Buffett Is Brilliant

Just spent some time reading this interview with Warren Buffett, and I remembered some of the best financial advice in the world is available in his newsletters for free:
Berkshire Hathaway Annual Shareholder Letters

My favorites from the post:

“Success is getting what you want, happiness is wanting what you get.” I won the ovarian lottery the day I was born and so did all of you. We’re all successful, intelligent, educated. To focus on what you don’t have is a terrible mistake.

Why do I come in at 7 every morning, can’t wait to get to work? because I get to paint my own painting and I like applause.

If I had been born earlier, I would’ve been some animal’s lunch. I can’t run, I can’t climb. I’d be talking about allocating capital and the animal would think, “Those are the kind that taste the best.”"

Almost always good things come from good behavior. Don’t keep score in life.

After a talk at Harvard, I told them to work for who they admired the most, so they all become self-employed.

Hearing The Music

Have you ever heard Twelve Tone classical music? In undergrad I overly ambitiously signed up for an advanced "set theory" class which met once a week at a famous professor's house, where he served us giant bowls of ice cream and we played "guess this song" with this 12 tone classical music. I guess partly because the squiggles on the board and Cantor arithmetic were over my head, I strained to hear the "good" in this weird sounding mess.

The optimism I have sought in the recent week or two in the markets brings this idea back - and I realize that the music is just plain bad...then and today.

More directly: my optimistic hope that the downside is somehow already priced in, or that maybe we will somehow collectively wave our hands and be OK is almost certainly mistaken.

The simple fact is that although the headlines today are resonating with the doom first expressed here in June and elsewhere much before, they nevertheless are just hinting at the potential for far deeper losses caused by things like further unwinding in the CDO market, the consolidation of failing SIV's on bank balance sheets, and the failure of financial institutions.
I spoke last night with a fairly well statured hedge fund manager who suggested that a bank failure was unlikely. However the more these writedowns continue to mount, the less room regulators have to act.

This article surely is not a coincidence: FDIC to Add Staff as Bank Failures Loom

Maybe that 12 tone stuff was really good and Aleph Naught to the Aleph Naught really matters. Or maybe the music is just really bad and people are finally beginning to notice. Keep listening.

Bad Mortgage Reform - Implemented Of Course

The government has finally acted to address the increasingly bloody residential real estate markets.

In a plan that includes a refund check to taxpayers, the government also agreed to lift the loan limit that Freddie Mac and Fannie Mae can purchase, which basically has the effect of lowering interest rates for loans above the previous cap of $419k up to the new cap which approaches $700k.

BUT

There is a catch: this does not apply to evenly across the board. In a sick twist that will have the effect of basically giving a government guarantee to help prop up those with more wealth in real estate, the loan caps are only lifted for communities where the average house price is greater than the previous cap.

The details are discussed in this article:

Stimulus Plan Aids Buyers of High-Priced Homes

The article suggests rightly that the markets feeling the most pain in the crash are are those in California and elsewhere where the median home does not currently qualify for federal mortgages.

However, the value of these homes also represents the relative wealth in these communities. Sure they are getting hurt now, but they also likely had a greater rate of appreciation in the bubble. They benefited from the excesses of Wall Street originated mortgages, but rather than letting the market correct these excesses with a reversion in prices, the Government is basically using taxpayer dollars (in the form of an implicit backstop for Freddie and Frannie) to bail out these overpriced assets.

Perhaps I am being a bit harsh, but a more equitable solution would have been to increase the cap across the board so that communities that have not yet realized the "American Dream" of ridiculous home values could have any chance to compete with the inflated values seen in the markets that will benefit from this rule.

Or better yet, the government could leave its too-late overly-simplified solutions on the sidelines until it came up with a more comprehensive rescue package like one suggested by Bank of America this week which envisioned the government buying mortgages and renegotiating with current occupants to prevent unnecessary foreclosures and wasted resources. Such direct social service seems to better represent the role of government in trying times like this rather than trying to play master of a market that is badly broken and clearly deeply misunderstood by most.

More Quant Carnage

According to Bloomberg, the mega quant fund AQR is down huge already this year:

AQR Hedge Fund Fell Almost 15% Through Mid-February

Why do these guys who have hired the most brilliant PHD's and built the biggest model continue to fail?

The past is not indicative of the future...especially when you never had credit markets or personal balance sheets like the ones we are facing today.

Don’t need to get any more complicated than that in my mind.

Open Source Credit Risk

This site has some ridiculously arcane sounding stuff on CD*'s. It seems like it is promoting open-source collaboration on what is obviously an important topic in risk management generally, but also for the future stability of the financial markets.

