Investors today have been flooding the gold market, pushing the nominal price per ounce to record highs. In volatile times, the safe haven of owning gold makes even the toughest risk-taker sleep a little easier. But it was not long ago that the shiny stuff alluring investors were mortgage bonds, backed by mortgage payment receivables, not the hard rock. These assets were deemed triple-A rated by credit rating agencies, and slapped with a big seal of approval by Wall Street investment banks, quite credible at the time. However, an entire multi-trillion dollar market was secretly hiding risks in an underground nuclear chamber. Complex and hidden from the naked eye, the subsequent explosion would forever change the face of the US. This is a tale of deception, inflation, and conviction. With easy financing and societal standards, policy-makers and Wall Street made it possible to get impoverished people into expensive homes, grow a bubble in US housing prices, and eventually compel themselves to own a piece of the pie. Moral of the story? Take responsibility for yourself. Do your own credit analysis and do not rely solely on ratings, do not underestimate the power of any market to create systemic risk, and watch Wall Street; the changes in incentives, business models, and risk management will indicate if we properly responded to this crisis.
The perfect storm.
The story of the financial collapse is one that starts with the purchase of a home, and the subsequent creation of an investment capitalizing on that sale. At the start of the twenty first century, everyone and their dog deserved a house for themselves. The size of the home and extravagance of the furnishings were dictated by societal entitlement and lax lending standards. From 2000 to 2003, mortgage originations jumped from $238 billion to $1.2 trillion. A growing percentage of these loans were to "sub-prime" and "Alt-A" borrowers, or people that may not be able to pay the loan back in full or who lacked proper documentation proving income and credit quality. In addition, interest rates were at historically low figures due to Greenspan's cozy relationship with the banking industry, allowing mortgage originators to offer cheaper financing and enticing promotions. With rising home prices as secure collateral for the loans, this was the perfect storm.
Hot potato.
Then came the game of pass around the risk. The mortgage originators were the sales people closing the deal. Once they could create a mortgage, they could then resell it as an asset - an entity that will generate economic benefits over time as the borrower pays off the loan. Wall street would happily purchase these assets and bundle them up into bond. This concept is one of diversification. If one mortgage defaulted in the bond, that would only be a small sliver of loses and minimally affect the bonds value. However, this sparked incredibly interesting financial innovation. What if you can take only the first payment of each mortgage (ie the payment the home buyer is most likely to make) and make that alone into a bond? This sort of creation would surely be less risky than a bond with whole mortgages in them. But then where should the rest of the mortgage go? This was the dilemma facing Wall Street and the obstacle that they would need to tackle. Fortunately, they had friends down the street willing to help. The credit rating agencies are in the private business of putting their opinion on the quality of fixed income investments. Triple-A suggests that the investment is top-quality. US Treasuries, assumed risk-free, are rated triple-A. The question would become, how can we get these junk tranches, meaning the riskier sections of a mortgage bond, triple-A rated? With a AAA stamp, we can sell this stuff to pension funds, mutual funds, institutional investment funds, and the works. And with that, the CDO was born.
Slice and dice.
For the sake of simplicity, think of a CDO, or collateralized debt obligation, as 5 friends pooling their money together to make a loan. There is a 50% probability (junk probability) that they can make $100 total from the loan, with a 50% chance of making less than $100 to losing the full amount. If you line up in order of payout (ie first person get the first $20, the second person gets the second $20 and so on), then you have redistributed originally 50% probabilities of success into new stronger probabilities for the first friend (rated triple-A) and weaker probabilities for the last friend (junk rated). Then the last friend that gets the last $20 in this structure (junk rated) may go to his other 4 friends and redistribute the risk to give him the first $4 ($20/5 friends) that comes in, calling that the top of the ladder, which would be rated triple-A! The concept is beautiful and incredibly misleading. If the original 50% probability was actually 25%, many triple-A rated stuff in the structure would be worth nothing. Game over. In addition, the 5 friends do not even need to make the loan, they could instead make a side bet on the loan (eg. credit-default swap) and do the same thing! This became known as the synthetic CDO and gained traction because there simply were not enough home buyers in the US market to satisfy the demand for these assets. If you are a little lost by this process, that's OK, so was everyone else on Wall Street. You take a mortgage, bundle it with hundreds of more mortgages, put that into a bond, bundle it with hundreds of more bonds, put that into a CDO, slice it up into different rated tranches, redistribute those tranches into CDO-squared, then make side bets using synthetic CDOs made up of credit-default swaps. At the end of the cash-flow line, no one knew not only how to quantify the risks involved, but what the risks even were. There were so many complex factors created by the machine that you would need to unwind every investment structure to the core underlying mortgages to even begin to understand the risks. The system was as transparent as oil.
