Mostly you should think about Las Vegas, Nevada, as a number of important analogies apply here.[1]
First – The Poker Table
You know the rule that if you’re sitting at the poker table, and you’re not sure who the sucker is, then it must be you?
That’s you, the retail buyer, in any IPO.
Why do I say that? How do I know that?
Buying an IPO as a retail investor – You do not have pocket Aces
The people who have the most information about Twitter are the insiders in the business. They are the founders and the earliest private equity investors, and they know this business inside and out. They have lived and breathed this company since its existence. You have not.
The next most knowledgeable people are the bankers and financiers, who evaluate newish companies, in emerging industries, with swiftly changing technologies, and uncertain cashflows, for a living. They live and breathe stories and companies like Twitter, which you do not.
Now, at the poker table, the insiders and the bankers know their own cards, and they also know your cards, as well as the next few cards coming up on the flop, the turn, and the river. Nine out of the ten folks at the table in this transaction know more than you do. Interestingly, they are extraordinary friendly and welcoming of you at their poker table.
You should not be thinking “Huh, this Twitter IPO looks like an Ace – Seven off-suit. If I can hit another Ace as a table card, I might do pretty well at this table with these so-called pros. That would be sweet!”
No. Instead, you should be thinking: ”My what big eyes they have,” and “My, what large teeth they have.”
Remember this: The insiders – the most knowledgeable people – with the help of their bankers – the next most knowledgeable people – are all selling their ownership in this company. They are indicating, in the clearest terms possible, that they believe the company is more valuable right now than it will be in the near future.[2]
Do you doubt this? If the insiders believed – on a probabilistic basis – that the company will be worth significantly more 1 to 5 years from now, they would not be selling their ownership. They would wait for it to become more valuable. These are all rational, smart, people.
You, on the other hand, are the easy mark. Have a seat. Come play poker with me.
Second – Extraordinary Payouts
“But,” you are quick to think, “I’m pretty sure from watching TV that there’s a lot of money being made somewhere in this IPO. Isn’t that what it’s all about?”
Yes, this is true.
State lotteries display big winners in their advertisements, and at press conferences. Casinos make sure to tout all the big jackpots their customers have made in slots, or poker tournaments, or on their easy roulette wheels and craps table.
Everybody loves those goofy oversized checks
And those winners are real people, with real payouts.
But that is not your role, as a retail investor, in an IPO. You do not get that goofy oversized check.
The people with the big payouts from the Twitter IPO are the insiders, the founders, the executives, and the early private equity backers of Twitter. The IPO represents a giant payout for them.
The massive payouts to insiders give the Financial Infotainment Industrial Complex the equivalent of that goofy oversized check to breathlessly illustrate a big transaction like Twitter’s IPO.
Remember, that payout is real, but it’s not for you.
Third – The Flashing Lights, Whistles and Bells
If you have walked the floor of any casino, the flashing lights and whistles and beeping buffeted you. These sounds and lights provide an untrustworthy signal that “Wow, somebody is making money here!”
The Financial Infotainment Industrial Complex goes into high gear with an IPO like Twitter’s to provide the flashing lights and beeping and sound of coins dropping incessantly.
Their goal – as always in all of this – is to capture newsstand sales, Nielson ratings, page views, and click-throughs, with emotionally gripping, eye-catching, events.[3] The Twitter IPO provides just such an event.
A flashy score for a small group of entrepreneurs and investors is that opportunity for the clink-clank-clink-clink of Triple Cherries, just as you slip past, flushed with heightened oxygen levels, trying to navigate the purposefully crooked casino floor, on your way to the restroom.
This is not how to think about an IPO outcome for you
In sum, try to buy a piece of the casino, but do not gamble
Unless you are an insider in some way to the Twitterverse, you have no business participating in the Twitter IPO, or practically any IPO for that matter.
To extend the casino analogy even further, long-term stock ownership is like owning a piece of the casino. You may have short-term ups and downs, but in the long run the odds will work out in your favor because you have house-odds, and you will build wealth, almost inevitably.
And also, please don’t get me wrong about Twitter. I’m agnostic about Twitter as an investment opportunity. I would describe every other highly-discussed IPO similarly.[4] I assume mutual funds that I own will end up purchasing some Twitter shares, and I’m perfectly fine with that, over the long run, and in a diversified portfolio.
I love public stock ownership, and I’m happy for the few folks for whom this Twitter IPO will be a meaningful event.
But the point here is that Twitter’s IPO is, and should be, entirely irrelevant to the rest of us and our financial lives. But the casino makes it hard for us to ignore it as we should.
[1] Really, this applies to any IPO. I don’t mean to pick on Twitter, except I’m fairly sick of hearing about it and its IPO should be totally irrelevant to all but a few dozen people on this planet.
[2] Warren Buffett on IPOs “It’s almost a mathematical impossibility to imagine that, out of the thousands of things for sale on a given day, the most attractively priced is the one being sold by a knowledgeable seller (company insiders) to a less-knowledgeable buyer (investors).”
[3] If you have not walked the floor of a casino because you prefer to stay home and knit tea cozies, that’s cool. I admire you. Let me give you another analogy for the relationship between us and the Financial Infotainment Industrial Complex. We are the kittens. They hold the ball of string.
A friend and I debated the merits yesterday of Alex Pareene’s recent article on Salon, in which Pareene praises the most recent $13 Billion fine against JP Morgan as justifiable punishment for greedy bankers and a morally-positive disincentive to the banking industry generally.
On the other hand, and despite my disagreement, Jon Stewart is better at what he does than anybody else is good at what they do (with the sole exception of Nate Silver). So I’m still totally entertained by his characterization of the massive JP Morgan fine, the Alex Pareene article, and the response of financial journalists.
The second Daily Show clip is here, in which he satirizes the financial media’s “shakedown, jihad, gun-to-the-head” characterization of the JP Morgan $13 Billion fine.
This is a shark, not a whale. But cool picture, no?
