Monday, December 28, 2009

Investing Over Business Cycles - Alpha

In this issue:
1. What is a Business Cycle?
2. Business Cycle Investing
3. Soros’ Theory of Booms and Busts
4. Cycles within Cycles
5. Glacial Cycles and the Fall of Rome

“History doesn't repeat itself, but it does rhyme,” wrote Mark Twain. His words apply to investing, where profits and returns come from cycles. Hence the most basic axiom of investing, “buy low and sell high,” can and should be put in context. Two things determine “high” and “low.” One is intrinsic value: an investor must be able to discount cash flows with some certainty, and compare this to prices. The other is cycles: an investor must know where in the business cycle we currently are because intrinsic values depend on earnings, which are a product of the economic environment. Below we lay out the case for business cycle investing and end with some comments on other cycles and where in the business cycle we are now (our subjective odds of a W, V, and L).

Please see the attached pdf file for this newsletter, here:

Investing Over Business Cycles - RISK OVER REWARD NEWSLETTER PDF

Fannie and Freddie Get a Blank Taxpayer Check - Alpha

A queer holiday update from Hussman here.

It was about a sneaky Christmas eve decision the US Treasury made regarding the largest buyer of mortgages (after the Fed) - and as the WSJ notes, the timing wasn't a coincidence.

Basically, the Fed and Treasury have kept the US property markets alive (residential, commercial, etc.). The Fed bought $1,040bn in agency and MBS in 2009 (more than a trillion dollars!), and $300bn in US Treasuries (monetized debt, where the Fed printed money). See here to compare Dec. 23, 2009 to Dec. 24, 2008 (the change):

The US Treasury bought $220bn through Fannie and Freddie. Both are more insolvent today than they were a year ago (the value of their assets have decreased even further, while their liabilities, held by bond funds and foreign central banks, have stayed constant without any defaults or haircuts).

For one example of how all property investors are dependent on Fannie/Freddie, here's what the largest apartment REIT company (EQR) in the US says about their dependence:
"The continued credit crisis has negatively impacted the availability and pricing of debt capital. During this time, the multifamily residential sector has benefited from the continued liquidity provided by Fannie Mae and Freddie Mac. A vast majority of the properties we sold in 2008 and 2009 were financed for the purchaser by one of these agencies. Furthermore, Fannie Mae and Freddie Mac provided us with approximately $1.6 billion of secured mortgage financing in 2008 and $500.0 million thus far in 2009 at attractive rates when compared to other sources of credit. Should these agencies discontinue providing liquidity to our sector, have their mandates changed or reduced or be disbanded or reorganized by the government, it would significantly reduce our access to debt capital and/or increase borrowing costs and would significantly reduce our sales of assets."

Remember, that the collapse of Fannie and Freddie is what caused the economic "equilibrium shift" from a mild recession to a depression (their death spooked investors, which then pushed the riskiest banks and insurance companies, like Lehman and AIG, to fail).

Here's what I find interesting from the Treasury release:
1) Does the following mean that the US Treasury will no longer support the MBS property market bubble through Fannie and Freddie buying MBS?
"Program Wind Downs
The program that Treasury established under HERA to support the mortgage market by purchasing Government-Sponsored Enterprise (GSE) -guaranteed mortgage-backed securities (MBS) will end on December 31, 2009. By the conclusion of its MBS purchase program, Treasury anticipates that it will have purchased approximately $220 billion of securities across a range of maturities.
The short-term credit facility that Treasury established under HERA for Fannie Mae, Freddie Mac, and the Federal Home Loan Banks will terminate on December 31, 2009. This credit facility was designed to provide a backstop source of liquidity and has not been used. "

2) Does the release mean the US Treasury will try to shrink Fannie and Freddie's asset base, meaning that real estate investors won't be able to get mortgages through them anymore (in some long-run scenario)? Or that it won't for three more years, which is the out that allows the Fannie/Freddie mortgage support (i.e. shell/monetization game) to continue? How "committed to principle" is the Treasury? Remember, that the $110bn that Treasury has given so far gets multiplied many times over, since it's an equity base that Fannie/Freddie lend off of. If a cap is $200bn and the multiplier is 10x, this is opening the door toward a further $2 trillion expansion of Fannie/Freddie's lending, where the $200 bn in front is loss-equity capital that taxpayers take (to bail out stupid homebuyers and debt issuers). This is a massive bailout... yet again.
"Amendments to Terms of Preferred Stock Purchase Agreements
At the time the Federal Housing Finance Agency (FHFA) placed Fannie Mae and Freddie Mac into conservatorship in September 2008, Treasury established Preferred Stock Purchase Agreements (PSPAs) to ensure that each firm maintained a positive net worth. Treasury is now amending the PSPAs to allow the cap on Treasury's funding commitment under these agreements to increase as necessary to accommodate any cumulative reduction in net worth over the next three years. At the conclusion of the three year period, the remaining commitment will then be fully available to be drawn per the terms of the agreements.
Neither firm is near the $200 billion per institution limit established under the PSPAs. Total funding provided under these agreements through the third quarter has been $51 billion to Freddie Mac and $60 billion to Fannie Mae. The amendments to these agreements announced today should leave no uncertainty about the Treasury's commitment to support these firms as they continue to play a vital role in the housing market during this current crisis.
The PSPAs also cap the size of the retained mortgage portfolios and require that the portfolios are reduced over time. Treasury is also amending the PSPAs to provide Fannie Mae and Freddie Mac with some additional flexibility to meet the requirement to reduce their portfolios. The portfolio reduction requirement for 2010 and after will be applied to the maximum allowable size of the portfolios – or $900 billion per institution – rather than the actual size of the portfolio at the end of 2009.
Treasury remains committed to the principle of reducing the retained portfolios. To meet this goal, Treasury does not expect Fannie Mae and Freddie Mac to be active buyers to increase the size of their retained mortgage portfolios, but neither is it expected that active selling will be necessary to meet the required targets. FHFA will continue to monitor and oversee the retained portfolio activities in a manner consistent with the FHFA's responsibility as conservator and the requirements of the PSPAs."

