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Kleinfeld says... |
"Subprime raises questions about investment managers" |
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The subprime mortgage meltdown exposes one of the great flaws of the globalised investment marketplace. That is, millions of savers and investors gave over their money to people they did not know, to buy investments that they did not understand, at risk levels that would normally be unacceptable. Anyone viewing the current financial crisis should not only be appalled by the extraordinary amount of losses but should start thinking about whether the investment managers actually knew what they were doing. Had the common investor been sold a bill of goods by wealth managers, would they be more successful in dealing with the key investment challenges as individuals just using common sense? Over the past months, we have all witnessed the enormous write-offs that have resulted from these so-called investment experts who have placed trillions of dollars in assets that were not much more than smoke and mirrors.
To be fair, some of the investments that have as their foundation actual real estate have residual value even if the banks and investment funds write down that value on their books and records. In fact, despite losing some value, the real estate is still valuable. The problem is that the investment managers do not hold real estate but hold some yet undefinable or determinable interest in some sort of security which in a convoluted way is related somehow to a real estate property.
The thought that perhaps the financial experts don’t have a clue as to what they are talking about occurred to me just last week when watching one of those live financial panel programmes on television. Five financial “experts” all of whom run large investment funds were on a panel programme and asked at the end what their stock pick for the week would be. The first one mentioned some sort of company that I had not heard of and gave within thirty or forty seconds the bullet points of why this would be a good stock pick. The moderator then asked the second panel member if that really was a good choice or did they have a better choice. The response was, of course, that the first choice had obvious flaws and that the second panel member pointed out a much better stock to invest in. This process was repeated then with the third, fourth and fifth panel member all of whom disagreed with the previous panel members and came up with some other investment suggestion and bullet points as to why this would be a more successful investment. Basically, it was an exercise in which five investment “experts” each pointed out why the other one doesn’t know what they are talking about. Interestingly, when I looked up their respective investment records as to performance, none of them came even close to Warren Buffett.
Basically, investment managers should try to enhance their client’s wealth. This is commonly understood to mean producing the highest financial return on a client’s investment money within the range of the client’s risk of tolerance. So there are clearly four variables within this equation. First, is making sure that the client’s investment principal is not lost. Second, is achieving a positive rate of return. Third, is understanding the potential for an investment’s possible risk. Fourth, is determining the client’s levels of tolerance for risk. The truth is that the investment gurus were very creative in devising schemes to generate fees, thereby earning for themselves millions in bonuses, but ultimately exposing their clients to billions of real dollar losses.
In recent years, the housing and leveraged acquisition market in the United States and around the world has heated up due to low interest rates and an accumulation of large dollar reserves. Not too long ago, homeowners and other real estate investors had to put down a substantial equity and show an ability to repay the loan before a financial institution would provide a mortgage. As a result, real estate was considered a stable asset class at low risk investment. However, this generated limited fees. By taking advantage of the growing amount of cash reserves available for investment, lower interest rates (which as expected stimulated the economy), and pliable credit rating agencies who obviously didn’t understand what they were rating, the investment managers figured out how to generate synthetic securities and almost unlimited fees for themselves.
Essentially, mortgage originators put together packages of subprime and other real estate related investments. These were then packaged into what is considered a security known as a collateralised mortgage obligation (CMO), such as a collateralised debt obligation (CDO). The packagers would then bundle these securities into slices called “tranches” with the lowest rated tranche (as rated by a credit rating agency) offering the borrowers highest risk at potential reward. The investment packagers realised that these securities, even though rated, were, in fact, undervalued. To compensate, at least on paper, the packagers would then tweak the package so that they appear to be over-collateralised in order to offset the reality that the underlying borrowers were actually unqualified. A simple example would be if there was a loan amount of USD1,000 then that would be sold for a bond of USD800. This compensating “collateral” of USD200 then allowed some credit rating agency to give these synthetic securities a higher rating. Thereby, the investors were told that they could have a degree of comfort in giving over their money. As it turned out, this all was basically a fraud.
It didn’t take long for the investment managers to realise that they could make even more fees by taking these same CMOs and use borrowed money to buy them. The magic of leverage. One example of how this worked (I read in an article) was a money market fund which lent money to a structured investment vehicle (SIV) in the form of commercial paper. The SIV bought the CDOs with the borrowed money, and that CDO took that money to buy another CDO. Essentially, the borrowed money was used to buy a synthetic “asset” which in the final analysis had no underlying equity. Certainly the “collateral” was not something that could be foreclosed on.
So what happened? The underlying borrower, that is the guy at the bottom of the pile, started to default on his obligation. This is the borrower who could not really afford to pay for the investment but was banking on being able to flip the property. The bigger fool theory at work. Because of the way these securities or “tranches” were layered, reality hit hard since unlike a simple foreclosure, these real estate securities transactions were not able to be unwound. The underlying legal agreements generally provided that the investors in the CDOs were required to cover and make up the deficiencies when the underlying assets were not generating enough cash to cover the debt obligations. This led to another problem – pricing.
The pricing problem arose since the value of the mortgage backed securities couldn’t be priced with any consensus. There was no regular market of buyers and sellers, or exchange in which these debt obligations were bought and sold. The result was that unlike regulated exchange markets there was no pricing transparency. People started to wake up to the fact that whatever this collateral was, it was worth a lot less than the amount invested. This then caused investors to start being concerned about other high yield investment bonds and commercial paper where there also is no mechanism from buyers and sellers to agree on valuation and pricing. In other words, the bubble began to burst.
I remember a few years ago sitting in with a client at a meeting about some hedge fund in London. Over a nice cup of coffee and biscuits I was quite impressed by the audio/visual presentation being made. There were charts and graphs, mathematical models and all kinds of statistical information which somehow proved that the presented investment would generate a high yield at a very low risk. All of which were assured safe because some rating agency had issued their report that the credit quality of the security being offered was very high indeed. At the end of the presentation, my client, who on his own is a very astute investor, asked me if I had any questions. The only thing I could think of was to ask a question of return. Which was, “Do you understand what you are buying?” My client turns to me and says, “You just earned your fee.” Then I said, “Let’s go to lunch.”
Subprime and other real estate packaged securities are not the only gimmick of investment managers that may be at risk. Not to be overlooked are special purpose acquisition vehicles which are the new fee generators. Basically a SPAC is a company with no product, earnings, or sales whose shares are used to raise money to buy other, yet undisclosed, companies. Which to me raises the same question of, what is the investor actually buying?
Even for those who have somehow managed to dodge taking a financial hit, the investment world is entering into a volatile economic time. The question becomes whether investors will have or should have faith in their investment managers. Let’s be real, if you have your investment funds with an investment manager that just took a multi-million dollar write-down because of investment losses, can this be someone or an institution that you want to trust with your money in the future? And, are you going to trust the credit rating agencies for their analysis of the risk involved in various types of securities and investments? Clearly, all investors will need to closely scrutinise their existing portfolios and investments. Even more so, investors will need to be much more careful in choosing who to trust as their investment manager.
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