I came across a word the other day and, having never seen it
before, looked it up in the good old Merriam-Webster dictionary to learn that
it means: confused or meaningless talk. It got me thinking about my last post,
entitled "Cui
Bono." The connection may not be immediately clear to you, so let me
elaborate.
In "Cui Bono," I explained that in ancient Rome, one of the
important questions that any legal inquiry would ask is "Who benefits?" It
really struck me that we need to be asking that question whenever we are making
an investment decision to avoid being charmed or sold something simply because
someone is persuasive. As I thought more about this concept, I realized that
the entire language of the broker-dealer community is based on the use of terms
that would confound any person not in the industry.
As with any highly technical industry, securities industry
professionals are used to hearing things shouted at them over the phone that
would sound like total gibberish to most people. This is mostly due to the fact
that it is very common for a trader to take down a position in a security and
then sell his sales force on the merits of his position so that they will sell
it on to end customers—folks like many of you. I am constantly hearing things
marketed in terms of duration, average life, spread, tight, wide, special
situation, cheap, and one off. These terms are all fine in the short term—the
short term over which the trader expects to own the position.
Let's focus on a couple of the most confusing and over-used terms that I see on offerings all the time. Number one on the list has to be duration.
Let's focus on a couple of the most confusing and over-used
terms that I see on offerings all the time.
Number one on the list has to be duration. If I were a betting man, I
would bet that more than 50% of brokers that throw out this term do not even
really know what it means. On the surface, it would appear to mean some kind of
length of time. If you look in the dictionary, the first definition of duration
is, "the time during which
something continues." If I told my kids that the flight will have a duration of
four hours, that would pretty quickly be understood. Unfortunately, in the
world of investing, the term has nothing to do with a measurement of time. Here
is the formula you will find for duration:
As it turns out, there are several different applications
based on adjustments to this formula: Macaulay's duration, effective duration,
modified duration, and several other more obscure versions. There are many
problems here. First and foremost is that all the formulas you will find
discussing duration assume that you know the exact cashflow schedule the
security will experience. This is possible only for bullet securities where we
do, in fact, know the cashflow schedule that is coming to us. In the case of
any amortizing security, or any security with imbedded options, we do not
have that required perfect knowledge. The reality is that the people who
developed this formula were actually attempting to measure short term price
volatility in a zero-time environment. The formula itself was never intended to
indicate anything about the length of time until maturity nor when you might
get your money back.
It's galimatias. Totally misused and misrepresented. But it's just so darn common.
At the beginning of
our educational programs, I always ask attendees to write down their definition
of average life. I do this because virtually every piece of documentation
around the sale of a pool or a CMO will highlight the average life. As you can
imagine, I get a wide range of answers. Most people will simply shrug their
shoulders and say "I don't know." And yet, so many decisions are made using
this metric. We could examine the formula to find the technical answer, but I
think I can describe it in a simpler way. It is simply the fulcrum of our
principal cashflows. I use this picture to help explain the meaning.
It turns out that it is analogous to a physics problem. How do we make the teeter-totter balance? We need to figure out the "weights" at each end as well as the length of the board, and then we can find the balancing point. With average life, the same math holds true. But, when we look at amortizing securities, we don't know the exact payment stream and therefore the advertised average life must be calculated with an assumed cashflow schedule. That schedule will be incorrect the moment an assumption is incorrect, but in the galimatias world of finance that fact is never discussed. In fact, the stark reality is that average life will change every single month as actual prepayments arrive.
Yield and spread are similarly compromised. Spread is very
simply the difference in yield between a benchmark (usually a Treasury note)
and the security we are considering. Unless the two items have the same exact cashflow,
this number quickly becomes meaningless as time goes by. Anything with
prepayments or imbedded call options cannot be accurately compared to a
Treasury whose cashflow is 100% certain and unchanging. For the vast majority
of securities that banks and credit unions buy, the cashflows cannot be known
ahead of time. Since we can't even accurately calculate yield in these cases,
just think how unrealistic it is to claim that we know the spread.
Galimatias + Hubris = Absurdity
So, how do we avoid this confusion-causing conundrum? As
Albert Einstein once said, "Everything should be made as simple as possible,
but not simpler." What did he mean by that? I believe the crux of the issue is
that he was saying that it is
desirable to keep even complex things as simple as they can
be, without losing the essence of those things. He would also have acknowledged
that some things cannot be reduced to something simpler or
they lose something of vital importance. For me, when I am making an
investment, I would like to know how much money I will actually make, over time,
and in different interest rate environments. And when I start moving into the
world of capital markets or instruments with some credit risk component, I will
have to add using a less simple representation—just as Einstein suggested.
When dealing
with an entire balance sheet of assets and liabilities, even more information
will be required, and less simple representations required. But we want to
still keep it as simple as possible for the situation. The important
thing to remember is that we should always be leaning towards making the
analysis or decision simpler—not more complex. The single statistic parameters
I discussed earlier do not help us achieve that goal.
To me, the
simplest starting point is always going to be TMI: time, money, and interest
rate scenarios. The fancy talk—galimatias—does
not help me achieve my goal.
But we want to still keep it as simple as possible for the situation. The important thing to remember is that we should always be leaning towards making the analysis or decision simpler—not more complex. The single statistic parameters I discussed earlier do not help us achieve that goal. To me, the simplest starting point is always going to be TMI: time, money, and interest rate scenarios. The fancy talk—galimatias—does not help me achieve my goal.
Final, final thought: Spring has seemingly sprung here in Illinois, which means I will soon be able to procure farm fresh vegetables like corn on the cob and fresh tomatoes (yes, I know they are fruit!). I look forward to roasted corn on the cob and a great Caprese salad…soon!
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