I'm waiting for Hussman's views on how to interpret this cryptic release. It just looked like the US govt. is writing its largest loss-driven blank check (after AIG) and no one is paying attention (of course, the Citigroup bailout/guarantees and the Fed's low-quality asset purchases will come home too).

UPDATE: Here are the interesting explanations from Hussman, Tim Duy's Fedwatch, and Paul Krugman at Princeton blogging for the NY Times.

Thursday, December 17, 2009

All that glitters... is GOLD - Alpha

Hypothesis: Gold will rise in dollar-terms as its major competitor currencies, the USD and EUR, are devalued when their governments inflate away the burden of debts but printing more fiat currency.
The boom-bust cycle is early in the boom phase for gold.

Analysis: The US government and Euro bloc countries will be forced to run deficits for the next 3-5 years, both to backstop banking losses (which are roughly 40-60% taken in the US and Euro, according to the IMF, not to mention the unsustainable social program spending that is expected soon. Medicare spending starts inching up in 2012, due to the first retiring boomers, and this will double all total outstanding US debt in 15 years (2012-2027). Until 2015, deficits will be about 12% in the US, and 4-12% in the Euro area (Germany is at 5% expected, Greece at 12% and above). See EU projections.

The only way the governments can meet their deficit spending is by:
i) Raising taxes and cutting spending. Some of this will happen on the margin, but spending is sticky and voters by their behavior prefer inflation to tax raises. Greece is the bellwether country for the PIIGS and European stability (testing the "no bailout" clause in the EMU pact).

ii) Borrowing money from the private sector, by crowding out through high interest rates or forced "gunpoint" borrowing. Note that in the US bank reserves have been held in USTs for the last 12 months - a shadow crowding out where private borrowers can't get money.

iii) By creating money through monetization/printing. The US did $300bn of this in October 2009, as the Fed admitted, and bought over $1,000bn in MBS and ABS.
When inflation worries reached their peak in the 1970s, gold reached an all-time, inflation-adjusted dollar high of about $2,200/oz.

Gold shouldn't be treated as an asset like land, stocks, or bonds. Rather, it’s money. Money has 3 uses: a medium of exchange, a measure of value, and a store of value. Gold will never be as good a medium of exchange as USD and EUR currency and checks (I ignore the Yen and pound because they haven't been major reserve currencies in the last 50 years, and also the yuan as it isn't fully convertible). The transactions costs are too high (it's easy to pay with dollar and euro bills or use your Visa/Mastercard to pay in them). Gold probably won't be as good a measure of value, if inflation is relatively low (under 10% annually), as people can still compare goods and services using USD and EUR "markings." Yet as an arbitrary store of value, gold will do quite well, because it's supply is fixed and slightly declining, while the supply of dollars and euros is exploding.

A decent overview of the many writings on gold is here: "Is Gold a Reasonable Investment"

The World Gold Council puts out an interesting quarterly report on gold, available here: (but beware proponent bias).

Supply Analysis:
The amount of actual resources in the world, loosely measured by "wealth stock" and GDP, stays fixed and grows at a stable rate of 2-5% (world GDP growth, a wide band give my lack of economic forecasting ability). The total amount of the world gold stock has actually come down from Q1 2000 (33.4K tons) to Q1 2009 (29.7K tons). See the attached spreadsheet from the World Gold Council. As a "currency", the supply of gold has decreased. I assume it stays flat in the future, but if it keeps decreasing, all the merrier.

