The thing is that nobody has enough brain power to question every assumption, to think about every single facet of an investment. There are certain things you need to take for granted. And people would take for granted the idea that, "OK, something that Moody's rates triple-A must be money-good, so I'm going to worry about the other things I'm investing in, but when it comes time to say, ‘Where am I going to put my cash?,' I'll just leave it in triple-A commercial paper, I don't have time to think about everything." It could be the case that, yeah, the power's going to fail in my office, and maybe the water supply is going to fail, and I should plan for that, but you only have so much brain power, so you think about what you think are the relevant factors, the factors that are likely to change. But often some of those assumptions that you make are wrong.
n+1: So the Moody's ratings were like the water running...
HFM: Exactly. Triple-A is triple-A. But there were people who made a ton of money in the sub-prime crisis because they looked at the collateral that underlay a lot of these CDOs [collateralized debt obligations] and commercial paper programs that were highly rated and they said, "Wait a second. What's underlying this are loans that have been made to people who really shouldn't own houses—they're not financially prepared to own houses. The underwriting standards are materially worse than they've been in previous years; the amount of construction that's going on in particular markets is just totally out of proportion with the sort of household formation that's going on; the rating agencies are kind of asleep at the switch, they're not changing their assumptions and therefore, OK, notwithstanding something may be rated triple-A, I can come up with what I think is a realistic scenario where those securities are impaired." And pricing on triple-A CDO paper was very, very rich. Spreads were very, very tight, and these guys said, "You know what? These assumptions that triple-A is money-good, or the assumptions that underlay Moody's ratings..."
HFM: In other words, if you buy a bond, you're going to get back your principle. It's money-good. You're going to get a hundred cents on the dollar back.
But in reality this was wrong, and people were able to short triple-A securities very cheaply. They weren't paying a lot to be short and they made huge money on triple-A securities and triple-A CDO paper that now trades at fifty cents on the dollar. I mean that is like the water's not running today, right? The sun didn't rise. But if you were trained in finance, you probably are more likely to take for granted that, "The rating agencies have a very sound process, credit analysis, the same process that I've been trained in, all the assumptions that I use are kind of the same as the assumptions they use." In the same fashion, if you assess the attractiveness of a trade based on historical data from a time when people weren't really actively doing that trade, and then suddenly everybody's doing that trade, the behavior of the trade will be different. And if you're trained the same way as everybody else, in general you're all going to behave the same. And when everyone behaves the same, that makes trades a lot riskier: everybody's buying at the same time, you get bubbles, everybody's selling at the same time, you get crashes.
Monday, May 11, 2009
A fascinating interview with a hedge fund manager. (Via) One good part: