November 09, 2008
New Names, Old Games
Posted by Mike Guttentag

I have highlighted in this series of posts the prominent role that a particular investment strategy, which combines an investment in a risky asset with the purchase of a put on that same asset, played in the market crashes of October 1929 and October 1987.  The prototypical example of this strategy is portfolio insurance, which played a pivotal role in the crash of 1987. The practice of purchasing equity primarily using borrowed funds, another example of this strategy, played a pivotal role in the stock market crash in 1929.

Is there evidence that a portfolio insurance-type investment strategy played a central role in the current financial crisis?  Certainly. The widespread use of this investment strategy contributed to problems in the residential housing market, in the collapse of over-leveraged financial institutions, and in the near-collapse of the credit default swaps market.  In earlier posts I also explained how and why this particular investment strategy should be regulated.  In this post I’ll detail the central role this strategy played in the current financial crisis.  My final post will consider how this investment strategy should be regulated to prevent the reoccurrence of similar problems in the future.

A sharp decline in residential real estate prices throughout the US was the first domino to fall in the chain of events leading to the current crisis. One cause of this decline in home prices was the widespread purchase of homes with little or no money down.  Purchasing a home in this manner is a variant of the investment strategy which combines the purchase of an asset with the purchase of a put on that asset.  The stake of the “homeowner” purchasing a home with little to no money down is self-evident, while the put on the home arises from the use of leverage.  This homeowner put is “in the money” if the price of the home falls below the value of the loan, and is “exercised” if the homeowner fails to make required payments. 

The widespread practice of purchasing homes using little or no equity is potentially destabilizing for the same reason that that widespread use of portfolio insurance destabilized stock prices in 1987.  If enough people have an explicit or implicit put on an asset (homes, in this case), and the party that who has written the put (often a financial institution) does not want to hold the underlying asset, then the aggregate demand for the asset (homes) will rise as the price of the asset (homes) rises, and fall as the price of the asset (homes) falls.  This price instability is heightened if the party that “writes” the put fails to correctly price the put (as was the case with portfolio insurance prior to the 1987 crash and margin lending prior to the October 1929 crash).  There is evidence that lenders in real estate transactions systematically underprice the put embedded in a non-recourse real estate loan.  (Glomer Zaring’s colleague Susan Wachter has several papers documenting this phenomenon.)  Conditions leading up to the recent residential real estate market crash were marked by the same destabilizing investment strategy which I identified as central to the market crashes of 1929 and 1987.

The next link in the chain of dominos implicated in the current crisis was the failure to maintain reasonable constraints on the ability of buyers to purchase homes putting little or no money down. Originators of mortgages, often using unscrupulous sales practices, sold the mortgages, and collected commissions, without worrying about whether the mortgages would be repaid.  These mortgages were bundled into marketable securities, which often received unduly favorable ratings, and were sold to investors who were often not cognizant of the risk associated with the higher yield they were receiving.  Throughout this process the opportunity for regulatory intervention, based on established principles of limiting conflicts of interest and enforcing anti-fraud protections, were sadly overlooked. 

Once these less-than optimal loans were made, bundled and frequently sold to unsuspecting investors, the next domino in the chain of events leading to the current financial crisis was put into play.  The value of the marketable securities created out of these risky mortgages (known as collateralized debt obligations, or CDOs) began to decline.  Many of the holders of CDOs were financial institutions, who did not have sufficient equity cushions to remain solvent, in part, because they had become highly leveraged under a scheme of self-regulation. Allowing excessive leverage creates the same destabilizing investment strategy which led to the October 1929 market crash.  Regulatory restrictions on the amount of debt financial institutions could incur, many of which were instituted as a response to the 1929 crash, were allowed to be circumvented.  In many cases the reduced capital reserves of financial institutions proved to be inadequate in the face of dramatic decreases in the value of CDOs.

The unexpected difficulties faced by numerous financial institutions revealed a further problem.  One of the largest issuers of credit default swaps, AIG, had not set aside adequate reserves to cover its obligations under these swap agreements.  The problem in this situation is again similar to one exposed by the use of portfolio insurance in 1987 and the use of borrowed funds to purchase equities in 1929.  AIG was selling a put on a risky asset, which is in many ways, fundamentally the same as selling an insurance policy.  Unregulated insurance markets have a history of failing, because insurers do not set aside adequate reserves without regulatory intervention. However, AIG was allowed to sell what was essentially an insurance product without any of the oversight that is customarily imposed as part of the fiduciary nature of insurance sales.  The ensuing federal bailout of AIG may prove to be the most expensive element of the current bailout package.

Time and again the problematic investment strategy of combining the purchase of a risky asset with the purchase of a put on that same asset has produced dramatic instability in market prices.  This investment strategy was a central factor in the equity market collapses of 1987 and 1929.  The discussion above illustrates how this investment strategy reappears in the failures which led to the current financial crisis, and provides strong justification for regulating this type of investment strategy.

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