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Is Portfolio-Wearaging Bad For Mortgage Lending?

The word misvaluation is used in economics to refer to a situation when an investor or financial institute misestimates the value of a certain firm. For example, if a bank believes that a given firm is worth ten dollars and invests five hundred dollars, it will be likely to earn fifty cents on each dollar it invests, or one percent. Similarly, in an investment fund, where a company’s value is estimated using historical data, the institution may be able to earn higher returns, but only up to a certain point, as in the case of a perpetual investment fund. The hypothesis predicts that firm investments should be characterized by greater volatility, with excess funds being liquidated quickly and excessive losses being avoided, or, conversely, by increasing returns being rapidly consumed before any earnings are realized.

Firm Investment

The flaw in this hypothesis is that it applies only to new investment bonds issued in the capital markets. Other types of bonds, such as those issued in the stock market and the commercial paper market, are not included in the definition. Thus, a rise in stock prices can also trigger a rise in bond prices and vice versa. Moreover, bonds issued by domestic corporations (usually financial institutions) are not included in this analysis. Finally, the assumption that the rate of return on firm value bonds is equal to the rate of return on other types of bonds, such as treasury bonds, municipal bonds, and corporate bonds, is also flawed.

This Hypothesis concerning the reliability of this Quantity is highly questionable, as is the supposition that the investment-risk component of the Firm-investment mix should be correlated closely with the quantity of company-type firms in the market. In fact, firms with a history of poor performance (a portfolio full of distressed companies) will tend to generate lower returns than would healthy companies. Likewise, firms with a history of significant share price appreciation will tend to generate lower returns than would healthy companies. It follows that there would be little need for a correlation between Firm-investment and portfolio-weight. Also, if the correlation were zero (and there is considerable positive correlation between FICO scores and portfolio value), then it would follow that an increase in portfolio-weight without an increase in Firm-investment would cause a reduction in the valuation of public firms.

The third hypothesis, that portfolio-weight would have little effect on investment-risk, is therefore not supported by the literature. Most academic research on the reliability of portfolio-weights finds only very minor effects on investment-risk, or none at all. It would follow that portfolio-weight would have very little impact on valuation of the total market capitalization, and hence, there would be no relationship between Firm and portfolio-weight. Again, the conclusion that there would be no correlation between investment-risk and portfolio-weight is highly questionable.

Finally, there is another argument that the elasticity of capitalization of firms and bond markets may account for the relatively stable real estate market over recent years, despite relatively high rates of house foreclosure. This argument goes like this: Since house prices have been falling, more financial assets have been offered to homeowners, and firms are now able to reduce their balance-of-force leverage because they have access to a greater amount of cash. Over recent years, as a result of the decline in house prices, there has been a shift from publicly held equity into non-equity forms, such as corporate bonds and equity lines. As these firms have reduced their balance-of-force leverage, they have also reduced liquidity.

One can look at all of these arguments to conclude that portfolio-weighting does not affect the pricing of firm fixed assets in the bond markets or the overall real estate market. But what about all of the studies that found a negative correlation between investment-risk and portfolio-weight? In all of the studies that examined this correlation, there was one that found a positive correlation. If that were true, then one could say that increasing the weight of your Firm relative to other firms on the asset-allocation table would have a positive effect on the pricing of securities, since you would attract more capital since you are considered a higher risk. If, however, the results of those studies were incorrect, it would mean that portfolio-weighting increases the Firm’s risk, and therefore increases the Firm’s cost of capital.