Tuesday, July 28, 2009

Toxic assets anyone?

You can be a vulture too :-)

Free leverage from Uncle Sam! What's not to like?

WSJ: ... New York-based fund giant BlackRock is launching a closed-end mutual fund aimed at allowing ordinary investors to put their money into the kind of toxic mortgage-backed securities that nearly brought down the financial system a few months ago. Shares are expected to go on sale in about a month.

The BlackRock Legacy Securities Public-Private Trust, which may raise up to about $1 billion, will be sold through brokers and advisers. It will try to buy mortgage-backed securities at distressed prices from banks looking to shore up their battered balance sheets. The fund will invest alongside the U.S. Treasury as part of the Public-Private Investment Partnership, or PPIP, launched earlier this year. BlackRock is among a small group of firms picked to take part in PPIP.

... The fund will also benefit from helpful financial engineering courtesy of the U.S. government. PPIP was set up to encourage private investors to help bail out the financial system. So for every dollar invested, Uncle Sam will provide another $2—$1 in equity and $1 in debt. The debt’s cheap, too: about two percentage points over the LIBOR interbank rate. That should boost returns.

Sources are hoping that, when you factor in the financial engineering, the fund will be able to earn maybe 10-12% annually over its ten-year life.

... “For now, the bulk of toxic assets are not going to be in play,” Harvard law professor Lucian Bebchuk, one of the intellectual architects of PPIP, told me. Changes to accounting rules and government stress tests, have taken off some of the pressure off banks, so Professor Bebchuk says banks are not as motivated to sell their toxic assets as they were when PPIP was set up in March. “For many types of toxic assets, even if the banks can get a price that’s fair, if it’s at a discount to face value they don’t have an incentive to do it,” he says.

Furthermore, thanks to the stock market rally the banks are feeling more confident—and have a lot more access to capital.

... Meanwhile, the fundamentals of MBS continue to worsen. Fitch Ratings says 6.8% of (non-agency) prime mortgages are now delinquent—twice as many as were delinquent six months ago. The figures for Alt-A are 21%, and for sub-prime, 40%. They’re still getting worse. Fitch director Grant Bailey says mortgage delinquency rates won’t stabilize until house prices and unemployment rates do.


Carson C. Chow said...

Hey Steve,

You never answered my question: Is compensation so high because of alpha or barrier to entry?

Steve Hsu said...

It's a hard question and I don't have a good answer.

I don't think it's genuine alpha in most cases. Alpha is too hard to measure.

Let's take a narrower question: take some particular hedge fund category or perhaps VC. Why is compensation 2 and 20? Who decided that? Is it really market forces? (Slightly less attractive funds charge their investors a bit less; others can charge more...)

Even if 2/20 is established in a competitive market, couldn't there be a "bubble" in pricing financial services? Investors might be overpaying for all kinds of reasons -- they might just be collectively wrong about the value; perhaps they could get equally good returns from cheaper managers. Check out William Bernstein at efficientfrontier.com I think he charges something like .3 percent.

I have no reason to think that the collective is any better at predicting the future alpha of some PM/VC than they are at predicting other complicated things.

In 50 years people might look back and wonder why investors (and society) were such suckers for financial hucksterism. Or, alternatively, in condensed matter theory power law fairy tale fashion we'll find some "universal law" of the cost of financial services that supports 2 and 20 ;-)

Nicolas said...

I too think the main pb is what do you call alpha.

alpha only exists in a linear world of gaussian distributed yields, and linear combination thereof. that is problematic in the age of options.

basic example : say you sell deep out of the money puts. you accrue some money through time by selling away protection, until some big event happens where you blow up.

the "good" part of your results will have positive expectancy, with a tiny variance. nice alpha (or sharp) will your investors say. until they see the other part.

Such multimodal distributions can not be properly accounted for with "alpha" afaik.

ps: 2/20 might be what investors are charged, but compensation of employees varies. it can be from 5pct to 25 for big stars.

anon said...

It is both.

1) Finding alpha is much more "capital intensive" than it used to be with capital in the form of super computers and software.

2) The largest IBs have great brand power.

It is niether.

A small percentage of a very large sum of money is still a large sum of money.

To call the income of these people "compensation" is a bit misleading. They deal in surplus value.

Carson C. Chow said...


Thanks for the responses. I was using alpha in a generic way to imply a skill or talent that was rare. So in that sense the ability to con people would be alpha. What I gather from your comments is that the barrier to entry is more psychological than regulatory.

I'm not sure I completely buy that. Let's leave out hedge funds for now since they didn't get bailed out and people complain less about their incomes. What I'm really interested in is why people in investment banks make so much money. Are they really that much more talented than a chemical engineer or an academic applied mathematician? Certainly for regular banking the government grants a monopoly to lend money. It seems to me that there is an advantage to being large if you are an investment bank because you can make bigger deals and absorb bigger losses (and also get bailed out because you're too big to fail). Hence, that provides a barrier to entry for other players. In that sense, the large compensation (surplus value if you wish) arises because of the knapsack problem: in order to compete you have to be big and there are only so many big players that can fit in the market. The market would have to grow for another player to enter, so in essence there is a effective monopoly granted to the existing players. If that is why the compensations are so high then I think that regulation limiting the size of the institutions would help. Big deals would then require collaboration between smaller entities. This would allow more competition and should then decrease compensation. What do you think?

Nicolas said...

I better see what you mean, carson.

I would say there are many factors pushing compensation higher.

The notion of alpha (or skills) is very debatable. Since this is a communicable property (to managers, investors, whoever) that many want to claim, it is very noisy. More often than not, it is an a posteriori justification for compensation, not a real cause.

A few factors pushing up compensation I would say were (are) :

- employees can leave easily. since the business is mostly know-how, they leave with your business. that's unlike, say, an airline company where progress are slow, linked to long term commercial alliances, etc...
When profitable, you want to secure the team and not have to rebuild an new one which will take you a precious time.. and give some to competition.

- banks prefer to pay a higher price for people managing important stakes. This is because the price of having the wrong person is much higher than the higher salary paid to hire the correct one.

To some extent, those factors relates not to the skills themselves, but with sensitivities of the salary to the business environment.

anon said...

I'll try to be clearer.

The reason for the high "compensation" at IBs is the same reason for the high compensation of real estate developers. That is, investment bankers and real estate developers and hedge fund managers deal in large amounts of money. The cost of their services is a sliver of these large sums. The sums are so large that the sliver is also large.

Carson C. Chow said...

I think I finally understand. Compensation is not the problem at all. The real question is why investment banks make so much money in the first place. Clearly they can only make so much money because there is an effective barrier to entry that gives them a monopoly. We should ensure more competition in investment banking, not how much they pay their employees.

freelikebeer said...

We should ensure more competition in investment banking

I don't think this will work. In investing, having more money than other people is power in and of itself. It is the strategically sensible thing to do to throw your lot in with a bunch of other people so you can collectively exercise market power [in lieu of actually having to exercise your speculative skill].

The barrier to entry is in actually finding enough people with enough cash to be competitive. Commercial banks have the luxury of deposits. Investment banks have the luxury of already sitting on big cash stockpiles.

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