Compare this to the monetary base of the USD and EUR. The Fed's adjusted monetary base has grown from $875bn to $1900 bn (2.2x), and the M1 measure in the Eurozone has grown from Eur. 3.8trn to Eur. 4.5trn (1.2x). Gold, meanwhile, averaged between $600 to $700 an ounce from early 2006 to mid 2007. My key assumption is that gold's "fair price" is its average price before the monetary expansion of $650. Gold's price peaked at in December 2009 at ~$1200. Assuming gold tracks the USD monetary base expansion in 2008 and 2009, it's fair price should be, by a back of the envelope calculation: 2.2*650 = $1430 per ounce. Compared to the euro: 1.2*650 = $780 per ounce. That's a wide range. But just look at the direction. Deficits in both the US and Euro area are unsustainable. My simplistic logic is that if the supply of gold is fixed, its price rise must match the increase in the world's fiat currency system of the USD and EUR. If the US monetary base goes up another 50% from current levels, then I believe gold should be "worth" 1430*1.5 = $2145/oz. Simply put, gold is a horrible asset to hold in normal times, when inflation is low and governments are stable. It's a great (speculative, not investment) asset at macroeconomic turning points, like early in the Great Depression and in the 1970s as the US went off the gold standard and inflated away debts.

US: The entire residential and commercial real estate markets (and hence banking system) is being kept alive by two things, thanks to Bernanke. One, zero interest rates for the big banks, who then subsizide housing and governments while penalizing businesses. Two, massive MBS and CMBS purchases by the Fed, to the tune of $1.3trn (not a typo, that's trillion), which must on face end in March, but will realistically continue and likely be monetized in one way or another. Ever wonder why Bernanke looks so haggard? It's not just the Fed losing its independence - my guess is that he knows he'll have to monetize.

But gold as a percentage of the US monetary base is VERY VERY low (bad paper money is crowding out the good, glitterin' metallic kind - Gresham's law at work):

Euro Area: The Greece situation, where the govt. initially forecasted a 3% deficit and then said, "Hey, we were lying!" and then came up with 12%, shows that the Mediterranean PIGS are untrustworthy. Either the richer countries take on more deficits to bail out the PIGS, or they suffer political blowout and monetary collapse together - an unappealing choice. As much as the direct pressure on Bernanke is high, the pressures on the ECB are only getting hotter. Do you really think the ECB can stop accepting shoddy Greek banks' assets as collateral, triggering a run, or will they have to monetize losses away? My main point is, historical evidence shows gold supply is shrinking, but I conservatively estimate it stays flat. Strong historical evidence suggests government debt goes up by 80% and monetization occurs after the end of such a crisis, esp. when the 2 largest economies in the world are involved (the US and the Euro-area).

Demand Analysis:
Note that in 2008, jewelry demand fell by 245 tons, but bar/coin, retail, and ETF demand went up by 498 tons.

China, the world's biggest reserve holder, needs a safer place to put its safe money. Among hard assets, that's either land, natural resources (metals, oil, etc.) or gold. Consider the Chinese discussion:
"Li Lianzhong, who heads the economic department of the party’s policy research office, said that China should use more of its $1.95 trillion in foreign-exchange reserves to buy energy and natural-resource assets. At a foreign exchange and gold forum, Li said buying land in the United States was a better option for China than buying US Treasury securities. “Should we buy gold or US Treasuries?” Li asked. “The US is printing dollars on a massive scale, and in view of that trend, according to the laws of economics, there is no doubt that the dollar will fall. So gold should be a better choice.” (Jakarta Globe,

Guess what, the Chinese bought almost no US Treasuries in October 2009. Where will China's excess reserve buying go, besides Australian and African mines? Buying American land is politically radioactive, so the most fungible and safe currency-like asset is… gold. It's difficult to say how much of China's excess buying will be offset by fewer Indian jewelry purchases (but the Indian central bank, the RBI, has increased its gold purchases lately). Again, consider China's reserve growth from 600 tons to 1054 tons from 2008 to 2009. Do not expect China to blare in the markets about their current buying.

Finally, consider the smart money, the hedgies. Legendary names such as Paul Tudor Jones of Tudor Investment and David Einhorn, founder of Greenlight Capital have also been enthusiastic. Mr Jones, whose company manages more than $11bn in bonds, equities and commodities, told investors recently that it was time to buy the metal. “I have never been a gold bug,” he wrote, but added: “It is just an asset that, like everything else in life, has its time and place. And now is that time.” John Paulson, another well-known hedge fund manager, has adopted a similar view, telling investors he was concerned about the dollar. “So I looked for another currency in which to denominate my assets. I feel that gold is the best currency.”,s01=1.html

Disconfirming Evidence and Arguments:
-Gold has risen from ~$300 in 2001 when central banks were selling to $1200 today when central banks are buying, a four-fold increase. Anytime any asset rises that much, you have to worry about a bubble.

-Gold yields nothing - it's not a productive asset. Hence it's tough to ever assign a fair value to it, through a DCF analysis, like stocks, bonds, and property. This is the best critique of gold. But then again, dollars and euros sitting in a bank don't yield anything either and it's tough to value them (despite the indecipherable moves of Fx market). Gold technically has a negative yield due to storage costs, unlike cash which banks will graciously hold for you today without charge.

-Historically gold has been highly correlated with oil prices, at about 0.70. If oil falls due to weak global growth or a second collapse, so will gold.

