Financial innovation keeps on keeping on

http://www.brisbanetimes.com.au/ffximage/2007/07/19/macbank200707_wideweb__470x312,0.jpg

July 20, 2007, MACQUARIE Bank chairman David Clarke yesterday was forced into a staunch defence of the controversial bonus scheme that delivered $200 million this year to its top 13 senior executives following an unprecedented shareholder revolt.

A good while ago I said to my broker I liked the look of Macquarie Bank and asked if I should buy some shares.  She said they were too expensive.  So I didn’t buy them. They were $8 at the time. Anyway, their fortunes have had a roller coaster ride.  They were certainly innovative, and some of the things they did even made the economy more efficient, a good deal and probably most of Macquarie’s financial innovation was driven by the search for ways to help their clients avoid tax.

Anyway, still surviving despite some ugly moments in the crisis, Macquarie is keeping on keeping on.  As yesterday’sfinancial newsletter The Sheet reports

High yield loans appeal to Macquarie

Macquarie Bank plans to buy corporate debt at a discount and to seek out special lending situations to fund troubled corporates at high rates of interest, the Sydney Morning Herald reported.

Macquarie is seeking high-yield lending opportunities worldwide and has established a dedicated business unit to seek out the opportunities. Ben Brazil crossed from corporate advisory to manage the new business unit, the newspaper reported.

Over the last three months the bank has raised around $14 billion in long-term debt, . . . more than any other bank.

This looks like good innovation non? It’s exactly the kind of thing that should be happening in the financial sector if it is to play its role in helping us out of the crisis. Because lending to business and working out what are relatively higher risks in doing so is something that competing banks will be much better at doing – or should be much better at doing – than government which is too slow moving, and too reliant on simple routines. and rules to really make it’s way surefootedly through the jungles of commercial finance. 

So it’s all good. Well except one thing.

Where those three dots are in the last sentence of the report, I’ve removed these words. “. . . with the aid of the Australian government guarantee”. Moral hazard here we come. So at least judging from this report, it has taken just a few months of the government guarantee for precisely the kind of moral hazard one might predict to emerge, for Macquarie to try to increase its margins by taking on more risk, all the while protected by – well you and me. Well the shareholders have got their equity to lose I guess, and they don’t want to do that. But the top executives will have pocketed millions by then – bonuses in hand and yachts on order.

I think that in handing out guarantees the government should be sticking as closely as it can to the more commodified parts of the financial markets that are easy to understand from the outside. Funnily enough a whole sector of finance is given over to the manufacture and on sale of just such financial instruments – instruments that have been designed to be understood by outsiders who would then invest in them. That’s what securitisation is.

Securitisation involves packaging up a bundle of well understood risks (for instance mortgages with an 80% loan to valuation ratio packaged with insurance) and then selling it to buyers in the money markets. You only have to have confidence that the trust deed was followed in writing the mortgages – and you can have that audited (again from the outside).  In the market for Australian securitised home loans buyers didn’t buy any toxic assets.  They understood what they were buying.

But as we all know, the markets in securitised assets have collapsed, not just because they were all tainted by the hijinks of Wall St repackaging of loans to people with no money, but also because this shadow banking system wasn’t backed by the panoply of liquidity supports and implicit guarantees to investors that is part of the institutional structure within which banks operate.  

And since the crisis the banks have received one favour after another, whilst the shadow banking sector has been tossed a few bare bones.  While I broadly support the government’s energy in propping up the financial sector, I’d rather be propping up assets than specific companies – because you can understand assets – or at least the kind of ones that get packaged up and securitised (OK, the ones that used to be securitised until the hyper innovators came up with CDOs). I’d say the government should proceed with great caution with the banks.  And it should have proceeded with less caution in helping the shadow banking system maintain its very healthy role as a competitive check on those within the official family.

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3 Responses to Financial innovation keeps on keeping on

  1. fascinating story Nick. A nice example of how a lot of financial innovation is driven by knee-jerk policies that were not well thought through (my opinion, not necessarily yours).

    Another example I would wish to add to yours that will keep haunting us until some politicians gets the courage to reverse it, is the assymetric tax treatment of superannuation introduced in the heat of the moment by Peter Costello when he was looking to get rid of his surplus in a politically advantageous way (those were the days!). This unequal tax treatment leaves the door wide open for people to hide income as pensions and spend untaxed income by borrowing with their superannuation as collateral. If you then resell the bought items (i.e. a house), the whole things becomes tax free. ‘SuperOutsource’ for instance advertises with this trick.

  2. pedro says:

    Nick, how exactly would the government stop the Macquarie plan being supported by the guarantee, other than by removing the guarantee from Macquarie. I imagine it is very hard to link the borrowing by a bank (which is guaranteed) to particular lending by the bank.

    Also, how will the guarantee work in practice? Assume Macquarie makes a meal of it and heads for insolvency. Will the govt guarantee only apply when the company is wound up? Or do the lenders/depositors get to claim on the govt as soon as Macquarie fails to pay. That is relevant to the risk being taken by shareholders.

  3. Pedro, I’ve not actually arguing in favour of the government removing the guarantee from Macquarie – I’ve not looked into it enough to be confident. But I’m drawing attention to the fact that the government has turned down someimportant opportunities to guarantee or otherwise support financial assets that they do understand, but they’ve declined. The RMBS – redidential mortgage securitisation – market is the classic.

    It was failure to defend it when it came crashing down in the first half of 2008 that was the beginning of the credit crunch in Australia – the banks moved into the newly vacated and highly profitable space increasing their margins (even taking into account their increased costs) as they went.

    The questions you ask in your second para were addressed by me. If my understanding of the way the guarantee would work is correct, then the shareholders are taking a risk. This is in fact one reason why all the talk about moral hazard is often overdone. Banks get rescued, but if things are done right their shareholders should be the first to lose money. That certainly should be the case where the bank is getting help with solvency rather than just liquidity.

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