The October 2008 issue of the IronBridge Capital Management L.P. investor newsletter gives readers an excellent primer on what has been roiling financial markets and why. IronBridge President Christopher C. Faber provided the insights … and permission to Budget & Tax News to reprint excerpts from that letter.
The unwinding of financial “sinnovation” (innovations based on financial “sins” such as use of seriously flawed risk models and misallocation of economic resources) accelerated in the third quarter, resulting in the phenomenal collapses of IndyMac, Fannie Mae, Freddie Mac, Lehman Brothers, AIG, Merrill Lynch, Washington Mutual, and Wachovia, and the rapid erosion of the Wall Street investment banking model.
Additional victims included hedge funds, which have experienced a 79 percent decline in flows. According to The Wall Street Journal, many hedge funds have failed to live up to their promises—nine out of 10 are not able to collect performance fees due to a lack of performance. Thirty-five hundred have closed so far this year.
The “Great Unwind” is driving a mass extinction of those who are guilty of financial sins and responsible for huge misallocations of capital.
Capital Markets’ Role Misunderstood
The market is not anyone’s friend. It does not exist to serve investors or deliver them a required return in order to fund their retirement or other liabilities. The market serves as a clearing function, where buyers and sellers meet and transact.
Market prices reflect terms balancing the wants of buyers with the needs of sellers. Thus changes in market prices reflect changes in the balance of wants and needs.
Investors sell the use of their capital. Borrowers buy the use of that capital. Neither the buyer nor the seller can independently control the terms of exchange. Only through the joint interaction of many buyers and many sellers can true balance be found. As such, capital constantly flows (allocates itself) to where it can achieve its highest return.
Thus the proper role of capital markets is to allocate capital to its most productive uses. If allowed to function freely, the market, through its use of price signals, is very good at this.
Unfortunately, major principles that allow markets to function properly have been abandoned by many stewards of capital:
1. Acting with Trust, Integrity
The widespread failure of multiple participants to act with trust and integrity contributed to the current crisis. Mortgage lenders originated massive numbers of loans giving massive amounts of money to people who could not afford them.
Many consumers fudged their income to qualify for loans and accepted irresponsible levels of debt. Investment bankers “repackaged” the questionable loans into structured investment vehicles (called SIVs) and represented them as investment grade credit to investors. Credit agencies advised the investment banks about how to obtain high-grade ratings for these opaque, questionable structures.
Because the credit agencies could neither understand nor analyze the quality of the assets in these structures, they advised investment banks to use the balance sheets of insurers (such as AIG) to attain the investment grade rating that was required to sell them to investors. Drawn by the illusion of higher returns with less risk, investors bought these structures, but failed to do due diligence to understand what they were buying. They simply relied on the credit ratings.
Trust and integrity are the pillars of the free market process and cannot be compromised without risk to the entire system.
2. Keeping a Level Playing Field
Government intervention promotes a misallocation of capital when it favors one group over another. Under these circumstances, capital unnaturally flows where it should not, in response to tax policies, subsidies, redistribution programs, and other various government programs designed to appease political contributors and the voting public or designed to try to hold back the creative destruction associated with free markets.
Tax policies and regulatory rulings drove the creation of structured investment vehicles (SIVs) and collateralized debt obligations (CDOs) as a natural tax arbitrage over traditional vehicles.
The offshore, tax haven-based domicile avoided most corporate tax, which led to a subsequent decline in credit spreads. Declining credit spreads forced banks to transition from a principal to an agency model of lending where the risk horizon for the bank credit officer declined from the term of the loan (30 years) to the sale of the loan (measured in days, weeks, or months). The decline in the credit horizon drove the decline in lending standards and credit quality.
Tax policy drove the demand for housing beyond what normal market forces would have called for. Government policies drove a misallocation of capital into the wrong places.
3. Sustaining Price Transparency
Price discovery requires transparency. When poor credit was alchemized into quality credit through the creation of SIVs and CDOs, price discovery was undermined, and regulators, or market participants, did not easily see the warning signals.
Risk premiums disappeared, so participants had a false sense of security. Those “innovative” financial products undermined the market price signaling and feedback loops required to direct the allocation of capital efficiently, until the entire financial system was at risk.
4. Investing to Own
“Investors” became enamored with the new products that Wall Street peddled to help them buy, sell, trade, and manage risk instead of investing to own. Historical default rates became a substitute for old-fashioned credit analysis. Thematic baskets of stocks (ETFs and index funds) became a substitute for old-fashioned equity analysis.
Lack of due diligence and analysis drove a massive misallocation of capital into investment structures that investors simply did not understand, but nevertheless invested in and borrowed against.