Process versus Outcome

We are coming to the end of the first decade of the millennium. If I have to think of one lesson that I have learnt over the last decade, then it has to be the one on 'process versus outcome'.

To illustrate this concept, let me cite an example from Michael Lewis' book Moneyball:

Paul DePodesta, a former baseball executive tells about playing blackjack in Las Vegas when a guy to the right, sitting on a seventeen, asks for a hit. Everyone at the table stops, and even the dealer asks if he is sure. The player nods yes, and the dealer, of course, produces a four. What did the dealer say? "Nice hit." Yeah, great hit.

Similar to this anecdote, in our daily lives, we measure performance by results. After all, results are what ultimately matter - they add to bottom line. Evaluating the underlying process is subjective and hard. So, we simplify our lives, by making the critical mistake of assuming that good outcomes are the result of a good process and bad outcomes are the result of a bad process. Besides, the only ones voicing against doing so are mostly people who have 'failed' in their endeavours.

But alas, reality is far more vicious than a game at Vegas. We all wish life was as simple as a game of blackjack where each card about to open up is one of the few known options. But often we are faced with a myriad of possibilities. Our folly is in picking a process that has the possibility of delivering a rare but fatal outcome. On top of that, a few repetitions of the process starts giving us a false sense of security - we start feeling that the sorts of things that happen to others will not necessarily happen to us. And then if nothing bad happens then we kick our self for being too worried.

Nassim Taleb, the author of Fooled by Randomness, offers a thinking tool called 'alternate histories' that I find very useful:

The concept of 'alternate histories' is similar to the many-world interpretation in quantum mechanics, which considers that the universe branches out treelike at every juncture; what we are living now is only one of these many worlds. Taken at a more extreme level, whenever numerous various possibilities exist, the world splits into many worlds, one world for each different possibility - causing the proliferation of parallel universes.

If we apply the 'alternate histories' way of thinking then the guy at the blackjack table got busted in one of the alternate worlds indicating that he was following a poor process. Even though this way of judging matters is abstract and counter intuitive, it is a good way to evaluate our process. After all, in the long haul, a good process gives us the most reliable way of raising our chances of a good outcome.

• Good process, Good outcome - Deserved success
  
• Good process, Bad outcome - Bad luck
  
• Bad process, Good outcome - Dumb luck
  
• Bad process, Bad outcome - Poetic Justice
  

Playing by the (Basel) Rules

US private debt grew from 20 trillion dollars in 2000 to over 50 trillion dollars in 2007, but FDIC regulated banks (referred to as banks for the rest of the discussion) continued to stay "well capitalized" during this period. How could total debt grow by 80% without leading to the deterioration of bank's capital?

To answer this question, we need to look at how banks are regulated. At the end of 1980s, the G-10 countries decided to coordinate their banking regulation through the Basel Committee on Banking Supervision of the Bank for International Settlements (B.I.S.) by setting capital adequacy requirements. According to the Basel rules, all banks and depository institutions in the countries that adhered to them must maintain a certain minimum fixed amount of capital in relation to its assets.

The capital adequacy requirement set by B.I.S is to protect the banks from unexpected losses, since the banks are protected by expected losses by accounting for them on their books. The term "capital" might give you the impression that it is cash held by the banks in their vaults. But such a usage is misleading. Generally speaking, capital is the portion of bank's assets that don't have to returned to creditors (depositors are also creditors). It is only because of the fact that this portion of its financing does not have to be repaid that the bank has the capacity to withstand unexpected losses. It is the capital that absorbs these unexpected losses. The Basel rules classify capital into 2 tiers - Tier 1 "core" capital and Tier 2 capital. Tier 1 capital largely consists of funds raised through selling common stock, disclosed reserves, and retained earnings. Tier 2 is defined as undisclosed reserves, revaluation reserves, loan-loss reserves, convertible bonds, cumulative preferred shares, and subordinated debt.

The Basel rules require that the banks hold certain minimum ratios of clearly defined capital (calculated at book values) against assets that are adjusted by clearly defined weights.

