Monday, February 4, 2008

Word o’ the Day: Finance (ABC’s of Financial Planning)

“Money, get away
Get a good job with more pay and you’re O.K.
Money it's a gas
Grab that cash with both hands and make a stash
New car, caviar, four star daydream,
Think I'll buy me a football team”
- “Money” (Pink Floyd)

You could substitute the word “Subprime” for the word “Money” in the song. The subprime crisis – while enormous in its reach and deep in its impact – is but the latest in a long list of financial excesses perpetrated by the so-called Masters of the Universe (see Tom Wolfe’s Bonfire of the Vanities – read the book though, the film was excremental). If you delve into the personnel at any major financial firm you will find an enormous number of people with MBA after their name. These people spend their waking hours figuring out how to make something from nothing – they are the alchemists of the modern age.

Finance used to be pretty simple: structuring Initial Public Offerings (IPOs) of stock and structuring offerings of corporate and municipal bonds. There were always excesses of some kind of course – where there’s money there are always predators to be found. But still, it was a pretty straightforward endeavor – structure financing for a business or government endeavor and fund it by finding people (investors) to invest.

As time went on, finance became more exotic, creating ways for investors (mostly institutional investors) to play both sides of the market, creating hedges for shorting (making money when an investment declines in value), building the proverbial “better spreadsheet” and engineering more and more ways to arbitrage minute differences in markets around the world. Tools created included: Hedge Funds of all shapes, sizes and flavors, Hedge “Fund of Funds” as diversification, Private Equity Funds, Commodity Pools, Private Financing, and on and on. What was truly created? Fees for fund originators, fund salespeople and fund operators.

Players in the current Subprime charade (Bill Gross of PIMCO referred to it as “…the pyramid scheme, chain letter driven structure of modern finance…”) were driven by fee income generated at every step of the transaction. At the bottom of the pile is the lowly mortgagee, the person upon whose timely monthly mortgage payments the upside-down pyramid rests. So what happens to all the spreadsheet models when this person and many of his similary-situated brethren fail to deliver? No monthly payments equals no cash flow to the investors holding the bonds and derivative securities built on top of the timely monthly payment. The upside-down pyramid falls over, crushing the “new car, caviar, four star daydream”. And the “football team” too.


[View all lyrics here:]

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