Posts Tagged: Warren Buffet

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26
Aug 11

Bank of America – A Cautionary Tale

Many of my friends follow the advice of Bruce Berkowitz, founder of the Fairholme Fund.  They occasionally ask for mine as well.  Mr. Berkowitz has been one of the most successful mutual fund managers over the past several market cycles.  After the 2008 financial crisis, Mr. Berkowitz invested heavily in financial stocks such as Bank of America, Citicorp, AIG and others.  I did not want to disagree with a guru such as Mr. Berkowitz, but I expressed doubt about investing in financial stocks, especially the trio he selected.  Why? Even for an expert it is difficult to get an accurate financial picture of large financial companies.   Problems are often held off the balance sheet in structured investment vehicles that are discreet and hidden.   It is impossible to examine the net exposure and counter party risks associated with their burgeoning credit derivative businesses.  In fact, the financial crisis and testimony before the Financial Crisis Inquiry Commission revealed that even executives inside these institutions did not fully appreciate the risks their companies were undertaking.  Suspension of “mark to market” accounting further clouded the true financial picture of securities and mortgages the banks held.

In March 2010, Mr. Berkowitz gave an interview to Barron’s.  He described his rationale for investing in the big three mentioned above:

The financial system in the United States doesn’t work without Citigroup and Bank of America and, hence, the government’s involvement. But what’s nice about the government is that at the end of the day, it will make a profit on all of its investments in these companies.

There are just certain institutions that are interwoven into the fabric of the United States. That’s the case with Citigroup and Bank of America, which make up a key part of our banking system. The same is true for AIG in the insurance area.  See After the Apocalypse

Mr. Berkowitz believes that these “too big to fail” financial institutions are essentially in partnership with the government and will be assured profitability and ever rising stock prices.  When I realized this, I firmly decided that he was wrong and that his strategy would ultimately fail.

On Tuesday, Bank of America closed at $6.30 down almost 2% on the day and nearly 48% for the year.  (After Thursday’s announcement of Warren Buffet taking a stake in the preferred stock of the company the price has recovered to the mid $7 range.)  Fairholme Fund is down nearly 13% this year.  While of course I am skeptical of Mr. Berkowitz’s strategy, I urge the more important point about the havoc the government has fostered, the risks of investing in any financial firm, and the folly of blind faith in guru investors.

What is Wrong with Bank of America?

The short answer is that no one knows for sure.  But there are two ominous signs: the drop by nearly half of the yearly stock price, and the soaring cost of insuring Bank of America debt in the credit derivative market (385 basis points –August 23).  Yves Smith of Naked Capitalism summarizes the distress in the stock:

  • An analyst believes that the company will need to raise $40-50b in additional equity diluting current shareholders
  • The company is having difficulty in selling assets which would improve their financial position (China Construction Bank, Merrill Lynch)
  • The company is unable to complete a broad settlement of mortgage litigation
  • The stock is susceptible to manipulation by high frequency traders
  • The company’s second liens are overvalued
  • Commercial loans are impaired, and have not been recognized as such.
  • Management has overstated good will from the Countrywide and Merrill Lynch transactions
  • There are undetermined European exposures, especially to the debt of foreign banks.  See Why is Bank America’s Stock Cratering Yet Again? It’s the Extend and Pretend Endgame

Extend and Pretend

It was governmental policy to suspend mark to market accounting policy.  Basically this permitted the banks to make their own value determinations for mortgages and other potentially impaired assets.  Ms. Smith points out how pernicious this policy is:

We are now seeing the downside to extend and pretend. Years of regulatory forbearance mean that investors know the marks on the balance sheet of a beast like Bank of America (and frankly all the other big banks) have a ton of air in them. And now that the economy is looking seriously wobbly and the odds of son of Credit Anstalt are well above zero, it means big banks are at real risk of getting seriously whacked in a major stress event. Worse, with Dodd Frank (supposedly) barring bailouts and Tea Partiers on an anti-bank, anti-Fed, anti-spending warpath, it might not be so easy for the authorities to rescue a big bank if a run started…. See Why is Bank America’s Stock Cratering Yet Again? It’s the Extend and Pretend Endgame

Credit Anstalt refers to the 1931 failure of an Austrian bank which set off a chain of European bank failures, deepening the Great Depression of the 1930’s.

