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Friday, May 6, 2011
A new economic era??
I've been thinking a lot about structured products recently mostly because of things Chris has said and written about. If you think about money as a way to create credit and further investment, then the need to link credit expansion to existing investments in a meaningful way seems relatively clear. The beauty of mortgage-backed securities and commercial debt obligations is that they are ways to aggregate small individual real investments in one area of the world economy into financial products that can then be used as a platform for credit expansion throughout the world. It seems to me that we have created the tool and now we need to figure out how to use it (ie., what kinds of rules and laws need to govern the creation, sale, and disposal of such instruments under different kinds of economic conditions). We have created a globalized real economy and now we have to create structures that support that global economy.
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I think increased transparency is the number one thing that will begin to build the frame work for such regulation.
ReplyDeleteAs we spoke about in class MBS's and their cousin CDO's lack a level of transparency in both the underlying assets attached to the derivative and an understanding of the product by the investor. These products are quite esoteric and as we eventually saw this contributed to their collapse.
I think first and foremost these derivative products need to have some form of regulation attached which will increase transparency. By increasing transparency we allow for more efficient pricing of these assets and this will hopefully prevent investors from waking up one day to find their AAA rated investment has defaulted.
I think we have seen a growth in the demand for derivative securities in recent years because, when used properly, these types of investment vehicles provide many great benefits to their owners. But what does it mean to use these properly? I agree with you Dr. McKinney that we need to figure out how to use them, but it might just be that these vehicles and other financially engineered products should be reserved for the "investment elite". As Jennifer (or someone) mentioned in class, if individuals don't understand EXACTLY what they are investing in and what the worst-case scenario is, then there should be no reason for banks and advisers to recommend these products for their customers' portfolios.
ReplyDeleteWikipedia gives some excellent pros/cons do these types of investment products:
Benefits of structured products may include:
* principal protection (depending on the type of structured product)
* tax-efficient access to fully taxable investments
* enhanced returns within an investment (depending on the type of structured product)
* reduced volatility (or risk) within an investment (depending on the type of structured product)
Disadvantages of structured products may include:
* credit risk - structured products are unsecured debt from investment banks
* lack of liquidity - structured products rarely trade after issuance and anyone looking to sell a structured product before maturity should expect to sell it at a significant discount
* no daily pricing - structured products are priced on a matrix, not net-asset-value. Matrix pricing is essentially a best-guess approach
* highly complex - the complexity of the return calculations means few truly understand how the structured product will perform relative to simply owning the underlying asset
Well put Jared, I also believe demand for such investment vehicles is growing like has been becuase if used correctly they can be very beneficial and thus very attractive to financial elites. As we talked about in class, their structures are very complex in nature and I don't think that should change. I absolutely think investment vehicles like these can thrive in the globalized real economy that we have created today, but that doesn't mean that everyone has to understand exactly how they work; nor does everyone have to use them. As Jared mentioned, investment innovations like these should be used by the 'investment elites'... We live in a world with unbelievable amounts of information and there simply is no way to understand everything, and I think this is a prime example of that..but the ones who do should have every right to benefit from them.
ReplyDeleteI really am liking this discussion. I think the OP was poetical and explained things in a way that resonated with me.
ReplyDeleteI agree that there is a wealth of potential in types of investments like derivatives but I think standards need to be set in place. I think there should be a body that sets out rules for what can be created, how and sold to what type of investor. I think that standards are the only way to getting more transparency.
Hmm, I may be way off of the reservation here, but I really do not think that derivative regulation is necessary. I don't think that consumers need to understand these products. I would say that fewer that half of the people who invest in mutual funds actually know what they are investing in. That's the beauty of the financial industry (ignoring the possible credit default goldman conspiracy), the banks want to make sure these investments are accurately assessed.
ReplyDeleteThe major problem here was the housing bubble. Sure, there is no doubt that the increased demand through derivation helped to inflate the bubble. So did the huge increase of wealth in China, India, Brazil and other countries. And, so did the interest rate policy by Greenspan. But, the underlying problem, needing regulation, is the mortgage standards.
Had the standards for mortgages not been so ridiculously low, none of this would have unfolded. What we need more than anything is mortgage regulation. Derivatives are an awesome tool! They allow investors, without the necessary capital leverage, to invest in assets that they otherwise would not be able to. The complexity is of little concern to me.
Check out this video I just found after looking for an article to better explain my point...
http://www.youtube.com/watch?v=HkD2JO0ZgRM&feature=related
When securitization of mortgages began, it was too hard to provide visibility into the underlying assets. Today, information technology has made it easy and inexpensive to make it possible. Investors and traders can and should be able to discover exactly what’s behind the MBS certificate. Moreover, fixing existing the securities to “retrofit” transparency would not be terribly difficult or all that expensive. While mortgage originators are back to exercising diligence in documenting the loans they make, I don't think that this is a perfect substitute for being able to assess the current state and creditworthiness of each and every mortgage that is behind each and every certificate. I feel like this must be a requirement going forward. A lack of transparency in “toxic” securities is one of the most important issue facing the financial markets today and into the future. I think that with some transparency it can be addressed relatively easily and quickly.
ReplyDelete