Found via the Distressed Debt Investing blog.
Related previous posts:
Found via the Distressed Debt Investing blog.
Related previous posts:
Scientists at the Large Hadron Collider managed to make two proton beams collide at high energy Tuesday, marking a "new territory" in physics, according to CERN, the European Organization for Nuclear Research.
Found via Simoleon Sense.
With the private sector largely incapacitated, the GSEs and FHA became virtually the only source of mortgage financing. This is a paradoxical situation in which a fundamentally unsound business model holds a quasimonopolistic position. This cannot last.
There is a proven mortgage financing system already up and running. The Danish model has been in use, continuously, since the aftermath of the Great Fire of Copenhagen in 1795. It has not prevented housing bubbles, but it has never broken down. And it proved its worth again in 2008.
In the Danish system, homeowners do not borrow from either a mortgage originator or a GSE. They borrow from the bond market, through a mortgage credit intermediary. Every mortgage is balanced by an equivalent amount of an identical, and openly traded, bond. This is called the Principle of Balance.
Mortgage Credit Intermediaries operate the POB system. They help homeowners understand and navigate the process. Most important, MCIs bear the credit risk of the mortgages — they remain “on the hook” in the event of delinquency or default.
In Denmark, these mortgages are not insured by a government agency. This would have to be modified in America. Given the current demoralized state of the market, a government agency would have to guarantee mortgages, but the MCIs would be required to keep “skin in the game” with a stake of, say, the top 10 percent.
A key benefit of the POB system is that it offers performing homeowners the opportunity to buy back their loans when interest rates rise. If the price of the associated mortgage bond drops, the homeowner can buy the equivalent face value of bonds at a discount, to redeem the existing home loan.
This helps forestall foreclosure crises. And it would have a counter cyclical effect: Homeowners repurchasing mortgages help moderate upward pressure on interest rates. By contrast, the current system tends to exacerbate upward pressure by lengthening duration, a likely near-term prospect.
It would eliminate the agency problem that was the primary cause of failure. It would separate the credit risk from the interest rate risk. It would be transparent. And it would be open: The duopolistic position of the GSEs would disappear.
WAS THE GREAT STIMULUS A SILVER BULLET? - THINK AGAIN: It now appears that the great stimulus provided by almost all governments has averted the second Great Depression and the North American economy may well be on its way to recovery. However, looking forward, unless we find a credible way to repay or at least comfortably service the enormous and growing burden of government debt, we are going to face immense challenges. By overloading governments with too much debt, the stimulus may have pushed the problem from the private sector to the government sector and may have made it worse. If we take a snapshot of the growing gross debt as a percentage of GDP before and after the meltdown, we get a pretty good picture of the potential trouble some countries may face in the future.
While we all wished the great stimulus would prove to be a silver bullet that would resolve all the problems stemming from the world financial crisis, that has hardly been the case. If history is any guide, it takes a long time for countries to successfully emerge from a financial crisis. They must deal with a huge increase in unemployment along with a profound increase in government debt. The problem is exacerbated by lower tax revenues in the future caused by lower output and unemployment. We think the next few years will be rocky, with economies lurching from one crisis to another.
Related previous post: 2009 Chou Funds Semi-Annual Report
THE economy is recovering, in baby steps, from the financial crisis and deep recession of 2008 and 2009. A big question still looms on the horizon: What can policy makers do to prevent this kind of thing from happening again?
One thing we cannot do very well is forecast the economy. The recent crisis and recession caught most economists flat-footed. This is nothing new. We have never been good at foretelling the future, but when the news is favorable, others forgive our lack of prescience.
Tariq at the Street Capitalist blog had a great post on learning from Michael Burry.
Excerpt from Tariq’s post:
Later, he cites the Rediscovered Benjamin Graham book’s material in order to argue that going long value stocks may not be enough if we are faced with a downturn:
“I’d like to think that if I own real absolute value stocks it won’t matter if the big indexes drop 50%. But that might be wishful thinking. ”
Jim, in that Rediscovered book, Graham makes it quite clear that value stocks will be punished every bit as much and probably more in a market downturn, according to his research. He of course advocates raising cash or adjusting to bonds if one thinks the market is too high. In another area, though, he talks of the tremendous values that can be found even in a high-priced market. I find this book fascinating — lots of stuff I hadn’t read before.
