Saturday, October 18, 2008
Truth is eternal
Megan and I both linked to this article about Enron in 2002. Consider the relevance today:
I would say the exact same principles applied to the use of structure as proxy leverage (CDOs, etc.) and the exploitation of the "AAA" loophole in risk-based capital. And here we are.
Early in the process, as the arbitrage innovation is introduced, profit opportunities may exist. Also, the number of players arbitraging the inefficiency may be small enough so as not to impact the market-clearing price in a significant way. The arbitrage profits booked in a current period do not actually get realized until the transaction is completed or unwound. And the profit depends critically on market equilibrium conditions. If the number of arbitrageurs is small enough, market conditions will not change and the profits realized will be exactly the same as the profits booked. Accounting for these profits is a fairly straightforward task.
A major factor limiting potential profits is the scale of the arbitrage operations. One way to increase the scale of the operations is through leverage. So, early in the process, a company can increase profitability by using leverage. However, over time, new entrants come into the market, players become more sophisticated, and profit margins get squeezed. A normal equilibrating process will eventually lead to a complete elimination of the excess rate of returns.
So, in an attempt to prevent a reduction in profits, these companies increase their leverage factor. This simple process illustrates how, under some general conditions, a company involved in the arbitrage business will ultimately increase its level of investments and debts, and use ever more complicated accounting techniques to book profits. And a slight mistake could lead to the unraveling of the whole process.
Of course, in a perfect world, and with a true arbitrage process, such a mistake can never occur. But this is the real world. What happens when the world is not exactly as it is being modeled?
The possibility always exists that some unforeseen event will take place, so companies incorporate risk-control strategies (such as insurance) and plan for the best. But a company's upside is not the concern here. The more interesting case is what happens when the shock unforeseen by the risk-control strategy is an adverse one?
The immediate response is to cover the position. In some cases that requires reversing or unwinding some of the hedges and going into the market. Now here is where size matters. If the hedging entity is a small and un-influential player it will have no market impact. However, if large, it will effect the equilibrium prices. The attempt to cover the position will induce the price to move further away from the original market-clearing price.
The possibility of the hedging company crashing is clearly present, and to the extent that they are large enough, their impact on the market could destabilize other companies and the overall market.
This is a plausible explanation that relates the financial crisis originated by companies like LTCM with the fate that Enron has experienced. Almost all press accounts attribute the failure to bad investments, mountainous debts, and in some cases dubious accounting. Yet, as one looks deeper into the various failures, these are symptoms — and they are, in fact, the result of Enron's failure to understand the concept of general equilibrium.
I would say the exact same principles applied to the use of structure as proxy leverage (CDOs, etc.) and the exploitation of the "AAA" loophole in risk-based capital. And here we are.
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