7 Controversial Investing Theories

When it comes to investing, there is no shortage of theories on what makes the markets tick or what a particular market move means. The two largest factions on Wall Street are split along theoretical lines into adherents to an efficient market theory and those who believe the market can be beat. Although this is a fundamental split, many other theories attempt to explain and influence the market - and the actions of investors in the markets. In this article, we will look at some common (and uncommon) financial theories.

Efficient Market Hypothesis
Very few people are neutral on efficient market hypothesis (EMH). You either believe in it and adhere to passive, broad market investing strategies, or you detest it and focus on picking stocks based on growth potential, undervalued assets and so on. The EMH states that the market price for shares incorporates all the known information about that stock. This means that the stock is accurately valued until a future event changes that valuation. Because the future is uncertain, an adherent to EMH is far better off owning a wide swath of stocks and profiting from the general rise of the market.

Opponents of EMH point to Warren Buffett and other investors who have consistently beat the market by finding irrational prices within the overall market.

Fifty Percent Principle
The fifty percent principle predicts that, before continuing, an observed trend will undergo a price correction of one-half to two-thirds of the change in price. This means that if a stock has been on an upward trend and gained 20%, it will fall back 10% before continuing its rise. This is an extreme example, as most times this rule is applied to the short-term trends that technical analysts and traders buy and sell on.

This correction is thought to be a natural part of the trend, as it's usually caused by skittish investors taking profits early to avoid getting caught in a true reversal of the trend later on. If the correction exceeds 50% of the change in price, it's considered a sign that the trend has failed and the reversal has come prematurely.

Greater Fool Theory
The greater fool theory proposes that you can profit from investing as long as there is a greater fool than yourself to buy the investment at a higher price. This means that you could make money from an overpriced stock as long as someone else is willing to pay more to buy it from you.

Eventually you run out of fools as the market for any investment overheats. Investing according to the greater fool theory means ignoring valuations, earning reports and all the other data. Ignoring data is as risky as paying too much attention to it; so people ascribing to the greater fool theory could be left holding the short end of the stick after a market correction.

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Odd Lot Theory
The odd lot theory uses the sale of odd lots – small blocks of stocks held by individual investors – as an indicator of when to buy into a stock. Investors following the odd lot theory buy in when small investors sell out. The main assumption is that small investors are usually wrong.

The odd lot theory is contrarian strategy based off a very simple form of technical analysis – measuring odd lot sales. How successful an investor or trader following the theory is depends heavily on whether he checks the fundamentals of companies that the theory points toward or simply buys blindly. Small investors aren't going to be right or wrong all the time, so it's important to distinguish odd lot sales that are occurring from a low-risk tolerance from odd lot sales that are due to bigger problems. Individual investors are more mobile than the big funds and thus can react to severe news faster, so odd lot sales can actually be a precursor to a wider sell-off in a failing stock instead of just a mistake on the part of small-time investors.

Prospect Theory (Loss-Aversion Theory)
Prospect theory states that people's perceptions of gain and loss are skewed. That is, people are more afraid of a loss than they are encouraged by a gain. If people are given a choice of two different prospects, they will pick the one that they think has less chance of ending in a loss, rather than the one that offers the most gains. For example, if you offer a person two investments, one that has returned 5% each year and one that has returned 12%, lost 2.5%, and returned 6% in the same years, the person will pick the 5% investment because he puts an irrational amount of importance on the single loss, while ignoring the gains that are of a greater magnitude. In the above example, both alternatives produce the net total return after three years.

Prospect theory is important for financial professionals and investors. Although the risk/reward trade-off gives a clear picture of the risk amount an investor must take on to achieve the desired returns, prospect theory tells us that very few people understand emotionally what they realize intellectually. For financial professionals, the challenge is in suiting a portfolio to the client's risk profile, rather than reward desires. For the investor, the challenge is to overcome the disappointing predictions of prospect theory and become brave enough to get the returns you want.

Rational Expectations Theory
Rational expectations theory states that the players in an economy will act in a way that conforms to what can logically be expected in the future. That is, a person will invest, spend, etc. according to what he or she rationally believes will happen in the future. By doing so, that person creates a self-fulfilling prophecy that helps bring about the future event.

Although this theory has become quite important to economics, its utility is doubtful. For example, an investor thinks a stock is going to go up, and by buying it, this act actually causes the stock to go up. This same transaction can be framed outside of rational expectations theory. An investor notices that a stock is undervalued, buys it, and watches as other investors notice the same thing, thus pushing the price up to its proper market value. This highlights the main problem with rational expectations theory: it can be changed to explain everything, but it tells us nothing.

Short Interest Theory
Short interest theory posits that a high short interest is the precursor to a rise in the stock's price and, at first glance, appears to be unfounded. Common sense suggests that a stock with a high short interest – that is, a stock that many investors are short selling – is due for a correction. The reasoning goes that all those traders, thousands of professionals and individuals scrutinizing every scrap of market data, surely can't be wrong. They may be right to an extent, but the stock price may actually rise by virtue of being heavily shorted. Short sellers have to eventually cover their positions by buying the stock they've shorted. Consequently, the buying pressure created by the short sellers covering their positions will push the share price upward.

The Bottom Line
We have covered a wide range of theories, from technical trading theories like short interest and odd lot theory to economic theories like rational expectations and prospect theory. Every theory is an attempt to impose some type of consistency or frame to the millions of buy and sell decisions that make the market swell and ebb daily. While it is useful to know these theories, it is also important to remember that no unified theory can explain the financial world. During certain time periods, one theory seems to hold sway only to be toppled the next instant. In the financial world, change is the only true constant.

The Greater Fool Theory

The Greater Fool Theory:  Buy from Suckers, Sell to Suckers

What’s Wrong with the Stock Market?

What’s Wrong with the Stock Market?

April 14th, 2009

The problem with the stock market started back before the end of the 18th century—in 1792 as a matter of fact. This was when the stock market as we know it was born under a tree in lower Manhattan. It was there and then that those who first bought and sold stocks as a business got together and formed what became the New York Stock Exchange. From those beginnings, an industry was born that has grown to be one of the most powerful and financially influential in the world.

Transaction-based Compensation – the Wrong Dynamic
Actually, the problem arose from the fact that these people made their money not from any appreciation in the value of the investments they bought and sold but rather from just putting buyers and sellers of those shares together. They profited from the transaction itself. To this day, the majority of brokers receive their compensation as a result of the purchase or sale. It makes no financial difference to them whether their customer gains or loses.

I don’t mean to imply that, just because these people fill a need and are compensated for doing so, they’re bad people. Certainly the existence of this industry is what makes the ownership of stock feasible for the average person. It’s responsible for elevating common stock to the level of liquidity that allows us to own it without fear of being stuck with it when or if we choose to sell it. And it certainly makes it much easier for us to buy those shares when we wish to. If we’re interested in putting our money to work for us in what is arguably the most lucrative manner possible for the least amount of risk, we can’t get along without this industry. But, the difference in perception and fact between what a broker does or is qualified to do and what the uninitiated think he or she is qualified to do is a major source of the problem.

In the beginning, the whole idea of shares was just that: sharing in the fortunes of an enterprise. Where it might be difficult for a company or individual to come up with enough money to finance all that was necessary alone, sharing the business with others in a fashion that limited their liability and exposure to only the amount of money invested was a great way to obtain the necessary funds. Anyone who wanted to participate in a business—sharing both the rewards and the risks—would buy shares and hold them as legal documents that vouched for their entitlement to a proportionate share in the fruits of that enterprise’s operations. Originally, therefore, folks bought shares because they thought the business would be profitable one and they wanted a piece of the action.

The formation of a ready market for stocks, while it performed a very useful service in terms of liquidity and convenience, had a serious side effect. So easy was it to trade that the perception of what a share of stock really was became obscured, giving way to the notion that the stock, like currency, had some intrinsic value that could vary for reasons other than the success or failure of the underlying enterprise.

Easy Trading changed the Nature of the Market
Moreover, the ability to manipulate the perceived value of those shares erected a persistent barrier between those that manipulated it and those that didn’t. It was de rigueur for unscrupulous traders to spread rumors appealing to the fear of the uninitiated, driving down the price of a certain stock, and furnishing an opportunity to pick up a large position at that favorable price. And then it was an equally simple process for those same individuals to spread favorable rumors that appealed to the greedy, drove up the price, and resulted in a great selling opportunity for those who then owned it. Not until well into the 20th century, after the devastating crash of 1929, was there a real effort to address that issue legislatively and make such activities illegal.

However, there was—and is—no way to legislate the greed and fear out of the stock market. Those are still its basic drivers. In fact, as recently as within the last decade, a young kid from New Jersey managed to make nearly a million dollars when he flooded the Internet with glowing stories about a penny stock he had selected for his venture. Unwitting investors bid up the price of the stock with no more to go on than his fiction; and he made a killing.

Disconnect Between Value and Price Creates Bubbles and Busts
The very same dynamics of greed and fear were responsible for an even more spectacular event that impacted millions of shareholders. The appeal of the dot.coms, most of them with no visible means of support—and the technology companies that depended upon them for their burgeoning customer base—inflated one of history’s biggest bubbles. Investors, eager to make a killing, continued to bid up the price of the stock in those companies with no regard for or even any understanding of the factors that comprised their underlying value. This was what the Street refers to as the Greater Fool Theory: “I may be a fool to buy this stock at this price; but I’ll find a greater fool to take it off my hands for more than I paid for it!”

The market of course collapsed when those companies—like Wiley Coyote racing off a cliff only to discover he had nothing under him—learned the hard way that a company had to earn money to live. The extent of that collapse went well beyond rational concerns about the profitability of the affected companies, being exacerbated in large measure by irrational fears growing out of the September 11th, 2001, attack on New York’s World Trade Center and our country’s bellicose activities following that tragedy.

http://www.financialiteracy.us/wordpress/articles/what%E2%80%99s-wrong-with-the-stock-market/

Buffett restates the greater fool theory

The Oracle of Omaha restates the greater fool (note the lower case ‘'f'’!) theory: “the rising price has on its own generated additional buying enthusiasm, attracting purchasers who see the  rise as validating an investment thesis. As "bandwagon" investors join any party, they create their own truth – for a while”.

Buffett: The case for shares. "It will be by far the safest."

Unsurprisingly, Buffett makes the case for investing in shares – the productive capacity of democratic capitalism. He also gives a sense of the best businesses to own. Buffett prefers '‘first-class'’ companies that can keep up with inflation and that also require only minimal new capital to produce their returns. Buffett cites Coca-Cola (NYSE:KO) as one such example.

He says “I believe that over any extended period of time this category of investing will prove to be the runaway winner among the three (gold, cash & bonds and shares) we've examined. More important, it will be by far the safest.”

That’s a critical point – equities are often characterised as risky, volatile and complex (and some companies’ shares can be all three), but when compared to the risk taken by buying assets that don’t sustain your purchasing power, Buffett argues that the safest way to secure your financial future is to swap some shorter term volatility for longer term ‘'purchasing power'’ protection.

Comparing the returns from investing in the three asset classes discussed since 1965.

• $US100 invested in US government bonds would have compounded to be worth $US1336 by the end of 2011. 
• Gold would have far outpaced cash, turning into $US4455. 
• But equities would have done over one-third better, compounding its way to $US6072.

Read more: http://www.watoday.com.au/business/motley-fool/why-buffett-is-cold-on-gold-20120214-1t3vk.html#ixzz1mUyR1s59

The Oracle of Omaha restates the greater fool (note the lower case ‘'f'’!) theory: “the rising price has on its own generated additional buying enthusiasm, attracting purchasers who see the rise as validating an investment thesis. As "bandwagon" investors join any party, they create their own truth – for a while”.

What’s Wrong with the Stock Market?

What’s Wrong with the Stock Market?
April 14th, 2009

The problem with the stock market started back before the end of the 18th century—in 1792 as a matter of fact. This was when the stock market as we know it was born under a tree in lower Manhattan. It was there and then that those who first bought and sold stocks as a business got together and formed what became the New York Stock Exchange. From those beginnings, an industry was born that has grown to be one of the most powerful and financially influential in the world.

Transaction-based Compensation – the Wrong Dynamic
Actually, the problem arose from the fact that these people made their money not from any appreciation in the value of the investments they bought and sold but rather from just putting buyers and sellers of those shares together. They profited from the transaction itself. To this day, the majority of brokers receive their compensation as a result of the purchase or sale. It makes no financial difference to them whether their customer gains or loses.

I don’t mean to imply that, just because these people fill a need and are compensated for doing so, they’re bad people. Certainly the existence of this industry is what makes the ownership of stock feasible for the average person. It’s responsible for elevating common stock to the level of liquidity that allows us to own it without fear of being stuck with it when or if we choose to sell it. And it certainly makes it much easier for us to buy those shares when we wish to. If we’re interested in putting our money to work for us in what is arguably the most lucrative manner possible for the least amount of risk, we can’t get along without this industry. But, the difference in perception and fact between what a broker does or is qualified to do and what the uninitiated think he or she is qualified to do is a major source of the problem.

In the beginning, the whole idea of shares was just that: sharing in the fortunes of an enterprise. Where it might be difficult for a company or individual to come up with enough money to finance all that was necessary alone, sharing the business with others in a fashion that limited their liability and exposure to only the amount of money invested was a great way to obtain the necessary funds. Anyone who wanted to participate in a business—sharing both the rewards and the risks—would buy shares and hold them as legal documents that vouched for their entitlement to a proportionate share in the fruits of that enterprise’s operations. Originally, therefore, folks bought shares because they thought the business would be profitable one and they wanted a piece of the action.

The formation of a ready market for stocks, while it performed a very useful service in terms of liquidity and convenience, had a serious side effect. So easy was it to trade that the perception of what a share of stock really was became obscured, giving way to the notion that the stock, like currency, had some intrinsic value that could vary for reasons other than the success or failure of the underlying enterprise.

Easy Trading changed the Nature of the Market
Moreover, the ability to manipulate the perceived value of those shares erected a persistent barrier between those that manipulated it and those that didn’t. It was de rigueur for unscrupulous traders to spread rumors appealing to the fear of the uninitiated, driving down the price of a certain stock, and furnishing an opportunity to pick up a large position at that favorable price. And then it was an equally simple process for those same individuals to spread favorable rumors that appealed to the greedy, drove up the price, and resulted in a great selling opportunity for those who then owned it. Not until well into the 20th century, after the devastating crash of 1929, was there a real effort to address that issue legislatively and make such activities illegal.

However, there was—and is—no way to legislate the greed and fear out of the stock market. Those are still its basic drivers. In fact, as recently as within the last decade, a young kid from New Jersey managed to make nearly a million dollars when he flooded the Internet with glowing stories about a penny stock he had selected for his venture. Unwitting investors bid up the price of the stock with no more to go on than his fiction; and he made a killing.

Disconnect Between Value and Price Creates Bubbles and Busts
The very same dynamics of greed and fear were responsible for an even more spectacular event that impacted millions of shareholders. The appeal of the dot.coms, most of them with no visible means of support—and the technology companies that depended upon them for their burgeoning customer base—inflated one of history’s biggest bubbles. Investors, eager to make a killing, continued to bid up the price of the stock in those companies with no regard for or even any understanding of the factors that comprised their underlying value. This was what the Street refers to as the Greater Fool Theory: “I may be a fool to buy this stock at this price; but I’ll find a greater fool to take it off my hands for more than I paid for it!”

The market of course collapsed when those companies—like Wiley Coyote racing off a cliff only to discover he had nothing under him—learned the hard way that a company had to earn money to live. The extent of that collapse went well beyond rational concerns about the profitability of the affected companies, being exacerbated in large measure by irrational fears growing out of the September 11th, 2001, attack on New York’s World Trade Center and our country’s bellicose activities following that tragedy.

http://www.financialiteracy.us/wordpress/articles/what%E2%80%99s-wrong-with-the-stock-market/

Goldman Sach and CDOs: Banks Bundled Bad Debt, Bet Against It and Won

December 24, 2009

Banks Bundled Bad Debt, Bet Against It and Won

By GRETCHEN MORGENSON and LOUISE STORY

In late October 2007, as the financial markets were starting to come unglued, a Goldman Sachs trader, Jonathan M. Egol, received very good news. At 37, he was named a managing director at the firm.

Mr. Egol, a Princeton graduate, had risen to prominence inside the bank by creating mortgage-related securities, named Abacus, that were at first intended to protect Goldman from investment losses if the housing market collapsed. As the market soured, Goldman created even more of these securities, enabling it to pocket huge profits.

Goldman’s own clients who bought them, however, were less fortunate.

Pension funds and insurance companies lost billions of dollars on securities that they believed were solid investments, according to former Goldman employees with direct knowledge of the deals who asked not to be identified because they have confidentiality agreements with the firm.

Goldman was not the only firm that peddled these complex securities — known as synthetic collateralized debt obligations, or C.D.O.’s — and then made financial bets against them, called selling short in Wall Street parlance. Others that created similar securities and then bet they would fail, according to Wall Street traders, includeDeutsche Bank and Morgan Stanley, as well as smaller firms like Tricadia Inc., an investment company whose parent firm was overseen by Lewis A. Sachs, who this year became a special counselor to Treasury Secretary Timothy F. Geithner.

How these disastrously performing securities were devised is now the subject of scrutiny by investigators in Congress, at the Securities and Exchange Commission and at the Financial Industry Regulatory Authority, Wall Street’s self-regulatory organization, according to people briefed on the investigations. Those involved with the inquiries declined to comment.

While the investigations are in the early phases, authorities appear to be looking at whether securities laws or rules of fair dealing were violated by firms that created and sold these mortgage-linked debt instruments and then bet against the clients who purchased them, people briefed on the matter say.

One focus of the inquiry is whether the firms creating the securities purposely helped to select especially risky mortgage-linked assets that would be most likely to crater, setting their clients up to lose billions of dollars if the housing market imploded.

Some securities packaged by Goldman and Tricadia ended up being so vulnerable that they soured within months of being created.

Goldman and other Wall Street firms maintain there is nothing improper about synthetic C.D.O.’s, saying that they typically employ many trading techniques to hedge investments and protect against losses. They add that many prudent investors often do the same. Goldman used these securities initially to offset any potential losses stemming from its positive bets on mortgage securities.

But Goldman and other firms eventually used the C.D.O.’s to place unusually large negative bets that were not mainly for hedging purposes, and investors and industry experts say that put the firms at odds with their own clients’ interests.

“The simultaneous selling of securities to customers and shorting them because they believed they were going to default is the most cynical use of credit information that I have ever seen,” said Sylvain R. Raynes, an expert in structured finance at R & R Consulting in New York. “When you buy protection against an event that you have a hand in causing, you are buying fire insurance on someone else’s house and then committing arson.”

Investment banks were not alone in reaping rich rewards by placing trades against synthetic C.D.O.’s. Some hedge funds also benefited, including Paulson & Company, according to former Goldman workers and people at other banks familiar with that firm’s trading.

Michael DuVally, a Goldman Sachs spokesman, declined to make Mr. Egol available for comment. But Mr. DuVally said many of the C.D.O.’s created by Wall Street were made to satisfy client demand for such products, which the clients thought would produce profits because they had an optimistic view of the housing market. In addition, he said that clients knew Goldman might be betting against mortgages linked to the securities, and that the buyers of synthetic mortgage C.D.O.’s were large, sophisticated investors, he said.

The creation and sale of synthetic C.D.O.’s helped make the financial crisis worse than it might otherwise have been, effectively multiplying losses by providing more securities to bet against. Some $8 billion in these securities remain on the books at American International Group, the giant insurer rescued by the government in September 2008.

From 2005 through 2007, at least $108 billion in these securities was issued, according to Dealogic, a financial data firm. And the actual volume was much higher because synthetic C.D.O.’s and other customized trades are unregulated and often not reported to any financial exchange or market.

Goldman Saw It Coming

Before the financial crisis, many investors — large American and European banks, pension funds, insurance companies and even some hedge funds — failed to recognize that overextended borrowers would default on their mortgages, and they kept increasing their investments in mortgage-related securities. As the mortgage market collapsed, they suffered steep losses.

A handful of investors and Wall Street traders, however, anticipated the crisis. In 2006, Wall Street had introduced a new index, called the ABX, that became a way to invest in the direction of mortgage securities. The index allowed traders to bet on or against pools of mortgages with different risk characteristics, just as stock indexes enable traders to bet on whether the overall stock market, or technology stocks or bank stocks, will go up or down.

Goldman, among others on Wall Street, has said since the collapse that it made big money by using the ABX to bet against the housing market. Worried about a housing bubble, top Goldman executives decided in December 2006 to change the firm’s overall stance on the mortgage market, from positive to negative, though it did not disclose that publicly.

Even before then, however, pockets of the investment bank had also started using C.D.O.’s to place bets against mortgage securities, in some cases to hedge the firm’s mortgage investments, as protection against a fall in housing prices and an increase in defaults.

Mr. Egol was a prime mover behind these securities. Beginning in 2004, with housing prices soaring and the mortgage mania in full swing, Mr. Egol began creating the deals known as Abacus. From 2004 to 2008, Goldman issued 25 Abacus deals, according to Bloomberg, with a total value of $10.9 billion.

Abacus allowed investors to bet for or against the mortgage securities that were linked to the deal. The C.D.O.’s didn’t contain actual mortgages. Instead, they consisted ofcredit-default swaps, a type of insurance that pays out when a borrower defaults. These swaps made it much easier to place large bets on mortgage failures.

Rather than persuading his customers to make negative bets on Abacus, Mr. Egol kept most of these wagers for his firm, said five former Goldman employees who spoke on the condition of anonymity. On occasion, he allowed some hedge funds to take some of the short trades.

Mr. Egol and Fabrice Tourre, a French trader at Goldman, were aggressive from the start in trying to make the assets in Abacus deals look better than they were, according to notes taken by a Wall Street investor during a phone call with Mr. Tourre and another Goldman employee in May 2005.

On the call, the two traders noted that they were trying to persuade analysts at Moody’s Investors Service, a credit rating agency, to assign a higher rating to one part of an Abacus C.D.O. but were having trouble, according to the investor’s notes, which were provided by a colleague who asked for anonymity because he was not authorized to release them. Goldman declined to discuss the selection of the assets in the C.D.O.’s, but a spokesman said investors could have rejected the C.D.O. if they did not like the assets.

Goldman’s bets against the performances of the Abacus C.D.O.’s were not worth much in 2005 and 2006, but they soared in value in 2007 and 2008 when the mortgage market collapsed. The trades gave Mr. Egol a higher profile at the bank, and he was among a group promoted to managing director on Oct. 24, 2007.

“Egol and Fabrice were way ahead of their time,” said one of the former Goldman workers. “They saw the writing on the wall in this market as early as 2005.” By creating the Abacus C.D.O.’s, they helped protect Goldman against losses that others would suffer.

As early as the summer of 2006, Goldman’s sales desk began marketing short bets using the ABX index to hedge funds like Paulson & Company, Magnetar and Soros Fund Management, which invests for the billionaire George Soros. John Paulson, the founder of Paulson & Company, also would later take some of the shorts from the Abacus deals, helping him profit when mortgage bonds collapsed. He declined to comment.

A Deal Gone Bad, for Some

The woeful performance of some C.D.O.’s issued by Goldman made them ideal for betting against. As of September 2007, for example, just five months after Goldman had sold a new Abacus C.D.O., the ratings on 84 percent of the mortgages underlying it had been downgraded, indicating growing concerns about borrowers’ ability to repay the loans, according to research from UBS, the big Swiss bank. Of more than 500 C.D.O.’s analyzed by UBS, only two were worse than the Abacus deal.

Goldman created other mortgage-linked C.D.O.’s that performed poorly, too. One, in October 2006, was a $800 million C.D.O. known as Hudson Mezzanine. It included credit insurance on mortgage and subprime mortgage bonds that were in the ABX index; Hudson buyers would make money if the housing market stayed healthy — but lose money if it collapsed. Goldman kept a significant amount of the financial bets against securities in Hudson, so it would profit if they failed, according to three of the former Goldman employees.

A Goldman salesman involved in Hudson said the deal was one of the earliest in which outside investors raised questions about Goldman’s incentives. “Here we are selling this, but we think the market is going the other way,” he said.

A hedge fund investor in Hudson, who spoke on the condition of anonymity, said that because Goldman was betting against the deal, he wondered whether the bank built Hudson with “bonds they really think are going to get into trouble.”

Indeed, Hudson investors suffered large losses. In March 2008, just 18 months after Goldman created that C.D.O., so many borrowers had defaulted that holders of the security paid out about $310 million to Goldman and others who had bet against it, according to correspondence sent to Hudson investors.

The Goldman salesman said that C.D.O. buyers were not misled because they were advised that Goldman was placing large bets against the securities. “We were very open with all the risks that we thought we sold. When you’re facing a tidal wave of people who want to invest, it’s hard to stop them,” he said. The salesman added that investors could have placed bets against Abacus and similar C.D.O.’s if they had wanted to.

A Goldman spokesman said the firm’s negative bets didn’t keep it from suffering losses on its mortgage assets, taking $1.7 billion in write-downs on them in 2008; but he would not say how much the bank had since earned on its short positions, which former Goldman workers say will be far more lucrative over time. For instance, Goldman profited to the tune of $1.5 billion from one series of mortgage-related trades by Mr. Egol with Wall Street rival Morgan Stanley, which had to book a steep loss, according to people at both firms.

Tetsuya Ishikawa, a salesman on several Abacus and Hudson deals, left Goldman and later published a novel, “How I Caused the Credit Crunch.” In it, he wrote that bankers deserted their clients who had bought mortgage bonds when that market collapsed: “We had moved on to hurting others in our quest for self-preservation.” Mr. Ishikawa, who now works for another financial firm in London, declined to comment on his work at Goldman.

Profits From a Collapse

Just as synthetic C.D.O.’s began growing rapidly, some Wall Street banks pushed for technical modifications governing how they worked in ways that made it possible for C.D.O.’s to expand even faster, and also tilted the playing field in favor of banks and hedge funds that bet against C.D.O.’s, according to investors.

In early 2005, a group of prominent traders met at Deutsche Bank’s office in New York and drew up a new system, called Pay as You Go. This meant the insurance for those betting against mortgages would pay out more quickly. The traders then went to the International Swaps and Derivatives Association, the group that governs trading in derivatives like C.D.O.’s. The new system was presented as a fait accompli, and adopted.

Other changes also increased the likelihood that investors would suffer losses if the mortgage market tanked. Previously, investors took losses only in certain dire “credit events,” as when the mortgages associated with the C.D.O. defaulted or their issuers went bankrupt.

