Tuesday, September 30, 2008

CNN Interview with Lee Kuan Yew

CNN conducted a two part interview with Lee Kuan Yew, former Prime Minister of Singapore. I am currently reading his memoirs, which is a fascinating read about a fascinating individual. In approximately 30 years under his control, Singapore grew from $1000 GDP per capita to $22,000 (and even more today). The two part interview is embedded below:

Part I:

Part II:

Thursday, September 25, 2008

The Doctor's Bill

The Economist has a very good special report on the events leading up to the current bail-out plan, plus an analysis of where to go from here. You can find a direct link to the article here.

P.S. I've been fairly busy this week, but I hope to put up some original commentary in the next few days.

Thursday, September 18, 2008

Economies Of Scales

From The Economist:

Like most other fisheries in the world, Alaska’s halibut fishery was overexploited—despite the efforts of managers. Across the oceans, fishermen are caught up in a “race to fish” their quotas, a race that has had tragic, and environmentally disastrous, consequences over many decades. But in 1995 Alaska’s halibut fishermen decided to privatise their fishery by dividing up the annual quota into “catch shares” that were owned, in perpetuity, by each fisherman. It changed everything.

Wednesday, September 17, 2008

Nassim Taleb On The Fourth Quadrant

Nassim Taleb, author of The Black Swan, has submitted a wonderful essay to the Edge that is available for all of us to read. I HIGHLY recommend everyone click on the link and read the entire thing- it is filled with concepts that I think no one should live without. (Opening intro is pasted below)


When Nassim Taleb talks about the limits of statistics, he becomes outraged. "My outrage," he says, "is aimed at the scientist-charlatan putting society at risk using statistical methods. This is similar to iatrogenics, the study of the doctor putting the patient at risk." As a researcher in probability, he has some credibility. In 2006, using FNMA and bank risk managers as his prime perpetrators, he wrote the following:

The government-sponsored institution Fannie Mae, when I look at its risks, seems to be sitting on a barrel of dynamite, vulnerable to the slightest hiccup. But not to worry: their large staff of scientists deemed these events "unlikely."

In the following Edge original essay, Taleb continues his examination of Black Swans, the highly improbable and unpredictable events that have massive impact. He claims that those who are putting society at risk are "no true statisticians", merely people using statistics either without understanding them, or in a self-serving manner. "The current subprime crisis did wonders to help me drill my point about the limits of statistically driven claims," he says.

Taleb, looking at the cataclysmic situation facing financial institutions today, points out that "the banking system, betting against Black Swans, has lost over 1 Trillion dollars (so far), more than was ever made in the history of banking".

But, as he points out, there is also good news.

We can identify where the danger zone is located, which I call "the fourth quadrant", and show it on a map with more or less clear boundaries. A map is a useful thing because you know where you are safe and where your knowledge is questionable. So I drew for the Edge readers a tableau showing the boundaries where statistics works well and where it is questionable or unreliable. Now once you identify where the danger zone is, where your knowledge is no longer valid, you can easily make some policy rules: how to conduct yourself in that fourth quadrant; what to avoid.

John Brockman

Stuck Holding the Bag

I posted a little while back about the silliness of this comment I heard on CNBC:
Pisani : …What fool would buy Fannie Mae now when everyone knows the equity is worthless? Here’s a fool who just bought Fannie Mae this morning. Now, what’s going on, why would you buy Fannie Mae right after the open, what price did you buy it at, what price did you get out at, and why?

Redler: Well as active traders we loFok for over-emotion. Everyone on TV was saying Fannie and Freddie are zeros. They might as well be zeros, but it doesn’t have to be a zero tomorrow…

Essentially, this trader was playing with fire. There was no actual value underlying the common shares- as far as I'm concerned, he might as well have been trading tulips. He was buying an asset he was willing to admit to be worthless, on the hope that he could sell it to someone else for more before the "jig was up", so to speak.

Well, Fannie and Freddie both rallied that day, to close at $4.85 and $3.16 per share, respectively, earning this trader a short segment on CNBC. Today, these stocks closed at $.43 and $.27 . Thats a loss of 91% for these stocks in a little under a month. What you will not see on CNBC though, are the millions of traders who tried to play the game and were stuck holding the bag.

Sunday, September 14, 2008

War, Part II: Strategy, Operations, and Tactics

In any war, the planning is broken down into three categories: tactics, operations, and strategy. Tactics refers to the plans within a battle; operations refer to the plan within a broader campaign; and strategy refers to the final military and political goals of the war. The history of warfare provides infinite examples of mistakes made in all three. And the same holds true in the battlefield of business. We can use the separation to great utility in investment research. Is the business we are looking at facing problems because of the recent direction it has taken with the company? Is it in dire straits because its method of fulfilling its consumer need is becoming ineffective? Or, is there really no need for their service in the first place?

