Opinion

Felix Salmon

Why the Abacus investors weren’t speculators

By Felix Salmon
April 19, 2010

Back in 2007, I embarked upon a doomed attempt to explain that asset bubbles were not necessarily speculative bubbles. There might be a bubble in the art world, I said, but it wasn’t speculative. And neither were home-price increases speculative in 2000, before the tech bubble had even burst. (Now that was a speculative bubble.)

In my book, a speculator is someone who buys an asset with the express intention of selling it after it rises in price. (Or, conversely, someone who shorts an asset with the idea of profiting from a downward price move.) A buy-and-hold investor, pretty much by definition, can’t be a speculator.

But Jim Surowiecki seems to have a different conception of what speculation comprises:

The economics of subprime lending, and of C.D.O.s, depended on the assumption that there wasn’t a housing bubble, and that therefore housing prices would not fall sharply. That was a speculative assumption, given the massive runup in housing prices between 1998 and 2006, and if you acted on it you were speculating, even if you described it to yourself by another name.

I think this is a little unfair to the people who invested in CDOs. They didn’t make an explicit assumption that there wasn’t a housing bubble, or even that housing prices would not fall sharply. (These are not the same thing: you can have sharp falls in housing prices without a housing bubble, as anybody in Detroit will be able to tell you.)

Instead, the CDO investors relied on complicated models and Monte Carlo simulations, and the complicated models relied on the history of house prices in the US, and the history of house prices in the US was that although there had been localized drops in price, there had never been a national drop in house prices.

Smart people like John Paulson were clever enough to grok the weakness in the models, and to notice that they resulted in some massively mispriced securities. That insight was ultimately what drove The Greatest Trade Ever. But I think it’s a bit much to say that everybody on the other side of that trade was making a speculative bet, when in fact they were buy-and-hold investors buying triple-A-rated securities paying 85bp or 110bp over Libor.

As far as the bond investors were concerned, the risk and speculation was carefully and deliberately consigned to the equity tranche of the Abacus deal. In fact, there was a line of thought at the time which said that these kind of instruments were actually better investments because the housing bubble was bursting. It seems crazy now, with hindsight, but it’s worth remembering that at the time, everybody thought that the problem of default risk had been solved by overcollateralizing and tranching the CDO so that the default risk was borne by the equity investor. The big remaining risk in any mortgage pool was prepayment risk — the risk that homeowners would pay off their mortgages very quickly, sticking the investor with cash which then might not be able to be reinvested at such a high interest rate.

Since mortgage prepayments mainly came from refinancings, it was seen as good news to mortgage investors that various subprime mortgage originators in California and elsewhere were closing their doors. Fewer originators meant fewer prepayments, and fewer prepayments meant higher and more reliable total returns. The fact is that a housing bubble is bad news for mortgage investors, since if you flip your house, that’s a prepayment, and if you refinance your house, that’s a prepayment too, and prepayments are always the last thing a mortgage investor wants to see. So it’s entirely reasonable to assume that IKB and ACA were happy to see the housing bubble coming to an end. So Jim’s wrong here, I think:

If you were buying subprime C.D.O.s in early 2007, you were betting that the housing bubble wasn’t going to burst, even though in much of the country it already had. That was a dubious bet at best.

My feeling is that if you were buying subprime CDOs in early 2007, you were obviously short-sighted and not very good at doing your due diligence. But I don’t think you had any particular desire for the housing bubble to continue. It’s clear with hindsight that a bursting housing bubble could wipe out the principal not only of the triple-A tranches of CDOs but even of the super-seniors. At the time, though, very few people saw that coming: remember Morgan Stanley’s Howie Hubler, who saw the market collapsing, put on a big bit that the collapse would happen, but then tried to fund that bet by selling protection on the triple-A tranches of the same CDOs. “He was smart enough to be cynical about his market,” writes Michael Lewis in The Big Short, “but not smart enough to realize how cynical he needed to be.”

In other words, even ultrasophisticates like Hubler, who saw the collapse coming and bet on it happening, thought the triple-As were safe. So let’s not say that investors like IKB were making a speculative bet that the housing bubble was not going to burst.

