FSO editorials

Risky Businesses?

Part 2

by Richard A. Eckert, CFA| September 1, 2009

Expected return per unit of risk assumed

risky business If one subscribes to classic economic theory, it is no surprise the financial services and real estate sectors poached some of the best and brightest from scientific and technological endeavor. After all, human capital, like financial capital flows to those projects and enterprises with the greatest expected return per unit of risk assumed. And, given reports of stratospheric salaries and bonuses paid on Wall Street and talk among one’s family, friends and colleagues about how much money one could making brokering loans or selling real estate juxtaposed against the realization that none (or very little) of one’s own capital was at stake, it is easy to understand the large numbers of existing workers flocking to the financial services sector from other fields or students abandoning the rigors of an scientific or engineering discipline for a career in business (or law).

With the exodus of human capital from scientific and engineering fields, it is also no surprise that true innovation outside of the financial services sector was wanting. But, even within the financial services industry, true innovation went lacking—notwithstanding the wholesale re-allocation of the nation’s human and other resources to the industry. What we—the United States—got instead was “subprime” loans, “Alt-A” loans, and “option ARMs”. Despite the new monikers (euphemisms?), these products did not represent new ideas. Alternatively know as “hard money” lenders or “consumer finance” companies, subprime lenders had been around for decades. Associates First Capital (The Associates), for instance, which was acquired by Citigroup earlier this decade, dated back to 1918. Household International Corp. (Household Finance), now part of the HSBC family, had a history that goes back to 1878. The Money Store—perhaps best known for its Baseball Hall of Fame pitchmen, Jim Palmer and Phil Rizzuto—was formed in 1967.

What was new, however, were advances in financial engineering—the creation of new vehicles and structures to house nontraditional credits and/or disperse the accompanying risks—that enabled fixed-income investors the world over to look at credits and collateral types they would have spurned a decade earlier. That, in turn, allowed for an unprecedented expansion in household credit and superior risk-adjusted returns—at least early in the cycle—for holders of ABS (and related derivative instruments) backed by subprime mortgages and other types of nontraditional credit. Among the earliest and most vocal champions of “structured finance” was former Federal Reserve Chairman, Alan Greenspan.

“Perhaps the most significant innovation has been the development of financial instruments that enable risk to be reallocated to the parties most willing and able to bear that risk. Many of the new financial products that have been created, with financial derivatives being the most notable, contribute economic value by unbundling risks and shifting them in a highly calibrated manner.” (Boston College, Conference on the New Economy, March 2000)

Such instruments appear to have effectively spread losses from defaults by Enron, Global Crossing, Railtrack, WorldCom and Swissair in recent months from financial institutions with large short-term leverage to insurance firms, pension funds, or others with diffuse long-term liabilities or no liabilities at all.” (London, September 2002)

Since chastened, Mr. Greenspan now blames securitization for the current crises.

“What went wrong with global economic policies that had worked so effectively for nearly four decades? The breakdown has been most apparent in the securitization of home mortgages. The evidence strongly suggests that without the excess demand from securitizers, subprime mortgage originations (undeniably the original source of crisis) would have been far smaller and defaults accordingly far fewer.” (Washington, D.C., before the House Committee of Government Oversight and Reform, October 2008)

Once again, genuine invention proved to be elusive. The alphabet soup of ABS, CDOs, CDS, etc. represented not so much innovation as they did opacity and illusion. The proliferation of new structures actually rendered it more difficult to ascertain where the real risk resided and in which concentrations. Furthermore, they fostered a sense of complacency, a false sense of security, among all participants along the mortgage food chain: broker, appraiser, account executive, underwriter, loan processor, mortgage banking executives, the Wall Street mortgage desks purchasing and securitizing most nonconforming loans, ratings agencies, ABS investors, and secondary market traders. The dispersion of risk—or widespread perception that risk was being dispersed—translated into a dispersion of responsibility for due diligence and the evaporation of all common sense. In the words of one observer:

“Common sense says that you can’t start lending money to very risky borrowers without taking on lots of credit risk – but somehow, by the time the loans made their way through the system, almost nobody thought that they were taking on credit risk. Most of the participants in the market thought they had triple-A-or-better debt, and they all believed, without ever really stopping to check, that the enormous amounts of credit risk being produced were being willingly held elsewhere.”

Counter intuitively, attempts to disperse risk only seem to heighten it, because when everybody owns it, nobody is accountable for it.

