Collateral dominates structure.
That’s a phrase I coined twenty-five years ago when I was an institutional bond investor. At that time, Mortgage Backed Securities were still pretty new. Brokers would take MBS “pools” and put a bunch of them into a single trust. Then the trust would issue its own bonds, with different bonds getting paid first, some bonds taking more prepayment risk, other bonds protected, and so on. They called these bonds Collateralized Mortgage Obligations. They were structured to protect investors from prepaymenta.
During the housing bubble, the Street tried to do the same thing with credit risk. They took a lot of junky mortgages where the borrower had junky credit or a junky home or some other problem and put them into Collateralized Debt Obligations, issuing bonds that were prioritized in terms of credit risk. They thought that by having some bonds bear most of the credit risk, the CDO could turn a junky-credit sow’s ear into a non-junky-credit silk purse.
But when we experienced massive mortgage refinancing in the early ‘90s, or when the Financial Crisis hit devastated housing market, all those pretty structures were overwhelmed by prepayments or credit losses. The collateral underlying the CMOs or CDOs dominated the structures, and investors either had to write off their bonds’ premiums in the mid-‘90s or their bonds’ credit in the late-‘00s.
Fannie Mae Prepayments. Source: Bloomberg
The same thing happens in business, only it has to do with people and business strategy. Companies make elaborate plans, only to have them overwhelmed by personnel issues. If you don’t have the right people, you’ll never be able to execute your strategy. Management guru Peter Drucker put it this way: “Culture eats strategy for breakfast.” There are all kinds of examples of how this works out.
Southwest Airlines didn’t earn the highest loyalty in their industry with its bags fly free policy or fuel hedging strategy. They did it by making Southwest a great place to work. When fuel prices spiked in 1991, Southwest didn’t have to impose pay cuts. Employees volunteered for them. In contrast, high union wages didn’t doom the Twinkie. Firms have had to negotiate union contracts for over a century. Rather, it was a culture of labor-management hostility: neither side trusted the other, until it was too late.
Photo: Larry D. Moore. Source: Wikipedia
When strategy and culture collide, culture wins. A firm’s culture determines who wants to work there, and what they do with their energy. If you can’t get the right folks onto the bus, your travel plans become irrelevant. That’s why collateral dominates structure. When times get tough, it’s your people – not your plans – that really matter.
Douglas R. Tengdin, CFA