“I like the symmetry here. On November 21, when Barack Obama announced that he was nominating Tim Geithner to be his Treasury secretary, the Dow rose 494 points and broke through the 8,000 barrier. On February 10, when Geithner gave his first major speech as Treasury secretary, the Dow fell 273 points and broke through the 8,000 barrier.”

I once wrote that “the market is a lot like a fun house mirror”. New data affects prices indirectly. And sometimes the reflection comes out warped. Ben Graham said it best:

“...the influence of...analytical factors over the market price is both partial and indirect – partial, because it frequently competes with purely speculative factors which influence the price in the opposite direction; and indirect, because it acts through the intermediary of people’s sentiments and decisions.”

I’m not sure if the market decline had more to do with the substance of Geithner’s speech or the sentiments of traders. I certainly didn't think it justified marking American businesses down a couple percentage points.

Personally, I didn’t find the plan especially bad. I thought it would have a lot more detail. I’m glad it didn’t. How could anyone come up with a detailed plan at this point?

Some banks – some very big banks – are going to have to be recapitalized. The only way to start that process is to look at the economic reality under the accounting fictions that are bank balance sheets.

It doesn’t matter if you use mark-to-market or mark-to-model, you’re still going to end up with some very inaccurate balance sheet numbers in times like these.

Markets – be they liquid or illiquid – value assets oddly from time to time. And models are as flawed as their makers.

At least Geithner is talking about a stress test. That sounds like the first step toward recapitalizations.

Unfortunately, he’s also talking about private money coming in to buy toxic assets. Unless there are ironclad government guarantees involved I’m not sure that will fly.

Some of these assets weren’t just overpriced the way houses were – they were inherently flawed.

Toxic Assets

Accountants record. They don’t analyze.

There isn’t a right number and a wrong number. There are just useful numbers and useless numbers.

For example, it makes not one iota of difference to me – as an investor – what dollar value public Company A assigns its 23% stake in public Company B, because public Company B files with the SEC. All I need to know is the number Company A put on its books and where I can read all about Company B. The rest is up to me.

Unfortunately, you can’t do this with “toxic assets”.

In her book Dear Mr. Buffett, Janet Tavakoli quotes an email from Warren Buffett:

“I’ve looked at the prospectuses, and they are not easy to read. If you want to understand the deal you’d have to read around 750,000 pages of documents.”

If you want to understand how CDOs and other toxic assets are built, read Janet's book.

A lot of people make the argument that these assets are not toxic at some prices.

Theoretically, that’s true. If there’s value in an asset – at some deep discount to par – a high-risk asset can become a low-risk investment.

But, as I wrote in my review of Janet’s book, these toxic assets are “meta-bets”. A low price is little help if there is inadequate cash flow or collateral built into the asset.

A low price can’t fix an inherent flaw in an asset. If the cash flow generating potential of the asset is almost non-existent, the asset is essentially worthless.

Warren Buffett gave a great example of this kind of inherently worthless asset in his 1990 letter to shareholders:

“At the height of the debt mania, capital structures were concocted that guaranteed failure: In some cases, so much debt was issued that even highly favorable business results could not produce the funds to service it. One particularly egregious "kill- 'em-at-birth" case a few years back involved the purchase of a mature television station in Tampa, bought with so much debt that the interest on it exceeded the station's gross revenues. Even if you assume that all labor, programs and services were donated rather than purchased, this capital structure required revenues to explode - or else the station was doomed to go broke.”

A lot of these toxic assets were similarly structured. They were built to fail.

A bad house is a good value at some price. A risky mortgage is a good value at some price. But “meta-bets” are trickier. They can suffer from the same sort of problem Buffett described with the very worst junk bonds – you can actually take a good asset, with good cash flows and then put so much debt on top of it that the only way you can fix the problem is by restructuring the debt.

In such cases, a low price is no longer enough. The terms are the problem.

Nationalization

Nationalizing the biggest banks – a surprisingly popular view among bloggers if not investors – doesn’t address the underlying issue of payment obligations that can’t be met.

Recapitalizations would help banks lend, but problems would still linger. And unless nationalizeed much smaller banks – and some clearly don’t need it – I’m not sure you could ever get the kind of clean purge investors and lenders so desperately want.

Restructuring

John Hussman has written about a different approach:

“The heart of this problem continues to be the need to restructure the payment obligations of borrowers. For the better part of a year now, I have repeatedly (and increasingly urgently) advocated the restructuring of mortgage obligations by a variety of methods (collecting the pieces of securitized mortgages through “all or nothing” auctions, writing down principal in return for “property appreciation rights”, etc).”

I agree. We could use a little innovation here. Economists, politicians, and pundits seem to be drawn to the same stale ideas.

We need to fix the balance sheets of both banks and homeowners. The way to do that is to admit that mortgage debt is improperly structured. We need to apply some bankruptcy court like thinking to our approach to insolvent banks and borrowers.

Their current capital is as unsustainable as the TV station Buffett wrote about in 1990. Just as you can’t keep corporations – even good corporations – under a mountain of high-yield debt greater than their cash flows, you can’t keep homeowners in a state of insolvency.

We wouldn’t allow it in individual cases. And yet we’re basically encouraging borrowers to keep trying to meet terms that are unsustainable.

In both cases, we need to admit the insolvency and then move to remedy it through debt restructuring.

That won’t eliminate the need to recapitalize some of America’s biggest banks. But without debt restructuring, I’m not sure recapitalizing those banks that are too big to fail will be sufficient to avoid a long-term credit freeze.

Just think how long it would take borrowers to get out from under their current debt burden. We’re talking about a process of balance sheet rebuilding that would go on for years and years – long after the official end to this recession. I’m not sure you could resume anything like normal economic growth under those conditions.

The President began by painting gloomy word pictures of a Depression – without actually using the “D” word:

“…They can't pay their bills and they've stopped spending money. And because they've stopped spending money, more businesses have been forced to lay off more workers. Local TV stations have started running public service announcements that tell people where to find food banks, even as the food banks don't have enough to meet the demand... As we speak, similar scenes are playing out in cities and towns across the country. Last Monday, more than 1,000 men and women stood in line for 35 firefighter jobs in Miami.”

Theory

Although the President said – correctly I think – that most economists agree a stimulus is necessary, agreeing a stimulus is necessary and agreeing it is sufficient are two different things. Economists don’t agree a stimulus is sufficient. Nor did most of them think very highly of a New Deal redux like this one until more proven measures – like monetary stimulus – were already depleted.

What economists do agree on is that the economy is very bad and that the number of tools that have been tried before and not yet tried this time around is very low. In technical terms, they are advocating a kitchen sink approach.

Seventy years of social science have given government a whole new toolbox with which to approach the same problems (of 1929) and despite the change in process the outcome has remained the same.

Eventually, this will make for an interesting case study. The idea that the Great Depression was a unique and unrepeatable event will be challenged. The idea that lessons learned in retrospect can be applied in the future has been seriously compromised. It is not clear that in an ever-changing system like an economy, theory could keep pace with reality. Prescriptive economics may not work. But prescriptions have to be made nonetheless.

Politics

The President made some errors last night. He gave in to partisan temptations and reminded Republicans of their previously profligate ways.

An excellent point – if he was aiming for honesty – but honesty is rarely the best policy. Utility is.

He needs to pass bills – not win elections – and maybe his little reminders helped Democratic chances at the ballot box, but he hurt the country’s chances of getting the bills it needs passed. It was an understandable but idiotic mistake. It wasn’t just partisan politics, it was poor tactics.

The President is a lot weaker than he appears. Constitutionally, his legislative powers are – well – non-existent. A President is not a Prime Minister.

The man himself is popular. His policies are not. His party’s majorities are large, but not large enough to pass bills in the Senate – even without any Democratic defections. And there will be defections. Remember, this is a Democratic caucus that includes both a Socialist from a Vermont and a Conservative from Nebraska.

The President, still glowing with inaugural stardust, has had a tough time passing a stimulus bill that most Senators – on both sides of the aisle – actually support in principle. Sure two-fifths of them voted against it, but when has a Senator’s vote told you anything about his principles?

The Hard Part

Most Senators want a stimulus – some stimulus – to pass. The TARP is a different story. It is not popular. It is merely necessary.

Today, the Secretary of the Treasury will present the latest incarnation of the bank-bailout.

The public will hate it. They won’t understand it - neither will I, but that won’t stop me from writing about it – but they will hate it.

The job of Secretary of the Treasury of the United States is one of the most thankless jobs on planet earth.

Throughout history, the post has been filled by some of the country’s most illustrious men – and none of them, not one – has ever gone on to be President.

Clinton is better known than Geithner, but Geithner has the more important – and more difficult – job.

Today, Geithner has to sell the American people something they don’t want.

The President paved the way for him by painting a very dire picture.

Depression

The situation is dire. It is no longer enough to say this is the worst “recession” since the Great Depression. We can now say the only thing comparable to the current economic downturn is the Great Depression.

I’ve been reading a lot of fourth-quarter earnings call transcripts over at Seeking Alpha. And I can tell you the anecdotal evidence is worse than the composite picture.
The biggest thing that jumps out at you – especially when you read about the kind of simple, predictable, “recession resistant” businesses I like – is just how clear the signs of deflation are.

Deflation

Deflation is an increase in the perceived value of cash. When the value of cash rises, the cash price of everything else falls. This is usually when deflation is recognized by economists and journalists. But the root cause of deflation is not a decrease in man’s appetite for goods and services but an increase in his appetite for cash.

A lot of asset prices – like houses, stocks, bonds, gold, and oil – are driven in part by the prices themselves.

What Charlie Munger said about stocks applies equally to other quoted assets:

“They are valued partly like bonds, based on roughly rational use value in producing future cash. But they are also valued like Rembrandt paintings, purchased mostly because their prices have gone up so far.”

This Rembrandt effect makes quoted asset prices unreliable indicators of deflation. Yeah – cash is worth a lot more relative to houses, stocks, and oil than it was a year ago – but is that because the value of cash has risen or because the value of those assets has fallen due to a total Rembrandt reversal?

It’s too difficult to insulate each side of the price ratio from the other. But when demand for goods and services that are repeatedly purchased without much awareness of price suddenly drops off, you have a strong indication that deflation is already occurring.

The reason is simple. The other side of the ratio is pretty stable. For instance, the value of hair cuts doesn’t change much.

Yet, Regis (RGS) reported its first same-store sales decline in 87 years. Regis controls about 4% of the U.S. hair salon industry and operates different salons under different names; so it’s unlikely that its horrific December sales numbers were company specific. Industry-wide numbers are probably about the same.

That means customer counts at U.S. hair salons were down over 10% in December. That doesn’t happen in “normal” recessions. The clear culprit is an increase in the perceived value of cash.

Consumers want to hoard cash more than they want to get their hair cut. That means deflation. And that’s bad.

The Press

Also bad: the performance of the press last night.

These are not normal times. Last night both the President and the country wanted to converse about a single topic of extreme importance – the economy – and the press (with a few exceptions) treated the whole thing like business as usual.

The President’s worst moment was when he answered the Alex Rodriguez steroid question with the same serious tone he had used while explaining the country’s dire economic conditions.

In the President’s defense – he has one setting: serious.

But the combination of the press throwing out the same political potpourri and the President’s face giving equal weight to questions on the economy, baseball, and Iran undermined the purpose of the press conference.

Last night was supposed to be about the economy. No one cares about Iran. Times change and the press needs to change with them.

Related Reading

On Keynes, the Stimulus, and Old Ideas

Much of the focus in value investing texts is on finding the right company at the right price, very little time is spent discussing when to sell. Since the decision to sell is contextual to each investment I would like to get an idea of your thought process when it comes to selling.

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How can I apply the concept of intrinsic value to currencies in my international investments? I know how to handle business risk and market risk - but how can I apply the principles of value investing to exchange rate risk?

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When should you focus on free cash flow and when should you focus on earnings?

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Janet Tavakoli’s Dear Mr. Buffett is an unusual amalgam of a simple, personal story and a complex, public one.

The personal story begins with an invitation from the Oracle himself:

“Be sure to stop by if you are ever in Omaha and want to talk credit derivatives...”