Risk is in the eye of the beholder

The weaknesses in those beliefs—and indeed, the whole process by which mortgages were originated, aggregated, sold, securitized, rated and distributed in pieces to fixed-income investors throughout the world—are outside the scope of this discussion. The point being made here is that the financial crisis took root not in excessive risk-taking, but the absence of risk-taking—or, more precisely, efforts to avoid it and the conviction that those efforts had succeeded.

Although risk-avoidance pervaded the entire economy—and we will speak briefly about this in the following section—we are most intimately acquainted with the mortgage banking and broader financial services industries. Therefore, the examples that come most readily to mind are those found within that sector. We are also of the belief that they are, perhaps, the most illustrative of risk-avoidance. Take the whole mortgage banking model, for instance: originating loans for sale or securitization. The model was designed to minimize or eliminate credit exposure. Most of the exposure could be laid off on Fannie Mae or Freddie Mac or the private ABS markets. And as long as home values kept appreciating the residual risk—repurchase requirements and interests retained in private-label securitizations—could be minimized. The loans so repurchased or underlying retained interests could be refinanced, the borrowers forced to sell—often at a small gain—or, in a worst case, scenario, the properties securing the loans foreclosed upon and disposed of. Even in the worst case scenario, sharp increases in home prices could keep potential losses very small.

The trouble with devoting all of one’s energy and resources to evading risk is that such efforts ultimately blind one to the largest exposures. In this case, the two 800-lb gorillas in the room no one noticed were assumptions about liquidity and home prices (some may argue that these are related in that misgivings about the latter were a major factor in driving the former from the RMBS markets). Mortgage banks amounted to nothing more than leveraged bond trading desks. These desks leveraged their capital 30x or more to acquire increasingly illiquid assets called subprime mortgages, Alt-A loans and option ARMs on the presumption they could quickly find a buyer(s) for these loans or securities collateralized by them. But, even in the best of times, a small disruption in the global bond markets—perhaps one unrelated to mortgages or credit issues at all—could create a period of temporary illiquidity, which, in turn, depresses the market value of all securities. The resulting margin calls and other actions could wipe out the equity of the lender or investor and then some—even if not one of the underlying loans was delinquent or in foreclosure. Thus, the absorption—obsession?—with credit risk diverted attention from the liquidity issues that eventually did the independent mortgage banking industry in.

All of the above being said, though, taking this analysis to the next step—the personal level—renders discussions about “800-lb gorillas” irrelevant. Individual actors took on little or no risk. No one had their own money at stake. Certainly no one at the smaller rings of the mortgage food chain. Brokers, even those doctoring up mortgage applications and supporting documents, were not compelled to return their commissions. Ditto appraisers, account executives, underwriters and loan processors. None had to give back the bonuses and incentives “earned” during the bubble years. The only risk was that one day the party would end and, for those without any foresight, they would have to once again earn an honest living, one that required they work a whole lot harder for a whole lot less money.

Up higher in the food chain, we are not aware of any mortgage banking executive who has had to return any portion of his/her compensation from the 2001 -2006 timeframe—even after their companies collapsed under the cumulative weight of bad decision-making. None has had to disgorge any profits from the sale of company shares, most of which were acquired at little or no cost, usually through options and stock awards (very few had more than a token personal investment in their firm). Many were divesting themselves of their personal stakes even as the bubble began to burst. Only one top manager, Angelo Mozilo, of Countrywide and several of his lieutenants—to our knowledge—have even been challenged on this score. Earlier this summer the SEC filed civil suit, claiming these executives sold large amounts of stock on inside information.

Higher, yet, the same assertions can be made. Traders and salesmen and structured finance analysts at the large commercial and investment banks buying and securitizing nonconforming loans have not had to return their salaries and bonuses. Ditto the analysts and managers at the ratings agencies rating what later came to be deemed toxic as AAA. Because there were no clawback provisions in their contracts, top executives at the nation’s money center and global investment banks did not have to forfeit the huge sums of money made during the boom years—despite their companies reporting losses in 2007 and 2008 that wiped out much the earnings retained from those years. Even disgraced executives carried home $10s of millions in severance and deferred income after being discharged.

