Structural problems


The regulatory response to the Wall Street Crash of 1929 was the Glass-Steagall Act, which separated commercial ‘socially vital’ banking on Main Street from the more speculative ‘markets trading’ banking of Wall Street: the one to physically maintain the payments system and lend in an economically critical and regulated capacity, (‘systemic’ and guaranteed as such by the State); and the other to design, manufacture and trade financial products, without guarantees for, by implication, the less vital or useful purpose of mere speculation and profit. The US economist JK Galbraith, who chronicled The Great Crash (published in 1955), dedicated a whole chapter to the kinds of structure and ‘innovative design’ that in hindsight today appear to have been at the centre of most crises since – the marvels on that occasion being the Shenandoah and Blue Ridge corporations. It’s well worth a read and, notably, it took him a generation to find his perspective on those events and their aftermath, including a world war.

There are many ‘structured’ products that have become an ubiquitous part of the investment landscape, yet which, for some, echo similar precedents: variable bank capital instruments such as contingent convertible capital instruments (CoCos) are now banned for sale to retail investors; we probably have not heard the last of insurance mis-selling; Libor, currency and gold-fixing inquiries are ongoing; emerging markets debt issuance is again sounding alarm bells; mortgage-backed securities, CDOs and special purpose vehicles are all back in business; controversy surrounds ETFs; the merged incentives of ‘insurer and assassin’ in credit derivatives are integral to the modern bond market; recent moves to bid pricing for some of the UK’s leading property funds recall the illiquidity and damage in the sector in the aftermath of 2008; black box hedge funds and multi-asset absolute return funds can be so complex as to leave even the experts at a loss to understand their workings.

Traditionally, structure was priced to yield a premium return in order to compensate for all the ‘difficulties’ of investing in them. Come crunch time, investors who were the buyers of the returns become the sellers of the structure and capitalise losses permanently. The really useful structured products are best designed and bought for the long term – caveat emptor, if you ever need a change of horses on the way.