{"id":2977,"date":"2014-10-20T12:40:29","date_gmt":"2014-10-20T07:10:29","guid":{"rendered":"http:\/\/teekhapan.wordpress.com\/?p=2977"},"modified":"2014-10-20T12:40:29","modified_gmt":"2014-10-20T07:10:29","slug":"reversification-a-one-word-explanation-for-whats-wrong-with-the-world-of-finance","status":"publish","type":"post","link":"https:\/\/vivekkaul.com\/2014\/10\/20\/reversification-a-one-word-explanation-for-whats-wrong-with-the-world-of-finance\/","title":{"rendered":"Reversification: A one-word explanation for what\u2019s wrong with the world of finance"},"content":{"rendered":"

\"how<\/a><\/p>\n

Vivek Kaul <\/span><\/span><\/span><\/p>\n

When MTV first came to India in the early 1990s, I was hooked on to the channel in a matter of a few months. Growing up in a small town, the channel was my first \u201creal\u201d exposure to what we called \u201cEnglish\u201d music. Until then my only exposure to English music was \u201cMichael Jackson\u201d and like others of my generation I was more aware of his mannerisms than his songs.
\nOne of the things that got me hooked to MTV was reggae music. And one of the first reggae songs that I heard was Inner Cirlce’s <\/span><\/span><\/span>Games People Play<\/span><\/i><\/span><\/span><\/span><\/span><\/a>. <\/i><\/span><\/span><\/span>Other than the music of the song which was very peppy, what I liked was that for the first time I was able to make out the lyrics of an English song.
\nOne paragraph of the song went like this:
\n<\/span><\/span><\/span>Oh the games people play now
\nEvery night and evety day now
\nNever meaning what they say, yeah
\nNever saying what they mean.<\/i><\/span><\/span><\/span>
\nThis paragraph has stayed with me since then and I have realized its meaning in various contexts at various points of time over the last two decades. One area where this paragraph particularly applies is finance. The writer John Lanchester in his new book <\/span><\/span><\/span>How to Speak Money <\/i><\/span><\/span><\/span>comes with a new term to explain this . He calls the term \u201creversification\u201d. He defines reversification as a \u201cprocess in which words come, through a process of evolution and innovation, to have a meaning that is opposite to, or at least very different from, their initial sense.\u201d
\nA good example of reversification in finance is the much used term \u201cChinese wall\u201d. In real life, the Great Wall of China is a very big wall that was built over several centuries to keep the enemies out of China. One of the biggest misconceptions about it is that it is visible from the moon.
\nSo, what does it mean in finance? \u201cInside the world of money, though, the term ‘Chinese wall’ means an invisible barrier inside a financial institution which is supposed to prevent people from sharing information across it, in order to avert conflict of interests,\u201d writes Lanchester.
\nLet’s take the example of the Chinese walls that are supposed exist between stock analysts who make investment recommendations to investors (i.e. whether to buy, sell or hold the stock of a company) and the investment banking division, which takes companies public, by getting them listed on a stock exchange.
\nThis wall is regularly broken whenever a profitable investment opportunity comes up. Take the case of the dotcom bubble in the United States in the 1990s.
\nEven with many internet firms wanting to go public, Wall Street still wasn\u2019t in a bargaining position. The bargaining power was with the 20\u201330 year olds, who ran most of these new internet companies, or the Silicon Valley venture capitalists (VCs) who had backed them. The youngsters and the VCs did not ask for a cut in Wall Street\u2019s fee. What they wanted instead was an assurance that the Wall Street firm would support the price of the stock after it had been listed on the stock exchange.
\nAnd, of course, this had to be done legally. This was important for the Wall Street firms because new companies wanting to come out with their IPOs looked at this parameter before choosing the Wall Street firm which would handle its public offer.
\nThe way Wall Street handled this was very clever. Before going public, the Wall Street firm promised the company that the in-house analyst of the firm would initiate coverage of the stock a few days after it got listed on the stock exchange. No favourable coverage or for that matter, a \u201cbuy\u201d rating was promised because that would have been going against the law. It was assumed that the Wall Street firm would have nice things to say about the company it had just taken public. And so the Chinese wall was broken. Even in India, it has been observed that the stock broking division of a financial institution has nice things to say about a company that has just been taken public by the investment banking division of the same financial institution.
\nThe way the financial system has evolved large financial institutions have different businesses which \u201cif the system is to function without conflicts of interest \u2013 shouldn’t really be there.\u201d But that is not the case. Hence, as Lanchester puts it \u201cthe Chinese walls…were worse than non-existent; they were opportunities for the bank to make money…that’s reversification.\u201d
\nAnother excellent example of reversification is a hedge fund. As Lanchester writes \u201cthe word ‘hedge’ began its life in economics as a term for setting limits to a bet, in the same way that a hedge sets a limit to a field…The idea is that by putting a hedge around a bet, you delimit the size of your potential losses.\u201d
