Financial Markets: There's Nowhere to Hide

The history of Wall Street is littered with financial products that work well in theory and then when they are introduced on a small scale. Next comes the overhyping by salespeople who don't (and may not want to) understand the risks. Sales ramp up to customers who have even a smaller understanding but who are enamored by prospects of high returns. At some point an event sparks some selling in these "low-risk" assets, buying dries up, panic selling ensues, then governments must step in to save the entire system.

We saw this pattern in 1987 with portfolio insurance and in 2008 with mortgage-backed securities and collateralized debt obligations.

Now there are warnings about exchange-traded funds (ETF's):

these funds rely on a complex Wall Street trading ecosystem. An investor never trades directly with the fund company; instead, shares are created or redeemed through major investment banks and brokerage houses, such as Goldman Sachs. These firms, called authorized participants, or APs, are always a step removed from the end investor, and function as the ETF market's hidden chemists. Their buying and selling securities in exchange for ETFs is what keeps ETF prices accurate and close to the index a fund is supposed to track.

The specific task of APs is to exchange baskets of securities for ETF "creation units," which are sliced up for purchase by individual investors, advisors, and small institutions. APs also do the same in reverse, retiring unwanted ETF shares by exchanging them for the underlying assets.....The result is that exchange-traded fund prices mostly hew to the value of their underlying baskets, thanks to arbitrageurs who boost the supply of ETF shares when they're in demand (as exhibited by an ETF's price rising above the fair market value of its assets) or reduce it when an ETF's share price sinks below net asset value.

When there are many buyers and sellers of shares of both the ETF's and the assets that ETF's hold, all is well. But the words "complex Wall Street trading ecosystem", "creation units," and "arbitrageurs" should be setting off alarm bells to experienced observers of the Wall Street scene.

For our own portfolios we can try to limit the damage by avoiding ETF's altogether, but as recent events have taught us there's nowhere to hide.

Slicing and Dicing the Apple

AAPL rose Thursday when a hedge fund called for cash payouts on new preferred shares.

On Thursday Apple investor David Einhorn filed a lawsuit to defeat Apple's shareholder proposal that would make it more difficult to issue preferred stock. Mr. Einhorn believes that a new issue of preferred will enhance total shareholder returns more than other actions, such as simply raising the common stock dividend.

Sidebar: preferred stock is commonly viewed as a hybrid security having characteristics of both debt and equity. Like debt, it usually carries a fixed coupon and has priority above common stock in cash distributions. Like common stock, there is no "principal" to be repaid by a certain date and no legal obligation to pay dividends, which may be suspended if the board decides (the unpaid dividends accumulate and normally must be brought current before common dividends can resume, however). The income tax treatment of preferred stock dividends is the same as common stock, both for payor and payee.

In Mr. Einhorn's estimation, Apple preferred will be snapped up by fixed-income investors, that is, many of the same people who buy bonds.

Assuming a 5% yield, a preferred security from Apple that paid $2 billion in total annual income would have an implied market value of $40 billion. Thought of another way, it would sport an earnings multiple of 20 times.

This is where we need to get out our sharp pencil. Apple's market capitalization at today's closing price totaled $446 billion ($474.98 x 939 million shares). In theory that amount represents the market's calculation of the present value of all cash flows that common shareholders will receive in the future, discounted at a rate appropriate to Apple's risk. Mr. Einhorn thinks that that discount rate is too high and penalizes Apple's valuation.

If we follow the example in the WSJ article, preferred shares with an annual payout of $2 billion will be worth $40 billion. The $40 billion isn't coming out of the air: there will be $2 billion per year that will no longer be available to the common shareholders at some point in the future (the current dividend of $10.60 per year won't be reduced and is very safe). In theory the value of the common shares will go down because the new preferred skims off the least risky equity cash flows, but the drop should be much less than the $40 billion added by the preferred.

[Update - 2/9 from Barron's: "We think for every $50 billion of preferred that Apple issues, it would unlock about $32 a share in Apple," Einhorn told CNBC. He seems to be saying investors would get $50 of preferred and see the common fall about $18 a share.]

We have seen this act before. In the heyday of securitization sharp financiers sliced and diced the cash flows. They issued a multitude of debt securities that were assigned low discount rates (and high prices) by a marketplace that misapprehended risks and relied on fallible rating agencies to evaluate them properly. Through financial legerdemain the sum of the new securitized parts was worth more than the original whole, even after generous fees were paid to Wall Street. After the financial collapse, many of the securities, even some with an AAA rating, became worthless.

True, it's unlikely that there will be negative consequences if Apple does go ahead with a preferred stock issue, but why take that risk and complicate matters? If bulls are correct, eventually the market will come to its senses and assign a higher price to Apple common shares, although not as quickly as hedge fund managers like David Einhorn would like.

Speaking as an individual little-guy investor, I say let Apple's finances be clean and simple, just like its products. © 2013 Stephen Yuen

Fool Me Twice, Shame on Me

The troubles of too-big-to-fail banks weren't the only reason that the world financial system nearly collapsed in 2008.

Another major problem was the widespread use of complex financial products that didn't react as their investors thought they would to changing market conditions . The most infamous of these are derivatives, which Warren Buffett prophesied in 2003 were "financial weapons of mass destruction".

Less well-known, but just as damaging, were bonds based on securitizations of cash-generating assets such as credit-card receivables, home mortgages, or airplane leases. In a typical securitization thousands of assets are sold by one or more financial institutions to a special-purpose vehicle (SPV) that issues bonds to pay for the assets.

Quantitative modeling by investment banks "proved" through stress-testing that, for example, the "AAA" tranche of bonds will always get paid its principal and interest even under dire economic circumstances. The AAA bonds were able to command a low interest rate because they were low-risk; the B and C tranches had higher risk because they had a lower priority in the cash flow "waterfall" and had to pay a higher interest rate. Through the magic of financial structuring and computer modeling, the total of A, B, and C bond proceeds often exceeded the cost of the original assets, and financial institutions were able to make a pretty penny by flipping their portfolios into securitization SPV's.

Of course, when people stopped paying their mortgages, credit cards, and leases, it turned out that the administration of late payments, penalties, interest, and liquidation proceeds was much trickier than had been designed on paper. Even the triple-A bondholders had to take a haircut.

Which brings us to the latest brainstorm by the creative geniuses on Wall Street: the securitization of rents on foreclosed homes. There are many questions about how this securitization would work, beginning with whether the SPV actually owned the homes or merely owned the rents under contract. If the SPV did not own the homes, it seems to this observer that there is too great a risk of conflict with the property owner. Also, the bonds would have to pay too high a rate to make a securitization worthwhile. So it's likely the property, as well as the rents, is part of the deal.

Whatever the structure or yield, I can't see how or why any prudential investor would want to invest in this stuff now, having been burned very recently. Caveat emptor.