But the new rules meant that C.D.O. holders would have to make payments to short sellers under less onerous outcomes, or “triggers,” like a ratings downgrade on a bond. This meant that anyone who bet against a C.D.O. could collect on the bet more easily.

“In the early deals you see none of these triggers,” said one investor who asked for anonymity to preserve relationships. “These things were built in to provide the dealers with a big payoff when something bad happened.”

Banks also set up ever more complex deals that favored those betting against C.D.O.’s. Morgan Stanley established a series of C.D.O.’s named after United States presidents (Buchanan and Jackson) with an unusual feature: short-sellers could lock in very cheap bets against mortgages, even beyond the life of the mortgage bonds. It was akin to allowing someone paying a low insurance premium for coverage on one automobile to pay the same on another one even if premiums over all had increased because of high accident rates.

At Goldman, Mr. Egol structured some Abacus deals in a way that enabled those betting on a mortgage-market collapse to multiply the value of their bets, to as much as six or seven times the face value of those C.D.O.’s. When the mortgage market tumbled, this meant bigger profits for Goldman and other short sellers — and bigger losses for other investors.

Selling Bad Debt

Other Wall Street firms also created risky mortgage-related securities that they bet against.

At Deutsche Bank, the point man on betting against the mortgage market was Greg Lippmann, a trader. Mr. Lippmann made his pitch to select hedge fund clients, arguing they should short the mortgage market. He sometimes distributed a T-shirt that read “I’m Short Your House!!!” in black and red letters.

Deutsche, which declined to comment, at the same time was selling synthetic C.D.O.’s to its clients, and those deals created more short-selling opportunities for traders like Mr. Lippmann.

Among the most aggressive C.D.O. creators was Tricadia, a management company that was a unit of Mariner Investment Group. Until he became a senior adviser to the Treasury secretary early this year, Lewis Sachs was Mariner’s vice chairman. Mr. Sachs oversaw about 20 portfolios there, including Tricadia, and its documents also show that Mr. Sachs sat atop the firm’s C.D.O. management committee.

From 2003 to 2007, Tricadia issued 14 mortgage-linked C.D.O.’s, which it called TABS. Even when the market was starting to implode, Tricadia continued to create TABS deals in early 2007 to sell to investors. The deal documents referring to conflicts of interest stated that affiliates and clients of Tricadia might place bets against the types of securities in the TABS deal.

Even so, the sales material also boasted that the mortgages linked to C.D.O.’s had historically low default rates, citing a “recently completed” study by Standard & Poor’sratings agency — though fine print indicated that the date of the study was September 2002, almost five years earlier.

At a financial symposium in New York in September 2006, Michael Barnes, the co-head of Tricadia, described how a hedge fund could put on a negative mortgage bet by shorting assets to C.D.O. investors, according to his presentation, which was reviewed by The New York Times.

Mr. Barnes declined to comment. James E. McKee, general counsel at Tricadia, said, “Tricadia has never shorted assets into the TABS deals, and Tricadia has always acted in the best interests of its clients and investors.”

Mr. Sachs, through a spokesman at the Treasury Department, declined to comment.

Like investors in some of Goldman’s Abacus deals, buyers of some TABS experienced heavy losses. By the end of 2007, UBS research showed that two TABS deals were the eighth- and ninth-worst performing C.D.O.’s. Both had been downgraded on at least 75 percent of their associated assets within a year of being issued.

Tricadia’s hedge fund did far better, earning roughly a 50 percent return in 2007 and similar profits in 2008, in part from the short bets.

http://www.nytimes.com/2009/12/24/business/24trading.html?_r=1&src=me&ref=business






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Goldman Sachs Responds to The New York Times on Synthetic Collateralized Debt Obligations
December 24, 2009

Background: The New York Times published a story on December 24th primarily focused on the synthetic collateralized debt obligation business of Goldman Sachs. In response to questions from the paper prior to publication, Goldman Sachs made the following points.

As reporters and commentators examine some of the aspects of the financial crisis, interest has gravitated toward a variety of products associated with the mortgage market. One of these products is synthetic collateralized debt obligations (CDOs), which are referred to as synthetic because the underlying credit exposure is taken via credit default swaps rather than by physically owning assets or securities. The following points provide a summary of how these products worked and why they were created.

Any discussion of Goldman Sachs’ association with this product must begin with our overall activities in the mortgage market. Goldman Sachs, like other financial institutions, suffered significant losses in its residential mortgage portfolio due to the deterioration of the housing market (we disclosed $1.7 billion in residential mortgage exposure write-downs in 2008). These losses would have been substantially higher had we not hedged. We consider hedging the cornerstone of prudent risk management.