-Gold's day-to-day jewelry demand use, in India, seems to top out at $700 to $800/oz (buying dips significantly above those levels, as people substitute silver and other precious metals). I need to talk to more Indians in the jewelry business to see whether they are re-anchoring expectations to a new price, or substituting other metals and avoiding gold. Since jewelry demand is by far the highest portion of the annual gold demand (about 2/3), higher prices could put a natural dampener on this.

-It's unclear what gold's industrial value substitute $-level is, but here are the uses:

-The best critiques of gold come from the inimitable Professors Buiter and Roubini (but they see it as an asset, not as a currency):

Monday, December 14, 2009

Buffett Avoids the Lehman Brothers Bullet - Alpha

In a WSJ article this weekend (Scott Patterson, "In Year of Investing Dangerously, Buffett Looked 'Into the Abyss'", WSJ, DECEMBER 14, 2009), Warren Buffett claims he had a mediocre year in 2008, where his best deals were bad deals he avoided. He says: "I made plenty of mistakes," he says. "I didn't maximize the opportunities offered by the chaos. But in the end, it worked out OK."

As one example of a well-missed deal, Buffett avoided investing in Lehman Brothers Holdings before it went bust. Attached as a pdf, the WSJ published Buffett's scribbles on Lehman's 10-K, where Buffett noted pages where he found problematic items. The 10-K is here (and if you go to the "Print Preview" mode in Firefox, the page numbers approximately correspond to Buffett's notes):

Also, for the concerns that the short seller David Einhorn, of Greenlight Capital, had with Lehman Brothers, here see Einhorn's speech at the Ira Sohn conference in May 2008:

Below are some comments on what I believe Buffett found troubling, given his notes/scribbles:

1) LIQUIDITY POOL FUNDING INADEQUATE: Lehman's Liquidity pool (to cover expected cash outflows for the next 12 months, in a stressed environment), is only sized for a ratings downgrade of one notch (compare to Enron and Dynergy, who suffered multiple notch downgrades in the early 2000s, as wholesale funding ran out and the fell into a vicious circle of downgrades and fleet-footed funding).

2) LEHMAN's BOGUS LEVERAGE RATIO: Lehman has a bogus "net leverage ratio", where it reduces debt and increases equity to make leverage look lower. The actual leverage ratio is horrible. For example, the net leverage ratio only increased from 14.5x to 16.1x from 2006 to 2007 (11%), but the real leverage ratio increased from a shocking 26.2x to 30.7x (17%). Only Fannie and Freddie, of major financial entities, have higher leverage ratios (and note they went bust a few weeks before Lehman). Here is their definition and the table:

Lehman's "go-for-bust" definition of a leverage ratio:
"Our net leverage ratio is calculated as net assets divided by tangible equity capital. We calculate net assets by excluding from total assets: (i)cash and securities segregated and on deposit for regulatory and other purposes; (ii) collateralized lending agreements; and (iii) identifiable intangible assets and goodwill. We believe net leverage based on net assets to be a more useful measure of leverage, because it excludes certain low-risk, non-inventory assets and utilizes tangible equity capital as a measure of our equity base. We calculate tangible equity capital by including stockholders’ equity and junior subordinated notes and excluding identifiable intangible assets and goodwill. We believe tangible equity capital to be a more meaningful measure of our equity base for purposes of calculating net leverage because it includes instruments we consider to be equity-like due to their subordinated nature, long-term maturity and interest deferral features and we do not view the amount of equity used to support identifiable intangible assets and goodwill as available to support our remaining net assets. These measures may not be comparable to other, similarly titled calculations by other companies as a result of different calculation methodologies."

3) LEHMAN's CONDUIT: A conduit is a structure where a bank borrows short-term to lend long-term to poor credit-risks using highly illiquid assets as collateral. A very bad idea - some major banks in Germany were ruined by their conduits, and Citigroup had to tap dance like an elephant to overcome its conduit and VIE exposure. Overall, Lehman's $2.4bn conduit isn't that large (but it's basically an off-balance sheet liability).

4) LEHMAN's ACCOUNTING FOR PENSION LIABILITIES: Under SFAS 158, it seems Lehman underreserved for what it's pension liability would be. For 2007, that would have lowered earnings by $210mn. A drop in the bucket given other concerns.

