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Value Talk: What Happened?... Financial Engineers... Quant Funds... Lesson Learned

September 23, 2007
Charles Mizrahi

Charles Mizrahi

19 followers

Value Talk: What Happened?... Financial Engineers... Quant Funds... Lesson Learned

After a year of trying, 24-year-old Warren Buffett finally landed his dream job, which was to work for his mentor and teacher Benjamin Graham. Buffett came to New York with his wife, Susie, who was pregnant with their second child. Graham helped Buffett land a position at Scarsdale High School teaching an adult education class on investments. Those in the class recall Buffett telling them that he was going to share with them the secret of how to become rich. He told them to first close the door and windows. He then whispered that the secret to wealth is “to be greedy when others are fearful and fearful when others are greedy.”

As simple and as basic as that advice sounds, few investors follow it, and I can hardly blame them. Studies have shown that humans are wired to act in irrational ways when faced with fear. If our caveman ancestors did not have fear when faced with a charging saber-toothed tiger, they would have ended up as the feline’s lunch. Evolution has wired us for self-preservation. This allows us to run away and live to fight another day. The investor who is able to keep his head when those around him are losing theirs will reap large rewards as markets come back to normal.

Over the past several weeks, world markets have been in panic mode. Many point to the beginning of the panic as having started on July 18. It was then that Bear Stearns, a leading investment bank and brokerage firm,admitted that they could not figure out how much money two of their hedge funds had lost. Less than two weeks later, the funds filed for bankruptcy protection, losing 91 percent in one fund and 100 percent in the other.Bear Stearns’problem soon became a world market problem as fear spread at lightning speed,and both equity and credit markets suffered sharp losses and volatile trading.

What Happened?

As a value investor, it is very important to review what happened over the past few weeks and try to glean any lessons from this debacle. The purpose is not to gloat over others’misfortune,but to gain insight as to how we can take advantage of market inefficiencies.

The first part of our quest is to try to determine how Bear Stearns’hedge funds suffered such devastating losses. We also need to understand what they invested in,why they couldn’t figure out how bad the situation was and how the problem spread. Before we do that, I want to look back at the past two decades and identify four economic bubbles that are crucial to our discussion. An economic bubble occurs when speculation in a commodity or security causes prices to increase, thus producing more speculation. The price of the commodity or security then reaches absurd levels. The bubble is usually followed by a sudden drop in prices,known as a crash.

The four economic bubbles over the past 20 years

* Late 1980s: Japanese stocks
* Mid-1990s: EastAsian stocks and real estate
* Late 1990s: U.S. and European stock markets
* Mid-2000s: Housing market in U.S. and other developed countries

We are currently witnessing the unraveling of the housing market bubble. Over the past several years, buying houses became the rage. Everyone knew someone who bought a house, condo or co-op and then “flipped” it to another buyer and made a year’s income in less than a week. In most cases, all one needed to put down was 5 percent of the purchase price and banks, mortgage companies, builders, etc., were more than happy to lend buyers the rest. A low credit score or a history of bankruptcy was no impediment,either, as lenders charged higher interest rates to those borrowers referred to as subprime. Lenders reasoned that the real estate would continue to appreciate and they could always take it back from the borrower and sell it at a higher price. Financial Engineers

During this time of easy credit, money market interest rates were way down as well. Most money markets were paying between 3 and 4 percent annually. Not satisfied with such low returns, investors turned to hedge funds, which were able to invest in almost anything to increase their returns. Wall Street investment banks saw this as an opportunity and created complex instruments that offered high returns with virtually no risk to feed the demand. Without getting too technical, Wall Street created financial derivates such as collateralized mortgage obligations (CMOs) and collateralized debt obligations (CDOs), which paid much higher interest rates than money markets and were also considered virtually risk-free.

These financial derivatives were gobbled up by yield-hungry hedge funds and institutions. In order to increase returns even more, hedge funds were able to borrow from brokers up to 10 times the face value of these newfangled derivatives. A hedge fund would now be able to purchase an 8 percent CMO, borrow against it and, after paying all costs and transaction fees, return in the mid-teens to investors. This was the best thing since sliced bread. Like all good things, this, too,would soon end. The CMO, which was a complex bundle of mortgages packed into one security backed by real estate, and the CDO, which was a complex bet on how many borrowers would repay the money lent to them to buy their homes, hit a brick wall. Data started to show that borrowers were beginning to default on their mortgages. This had a daisy-chain effect as brokers that lent money to the hedge funds marked down the values of the CMO and CDO. Since hedge funds leveraged them very highly, small downward repricings were amplified. A 5 percent markdown with 3:1 leverage now turned into a 15 percent lower value. Brokers told the hedge funds they needed to put up more cash immediately, as the value of the derivative was marked down.

