The dangers of financial commoditization
Lessons for housing stock
Commoditization - what is it?
A commodity is a product which can be sold in bulk because its quality can be specified clearly on the basis of recognised standards. The current price (spot) of a commodity will apply to all of that commodity corresponding to a given specification against which the price is quoted. Differences in what people pay for a commodity normally relate to costs of transport and storage in moving the product from points disembarkation and its delivery to the final buyer as well as some associated fees such as insurance and quality inspection.
Commodity markets are well down the monetary risk learning curve
Mature commodity markets operate on the basis of secure specifications (product ratings) and liquidity buoyed up by short term financial commitments as opposed to long term financial commitments |
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Agricultural commodity markets have evolved from an ancient activity and today are quite sophisticated. Commodity markets work successfully because they are highly competitive and they have, built into them ways to sustain liquidity.
Maximising liquidity
Thus futures markets which constantly update the future price quotations permit companies as well as individuals to hedge as a basis of spreading risks between current and future outlays. On the other hand some futures trading is purely speculative. In general futures prices tend towards the proximate spot prices, in other words the shorter the maturity of a futures contract the closer it will be to the current spot price. One of the key characteristics of futures markets which sustain liquidity and "make" prices is that such transactions minimise the commitment of funds when a futures contract is taken out. Full payment comes from those who actually purchase and take delivery of the physical commodity. Thus if someone takes up a position by purchasing a futures contract, they can do so by paying a very small percentage of the stated value. If the eventual futures price moves the effective trade is on the difference (a gain or a loss) and the buyer pays the full delivered price. This form of trading results in the funds "tied up" in a futures contract being less than 10% of the delivered value. As a result the contractor's funds are not commoditized.
Financial commotitization avoided
In agricultural comodity markets it is not normal for traders and intermediaries to actually outlay the full value of a commodity consigment and to store it in the hope that its value will increase. These sorts of actions will be taken however by the producers and the final users. Thus farmers' cooperatives will store grain so as to avoid the price depression normally associated with harvest periods. Large grain terminals where ships are loaded with grain, need to sustain a very large product flow and the only way to guarantee this and enable efficient ship turnaround is to store many days worth of trade in silos.
Knowledge-based financial commoditization reduces risk
Millers buy wheat as a function of their required product flow to satisfy known demand for flour. Coffee roasters purchase bagged green coffee on the same basis. The important point to note is that money is committed or becomes commoditized only in the context of knowledge of the profitability of the process the commodity will be used for and the time horizon between commodity purchase and receiving payment for the processed output would normally be within a period of less than six months.
Liquidity, low risk and no long term finance
Broadly speaking this form of operation only ties up money in the commodity for a short time subject to known limits of variability of the value of the commodity and processed commodity. In other words the expectation that the value of input might be lower than output sold is low. As a result cash flow is maintained. Liquidity throughout the supply chain is maximised in an attempt to avoid the commoditization of funds invested in commodities. Broadly speaking this approach to commodities has been successful. Another reason for its success is that commodities markets do not generally depand upon long term finance.
Long term finance for specific players
Long term finance might be used in investing in the establishment of a mine, farmers need to finance a season's production but the process of buying and selling of commodities is either on the basis of small-outlay futures contracts or very short-term turnaround between the purchase of a physical commodity, its use and resale of the processed product. Under such circumstances finance would tend to be a working capital roll-over fund as opposed to a long term financial commitment.
If funds are locked into a commodity their value will move with the value of the commodity |
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The value of money
Money has two broad types of value. One is its declared value in terms of the size of the each currency component denomination such as a penny, a five pound note or a fifty pound note. These denominations will normally be exchanged at their nominal values for goods and services whose prices are quoted in nominal values. The reason people use such fiat 1 currency is that they are confident that it will be accepted in exchange for any transaction now and in the future. Based upon this foundation of confidence the other value of money is as a store of value in the form of savings. Generally, money that is saved is lodged with a financial intermediary such as a bank to whom, in effect, the savings are rented. In exchange for the right to use savings as collateral banks pay a rent generally known as the savings interest rate. Banks can pay this rental because they are using the collateral of primary savings to lever the advance of funds to other economic units for purchasing assets through loans or making investments with a view to generating a return. The Bank's profits are to be found within the difference between the rental (interest rate) they pay primary savers and the rental (interest rate) they receive from borrowers.
