Tynegwick Gawcott is a new blogger. He (for I know it is a he) will be one to watch. In his first blog he says:
John Kay, (www.johnkay.com) who was a director of Halifax at the time of privatisation, makes the astute observation that financial engineering is a zero sum game. If you added up the value of all the CDOs and credit derivatives (look 'em up in Wikipedia), they should have come to no more than the value of the underlying securities. Did any of the auditors blithely putting their names to the accounts of financial institutions ever do a ballpark check?
You can be they didn't Tynegwick.
Thanks for reading this post.
You can share this post on social media of your choice by clicking these icons:
You can subscribe to this blog's daily email here.
And if you would like to support this blog you can, here:
I’m not sure that claim is 100% correct.
The whole point of the financial engineering was to (try to) turn lower value securities into higher value ones.
Now, it is clear that one cannot conjure up cashflows from nowhere or change the overall risk of default on a package of bonds. So, in a perfectly sensible world it should be impossible for the engineered securities to be worth more than the original ones. Indeed, they should be worth less since the engineer presumably takes a cut.
However, the market for debt instruments is not perfectly sensible.
One example of why not occurs with mutual funds. If they are only allowed to invest in “investment grade” instruments there will be lower demand for junk and higher demand for the good stuff than would otherwise be the case.
Therefore, somebody who could turn a pile of junk into a small amount of investment-grade debt (plus lots of other junk) might just be able to benefit from this mismatch in demand. i.e. the total value of the resulting securities may be higher than the inputs.
That’s just one example. Another stems from the fact that ratings agencies assign discrete ratings rather than measuring instruments on a continuous scale.
None of this should be taken to say that the financial engineering was a good idea. But it does explain why rational people could have genuinely *believed* they had created value.
As a non-economist and non-banker, I’m not qualified to opine on whether they actually had or not.