Friday, October 17, 2008

Banking's Manhattan Project

"Holed up for most of the weekend in a conference room at the pink, Spanish-style resort, the JPMorgan bankers were trying to get their heads around a question as old as banking itself: how do you mitigate your risk when you loan money to someone? ... But what if JPMorgan could create a device that would protect it if those loans defaulted, and free up that capital. ... JPMorgan would then get to remove the risk from its books and free up the reserves. The scheme was called a 'credit default swap,' and it was a twist on something bankers had been doing for a while to hedge against fluctuations in interest rates and commodity prices. ... It built up a 'swaps' desk in the mid-'90s and hired young math and science grads from schools like MIT and Cambridge to create a market for the complex instruments. ... 'I've known people who worked on the Manhattan Project,' says Mark Brickell, who at the time was a 40-year old managing director at JPMorgan. "'And for those of us on that trip, there was the same kind of feeling of being present at the creation of something incredibly important.' ... 'We made it possible for banks to get their credit risk off their books and into nonfinancial institutions like insurance companies and pension funds,' said [Terri] Duhon who know heads her own derivatives consulting business in London", Matthew Phillips at Newsweek, 6 October 2008.

Fools! If you won't assume the risk, don't make the loan. The credit risk never goes away. In equilibrium, the cost of CDSs should equal the expected default loss. The banking and insurance regulators should have prohibited banks, insurance companies and pension funds from dealing in CDSs. This market should not exist. CDSs convince ignoramuses there is less risk around than there is because they spread risk. However, by spreading risk you increase it by causing yourself to believe you've mitigated it. Why should banks exist if they do not assume credit risk? Brickell thinks creating CDSs was as important as the Manhattan Project! Next, he'll want a Nobel Prize in Physics. Look at it this way: X company, the ultimate debtor, is worth X, no matter how it is capitalized. That's what finance teaches today. How can you increase the value of X's debt and X by dealing in derivatives? It violates the "conservation" principle. Did financial engineers go to: Chicago, Wharton, Stanford or a number of other MBA schools at any time in the last 40 years?

No comments: