The Response...

We all know the tale...the man, given the gift of flight and able to fashion the perfect wings, only to take advantage just a little bit too far, melting off the coating of adhesive wax and falling back to the earth below. Time and time again throughout history, societies could have done well to heed the lessons inherent within this story. And yet, human nature drives us...no, it FORCES us to just try to take that one little bit more. That fateful..."if I could just...then I will be done...really..." The first mortgage brokers who sold subprime loans and got rich doing it...the first insurance companies who wrote massive amounts of Credit Default Swaps...the first rating agencies that "rated" packages of loans AAA...these entities were not the problem. The problem lies in the addiction...that need we all have to get just a little bit more and to eek out that last remaining possibility of performance. When bad practices with selfish aims begin to crowd out and erode more prudent foundations, it's only a matter of time before a house of cards comes crumbling down, or, better yet, wings of wax wither and melt as the fundamental forces of physics dictate a final trajectory.

2008. The year of the "structured product." There is nothing wrong with structured products. These securities, derivatives, are meant to hedge risk. Their returns are based on price movements or returns generated by some "underlying assets." The problem arises when the term "hedging risk" becomes synonomous with "eliminating risk," and clients eventually believe their accounts can never go down. The important thing to always remember, the first question to be asked with ANY security is HOW DO I POTENTIALLY LOSE MONEY? That's it, right there, plain and simple. If it's not FDIC insured...if it's not a CD...if it's paying more than some "risk free" rate, then, by definition, there is a risk, and there is a potential of loss. After 2008, it should be crystal clear to all investors that the idea that they "don't have to worry about a risk that is so miniscule, so infinitessimally small, that it could never happen", that idea, it has to be thrown out the window.

I recently read a paper regarding asset and liability matching and M-notes. Asset and Liability matching is a technical term, frequently used to duration match the cash flows of fixed income portfolios with pre-set or predetermined liabilities, or liability projections. It is used most often with large institutional pensions...they have assets that need to be there for retirees, and those assets need to be managed in such a way that there is the best possible chance that what is needed will always be there. It's tough, in my view, to take that approach and apply it to an individual person. If you think of a company as a large group of people, you feel like, as the group gets larger and larger, for the most part, the behavior of the group as a whole, which will have many common and similar interests, will be easier and easier to predict. Not with 100% certainty, and not for 100% of the members all the time. But, the averages used in the actuarial calculations for large groups of people are those for a reason...there are always deviations but, for the most part, projections can be made to reasonably conform to reality. Trying to do any such thing for an individual or single household...WOW. That would be tough. Not because the intellectual foundation is wrong or incorrect, rather, it's just so hard to know the exact liabilities that one will incur next week, next month, next year, or over the next 10 years. If one were to base their calculations on the averages for the population at large and then have an experience drastically different from the average of that population...well, I would shudder to think. Until one has a crystal ball, I'm not sure that this institutional approach is going to have widespread applicability to individuals, especially since those truly concerned can position portions of their portfolios in guaranteed products, like annuities.

M-notes are interesting. My understanding is that they cap both upside and downside of "an index." A cursory read seems to make it appear that there is no way to lose money. At worst, principal is returned. I am disconcerted, not because it seems like a horrible idea, but because it seems like too good of an idea. How is the "packager" making money? How does the investor "lose"? Where is the catch? It is unclear. Why is this different from an annuity or other product with some type of "guarantee" attached? Not enough is known to draw a complete opinion at this point, but, when in doubt I will always return to the fundamental truths. Risk always persists. Always look for the ways in which you can lose, and be surprised and even skeptical when these seem to be outweighed by the probability of a win. The extra thought and care, it will have no effect on the intrinsic value of the opportunity and, over the long-haul, you'll be glad you made the extra investment in time and effort. No idea can fly forever...they always come back to earth. Let's never be surprised.