I have a good deal of respect for Gillian Tett, but I disagree with her analysis in a Financial Times piece today:
A decade ago, it was fashionable for Western consultants, bankers and business people to decry Japan’s domestic service industry. For Japanese business sectors, ranging from milk production to financial broking, have long been plagued by complex distribution chains and numerous middlemen.
So, Anglo-Saxon consultants – such as McKinsey – would regularly urge the Japanese to reform their distribution chains, and flourish data showing how much more “efficient” the US was than Japan in sectors such as retailing.
Back then, I was working in Tokyo as a reporter. So I dutifully reported those studies-cum-sermons on the evils of middlemen.
However, amid all that debate about American efficiency, one point that Western commentators almost never discussed was the proliferation of middlemen in America’s financial world.
If you were to sketch a map of how credit has been sliced and diced in 21st century banking, for example, there would be so many stages – and commission-hungry middlemen – in that process, the Japanese dairy industry might seem positively rational. Yet, for many years the apparent contradiction went almost entirely unnoticed, by Western politicians, bankers, and consultants alike. Middlemen were regarded as bad in Japan; but they were somehow overlooked in America’s financial world.
As incredible and counterintuitive as it may sound, Tett has the basic premise wrong. I worked for the aforementioned McKinsey in the 1980s and the firm had tons of analyses showing how securitization was fundamentally cheaper than on-balance sheet lending. The reason was the cost of bank equity and FDIC insurance.
Let us put it another way: if old fashioned banking was cheaper, there would be no obstacle to going back to that system. The economics would be obviously superior and the banks would be able to raise equity to reclaim the securitization business they ceded.
The problem is that this more efficient system entailed information loss. There was no free lunch. By reducing the role of the bank, you eroded credit screening, had no ability to monitor the borrower, and wound up losing the ability to do workouts (that was not inherent to the securitization model, you could in theory have servicers do workouts, but the focus was on streamlining processes as much as possible. The servicers became factories with standardized processes, and successful mods require work and tailored solutions. That is an underappreciated reason why so many mortgage mods are failing. We are using a vastly different template than the traditional one).
Another symptom of too much rather than too little efficiency is that the system is tightly coupled, meaning processes move so quickly that they cannot be interrupted. As Richard Bookstaber pointed out in his Demon of Our Own Design, tightly coupled systems are unstable.
Tett hits another possible wrong note:
And securitisation has produced a particularly curious – or absurd – paradox. A few years ago, it was widely assumed that the process of slicing and dicing credit would create a more “complete”, free-market financial system.
The concept of “completing markets” has nothing to do with structured credit. It refers to a 1953 paper by Kenneth Arrow and Gerard Debreu, which is arguably the most celebrated paper in economics, the Arrow-Debreu theorem (personally, I take a dim view of it, but my opinion on such matters is of no importance).
Arrow-Debreu establishes that a general equilibrium can be achieved, but under absurdly restrictive assumptions: there are hedging markets for everything conceivable (all places and all future periods) meaning from now till the end of time, AND everyone had perfect foreknowledge (everyone knows what will happen until the end of time, so they know what they might want to hedge). The idea of “completing markets” is the justification for creating more derivatives, since you need derivative of all sorts of crazy flavors to hedge all the contingencies the universe will offer from now until the end of time. As I understand it, the role of hedges in Arrow Debreu is strictly about hedging real economy exposures. My impression is that risk shifting within the financial realm is not a feature of that model although some may argue it is implied (but A-D would seem to call for it via a hedging instrument, rather than the less efficient mechanism and as we now know ineffective means of creating bundled products that in fact were poor means of reducing risk).
I’d be curious to get reader input, but Arrow Debreu as a justification for structured finance, as opposed to derivatives, seems a pretty big stretch. (financial markets tend to play a limited role in economic models, mainly to provide important inputs like the price of money),
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I'm just a lowly small-town lawyer who closed a lot of bad (ultimately securitized) loans, but it is/was abundantly clear that there is a very real and problematic paradox at the heart of the whole process: the middle(people)men drive costs down. 10 times out of ten, a loan that had a broker, aggregator, funding lender and ultimate pooled ownership was less-expensive than a directly-originated portfolio loan. The middle-people (can) make a lot of cash flow in delivering a less-expensive product. The problem is very few of the middle-people businesses really make money in the long run as back-end liabilities pile up and bring them down.