Buffett had just re-read Tavakoli’s Credit Derivatives & Synthetic Structures and noticed a letter from the author tucked between the book’s pages. With a quick apology and the above invitation, Buffett unknowingly set in motion a process that would give the public a rare glimpse inside his inner sanctum.

Tavakoli took Buffett up on his offer and recorded the ensuing encounter in Chapter 2 of Dear Mr. Buffett.

The promise of this tantalizing morsel will draw buyers in. But readers will find much more than another book on Warren Buffett.

The real story begins in 1998. That’s when Buffett’s Berkshire Hathaway bought General Re. Berkshire was a major insurer with a home-grown reinsurance business. General Re was considered the crème de la crème of reinsurers.

I say “considered”, because unbeknownst to Buffett there was a lot of crap among the crème. That crap came in the form of derivatives.

Meta-Bets

Derivatives are exactly what they sound like. The value of a plain vanilla security like a stock or bond is derived from the underlying business – its assets, earnings, and capacity to meet obligations. These are simple, straight bets.

Derivatives are meta-bets. Like an ironic narrator, they stand a level above the action. Instead of betting on a business, they bet on the betting on that business. Instead of betting on a borrower’s future income and collateral they bet on the bet a banker made on that borrower’s future income and collateral.

If the investment banks that created these derivatives used the same ad agency as BASF, their slogan would be: “We don’t make a lot of the securities you buy; we make a lot of the securities you buy riskier”.

Theory of Everything

Tavakoli has her own Theory of Everything in Finance:

“The value of any financial transaction is based on the timing of cash flows, the frequency of cash flows, the magnitude of cash flows, and the probability of receipt of those cash flows.”

It’s a simple theory. Derivatives are complex. But no amount of complexity can free a security from this iron clad rule.

“In finance, we make up a lot of fancy and difficult to pronounce names and create complicated models to erect a barrier to entry that keeps out lay people. High barriers tend to protect high pay. I’ve written about some of these esoteric products: credit derivatives, CDOs, and more, but before I look at the latest hot label dreamt up, I look at the cash to find out what is really going on.”

So does Warren Buffett.

Buffett Bets

As Tavakoli points out, financial journalists seized on Buffett’s description of derivatives as “financial weapons of mass destruction” while completely ignoring another passage in his 2002 letter to shareholders:

“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.”

Although Buffett was concerned with the macro-risk presented by derivatives – especially the risk of a collateral requirement death spiral – he was still open to engaging in large-scale derivative transactions when it made sense for Berkshire.

Buffett takes risk from Wall Street firms willing to pay Berkshire well. For instance, Berkshire has assumed the risks of owning certain junk bonds.

But he sets the ground rules:

“He chooses the specific corporate names; he refuses ‘diversified’ portfolios containing a large number of corporations. He does trades in massive size – $100 million or more, if possible.”

Buffett applies the same principles he uses in common stock investing. He likes to be greedy when others are fearful and fearful when others are greedy. He likes opportunities where there is a perception gap – an inappropriate quantitative relationship between price and value that arises from some qualitative bias. And he likes to focus on what he knows. When he bets, he bets big. When he’s unwilling to bet big, he doesn’t bet.

Margin of Safety

Buffett is occasionally willing to assume first-to-default risk on a basket of junk bonds:

“Normally, first to default trades are viewed as the riskiest trades, and junk debt is viewed as the riskiest kind of asset; but Warren builds in a margin of safety that makes this a wise investment as long as Wall Street misprices the risk.”

Market participants who focus entirely on conventional indicators of quality – like triple-A ratings – miss opportunities to get great returns in “bad” assets and open themselves up to the danger of buying supposedly “good” assets at prices that provide no margin of safety – and when levered – provide a real risk of catastrophic loss.

Remember, Buffett bought into Moody’s common stock. He didn’t buy into their ratings system.

With lots of leverage and little value relative to price, you can go broke betting on good assets. Conversely, with little leverage and lots of value relative to price, you can get good returns from bad assets.

