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Being a long time student of finance (starting digging into the markets at the age of 13) I have been particularly interested in the financial crisis that we are in the midst of.  I have been thinking through why something as large as this crisis happens.  Of course, for something so large and complex, there are a number of things that had to come into play to create the scenario but one macro theme in particular leaped out at me.

The theme I am talking about is removing faces from finance.

What do I mean by that?  My thinking is this: once you remove relationships from financial transactions and instruments things start to get messy.

If you are once removed, for example when you buy the stock of a company that you don’t have any personal relationship with, you are probably OK and you hope that the management is giving you quality data to asses.  There’s trust there.  However, when you get further and further away from a face to face relationship with, say, derivatives like CDOs, things simply get out of hand.

I have never been a fan of derivatives and other “abstract” financial instruments.  I always found it odd that no one really knew what the underlying assets were.  Was it Joe’s house, Acme Corp., both? To the creators and traders of these securities it was just paper (digital “paper”) with an assigned value.

I am not the only one who was worried about the issues that could be caused by abstracting finance.  Warren Buffett was worried too.  He once referred to derivatives as “financial weapons of mass destruction.”  Buffett also referred to derivatives this way:

“There is an electronic herd of people around the world managing an amazing amount of money who make decisions based on minute-by-minute stimuli,” said Mr. Buffett, adding, “I think it’s a fool’s game.”

His partner Charlie Munger was also not a fan.  Munger once said:

“The accounting being deficient enormously contributes to the risk,” said Munger, lamenting that executives and shareholders were getting paid on “profits that don’t exist.”

Exactly. Profits that don’t exist and assets no one really understands or can put a face to is a recipe for disaster.

At this point I should note that when I say face to face I don’t necessarily mean it literally.  I am more or less referring to the relationship one has with an asset and how close they are to it.  That being said, let’s take a look at the banks.  I will keep it short since I all of you already know what I am going to say.

Banks, given the market’s appetite for CDOs, were able to grant loans and then immediately get rid of them to someone who would package them up and send them off to a big bank like Merril Lynch who would then create CDOs, etc. etc.  Do you see the issue here?

A bank’s business is to take in money in the form of savings and distribute it (and thus take on risk) in the form of loans on which they make their interest (i.e. their profit).  Normally the banks have to look someone in the eye and really figure out if the person will pay the bank back since the bank is stuck with a bad loan if the person doesn’t pay.  The loan default is the bank’s risk.

With CDOs the bank can make a loan and immediately offload their risk (although as we saw a lot of banks didn’t offload the risk fast enough).  Now, as you can see, the bank isn’t incented to look at borrowers as closely.  They are incented to give as many loans as they can and then ship them out the door.  That is when finance becomes faceless, and also “risk-less” for one party, and when one persons transaction is viewed as risk-less the outlook becomes bleak since nothing is really inherently risk-less (just like there is no such thing as a free lunch).

We need to get back to face to face finance where people make deals with people they know and trust and they have to since they have to hold that risk.  We should really think twice the next time we try to abstract finance and create derivatives.  While cool and intereting to finance wonks creating derivatives is probably not a good practice nor does it create long term value for society.