Late in the last go-around (and I believe continuing now) is the practice by big lenders trading on their brands and charging higher fees and ignoring underwriting standards altogether. That is where their competitve advantage comes in.
It's very counter-intuitive (and thus nearly impossible to convince people), but the middle-people heavy model is more efficient as to cost, and arguably better in terms of risk (since many parties need to clear hurdles). I don't "know" this, but the large portfolio lenders (or portfolio-ish) are lying about their loan qulaity.
Bottom line is they get a brand premium up front and TARP money on the back which makes their businesses more pleasing.
Yves,
This post makes me think of Richard Kline's piece (the best single thing I ever saw on your blog) wherein he talks about inefficiencies in financial systems. It turns out that these inefficiencies (regulation, currency conversion, capital controls, to name a few), which cost money (lost efficiency) in normal times, serve as buffers in times of stress, helping to slow down contagion.
His insights are equally applicable to networked computer systems, my specialty. Passwords, firewalls, proxies, VPNs, and all that are obstacles and nuisances until the moment you need them. So it likely is with finance.
There's no magic formula for these things. It's always a judgment call, always a balancing of priorities.
For me efficiency is a trade off between cost, speed and accuracy and depends on your perspective. It appears to me that your argument is that reduced cost of equity and FDIC insurance (both of which may have been mispriced) outweighed the loss of quite a few taking a cut along the way. Here I think from a banks perspective you may be ignoring speed and accuracy. In terms of speed I doubt whether there would be much in it with a single slow decision maker being matched by multiple transactions in a chain. It’s the accuracy component that concerns me with rough and ready computer decisions loosing money from denying some applications and increasing risk by accepting other applications.
Taking into account such things as staffing levels, ability for system abuse and I guess in the long run the efficiency would be pretty much matched. I think the reason why banks don't want to return to that model is partly they don't have the infrastructure to do so and more importantly bankers might be more accountable and need a broader knowledge. That could be a threat to the existing hierarchy within banks, but thats just my opinion.
To Anon @8:23:
When you write,"10 times out of ten, a loan that had a broker, aggregator, funding lender and ultimate pooled ownership was less-expensive than a directly-originated portfolio loan."
The reason these loans are cheaper is NOT because middle men are driving the costs down…
Quite the contrary, it's because the existence of the middleman allows the Funding Lender to claim ignorance.
If the Funding Lender performs all the functions of the middleman… and then sells the loan off, there is no plausible denial when the loan is proven to be clearly fraudulent. With the middleman, however, the Funding Lender as Ostrich can take on a ridiculous loan, sell it off…and if it goes sour, tough luck. "We didn't order the appraisal….We didn't verify the borrower's income. The mortgage broker did this."
In the pervasive fraud that occurred in the past several years, the funding lender could always claim it was the one that was defrauded. Only, in this case, the one "being defrauded" induced the fraud by sticking it's head in the sand.
The active fraud of the mortgage brokers deservedly gets a lot of play…but it was the passive fraud of the funding lenders that did so much more damage. The Middlemen you write about exist for fraudulent expediency; not expense efficiency.
Hell, why do you think the mortgage industry is having such a fit over the recent change to appraiser laws? The appraiser still performs the same function; it's just that now the appraiser is essentially removed from the middle-man apparatus. The Funding Lender now has to "own" the appraisal and can no longer has plausibly deny any responsibility with respect to a loan given on woefully inadequate collateral.
If the middle-man is ever deemed to be an Agent of the Funding Lender, as opposed to independent contractor, you'll see 90% of the mortgage brokers go out of business overnight. If these brokers really did drive down costs, there would still be a place for them in the industry…even if as Mortgage Agent, instead of Mortgage Broker.