My guess is that most of Wall Street did not bother to wade through the hundreds of pages that comprised a subprime MBS. Unlike Burry, who sat in an office and learned these bond deals by himself, most of Wall Street likely deferred their judgement to the ratings agencies or sell side contacts. Ultimately, those groups lacked any substantial knowledge about these securities, they models were flawed which made their opinions flawed. So when investor groups came to them to get their opinions, they were almost always given the wrong answer.
Going through all of Burry’s posts, you will see that he was constantly analyzing stocks. To the point where he was at least posting a few ideas every week, in addition to his day job. To me, that is the definition of deliberate practice for an investor. You really have to get into the habit of frequently analyzing and valuing companies. In one post, Burry mentions that he has built a watch list of over 80 companies that he would be ready to pounce on if they ever hit his target price. That level of work, with a tendency to think independently, should help improve anyone’s investing.
This quote by Michael Burry in The Big Short says it best:
I have always believed that a single talented analyst, working very hard, can cover an amazing amount of investment landscape, and this belief remains unchallenged in my mind.
Related previous posts:
Economic growth dipped in 09, but there is widespread complacency that Asia is now back to 'business as usual'. That would require commensurate growth in the availability of energy. (The energy intensity of US GDP has fallen, but it is far from clear that this would have been the case if manufacturing had not been offshored. It seems far from clear that 'green growth' is possible.) A look at the implications of compound growth, and the levelling / decline of some Asian energy sources, highlights the potential constraint of energy availability. China's energy demands are much in the press, and its government is clearly very aware of energy security. Some other countries appear almost oblivious, having received an energy windfall and forgotten its magnitude, and may be surprised to find that they cannot grow as fast without it.
Edward Chancellor, a member of GMO's Asset Allocation team, takes an in-depth look at today's China. He begins with a section on Identifying Speculative Manias and Financial Crises and follows with an analysis as to whether The China Dream is nearing an end given current signs of financial fragility.
As a November IMF staff position note aptly pointed out, high fiscal deficits and higher outstanding debt lead to higher real interest rates and ultimately higher inflation, both trends which are bond market unfriendly. In the U.S. in addition to the 10% of GDP deficits and a growing stock of outstanding debt, an investor must be concerned with future unfunded entitlement commitments which portfolio managers almost always neglect, viewing them as so far off in the future that they don’t matter. Yet should it concern an investor in 30-year Treasuries that the Congressional Budget Office estimates that the present value of unfunded future social insurance expenditures (Social Security and Medicare primarily) was $46 trillion as of 2009, a sum four times its current outstanding debt? Of course it should, and that may be a primary reason why 30-year bonds yield 4.6% whereas 2-year debt with the same guarantee yields less than 1%.
The trend promises to get worse, not better. The imminent passage of health care reform represents a continuing litany of entitlement legislation that will add, not subtract, to future deficits and unfunded liabilities. No investment vigilante worth their salt or outrageous annual bonus would dare argue that current legislation is a deficit reducer as asserted by Democrats and in fact the Congressional Budget Office. Common sense alone would suggest that extending health care benefits to 30 million people will cost a lot of money and that it is being “paid for” in the current bill with standard smoke, and all too familiar mirrors that have characterized such entitlement legislation for decades. An article by an ex-CBO director in The New York Times this past Sunday affirms these suspicions. “Fantasy in, fantasy out,” writes Douglas Holtz-Eakin who held the CBO Chair from 2003–2005. Front-end loaded revenues and back-end loaded expenses promote the fiction that a program that will cost $950 billion over the next 10 years actually reduces the deficit by $138 billion. After all the details are analyzed, Mr. Holtz-Eakin’s numbers affirm a vigilante’s suspicion – it will add $562 billion to the deficit over the next decade. Long-term bondholders beware.
Just a few weeks ago, I published “Tell Me I’m Wrong,” my latest list of things in the investment environment that I find worth worrying about. I’m going to devote a few pages here – I promise this’ll be the shortest memo in years – to a point I touched on in “What Worries Me” (August 28, 2008) but omitted from the more recent piece.
It is important to note that our current defensive position is driven by the present combination of overvalued, overbought, overbullish conditions, coupled with upward yield pressures, and is independent of my larger concerns about the potential for a second wave of credit strains. So there are two distinct sets of concerns here, one that would exist even in the absence of credit concerns, and the other that directly involves those concerns.
