Tuesday, December 29, 2009

Monday, December 28, 2009

Sprott December Comment: Is it all just a Ponzi scheme?

In the latest Treasury Bulletin published in December 2009, ownership data reveals that the United States increased the public debt by $1.885 trillion dollars in fiscal 2009. So who bought all the new Treasury securities to finance the massive increase in expenditures? According to the same report, there were three distinct groups that bought more than they did in 2008. The first was “Foreign and International Buyers”, who purchased $697.5 billion worth of Treasury securities in fiscal 2009 – representing about 23% more than their respective purchases in fiscal 2008. The second group was the Federal Reserve itself. According to its published balance sheet, it increased its treasury holdings by $286 billion in 2009, representing a 60% increase year-over-year. This increase appears to be a direct result of the Federal Reserve’s Quantitative Easing program announced this past March. Most of the other identified buyers in the Treasury Bulletin were either net sellers or small buyers in 2009. While the Q4 data is not yet available, the Q1, Q2 and Q3 data suggests that the State and Local governments and US Savings Bonds groups will be net sellers of US Treasury securities in 2009, while pension funds, insurance companies and depository institutions only increased their purchases by a negligible amount.


Hussman Weekly Market Comment: Bayes' Rule (January 29, 2007)

Fun with Bayes' Rule: Birds and Hamsters

Suppose that you've got a truckload of animals in boxes, but you can't actually see the animals. If the animal is a hamster, there's an 80% chance the box is green. If it's a bird, there's only a 20% chance the box is green. You're given a green box. How likely is it that the animal inside is a hamster?

Though it's tempting to answer that a hamster is most likely, we need more information. We have to know what proportion of the animals are hamsters.

Suppose that only 10% are hamsters. Then given it's a hamster (10%) there's an 80% chance the box is green. So 10% x 80% = 8% of the time we'll have a hamster and a green box. However, we'll also have a green box in 20% of the cases where the animal is a bird (90% of the animals). So 20% x 90% = 18% of the time we'll have a bird and a green box.

Bayes Rule says that the probability it's a hamster when you're handed a green box is:

8% / (8% + 18%) = 31%.

Most likely, there's a bird in the green box. Notice that choosing a green box increases the probability it's a hamster (which you would expect just 10% of the time if you had no information about the box), but it's not enough to make a hamster the most likely expectation.

Thursday, December 24, 2009

Wednesday, December 23, 2009

Grant's Winter Break 2009 Issue

Hussman Weekly Market Comment: Clarity and Valuation

So overvalued, check. Overbought, check. Overbullish, check. Upward pressure on yields, check. Market internals? – certainly mixed, but not bad – and there's the wild card. Historically, markets featuring a combination of these other risks have been vulnerable even without clear deterioration of internals. What the mixed internals (rather than clearly negative) buy you is variability in the timing of subsequent weakness. Sometimes the market plunges immediately, but often it bounces around for a while and continues to make marginal new highs. More often than not, what the syndrome produces is an abrupt plunge within a window of about 10-12 weeks. Not a forecast, just a regularity. This time might be different, but we wouldn't risk a great deal hoping it will.

It's important to recognize that when I quote probabilities, I am generally using a form of Bayes' Rule. So when I say, for example, that I estimate a probability of about 80% of fresh credit difficulties accompanied by a market plunge over the coming year, that figure is based on various combinations of historical evidence, and what has (and has not) happened afterward, and how often. As a side note, a “market plunge” in this context need not be a “crash.” In the context of a credit-driven crash and rebound (which is what I believe we've observed), a typical post-rebound correction would be about -28%, but even that would take stocks to less than 20% above the March lows.

Probabilities, however, are not certainties. If the probability of a given event is “p”, then the probability of “not that event” is (1-p). This, in my view, is what makes probabilities and average outcomes different from forecasts. When people forecast, they say “this or that is going to happen,” and very often they establish investment positions that will do them a great deal of harm if they are incorrect. What we try to do is say, “on average, these conditions have been associated with this typical outcome, as well as a range of other possible outcomes (risk) that is this wide.” The larger the typical outcome is, compared with the possible range of outcomes, the larger a commitment we are willing to make. But if the average outcome is weak, and the range of outcomes is wide, we'll defend against the risk.

