Wednesday, January 23, 2008

No Fiduciary Mulligans

Many unsuspecting investment fiduciaries will be forced to pick up some pieces of their portfolios resulting from the breakage of the housing bubble and the structured investment and credit market collapse. While most prefer to spend their resources looking ahead, all should look back over this episode and try to learn something about they can improve of modify their investment philosophy and/or investment allocation and selection practice.

The Federal Reserve Bank of New York recently hosted a Liquidity Conference to go through this process. Reflective fiduciaries can take advantage of some esteemed thinking in this area. I have provided 3 examples of work that can be found at their conference site.

Understanding the Subprime Mortgage Crisis
"We find that during the explosive growth of the subprime market in 2001-2006 the quality of loans monotonically deteriorated and underwriting criteria loosened. In this respect, the rise and fall of the subprime market resembles a classic
lending boom-bust scenario, in which unsustainable growth leads to the collapse of the market. We show that the
problems in the subprime market were imminent long before the crisis in 2007, securitizers were to some extent aware of it,
but a high house price appreciation in 2003{2005 masked the true riskiness of subprime mortgages."

Understanding the Securitization of SubPrime Credit

"In this paper we provide an overview of the subprime mortgage securitization process and the seven key informational frictions which arise. We discuss how market participants work to minimize these frictions and speculate on how this process broke down. We continue with a complete picture of the subprime borrower and the subprime loan, discussing both predatory borrowing and predatory lending. We present the key structural features of a typical subprime securitization, document how the rating agencies assign credit ratings to mortgagebacked securities, and outline how the agencies monitor the performance of mortgage pools over time."

What Happened to the Quants provides the following conclusions:
"A small random shock in the global financial system can propogate rapidly"
"certain hedge funds and investment strategies may be more correlated than assumed", and
"regulations and registration may not address the systemic risks that hedge funds pose to the global financial system"

Unfortunately, fiduciary responsibility doesn't provide for mulligans. Fiduciaries should take full advantage of the unique clarity that is only provided by direct experience and hindsight to understand what happened to their investments. This will yield dividends in their futre decision making process.


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