This distinction is important, because as we've anticipated for months now, we have finally entered the window in which additional credit strains - if they are indeed likely to emerge - should actually begin appearing in the data. Specifically, beginning with data for February 2010 and later, the concern is that we will begin to observe a spike in delinquencies - first in the form of "30-day delinquencies" and gradually in either large increases in loan loss provisions or in the actual onset of foreclosures.
So the several few months will be important in gauging the extent to which "second wave" risks are or are not materializing. While it would be difficult to take a lack of fresh credit strains as evidence of restored health in the banking and lending system, we can't rule out the possibility that the Rube Goldberg machine created by the Fed and the Treasury will be enough to take us through a period of years (or if we follow Japan's example, decades) where we will gradually bury the losses of the banking system, trading a short-lived period of adjustment instead for a long-term period of stagnant credit.
We will not retain our concerns about second-wave credit strains if the data do not support it. As we move through this year, absent fresh credit strains, we will gradually assume a "post-war" world. If these strains do not emerge, we will scale (in an approximately linear way) our weights through 2010 to place greater weight on the "typical post-war recovery" dataset, while gradually fading our concern about abrupt solvency problems in our financial system. That is, we will move gradually with the evidence.
"The most difficult subjects can be explained to the most slow-witted man if he has not formed any idea of them already; but the simplest thing cannot be made clear to the most intelligent man if he is firmly persuaded that he knows already, without a shadow of doubt, what is laid before him." –Leo Tolstoy
But we bloggers are writing the first draft now. And there’s plenty of good fodder on Lehman’s final days, including fresh details on its effort to get support from billionaire investor Warren Buffett.
But the level of detail provided by this report is pretty astounding. It offers a pretty amazing snapshot of Buffett’s conversation with Lehman CEO Dick Fuld as well as a remarkable window on how the Oracle negotiates during times of crisis.
Fuld and Buffett spoke on Friday, March 28, 2008. They discussed Buffett investing at least $2 billion in Lehman. Two items immediately concerned Buffet during his conversation with Fuld. First, Buffett wanted Lehman executives to buy under the same terms as Buffett. Fuld explained to the Examiner that he was reluctant to require a significant buy-in from Lehman executives, because they already received much of their compensation in stock. However, Buffett took it as a negative that Fuld suggested that Lehman executives were not willing to participate in a significant way. Second, Buffett did not like that Fuld complained about short sellers. Buffett thought that blaming short sellers was indicative of a failure to admit one’s own problems.
Following his conversation with Buffett, Fuld asked Paulson to call Buffett, which Paulson reluctantly did. Buffett told the Examiner that during that call, Paulson signaled that he would like Buffett to invest in Lehman, but Paulson “did not load the dice.” Buffett spent the rest of Friday, March 28, 2008, reviewing Lehman’s 10-K and noting problems with some of Lehman’s assets. Buffett’s concerns centered around Lehman’s real estate and high yield investments, lending-related commitments derivatives and their related credit-market risk, Level III assets and Lehman’s securitization activity. On Saturday, March 29, 2008, Buffett learned of a $100 million problem in
At some point in their conversations, Fuld and Buffett also discovered that there had been a miscommunication about the conversion price. Buffett was interested only in convertible preferred shares. Buffett told Fuld that he was willing to agree to a $40 conversion price per share, while Fuld thought Buffett was offering to buy in at “up- 40,” or 40% above the current market price, which would have been about $56 per share. On Friday, March 28, 2008, Lehman’s stock closed at $37.87. Fuld spoke to Lehman’s Executive Committee and several Board members about his conversations with Buffett. Lehman recognized that an investment by Buffett would provide a “stamp of approval.” However, Lehman already had better offers for its April capital raise, and Lehman did not think it could give a better deal to Buffett at the same time it gave a less attractive deal to others. On Monday, March 31, 2008, before Buffett could tell Fuld that he was not interested, Fuld called Buffett to say that Lehman could not accept his terms.
At the end of Sprott’s latest commentary, they mentioned the Kondratieff Cycles, which I had never heard of. When I searched for more information, I came across a 1984 article from Murray Rothbard that discussed the topic and that I thought was interesting, although I enjoyed his comments about forecasters - in which he uses one of Munger's favorite words, "twaddle" - more than the comments about the Kondratieff Cycle. Some excerpts and a link to the article are below.
