Sunday, February 10, 2013

Investment Dangers from Extrapolating Historical Trends

Last week the expected outgoing US Attorney General began a lawsuit against McGraw-Hill (Standard & Poor’s) for failing to see the future.  S&P is in the somewhat distinguished company of various Presidents, members of Congress, government agencies and Departments; e.g., Treasury, Federal Reserve, SEC, as well as a number of government sponsored mortgage-related companies (GSCs). The private sector has an equally long list of participants which did not see the end of the rising house price trend.

These errors of human judgment are also found in betting that various streaks will continue.

The mortgage mess

The DOJ alleges that the ratings of a small number of credit ratings issued on subprime-related, structured underwritings by S&P were faulty. (Focusing on only the specific issues in question, based on selected internal emails, the fees earned by S&P were on the order of $13 million.)

Disclosure: I have personally owned shares in McGraw-Hill for many years and my fund has a long position in Moody’s. The high price on Moody’s last week was $55.39, and the low $40.67, with a close of $43.37.

US vs. Mc-Graw-Hill

The case against McGraw-Hill has generated heavy news media coverage, which is ironic as the media itself should be considered a contributing factor in this debacle. As Wall Street Journal columnist Holman W. Jenkins, Jr. pointed out on Saturday, “S&P was not responsible for the destruction of underlying housing collateral (caused) by politicians who made it nearly impossible to foreclose on delinquent homeowners.”  Jenkins also reminds us of the Fed chairman’s illuminating quote:  "You know, the stock market goes up and down every day more than the entire value of the subprime mortgages in the country."

Seven  reasons why I believe the suit is misguided

1.    Within any sizeable organization that deals with opinions such as credit ratings, there is likely to be differing opinions, particularly from those on the lower and middle rungs of the power ladder.

2.    We know that the Federal Reserve Board was not too concerned about housing and subprime loans during the period in question.

3.    There is significant legal risk if a credit rater is early in downgrading ratings without firm facts that seriously contradict past history.

4.    In my work over the years, I generally felt that credit ratings were a lot like performance statistics; i.e., a backward-looking device with not much predictive value if things change.

5.    While the SEC has been mandated to reduce the power of the credit rating agencies, it has not been able to do so yet, and the SEC has not joined in the suits.

6.    I suspect the states who have joined the suit are trying to aid in the defense of their own pension plans who did not do their own credit research.

7.    In most cases of the so-called AAA paper, it was only the top tranche that had that highest rating, and the lower tranches had lower ratings. It was the lower tranches with higher (leveraged) yields that investors bought, ignoring the lessons of the market that higher yields often show a market judgment of potential risk of loss of capital.

There are no innocents

There are no innocents in this train of unwise and intellectually challenged decisions. The list includes both Congress and the administration, the Fed and the SEC, the builders and real estate agents, the public who lied either to themselves or to the mortgage companies, the investment  and commercial banks who couldn't get rid of the paper off their own books quickly enough, insurance companies and pension funds who let their insatiable need for yield override their own sense of fiduciary controls, the media that stoked the desirableness of owning ones' own home and the ease of getting a mortgage and of course the credit raters who relied completely on history and not a fundamental understanding of supply and demand and the dangers of leverage.

In my opinion, there were NO innocents, all of the parties overlooked one or more important signal.

Lessons to be learned from the mortgage mess

There are a number of great lessons from these tragedies. The first is to be wary of sponsored mass movements in any one direction. (In this case, new home ownership based on very large borrowing.)

Second, one needs to anticipate the possibility of a “black swan” effect, of something happening that is beyond our historical context (house prices dropping materially).

Third, when there are too many middlemen in the process there is little discipline (politicians desire to change voting patterns, new builders starting with little experience and less capital, inexperienced buyers, mortgage brokers and loan officers, etc.).

Fourth, we live both individually and collectively in a cyclical world of ups and downs and the longer we go from a key market turn, the more likely that there will be a major change in direction.

Buy the leader and be wary of number two

One of the characteristics of a bear market and many flat markets is the lack of faith in various companies and types of securities. In times like the present when investors believe that despite the globally troubled economies they must invest, they all too often take a historical approach. They look for the single leading company in a sector that is already expanding. They forget two important lessons.

The first is from the sports world, be it with human athletes or thoroughbred horses, though I prefer the latter group. Unless there is a premature retirement, winning streaks always end. Often they do not immediately resume, at least that is my experience with a number of portfolio managers. 

As with the lessons from the mortgage mess, investors often do not anticipate the arrival of a black swan. These can be unexpected changes in personalities, government regulations, structures of commercial and financial marketplaces, etc. Often once a market surge is underway the number one company’s stock rockets up to a price that is beyond a fair level. In this case there is a tendency to jump on the number two company in the sector, whose price has not appreciated to the same degree. I have studied this phenomena in the financial services area, and I believe that it is also applicable to some other sectors. 

For years whichever retail brokerage firm had the second largest number of salespeople to Merrill Lynch was favored by some investors in the belief that it was selling at too big a discount to Merrill. Going all the way back to Bache, none of these number two companies did as well as the leader. There is a sound reason why the gap did not materially close. When a firm believes it must compete across all product lines with a leader, it will come to the party late in terms of loyal experienced people. 

Today, Morgan Stanley through acquisition of Citigroup’s sales force, is now the firm with the most active employee salespeople. This is somewhat ironic as its CEO came out of McKinsey and Merrill Lynch is now tucked into Bank of America. We will see what it can accomplish as number one. Judging by the large number of experienced brokers who are leaving it won’t be easy. Morgan Stanley is the original major competitor in the investment banking business though Goldman Sachs remains the “go-to” banker on large, difficult deals.

(We own a much larger position in GS than we do in MS which may be an indication of my concern about betting that a number two can become number one.)

Bottom line

One should understand past history, but be aware that the future, at some point in time, will not look like the past.
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