New Onion

I wrote this about 2 weeks ago, but didn’t finish it until just now… but this is a bit of a break from the normal existential ramblings in favour for a bit of financial existential ramblings of what I see in the current US sub-prime & other credit markets… which will probably spread to other markets and could potentially result in a very ugly global meltdown (although I think it’s pretty unlikely in a world of floating currencies). If you don’t understand a term please use Wikipedia to look it up.

In investing much of the institutional research looks over very short time horizons – 2 years at most, but normally a quarter. And most research and most investment decisions (including those made by the senior managers of the publicly traded companies that are themselves the investments) are made by people who have spent their lives working in finance and being financially rewarded (and punished) for their decisions over short time horizons – usually a quarter, but sometimes as long as a year and in addition due to our primate brains we (humans) tend to view our successes as skill and our failures as luck (if we bother to remember failures at all). When institutional investment “research” does manage to take analysis out to a longer time horizon they generally go back 10-12 years and produce averages that inevitably include wildly non-rational markets and valuations from the late 1990s, a period of significant duration that will materially skew any data and from that starting point it is easy to make conclusions that do not appear wise when judged against the long history of financial markets. Extraordinary Delusions and the Madness of Crowds is hardly a new aspect of the human condition.

Where is this all going?

Quantitative models being used by many of the investment firms pricing debt and other securities reflect mathematical history rather than the underlying events. For example, one major bank’s affordability index is showing that property is marginally more affordable than it was in 2005 – and suggests that property hasn’t been this expensive (in affordability terms) since the period 1977-1992 (yes, the whole time). What this neglects to mention is that on the ground it has suddenly become dramatically more difficult to buy a property for any given level of income. Anecdotal reports of current quoted mortgage rates suggest that in the very immediate term (the past month or so) lending, and thus housing, has become far less affordable, at least in the hot markets that were driving much of the US real estate price increases as the major lenders in the areas do the rational thing and stop writing loans except under very favourable terms (to the lender) with high interest rates and money down, or they just plain go bankrupt… which comes back to my original point. Those lenders were incentivised in a structure that virtually guaranteed bankruptcy.

Incentive mismatch

Under the old regime banks would carry the bulk of a loan’s value on their own balance sheet. This left the issuing bank with good incentives to ensure that high quality loans were being made, and in the event of a default it encouraged banks to work with distressed lenders to come to a solution other than immediate foreclosure (for a fascinating look another possible alternative then the history of Japanese banking post WWII is a perfect case study)… but back to America. With the growth of secondary markets for collateralsed debt obligations consisting of home mortgages the balance of incentives shifted toward loan companies who were incentivised simply to produce loans and then move them on to investors (so that the loan officers got their commission and the executives met their quarterly numbers). Because they were finance monkeys (and not front-line risk managers) those investors and the rating agencies were valuing those packages of loans on a faulty basis (sub-prime history since 1998) because during a rising market there were no defaults as distressed debtors were able to sell their houses in a rising market rather than default and foreclose as they would have to do a flat or falling market.

I had a front row seat to some of the earlier excesses as I was living and working in real estate in one of the US’ hottest real estate markets in the early part of the bubble (when speculative buying was a new thing) and saw how the old-fashioned real estate investors and employees were being replaced by young guys and girls (in their 20s) who were able to make silly money and out-compete the fundamental investors because these young people were playing in a game where prices always rose, and where it was possible to speculate and arbitrage rather than having to add value in a real sense. Individuals almost always behave rationally. However, they behave rationally based on aims and heuristics that do not suit most people’s stated long-term aim of capital protection and appreciation… and the young guys driving the SoCal/Nevada real estate market were driven by fast money, fast cars, and fast women – not long-term asset valuation based on rental yields, construction price, land scarcity, and best use.

What does this have to do with us?

For the most part asset managers in our retirement portfolios and in greater capital markets are judged on relative performance on a quarterly or annual basis, at best over a three year period and so for most of them their rational time horizon (ie. forever) is next quarter. If a risk is looming in the future and is inevitable, it’s largely irrelevant as the market could still go up by 10% next quarter and if you miss it then long-term performance (the manager’s long-term, not yours) will be crippled. Equally, for hot real estate markets the individuals driving the market in the loan companies, in the buying public, in the homebuilders, in the real estate brokerages were all incentivised in a vicious cycle to get the deal done as fast as possible, racing against everyone else to get it done fast at a high price (or else prices would be higher tomorrow). George Soros called it “Reflexivity”, but whatever the name it’s a disaster waiting to happen.

How does this relate to Bermuda?

Quite simply, I see none of the speculative excess in Bermuda’s real estate market. Money in real estate is driven by fundamentals – builders adding value by raising the economic value of property, rental yields at investment levels, and lending characterised by generally sensible risk controls (lending 55% of income to someone with sufficient income to buy in Bermuda is not a major risk as 45% of income or even 25% of income is enough to cover fixed expenses in a crunch. I do think that construction is in an excessive boom in part due to inefficient markets resulting in excessive prices in some cases, booms always lead to the possibility that there will possibly be a cull of the more poorly capitalized and run construction firms in the next few years.

What’s the lesson?

What are decision maker’s incentives? Are they aligned with our interests as long-term shareholders of the economic vehicle we call Bermuda?

As always, thanks for reading (especially if you made it this far).