History of Financial Modeling
In the early 1980’s the US economy faced a banking crisis, the outgrowth of which significantly impacted the way
they did business. The changes they made are actually quite beneficial for individual investors as well. While it
has taken 30 years, it seems the trend is finally within reach of producing positive effects in our lives.
The 1960’s banking model was once described as the 3-6-3 model. Borrow at 3%, lend at 6% and be on the golf
course by 3pm. They were known to be in the business of borrowing short and lending long. The industry was sleepy
and did not consider the interest rate risks they took. When the late 1970’s and early 1980’s showed up with an
inflation shock, many bankers found themselves at risk of bankruptcy. Government regulators stepped in and mandated
they match the interest rate risk of their assets against their specific liabilities. Since then interest rates
have seen some significant periods of volatility both up and down, and the banking industry has been able to
weather the storm. (The 2008 crisis was one of credit risk, which is a different story.) In addition, life
insurance companies match their assets closely to their liabilities.
I believe this image is self explanatory...
|While these institutions focused on being able to pay their bills, pensions and
individuals continued to focus on the best ways to maximize wealth without regard to what they
needed the wealth for – to pay their bills. The idea presumably is that if you come up with the
most efficient way to maximize your wealth, you will be better able to pay your bills anyway. But
the problem with that theory is that it depends on what your bills do. For example if they go up
faster than your assets, you will have a problem. If you earn most of your great returns before you
saved very much and have dismal performance when you have saved the most, high returns will not
translate into significant assets. The pension fund industry is feeling these effects in full force
now as many see the days of the defined benefit pension plans are numbered. Their liabilities are
bond like in nature and they continued to invest heavily in stocks without regard to the risk they
were taking relative to their liabilities. As the industry struggles to fill the void of the
defined benefit pension model, a number of professors are working to make better technology
available to the public to manage their own affairs. (examples include Merton and Kotlikoff). But
at the moment, the majority of individuals have neither the tools nor education necessary to avoid
the troubles the pensions are now facing.
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