Is our financial life too complex?
Among the various causes of the financial crisis, one of the least cited has been complexity. Complex financial firms bought complex financial instruments that had a complex relationship to less-than-ideal creditors and collateral. When the system began to unravel, investors switched to the simplest securities possible—US Treasury Notes—and shunned anything else even modestly complicated.
We saw this borne out even within the US Treasury market. Inflation-linked securities (TIPs) fell dramatically in price relative to traditional notes. There is no difference in the credit. The bonds are guaranteed by the full faith and credit of the United States. But because the interim payments are based on an arcane formula that involves the unweighted Consumer Price Index, investors found them less attractive.
This is a good illustration of the liquidity crisis that was a large part of the crash. Complexity led to illiquidity—and a fat pitch for investors who understood the risks.
It’s a fair question to ask why finance has to be so complex. At its heart, finance boils down to three basic questions: what is your income versus expenses, what are your assets against your debts, and how are you using your cash. Yes, there are judgment calls and grey areas, but not so many that would lead to the crippling complexity we see in almost every large company.
It seems that complexity has grown because life itself is more complex than it used to be. Cars have onboard computers. Cell phones have built-in satellite navigation systems. Finance merely echoes this change. It we want to remain connected, we need to prepare for the occasional failure.
Douglas R. Tengdin, CFA
Chief Investment Officer
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