Financial intermediaries
The overall levels of risk to which financial intermediaries are exposed vary with the type. Building societies established for the purpose of assisting families purchase their homes were normally mutual associations. These were and are bound by specific regulations restricting the types of application of savings. In general household savers pay their funds into savings account "through the back door" and building societies make loans (mortgages) to families buying houses "through the front door." This mutual system avoided risk by establishing knowhow in how to assess the ability of families to pay their mortgages and then to establish a maximum percentage of the proportion of net-of tax disposable income for the repayment of mortgages. Another variable, used to reduce financial risk was vary the duration of a mortgage contract so as to vary monthly outlays as well as the percentage of the estimated value of the property being purchased covered by the loan. Where a mortgage did not cover 100% of the house value, then an initial downpayment would be required to make up the difference between the purchase price and the mortgage advanced.
The operation of British mutual mortage organizations has been successful largely because savers and borrowers were the shareholders and there was a sense of social value in supporting the funding of the purchase of homes through such organizations and borrowers remained aware that it was largely other householders who were advancing the funds they borrowed. The very close proximity of the interests of lenders and borrrowers resulted in mutual building societies operating a prudent operation geared to a very low level of risk. This is somewhat remarkable and in contrast to commodity markets because such societies sustained a low risk status in spite of the fact that their funds had been effectively commoditized. That is, the value of funds outlayed depended entirely on the value of the housing stock held and the currrent ability of mortgage holders to pay.
Demutualization and the launch into higher risk mortgage systems
In 1987, the Conservative government in Britain introduced the Building Society Act of 1986 which demutualised the provision of mortgages. This enabled banks to enter the mortage market. This saw a growth in banks purchasing real estate agencies as a move to vertically integrate the processes supporting their entry into the mortgage market. This move was a reflection of the naivity of the banks' assumptions on the gains from such diversification. Indeed, the risks faced by the banks increased because unlike mutual organizations the banks faced, and continue to face, a conflict of interests between making a profit to deliver dividends to shareholders and delivering value for their customers. The concept of "competition" leading to "mutual benefits" has not worked out as originally expected simply because banks have an almost unavoidable management overhead of something like 35% more than the the mutual organizations once dividend payments to shareholders are taken into account. Therefore in the case of house mortgages the risk on the side of the lender is higher in the case of the bank.
The commoditization of money
One of the fundamental tenets of good banking is advancing funds under conditions where the downside risks on any part of a bank's loan portfolio can be borne by the profit from the rest of the portfolio to end up with overall acceptable returns. Naturally a key strategy is to diversify the loans portfoilo to spread risk. This approach also helps sustain liquidity through a healthy cash flow of new saver's deposits, new loan advances and repayments of loans with tolerable default levels.
Managing commodity risks
As reviewed above, if money is invested in a saleable asset or commodity such as oil, wheat or even coffee the investment is often made through so-called futures markets. The reason this system works is because the cash flow coming into the market to purchase the delivered commodities is truly massive, in most cases it is global market cash flow. All of this means that although money is being used to "deal in" commodities, the money is not exposed to the sort of risk of, for example, of the world not being in a position to continue to buy the commodities concerned, there is almost always liquidity and cash flow. As a result of futures markets, money is not commoditized, its value is not wholly dependent upon the total value of commodities.
Housing stock is not a commodity
Excessive commoditization of housing stock without adequate quality standards (ratings) exposes the commodity buyer to multiple risks including those arising from fiscal and macroeconomic polcies.
These risks increase when trades take place over the international boundaries of countries pursuing different current fiscal and macroeconomic policy decisions. |
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In the case of housing stock one is dealing with a collection of discrete "lumpy" assets each of which are purchased directly by the "final consumer", that is a family each of which will experience a unique financial profile of earnings over time. Unlike all other commodities, which are all essentially consumed (except for precious metals and stones), houses represent one of the most significant assets which most families will ever purchase. All families face different prospects in terms of the status of employment of wage earners and personal habits. As a result the care with which a bank or building society assesses the risk associated with the advance of a mortgage needs to be an assessment which takes into account ability to pay now and the likelihood of ability to pay in the future. Care needs to be taken to assess the resales value of the property which has the status of the guarantee of the mortgage (loan) as long as the loan is not paid off.