Synthetic CDOs were an established product for corporate credit risk as early as 2002. With the introduction of credit default swaps referencing mortgage products in 2004-2005, it is not surprising that market participants would consider synthetic CDOs in the context of mortgages. Although precise tallies of synthetic CDO issuance are not readily available, many observers would agree the market size was in the hundreds of billions of dollars.

Many of the synthetic CDOs arranged were the result of demand from investing clients seeking long exposure.

Synthetic CDOs were popular with many investors prior to the financial crisis because they gave investors the ability to work with banks to design tailored securities which met their particular criteria, whether it be ratings, leverage or other aspects of the transaction.

The buyers of synthetic mortgage CDOs were large, sophisticated investors. These investors had significant in-house research staff to analyze portfolios and structures and to suggest modifications. They did not rely upon the issuing banks in making their investment decisions.

For static synthetic CDOs, reference portfolios were fully disclosed. Therefore, potential buyers could simply decide not to participate if they did not like some or all the securities referenced in a particular portfolio.

Synthetic CDOs require one party to be long the risk and the other to be short so without the short position, a transaction could not take place.

It is fully disclosed and well known to investors that banks that arranged synthetic CDOs took the initial short position and that these positions could either have been applied as hedges against other risk positions or covered via trades with other investors.

Most major banks had similar businesses in synthetic mortgage CDOs.

As housing price growth slowed and then turned negative, the disruption in the mortgage market resulted in synthetic CDO losses for many investors and financial institutions, including Goldman Sachs, effectively putting an end to this market.

http://www2.goldmansachs.com/our-firm/on-the-issues/viewpoint/viewpoint-articles/response-scdo.html

The Professionals' Trade Secrets or What Methods do They Use?

In order to make a profit in the stock market, an investor must have some ideas regarding how the prices of stocks behave.  If he knows the behaviour patterns of stock prices, he may be able to forecast correctly what the price of a stock will be in the future. 

If his forecasted price is higher than the present market price of a particular stock, he ought to buy and reap the profit when the price rises to his forecasted level.  The reverse also applies in that if he thinks the price of a stock he is holding will decline in the future, he ought to sell it now and buy it back later on when the price will be lower. 

Stock market investment has become a very sophisticated, very scientific pursuit in the West and several schools of thought, that is, ways of thinking regarding how the stock prices behave, have been developed.  Each school is different from the other and may even be totally opposite; each attracting different supporters. 

There are what may be termed THREE 'legitimate ' schools of thought and AN 'unofficial' one. 

The unofficial school of thought is generally called

• 'The Greater Fool Theory' or'Buy from a Sucker and Sell to a Sucker' 

while the three legitimate schools are as follows:

• (1)  Random Walk / Efficient Market Theory (Hypothesis)
• (2)  Technical/Chartist School; and
• (3)  Fundamentalist School.

The stock market behaviour knows no boundary in place and time.  These various stock market theories developed in the West can be applied here too and a serious investor has to be familiar with these theories. 

Which of these four schools of thought is/are applicable to the local Malaysian market?  I am of the bias opinion that the fundamentalist school of thought is the one most applicable here.  It is most likely that many do not agree.

No expert agrees exactly with another regarding stock values. 

"There is no such thing as a final answer to stock values.  A dozen experts will arrive at twelve different conclusions" - Gerald Loeb


Ref:  Stock Market Investment in Malaysia and Singapore by Neoh Soon Kean

Greater Fool Theory

Greater Fool Theory

One of the assumptions of the discounted cash flow theory is that people are rational, that nobody would buy a business for more than its future discounted cash flows. Since a stock represents ownership in a company, this assumption applies to the stock market. But why, then, do stocks exhibit such volatile movements? It doesn't make sense for a stock's price to fluctuate so much when the intrinsic value isn't changing by the minute.

The fact is that many people do not view stocks as a representation of discounted cash flows, but as trading vehicles. Who cares what the cash flows are if you can sell the stock to somebody else for more than what you paid for it? Cynics of this approach have labeled it the greater fool theory, since the profit on a trade is not determined by a company's value, but about speculating whether you can sell to some other investor (the fool). On the other hand, a trader would say that investors relying solely on fundamentals are leaving themselves at the mercy of the market instead of observing its trends and tendencies.

This debate demonstrates the general difference between a technical and fundamental investor. A follower of technical analysis is guided not by value, but by the trends in the market often represented in charts. So, which is better: fundamental or technical? The answer is neither. Every strategy has its own merits.

In general, fundamental is thought of as a long-term strategy, while technical is used more for short-term strategies.