This past weekend I saw the film Food Inc, which I recommend highly to anyone looking to see how deregulation has affected industries other than finance. While the subject of Food Inc was how the industrialization of food policy in the U.S. has had unintended negative consequences, I couldn’t help but draw connections to the world of finance. The one area that had the most salient overtones was the part of the movie dealing with diversification.
In the food industry, economic policy has favoured large enterprises such that there is significant concentration of production and distribution. At one point in the film, we learned that there were just a handful of slaughterhouses in the United States which account for the vast majority of the beef we eat. While this has reduced food prices for end consumers, it has also meant that those few companies controlling America’s distribution system have an enormous diversity of animals running through their slaughterhouses. Any hamburger we consume might contain the beef of hundreds of different cows.
That can be problematic. The filmmakers brought this point home by showing a clip of a cow too weak to stand on its own legs being coerced to the slaughterhouse. Imagine that this cow is diseased. E.coli gets into the production process. Suddenly, you have tens of thousands of tons of beef that is infected and could kill. This is why the beef industry has seen fit to recall hundreds of thousands of tons of beef in order to protect end consumers. These measures are draconian and costly, but necessary.
In effect we are seeing a case in which large firms bring advantages through economies of scale that lowers cost. Nevertheless, the diversity inherent in the production at those firms carries hidden risks in that one or two bad animals can taint thousands of tons of beef.
This is also exactly what you see in financial services through the securitization process. We have Mortgage-backed securities (MBS) and Collateralized debt obligations (CDOs) and CDOs of CDOs which contain all manner of debt from credit cards to residential mortgages, commercial mortgages, auto loans, student loans, and on down the line. The enormous companies which package up these securities take the debt obligations from thousands of people and businesses in order to create their securities.
Think of these securitization groups as the slaughterhouses of finance. the securitization groups go on to distribute their packaged securities to investors of all ilk through their vast network of retail and institutional customers. In fact, they carve up these obligations so finely that what seemed like dodgy credits on an individual basis often got the AAA seal of approval from the credit rating agencies. Diversification seemed to make a sow’s ear into a silk purse. It’s almost like financial alchemy – turning the riskiest of risky assets into bullet-proof top-of-the-line securities that even widows and orphans could invest in.
There is one problem, though – alchemy doesn’t work. The financial slaughterhouses were destined to take on too many bad loans eventually. All it takes is one or two extremely depressed economic area in Los Angeles or Las Vegas or Stockton to taint dozens of pools of mortgages. Think of it this way: a fairly large area like Las Vegas gets crushed by an economic downturn and the result is people defaulting on credit card loans, student loans, auto loans and mortgages. Businesses then default and commercial property loans go sour too. The result? All of the AAA asset pools are now infected with sick loans. Large losses can be expected across the board. Diversification has gone from being a boon to a nightmare.
I would argue that diversification, in spreading junk assets widely – even into the best fixed income asset classes – created a problem that was an order of magnitude larger than had these assets been held to maturity on the loan originator’s books. Forget about the fraud or the incentives to securitize more and more for a second. Even without those problems, the fact that dodgy assets were spread far and wide guaranteed some measure of systemic risk when asset pools became infected.
In the food industry, companies recall tainted meat at huge cost to the distributors. The analogous action in financial services would have seen the same practice, with banks buying back their dud assets as they did in the auction rate securities scandal. But, we all know why that never happened. If they had done, many a bank would be bankrupt. So, instead, the banks were bailed out. Slaughterhouses, indeed.