The last thing this world needs is another comment on the London Whale, but I’ve been silent on the topic for over a year, and today’s announcement that JP Morgan will pay $920 million in penalties, plus offer an apology, inspired a few quick thoughts.
The settlement is meaningless, as punishment
All along, the London Whale narrative of the past 1.5 years has been a scarcely concealed proxy fight over the so-called Volcker Rule, namely the idea that investment banks may, or may not, have to get out of the proprietary trading business, as a result of Dodd-Frank.
To the extent the London Whale position started out as a risk-reducing hedge, later became a profitable proprietary position, and then still later an unprofitable proprietary trade, it serves as a nice specific example for critics of proprietary trading to embarrass the pro-proprietary trading side of the argument.
Prop trading losses are self-correcting
What should not require explanation, but I think does, is that fact that proprietary trading losses already offer efficient argument against bad risk management in proprietary trading. When a bank loses money in prop trading, you really don’t need to fine the bank for losing its own money.
Proprietary trading losses are a self-correcting thing.
JP Morgan reportedly took a $6.2 Billion write-down against the position. The traders were fired, the risk managers were fired.[1]
As the SEC, you really don’t need to pile on an extra $920 million in fines to rub JP Morgan’s little doggy nose in the mess it made. They got the message already, a year ago.[2]
All that happens when Wall Street folks see this kind of gratuitous SEC enforcement action is that they roll their eyes and think to themselves, “the regulators don’t get it.”
“But JP Morgan admitted wrongdoing, so there must have been bad behavior, right?”
Wrong. JP Morgan admitted to an “SEC violation.”
In a new precedent set within the past year, banks now have to admit wrongdoing when they settle something like this, because that’s the new SEC mode. But the admission itself is silly as an SEC violation.
Their admission was that senior management didn’t tell members of the audit committee of the board of JP Morgan about the extent of losses from the trade in a timely fashion. Seriously, that’s the admission.[3]
So let’s think about that SEC violation. That’s also a self-correcting mechanism. If the board is bent out of shape about senior management’s ‘failure to timely inform them,’ its pretty easy to correct that problem. They can just fire the CEO. That’s the board’s job and the board’s right, and they haven’t exercised that right at this time. Which means they are fine with management, and Jamie Dimon in particular.
The SEC’s role in protecting the board audit committee is really a silly kind of ‘SEC violation’ that isn’t necessary. The SEC was not talking about protecting widows and orphans from bad banks. The SEC was talking about protecting JP Morgan’s board members from the bank’s senior management.[4]
The senior management, incidentally, serves at the board’s pleasure. So in essence the SEC was protecting the bosses (the audit committee of the board) from their employees (Dimon and his team).
“But ‘banks = bad,’ so I like it whenever the government sticks it to The Bad Man”
Grrr.
Banks need to be regulated of course, but banks need to be regulated in ways that aren’t gratuitous or done for excessively symbolic reasons.
This SEC enforcement action is nothing but a big, unnecessary proxy action for the Volcker Rule fight.
Wall Street knows this, JP Morgan knows this, and they’re willing to lose this battle in order to win the larger war regarding proprietary trading.
Ultimately it’s about respect for the rule of law
In the long run, symbolic and gratuitous enforcement actions[5] weaken respect for the rule of law.
As in: We (the government) pretend to have found something wrong and you (the bank) pretend to be contrite for doing something that you do in the ordinary course of business. With each of these pretend enforcement actions, over time you whittle away at any respect the bank may have had for its regulators.
With each of these pretend enforcement actions the question in bank management’s mind is less “How can we be better stewards of our industry?” and more “Ok, just tell me how much this is going to cost me, to make this regulator temporarily go away?”
At some level regulators know this, and they know they can make a big high-dollar score against the finance industry. Elected officials certainly know this, and can work the delicate game of being useful, in the right circumstances and with the right industry support, at key moments. All of this is not a move in the right direction.
The London Whale penalty, in the long run, is a victory for nobody.
[1] Jamie Dimon of course was not fired, because he’s Jamie Freaking Dimon.
[2] And incidentally, while the headlines losses are nominally big, they are immaterial to the operation of JP Morgan overall. At no point has anyone even remotely believed that the London Whale losses matter existentially to JP Morgan. The bank is fine.
[3] And frankly there’s a good-to-overwhelming probability that senior management themselves had no way of knowing the extent of the losses at the time. The position was still on, and markets move, and losses may get bigger or smaller. You don’t know until you completely unwind the position.
[4] Just for fun, who exactly is the SEC protecting, on the audit committee of the board? James Bell, former Boeing executive, and board member also of Dow Chemical; Crandall Bowles, Chairman and former CEO of Spring Industries and member of the board of the Brookings Institution, The Wilderness Society, and the Packard Center for ALS Research at Johns Hopkins; and Laban Jackson, the Chairman of Clear Creek Properties, Inc., director of Markey Cancer Foundation, director of the Federal Reserve Bank of Cleveland, and former director of The Home Depot. I think these people can defend themselves.
[5] something Eliot Spitzer made a career of and rode all the way to the NY Governor’s office
Nickel and Dimed – On Not Getting By In America, by Barbara Ehrenreich. Want to understand what it’s like to be part of the structurally poor in America? No? Well you won’t ever see it depicted in mainstream media, but here’s a good place to start.
The Death And Life Of Great American Cities, by Jane Jacobs. This classic on urban planning policy from 1960 struck me as entirely relevant today. Jacobs writes convincingly on low-income housing policy, the problem with parks, the benefits of walkable cities, the importance of mixed uses, the essential nature of diversity in great cities.
Cities and the Wealth of Nations, by Jane Jacobs. By switching the economic unit of analysis from nations to cities, Jacobs offers still-relevant insights into development, inequality, currency regimes, and the decline of empire.
The Making of Donald Trump by David Cay Johnston. A review of thirty years of Trump’s businesses practices, associates, and personal style, from a Pulitzer Prize-winning journalist who covered him over the years. I wouldn’t say I was surprised by the revelations, but the details are important. Not a book about ‘inequality’ per se. But not entirely unrelated to the theme either, in the broadest sense.
