Monday, October 6, 2008

Brilliance, Guilty and Bounce Back


Writing this blog on the Sunday after the Emergency Economic Stabilization Act (EESA) has become law, has caused me to think through my immediate reactions and my long term investment strategies. Others should as well, remembering what has been attributed to Mark Twain: “The opposite of progress is Congress.”

EESA started out as a brilliant investment analysis of a clogged, dysfunctional mortgage market that was preventing banks from lending to other banks and from extending new credits to existing customers. The original, politically naïve, work-out plan evolved into a vehicle to address too many other political needs of Congress at election time. Paulson recognized that under the universal mark-to-market accounting rules, banks and other mortgage providers could not make any new mortgages. Too many existing mortgages and mortgage securities were being valued with no known bids, roughly the equivalent of having little or no equity in them. Without the equity from these assets, their various balance sheet ratios could not support any additional assets with implied risk. The magic of the Paulson plan is that it creates the illusion that the mortgages have some value.

(The key to making a loan to you is the financial institution’s ability to borrow from someone who is examining its financial statements. In other words, if a bank can not borrow, it can not lend. While you may feel that your great aunt's shawl and fans have significant value, unless you can find a professional buyer, the lender can't count the shawl and fans as good capital.)

Paulson’s solution was to hold reverse (or “Dutch” auctions) to offer to buy the most “toxic” mortgage securities at the lowest prices. This creates a bottom for the market by putting a price on the most problematic paper. Institutions can then price their remaining securities at equal to, or better prices.

Disclosure: As he was evolving his thinking through “listening tours,” I have met with Secretary Paulson twice at small meetings of the New York Society of Security Analysts.

Under present accounting rules, assets have to be priced at tradable prices. Assets may also be valued by an internally created mathematical formula (“market by myth”). These values are referred to by their catchy titles: Level 1, 2, or 3. Under Paulson’s structure, financial institutions can move some assets from Level 3 to Level 2, which automatically improves their capital ratios. Even those that don’t move up their Levels. The financial institutions with assets that they could not price can now maintain that the mere existence of the Troubled Assets Relief Program (TARP) means that there is a potential market for the securities that they could not sell previously. These moves should go a long way to unclog the mortgage and related markets without a wholesale change of the mark-to-market rules. (The US Government has never had an audit under generally accepted accounting standards and thus they alone can carry assets at purchase price.)

I am happy with this solution to unclog the housing market. However, I am unhappy to see these principles extended to credit card receivables, a subject which merits a separate discussion.

The Guilty

Any time something goes wrong there is an immediate search for the bad guys who created the problem. In this case that great moral philosopher Pogo got it right by saying, “We have met the enemy and the enemy is us.”

There is enough blame to include just about everyone. Mortgages and particularly mortgage securities could not be sold if there were no buyers. These buyers disregarded the common sense rules I describe in Chapter 10 of Money Wise, “Bad Things Happen: Taming and Managing Risk.”

Two of the causes for bad things are (1) Overconfidence and (2) Unanticipated events. Think of retirees directly purchasing this soon-to-be toxic paper, either directly or through fund vehicles. They heard “fixed income” and in their mind translated that to mean “fixed solution.” Nothing could go wrong, particularly through the implied guaranty of some third party institution. “They wouldn’t lie to me face to face,” many assumed. No, they did not intend to lie to you (or perhaps more importantly lie to themselves) they just didn’t know any better. They did not do their homework on massive defaults. Both the buyer and the seller were overconfident.

One of the other causes for “bad things” is unanticipated events. In scientific literature these events are called the emergence of the Black Swan. For many centuries Europeans believed that swans only came in white. The discovery of black swans in Australia changed their expectations. While we knew that some people could not afford to make the home purchases that they did, we did not recognize that their numbers would be swelled by the simultaneous lowering of underwriting standards, changes in accounting rules and a slowing economy diminishing the income potential of both new buyers and current owners. Real estate problems of this size were last created in the 1920s and the resulting foreclosures and slump in real estate prices did not happen until the early 1930s.

The retirees mentioned above, and/or their agents violated a basic investment rule: Know What You Own. They did not recognize that mortgages and related securities were a distinct asset class. There may be a sign of vulnerability any time an undifferentiated asset class is more than 10% of the total portfolio. If the single asset class exceeds 25%, there must be other assets invested to hedge the primary asset class driver. Finally, there is a smell test: If one is urged to borrow against this asset, or if the seller is heavily leveraged, and too demanding of a quick purchase, there is the risk that time can work against the buyer.

Bouncing Back

We are all human and therefore are capable of making mistakes. Despite being a Trustee of Caltech, I have learned that humans are not as predictable as the laws of physics. One of the great lessons of the 1990s was that Long Term Capital Management, with all the brain power of a couple of Nobel Prize winners, not only failed, but could have pulled down half of Wall Street had it not been for the Federal Reserve’s behind the scenes pressure.

A lesson from LTCM’s collapse is that very smart people can, and do make mistakes. A second and more powerful lesson is that a number of the LTCM participants were able to raise money and start new ventures, in some cases from the same groups that had invested in LTCM. Wall Street believes in bouncing back and often funds those who have fallen with the belief that with more caution, they can succeed the second time around.

For a fuller discussion of “Bouncing Back: The Art of Recovering from Mistakes,” see chapter 12 of Money Wise.

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