Tuesday, September 30, 2008
Thursday, September 25, 2008
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
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
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.
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?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.
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…
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
I'll give you some examples which I think qualify. Back in 1963, American Express got caught within the "Salad Oil Scandal":
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.
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%.
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 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
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
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:
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.