Capital In The Twenty-First Century by Thomas Piketty. Sets the standard on data collection on wealth concentration in rich countries. Has a mathematical model that suggests ossification of aristocracy may be in our future, unless addressed through tax policy.
Words and Money, by Andre Schiffrin. A French-American from the traditional publishing world explains why for-profit behavior by media companies – in publishing, movies, book-selling, newspapers – are hurting society. Some proposed solutions which sound very European.
The Price of Inequality, by Joseph Stigliz. I started out sympathetic to his politics but his style of argumentation – hammer, hammer, hammer – is tedious. Also made me more in favor of inequality, because I’m a contrarian cuss.
On Personal Finance
The Automatic Millionaire by David Bach. A surprisingly well-done book on what may be simplest first two principles of investing: First, you DO have enough to invest. And the second principle: You HAVE to do automatic deductions. Peace and Plenty, by Sarah Ban Breathnach. The worst personal finance book I’ve ever read, by the narcissistic, materialistic, unreflective author of Simple Abundance, a popular book from the 1990s endorsed by Deepak Chopra and Oprah Winfrey.
Why Smart People Make Big Money Mistakes, by Gary Belsky and Thomas Gilovich. The authors translate Behavioral Economics research with memorable anecdotes and illustrations to help us understand why we make sub-optimal personal finance decisions.
The Four Pillars of Investing by William Bernstein. At this point a personal finance classic. Great writing, great reviews of all the big ideas, great guidance to what we should all be doing with our investment money.
The Delusions of Crowds by William Bernstein. Bernstein anticipated 2021 and nailed it with this historical review of both religious and financial nuttiness that we humans are apt to repeat over and over again.
The Richest Man In Babylon, by George Clason. “Babylonian” fables written in the 1920s that retain timeless wisdom about of thrift, savings, skepticism, and self-reliance.
Secrets of the Millionaire Mind: Mastering the Inner Game of Wealth, by T. Harv Eker. Some interesting points to make on psychological limitations we may have about money, along with cognitive behavior techniques to overcome those limitations, but unfortunately told by a seminar-upselling jackass.
The Way To Wealth, by Benjamin Franklin. A greatest-hits of memorable aphorisms about thrift and industry by the founding father Benjamin Franklin, in his persona as Poor Richard.
Think and Grow Rich, by Napoleon Hill. This personal finance classic offers ‘the secret’ to getting wealthy, and has inspired the world’s Dale Carnegies, Tony Robbins, Guy Kiyosakis. The ‘secret’ is not so hidden, and the prose is cheesy, but I’m willing to concede that the book could put you in the right mind-set for building wealth.
The Psychology of Money, by Morgan Housel. The best living finance writer with an instant classic of behavioral finance.
Investing Demystified: How To Invest Without Speculation And Sleepless Nights, by Lars Kroijer. A former hedge funder offers a simple, low-cost way to construct an effective global portfolio, keeping in mind the efficient market hypothesis (you don’t have an edge!) and the efficient frontier theory of portfolio construction.
A Random Walk Down Wall Street, by Burton Malkiel. The classic that launched the index fund market and popularized the efficient market theory. And its surprisingly interesting to read. You should read this!
Behavioral Investment Counseling by Nick Murray. Another Murray classic, directed at advisors, to convince them that client behavior matters more than anything, and therefore how an advisors time, effort, and talent should and should not be allocated.
Innumeracy: Mathematical Illiteracy And Its Consequences, by John Allen Paulos. An interesting and entertaining book on the importance of mathematical literacy, although I don’t think one of the intended audiences – innumerates – would ever read it.
Stocks For The Long Run, by Jeremy L. Siegel. A classic in which Siegel present the 200+ years of data to show the overwhelming advantage of stocks over ‘safe’ investments when it comes to building wealth.
If Your Money Talked What Secrets Would It Tell, by Gary Sirak. Sirak offers real-life illustrations of his 8 Principles of Money, based on his career as a financial advisor for the last 30 years. He also argues persuasively that most of our trouble with money is caused by our own personal beliefs about money. The Millionaire Next Door – Surprising Secrets of America’s Wealthy, by Thomas J. Stanley and William Danko. An influential (at least in my life) best-seller on the difference between having wealth and displaying wealth, and solid ideas on how to accumulate wealth.
The Millionaire Mind, by Thomas Stanley. Attributes of wealthy folks, such as their frugality, monogamy, purchasing habits, entrepreneurship. The Only Investment Guide You’ll Ever Need, by Andrew Tobias. Funny and Useful, it’s a personal finance guide that actually lives up to its hyperbolic name.
My Vast Personal Fortune, by Andrew Tobias. Funny, quirky, and revealing anecdotes on real estate and advertising. Features Tobias’ obsession with auto-insurance.
Mathematics Standard Level for the International Baccalaureate, by Alan Wicks. I didn’t actually review this book, but just referred to it in my discussion of compound interest. The International Baccalaureate is how I learned about “Sequences and Series,” the mathematics behind compound interest. Also, this was written by my high school advisor and math teacher, so you should buy it!
The Contrarian: Peter Thiel and Silicon Valley’s Pursuit of Power by Max Chavkin. The first review in my series on our new billionaire philosopher kings. Peter Thiel has made some brilliant investments. He is also not a good guy. It’s his “nazi curious” leanings that make me particularly nervous.
The House of Morgan, by Ron Chernow. Fascinating history of the origins of JP Morgan, Morgan Stanley and Deutsche Bank (which absorbed the UK’s Morgan Grenfell). Even does much more in a few short chapters on recent history to explain how Goldman Sachs “came to rule the world,” than does Cohan’s book by that title.
Money and Power – How Goldman Sachs Came to Rule the World, by William Cohan. Cohan doesn’t answer the question in the title, and he cherry-picks a series of embarrassing episodes from Goldman’s history to offer it up as a scapegoat. The one useful section is his chapter on the mortgage department, in the years just prior to Crisis of 2008.
