Friday Letter: Outlook Good

The optimists were out in full force in LA this week, banking on innovation as one of the levers to pull in the recovery of the financial system.  

Los Angeles is a star-studded town and the think tank Milken Institute's annual conference this week in Beverly Hills was no exception. Celebrity speakers included Andre Agassi and Arnold Schwarzenegger, who addressed several thousand delegates.

But the star attractions of the glitzy, three-day summit were more likely to be stalked by aspirant MBA graduates than the city's infamous paparazzi.

Financial luminaries dominated the event offering their views on the subprime mortgage crisis, liquidity and corporate credit deficiencies as well as the downturn challenging the broader economy. Opinions diverged on the severity and stamina of these interconnected crises – and the opportunities they may afford private equity and other investors – but the consensus was “outlook good”.

The creators of some of the complex financial instruments blamed for current market woes hosted one of the most salient and well-attended sessions, “Complexity isn't innovation, leverage isn't credit”.

“I hear a refrain over and over and over again … that rhetorically asks whether financial innovation has gone too far, became too complex, and whether it's the cause of all of our problems,” said Lewis Ranieri, the founder of Hyperion Private Equity Funds, who is credited with developing mortgage securitsation.  The “root of all evil” exhortation has always followed financial innovation and is exaggerated, he added.

“If you look at this crisis, the causes are not amazingly complicated and they have only peripherally to do with financial innovation,” Ranieri said. “It is financial innovation and financial technology which will get you out of this crisis without allowing it to spiral so totally out of control that we run the risk of this being the worst financial calamity including the Great Depression.”

The root problem is a lack of financial literacy coupled with a poor understanding of risk, argued Michael Milken, the think tank's founder who pioneered high yield debt securities in the 1980s at Drexel Burnham Lambert.

“Essentially finance and financial structures are based on trust at some point, trust in one another, trust in the system,” he said, criticising investment strategies that were overly reliant on ratings and leverage as opposed to proprietary research and due diligence.

“What has got everyone nervous, including the government, is that people have lost money in things they did not think they were taking any risk in,” Milken said. “It is my estimate that more money will be lost in AA and AAA securities in a 2 to 3 year period of time than all money lost in non-investment grade debt since World War II.”

Two years ago, the same panel might have worried over hedge fund activities, said Richard Sandor, the chairman and chief executive of the Chicago Climate Exchange credited with developing futures exchange and carbon trading instruments.

“It's not these Wild West cowboys that have mismanaged risk and melted” the market's liquidity, but America's highly regulated financial institutions, he said.

But it's nothing that hasn't been seen before, be it with the “nifty-fifty” stocks prevalent in the 1970s or sovereign loan losses in the 1980s, said Milken.

If left to its own devices, with perhaps a little regulatory relief, the financial system will self-correct, said Ranieri.

That of course is not the same as saying it won't hurt, but pain is more bearable when you know it will stop.