Financial Meltdown Recalls Lessons of “Texas Hedge” (Market Forecast by Scott Alaniz)

Like most business school students at the University of Arkansas during the 1980s, I survived Dr. Modisette for Accounting, Dr. Britton for Economics, and Dr. Kennedy in Investments.

Despite all that financial wisdom imparted to me in the B-school, the keys to the financial crisis that has ravaged Wall Street was learned in an Agricultural Economics class.

On the other side of campus, Dr. Ed Fryar was teaching future farmers the mechanics of futures and options to help them manage financial risk in crops, grains, cattle and porkbellies.

A primary building block of agricultural, business, and financial markets is hedging.

A “hedge” is an investment that is taken out specifically to reduce or cancel out the risk in another investment.

A bank, for example, lends $100,000 to a business customer for 5 years at 7 percent interest rate.

The bank may borrow money by issuing a $100,000 certificate of deposit to a customer paying them 4 percent. The bank has “hedged” its interest rate risk — whether interest rates increase or decrease, it is assured of earning 3 percent profit (7 percent minus 4 percent) over the 5 years.

To keep us inmates on our toes (that might be an insult to actual inmates), Dr. Fryar would intermittently insert a joke in a test.

On one such occasion, he posed the question “What is a Texas Hedge?” The correct answer from the multiple choice format was “long cash and long futures” — in other words, no hedge at all.

Poking fun at our rivals’ intellect from the old Southwest Conference, a “Texas Hedge” is the illusion of a hedge, but is actually a doubling of the risk.

Wall Street and banks across the country operated under this same illusion – that they had “hedged” away their risk, when in actuality, they had increased their risk.

The risks were exposed when homeowners began falling behind on their mortgage payments rendering the mortgage securities these firms owned nearly worthless.

Exhibit A is Merrill Lynch, the biggest stock brokerage firm in the U.S. In August, Merrill sold $31 billion in mortgage assets at $0.22 on the dollar.

Previously, Merrill mentioned the word “hedge” a mere 124 times in its most recent quarterly financial filing. From its peak in 2007, Merrill investors have watched the value of their investment drop nearly $70 billion before Bank of America acquired the teetering brokerage firm in a blue light special.

How do you lose $70 billion dollars if you are “hedged?”

The heart of the financial crisis lies in the mortgage market — where big banks, pension funds and “hedge” funds create, buy and sell mortgage securities.

The market size is staggering: in 2007 nearly $2 trillion in mortgage-related securities were issued.

There are four main players involved in this arena: mortgage brokers, investment banks, rating agencies and investors.

Here’s how the market works in a nutshell. First, the mortgage broker earns a fee for getting you a mortgage, and passes your mortgage on to a mortgage company or an investment bank.

The banks then package the mortgage loans in to something called residential mortgage-backed securities. These are broken down into various subgroups with different maturities and payment schemes.

Those various subgroups or “tranches” are then purchased by banks, pension funds, mutual funds, hedge funds and other investment banks.

These experts use sophisticated computer models to evaluate the securities, manage risk and hedge their portfolios.

Unfortunately, no one told the computer models what to do when loans are made to people who can’t pay them back.

The meltdown in financial stocks resulted from three factors:

First, during the early part of this decade, the Federal Reserve initiated an “easy money” policy, which created a boom in real estate lending, driving home prices skyward.

This period of abnormal profits lasted just long enough for developers, investors, and bankers to assume that it was “normal” and they further assumed that the future would behave like the recent past.

This combination of low interest rates, rising home prices and no money down deals meant easy credit for everybody — If you had a pulse, you could get a home loan.

Enter the subprime loan.

These loans are riskier than conventional mortgage loans and generally mean the borrower has minimal income, a poor credit rating and/or job history and is putting in little or no equity into the house that they are purchasing (in other words, they have nothing to lose if they default on the loan).

Indeed more than $1 trillion in subprime mortgages exist today and serve as collateral for securities owned in 401(k) plans, retirement funds, hedge funds, and maybe the bank down the street.

Second, Wall Street was actually taking on even greater levels of risk. But because home prices were rising and interest rates were low, it appeared that they were taking on less risk.

And, everyone piled into the market.

A factor that sociologists call “pluralistic ignorance” pervades the brokerage industry. This is the tendency for everyone to look and see what everyone else is doing before making a decision and is usually driven by greed.

This propensity to “follow the stampeding herd over the cliff” sucked in even more participants — investment banks, hedge funds, pension funds.

Since subprime loans are risky, they do not carry the investment grade rating that most big investors usually require before they invest.

Enter the rating agency.

A rating agency’s job is to examine the safety and soundness of bonds — sort of like a Consumer Reports for corporate and municipal debt.

Cigarettes are a good analogy to a subprime loan. The Surgeon General tells us that smoking the cigarette is dangerous to our health. Likewise, the rating agencies would tell us that a single subprime loan is a risky investment.

When cigarettes are packaged together, the Surgeon General still reminds us that cigarettes are risky and notes that the more you smoke, the greater the risk.

Here the rating agencies go off-course. When subprime loans are packaged together (a few from California, a few from Florida, along with loans from all over the country, for example), the rating agencies, in defiance of logic, often assigned their top rating (AAA) to many of the new securities. This move gave the green light for brokers and less wary investors to load up on the toxic securities and set the stage for the final factor — leverage, to deal the death blow.

Finally, the large investment and commercial banks aren’t financed like normal businesses. These behemoths operate with little equity and borrow billions.

Typically, they have 20 to 30 times as much debt as owner’s equity; they borrow the money and then invest in various instruments like the mortgage-backed securities we’ve been discussing.

Leverage works great if prices go in your favor. It’s like buying a $500,000 house with only $17,000 down.

It seemed like a good investment idea at the time since real estate always goes up, right?

But reality is harsh. Even a mere 3 percent drop in home prices essentially wipes out all of your equity.

Indeed, as homeowners fell behind on their mortgage payments it caused mortgage security values to decline sharply, crippling these large financial institutions that were supposedly hedged.

The mortgage mess has Government officials busy.

Regulators engineered the bailout and sale of Bear Stearns, provided a lifeline to AIG, the country’s biggest insurance company, and have enabled Goldman Sachs and Morgan Stanley access to low-cost funds.

Last but not least is the takeover of Fannie Mae and Freddie Mac, two quasi-government giants that were created to hold mortgages.

The lesson for investors – the biggest risk you take is not knowing that you are taking a risk.

Scott Alaniz is a professional money manager with Boston Mountain Money Management. www.bostonmmm.com