I'll give you some examples which I think qualify. Back in 1963, American Express got caught within the "Salad Oil Scandal":

The scandal involved the company Allied Crude Vegetable Oil in New Jersey, led by Tino De Angelis, which discovered that it could obtain loans based upon the inventory of its salad oil.[2]

Ships apparently full of salad oil would arrive at the docks, and inspectors would confirm that the ships were indeed full of oil, allowing the company to obtain millions in loans. In reality, the ships were mostly filled with water, with a only a few feet of salad oil on top. Since the oil floated on top of the water, it appeared to inspectors that these ships were loaded with oil. The company even transferred oil between different tanks while entertaining the inspectors at lunch.[3]

The money was splurged and banks were stuck holding loans with worthless collateral. The scandal cost American Express over 58 million, and the stock dropped over 50%.

But what had really happened here? The problem was not that the company's services were poorly delivered and unnecessary. Rather, it was a one-time bad decision to loan money to characters with deceitful intent. The underlying business was in fact still very valuable, with several competitive advantages to protect its future profit stream. The stock subsequently rose significantly and became one of Warren Buffett's prized investments.

What about an operation problem- one where the fulfillment of a need proves inefficient? For example, consider classified advertising after the introduction of the internet. If you wanted to find or sell something in the old days, you really had only one product which would reach your local market, and that was the newspaper. Newspapers recognized this and made a killing by chaarging high rates for putting these into their papers. It's no wonder that newspaper execs often looked at classifieds as their "gold mines."

But the internet not only introduced competition to this field, it also slowly began to demonstrate a superior ability to fulfill the need for classifieds. The internet had several advantages: it could be posted for cheaper, it could reach a larger audience, and once it was posted it would remain up there for as long as the poster wanted. The internet also made it easier to search and find what their customers wanted. All this served to slowly make newspaper classifieds less and less effective, and their recent results reflect that.

Finally, a problem in strategy. Can businesses really exist and thrive for some period of time when they are reality adding no value to their customers. The answer is yes. I've mentioned one example before with the rise of the mortgage lenders. During the housing boom, the business of loaning money to people soared, and more importantly, people would pay a premium to loan value to buy these loans off you. This allowed several mortgage lenders to spring up and thrive by making loans and dishing them off to other lenders. But in principle, it was founded on an unsustainable practice. Economically, all these firms were doing was saving their customers the trip to their local bank (or providing them with exotic products that just really shouldn't have been made). Either way, competition would have eventually narrowed the gap and vastly eliminated this business.

So there you have it- examples of problems in strategy, operations, and tactics. As an investor, its important to recognize which type of problem you are dealing with and to include that information into any investment analysis.

Monday, September 08, 2008

The Fannie/Freddie Bailout, And Lessons To Be Learned

The government yesterday announced their plans for supporting the continued functioning of Fannie Mae and Freddie Mac(The "GSEs"). The specific details of the plan can be found here, but essentially it boils down to the government stepping in and backing GSE debt obligations with the full faith of the U.S. government, thus ensuring their full principal value. What does this mean, who gets affected, and why was this necessary? These are all questions I'll try to briefly answer.

The GSE's are massive organizations which were created with the intent of promoting homeownership and adding liquidity into the marketplace. The organizations were mostly involved in two lines of business. First, they operated as guarantors in the mortgage market. Banks could sell mortgage loans qualifying under certain criteria to the GSE's. They would then package them into securities, guarantee them, and take a portion of the interest payments as a fee in return for the guarantee. The second line of business involved issuing large amounts of debt (for cheap) and then using that money to purchase mortgage loans which gave a higher interest rate and had historically performed well.

But history is a bad measure, and the institutions were hit from multiple angles. They ended up under-pricing the risk of their mortgage guarantee business, and the mortgages they purchased with debt began to decline significantly in value. These combined to completely wipe out equity, at least if you were looking at their equity from a "fair value" basis. (The company for several quarters has insisted on using its own projections to value its assets/liabilities over the market's pricing, but they provided both figures.) That lead to the questioning of their viability, and the cost to issue debt for the institutions began to rise sharply. That began to add even more devastation to their second line of business, because they could no longer fund their mortgage assets with cheap debt. It would have only been a matter of time before the companies went into bankruptcy.

Now, the government has stepped in and essentially gauranteed full value for the debt issued by Fannie/Freddie, as well as their obligations for guaranteed mortgage securities. Those combine to total over 5 trillion. Those are backed by mortgage assets, and the first losses will accrue to common and preferred shareholders. Still, that is little comfort to me, as by fair value measures these institutions have been equity-negative, and I perceive things to continue to worsen for some time. Their will ultimately be big losses for government. That means taxpayers will be suffering for the benefit of the investors in mortgage assets.

That is a redistribution I would prefer without. And there is one more negative hazard to this deal as well, but these are completely over-shadowed by the systemic necessity of the deal. But first, that negative is that government has now taken over the judgment of future mortgage risk. It makes me shudder to think that we have offloaded the task of judging risk from hundreds of thousands of banks to one central institution (although we got into this mess because there was a complete lack of risk judging by banks, in the first place). Instead, everything will now dance to the tune of the GSE guidelines. The government has committed to wind down the GSE business over time and diminish its role in the mortgage market, but that will be a long time.

