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Once, in San Francisco, I saw a guy (long hair, flip flops) wearing a t-shirt with “Google is SkyNet” written on it. For those not up on their terminator-ania, SkyNet is the computer system that runs amok and starts a nuclear war, necessitating four sequels-worth of to-ing and fro-ing through time. The plot of all three terminator movies is driven by our heros trying to destroy a big computer before it ends the world. The first movie came out in 1984 (when companies had UnNecessary CapitaliZations in their names) and the second clanked and whistled into theatres in 1991, and in between, a real, giant computer system almost destroyed the financial system.
Portfolio insurance, devised by two UC Berkeley finance professors, works on the idea that an institution with a large, diversified portfolio can hedge its exposure to market downturns by engaging in a little time travel – in the stock index futures market. Thus, if your portfolio is so large that it represents the whole stock market, you can take the opposite position by trading stock index futures. The trading is done by computers, using Black-Scholes and other options-pricing arcana, to decide when to buy and sell (this is called “dynamic hedging”).
LOR, the first portfolio insurer (and the creation of those finance professors I mentioned), was organized in 1980. The company was so successful that it soon had imitators and by 1987, the three largest portfolio insurers were “insuring” $60 billion in investments. I put insuring in quotes because portfolio insurance isn’t really insurance – it’s an investment strategy (hello, FTC!) and in October of 1987, the “insured” discovered the negating power of those quotation marks.
In October of 1987, computer trading converted a market downturn into the most severe one-week decline in the history of US stock markets. In mid-October of 1987 there were a couple of gloomy economic indicators – a high trade deficit, a proposed tax law that made a number of pending mergers unprofitable – and the stock market started to decline. Eventually, the losses told the portfolio insurance computers to start selling stock index futures and because they were all using the same strategy, they all started selling at the same time – “on October 19, sell programs by three portfolio insurers accounted for just under $2 billion in the stock market; in the futures market three portfolio insurers accounted for the equivalent in value of $2.8 billion in stock.” So said The Report of the Presidential Task Force on Market Mechanisms in its after-action report (known as the “Brady Report”). Other computers, belonging to arbitrage traders, noted the price difference between the stock market and the futures market and started doing a little automated trading of their own.
The Brady Report’s conclusion was that the portfolio insurers, et al, failed to realize that “from an economic viewpoint, what have traditionally been seen as separate markets – are in fact one market.” Thus, a price drop in one market is quickly transmitted to the other. “As the data … make clear, the market’s break was exacerbated by the failure of institutions employing portfolio insurance strategies to understand that the markets in which various instruments trade are economically linked.”
For $6.95 you can buy the HBR case study where the founders of LOR try to decide what to do next with their business.
Also, just a quick mention of the fabulous and wonderful Treasury Library Consortium on archive.org. An expanding wealth of great information!
Feelin’ Dirty
I don’t have access to Westlaw anymore. So these days, through my membership at the Social Law Library, I have been rediscovering the myriad joys of HeinOnline. Yesterday, I stumbled upon an article from a 1982 Law Library Journal titled Research in Securities Regulation: access to sources of the law (75 Law Libr. J. 98, 1982) by Mark A. Sargent and Emily R. Greenberg.
You’d think an article of such advanced vintage would be mostly of historical interest (and prurient, Mark Sargent recently resigned as Dean of the Villanova law school in a prostitution scandal), but that isn’t the case. The first five pages are a great introduction to securities law research and starting on page 109 there’s a guide to using the CCH Securities Law Reporter (if you’re doing securities research and not using the CCH, you’re wasting your client’s money). Also, aside from a weird tendency to transpose the first initials of authors, the treatise section is still useful. Many of the books mentioned, Takeovers and Freezeouts (by Ertie Lipton), and Securities Fraud and Commodities Fraud, by Balan Lowenberg and Alewis Lowenfels for instance, are still in print. Sorry – that was such a cheap shot. I feel dirty.
Closed Doors
Good morning, librarian! Unless something has changed, this morning you will still won’t be able to find the new version of the Senate’s financial reform bill (promised by the Wall Street Journal on Tuesday morning). Last time I checked (11pm, March 4th) the Senate Banking Committee was still trying to hash out the details.
Wait! It gets better! According to Reuters, the administration has prepared some kind of draft legislation that would put into place elements of the so-called Volcker Rule. This document has also failed to surface. If you’d like the see the latest, I recommend avoiding the page marked “the latest” on financialstability.gov
OpenCongress.org has a good summary of the documents that have been made public. They’re mostly from November. You weren’t holding your breath, were you?
