Foolish ‘nice’ and Sub-prime Monarchs!

I would be very happy if you said after reading this article that it is a ‘nice’ article as it would mean a compliment. But if I wrote some article few centuries ago and you said it’s a ‘nice’ article, it would be not be compliment; it would be an insult to me! Why?

Well few centuries ago, ‘nice’ did not mean ‘nice’ or good but it meant ‘foolish’ or ‘ignorant’! Surprised. Don’t be. Look carefully at the word ‘nice’. The word comes from Latin word nescius. Travelling through the old French nescius reached English and ended up as nice. Nescius is derived from nescre which means to be ignorant. In root of nescius is scire that means ‘to know’ and gives us so many words related to knowledge such as science, omniscient (all knowing), conscience, conscious and prescient. However, over centuries the meaning and the form of nescience has changed from foolish or ignorant to nice. But nescient is still usable adjective which means ignorant. Isn’t this a ‘nice’ story about journey of word ‘nice’? Bye the way there is also a nice town called Nice in southeast France! Let’s move from Nice to Venice and Florence in Italy the hotbed of commerce and banking in middle ages.

Venicians and Florentians contributed a lot to modern banking development. The word bank comes from banca meaning a bench on which the money lenders and exchangers sat and did the lending, borrowing and guaranteeing payments for facilitating trade. However, if a banker incurred losses and was unable to honour the agreements, he would be taken out of the business and his bank (bench) would be literally broken. Latin word rupta means broken. Combine bench+rupta and you get bankrupt that we use today to describe a business enterprise or individuals who have more to pay than what they own.

Everyone reading this, I am sure by now knows that some American and European banks collapsed in 2007-08 after their borrowers, particularly the US house-owners failed to pay their housing loan instalments. These banks went bankrupt or were taken over by the governments with tax payers’ money. In this case the cause of bankruptcy of some of the banks was poor business judgement and or greed to make quick money. But in the middle ages (roughly 5th century to 16th century AD) the biggest risk of bankruptcy for European banks came from the kings and the queens. The monarchs used to borrow very heavily from banks to finance the innumerable wars which went on. Some monarchs paid as high as 45% interest rate. However, if the monarchs could not return the loan, the bankers could not do much, they simply went bankrupt. Lending to monarchs was as big a gamble (or unavoidable risk if they were forced to lend) by those middle ages’ banks as some of the contemporary banks took by lending to poor quality borrowers in the US housing markets. Many monarchs of middle ages in Europe and the humble households of the present day US thus share a poor creditworthiness, an equality not very welcome. Sub-prime loans are not new!

Big Bonuses in failed banks: corporate governance failure

One of the big issues in the current banking crises in the western banks has been 'excessive bonuses' and executive compensation paid in banks that incurred huge losses and were saved by tax payers money. Read this article for more on bonus culture and corporate governance issues. More...

What explains the financial crisis of 21st century?

Literally millions of words have already been written to talk about financial crisis of 2007-08 that has caused global economic recession. So one is unlikely to say something which is new on this issue now! One explanation is that savings from fast growing Asian economies and Middle Eastern savings from rising oil prices found their way into spending spree by the consumers in the developed west where, in particular, the US, these savings also fuelled housing boom. So when that unsustainable boom arising from consuming west and saving east burst we got the financial crisis. Therefore, why bother reading any more about it you may ask.

That’s perfectly valid question to ask. Here are some questions for you to check. What explains this crisis? why did highly paid and highly ‘qualified’ risk managers of some of the biggest banks in the world goof up? what is the meaning of moral hazard? and how that affects our daily life decisions? If you know the answers to these questions, please don’t read further. But if you are interested in exploring the answers to these questions with me, read on.

We begin by noting that social innovations have impact and many unintended consequences too on the society. The present financial crisis is an example of how the financial instruments that were invented to manage risks ended up creating financial risk for whole world. Let’s see how.