In order to raise the cash, hedge fund managers tried to sell these derivatives but found out that many other funds were facing the same problem. There were too many sellers and no buyers! To complicate matters more, no one really knew how much they were worth. As the value of the collateral (real estate) went down and the default rate (borrowers not paying back) went up, valuing them was like trying to catch a greased pig; you really can’t hold it for long. Since managers couldn’t sell them and needed to raise cash in a hurry, they began to sell their portfolios of stocks. As more managers began selling stocks, stock prices moved lower, resulting in more sales in order to raise cash, resulting in even lower stock prices. The contagion then spread across world markets, and in a very short span of time, prices of stocks plunged. If that wasn’t bad enough, this selling sparked another event that made matters go from bad to worse.

Quant Funds

Not widely known to the public is an investing style known as quantitative investing. Math Ph.D.’s and computer scientists use complex computer models to make trading decisions. Some of the smartest and best-regarded investors used this approach to produce eye-popping returns over the past several years. Quant funds have computers scan world markets looking for small anomalies among different securities and then leverage them to turn small gains into large ones. It is said that two giant quant funds account for more than 50 percent of the daily volume on the NewYork Stock Exchange. Over the past week, quant funds suffered a rude awakening. Events were not happening the way the computer models said they would. Since the financial derivatives at the heart of the global credit crunch did not exist 10 years ago, the computer models used to trade markets couldn’t account for them and how they would behave. Goldman Sachs, one ofWall Street’s smartest players, had losses of 30 percent in one of their quant funds in only one week. The recent market moves were labeled as a “25-standard deviation event,” which means that such an event should happen only once every 100,000 years.

While the picture is still developing, here is what happened to quant funds over the past few weeks. Losses on CMOs and CDOs forced hedge fund managers to sell them as brokers demanded more cash. Pricing these derivatives was next to impossible and buyers couldn’t be found. In panic mode, hedge fund managers began selling the most liquid, fundamentally sound stocks in their portfolios at any price. Quant funds took a hit as their computer models never accounted for such a distortion; blue chip companies plunged while less financially worthy stocks held their own. That in turn forced quant funds to suffer loses and de-leverage their portfolios as brokers demanded they put up more cash.

Lesson Learned

Recent market plunges have clearly demonstrated that, at times, the stock market is very inefficient. A company’s fundamentals go out the window as panic sets in and investors need to sell at any price in order to raise cash. Here are a few lessons that you should keep in mind in order to profit from Mr.Market’s chaos.

1.Understand what you are investing in. It strikes me as ludicrous that it took Bear Stearns’ Asset Management team close to two weeks to figure out that securities in their hedge funds were worthless. Sadly, this was not the first time financial wizards were not able to calculate their losses. American Express lost $826 million investing in complex derivatives in 2001 and later admitted they “did not comprehend the risk.” If you can’t understand the investment, you are playing with fire by investing in it.

2. Use Mr. Market to serve you, not guide you. Much of the recent markdown in stock prices of great companies has nothing to do with fundamentals. Many of these companies are reporting record earnings, yet they have seen their stock price fall 15 to 20 percent. Many companies that have no exposure to this derivative mess have seen their stock prices fall sharply. I have already shown you how stock prices over the last few weeks have little in common with the fundamental of the company. If you know the value of the company, don’t pay attention to the daily gyrations of the stock market. Over the long term, it is the earnings of the company that determine its value.

Regardless of the short-term price swings that we are seeing, buying great companies at attractive prices still makes all the sense in the world to me.

 

 

About the author:

Charles Mizrahi
GuruFocus - Stock Picks and Market Insight of Gurus

Rating: 3.3/5 (29 votes)

Comments

hameed
Hameed - 6 years ago
This last comment of yours is extremely important - "Regardless of the short-term price swings that we are seeing, buying great companies at attractive prices still makes all the sense in the world to me."

Now which particular great companies are trading at very attractive prices? How do you determine intrinsic value?
commodity
Commodity - 6 years ago
Things are not that simple in life.

Warren Buffett is a genius most people are not.

Finding true value is not easy.

Seeing value is not easy.

Avoiding value traps is not easy.

However ,you can buy LUK. Easy as pie.

Please leave your comment:


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