Alchemy.
For these mortgage investments to go to zero, house prices need not decrease, but simply increase at a slower rate. As home prices turned in 2006, the risks inherent in these triple-A rated mortgage-backed securities began to unwind, and demand ceased. The investment banks marketing CDOs were also retaining big pieces for their own portfolio, as they too began to believe the crap they were creating. The total financial system was in peril and would go through several years of deleveraging, while being allowed to sell their toxic mortgages off their books and into the taxpayer's hands. Years later we can better understand what happened: a deadly combination of excesses in society, lax policy in Washington, low interest rates set by the Fed, incest between banks and the credit-rating agencies, and leverage to multiply the effects. I wrote this post because there are several things I think that must be learned from this mess.
1) Look out for your own investments. Don't trust a credit-rating from S&P and don't trust a money manager who structures a portfolio based on credit rating. Don't trust a broker that says an investment is a sure win, especially one without a proven track record. Make it a point to do your own research, gain your own understanding, and exercise your own judgment. Even without a background in investments, if you have money to invest, you are more capable than you think.
2) If a financial transaction seems odd to you, question it. If a bank wants to give you a loan without seeing proper paper work or income verification, the terms of the loan may not be favorable (eg embedded teaser rate / future adjustable-rate) or actions pursued in default may be unfair.
3) Correlation always finds its way back to 1. Diversify to prevent major losses from systemic risk. One of the biggest mistakes on Wall Street models was that if a mortgage defaulted in Wyoming, the probability of a mortgage defaulting in Maine was unrelated. In reality, the entire mortgage market was connected and when real estate popped, every house in the country fell in value.
4) Watch Wall Street and how they align their incentives. Incentives that tie management compensation to long-term company success will mean stronger risk management, less leverage, and more emphasis on credit analysis. The sub-prime mortgage market was entirely driven by short-term profitability.
You can't turn junk into gold. However, this was done for years. We took bad quality assets, stamped with strong quality ratings, and created massive demand until the point of total collapse. This will surely not be the last act of alchemy in our investment world. Be aware of the signs and tread carefully.
Sunday, June 27, 2010
Friday, June 18, 2010
Parting is such sweet sorrow.
The energy debate is one of love and departure. As Juliet once said to Romeo, "parting is such sweet sorrow" and with that the dissolution of one of the best-known romances in history. Today's finale of Romeo and Juliet is not illustrated with a small vile of poison but instead of millions of gallons of thick crude lining our shores. As the world watches America's brightest engineers (along with one of the most powerful and profitable corporate entities of our time) navigate the Gulf crisis at an incredibly slow and sloppy pace, one must question the structure of our energy industry, the future of its players, and protective environmental policies moving forward. As this topic is very debatable, consider my insight a subjective response to hard data. That said, I believe action will be taken and sacrifice will be made, however the transitional ease of implementation and the degree of such sacrifice are what law makers are wrestling with today.
Oil, Coal, and Natural Gas.
By the time it takes you to finish this sentence, the world would have consumed well over a quarter million gallons of oil. By the end of the day, the US alone will have consumed over 800 million gallons (2008 statistics). So what exactly does that compare to? Well, the DeepWater Horizon Oil Spill, as we have come to name the most devastating oil spill in human history, has spewed somewhere between 40-80 million gallons into the Gulf thus far. The second most catastrophic oil spill, the Exxon Valdez oil spill in 1989, leaked around 10 million gallons of crude into Prince William Sound. Not surprisingly, the day after the Transocean explosion, which killed 11 individuals and unleashed a highly dense reserve of crude thousands of feet beneath the surface of the ocean, oil prices fell and have continued to fall since. With massive current reserves outstanding, this is primarily a demand-driven market. The point I'm trying to make is of relative perspective and the emotion I am trying to generate is of concern. We live in a world that runs on poison. Oil, coal, and natural gas make up the primary energy sources (87%) used by the human species. If we are to properly react to the disaster in the Gulf, we should again recognize our addiction and reevaluate possible remedies.