Buffett knows that. And he preaches what he practices:

“Investing in junk bonds and investing in stocks are alike in certain ways: Both activities require us to make a price-value calculation and also to scan hundreds of securities to find the very few that have attractive reward/risk ratios. But there are important differences between the two disciplines...Purchasing junk bonds, we are dealing with enterprises that are far more marginal. These businesses are usually overloaded with debt and often operate in industries characterized by low returns on capital. Additionally, the quality of management is sometimes questionable. Management may even have interests that are directly counter to those of debtholders. Therefore, we expect that we will have occasional large losses in junk issues.”

(2002 Letter to Shareholders)

A man famous for stressing the importance of buying into good businesses with high returns on capital run by able and honest management is willing to buy junk bonds of bad businesses with low returns on capital run by incompetent and “questionable” management – when the price is right.

Buffett is always focused on the relationship between price and value.

Tavakoli’s book chronicles the words and deeds of people who dealt in derivatives without knowing – and often without caring – what that relationship was.

Some will call her book a morality tale. I call it a rationality tale.

You mentioned that an hour a week is not good enough for being a successful investor. My question is how much time is enough? I make an effort to read industry news articles and read several value investing blogs everyday but I don't always spend time on a stock screener. I only read financial statements when something catches my eye and before investing, I make it a point to read at least the last 5 years of annual reports of the company. Can this be considered active value investing or should I just restrict my investments to ETFs ?

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1. Mohnish Pabrai is about as close to mimicking the Buffett partnership as there is out there right now. What are your thoughts on his recent change in approach to diversification? I understand that he's still remaining concentrated, but he has made a fairly drastic change from just a year or two ago.

2. The second question has to do with top down analysis. Buffett and Lynch are famously not interested in top down analysis, however those that famously called the current crisis (Grantham, Fred Hickey and the like) basically did it on a top down basis, and of course it has me thinking that one of the first questions has to be, "how invested should you be in the first place"? I think you somewhat agree with this, particularly in light of the work that you did on long term normalized earnings of the market, and normalized profit margins, but how do you marry that with Buffett/Lynch's views on limited value of macro analysis?

I answer...

I'm a computer programmer by trade, as such I find that most of the companies that fall within my circle of competence are tech companies. Should I be concerned about my portfolio being very (perhaps overly) concentrated in the technology industry?

I'm currently finding plenty of interesting companies to look at within the tech industry. But as this has been a notoriously overvalued sector in the past, I expect it will be again at some point in the future. How much time should I be investing in learning about other industries?

I answer...

Buffett described these derivatives in his 2007 letter to shareholders:

“Last year I told you that Berkshire had 62 derivative contracts that I manage (We also have a few left in the General Re runoff book). Today, we have 94 of these...”

Financial Weapons of Mass Destruction

Before criticizing Buffett, we need to take a moment to praise him. After all, the guy had the foresight to clean out the General Re derivatives before the credit crisis hit.

Yes, Berkshire took a loss. And, yes, Buffett clearly overestimated both the rationality and morality of the human capital over at General Re – much as he had at Salomon.

Buffett was never well-liked at Salomon. And I’m sure there are some folks (or ex-folks) at General Re who don’t find him quite as avuncular as he is reputed to be.

I would say they simply don’t understand each other, if I didn’t think the truth was exactly the opposite. Buffett got to know Salomon and General Re better with time – and the better he knew them, the less he liked them.

The General Re derivatives were a disaster averted. Had Berkshire kept the book intact or never acquired General Re, we’d be hearing a lot more about what was in that book.

Is it a mere coincidence that Buffett, the CEO who made the decision to unwind the General Re book, called derivatives “financial weapons of mass destruction”?

No. Buffet saw something in that book. And he did something about it. Most CEOs did not.

Style Drift

Enough praise. Back to the blunder:

“Over the past five years, Buffett frequently called derivatives ‘financial weapons of mass destruction’, comparing derivates to ‘hell...easy to enter and almost impossible to exit.’ Yet, he has, very much out of character, immersed himself in a large and, thus far, unprofitable derivative transaction. His investment successes have not been in speculating in the market (something he has been critical of) but rather by purchasing easily understandable companies with dependable cash flows…”

That’s Doug Kass writing lasting year about Buffett’s style drift. He goes on to write:

“It immediately occurred to me after gazing at Buffett's style drift (manifested in Berkshire Hathaway's large first quarter derivate losses) that he might be increasingly viewed as the New Millennium's Ben Franklin, a man who wrote ‘early to bed and early to rise’ but spent many of his evenings in France, whoring all night…”

Not surprisingly, Kass is negative on Berkshire stock. I won’t argue that point. Berkshire has fallen. And short sellers have made money.