Capital ratio = Capital / Risk-weighted Assets

Under this framework, banks to be considered "capitalized" are required to hold no less than 8 percent capital against total risk-weighted assets.

The system of assigning weights to assets is fairly standardized requiring minimal supplementation by various national banking regulators. In the United States some of the risk weighting rules are as follows (for details look at BIS 1988):

• 0% weight to cash, gold, and bonds issued Organization for Economic Co-operation and Development (OECD) governments


• 20% risk weight for AAA and AA rated asset-backed securities and claims on OECD banks, local public-sector entities, and agencies of OECD governments, such as the government sponsored enterprises Fannie Mae and Freddie Mac.


• 50% risk weight to mortgage loans


• 100% risk weight to all claims on the private sector and non-OECD governments, to investments in real estate, equities, corporate bonds, and all other assets rated lower than AA

In addition to the Basel rules, the FDIC in the United States require that banks aspiring to be deemed "well capitalized" - and thus enjoy valuable privileges like securities underwriting - must hold their capital in a configuration that meets additional three additonal ratios: capital to risk-weighted assets of 10 percent, tier-1 capital to risk-weighted assets of 6%, and tier-1 capital to total assets of 5%. The chart above plots these three ratios for American FDIC banks leading upto the financial crisis. It should strike you that, as per the Basel rules, banks were a few percentage points higher than those mandated by FDIC for being "well capitalized". This might seem hard to square with the expansion of indebtedness that took places during the credit boom years.

The regulatory ratios can be achieved by either increasing the numerator or by decreasing the denominator - by building up capital, or by cutting back on lending or reducing the riskiness of the balance sheet. But, with the credit boom underway, neither might seem feasible. But in fact, both methods were used extensively, which led to the impression of a financial system that was safer than it really was.

To illustrate the kind of games that the banks played, lets use an example offered by Robert Merton:

If a bank were managing and holding mortgages on houses, it would have to maintain a capital requirement of 4%. If, instead, it were to continue to operate in the mortgage market in terms of origination and servicing, but sells the mortgages and uses the proceeds to buy U.S. government bonds, then under the BIS rules, the US government bonds produce no capital requirements and the bank would thus have no capital maintainance. However, the bank could continue to receive the economic equivalent of holding mortgages by entering into an amortizing swap in which the bank receives the total return on mortgages, including the amortizing features and prepayments, and pays the return on US Treasury bonds to the swap counterparty. The net of that series of transactions is that the bank receives the return on mortgages as if it had directly invested in them. However, the BIS capital rules, instead of being 4 percent, apprears to produce a capital requirement using the swap route of only 0.5 percent.

Central to this example is the active management of a bank's balance sheet by selling and swapping assets through securitization. Playing this game is also called as regulatory arbitrage - restructuring a bank's portfolio so that it has the same or even greater risk as before, but a lower capital requirement.

It is costly to maintain capital - it lowers the profitability of the bank and constraints its growth. Thus, it is in the bank's interest to not hold mortgages on its books, but to transfer the mortgages to a securitizer such as Fannie Mae or Bear Stearns or "hide" it in its shadow bank conduit, freeing up the its capital. The freed up capital can either be used to pay down its debt (not what happened during the credit boom) or to expand its balance sheet by making more loans (what happened during the credit boom).

This is how banks continued to appear well capitalized and not reflect the economic reality of an indebted economy

Investor's Myth: 'Higher the risk, higher the return'

I had a party at my place during the holidays and the men starting talking about investments they have been making. One of the guests started describing his success with speculative investments in the currency market and ended by saying: "The higher the risk you take, the higher the return". This is one of the most often repeated maxim (and I am about to argue it to be a false) in finance, but having read "How to win friends and influence people", I played the friendly host by avoiding an argument and politely changing the topic to the appetizing food at the party.