Monday, December 21, 2009

Ben Stein: My dinner with Warren

First, his office had changed a little bit since I was there a couple of years ago. He now has model trains everywhere, emblematic of his recent buy of Burlington Northern Santa Fe -- apt gifts, because Warren has been a model train collector since his childhood. Phil had brought him a 1930s Lionel catalog, which Warren read eagerly, Citizen Buffett with his Lionel trains Rosebud.

I asked him why he thought Burlington Northern was such a great buy and he answered in characteristic fashion...with numbers. He explained that Berkshire had gotten so big that even a very successful small purchase would hardly affect earnings at all.

But a medium successful large purchase would be more helpful. (He explained this with numbers in such a rapid fashion that it was as if a computer were spitting out the analysis, which, in a way, it was. He is so astonishingly facile with numbers that it is almost eerie.)


I did not have the wit to ask him how one defined value in a constantly shifting world. We all agreed that interest rates would change towards the upside at some point, although we did not know when or by how much (of course).

Buffett, like everyone else, is mystified by the Japanese example of super high deficits, a huge national debt, and no inflation and ultra-low interest rates. Something like that is apparently happening here, he suggested, which we would all agree is true (although this week's producer prices number was worrisome and had not come out as of our dinner). But why it is happening now and did not happen in the past (there was inflation between 1933 and 1937, in a far worse economic environment), no one knew.

Wednesday, December 16, 2009

2001 Jim Grant Article: Sometimes the Economy Needs a Setback

This 2001 article was written in regards to the Internet bubble, but it has some timeless insights about booms and busts.

The weak economy and the multi-trillion-dollar drop in the value of stocks have raised a rash of recrimination. Never a people to suffer the loss of money in silence, Americans are demanding to know what happened to them. The truth is simple: There was a boom.

A boom is a phase of accelerated prosperity. For ignition, it requires easy money. For inspiration, it draws on new technology. A decade ago, farsighted investors saw a glorious future for the personal computer in the context of the more peaceful world after the cold war. Stock prices began to rise -- and rose and rose. The cost of financing new investment fell correspondingly, until by about the middle of the decade the money became too cheap to pass up. Business investment soared, employment rose, reported profits climbed.

Booms begin in reality and rise to fantasy. Stock investors seemed to forget that more capital spending means more competition, not less; that more competition implies lower profit margins, not higher ones; and that lower profit margins do not point to rising stock prices. It seemed to slip their minds that high-technology companies work ceaselessly to make their own products obsolete, not just those of their competitors -- that they are inherently self-destructive.

Booms not only precede busts; they also cause them. When capital is so cheap that it might as well be free, entrepreneurs make marginal investments. They build and hire expecting the good times to continue to roll. Optimistic bankers and steadily rising stock prices shield new businesses from having to show profits any sooner than ''eventually.'' Then, when the stars change alignment and investors decide to withhold new financing, many companies are cash-poor and must retrench or shut down. It is the work of a bear market to reduce the prices of the white elephants until they are cheap enough to interest a new class of buyers.

George Soros Lectures

I finally got around to reading the transcripts from the lectures given by George Soros at the end of October. They certainly made me think.

Link to the five-part lecture series:


Monday, December 14, 2009

The Yellowstone Syndrome - By Chris Mayer

Most people in finance operate under a giant self-deception: they think future economic trends are much more knowable than they actually are.

The economy is like a complex ecosystem. You cannot alter one piece of it without causing effects elsewhere in the system. Investors who understand this reality can also understand (and avoid) the hazards of over-confident investing.


If an investor hopes to minimize or avoid losses of this magnitude, they must understand that economies are complex adaptive systems – replete with feedback loops and black swans and power laws. Investors must approach the future with humility. And that means fearing risk more than craving reward. A humble investor will also insist on a margin of safety in each investment.


Books mentioned in article:

Think Twice

More Than You Know

Fooled by Randomness

The (Mis)behavior of Markets

DER SPIEGEL Interview with Paul Volcker

Volcker: The recovery is quite slow and I expect it to continue to be pretty slow and restrained for a variety of reasons and the possibility of a relapse can't be entirely discounted. I'm not predicting it but I think we have to be careful.

SPIEGEL: What is the difference between this deep recession and all the other recessions we have seen since World War II?