The ChickenShit Club:The Justice Department and Its Failure to Prosecute White-Collar Criminals, by Jesse Eisinger. Eisinger explains in detail why nobody went to jail as a result of the mortgage crisis, with specific focus on the weakening of the Justice Department’s will to aggressively prosecute individuals and companies after the Enron/Arthur Anderson debacles. The Intelligent Investor, by Benjamin Graham. My kids will be reading this when they get old enough, because, 65 years later, it’s still fresh, and it will still be fresh in another 15-20 years.
The Hard Thing About Hard Things, by Ben Horowitz. Horowitz led his company through harrowing crashes and extraordinary success. He describes the painful decisions and gut punches of being CEO during the bad times. The latter-half of the book is less interesting, but the first part is intertwining and useful.
Systems of Survival – A Dialogue on the Moral Foundations of Commerce and Politics, by Jane Jacobs. This isn’t about Wall Street, but rather about two interdependent systems of survival. Guardians (government functions) and Commercials (business functions) work well together but operate by separate precepts. Each has its own internally consistent moral code, but the breach and mixing of precepts can lead to monstrosities. I love this book as it practically explains everything you need to know about Left-Right/Democrat-Republican/Government-Business debates.
Flash Boys: Not So Fast by Peter Kovac. In insider from the high frequency trading world explains how Michael Lewis got so much wrong in his book Flash Boys.
Boomerang – Travels in the New Third World, by Michael Lewis. The silliest of Lewis’ Wall Street books, but nevertheless entertaining cultural snapshots of countries in the 2008 Crisis.
The Big Short – Inside the Doomsday Machine, by Michael Lewis. Funny and accurate review of the 2008 Crisis, in which Lewis does what no other journalists did – he makes the short-sellers the heroes.
Liar’s Poker, by Michael Lewis. The original classic. Start your Wall Street reading here, about Lewis’ short stint as a bond salesman, at Solomon Brothers, in the mid-1980s.
The Lean Startup by Eric Ries. Redefining the metrics of startups, and a whole new way of thinking about them. Don’t start a company, instead start a series of experiments to test your business hypothesis.
Where Are The Customers’ Yachts? by Fred Schwed. I had not expected this to be as funny as it was. Somehow, it turns out I dig 1940s financial humor, with some sly lessons on how Wall Street really works.
The Green And The Black, by Gary Sernovitz. Funny, informed, complex – A great overview of the implications of the shale revolution, aka the fracking revolution in the United States.
Too Big To Fail, by Andrew Ross Sorkin. Should be titled “Too Connected to Criticize” as Sorkin protects his present and future sources – the Wall Street CEOS of 2008 – from any criticism or real analysis of their responsibility for 2008.
Black Swan – The Impact of the Highly Improbable, by Nassim Nicholas Taleb. Taleb explains how the unexpected tends to shape everything, and our models never see the unexpected before it’s too late. Also, his timing on this book, right before the 2008 crisis, was awesome.
Fooled by Randomness, by Nassim Nicholas Taleb. Taleb’s first book blasts the traditional Wall Street world-view with his empirical skepticism and brash, take-no-prisoners, style.
Fiction
The Lives Of Animals, by J. M. Coetzee. A challenging, only semi-fictional philosophical exploration of the moral relativity of animals, compared to humans. Are we perpetuating an unthinking Holocaust on animals? Accompanying essays help flesh out the ideas. The Pickup, by Nadine Gordimer. A novel exploring the immigrant and emigrant experience, and maybe, the impossibility of true understanding between people. The Mystery of the Invisible Hand by Marshall Jevons. Two economists write this series of murder mysteries in which an economist applies economic theory to catch the criminal. This one takes place in San Antonio TX so I had to read and review it.
Capital, by John Lanchester. This book review, by Michael Lewis, contains great observations about English writing, and English attitudes towards capitalism.
A Conspiracy of Paper by David Liss. Explore 18th Century London stock markets just prior to the crash of the South Sea Company, as proto-private eye Benjamin Weaver investigates stock fraud and the death of his father. Fun stuff!
The Earl Next Door: The Bachelor Lords of London by Charis Michaels. American heiress Piety Grey battles scheming relatives and a literally falling-down London townhouse, while navigating the romantic pull of the Trevor Rheese, the Earl next door who thinks he just wants to live alone, unencumbered by responsibility for others.
Undermoney by Jay Newman. A prescient novel about Deep State power brokers, mercenaries, murderous kleptocrats in Russia and New York City. Newman somehow has the chops to describe their world in a way that feels like he knows what it’s like. Also, Newman is a bad ass hedge funder, so definitely has experienced some of this first hand.
Going Going by Naomi Shihab Nye. I reviewed this young adult novel in part because it takes place in my neighborhood and in part because it gave me a great excuse to discuss some meditations on what makes for a good city, and a good life.
The Turtle of Oman, by Naomi Shihab Nye. We brought this young adult novel on a trip to Big Bend National Park, which happens to be the perfect place to experience Oman. My older daughter and I enjoyed this tremendously.
The Way We Live Now, by Anthony Trollope. A book review by a friend, of a favorite book and favorite author, featuring the 19th Century British Bernie Madoff.
Theory of Knowledge
An Illustrated Book of Bad Arguments, by Ali Almossawi. Almossawi’s online book is a pleasurably illustrated taxonomy of terrible logic, of the kind we so often hear from political pundits or members of the Financial Infotainment Industrial Complex.
An Illustrated Book of Bad Arguments
Risk Savvy, by Gerd Gigerenzer. Ultimately disappointing book that has some points to make about the limitations of building complex risk models for highly complex systems. But too much seems to be culled from presentations to rooms full of doctors, or something, and I was bored. I’d prefer to go with Nate Silver any day.
Dark Age Ahead, by Jane Jacobs. One of my favorite authors, with a title that made me need to read it. Jacobs has a theory of what will break civilization apart, and its all plausible.
