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Recent Research: Highlights from May 2013

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"The Deeper Causes of the Financial Crisis: Mortgages Alone Cannot Explain It"
The Journal of Portfolio Management (Spring 2013)
Mark Adelson

Losses on US residential mortgage loans are too small to explain the magnitude of the 2008 financial crisis. Total losses, including both losses realized to date and those yet to be realized, should fall in the range of $750 billion to $2 trillion. The global magnitude of the crisis is significantly larger, probably in the range of $5 trillion to $15 trillion, depending on the measuring approach. This implies that losses on residential mortgage loans cannot be the main cause of the crisis. They can only be a trigger that unleashed the true causes. The failure (or near failure) of a significant number of major financial firms suggests that high leverage and strong risk appetites were important immediate causes of the crisis. However, explaining the sources of high leverage and strong risk appetites requires probing for deeper causes that developed over a longer period. This article proposes deeper causes that include securities firms' conversion from partnerships to corporations, the 30-year deregulation trend, the quant movement, the spread of risk-taking culture throughout the financial industry, and globalization.

"Forecasting and Stress-Testing US Vehicles ABS Deals"
The Journal of Structured Finance (Spring 2013)
Juan Carlos Calcagno, Jian Hu, and Benjamin Kanigel

In this study, an econometric model has been developed to forecast and stress test the collateral backing global asset-backed security/residential mortgage-backed security (ABS/RMBS) deals. The authors outline a modeling approach they use to forecast and stress test the cash flow backing US vehicle ABS deals. Their econometric approach considers loan characteristics, economic conditions at loan origination, past pool performance, and dynamics in the macroeconomic environment over time to explain changes in pool-level performance. The main outputs of these models are scenario-based default, prepayment, and severity vectors based on macroeconomic assumptions. These vectors provide all necessary data to run waterfall valuation engines and thus compute fair value and expected loss under baseline as well as stressed economic conditions.

"Human Capital and Behavioral Biases: Why Investors Don't Diversify Enough"
The Journal of Wealth Management (Spring 2013)
Robert R. Johnson and Stephen M. Horan

An often-ignored component of an individual's wealth, but one that can dominate one's portfolio, is human capital. More often than not, individuals don't take their biggest asset-human capital-into account when making portfolio decisions. In fact, quite often, individuals fail to recognize that human capital is even a part of their overall portfolio, instead focusing simply on financial assets and real estate. Many wealth managers neglect to consider the enormous impact of human capital on wealth management decisions for their clients, and the consequences become most evident during economic downturns. We posit that behavioral biases play a major role in the poor choices individuals make with respect to portfolio decisions related to human capital, particularly in the decision on how to invest their retirement assets-oftentimes choosing to concentrate their holdings in their own company stock. We believe that the failure to take human capital into account when making individual investment decisions can be explained to a large extent by emotional and cognitive biases that have been identified by behavioral economists. In essence, certain types of decisions and problems may simply be too complex for individuals to master on their own. This is where the wealth manager can provide value to clients. By recognizing the importance of human capital and having a dispassionate understanding of their clients' biases toward it, wealth managers can suggest effective measures to address the issue.

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