For more than a decade, economic policymakers and investment bankers waxed lyrically about the wonders of financial engineering. The ability to package disparate bundles of risks was an ingenious way to diversify and optimize returns. Mathematicians and engineers were press-ganged into designing vast correlation matrices of risk profiles. Complex covariance models were created to justify low risk levels to the credit rating agencies. They, in turn, used the models to assign AAA credit ratings. As a result, bankers were able to securitize a wide range of credits, from credit cards to car loans to mortgages, and the size of the structured products market soared six-fold between 1996 and 2007, cresting at $2.7 trillion. These products became huge sources of revenues, as bankers and credit rating agencies demanded higher fees for constructing and analyzing the packages. At the same time, the creation of the Credit Default Swap, another wonder of financial engineering, allowed investors to buy protection against the risk they were assuming. Unfortunately, the intricate lace of financial structures came tumbling down in 2008, with the collapse of Bear Stearns and Lehman Brothers. The Great Depression of the 1930s was averted by the massive injection of liquidity by the Federal Reserve and European Central Bank, as well as an equally daunting set of fiscal stimulus packages. However, we are now dealing with the detritus of the financial bonanza, and what we see is not pretty.
In their haste to bundle mortgages and generate fees, there was alot of slop. There was such a frenzy of activity that there were serious problems with the documentation process. Mortgage servicing units lost many of the original or copied documents. Now, the banks are facing serious challenges as they try to foreclose on properties. During the hearing process, banks need to present the documents that outline the terms and conditions of the loans. However, many of them were unable to do so. As a result, the foreclosure process ground to a halt as lenders scurried to find the necessary paperwork. Moreover, in the process of investigating what when wrong, regulators found that many of the banks improperly processed the loans, thus making it harder for them to retake possession. All of this is creating serious problems for the future of the structured products market. Investors are insisting that banks repurchase problem mortgages, which will only generate more losses for financial institutions. It is also darkening the prospects for the reactivation of the structured products market. Many analysts were hopeful that the revival of the securities industry and growing appetite for risk would induce investors to renew their demand for structured products. However, the foreclosure crisis is only highlighting some of the flaws of the financial innovations that were made during the past 15 years. Today, the main sources of mortgage lending remain with Fannie Mae and Freddy Mac, two state-owned institutions that are struggling to stay alive while on life-support.
With the most lucrative parts of the industry dead, financial institutions have no other choice but to pile into the cash market. It is the only segment that is alive. During the 1990s, the banks abandoned the cash business. The SEC and NASD (now FINRA) progressively made equity and bond trading more transparent, reducing profit margins. Likewise, bond and equity underwriting fees were paltry in comparison to the spreads generated by derivates and structured products. However, the banks have no other choice but to return to the cash markets. In the process, they are driving down spreads and commissions. A look at third quarter results shows that trading margins are collapsing. Like the rotting zombies of B-rated horror movies, the banks are devouring the flesh of the last remaining financial business. They can do it because they are flush with cash, thanks to zero-percent interest rates and QE. However, their businesses are no longer viable. Their overhead costs are bloated, thanks to higher base pays and generous guarantees. Fancy buildings and fleets of private jets cannot be sustained by the razor thin margins provided by trading cash bonds and equities. Moreover, the government support systems will not be around forever. Political changes are bringing in new teams of legislators and regulators who will not be so kind. Therefore, all of the financial engineering of the last 15 years was alot of fun while it lasted, but it was no substitute for basic credit analysis and fundamental business relationships. Unfortunately, the financial voodoo only served to create an army of zombies that will eventually meet their bitter end.