Alternatives.
The dictionary defines alternative as "serving or used in place of another." However, solar, wind, and hydro should not be currently falsified by use of such nomenclature. These alternative energy sources are no where near capable of replacing our precious crude and rock, as illustrated by our modern infrastructure. Most notably, gasoline engines, although testing electric suitability, continue to puncture holes in our earth's protective coating. Based on macroeconomic indicators and environmental concern, it is time for the US to buy into alternatives. Like all investment decisions however, the valuation process and comparative price analysis is of key importance. President Obama addressed the nation Tuesday night in an attempt to solicit support for clean energy investment, stressing job creation. But in reality, the bigger benefit of R&D is more likely lower alternative energy prices, not jobs. I couldn't help but think, 'maybe when the engineer at BP retires, he will take up take some pro bono work on a wind farm.' While the activist will not deny the importance of clean energy, the current financial feasibility is unquestionable. This brings up a big point: the ultimate challenge will be to put in place the proper guidelines and incentives today to make usage affordable in the future. As the world economic leader, the US has both the influence and resources to shape the energy industry in global markets. Without such support, alternative energies will remain weak and obsolete. However, with a bipartisan call to action, alternatives just might have the opportunity to live up to their title.
When To Act?
In a recent Daily Show with Jon Stewart, he highlighted video clips of the last eight presidents publicly pushing toward clean energy reform. In each clip, the presidential proposal would sound almost identical, "energy-efficient homes, freedom from foreign oil, job creation!." Unfortunately, the aftermath was identical as well, with no action and no follow-up. Why is it that we continue time and again to refuse tackling this issue? How has such a serious presidential line item become just a talk-show joke? Well, although seemingly straightforward, the lobbying world of energy reform is as complex as they come. Issues of cost, sustainability, environmental impact, jobs, and short/long-term economic health are only some of the vast plethora of obstacles. Simply put, we do have our reasons to be skeptical and postpone, but that luxury may be running out. A very observing scientist on the Planet Earth series says it best when he describes "sustainable development" as an oxymoron, referring to "sustainable retreat" as the only possible solution to the destructive exploitation of our natural resources. While potentially dramatized, he stresses the immediate need to reverse damage caused by carbon emissions. Unfortunately, current economic and political restrictions make this unlikely. Instead, we need realistic goals, solidified guidelines, and proposals pushed through Congress. And this brings me to my major argument. What law makers need to focus on is transitioning from our current energy forms as well as usage, while sacrificing the current growth rate of economic wealth for the investment of future stability. It is up to government today to ease into proper energy reform to prevent that which would transpire from a very abrupt change down the road, driven by sudden environmental necessity. Notice my usage of words: I say "government" not "people" when describing who must act. Unfortunately, I am pessimistic of majority support, as short-term sacrifices are surely hard to swallow for most people. However, my only hope is that top officials and influential lobbyists that value long-term perspective will push us forward. America's future as a global leader on this planet depends on the structure of our energy policy tomorrow, which will be decided on today. I end this post with an analogy: When I was five (more so than today), I always kept my room very clean. I did so because it was worth it for me to tidy up before I went to bed than to wait until the end of the week when my room appeared more like a bomb shelter. I made the initial investment, sacrificed some opportunity cost, and took proactive action to prevent future catastrophe. Investment, sacrifice, and early implementation will be the crucial areas of focus powering our country through reform.
Oil, Coal, and Natural Gas.
