01 May Value Creation vs. Optimization
Dear Prof.Rutledge, dear Prof. Raynes, …, you distinguish value creation and optimization.This distinction is important indeed, I may ask you to let me know, where this critical distinction is expanded and profounded ( literature, artcles etc). Yours sincerely, Hubert Gantz WP.u.StB. /CPA
Dear Mr. Gantz,
First, let me thank you very much for your question and apologize for taking so long to respond. I will first quote from the book so that the context of your query is clear to other readers:
“Optimization increases average wealth by redistributing the margins of risk and return locally; value creation increases total wealth,” Raynes & Rutledge, The Analysis of Structured Securities, OUP 2003, p. 92.
Optimization is a financial rearrangement that produces more bang for the buck. It is the purpose of structured finance. It can be a rearrangement with respect to tax rules (tax arbitrage) or corporate finance norms (corporate rating arbitrage). The type of optimization I carried out as a Moody’s employee was the latter. Sellers were able to lower their funding costs and reduce the average risk on their balance sheets by issuing rated debt from ABS, RMBS, CMBS, CDO, ABCP and SIV structures. At Moody’s, we used proprietary, unpublished, numerical (they must be numerical) benchmarks for rating the structured market (Aaa, Aa, etc.) to do this.
In sum, optimization does not necessarily create value. It can also destroy it. Optimization facilitates leverage, which magnifies risk and return. If perceived value turns out to be illusory, risk increases.
By contrast, value creation in finance uses information about the risk/return features of financial assets that were not previously known or apparent. Here I am talking about ABS, RMBS and possibly CMBS, but not CDO, ABCP or SIV structures.
The “value discovery” step happens when the financier gains access to private asset performance data and sees that, indeed, traditional investors in the company are being paid too much or too little, based on transparent arm’s-length benchmarks, for the risk taken on.
If investors are being paid too much in relation to these benchmarks, then new investors may be willing to supply risk capital; and competition will drive down the cost of capital for the seller. More of the value created by the seller is retained and available for reinvestment. If investors are not being paid enough in relation to the benchmarks, then they may negotiate for a higher risk premium.
When this kind of analysis is properly carried out, we have better incentives for capital provision for true value creation, and everyone is better off: investors, sellers, regulators and other parties hurt by perverse incentives. That is what I mean by value creation increasing total wealth.
If my explanation leaves you with doubts, I fervently hope they include doubts about where these transparent benchmarks can be found! This is the dirty little secret that no one on Wall Street wants you to bring up.
If we don’t push for transparent credit quality benchmarks, we are setting ourselves up for another Crisis.