This site description is what got me...cool...now if only he would have developed this a few years ago!

DefaultRisk.com the web's biggest credit risk modeling resource

This is not a vendor site. It is just my own. I have been excited by credit risk methodologies throughout my career (I work at Fitch Ratings with a crack quant team). Although I am the principal author of CreditMetrics® and LossCalc™ (and have a natural affinity for them), I am more of an advocate for the continued study of credit risk modeling. Wonderfully, there are over fourteen hundred researchers featured on this site (see full list)!

"I'm trying to make the world a less risky place;
one credit portfolio at a time!"

-- Greg M. Gupton

What I want is to advance the state-of-the-art of credit risk management ... through YOU. I hope to give you all the tools to understand the strengths and limits of credit value-at-risk models so you can take the best and ... I trust ... create better ones. This site has been under continual development since 2000 and will continue to grow. I'm trying to satisfy two audiences:

Practitioners have a no-nonsense need to address risk in a timely fashion. Institutions hire research people to develop internally (and adapt from external sources) risk measurement and pricing systems to address tangible needs.

Academics have the more strategic, but no less difficult, need to efficiently access the many disparate sources of prior research and to gain insight into current practitioner practice & demand.

More Gagging

For some reason the news is rife with people trying to shut down open dialogue lately.

I have never heard of this site, but the very idea that a Federal Judge ordered them to shut down because of their whistleblower status just strikes me as unAmerican.

Of course the Internet is the friend of liberty and apparently these guys have found a way around the block...

Whistleblower Website Ordered Shut Down

(02-19) 19:03 PST SAN FRANCISCO -- A San Francisco federal judge has taken the highly unusual step of ordering the shutdown of a Web site devoted to anonymous allegations of high-level wrongdoing after it posted documents purporting to describe offshore activities of a Swiss bank.

U.S. District Judge Jeffrey White issued an injunction Friday ordering a Bay Area Internet host to disable the Wikileaks.org site and prevent the organization from transferring to any other server until further notice.

Wikileaks, founded in 2006, describes itself as an enabler of "principled leaking" by government and corporate insiders. Its site was the first to post the confidential Defense Department manual about operations of the U.S. detention camp at the Guantanamo Bay naval base in Cuba, and has also posted rules of engagement for U.S. forces in Iraq.

Despite the order aimed at its domain name, Wikileaks remained accessible Tuesday through its Internet Protocol or IP address, 88.80.13.160, and through so-called mirror sites in Europe that replicate its contents.

Personal Creativity? Not At CNN

This story, which hit the front pages of SlashDot is absolutely staggering to me. As I discussed with my father last night, the lack of ethics in politics and society in general never ceases to amaze me, no matter how often I hear of stories like this:Mike Bloomberg Claims Vote Fraud.

However, the idea that a news station would fire one of its workers because he started a personal blog while dealing with the realization that he had a brain tumor is beyond the pale.

As he discusses here, on said blog,he started the blog

mostly to pass the time, hone my writing skills, resurrect my voice a little, and keep my mind sharp following the surgery.

Apparently having an independent voice and set of opinions is not within the job description of an employee of a news agency. The fact that such editorial domination is required only begs the question: what are they trying to hide?

Right before I hung up, I asked for the "official grounds" for my dismissal, figuring the information might be important later. At first they repeated the line about not writing anything outside of CNN without permission, but HR then made a surprising comment: "It's also, you know, the nature of what you've been writing."

If you still believe that the mainstream media is a reliable source of unbiased information please take a moment to think about the hypocrisy of such a decision...and please change the channel.

Another Sign of General Fear

The next shoe to drop has to be bigger than the last...right?

At least that seems to be the sentiment lurking in the shadows around the financial markets...perhaps it is just my contrarian nature, but this irrational paranoia (yes, I am saying others may be becoming too paranoid) just seems to create the potential for a buying opportunity if disaster can be averted.

In other words, now that the extreme downside cases are clearly being articulated, as is discussed here (thx to WLH): CDS report: “Horrible” fall-out scenario preoccupies market, perhaps the risk of an unforeseen collapse is dissipating.

Last summer, when the powers and minds of the masses were looking forward under the guise of "containment" it seemed much more likely that they would be blindsided by the oncoming train of defaults and contraction. But now that contagion has become the theme of the day, perhaps those in the line of fire will be quicker to dodge the bullets.

That is, of course, assuming that the masses really have their eyes wide open and can move with at least some precision...or maybe I am just hoping beyond hope that the darkest scenarios can somehow be defeated by ingenuity.