But I can make my case on my blog (that has very few readers and hopefully not the ones that came to the party). The notion of risk is one of the most misunderstood concepts in finance. So, what is risk? If you went to University of Chicago (I love my Chicago MBA friends - no offense to you guys), risk is explained using the capital asset pricing model (CAPM). In the case of the equity market, this risk is quantified using a statistical concept called the beta. As an example, lets look at the stock market. By defintion, the market is considered to have a beta of 1.0, and individual stocks in the market are ranked according to how much they deviate from the market. So, higher-beta stocks are the ones that are more volatile, and are considered 'riskier', according to CAPM. According to this theory, 'riskier' (high-beta) investments should have high long-term returns. And hence the statement: 'Higher the risk, higher the return'.

However, for this theory to be true, investors have to demand higher returns from 'riskier' (high-beta) stocks. There have to be people that demand such a relationship. In practice, there aren't many people who demand such a pricing, because most participants understand that risk is not the same as volatility. There are various types of risk: business risk (possibility of detoriation of operations, profit margins etc), financial risk (catastrophe due to high leverage), valuation risk (stock priced much higher than underlying intrinsic value of the business leaving little margin of safety), liquidity risk (inability to sell the stock in the market without affecting the price), and volatility risk (market price fluctuation). Off all these risks, volatility risk is of much smaller importance to most participants in the equity market. Besides, everybody knows that past results bear little resemblance to future results. So, why should historical volatility matter much to the future of the enterprise.

Since volatility is poor measurement of risk, lets replace the word risk with business risk and re-examine the maxim: 'Higher the business risk, higher the return'. Obviously, riskier (defined as business risk) investments cannot be counted on to deliver higher returns. Because if that were the case, then there is nothing risky about the investment. The correct formulation is that in order to attract capital, riskier investments have to offer the prospect of higher return. But there is absolutely nothing to say that these prospective returns will materialize.

Often, this simple logic is forgotten. Here is what really happens: Riskier investments are priced to deliver higher returns (if the investments materialize). Such a pricing is required to start attracting capital. In some cases, these investments start paying off handsome returns. The maxim 'Higher the risk, higher the return' starts getting repeated. And, hence the investment attracts more capital and bids up the price of such investments. At some point, the pricing of these investments are bid-up to such an extent that the investor is not compensated adequately to take the risk. Warren Buffet often says: 'What the wise do in the beginning, the fools do in the end'.



Here is a specific example from the recent credit boom and bust. At the begining of 2003, credit spread for high-yield bonds (another name for junk bonds) was at historical highs of over 1000 basis points. Investors were getting paid a premium of 10% over the default risk-free US treasury bonds to take the (credit, liquidity, market) risk of investing in junk bonds. In 2005, the investors were paid a mere premium of 200 basis points.

Here is another example. Cisco's stock was priced at 77$ in its peak in 2000 and had earnings of 0.36$. So, the investor in Cisco's stock in 2000 was paying 213x for the 0.36$ of earnings it had at that time. That is the equivalent of a mere 0.46% yield. Risk-free US treasuries were yielding over 6% at this time. This is yet another example of inadequate compensation of taking the risk of investing in the Cisco stock. Investor's were so seduced with the story of the internet boom that they overbid the price of the Cisco stock to an extent were they were paid nothing to take on the risk. We all know what happened in the end. Those who invested in the stock in 2000 are still waiting to make their return and this is from a successful enterprise that makes really phenomenal products



Investments are not risky inherently but only in relation to its market prices. So, the next time someone recommends a 'risky' investment as one with higher return, the first question you want to ask yourself is whether the investment is priced appropriately to compensate you for the risk you are about to take.

Was the U.S. monetary policy too loose during the housing boom?

John Taylor is an economics professor at Stanford University. In a 1993 paper, he introduced the Taylor rule, which provides guidance to central banks on how to determine short-term nominal interest rate (called the federal fund's rate in the US). It relates the interest rates to the amount of slack in the economy and the inflation rate.

He presented at the Fed's annual conference at Jackson Hole in 2007 evidence that suggested that the Fed's loose monetary policy in the 2000-2006 period was too loose. He then uses this data to argue that it was one of the biggest triggers of the housing boom in the US.

