Talk is cheap

Mark Twain said those who carry a cat by the tail will learn a lesson that can’t be learned any other way.

The world is now learning an equally painful lesson about the consequences of financial engineering gone mad.

Let me offer a description of financial engineering that is over-simplified and excessively cynical, yet contains enough truth to be pointed: You find an opportunity to make a small margin with reasonable risk. Very good. You split the risk with a product promoter, so there is a reduced profit for you. The product gears into the opportunity. This magnifies the small margin into a bigger return for you and a fatter fee for the promoter. Then some unexpected factor occurs that contracts the margin or reduces the value of the asset. You have geared into this reduction. You are surprised by volatility. The manager suspends redemptions. It does not refund its fees, which were proportional to gearing. The lawyers arrive. You are at the leading edge of financial engineering.

Before product promoters compose letters of abuse (which, incidentally, the editor loves to publish), please read on — I show some balance below. Nonetheless, a number of failed products in Australia, and many more overseas, can be summed up in these terms.

The pervasiveness and complexity of financial engineering is unprecedented. To the extent that engineering was the main tool for the recent global over-leverage, we can identify it as a major contributor to the current global crisis.

Consider that losses in sub-prime would have been contained had they not been packaged up in tranches, leveraged up past the nostrils, presented as opaque securities with a ‘highly rated’ stamp and bought in droves by people who knew not what they owned.

Further, today, no financial institution knows who owns what quality asset and, in the face of this uncertainty, financiers are hesitant to lend to anyone. Voila — a credit squeeze!

Currently, other ‘sophisticated’ structures stand as potentially unstable dominos, which could exacerbate the existing crisis (eg, credit default swaps, which, as Soros put it, allow anyone to be an “unregulated insurance company”), Eastern European foreign currency home loans and so on.

However, these are extreme examples that may excessively blacken the concept of financial structuring. Let’s bring some perspective.

Underneath the bonnet of financial vehicles

Financial engineering has a long history in this country, beginning (as Macquarie reminds us via their logo) with the ‘Holey Dollar’.

The young colony solved its lack of currency by punching out the centre of Spanish sovereigns, making two coins — one with a hole in it (the ‘Holey Dollar’) and the middle piece (the ‘Dump’).

These had a combined value of more than the original coin.

This was not the last time that value was created out of nothing by a bit of clever repackaging. (I refrain from commenting on the period when rum was a de facto currency in the colony for fear that it might provide Bundaberg with a historical basis for its sense of being the centre of Australian culture.)

At one end of any financial structure are underlying markets, things like shares, property, cash, bonds, commodities, currencies, and so on, which go up and down in value, may produce income and may grow over time according to their various cycles.

At the other end are investors, who put in their money and wait for the return.

Between these two simple elements stand product creators/promoters, armed with a set of financial tools including gearing, options, futures, swaps, and so on, and not forgetting fees.

All financial products, ultimately, can be understood to be a combination of underlying assets within a structure created by the application of the various financial tools.

If you can analyse what tools are applied to what assets, you can see through the arcane mystery that these products may otherwise appear to be.

However, this is not so easy to do.

Many promoters are not inclined to make their intellectual property available to the world. Some don’t wish to because the structuring is motivated to embed high fees.

Further, naughty promoters sometimes present misleading descriptions of their products.

In order to avoid matters that may come before the courts, let’s confine our discussion to those promoters who are genuinely attempting to develop attractive products for investors.

The simplest structure of all is a conventional managed fund that buys assets and the investor gets the return these assets produce, minus a fee.

Some fund managers try to mould the outcome somewhat with the inclusion of cash alongside more volatile assets.

Others go further, occasionally shorting a market or security.

At this point we have perhaps entered the lowest foothills of the financial engineering mountain (as reflected in the difference of views about whether Platinum or PM runs managed funds or hedge funds), though its clouded peak is far from such comprehensible structures.

Even at this level, though, we must acknowledge that there is a risk/return trade-off for attempting to alter investors’ experience away from simply tracking the underlying assets, which is the essential objective of all financial structuring. The manager will exercise judgement about how much cash to hold, or what to short and when. These judgements may be sound or in error.

This is the key point: all financial structuring represents a substitution of risks. If planners don’t understand both the risks avoided and the risks taken on by a specific structure, they don’t know enough to recommend it.

This lesson had been learnt in earlier cycles (though forgotten since it seems). Unlisted split property trusts were a relatively simple structure that failed in the early 1990s. These funds artificially split the income and property returns from illiquid assets and directed them to different classes of units. In the same era, certain reserve-backed capital guaranteed funds (which invest in volatile assets but engineer a capital guarantee and a smoothed return) experienced stress and required restructuring.

Both altered the return to investors away from that achieved by the underlying assets — until they found themselves in market environments that their creators had not foreseen.

This brings us back to the past six months and complaints by failed product promoters that the credit crunch should not have happened! Their computer models told them that such an event was a “once in a 1,000-year event”. Unfortunately, the models omitted to mention that 2008 was going to be the thousandth year.

In this writer’s view, financial engineers go too far the moment they believe they can stand between underlying markets and end investors and perform magic that enhances return yet reduces risk.

You can slice risk and parcel it out (eg, put the lowest quality mortgages in one collateralised debt obligations (CDO) not labelled ‘AAA’ but ‘Toxic Waste, not to be taken with breakfast’), but someone has to carry that risk.

When structurers imagine they can eliminate risk, they have fallen into the trap of human vanity.

The world is a lot bigger, more complex and less predictable than any financial genius-of-the-year’s spreadsheet. This was forgotten, especially by product promoters in the land of the free (which many Americans must have thought meant risk-free).

A matter of degree

Anyone who has borrowed to buy a house has applied the basic financial tool of leverage to their situation.

Thus it is absurd to scorn all financial engineering.

To eliminate structuring from all investment products would take us back to the pre-computer era, where complexity was limited to the capacity of a hand calculator and lead pencil.

The fundamental task for planners is not to spurn all engineering, but to ensure they understand any structure in terms of its underlying constituents.

In my view, this would greatly reduce the appeal of certain common practices. Many products pay enhanced distributions in their early years, greater than the income they actually earn, funding the increase by borrowing.

I cannot comprehend why investors would pay a manager to borrow money on their behalf and distribute it to them as if it was income. This is a zero sum game.

However, some managers have even received performance fees because the market was silly enough to think this created value, as if by magic (ie, pricing the fund on its high ‘yield’), when they have simply taken on debt.

Not surprisingly, down the track, future buyers of the product may be less enthusiastic to take on the accumulated debt, used not to purchase more assets but to bulk up past distributions.

There is a big difference between financial structures and real ones. It is much easier to destroy a building than to build it.

By contrast, the past half-decade saw the world effortlessly adopt high risk and stratospheric leverage, embedded in numerous financial products — but the dismantling is causing great difficulty.

The value of caution and scrutiny has now been remembered (no doubt only until the next big jump in equities).

The lesson for planners is that if they can’t quantify the potential risks in a product there is no basis for a recommendation.

The challenge for researchers is to explain such products in comprehensible terms. If they can’t do that, they should not approve them.

Robert Keavney CFP is the chief investment strategist at Centric Wealth Advisory.