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Historia NOT Magistra Vitae. How central banks are exacerbating investment banks

The human learning ability, followed by the possibility of improving what has been done before, counts mainly on our own life experience, or in other terms our “history”. Everyone is either consciously or unconsciously learning from the past and taking decisions based on her/his own experience. In the masterpiece “De Oratore” Cicero, one of Rome’s greatest orator, politician and constitutionalist, uses the words historia magistra vitae: history is the teacher of life. Unfortunately, human history is characterised by an uncountable number of episodes where this Latin locution has not been applied entailing the recurrence of same mistakes. One of the most representative and impactful episode falling into the context of our long prologue is happening right now and almost the totality of market agents ignore its entity.

CDOs and CDSs
How most folks, curious of understanding about what tore the global economy down in 2007, should have run into two financial instruments: collateralised debt obligations (CDOs) and credit default swaps (CDSs) which played a leading role in the 2007-08 financial crisis. In simple terms, CDOs are packages of different assets such as mortgages loans, bonds and loans of different nature legally put together by banks and sold to private investors and funds. CDSs are the most common credit derivatives and work as an insurance policy. However, as the experience of the global financial crisis taught us, both instruments are extremely complex and hard to be assessed, even by rating agencies. The latter were harshly accused by the public for the bad work on assessing the quality of these financial instruments. In the aftermath of financial crisis reliable rumours reported that such rating agencies had their hands tied threaten by investment banks to turning to competitors for assessing their products issued. However, since “the yield hunting” never ends, demand for CDOs grew exponentially and greedy banks began issuing very low quality “sub-prime” mortgages loans. As one might expect, homeowners began to struggle for paying their mortgages and defaulted on their houses causing a devastating domino effect starting from the US housing markets and spreading across any aspect of the global economy.

The Big Short: Art imitates life
Now the history is set to repeat itself. Indeed, in the last year the first warnings sprang out and the monetary policy conditions are analogous with the ones just before the financial crisis. For the sake of our understanding, let’s start from the beginning. First, on the 4th February 2015, Bloomberg published an article reporting on an email sent from a Goldman Sachs employee addressed to investors of Wall Street proposing a new fancy financial product able to offer “exposure to diversified risk with the possibility of leverage, credit enhancement and enhanced returns”: bespoke tranche opportunity (BTO). Second, the recent winner of the Academy Award for Best Adapted Screenplay, the movie The Big Short, offers an alternative prospective of the subprime mortgage crisis through the eyes of hedge funds and its final warning to the public that the history is doomed to repeat itself.

A BTO is essentially a combination between CDO and CDS. In more technical terms, according to Bloomberg it is a CDO backed by single-name credit-default swaps pursuing to meet specific investors’ needs. The latter purchase generally only a tranche of the bespoke CDO as the pools of derivatives are divided in varying layers of risk. In this way, getting exposure to diversified risk and exploiting the leverage, the investor can obtain higher returns. According to the most recent data provided by BNP Paribas SA, transactions related to BTO peaked $20 billion in 2014, from less than $5 billion in 2013.

Is history set to repeat itself?
One might legitimately ask: How is it possible that the history, including central banks and investment banks risking to commit the same mistakes, is set to repeat itself? Well, before we mentioned that the monetary policy situation is similar to the years before the financial crisis. In the paper “Housing and Monetary Policy”, Taylor states that during the period from 2002 to 2005 the Federal Reserve (Fed) set the interest rates below the correct rate encouraging the house-price boom. Such excessively low interest rates induced financial institutions to over leverage their balance sheets chasing higher and higher returns turning out with the creation of “toxic” structured financial products such as CDO and CDS. From the aftermath of the financial crisis the situation is taking an analogous path. In 2008 the Bank of Japan (BoJ) and Fed, last year, adopted a new unconventional monetary policy based on zero interest-rate. Now, the European Central Bank and again BoJ surprised markets by cutting their interest rates below zero meaning that depositors are charged to keep their money in an account. The central banks’ aim seems quite clear, stimulating economic growth and increasing inflation. However, there is no common opinion among specialists about the effectiveness of this move. Some economists approved this orthodox strategy, whereas others consider it as act of desperation claiming that traditional policy is no longer effective. Time will tell.

Nowadays, just like the years running up to the financial crisis, banks longed for exploiting the current situation. With negative and zero-interest rates, investment banks are losing their patience. Greedy to make profitable investments and supported by progressing financial engineering, they have just begun to create new more risky and complex products. To conform this hypothesis, the Bank for International Settlements’ Working Paper no.514 “The influence of monetary policy on bank profitability” shows empirically that when the short-term interest rate rise (the policy rate set by the central bank) return on assets (bank profitability) also rises, and the relationship is amplified when the interest rates are lower. In other terms, low interest rates erode bank profitability and, in turn, it seems clearer why investment banks are trying to find a shortcut to pursue higher yields.

Conclusion
BTO is the first example of new structured financial product and probably exempt by Dodd-Frank Wall Street Reform and Consumer Protection Act, a financial reform signed under Obama administration aiming to prevent the recurrence of the same events that caused financial crisis. The approval of the compendium of federal regulations has obviously clashed with the lobbyist resistance and major players of global financial industry. The complex articulation of global markets and the increasing progress of financial engineering requires, in turn, more and more cooperation from all national and international regulators. Probably, Dodd-Frank Act may be seem as the first step to scale down Wall Street’s ambitions, but the financial regulation is still too fragmented and weak to provide a prompt response to issue of new financial products invading global markets.

Sathya MellinaThis Blog post was written by Sathya Mellina, Doctoral Researcher in the SBE in Economics.