What Could Go Wrong?
Although we are by nature humble, low-key and normally not taken to engaging in unseemly self-adulation, we are at the moment absolutely bursting with pride! To see why, we invite our readers to go back and review the January 1994 issue in which our hard-hitting prose questioned the easy optimism of the day and identified certain disconcerting financial practices which, as things turned out, couldn't withstand the pressures of the higher interest rates and unstable financial markets to come. Although we are certain you keep our back issues ready at hand on your coffee tables, just in case they disappeared with the last dinner guests we thought we'd quote a few salient lines. After commenting on several silly ideas that were abroad at the time, such as the notion that “cash is trash”, we continued as follows:
More ominous to us are developments in the financial world about which the public hears little and the implications of which, in some cases, are not understood even among the professionals involved. Margin debt (purchasing stock with borrowed money), for example, is at record levels. Certain types of investment organizations [hedge funds] are using leverage (borrowing) of as high as 50:1 ($50 debt to $1 of equity) to speculate in marketable securities. New types of securities are being created which react in totally unexpected ways to events which impact the financial markets: so-called interest-only and principal-only “strips” have been among the latest disasters mentioned in the press. Finally, some of the biggest banks and securities firms have created and expanded an unregulated (so far) industry based on “derivatives”. Derivatives, simply stated, are artificial securities that are based upon an underlying instrument, hence the term “derivative”....The amount of derivatives outstanding is huge and they create enormous potential obligations for the guarantor institution (bank, brokerage firm), none of which appear on their balance sheets. Just what impact such “high-tech” instruments could have in some future financial crisis is not entirely understood.
For those of you who may have little interest in following financial current events, some hedge funds lost hundreds of millions of dollars in just a few days in February of last year after the Federal Reserve started to increase interest rates and the fallout from derivatives continues unabated as numerous corporations, municipalities, colleges and mutual funds report losing billions on these risky instruments, usually through misguided use.
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“Riding The Yield Curve”
Interesting, isn't it, how an official in Orange County, California earning about $100,000 per year could be responsible for $2 billion in “investment” losses that will cost hundreds of people their jobs and cut services to thousands of others. Incidentally, he had help from guys on Wall Street with salaries several times as large who get paid big bonuses for creating and marketing the financial gadgets that help cause such disasters. Given the press attention to this affair, we thought our readers would appreciate some insight into how these things happen. Now derivatives are complex instruments and, not being rocket scientists, we have little working knowledge of their creation and structure. However, the concepts underlying their use in the California case are quite simple, even old-hat, and warrant reviewing.
We will begin with the concept of the yield curve, a simple graph that results from plotting yields and corresponding times to maturity of fixed-income securities. Under normal circumstances the yield structure looks like the one in the example below, with rates rising as time to maturity lengthens, producing a positively sloped curve.
It can be seen from the figure that if you could borrow at low rates at the short end and lend the funds at the higher rates of longer maturities, you could print money. This is essentially what banks and other financial institutions do: they use their ability to obtain funds at low rates (e.g. your bank CDs) in order to lend them at higher rates (home mortgages), earning income on the “spread”. In the old days when interest rates were regulated, it was almost this simple. In years past “bankers' hours” jokingly meant work in the morning, go to lunch and play golf the rest of the afternoon. With the deregulation of interest rates in the early 1980s things became more complicated as rates fluctuated freely and bankers found that their cost of funds could become higher than what they earned on their loans (the yield curve became “inverted”). The difficulties caused by the need to adjust to this new state of affairs eventually contributed to the savings and loan disaster of the late 1980s.
The second concept we need to discuss is that of leverage. Leverage simply means using borrowed funds to purchase more assets than you would otherwise be able to afford. Beneficial uses of leverage occur, for example, when a business borrows to increase its capacity to serve a growing market: in this case, increased earnings power more than offsets the cost of borrowing and the increased profits, after the added costs, flow to the business owners. On the other hand, if the expected growth doesn't materialize and/or the borrowing costs are too high, the business may have to dip into its own capital to pay the additional expenses: this is the downside of leverage.
What happened in Orange County? The county had a fund of about $7.5 billion which was to be invested to provide income for use in the usual county services, including schools, roads, etc. The fund was largely invested in government agency securities of about 5 years average maturity--high quality paper. Convinced by a financial consultant at the nation's largest brokerage firm (which will go unnamed) that there was no way that short term interest rates would rise (this, by the way, was still going on a mere 12 months ago), county officials proceeded to use their security portfolio as collateral for short term loans that ultimately totaled about $14 billion. The loan proceeds went to the purchase of more longer-term securities: in other words, borrow short and lend long.
