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of all guest columns written by Dennis C. Butler, CFA
Normally, investors have a decent idea where they stand. You own a stock or bond, collect a dividend or interest, and maybe the price changes a little; that is your return on investment. When it comes to “sophisticated” operators, such as hedge or “private equity” funds, it can get more complicated. Paid to go for all the gusto they can with fat management fees and a nice piece of the profits, fund managers are incentivized to take extraordinary measures to enhance their gains. Typical is the use of leverage — borrowed money — which can boost outcomes from even the most ordinary of investment stratagems. But competition is fierce among the burgeoning numbers of funds, so managers are forced to go far afield in search of “alpha” — that above-the-average return which fund investors expect for taking risks and paying those hefty fees.
Enter “CDOs” —
Collateralized Debt Obligations. Often the products of impressively creative financial engineering, CDOs are among a myriad of so-called “asset-backed securities”—instruments representing claims on the cash flows of pools of underlying fixed-income securities, which may include anything from mortgages to bank loans and junk bonds. Depending on the type of CDO and how it is structured, it may offer a higher yield than these underlying assets, or its value may change violently as the price of the assets fluctuates. It is these latter qualities that attract risk-takers such as hedge funds. Indeed, CDOs and other complex financial creations known as “derivatives” (because their value is dependent upon another asset) are often touted as financial system stabilizers due to the effect of spreading financial risks broadly among players able and willing to accept them. It is worth noting that this assertion remains subject to debate, as the haze of CDOs, CMOs, CBOs, MBSs, derivatives, etc. surrounding the financial globe has yet to be probed by a real financial crisis.
Just how complicated (and potentially nasty) all of this can get was revealed in June when a couple of hedge funds sponsored by one of the big Wall Street investment banks ran into trouble. Using investors’ capital, multiplied by lots of borrowed money, the funds (with names like “High-Grade Structured Credit Enhanced Leverage Fund”) had acquired heavy exposure to instruments backed by so-called subprime real estate loans — loans made to people who, through the normal vicissitudes of life (including the odd recession or two that may occur during the lifetime of a mortgage), probably will have trouble repaying the money. It goes without saying that only during boom times, when financial morals are loose, can such borrowers have the ready access to loans that we have seen in the last few years. Be that as it may, the two funds (like the rest of the hedge fund crowd) had been attracted to these products of go-go optimism because yields are higher, and the fund managers believed they could make above-average profits while the getting is good and get out before the going gets tough.
During the last several months, however, rising interest rates and technicalities related to the terms of certain popular types of mortgages caused the environment for lending to questionable borrowers to deteriorate, and default rates are rising (not unexpectedly, we might add, as the potential consequences of risky lending practices have been discussed for years). The problems in the subprime mortgage arena began to negatively impact the market for the CDOs held by the two hedge funds in question. The fallout from the CDO collapse was magnified by the amount of financial leverage the funds had taken on (leverage, as we see, can exacerbate losses in addition to enhancing gains). The situation deteriorated to the point where the funds’ creditors (including other large Wall Street firms) began to seize collateral (the funds’ CDO holdings) with the intention of selling it to cover their loans — in other words, a margin call. This is where the story gets interesting: what was the collateral worth? As it turns out, mortgage-backed securities of this type trade infrequently and with difficulty, making their true market value difficult to ascertain. To compensate for this minor inconvenience, hedge funds use elaborate computer models to value their portfolios. In this case, creditors soon discovered that their collateral was difficult to unload, calling into question the validity of the valuations used not only by these particular funds, but all funds employing strategies involving illiquid asset-backed products. Fearing a widespread deflation of values should actual transactions place a real value on these securities, the sponsoring firm was “encouraged” to pledge up to $3 billion to shore up its funds. (In contrast, at about the same time two funds in London were forced to reign in risk-taking, sell assets, and even close down due to similar exposures to the U.S. subprime crisis). Small wonder that banks are beefing up their staffs of distressed debt specialists, in preparation for the coming deluge.
It is ironic that Wall Street, that bastion of free enterprise, should be afraid of something so basic as price discovery, but having money in the game focuses the mind, we suppose. If it turns out that the valuations assigned to hundreds of billions of dollars of financial assets are, in reality, fictitious, $3 billion may be the tip of the iceberg. Perhaps the fate of those London firms is a sign of things to come in New York and Greenwich, Connecticut (hedge fund capital of the U.S.). Not that we would mourn the demise of a bunch of hedge funds — “creative destruction” is a healthy economic process. Nor would we shed many tears for the fate of those wealthy enough to speculate through these vehicles. Nevertheless, stress in the speculative fund world could be disruptive, which is something to watch out for.
