Fear & Loathing In The Capital Markets

When I read that some state pension funds (South Carolina and Pennsylvania, see http://biz.yahoo.com/ap/080321/state_pensions_mortgages.html) were buying distressed mortgage-backed securities in an Associated Press story during March, I knew the credit markets had reached some sort of tipping point.

It’s not that state pension funds aren’t good investors. Generally, they hire the best managers in the world and are often quite dynamic. But because they endure more oversight than say your typical hedge fund, and because there are political cross currents in state pension funds, they are the least likely investors to do something outwardly foolish, or even seemingly foolish.

So when they start dipping their toe in the market for mortgage backed securities, it tells me that values in that market have lost touch with fundamentals and are so outrageously compelling that even the most constrained investors cannot ignore them.

How did things ever get this far out of whack?

I’m almost certain there’s an economist at one of the top universities who can map it all out.

But I put it down to something much more simple and much more fundamental: human nature. A portfolio manager who got burned on AAA mortgaged backed securities quickly realized that there were many elements about those assets that he or she did not fully understand. In response, they are now afraid of all [italicize all] asset-backed securities.

So now, no matter how good the underlying asset of an asset backed security may be, or how unrelated to mortgages it may be – aircraft leases, auto loans, credit card receivables, obligations of investment grade insurance companies -- the issuers of those securities are finding no demand, or are paying a much higher spread over treasuries than they used too. Some are finding no demand at all not matter what rate they may be willing to pay.

This is gumming up the works to be sure. But I don’t want to go there. Rather, I’d like to comment on one unfortunate quality of the fear gripping the asset backed market: it’s contagious and it spreads. Suddenly banks are lending, investment banks aren’t doing IPOs, and private equity investors have pulled in their horns.

But if fear spreads, so does opportunity too. That is, if even state pension funds can find compelling opportunities in what are now deemed to be toxic mortgage backed securities, that means there’s opportunity wherever investors have retreated. And that’s why I’m so excited about private equity right now. Sure it’s scary out there. Yes, fewer deals will get done. But if you can look past the pervasive, and in many instances, groundless fear and loathing in the markets, and instead have the courage to focus on facts, you will quickly realize you are uniquely well positioned succeed on a grand scale as an investor or entrepreneur.