The best credit analyst who ever lived, the Einstein of forensic accounting and the Da Vinci of the deal, is of course Michael Milken, who in my view was unfairly scape-goated for the excesses of the high yield market of the 1980s. In 1997, his Milken Institute held a conference in Los Angeles at which Milken sat on a panel with a group of Nobel Prize winners, including Kenneth Arrow, Harry Markowitz, Eugene Fama and Gary Becker. In opposition to (most of) the economists, who argued that efficient markets knew how to price securities and that mark-to-market accounting would benefit the banking system, Milken made this observation: the whole US banking system would have been insolvent on a mark-to-market basis in 1981 and again in 1991. Banks always will be insolvent on a mark-to-market basis in deep recessions. Do we really want to liquidate the banks in every recession? Milken asked. Answer came there none from the Nobelists.

Why can’t markets see over the rise and mark securities according to their long-term value? Why should we rely on the wisdom of the marketplace? Let’s put the question practically: why was the multi-trillion-dollar universe of structured securities vastly overpriced before July 2007 and vastly underpriced by the middle of 2008? It was obvious to anyone with eyes that this was the case. As strategist for Asteri Capital, I made presentation after presentation to investment professionals explaining that our business strategy was to take advantage of the mis-pricing of AAA risk. “We cheat the other guy [the AAA investor] and pass on the savings to you,” I would say, and everyone laughed. We didn’t hide this; we shouted it from the rooftops. Everyone knew it was true (well, not everyone — Bear Stearns’ hedge fund managers actually seemed to believe that subprime AAA’s were worth 100 cents on the dollar). But no-one thought it implausible that risks were underpriced.

Now you can’t get rid of the AAA’s at 35 cents on the dollar, and it is obvious that they are cheap. I have in front of me yet another hedge fund pitchbook showing that unlevered returns are available on mortgage-backed securities in the 20 percent range under extreme stress scenarios. The trouble is that the existing hedge funds already own hundreds of billions of dollars of these securities and don’t have the capital to keep holding them. Suspending redemptions only postpones the inevitable, and they will have to sell at cheap prices. My investment thesis is that the cheap securities will fall into the laps of the commercial banks, allowing them to maintain a zombie-existence with positive cash on cash returns, which is why I like bank preferreds at yields in the mid-teens or even 20s better than common.

Institutional behavior made these assets rich before 2007, and institutional behavior makes them cheap now. It’s the classic agency problem: if you don’t trust the intermediary, how do you reconcile the knowledge and risk appetite of the ultimate beneficiaries with the activities of the agents? The question becomes especially poignant after the Madoff scandal. You can’t convince people to put money into hedge funds that they don’t understand after they lost 20% last year. The market is NOT efficient because large parts of it can’t be traded in small units in an auction format.

That is why there’s no substitute for the human interface. You need banks with deep pockets and long experience to smooth out the cycles. Otherwise the procyclical behavior of institutions will make things work. The trouble today is that the bankers have lost the trust of the public as well as of the professionals. That makes recovery all the more difficult.

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