On the last day of 16th century, 31 December 1600, Queen Elizabeth I of England granted a charter to group of merchants from England forming a joint stock trading company called East India Company (EIC). The EIC lasted 258 years and did much more than just trading. The point is that joint stock company form of organising and managing trade got quickly replicated by Dutch and French too. Eventually, company as a form of organisation would transform the way business is done throughout the world. The limited liability public company is one of the most important social innovations of the last 4 centuries as it ensured that large scale business operations could be undertaken and that the smallest amounts of savings could used to finance those operations with the liability for the shareholder restricted to the nominal value of the equity share. Equity share in this way offers a maximum downside loss equal to the purchase price but the potential gains are unlimited if company performs well. But large number of shareholders meant that business of companies is managed by managers who may or may not be the shareholders. This results in potential conflict of interests between the shareholders (owners also called principals) and managers (agents). This agency problem can be very severe if the agents have far more knowledge about the business than the principals. And this is true in case of public limited companies. The knowledge and information advantage can create a moral hazard situation.

What is moral hazard? Moral hazard occurs when one of the two parties to a transaction behaves in a way that may potentially harm the interest of other party. This could happen when say a seller has more information about a product than a buyer has. For example, if as an insurance salesman I sell you an insurance policy which is of little real use in protecting your interests or I sell you a mortgage knowing that you may not be in position to honour the payments in time. Why will I do so? Well if my employment contract offers me incentives based on how many mortgages I sell I will do so. Moral hazard is very common in many day to day situations for example between professional advisors and their clients in medical, law or accounting and finance settings. Associated with moral hazard is the agency problem.


To deal with moral hazard and agency problems, most professions have their codes of conduct and so it is true for the managers of commercial companies, there are what is called corporate governance codes such as Combined Code in the UK and Sarbanes Oxley Act in the US which try to align the interests of principals and agents. However, the recent experience with the banking industry taking enormous levels of risks, has highlighted that the agency problem and moral hazard when they occur, can have devastating effects on not only the shareholders’ wealth but also on the wider community. Managers of banks giving housing loans to those borrowers who were not creditworthy enough were essentially taking business risks far beyond what prudential bankers would do. How does one explain this behaviour by not one odd small bank but by some of the biggest banks managed by highly qualified people? It can not be that they were unaware of the level of risks they were taking.

What would explain this behaviour is a combination of things. First is that there were incentives built into the remuneration packages of managers to maximise lending to earn higher returns by lending to high risk borrowers. But this alone was not sufficient condition. There are banking regulations and norms on capital requirements that would work as inherent check on the amount of lending that a bank could do. What helped the expansion of lending was the ability of banks to sell existing loans on their balance sheets to other investors and restart one more cycle of lending. This is a financial innovation called securitisation but it is not new and has been around for quite sometime. However, this process is not easy, before those bundles of loans can be sold to other investors, they have to be seen as worthy investments. For this, the prospective investors look at the credit ratings given by the agencies such as Standard and Poor and Moody’s. These ratings effectively are a judgement by these agencies about the soundness of those bundles of loans. In this case it turned out that many such assets with high ratings, called investment grades, later turned out to be much more risky than their ratings indicated. A further boost to the market for such mortgage based securities was provided by another financial innovation. Investors investing in securitised assets knew that there are always chances of some mortgage borrowers defaulting and therefore, the investments comprising such assets would be worthless in such situation. So companies like American International Group (AIG) would offer insurance protection against such assets becoming worth less. This is called Credit Default insurance. Thus the recipe for taking big risks by loan originating banks was complete and most banks participated in the housing finance boom in the US until it burst.

The cycle worked like this: Easy funding for banks from wholesale money markets, incentives for bank managers to lend more without due regard to creditworthiness of the borrowers, transfer the risky loans from balance sheet by selling them as bundles of loans (called asset backed assets or securitised assets) to other investors, those investors bought those because credit rating agencies gave them 'investment worthy grades' based in part on the fact that many of these loans were protected against the risk of defaults assured by insurance companies such as AIG, Freddie Mac and Fannie Mae. The cycle went on till 2006-07 when the borrowers of home loans started defaulting.

