Comment To John Carney's Article On Financial Crisis Inquiry Commisssion

Below is the comment I posted to John Carney's article I discuss in the immediately preceding blog post, "The Financial Crisis Inquiry Commission Doesn’t Get It."

Great article John.

Investing is not rocket science. There are two simple rules. There is no free lunch and do not put all your eggs in one basket.

Sophisticated Investors always had the choice to place funds into US Treasury Securities, which are highly liquid and which have a low risk of default. You do not need to hire an investment manager and pay a high salary to put all your funds into Treasuries.

Pension funds, mutual funds and other sophisticated investors hire investment mangers to take risks to attempt to achieve returns higher than the returns from US Treasuries. The only way to get a higher return is to take risks. Those additional debt risks include extra defaults and more concentration in a single sector (residential mortgages), i.e. less diversification. (Mortgages also have prepayment risk, but that is a different kind of risk and does not result in a loss of principal.)

Sophisticated investors knew they were taking risk because they knew the expected return was higher than a US Treasury or a GNMA of the same maturity. If the return were not higher, they would not have bothered buying the mortgage related securities from Goldman. These investors also know the risk of placing too much money into a single sector (housing), and a single product (non-government insured mortgages). Only the most inexperienced and stupid fund manager thought there was a free lunch. They did not have to read the documentation to know that there was risk.

The credit rating is irrelevant to most sophisticated investors except to the extent some are restricted by law from investing in categories below a certain rating. If the sophisticated investor relied on the credit rating to determine his investments, then the problem was with that organization for not going out and hiring experienced investment managers who understood risk and who knew what questions to ask. The credit rating in the aftermath of this financial crisis is being used as a memo to file to CYA since there has been a lot of Monday morning quarterbacking, but the managers knew what they were doing despite their claims of denial now. The investors are just trying to deflect blame from themselves for their stupidity.

Despite what those who are unfamiliar with the process think, institutional sales people, from Goldman and other firms, are used to tough questions about their products. Buyers know these products are complex. Sophisticated investors usually have to get approvals from a committee or a least a head person to buy. Salespeople and analysts from Goldman and other firms are willing and often do talk to clients to answer any questions. Sensitivity charts are prepared to show what happens under different scenarios, such as if interest rates go up, down, defaults are below, above x, etc. If a selling firm cannot answer a reasonable question, such as how will your product perform if defaults go up by x percent or house prices decline by x percent, there is always a competitor who will be glad to get the business, especially to take it away from Goldman, do the analysis and sell the product to you. Otherwise,, the buyer should and can just walk away from the product and invest in something else. Many products fail to sell because sophisticated investment buyers are not convinced it met their needs, is sufficiently analyzed or understood by the selling firm.