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of all guest columns written by Dennis C. Butler, CFA
A �seasoned security� is not the same as a �hot stock,� and the rating agencies, upon whom so many investors rely for risk analysis, would do well to keep the distinction in mind. In the markets for securities, seasoning refers to the process by which a speculation becomes an investment (to use somewhat old-fashioned terminology). Issuers gain a reputation for reliability over time � interest is paid unfailingly when due, the business is run prudently and becomes more valuable as profitability is nourished, earnings grow, and financial strength is consistently maintained. The issuer�s behavior becomes �predictable,� and as security buyers become comfortable with owning an organization�s bonds or stock, the aura of speculation � or �taking a flyer� on something new and untested� is removed. Seasoning is important as it reduces the cost of raising capital for the issuer, and signals investors that a business has reached a level of maturity that makes it worthy of their consideration. The process can take years and the highest-rated issuers and securities tend to be the most seasoned, having successfully withstood the tests of time, economic fluctuations, and the vagaries of their industries.
In recent years the major rating agencies played an integral part in a Wall Street magic act: pooling large numbers of often low-quality loans and issuing a variety of securities against them (�asset-backed� securities), some of which the agencies somehow viewed as being as safe as U.S. treasury bills. What we have ended up with is triple A-rated junk. We are not familiar with the details of how the rating agencies dealt with these newfangled instruments (presumably they relied on the same statistical models the originators of the issues employ), or what in their analyses led them to bestow such high marks on the issues, but we suspect that seasoning had nothing to do with it. Indeed, it seems to us that these things never got beyond the speculation stage.
With tens of billions of dollars of mis-priced assets already written off (and probably tens of billions more to come) and the world economy at risk, it is important to ask how this situation came about. John Kay, in a recent column in the Financial Times, offers an interesting insight. In most endeavors, he writes, the hero is the risk-taker and problem solver. The �cautious captain,� the one who avoids undue risk and prevents problems from arising in the first place, will not �remain long on the bridge.� Where big bonuses based on short-term results are involved, especially on Wall Street, the incentive is to go for all the gusto you can. Bonuses are not earned by playing it safe, nor are jobs kept for long.
Securitization � the process of turning non-marketable and often risky assets into marketable securities, some of which obtained the highest of ratings � earned big fees for their creators, and supported equally big bonuses. The $38 billion paid out in bonuses by Wall Street firms in 2007 provides some indication of just how profitable this business has been. But greed on the part of investment bankers does not entirely account for the growth and popularity of securitization � after all, there were eager buyers. In fact, a worldwide hunger for income in a low interest-rate environment meant there was a ready market for asset-backed paper, which became a hot item as it offered somewhat higher returns than equally-ranked government securities of supposedly equal risk. This brings us back to the rating agencies.
Some small rural communities in Australia entered the world of international finance, having purchased securities backed by assets created half a world away. Attracted by above-average yields and the AAA imprimatur of a leading rating agency, what local board in charge of investing community funds would not be interested in securing the �highest return commensurate with risk?� Unfortunately, local authorities are often inexperienced in dealing with sophisticated securities salesmanship. In this case no one had reason to question the ratings, or suspect that unusual risks were lurking unseen. Now these small communities in Australia are dealing with permanent losses due to their exposure to poor-quality American real estate loans. They are not alone, as various funds and institutions across the U.S. and Europe are facing the same problem.
It is perhaps ironic that the creators of these highly engineered financial products (who include some of the brightest and most creative people in finance), probably did not really understand the risks any better than the raters or buyers. One suspects that had the creators and raters relied more on the traditional notion of seasoning, and less on modern statistical analyses, perhaps they would have been less eager to risk their reputations by engaging in ill-advised marketing practices and mislabeling risky assets. Unfortunately, although those small rural communities may deserve restitution, that $38 billion in bonuses is not going to be given back. (This is one reason why we have long felt that certain businesses, such as investment banking, should not be carried out by public companies � banks and brokerages � with absentee owners. When other people�s money is involved, it is best that the decision-makers have their own wealth at risk as well. The current �heads I win, tails you lose� incentive system found on Wall Street inevitably leads to such abuses and losses as we have seen this past year.)
