Wall Street has a strong incentive to create new products for investors to trade in, but not so much incentive to make sure that they are high-quality stores of value in the long run. In this piece, I want to dive into history and look at a notable "investor fad" that had its place in the sun a few decades ago, a topic which was explored by Seth Klarman in his book "Margin of Safety."
When the whole is more than the sum of its parts
Mortgage-backed securities got their start in the late 1970s at Salomon Brothers. If you would like to know more about the backstory of all this, Michael Lewis’s excellent book "Liar’s Poker" provides a first-person account into the sometimes exciting, often sordid history of this institution, as well as the creation of mortgage-backed securities (Lewis worked at Salomon in the 1980s). This book layed the groundwork for Lewis to write "The Big Short" decades later.
Two interesting financial oddities that were very popular in the 1980s were the hybrid mortgage securities. If you’ve ever taken out a mortgage (or any loan), you will know that there is the principal (the initial sum loaned that must be repaid) and the interest (the "rent" you pay to compensate the lender for borrowing their money). When mortgages were first packed together and sold to outside investors en masse, investors owning the bonds would receive both principal repayments and interest payments.
At some point, an exciting new set of hybrid products was created: interest only (IOs) and principal only (POs). The financial engineers at Salomon had stripped apart the traditional mortgage backed security and created two new instruments to cater to two different types of investor. Of course, as with many financial (and non-financial) innovations, many investors had to be convinced that this was something that they actually needed by the salespeople at Salomon (of whom Lewis was one, although he worked on the corporate bond desk, not the mortgage bond desk).
Without going too deeply into the technicalities of how these complex instruments behave, I'll just say that IOs and POs reacted differently to interest rate changes, and they behaved differently to the original "whole" mortgage backed securities. Now, in theory, there is no problem with this - if you are an investor, you could just figure out what you need and build your bond portfolio accordingly.
In practice, however, these hapless investors were at the mercy of the traders at Salomon who understood the real value of these new securities far better than their customers (although, to be fair, not everyone at Salomon knew what they were doing either). They ended up paying a substantial premium to fair value. To make matters worse, it quickly turned out that the IOs and POs were worth less as two separate entities than they were as a single one; many investors had assumed that the whole would equal the sum of the parts.
This historical incident should act as both an illustration of Klarman’s argument that financial innovation is not always good for clients and investors and as yet another warning to ordinary savers and investors.
Disclosure: The author owns no stocks mentioned.
Read more here:
- Seth Klarman: Is Financial Innovation Good for Investors?
- Why Are Big Financial Institutions Almost Always Bullish?
- Seth Klarman: Why Institutional Investors Lose Money
Not a Premium Member of GuruFocus? Sign up for a free 7-day trial here.