[Conversely, if it's ever ruled that Funding Lenders must assume responsibility for failed loans for longer than the paltry 3-6 months…to maybe 18-24 months…again, mortgage brokers are going out of business.]
Well said Dan D.
Those at the top of the food chain are always looking to off load negative legalities/ responsibility's via
intermediary's.
Skippy…its called risk aversion.
Never Forget
One man's cost is another man's revenue.
The logical peak of efficiency is one poor slob doing everything, using a machine, and everyone else standing around watching.
Or the machine doing everything. And everyone doing nothing.
As the sage saith: "Not everything that can be counted counts, and not everything that counts can be counted."
@Dan Duncan
Nice explanation. The funding lender's default risk (in the old days, that is) was a 'fat tail': small probability, high impact. By cutting the liability chain at every step, you eliminate that tail. It was such a fat tail that, even with a lot of middleman commissions, you still show a lower transaction cost.
It also simplifies the business, as there's no need to assess the default risk, as there was with the local banker, and no need to pay an experienced person to do this. You can bulk process everything and ramp up the volume. This passes for efficiency.
I frequently think of Buffett's "Gotrocks" family.
Finance, overall, plays far too large a part in our society.
Debt itself is nothing but promises, promises. So is insurance. The basic premise of insuring debt is promises, promises squared. It exists IMHO only to enrich players in financial products.
The Western financial products industry is a bloated parasitic tax upon productive enterprise.
This is why I favor reimposition of a separation of depository function banking from "gambling".
This is Taleb's suggestion.
Once the gamblers in all these wild and crazy products have to pay their way free of explicit or implicit government subsidy, much or most of the gambling will stop, because since it is a zero-sum game, it is a net cost after operating costs.
More people can then do more useful things than financial stuff, such as in pursuits that brought us to this advanced state, such as in science, medicine, education, etc.
There is still the problem of the directly-originated loan being both more expensive and more risky. You can trash the middlepeople all you want (they typically are better-paid than the bank drones), but I'm almost certain that the banks now "earning their way back to solvency" are going to make folks wish for the days of the intermediary. CWide is now the model for all the large originators (owned outright by BOA, but WF, USBank, Chase, etc. are all doing the same thing now.) The pay their people poorly – do you think they're inside originators care whether the commish is for a bad loan or not? I do think they do.
I'm not sure I see how Tett is wrong. Yves says the financialized model is more efficient in the sense of being cheaper, but that doesn't negative Tett's observation.
The relatively straightforward cost of regulated equity and workable insurance was replaced by a daisy chain of middlemen. The primary job of the middlemen was to conceal the risk that was no longer controlled by effective regulation and insurance. They concealed the risk on the front end as Dan D. describes, and they concealed the risk on the back end by creating wacky derivatives and synthetics and selling them to Wisconsin teachers' pension funds.
Tett is right on one level – the middlemen certainly existed. And the middlemen were worth less than they cost in hindsight, although they may have cost slightly less than effective regulation and insurance would have cost.
Journalists are just as “complicitous silent”
Gillian Tett comes down quite hard on politicians and regulators accusing them, in terms developed by Pierre Bourdieu, of “complicitous silence” and urge them to start thinking more about power structures, vested interest – and social silence”. As a journalist Tett could use herself a little spoonful of the medicine she prescribes.
In her interesting and very readable book “Fool’s Gold”, Tett manages to be very “complicitous silent” about the financial regulations coming out of the Fed and the Basel Committee; which did so naively ignore that by assigning so much power to the credit rating agencies to decide how much equity the banks needed, the regulators set the agencies up for big time capture.
If the banks invest $1.000 billion dollars in AAA rated instruments they have only to put up $16 billion as equity… because the opinions of the credit rating agencies cover the other $984 billion even though for these opinions there are no capital requirements at all. Compared to the above, the other and indeed absurd paradox she refers to in her article could be regarded as of a secondary importance.
The broader discussion is about degrees of optimization.