Everyone now knows the amount of risk that these banks took and its consequences are still unfolding. However, one big consequence of this has been a breakdown of trust between borrowers and lenders. Growth of finance and banking, just like the rest of the economy depends critically on the trust between the parties. If you reflect on the process we described earlier about expansion of lending it shows that managers of banks were entrusted by their principals, shareholders to manage the banks prudently, but they put their legally allowed remuneration interests ahead of overall risk they were creating. This brings into question the effectiveness of the remuneration committees in approving such compensation packages. Credit rating agencies failed in understanding the complexity and risks of the securitised products they were rating. Insurance companies offering insurance for products that were inherently very risky also failed their principals. The net result is crisis of confidence which has lingered on as lost trust among all stakeholders. This trust was built over decades but was destroyed in few months.

What is the way forward? For a start, individual incentives and behaviour cannot be ignored in analysing the current crisis. Hence remuneration policies and accountability will need to be factored into any new policy measures that the governments may consider. There is a simple but most powerful principle in economics and it is the relation between risk and reward. The remuneration policies in the banking industry simply violated this principle. While rewards were given in the short term, risks borne were of long term nature. The accountability in future must be individualised. Private gains and private losses both should be captured in the managerial compensation deals. The rebuilding of trust is bound to be a slow process and it can not be simply achieved by more and international regulation. The present crisis has shown there were regulatory failures and they need to be understood as well. More regulation, whether of national or supra-national character, will suffer from limitations of regulatory capabilities and competence. Confidence in markets where prudent management is rewarded will be slow to build, but that would seem more appropriate response.

Social innovations and their impact

The word ‘invention’ usually bring up image of science and technology in our mind. But there are social inventions, purists may disagree and say no they are innovations. Granted! There are social innovations. For example, innovation to manage things differently, concept of money, concept of a limited liability company, concept of family and so on. These social innovations have made human life more orderly and generally enhanced quality of life. It is generally true that necessity is mother of inventions/innovations. Born of necessity, innovations are legitimate children but born of greed and other motivations they could be ‘weapons of mass destruction’.

Financial Innovations:

Necessity: How to overcome difficulty of barter system in trade? Innovation: Imagine I have got 2 litres of milk from my cow and you have got 4 eggs from your stock of hen and the third person has got 10 kgs of wheat from her farm. We all need bit of each of these commodities. How to decide exchange rates? What if I don’t want eggs? Or you don’t like milk? So there was need for some common medium of exchange. After many trials and errors the social innovation: CONCEPT of MONEY arrived. This is a fantastic innovation if you think about it. It introduced a huge social change. It separated the production from the consumption. With money around I could now sell milk today and use part of money to buy eggs today and part to use buy eggs after one week. In other words it helped to conserve my wealth (ability to consume my income) over time. We see separation between production and consumption most clearly in form of pension fund. One saves during the working life to provide one’s pension after retirement. But what do you do with savings meanwhile? Give it to businesses who can invest in real business. But how?

Necessity: How to pool small savings to mobilise large sums to take up large scale business investments?

Innovation: Company form of organisation. There is more to be said about this in the next posting.

Necessary: How do you bring together small savers in touch with business promoters (funds deficit) who need funds?

Innovation: Several innovations made it possible. Intermediary players and rules/legislation made it possible. Collectively this is called financial system including bankers, brokers, stock exchanges and so on.

Necessity: What surety do small savers and depositors have about getting their money back and some return on their investments?

Innovation: Safety/surety depends on where one invests saving. Several innovations here.

A.For those who don’t want to take any risk, deposit the savings with government by buying certificates guaranteed by the government i.e., Treasury Notes or Treasury bills or bonds issued by government. (By the way government securities are considered ‘risk free’ because government has coercive powers to tax people. Takeaway that power, government securities are worse than junk bonds because government’s only real source of revenue is tax!)

B. For those who want little more return and are ready to take little more risk: There are deposit certificates offered by the banks not as safe as those offered by the central bank or the sovereign banks.

C. For those who want little more risk than savers in category B, they could buy the fixed income securities such as bonds issued by companies.