Volcker: What complicates this situation, as compared to the ordinary garden variety recession, is that we have this financial collapse on top of an economic disequilibrium. Too much consumption and too little investment, too many imports and too few exports. We have not been on a sustainable economic track and that has to be changed. But those changes don't come overnight, they don't come in a quarter, they don't come in a year. You can begin them but that is a process that takes time. If we don't make that adjustment and if we again pump up consumption, we will just walk into another crisis.

SPIEGEL: As chairman of the Economic Recovery Advisory Board, you advise President Barack Obama on how to prevent such a recurrence. Is he following your guidance?

Volcker: We have various working groups that work on and make recommendations on particular problems like retirement programs and social security. We made some recommendations on financial reforms which were not accepted, but that is part of the game. The president is more eloquent than I can be on these issues. Getting it done as compared to talking about it is a problem, but we have some suggestions along that line.

SPIEGEL: The US has not yet instituted any kind of reform policy. What we see is the government and the Federal Reserve pouring money into the economy. If one looks beyond that money, one sees that the economy is in fact still shrinking.

Volcker: What should I say? That's right. We have not yet achieved self-reinforcing recovery. We are heavily dependent upon government support so far. We are on a government support system, both in the financial markets and in the economy.

SPIEGEL: To get the recovery to the point where it is right now has cost a lot of money. National debt will probably reach $12 trillion in 2019. Just serving the debt costs $17 billion a year -- at least according to this year's forecast. That's difficult to sustain.

Volcker: You've got to deal with the deficit and you've got to deal with it in a timely way. Right now, with the unemployment rate still very high, excess capacity is still evident, and the economy is dependent on government money as we said. We are not going to successfully attack the deficit right now but we have got to prepare for attacking it.

Niall Ferguson on WealthTrack


Friday, December 11, 2009

Charlie Rose Interview with Julian Robertson in 1998

Link to: July 1998: Julian Robertson on Charlie Rose

FPA’s Rodriguez Flouts ‘Small Mind’ Investor Rules to Top Funds

Robert Rodriguez ignores most rules of the mutual-fund industry, an approach that’s helped him beat all rival managers over the past 25 years.

Rodriguez, who runs the $1.1 billion FPA Capital Fund, puts most of his money into two or three industries at a time, has stopped taking new investors for 12 of the past 14 years and has held as much as 46 percent of assets in cash. His 15 percent average annual return since 1984 is best among diversified U.S. equity funds, according to Morningstar Inc.

“His approach is at odds with how the mutual-fund industry runs its money,” Christopher Davis, an analyst with Chicago- based Morningstar, said in a telephone interview.

The 60-year-old says he looks for companies with a market value of $1 billion to $4 billion that sell at what he considers bargain prices, and holds cash if he can’t find enough stocks that meet his criteria. That strategy helped Rodriguez limit losses from the technology stock bubble in 2000 and the credit crisis that started in 2007.

Since 1998, the fund has had an average cash position of about 30 percent. Stock mutual funds hold an average of 4.3 percent.

“People told me, ‘You are not paid to manage cash,’ ” he said in a telephone interview from his home in Zephyr Cove, Nevada, where he moved three years ago from California. “I am paid to exercise my best judgment. If you don’t like it, you can leave.”

As a student at the University of Southern California, where he earned a bachelor’s degree and a master’s of business administration, Rodriguez said he heard Charles Munger, now vice chairman of Omaha, Nebraska-based Berkshire Hathaway Inc., belittle the importance of holding a diversified portfolio.

“He called diversification the hobgoblin of small minds with little confidence,” Rodriguez said.

Rodriguez has criticized rival fund managers for selling products based on marketing considerations instead of investment opportunities. Rather than attract more money than he’s comfortable investing, Rodriguez said he keeps the fund closed to new investors. Morningstar data show that 6.5 percent of stock mutual funds are currently closed.

Rodriguez says he hasn’t bought a single stock since March, anticipating that equity markets may take as long as a decade to reach the previous highs.

Rodriguez will begin a one-year sabbatical in January that had been planned since 2003. FPA Capital will be run by Dennis Bryan and Rikard Ekstrand during that period, both of whom are portfolio managers on the fund. Rodriguez said he will keep his money in FPA’s funds.