Investors are wary that Bank of America could collapse just as Lehman and AIG did in 2008.

Understanding Banks

This brings us to gurus and financial analysis.   Mr. Berkowitz is not the only guru piling into Bank of America stock.  John Paulson (who worked with Goldman Sachs to short the mortgage market during the 2008 financial crisis) and David Tepper, both considered two of the best hedge fund managers, also bet heavily on Bank of America, Citicorp , AIG and other financial stocks.   But in a brilliant analysis, Steve Waldman, author of Interfluidity, points out that it is near impossible to evaluate large, complex, financial institutions:

Bank capital cannot be measured. Think about that until you really get it. “Large complex financial institutions” report leverage ratios and “tier one” capital and all kinds of aromatic stuff. But those numbers are meaningless. For any large complex financial institution levered at the House-proposed limit of 15×, a reasonable confidence interval surrounding its estimate of bank capital would be greater than 100% of the reported value. In English, we cannot distinguish “well capitalized” from insolvent banks, even in good times, and regardless of their formal statements.  See Capital Can’t Be Measured

Thus, it is hubris to posture on the investment potential of Bank of America or other financial institutions.   Thinking about Mr. Berkowitz’s comments in Barron’s, it appears that his investment was faith-based, meaning that he relied on the government bailing out Bank of America, again and again ensuring stock market profits.  Government is often an unreliable business partner.

Some Lessons

Extend and pretend accounting games are catching up with the “too big to fail” banks.   European banks are already in shambles. Distrust between and among banks is high and growing.  This can lead to a dramatic loss of liquidity when least expected. And thus could begin the next wave of financial crisis.

Investment gurus usually have one or two good ideas during their investment lives.  Investors who follow the recommendations of these gurus once the financial environment is radically different do so at their peril.   It pays to be skeptical.

Finally, reliance on government to protect investors is folly.  Remember it is the government that coaxed Bank of America into purchasing the troubled Countrywide and Merrill Lynch companies.   In the current Tea Party-dominated congressional environment will another TARP be enacted to save the banks?  With Rick Perry calling money printing by Ben Bernanke treasonous, will the Federal Reserve be able to step in and save the banks?

At the moment the market is putting much weight on the Buffet purchase of Bank of America preferred stock. Investors should think critically about this purchase.  First, it gives lie to the claim of Bank of America management that it did not need to raise additional capital.  Second, the Buffet deal came at a high price to current shareholders. It was a costly financing.  Third, it is merely a small down payment on the much larger sums of money that the company must raise to maintain appropriate capital ratios.  I wish Mr. Berkowitz and other investors much luck, but I think we have not heard the end of Bank of America’s troubles.

 

 

 

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16
Aug 10

Bring Back the Robber Barons

Bill Gates and Warren Buffet have encouraged wealthy families to give half their wealth to charities, and many have done so.  One year into the effort, Buffet announced that forty families have agreed to pledge more than half their wealth to charity.   Emblematic of our current age, most of these families have made their money in the finance industry.

A Different Time in America

Once upon a time in America there was an entrepreneurial class that did more than shuffle pieces of paper.  They produced real things.  Historians originally referred to this group as “Robber Barons” because the large fortunes they amassed involved ruthless and sometimes uncompetitive business practices.  While some made their fortunes in finance, the overwhelming majority laid the foundation for America’s 20th century industrial dominance:

