Securitization & Markets — Investor Amnesia

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“A crowd of capitalists on Wall Street fleeing a volcano labeled “Common Honesty” erupting in the background; they are carrying packages labeled “Secret Rate Schedules, Rebate Agreements, Watered Stocks, [and] Frenzied Accounts”. The top of the volcano shows the face of Theodore Roosevelt.”


Visualizing History 

 


From the Archives

A Guide to Profitable Speculation (1874)


Sunday Reads

If history teaches us one thing, it’s to expect the unexpected.

In a 19th century of The Spectator, an article on the topic of Speculation described the challenges that faced any speculator. Specifically, the journalist wrote that it is the speculator who feels (or even is) the most knowledgeable about speculating is often the one that fails. The knowledgeable and experienced speculator grows to be too comfortable, and under appreciates the likelihood of an unexpected risk event:

“The temptation of easy and large success is too strong for him, and sooner or later he does something silly… the man of broad knowledge is the man who ought to succeed in speculation; but it may be decided on irresistible evidence that he does not. Either he does not know some necessary detail, like the speculator in hops who had never heard of camomile, or he habitually disregards the tertium quid, the accident” which is outside human prevision, and which in every branch of the speculator’s art may destroy any combination whatever. The profoundest chess-player may see an inevitable mate, and yet, if the chandelier falls upon the pieces, may never win that game.”

That last line is the one that sticks with me the most, and is worth repeating here:

“The profoundest chess-player may see an inevitable mate, and yet, if the chandelier falls upon the pieces, may never win that game.”

In today’s world, this could metaphor could be applied to the risk models in 2008 that might have calculated everything to perfection, but failed to account for the wild possibility that the housing market would precipitously drop in 2008. The Spectator article continues to describe how the ‘well-informed’ and confident speculator is likely to fail because he has no respect for this possibility of the chandelier falling (a black swan event).

“Whatever the cause, the well-informed man is believed by experienced brokers to be of all men the one who is most unlucky. Indeed, they rather distrust knowledge of any wide kind, averring, in a sort of epigrammatic slang, that “with good information and cheap money, a man may be bankrupt in a week,” an opinion in which, so far as it refers to what is called “early information,” most able editors will coincide.”

So what does any of this have to do with today’s Sunday Reads?

Well, last week’s post focused on one of the major knock-on effects of COVID-19: Bankruptcies. As the economic impact of global lockdowns and shift in consumer spending habits continue, it is worth spending more time on the financial and economic implications of coronavirus. In addition to bankruptcies, another second-order effect of COVID-19 is the uptick in leveraged loan default rates, and the subsequent impact on securitized instruments like CLOs.

A looming question for investors is how prepared the financial system was for a rare negative shock like COVID-19, which has shut down entire industries. Are products like CLOs, which are made up of leveraged loans, equipped to handle the economic and financial ramifications of COVID-19? Or is this global pandemic the chandelier that falls onto the chess board, like our 19th century journalist described?

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Securitized products like CLOs are designed to mitigate risk through diversification so that any one default is offset by a large pool of performing loans. As we’ve seen all too recently in the case of 2008, however, if everything goes south then diversification can only help so much.

With the uptick in leveraged loan default rates over recent months as the result of the pandemic, this week we will focus on the history of securitized products. So let’s dive in!

Subprime Plantation Mortgages (On Manias, Ponzi Processes and Illegal Trade)

While this article does cover subprime mortgages, they’re not those subprime mortgages. Instead, rather, this piece focuses on subprime plantation mortgages in the 18th century, which the author argues is a prime example of a Kindleberger-Minsky bubble:

‘When testing different economic theories, we find that the negotiatie system is fits very well in Kindleberger and Minsky’s model of a classic bubble. Rising prices, especially for coffee, together with a form of  financing the new subprime plantation mortgages, provided the ‘displacement’. This seemingly profitable business attracted many a planter, fund director and investor. Once some setback occurred between 1769 and 1771 – drought, declining prices and maroon attacks- the mania started to crumble down. Those with a keen eye, selling their plantations or bonds before the phase of distress began, were winners. Those who held on to their investment were losers. The 1772-3 crisis was not the event that destroyed the negotiatie system, it was just another way of pointing out to the ignorant that the phase of discredit had arrived. This also explains why there was no immediate stop in granting mortgages: there were still people who had not accepted the system defeat. After Ter Borch’s bankruptcy was effectuated in 1774 this became even harder to ignore, so that is why the stream of mortgages almost dried up in the two years afterwards.’

Returning to the three financing types outlined earlier (hedged, speculative, ponzi), this article exhibits the evolution of subprime plantation mortgages into ponzi financing. Remember, this is generally a scenario in which ‘cashflow covers neither principal nor interest; firms are betting only that the underlying asset will appreciate by enough to cover their liabilities. If that fails to happen, they will be left exposed.’

