Creativity Has Its Consequences

FINANCIAL ENGINEERING AND STRUCTURED PRODUCTS
Financial engineering is the term used to describe an institution’s innovation in security design. The rapid pace of financial innovation is driven by the competition among firms, usually investment banks.

The application of mathematical and statistical modelling, together with advances in computer technology, provides the necessary infrastructure for financial engineering. Through financial engineering, investment banks strive to meet the needs of borrowers and investors, including the need for hedging, funding, arbitrage, yield enhancement, and tax reduction. This branch of investment banking drives the explosive growth in the markets for structured products and derivatives and allows dealers to offer customized products based on what they perceive as end-client demand.

Securitization
Securitization is one of the outcomes of financial engineering. The principle of asset or product securitization is theoretically simple: financial products are repackaged to change the risk-to-return characteristics of the resulting securities. Investors typically hold these securities for any of three main purposes:
1) They seek a higher or lower risk- return mix than the underlying security itself. For example, an institutional investor might want to invest in a AAA-rated security with real estate as the underlying asset. A hedge fund, on the other hand, might hold an equity tranche for speculative purposes.
2) They seek the higher returns that these high securities provide. For example, a AAA tranche would pay more than an equivalent Treasury bill with similar features.
3) As new investors, they have access to certain asset classes that were previously unavailable. For example, many investors are unable to enter commercial real estate physically by purchasing entire buildings. However, by holding the securitized instruments, they can hold a percentage of the pool – small or large, as needed.

Typically, securitized products have three tranches that provide cash flows to the holders: a AAA tranche, a mezzanine tranche, and an equity tranche. Although great revenues are generated from securitization, the risk is that securitized products are highly specific without a ready secondary market. Holders must therefore accept illiquidity as a cost, which increases the risk component in the risk-to-return ratio.

Importantly, investment banks that structure and issue these products could also have trouble unloading them in times of market stress. When default probabilities are high, securitized products can become overrated and overpriced. For example, if the probability of default is seen as far higher on the securitized products than on the products they are based on, the price of the instruments will plummet. With far fewer buyers than expected, bid prices are pushed down. Consequently, those who structured the products have excess supply, which pushes ask prices down as well.

Outcomes of the US Sub-Prime Crisis
Structured and securitized products have contributed strong revenue growth to a number of investment banks, but with unpredicted outcomes. The collapse of Lehman Brothers, arguably the oldest investment bank, is an example. Although Lehman was a diversified, full-service investment bank, its roots and core strength were in the area of fixed income, loans, and mortgages. Because of its ready access to loans, it developed strong expertise in a securitized product called mortgage-backed securities (MBS). In 2006 and 2007, it became the top MBS originator in the United States, with more than 10% of market share. Lehman and other investment banks realized that high revenues could come from the securitization business in several ways. First, they could originate the loans and generate fees from that activity. Then, they could generate more fees by securitizing the loans and reselling them to other institutions. The 2008 sub-prime crisis dramatically revealed the high cost of these financial innovations and the consequences of failing to understand the character and strength of the underlying assets that collateralized the loans in question. Weaker markets pushed investment banks and Wall Street firms away from securitized products, which put downward pressure on the sector. At the same time, those already holding the instruments were trying to unload them, further creating a price collapse. Lehman Brothers suffered heavy losses from holding on to large positions in sub-prime and other lower-rated mortgage instruments. Rating agencies downgraded the firm, and eventually it lost the confidence of the market and was forced into bankruptcy. Although this crisis arose in the United States, the issues it revealed are equally applicable to the Canadian marketplace. The investment banks that manufacture these products must design them in such a fashion that the risks can be properly explained. Additionally, where the underlying assets themselves (e.g., the mortgages underlying an MBS) are improperly valued, additional market stress occurs. As history has shown, additional stress can escalate into a full-blown market collapse.

As we can see, in product design, attempting to alter the very nature of a financial product requires additional levels of diligence and can have unintended consequences. For investors, extreme caution is required when considering adding these types of products into a portfolio. ■