Harnessing the benefits of Financial Innovation rather than falling prey to its demons
by Rajat Bhatia
FINANCIAL INNOVATION AND 25-SIGMA“FINANCIAL CHERNOBYLS”:
During the 2007-2008 financial crisis, the CFO of Goldman Sachs, David Viniar, announced in August 2007 that Goldman’s flagship GEO hedge fund had lost 27% of its value since the start of the year. Mr. Viniar explained, “We were seeing things that were 25-standard deviation moves, several days in a row.”
One commentator wryly noted:
That Viniar. What a comic. According to Goldman’s mathematical models, August, Year of Our Lord 2007, was a very special month. Things were happening that were only supposed to happen once in every 100,000 years. Either that … or Goldman’s models were wrong (Bonner, 2007).
To give a more down to earth comparison, on February 29 2008, the UK National Lottery is currently was offering a prize of £2.5m for a ticket costing £1. Assuming it to be a fair bet, the probability of winning the lottery on any given attempt is therefore 0.0000004. The probability of winning the lottery n times in a row is therefore 0.0000004^n , and the probability of a 25 sigma event is comparable to the probability of winning the lottery 21 or 22 times in a row.
But sadly Goldman were not alone. In 2007 alone, massive losses were announced by Bear Stearns, UBS, Merrill Lynch and Citigroup, and then there were the earlier financial disasters – 1987, Daiwa, Barings, Long-Term Capital, the dotcoms, Russia, East Asia, and so on – and afterwards Société Générale and Bear Stearns again in early 2008, with rumours of more yet to come.
Citi’s case was particularly interesting. To quote from the same commentator:
Gary Crittenden, Citi’s chief financial officer, claimed … that the firm was simply a victim of unforeseen events. … No mention was made of the previous five years, when Citi was busily consolidating mortgage debt from people who weren’t going to repay … pronouncing it ‘investment grade’ … mongering it to its clients … and stuffing it into its own portfolio … while paying itself billions in fees and bonuses. No, according to the masters of the universe, downgrades by Moody’s and Fitch’s were completely unexpected … like the eruption of Vesuvius; even the gods were caught off guard. Apparently, as of September 30th, Citigroup’s subprime portfolio was worth every penny of the $55 billion that Citi’s models said it was worth. Then, whoa, in came one of those 25-sigma events. Citi was whacked by a once-in-a-blue-moon fat tail.
FINANCIAL ENGINEERING AND THE MAJOR GLOBAL BANKS
An analysis of the behavior of stock prices of major global banks and derivatives houses during the last five years paints an interesting picture. With the exception of Macquarie Group, an Australia based global investment banking and derivatives firm, whose stock price is up 124% over the last five years and JP Morgan whose stock is up 45% over the same period, all the other banks who are active in investment banking, financial markets and OTC derivatives, are in the red. It is worth noting that the S&P 500 index is up 47% in the same period and HDFC Bank, an India based bank focused on consumer banking and working capital finance recorded an increase in its stock price by 125%.
Stock price performance of major banking institutions benchmarked against S&P 500 over the last five years ending on 26 February 2016.
Clearly, the derivatives, structured products and financial engineering firms are facing headwinds. These headwinds, have been most pronounced in the case of two European banks (1). Deutsche Bank whose stock price is down 67% over the last five years and which has been rumored to be running into the reefs just like Lehman Brothers did in 2008; and (2). Credit Suisse whose stock price is down 63%.
In the final post by Rajat Bhatia, we will talk about lessons learned from the wave of financial innovation. You do not want to miss that!
This, of course, is just a teaser to what you can expect at o
ur 2-day Management Development Program on Structured Products and Financial Engineering by Rajat Bhatia on 28th and 29th April, 2016. Enrol Now!