Help, Thanks, Wow by Anne Lamott. Not really related to finance or even theory of knowledge. Just a meditative book that struck me as important to read and review. I highly recommend it if you need a good cry.
The Signal and the Noise: Why So Many Predictions Fail – But Some Don’t, by Nate Silver. Silver argues that applying Bayesian probabilistic thinking to a wide range of complex phenomena like sports betting, weather, earthquakes, Texas Hold ‘Em Poker, and politics help us understand the present and forecast the future far more than most legacy models we work with.
Snowden betrayed the US and the intelligence community for a higher cause. I find his arguments utterly compelling. We are not thinking hard enough about the implications of the new surveillance society and surveillance marketplace.
“When Issued” forward-trading of mortgage origination supply
The packaging of homeowner loans into plain vanilla mortgage bonds
The role of mortgage servicers and mortgage insurers in the bond market
This post will cover subsequent features of mortgage bond trading and structuring
The basics of mortgage trading – Prepayment risk!
The basics of CMOs – mortgage derivative structuring.
Recent market moves must have caused a bloodbath on most Wall Street mortgage desks
Contrary to popular wisdom, mortgage derivatives are not generally a risky business
Mortgage Trading – All about the prepayment risk
So how do mortgage bonds trade on Wall Street? How do investors think about the product?
Contrary to popular reports, plain-vanilla mortgage bond trading and investing remains among the safest type of investing from a ‘credit’ perspective. Investors can always expect their full principal and interest returned to them.[1]
Our simple FN 8720331 4% bond issued in October 2013 offers investors AAA-risk comparable to US Government bond risk and extreme liquidity, meaning an investor can sell the bond at any time and not pay much in transaction costs.
The main and only significant difference between our FN 4% bond and a similar US Treasury bond is the uncertainty of the timing of principal payments. Meaning, the US Treasury does not generally pay back its bond principal early, but a mortgage bond, by contrast, pays a little bit of principal, every single month. In addition, if any of the 2,000 underlying homeowners decides to sell or refinance his house, an unexpected principal repayment flows through to the bondholder.
Not if, but when
The risk to the bond-holder, therefore, is not if he’ll get paid back, but when. Since in our example 2,000 individual homeowners have the choice over when, anytime in the next 30 years, their individual mortgage gets paid back, the mortgage bond holder is subject to other people’s choices, which the investor cannot control.
The mortgage bond holder, by purchasing the bond, has implicitly sold 2,000 little 30-year options to homeowners.
In financial terms, when you sell an option you get paid a premium for that option. That premium shows up in the form of extra ‘yield,’ or investment return over comparable US Treasury bonds. This makes plain vanilla mortgage bonds ‘yield’ more than other AAA-rated bonds, but it also burdens the bond holder with ‘prepayment risk.’ Mortgage investors and mortgage traders spend all of their waking hours stressing about prepayment risk.
NSA-sized computer servers, and the greatest minds of our generation are dedicated right now, as I write this, to modeling prepayment risk in mortgage bonds. I didn’t say they were tapping the phones of those 2,000 homeowners to get a sense of when they will refinance, but I mean seriously, do you doubt it? There’s a lot of money at stake here, after all.
The problem of being a mortgage bond holder, just to dig a bit further into the prepayment problem, is that homeowners always exercise their option to refinance their home at the precisely wrong time, for bond investors. What do I mean by that?
Always on the losing end of volatile markets
I mean mortgage bond holders get paid early just when they don’t want to, and they don’t get paid back early when they would like to be paid early.
When rates drop strongly, for example, many more of our 2,000 homeowners will choose to refinance early to take advantage of the new interest rate savings. That uptick in refinancings will send early payments to the bond holder and amortize his 4% bond more quickly than expected. Unfortunately for the dedicated mortgage bond investor, however, he has to own mortgage bonds, that’s what he does for a living. So he needs to invest in new mortgage bonds to keep his money earning money. He will have to reinvest his cash at the new lower rate, which might only earn him 3%, since rates dropped strongly.
Rate hikes can be even more deadly. If mortgage rates jump to 6%, for example, many fewer of our 2,000 homeowners than usual will opt for refinancing. In fact, only people who move houses (or get foreclosed on) will pay off their mortgage early.
Few homeowners elect to refinance into higher interest rate mortgages. Hardly any prepayments flow to the bondholders to amortize the bond. Our bondholder anticipated a certain amount of prepayments and hoped to invest his proceeds at the new higher rates. He can’t. In the new 6% interest rate world, new mortgage bonds pay close to 6% but our mortgage bond investor still holds our dumb old 4% bond, with less-than-anticipated cash to put into the higher yielding bonds.[2]
The more that interest rates move, the worse off the mortgage bond holder fares, in both directions, because he’s short the prepayment option.
In times of volatile interest rate moves, the homeowner holds this very valuable option, and the bond holder suffers as a result.
Everything about mortgage trading and investing flows from this fundamental problem – the problem of prepayment risk.
Mortgage Servicing and Mortgage Derivatives – attempts to solve prepayment risk
The 2,000 individual homeowners paying their monthly mortgages underneath our theoretical $750 million Fannie 4% bond are really raw financial clay with which Wall Street artistes create financial sculptures.
If prepayment risk is the ultimate heavy burden of mortgages, the point of the financial sculpture of mortgage derivatives is to shift risk in ways to defy gravity, ultimately matching investor appetite for prepayment risk.
The mortgage servicer who separately pays interest and principal payments to bond-holders plays a key role in making these works of art possible
Simple mortgage derivatives
CMO – A Collateralized Mortgage Obligation is a generic term for relatively simple mortgage derivatives, first created 30 years ago, that typically shift prepayment risk forward or backward in time over the life of a mortgage bond.
A Wall Street bank may decide to sculpt our FNMA 4% bond into a CMO structure to split the timing of mortgage prepayments.
As a simple example, let’s assume three different investors want three different types of investments.
