Innovation is the hallmark of American finance. But Wall Street also needs to weigh risks, or its next down cycle will come harder still
The shipping market is booming, and yet again Wall Street is speeding into the middle of a once-sleepy market. Bankers are rushing in to broker capacity, finance construction of new ships, and link buyers and sellers around the globe. And just as they did in the mortgage-lending business years earlier, traders are creating widespread use of derivatives. In just five years, the Street has introduced shipping derivatives valued at more than $50 billion, dwarfing the $7 billion cash market.
In the shipping business, executives are stunned by the influx of complex and risky instruments and the wave of hedge funds that have shaken their historic way of operating. But on Wall Street, it's merely the latest example of business as usual.
Is the Street rushing toward what Yogi Berra described as déjà vu all over again? Even as the mortgage derivatives fiasco continues, have the banks locked onto yet another target for products with too much risk and at too furious a pace? If financiers are rushing new products to market in shipping just as they have been doing elsewhere for the past two decades, odds are not even the bankers who crafted those instruments know for sure.
Many have argued that Wall Street's strength is its ability to manage risk innovatively—whether in mortgages, shipping, consumer credit, or any other market. But recent events have undermined that claim. Rather than controlling its risks, the financial services industry has generated massive systemic risks in the short-term pursuit of profits.
While a few innovators have gotten rich quick, the companies they work for—lacking the ability to understand and manage the ever-quickening impact of new financial instruments—are suffering in the long term. The traders who pushed high-yield bonds in the '80s and leaped into leveraging Asian currencies in the '90s made a lot of quick money. But when those big bets ended badly, it was their employers, shareholders, and the public that paid the highest price.
Innovation is the hallmark of American finance. It would be a mistake to stifle it. But if Wall Street doesn't balance its fixation on speed to market with the ability to stay on track, the next down cycle will come harder and faster than the current one.
Recent Track Record
Think of the biggest busts of the past decade, from Long Term Capital Management to Bear Stearns. What do they have in common? A few brilliant traders. New products promising huge profits on the back of leveraged assets. Companies unaware of the risks—or even how to measure them accurately. An idea is hatched, and soon everyone rushes to grab a piece of the pie, because speed to market is not only a key part of doing business, but a badge of honor.
The breathtaking rise and fall of the collateralized debt obligations (CDO) market is a case in point. In the first quarter of 2004, global CDO issuance was $25 billion. A year later it was $50 billion. By 2006 it had doubled again, until in the first quarter of 2007 the number was $186 billion—a phenomenal 644% increase in just three years. This rush to market allowed some people to make handsome profits before the market became commoditized. But one thing was overlooked: the risk, which only became apparent when the bottom fell out.
In the first quarter of 2008, CDO issuance plummeted to just $11 billion. And suddenly, the inability of companies to understand and handle the risk they'd taken began hurting. To date, financial firms have written down more than $150 billion in bad CDOs. Even firms that have avoided Bear Stearns' fate have seen many billions more lopped off of their market caps.
Origins in the 1980s
How did we get to this point? The start came in the '80s, when Salomon Brothers revolutionized the industry, turning away from the investment banking that had been Wall Street's bread and butter toward proprietary trading. Soon everyone saw greater profits in trading their own books.
Then in 1999, the Gramm-Leach-Bliley Act opened the door to financial firms offering services well beyond their traditional fields, from insurance to consumer banking. With the whole world seemingly opened up, glory came to those who could craft new ways of securitizing and repackaging everything from municipal debt to first-time homebuyer mortgages.
And since any good idea is quickly imitated on the Street, the new priority became getting the idea out on the market before everyone else did. Those who so much as tapped the brakes risked seeing others grab their profits—or worse, having their talent walk out the door, launch the idea for a competitor, and make a mint.
The solution is, of course, not to curtail innovation. Vibrant capital markets are powerful growth engines for the global economy. We need product innovation, we need cheap access to capital, and we need mature hedging instruments.
But Wall Street also needs to do a better job of managing innovation. That ability comes from a more "industrialized" approach to new product introductions—akin to proven practices in other industries—combined with a focus on comprehensive risk management systems, financial accounting systems, and matching and settlement platforms. Building and managing products—both established and new ones—on common platforms gives managers a clearer sense of how a company's positions affect its risk exposure and capital commitments in real time. These platforms also slash IT costs, compliance expenses, and development costs. Ultimately, that makes bringing new products to market quicker, easier, and safer.
Yet we consistently see companies building new product platforms from scratch, often to feed the egos of division heads or provide bragging rights to salespeople. One international bank built a currency-trading platform from scratch for its hedge fund division when it already had one on its established trading desk. When completed, the two systems couldn't even talk to each other. Now the bank has to manage two disparate systems for the foreseeable future, adding more time, overhead, and risk to its operations. And with all of that effort, getting a picture of the firm's overall currency risk still isn't easy.
What's worse, that situation isn't unusual. There has been no shortage of instances where firms first launched a new financial instrument, and then months later built the reporting systems, only to find that their economic models were wrong and they were losing money.
Defending the Kingdom, Not the Fiefdoms
It is an unpleasant job to wrest control from the fiefdoms that have formed in the personality-driven, short-term thinking atmosphere of Wall Street. But as a matter of survival, management needs to face its responsibility to the company and shareholders and press for answers about the potential risk of new products beyond the short-term cash flow it may generate. Specifically, firms must have industrial-strength management and reporting systems in place before they launch these products and adopt the global, cross-asset class discipline to manage them.
The investment-bank-led Counterparty Risk Management Policy Group III said as much in its report to the Federal Reserve in August. In the name of the common interest, firms need to invest in human and technological capital and change the business processes that have undermined the financial industry. The short-term costs of these initiatives are insignificant, the group asserted, compared to the long-term costs of doing nothing.
Common IT platforms in the back office are a big step in the right direction and a critical advantage that Wall Street has done little to adopt. The auto industry, another highflier facing painful times, is a good model to think of. With SUV sales dropping, the companies that looked ahead and built flexible systems are now able to "flip a switch" to make hybrids on the same factory line. Those carmakers can produce a wide variety of products from a single platform at manageable costs, quality, performance, and risks, while their competitors are stuck looking to retool their whole operations. The same concepts can be applied to finance.
Ultimately, common platforms streamline the back end and improve Wall Street's speed to market. But they also allow better control and understanding of risk, which are essential factors to consider with the prospect of new speed limits coming into effect.