5) LEHMAN's MBS AND ABS EXPOSURES: Lehman (almost proudly) states:
"We originated approximately $47 billion and $60 billion of residential mortgage loans in 2007 and 2006, respectively, and approximately $60 billion and $34 billion of commercial mortgage loans in 2007 and 2006, respectively."
The question is, how much of this did Lehman sell to suckers in other countries, and how much did they keep on their balance sheet? Ouch! The inventory from the past few years, which they kept, is quite high (and the subprime stuff is worth pennies on the dollar):

6) LEHMAN's DERIVATIVES BOOK: This is basically a black box, as over-the-counter derivatives are valued by Lehman itself. Lehman's total derivatives contract book is a stunning $738bn. Buffett writes elsewhere: "Like Hell, both [reinsurance and derivative contracts] are easy to enter and almost impossible to exit." Hence Lehman can sell an OTC derivative to a counterparty and book a $50mn profit, while the other side can also book a $50mn profit (traders on both sides get year end bonuses on these gains). But one side is wrong, and you only find out years and years later with massive losses, as Buffett laments about his General Re acquisition here (see the "Derivatives" section on page 13): (this is also pasted in the most recent post on this blog). Buffett's final comment: "When Charlie and I finish reading the long footnotes detailing the derivatives activities of major banks, the only thing we understand is that we don’t understand how much risk the institution is running." (If that's true, Mr. Buffett, why buy convertible debt in GE and Goldman Sachs?)

7) LEHMAN's ASSET LIABILITY MISMATCH PER ITS FAIR VALUE TABLE: All financial firms need to list the liquidity level of their assets, per the accounting rule SFAS 157 on Fair Value. Assets at Level 1 are very liquid and easy to value, wheras Level 3 are illquid and hard to value. Lehman has many Level II and Level III assets (~$219bn are Level 2 and 3 out of $291bn total ), but the liabilities behind these assets are Level 1 ($109bn out of $149bn total). Hence, wholesale funders can ask for their money back but Lehman can't sell assets to pay them (this is how Lehman actually went bust). To be fair to Lehman, all the big broker-dear/money center banks had this problem (all banks do, to some extent). It's just that Lehman was swimming much more naked than the rest (and didn't have a former CEO as the US Treasury Secretary to bail them out).

8) LEHMAN's SECURITIZATION MODEL: Lehman is heavily in the business of buying small assets (mortgages, credit card loans, auto loans, etc.) and securitizing them (making bonds out of pools of loans). It then sells these securities to foreign buyers. Two points to this. First, Lehman has $798bn in client securities, and it pledges $725bn of them as collateral for Lehman's own financings. This was made painfully clear to hedge funds who used Lehman as a prime broker and found out what the word "rehypothecate" meant when they couldn't get their money and securities back in 2008. Second, Lehman's machine is a monster and it's heavily exposed to residential mortgages (what turned out to be the worst stuff to securitize, unlike auto loans which pay off in 5 years). Lehman issued $294bn of securitizations in 2006 and 2007, of which $246bn was for residential real estate.

9) LEHMAN's QSPE AND VIE EXPOSURES, PLUS LENDING COMMITMENTS: QSPE's and VIEs are off-balance-sheet vehicles to make (often dumb) investments. Lehman engaged in writing credit default swaps and investing in real estate deals. For Lehman's real estate prowess, read about some of its deals here:
Lehman also has a mindboggling $122bn of lending commitments it has to make in 2008, many of them to private equity firms for bonds and loans in dumb buyout deals (it has to break out the deal lawyers and try to get out of these).

10) LEHMAN's EMPLOYEE COMPENSATION: Like most Wall Street firms, it's outrageously high in terms of total levels and composition (far too short term, heavy on cash and light on restricted stock). For example, Lehman has stock compensation amortization at ~$1bn to 1.3bn on average, but pays out a whopping $8.7bn to 9.5bn in total compensation. That's because the employees are smart and don't want to own equity (who would, for such a doomed ship)? They prefer hard cash paid monthly, with that big annual bonus.

Warren Buffett on Derivatives in 2002

From the 2002 Berkshire Hathaway Chairman's Letter (p.13):

Charlie and I are of one mind in how we feel about derivatives and the trading activities that go with them: We view them as time bombs, both for the parties that deal in them and the economic system.

Having delivered that thought, which I’ll get back to, let me retreat to explaining derivatives, though the explanation must be general because the word covers an extraordinarily wide range of financial contracts.

Essentially, these instruments call for money to change hands at some future date, with the amount to be determined by one or more reference items, such as interest rates, stock prices or currency values. If, for example, you are either long or short an S&P 500 futures contract, you are a party to a very simple derivatives
transaction – with your gain or loss derived from movements in the index. Derivatives contracts are of varying duration (running sometimes to 20 or more years) and their value is often tied to several variables. Unless derivatives contracts are collateralized or guaranteed, their ultimate value also depends on the
creditworthiness of the counterparties to them. In the meantime, though, before a contract is settled, the counterparties record profits and losses – often huge in amount – in their current earnings statements without so much as a penny changing hands.

The range of derivatives contracts is limited only by the imagination of man (or sometimes, so it seems, madmen). At Enron, for example, newsprint and broadband derivatives, due to be settled many years in the future, were put on the books. Or say you want to write a contract speculating on the number of twins to be born in Nebraska in 2020. No problem – at a price, you will easily find an obliging counterparty.

