THE BEAR'S LAIR Demand transparency
By Martin Hutchinson
Perhaps the most sobering thing we have learned during 2008, or rather since
the subprime crisis broke in the middle of 2007, is the benefit of transparency
in business dealings. Time after time, when a fiasco has occurred, it has been
due to a lack of transparency in a transaction or series of transactions.
Subprime mortgages, collateralized debt obligations and credit default swaps
were all financial innovations that relied crucially on nobody asking too many
questions. Now a US$50 billion Ponzi scheme run by Bernard Madoff turns out to
have involved some of
the most sophisticated investors in the world, and to have rested on the same
fatal human omission.
In the subprime mortgage case, investors were not given sufficient information
on the contents of the mortgage pools in which they invested, but instead chose
to rely on the debt ratings given the pools by the rating agencies. As it
turned out, the rating agencies' models were insufficiently sensitive to
correlations between different assets in the same class, and did not deal at
all with the possibility that some of the mortgages themselves or the
valuations underlying them might be fraudulent. In the old North Country
English phrase, investors were buying a "pig in a poke" and should not have
been surprised when the "poke" was opened and the pig turned out to be a rat.
Collateralized debt obligations were un-transparent in two ways. First,
investors in the pools themselves were given inadequate information on the
assets backing them. Second, bank investors were not informed about the extra
liabilities that the banks had incurred off their balance sheet in separate
securitization vehicles. Hence, when the commercial paper markets dried up and
banks were forced to choose between defaulting on collateralized debt
obligations (CDOs) they had sponsored and bringing the assets back on their
balance sheet, their leverage suddenly markedly increased.
Banks that had appeared to be conservatively capitalized were found to be
highly risky operations. The worst effects of this problem were avoided for
depositors through deposit insurance, but the lack of transparency eventually
caused a liquidity collapse in the money market.
The scale of credit default swaps (CDS) sneaked up on everybody, becoming a $62
trillion market, nearly three times the sum total of all US debt obligations
outstanding, without anyone outside the business knowing much about it.
Settlement procedures were untried in a large bankruptcy, and have since shown
themselves to be highly arbitrary, since prices for settlement of billions of
dollars of CDSs are based on a mini-auction involving a tiny fraction of the
amount of CDSs outstanding.
As the Bear Stearns, Lehman and AIG debacles showed, credit risks in the CDS
market are highly non-transparent. As a holder of a CDS, you don't know whether
your counterparty has issued only a few of your CDSs, in which case you'll
probably get paid in a bankruptcy, or whether he has issued 50 times the
outstanding debt you're trying to hedge, in which case you're pretty unlikely
to get paid. Knowing that he manages his risk by the Value-at-Risk method,
which blows apart in turbulent markets, would prevent you from assuming he has
managed risk competently.
Finally, we have Madoff. The Madoff scheme could not have happened 30 years
ago. Any professional investor would have wanted to know how Madoff expected to
make his high and consistent returns, and there were no options markets of
sufficient size for him plausibly to claim them as sources of exceptional
profit. Professional investors in 1975 knew how money could be made in
quantity; in 2005, they didn't because with derivatives and options, there were
an infinite number of arcane trading strategies that might in theory produce
superior returns.
Charles Ponzi could not have swindled professional investors using postal
coupons, even in 1920. He relied on finding enough gullible wealthy individuals
who would calculate that his scheme might work, and not figure out that it
could not be scaled up to the size needed (Ponzi would have needed to deal in
120 million postal coupons to work his scheme on the $10 million he had at his
peak; the total global postal coupon "float" was only around 27,000.)
Lack of transparency bears a considerable responsibility for the current
debacle - less perhaps than over-expansive monetary policy, but more than any
other single factor. A key requirement for recovery is thus to overcome the
transparency deficit.