Sure enough, the planters discussed in this article ‘could at best pay the interest on their mortgages, making them speculative borrowers.’ Similarly, ‘they were vulnerable to shocks, such as decreasing product prices and droughts, and this could add to their debt burden…’

With the above observations we have come to the Ponzi aspects of the system. The points is that the negotiatie structure could only continue as long as new money was put into it. A naturally occurring Ponzi process was created as early investors were rewarded with high interest payments and it is likely that their positive stories, next to those of the fund managers, convinced more people to put their money into the system. This was badly needed, for there were few hedge borrowers in the negotiatie structure. Most planters could at best pay the interest on their mortgages, making them speculative borrowers. However, they were vulnerable to shocks, such as decreasing product prices and droughts, and this could add to their debt burden, just like conspicuous consumption did. If this continued, the planters became a Ponzi borrowers and obtaining more credit was then the only way forward. Either a higher prisatie or a new mortgage with another fund would suffice, but this could not go on forever. As the share of Ponzi borrowers in the system increased, it became unstable and was bound to collapse.’

However, the ‘Minsky moment’ (which I’ve covered before) could be found in the collapse of coffee prices, which was the crop of choice for many plantations. Suddenly, the ability to make mortgage payments were slim to none as profits were dramatically reduced:

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The Financial Market and Government Debt Policy in France, 1746-1793

I wrote about this crazy story of securitizing children’s lives here, and here is an excerpt from the article:

Although life annuities are the sworn enemy of many advisers today, these financial contracts proved very popular with the French government in the 18th century. The state had used ‘age-dependent rate’ annuities to finance three military campaigns, before then reintroducing ‘flat-rate’ annuities (which were priced irrespective of age) in 1761. Starting in this year, two key factors led to an attractive investment opportunity for a group of clever Genevan bankers.

The first was a crucial flaw in the flat-rate system. Most notably, the calculations used to price the annuities still relied on the assumption that purchasers would hover around the age of 50. There was little consideration given to the idea that a younger person may purchase an annuity, and receive a substantially higher yield on their investment for the rest of their life.

The second factor, and perhaps more important was that the bankers could purchase annuities on other individuals by designating them as the ‘tête’ (nominee) in a contract.

“The flat-rate prices gave near-market yields on adults around the age of 50. Older adults were discriminated against by the flat-rate prices. To earn a higher yield, annuities had to be bought on the lives of children. There was no legal restriction on naming third parties as contingent lives.” — Velde and Weir

As the above table exhibits, life annuities on healthy children were the highest yielding investment in France. Operating out of their Paris office, a group of Genevan bankers purchased annuity contracts on young Genevan girls. Buying an annuity on a single girl, however, was a risky investment. If she died, the banker’s stream of income immediately ended. To protect against this risk, the bankers set screens for sourcing the healthiest children and established a diversified portfolio of 30–50 annuities on these young girls.

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In terms of screens, the bankers searched for girls that had survived smallpox and came from wealthy families that could afford quality healthcare. Each of these screens reduced the odds of premature death in their portfolio, and loss of income.

The newly securitized assets became so popular that banks even sold tranches of their annuity portfolios to investors:

“The Genevan banks purchased large amounts on each life to reduce transactions costs, but pooled together annuities on enough different lives to reduce the risk… The banks resold small fractions of their pools of annuities to individual investors and usually collected the annuity for them. They restructured the dividends into other packages, including tontines.” — Velde and Weir

Finally, here is the full excerpt from Velde and Weir’s paper that I used as key resource in my paper:

“In the 1750s and 1760s flat-rate pricing had relatively little impact on the total cost of government borrowing because most life annuity purchasers continued to be adults who bought annuities on their own lives, their spouses’, or their adult servants’.77 The flat-rate prices gave near-market yields on adults around the age of 50. Older adults were discriminated against by the flat-rate prices. There were few major alternative suppliers of life annuities, so the government may have profited from public demand for assets to smooth out life-cycle consumption. To earn a higher yield, annuities had to be bought on the lives of children.

There was no legal restriction on naming third parties as contingent lives. The two main impediments were (1) the risk that all the income would be lost to the investor if the third party died and (2) the transaction costs involved in documenting survival of the third party every year to collect the annuity. The technical solution to the problem of investing on children’s lives emerged in the early 1770s in a famous scheme known as the “trente demoiselles de Geneve.”80 It began as the exclusive domain of Genevan banks, through their branches in Paris. The banks developed lists of young girls from Genevan families to name as contingent lives. The families were selected for their record of health and longevity. The girls were mostly between the age of five and ten, and were selected only after surviving smallpox (or after inoculation, which was introduced in the 1780s).

The Genevan banks purchased large amounts on each life to reduce transactions costs, but pooled together annuities on enough different lives to reduce the risk. The most common number of individual lives in a pool was 30, hence the name of the scheme.’ Equally important was innovation in marketing the life annuities to the investment public. Genevan plan life annuities became an easily negotiable asset, unlike life annuities bought on one’s own life or the lives of family members, because the bank’s dispassionate selection of lives eliminated problems of asymmetric information and moral hazard. The banks resold small fractions of their pools of annuities to individual investors and usually collected the annuity for them. They restructured the dividends into other packages, including tontines.”

