Financial Advice, pt. 3

In re-reading Charles R. Morris’s, The Trillion Dollar Meltdown, I am reminded of one thing about the market place that we all know and still . . . forget.  Let the buyer beware.  In other words, no matter what the deal, you are on your own when it comes time to add things up.  With that said, lets continue with

Chapter Three:Bubble Land:Practice Runs

I think it is fair to say at the start, we never seem to learn that the money changers are playing a shell game and we are the pigeons.  This chapter cites three examples – The residential mortgage crash of 1994, the 1987 Stock Market meltdown of 1987, and the 1998 Long-Term Capitol Management crisis.  With hindsight firmly fixed, these three can be seen as the early models for our current sub-prime mortgage and credit bubble dilemma.  The advent of desk-top computing power, the use of mathematical modeling strategies, and the afore-mentioned leveraging quality of the pension funds, foundations, endowments, and hedge funds; all played their part.

Mortgage-Backed securities

The overview of the real estate lending business reads like this.  In the New Deal era, S&Ls were the base from which home loans grew through quasi-federal agencies called Fannie Mae, Ginnie Mae, and Freddie Mac.  These agencies bought up mortgages and then sold mortgage-backed securities or mortgage pass-throughs to maintain their own liquidity.

A pass-through is created by transferring a slug of mortgages to a trust, which in turn issues certificates representing a pro rata slice of all the principal and interest it receives.  A trust comprising $100 million in mortgages paying an average interest rate of 6 percent would sell a certificate entitling the investor to, say, 1 percent of the trust proceeds.

Big investors, however, found this format to be slightly cumbersome and not always rewarding.  In 1983, Larry Fink at First Boston bank came up with a solution.  The CMO, a collateralized mortgage obligation, an investment model that allowed a bank to transfer mortgages to a trust just like a pass-through “but the mortgages were then sliced, or tranched, horizontally into three segments, with different bonds for each segment.”  The top tier got first claim on all cash flows and triple-A ratings, the middle tier was rated lower but sold at a higher yield, and the bottom tier, or toxic waste, sold as junk bonds with high risks but higher returns.

As with the previous chapter, Morris points out that at first the new model worked well.  “An academic study concluded that by the mid-1990s, CMOs saved homeowners $17 billion a year.  It is a classic illustration of the social contribution of financial innovation.”  What followed, of course, is a classic reminder of free market competitions amplified by the new technology of computer power.

But by the 1990s, when Sun workstations were standard furniture, CMO shops gleefully spewed out phantasmagorical 125 tranche instruments that no one could possibly understand.  No matter how clever the structuring, however, a CMO was still a closed system: All the tranches drew their payouts from the same pool of mortgages.

Disposing of the toxic waste soon became the primary limit on growth. 

A market shift, a change in the Fed rate, and it all came tumbling down.

Next up, the 1987 Stock Market Crash and another new quant product called portfolio insurance.  Get ready to test your trading knowledge.  Are you familiar with your trading options, puts and calls and the futures market?  Did you know you can bet on the up side, a call, or the downside, a put, or even better yet, on the financial future of being able to sell or buy through a fixed contract, a commodity at a fixed and firm rate?  Did you know,

Synthetic trading strategies executed with options and futures are often more efficient and less expensive than trading the underlying instruments, and often easier to mask from the competition, so they became an essential tool of megaportfolio asset management.

and that “The portfolio insurance that so enamored big investors was actually a futures-based hedging strategy.” based on using a Black-Scholes type formula.  Black-Scholesis arguably “the most famous equation in the history of finance.”  since it solves for the price of a futures option.  And “Since any financial transaction can be cast in the form of an option, Black-Scholes became the tool for pricing everything.” 

With such an efficient tool in their hands who would be willing to bet that only a few managers would use it.  According to Morris, “By the fall of 1987, some $100 billion of stock portfolios were insured.”

The resulting crash, aptly named Black Monday, resulted in the New York exchange instituting “circuit breaker” rules to shut off trading and the newly named Fed chair, Alan Greenspan, to release tons of new money to keep the brokerages from collapsing.  Sound familiar?

Meanwhile, Morris offers us one more road marker to take a look at, the LTCM ( Long-Term Capitol Management) hedge fund that was created in 1993 by John Meriwether and by 1998 had forced the Fed into another miracle money rescue.

When Meriwether opened his books to Fed staff in late September, they were shocked.  No one had imagined the LTCM had positions in excess of $100 billion on an equity base that had shrunk to only $1 billion.

Morris leaves this chapter with one direct question and an implied answer.  Why did the Fed force the banks to bailout LTCM and coverup the scandal of the fact that a small number of financiers had been able to borrow hundreds of billion of dollars without any oversight in sight?   Friends help friends.

Maybe we will find out for ourselves in Chapter Four: The Wall of Money

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2 Comments »

  1. givvi said

    Very interesting post. Thank you.

  2. mel said

    Good post, it points out that individual investors will always be left responding to the LAST financial movement, instead of the next one. There are always issues, yet individuals who invest with a plan end up ahead in the long run- How to be a professional investor to come out ahead

    A specific plan helps individuals ensure they reach their long-term financial goals, as opposed to random hoping or guessing.

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