In his year off, Rodriguez plans to travel and read books, including “Democracy in America” by Alexis de Tocqueville and “Roughing It” by Mark Twain. He also will devote more time to his hobby: driving Porsches at 155 miles per hour.


Related previous post: FPA Capital Fund Letter to Shareholders which includes the Final Fund Commentary from Robert Rodriguez

Thursday, December 10, 2009

The Academic Works of Joe Calandro, Jr.

The great Miguel Barbosa at Simoleon Sense has tracked down some papers from Joe Calandro, Jr., whom he interviewed a short while back.


Here's a direct link to the pdf of one of the papers:

Wednesday, December 9, 2009

Interview with Andrew Boord – Manager of The Fenimore Banking Research Portfolio

Below is an interview I did with Andrew Boord, Manager of The Fenimore Banking Research Portfolio. If you’ve never heard of Andrew, then he may just be one of the best business analysts you’ve never heard of (though he’ll never admit it!). You can also download the interview: HERE. Enjoy!

Interview with Andrew Boord – Manager of The Fenimore Banking Research Portfolio

JK: Let’s start by having you give us a little background on yourself, your professional career, and Fenimore Asset Management.

AB: I never really intended to be an analyst. I earned a couple of accounting degrees and became a CPA. At the time I was studying accounting frauds and thought about going for a PhD. But one thing led to another and I spent a few intense years as a short seller.

Eventually I found my calling as an analyst and portfolio manager in the long-only, small to mid cap value world. I’ve dedicated most of the last decade to banking and transportation.

I joined Fenimore 4.5 years ago as an analyst. Our primary focus is managing $1.3 billion of small to mid cap value equities across two mutual funds and a few hundred separate accounts. Fenimore is what I would call a “quality value” shop, as opposed to a “deep value” shop. We focus on buying the best companies, usually with tons of free cash flow and high returns on capital, at attractive prices. We pride ourselves on doing quality, ground up research on a modest number of names. With low turnover we often build in-depth knowledge of a particular company over the years.

JK: You launched the firm’s banking product a little over a year ago and, from what I understand, you are the one in charge making the investment decisions. Tell us a little about that product, why you decided to pursue it, what the goals are for that product, and how the performance was for the first year.

AB: The Fenimore Banking Research Portfolio is a separate account offering. Each account holds about 15-20 investments, primarily micro to small cap community banks.

After a decade or so of following small to mid sized banks for our broader products, the timing was right to launch this offering. So about two years ago I began laying the groundwork on my own time. In October of 2008 we launched our first account, which consisted of my money and some Fenimore was kind enough to contribute. I could see that banks were headed for tough times, although I underestimated just how tough. This may sound counter intuitive, but historically every downdraft in the banking cycle has preceded a multi-year period of very healthy returns as earnings rebounded and valuations returned to “normal.” I expected wonderful opportunities to buy great banks at what would ultimately prove to be cheap valuations.

Also, I was ready. After years of daydreaming about a bank investment strategy, the time came when I was ready, primarily in terms of accumulated knowledge. Thankfully, everyone at Fenimore agreed and gave their blessing to pursue this project.

We have only been taking outside money for a few weeks, but we are off to a nice start. We may only accumulate a few million dollars in the first year, but that is plenty to get started.

My goal, first and foremost, is to put up impressive long-term, after-tax returns. If I pull that off, then everything else will fall in line with minimal effort. I am pleased with our start. Our first account is up 8% before fees since our October 13, 2008 start through November 30, 2009, which is modest but obviously much better than the various bank indices. It helped that I gradually invested our cash as the market cratered.

Ultimately, I would like to build a modest-sized business within Fenimore. Perhaps $100-$200 million spread across 20-30 positions. I am much less interested in being so large that I must own hundreds of positions or shift into large cap banks.

JK: From what I’ve heard, banks have had a few issues over the past couple of years. Many banks have gone under and many investors have been burned by investing in banks too early. But as value investors know, amid chaos comes opportunity and it is usually worthwhile over the long run to be greedy when others are fearful. So, can you give us a little more insight into your bottom-up selection process? How do you separate the potential good banks from the crowd? What do you view as the most important metrics when analyzing a bank? What type of system or database do you use to keep track of the industry? Etc.

