Succinct Summations of Week’s Events 5.28.21 (plus Investor Amnesia)

To close out the 2021 Memorial Day weekend, below is the weekly summation, the main positive that more than half of all U.S. adults are now fully vaccinated and jobless claims fell over 10 percent. All the negatives being that new home sales, personal income, durable goods orders, pending home sales, and retail inventories all came in below expectations. 

The bonus tonight is an article posted this weekend on The Big Picture blog from the magazine "Investor Amnesia" resurrecting a 19th century financial scandal and how the same conditions remain in place in the markets today. It's long so I'm only including the opening and closing paragraphs below but there is a link to the entire article and it's quite an eye-opener.  Hope everyone enjoyed this very pleasant holiday weekend.  

Succinct Summations of Week’s Events 5.28.21

May 28, 2021 5:30pm by Barry Ritholtz

Succinct Summations for the week ending May 28th, 2021.

Positives:

1. More than half of US adults are fully vaccinated; 292 million doses have been given so far.
2. Corporate profits rose 25.2% y/o/y, above previous increase of 4.1%.
3. Jobless claims fell 44k w/o/w from 450k to 406k.
4. Case-Shiller Home Price Index rose 1.6% m/o/m, above expectations.
5. FHFA House Price Index rose 1.4% m/o/m, above expectations.
6. Wholesale inventories rose 0.8% m/o/m

Negatives:

1. GOP kills January 6 investigation, now party of Insurrectionists.
2. New home sales came in at an annual rate of 863k in April, below expectations.
3. Personal Income fell 13.1% m/o/m, below expectations.
4. Durable goods orders fell 1.3% m/o/m, below expectations.
5. Pending home sales index fell 4.4% m/o/m, below expectations.
6. Retail inventories fell 1.6% m/o/m, below the previous decrease of 1.4%.

 

Marias 5-31-21 Times of Fraud, Mania & Chicanery — Investor Amnesia

Times Of Fraud, Mania & Chicanery A 19th century account of financial fraud that reads as relevant today as it did back then: “Without any great violence, all the incentives to commercial crime may be brought under the one common rubric — the desire to make money easily and in a hurry. (Investor Amnesia)

Why This is Relevant:

It seems at odds with the times that in an age of such mass information and transparency, there could still be such widespread examples of fraud and wrongdoing in markets. However, as previous editions of this newsletter have covered, increased information certainly does not mean increased knowledge or efficiency. This paper looks at how the increasingly distant relationship between an investment bank’s reputational risk and underwriting duties led to more instances of default. When the credit rating agencies began to form, investment bank’s could simply rely on their ratings and no longer worry about the reputational risk of underwriting a bond offering that defaulted. If that were to occur, it would be the rating agency’s fault, not the bank’s. As the authors note, this led to a “market for lemons”.

Summary:

The role of underwriters today is vastly different than it was in the past. This thought provoking article explores the evolving duties of underwriters and rating agencies over time. Perhaps the best overview is found on page 3 of this article:

“In the past era (by which we mean the long-run period that began in the early 19th century and ended with the interwar crisis), underwriters provided valuable certification services. They tried to secure prestige by convincing investors that their name was associated with safer products. They did this not for the sake of honesty, altruism, or self-esteem but rather because doing so entailed benefits.

Today is different: underwriters have shed their role as certifiers and have outsourced it to rating agencies. The resulting reduction in liability risk also means that more competitive banks are prepared to issue riskier securities. We suggest that this new situation has given birth to a market for lemons, a market that did not exist in the past. We conclude that the next sovereign debt tsunami will crash on a foreign debt market that is by design more accident prone than its predecessors.”

This stark contrast in the roles of underwriters in each time period has led to what the authors call “the default puzzle”. This puzzle stems from the fact that underwriters used to have a vested interest in how the bonds they underwrote performed, as it could hurt or benefit their corporate brand. This meant that banks acting as underwriters were responsible for carrying out the roles of modern credit rating agencies. If a bank underwrote bonds that ended up defaulting, this would tarnish the bank’s reputation. Investors would ask “How could they fail to see the default risk before deciding to underwrite?”. 

The result was a bond market in which very few ‘junk bonds’ were issued, as underwriters were wary of putting their reputations at stake. The defaults that occurred were generally clustered around the few financial intermediaries that were willing to underwrite the ‘junkier’ bonds, and take on the reputation risk.

BUT! As we all know, credit ratings changed everything.

“The investment banks that became involved in the new market probably welcomed the transformation (they included reincarnations of interwar New York leaders such as JP Morgan or National City Bank).  Fees were now smaller, of course, but liability risk was also reduced. Rating agencies would be the new lightning rod for accusations of financial malpractice. The banks, although undoubtedly informed, would now be able to show to unhappy customers the grades given by (possibly less informed) rating agencies.”

In essence, there’s no longer a need to worry about reputation risk attached to underwriting, because if anything goes wrong, it is the rating agency that is blamed. Consequently, there is now a booming “market for lemons.”