This strategy produced terrific results--as long as rates were stable or fell, which was the case for a few years in the early 1990s. The county was able to invest in securities yielding about 5% and borrow at rates as low as 3%. 1994 proved to be a different story. In the midst of the worst bond market debacle since recordkeeping began in 1927 (an event which the financial consultant had, unfortunately, failed to foresee), two things began to happen: first, short term borrowing costs increased, narrowing the spread between what the fund earned on its investments and what it paid to borrow. Second, the value of the bonds backing the loans declined (bond prices fall as interest rates rise), prompting the brokers who had extended the loans to call for more collateral. As the year progressed county officials got more desperate, borrowed more money for shorter and shorter terms and bought more securities in the hope that interest rates would begin to fall. Eventually the whole structure capsized as borrowing costs began to exceed investment income.
The coup de grâce was delivered by a wad of derivative securities the county had purchased with its borrowings. As of March 31, 1994 fully 25% of the total leveraged portfolio of about $20 billion was in derivatives. This figure grew to more than 40% in the months following. These securities had some interesting and, as their owners soon discovered, rather nasty characteristics. As interest rates fell, they produced additional income and made the county investment managers look like even bigger geniuses. When rates rose, however, the derivatives produced less income and their values fell. The officials who are now guiding the county through its bankruptcy woes are still trying to sell these things, at substantial discounts to their original cost.
Why did a supposedly conservative municipal fund get involved in the business of making huge, leveraged bets on the direction of interest rates? Hubris, perhaps? Possibly pressures caused by a public demanding more services while refusing to pay for them. We suspect the usual “institutional imperatives” of competition and the like also played a part. After all, the county managed funds for other municipalities, presumably for a fee, and probably had an incentive to attract more assets. Interestingly enough, the same broker who consulted Orange County had in 1984 convinced the city of San Jose, CA to employ a similar type of leveraged investment strategy that ended up costing that burg $60 million. In any case, encouraged and comforted by the biggest dealers on Wall Street, Orange County officials proceeded with what probably seemed like a safe bet with, as usual, other people's money.
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Turning now from the absurd to the sublime....At about the same time as news of the financial trouble in southern California was making headlines, another event quietly took place which poignantly demonstrated how the investment profession, seemingly like no other, can contain within its bounds startling contrasts; how one person's roulette wheel is another's business, to be conducted in a business-like fashion according to business-like rules. Early in December the New York Society of Security Analysts sponsored a luncheon in honor of Benjamin Graham, whose 100th birthday would have been in 1994. Graham is known as the father of “value” investing and his book Security Analysis, co-authored with David Dodd and originally published in 1934, is regarded as a basic work in the investment field. Several individuals who had worked or studied with Graham (he taught for many years at Columbia University) attended the meeting and a few spoke about their experiences. Warren Buffett, Chairman of Berkshire Hathaway and widely regarded as the greatest investor of our time, described Graham's three basic ideas: first, look at stocks as small pieces of businesses and purchase them with the intent of becoming a part owner of a business. Viewing stocks as mere pieces of paper leads down the road to speculation. Second, use market fluctuations to your advantage. Changes in market prices sometimes provide an opportunity to buy businesses cheaply. Divining some kind of meaning from fluctuations in and of themselves or trying to use them for short term trading is a waste of time. Third, employ a “margin of safety” in your operations. Business valuation is very imprecise and circumstances and people change--allow ample room for error by purchasing at prices significantly below the calculated value.
We trust our regular readers are already familiar with these time-tested principles. Clearly the responsible individuals in Orange County were not. There was little or no margin of safety in the leveraged purchase of bonds at historically high prices. Certainly there was none at all to be found in new, exotic and untested securities. Security Analysis has been around for sixty years. Buffett's humorous twist on an old axiom, “Never a short-term borrower or long-term lender be.”, is well-known. Financial history provides countless examples of people who have overreached, thinking they could get out in time, before the crowd stampeded toward the exits. In other words, there exists plenty of information and wisdom in the public domain to help sensible people avoid these outrageous catastrophes. For those who would invite trouble there is little that can be done. Intelligence and the ability to learn from the errors of the past are not lacking in the investment community. But common sense and discipline are needed to curb greed.
Dennis Butler, MBA, CFA