Kass presents Buffett’s derivative transaction as “speculating in the market”.

Insurance

Let me offer an alternate explanation.

Berkshire Hathaway has substantial insurance operations. It is, in fact, a huge insurer of large, often unusual risks. In some cases, Berkshire prefers to keeps such risks to itself instead of sharing them with other insurers.

Buffett does not believe in the Noah’s Ark school of investing and Berkshire does not practice the Noah’s Ark method of insuring. The company bets big in stocks and takes big risks in insurance provided the odds look good and the cost of a losing bet would not imperil the holding company’s health.

That’s the business model. And I love it. If you don’t love it, don’t buy Berkshire. Buffett has been explicit about both parts of the process – the generation of float and the allocation of capital – and he has been explicit about the fact that Berkshire is not a conventional insurance company.

This brings me to a critical point. I disagree with Kass. The put options Berkshire sold aren’t an instance of style drift, because they aren’t investments – they are insurance.

Here’s how Buffett described them:

“These puts had original terms of either 15 or 20 years and were struck at the market. We have received premiums of $4.5 billion, and we recorded a liability at yearend of $4.6 billion. The puts in these contracts are exercisable only at the expiration dates, which occur between 2019 and 2027, and Berkshire will then need to make payment only if the index in question is quoted at a level below that existing on the day the put was written…I believe these contracts, in aggregate, will be profitable and that we will, in addition, receive substantial income from our investment of the premiums we hold during the 15-or-20 year period…in all cases we hold the money, which means we have no counterparty risk.”

As Whitney Tilson noted, it appears Berkshire is not required to post (much) collateral:

“Under certain circumstances, including a downgrade of its credit rating below specified levels, Berkshire may be required to post collateral against derivative contract liabilities. However, Berkshire is not required to post collateral with respect to most of its credit default and equity index put option contracts and at September 30, 2008 and December 31, 2007, Berkshire had posted no collateral with counterparties as security on these contracts.”

Trust

Considering these facts, two possibilities exist:

a) Buffett is lying or otherwise intentionally and materially misrepresenting Berkshire’s derivatives situation.
b) These derivatives pose little to no risk to Berkshire’s solvency or long-term financial health

If Buffett is lying, Berkshire’s shareholders are screwed. But that’s not news.

When you buy Berkshire you are banking on Buffett’s integrity. The guy doesn’t have to be a saint, but he does have to be a halfway decent human being. He controls the company and conducts complex transactions on both the investment and insurance side.

Trust has always been required of those who invested alongside Buffett. In his early partnership days, his disclosures were next to nil, investors’ money was locked up until year-end, and they were putting their trust in a slightly odd young man who worked from home. Those were the ground rules. And they turned some people off. The rest got rich.

If you don’t trust Buffett, don’t buy Berkshire, and don’t believe anything about these derivatives contracts.

Me?

I trust the guy. I’m probably biased. But I’m also probably right.

A Good Bet

Also, I have to admit, if I were running Berkshire and was offered a deal to sell those puts on the terms Buffett did, I would take it.

There is a difference between a good bet and a winning bet. A bet is good when the odds are in your favor and your bankroll can bear the full brunt of an utter and unpredictable loss. A bet is winning when you win. Most people judge themselves on outcomes. That’s insane. You can’t control outcomes. Only process.

Buffett once wrote:

“You will be right, over the course of many transactions, if your hypotheses are correct, your facts are correct, and your reasoning is correct. True conservatism is only possible through knowledge and reason.”

Those words were written 47 years ago – before Berkshire, before the insurance business – before everything but Graham’s training and Buffett’s rationality.

I don’t know if Buffett will lose this bet. But I do know his style hasn’t drifted an inch.