Finally, there are the investors. But most of them are institutional—i.e., managing other people’s money. With very little or none of their personal net worth at stake, these individuals have little to lose. They make handsome management and performance fees in good years. And not so much (or nothing) in bad years. Once again, there is no penalty for losing money, no forfeiture of performance bonuses earned in good years—even if losses in one year wipe out the gains from several of the previous years. There is, of course, the risk that a good number of investors will defect, redeeming their investments and sharply reducing assets under management. But, unless they are too far off their benchmark—or their performance was significantly worse than their peers (not likely since they either use the same benchmarks or chase the same trades in an effort to stay close to the pack)—they will probably keep their jobs and live to fight another day.

Unless the individuals in the last three categories spent frivolously—or invested their ill-gotten gains with Bernie Madoff—the downside to their actions during the housing/housing finance boom is practically nil, in our estimation. Many will probably never have to work another day in their lives. Others may have to continue to work, but not very hard. And, although there is the risk of litigation, we get the sense—even if we are, admittedly, not legal experts—that little evidence of wrongdoing will surface. Only a few of the most egregious offenders are likely to face either civil or criminal action. And of those, most will probably end up settling for some tiny fraction of the money they made during the first six or seven years of this decade.

“Nothing ventured, nothing lost……and everything to gain”

But what about the real economy?

The data plotted on the Exhibits VIII and IX below are consistent with our findings above. That is, a flattening of business investment and an absence of genuine innovation, both within and without the financial services industry. But for the last two recessions—1990 thru 1991 and 2000 thru 2001—and the current malaise, corporate profits climbed in both nominal dollars and as a percentage of nominal GDP, apparently at the expense of business investment and employee compensation.

Exhibit VIII

It is our surmise that, with the lower personal and corporate tax rates enacted in the 1980s—in particular, the dismantling of the progressive tax structure—corporate executives were much more incented to maximize reported revenue and earnings in any given period, thereby maximizing their own performance- and stock-based compensation (assuming large and growing streams of revenue and earnings were reflected in share prices in timely fashion), rather than building brands, franchises or economic value. We add here it appears to us that, most often, performance = reported revenue or profits, not anything truly meaningful to shareholders, like ROE or ROIC. But, as long as shareholders did not hold managers to these loftier—in our own humble opinion—standards, those managers continued to devote their energies and the resources of their companies to reporting increasingly higher levels of revenue and earnings.

Exhibit IX

One of the most efficient ways of maximizing profits in the near term was to keep capital spending to a minimum and to avoid unnecessary risks. Which would explain the dearth of bona fide new ideas and products.

The most illustrative—and striking—examples of this fixation with current period and near term operating results, in our estimation, resided in the small- and microcap space, particularly in newly public organizations. Company insiders and founders, who maintained a large and, in many cases, controlling stakes in their companies acquired those stakes for very little or nothing. Really, what kind of capital investment is required to start up a business that measures its progress and success in “eyeballs”? And despite the lip service often paid to “access to capital”, the only motivation we could descry in going public was to monetize and maximize the value of the public currency that would attach itself to the personal stakes of the founders and managers—stakes that were, once again, acquired with little or no capital investment. Therefore, insiders retained most of the upside opportunity while foisting off most of the downside risk on external stakeholders.

Even for companies with a commercially viable product, access to public capital meant that, increasingly, firm resources were given over to financial planning and reporting, SEC compliance, and managing relations with various constituencies in the capital markets. And also that product engineering gave way to financial engineering. Newly raised capital was not used to improve products or invest in the future of a firm’s franchise. Rather, it was used to make disparate acquisitions—for the purpose of bolting on revenue and/or EBITDA—or to fund promotions and sales force incentives, among other maneuvers aimed at boosting reported revenue and earnings. The goal became keeping these measures moving in an upward trajectory so that if the public equity markets acted as predictably and irrationally as they are wont to do, they would catapult the market value of insiders’ stakes into the $10s or $100s of millions. Then, as soon as stock options and restricted stock awards vested, insiders could begin exercising them and selling them—as well as portions of their original stakes. Cash compensation was also inflated by rapid increases in reported revenue and profits.

Even if the steps taken to turbocharge a company’s short-term measures of financial performance ultimately led to its demise, managers and founders were often indifferent. They had already amassed a small fortune. Unless there was a clawback provision or a violation of insider trading rules—and violations are ridiculously easy to avoid—they were free to take their fortunes and move on.

Once more, “nothing ventured, nothing lost……and everything to gain”

There is no free lunch

We could entertain arguments that external stakeholders were assuming the risk here. But the low return expectations implied by debt and equity valuations and paucity of due diligence are suggestive of something else: abdication of responsibility. Failure to supervise, hold accountable and/or insist on a role in the decision-making process cannot be equated with risk-taking. Some will contend that in a well-diversified portfolio, the risks associated with a single company are small and manageable. Hiding behind diversification and expecting to generate better-than-market returns. Another example of avoiding risk and shooting for above-average rewards. That, however, is a topic for another day.

