Thursday, May 27, 2010

20/20 Hindsight

We are all used to hearing how the big banks caused the Great Crash by creating asset-backed securities of doubtful creditworthiness and then pretending that they could make some subpools safer for some buyers by dividing up the pools into tranches of greater and lesser creditworthiness. The big banks may have told some whopping lies in the runup to Lehman, but that wasn't one of them. It is perfectly reasonable and not at all meretricious to divide an asset pool into tranches some of which are safer than the average of the pool holdings, and some of which are less so. The simplest way to do this would be to schedule both principal and interest payments on the various tranches in such a way that the less safe tranches don't even start receiving any payments until the safer tranches have received most of theirs. That way, to the extent which the underlying debtors become insolvent before the securities are paid off, it is the less safe tranches which absorb the losses, just as the holders of all of the tranches were promised. This is the way the much maligned CMOs actually work, just as their prospectuses and much other written material on them explain. I imagine that many other asset-backed securities work similarly, but I have only studied CMOs because they are the only ABSs which I have held extensively.

The talking heads now hint that this system of tranches is inherently unsafe and inherently dishonest. I have been buying CMOs since July, 2000. Since that time my real-world annualized ROI on them, without reinvestment, as reported by my software, is 5.38%. That same software reports the AROI for SPY, a reasonable benchmark for any portfolio held by a private investor, as 1.28% with reinvestment. Without reinvestment, which would be a better comparison, the S&P 500 would be heavily negative. So far, I have never had any loss of principal (though who knows what tomorrow may bring). So why have I not suffered from the inherent danger?

In fact, everybody, including the talking heads who yell against it, accepts to this very day the principle of tranchification of credit risk. Isn't that what is done when a company sells bonds, preferred stock, and common stock based on the same underlying assets and the same underlying business?

And if the dangers of tranchified asset-backed securities are inherent and obvious, where were the current experts when these securities were being actively marketed, before Lehman? Are you telling me that these experts were approving and recommending complex securities without having read and understood the prospectus, much less the more objective and deeper academic background literature?

There is no inherent danger or dishonesty in tranchifying asset-backed securities in order to change their credit profile for the end consumer. The danger is in a securities industry - in which category I include the supposed regulators - which is run from top to bottom by people who are neither honest nor well educated.

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