Update: Surowiecki responds. (Hey, if nothing else, I’ve got him blogging again!) He makes the entirely valid points that “this entire system was itself an artifact of the housing bubble”, and that “the bubble mentality was very hard for even sophisticated investors to escape”. Both true. But my point is that just because you’re caught up in the bubble mentality, doesn’t make you a speculator. To quote myself, from 2007:

Not all bubbles are speculative bubbles, and momentum can drive prices upwards even in the absence of speculation. Consider a housing market which has been rising at say 15% per year, or more. When a house comes on the market, a bidding war ensues. Each house that comes onto the market sells for more than previous comps. Sellers get greedy, ask for silly amounts of money, and, surprisingly often, get what they ask for. Buyers get scared about being priced out of the market, and desperately try to buy anything they can, just to get a foot on the property bubble. You know the story: we’ve all seen it happen. But the point is, there’s no speculation: the buyers aren’t buying to flip at a profit, and aren’t motivated by the prospect of selling at a higher price in the future. In fact, their real motivation is fear (of never being able to afford a house), not greed.

Does it make sense to say of these people that they “were betting that the bubble would not burst”? Maybe on some theoretical level it does — but that’s not what they thought they were doing. And if you start describing these people as “speculators”, that weakens the term far too much for those who really deserve the label.

Comments
10 comments so far | RSS Comments RSS

So if I thought I was making a sensible investment by sending a “deposit” to Abu Ibrahim in Lagos that would according to him allow a UN Bank deposit in my name to be wired to me, I would not be being reckless?

You mean that a bank that employed scads of high priced “risk analysts” and that invested money in a bet on the returns of a pile of mortgages that they didn’t bother to examine because someone who was getting paid to sell it told them it was safe, was not making a speculative investment because the magazines in first class airplane seat pockets said this stuff was all in the bag?

Are there no standards for fiduciary duty for bankers beyond “everybody said it was ok”?

Posted by rootless | Report as abusive
 

“Instead, the CDO investors relied on complicated models and Monte Carlo simulations, and the complicated models relied on the history of house prices in the US, and the history of house prices in the US was that although there had been localized drops in price, there had never been a national drop in house prices.”

Past performance is no guarantee of future results. I think I read that somewhere.

Posted by rootless | Report as abusive
 

your definition of a spec as “someone who buys an asset with the express intention of selling it after it rises in price” is too narrow. Yield-hungry “buy-and-hold” investors like IKB or Mrs. Watanabe buying kiwi dollars in the mid-2000s or the millions of US retail investors pouring money into high yield bond funds today are speculating in a less obvious way. They are essentially betting that they will suffer little or no capital loss, often ignoring that the extra yield they get is not a freebie but rather compensation for the risk of capital loss. It doesnt matter that they have no plan to sell later at a higher price–they are betting that the capital loss doesnt happen to them (which is, in my mind, speculative)

Posted by siraca | Report as abusive
 

Time to stop calling CDOs that aren’t literally mortgaged-backed (i.e. most of them) “mortgaged backed” – think, at best, “mortgage-linked” (a la FT) because after a nominal admixture of real-estate barely worth mentioning, they’re often as much as 95% pure fluff. So enough with the tenuous mortgage analogies. Really. Goldmantics and home-ownership have right about zero in common.

Think fluff, pure navel lint soaked in kerosene, as average CDO core value; think how many insured CDS have shill or even fictitious counterparties and your logic’ll be back on the right track.

Like American tobacco – read the patent – any old garbage qualifies for inclusion in CDOs. And like American tobacco, most MBS were designed to burn down to the butt in no time, leave an awful aftertaste and interfere with your health.

Posted by HBC | Report as abusive
 

HBC you are lifting the scales from my eyes!

Posted by IanFraser | Report as abusive
 

How many people buying these “bonds” were driven to such devices as the safe yield provided by government bonds no longer existed?
I think before we call these people speculators we have to consider that, as well as the imprinteur given to these instruments by government sanctioned rating agencies.

