Current Newsletter (March 2008)

Director's Comments

A Day Late and a Dollar Short

As the sub prime crisis has evolved over the past several months, I have been asked by several of my fellow academics and practitioners why CISDM, or other academic centers who focus on alternative investments, failed to warn the public as to the potential risks associated with the creation of investment structures which depended on sub prime mortgages as form of investment.

My first reaction was to remind them of the classic retort that if I was smart enough to forecast with certainty the future I would not make my living as a relatively poorly paid academic. I refrained from doing so, out of the good sense that I still had a job and in some cases they did not. The fact that there job was often to make ‘tactical’ bets on the future of mortgage markets and mind was not discussed either.

What I did remind them was the fact, that academics and practitioners had in fact pointed out the potential risks for these instruments. For example, Brett Hellerman in an article in the Journal of Alternative Investments (The official journal of the CAIA and for which I am the Editor) in the Spring, 2004 issue pointed out:

“Hedge fund investors prefer transparency and they want mark-to-market pricing. In most asset classes this is easy. Markets are transparent and liquid….For fixed income securities-and especially mortgage –backed securities- however, the issue is not so clear-cut. These securities trade over the counter. There is no centralized market that can be sourced to price them. ….Accurate pricing is a big problem for mortgage hedge fund managers, indeed the major problem in their business. “(page 90). Brett continues that “Many investors can “just say no” to mortgages and they do. Non-transparent pricing is just one of the many reasons to hate them …notorious mortgages fund blow-ups of the past decade are others. (page 90).

Obviously, many of my associates had failed to read Brett’s comments or if they did they failed to understand that ‘in any risky’ investment there is the probability of loss given the possibility of certain negative events. The problem is that each of us has different loss functions related to this possibility of negative events. For academics, the risks of mortgage backed bonds are a positive with many potential articles in the wings. For dealers, the long term risks of mortgage back securities are of little consequence. Dealers will buy or sell bonds simply on their ability to resell the bond. This is the current price under a very limited set of liquidity conditions. Under an entire different set of conditions, the price is different.

People must come to appreciate that there is no “one’ price for a bond. There is a current price given current market demand and supply conditions. Some people (dealers) will buy to sell or individuals will buy do hold but each hopes the price will change to their benefit (e.g., in this case Paulson made the right choice ex post). But the every risk that enables on to make money on an investment is the very risk that one can loose. Even the assurance of a rating does not alter the situation. Both academics and practitioners know that ratings are a poor measure of market risk.

I appreciate the fact that we all want a cheap option. If I loose I have to blame someone, academics, hedge funds, market makers, my aunt, someone…. but as it is pointed out “saying it so don’t make it so”. In this case many investors should have, could have, would have if they had only remembered ‘Finance 101’.

In this case they were a Day Late and a Dollar Short. Stop blaming others for a risk gone bad and as my Dad would say, ‘pick yourself up and get back on the horse’ and start to get somewhere else. A lost investment is a train that has left the building.

Thomas Schneeweis
Director/CISDM