  • John Jacob Astor  (real estate, fur)
  • Andrew Carnegie (steel)
  • Jay Cooke (finance)
  • Charles Crocker (railroads)
  • Daniel Drew (finance)
  • James Buchanan Duke (tobacco)
  • James Fisk (finance)
  • Henry Morrison Flagler (railroads, oil, the Standard Oil company)
  • Henry Clay Frick (steel)
  • John Warne Gates (steel)
  • Jay Gould (railroads)
  • Edward Henry Harriman (railroads)
  • Milton S. Hershey (chocolate)
  • Mark Hopkins (railroads)
  • J.P.Morgan (banking, finance, steel, industrial consolidation)
  • Henry B. Plant (railroads)
  • John D. Rockefeller (Standard Oil)
  • John D. Spreckels (San Diego transportation, water, media)
  • Leland Stanford (railroads)
  • Cornelius Vanderbilt (railroads)

These individuals were also the backbone of American philanthropy.  For example, think of:  Carnegie (libraries); Rockefeller (University of Chicago, the Rockefeller Foundation) and Leland Stanford (Stanford University).  The Robber Barons not only focused on industrial wealth creation.  They were equally concrete and focused in charitable giving that provided tangible benefit to American institutions and society.

In contrast, the Gates Foundation focuses on world health concerns, a worthy but certainly more amorphous goal.  As an aside, the Gates-funded vaccination and AIDS treatment programs have received criticism for singular focus on certain diseases to the derogation of comprehensive health care and diversion of important medical resources.  Few of the Gates Foundation initiatives benefit Americans.

The Over Financialized Economy

The wealthy donors signing on to the pledge are one more reminder of the over financialized American economy.   See The Mirage of a Financialized Economy; The People v. Wall Street.  Today’s fortunes were earned at the expense of the industrial economy, rather than in pursuit of its success.   Two recent commentaries support the deleterious effect of an economy over-focused on the financial:

Boston-based asset manager Jeremy Grantham in Summer Essays criticizes his own profession:

“In 1965, 3% of GDP that was made up of financial services [and that] was clearly sufficient to the task, the proof being that the decade was a strong candidate for the greatest economic decade of the 20th century. We should be suspicious, therefore, of the benefits derived from the extra 4.5% of the pie that went to pay for financial services by 2007, as the financial services share of GDP expanded to a remarkable 7.5%.

This extra 4.5% would seem to be without material value except to the recipients. Yet it is a form of tax on the remaining real economy and should reduce by 4.5% a year its ability to save and invest, both of which did slow down. This, in turn, should eventually reduce the growth rate of the non-financial sector, which it indeed did: from 3.5% a year before 1965, this growth rate slowed to 2.4% between 1980 and 2007, even before the crisis.”

Professor Steve Keen, an Australian economist and author of Debtwatch believes that the percentage of GDP going to the financial sector should be even lower:

Because of that debt level, bank profits have gone through the roof as a share of GDP. Back before we had a financial crisis—when debt levels were far lower than today—so too were bank profits as a share of GDP. A sustainable level of bank profits appears to be about 1% of GDP.  See Bank Profits a sign of economic weakness, not health

Bring Back the Robber Barons

We need a political and economic re-set button.  The Obama and Bush Administrations have attempted to uncritically favor the financial sector through loan guarantees, TARPs and other artifices.  No one has asked the critical question of why we are favoring this sector that has absorbed a disproportional share of GDP at the expense of a productive reality-based economy that makes real things and employs real people.

No wonder unemployment has remained stubbornly high, and the economy is poised to enter a “double dip” recession.  Perhaps we need a new class of wealthy people focused on creating real wealth and jobs in America.   Maybe it is time for some twenty-first century Robber Barons.

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7
Jun 10

The Responsibility Index

Wall Street seems to manufacture measurement indices at the speed of light. Why not a “Responsibility Index” to track bad behavior?  Having one would force bad behavior into the spotlight, something that has been sadly lacking.

How to Be Responsibly Irresponsible

Unfortunately, irresponsible financial and business behavior is everywhere.  Moreover, offenders in search of exoneration have learned to “spin” their irresponsible actions.   Here is a short tour through a world of irresponsibility:

-          The Oracle of Omaha, Warren Buffet, testified before the Financial Crisis Inquiry Commission.  Buffet followed in a long line of CEOs such as Charles Prince who feigned ignorance about the housing crisis.   Buffet defended Moody’s lavish granting of AAA ratings to virtually all housing related bonds.

