Monday, July 6, 2009

Who Was Buying It?

In a recent Twitter debate with Felix Salmon regarding Matt Taibbi’s scathing Rolling Stone article on Goldman Sachs, financial reporter Heidi Moore raised an interesting point: investment banks and others could not have created many of the structured finance products that have played a key role in the current crisis if there was no demand for them. So it’s worth examining not just the sell-side of the market, but the buy-side, too.

Personally, I don’t know enough about the specifics of the CDO ABS market to speak authoritatively on who was buying these products and why (and I doubt you want to hear about them).* However, I think we can look at the problem more generally to determine why seemingly sophisticated institutional investors time-and-time again get suckered into buying into the latest fad the investment banks are peddling, whether it be Internet IPOs, mortgage-backed securities, or whatever else they’ll cook up next.

*Although if you do, Yves Smith over at had a great conversation with a commenter that explores this issue.

I have three theories:

1.) Forgetting the SALES in Salesman – People tend to think they’re getting unbiased advice when it comes from financial-services professionals. That nice mortgage broker really wants to help you afford a new home. The Merrill Lynch man suggests you buy a certain stock to start stashing away for your son’s college fund. Unfortunately, you can no more rely on the people on the sell-side of the market for help than you would your average car-dealer.

The job of people on the sell-side of the market is, not surprisingly, to sell. The mortgage broker really wants to sell you a mortgage not to help you get that house but to make his own commission. Same thing with the Merrill Lynch broker. When it comes to the salesman selling to institutional investors it’s no different. Michael Lewis chronicled in Liar's Poker the art of "blowing up a customer." One player in a story Lewis wrote for Portfolio remarked how he would always ask salesmen from the investment bank: “I appreciate this, but I just want to know one thing: How are you going to screw me?”. Come to think of it, I might prefer the used-car salesman.

Most people would probably be surprised to learn investment banks don’t really have any fiduciary duties. When they’re underwriting a deal, they don’t have a responsibility to get the best deal for the client coming to market with stocks or bonds. When they’re selling those stocks or bonds, they don’t have any obligation to the investor to make sure the product they're selling is worth the investment. It’s a wonder why anyone keeps believing them.

2.) Let's Make a Deal – I also suspect that some institutional investors often invest in certain deals expecting to get a deal on another. The investment banking salesman and the institutional investors are engaged in repeated interactions**. If an institutional investor participates in one deal he's not so certain about, I’m sure salesman offers to get the investor a big discount on another deal.

** Which you think would deter the activity in Theory 1, but it clearly does not.

3.) But Mom… - Finally, I suspect many institutional investors buy these product because of the everyone-else-is-doing-it philosophy. On one hand, you might say this is simply stupid. But from an individual perspective, it may make some sense.

Institutional investors are judged based on how they do compared to other institutional investors. Sure, manager X may think the market is overvaluing Internet stocks, for instance, but if he doesn’t invest in them he will find himself falling behind ever other manager that is investing in them. With returns consistently lagging the market, he will likely see investors pull their money out of his fund. Consequently, he may lose his job before the market crashes and he’s proven right.

Alternatively, manager X might suck it up and just invest in the overpriced Internet stocks. When he is right and the market crashes, he fund loses — but so does every other competing fund. He doesn’t look any worse than any other manager that “didn’t see it coming” and hangs onto his job. It's OK to fail as long as everyone else does to.

Anyway, that's not meant to be a definitive list. Just some ideas kicking around in my head. Take it for what it's worth.

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