The Economist published an article, Fast and Loose, in Oct 2007 that illustrates the monetary excesses. Below is a chart from the article.

The dot-com bubble had burst and the economy was in recession. By 2003, Mr Greenspan, the chairman of the Fed then, had lowered the federal fund's rate to 1%, the lowest since 1958. He kept the interest rate at 1% for an entire year. He justified this decision by saying that he feared that America was on its way to deflation. As per Taylor's rule, the interest rate should have been above 3%. So, even though the Taylor rule is only a guide, Mr Greenspan had missed the mark by about a mile. Furthermore, Mr Greenspan said that interest rate would be low for "a considerable period" and that the Fed would rise it slowly at a "measured pace".

Gradually the Fed started raising the interest rates in quarter point steps. By June 2006, the interest rate was at 5.25%, as recommended by the Taylor's rule. So, looking back at the chart, US had over 4 years of loose monetary policy - enough time for an asset bubble to grow - all in the fear of deflation.

The housing bubble has burst. And coincidentally, Mr Bernanke, the current chairman of the Fed, just repeated Mr Greenspan's 2003 words - low interest rates for a "considerable period" and Fed will raise the interest rate slowly at a "measured pace". Would it be a coincidence that the current loose monetary policy is giving birth to yet another asset bubble?

LIBOR-OIS spread

The Libor-OIS spread is an important barometer of stress in the banking system. The term London interbank offer rate (LIBOR) is the rate at which banks indicate they are willing to loan to other banks for a specified term of the loan. The term overnight indexed swap (OIS) rate is the rate on a derivative contract on the overnight rate (In the U.S. the overnight rate is the effective federal funds rate.) In such a contract, two parties agree that one will pay the other party a rate of interest that is the difference between the term OIS rate and the geometric average of the federal fund's rate over the term of the contract. Thus, the term OIS rate is the market's expectation of the federal fund's rate over the term of the contract. There is very little risk in the OIS market because there is no exchange of principal; funds are only exchanged at the end of the contract, when one party pays net interest obligation to the other party. The term Libor-OIS spread is be a measure of the health of the banks because it measures what banks believe is the risk of default associated with lending to other banks. Changes in Libor-OIS spread reflect changes in risk premiums and liquidity premiums.

Modern shadow banking system

Paul McCulley is a managing director at PIMCO. He is particularly influenced by Hyman Minsky, and coined phrases like the shadow banking system and the Minsky moment. Here is an extract from his May 2009 speech. I particularly liked reading this speech because it clearly explains how the financial crisis came about within the modern financial banking system:

"The conventional banking system is based on what is known as the fractional-reserve banking system. Customers deposit funds at a bank to store savings in the form of a demand claims on the bank. Holders of the demand deposits can withdraw all of their funds at any time. Banks use most of these short-term funds to invest in longer-term interest bearing loans and securities. This is called borrowing short to invest long. The assets being longer term (and riskier) have higher yields than the short-term liabilities. This is how the banks make their profits.

However, this also causes a cash-flow insolvency. If all the depositors showed up at the same time, it can cause a bank run and cause the bank to collapse. In the absence of crisis that cause a bank run, fractional-reserve banking functions well because only a few depositors will make cash withdrawals compared to the total amount of deposit (liabilities are sticky), and a cash reserve is maintained to meet the demands of depositors seeking withdrawals.

A key reason that the depositors can sleep well at nights not worrying about bank runs is the fact that since 1913 here in the United States, banks have access to the Federal Reserve as a lender of last resort. This is known as having access to the Federal Reserve's discount window, where banks can post assets for loans to redeem flighty depositors. A second government sleep-well safety net was introduced, post the great depression, in 1933. Taxpayer-backed deposit- insurance (FDIC), in which the federal government insures that deposits up to a limit will not lose value, no matter how foolish the bankers may have been. Obviously, deposit banks don't just get this for nothing - they have to submit to strict regulatory standards in exchange for such a government safety-net.

