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BACK IN the days of the dot.com bubble of the late Nineties the world was basking in the marvel of the “new economy” as e-commerce became the buzzword at companies worldwide. In October 1998, Henry Blodget, an obscure equity analyst at Oppenheimer and Co, predicted Amazon.com’s share price would double and reach US$400 by year-end. He was right. The price more than doubled inside a month and Blodget received an offer to go and work for Merrill Lynch on its global Internet research team.
So what’s wrong with that, you ask? Equity analysts, who are paid to conduct research and then write recommendations to investors on the companies they cover, are usually part of a bigger investment bank that also handles corporate finance, structured debt transactions and initial public offerings (IPOs). That’s where banks really make their money: research is just the value-added service they offer to their clients in exchange for their trading business.
But in 1998, as is the case with every stock market boom, there were literally thousands of companies coming to market through IPOs and most of them were IT companies. Investment banks were making killings from listing those companies, regardless of their quality or prospects, while investors were caught up in the madness of the moment in their effort to get their hands on the “new economy” shares.
Blodget could see the writing was on the wall and in a series of internal emails, described the new listings to be “s**t”, “crap” and “junk” (respectively). Publicly, though, Merrill insisted that Blodget continue to churn out his bullish buy recommendations.
The fortunes lost when the dot.com bubble finally burst burnt many investors that to this day still carry the scars. For Blodget it meant in 2003 he agreed to pay a US$4m fine and accepted a lifetime ban from working in the securities industry.
The ratings agencies and the sub-prime property market
To examine the conflicts of interest that led to the global financial crisis of 2007/2008 we must delve into the murky and complex world of mortgage-backed securities (MBS). What happened in 2007/2008 is almost strikingly similar to the madness of the late Nineties.
An MBS is its own little corporation with a collection of individual mortgages that get thrown together and sold to investors. The interest and capital that would normally be repaid to the bank now goes to an investor who has bought the entire structure, or just a certain tranche within the structure.
So imagine, if you will, all of the mortgages on the houses on your street being stacked on top of one another. Within that big tower of mortgages we then sub-divide them into smaller parcels (“tranches”) designating in what order investors get their money back. The investors that buy the top tranches are guaranteed to get their money back first, investors buying the middle tranches get paid only after everyone in the top tranches has been paid, and so on, until you get right to the bottom tranche – the “sub-prime” portion.
Each MBS is created by a team of lawyers working in conjunction with an investment bank. The investment bank, such as JPMorgan or Goldman Sachs, would then hire an independent ratings agency like Fitch or Standard & Poor’s, to independently evaluate the different tranches. The point of the exercise is to have the tranches graded so investors can gauge their creditworthiness. The ratings agencies use designations such as AAA if it’s extremely unlikely borrowers will default on their repayments or BB if it’s expected there will be some defaults. These designations were key to how potential investors viewed the MBS.
So ratings agencies – paid to pinpoint the risks for investors – found themselves in a conflicted position. Why? Because at the height of the property boom in the United States thousands of MBSs were being created by investment banks and sold to institutional investors the world over. As you can imagine, this was very lucrative work.
So who was paying the ratings agencies to produce these favourable ratings? The investment banks who were pushing them out to unsuspecting investors around the world?
What does that all teach us? Ignore all the bunk from bankers and investment advisers about ethics and reputation and begin the engagement with: So how do you get paid? Because that’s probably the most direct way of predicting whose interest will take precedence when push comes to shove.
WARREN DICK
Independent
DICK graduated from Unisa in 2002 and then spent six years working for Investec Private Bank. He now conducts research on small and mid-cap companies, which he supplies to both the institutional and retail markets through his website www.investorcentre.co.za. He also writes for Investors Monthly.
So what’s wrong with that, you ask? Equity analysts, who are paid to conduct research and then write recommendations to investors on the companies they cover, are usually part of a bigger investment bank that also handles corporate finance, structured debt transactions and initial public offerings (IPOs). That’s where banks really make their money: research is just the value-added service they offer to their clients in exchange for their trading business.
But in 1998, as is the case with every stock market boom, there were literally thousands of companies coming to market through IPOs and most of them were IT companies. Investment banks were making killings from listing those companies, regardless of their quality or prospects, while investors were caught up in the madness of the moment in their effort to get their hands on the “new economy” shares.
Blodget could see the writing was on the wall and in a series of internal emails, described the new listings to be “s**t”, “crap” and “junk” (respectively). Publicly, though, Merrill insisted that Blodget continue to churn out his bullish buy recommendations.
The fortunes lost when the dot.com bubble finally burst burnt many investors that to this day still carry the scars. For Blodget it meant in 2003 he agreed to pay a US$4m fine and accepted a lifetime ban from working in the securities industry.
The ratings agencies and the sub-prime property market
To examine the conflicts of interest that led to the global financial crisis of 2007/2008 we must delve into the murky and complex world of mortgage-backed securities (MBS). What happened in 2007/2008 is almost strikingly similar to the madness of the late Nineties.
An MBS is its own little corporation with a collection of individual mortgages that get thrown together and sold to investors. The interest and capital that would normally be repaid to the bank now goes to an investor who has bought the entire structure, or just a certain tranche within the structure.
So imagine, if you will, all of the mortgages on the houses on your street being stacked on top of one another. Within that big tower of mortgages we then sub-divide them into smaller parcels (“tranches”) designating in what order investors get their money back. The investors that buy the top tranches are guaranteed to get their money back first, investors buying the middle tranches get paid only after everyone in the top tranches has been paid, and so on, until you get right to the bottom tranche – the “sub-prime” portion.
Each MBS is created by a team of lawyers working in conjunction with an investment bank. The investment bank, such as JPMorgan or Goldman Sachs, would then hire an independent ratings agency like Fitch or Standard & Poor’s, to independently evaluate the different tranches. The point of the exercise is to have the tranches graded so investors can gauge their creditworthiness. The ratings agencies use designations such as AAA if it’s extremely unlikely borrowers will default on their repayments or BB if it’s expected there will be some defaults. These designations were key to how potential investors viewed the MBS.
So ratings agencies – paid to pinpoint the risks for investors – found themselves in a conflicted position. Why? Because at the height of the property boom in the United States thousands of MBSs were being created by investment banks and sold to institutional investors the world over. As you can imagine, this was very lucrative work.
So who was paying the ratings agencies to produce these favourable ratings? The investment banks who were pushing them out to unsuspecting investors around the world?
What does that all teach us? Ignore all the bunk from bankers and investment advisers about ethics and reputation and begin the engagement with: So how do you get paid? Because that’s probably the most direct way of predicting whose interest will take precedence when push comes to shove.
WARREN DICK
Independent
DICK graduated from Unisa in 2002 and then spent six years working for Investec Private Bank. He now conducts research on small and mid-cap companies, which he supplies to both the institutional and retail markets through his website www.investorcentre.co.za. He also writes for Investors Monthly.
