Financial realities

Here’s an interesting idea. What if you tried to understand the economic muddle of the world today… not by separating into developed and developing world, but into the financial economy and the real one?

Corporate Finance teaches us about two kinds of assets, real and financial. House: real asset. Collateralised Debt Obligation secured against that house: financial asset. The two are connected, but different. And with modern finance layering in ever more separation between the real and the financial, that connection is getting weaker all the time.

Take junk bonds, for instance, which have quietly become a normal part of finance thanks to learnings gained after the disasters of the 1980s. (In a similar way, CDOs and CLOs will rise again post-subprime, but that’s another story.) Junk bonds are, essentially, a financial asset with ZERO connection to the real world. All they’re backed by is an idea: an idea that might be successfully executed by the people who dreamed it up, and might produce profitable real assets some years from now. Often they don’t, which is why the coupon payments on such bonds tend to be high (reflecting the risk premium demanded by the financier.) But even in the absence of those real assets, the junk bond has a life of its own. It can be traded, gain value, lose value, or be destroyed like any real asset. To say financial assets occupy the same economy as real assets is missing the point.

Take the subprime mess. A single CDO paying 6% owned by an Australian pension fund was a perfectly valid investment until 2007. That CDO was part of a grab-bag of similar CDOs, paying different returns due to different levels of risk. Those CDOs rested on paperwork agglomerating sixteen billion-dollar tranches of residential debt, which themselves were supported by traded off-balance-sheet obligations collected together by four agencies acting for 200 banks in thirty US states, whose creditworthiness was rated by various other agencies from AA to B+, making home loans to a range of customers in social groups AB1 down to C2 and below. All of these bits of paper have an independent existence far from the real world.

Somewhere, at the bottom of the pyramid – where the paper chain’s first page details a recurring 25-year stream of interest coupons at 4.5% plus a 3.5% risk premium – is the only link to the real economy, where Mr Williams from Alabama is trying to make the next payment on his pricey 8% mortgage.

That’s it. That’s the only link. And when certain circumstances exist in that real economy – for example, house prices rising steadily for a decade – that real economy doesn’t affect the financial economy at all.

In fact, that link is now so weak you can disregard it, as many bankers already do. The real, asset-backed economy and the floaty, financial economy are two different worlds; they have different KPIs, different interest rates, different inflation levels, unemployment rates, and measures of money. In fact, they’re as different as it’s possible to get.

Yet all our economic indicators – inflation (just 2.5% in the UK today? Don’t make me laugh), interest rates, tax – are gained from glomming the separate economies together, and are therefore completely WRONG. Let’s treat these two worlds as what they are – separate – and start understanding our world a little better.

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