The financial crisis did not originate within the confines of the highly regulated fractional-reserve banking system. Instead, it originated within the shadow banking system which operated legally, yet almost completely outside the realms of the regulatory system. The rise of this system drove one of the biggest lending booms in history, and collapsed into one of the most crushing financial crisis we have ever seen.

Unlike the conventional regulated banks described above, unregulated shadow banks fund themselves with uninsured short-term funding. They do so by raising funding in the non-deposit markets, unsecured debt through commercial paper, and secured borrowing such as reverse repo and asset-backed commercial paper. Since they fly below the radar of traditional bank regulation, these leveraged financial institutions operate in the shadows without backstopping from the Fed's discount window or access to FDIC deposit insurance. Examples of such shadow banks are investment banks (Bear Stearns and Lehman Brothers), conduits, SIVs (at Citi), money market funds, monoline insurers (Ambac and MBIA) and hedge funds (Bear Stearns High-Grade Structured Credit Fund).

Structured to not have access to the government safety-nets, the shadow banks essentially avoided regulation, notably on the amount of leverage, the size of their liquidity buffers and the type of lending and investing they could do.

In the absence of the government backstopping, the shadow banks needed some seal of approval, so that the providers of short-dated funding could convince themselves that their claims were just as good as the deposits at the regulated banks. Conveniently the friendly faces at the ratings agencies, paid by the shadow bankers, stood at the ready to provide such seals of approval. Moody's and S&P would put an A-1/P-1 rating on the commercial paper, which in turn would be bought by the money market funds. Of course, its inherently an unstable structure. The ratings agencies face an in-built problem of putting ratings on new innovations, because they haven't had a chance to observe a historical track record - to see their performance over a full cycle.

Over the last three decades or so, the growth of the "banking" outside formal, regulated banking has exploded, and it was a great gig so long as the public bought the notion that such funding instruments were 'just as good' as bank deposits. Keynes provides the essential - and existential - explanation as to why the shadow banking system became so large. It was a belief in a convention, backed by the length of time that belief held: shadow bank liabilities were 'just as good' as conventional bank deposits not because they are, but because they had been. And the power of this conventional thinking was aided and abetted by the government-blessed rating agencies. Until, of course, the convention was turned on its head, starting with a run on the asset-based commercial paper market in August 2007, the near death of Bear Stearns in March 2008, the de facto nationalization Fannie Mae and Freddie Mac in July 2008, and the actual death of Lehman Brothers in September 2008 (all being examples of banks runs on the shadow banking system.) Maybe, just maybe, there is something special about a real bank, as opposed to a shadow bank! And indeed that is ambiguously the case, as evidenced by the ongoing partial re-intermediation of the shadow banking system back into the government supported conventional banking system, as well as the mad scramble by the remaining shadow banks to convert themselves into conventional banks, so as to eat at the same government-subsidized capital and liquidity cafeteria as their former stody breathen."

Curse of AAA

Chris Davis of Davis Funds sites three reasons for the collapse of AIG. (1) the financial sophistication of management, (2) the leverage of derivatives and (3) the danger of collateral requirements tied to mark-to-market accounting.

Lets talk about the third factor again. AIG was originally AAA rated. Reserve requirements to meet possible CDS losses were minimal (or possibly none) since the rating agencies thought AIG had a "strong" AAA balance sheet. When the financial system came crumbling down, the estimated losses for the swaps started going up. At this point (too late in my opinion) the rating agencies reevaluated AIG's AAA rating, and downgraded it from being AAA. They should have done this years ago when AIG's CDS exposure was going up, and not after the fact. David Einhorn at Greenlight capital calls it the Curse of AAA. Here is an extract from his May 2009 speech at IRA W. Sohn Investment Research Conference:

"Both President Obama and Chairman Bernanke have said that the problem with AIG was that greedy people put a hedge fund on top of an insurance company. As I see it, AIG failed precisely because it was not a hedge fund, but a highly regulated, AAA rated insurance company. Call it the Curse of AAA. The market incorrectly believed that regulators and rating agencies carefully monitored its risk profile and activities. As a result, AIG was able to abuse its access to unlimited cheap financing without any of its counterparties performing any additional credit analysis or demanding any collateral. Hedge funds can't abuse the system the same way, particularly in the aftermath of Long Term Capital Management, as lenders pay much more attention to hedge fund counterparty risk and collateral requirements. Had AIG been a hedge fund as President Obama and Chairman Bernanke claim, none of this could have happened.