SEC Open Meeting Report – quotes
The Schapiro SEC is enamored of coining new terms and the last open meeting was no exception. Thus my profligate use of quotation marks in the post that follows.
At last week’s open meeting, the SEC adopted one of the “alternative” uptick rule proposals. For those who can’t remember back to April, when these rules were floated – the old, non-alternative uptick rule forbade short selling on a falling stock – you know, like that cartoon where Yosemite Sam goes off the end of a diving board and Bugs Bunny hands him an anvil? The old uptick, repealed under Chris Cox, could potentially have slowed the bank runs that destroyed Bear Stearns and Lehman Brothers. The new, alternative uptick rule (Rule 201) has a “circuit breaker” that cuts off short selling, for the rest of the day, if a stock’s price falls 10%. Exchanges have six months to adopt rules implementing 201. Click here for more.
Also discussed, but not made public, was a “Work Plan” for studying “convergence.” Convergence is what happens when the US starts using international accounting standards. Apparently, in 2011 the SEC is going to decide whether convergence is a good idea. The Work Plan is supposed to get the agency to the point where they can make and intelligent decision (always a good thing). Click here for more.
Superlatives
A librarian at Harvard Business School mentioned to me that she has often found pre-SEC prospectuses in old newspapers. “Are these notices like tombstones?” I naively inquired – she sent me a sample. Wow. Even with the advent of the Free Writing Prospectus we still have far to go before we’re back in the day of: “the best investment ever offered to the American public!” – that would be the American De Forest Wireless Russo-Japanese War News Service, pitched on June 16, 1904 in the New York Daily Tribune. Another iron-clad money maker was The Mexican Plantation Co. The company’s underwriter, W.E. Pentz & Co., took out an ad in the January 1, 1899 New York Daily Tribune to proclaim that “we have carefully investigated this business and recommend it as … the finest we have ever handled.” For those still harboring doubts, Pentz & Co. offered a more scientific assessment of the Plantation Co.’s prospects, “other companies doing practically the same business have been … declaring dividends from 100 to 300 per cent per annum.” Where’s my checkbook?
To see more, check Library of Congress historical newspaper collection:
http://chroniclingamerica.loc.gov/search/pages/
The Past – Still a Foreign Country
Last week, my foray into economic research about the 1920’s real estate market led me to NBER Working Paper 15573, “Lessons From the Great American Real Estate Boom and Bust of the 1920’s,” by Eugene N. White, a particularly florid example of the limits of using the past to understand the present. White (like Goetzmann) observes that the bubble in US real estate prices that popped in 1926 shared many similarities with the 2008 real estate market crash. White also notes that although the 1926 real estate market crash was bad for the real estate sector, it didn’t take the banking system down with it. So, he concludes, if we can isolate the differences between 1926 and 2008, we can figure out why the 2008 real estate market collapse also took down the US banking system. Then, he lists the purported causes of the 2008 collapse, eliminates the factors not present in 1926, (FDIC insurance and a public policy of encouraging home ownership) and voila!
Political axe grinding aside, the paper contains a trove of interesting information about the 1920’s real estate market. One of the entities that White unearths is yet another multi-tasking real estate thingy called a private mortgage insurance company (specialization appears to be one of the great advancements of post-Depression finance). Private mortgage insurers offered default insurance, but they also acted as mortgage originators and sponsors of a variety of real estate securities (including “participation certificates” backed by mortgage pools).
The private mortgage insurance business was invented in New York in the late 19th century and thanks to what appears to have been complete regulatory capture, these companies convinced the New York legislature to legalize and gradually deregulate their industry between 1904 and 1924. The business grew from one company in 1887 (Title Guarantee Company of Rochester) to 50 by 1929. In the period following the crash of 1929 these companies began going out of business. The “Alger Report” in 1934 portrayed the industry as essentially criminal and New York outlawed default insurance in 1938.