By the time it takes you to finish this sentence, the world would have consumed well over a quarter million gallons of oil. By the end of the day, the US alone will have consumed over 800 million gallons (2008 statistics). So what exactly does that compare to? Well, the DeepWater Horizon Oil Spill, as we have come to name the most devastating oil spill in human history, has spewed somewhere between 40-80 million gallons into the Gulf thus far. The second most catastrophic oil spill, the Exxon Valdez oil spill in 1989, leaked around 10 million gallons of crude into Prince William Sound. Not surprisingly, the day after the Transocean explosion, which killed 11 individuals and unleashed a highly dense reserve of crude thousands of feet beneath the surface of the ocean, oil prices fell and have continued to fall since. With massive current reserves outstanding, this is primarily a demand-driven market. The point I'm trying to make is of relative perspective and the emotion I am trying to generate is of concern. We live in a world that runs on poison. Oil, coal, and natural gas make up the primary energy sources (87%) used by the human species. If we are to properly react to the disaster in the Gulf, we should again recognize our addiction and reevaluate possible remedies.
Alternatives.
The dictionary defines alternative as "serving or used in place of another." However, solar, wind, and hydro should not be currently falsified by use of such nomenclature. These alternative energy sources are no where near capable of replacing our precious crude and rock, as illustrated by our modern infrastructure. Most notably, gasoline engines, although testing electric suitability, continue to puncture holes in our earth's protective coating. Based on macroeconomic indicators and environmental concern, it is time for the US to buy into alternatives. Like all investment decisions however, the valuation process and comparative price analysis is of key importance. President Obama addressed the nation Tuesday night in an attempt to solicit support for clean energy investment, stressing job creation. But in reality, the bigger benefit of R&D is more likely lower alternative energy prices, not jobs. I couldn't help but think, 'maybe when the engineer at BP retires, he will take up take some pro bono work on a wind farm.' While the activist will not deny the importance of clean energy, the current financial feasibility is unquestionable. This brings up a big point: the ultimate challenge will be to put in place the proper guidelines and incentives today to make usage affordable in the future. As the world economic leader, the US has both the influence and resources to shape the energy industry in global markets. Without such support, alternative energies will remain weak and obsolete. However, with a bipartisan call to action, alternatives just might have the opportunity to live up to their title.
When To Act?
In a recent Daily Show with Jon Stewart, he highlighted video clips of the last eight presidents publicly pushing toward clean energy reform. In each clip, the presidential proposal would sound almost identical, "energy-efficient homes, freedom from foreign oil, job creation!." Unfortunately, the aftermath was identical as well, with no action and no follow-up. Why is it that we continue time and again to refuse tackling this issue? How has such a serious presidential line item become just a talk-show joke? Well, although seemingly straightforward, the lobbying world of energy reform is as complex as they come. Issues of cost, sustainability, environmental impact, jobs, and short/long-term economic health are only some of the vast plethora of obstacles. Simply put, we do have our reasons to be skeptical and postpone, but that luxury may be running out. A very observing scientist on the Planet Earth series says it best when he describes "sustainable development" as an oxymoron, referring to "sustainable retreat" as the only possible solution to the destructive exploitation of our natural resources. While potentially dramatized, he stresses the immediate need to reverse damage caused by carbon emissions. Unfortunately, current economic and political restrictions make this unlikely. Instead, we need realistic goals, solidified guidelines, and proposals pushed through Congress. And this brings me to my major argument. What law makers need to focus on is transitioning from our current energy forms as well as usage, while sacrificing the current growth rate of economic wealth for the investment of future stability. It is up to government today to ease into proper energy reform to prevent that which would transpire from a very abrupt change down the road, driven by sudden environmental necessity. Notice my usage of words: I say "government" not "people" when describing who must act. Unfortunately, I am pessimistic of majority support, as short-term sacrifices are surely hard to swallow for most people. However, my only hope is that top officials and influential lobbyists that value long-term perspective will push us forward. America's future as a global leader on this planet depends on the structure of our energy policy tomorrow, which will be decided on today. I end this post with an analogy: When I was five (more so than today), I always kept my room very clean. I did so because it was worth it for me to tidy up before I went to bed than to wait until the end of the week when my room appeared more like a bomb shelter. I made the initial investment, sacrificed some opportunity cost, and took proactive action to prevent future catastrophe. Investment, sacrifice, and early implementation will be the crucial areas of focus powering our country through reform.
Friday, June 11, 2010
Keep it simple stupid.