In the same way, the astrologers fudge on their predictions. If you are a Pisces, they will proclaim that you are a mystic, who loves water. If you say, "You're right," they will smile triumphantly upon this confirmation of their analysis. But if you say, "Wrong. I'm a skeptic who hates water," they'll say, "Ahh, that's because your Jupiter is rising, and you're fighting your stars," or some such twaddle. The key point is that, with any guru worth his salt, there is no way ever to prove him wrong. He will always come up with the fudge factor. And, it should be clear to the wise that a prediction that somehow can never be proved wrong is worth far less than the paper it is printed on.
Furthermore, when anyone spends a lot of time predicting, on whatever grounds, once in a while some of these forecasts are bound to be proved right, just by chance. And so, in the world of economic as well as astrological forecasting, the soothsayers trumpet any successes they may have ("I predicted . . . !") while quietly burying their mistakes.
It should be recognized that most business-cycle theories – Keynesian, Marxist, Friedmanite, or whatever – and remedies are grounded in the assumption that the cycle stems from some deep flaw in the free-market economy. But if micro-theory is correct, then it must apply to the "macro" sphere as well. The economy is not some entity split between a micro and macro half; it is a seamless web, inextricably linked together by the use of money and the price system. Therefore, whatever applies to one part of it must apply to all. The explanation for business cycles must somehow be integrated with the explanation of the micro-economy.
The Cycles Multiply
One of the worst things about the "business cycle" is its name. For somehow the name "cycle" caught on, with its implication that the wave-like movement of business is strictly periodic, like the cycles of astronomy or biology. An enormous amount of error would have been avoided if economists had simply used the term "business fluctuations." For man is all too prone to leap to the belief that economic fluctuations are strictly periodic and can therefore be predicted with pinpoint accuracy. The fact is, however, that these waves are in no sense periodic; they last for few years, and the "'few" can stretch or contract from one wave to the next. The periodic notion was unfortunately fed by the fact that the early panics seemed to be ten years apart: 1837, 1847, 1857, but pretty soon that periodicity broke down.
At that point, those who had made their reputations as forecasters of the cycle had two options: they could have simply given up the idea of periodicity. But that would have detracted from their aura of omniscience. And so, many of them introduced the first big fudge factor: the idea that cycles, despite appearances, are still strictly periodic, except that there are several mystical cycles all occurring simultaneously beneath the data, and that if you manipulated the data long enough, you could find these simultaneous, parallel, strictly periodic cycles, all going on at the same time. The apparently non-periodic data are only the random result of the interactions of the strictly periodic cycles.
This doctrine is mystic for two basic reasons. In the first place, very much like the "epicycles" of the Ptolemaic astronomers who fought against the Copernican Revolution, there is no way ever to prove the cycles wrong. If the cycles don't fit the facts, you can always conjure up one or two more "cycles" so as to make a perfect fit. Note that the fit has to keep changing in order to adapt to the new data that are always coming in. More epicycles get folded into the data. Secondly, as we noted above, the market is a seamless web. All facets of the market are interconnected through the price system, and the profit-and-loss motive. Booms and busts spread throughout the system; that is precisely why they are important. It is absurd to think that one part of the economy can peg along on a nine-year cycle, another on a three-year cycle, and still another on a 25-year cycle, with each of these cycles barreling along on a hermetically sealed track, not influencing and modifying each other. In fact, there can only be one real cycle going on in the economy at any one time.
Why Business Cycles?
If "the Kondratieff cycle" is a myth and a chimera, why are there business cycles at all? There is no space here to present a positive solution to the business-cycle phenomenon. But we have already seen (1) that since the market is interrelated and a seamless web, there can be no multiple "underlying" and interacting cycles; there is only one business cycle. And (2) the real business cycle is in no sense periodic, but is a continuing, wave-like motion that varies considerably in length and intensity.
We can only sum up the correct answer to the problem of the business cycle. We have already seen a hint of the solution: that inflation and the inflationary boom are caused by bank credit expansion generated by governments. In fact, government's central banking system provides the key causal element for all business cycles, a cause exogenous to the market economy. Continuing government intervention sets in motion business cycles by generating inflationary booms. Because these booms distort the signals of the market place in interest rates and in relative prices they bring about grave distortions of production and prices, which must be corrected by recessions and depressions.