Come to think of it, many of the spectacular failures during this crises bore AAA ratings. The Government Sponsored Enterprises (GSE), the monoline insuraners (Ambac and MBIA), AIG, and General Electric, whose slow moving train-wreck is ongoing, suffered the Curse of AAA and damaged their companies with sizable harm to the economy at large. The only AAA rated (or atleast until recently AAA) financial institution I can think of that didn't abuse its status is Berkshire Hathaway.

Investors who bought AAA rated structured products thought they were buying safety, but instead bought disaster. They can forgive themselves by blaming the rating agencies. But if the credit markets improve to the point where newly issued AAA rated bonds price with tight spreads only to later widen or ultimately fail, investors will have no one but themselves to blame. Fool me once ...

Investors have figured this out and many deny that they buy bonds based on ratings unless they are forced by law. Even Moody's largest shareholder, Warren Buffet, has said that he doesn't believe in using ratings.

We are short Moody's Investors Service. If your product is a stamp of approval where your highest rating is a curse to those who receive it, and is shunned by those who are supposed to receive it, you have problems.

Moody's says it has enormous incentive to do a good job with the ratings because the ratings are the brand. Imagine yourself the head of Moody's a decade ago. If your goal was to destroy the brand, would you have done differently?

The truth is that nobody I know buys or uses Moody's credit ratings because they believe in the brand. They use it because it is part of a government created oligopoly and, often, because they are required by the law. As a classic oligopolist, Moody's earns exceedingly high margins while paying only the needed lip service to product quality. The real value of Moody's lies in its ability to cow the authorities into preserving its status.

The ratings agencies' lobby is pushing 'reform' through modest changes to the ratings process. Why reform them when we can get rid of them? Are we waiting to blow up the Lunar economy as well? Some wonder what would happen without government sanctioned ratings. It is hard to imagine how things would be any worse.

Even if ratings were free of conflict, the unfixable issue is that the rating system is inherently pro-cyclical and economically destabilizing. When times are good, rating upgrades reduce borrowing costs and contribute to credit bubbltes. The more debt they rate, the more profit they earn. When times are bad, rating downgrades accelerate a negative feedback loop and can be catastophic for entities that rely so much on their credit rating that a rating downgrade jeopardizes their existence. The monoline insureres (Ambac and MBIA) and AIG suffered this fate. This empowers the rating agencies to decide whether a company lives or dies. The rating agencies are sensitive to this responsibility. As a result, they fail to use the downgrade as a warning signal to investors, and when they finally do act, it is often coup de grace.

Regulators can improve the stability of the financial system by eleminating the formal credit rating system.

Credit analysts don't believe in credit ratins; equity analysts do. Moody's share trade at 19x estimated earnings that, wink-wink, they are supposed to beat. Ironically, for a firm that evaluates credit, its balance sheet is upside down, with a negative net worth of $900 million.

That is a lot to pay for a franchise with a socially undesirable product and a shattered brand that exists at a time when the government is considering broad reform in its mission to fix some of the systemic regulatory issues that got our economy into trouble in the first place."