As a new investor, sometimes I like to take a step back and ask rather simple questions. "Keep it simple stupid" is an overused mantra in my office, as our 3 person shop plugs away on structured credit hedge fund analysis and call ourselves experts in the same products that our parents got screwed by. Today, Wall Street execs still hum the familiar quote from Jerry Maguire as they scramble to predict market movements and price securities for their clients, a very complicated feat. But why is it complicated? How can the brightest minds in the wealthiest country in the world stand by and watch the stock market awkwardly fluctuate like a elementary school student learning to play the trumpet? I like to keep it simple.
Europe.
I start with Europe because I like Europe. I studied in Ireland for 3 months, while traveling to several other surrounding countries, absorbing and consuming the rich cultures while discovering new and interesting people. I never visited Greece. How can such a beautiful country that brought us the yo-yo become such a massive target for market shorts? As April was coming to a close and the market teetered at nearly 80% higher than its low less than one year before, bulls decided to let Greece win. The beautifully engineered credit default swaps on Greece debt surged as bond holders rushed to insure what would seem like rising exposure to default. Heck, investors that didn't even own Greece bonds wanted in on the action, pushing the cost of insurance higher and higher. As the EU contemplated what needed to be done, it became more apparent that Greece was too interconnected to the rest of Europe and just as importantly to the value of the 10-yr old Euro to let the country go bankrupt. So just as all governments react to threats, they began to throw money around. Sitting in that conference room must have been a joke... "a billion dollars here, a billion dollars there, lets just go ahead and make it an even trillion, that will be sure to spur markets up." And it did, for maybe one or two market sessions. The point I would like to make about Europe has nothing to do with Greece. The governments in Europe reacted in a way that suggests Greece is only illiquid, not insolvent. This is the problem. The difference between liquidity and solvency is time. When a business is illiquid, it may need a quick pump-up of cash to get things going. In contrast, insolvency is when a business's balance sheet can be accurately compared to toilet paper, not the Charmin Ultra Soft kind either. An infusion of cash may allow an insolvent business to continue to run temporarily, but eventually it's going down the toilet. Europe does not need to show us that it is capable of levering up its countries, but instead that it can get back on track to productivity and growth. Until performance and growth numbers can be shown to represent such change, markets will continue to act unkindly. And we have finally reached my simple epiphany: economic growth.
United States.
We now move across the Atlantic to the land that holds the wealthiest stock market in the world, the USA. However, the focus remains on growth. Bill Gross, the founder of PIMCO, a bond fund, writes an investment outlook every month (its fantastic, every investor should read it). He came out with a catchy term months ago in one of his reports called "the new normal." What he wanted to express was the idea that growth would simply slow down. That we are not a slinky that will shoot right back up from this recession but instead fall short due to the gravity of changes in global economies. He suggested that GDP growth would not be the usual 3+%, but instead waver around 1-2%. If Wall Street had a spine, it would have shivered at this thought. As a bond investor, he may have biases against equities, but you still need to absorb such a powerful statement and think about the implications. If growth projections change even 1% on valuation models across Wall Street, just think of the wave of sell orders drowning brokers on such massive price repercussions. Months later in March, I was draining my morning cup of coffee while scanning business news, and I found an interesting article that made a lot of sense. The headline was something like.. "Look at Sales." Wall Street was looking at sales too, but it was mainly to calculate earnings by netting costs. What I realized that morning was that although markets were reacting strongly to great earnings numbers, they weren't much interested in the growth of sales. As earnings are a great indicator of business efficiency, it is sometimes a poor representation of revenue growth and demand, both of which were lacked over our "recovery period." Businesses were restructured during the last year to deflect poor demand, and squeeze out useless costs, creating a leaner and often times more profitable business. However, this doesn't show the US economy is improving, it shows companies are learning how to better adapt to a weak aggregate demand environment. We need demand, which brings sales and growth to our economy. Only until sales increase can costs increase, lowering unemployment and sparking a new cycle of demand.
Where are we?
Referring to the state of the economy, my senior seminar finance professor used to ask at the beginning of each lecture, "Where are we?" It's already difficult to predict what's ahead, but how can it be this hard to just know where we stand? There is a lot of noise in the world today that makes this question very difficult to assess. As an investor right now, I believe you need to filter out all the junk that has been dragging the market wildly in all directions, and focus on the bigger picture. The stock market is simply a collection of contracts that represent the value of businesses. These businesses need to grow in order for the value of the stock market to go up. How and when will businesses grow? How much will they grow and how fast? These are the issues at hand and this is where I am focusing my energy moving forward.
