Sudip Bandyopadhyay’s Blog

Sherman McCoy, the fictional 1980s “Master of the Universe” Wall Street bond trader, had his sights set on a deal that could earn him $ 1.7m in commission payments, money he needed to pay off the mortgage on a lavish Park Avenue apartment.  “The only real problem was the complexity of the whole thing,” readers of Tom Wolfe’s The Bonfire of the Vanities are told.  Yet, by today’s standards, the deal in question – a gold-backed French government bond – appears rather straightforward.  When novels are written about the modern-day masters of the universe – Wall Street’s hedge funds and structured finance gurus – the big financial plays that shape the dramas will be collateralized debt obligations, or perhaps credit default swaps on collateralized debt obligations.

Interesting lessons emerge from a look back to the 1980s excesses as recounted through the tale of Mr. McCony’s rise and fall.  He knew that he could only sell his big deal to investors who trusted him.  In recent years confidence in bankers with track records has been replaced by confidence in credit ratings.  The unquestioning faith in the bullet-proof status of a triple A credit rating led to the buying of billions, not just millions, of structured bonds that are now worth little or nothing.  The credibility of ratings has been questioned by both insiders and outsiders.  Yet the poor service the rating agencies gave many of their structured finance customers has also left a stain on the bankers who touted the products. Wall Street and the rating agencies are inextricably linked.  Unlike equity, which need not be serviced in bad states, debt has to be, irrespective of whether the originator is doing well or poorly. It, therefore, becomes critical for any potential buyer of any debt paper to get an impartial ‘true and fair’ independent assessment of the entity’s capability to service the debt. Thus, the genesis of the so called independent credit rating agencies. And ever since debt papers began to be appraised by these agencies, the ratings determined the risk and, hence, the price and cost of investing in any such instruments. High ratings allowed the issuer to get a good price for their paper. Poor ratings sharply lowered the price. We bought or did not buy based on the trust that we bestowed on the rating agencies. Today, most will agree that these fiduciaries have abjectly failed in discharging their trust to the global investing community.  More than $1.5 trillion of high-risk sub prime mortgages originated in the US between 2004 and end-2007. If you added to this marginally lower risk below prime mortgages, the amount will total over $3 trillion. These mortgages were aggregated, sliced, window-dressed in every conceivable manner to create myriad portfolios of CDOs which, after a few iterations and re-slicing, had no clear relationship to the real underlying assets. Each agency assigned fairly attractive ratings to most of these securities based on arcane mathematical models. Armed with good ratings, these pieces of paper were sold everywhere — pension funds, private equity firms, municipal treasuries, sovereign funds, mutual funds and the rest. No buyer knew the quality of what they were purchasing. They bought on the trust and faith they reposed on the rating agencies.

As the market shifts its focus from the financial crisis to the now possible economic slowdown, many of the assumptions that have shaped our industry for the past few years are being tested and questioned.  We will soon see, as Warren Buffett has already noted, who has been swimming naked.  For so long now, the equity market’s focus has seemed to be solely on earnings.  Analysts’ attention has been on the company’s profit and loss statement, without much, if any, regard for cash flow or the balance sheet.  Moreover, the focus has been purely on the equity of the company, without sufficient regard for the company’s other sources of financing and their effects on that stock.  For many new participants in the widening asset management industry, a simplistic and easily understandable type of revenue less cost analysis had seemed good enough.  It isn’t now.  Indeed for many investors, it seemed that a simple understanding of whether quarterly earnings were going to beat or miss consensus estimates was enough.  Many quantitative models were driven largely by earnings and the “earnings surprise factor”.  Many hedge funds have thrived on this as well.  This kind of narrow focus won’t do any more.  A key question people need to ask today is whether a company can fund its business, irrespective of its level of growth as well as whether it can repay short-term debt, what its working capital requirements are and how they will be funded.  Not enough people, it seems, have been asking these questions.  Bill Gates has said:  “Success is a lousy teacher.  It seduces smart people into thinking they can’t lose.”  For a long time now we have trusted the capital structures of the listed sector, so much so that in the most recent phase many investors were actively encouraging companies to shrink their capital base to boost earnings per share.  In recent days, equity investors have had to reacquaint themselves with a company’s capital structure and its funding fundamentals.  This is a good thing.  The industry will be better for it.