Monday, May 24, 2010

HOW THE FIN SECTOR TURNED INTO A HEDGE FUND AND WHAT TO DO ABOUT IT

INTRODUCTION
The financial services industry in the Western world is still in big trouble. Maybe not so much a default crisis to the extent that we could even think about collective bankruptcy like 15 months ago, because the government bail out saved us... from that. However, governments paid a huge price for it. Ex-post we can of course argue that - with the system not collapsing - governments did the right thing. But serving bad firms is not a regular task of governments. And the 'too big to fail' argument was used way too easily by many firms in trouble.

The financial services industry was characterized by the following factors:
* Internationalization and Globalization
* Creation of more complex, structured products
* The bulk of client money stayed in relatively straightforward, low-fee, low-turnover products. Even when performance was bad, turnover remained (too?) low. The latter was often the mistake of clients themselves. They didn't listen carefully to consultants and/or didn't even hire one (penny-wise, pound-foolish cost saving behavior). And besides: banks were treated like accountants. They were fiduciary role models.

THE FINANCIAL SECTOR AS ONE BIG HEDGE FUND
There was a growing importance of levered overlay-style products ran by financial institutions as part of their ''own book'' of business. But these portfolios were not really on their own risk / own account. Without the underlying stable client-related business it would never ever be possible to run these risky strategies.

As a kind of natural side-effect of the interest in overlay strategies we also saw a growing interest in volatility-related products (e.g. VIX based).

There was also more talk about agency problems (i.e. conflicts between management on the one hand and shareholders and/or clients on the other) or in other words: doubts about the fiduciary quality of financial firms. Finally! And this was actually not illogical. Let us try to explain it.

With the stable, non-moving basic client business financial institutions have created a good cash flow base. Albeit that fees were under pressure. Reason: growing international competition between financial institutions on the one hand, and a better understanding on the client's side about what a 'good' performance would imply on the other. In other words: turnover and replacement of service providers were getting more common.

The overlay-style portfolios where the financial institutions make their real money made them like hedge funds. But unlike the situation some 10 years ago with Long-Term Capital Management (LTCM) they were hedge funds that used their regular client business as collateral. At first they were used as collateral so as to be able to introduce larger amounts of leverage. When interest rates in the world dropped and the global business climate turned more optimistic due to the successes in Emerging Markets, key decision takers in financial firms in Europe and the US increased the risk levels of their overlay strategies even further. At the same time the fee base related to regular client business was not really growing anymore.

Result: a growing need for more profitable overlay products and/or new forms of products.

Clients treated as dummies, and a business model that avoided the risks of the LTCM hedge fund debacle....did financial institutions create the ultimate money machine for themselves instead of for their clients?


VOLATILITY AND BLACK & SCHOLES: DID FINANCIAL FIRMS CREATE THE ULTIMATE BUSINESS MODEL?
The Black & Scholes Option Theory teaches us that volatility is one of the most important pricing components in option-like strategies. The overlay strategies could easily be structured in such a way that they resemble options to quite some extent, especially when structuring them in a way that involved a) using the client base as collateral (i.e. so as to be scalable enough) and b) that clients were even used as counter party. Even when they didn't know about it!

With respect to b): when creating a structure in which you bet against the client using a levered option in a situation where you also ensure that the position is to some extent hedged through another option-like product that would benefit when the opposite occurs, you will gain in a volatile climate. One way or another.

Regular folks like you and me would not be able to create such a win-only business model, because we can of course not bet against our own underlying portfolios and second, we could never get the scale right to make it really profitable.

In the case of financial services firms in the Western world they would - in case the bet against the clients and the client position is correct loose the option value but still have the 'satisfied' client business book on which they would receive fee money. On top of that there was also a reasonably nice profit on the counter-steering overlay portfolio component that followed the signal on the underlying client portfolio. In other words: two wins and one loss and a nice net effect.

Suppose that the financial services firm's traders were right, they would make huge money on the overlay portfolio (big profit on the main strategy leg and loss on the protective leg) and just a little bit of loss on the client portfolio. ''Clients wouldn't run away quickly....they trust us....and we could always get away with some silly story''.

No wonder financial services firms executives made fortunes without real entrepreneurial business risks.

BUT THINGS WENT WRONG ANYWAY - THE DEMISE OF A SCAM?
But things went wrong when the turnover in the system went up. Reason: the amount of savings and other money that ended up in financial products didn't grow that fast anymore. Western countries were paying a lot for energy from the Middle East, cheap labor products from China, software from India et cetera. And these 'newly rich' weren't part of the client base of Western financial services firms yet. At least not the same way as institutional investors and high net worth clients were. Let alone the big bulk of savers that were kinda stuck to their 'home bank', financial intermediary and insurance firm. Adding that to lower income due to low interest rates and problems in the pension community due to low interest rates and increases in life expectancy, the 'chicken with the golden eggs' business model ended up in trouble.


Result 1: the overlay strategy turned into an unprotected or at least less-protected one. And unprotected overlays with insufficient underlying funds are high risk. Reason: counter party risk became a reality now. The collateral could easily turn out to be insufficient and leverage was too high.

Result 2: The combination of panic in the West - which normally would lead to higher volatility (i.e. something good for the overlay producers - and different behavior of the Chinese and Middle Eastern sovereign wealth funds lead to volatility irregularities, i.e. patterns with quick increases and drops in volatility during relatively short time intervals that made pricing more complicated. It lead to increased risks of failure. In other words: whereas the idea was to create something that couldn't loose the end result was something that could easily end-up worthless and that was now such a big time bomb that the whole system could collapse because of it.

EVALUATION - OLD BUSINESS VALUES AND ETHICS SHOULD RETURN

Financial services firms were effectively transforming into hedge funds. New generations LTCM's that were supposed to score where LTCM failed. They used client money as a collateral, protective device. Great thinking when looking at it using option theory. But horrible when it comes to what business is all about: creating good products for YOUR CLIENTS. If financial institutions like the concept of hedge funds, they should become one. Not play it the way they did.

We believe that - after a quick study of the elements of Obama's plans for the industry - that it is a good thing to ensure that financial institutions will have to choose between a business model that a) is focused on client money or b) one that is based on trading for your own account. In the first one revenues will come from fees (probably a fixed component for work done and a variable one related to performance). In the second one profits should come from correct betting on market movements.

Too often we ended up in situations where clients thought their bank was trustworthy because of the aligned interest within business model type a). Whereas actually the real money for the bank came from b), even when b) was sometimes against clients' interest. In the new plans that should be avoided.

To some extent we could say that Western financial institutions could have learned a lesson or two from the experience of Islamic Finance based institutions. Sure, their revenue stream and profitability is less sensational, but in the long run the system is feasible and much less sensitive to failure and misalignment of interests. We are not saying that the restrictions on interest income that are an integral part of Islamic Finance are necessary for non-Muslims, but it would be silly to close our eyes and go back to business as usual.

And of course there were also some good financial institutions that gained market share because of their solid, good quality product offering. The growth of Blackrock is a good example. It was even capable of buying Barclays Global Investors (BGI) to become a 1000+ billion USD financial giants.

The Crisis was no coincidence. Governments and Supranational bodies are in charge right now. And they should use their power to solve this issue and split up business models of financial firms. That is far more important than discussions over bonuses. In the new structure only those that really did generate big profits will get a bonus. Not the ones that were shrewd enough to create structures with client money as underlying collateral for their own games. And that is what a healthy financial industry should be all about!

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