

Lenders also service these loans, monitoring the ongoing health of the borrower, the collateral, whether he is paying interest, etc. Risk here is operational, in that one must be able to monitor payments, and actually repossess the collateral.

These investments are then finally warehoused as 'assets'. Presumably, idiosyncratic risks are no longer relevant, and so one is left with various exposures to systematic risks: credit cards, housing, banking in general, etc. The ultimate risks due to broad covariance with 'the market', of course, do not disappear, which is the basis of portfolio theory, that only these risks are 'priced' in the sense that one expects a premium for their discomfort. Alas, that theory fails empirically, in that no one has been able to find a general covariance that explains the relative returns of assets (see my book, Finding Alpha).

These 5 attributes of finance are complements, and so many firms have overlapping functions. Yet, some specialize, and so investment companies often are merely in the process of warehousing, buying equities or debt and bundling them into portfolios. As the ultimate owners, these warehousers hold most of the value of the investment, yet, some of the value must be apportioned to each, necessary part of the financial process, and so servicers, clearing firms, market makers, and originators receive some of the money, often a fixed transaction cost. It is wise to keep originators honest, and servicers diligent, by having them retain some of the residual risk of any investment.

This does not contradict the idea of financial intermediation as risk transfer, yet it highlights the fact that the basic risks that are kept away from the warehousing are generally those that are presumed to disappear. A good originator, or servicer, monitors and manages his task so that an investor can assume his asset has a certain expected return and variance and covariance.

In the housing crisis, the complexity of the CDOs and derivatives was incidental to the assumption that housing prices across the country, would suffer only negligible year-over-year declines. Everyone made this mistake: greedy bankers, clueless academics, regulators, even Robert Shiller in 2005 could only muster up the observation that the increase in housing prices was probably not going to continue, and further, some cities might experience declines. Add to that the power of diversification, and complexity grows. Unfortunately, when the AAA-rated Mortgage backed securities defaulted, the question arose as to what was the essence of the 'mistake': housing? AAA ratings? Rating agencies? Securitization? Bankers? The Fed? All AAA rated debt became suspect, and raising this rate across the board made many projects unsustainable.

So, I don't think it was 'too much opacity' that was the essence of our recent problem. Rather, it was a bad assumption, one that very few people mentioned prior to 2007 (see Stan Liebowitz). That was not a risk hidden via the other participants in the intermediation process, rather, the many people who witnessed the degradation in lending standards for homebuying thought they were doing something morally right and empirically innocuous, not worth highlighting.


Plamen said...

Kling's response to your comment. I personally get a feeling he does not buy your arguments, but enjoys the overall positive review - not that there's anything wrong with that [chuckle].

Anonymous said...

"These 5 attributes of finance are compliments ..." Complements, presumably?