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2 THE BEAR'S LAIR Why financial engineering
doesn't work By Martin Hutchinson
phenomenon of volatility "smile" in
option pricing, whereby the implied volatility of
out-of-the-money options is considerably higher
than that of at-the-money options, is a sign that
the underlying theory, which postulates constant
volatility over the full range of strike prices,
is hopelessly flawed.
The valuation
problem is worsened for financially engineered
products with multiple embedded options. In these
cases, some
of
the options are at-the-money, some in-the-money
and some out-of-the-money. Even when the majority
of market participants are using valuation models
that produce similar answers, those models may
bear little relationships to true market value.
This problem is worsened when the characteristics
of an asset class upon which its derivatives'
valuation is based come seriously into question.
In the subprime mortgage case, for
example, it had been assumed that mortgage
defaults were essentially independent of each
other, enabling valuers to use "laws of large
numbers" to "prove" that the probability of a
default of more than 20% of principal was very
small. That allowed securities based on that
senior slice of the assets to be rated AAA. In
reality, defaults on subprime mortgages are not
independent events. A mortgage bubble such as that
of 2004-06 causes a simultaneous slackening of
underwriting standards, with even minimal control
procedures being abandoned throughout the entire
asset class, while a nationwide house price
decline or interest rate rise causes the entire
class of subprime mortgages to get into
simultaneous difficulty.
Finally, some
trading strategies are particularly attractive to
market participants because they pull income
up-front, enabling participants to recognize
larger profits (and presumably receive larger
bonuses) in the current year while deferring
losses into future periods when they may have left
the group.
Thus the valuation of a complex
financial engineered product (i) may not be
generally agreed among market participants, (ii)
may quite simply be wrong (iii) may be proved
hopelessly flawed by new discoveries about the
underlying asset class or (iv) may be affected by
distorted incentives so that the owners of the
product, the banks concerned, receive different
rewards from the agents controlling the product,
the executives. These problems may lie dormant for
a decade or more and then manifest themselves
sharply in periods of market turbulence, causing
confidence among market participants to vanish.
Finally, the risk management models used
by institutions to control the risks of their
financially engineered holdings are themselves
hopelessly flawed, particularly the Value-At-Risk
system. Under VAR, the risk of an asset holding is
calculated as the maximum fluctuation in the value
of that holding in 99% of cases. The gross
assumption is then made that price movements are
normally distributed, so the risks in the other 1%
of cases can be assumed to be only modestly
greater than the stated VAR. As Goldman Sachs
showed, in announcing a "25 standard deviation"
event that should under VAR assumptions happen
only once in the life of the universe, this is
just plain wrong. It again rests on the flawed
underlying postulate that market events are
random, which has repeatedly been shown to be in
many cases false.
VAR's underestimation of
risk is particularly severe for financially
engineered products that have large numbers of
embedded options, or that depend on an asset class
such as subprime mortgages with extreme risk
characteristics. The problem is exacerbated by the
valuation uncertainty of such products, and by
their tendency to become completely illiquid in
times of market turbulence. Thus two balance
sheets with an equal VAR may have a very different
level of risk; the institution that has been more
aggressive in its financial engineering activity
is likely to be much riskier than the other. Even
if an aggressive trading house and a conservative
new-product-averse commercial bank claim similar
levels of VAR in their portfolios, the trading
house's true risk is likely to be much higher,
because it will have a higher concentration of
aggressively engineered assets with numerous
embedded options, flaky underlying assets and
severe turbulent-market liquidity risk.
The profitability of financial engineering
to its practitioners is unquestionable. Its
profitability to the institutions that employ
those practitioners may have been almost equally
solid in the past, but could be undermined in the
future by a period of market turbulence that
produces gigantic write-offs - a house like
Goldman Sachs, with "Level 3" assets, the most
illiquid, of twice its capital could in principle
suffer losses that wiped out all its financial
engineering profits of the last quarter century.
Financial engineering's benefit to the
global economy is questionable at best and the
increases it has produced in the financial
services sector's share of global output may have
been mere successful rent seeking. In the long
run, less opulent compensation for financial
engineers, more aggressive audit and supervision
policies for financial institutions' engineered
assets and a healthy cynicism about financial
engineering in general may put this genie at least
half way back into its bottle. That is likely to
prove a positive development.
Martin
Hutchinson is the author of Great
Conservatives (Academica Press, 2005) - details
can be found at www.greatconservatives.com.
(Republished with permission from PrudentBear.com.
Copyright 2005-07 David W Tice &
Associates.)
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