FEBRUARY 16, 2016
The Narrative Audit ™ We all love a good story. Since we were infants, stories have been important in teaching us about the world. It turns out that we remember things more easily if they are in the form of a story or narrative than rather than as unconnected fragments of information. There seems to be a hardwired need that we have for imposing order and causality to both historical and future events. The Narrative Fallacy has been singled out as a key element of behavioral finance to mean that we connect elements that may or may not have a real connection. In the world of finance, narratives run rampant. Every product is sold using a story. Analysis and forecasters product narrative forecasts and analyses by the thousands as do companies in statements and annual reports. You rarely see a newsletter that states “the Dow will reach 2,000 in a year” without a long accompanying narrative to justify the forecast. Unfortunately, narratives often serve to distract us from
the underlying facts or even distort the information at hand. By making connections and presenting causalities that are not real, listeners are led to draw conclusions that are not warranted, often leading to poor trading and investment decisions. One way of saving us from the potential downside to narrative is what I call the Narrative Audit ™. This audit lays out the complete narrative of a security or investment and then dissects the narrative into its factual and non-factual components. At this point it is possible to analyze and interpret the factual situation separately from the imputed causality, historical interpretations and forecasts. Not that the latter are necessarily disregarded, but they are placed in the context of material that includes conjecture and forecasts that need to be examined. As an example of a Narrative Audit, let’s take a look at the Credit Crisis and specifically mortgage backed securities. Subprime Mortgage Backed Securities Because of the scale of the narrative and the enormous dislocations it caused in the lives of so many, I have chosen to focus on subprime mortgage backed securities (MBS) that were commonly sold in the 2006-8 years to all manner of investors from individuals to pension plans. The narrative that went with these securities was as follows: Subprime MBS are an excellent investment both because of their high yield and their low risk. (it is telling that so many narratives include high yield combined with low risk). They are backed by mortgages on houses whose prices have been rising and will continue to rise in the future, making the creditworthiness of the mortgage holders largely irrelevant. Furthermore, MBS are a complex product with built in features such as “waterfalls” that protect investors from possible but unlikely defaults on these mortgages. Preferred investors (those purchasing securities rated as AAA by the major rating agencies) are comparable to those standing on the dry mountaintop while the people in the plains below suffered from floods. The key elements of this narrative include “high yield,” “continued rise of housing prices,” “investor protection in case of defaults.” The Narrative Audit requires that each of these be examined to separate fact from story, appeal to logic and appeal to emotion. High Yield As the accompanying chart indicates, by 2006 the spread between AAA rated subprime mortgage backed securities and U.S. treasuries had narrowed to well under 1%. In other words, the yield on mortgages was barely above that gained by investing in the most risk-free security.
Continued Rise of Housing Prices The chart below shows the increase in the price of houses leading up to the credit crisis of 2007-8. The steep rise in prices at the very least would give one pause that these prices could continue to rise, certainly not at the same rate of increase. Yet, the entire subprime securities risk protection hinged on the continued risk in the price of houses to offset the deterioration in the credit quality of the mortgage holders and underlying mortgages; this was a clear narrative that took historical trend and projected it into the future.
The “Waterfall” Structure of the Securities Another risk protection mechanism was the structure of the underlying securities and the protection they afforded to security holders, especially those holding higher rated securities. Rather than go into the detail of these securities, the chart below shows their incredible complexity. It is fair to say that the majority of the buyers of these securities had a passing (if any) knowledge of the details of this structure, relying instead on the narrative that these securities provided U.S. Treasury like protection for AAA holders.
Summary By breaking the narrative surrounding the credit crisis into its components, it becomes clear that several of the elements are appeals to emotion rather than logic and impute a causality and future that is not warranted by the facts alone. The parts of the story that related to the securities’ low risk are especially unsupported by facts and can only be supported by appealing to faith or emotion. Similarly, the alleged continued increase in the price of houses, which was the ultimate support for the entire structure, became increase myth-like over time. This is not to say the conducting a Narrative Audit would have stopped one from investing in these securities. However, it would certainly have led to the logical side of the brain kicking in and having a debate with the emotional side, perhaps leading the investor to forego this investment.