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Editor's Desk: Rocket science?

31 Dec 08

The anniversary of the giant step for mankind reminds Robert Outram that today’s great brains work not at NASA but in the City, designing the products behind the market crunch

by Robert Outram

This year will see the fortieth anniversary of the first landing on the Moon. It was an incredible achievement, especially given the comparatively crude technology of the time.

Could we repeat such a feat? The answer is, “probably not”, and not just because the Obama presidency will have its hands full baling out the banks, the carmakers and whichever major US industry is next to hit the rocks.

An additional reason is that NASA’s achievement was due in no small part to the mathematical geniuses whose calculations made the lunar expeditions possible; and their 21st century equivalents are not working in the aerospace industry. They are, or have been up to now, employed on much more lucrative business – devising ever more complex financial instruments for Wall Street and for institutions around the world.

Just one example of how far all that went can be summed up in a word I have only just encountered: “rehypothecation”.

Hypothecation is straightforward enough; basically, it is the interest or claim that a lender has over a pledged asset, as when a property is mortgaged.

Rehypothecation multiplies that concept. For example, if broker A wants to buy a block of equities, it can pledge them to investment bank B to get the cash. The pledge itself is an asset that can be used by B to raise funds from C, and so on. The process can continue well past the point when all the letters of the alphabet are exhausted, and a huge structure of traded money is based on one, genuine, underlying asset.

It is not surprising, in retrospect, that such a house of cards is doomed to fall eventually. Or that the administrators of Lehman Brothers, the failed bank at the centre of countless deals and trades, believe that unravelling exactly who owes what to whom could take ten years or more.

One of the questions addressed by the Corporate Governance Panel, hosted last month in Edinburgh by ICAS with PricewaterhouseCoopers (see page 73), was how exactly can company boards truly assess the risks the business is facing, and how well is that risk managed, when so much if is so opaque?

Non-executive directors especially can find it very hard to exercise their oversight role when many of the company’s financial risks and rewards are based on such complex instruments.

As the panel agreed, training for the board as a whole is crucial, and especially for the audit committee. It is also important to ensure that there is an appropriate balance of directors with financial skills and experience.

Non-executive directors do have one advantage: like journalists, they have licence to ask questions that might seem daft or obvious. It is a good rule that non-executives should not be happy with anything that the executive directors cannot explain in fairly straightforward terms. After all, however complex it may be, it’s not rocket science.

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