Risk & Uncertainty
Investors would love to have a crystal ball so they could ask just the right questions and get specific answers about the future. Whether it’s about earnings reports, economic data releases, Federal Reserve policy decisions, or whatever else may be coming down the pike, we’d all love to be able to be told exactly what to expect.
The investing world, however, sometimes involves complete unknowns. How many people foretold the “Flash Crash” of May 2010, when trading software sparked a 600-point plunge in the Dow in a matter of minutes? No one saw it coming – so even if you had a crystal ball, you wouldn’t have known to ask whether it might happen.
What can investors do to anticipate these unknowns? Stay as informed as you can, and remain diversified. You can’t foresee every possible risk, but with enough information you can get a better picture of the market environment as a whole. The unknown does not always need to be the unexpected.
What Risks are Relevant to Investors?
Some of today’s more pressing investor problems involve risks that were at least somewhat foreseeable at the time of the investment.
The recent fury of some hedge fund investors against having their bond holdings in Portugal’s Banco Espirito Santo written down to zero was at least somewhat foreseeable. The bonds in question were an especially risky variety of junior debt securities. The funds had piled into the securities as they plunged to 80 cents on the dollar, as fears mounted over the health of the Portuguese bank. Convinced that the bank would either be able to raise the needed funds or get bailed out by the government, these investors were unpleasantly surprised when the bank reported larger-than-expected losses and the central bank had to step in. The hedge fund investors are now weighing a legal action against the bank, but European officials have made it clear for several years now that investors who speculate in the risky junior bonds of troubled banks will receive little sympathy if the bank actually fails.
Problems on the Home Front
In the U.S., there are increasing concerns that a wave of potential defaults could start arriving in the next few years with respect to home equity lines (second-position mortgages) that were originated nearly ten years ago. This threat may be especially pronounced in California, where risky lending in inland areas had led up to the housing meltdown and the Great Recession. Many of these are home equity lines of credit (HELOCs) that are nearing their end-of-draw terms, and borrowers that were previously paying “interest only” may now need to pay back principal as well, leading to potential “payment shock.”
This most recent threat is manageable, though, says Ezra Becker, the vice president of TransUnion, one of the leading credit bureaus. A study that Mr. Becker authored found that less than 20% of the affected mortgages could be at an elevated risk of defaulting in the next few years. That’s not a small number, but Becker and others think the risk is manageable. The Office of the Comptroller of the Currency has already been proactively urging lenders to reach out to borrowers ahead of time to mitigate the risks, encouraging lenders to extend workout or modification programs to borrowers if necessary.
All of this, of course, points to the need for investors to do their due diligence and to be careful about “chasing yield” without concerning themselves with the risks associated with an investment. Mezzanine, or second-position, debt (or other junior debt securities) can pay higher yields than loans involving a first-position lien; but the risks are greater as well. Investors with Realty Mogul or any other firm must be aware that no investment is guaranteed; but when investors stay informed, and diversified, they are likely to have a better understanding of the larger market and are less likely to run into “unexpected” events along the way.
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