Financial Innovation as Extra Risk
Pfäffikon SZ, Switzerland – The financial world and the economy as a whole are, in my view, difficult to fully comprehend. It is for this reason that we focus on strategy that at its core, is easy to understand. After all, the financial factors with which we have to deal with today have become distorted to the extent that we’ve never seen in modern history. It is an indicator that the times we live in are – to say the least – unique. The more the reason to operate cautiously.
Benign
Over thirty years ago financial innovation made its way onto the stage; by the way, I’d rather refer to the practice as “financial engineering”. The process of financial engineering is, in the first place, a benign process. Acute students, through various balancing acts, attempt to create a product whereby both the issuer – usually a bank – as well as the consumer, both reap benefits. This sounds relatively benign. The most illustrious example are the astute students at Goldman Sachs that introduced the subprime securitization. Subprime securitization represents the issuance of obligations with collateral. The next stage in this development led to the selling of baskets of mortgages, also known as MBS (mortgage backed securities) loans. Yours truly was involved with the launch of one of the first listed Dutch MBS loans from the then “Nationale Investeringsbank” (now NIBC), through securities broker Strating Effecten N.V. in Amsterdam.
Misuse
In the eighties of the last century we had to deal with the debacle in junk bonds and at the end of the nineties we were in a tech bubble. Now that the most recent financial crisis has affected pretty much everyone, the questions becomes: Do we benefit from all this financial hocus pocus? It has become clear that many market participants have no clue what they are buying or selling. What started as a benign process, has been gruesomely misused. This has, in effect, introduced several layers around the financial industry, which renders it impossible for a layman to understand what he or she is doing. Moreover, the last several years various additional financial instruments have been added to the financial palette, which make a true assessment of the risks, extremely complex. In this manner, portfolios quickly turn into a hornet’s nest.
Several fund managers are, more than happily, using the current situation to their advantage. A well intentioned civil servant from a municipality or a half-witted manager of a housing corporation are easy targets. By now, meaningful revelations have seen the light of day, but my careful assessment is that this is merely the tip of the iceberg.
Smugness
Financial innovation has played into the hand of smugness. By cleverly rearranging the risks, the issuer is able to keep his hands clean while directing one’s attention towards the infamous small print in the contract. Among professional parties the term “duty of care” is cleverly rendered inert. It becomes a hard lesson for the opposing party, as well as a tough nut to crack for the regulator. Invest in what you understand and what you support; that’s hard enough. Financial innovation can be useful when you thoroughly understand what you’re doing.
It remains for me to wish you a good weekend.
Jan Dwarshuis is a senior asset manager at Thirteen Asset Management AG, where he is responsible for the Thirteen Diversified Fund. Dwarshuis writes his columns in a personal capacity and is not paid for them. Nor is he paying for his columns to be placed. Professionally, he holds positions in major European, American and Russian stock funds. The information in his columns is not intended as professional investment advice or a recommendation to make certain investments. At the time of writing, he has no position in the above shares and has no intention of doing so in the next 72 hours.
