DO Diligence

27 Jan

Image Copyright Goddard (etc)

Riddle me this: how could a relatively “bit player” of a hedge fund – Paulson & Co – with little-to-no prior mortgage investing experience do the research/diligence to uncover “The Greatest Trade Ever,” yet somehow massive institutional investors somehow get a pass because they “don’t have the resources to conduct their own diligence?”

That is bullshit of the highest order.

I like Mark Thoma, he’s smart, actually gets twitter (rare for Economists), and I think all around a good guy, but I absolutely cannot stand this sort of “logic” in his response* to the dissenting opinions from the FCIC report

Securitizers lowering credit standards, a failure of credit agencies, and buyers failing to do their own due diligence. Once again, regulation can help where the private market failed. The ratings agencies exist because they help to solve an asymmetric information problem. The typical purchaser of financial assets does not have the resources needed to assess the risk of complex financial assets (which is why saying that they should have performed their own due diligence misses the mark). Instead, they rely upon ratings agencies to do the assessment for them.

Nonsense! IKB had an entire team of structured finance/mortgage professionals on staff when they contemplated and eventually bought-into the infamous ABACUS transaction. Here’s a simple rule: If you can’t analyze a security yourself DON’T FREAKING BUY IT.

How hard is that?

Now IKB, despite having this relatively large investment team apparently did little, if any diligence. In hindsight it seems they, like so many institutional investors in complex securities, took innumerable short cuts in their investment analysis, likely in no small part because of perverse incentives.

What do I mean perverse incentives? Take a look at CalPERS or any other big institutional asset manager.  They’re limited to certain investments and limited further by minimum ratings those investments must carry.  (All thanks to government-created oligopoly NRSRO regulations, mind you.)  Ceteris paribus, many (dare I say most?) institutional asset managers are incentivized to buy the highest-rated securities that meet their minimum investment criteria.  Best case, they outperform their benchmark.  Worst case, they blame the ratings agencies and the banks who structured/sold/rated the securities they bought for duping them into buying garbage.  Nice work if you can get it, eh?

I’ve beaten this horse to death over the past few years (to the point where this entire article would be a series of hyperlinks were I to reference all of my previous work) but apparently my efforts are largely for naught.

Pension and Endowment trustees need to hold their managers to higher standards and stop drafting investment criteria that allows, nay, enables managers to shirk responsibility and shift blame.  The Government needs to vastly reform NRSRO (and related) regulations and stop rewarding inept/incompetent/lazy actors. Ratings agencies are an unmitigated disaster as is an entire industry that’s legally/contractually/etc required to rely upon them.  Financial institution investors (equity and debt) need to hold management to MUCH higher standards.  If I were a large IKB shareholder I would be roasting management over the coals when I found out about their involvement in ABACUS.  I mean I would be F*CKING LIVID.  I mean I would make sure no one involved remained employed there.

Enough of the excuses.  Enough of this extend and pretend bullshit.  The longer we put off dealing with these issues the less likely we’ll be able to do anything about them.  I fear – for what is astoundingly clear good reason – if we continue on as we have for the past few years these issues will never be adequately addressed, and that, my friends, will result in a crisis that will make this most recent one look like a day at the beach.

*In a larger, more focused discussion, I expect Thoma’s views are more nuanced than in this narrow context.  I’m not picking on him, just merely using that text as an example of the kind of rhetoric and logic that I see perpetuated throughout Academia, the media, etc.

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7 Responses to “DO Diligence”

  1. flatpacked January 27, 2011 at 2:49 pm #

    A bit of a stream of thoughts.

    The purchase by ratings, while foolhardy, was incredibly wide spread. Some of the most unlikely organizations managed to build solid portfolios of CDOs, CDO^2, TRuPS, synthetics, RMBS, CMBS…. all purchased because they provided a really solid yield relative to their peers in that credit rating. They all wanted the highest yield within their investment criteria and trusted the rating agencies.

    In all the cases I saw, the ability to price and understand – beyond receiving collateral reports – was non-existent. Even as certain tranches when to 3c on the $, they didn’t even know how to use a Gaussian Copula to work out which bits represented value.

    With IKB it is interesting they have been open about ABACUS. There are hundreds of institutions pursuing litigation out of the public eye, as it is in the interest of all parties.

    In a way this points to how little detail investors really get on write-downs and disclosures in accounts. That IKB has chosen to be open about it all could well be a signal that they are working to resolve problems that others are trying to keep under wraps.

    • The Analyst January 27, 2011 at 4:09 pm #

      Has IKB ever issued any explanations as to what diligence they did, and why (assuming they did any), they still thought it was a good buy?

      As lawsuits and investigations are showing, the entire mortgage industry, from sales/origination all the way down to the most mangled derivatives was and still is full of procedural/processing issues. In fact, the entire financial services industry is still largely based upon antiquated processes, but that’s the topic of another post I’ve been writing for quite some time.

      Question to ponder though: Why is IKB being so relatively transparent when so many others are not?

      • flatpacked January 27, 2011 at 4:39 pm #

        I would guess IKB released on Abacus tactically. They were probably looking into a case and, with the MSM blow up, perhaps thought they could force a good settlement on the deal quickly. Lawyers fees mount up on this type of thing.

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