It was the realisation
of the risks associated with CDOs and other derivatives that lead to the
massive drops in sales of them after the subprime mortgage crisis. Now,
however, things are beginning to change- the graph below shows that CLO volumes
for the US alone have been increasing rapidly, with further increases expected
in the coming years (see Fig. 1 and Fig. 2)[i]. Now, due to the new laws surrounding
banks’ levels of equity enforced by the FCA and PRA (in the UK), and much
stricter rating agencies there should be less undervaluing of risks incurred by
CLOs. Does this make the sudden surge in CLO sales from the likes of Citi, Bank
of America, and Barclays, with a total of $9bn in sales of CLOs, less worrying
than the rise that happened before the subprime-mortgage market crash? At first
sight, the answer would be no, but this would be ignoring typical human nature
and history. After the Great Depression of 1929, one of the most severe
deleveragings in history, the SEC, the FDIC and the Glass-Steagall Act were all
set up in order to prevent another crash: both the SEC and the FDIC failed to
prevent the speculative markets from returning and causing another
deleveraging; and the Glass-Steagall Act was actually revoked in 1999 by
Clinton[ii]. So, with the benefit of hindsight, will
this sudden change of heart of financial institutions be permanent, or is
simply another phase in the long-term debt cycle?[iii] Well, while some may, speculate that this
is a change for good off of the back of one of the worst global financial
crises in history, History has a tendency to repeat itself and humans, in mass,
tend to repeat themselves. One of the main problems identified by Warren
Buffet, Ray Dalio, Felix Salmon, and so many others with derivatives as an
entire investment branch is that they are becoming increasingly complex ever
day- with the likes Fabrice Tourre prowling the markets with these tools at
their disposable many unsuspecting investors will be ensnared[iv]. Also, as derivatives become more and more
complex due to efforts to gain higher and higher profit margins on short term
bids, even if the financial authorities sustain their current high standards,
the market will repeat itself –in both the long and short-term debt-cycles.
So what should the
‘intelligent investor’ do? Firstly, to define the intelligent investor-
Benjamin Graham and David Dodd in their books Security Analysis, and The
Intelligent Investor committed to
writing the most sound investing techniques to date with regard to
‘margins of safety’ and long-term investing strategies. Buffet called The Intelligent Investor, “by far
the best book on investing ever written”-
it revolutionised the way in which people approach value-investing. The
intelligent investor researches the underlying value before investing in
anything and is not swayed by short-term market fluctuations; always having an
appropriate ‘margin of safety’ on each investment, avoiding high-risk
high-reward opportunities. The ‘conservative investor’ will adhere to a
stratagem of purchasing stocks and bonds with steadily growing value –not
price- that will create a portfolio that does not need to be altered more than
twice every year. The ‘enterprising investor’ has the same high standards when
they pick their investment opportunities, the only difference being in the
amount of time and effort that they are able to commit to their choices.[v]
Apart from the
occasional CLO which may be undervalued and of a low risk, these types of
investment are simply not appropriate for even the most ‘enterprising’
investors: better would be premium bonds, and ‘bargain price’ high underlying
value stocks. Of course, these are extremely simplified parameters around which
one should invest, but they offer a rough guide to those whom are interested.
Sound advice for any individual planning to begin investing should take the
time to read and fully understand the strategies of the most successful
investors of history and the present day. Two of the fatal flaws of many of
those who lose money in the markets of today are that they over-commit, and
that they fall victim to the overly complex deals of financial predators. Jason
Zweig writes on the former of these two traps in his additions that he made to
the most recent edition of ‘The Intelligent Investor’:
He notes that “Nearly all the richest people in America
trace their wealth to a concentrated investment…”
but he then points out “To make it onto
the 2002 Forbes 400, the average 1982
member needed to earn only a 4.5% average
annual return… Only 64 of the original members – a measly 16%- were still on
the list in 2002.”[vi]
With regards to the
latter of the aforementioned pitfalls, Warren Buffet, Alan Greenspan, and a
senior analyst at DuPont with whom I have spoken have outlined that many a
feckless investor have and will continue to fall prey to derivatives and
schemes that are designed to be so complex that misplaced trust will lead to
large returns for the issuer and large losses for the purchaser.
Fig. 1- US CLO volumes in the pre and post-Lehman world
Fig. 2- US CLO volumes (in $10 millions) plotted
against the S&P 500
[i]
T. Alloway and N. Bullock (2013), CLO
issuance hits highest level since before financial crisis. The Financial
Times.
[ii]
J. Penthokoukis (2013), The 21st-Century
Glass-Steagall Act. American Enterprise Institute, Economics.
[iii]
R. Dalio (2014), How the Economic Machine
Works. Bridgewater Press.
[iv]
B. Voris (2014), Ex-Goldman’s Tourre
Ordered to Pay $825,000 in SEC case. Bloomberg.
[v]
B. Graham and D. Dodd with various other contributors (2008), Security Analysis. McGraw Hill Financial.
[vi]
B. Graham featuring J. Zweig (2003), The
Intelligent Investor. Harper Business Essentials.
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