Asset-based derivative - read commoditized funds
In the United States an attempt was made to increase the level of commoditization of financed housing stock so as to introduce the concept of commodity trading contracts offering an ability of financial institutions to take up "positions" by buying such contracts. This was an attempt to indroduce flexibility and liquidity into the current levels of commoditization as described under the mutual mortgage operations. This was also an attempt by the banks to escape from their structural inefficiency on mortgages advanced when compared with mutual organizations by increasing seeing "tradeability" and "liquidity" as somehow more sophisticated to the mutual organizations being "locked in" to lots of individual contracts. In order to create this "tradeable commodity" some large banks, who were underwriting mortgages in the USA, combined many mortgage contracts into a single portfolio, known as a derivative. These so-called "asset-based securities", or derivatives, were sold as commodities or as paper which earns a specific income, the net difference between mortgage payments and ongoing costs plus assets, or "capital", made up of the current resales value of the properties in the portfolio.
Lack of independence in specifications (rating) and inherent international trade risks
The image promoted was that such derivatives were equivalent to "commodities" backed by a specification on standards, known as ratings, created by agencies who in fact were part of the very banks selling these commodities. In the agricultural commodity world no such a dependency exists and there are very well worked out procedures for compensation when quality standards are not met. The risks associated such commodities related to the confidence in quality specifications (ratings). However, the determination of risks becomes extremely difficult when such commodities come to be traded internationally between banks in different countries simply because the variables of exchange rate come into play.
Buyer beware
What was missing was a futures market and any serious hedging. The reason there could be no real futures market or practical hedging was that the cash flow, liquidity was wholly dependent upon the advance of the full value of the house in the form of a loan. This very high risk condition was also intensified, or alleviated, by the conditions in the United States economy. Thus any differential movements in the US interest rates had a likelihood of either lowering the value of the dollar or causing mortgage holder to default. These effects paradoxically would both cause a decline in the exchange rate of the dollar against other leading curencies (ceteris paribus) as well as a decline in the value of the cash flow gained from the security. The other severe constraint on this commoditization was the nature of house disposals. With no futures markets the real estate sector goes through the process of repossessions. When the banks holding derivative papers backed by such assets and literally offshore, property repossession and disposal to recoup the remaining funds tied up in the property depends upon the services of several third parties; this raises costs. If a foreign bank holds such derivative as assets in their porfolio and, as happened, the USA rises in interest rates caused a significant level of loan defaults, then falling dollar exchange rates depreciated the value of the cash flow being received as repayments on the mortages which had not defaulted. In other words there was no buoyant global market providing a ready low loss means of disposal on a small advance of funds.
Where future's contracts did not work
In a sense the purchase of such asset-based derivatives was somewhat like a futures market contract which runs through to physical delivery of the product. Because the liquidity of the holder is closely related to the liquidity of the mortgage buyer and both upon US fiscal and macroeconmic policy there are multiple inhererent risks in the purchas of such commodities.
Specification standards
It is clear that since fiscal and macroeconomic policy influence derivative performance to such an extent that the ratings used are not comparable with the specifications applied in commodities markets. These tend to be physical measurements such as type of wheat, humidity, percentage not wheat etc. In the case of the house purchase there are several unknowns because the status of each house mortgage contract depends upon specific family circumstances and policies. Policy cannot change the humidity of wheat or its type.
Enter Northern Rock
Nothern Rock is a prime example of how British legislation combined with imprudent management to create chaos. Northern Rock started out as the Northern Community Fund about 150 years ago. It was established as a mutual association by a group of shopkeepers. In 1968 it merged with the Rock Permanent Benefit Building Society. The beginning of the end was its transformation to the status of a bank in October 1997 when it scrapped its building society status and amalgumated with another 53 societies. Northern Rock became far too exposed to the US-based derivatives because it thought they were safe commodities. Even although the agencies who rated the risk of such derivatives worked for the very people selling them, did not raise any questions. Indeed, no one seemed to be curious as to why the US traders were off-loading such high volumes of such derivatives to foreign buyers who were likely to face higher risks.
