Have we forgotten what finance is?

And finally I did wake up from the long slumber of laziness to pen down my thoughts on the recent financial turmoil which has taken the whole world by surprise. This post is a long due and in response to the request put forth by a coupla my friends who aspired to become Mostly Below Average (read MBA) and are currently contemplating whether they should quit their cushy jobs for this “holy” pursuit.

Coming to the core of the issue, the major problem with the financial architecture of the world is that finance is not playing the role which it’s supposed to. If you look back at the history why did finance as a function originate? Why were banks set up? How the concept of currency sprang up?

The world of commerce started off with the barter system of trade and then people realised that with the number of items traded increased, the complexity of valuation of items increased. To speak the computer algorithm lingo it became a function of O(n^2) (read order of n squared). As in, if you have four products A, B, C and D in the market then A has to be valued in terms B, C and D, and B in terms of A, C and D and so on. So for just 4 kinds of products there were about 12 different conversion standards (A to B and B to A are considered different). So for n products there were n(n-1) combination and as ‘n’ grew it became cumbersome for traders to trade and hence they agreed upon a common currency standard like gold where for A, B, C, D there are just 4 values in total. To again speak the computer lingo, the algorithm was optimised for the solution to be O(n).

Slowly financial institutions – banks, in this case were set up which started off as a means to protect the gold against the robbers. In no time banks realised that there is a better way of doing business by putting the gold deposited to better use by lending it to the needy. Thus originated finance. So finance can be thought of as function which enables the exchange of money from the hands of people who have some extra money to the hands of people who need money (read capital) for business which comes at a cost (read interest rates). So essentially finance is all about putting money into productive use. And these banks used to make money by the interest rate spread between borrowers and lenders. And it’s evident from the history that whenever this transfer of funds happened and the money was put into speculative use rather than productive use, there have been bank runs and financial turmoils.

And this is what we are witnessing now. The financial institutions of repute which should ideally support other businesses by providing capital (remember: putting the money into productive use) are increasingly getting into the business of money itself. Trading of money is happening more than the lending and borrowing of money. This is where the financial architecture becomes complex and difficult to fathom. The subprime crisis is an excellent case in point. Banks lent excessively to home and property buyers and in turn sold the loans off to Investment Banks. The investment banks in turn sliced and diced these loans and created bonds named as Mortgage Backed Security/Asset backed Security and sold it off to a lot of investors like hedge funds, mutual funds, pension funds. So there was essentially flow of funds from the hands of end investors like hedge funds to the hands of I-Bankers and from the hands of I-bankers to the hand of normal retail bankers. And retail bankers hand sudden liquidity (which otherwise they would have got after the payment of loans by the borrowers say after 10 years). This liquidity situation enabled retail bankers to further lend excessively. To make matters worse the MBS/CDO were insured by players like AIG and they named the fancy instrument as Credit Default Swap (CDS).

The investors in these securities were big names like Japanese Pension funds which invested for the greed of higher coupon rates (interest rate on these CDO securities). The higher interest rate was a classical case of supply demand situation. There were a lot of buyers of property and hence investment bankers kept on buying the loans from the retail banks and sold them off as CDO and investors like pension funds kept on buying these instruments.

There was one inherent but wrong assumption in this whole chain that the property prices would keep on increasing whatsoever the external conditions would be. The retail banks thought that even if the home buyer defaults on payments, the banks can seize the property and sell it off at a higher price and make for the loss of default.

But when the market interest rates went up and the borrowers could not pay the EMIs (as the loans were issued at floating rate of interest), the property market bubble had bust and there were no takers of the loans. Again the supply demand forces came into picture and these ‘mighty’ instruments called as CDO/MBS took a bath. The end investors started selling off but there were no buyers and the investment banking fraternity went bankrupt.

But again would this have happened if the investors like the very reputed hedge funds had questioned the assumption that is the money getting invested for the purpose of productive use? This is the first lesson Finance 101 would teach you and the one MBA Fin graduates and Quantitative fin PhDs from the Ivy League missed to remember!! And all these investors are financial institutions themselves and hence the question again arises: Is finance playing the role what it is supposed to? Is it the financial architecture to be blamed or the regulators?

To make things simple whenever you invest your hard earned money in any instrument or share or whatever security it may be, just try to figure out if your money is being put into productive use. If you are investing in the stock of a bicycle company, just go to the road and see how many people use bicycles of that particular company. Many times common sensical approach is far better than advanced quantitative models!!