Published Work

Controlled Chaos

These are hard times for investors and fund managers alike. After the 2008 financial crisis, central banks have spoon-fed billions of “cheap” money into the global financial system and lowered the interest rates to a bare minimum. In Europe, the ECB has gone even further when it introduced negative interest rates in June this year. These measures were necessary to revitalize the economy. Pumping money into the economy through asset purchases has prevented the risk of a downward spiral and sell-off after the crisis. The rock bottom interest rates have stimulated commercial banks to lend, as depositing money with central banks would earn them sub-par or negative returns.

.tyzden - published in January 2015
.tyzden – published in January 2015

Albeit often criticized for being too aggressive, these measures have done their job. Unlike during the great depression of 1930s, we have been spared the drama of bank runs, stock market collapses, poverty and a sharp rise in suicide attempts. However, paradoxically, the economic policies adopted after the crisis have worked too well, making the life for investors harder.

“Great moderation” is a state of decreased market volatility and inflation, when the economy becomes predictable and contained. It is the ability to keep the business cycle within set boundaries and a result of our virtue to control economy better. It is precisely where the world economy is at the moment. Paradoxically, the great moderation is a dangerous state for the economy, which has led to the financial crisis of 2008. The combination of low interest rates and the perception that we are in a range-bound economy with predictable policies and limited opportunity to earn excessive return tend to make investors much less risk-averse.

When investors start searching for above average return, things can go quickly wrong. Their herd-like pursuit of profit has made the financial system opaque and morally corrupt. Thanks to the financial alchemy, banks were happily giving out mortgages to risky borrowers, which were then sliced, diced, repackaged and sold onto investors in the form of financial derivatives. As the derivatives became ever more complex, their risk ratings and market price became distorted, which eventually led to spiraling sell-off and a distrust in the system.

Six years after the financial crisis, we have entered another era of great moderation, which is turning investors numb to risk once again. According to El-Erian, former CEO of Pimco, one of the world’s largest bond investment management company, there is a real threat of a credit boom and collapse, as the market enters a period of decreased macroeconomic volatility. The average yields across US junk-bond market are reaching all-time lows, as the investors rush to buy these risky assets in their search for a higher return. When there are few opportunities to make profit, financial alchemy creeps in.

The worst financial crisis in the history has left its impact. The business of mortgage origination has turned sour for banks as it became heavily scrutinized by regulators. Although people themselves have much smaller appetite to take on mortgages, the signs of improving economic stability and social security are prompting them to spend. When home purchase is not an option, shoppers turn to a next big thing – cars. The years of striving during the crisis has left many with outdated vehicles and an itching desire to buy, especially as they are lured in by attractive financing offers. The bankrupt US automotive industry has risen from ashes after the crisis, not least thanks to bold subprime auto loans. Similarly, in UK, the car sales supported by easy credit have seen car sales rising 27th month in a row in June. Somehow, lending to risky car buyers has escaped the attention of regulators so far.

There is another important angle to the booming auto lending. Like mortgages before the crisis, the auto loans are sliced and diced into securities, for which there is a booming demand in the market as investors clamour for higher yield. The financial alchemy of “securitization” is leading to even more lending, because it allows auto lenders, banks and other financial companies to get the loans off their balance sheet. Sales of asset-backed securities comprised of subprime auto loans surged 18 per cent to $21.5bn last year, according to figures from Deutsche Bank. Morally sound in its own right, the auto loans securitization may lead to a vicious circle of credit quality deterioration. Immune to risk and hungry for above average return in the economy of “great moderation”, the investors will continue to demand auto loan securities. As a result, lenders will move further down the credit spectrum and start lending to even more risky car buyers.

Despite this, the risk of another financial breakdown is remote. At $21.5bn this year, the size of the market for subprime auto bonds is minuscule compared to the subprime mortgages before the crisis. Let us not forget that people tend to be emotionally attached to their cars and are often prepared to sacrifice a good deal before turning in their darling for repossession. Occasions of creditors, who prioritized car installments over mortgage repayments are not rare. New and interesting, the U.S. industry of subprime auto-lending reminds us of wild west – new cars are often equipped with remote stop-start devices that give lenders ability to shut down cars of borrowers who are behind with their repayments. Although it is based on the same type of financial alchemy, which led to the financial crisis, the subprime auto lending is contained and helps the economy grow. At least for now.

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