Lovers of regulation have been claiming for months that the solution to the
transparency deficit is additional government regulation. The Madoff case has
surely shown that to be a false protection. The Securities and Exchange
Commission, with 70 years of legislation behind it, turned out to be incapable
on repeated occasions of spotting a $50 billion Ponzi scheme audited by a
three-person outfit. Thus, giving the SEC a new transparency rulebook will
simply add bureaucracy and not protect significantly against fraud, let alone
simple gullibility and failure to take adequate account of risk.
If governments cannot be expected to provide foolproof transparency for
investors, then investors will have to take care of the matter for themselves.
Good old-fashioned bear-market skepticism can do much of the job. Don't buy
mortgages on the basis of a third-party guarantee, nor slices of mortgages
sliced up into incomprehensible securities packages. If investor demand for
mortgage-backed securities (MBS) is removed, banks will be forced to hold
mortgages on their balance sheet. This will not only be more secure, it will
also be cheaper; as I documented some months ago, the cost of mortgages,
expressed as a spread over Treasury bond yields, became higher in the
securitization era of 2000-06 than it was in the direct-lending era of 1971-77.
In bond investment, demand simplicity. Complex credit structures offer too many
opportunities for fraud or simply fudging, and the rating agencies are
incapable of giving you an accurate assessment of their merits. Hence, direct
obligations of companies with published financial information and a
straightforward business model should be preferred over messy conglomerates,
let alone artificial debt structures.
If as an investor you wish to stretch your risk parameters in order to get a
higher yield, make sure that the additional risk is in the form of clearly
visible leverage in an easily comprehensible situation. Similarly, when
investing in international credits, demand obligations of countries such as
Brazil, whose governmental systems are transparent and debt levels are well
known, rather than countries such as China, where the entire banking system is
masked by a fog of obfuscation and the political system is both rigid and
opaque.
As an investor, you should avoid credit default swaps altogether. The idea that
by buying a risky bond and a credit default swap against it you can achieve a
risk-free return is nonsense. If the bond defaults, the CDS will pay out some
arbitrarily determined amount that bears no relation to your loss on the bond.
Further, in buying a CDS, you are assuming a counterparty risk that depends not
only on the counterparty's overall business but on his exposure to that
particular credit, and his success in hedging that exposure.
Finally, investors should avoid buying investment products where the mechanism
by which returns are achieved is not transparent. In the modern world,
relationships and trust are unfortunately not enough - having been at college
with Madoff made you more likely to be defrauded by him, not less.
However, the prohibition against non-transparent investment should not extend
merely to the "black boxes" offered by Madoff and most hedge funds. It should
also include many of the artificial derivative-driven products that have in
recent years become fashionable investments for retail investors. As well as
deliberate opaqueness, the magic world of derivatives can also lose you money
through its lack of "operating transparency".
Exchange traded funds (ETFs), in particular, are sometimes not what they seem
to be. For example, let's say an ultrashort ETF claims to track various stock
and bond indices in reverse, using 200% leverage. This is achieved generally by
taking a short position in the relevant futures contract. The whole structure
is entirely above board; both the aim of the funds and the method by which the
managers hope to achieve it are made quite clear.
However, investors may not realize that, in order to track the relevant index,
the ETF must be rebalanced periodically (usually daily) and that such
rebalancing can introduce large tracking errors if the index being followed is
volatile. For example, one ETF that shorts the Chinese market on a leveraged
basis is down almost 50% over the past year, though without "tracking error''
it should have trebled in value. Thus an investor a year ago correctly
assessing the overvalued state of Chinese shares and buying this ETF would have
been rewarded by the nasty surprise of losing half his money, even though his
market view was correct.
The ETF may have done what it said it would do; nobody has been dishonest. But
overall, the investor has lost money. That's because of a lack of operating
transparency.
Investors can achieve transparency, and so sleep at night about their
investments; but in order to do so they must demand it. No regulator can
provide it reliably.
Martin Hutchinson is the author of Great Conservatives (Academica
Press, 2005) - details can be found at www.greatconservatives.com.
(Republished with permission from PrudentBear.com.
Copyright 2005-08 David W Tice & Associates.)
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