Since last summer, major central banks, including our own Federal Reserve, have been busy trying to prevent this nasty situation in the credit markets from affecting the �real� economy � the one that provides jobs, services, and income. Hundreds of billions of dollars have been injected into the banking system in an attempt to restore confidence and promote lending. Some critics maintain that, in reality, the banking authorities are bailing out speculators, Wall Street, and everyone else who stands to lose a bundle on misplaced bets. Central bankers are not the only ones in this game, however. The heads of some of our largest financial institutions have been going hat in hand to the Middle and Far East, tapping the big pools of capital there by selling stakes to shore-up balance sheets damaged in a series of huge write-offs.
Lest Americans lose sleep about surrendering control of national assets to sovereign wealth funds, remember that foreign investors have a history of getting in late, paying the most, and losing in the end. This time around, however, because the sellers are rather distressed, the oil-rich states and China are probably getting better deals than the Japanese did in the 1980s. In any case, the current round of foreign investments so far amounts to only a modest share of corporate equity. However, the investments represent just a tiny portion of foreign accumulations of wealth. Such is the change in economic power taking place in the world, and we all better get used to it. The real estate debacle is only a highly-visible example of the consequences of people in the U.S. living beyond their means. There will be other repercussions eventually.
There is some doubt as to whether or not the central bank cash injections will work as well as they have in past crises involving frozen lending among banks. The practice of securitization has created a �parallel banking system�in which loans are ultimately funded by pools of capital such as hedge funds and special investment entities set up by many banks, instead of bank balance sheets. As lending becomes more �market-oriented� and controlled by entities that are sometimes beyond the purview of the regulatory authorities, the implications of this unplanned and un-debated development are interesting to contemplate.
The stock market in the U.S. has enjoyed generally positive conditions for much of the last 25 years. Even the crash of 1987 did not dampen spirits for long, and the unpleasantness at the beginning of this decade mostly reflected the implosion of a bubble involving a relatively small number of technology companies; many stocks rose smartly in spite of the sharp downturn in the market indexes. As a result, there is a general aura of bullishness underlying the markets; people want to own stocks. Whether due to the �Greenspan Put� (the feeling that the U.S. central bank is there to help the markets in time of trouble), or to a belief that stocks will always go up if given enough time, the view holds sway among professionals managing huge sums of money, and this fact supports stock prices. So, in anticipation of better days ahead and in spite of the afore-mentioned turmoil in 2007, the markets did not fare too badly last year. The major averages rose, if by less-than-average amounts in many cases. The safest of bonds � U.S. treasuries � fared extremely well in the fixed income arena, owing to the �flight to quality� phenomenon one sees during periods of fear and uncertainty.
How the 2008 proceedings will unfold is anyone�s guess, and we will not hazard one ourselves. We prefer to keep in mind that there was a time not so long ago when people did not want to own shares. Could this happen again? There are plenty of potentially risky conditions that could cause a change of heart: war, high oil prices, inflation, etc. Then there are the �unknown unknowns� that are always a hazard when current security prices reflect optimism, as continues to be the case on average. On the other hand, the hundreds of billions of dollars of liquidity that central banks have pumped into the financial system should, in time, have a salubrious effect � it almost always does.
In spite of a modestly positive year, markets declined in the fourth quarter of 2007, and the opening days of the current year were decidedly negative. Such events elicit all sorts of pseudo-analysis on Wall Street � comparisons with previous years, �As goes January, so goes the year,� and such. For us, falling prices mean nothing more than rising expected future returns. At some point, if expected returns continue to rise, they become compelling. It is for this reason that we await events with curiosity, anticipation � and considerable amounts of cash.
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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.
"Intelligent Individual Investor", an article by Dennis Butler, appears in the December 2, 2008 issue of NYSSA News, a magazine published by the New Yorks Society of Security Analsysts, Inc. "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: [email protected]
URL: http://www.businessforum.com/cscc.html
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