Sunday, September 21, 2008

exotic securities

I worked for one of the big investment banks (there used to be five - as of this week there are two) and it introduced me to the wonderful world of exotic securities.

By "securities" I mean basically, stocks and bonds and options and... but we'll just say stocks and bonds for now. The things Mr. Howell used to obsess about while he and Lovey were stranded with the other castaways.

And if you've seen the movie "Trading Places" you'll have some understanding of short selling - which is basically betting that a stock or bond will fall in price.

For the longest time there were just stocks and bonds, which were straightforward, fairly easy-to-understand financial investments. What are now called, in the industry "plain vanilla" securities. Then options were added.

Then came the "exotics." An exotic can be almost anything - but especially a combination of anything. An exotic can be a "basket" which means a collection of virtually any type of security in the world - stocks, bonds, options, warrants, etc. in varying percentages, all rolled into one traded "instrument."

Robert Kuttner at the Boston Globe says:
financial firms created credit by inventing exotic, little understood securities.

I worked in the investment bank's Compliance department - the department that was charged with making sure that the bank's securities holdings met regulations all over the world. And as I watched the computer programmers wrestle with ways to track the securities holdings, to see if they were in compliance with the regulations I realized that when it came to exotics - they really could not. Because basically an exotic could be virtually anything the investment bank wanted it to be.

And, hence, as Robert Kuttner observes:
There was scant disclosure to regulators or investors, who mistakenly trusted bond-rating agencies. Credit has now frozen, as markets belatedly downgrade these assets.

more here

So basically, the bluff has been called, and the investment banks don't trust each other because they know the other guy's been doing the same thing, inventing new, complex, unregulated exotics, which means nobody really knows the value of the bank's securities holdings. The real value, as opposed to what the bank says is the value.

And that's why the financial world is in turmoil right now.

AND the feds still haven't caught up with the shenanigans underlying exotics trading. And that's why the crisis is not quite over yet.

Although they have suspended short selling, which helps a little. But shorting is not the actual problem - it's the under-regulation of exotics.