AB: Those are certainly the key questions. In many ways, this is the best time ever to study banks. In less treacherous times, all the bankers tell you how wonderful they are and it is quite difficult to judge the truth of the matter. Now however, the tide has gone out and it is readily apparent that many banks were swimming naked. The worst bankers are now self identifying.

I am looking for something very specific. Most of our banks earn a mid-teens or better return on equity (ROE), but with lower than average credit risk. Think about basic economics. Banks with lower than average credit risk also earn less than average on their loans. So to produce a solid return on equity they must either possess very low cost deposits or spend considerably less on back office operations than peers. Banks that take a lot of credit risk are like shooting stars – beautiful right until they disintegrate. However, a bank with low costs deposits and efficient operations is creating sustainable value for shareholders. So the vast majority of my efforts are focused on finding these banks.

Finding high quality, micro cap community banks is not overly complex, just hard work. The one who looks under the most rocks wins. I try to find evidence of superior banks any way I can. I read as much as possible about banking, which turns up ideas occasionally. Obviously, Baseline screens are interesting, as are American Banker’s lists of banks with high ROEs or ROAs. I also assembled a list of every publicly-traded bank I could find, roughly 1100 in total, and began compiling some basic statistics.

At times you just have to do the dirty work of looking at SEC filings and call reports for as many banks as possible. For instance, I recently looked at 10-Q filings for dozens of Pennsylvania community banks and narrowed it down to about six to investigate further.

Once I find a bank exhibiting superior quantitative metrics then I come at it from a qualitative side too. The numbers are just the “effect,” but the management is the “cause.” I love to talk to bankers. I always learn something, if not about the bank in question, then about the industry, the economy, or other banks. To really understand a bank I have to know management. That just takes time. My job is to put in that time.

In the case of the Pennsylvania banks, my next step is to read as much as possible about each bank. If I am still interested then I will contact them about setting up a visit or at least a phone call with someone in senior management. So far I have visited two and will see a third next week. This process will likely produce one or two banks which I can then purchase if they trade down to a discounted valuation. Thankfully, I only need to own about 20 or 30 banks, so I feel no pressure to force one of these ideas into the portfolio.

Again, most of my efforts are directed toward finding the best banks earning a mid-teens or better ROE with low credit risk. Hopefully, I can then accumulate stock cheaply. This way I avoid much of the worst pain from bad loans. At times the worst banks will outperform, but I believe over the long term a portfolio of well run banks should win the race.

JK: I know you have an investing checklist for banks that you run your ideas through. What are the main categories on your checklist and how many items are currently on the list? What benefits have you gained from using the checklist?

AB: While the checklist is full of questions, some vague and theoretical and some very specific and technical, they are designed to do two things: make sure I completely understand the bank and to avoid significant mistakes. I need to be as sure as possible that I understand all the key aspects of the story. Kind of like Porter’s SWOT analysis. Fortunately or unfortunately, after looking at hundreds of banks I have seen many, many ways for a bank to shoot itself in the foot. So I try very hard to look for all the various warning signs I can think of, like too many land loans, growing loans too fast late in the cycle, overpaying for acquisitions, an asset/liability mismatch, etc. The checklist changes regularly and is truly a living document.

I need the checklist to help organize my thoughts, to make sure I don’t skip any steps, or become overly enamored with a strong personality. I have always been disorganized and disheveled, thinking about ten things at once. I multitask well enough to keep most of the balls in the air, but it is way too easy to skip a step or forget to ask a question. You know how the world works – it is that one missed variable that blows you up.

JK: Can you discuss some of the current macro risks for banks? Many people have mentioned that there are still big write downs to come in the industry – largely as a result of the commercial real estate problems, growing number of home foreclosures, and the Option ARM and Alt-A resets that lie ahead. How do you incorporate those types of macro risks in your analysis? How has government involvement affected the smaller banks you focus on, both on an absolute level and relative to bigger competitors? What positive effect has this period had on the well-run banks?

AB: You are absolutely right that more problems are coming. Where I differ from some is in my opinion of the extent and universality of the problem. Some investors conclude that the sky is falling and that the answer is to avoid all financials. I believe you can make healthy returns on well run banks with modest credit problems and even a few special companies intent on buying or financing distressed real estate. With so many investors panicked, you get a nice margin of safety.