When we purchased Gen Re, it came with General Re Securities, a derivatives dealer that Charlie and I didn’t want, judging it to be dangerous. We failed in our attempts to sell the operation, however, and are now terminating it.
But closing down a derivatives business is easier said than done. It will be a great many years before we are totally out of this operation (though we reduce our exposure daily). In fact, the reinsurance and derivatives businesses are similar: Like Hell, both are easy to enter and almost impossible to exit. In either
industry, once you write a contract – which may require a large payment decades later – you are usually stuck with it. True, there are methods by which the risk can be laid off with others. But most strategies of that kind leave you with residual liability.

Another commonality of reinsurance and derivatives is that both generate reported earnings that are often wildly overstated. That’s true because today’s earnings are in a significant way based on estimates whose inaccuracy may not be exposed for many years.

Errors will usually be honest, reflecting only the human tendency to take an optimistic view of one’s commitments. But the parties to derivatives also have enormous incentives to cheat in accounting for them.

Those who trade derivatives are usually paid (in whole or part) on “earnings” calculated by mark-to-market accounting. But often there is no real market (think about our contract involving twins) and “mark-to-model” is utilized. This substitution can bring on large-scale mischief. As a general rule, contracts involving multiple reference items and distant settlement dates increase the opportunities for counterparties to use fanciful assumptions. In the twins scenario, for example, the two parties to the contract might well use differing models allowing both to show substantial profits for many years. In extreme cases, mark-to-model degenerates into what I would call mark-to-myth.

Of course, both internal and outside auditors review the numbers, but that’s no easy job. For example, General Re Securities at yearend (after ten months of winding down its operation) had 14,384 14 contracts outstanding, involving 672 counterparties around the world. Each contract had a plus or minus value derived from one or more reference items, including some of mind-boggling complexity. Valuing a
portfolio like that, expert auditors could easily and honestly have widely varying opinions.

The valuation problem is far from academic: In recent years, some huge-scale frauds and near-frauds have been facilitated by derivatives trades. In the energy and electric utility sectors, for example, companies used derivatives and trading activities to report great “earnings” – until the roof fell in when they actually
tried to convert the derivatives-related receivables on their balance sheets into cash. “Mark-to-market” then turned out to be truly “mark-to-myth.”

I can assure you that the marking errors in the derivatives business have not been symmetrical. Almost invariably, they have favored either the trader who was eyeing a multi-million dollar bonus or the CEO who wanted to report impressive “earnings” (or both). The bonuses were paid, and the CEO profited from his options. Only much later did shareholders learn that the reported earnings were a sham.

Another problem about derivatives is that they can exacerbate trouble that a corporation has run into for completely unrelated reasons. This pile-on effect occurs because many derivatives contracts require that a company suffering a credit downgrade immediately supply collateral to counterparties. Imagine, then, that a
company is downgraded because of general adversity and that its derivatives instantly kick in with their requirement, imposing an unexpected and enormous demand for cash collateral on the company. The need to meet this demand can then throw the company into a liquidity crisis that may, in some cases, trigger still more
downgrades. It all becomes a spiral that can lead to a corporate meltdown.

Derivatives also create a daisy-chain risk that is akin to the risk run by insurers or reinsurers that lay off much of their business with others. In both cases, huge receivables from many counterparties tend to build up over time. (At Gen Re Securities, we still have $6.5 billion of receivables, though we’ve been in a
liquidation mode for nearly a year.) A participant may see himself as prudent, believing his large credit exposures to be diversified and therefore not dangerous. Under certain circumstances, though, an exogenous event that causes the receivable from Company A to go bad will also affect those from Companies B through
Z. History teaches us that a crisis often causes problems to correlate in a manner undreamed of in more tranquil times.

In banking, the recognition of a “linkage” problem was one of the reasons for the formation of the Federal Reserve System. Before the Fed was established, the failure of weak banks would sometimes put sudden and unanticipated liquidity demands on previously-strong banks, causing them to fail in turn. The Fed now insulates the strong from the troubles of the weak. But there is no central bank assigned to the job of preventing the dominoes toppling in insurance or derivatives. In these industries, firms that are fundamentally solid can become troubled simply because of the travails of other firms further down the chain.

When a “chain reaction” threat exists within an industry, it pays to minimize links of any kind. That’s how we conduct our reinsurance business, and it’s one reason we are exiting derivatives.

Many people argue that derivatives reduce systemic problems, in that participants who can’t bear certain risks are able to transfer them to stronger hands. These people believe that derivatives act to stabilize the economy, facilitate trade, and eliminate bumps for individual participants. And, on a micro level, what they say is often true. Indeed, at Berkshire, I sometimes engage in large-scale derivatives transactions in order to facilitate certain investment strategies.

Charlie and I believe, however, that the macro picture is dangerous and getting more so. Large amounts of risk, particularly credit risk, have become concentrated in the hands of relatively few derivatives dealers, who in addition trade extensively with one other. The troubles of one could quickly infect the others.

On top of that, these dealers are owed huge amounts by non-dealer counterparties. Some of these counterparties, as I’ve mentioned, are linked in ways that could cause them to contemporaneously run into a problem because of a single event (such as the implosion of the telecom industry or the precipitous decline in the value of merchant power projects). Linkage, when it suddenly surfaces, can trigger serious systemic problems.