D. For those who want to take more risk than savers in category C, they could buy equity shares of companies.

Necessity: There is a farmer, growing potatoes, harvesting season is three months away. She is not sure of weather or attack of pests or demand for potatoes in three months time. All this means farmer is not sure how much she will realise per quintal of potatoes. Chances are that the price might be $ 20 for quintal or it could be $ 40 per quintal. She wants some certainty about her sale price in three months time. Now suppose there is a potato crisp producer who is in opposite situation as the farmer and wants to ascertain the cost of potatoes that he will have to pay in three months’ time. Both meet and strike a financial innovation.

Innovation: A contract between the farmer and the potato crisp producer that says that the farmer will sell potatoes at $ 25 per quintal to crisp producer in three months’ time is called Forward Contract. So one more innovation which is need based.

Necessity: Suppose the crisp producer thinks that the price of potato may be less than $ 25 in 3 months’ time in that case if he went for Forward Contract there is a risk that he would lose money as the market price will be less than $25 but he's agreed to buy potatoes at $25 per quintal. Is there a better way he could lock in a price of potato at maximum $25 or less.

Innovation: Suppose the farmer agrees to a contract whereby the crisp producer will have a right to buy potatoes at $ 25 per quintal after 3 months but not an obligation to buy. The contract further stipulates that the farmer will be obliged to sell at $25 if the crisp producer decides to buy the potatoes at $25. So this is a right to buy for potato crisp maker and an obligation for the farmer. Obviously the farmer is exposed to risk of losing money if price turns out to be more than $ 25 in three months time therefore, the farmer will expect some compensation for entering into such a contract.

That compensation in above situation is called premium and this contract is called an Option. The crisp producer buys an option from the farmer say for $ 0.5 per quintal. These contracts are also called derivatives. Why? Because the premium (value) of option $ 0.5 will vary with the underlying asset, in other words here the value of option is ‘derived’ from the value of potato. Valuation of options involves complex equations and the gentlemen who worked those equations out got Nobel Prize for Economic Sciences.

Options are not new though. They are as old as trade via sea or other dangerous routes but they appeared in a different form. When the goods moved by sea for example there was always a risk that they may be lost on the way due to piracy or accidents. Traders needed some protection against such losses. Some people who could understand the likelihood of such events occuring offered insurance contracts to the traders and this must have started very early on. But modern marine insurance contracts can be regarded as main predecessors of today's insurance industry. Insurance contract is nothing but an option for the policy holder. A car insurance policy for example provides a policy holder an option to surrender (a right to sell) a junk (after accident) car to the insurance company who are obliged to ‘buy’ the junk for agreed amount stated in the insurance policy.

We’ll stop with description of financial innovations here by just noting that the markets create new financial contracts to meet the varying needs of investors. Investors have different risk tolerance levels and return expectations. Financial markets thus innovate to meet those needs. Before we move on a note of caution: Never forget a simple and elegant rule of economics applicable to all the financial contracts: Higher rewards imply higher risks. There are no free lunches out there including this blog (you thought may be it is free because you are using your office computer and power connection! Well at least the time is yours and the confusion that you build up and the pain of trying to understand by reading what is written here are exclusively yours, that’s your cost, so no free lunch).

The above write up is 1291 words excluding the title. Now if you were reading to memorise it, it would take average 12-13 minutes or so, if your were reading to understand it would have taken about 5-6 minutes and if you have been skimming then perhaps you read it in about 3-4 minutes (how do I know this? well Wikipedia tells me the average reading rates). But trust me the rates for writing 1291 words will vary significantly. Anyway trivia apart, the above was written to make the readers familiar with some of the financial innovations as in my next blog posting I want to touch upon the role of options and derivative contracts and another important social innovation to discuss the financial and banking crisis. So this posting is a preparation for the uninitiated for the next posting which hopefully will be done during coming weekend. I’ll also mention what seems to me to be some of the biggest ever option contracts written after the banking crisis. Till that time ciao!

DISCLAIMER: NOTHING MENTIONED IN THIS POSTING OR ANYWHERE ON THIS BLOG SHOULD BE CONSIDERED PROFESSIONAL ADVICE. THE BLOGGER DOES NOT TAKE RESPONSIBILITY FOR ANY DECISIONS BY THE READERS AND THEIR CONSEQUENCES IF ANY WHATSOEVER.