A Dark 12-Step Program

The ominous clouds that have been lurking on the horizon have yet to materialize in the darkest forecasts imaginable, and the repeated commitment of the government to bail out the financial institutions at the crux of these issues makes me start to wonder if maybe we will be able to avert disaster through psychology, inflation, or some other means.

Someone with a contrary view is Nouriel Roubini of New York University's Stern School of Business, who suggests that we are on a 12-step course to what he calls "The Mother of All Meltdowns" which he discusses in this article: America's economy risks the mother of all meltdowns

Here are the 12 steps:

Step one is the worst housing recession in US history. House prices will, he says, fall by 20 to 30 per cent from their peak, which would wipe out between $4,000bn and $6,000bn in household wealth. Ten million households will end up with negative equity and so with a huge incentive to put the house keys in the post and depart for greener fields. Many more home-builders will be bankrupted.

Step two would be further losses, beyond the $250bn-$300bn now estimated, for subprime mortgages. About 60 per cent of all mortgage origination between 2005 and 2007 had "reckless or toxic features", argues Prof Roubini. Goldman Sachs estimates mortgage losses at $400bn. But if home prices fell by more than 20 per cent, losses would be bigger. That would further impair the banks' ability to offer credit.

Step three would be big losses on unsecured consumer debt: credit cards, auto loans, student loans and so forth. The "credit crunch" would then spread from mortgages to a wide range of consumer credit.

Step four would be the downgrading of the monoline insurers, which do not deserve the AAA rating on which their business depends. A further $150bn writedown of asset-backed securities would then ensue.

Step five would be the meltdown of the commercial property market, while step six would be bankruptcy of a large regional or national bank.

Step seven would be big losses on reckless leveraged buy-outs. Hundreds of billions of dollars of such loans are now stuck on the balance sheets of financial institutions.

Step eight would be a wave of corporate defaults. On average, US companies are in decent shape, but a "fat tail" of companies has low profitability and heavy debt. Such defaults would spread losses in "credit default swaps", which insure such debt. The losses could be $250bn. Some insurers might go bankrupt.

Step nine would be a meltdown in the "shadow financial system". Dealing with the distress of hedge funds, special investment vehicles and so forth will be made more difficult by the fact that they have no direct access to lending from central banks.

Step 10 would be a further collapse in stock prices. Failures of hedge funds, margin calls and shorting could lead to cascading falls in prices.

Step 11 would be a drying-up of liquidity in a range of financial markets, including interbank and money markets. Behind this would be a jump in concerns about solvency.

Step 12 would be "a vicious circle of losses, capital reduction, credit contraction, forced liquidation and fire sales of assets at below fundamental prices".

For me...once we get to step 9 or so, the connections between the dots start to become hazy. Although the "shadow" financial system is indeed a bit scary in some senses, it is unclear to me that there will be a fundamental collapse in said system barring some direct event. I am not saying that such a collapse is impossible; it is just such broad generalizations seem to come from the fear of the unknown more than anything else.

I guess what I am saying is that given the level of consciousness that is being brought to bear on the other major challenges that we face, that perhaps through collective innovation, or pure financial sacrifice, we may finally be able to stop the bleeding and carnage.

More On The Consumer

This article: Credit-Card Pinch Leads Consumers To Rein In Spending in the Journal Friday was spurred by a fall-off in consumer borrowing, which seems more reasonable in the current environment that what we saw last month and I discussed a few week ago.

A few friends and I had a healthy debate about what this means. Some suggested we are reaching a bottom...I disagreed. Here are my thoughts:

Consumers have already maxed out their credit cards. Judging from this Fed data: Consumer Credit data it looks like revolving credit hit a peak in November... (or look at any macroeconomic data on household debt-levels). There is just no more room for borrowing at the household level.

As incomes decline and the ARM's continue to reset (yes, there are still billions of dollars worth of ARMs out there yet to kick in) more and more people will feel the pinch.

Couple this with the tightening credit, and they will no longer be able to roll-over their zero-percent introductory rate balances as their mini-consumer-ARMs kick in (nor will they have HELOC's to supplement their spending habits).

And as defaults continue to rise on credit cards, this will only exacerbate the household crunch as late-payment penalties and ridiculous APR's kick in. (note: in my mind these people in the article should file for Chapter 7).

And that is before taking into account the job losses from: mortgage origination firms, mortgage brokers, home builders, home-suppliers, wood processing firms, construction workers, investment bankers, etc. etc.