For instance, I think there is a big difference between a commercial real estate loan on a midtown Manhattan office building purchased at the top of the market by a speculator using a 90%+ loan to value (LTV) vs. a 65% LTV, owner-occupied warehouse loan with personal guarantees in Scranton, or some other market that never experienced a spike in real estate prices. In the first example, the lender is in major trouble. But if a community bank has a diversified portfolio of loans like the second example, then sure they will take some losses, but they will be able to get through the downturn. Particularly if their pre-tax, pre-provision earnings are strong, which is something I look for.

I also want to play offense. You are absolutely right that a great deal of bad commercial real estate loans must be dealt with. However, somebody is going to be able to buy or finance these underlying buildings at attractive prices. A great example of a potential beneficiary is Winthrop Resources (FUR), a small finance REIT with plenty of capital and a CEO who is very scrappy -- the kind of guy who will buy or finance distressed real estate on good terms and then fight like mad to improve the building. FUR is one of the few non-bank financials we own in the Banking Research Portfolios.

The impact of government intervention is tricky to judge. Government intervention is rarely helpful. I have definite ideas on what should be done, but I am under no illusion that logic is a component of the process in Washington. So I am watching the various bills and proposed regulatory rules closely. I think in most instances the rules can be dealt with. For example, efforts to limit non-sufficient fund (NSFs) fees will just lead to the rest of us paying higher fees. Banks will not suddenly become benevolent aid societies. They will find another way to make money.

The one positive I see is a significant decline in competition. While loan growth is limited, spreads and terms on new loans are improving. Over the past two years most of the worst lenders that were under pricing failed and the “shadow banking system” (e.g., CDOs) dissipated. At the same time, new bank charters are rare. Therefore, you have less competition. It will be interesting to see how long this lasts, but the banking system could resemble the one we had twenty or so years ago. Banks had plenty of deposits (often more than they could loan out), healthier spreads, strong capital ratios, and returns on equity at the best banks were in the mid to high teens. I could live with that.

JK: In your October letter, you mentioned Cambridge Trust (CATC) and Burke & Herbert Bank & Trust (BHRB) as banks that fit your criteria. Can you briefly discuss why you like those banks and/or any others that you are able to reveal that may give readers a good idea of the types of things you are looking to invest in?

AB: As I said earlier, the factors I really admire in a strong bank are low cost deposits, combined with lower risk lending, and efficient operations. Both CATC and BHRB score very highly on these metrics.

Cambridge operates in some very nice areas of Boston and has extremely low cost deposits. In the third quarter they paid only 0.70% on $870 million of deposits and borrowings, the second lowest among banks I follow. This was invested in $500 million of loans and $440 million of bonds. Their credit performance has been outstanding, with only 0.28% of loans not performing. CATC’s efficiency ratio (operating expenses as a percentage of total revenues) is “middle of the road” at 66%. They are also growing nicely thanks to the renewed interest of customers in community banks. The end product was 24% earnings growth and a 16% ROE in the third quarter.

Burke & Herbert is a rather unusual bank in Northern Virginia. They are an old school, high touch business bank. They too have very low costs deposits (1.22%), not quite as low as CATC’s but still impressive. BHRB is extremely lean, with an efficiency ratio of 40%. They take a little more credit risk, but so far loan losses are very modest. BHRB posted an amazing 17% ROE in the third quarter and grew earnings 24%. We purchased shares at about 1.5x tangible book earlier this year, but the stock has since moved higher.

These are two shining examples of the kind of banks I want to partner with. It is difficult to find banks like these, but thankfully we don’t have to find too many of them.

JK: What new insights have you gained from the investing environment over the last year or two and/or what old lessons have been especially reinforced during this time?

AB: Frankly, I am frustrated with myself. We avoided most of the worst situations because we keep an extensive list of risks to avoid such as large derivatives books, repo financing, subprime loans, fast growers with huge egos, etc. And we tried very hard to understand mysteries like, “Who buys the riskiest pieces of subprime securitizations?” And “How can a REIT make a good ROE on a new building at a 5% cap rate, just like they did at 9% cap rates?” It is amazing how many people, who were dependent on sustaining an unsound situation, gave us answers with perfect delivery (they sounded great) that did not hold up to further investigation.

