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Complex and useless finance is still there

While complex finance should be preferred to improve risk modeling, it continues, in times of market stress, to help designing unmanageable and useless complex structured products

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Unmanageable since those investment vehicles lack liquidity, are almost impossible to price during period of market stress, have very low transparency, not to mention investors’ poor understanding of the products.

This reflects once again the disempowerment of investors (and it more than ever has to end) who hide behind a number of elements:

  • A capital’s Guarantor, usually a bank that issues a structured asset that is rated "above all suspicion". I recently recalculated "just for fun" the 1 year default probability associated with the agencies rating such as Standard’s & Poor’s: the confidence level used is 100% for ratings ranging from AAA to AA (i.e. no default at all in any case!!!!); a confidence level of 99.93% for A ratings (i.e. a default probability of 0.07% corresponding to seven defaults triggered every ten thousand years). As a statistician, I can only be satisfied with such results but as a markets specialist, such probabilities confuse me.
  • A structurer with a proven track record in financial engineering (and who is often himself the issuer of the structured asset)
  • Finally ratings above all suspicion of the issuer and the structured deal as well; We still do we remember in a not so distant past the complacency of the rating agencies mainly linked of their status as judge and jury as to the rating of complex structured issues: the better the rating, the easier the commercialization, and the higher the commission...

Unnecessary because the risk-reward tradeoff is very poorly optimized. This due to capital consumption, poorly controlled risk and so called forecasts of over-profitability of this type of products (we will see later how this race to over-profitability has led to develop "ridiculous" financial engineering).


« Libyan Investment Authority (LIA), which managed $ 53.3 billion in assets in 2010 is said to have invested $ 3.45 billion in structured products. Société Générale has received more than half of those funds dedicated to structured products, about $ 1.8 billion.

The French bank did not really manage to grow that capital:
- A billion dollars was invested in the product Soc Gen Europe Meduim. At the end of the first half of 2010 the value of this investment was 284.5 million dollars, a 71.55% loss.
- $ 500 million had been invested on the product Soc Gen Strategic Equity Fund Codeis. At the end of the first half of 2010 the value of this investment was $ 567 million, an increase of 13.4%.
- And finally $ 300 million had been invested on the product Soc Gen -Cross Roads 5Y Link Notes. At the end of the first half of 2010 the value of this investment was $ 204.3 million, a 32% loss.

In total, $ 1.8 billion managed by Société Générale was worth only 1.055 billion, resulting in a capital loss of 41%! As a result of international sanctions given to Libya, the funds are blocked and continue to be managed by the bank until further guidance from the European Union on this issue. »

Recent events confirm the theories I just developed. I would read the Maxime Onan’s article on Next Finance’s website regarding the Libyan Investment Authority’s (LIA) financial misfortune.

I’m not an expert on geopolitics and I will not make any discussion on the world’s most absurd and cruel dictatorships that unfortunately holds a duration record (42 years in 2011); I do believe that we can and we must balance ethics and finance and beyond the probably poorly modeled and badly misunderstood structured assets, allow me to be indignant about this other aspect of finance at the service of dictatorships.

I’m just a financial markets specialist and, as such, I cannot help but look back on recent events, marked by a certain misunderstood structured finance that prevailed with insolence and recklessness.

Between 2004 and 2007, the traditional investment vehicles such as the OECD government bonds and corporate bonds and bank in low risk premiums can no longer satisfy the performance requirements of investors. Investment banks then will manufacture and sell to investors around the world credit structured products more profitable than traditional assets (thanks or rather “because” of leverages).

Amongst these credit structured products, are the so-called CDO (Collateralized Debt Obligation), all kind of debt backed securities or rather all kinds of debt derivatives. But as a result of mimicry of investors and imbalance between supply and demand, the profitability of the first generation of CDOs (synthetic) will greatly decrease. And with required returns by shareholders not decreasing, comes the birth of products more and more opaque and leveraged: CDO of CDO (CDO square) or CDO of CDO of CDO (famous CDO-cubed)

CPDOs were inspired by the opposite of the ABC of finance
Mory Doré

All of these products being no longer sufficient to meet the needs of excessive profitability and greed, CPDOs were created (we will come back to this product). It was the worst kind of product market finance had imagined: with leverages, the riskier markets became with higher risk premiums on issuers, the more you borrowed to take the risk and vice versa. Based on the fact that credit spreads would always return to an average (presumably that of the normal distribution that led to so many trading and arbitrage disasters). Anyways, the CPDO was inspired by exactly the opposite of what is taught by the ABC of finance.

My apologies, but I have to detail some technical issues of this product while trying to be as pedagogical as possible. Because, non-specialists need also to understand how far some kind of market finance could have gone.

1/ A CPDO (constant proportion debt obligation) is a very risky security with an exposure that is expected to decline during a tightening of spreads (when risk aversion declines) in order to capture valuation gains, and to increase when spreads get larger (i.e. when risk aversion increases) to increase the cost of carry. In an idealistic scenario, there is no credit exposure between 5 and 7 years in positions that often have contractual maturities of 10 years since the title is a "risk free" asset with accumulated carry... unfortunately, this scenario has never happened

2/ In fact, the amount invested by investors is partly to pay the set up costs while the remainder are invested in a Reserve Account. The amount deposited in the Reserve Account is then placed in AAA debt assets that pay the Euribor.

3/ On the other hand, the dealer takes a leveraged exposure on a debt portfolio (for instance, if the average spread is 25 bps, with a leverage of 10, the total premium earned on this exposure is 250 bps). Part is used to pay the coupon and the operating costs while the remainder is placed in the Cash Reserve Account.

4/ When the value of the cash reserve account reaches a level equal to 100% of par plus future coupons plus fees, the strategy stops (to investors’ delight). This is what we call the cash in.

Most CPDOs that were sold between January 2006 and July 2007 have naturally failed, and instead of cash in there were cash out. Those products were removed from the financial world since then but we’re not sure at all that this type of toxicity does not remain in some balancesheets.

At a time where credit spreads were at their historical lowest levels and risk of increased volatility of some issuers, even a defensive debt arbitrage strategy (buy/sell) was highly risky.

Moreover, was it right to go long on low volatile debts with an alleged tightening potential in order to claim maximum carry ?

In addition, one of the greatest heresies was that we have often favored leverage given by algorithms rather than discretionary processes in order to understand the evolution of debt markets (which could have helped increase its exposure when a tightening of spreads was anticipated and vice versa). All this could have helped optimizing returns and accelerate the cash-in that no one will ever see. Once again, history have shown the inability of experts and officials to learn from failures, traumas and crises.

Mory Doré , Next Finance , June 2011

Article also available in : English EN | français FR

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