In Moody’s defense, Mr. Buffet pointed out that nearly all Americans were caught up in the housing bubble and very few market participants predicted a nationwide crash in housing prices. In addition, Mr. Buffet stated that he personally did not realize the extent of the bubble before it broke. See Was Buffet too easy on Moody’s in FCIC Testimony?.

Paraphrased another way, if no one could see the train wreck coming then no one was responsible.

-          The Deepwater Horizon oil disaster is a veritable case study on shirking responsibility.

a.  First we have the President informing the public that this is entirely BP’s responsibility.

b.  Then we have Ben Stein, a financial commentator and Yale Law School graduate, standing corporate law on its head with the following:

Look, I’m a stockholder of BP through mutual funds. You are, I’m sure, too. I’m sure most of your viewers are in their retirement fund. Why should we be punished? Why shouldn’t it be people who actually were there on the watch and made the mistake be put in prison if they did it criminally negligently? See CNN Transcript

When you buy stock in a corporation, you vote for the board of directors and as an equity holder you risk losing your entire investment.  The fact that BP stock is held in pension funds does not exonerate shareholders from financial responsibility.

c.  Finally,  in an interview with the Financial Times of London, Tony Hayward confessed that BP was ill-prepared for the disaster:

BP did not have all the equipment needed to stop the leak from its Macondo well in the Gulf of Mexico in the aftermath of the explosion on an oil rig six weeks ago, the UK company’s chief executive admitted.

Speaking to the Financial Times in Houston as engineers worked on their latest bid to trap the escaping oil, Hayward said BP was looking for new ways to manage “low-probability, high-impact” risks such as existed on the the Deepwater Horizon oil rig.

“What is undoubtedly true is that we did not have the tools you would want in your tool-kit,” Mr. Hayward said.  He accepted it was “an entirely fair criticism” to say the company had not been fully prepared for a deep-water oil leak. See BP CEO: We Were Unprepared for the Disaster

Thus, if you are BP, you should not be responsible for drilling in 5,000 feet of water through 13,000 feet of rock because a blow out is a low probability event?

-          We can draw an analogy in hometown America.  The New York Times highlighted the Pemberton family who have not paid their mortgage for two years.  However, with the extra money available, the Pembertons have funded their family business, gone out to dinners, fueled their air boat and visited casinos.  Their justification is emblematic of the age we live in:

Any moral qualms are overshadowed by a conviction that the  banks created the crisis by snookering homeowners with loans  that got them in over their heads.  See Owners Stop Paying Mortgages, and Stop Fretting.

The Pembertons therefore consider all the banks to be “crooks,” but not themselves for breaking their bank mortgage contract.

Personal Responsibility

We live in an age of moral relativity where we shirk responsibility as easily as we change shirts. Let’s summarize the shirking of responsibility:

-          Mr. Buffet and Moody’s are not responsible since no one could see the collapse in house prices.   Didn’t John Paulson and Goldman make billions in shorting the housing market?

-          Ben Stein does not want the BP shareholders to be punished.  Didn’t shareholders accept this risk when they purchased BP shares?  What if BP committed antitrust violations? Would Mr. Stein have the same opinion?

-          We should excuse BP since the spill was a low probability event? Haven’t spills occurred in Mexican and Australian off shore sites?  A $200 billion company did not have the proper tools in their “tool-kit”?

-          It is alright to default on a mortgage and live in a house rent free.   Didn’t the Pembertons sign a contract promising to repay all the monies they borrowed?  Is this behavior fair to their neighbors who diligently make their mortgage payments?

The Animal House Defense

In the classic comedy film Animal House, Otter, the fraternity president, argues against college expulsion on the following grounds:

But you can’t hold a whole fraternity responsible for the behavior of a few, sick twisted individuals. For if you do, then shouldn’t we blame the whole fraternity system? And if the whole fraternity system is guilty, then isn’t this an indictment of our educational institutions in general? I put it to you, Greg – isn’t this an indictment of our entire American society?  See Animal House Memorable Quotes.

