Monday, November 17th, 2008
too many arrows

The era of structured finance brought forth a common way of mapping out the contractual relationships at its heart:

The arrows are used to illustrate the flows of money and promises, to make it easier for all to conceptualize the structure of the deal.  Unfortunately, too often these days we find such diagrams within published analyses of “what went wrong,” and are there to enlighten those without a working knowledge of the arcana.

When the structures work, they give to each party exactly what they want — a tailored recipe of risk and return that matches their particular needs.  Looks can be deceiving, however, and it turns out that a large number of the cakes that came out of the oven were not as promised.  One reason was the perennial problem of gifted salespeople meeting unwitting buyers, as with an example cited recently in the New York Times,The New York Times | These ill-conceived forays have financial consequences, and personal ones too.  Shawn Yde of the Whitefish Bay school board said, “This is something I’ll regret until the day I die.” in which one David Noack played the first part and the boards of several Wisconsin school districts played the second.  We don’t know if Noack ever trotted out the arrows, but he made the sale:

“What’s the best investment? It’s called a collateralized debt obligation,” or a C.D.O., Mr. Noack said. He described it as a collection of bonds from 105 of the most reputable companies that would pay the school board a small return every quarter.

“We’re being very conservative,” Mr. Noack told the board, composed of lawyers, salesmen and a homemaker who lived in the affluent Milwaukee suburb.

Soon, Whitefish Bay and the four other districts borrowed $165 million from Depfa and contributed $35 million of their own money to purchase three C.D.O.’s sold by the Royal Bank of Canada, which had a relationship with Mr. Noack’s company.

Yes, you read correctly, the districts added that fateful arrow of leverage on top of an investment they didn’t understand, and at just the wrong time.  They were not alone in this specific case, or the general one, since bankers often take advantage of unsophisticated purchasers to “sell them products stuffed with junk,” according to Janet Tavakoli, a consultant cited in the article.

At the endpoints of the arrows in any of these diagrams you’ll find counterparties on whom you need to rely and some assets or indicators on which the ultimate value of the enterprise is derived.  We have found in the recent past that sophisticated investors did not understand the intricacies that had been incorporated or the realtionships assumed, meaning that the casual speculator or part-time fiduciary had no chance whatsoever.  There are broken arrows everywhere.

The market response is unmistakable, and can be summed up in a phrase I heard at the height of the credit fears in early October:  “Complexity is a short.”the research puzzle | I wrote three dispatches after the CFA Institute’s fixed income conference, at which this phrase was heard, including the linked posting (“a nasty habit”), about the rapid disappearance of the liquity that had supported these structures. That trade is still being made by most market participants.

Which leads us to wonder:  When and how will that change?  The huge infrastructure that had been created to construct and trade this paper is being dismantled at some firms and demolished at others.  Tens of thousands have lost their jobs and more will soon.  Will “the market” for arrows ever come back?

I have previously expressed skepticism that things will be as they had been, but that’s an easy call.  Of greater interest is what will “structured finance” look like down the road?  Who are the buyers, who are the sellers, what are the structures that will be used, and how will they be traded?  Who will the advocates be within firms, in the blogosphere,Derivative Dribble | This is one example of a new blog that tries to describe how derivatives work (yes, including arrows and even formulae) and to counteract inaccuracies and misconceptions about their use. and in the marketplace?

Amid the destruction, surely opportunities have been created.  To the brave souls who would attempt to capitalize on them, some recommendations:

The models on your computer don’t provide answers, they provide questions.  Know what they are.

Without the (expensive) due diligence needed to understand the details of every element of the structure, you shouldn’t be playing the game.

If you are in an organization that hasn’t gotten smart about incentives, remember that sometimes those kinds of firms don’t make it to bonus time.  If you run such a firm, get smart.

While opacity led to fat margins and fat paychecks, you’ll need to sacrifice some of each.

Know and care about how your creations are sold and to whom.

And keep some of the arrows in your quiver.