Margin-of-Safety

The Nature of Wall Street Works Against Investors 44
IOs, interest payments stripped from a pool of mortgages, fluctuate in value for a given change in
interest rates in the opposite direction from conventional mortgages. The reason is, if interest rates
rise, interest payments on an IO will be received for a longer period. Experience shows that the
present value of a larger number of payments is more than that of a smaller number of payments,
even at a somewhat higher discount rate. Because of this counterfluctuation, such mortgage
investors as thrifts and insurance companies are attracted to IOs as a potential hedge against
changes in interest rates. The price of POs, conversely, moves in the same direction as conventional
mortgages in response to interest rate changes but with greater volatility. Thus they are potentially
useful instruments for any-art wishing to speculate on interest rates.
Wall Street was able to earn substantial fees and trading prof-its by creating these hybrid
securities. The question, as with any financial-market innovation, is whether anyone else was
better off. especially after allowing for the commissions, fees, and dealer markups. The buyers,
frequently thrifts and insurance companies, were betting on their own ability to understand a
brand new security. They needed to understand it better than other market participants, and at
least as well as Wall Street, to avoid being exploited. They depended on the emergence of a
sustained, liquid market for the securities they bought. And they were implicitly assuming that the
two parts were worth at least as much as, and perhaps more than, the whole—clearly an
optimistic assumption.
What if IOs or POs failed to trade in a liquid and orderly market narrow bid/asked
spreads? What if accurate and timely information on these securities ceased to be available on a
continuing basis? What if interest rate fluctuations rendered each of these securities more volatile
than expected? Then holders were in trouble, for it is far easier to separate a mortgage into two
parts than it is to glue it back together again. There was no assurance, or even reason to think it
likely, that the holder of one piece would be interested in any proposition made by the holder of
the other piece to recombine. It was, in other words, possible