We are perilously close to the Animal House defense that if we are all responsible, then no one is responsible.  We need to bring back individual responsibility and none too soon.  Otherwise,  seriously irresponsible people will be shorting the Responsibility Index.

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18
Feb 10

A Reputation as Good as Goldman? Part I

Part I of II in a series. Part II here.

“It takes 20 years to build a reputation and five minutes to ruin it. If you think about that, you’ll do things differently.”

Warren Buffett

Arguably the greatest living investor, Warren Buffet, clearly valued a person’s or an organization’s reputation.   In 2008 Buffet was the “white knight” investor for a struggling Goldman Sachs, investing $5b in the firm.  A mentor of mine had wise complementary counsel to Buffet’s:  when providing legal advice, be sure that you would be comfortable if that advice were to appear in a New York Times, Washington Post or Wall Street Journal front page article.

We live in  an age of greed, and indeed supreme irony.   Perhaps Mr. Buffet never shared his wise advice with the senior management of Goldman Sachs.  Worse, maybe he did and they ignored him.  In any event, how has Goldman’s reputation fared?  Let’s examine three separate front page New York Times articles.

Banks Bundled Bad Debt, Bet Against It And Won (NY Times, December 24, 2009)

Goldman Sachs sold mortgage-backed debt securities to pension funds and insurance companies. To hedge their position and to profit from a decline in the housing market, Goldman created a synthetic derivative security called Abacus. This second security was a direct bet against the position of their institutional clients. The mortgage-backed debt securities sold to the institutional clients performed poorly, with losses in the billions. Some of the original securities were of such poor quality that losses occurred within months of issue. Goldman created these synthetic securities well in excess of any hedging needs, permitting it to profit handsomely at the expense of its institutional clients.  The obvious ethical problem was succinctly stated:

“The simultaneous selling of securities to customers and shorting them because they believed they were going to default is the most cynical use of credit information that I have ever seen,” said Sylvain R. Raynes, an expert in structured finance at R & R Consulting in New York. “When you buy protection against an event that you have a hand in causing, you are buying fire insurance on someone else’s house and then committing arson.”

The SEC and other governmental agencies are investigating Goldman and other firms to determine whether or not they violated “fair dealing” rules.

Testy Conflict with Goldman Helped Push A.I.G. to Edge (NY Times, February 7, 2010)

AIG insured some of Goldman’s complex mortgage securities.  When the housing crisis deepened, AIG paid Goldman $2b to cover potential losses. AIG later asserted that Goldman had inflated the potential losses and sought monies back. Goldman countered that it was due even more money.  The SEC is now looking into whether or not Goldman’s demands for loss coverage depressed the mortgage market and hastened AIG’s demise.

In another supreme irony, after the government took over AIG, Goldman received an additional $12.9b from taxpayers, one hundred percent of expected losses.

Wall St. Helped to Mask Debt Fueling Europe’s Crisis (NY Times, February 14, 2010)

Goldman’s questionable financial maneuvers were not confined to the United States.

As worries over Greece rattle world markets, records and interviews show that with Wall Street’s help, the nation engaged in a decade-long effort to skirt European debt limits. One deal created by Goldman Sachs helped obscure billions in debt from the budget overseers in Brussels.

Even as the crisis was nearing the flashpoint, banks were searching for ways to help Greece forestall the day of reckoning. In early November — three months before Athens became the epicenter of global financial anxiety — a team from Goldman Sachs arrived in the ancient city with a very modern proposition for a government struggling to pay its bills, according to two people who were briefed on the meeting.

The bankers, led by Goldman’s president, Gary D. Cohn, held out a financing instrument that would have pushed debt from Greece’s health care system far into the future, much as when strapped homeowners take out second mortgages to pay off their credit cards.