Interestingly, although the PMI industry was under no obligation to align their cash reserves with the value of mortgages they insured, they appear to have done so. Table 6 in White’s paper (using data derived from the Alger Report) shows a consistent 10-to-1 ratio of insured debt-to-assets that doesn’t change when new companies enter the business or as real estate values decline. I have trouble squaring this careful maintenance of capital ratios with the contemporaneous portrayal of the industry as shady, or worse. Robert Moses, for instance, resigned from the board of the New York Title Insurance Company and then wrote to the New York State Insurance Commissioner to complain. He had no desire, he wrote, “to have my name used to make a bad thing look good.” (Moses Denounces the Alger Report, New York Times, October 9, 1934)
For More See:
Herzog, History of Mortgage Finance With and Emphasis on Mortgage Insurance (2009)
Canner, Private Mortgage Insurance, 80 Fed Res Bull 883 (1994)
Browne, The Private Mortgage Industry, The Thrift Industry, and the Secondary Mortgage Market, 12 Akron L Rev 631 (1978-1979)
Johnson, Regulation of Private Mortgage Insurance, C.P.C.U. Annals 92 (1974)
Alger, Report to His Excellency Herbert H. Lehman, Governor of New York (1934)
Chapter 543, Laws of New York, 1904
Chapter 525, Laws of New York, 1911
New Asset-Backed Securities Recording
I just posted the latest installment in my series on asset securitization. Before you go to the main recording page to listen to part B: Meet the Parties, please grab a copy of the July 27th 424B5 prospectus supplement filed by Lehman Mortgage Trust 2007-7 (CIK 0001405723) on August 1, 2007. This link will take you to that document’s index page at sec.gov.
Book Review: The Myth of the Rational Market
In The Myth of the Rational Market, Justin Fox, Time Magazine’s business and economics columnist, provides a brief and entertaining history of economic theory since the great depression. In deference to non-business types like me he manages to tell the story without using math. This is astonishing because after reading the book I really feel I understand, for instance, why efficient market types aren’t interested in psychology (”Rabbi economics,” sniffed Myron Scholes), or why it was an important leap forward when Larry Summers pointed out that most investors are “idiots.”
Unfinished Business, part 1
In December, when I was laid off, I was in the middle of presenting a series of securities law classes. I’d done parts 1 and 2 in a number of places around the country, but I never got to do part 3 (except in Houston – hello, Houston!). So, because so many people invested so much of their time sitting through parts 1 and 2 and because I don’t like to leave things unfinished, I am posting part 3 here as a series of audio recordings. This first piece is about the creation of the asset-backed securities market. Click below to listen. I hope you enjoy it! More to come, soon!
Part A: Introduction to Asset-Backed Securitization
More Asymmetry from the 1920’s: real estate exchanges
In 1899 a newly organized company called the New York Realty, Bond, Exchange and Trust Company (Bond Exchange) bought a building on Liberty Street, on a lot now occupied by a huge black glass tower (there’s a big red cube in front – you know the one?), called the Real Estate Exchange Building. The Real Estate Exchange Building had been home to an auction house for real estate brokers that failed because it set its commission rates too high.
The Bond Exchange was a wildly ambitious and diversified real estate business. It aimed “to assist in making real estate negotiable and useful as a collateral” by engaging in a wide variety of ventures including “an exchange for … the purpose of dealing … all manner of securities based upon real estate values.” (Real Estate Exchange, New York Times, May 11, 1899) In addition to establishing that real estate securities existed in the nineteenth century, this is the earliest articulation I could find of the desire to inject more liquidity into the real estate market by creating an exchange for real estate securities. As Time Magazine put it in 1929, “the realtor handles an excellent product but is handicapped by a primitive distribution system.” (Unfreezing Assets, Time, 8/12/1929)
Thus, when trading started, on December 16, 1929, on the New York Real Estate Securities Exchange (Exchange) it was the culmination of the long-held dream of many real estate developers. (Securities Exchange Marks New Era For Real Estate, New York Times, 12/8/29) The Real Estate Board of New York, the organization behind the Exchange, first floated the idea of creating an exchange for real estate securities in 1913. (Realty Exchange Studied For Years, New York Times, 9/15/1929) The idea languished during the red-hot real estate market of the 1920’s, but got dusted off in 1928 when the market for real estate securities started to collapse – “money has been tight, credit high, realtors embarrassed. So the exchange idea was revived.” (Time, id)
The Exchange was formally organized in November of 1928 and trading was scheduled to start in October of 1929. As October of 1929 wasn’t the most salubrious time to start a stock exchange, the real estate developers had to wait until December to get their venture off the ground. Responding to the public’s desire for safe, stable investments the Exchange promoted itself as regulator, clearinghouse, and research analyst – “the Exchange will guarantee the validity of the securities listed, will appraise property values, investigate financial conditions … and provide the investor with reliable and impartial information on his prospective investments.” (Time, id)
Unfortunately, the Exchange was doomed from the start – there was no stopping the real estate securities market collapsing under the weight of a decade of irresponsible growth. In 1941 the Exchange withdrew its SEC registration. (Exchange Drops Registry, New York Times, 6/6/41)