Posted by fresnodan | Report as abusive
 

“Consider a housing market which has been rising at say 15% per year, or more. When a house comes on the market, a bidding war ensues. Each house that comes onto the market sells for more than previous comps. Sellers get greedy, ask for silly amounts of money, and, surprisingly often, get what they ask for. Buyers get scared about being priced out of the market, and desperately try to buy anything they can, just to get a foot on the property bubble.”

15% per year indicates a housing market that is not behaving within historical, and I would say rational, bounds. I was advised by many friends and family to get into a house, any house, so as not to be left behind the market. Knowing that house price vs. rent (and income, for that matter) ratios were way out of whack I declined. It looked way too much like the tech bubble and the “logic” I was hearing then, and I didn’t want to be shackled to an large and illiquid asset should I need to get rid of it (job change, etc.).

If you can’t make expected payments with existing income, and instead have to rely on a rise in housing prices to afford your home, that’s speculation, pure and simple. Housing bubbles suck in that they distort a market that affects normal people’s lives in a very tangible fashion. But as long as rentals exist that allow for “shorting” the market, trying to get in on that 15% annual increase is just trying to ride the bubble.

Posted by blarf | Report as abusive
 

“Investment is something that upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.” – Benjamin Graham

By Graham’s definition the Abacus “Investors” were indeed speculators. The CDO investment appraisal did not conclude that the housing market was overvalued, which, as Jim rightly says, given the massive runup in housing prices between 1998 and 2006, they probably ought to have done. Did this market promise safety of principle? Obviously not.

Of course, Jim and I are being very harsh here. Not everybody analyses each market’s price level each year and sells their holdings when these levels are high enough to be deemed dangerous.

But maybe they should.

Maybe it is the term “investor” which has been weakened far too much for those who – by actually doing their due diligence – really deserve the label.

Posted by MrBarrow | Report as abusive
 

Ok, they weren’t “speculators.” How about “idiots” instead?

Mr. Barrow is exactly right. What is interesting about the financial crisis is that almost everyone involved has received, fairly or not, their share of opprobrium – housing speculators, feckless home owners, predator lenders, rapacious investment banks, incompetent regulators, Fannie Mae and Freddie Mac, the CRA, the Fed, etc. et al. Everyone, that is, except those whose failure to perform rudimentary investment analysis enabled the creation of the doomsday machine – the pension fund and bank purchasers of RMBS and CDOs.

The managers of these funds were fiduciaries, trusted to be stewards of their beneficiaries’ capital. There is no way, with even a modicum of due diligence and analysis, that a steward of capital could determine that a cash CDO (leaving aside synthetic CDOs), the assets of which consisted of the BBB tranches of subprime RMBS, had no risk of loss. Yet there they were, scooping them up like candy in an insane reach for yield. For these investors, Warren Buffett’s rules of investing should be modified thusly: Rule #1 – do not reach for yield. Rule #2 – don’t forget rule #1.

By reaching for yield, they failed abysmally in their fiduciary mission to safeguard their beneficiaries’ capital. The market, however, presented them with a chance to redeem themselves. In late 2008, AAA prime RMBS were trading at 70 to 80 cents on the dollar, if not less. Under no scenario short of nuclear war could one envision these securities returning, on a hold to maturity basis, less than 90 cents on the dollar. These “investors” now had available to them mortgage securities which were significantly safer and yielded significantly more than the CDOs that previously poisoned their portfolios. Did they take advantage of this opportunity, or did they turn and run as fast as they could (“mortgage securities all being toxic you understand”)?

Investors my ass.

You may not approve of Goldman’s ethics, but in my view the real criminals here were the fiduciaries pissing away their beneficiaries’ money reaching for yield.

Posted by MPTISFOS | Report as abusive
 

I agree with you, Felix. If you look at the Magnetar Trade described by ProPublica, JPMorgan helped create the CDO and then lost $900M on that deal. In 2007 nearly everyone agreed that the super senior tranche couldn’t lose. I’m not a finance guy, but I’m guessing they wanted a large stack of high-yield AAA securities to help fund themselves in the repo market. So I don’t think they were speculating (i.e. flipping to a greater fool), but were squeezing an extra point out of their borrowing costs.

Posted by projectshave | Report as abusive
 

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