Securitization in the 1920’s

“This paper quantifies the scale and scope of the commercial real estate mortgage bond market in the period surrounding the 1920s in an attempt to better understand the role of retail mortgage debt in early urban development. In particular, this paper quantifies the size of the market, identifies risk factors affecting the coupon yield spread over Treasuries and utilizes a unique data set to construct a commercial mortgage price index over the period 1926-1935.

A substantial retail appetite for real estate securities during this period may have significantly contributed to a real construction boom, but overly optimistic speculation in these securities may have led to overbuilding. The rapid deterioration of these securities and a near complete drop in issuance show, ex post, that investors were overconfident in building fundamentals during the boom years. The breakdown in the value of real estate securities as collateral assets preceded the crash of 1929 and may have contributed to the fall of asset prices more generally.”

Responding to a Shadow Banking Crisis: The Lessons of 1763

In this article by the Atlanta Fed, the authors cover the Crisis of 1763, which features a similar ‘shock’ in the form of a bank failure following the Seven Years’ War, which causes a chain reaction in other areas of the financial sector.

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‘In August 1763, northern Europe experienced a financial crisis with numerous parallels to the 2008 Lehman Brothers episode. The 1763 crisis was sparked by the failure of a major provider of acceptance loans, a form of securitized credit resembling modern asset-backed commercial paper. The central bank at the hub of the crisis, the Bank of Amsterdam, responded by broadening the range of acceptable collateral for its repo transactions. Analysis of archival data shows that this emergency source of liquidity helped to contain the effects of the crisis, by preventing the collapse of at least two other major securitizers. While the underlying themes seem to have changed little in 250 years, the modest scope of the 1763 liquidity intervention, together with the lightly regulated nature of the eighteenth century financial landscape, provide some informative contrasts with events of late 2008.’

In conclusion, the authors find:

‘The Panic of 1763 records a distressingly familiar recipe for financial conflagration. Flammable ingredients include a system of securitization with numerous cross exposures (acceptance loans), an aggregate shock to collateral values (the end of the Seven Years’ War), and erratic policy decisions (on the part of the Prussian monetary authorities). The spark is provided by the collapse of a single participant (de Neufville) who is “too interconnected to fail” (in the view of Hamburg petitioners), but who fails nonetheless. Missing from the mix are the too-big-to-fail distortions of modern financial environments, but these seem not to have been necessary in the lightly regulated world of eighteenth-century finance.’

The Anatomy of a Residential Mortgage Crisis: A Look Back to the 1930s

“Looking back to the 1930s provides the opportunity to examine one severe mortgage crisis as we live through another. This paper examines the development of the residential mortgage market during the 1920s, the institutional disruptions that occurred in the 1930s and the policy response of federal and state governments. The crisis reshaped the structure and development of the residential mortgage market and led to a postwar system in which portfolio lenders dominated both local and interregional markets. Some pre-1930 innovations—mortgage insurance and high-leverage, affordable loans—were written into federal programs and became part of the new system. But early experiments and proposals for securitization did not survive the 1930s and the implementation of this innovation was delayed for forty years.”

This article covers an American mortgage crisis, but no, not the one in 2008. Looking at the mortgage crisis in the 1930s, the author finds “four elements that shaped the 1930s crisis and define its long-run impact on the nation’s housing mortgage market:

  1. The crisis was preceded by a decade during which the nation’s residential mortgage debt grew at an unusually rapid pace while financial innovation reshaped the mortgage market itself. Three innovations of the 1920s figure prominently—high-leverage, affordable home mortgage loans, private mortgage insurance and two early forms of securitization.
  2. Each of the intermediaries that brought innovations to the market in the 1920s suffered prolonged liquidations during the 1930s. These complex processes were publicly-managed but not publicly-financed.
  3. Federal emergency measures, including a publicly-financed ―bad bank‖ (the HOLC),  strengthened institutional portfolio lenders while the innovators of the 1920s were liquidating. Additional regulatory change created institutional structures within which these portfolio lenders dominated the residential mortgage debt for the next four decades.
  4. Proposals were offered to incorporate each of the innovations of the 1920s into new federal programs. One effort—for high-leverage, insured mortgages—succeeded in the form of the FHA loan program; the other—for a publicly-sponsored securitization structure—did not. As a result, securitization in the residential market was delayed for four decades and then took on a fundamentally different institutional structure.”

 

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Jamie Catherwood
My name is Jamie Catherwood, and I’m a Client Portfolio Associate at O’Shaughnessy Asset Management. Get your financial history fix through reading my articles, or those that I link to in my weekly “Financial History: Sunday Reads”.
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