Europe.
I start with Europe because I like Europe. I studied in Ireland for 3 months, while traveling to several other surrounding countries, absorbing and consuming the rich cultures while discovering new and interesting people. I never visited Greece. How can such a beautiful country that brought us the yo-yo become such a massive target for market shorts? As April was coming to a close and the market teetered at nearly 80% higher than its low less than one year before, bulls decided to let Greece win. The beautifully engineered credit default swaps on Greece debt surged as bond holders rushed to insure what would seem like rising exposure to default. Heck, investors that didn't even own Greece bonds wanted in on the action, pushing the cost of insurance higher and higher. As the EU contemplated what needed to be done, it became more apparent that Greece was too interconnected to the rest of Europe and just as importantly to the value of the 10-yr old Euro to let the country go bankrupt. So just as all governments react to threats, they began to throw money around. Sitting in that conference room must have been a joke... "a billion dollars here, a billion dollars there, lets just go ahead and make it an even trillion, that will be sure to spur markets up." And it did, for maybe one or two market sessions. The point I would like to make about Europe has nothing to do with Greece. The governments in Europe reacted in a way that suggests Greece is only illiquid, not insolvent. This is the problem. The difference between liquidity and solvency is time. When a business is illiquid, it may need a quick pump-up of cash to get things going. In contrast, insolvency is when a business's balance sheet can be accurately compared to toilet paper, not the Charmin Ultra Soft kind either. An infusion of cash may allow an insolvent business to continue to run temporarily, but eventually it's going down the toilet. Europe does not need to show us that it is capable of levering up its countries, but instead that it can get back on track to productivity and growth. Until performance and growth numbers can be shown to represent such change, markets will continue to act unkindly. And we have finally reached my simple epiphany: economic growth.
United States.
We now move across the Atlantic to the land that holds the wealthiest stock market in the world, the USA. However, the focus remains on growth. Bill Gross, the founder of PIMCO, a bond fund, writes an investment outlook every month (its fantastic, every investor should read it). He came out with a catchy term months ago in one of his reports called "the new normal." What he wanted to express was the idea that growth would simply slow down. That we are not a slinky that will shoot right back up from this recession but instead fall short due to the gravity of changes in global economies. He suggested that GDP growth would not be the usual 3+%, but instead waver around 1-2%. If Wall Street had a spine, it would have shivered at this thought. As a bond investor, he may have biases against equities, but you still need to absorb such a powerful statement and think about the implications. If growth projections change even 1% on valuation models across Wall Street, just think of the wave of sell orders drowning brokers on such massive price repercussions. Months later in March, I was draining my morning cup of coffee while scanning business news, and I found an interesting article that made a lot of sense. The headline was something like.. "Look at Sales." Wall Street was looking at sales too, but it was mainly to calculate earnings by netting costs. What I realized that morning was that although markets were reacting strongly to great earnings numbers, they weren't much interested in the growth of sales. As earnings are a great indicator of business efficiency, it is sometimes a poor representation of revenue growth and demand, both of which were lacked over our "recovery period." Businesses were restructured during the last year to deflect poor demand, and squeeze out useless costs, creating a leaner and often times more profitable business. However, this doesn't show the US economy is improving, it shows companies are learning how to better adapt to a weak aggregate demand environment. We need demand, which brings sales and growth to our economy. Only until sales increase can costs increase, lowering unemployment and sparking a new cycle of demand.
Where are we?
Referring to the state of the economy, my senior seminar finance professor used to ask at the beginning of each lecture, "Where are we?" It's already difficult to predict what's ahead, but how can it be this hard to just know where we stand? There is a lot of noise in the world today that makes this question very difficult to assess. As an investor right now, I believe you need to filter out all the junk that has been dragging the market wildly in all directions, and focus on the bigger picture. The stock market is simply a collection of contracts that represent the value of businesses. These businesses need to grow in order for the value of the stock market to go up. How and when will businesses grow? How much will they grow and how fast? These are the issues at hand and this is where I am focusing my energy moving forward.
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