When you worry, but nothing goes wrong for years at a time, you begin to wonder if maybe you are just missing some factor. About the time you get sick of reading Jim Grant or Fred Hickey complain about some bubble, you should actually double your focus, not avoid the uncomfortable. We sold H&R Block because of their subprime business and most of our REITs when their valuations skyrocketed. But I missed the severity of the underlying problem and most of the second and third derivative impacts. I expected the subprime bubble to pop, but failed to anticipate the impact on home prices and then home equity lending and the resulting impact on consumer spending. I was surprised when one of our insurance holdings, Protective Life (PL), took massive marks in its loan portfolio. We own a book manufacturer who now does not sell as many home improvement titles because fewer people are interested in that new deck or addition. The vast majority of our holdings did not face near death experiences and will be fine, but nonetheless I could have executed better.

The one group of people that did not fail are what we now affectionately call “retired bankers.” There is a long list of great bankers who sold out before the cycle turned. Remember Golden West, Northfork, Southtrust, National Commerce, Pacific Crest, or Alabama National? Next time a large number of smart bankers retire you will find me at the pool with all my money in T-bills.

My personal response is multi-tiered. First, to realize I need more patience and confidence. Self awareness is probably the most important, yet most difficult, aspect of investing. Second, I need to improve and broaden my knowledge of both macroeconomics and the bond market. In the past few months I focused my reading on economic and financial history and Austrian economics. Perhaps the banking panic of 1893 can shed light on today. I also began studying more macroeconomic data, particularly reports related to banking. Infallibility is out of reach, but perhaps I can avoid making the same mistakes twice.

JK: Finally, if someone is interested in investing in the Banking Research Portfolio, how do they go about doing investing with you? What is the account minimum and management fee?

AB: Thanks for the plug. We offer separate accounts with a minimum investment of $250,000 and a 1% management fee. Each account typically holds 15-20 positions. If anyone is interested, then they should email me at aboord@famfunds.com. Thanks Joe.

JK: Thank you, Andrew.

*Nothing in this interview should be taken as a recommendation to buy or sell a security. Please do your own research before making an investment decision.

Tuesday, December 8, 2009

A world of hits

Ever-increasing choice was supposed to mean the end of the blockbuster. It has had the opposite effect

NOVEMBER 20th saw the return of an old phenomenon: the sold-out cinema. “New Moon”, a tale of vampires, werewolves and the women who love them, earned more in a single day at the American box office than any film in history. The record may not stand for long: next month “Avatar”, a three-dimensional action movie thick with special effects, will be released (see picture). This film’s production budget is reportedly $230m, which would make it one of the most expensive movies ever made. “Avatar” will be a great disappointment if its worldwide ticket sales fail to exceed $500m. Yet it is a reflection of how things are changing in the media business that such an outcome is unlikely.

There has never been so much choice in entertainment. Last year 610 films were released in America, up from 471 in 1999. Cable and satellite television are growing quickly, supplying more channels to more people across the world. More than half of all pay-television subscribers now live in the Asia-Pacific region. Online video is exploding: every minute about 20 hours’ worth of content is added to YouTube. The internet has greatly expanded choice in music and books. Yet the ever-increasing supply of content tailored to every taste seems not to have dented the appeal of the blockbuster. Quite the opposite.

This is not what was predicted by one of the most influential business books of the past few years. In “The Long Tail”, Chris Anderson, editor-in-chief of Wired, a technology magazine (and before that a journalist at The Economist), argued that demand for media was moving inexorably from the head of the distribution curve to the tail. That is, the few products that sell a lot were losing market share to the great many that sell modestly. By cutting storage and distribution costs, the internet was overturning the tyranny of the shop shelf, which had limited consumers’ choices. And, by developing software that analysed and predicted consumers’ tastes, companies like Amazon were encouraging people to wallow in esoterica. Such companies did not just supply niche markets—they helped create them.

“The Long Tail” set off a lively debate. Professors at Harvard Business School questioned whether many companies can profit from selling a little of a great many things. The supply of obscure films and music seems to be growing faster than people are discovering them. Harvard’s Anita Elberse argued in an article last year that only a foolish firm would shift its focus away from the mass market. People in the media business, who have to back their judgments with money, have a different view. In a sense, they say, both Mr Anderson and his detractors are right. At the same time, both are missing the real story.

