October 20, 2007
Recent financial market events, including subprime loan losses, hedge fund and quant fund woes, and the bailout or takeover of numerous financial institutions and structured vehicles, that are suddenly strapped for cash, highlight the extreme risk taking and leverage that have lately permeated our financial system. The current distress will likely create opportunities for patient investors, but while proper investing requires a disciplined and long-term perspective, few market participants are able to ignore short-term phenomena. The daily blips of the market are, in fact, noise—noise that is very difficult for most investors to tune out.
Investors unfortunately face enormous pressure—both real pressure from their anxious clients and their consultants and imagined pressure emanating from their own adrenaline, ego and fear-to deliver strong near-term results. Even though this pressure greatly distracts investors from a long-term orientation and may, in fact, be anathema to good long-term performance, there is no easy way to reduce it. Human nature involves the extremes of investor emotion—both greed and fear—in the moment; it is hard for most people to overcome and act in opposition to their emotions. Also, most investors tend to project near-term trends-both favorable and adverse-indefinitely into the future. Ironically, it is this very short-term pressure to produce—this gun to the head of everyone—that encourages excessive risk taking which manifests itself in several ways: a fully invested posture at all times; for many, the use of significant and even extreme leverage; and a market-centric orientation that makes it difficult to stand apart from the crowd and take a long-term perspective.
Right at the core, the mainstream has it backwards. Warren Buffett often quips that the first rule of investing is to not lose money, and the second rule is to not forget the first rule. Yet few investors approach the world with such a strict standard of risk avoidance. For 25 years, my firm has strived to not lose money—successfully for 24 of those 25 years—and, by investing cautiously and not losing, ample returns have been generated. Had we strived to generate high returns, I am certain that we would have allowed excessive risk into the portfolio—and with risk comes losses. Some investors target specific returns. A pension fund, for example, might target an 8% annual gain. But if the blend of asset classes under consideration fails to offer that expected result, they can only lower the goal—which for most is a non-starter—or invest in something riskier than they would like. Pressure to keep up with a peer group renders decision- making even more difficult. Then, there is no assurance whatsoever that the incurrence of greater risk will actually result in the achievement of higher return. The best investors do not target return; they focus first on risk, and only then decide whether the projected return justifies taking each particular risk.
When the herd is single-mindedly focused on return, prices are frequently bid up and returns driven down. This is particularly so when leverage is used. Leverage does not have to be dangerous. Non-recourse debt on an asset can serve to make a large purchase more affordable. Taking out a non-recourse loan on an already owned asset can actually reduce risk, since the borrowed funds become yours, while the risk of loss is transferred to the lender. But recourse debt is something else entirely. If you purchase some investments, and then borrow with recourse debt to buy more, you are now vulnerable to mark to market losses in what you own. Depending on the precise terms of the debt, a decline in the value of your holdings could force
you either to put up more collateral—which you may not have—or to sell off some of the investments you purportedly like to meet margin calls. By borrowing, you have ceased to be the master of your own fate and allowed the lender—or actually the market—to be. How ironic to allow the market, which has dished up your current portfolio of opportunity, to dictate to you the need to sell your attractive holdings in order to survive.
The availability and use of margin or recourse debt is especially pernicious. Had you purchased an investment without leverage that declined in price, you could have used any available cash to buy more. Alternatively, you could sell another investment that did not decline or declined less to afford more of the now better bargains. This, in fact, is a healthy discipline, forcing you to choose among investments to own the ones you like best, and necessitating that you carefully decide when to hold onto cash and when to put it to work. Recourse leverage changes this equation, as you can seemingly own all the investments you want simply by borrowing to buy them. There is no healthy portfolio discipline enforced by the desire to make new purchases or the anticipation that you may want to. There is also a bit of a slippery slope in that if a little leverage is good, why isn’t more leverage better? When do you stop?
One way that vast leverage has been introduced into the financial markets has been through Wall Street’s securitization engine. In the late 1970’s, to help financial institutions achieve diversification and – at least arguably – liquidity, Wall Street began to pool mortgages (and more recently corporate and other consumer debt) and then sliced and diced these aggregations into new tranches of debt securities that offered varying degrees of risk and return. In recent years, many of these tranches were again pooled and retranched into still more finely calibrated and opaque financial instruments. These transactions were blessed by remarkably unworried rating agencies, who granted their investment grade imprimatur to some quite dubious
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