Financial complexity is not the same as sophistication

I am intrigued by the current financial market issues. I don’t pretend to be an expert, or even hugely widely informed, but I have had enough exposure to be able to read between the lines, and do at least know what a CDO is. In addition, there has been a load of commentary about this from folks who are well informed, and it makes interesting reading (the FT and the Economist seem pretty good).

But, one area that I do find intriguing is how frequently these debt market instruments are described as ‘sophisticated’ (or similar wording). From what I have seen the collateralised debt markets are an elegant idea since they should allow better matching of risk appetite in debt, in the same way the normal stock market does for company ownership. And, they seem to have allowed a lowering in loan rates for many situations. That may have lead people into difficulties since it reduced the debt servicing burden, but didn’t raise skills in handling the now relatively increased volatility risk – but that feels like a social issue, not a vote against a more efficient market.

But, I struggle with calling them sophisticated – instead I think there more defining characteristic is complexity. The securitised loans have dense legal agreements underpinning a huge web of interactions and parties (e.g. originator, servicer, manager, and three or four classes of investor from AAA downwards). These agreements are designed to ensure everyone does what they should under a wide range of scenarios, as well as being able to understand critical parts like cashflows. Moreover, the initial loans can then be packaged up into other loans that put together all sorts of types of loan, with the goal being matching risk levels and/or handling capital … but making it harder to understand how the performance might change if the basic assumptions used in the constituent loans needed revisiting (as they inevitably will over time)

What seems to be missing (AFAIK), and what I would have expected when people describe these vehicles as ‘sophisticated’ is a way to have new information and models cleanly and simply ripple through the web of CDO’s and similar vehicles. The new information could be new news such as recent US sub-prime lending not looking like older lending, as had been presumed when these loans were first rated (no shit – the standards relaxed dramatically – why was it reasonable to expect them to behave the same?). Or, it could be scenarios to aid stress contingency planning.

What actually happens (again, from my limited knowledge) is that a few critical metrics for each CDO are published monthly – for example, loan loss and income. These can be used by investors in their own models to assess performance, or by ratings agencies in rating new compound CDO’s … but it is hard to use them routinely to establish current risk unless the models and infrastructure are sophisticated.

And, that’s the rub – the financial vehicles themselves aren’t especially sophisticated, it’s the investors who need to be sophisticated. Indeed, their complexity and opacity puts an extra burden of sophistication on the users. That leads to a couple of issues, both of which seem to be visible at the moment. Firstly, the institutions who get the biggest surprises will be those who weren’t sophisticated enough – for example smaller German banks. This is just the latest way of showing the age old paradigm that the risks will be left with those least able to understand them. Secondly, the sheer complexity is stretching even sophisticated modellers, partly because the number of cross-linkages forces them to be dependant on less good modellers.

The use of ratings agencies should of course help here (that’s the basic idea), but that doesn’t feel like a sophisticated structure, even if the agencies are good at modelling. The use of a few distinct ratings (AAA, AA etc.) and the non real-time nature of ratings means that there will inevitable instabilities. The use of compound vehicles magnifies these. Moreover, the ratings are averages of default risk when exposed to the agencies stress models, so make it harder for the market to understand the impact of distinct shocks – sophisticates might manage it, but the market needs everyone to do it for even the sophisticates to really benefit.

All of this really relates to why I react against the description of ‘sophisticated’, not analysing how the markets have frozen up (I’m waaay too ill informed for that – I’d rather read others views). But, I would note that it kind of precedes the actual market freeze-up and the impact that had on folks like Northern Rock. That feels more like a re-proof that in really stressed times all risk become heavily correlated, so you’ll get unpredictable outcomes.

Let me end as I started. I’m not an expert on this – it’s just musings, and I could have the wrong end of the wrong stick.

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