Collapse of AIG

The Selected American Funds (SLADX) took a big hit when their investment in AIG blew up. Despite this mistake, in my opinion, Chris Davis and Ken Feinberg who run the Selected American Fund are very capable and honest managers. They eat their own cooking. The Davis Family, employees, and the directors have over 1.5 billion dollars invested side by side with the shareholders in the funds that their firm manages. They have very low fees for a actively managed funds. They are honest in their communication, and share very candidly their investment successes and more importantly their investment errors. In general, they set a great example for the rest of the mutual fund industry on how to live by their fudiciary responsibilities. So when their investment in AIG blew up, they shared what happened at AIG and why they continued to hang onto AIG as the situation got worse (which in hindsight was a bad idea). Here is an extract from 2009 Q1 manager's commentary:

"By far our largest mistake over the last five years was our investment in American International Group (AIG), which cumulatively detracted roughly 6% from our returns, almost three times as much as any other mistake. In essence, this mistake resulted from our incorrectly assessing three factors: the financial sophistication of management, the leverage of derivatives and the danger of collateral requirements tied to mark-to-market accounting.

Starting with management, the chief executive officer of a complex financial institution also serves as the de facto chief risk officer. He or she must understand the nature and extent of the risks being taken and must have the courage to forgo profits if the risks, however remote, could prove catastrophic. At AIG, the need for a highly capable CEO was accentuated by the diverse business models and risk profiles of its semiautonomous divisions. Unfortunately, the abrupt ouster of its longtime CEO and the promotion of a far less able successor came at the worst possible time. Although this successor had deep experience in the field of property and casualty insurance, the company’s financial operations and risks went far beyond this sector into areas in which new management had virtually no expertise.

The second factor that we–and this new management team–grossly underestimated lay in a relatively small division of AIG called AIG Financial Products. This unit contributed about 5% of total profits, only a small portion of which came from selling a type of highly complex and highly leveraged derivative known as a credit default swap, or CDS. At its heart, a CDS is a type of financial insurance in which a buyer would pay AIG a tiny premium in exchange for coverage against a highly unlikely financial event, such as the default of a triple-A security. In some cases, the premium could be as low as $1 for $1,000 worth of coverage. Unfortunately, many of the triple-A securities that AIG insured were tied to mortgages and presumed that residential real estate prices would never go down substantially. To make matters worse, unlike normal insurance contracts, credit default swaps are marked tomarket, meaning that they are priced not for what the actual losses are today but for what the market estimates the losses will be in the future. This mark-to-market accounting brings us to the third aspect of our mistake.

As the estimated losses on the contracts went up, AIG was required to post cash collateral for the buyers of the swaps. Worse still, the amount of cash collateral was also tied to AIG’s own credit rating. As is now apparent, all the factors were in place for a spiral. Because these contracts assumed virtually no losses, small increases in loss estimates led to huge losses. As these losses mounted, rating agencies became concerned and downgraded the company. Thus, AIG was required to post more collateral for both higher estimated losses and its lower credit rating. Adding to these liquidity demands, the company engaged in a massive securities lending program in which it lent out many of its investments. These loans were themselves collateralized with cash. Unfortunately, rather than simply hold this cash in short-term liquid instruments, the company invested much of it in illiquid, often mortgage-related securities. As nervous customers returned borrowed securities and immediately demanded their cash back, AIG was forced to try to sell these illiquid securities at a time when there were no buyers. In just a matter of months, these liquidity demands exceeded AIG’s available resources. Facing default, AIG asked for government intervention. In exchange for providing the necessary liquidity and guaranteeing or assuming responsibility for a number of assets and liabilities, the government took equity warrants for approximately 80% of the company.

All of the above analysis begs the question: “Why did we continue to hold the shares even as the situation got worse and worse?” The answer is twofold. First, we remained focused on the fact that the company had close to $100 billion of tangible equity, more than $1 trillion in investments and more than $20 billion of pretax earnings from global insurance, leasing and asset management operations. Furthermore, in contrast to a bank, it is difficult to have a run on an insurance company, as policyholders, unlike depositors, generally cannot suddenly take back their premiums. Thus, we thought the company’s powerful diversified earnings, tangible equity and assets would more than cover the losses over time. This thinking ignored three important facts. First, because of the collateral requirements discussed above, the company did not have the luxury of time but needed to come up with the cash immediately. Second, because there had been inadequate disclosure about the massive securities lending operation, the scale and immediacy of the cash requirements were far greater than anyone imagined. Finally, although the company’s financial statements showed a huge amount of liquid assets, most were held in the company’s insurance subsidiaries. As regulated entities, these subsidiaries were not permitted to release the assets to the parent company in order for AIG to meet these collateral calls. As a result, even if these mark-to-market losses proved temporary rather than permanent (as they still could), even if the company’s net worth remained substantial, or even if the company could have earned enough in the next five years to pay the losses as they came due, it still faced bankruptcy as a result of defaulting on the collateral calls.