Indeed, in 1998, the leveraged and derivatives-heavy activities of a single hedge fund, Long-Term Capital Management, caused the Federal Reserve anxieties so severe that it hastily orchestrated a rescue effort. In later Congressional testimony, Fed officials acknowledged that, had they not intervened, the outstanding trades of LTCM – a firm unknown to the general public and employing only a few hundred 15
people – could well have posed a serious threat to the stability of American markets. In other words, the Fed acted because its leaders were fearful of what might have happened to other financial institutions had the LTCM domino toppled. And this affair, though it paralyzed many parts of the fixed-income market for
weeks, was far from a worst-case scenario.

One of the derivatives instruments that LTCM used was total-return swaps, contracts that facilitate 100% leverage in various markets, including stocks. For example, Party A to a contract, usually a bank, puts up all of the money for the purchase of a stock while Party B, without putting up any capital, agrees that at a
future date it will receive any gain or pay any loss that the bank realizes.
Total-return swaps of this type make a joke of margin requirements. Beyond that, other types of derivatives severely curtail the ability of regulators to curb leverage and generally get their arms around the risk profiles of banks, insurers and other financial institutions. Similarly, even experienced investors and
analysts encounter major problems in analyzing the financial condition of firms that are heavily involved with derivatives contracts. When Charlie and I finish reading the long footnotes detailing the derivatives activities of major banks, the only thing we understand is that we don’t understand how much risk the institution is

The derivatives genie is now well out of the bottle, and these instruments will almost certainly multiply in variety and number until some event makes their toxicity clear. Knowledge of how dangerous they are has already permeated the electricity and gas businesses, in which the eruption of major troubles
caused the use of derivatives to diminish dramatically. Elsewhere, however, the derivatives business continues to expand unchecked. Central banks and governments have so far found no effective way to control, or even monitor, the risks posed by these contracts.

Charlie and I believe Berkshire should be a fortress of financial strength – for the sake of our owners, creditors, policyholders and employees. We try to be alert to any sort of megacatastrophe risk, and that posture may make us unduly apprehensive about the burgeoning quantities of long-term derivatives contracts and the massive amount of uncollateralized receivables that are growing alongside. In our view,
however, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.

Sunday, December 13, 2009

The Yield Curve - Vega

In this issue:
1) Basic Theories of the Yield Curve
2) Basics In Action
3) What has the Yield Curve Told Us in the Past?
4) Is the Yield Curve "Smart"?
5) Chinese Demand

Dear Friends, Colleagues, and Investors:

The yield curve is the collection of interest rates offered by Treasury securities at various maturities (see graph below for current yield curve). The yield curve has historically provided a great deal of information about the future of the economy. The New York Federal Reserve regards it as a valuable forecasting tool in predicting recessions about a year ahead of time; it's been consistently more accurate at predicting recessions than professional economists over the last 30 years. Today the yield curve appears to be pricing in moderate growth and little inflation, while the equity and commodity markets appear to be pricing in robust growth and significant inflation. In this newsletter I'll explore the Treasury yield curve and explain what it's telling us today.

Please click on the link below to read the newsletter with all its graphics:

1) Basic Theories of the Yield Curve

The yield curve refers to the relationship between the interest rate on debt versus the maturity of the debt. For a bond, the higher the price, the lower the yield. There are a few different ways to think about the yield curve, each of which contributes to our understanding.

Pure Expectations Hypothesis: This simplistic view is that investors price each individual Treasury entirely based on their expectations for future short-term interest rates. So if the yield curve is sloping upward (i.e. if 10 year treasuries yield more than 2 year treasuries), investors must believe that short-term interest rates will be higher in 2 years.

Liquidity Preference Theory: This adjusts the "Pure Expectations Hypothesis" to take into account the fact that investors generally don't like to be locked into a long-term contract. Most investors will demand more yield to commit their money for a longer period of time. The Liquidity Preference Theory explains why the yield curve is usually upward sloping.

Preferred Habitat Theory: This more subtle theory acknowledges that investors sometimes want to hold debt for a specific amount of time. For example, a company may want to earn interest for 6 months until they must invest in a new factory. Alternatively, an insurance company may want to lock in a higher yield for 30 years to match the longer term liability of the life insurance contracts they provide. The Preferred Habitat Theory can explain any shaped yield curve.

2) Basics in Action
The yield curve is generally upward sloping. If investors expect inflation and short-term interest rates to remain steady, the yield curve will slope upward because investors value liquidity (as explained by the Liquidity Preference Theory). If investors expect interest rates to fall, the yield curve may be flat or even downward sloping (inverted). Investors will accept a lower return to lock in a yield for a longer period. For example, if short-term rates are currently 4% and the market expects rates to fall to 1%, you might accept a 2% rate of return over 10 years (as explained by the Pure Expectations Hypothesis). Throughout much of the 19th century the US experienced deflation so the yield curve was often inverted.