What a savings and loan bank wants
A traditional savings and loan bank might be looking for a place to park its cash for up to 2 years and is happy to earn a safe 2% return on its money. Our theoretical bank investor needs everything it is investing in a mortgage bond returned over the next 2 years to make its budget, and it cannot risk tying up its capital much past the next 2 years. Our savings and loan bank needs a CMO structured to receive lots of mortgage prepayments.
What an insurance company wants
An insurance company, by contrast, typically seeks long-term bond investments to match its need to meet its long-term liabilities, like life insurance payouts. The insurance company seeks a way to invest its capital for 10 years, but needs something more than a bank for that long term investment – it seeks a 4.5% return. In addition, the insurance company really does not want to receive early principal payments. The point is to keep its capital earning the 4.5% rate for as long as possible, so the insurance company really wants a CMO structured to help it avoid prepayments.
Limited pre-payment risk at attractive yields: Its what every white boy off the lake wants
Finally, a hedge fund has a flexible view of yield and the timing of return of capital, but thinks it has a better sense than the rest of the market on the true likely prepayment speed of this FNMA 4% October 2013 cohort. The hedge fund wants to earn extra yield and is willing to stomach the risk of a wider range of bond payment timing outcomes. In financial lingo we’d say the hedge fund earns the extra premium by being “short” a volatile pre-payment option. By buying the CMO with the most volatile outcome, the hedge fund has done the financial equivalent of selling many call and put options to homeowners, and it hopes to profit from this implied sale, if the interest rate environment turns out to be less volatile than expected.
Our clever Wall Street firm can assign our FNMA 4% bond to a CMO structure and instruct the mortgage servicer to follow a set algorithm as prepayments arrive over the next 30 years.
All principal payments first go to pay the bank’s CMO until that bond is completely paid off, followed by the hedge fund CMO, followed finally by the insurance company’s CMO.
For the bank’s CMO all principal payments – both the scheduled principal amortization and the unscheduled prepayments – get forwarded to this short-term bank CMO. As a result, this bond pays down extremely quickly and will likely return all capital to its holder within the 2 year time frame. There is some uncertainty about timing, but the fact that the bank CMO gets every single principal payment really limits the prepayment timing to within a nice, tight, short range.
The bank’s CMO structure also makes the next two CMOs created from the same FNMA 4% bond possible.
The hedge fund CMO only receives principal prepayments after the bank CMO has been fully paid off. As a result, the hedge fund knows it will not be subject to prepayments for some period of time in the very near future. As it is second in line for principal payments, this CMO acts kind of like a shock absorber for the other two bonds, and will be quite sensitive to changes in interest rates and therefore prepayment speeds. The investor in this type of bond, like a hedge fund, will likely believe it has a better read on prepayment risk than others in the market. Because it takes on the most prepayment risk of the three bond structures, the hedge fund will demand the most yield enhancement over comparable AAA bonds to compensate for this increased risk and uncertainty.
The insurance company’s CMO, as third in line for prepayments, has two layers of prepayment ‘protection.’ Although the timing of principal payments may ultimately differ significantly from the insurance company’s expectations, the two layers of protection cushion the prepayment risk and keep it within a tighter range than would be otherwise available from a plain-vanilla 4% FNMA bond.
By slicing up our mortgage bond pool to meet the demand of three separate investors, the Wall Street firm can, ideally, sell the entire pool at a higher implied price than would be otherwise available in a plain vanilla format. Happy customers, and higher fees, follow.
Interest only bonds and principal only bonds – another simple CMO structure
Because interest and principal payments for our $750 Million 4% FNMA bond can be easily separated by the mortgage servicer, Wall Street desks quickly figured out that some investors want interest only bonds, while others prefer to receive only principal.
Who would want an interest-only bond?
The first feature of an interest-only bond is its potentially volatile and leveraged nature – it fluctuates widely in value if you get the bet right. The second feature is that it moves in the opposite direction of most bonds due to changes in interest rates.
Most bonds go down in value as interest rates rise. But interest-only bonds created by mortgage pools will increase in value as rates rise. That’s because we expect prepayments will drop with a rise in rates, which means that you will receive interest payments on the 2,000 underlying pools for a much longer time, as fewer homeowners extinguish their mortgage through refinancing.
The price of an interest only bond will shoot upwards if interest rates unexpectedly shoot upwards and prepayment expectations drop accordingly.
If I as a mortgage investor need to hedge my mortgage portfolio against an unexpected rise in rates, I might shop for interest only bonds. If my entire portfolio is likely to lose value when rates rise, I benefit from the hedge of owning bonds that rise in value when rates rise.
Conversely, a bet on a principal only mortgage bond may be a type of bet on a decline in interest rates. Principal only mortgage derivatives will be especially sensitive to changes in rates.
Principal only mortgages trade at a discount to face value. If prepayments arrive more quickly than expected (due to, say, an unexpected increase in refinancing activity) the principal-only mortgage holder wins. Every principal payment is made at ‘par,’ causing an investment gain versus the discounted price at which the investor bought the entire principal-only mortgage derivative.
If for example I bought my principal only bond at 80 cents on the dollar, but 10% of my 2,000 underlying mortgages prepay early this month, I’ll get 10% of my investment returned to me at 100 cents on the dollar. That’s a win.
Funkier structures – More CMOs
Traditionally, mortgage structuring desks attracted some of the brainiest folks on Wall Street.[4]
With the raw material of a home mortgages, the creativity of these artistes knows few limits. Some CMOs provide precise prepayment certainty to risk-averse investors, as long as other ‘companion bonds’ serve as shock absorbers for unpredictable prepayment risk. Companion bonds will be retained by Wall Street mortgage desks comfortable with the risk, or may be bought by hedge funds with a higher risk appetite or a strong conviction about future prepayment risk.
Some CMOs offer floating interest rate structures to investors seeking to eliminate interest-rate risk exposure, while creating ever-more algorithmically complex ‘companion bonds.’
