Monday, May 30, 2022

Great Power, Questionable Responsibility

Financialization, as I have pointed out before, allows for some truly powerful dynamics that would not otherwise be available to market participants but, as the old comic book adage states, “with great power, comes great responsibility” and responsible use of innovations in finance, being subject to the whims and foibles of human nature, has lead to significant economic calamity.

Think of the farmer who has to contend with the ever-changing variables of his trade; weather, pests, labor, material input costs all in advance of the day when his crops or livestock are ready for market and in the hope that the prices they will fetch are favorable by the time he gets them there.

This is clearly a significant challenge and even with decades of direct experience and generations of shared knowledge, success comes with considerable risk and failure comes frequently as the result of circumstances that are beyond his control.

But with the right dose of financial engineering, namely commodity futures contracts and commodity exchange markets, farmers and their counterparts (wholesalers, buyers, etc.) are able to spread risk, allowing participants to enter into “forward” contracts (for delivery of real product) that are themselves “fungible” and able to be continuously traded for better, even more efficient agreements given the ever changing conditions and considerations specific to a given participant.

Commodity futures markets, originally pioneered in the 1700 and 1800s, have been continually modernized to the point where contracts can now be traded digitally through the Chicago Mercantile Exchange (CME) or the New York Mercantile Exchange (NYMEX) by traditional market participants as well as strictly speculative actors who view these contracts as purely financial abstractions traded to gain a desired level of price exposure to a given commodity for their own purposes (e.g. hedge funds and other money manager seeking to perform hedging activity).

Further, in the last two decades, the advent and popularization of the exchange traded fund (ETF) has allowed money managers to utilize digital commodity futures contracts to create highly liquid funds traded as shares on typical stock exchanges with marketable, sometimes even comical ticker symbols (e.g. COW for livestock commodities, CORN for corn, JOE for coffee) thereby allowing retail investors to effortlessly buy and sell these commodities at will through any typical stock trading console and even utilize “put” and “call” options contracts to trade with leverage.

Stop and take a moment to really think about the above detailed scenario; layers of complex financial arrangements standardized and simplified through fungible abstractions that are then pooled and package and digitized, and yet packaged again all working to motivate interests and, more importantly, enabling capital from countless participants to flow freely in vast pools of financial liquidity spreading risk and powering participation on a scale that the original “real” goods market participants could scarcely ever imagine.

But what are the limits of this type of financial engineering?

Commodities, while a great tangible example of successful financial engineering (at least to date that is) are hardly the only asset class in finance involved in packaging, pooling and spreading risk through highly engineered financial innovation.

In 2008, the world was made acutely aware of the potential downsides of financial engineering as the U.S. housing bubble imploded, disclosing the fragility of the highly complex financial arrangements that undergird the U.S. mortgage market.

Who can forget the endless panic and hand wringing that ensued as the various “tranches” of securitized mortgage assets (the famed packaged “mortgage backed securities”) hung in the balance and with each leg down in home prices and up in foreclosures, went bad like so many rotting fruit in baskets of otherwise healthy produce.

Make no mistake, like the commodity example, the whole complex of mortgage financialization was resting on a foundation of real assets, real mortgages tied to actual real estate, that were packaged and re-packaged into financial products that gave the investor class price exposure to the U.S. housing market.

These highly financilized mortgage securities, once viewed as “good-as-gold” nearly riskless investment products found their way into safe income producing funds the world over, and, when the tide turned on housing, sullied whole portfolios, destroying wealth in grand scale and ultimately bringing the global economy to the brink of collapse.

A truer example of shared risk has never existed as foreclosure activity that in past eras would have been born directly by the local banking system within the affected real estate market (or markets… see the Savings and Loan crisis of the late 1980s) instead, decimated the value of assets that were now, through the miracle of financial engineering, spread far and wide.

When the fate of the world economy seemed bleakest, the “Apex-lender of Last Resort”, the Federal Reserve itself, ultimately choose to step in, backstopping and bailing-out failed banks, broker dealers and other financial institutions, absorbing “toxic” assets and thereby assuming the liabilities of a generation of “high finance” who had previously viewed themselves as the “masters of the universe”.

Further, the mortgage market, being seriously impaired (and even non-existent in some lending categories) required the Fed to also step up and start lending through the giant government-sponsored enterprises (GSEs, Fannie Mae, Freddie Mac and Ginnie Mae) in an effort to maintain a degree of market function.

This portion of the Fed’s “quantitative easing” (QE) campaign saw the Fed minting monetary base at breakneck speed, ultimately creating about $2.7 trillion (to date) and deploying that capital by purchasing mortgage-backed securities directly from the GSEs on an on-going basis.

In fact, Bloomberg recently estimated that even today, as much as 30% of the overall U.S. mortgage market is still being financed directly by the Federal Reserve.

So, roughly two thirds of the U.S. mortgage market is organic natural market function while a whopping one third is still, even to this day some thirteen years after the housing debacle, being essentially centrally planned and facilitated by unconventional monetary policy and specifically fueled through direct injection of fiat money creation.

This outcome, unlike the prior commodity example, clearly is not desirable and illustrates the risks involved with financial innovation.

The mortgage market was transformed by financial engineering from a relatively simple and mostly local traditional banking function into a global market of deeply liquid securitized mortgage assets, thereby spreading and even amplifying through leverage, the risk of a single nation’s property market across the entirety of the global financial system.

In the end, the unwinding of this massive financial scheme worked to impair the U.S. economy and degrade the credibility of its central authorities (both fiscal and monetary), thereby undermining the worlds principal monetary regime and leading to our current era of rampant speculation in stocks, housing and other speculative assets and, likely, a new even more difficult economic reckoning as the Fed is now forced to rise to the challenge of somehow drawing down excessive accommodation in the face of the monetary inflation it caused through its own prior policy. 

There is no doubt by now that, through financial engineering, our financial institutions and central authorities are very “powerful” but given all that we have witnessed in the last two decades of economic tumult, one has to wonder if history will ultimately judge us to be truly “responsible”.

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