Beyond the shape of the yield curve, its absolute level gives us information about inflation expectations and risk aversion. If investors expect inflation of 5%, they’re likely to demand at least 6% return to loan their money to the government. If investors view the world as volatile and scary, they’re likely to accept a lower return in exchange for the safety of Treasury securities.

The effect of "Preferred Habitats" is more subtle. This point is debatable, but I believe that as China has become a large but reluctant buyer of treasuries over the last decade, their preference for shorter-term debt has reduced short-term rates relative to long-term rates.

3) What has the Yield Curve Told Us in the Past?

An inverted yield curve usually precedes a worsening economic situation. For example, in August of 1981, the yield curve was inverted, meaning that short-term interest rates were higher than long-term interest rates. The next year saw a severe recession and stock market correction. In April of 1992, the yield curve was steep with long-term bonds yielding 5% more than short-term bonds; the bond market was correctly anticipating robust growth and the stock market performed well over the next couple years. The graph below shows that the yield curve has become inverted about a year before every recession since 1950. You may also notice that there have been a few "false alarms" where the yield curve became inverted but no recession followed.

In the 1920s, the yield curve inverted in both 1923 and 1927, so its success rate as a recession predictor was only 50/50. From 1934-1950, the yield curve never inverted; it failed to predict 3 recessions (see graph below).

4) Is the Yield Curve "Smart"?
Why is the yield curve a useful tool in prediction recessions and equity returns?

One hypothesis is that bond investors are simply “smarter” than equity investors. Mom & Pop gamble on stocks in their retirement accounts, while bond trading is generally reserved for financial professionals. Perhaps bond investors can somewhat accurately predict recessions and their opinions are reflected in the bond market earlier than in the equity market.

Another possible explanation is that the shape of the yield curve directly impacts economic growth. For example, with a very steep yield curve, banks can easily produce great profits. They effectively “borrow” short-term via deposits and lend longer term via loans or buying treasuries. If the yield curve is steep they may be able to pay depositors 0.25% and then buy treasuries yielding 5% for easy profits. If the yield curve is inverted, it becomes extremely difficult for banks to make money.

A final and often ignored factor is that the shape of the yield curve is a reflection of recent actions of the Federal Reserve. Long-term interest rates tend to be anchored as investors correctly believe that interest rates revert to a common mean over many years. So, if the Federal Reserve reduces short-term interest rates, this is likely to produce a steeper yield curve; this effect is strengthened by the fact that lower short-term interest rates may increase long-term inflation expectations, which helps prevent the yield curve from falling in parallel. A steeper yield curve correlates to higher economic growth, but that may be a "confounding variable." Perhaps the growth is coming purely from the lower short-term interest rates, and the steeper yield curve is a byproduct. Similarly, a flat yield curve frequently occurs after the Federal Reserve raises short-term rates which has the effect of depressing growth. In other words, it may be the change in short-term interest rates that matters; the change in the yield curve is a byproduct of long-term interest rates moving less than short-term interest rates.

Each of the three explanations above is probably somewhat true and contributes to our empirical observation that the shape of the yield curve does a good job of predicting recessions.

5) Chinese Demand

A unique dynamic exists today that we must consider when extrapolating from the past. Our unprecedented trade imbalance with China makes them captive Treasury buyers. When Americans import more than we export, foreigners are left holding US dollars. Our greatest trade imbalance is with the Chinese who have been extremely risk averse with their dollar holdings. The Chinese government has maintained the trade imbalance by pegging their currency to ours to support their export sector. By pegging their currency, they’ve accumulated about $4 trillion US dollars. Some of that money is kept in simple currency, but they’ve used about $800 billion to buy treasuries. Maybe they’re thinking that a 2% yield, while small, is still better than nothing. Maybe they’re thinking that by lending us the money they are supporting the value of the total $4 trillion of US dollars they hold. Regardless, the Chinese policy decision to maintain the trade imbalance has the side effect of making them big Treasury buyers almost regardless of yield. They are rightfully concerned about the sustainability of our deficit though, so most of their Treasury holdings are short and medium-term. Under the "Preferred Habitat" lens, this means that the biggest marginal buyer of our treasuries does not want to hold our long-term debt. The result is that the price of our long-term debt drops relative to our short-term debt which means that the long-term yield rises; the yield curve steepens.

Economists who reject the "Preferred Habitat Theory" argue that the current yield curve means the market is predicting modest economic growth. While the yield curve throws doubt on the equity and commodity markets, it still appears more sanguine than many analysts. However, if the "Preferred Habitat Theory" is the dominant dynamic, the yield curve may not be a meaningful predictor today at all; without the large trade imbalance, perhaps the yield curve would be flatter today.

Your "Upward Sloping" Trader,

Risk over Reward: A conversation about intelligent investing – we discuss the nature of risk and uncertainty, macroeconomics, security valuation, and how to think about markets and invest profitably -

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