For those curious about the ever-awesomer financial sculptures the smartest minds of our generation can create, I recommend this Wikepedia page.
Recent market moves must have been ugly
Interest rates shot up more than 0.5% in May and June. For mortgage bond holders, interest-rate volatility generally hurts, and rising rates provide a double whammy to the problem.
There is no doubt this kind of movement is career-making and career-ending for Wall Street folks. Rates have been so low, for so long, that some mortgage desks will be positioned right, and many more will prove in retrospect to have been positioned wrong.
If you held a preponderance of IOs, or some extraordinary floating rate structures, or got massively short interest rates in April 2013, you’re probably ok.
For a great number of mortgage investors and traders, however, I suspect they didn’t save themselves from huge losses.
[1] Before you get smart-assed about all the scary bond losses you read about once in a Gretchen Morgenson article, let me reiterate that I said plain-vanilla mortgage bonds, not risky portions of mortgage-backed CDOs or sub-prime structured products.
[2] Adding insult to injury, if it’s an un-hedged mortgage bond position, his bond also trades significantly below par. So if he decides to sell the 4% bond to buy a 6%, he’ll take a loss. Rate hikes are hard on all bond investors, but especially mortgage bond investors.
[3] If you were born around the same time as me, it’s what you want Joel. Its what every white boy off the lake wants.
[4] Plenty of raw idiocy and barbaric types too, of course, like any testosterone-fueled environment, anywhere. For a humorous depiction of the brutal origins of the market, look no further than the original Michael Lewis classic, Liar’s Poker.
None of the following is essential to understanding mortgages from a personal finance standpoint, I just thought the details of mortgage securitization and mortgage bond trading and structuring would be interesting for some people.
I sold mortgage bonds at Goldman for a few years in the early 2000s, so this sausage-making was my daily life. Below, and in a subsequent post, I introduce some Wall Street concepts of the mortgage bond market.
“When Issued” forward-trading of mortgage origination supply
The packaging of homeowner loans into plain vanilla mortgage bonds
The role of mortgage servicers and mortgage insurers in the bond market
The demise of the big mortgage insurers in 2008
The basics of mortgage trading – Prepayment risk!
The basics of CMOs – mortgage derivative structuring
Recent market moves must have caused a bloodbath on most Wall Street mortgage desks
In this post, I’m going to describe points 1 through 3.
Subsequent posts will describe points 4 through 7.
Conforming mortgages, the forward trade
In July 2013, Wall Street is now “forward trading” the October 2013 30-year 4.0% mortgage bonds. October 2013 mortgages are part of the ‘When Issued” market, which is kind of like a grain farmer selling wheat on the commodities exchange 3 months before his harvest. The farmer has an approximate idea of what yield he’ll get soon, but he may trade on a commodities exchange as his estimate changes, and as his sense for the attractiveness of prices changes.[1]
As the largest originator in the US, Well Fargo, in recent times, originates over $100 Billion in mortgages per quarter.
That means that on any day in July, and in fact for the next two months, mortgage traders at a big mortgage originator like Wells Fargo will call up their salesman at Goldman Sachs and ask Goldman to purchase some amount of their mortgages that will be originated by October 2013.
This “When Issued” mortgage market is just about the most liquid market in the world, and a $1 billion trade happens in seconds.
“Hello, this is Goldman,” said in a shouty but efficient voice
“Bid 750 Fannie 4s in October!” *
“22+” **
“Done” ***
“Done. GS buys $750 million Fannie 4s in October at 100-22+. Thanks for the trade.” Click.
****
[And…let’s translate:
* Wells Fargo today, in July 2013, is selling $750 million worth of future mortgage supply, which it will ultimately originate in October 2013. Wells has an idea of its future October volume, however, because of the recent amount of customers who have locked in their current interest rates. Many of these will end up as loans eligible for inclusion in a Fannie Mae securitization of similar mortgages.
**The mortgage salesman’s price is a fractional short-hand for how many 64ths Goldman will pay, in this case the 22+ means 22 and a half/32nds, or 45/64ths, or .703125. This quote assume everyone knows on the buying and selling side knows the ‘handle,’ which is the main price, near par, that the bond will trade at during origination. Newly issued mortgage bonds, like most newly issued bond generally, will trade somewhat near 100, but during periods of rapid interest rate changes this handle could be in the 95 to 105 range. The Well Fargo trader and Goldman salesman will now ahead of time and won’t waste time reviewing this info, until after the trade is done.
***I agree to your price. Not only that, but I agreed to your price so quickly (within a second or so) that you as broker are held to the price even if the market moves against you in the subsequent 10 seconds, or minutes, or days. Goldman is now at risk as a future owner of $750 million in bonds
****Ok, I bought your bonds.
Now back to your regularly-scheduled description of mortgage origination and hedging.]
As Wells Fargo’s mortgage origination supply fluctuates between July and October, Wells may find itself needing to sell more ‘When Issued’ mortgages, or it may buy some back if its mortgage origination supply drops. If mortgages expected to close in October instead actually close in November, then Wells may end up selling fewer mortgages in October and will instead do a trade so that it can deliver them in November.
Delivery, again, is like the futures market for wheat.[2] The farmer, in this case Wells Fargo, anticipates his yield, and manages and hedges his future production by selling his ‘When Issued’ mortgages to Wall Street.
Delivery and Securitization
When October arrives, Wells Fargo delivers its $750 million in conforming[3] mortgages to Goldman. Goldman may then choose to turn over this inventory of raw mortgages to Fannie Mae for securitization as a 4% Fannie Mae bond.
Securitization, the process by which a few thousand similar-vintage mortgages become a tradable bond, is the process that occurs to most home mortgages, further separating the home owner from the bank. Not incidentally, it’s part of what makes our home mortgage rates so affordable.
