I have a growing list of things that are certain in life:
- Obnoxious opinions
- The madness of markets
But I’d like to add something to the list:
- The ability of investment bankers to find and securitise any and every stream of cash flow.
Cash Flows are a form of Moral Philosophy
Statement: all life’s paths can be represented as a series of cash-flows.
Statement: the greater the stream of future cash flows, the better the decision being made.
Statement: moral failure occurs when the stream of cash flows is reduced to its present day value, rather than being nominally cumulative*.
Statement: present day value does not equal the cumulative value because of usury and inflation.
Obvious Conclusion: the root of all evil is the nominal interest rate**.
But jokes aside, even you can be represented as a stream of future cash flows. Over the course of your life, you’ll probably earn a salary or some other income every year. And as you get older, you’ll begin to take on more executive roles, and earn bonuses, and build assets (hopefully). Some of that will be a function of your education; some of that will be a function of your career choices and networking abilities. Most of it will probably be plain Providence.
An investment advisor would refer to the value of that cash flow stream as your “human capital“. And as time goes on, that human capital will decrease (because those future cash flows soon become the parts of your bank account that you blew on a holiday to Thailand and a wardrobe of hand-tailored suits). But hopefully, the decrease in human capital is matched by an equal or greater increase in financial capital (investments). And interestingly, your investment advisor will change his investment advice depending on the type of human capital that you possess.
For example, if you’re young and you work as an Investment Banker – you might think that you should go out and buy shares, because that’s what bankers do. But that’s not quite true – because your job security and bonus is directly linked to how well the market is doing. So if you do buy shares, then both your investments and your job security will disappear in a market crash; which is counter-productive – because your investments are meant to be a safeguard. A teacher, on the other hand, whose employment has nothing to do with the market, should be buying units in the Allan Gray Equity Fund with every spare cent.
Back to the Point of the Post
I’ve been wanting to talk about cash flows and their importance for some time. So when I saw this article making headline news:
…then I knew that the time had come.
Some Background Theory
An economy is a fickle thing. Sometimes it does well; sometimes it does less well. And the question always is – where do I put my money so that I can do best when things are going well, and do well when things are going to hell?
And the basic rule of thumb: hold stocks in a boom, and bonds in a bust.
Which does make some sense, because debt-holders rank higher than equity-holders in the priority list of “who I pay first”. Just take a homespun example: you sacrifice the family holiday in favour of the mortgage repayment.
This has led to the conventional concept of debt being “safer” than equity, because it’s more reliable in a crisis***.
So in a world of much well-meaning regulation, the Big Institutional Investors (pension funds, provident funds, insurance policy pools, etc) are generally required to put large swathes of their capital into debt securities (more commonly referred to as “fixed income securities” – as the return is generally linked to a set rate of interest). The standard fixed income security is the government bond. But there are also corporate bonds. And since the late 1980s, there has been excitement around asset-backed securities.
Some Background Story
Asset-backed securities… So in the 1980s, Wall Street (and, specifically, the bank of Salomon Brothers), realised that there were two things that they could be certain of:
- Big Institutional Investors need fixed income securities; and
- Mortgages on property have some link to fixed income, if they could just work out what it is.
And they did work out what it is, and they started buying up books of mortgages from any bank/loan-house that would sell them, repackaging them as different types of fixed-income security (known as an Asset-Backed Securities), and then selling them to Big Institutional Investors****.
By a gradual process of over-excitement, this led to the Subprime Crisis.
And at that point, a whole chunk of the fixed income market disappeared. Gone were the mortgage-backed securities. And the credit-card-receivable-backed securities. And the car-financing-backed securities. And the student-loan-backed securities (the bankers had been very busy…). And the asset-backed-security-backed securities (called a Collateralised Debt Obligation). And the asset-backed-security-backed-security-backed securities (also called a Collateralised Debt Obligation).
And after that: Greece, Cyprus, Portugal, Spain and Ireland happened to the sovereign bond markets.
So where is a poor Big Institutional Investor meant to put all the money if the law still requires them to hold fixed income securities? Into all the bonds that were left, is where. Which is partly why we have this awkward situation with the low interest rates**.
But the point is – there is this open gap in the market for some type of fixed income security that would fill the gap left by the lost asset-backed securities.
Welcome Cerberus and their “First Key Lending” Outfit
Cerberus is hedge fund that is quite famous for investing in unwanted and distressed assets, and turning them into great success stories*****. And they have set up First Key Lending to go back into the housing industry.
Because they are looking at the housing industry and saying:
- The banks aren’t lending money for mortgages (those pesky reserve requirements);
- Which means that houses are relatively cheap; and
- Because of the past foreclosures, you’re seeing a rise in the number of people renting houses.
- And you know what? Rentals look like fixed income.
- So let’s give loans to people that want to buy homes to rent.
- And we’ll vet these landlords to make sure that they’re the type of landlord that’s not afraid to collect rent.
- And then we can take our investment to our investment bankers.
- And they’ll repackage the streams of rental income as rental-backed securities and sell those to the Big Institutional Investors.
- Which brings in more money for us to lend to more of those efficient landlords!
It’s a whole new era of bubble.
*If you are a douchebag today and you steal money – then that should land you in a future situation of no cash flow (prison). But if you see that risk as being far in the future, then the present value of the stolen cash has a higher value than the future cash flow you’ll lose by going to prison – and that theft then becomes a rational decision…
***This. This is a whole debate on its own. But another time.
****I described how asset-backed securitisation worked in this post: “What Is a Mortgage-Backed Security?”
*****People are often surprised by the profitability of distressed assets. But let’s say that a company is expected to pay its creditors 10 cents for every dollar that they owe. This means that the market-value of a $1 million loan is $100,000. Which sounds terrible to some. But I go and pay someone $100,000 for the right to that loan (that’s my investment in distressed debt), and then I help the liquidator to salvage 15 cents on the dollar. That means that, on liquidation, I get $150,000. Which is a 50% return on my investment! Don’t let the “cents on the dollar” line fool you. There is plenty money to be made off distress.