In short, government intervention cripples the market economy, and recession or depression is the painful but necessary adjustment by which the market reasserts itself, and liquidates the distortions committed by the government's inflationary boom. After each depression, the government generates inflation once again, because it is the government's natural tendency to inflate. Why? Quite simply, whoever is granted a monopoly of printing money (e.g., the Fed, the Bank of England) will use that monopoly and print – to finance government deficits, or to subsidize favored economic groups. Power will tend to be used, and the power to create money out of thin air is no exception to the rule.
And so we see – and this is the great insight of the "Austrian" theory of the trade cycle – that micro and macro economics are in harmony after all. The free market does tend to adjust harmoniously without boom and bust, without incurring clusters of severe business losses. It is government intervention in the market that creates the business cycle, and unfortunately makes the corrective adjustment of recessions necessary. The cause of the boom-bust cycle is not some mystical periodic Force to which man must bend his will; the fault, dear Brutus, is not in our stars but in ourselves, that we are underlings.
Related previous post: Economic Depressions: Their Cause and Cure - by Murray N. Rothbard
Found via Simoleon Sense.
Few economists predicted the current economic crisis, and there is little agreement among them about its ultimate causes. So, not surprisingly, economists are not in a good position to forecast how quickly it will end, either.
Of course, we all know the proximate causes of an economic crisis: people are not spending, because their incomes have fallen, their jobs are insecure, or both. But we can take it a step further back: people’s income is lower and their jobs are insecure because they were not spending a short time ago – and so on, backwards in time, in a repeating feedback loop.
The state of economic knowledge was just as bad in the Great Depression that followed the 1929 stock market crash. Economists did not predict that event, either. In the 1920’s, some warned about an overpriced stock market, but they did not predict a decade-long depression affecting the entire economy.
Indeed, the crisis knows no end to the list of its causes. For, in a complicated economic system that feeds back on itself in many ways, events that start a vicious cycle might be as seemingly trivial as the proverbial butterfly in the Amazon, which, by flapping its wings, sets off a chain of events that eventually results in a far-away hurricane. Chaos theory in mathematics explains such dependency on remote and seemingly trivial initial conditions, and explains why even the extrapolation of apparently precise planetary motion becomes impossible when taken far enough into the future.
Weather forecasters cannot forecast far into the future, either, but at least they have precise mathematical models. Massive parallel computers are programmed to yield numerical solutions of differential equations derived from the theory of fluid dynamics and thermodynamics. Scientists appear to know the mechanism that generates weather, even if it is inherently difficult to extrapolate very far.
The problem for macroeconomics is that the types of causes mentioned for the current crisis are difficult to systematize. The mathematical models that macroeconomists have may resemble weather models in some respects, but their structural integrity is not guaranteed by anything like a solid, immutable theory.
The most important new book about the origins of the economic crisis, Carmen Reinhart’s and Kenneth Rogoff’s This Time Is Different, is essentially a summary of lessons learned from virtually every financial crisis in every country in recorded history. But the book is almost entirely non-theoretical. It merely documents recurrent patterns. Unfortunately, in 800 years of financial history, there is only one example of a really massive worldwide contraction, namely the Great Depression of the 1930’s. So it is hard to know exactly what to expect in the current contraction based on the Reinhart-Rogoff analysis.
This leaves us trying to use patterns from past, dissimilar crises to try to infer the likely prognosis for the current crisis. As a result, we simply do not know if the recovery will be solid or disappointing.
The first thought that the above quote might provoke is - why would I begin a weekly comment by quoting an economic analysis that is nearly 5 years old? Two reasons. First, it should be evident that the recent credit crisis did not emerge as some unpredictable surprise, but was instead the very ordinary outcome of extraordinary recklessness. Though the mounting problems in 2005 were utterly ignored by the stock market for more than two years after this analysis was published, the fact is that even with the recent rebound, the S&P 500 remains below where it was in mid-2005. Overvaluation and reckless lending do not always translate into near-term market weakness, but they invariably haunt investors in the form of poor long-term returns.
Second, I've chosen a 5-year old analysis of mortgage lending specifically because the Alt-A (no documentation) and Option-ARM (negative amortization) loans discussed by the Economist commonly sported reset dates 5 years into the loan terms. So the observation that "payments surge as principal repayment kicks in" is not an event that was occurring then. Rather, it is an event that has just begun to occur with loans now hitting their resets. And while current ARM interest rates are only about 4.5%, these mortgages now demand a combination of interest plus principal repayment, on a loan balance that is most likely well above the current market value of the home. This is likely to be onerous relative to a previous payment that was less than the interest alone.