Unrealistic expectations
The excuses put out were that the characteristic of the financial derivatives markets is that they rely heavily on short to medium term likelihood of their resale and this in turn depends upon, eventually, unrealistic market expectations, and upon the ongoing capability of debtors supporting a derivative to sustain their payments. The predictions of the US housing market boom bursting have been around for at least 4-5 years so why did holders not try to sell them on 2-3 years ago? To class the Northern Rock financial strategy as financially sound was clearly a misrepresentation of the facts. What happened to Northern Rock was that simply because they were investing in a commodity which by its nature cannot be treated as a commodity, resulting in a significant proportion of their portfolio being at risk. Thus all of the funds tied up in these "commodities" began to depreciate in value because the outstanding loan's recoverable value rested on a falling resales value less "diposal costs". The issue of banks not sustaining short term inter-bank lending was not just an issue of trust, the sinking value of collateral had literally driven liquidity and cash flow out of a significant part of their portfoilios. Thus a £million invested could be transformed into £800,000 or even less, levered down by the falling dollar and rise in disposal expenses. The commoditized funds were trapped and literally eroding. The rental value of the money fell simply because the renters were leaving or/and because the dollar rental payments expressed in £s were out of kilter with UK market interest rates and expected returns because of the fall in the dollar.
Decision analysis
Sound decision analysis in financial intermediation requires that cash flow and liquidity be maintained, that there are always people entering and leaving the financial market in terms of taking up new loans and having paid off loans. Without this there would be no savers assisting those who wish to purchase homes. To prevent the degree of commoditization of the funds observed it is necessary to arrive at risk strategies which first and foremost protect the saver who puts up the funds. In order to do this it is necessary to cut the size of loans to ability to pay.
Monetary policy
The monopoly intervention of Monetarism in the floor rate of money rental (interest rate) can have a disruptive impact on both house prices with loan collateral effects as well as upon the ability to pay, lower real income resulting from higher interest rates. Given the banks higher cost structure and conflict of interests in serving savers and shareholders it would seem to make sense for the governmentto to reconsider the role of mutual organizations in housing finance and consider the possibility of making their loan contracts private agreements and not subject to interest rate interventions from governments. Since banks remain central to the current macroeconomic policy management then it is necessary to set out strict limits on either the holding of portfolios with derivatives funded from other national markets (e.g. USA) as well as introduce risk sharing based upon clear distinctions between the ability to pay and property values. It is also fairly obvious that to purchase derivatives which are not underwritten by a process whereby the changing needs of borrowers, arising from fiscal and macroeconomic policy decisions, are built in to their mortgage contracts only raises risks. Making such allowances could reduce the percentage of housing stock held going into repossession and an effective loss situation.
Lower the degree of commodization of housing stock
In the end, this story is one of intermediaries not facing up to their responsibility of ensuring prudent lending based upon rational risk assessment. There are many areas where this asset-based derivative saga has shown technical incompetence on the part of buyers and a certain lack of ethics on the part of sellers, especially in the area of the incompetent rating (specification) of products. As a result of this, as well as inappropriate fiscal and macroeconomic policy impacts, we see the perversity of KM 2 policies impacting savers and borrowers alike in an unacceptable fashion. The fact remains that the existing macroeconomic and fiscal policies remain in conflict and are unable to address this issue and indeed had some role in exacerbating the state of affairs of derivative holders. The answer rests in reducing risk by separating the funding of mortgage loans from an asset-based derivative which commoditize money to such a degree that the risks arising from normal macroecomic policy decisions in the rest of the economy, or in mortgagee economies, impose intolerable burdens.
1 fiat: paper money authorised by governments.
2 KM signifies Keynesian-Monetarist. This term is used frequently by Hector McNeill in his writings on the Real Incomes Approach to emphasise the parallel impacts of macroeconomic policies based upon these approaches in creating perverse arbitrary impacts on the some segments of the economic and social constituencies. This analysis provides a convincing explanation for the parallels between the Keynesian-dominated policy crisis of the 1970s with the Monetarist-dominated policy crisis of 2008.
Updated: 19th April, 2008: clarified last sentence.
Updated 22nd June, 2008: added references.
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