Securitizations - An investor benefit?

Two recent WSJ commentaries highlight the delicate trade-offs that loan securitizations provide to the capital markets --- On one hand they allow lenders to diversify risk and investors to select the appropriate amount of it, but on the other they can make risk more difficult to quantify and evidence suggests they may actually increase the cost of the debt to the borrowers. These two articles discuss these trade-offs in greater detail.

Can the financial markets make a comeback?
This first article I found to be an excellent primer on securitization, by an early key participant in the industry, Ethan Penner: http://online.wsj.com/article/SB118817063701609287.html.

In addition to briefly explaining the process, Penner makes a couple of important points about the securitization process, using quotes from the controversial former investment banker Michael Milken.

Benefit: "The democratization of capital" (Milken), namely securitization:

1. Allows borrowers better access to the credit markets
2. Allows "investors to better target where they want to be on the risk/return spectrum"

Costs:

1. Low regulatory oversight - (cited by author as both a benefit and a cost)
2. Conflicts of interest - appraiser vs. debt holder vs. ultimate debt owner
3. Lax underwriting
4. Poorer transparency - like some CDOs, more difficulty pricing the risk associated with a particular debt offering
5. Poor liquidity - As I learned the hard way trading the VIX earlier this year, per Milken "liquidity is an illusion" in the sense that trading can instantly dry up when everyone is on the same side of an investment bet

In the second article I'll reference here: The Cost of Complexity (see bottom of article): http://online.wsj.com/article/SB118903970710218805.html my friends at BreakingViews make the argument securitizations are a net cost for the ultimate borrowers. They point out that although mishaps like the S&L crisis are now less likely given the diversification of risk across multiple creditors, the net spread of mortgage rates over T-bills has actually widened for borrowers. I would argue that the comparison might not be so simple, but this is an interesting insight nonetheless.

More on market correlations...

So, does investing internationally or across financial instruments shield you from losses? While diversification across asset classes and/or international markets was once seen as an accepted way to reduce risk, now there is debate about whether this strategy will really protect investors: http://online.wsj.com/article/SB118635012472388580.html?mod=mkts_main_news_hs_h.

As I note, here http://marketlevers.blogspot.com/index.html#7777250631725150197 and here http://marketlevers.blogspot.com/index.html#2178961660242578272, investing globally has historically had diversification benefits relative to the the S&P, but as the ubiquitous disclaimer states "past performance is not a guarantee of future results".

Merger Arbitrage

As the U.S. credit market starts to tighten, investors continue to express their view that some proposed mergers may not actually end up taking place. These lower probabilities are being reflected in the difference between the current price of several target companies and their "tender"/merger offer price. This difference is known as the "deal spread". Savvy investors can use these opportunities to buy good stocks at a discount, and earn the money in the middle - via "arbitrage".

A Merger Arbitrage Example
A good example is the proposed acquisition of Wild Oats Supermarkets by Whole Foods. Although Whole Foods is currently offering shareholders an $18.50 a share price to purchase the shares, the shares are currently trading at $16.10 (13% less than the offer price). In large part, this discount reflects the uncertainty surrounding the FTC's current antitrust actions against Whole Foods.

An interesting question, how does a $565MM acquisition dramatically change the competitive environment for companies like Safeway (SWY), which is a 14 billion dollar company? Answer: It doesn't. The funny thing is, although this has been noted in the media and by antitrust experts, the discount persists. An opportunity to pick up 13% --- I think so.

Some other examples, courtesy of Goldman:
For more interesting arbitrage examples, see this WSJ article from today: http://online.wsj.com/article/SB118584551204482942.html.

SPACs - Special Purpose Acquisition Companies

Good overview of the pros and cons of going IPO or PE vs an option like a SPAC, from an owner's perspective: http://www.cfo.com/article.cfm/9390689/c_2984367/?f=archives.