Suffice it to say that, even within the microcosm of small-cap companies, those making the decisions stood to reap the lion’s share of the rewards while taking on precious little of the risk. Indeed, they may even be thought of as risk-averse. And, similar to those migrating from the physical sciences and engineering to a career in the financial services/real estate sector, their behavior is entirely natural, rational and predictable. Using the IPO mechanism and financial reporting conventions (options?) permitted under GAAP, they are merely monetizing and locking in big gains on de minimis investments, thereby maximizing the return per unit of risk assumed.

But, just as the economic concepts of the “Paradox of Thrift” or “Fallacy of Composition” teach us, what is good for an individual household or organization is not necessarily good for the broader economy or nation. As articulated above, we believe that risk-avoidance has stifled business investment and restrained true innovation. And if every individual and organization is trying to lay off or disperse risk, it merely aggregates and mutates elsewhere, making it difficult to identify and mitigate/manage the consequences thereof.

In fact, it is our position that attempts at risk-avoidance only hastened the arrival of those consequences. Each bad SFR or commercial mortgage written in the early 2000s, for instance, no matter how seemingly innocuous—i.e., no matter how much collateral value ostensibly secured the property or what kind of debt service coverage the borrower’s stated income provided—hastened the paralysis in the securitization markets we are now observing. The fact that such loans were available was a testament to the excess liquidity in the secondary mortgage markets. That liquidity created an asset bubble and perverse incentives throughout the mortgage food chain. Soon, notwithstanding the Herculean efforts expended to avoid risk, it became readily apparent that borrowers could not even afford to make the first, teased-rate payment on their mortgages and investors could not rely on agency ratings of securities backed by those mortgages. Shortly thereafter, the truly unthinkable—a certifiable “black swan” event, in our estimation—occurred. Residential real estate value values began to decline and global fixed-income investors had no appetite whatsoever for securities backed by residential real estate loans. But really, this could not have been unexpected. Risk is cumulative. Every incremental exposure brings an individual or organization closer to a day of reckoning. So, once again, trying to avoid risk only intensifies and accelerates the arrival of its consequences. Risk has to be managed, not ignored.

For way too long, America was enjoyed a standard of living it hadn’t earned—at every level of society. Consumers freely spent money they hadn’t worked for, merely borrowing it instead. Corporations reported record profits (and, concomitantly, peak equity market valuations) by stanching the flow of investment into research and capital goods instead of stepping up their commitment to adding true economic and social value. Yet, neither consumers nor corporations felt they were taking any chances. Consumers were confident that sharp increases in the value of their homes and 401ks—after all, housing and stock prices went in only one direction, up—would cushion the blow of any temporary employment setback and provide for both growing debt service requirements and retirement. Businesses saw no need to invest in the future—or any real improvements to existing products—when consumers lapped up current offerings with such zeal. The sentiment seemed to be that introducing genuinely new products would not alter the demand function meaningfully. And, once again, credit intermediaries believed that they did not have to truly underwrite mortgages or price them fully for the associated risk as long as they could sell or securitize them almost immediately. Whatever risks remained—the potential losses on retained interests or loans that would not sell readily—would almost certainly be mitigated by rising home values.

The end result was a country that could only manufacture credit and export jobs—as opposed to value-added goods and services. After all, how much value is created when a dollar passes from doctor to lawyer to insurance agent to mortgage broker (in a refinance) to used car salesman to bartender.. and so forth and so on. The abrupt withdrawal of liquidity and contraction of credit didn’t create the deep recession we are now enduring; they merely exposed a languishing economy bereft of any new ideas and, certainly, any direction or higher purpose; the earlier, rapid expansion of credit—perhaps by design—merely papered over this sorry state of affairs.

The biggest of all risks is taking none. That has been the risk borne by the U.S. populace for most of the last three decades—and, from our point of view, the risk we still bear. Today’s recession and the slow growth it portends in the years ahead are perhaps just a reminder from the global financial markets that there truly is no free lunch.

Resources:

¹ Felix Solomon, notes from a speech to the Regional Bond Dealers Association in Dallas, TX, April, 2009.

Contact Information

Richard A. Eckert, CFA (415) 674-4996 | San Francisco, CA | Email