European authorities are looking into the role of Goldman and others in skirting EU rules.

Is There Another Way?

Has the American public been lulled into believing that this is an acceptable way of doing business, or do we require the people involved to be publicly excoriated, tried, convicted and jailed before we acknowledge their tactics were shabby?  Is Goldman Sachs an institution now synonymous with crafty machinations and greedy outcomes? Are its tactics symptomatic of a Wall Street “disease?”  Is there an alternative way of doing things?  Does reputation matter?  Part II will examine these issues and possibilities.

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12
Oct 09

Over Relying on Intermediaries

Overlooked in the financial crisis is the role of intermediaries.  The average American gives little thought to intermediaries.  But ever-increasing intermediation is intruding into and contaminating our financial decision making.  On a very basic level financial intermediation is defined as:

[T]the “matching” of lenders with savings to borrowers who need money by an agent or third party, such as a bank…

If this matching is successful, the lender obtains a positive rate of return, the borrower receives a return for risk taking and entrepreneurship and the banker receives a marginal return for making the successful match…. If the borrower’s speculative play with the depositor’s funds does not pay off, the depositor can lose the savings borrowed by the borrower and the bank can face significant losses on its loan portfolio.

Banks present as the most basic of financial intermediaries, and depositors do rarely examine how a bank makes money or the risks involved.   The FDIC guarantees further stifles the thought process with its increasingly suspect guarantee for deposits under $250k. See As of August 14,2009, FDIC is Bankrupt.

Cult of the Expert

Wall Street has been very clever at promoting the cult of the expert.  Standard advice: is that individuals should not pick their own products and should instead rely on our expertise.  Intermediation took off with a vengeance: from the mutual fund craze of the 1950s and 1960s, to Index funds, to exchange traded funds, to vulture funds, hedge funds, private equity pools to more exotic investments such as mortgage backed securities.   What Wall Street fails to mention is that the various intermediaries charge a hefty fee for their services.  Hedge funds pushed the envelope introducing the infamous “2 and 20” where the firms made 2 per cent for managing the investor’s funds and 20% of the profit.  In this scenario, where is the shared risk?

Current Financial Crisis Exposes the Wizard of Odds

The well burnished image of the expert financial intermediary has now collapsed.  Unless an intermediary invested in gold and T-bills, portfolios suffered significant losses last year.  All markets synchronized to the downside.  The mantra of diversification across a broad range of asset classes, i.e.: bonds, emerging markets, large capitalization, small growth and real estate, turned out perfectly wrong.  Robert Prechter referred to it as “all one market.” The bear market revealed that the past 25 years of financial wisdom was false.  Nevertheless, win or lose, just like Vegas casinos, intermediaries still received their cut.

Intermediaries in Other Financial Areas

The cult of the professional intermediary has spread to other areas, for example, the insurance industry. These companies collect premiums and lend the funds at a higher rate, earning profits on the spread.  Pension funds are another venue: employees defer their wages, and pool their investments under the auspices of a pension fund manager.  This professional is charged with investing to out-earn the stock indices in order to provide the employee a pension after retirement.  Even the great Warren Buffet is an elaborately disguised intermediary.  While Berkshire Hathaway sounds like a real company, it is essentially a private equity and investment manager buying whole companies and derivatives.  Despite the nomenclature, insurance companies, pension funds and even Berkshire Hathaway suffered major losses in the current crisis.

A Commentary on Society

As a culture we have glorified the “expert,” and financial intermediaries have prospered as a direct result.  Our educational system encourages greater and great specialization and accreditation.  But specialized information and knowledge does not equal good judgment. See Too Much Information and Too Little Wisdom. The financial crisis unmasked the cult of the expert.  With a low interest rate environment, investors can ill afford the fee structure of the intermediaries that cut sharply into yield. Why pay 50 basis points or more for investment advice when a portfolio may earn one percent of less? An educated investor who takes on more personal responsibility may be the wave of the future.  Perhaps personally supervised choices would not have been as devastating as of those of the “expert” intermediaries.

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