A scary statistic I heard recently: the median LTV for homeowners filing for bankruptcy thus far in 2007 is 90%. Think about that...that is on the "market value" of the home as they headed into bankruptcy, not on the value as it has declined since then. Projecting one year out, one can easily assume that the median distressed homeowner is underwater on their mortgage. This paints a pretty clear picture of continued overhang in the residential real estate market (ignoring the ridiculous squeeze on mortgage credit which further crimps demand).

The latest word amongst those with half-a-brain is that the housing market won't bottom until 2010.

I think Buffet mentioned today that in his opinion it isn't so much that there is a credit-tightening going on as much as a repricing of risk. Stupid money isn't as available in plenty as the leverage has been sucked out of the system from collapsing CDO's and SIV's (not to mention the rising default rates in consumer finance of all shapes and sizes)...oh, and don't forget the CLO/Leveraged loan market.

I am a little more bearish than Danny's new friend, Warren, (I think this IS a tightening of credit in addition to a repricing of risk as asset values force us to collectively "mark-to-market" at values below our underwriting, forcing collective liquidations), but then again, he is smarter than me.

So take your pick on what you want to see as the driver but the reality is: consumer spending is going to continue to decline.

That said, I am a bull on technology. There will be some cool gadgets and sweet toys in the world once we get out from under this cloud.

When The Music Stops

CDO Market Is Almost Frozen, JPMorgan, Merrill Say

For some reason this headline made me think of a brutal game of musical chairs where the music stops and the players are left with the option of jumping on a bed of nails or being kicked teeth first into the curb on the Street.

The never-ending slew of headlines on the deteriorating credit quality of these instruments only makes it more starkly obvious that the credit ratings placed on billions of these things were absolutely worthless.

Moody's virtually acknowledged as much today (see this article) by suggesting that it might adopt a set of "warning labels" for their ratings! The fact that their rating methodology is so suspect that they have to create the equivalent of a skull and crossbones would be laughable if it weren't so scary in its implications. In other words, Moody's is saying "you know those $billions of securities we said were 'AAA'...well...we didn't reallly mean it".

If the CDO market already froze up before such an acknowledgement, where do we go from here? What is the next market to freeze?

Maybe the murmurs in the leveraged loan markets will become full-fledged wails when the buyers in that market start to question the promise for their exit alternatives in a drying liquidity environment. What about CDS markets that actually have to consider counter-party credit risk? Probably not as easy to trade this stuff willy-nilly once you realize your insurer may not exist tomorrow.

Life is beautiful, but it sure does have a bad hair day sometimes.

Hedge Funds And Open Source

The world is really moving in an exciting direction notwithstanding of all of the recent madness in the markets. We are in the midst of what some are calling a "loss of privacy" on the one hand, while on the other hand we might instead call it "an improvement in information and transparency".

Case in point: Bill Ackman, a notoriously bearish hedge fund manager, has recently written an open letter to the insurance regulators regarding his multi-year negative view on the bond insurance companies that have been in the headlines of late.

The coolest part of his letter is not only the public display of his thoughts, but also his sharing of what he is calling an "open source model" which he has made available for download and collaboration.

Take a look at the letter, some of which is quoted below:


Bill Ackman's letter to insurance regulators

Our primary goal is to initiate what we call “Open Source Research” where all market participants can have equal access to the primary source data and construct their own views of losses without reliance on the analytical judgment of rating agencies or the bond insurance industry.

By focusing the discussion on a fundamental, data-driven approach, we expect that the dissemination of the Open Source Model will enable market participants and regulators to accurately estimate probable losses by relying on rigorous fundamental analysis of specific credit exposures, a departure from relying on the opaque, faith-based pronouncements that the bond insurance industry has promulgated to the marketplace.

In order to facilitate a comprehensive and accurate estimate of probable losses in the bond insurers’ exposures, we believe that you, as their regulators, must require the bond insurance companies to provide full disclosure to the market of their entire portfolio of insured exposures. This should include not only confirmatory data on CDO and related RMBS exposures detailed in the Open Source Model, but also municipal and other structured finance exposures, especially those exposures that have been or are in remediation, are rated below-investment grade, require claim payments or otherwise have been or are carried on so-called “classified watch lists.”

...

Only with a complete understanding of all of the bond insurers’ gross exposures to potential losses can the market gain a complete understanding of the insurers’ capital adequacy.

If the bond insurers truly believed that greater disclosure would help confirm the veracity of their loss estimates, one would have expected them to provide full transparency to the marketplace.

Download the model here - But be careful. This thing is huge (128mb) so it might destroy your system.

Thanks to WLH for sharing this.