“Both the hits and the tail are doing well,” says Jeff Bewkes, the head of Time Warner, an American media giant. Audiences are at once fragmenting into niches and consolidating around blockbusters. Of course, media consumption has not risen much over the years, so something must be losing out. That something is the almost but not quite popular content that occupies the middle ground between blockbusters and niches. The stuff that people used to watch or listen to largely because there was little else on is increasingly being ignored.

Mark Hanson: Why Millions More Homeowners are At -Risk than Most Think

Most look to loan type and equity position as two of the most important factors when forecasting loan default. In fact, I believe that epidemic negative-equity is the overarching reason that the default, foreclosure and housing crisis remains in the early innings. But…negative-equity with a caveat.

While negative equity is a threat in and of itself, being in an over-leveraged household debt position is the true default catalyst for most in a negative-equity position. And being over-leveraged is also the primary default catalyst for those is a positive equity position. Being in a negative-equity position with lots of top line and disposable income each month is generally more of a mental burden than a reason to fly the coop.

How many homeowners are over-levered and at imminent risk of default? This answer is…a lot more than most think, especially those who got a loan from 2003-2007 due to a radical, yet subtle shift in loan guidelines across the mortgage spectrum that kicked-off the bubble-years.

Yes, even Prime full-doc borrowers in 30-year fixed mortgages with 20% equity who got their purchase or refi from 03-07 are at much greater risk than most think. Being over-levered was condoned – all the lenders, investors and loan programs operated in the same manner.

In my research, I often assume that everybody knows the subtle idiosyncrasies of how loans are really structured. I understand this is not the case. So, in an attempt to highlight why the total residential mortgage risk exposure is so much greater than anybody’s expectations, this report drills down on Prime, Alt-A and Subprime allowable debt-to-income (DTI) ratios that were made ridiculously lax relative to pre and post 2003 – 2007. This, in my opinion, is the real tempest in the mortgage teapot that buckets millions more loans that are still in existence today across all loan types, as risky.


- How Big is the Total At-Risk Mortgage Universe?

Of the loans in existence today at least 75% were refinanced or attained through a purchase from 2003-2007 – the bubble years. On several occasions the past couple of years, Jim Cramer has quantified the at-risk loan universe as being around 14 million, which represents everyone who purchased a home between 2005-2007. But then he says ‘”here is no way everybody who bought a house from 2005-2007 will ever default”. So, he pairs it back to 20% or 25% of 14 million – whatever. He is incorrect on a number of levels.

First off, the bubble years were really 2003-2007. But aside from that, the number of people who purchased a home is only a small piece of the entire pie. The bubble years was not about purchases, rather refi’s. During the bubble years, cash-out refi’s and HELOCs were at least 5:1 over purchases. A purchase is no more risky than an existing homeowner with a great payment history who pulled out 90% or 100% of their equity at a 50% DTI. In fact, the latter are more risky…purchases in general are always considered the safest loans.

This means the true potential at-risk loan universe is any Prime, Alt-A, or Subprime borrower that did a purchase or refi from 2003-2007. Obviously, not every single borrower is at-risk but we have no way of really knowing how many of the 43 million + loans from that period still in existence today are destined for trouble. This is especially true when even borrowers with 800 scores and 70% LTV’s are at risk of default because their DTI started out at 50% and after the fact, they expanded their credit portfolio because all credit was so easily attained until a couple of years ago.


The last Mortgage Bankers Association report estimates that the total number of loans in some sort of delinquency, default, or foreclosure status to be about 8.2 million, or 14.41% of all loans. If the true number of Imminently at-risk loans is somewhere between 13 and 15 million, the default and foreclosure crisis is about 60% over.

The problem with the final 40% is that it crushes everyone other than Subprime households and likely happens over a longer period of time than the two-year Subprime Implosion.

In addition to the imminent defaulters, a large percentage will default for various unforeseen reasons tied to the macro. Throw in top strategic defaulters and we could easily see a situation over the next few years in which 20 MILLION homeowners are either delinquent, defaulted, or in the foreclosure pipeline.