Let’s say for simplicity’s sake that 2,000 different mortgage loans underlie the $750 million securitization, for an average loan balance of $375,000. They will cluster in interest rate, to the 2,000 homeowners, around 4.375% to 4.5%, and all will generally have ‘closed’ in October 2013. Astute readers will notice the extra 0.375% to 0.5% difference between the homeowner rate and the bond rate. This difference largely gets paid in monthly fees to two different entities, the mortgage bond servicer, and the mortgage insurer. I’ll next explain these two roles in the mortgage securitization market.
The plain-vanilla Mortgage bond
Once the 2,000 underlying mortgages get grouped together and assigned to a structure, and assigned to a mortgage servicer, and guaranteed by the mortgage insurer – Fannie Mae – it becomes a tradable bond. The bond will get registered, with a Cusip and ISIN[4], loaded into Bloomberg for ease of tracking, and assigned a Fannie Mae number. I’ll call this one “FN 8720331.”
Let’s say Goldman next sells this particular FN 8720331 to a Vanguard Fund dedicated to purchasing new mortgage bonds. For the next few years, the Vanguard Fund will receive a combination of principal and interest from FN 8720331.
FN 8720331 is a AAA-rated, safe security. Vanguard will earn 4% on its investment – I’m assuming that’s the coupon of the bond and that it was purchased at par – although the timing of payments is uncertain. If interest rates decline from here, many of the 2,000 homeowners will refinance before 30 years, shortening the ‘average life’ of FN 8720331 to something in the 3 to 7 year range. If instead interest rates rise – as seems more likely – homeowners may realize their 4.5% mortgages is a great rate, and they may not refinance for many years. FN 8720331 may end up as a 10+ year average life bond. Vanguard takes that risk, known as pre-payment risk.
Mortgage Servicer
The mortgage bond servicer earns its fee – a portion of the 0.375% to 0.5% difference between homeowner interest and bond-holder interest – making sure that the monthly mortgage payments of 2,000 homeowners get routed correctly through the structure that pays out monthly to Vanguard. Our theoretical $750 million bond pays a monthly portion of the 4% annual interest plus principal on a mortgage bond.
Just as an individual mortgage paid by a homeowner slowly amortizes – decreases in principal amount owed each month – so too does the servicer of the mortgage bond disburse a portion of underlying principal to Vanguard every month.
This means that 3 years from now our $750 million bond will have partly amortized, let’s say to 70% of its original face amount. Wall Street, if it trades this bond in the future, will still quote the original face amount, but mechanically only 0.7 of money will change hands at the time of a trade between Vanguard and its Wall Street broker. In other words If you want to buy $100 million of this bond – and it still trades at par – you’ll only need to pay $70 million to Vanguard for it, since it trades at a ‘factor’ of 0.7.
Each month the factor gets a little smaller, as each month more of the mortgage bond principal gets paid down. Toward the end of the life of a mortgage bond, you get to a sort of absurd factoring situation, in which only 10% of the bond face value is left, meaning a $1 million bond only has $100,000 principal left.
The mortgage servicer’s process is mostly automated, directing a precise amount toward the interest and principal, but the separation of the principal from the interest is essential.
If a homeowner pays off his mortgage early, or a foreclosure forces a sale of the home and repayment of a mortgage, that larger-than-expected payment shows up for Vanguard as a larger principal payment the next month. The mortgage servicer pre-pays a portion of the principal, reducing the bond factor faster than the original amortization schedule.
For the purposes of creating mortgage derivatives – the technology that makes mortgage lending even more efficient – the mortgage bond servicer separates the interest and principal amounts precisely before passing that on to bond holders. I’ll explain a bit more of that further down, after introducing the role of the mortgage insurer.
Mortgage Insurer
The mortgage insurer, in my example Fannie Mae, also earns a fee every month (a portion of that 0.375% to 0.5%) for guaranteeing loan defaults and loan losses within the portfolio. If a few of the 2,000 loans underlying the bond ‘go bad’ in any given month, Fannie Mae makes up the difference to bond holders owed a fixed amount, their 4% plus principal, every month.
Losses may occur because of delinquency – for example, some of the 2,000 homeowners stop paying on their mortgage for a few months. Fannie Mae makes up the temporary shortfall in funds, guaranteeing no diminishment of payment.
Losses may also occur because of foreclosure – some of the 2,000 homeowners lose their home. A special servicer will work to recover the proceeds of the foreclosure sale and apply that recovered money as an early payment of principal to Vanguard.
Under ordinary times, temporary losses from the 2,000 mortgages in non-payment remain relatively light. At any given time only a few homeowners are delinquent on their payments, and many of these resume payment as the homeowners stabilize their finances, or the house gets sold. In addition, bond holder losses due to foreclosure are typically not catastrophic, given that a 20% down-payment cushions bond holders from taking a loss, even when the house gets foreclosed upon.
Fannie Mae, and its close cousin Freddie Mac found this mortgage insurance business extremely profitable, for many years, leading up to the Crisis of 2008.
Under ordinary times, Fannie and Freddie were like insurance companies offering health insurance for 20-30 year-olds. Hardly anyone got sick. The occasional kid decided to ride a motorcycle and amassed huge fees after cracking his head open, but the majority of people never even saw a doctor. Fannie and Freddie collected fees for doing next to nothing.
Obviously, this comfortable arrangement all changed in 2008.
[1] My managing editor (aka wife) points out that nobody outside of Wall Street or farmers knows what commodity futures are either, so my analogy is about as useful as a bicycle is to a fish. But since that is an analogy everyone remembers from that U2 song, at least we have some pop culture reference in here somewhere. Right then, so, we cool?
[2] Which, again, I can’t really explain if you still have no idea what I’m talking about. But remember the orange juice plot line in Trading Places? That was the futures market for another commodity, recently explained here. The price of the future bond fluctuates in anticipation of future supply and demand. Like the most active part of the mortgage bond market.
[3] “Conforming” is distinguished from “Jumbo” mortgages by size. In most cases the current conforming loan needs to be smaller than a set limit, currently somewhere between $417K and $625,500 depending on local real estate prices.
[4] All securities get assigned these registration numbers for tracking purposes.
