Value? Exhorts the Reader to Pay Closer Term Paper

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value? exhorts the reader to pay closer attention to the drivers of value. He argues that bubbles typically occur when people in the financial community lose sight of value, and that this is something that should be guarded against. Tried and true economic principles, he argues, will always hold, and the prudent investor will never forget them.

The prompt for Koller's article is the recession of 2008-2009, which resulted in a crisis. He spends a few paragraphs explaining, in brief, how he sees the crisis as having emerged. He cites two key factors. One is that a misinterpretation of the concept of value led bankers and investors alike to consider mortgage-backed securities as safe when they weren't. The mistake about value was thinking that by securitizing mortgages, that added value. He makes the point that securitizing the mortgages did not enhance their value, and therefore these products should not have been any more marketable than the original risky mortgages were. The market felt that securitizing the mortgages reduced the risk inherent in them, and that was where the value was added. Koller points out that the cash flows were not affected by the securitization, and it is cash flows where value comes from. The securitization was intended to spread out the risk, but in truth all mortgages are related to interest rates, and therefore the risk of default on a given mortgage due to interest rate increases does not change.

The second thing Koller thinks contributed to the crisis was the borrowing using short-term debt in order to finance long-term risk. In particular, the illiquidity of the mortgage-backed securities was an issue. He points to a trend in asset bubbles of the past, where short-term borrowing was used to fuel demand for long-term illiquid assets. In all cases, when problems arise with the financing, such as rising rates or an inability to pay, the long-term asset cannot be easily moved. In the housing bubble, lenders assumed that the people buying the house would either make more money and be able to pay the higher interest rates, or that the house would still be going up in value and could therefore be either remortgaged or sold. Rising interest rates in the economy actually crushed the housing market as early as 2006, and the result was that the housing market became illiquid. Too many borrowers could not pay, and could not sell either. The lenders, who had been borrowing using short-term debt, were all of a sudden unable to meet their obligations because their own borrowers were unable to pay and the assets were difficult to sell. A cash flow problem occurred, and Koller notes that a similar pattern existing in several previous asset bubbles. Such bubbles, he argues, do not occur where markets are liquid, or they are at least not as destructive. He uses the example of the dot com bubble, which was nowhere near as destructive because equities have high liquidity.

Analysis

Koller uses his conclusions about asset bubbles to examine the issue of value. He argues that value comes from cash flows, and that only things that enhance cash flows enhance value. This is a fair assumption, and he specifically questions the idea that value can be derived by changing the type of financing. This notion of course goes back to Modigliani and Miller, though that theory rests on a number of assumptions that do not hold in the real world and therefore have been subject to considerable scrutiny. One of the first examinations of MM assumptions was the "no tax" stipulation, which of course is entirely unrealistic. Koller argues that capital structure is irrelevant to value. He cites tactics like borrowing to finance share buybacks as an example, but that may be cherry-picking. Firms engaged in such activity are seeking to restructure their capital structure, or they are seeking to artificially bolster share price in the short run. In the latter case, such a tactic will fail in the long run and stock price will not be bolstered, which is why for some investors aggressive share buybacks are a red flag. However, adjusting the capital structure is a different rationale, and one that makes more sense. Even MM admitted early in the discussion about their work that tax policy affects value. The U.S. tax code, for example, favors debt financing (Pagano, 2012). Thus, changes in capital structure can add value to the firm, because such changes do affect cash flows.

Koller's use of oversimplification again can be questioned with his assertion that securitization does not create value because as with capital structure, securitization can enhance cash flows.

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While it did not in the case of MBSs, normally diversification reduces risk, and by securitizing mortgages in a basket of other mortgages, risk should have been reduced. Thus, with lower expected volatility, the expected cash flows are subject to less risk. In the case of the mortgage-backed securities, it was not that the securitization failed to create value, it is that the MBSs were not nearly as diversified as people thought they were. First, some were so complex that nobody knew where the risk was, which led to assumptions that the risk must be with a different counterparty -- nobody assumed they were the ones holding the risk. Second, AAA ratings on the products misstated the risk, so buyers paid more than they should have for the products. Third, all mortgages as susceptible to increases in interest rates, which means again that buyers misunderstood the risks and overpaid for the products. Fourth, buyers misjudged the liquidity of the underlying assets because the liquidity conditions in a rising market are very different from the liquidity conditions in a falling market. These factors undermine Koller's contention that value is not created by securitization, and instead point to informational asymmetry as the cause of mispricing in the MBS market. Had these securities been fairly valued all along, the crisis would never have occurred. This is especially true given that much of the credit crunch is attributed to the erosion of trust in counterparties that emerged as the result of the confusion about the real risks inherent in the product.

None of this of course undermines Koller's core argument about value. That Koller's argument has logical flaws does not mean that Koller is entirely wrong. The article itself is an argumentative essay to persuade the reader to focus on underlying value when making investment decisions, and to be especially cautious of using short-term borrowing to pay for long-term illiquid assets. The first part of his exhortation makes a lot of sense. While it is tempting to believe in perfectly rational markets because they make our economic theories work better, the overwhelming preponderance of evidence suggests that markets are not rational. Ackert et al. (2003) note that there is a tendency towards irrational behavior that must be countered by market design. In a market such as that with MBSs where there is no opportunity for short-selling and where there are liquidity problems, irrationality is more likely to result in prolonged deviation from intrinsic value. Further, the MBS market was characterized by information asymmetry, another contributor to market failure.

As Koller's argument goes, if there is irrational market behavior, there can be asset bubbles, and in conditions of illiquidity these can be especially problematic. Investors who focus on factors other than underlying value put themselves in a position to be in a bubble -- they fail to gather adequate information about their investments and are therefore not acting rational. On that, Koller is right.

The other point of his argument is that that short-term borrowing should not be one for long-term illiquid assets. Again, Koller's point is valid. Wherever there is a fundamental misalignment between the source and disposition of cash flows, there is risk. Koller cites the MBS example, where asset value became trapped in an illiquid housing market. When house prices declined, borrowers were unable to pay, and the crisis began. He also cited the Asian currency crisis of 1997. In South Korea, for example, massive investments in factories were made using borrowings in dollars. This would have worked out had there not been overcapacity in those industries -- it was the overcapacity that made those factories illiquid because the market value of those assets is tied to future cash flows, not the cost of the asset in the first place. So Koller's maxim makes sense here as well. He is correct in persuading people to avoid the temptation to structure this sort of mismatch between financing and cash flows, because the risk on the cash flow side of an illiquid asset is high enough that should there be problems, a credit crunch emerges very quickly. This is why it only took a couple of years for the bad mortgages to be a problem -- the rates were increasing quickly Had those rates been locked in for a decade or more, the credit crunch would not have happened so quickly.

Koller….....

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