For my last birthday, my wife gave me a three-wheel cart for my golf bag, so I can push instead of pull.
Among its features, the cart has inflatable tires (with an attached air pump), a parking brake and a device for affixing a golf umbrella to the cart. It wasn’t cheap, but the user’s guide declared: “Admit it. You enjoy the minutiae of golf.”
Minutiae, in the form of exotic investment strategies, is in vogue on Wall Street, as well. Exchange-traded funds, collateralized debt obligations and currency swaps are among the complex instruments sold to investors bored by tried-and-true investment techniques.
After a rough summer for investors, optimism swelled anew when the Federal Reserve last month staged a surprise cut in interest rates in an effort to avert a recession and restore confidence to financial markets. Purveyors of investment minutiae emerged from the shadows. Sales of emerging-market funds and junk bonds blossomed.
Still, the soundtrack from the movie “Jaws” plays in the distance, said Gerard Caprio, a professor of economics at Williams College in Williamstown, Mass. The “rumble in the background,” as he calls it, is the accumulated and still unresolved problems in global banks and credit markets caused by concentrated and ill-advised risk-taking in debt securities.
As you save for your old age, you could buy and hold a broad global index fund of stocks and a broad index fund of top-rated fixed-income securities. If you contributed regularly to this diversified portfolio over many years, you would do as well as most sophisticated investors.
My golf buddy, who pulls a cart he bought for $5 at a garage sale, usually beats me.
Hedge fund boom
Nonetheless, when they have money to spend on minutiae, investors, including managers of pension funds on behalf of ordinary people, are likely to do it. The boom in hedge funds is ample evidence of this foible among investors who have the wherewithal to know better.
We learned from the subprime mortgage crisis that whatever appeal investment minutiae might have, the devil is in the details.
Even if you never bought a subprime mortgage-backed security, your bond fund might have. What’s more, the blowback from the debacle has tightened the availability of credit for good borrowers and bad.
“The availability of credit will be a lot less in the next five years than in the last five years,” said Richard Berg, chief executive of Chicago-based Performance Trust Capital Partners, a fixed-income investment and advisory firm.
Non-traditional debt created by investment banks and hedge funds to finance corporate takeovers, as well as home buying, has been a principal contributor to economic growth and stock market gains for several years, he said.
“That segment of the credit engine has been severely crippled for a while,” Berg said. “Credit drove the stock market. Credit drove housing.”
With a major portion of loan generation hobbled, even briefly, “the odds don’t look good” for investors going forward, Berg said. Yet, “the stock market is reflecting the underlying belief that things will improve,” he said.
‘We’re flying blind’
Investments tied to the worst of mortgage creditworthiness aren’t a good idea when no one knows how far U.S. house prices will fall, former Federal Reserve Chairman Alan Greenspan told a conference last week sponsored by Bloomberg News.
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“We’re flying blind,” he said.
In turn, Wall Street’s marketing of securities backed by subprime mortgages, as opposed to broadly based baskets of debt securities, make things worse, Greenspan said.
“If that had not happened, we would not have had a problem,” he said.
Promoting such minutiae in investment products violates the first three investing rules: diversify, diversify and diversify.
In mortgage-backed securities, as in all pooled investments, the parts are worth less than the whole. The more fine-tuning you do, the more likely you are to get static.
Put another way, an insurance company would charge you a lot more to insure your house against fire if your house was the only house the company insured. Regardless of the chances of fire, there is no way for the insurer to spread the loss.
“It might be the same odds [of fire], but the cost of being wrong is catastrophic,” said Berg.
In this way, Berg said, financial engineers have converted the risk of large numbers, investing in a well-diversified basket of assets, into the much greater risk of small numbers, investing in a portion of the basket.
Owning securities backed by a portfolio of red-white-and-blue U.S. home mortgages seemed like a good idea, especially to investors abroad who were unfamiliar with the shady practices of some mortgage originators.
But what many presumably sophisticated investors purchased was just the red (as in riskiest) tranche of less creditworthy mortgages, which had been subdivided from a national mortgage basket in order to advertise higher yields.
Moreover, hedge funds and other smart investors borrowed against their risky batches of mortgages, often from the same banks that sold them the batches in the first place. When the mortgages went sour, so did loans secured by the mortgages.
Janet Tavakoli, president of Chicago-based Tavakoli Structured Finance, a consultant to financial institutions, said slicing and dicing baskets of loans to meet various risk/reward demands of investors is not necessarily bad or contrary to the rules of diversification.
“If you understand, taking that risk is not a bad idea,” she said.
The problem arises when the investment banks packaging the products fail to adequately disclose their risks, she said.
“There is no point diversifying into a asset that is doomed,” she said.
Tavakoli believes the economy and financial markets can absorb the failures of subprime-mortgage packagers.
“We’re going to see volatility going forward as this stuff plays out, but we’ve seen things like this before,” she said.
Meanwhile, greater discipline by lenders might reduce overall credit availability, but “getting back to sound lending practices is going to be very good for the economy and very good for the stock market,” Tavakoli said.
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