Madoff + Mortgages = One Economic Mess

by Jeff Feldman

The past few weeks have been full of Bernard Madoff news and mortgage disasters. What is important, however, is what these twin tales paradoxically reveal -- trying to avoid risk in investing may lead us to the riskiest investments.

Madoff is a crook; lock him up and throw away the key. What about his “victims?” Are they blameless? They were seeking above average returns from an investment they perceived to have, little or no, risk. But most of them could not explain what they had invested in and knew little about the Madoff operation. All that mattered was there was no risk. And look what happened to Zsa Zsa Gabor .

Perhaps if they had been investing in something real, like Volkswagen beetles, this wouldn't have happened -- and they would have produced something that people could use.

And let's face it, derivatives based on mortgages are pretty vaporous, too.

The buyers of securitized mortgages thought the pools they were buying were rated AAA. That of course meant that they were taking no risk and thus could leverage those investments in order to get an above average rate of return.

Then there were the buyers of credit default swaps who were buying the credit risk of entities that they perceived had little or no chance of failing, thus allowing them to earn an above average return from the premiums earned. Yet, would these people have bought into the argument that decaffeinated coffee crystals are equivalent to a high quality brew (apologies to Lauren Bacall)?

So we invested trillions of dollars, all of which were going to earn above market returns for no risk, violating every principle of finance.

Then there are the folks who have engaged in 130/30 strategies and “portable alpha” strategies under the assumption that they reduced risk without giving up any return. These investors built models based upon asset allocations, algorithms and the efficient frontier without ever giving any consideration to what was actually going on inside the companies that made up their portfolios.

Over the last 15 years, with the advent of electronic trading platforms and the rapid expansion of proprietary trading desks, the investment community has labored ,and hard, to eliminate risk from investing. Of course, it turns out that that instead of eliminating risk, the engineers have made it pervasive and now we are suffering the consequences. But why did risk become such an anathema in the first place? There is no such thing as a low-risk, high-reward investment, certainly not for long. But after the tech bubble burst in 2000, institutional investors developed an aversion to risk. Hedge funds sprung up to offer the solution. But investors were not satisfied with the returns provided by the market because they were seeking to recover the losses from the tech bubble. They maintained their aversion to risk but required above market returns. Wall Street is always willing to oblige investors. So we got what we asked for. This is similar to what happened with Enron. Through the 80’s and 90’s it became common for analysts to predict quarterly earnings down to the penny and growth companies that missed estimates were severely punished by investors. So Enron created, out of whole cloth, the stable growing earnings pattern that we hungered for.

I have been on Wall Street for 40 years. I have accumulated a good deal of knowledge and I have seen a lot. My experience told me we would wind up exactly where we are and I spent two years on a public speaking tour trying to point out the problems. Many of you will recall my rants which did little good. It is dangerous to wave a flag in the face of a charging bull.

Now greed has been overwhelmed by fear but that will pass. When it does, investors will come out of their bunkers.

Those investors will be assuming risk. Some will make money; many will lose money but we will all be better off. The investors who backed Bell took a risk that other inventors would get to the market first. Other investors backed losing systems or thought the invention would go nowhere, notably Mark Twain.

Capital formation is the basis of economic growth. Financial engineering leads to the destruction of capital and we now all know where that leads.

We must now get back to basics and make our capital markets the engine of growth they have always been and to restore prosperity for all.

Hopefully, we will return to the fundamentals of investing; looking for companies that will offer tomorrow’s innovations which will improve life for all, like the telephone