\nBut is that the case? Before we get into that let’s try and understand what really is a hedge fund. Legally, there is no term called a \u201chedge fund,\u201d unlike, say, \u201cmutual fund.\u201d The term \u201chedge fund\u201d was apparently first used by the <\/span><\/span><\/span>Fortune <\/i><\/span><\/span><\/span>magazine in a 1966 article to describe an investment fund managed by Alfred Jones, a Columbia University sociologist, diplomat and steamboat purser who had turned into a fund manager. The article had a very interesting title. It was headlined \u201cThe Jones Nobody Keeps Up With\u201d.
\nIn 1952, Jones wanted to launch an investment fund which would not only buy stocks on which he was bullish on, but also short-sell the stocks (i.e., borrow and sell) which he felt were overpriced and, thus, would fall in price in the days to come. At the same time, he thought that with the expertise he brought to the table, the investors in the fund should be willing to pay him a slice of the profits he made for them.
\nJones wanted to buy as well as short-sell stocks. The money that he generated from short-selling stocks would partially fund the buying of stocks which he felt were undervalued. This way, he ensured that the exposure was \u201cmarket neutral,\u201d or, in a simpler language, he \u201chedged his bets.\u201d
\nThe strategy of Alfred Jones of buying some stocks and selling some others came to be known as the equity long-short strategy. He outperformed the mutual funds which could only go long, that is, buy stocks. They could not sell them short because it was deemed to be a risky strategy. Jones also used leverage, that is, borrowed money, to spruce up his returns. Jones received 20 percent of the returns he generated for the fund as compensation.
\nThe success of Alfred Jones was copied by many others. \u201cThe classic hedge fund technique, as created by Jones, is still in use: funds employ complex mathematical analysis to bet on prices going both up and down in ways which are supposedly guaranteed to produce a positive outcome,\u201d writes Lanchester.
\nBut is that really the case? A majority of the hedge funds fail. As Lanchester points out \u201c90% of all hedge funds that have ever existed have closed down or gone broke. Out of total of about 9,800 hedge funds worldwide, 743 failed or closed in 2010, 775 in 2011, and 873 in 2012 \u2013 so in three years, a quarter of all the funds in existence three years earlier disappeared. The overall number did not decrease, because hope springs eternal, and other new hedge funds kept being launched at the same time.\u201d
\nThis is reversification at its best, where the word ‘hedge’ has been turned into exactly opposite of what it originally meant.
\nAnother excellent example of reversification is securitization, which has \u201cnothing to do with making things more secure.\u201d Let\u2019s try and understand this step by step.
\nA big financial institution sells financial securities and raises money. The money is used to buy home loans or mortgages from banks. These home loans are then pooled together. The people who have taken these home loans pay interest on these loans as well as repay their principal. This money comes into the common pool. From this pool, the financial institution pays interest on the securities it has sold to investors. It also repays the principal out of it. This process is referred to as securitization.
\nIn the days when banking was a boring business, banks lent out the money they had collected from deposits. They also kept the loans on their books till they matured. They made money as long as the interest they paid on their deposits was less than what they charged on their loans,a ssuming that the borrower did not stop repaying.
\nBut with securitization the bank does not maintain the loan on its books any more. It passes on the risk to the investor who buys the securities being issued. As Lanchester puts it \u201cIt[i.e. the bank] only takes the RISK of the loan for the amount of time between making the initial house loan, and the moment when it has sold the resulting security \u2013 which can be a matter of days. The bank has no real interest in the financial condition of the borrower. The basic premise of banking \u2013 that you only lend money to people who can pay it back \u2013 has been broken.\u201d
\nHence, the bank is more interested in giving out home loans rather than verifying whether the borrower has the capability to repay. This was a major reason behind the current financial crisis which started in September 2008.
\nLanchester in coining \u201creversification\u201d has come up with a term which explains a lot of what is wrong in finance. The examples discussed above clearly show that. As Lanchester writes \u201cThese are all examples of how process of innovation, experimentation and progress in the techniques of finance have been brought to bear on language, so that words no longer mean what they once meant.\u201d
\nAnd this has created a major problem. \u201cIt is not a process intended to deceive…But the effect is much the same: it is excluding and it confines knowledge to within a priesthood \u2013 the priesthood of people who can speak money,\u201d concludes Lanchester. <\/span><\/span><\/span><\/p>\n

(Vivek Kaul is the author of the Easy Money <\/i>trilogy. He tweets @kaul_vivek) <\/span><\/span><\/span><\/p>\n","protected":false},"excerpt":{"rendered":"

Vivek Kaul When MTV first came to India in the early 1990s, I was hooked on to the channel in a matter of a few months. Growing up in a small town, the channel was my first \u201creal\u201d exposure to what we called \u201cEnglish\u201d music. Until then my only exposure to English music was \u201cMichael … <\/p>\n

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