Securitizing loans fully optimizes the loan process creating a single, tightly coupled value chain., As history has shown, the chain breaks and all hell breaks loose. Irrespective of where corruption lies, the loan value chain is very tightly bound, very efficient.
I would argue banking/finance's role needs to be less optimized, (less efficient) so failures have less of an impact.
I believe the consequences of a less optimized financial system would have Yves strongly disagreeing with me on ensuing level of regulation.
And then there is the separate matter (banking special interests would create the division) of the regulations keeping up with new securitization schemes.
asphaltjesus writes “banking/finance's role needs to be less optimized, (less efficient) so failures have less of an impact.”
Absolutely and below is how I worded the same feeling in my Voice and Noise of 2006
Too well tuned?
Martial arts legend Bruce Lee, whom many people regarded as immortal, died at the age of only 32 of a cerebral edema, or brain swelling, after taking some sort of aspirin. I have not the faintest idea whether that pill actually had anything to do with his death but I have frequently used (or misused) this sad death as an example of how an organism could be in such a highly tuned and perfect condition that it could not resist a small external shock. And I used this metaphor to explain why companies nowadays, pressured by the stock market’s expectations for the next quarterly results; the latest theories in corporate finance as to how squeeze out the last drop in results; and, perhaps, even some bit of creative accounting, might be so well-tuned (no little reserve fat left) that they would not be able to withstand any minor recession.
(Whenever I expose this theory, I can see in my wife’s eyes that she believes this is just my preparing an excuse for my growing—ok, grown—midline.)
I think Tett's paradox comment does stike one correct point – that is, that economists a decade ago, when faced with the proliferation of exotic derivatives and securitization, tended to take the view that these markets improved the efficiency of capital markets to the benefit of the real economy. They could do so, not by moving towards an idealized Arrow-Debreu world of complete markets, which you characterize well, but by providing unexploited opportunites for real hedging and risk pooling. Of course they also naively assumed that Wall Street knew how to value these instruments.
Some comments:
Obviously no finance theory assumes any kind of foreknowledge of the future.
Derivatives are not introduced in order to "complete" markets.
They are introduced since the playerz
hope that the markets are already complete.
In that case they (believe that they) can hedge the risk incurred in originating derivative contracts.
If the market was not complete the risk might be unhedgeable — something the playerz do not like at all.
The playerz are not in the game to make the world better (markets complete) but rather to make a buck.
There is no difference between "derivatives" and "structured products".
"By their fruits ye shall know them." -JC
I can't imagine how anything that has produced as much pain, broken lives, backbreaking debt, parasitical profits, counterfeited credit, miserably disordered monetary policy, maldistributed wealth, hopelessly distorted wages relative to any social utility and a legion of apparatchik whose "talent" for pradation is directly proportional to their absence of conscience can be even remotely called "efficient" — unless wanton societal destruction in the metaphorical manner of a neutron bomb detonation is the ultimate the goal.
It recalls to my mind how the poet Yeats would sneer at the "efficiency experts" of his day. Civilization can't be numbered in such metrics of monetary aggregates being sloshed around and scooped up by the toll takers.
To rip the people from their craft and make them unwilling slaves to money and credit seems to be the primary goal of such efficiency, even if its propagandists pretend otherwise. They are blind and their souls are closed doors to hope and to the possibility for transcendence.
Anon of 6:45,
I must tell you, the capital assets pricing model DOES assume knowledge of future covariances. And Arrow Debreu, which is where the "completing markets" idea comes from, explicitly assumes complete and perfect knowledge.
Google "Samuelson" and "ergodic axiom" for more details.
I'm gonna have to go with what I can get out of Koopmans' Three Essays – the material starting around page 60 and then again around 161. That sure reads like rational actors hedge "real economic exposure." Additionally, the model under uncertainty "implies each consumer is averse from or, in a limiting case, just neutral toward risk bearing." (p. 62) So on the occasion of choosing to buy an AAA tranche or a BBB tranche, one neutral to risk flips a coin?
Something about this calls to mind the line from Willem Buiter's essay linked a day or so earlier, on the inevitable socialization of health care: One cannot insure a sure thing…
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