2 posts tagged “options”

Securitization has become a panacea on financial markets.

Indeed, it is predicated on the simple idea that balance sheets are more often than not the best parking for risks. In other (shareholders) words, they are the most costly parking you can find. Hence, commercial banks with the structuring help of Wall Street firms have "shipped" assets and liabilities that were so far stored in their balance sheets to investors.

It sounds like a marvelous and lucrative never ending innovation spiral à la Merton where banks can do more business, investors have access to a wider spectrum of securities and risks are more efficiently shared.

Too good to be true: The subprime mess is a wake up call, one that calls for deep thinking.

There are some things that do not change. In October 1987, the equity market crashed and portfolio insurance was designated as the culprit. Portfolio insurance used to be considered as the solution to downside risk protection. Investors hate downside risk even more than they love upside. University of Berkeley mavericks, Hayne Leland and Mark Rubinstein (co-founders if LOR), came up with a technique that promised to replicate what a long put option does, namely pay off, when the market goes south. The "trick" was simply to use Black-Scholes-Merton option hedging argument to replicate the put option payoff. In other words, they were selling stock index futures (mechanically/dynamically) and going long T-bills (cash) when the equity market was tanking. When the market was rallying up, they did the opposite. That's why when the market crashed in October 87, LOR was accused of provoking/amplifying the downward trend. The argument is a bit odd: Mark Rubinstein rightly pointed out that nobody praised LOR when the market was going up for making the growth even stronger.

The truth is that while portfolio insurance is in effect more of car insurance than earthquake insurance type there is an important market item that it paradoxically "destroys": Information. Indeed, when lots of investors are willing to buy put options bidding the price up they signal their bearishness to the market. What portfolio insurance does is to break down a single (put) transaction into two separate transactions: stock index futures and T-bills. Information about market expectations may get distorted in the process as it is hard for the rest of the market to decipher the initial intent. Worse, as shown by Sanford Grossman and others when portfolio insurers sell mechanically to dynamically replicate the target put, people may mistakenly think that this signals bad news. Asymmetric information problems have increased and we know both from the seminal works of George Akerlof, Michael Spence and Joseph Stiglitz and casual business experience that this is a sure recipe for trouble.

Sadly enough, the same holds true with securitization as witnessed by the subprime mess. Bad loans have been securitized. As a result the shareholders of the originating banks do not bear the consequences, good or bad, of their loan activity anymore. They have no incentive anymore to monitor these loans that get "diluted" in securitization vehicles. Hence while risks seem to have been more efficiently cut into pieces and shared the overall situation has worsened drastically because asymmetric information problems are now more toxic (1). Asymmetric information is a market killer and we end up collectively harvesting what others have planted.

Not convinced. Well, think of what microfinance does. It does exactly the opposite: It reduces information asymmetries by putting monitoring and safety devices in the micro-lending process: Lend only to women, in a village where everybody knows each other, make the borrowers collectively liable when one of them defaults etc... This is why it is successful.

So, next time innovation in the form of sophisticated securitization knocks at your door, ask yourself whether information and incentives have been reduced or not before joining the bandwagon. If portfolio insurance and the subprime can teach us one thing or two, it is precisely this.

(1) Not to mention the fact that it becomes very hard, almost impossible, to restructure the (securitized) loans when disaster strikes.

Commerce

Si vous lisez régulièrement le Financial Times ou Les Echos, vous aurez sans doute l'impression que la finance n'a jamais été aussi active, aussi créative qu'aujourd'hui. Chaque jour, Wall Street et les banques d'affaires apportent leur lot de nouveaux instruments financiers, nouveaux produits structurés etc... Robert C. Merton, Prix Nobel d'économie et Professeur à Harvard, y voit le déroulement vertueux d'une spirale d'innovations financières qui contribue à "compléter" les marchés là où ils font "cruellement" défaut. Il faut ajouter à cette effervescence praticienneles apports nombreux de la théorie financière à laquelle Robert C. Merton a beaucoup contribué.

Toutefois, il serait hâtif et erroné de conclure que la finance de nos temps modernes a seule l'apanage de la modernité et de la créativité. Quiconque s'intéresse à la pratique financière des temps anciens ne peut manquer d'être émerveillé par l'ingéniosité avec laquelle les acteurs de l'époque dessinaient les transactions et des contrats financiers nécessaires au commerce. Le financier et l"économiste ont tout à gagner d'une telle visite attentive: les temps anciens sont précisément ceux qui correspondent sans doute le meiux à ce qu'ils appellent "marchés imparfaits". On imagine aisément, sans pour autant être un historien qualifié, combien au Moyen-Age par exemple il était difficile de se procurer une information fiable, combien les coûts de transaction de toute sorte (transport, taxes, etc...) et les risques de toute nature pouvaient gêner les commerçants dans leur expansion.

Pourtant, force est de constater que les chercheurs en finance ne sont pas très curieux de l'histoire. Il est tout aussi vrai que rares sont les historiens qui intègrent dans leurs investigations les enseignements de la finance moderne. Tous auraient à y gagner!

C'est ce que nous tentons de montrer dans un papier de recherche récent, Didier Joos de ter Beerst et moi-même. Ce papier (disponible dans sa version française ici) étudie un contrat passé en 1298 entre un célèbre marchand génois, Benedetto Zaccaria, et deux financiers génois eux-aussi, Enrico Suppa et Baliano Grillo. Ce contrat est un véritable tour de force. Ce contrat nous a passionné et sa lecture, à l'aune de l'histoire, de l'économie et de la finance, réserve quelques belles surprises. En particulier, le lecteur pourra constater combien les options, réelles ou financières, sont omniprésentes. Elles constituent la colonne vertébrale du contrat et lui permettent de remplir les nombreuses fonctions dont les parties de l'époque avaient clairement besoin. Ces fonctions rappellent l'approche fonctionnelle de Robert K. Merton, sociologue et père de Robert C. Merton (qui a contribué à popularisé l'approche de son père en finance.)

Cet article a été présenté à plusieurs congrès dont la toute récente conférence "International Economic History" à Helsinki en août dernier.