Dec 24, 2013

Watch for the conductor, not the musicians

Unlike in the early years of the 20th century, when one man, named J.P. Morgan, ruled the world of finance and was able to use his power to save financial markets from a collapse in 1907, today's highly complex and interconnected financial system does not dance to the tune of a single individual or institution. Instead, the modern financial system is reminiscent of a band of musicians that consists of the first violin and other performers. At times, however, one of the musicians puts his violin or contrabass away and assumes the role of a conductor. When that happens, the system becomes highly prone to financial calamities.

Up until the 2008 financial crisis, the role of a conductor was played by big US investment banks. These investment banks pooled interests of multiple constituents together: investors on supply side - namely, holders of cash pools; investors on the demand side - virtually every imaginable institutional investor; and other participants - credit agencies, insurance companies, commercial banks, and legislators in Washington. The investment banks were able to satisfy everybody – from ultimate borrowers, such as households, nonfinancial firms, and governments to ultimate savers, such as cash-rich corporations, asset managers, and securities lenders, to investors, such as hedge funds and foreign investment firms. The investment banks were able to beautifully orchestrate this intermediation network and profit from it enormously. On the flip side, the crisis would not have happened in the first place, if it was not for the investment banks assuming the role of a conductor.

A very LT investor should thus never forget to keep a close eye on the actions of a musician acting as a conductor. To identify the presence of a conductor and its influence, the following questions can be asked:

(1) Are individual market participants evolving their own way and competing among each other, or has one market participant spotted a profitable opportunity and is now engaging other market players, along with the Main Street corporations, consumers, and even foreign investors? For example, back in the 2000s, American bulge bracket investment banks pooled interests of various market participants together - from commercial banks that originated loans, to credit agencies that issued unrealistically high ratings, to institutional investors who bought structured products. These investment banks were more than just market players performing their services; they acted as an organizer of the entire assembly of market participants.

(2) More specifically, are market participants each offering their own products and services without much facilitation of other market players, or nearly all market members are involved in the production of the final product? The more complex the production chain is, the more inflection points are there in which the chain can break and crumble market participants through the domino effect.

(3) Finally, how influential is the conductor? Is the conductor setting the terms of the game, or market participants have some independence in their actions? For instance, before the 2008 financial crisis, investment banks explicitly told credit rating agencies what rating to give to this or that structured product, in effect depriving them of independence.

Financial history tells us that markets do not need conductors, but they do need regulators. When some market participants leave their musician's chairs and take the role of a conductor, a very LT investor should remember that a crisis is not far off.

1 comment:

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