As they say of the proverbial postman, neither hedge fund woes, nor subprime fears, nor foreign tensions deterred the markets from making their merry rounds last quarter. Interest rates rose in a dramatic fashion in May and early June to about 5.3% on 10-year treasury notes, up from approximately 4.7% previously. Some observers surmised that the long decline in rates that began in the early 1980s had finally run its course. Some feared that the demand for credit caused by worldwide economic strength and declining appetites for U.S. securities on the part of foreigners would result in higher borrowing costs. These concerns soon faded and rates receded back to the 5% range by quarter-end. Although signs appeared that the junkiest deals were “meeting resistance” — a development that could spell trouble for some of the more aggressive merger transactions — sellers of bonds continued to benefit from booming demand. Yield spreads between bond sectors remained tight, and even narrowed somewhat as treasury yields rose. Although the indices were somewhat volatile when compared with the experience of the last couple of years, generally positive economic data helped stocks do reasonably well. Exceptions to the positive tone in the markets came from the housing and related mortgage industries where foreclosures mounted and inventories of unsold properties grew. One of the few “healthy” ($1 million for a one-bedroom apartment) real estate markets was in Manhattan, home of the people who create those CDOs and other financial products and do the trading for the funds that buy them. Their bonuses spurred demand in an already hot housing market. As it was during the Gold Rush, it is among the enablers of speculation, whether they be purveyors of picks and axes or securities trading platforms, that the real fortunes are made.
An Age of Finance
From time to time we have discussed Wall Street’s role in capital allocation — the process of seeing that funds are efficiently allotted to projects and businesses that offer the greatest potential return on investment — in our economic system. Owing to the casino-like behavior often exhibited by the public financial markets, the process sometimes gets out of whack. The ease with which even the most tenuous of dot-com outfits got funding in the late 1990s is a great example. The frenzy of lending to those with poor credit and the funding of numerous alternative energy startups in the last couple of years may be shaping up as new and equally vast capital misallocations.
Infatuation with the financial sector of the economy, its products, and financial manipulation in general — as opposed to real economic activity — is usually not a good sign. The financial sector now accounts for more than 20% of the aggregate value of the Standard and Poor’s 500 stocks, a weighting comparable to that of energy during its heyday in the early 1980s. The most eagerly anticipated initial public offering of the year was that of a company in the business of managing other people’s money, using it to buy and sell other companies, earning fees and taking profits in the process. In a volatile business dependent on easy credit, deal-making talent, strong financial markets, and facing potentially unfavorable tax code changes, the firm was sold to the public for 25 times earnings. (By comparison, investment banks, which perform many of the same functions, currently trade for 11-12 times earnings.).
Investors in the firm’s funds include some of the deepest pools of capital run by some of the most knowledgeable people in the business, among them endowment and pension funds, foundations, and wealthy individuals. In fad-like fashion, such institutions (after learning of the resounding success that organizations such as Harvard and Yale have had with their “alternative” investment strategies) have allocated increasing portions of their capital to hedge and private equity operations; similarly, the wealthy have been encouraged to put money into alternative investments, including, naturally, those same hedge and private equity funds that have become familiar even to the man in the street. Backed by such financial power, “activist” funds have encouraged public companies to make their capital structures more “efficient” by loading up on debt in order to buy in shares and thereby boost the stock price, regardless of the difficulties businesses may face during less propitious times in the future as a result.
Capital from around the world, including that held in corporate coffers, was drawn to trading in Wall Street in 1929. In the early 1970s, institutional interest (including, prominently, Yale’s) in stocks — the “alternative” investment of the day — grew to record proportions. While we do not know if the current high degree of focus on finance will end in a fashion similar to these historical examples, it should be pointed out that all economic activities, real or financial, are subject to the laws of supply and demand. All things being equal, an increasing supply, whether of goods or capital, is met by a downward adjustment in price, or, in the case of investment, lower returns on capital.
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Dennis C. Butler, CFA, is president of Centre Street Cambridge Corporation,
investment counsel. He has been a practitioner in the investment field for over 23 years and has been published in
Barron's. He holds an MBA from Wharton and a BA in History from Brown University. His quarterly newsletter can be found at www.businessforum.com/cscc.html.
"Benjamin Graham in Perspective", an article by Dennis Butler, appears in the Summer 2006 issue of Financial History, a magazine published by the Museum of American Finance in New York City. To correspond with him directly and /or to obtain a reprint of his featured articles, "Gold Coffin?" in Barron's (March 23, 1998, Volume LXXVIII, No. 12, page 62) or "What Speculation?" in Barron's (September 15, 1997, Volume LXXVII, No. 37, page 58), he may be contacted at:
Dennis C. Butler
President
Centre Street Cambridge Corporation
Post Office Box 390085
Cambridge, Massachusetts 02139
Telephone: 617.441.9695
Email: cscc@comcast.net
URL: http://www.businessforum.com/cscc.html
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