Thursday, July 26, 2007

Wall Street: The World's Biggest Casino

As I was reading a Businessweek article entitled "Profiting from Mortality", I couldnt help but think that this is more of the same: gambling. Let me try to explain why these death bonds are just that, and how they differ from true investing. The new asset is life settlements, arrangements that offer people the chance to cash-out their life insurance policy early to investors, who keep paying the premiums until the sellers die and then collect the payout. Basically, the earlier the people in the pool die, the greater the profit. "Now, Wall Street sees huge profits in buying policies, throwing them into a pool, dividing the pool into bonds, and selling the bonds to pension funds, college endowments, and other professional investors... There's big potential." The truth is, this is just another Wall Street concoction to dope investors.

There are several reasons why these death bonds make terrible investments. The first reason is the all-important competition. The process of making a death bond has many self-interested parties along the way. First, there is the life insurance holder. He or she is looking for the best possible cash-out value for his policy, driving up the initial cost of the investment. Also note the inherent dilemma: A policy holder looking to cash out is more likely feeling healthier than average, meaning lower returns for the investor. But the process doesnt end here, because the settlement on a death bond isnt just between the policyholder and the investor- there are the middlemen. In this case, there is 1) the life settlement providers, who call and arrange the settlement for the policyholder, and 2) the investment banks, which package these settlements together into a securitization pool. Both of these industries are looking to take their share of fees in the process before finally selling the death bond, taking away much of the potential gains from the investor.

Why do investors bite for these esoteric products? Gullibility. Investors are going to be told the sales-pitch that these death bonds should return 8% a year and be uncorrelated to other markets. Most people just accept that right there, without digging further. Why 8% a year? What are those assumptions based on? What do the underlying life arrangements in the securitizations look like? These are questions rarely asked. Because the investor doesn't realize that he got the bad-end of the deal until much later, Wall Street can continue this scheme for some time. For a recent example, just look at the sub-prime market. Years of poorly underwritten loans made into securitizations are now being uncovered for what they really are, and many investors who 6 months ago felt like they were in on a great investment have all of a sudden been wiped out completely. But not before Wall Street and loan originators took their fair share of fees.

A real investment, on the other hand, is backed by solid logic and conservative assumptions. You need to dig to the core of the matter, research into what really matters, and uncover the underlying prospects. Even better is when you can find an investment whos intrinsic value will grow over time, such as stocks. Ben Graham's words ring true: "An investment operation is one, which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative."

As I've been thinking about this, I couldn't help but also think of two things: First was Sam Zell's Christmas Card, seen here. The other is John Bogle's recent speech entitled "A Tale of Two Markets" (Added to the new "Favorite Readings" tab on the right):

As professional institutional investors moved their focus from the wisdom of long-term investment to the folly of short-term speculation, “the capital development of the country [became] a by-product of the activities of a casino.” Just as he warned, “when enterprise becomes a mere bubble on a whirlpool of speculation, the job of capitalism is likely to be ill-done.”

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