Financial Engineering Goes… Right?
The banking collapse of 2008 serves as a cautionary tale, a prime example of the dire consequences of risky financial engineering. ‘Engineers’ or bankers bundled sub-prime mortgage debt, presenting the resulting pools as squeaky clean, triple AAA rated, low-risk mortgage-backed securities (‘MBS’) and collateralised debt obligations (‘CDO’). This was just the beginning, as firms went on to create (CDO)2, pools composed of the lower-quality portions of unsold CDOs. Insurance ‘engineers’ also played a role, with AIG writing insurance on CDOs and selling it to firms that didn’t even own the underlying CDO. The layers of leverage on leverage on leverage led to the collapse, a stark reminder of the potential dangers of financial engineering.
One may naively believe that a seismic event such as this would curtail financial engineering, and for the most part, it has, due to significantly improved regulatory standards for banks. However, in March 2023, we saw Silicon Valley Bank (SVB) fail, making it the largest bank failure since the Great Financial Crisis. There were several factors that caused the failure: concentration risk around clients and, therefore, a coincident need for liquidity; as well as losses incurred due to the magnitude and speed of interest rate rises that happened in the year leading up to the failure, which ultimately led to a run on the bank.
However, a number of other regional banks escaped failure due to another engineering ‘trick’ sometimes employed in the way entities account for securities held on balance sheets. Classifying their securities as ‘held-to-maturity’, they no longer needed to report mark-to-market valuations and, hence, did not need to show any (large) unrealised losses on holdings. These assets could then be reclassified as ‘available-for-sale’ once they had recovered in value, despite, on paper, not being any different than SVB’s assets.
More recently, we saw another use of financial engineering that may be more beneficial to society than the previous examples. President Zelensky attended the G7 Summit this year, to reinforce the message that aid is required urgently from allies and peers. The G7 nations of Canada, France, Germany, Italy, Japan, the UK and the US have been important financial and military supporters of Ukraine since Russia's full-scale invasion in 2022. The Russian assets that were frozen by the group, alongside the EU, when Moscow invaded Ukraine amounted to $325bn. Most of the assets of the Central Bank of Russia are being held in Belgium. Under international law, countries cannot confiscate those assets from Russia and give them to Ukraine, but with a bit of creative financial engineering, there may be ways these assets can still benefit Ukraine.
The plan is to take out a loan on the international markets, giving about $50bn a year to Ukraine, and use the c.$3bn in interest generated from the frozen Russian assets to net off the interest required on the Ukrainian loan. This will be massively beneficial for Ukraine in its efforts. A good outcome seems likely with the majority of the G7 in favour of the plan, potentially a case of financial engineering and innovation going right.
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