Updates and Thought Pieces


Beware the Greeks...
DStephan Breban, DWA Advisory Board member, offers a few thoughts on Greeks bearing gifts and some sound advice to follow the incentives.

No, this is not another cautionary note on the Greek bailout. Enough has been said about that, and if you still trust it, you only have yourself to blame. Rather, I refer to the proverb that arises from Homer's Iliad. “Beware Greeks bearing gifts”. “Caveat Emptor”, “Mea Culpa” and “if something sounds too good to be true, it probably is”, all come to mind. Ultimately, people should take responsibility for their actions, and not blame others for their own mistakes. I could be talking about those who invested in Madoff, mega buyouts, or any number of similarly inflated areas, but I am referring to those who invested in mortgage-backed securities and now wish to blame others for what can only be considered as their own stupid mistake.

Some 12 years ago I first investigated mortgage-backed securities. The basic sell message was:

Regional banks throughout the US write mortgages and package them up into securities that provide an income and a full repayment at any point before the end of the term, as holders pay off mortgages.

These are backed by residential properties.

The banks need to offload the mortgages as they are experiencing greater demand than in the past as more people want to own their own home.

The banks will then write more mortgages and offload them onto the market.

Investment banks package the original securities to create a nationally diversified exposure to residential property.

“The US has never experienced a nationwide decline in residential property prices”, only regional declines, so the risk is very low.

Sounds great, but anyone with an ounce of investment acumen will instantly spot that the underlying banks are not retaining any risk and so are not incentivised to underwrite the risk. Rather, the brokers are simply paid to write more and more business. In addition, if the banks don't have the capital to write the business then the market is probably growing too quickly. When asked if this was a risk, the investment banker laughed and said that these banks want to be there in the long term and would never allow risk underwriting to slip, and that the growth in demand for housing was a natural progression. It was like they'd never heard the word “bubble”.

The risk was blindingly obvious from day one, and we are not even talking about sub-prime mortgages. At the time I dismissed any such investments for my clients and for the clients of the firm I was working for.

If you were responsible for investment in mortgage-backed securities, you were stupid, greedy, or both. You deserve all that you got, and absolutely no sympathy. But let's take this one step further: the insurance companies that insured against losses on such securities. Trained, experienced risk underwriters, who apparently thought that, as the US had never had a national decline is residential property values, it never would. They should be taken out and shot. I am a great believer in evolution and where it has brought us, but sometimes it needs a helping hand.

Now, the Fed wishes to punish the sellers of such securities. And AIG wants to sue them. Gordon Brown wanted to punish the UK's largest taxpayer, and stop them from paying so much tax in the future. If that were not enough, when investment banks market a security, they should now disclose to clients all parties wishing to short the security. So much for client confidentiality! Interestingly, Paulson, while highly considered, was not the demigod then that he is now. Much of his current status came from this deal. Knowing he was on the other side of the deal would not have helped at that time. Most investors would have been more concerned to hear that Madoff was on the other side. To top that, the Fed claims that Goldman was disingenuous in not explaining that a synthetic security facilitated shorting. I guess the buyers simply figured the vendor preferred synthetics because he was allergic to wool. They had clearly never heard the expression “Beware Greeks bearing gifts”.

Maybe we should have taken another lesson from the Iliad, “Beware Trojans, they're complete fools.” The Trojans are the ones we should avoid, as are the advisers that led their clients to invest into these securities. They are the ones that should be banned from the securities markets for life, for their own good and the good of all those who follow them. Surely that would be a better protection for investors. If the SEC and FSA will not weed out the Trojans, then market forces, ultimately pension funds, insurance companies and other institutional investors, need to do the job.

OK, enough vitriol. What can we learn from this experience? Other than Greek government debt, what should you avoid?

First and foremost, consider your advisers. It is not just consultants that need to learn, but also their clients. Do you want to back the Greeks or the Trojans next time around? Do you want to employ Goldman Sachs or the guys that bought synthetic mortgage-backed securities at the height of the market?

China is one of the strongest markets just now, and has been for some time. In particular the growth of RMB-denominated funds worries me. These funds have a legislative advantage over US$ denominated funds in that many companies can only accept investments from RMB- denominated funds. There is a time delay when investing from US$ denominated funds, and so deals that have a sharp time deadline will be inclined to lean towards RMB-denominated funds. Finally, RMB funds attract local investors. Within private equity, local LPs may help in so many ways: dealflow, due diligence and ultimately helping portfolio companies. This is likely to place RMB denominated funds at a huge advantage to US$ denominated funds. In 2009, while actually receiving less commitments than US$ funds, RMB-denominated funds invested more into private equity deals than the US$ counterparts. While it may not be about to burst in the immediate future, there is definitely a bubble here. We all know the growth figures, but perhaps we should examine the premise for owning equity. It is to share in the wealth generated: to own the company. And this is where, for me, the concept of Chinese equity breaks down. How can you own anything in a communist society, let alone one that may enact legislation retrospectively?

The second bubble I see is the mid-market: the exact same market that every GP and his dog now claims to have stuck to throughout the bull market in mega buyouts. A number of GPs are already telling anecdotes where banks are offering 6 and 7 times ebitda on $500 million deals. It seems like the banks have identified this as the new market segment to flood with capital as it fared better than the mega buyouts, not understanding that it fared better simply because it had less leverage.

And what to buy? That's obvious: BP.

And remember, “Beware Trojans”, you really don't want to be anywhere near them when the next “market correction” goes down.


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