The mortgage meltdown has showed the uglier side of investing in dicey loans.
Now that the mortgage mess is on the front page of every newspaper and magazine you pick up, perhaps it's time to reflect on it a bit. How can a financial advisor keep a cool head in the face of chaos? What lessons might an advisor learn? Which is the best answer to how you should proceed?
A. Don't let a client take out a mortgage without putting 50% as a down payment.
B. Don't invest in the stock market when interest rates are low.
C. Don't be a mini-banker.
D. Do what it takes to stay in the game.
E. Expect things to get a lot more complicated before they begin to straighten out.
The answer is C: Don't be a mini-banker. What that means is don't put your clients' money in iffy loans, which might mean excluding mortgage-backed securities and all other spread products as well as products that are priced at a spread over Treasuries.
Surely this is too drastic? Maybe not. Let's take a look at what's happened to spread products. Time was when mortgages and other loans were held on the books of a small number of banks. When the bank loaned money for a mortgage, that mortgage went into the bank's portfolio; there was reason for caution in making the loan.
Today, though, mortgages are deposited into a large pool and then sliced up into "tranches" at different credit risk levels. The securities can be sold to a variety of investors, supposedly spreading the risk over the pool.
But several things happened to make securitized debt riskier than Treasuries and even corporates. Indeed, financial advisors may want to keep their clients in Treasuries for the fixed-income portion of their portfolios going forward. That's because any product that is priced at a spread over Treasuries, whether it's Ginnie Maes or AAA corporates, goes down when stocks go down. A decline in stocks drags down spread products as a result of the flight to quality. But Treasuries go up when stocks go down. That's when you tell clients: "You know those Treasuries you've been complaining about for so long? They went up when the stock market went down. That's why you own them."
Mortgages are no longer on the books of a small number of banks, of course. Today, "global capital movement is no longer controlled by banks," says Michael Baker, who left his position as a Bear Stearns managing director in middle-market institutional a year ago and joined one of his clients, Dennis Gibb, as a partner at Sweetwater Investments in Redmond, Wash. Baker quotes Michael Milken, the one-time Drexel Burnham Lambert "junk-bond king," who later served jail time for insider-trading- related scandals: "Securitization is the democratization of capital." Instead of being held on the books of a small number of banks, the capital can go wherever it wants. "Securitization was new in 1985," Baker says. "Now it stands at $3.5 trillion."
"Securitization lowered borrowing costs worldwide," he continues, "but it requires confidence and transparency to work." Instead, the securities "became too opaque, too complex, with investors blindly following the rating agencies." Part of the reason everyone got so comfortable was that interest rates were so low. With the fed-funds rate at 1%, it was easy to finance these issues.
But there are two problems with low rates: First, anyone can get together a packet of junk and throw it on the market. Second, the rates available on "safe investments" like Treasuries are so low that the little old ladies among your clients are crying.
And there's yet another problem with spread products. Banks didn't really figure out the flaws of the banking business until the 1980s, and that's when all these other investors began stepping in and putting themselves in the position of bankers. The problem, they discovered, was that bankers alternated between losing money on credit risk and losing money on interest-rate risk. When the yield curve was steep, bankers were buying long-term bonds and getting ready to lose money on interest rate risk. When the yield curve was flat, bankers couldn't buy short and lend long so they bought junkier credit and lost money on credit risk.
Back then, it was banks losing money on credit risk and interest-rate risk. Now it is investors in mortgage-backed securities who are losing money and home owners who are losing their homes, and it is our entire economy that's taken a hit.
One of the lessons from the mortgage mess is that investors relied too heavily on the rating agencies, Baker says. But, at the same time, these investors were grown-ups, and should have known what was going on. When a rating agency rates corporate debt, it looks at macroeconomics, at the corporation's financials, at how sturdy the company is and how likely it is that it will be flush and able to repay its debt. Mortgage-backed securities are a different asset, rated in a different way. "What Wall Street does is to create credit tranches that are blessed by rating agencies," Baker says.
Baker gives this example: Suppose a packager puts together a pool of $500 million in mortgages. What Wall Street wants is to create the biggest tranche of AAA possible. Perhaps the rating agencies will demand 5% subordination.
Not only are the mortgage-backed securities difficult to rate, but the major rating agencies are competing to get this business. Baker says, "It's like the appraiser is paid by the seller. If one agency is going to give a little larger tranche of BBB, it pays to go with them."
Baker believes the market will return to some sort of stability, at least for sophisticated investors like himself. "But I think to make the process liquid again, you need a third-party evaluator," he says.
When the market corrects, Baker will be back. He's an educated, professional risk-taker. He's taken plenty of risks in his personal life, too. His first job out of college was as a king crab fisherman in Alaska on the Bering Sea. "It was 100% impulse," he says. "I had studied history and literature, and I wanted to make enough capital to buy a boat and get some experience." In his first season on a boat, 1973, he made $50,000 in cash. As a captain, he made $250,000 in a season.
Once he'd put together his nest egg, he bought a sailboat and sailed all over the West Coast, then decided he needed "to move on and grow." Baker traded his own account with considerable success before joining PaineWebber, then Donaldson, Lufkin, Jenrette, and finally Bear Stearns, where he spent 20 years as a managing director. He says he left fishing because "I needed mental adsventure," but he retains a boat as well as a sea captain's license and a 1,600-ton master license.
Baker's next project is to launch a new product for Sweetwater called Income Flood, a short-term Treasury barbell portfolio, where he will sell puts and calls up to 15% out of the money on the Standard & Poor's 500 index. Sweetwater has back-traded the portfolio over 10 years and averaged a 14% return.
Fortunately for the mortgage-backed securities market, individual financial advisors stepped in to take the place of banks and provided some liquidity until everything went bust. A year ago, I read a prose poem of praise to MBS written by one financial advisor who included them in his portfolio.
Many advisors I know like romance. Why not? They see no romance in instruments like T-bonds or TIPS. Those have been around forever. They're boring. Everybody's heard of them. These advisors want to be original, sexy, dashing. They want to invest in the new, new thing, often at the prodding of clients who want bragging rights at the next cocktail party. As a financial advisor, you're paid to resist the emotional tugs and pulls of clients and to bring your financial wisdom to the process. Don't become a mini-banker.
Mary Rowland can be reached at firstname.lastname@example.org. She has been a business and personal finance journalist for 30 years, a half dozen of them as a weekly columnist for the Sunday New York Times. She wrote a column called "Practice Points" for Bloomberg Wealth Manager for six years. Her six books include two written for financial advisors: Best Practices, and In Search of the Perfect Model.