Unfortunately, the move was very, very necessary. If the GSE's were to announce bankruptcy, I believe you'd have a terrible hellish limbo (and please correct me in the comments if im wrong on this point). Unlike typical bankruptcies, nothing for the GSE's could function as usual. As I understand it, they could not pay off expiring debt, and they could not pay off guarantee obligations- simply, they couldn't do anything. That is because once in bankruptcy, their debt obligations would disregard time duration and instead put them on equal footing based on their class (senior, junior, etc). That means, a senior note expiring and scheduled to be paid back in 30 years would have the same value and rights as a senior note due tomorrow. That means the institution could not pay back anyone until it figured out what it could ultimately pay back. Well in the case of the GSE's, that could be ages. I mean, their assets are long duration mortgages to individuals which can't be redeemed, meaning you'd have to wait for them to slowly get paid back. And some of their guarantee liabilities extend for 10 years or more, and can change rapidly at any time depending on the mortgage market situation. Best case, you'd have to wait until the mortgage situation clears up and you find suitable buyers of its tremendous load of assets and guarantees. But considering the size of the liability, that is very unlikely for everyone except government.

And in the meantime, you have stagnation. The company would have to preserve all its capital and pay out nothing. That means that thousands of institutions around the world would be holding pieces of paper paying them no interest, with questionable ultimate value, and no idea of when any of that value may ultimately be able to be realized. Things would shutdown, people would be furious, and foreign lending to the US would cease. That could not happen, and sadly, that means the institutions could not be allowed to fail.

What can we learn from this saga? Well, the situation does not bode well for other mega-banks on shaky financial footing, especially those with long-duration credit default swaps. If one of these institutions were too fail, the same thing would happen here- everything would freeze up until ultimate liabilities can be determined, leaving a very large class of debt and CDS holders in stagnation for a long period of time. "Doomsday" would then ensue.

Friday, September 05, 2008

Lessons From War: Part I. Knights and Newspapers

I just so happen to be taking a class on War! this semester with a great professor on the subject, Ron Hassner. One week into it, I've already picked up many connections between the topic of war and the field of business.

Today's example looks at the introduction of the cannon into the field of warfare, which occurred in the early 14th century. At this time, armies were built around feudal knights, who were skilled with a lifetime of combative training. The introduction of guns and artillery changed everything though. A common man armed with a gun and a few weeks of training could now defeat a knight, meaning the knights had now lost their monopoly on force.

How did knights respond to this threat? "Stupidly" would be a fitting description. They decided to put on thicker and thicker armors, greatly sacrificing mobility for some safety. The strategy did little to help the knights, and their role soon diminished into nonexistence. But not before they suffered heavy casualties. Perhaps this inability to acknowledge reality is best seen at the Battle of Crecy, where a far outnumbered army of British longbow-men completely obliterate wave after wave of French knights and nobility. Afterwards people had no choice but to accept the new reality- after all, the knights of old had all just died.

To find a comparable example in business, we need an industry undergoing a dramatic shift in its business landscape. A good example is newspapers, and the introduction of the internet. The internet can do several things better than traditional newspapers. It is a more effective means of classified ads and it is a better source for information like weather, movies, etc. It has also introduced competition into a news field which had until then always been a local monopoly.

Newspaper companies, like the knights, were slow to react to this changing reality. By the time they realized the importance of the internet, their circulation was already in decline and they were too late to establish themselves as dominant internet firms. Some have tried to throw money at the problem, investing as much as they can now in internet projects to compensate for their past idleness. But I think the smarter ones will have to realize that the landscape has changed. A news company's only real asset is its staff of writers which collectively dominate the reporting of news happening in its locality. Whether that news will then best be transmitted on paper or on the internet, or whether it will be more subscription or advertising based, will have to be figured out. But there is still a place in the world for that company which aggregates and reports on local content- albeit, a smaller and more niche market with less attractive returns.

Tuesday, September 02, 2008

Who Do You Want To Be?

Warren Buffett often tells his audience to perform a simple exercise which runs like this: Imagine if you had to invest all your money today in a person, a friend. It would work similar to any investment, in that you would be getting a stake of his future income. Who would that person be? And more importantly, which of their qualities make you willing to put such faith in them? The point of the exercise is to get you thinking about qualities you admire, respect, and believe will lead to success.

I've run through this exercise countless times. I've found that the people I admire usually are:
Long term outlook

And no exercise would be complete without inverting the question.Which qualities do I dislike in others? That list of opposites would be something like:

Entity Mentality

Once I had this list, it became simply a matter of acting like the first list and avoiding the second. And although perfection is near unattainable, it helps immensely if you know what you are aiming for. Should you not uphold the qualities which you admire in others?

As you ask other people to perform this exercise, I think you will find the list of positives overlaps for many people; and you'd be hard-pressed to give approbation for any of the second list of qualities. The lesson has some bearing for the investors out there as well. It is difficult to find a truly great investment when you are entrusting your money in a crooked culture. So I recommend all of you to make your lists, study it closely, and start finding people and organizations which match your admirable ideals.