We will end this discussion with an example of the dangers of this sort of collateral posting requirement. Imagine a homeowner has a $400,000 home with a $300,000 mortgage. Now imagine he earns $100,000 per year of which he uses $50,000 for living expenses, leaving $50,000 to service the mortgage. If we add to this example as a given that this person will never move and will never lose his job, it would seem that the mortgage is virtually risk free. But if we change one feature that on its face seems minor, we completely alter the risk profile. Specifically, imagine that the mortgage requires that if the estimated price at which the house could be sold on any given day falls below $300,000, the homeowner must put the shortfall in an escrow account or face eviction. Now, even if the homeowner could service this mortgage forever and even pay it down completely over time with no risk to the bank, he could still be bankrupted by having to mark his house to market and post collateral. It was this type of liquidity risk that, in a matter of months, brought down what had been the most profitable and highly valued insurance company in the world."

Why is your checking account "free"?

I am currently reading an amazing book on behaviorial finance "Predictably Irrational" by a Duke professor Dan Ariely. Harper published a revised and updated version of the book in 2009. It includes a new chapter on the financial meltdown from a behaviorial finance perspective. He uses an interesting illustration to point out how insurance and banks operate in a way to take advantage of those who are already at financial risk.

"Think, for example, about the 'perk' of free checking that the banks so generously provide us. You might think that banks lose money by offering free checking, because it costs them something to manage the accounts. Actually, they make huge amounts of money on mistakes: charging very high penalties for bounced checks, overdrafts, and debit card charges that exceed the amount in our checking accounts. In essense, the banks use these penalties to subsidize the 'free checking' for the people who have sufficient amounts of cash in their checking accounts and who are not as likely to bounce a check or overdraw with their debit cards. In other words, those living from paycheck to paycheck end up subsidizing the system for everyone else: the poor pay for the wealthy, and the banks make billions in the process.

Now does the usary of the banks end there. Imagine that it is the last day of the month and you have $20 in your checking account. Your $2,000 salary will be automatically deposited into your bank today. You walk down the street and buy yourself a $2.95 ice cream cone. Later you also yourself a copy of the book Predictably Irrational for $27.99, and an hour later you treat yourself to $2.50 caffe latte. You pay for everything with a debit card, and you feel good about the day - it is payday, after all.

That night, sometime after midnight, the bank settles your account for the day. Instead of depositing your salary and then charging you for the three purchases, the bank does the opposite and you are hit with overdraft fees. You would think this would be enough punishment, but the banks are more nefarious. They use an algorithm that charges the most expensive item (the book) first. Boom - you are over your available cash and are charged a $35 overdraft fee. The ice cream and the latte come next, each with its own $35 overdraft fee. A split second later, your salary is deposited and you are back in the black - but $105 poorer."

What is a credit default swap (CDS) ?

A credit default swap (CDS) is a financial instrument originally invented to insure the owner of a bond against default. They exploded in popularity and were the cause of one of the greatest bubbles. The 50 employees at AIG's Financial Product division creating and trading CDS brought the insurance giant (120,000 employees) to its knees in 2008. Frank Martin at MCM Advisors in his 2008 annual report explains this exotic financial instrument through the 'HDS Fable':

Flash back to 2006 and engage your imagination regarding a particular house. Suppose, if you will, that 50 neighbors have become infected by the speculative virus. The ingenious neighbors concoct what becomes an active market in HDS (home destruction swaps), buying and selling contracts, essentially taking both sides of the bet that the house will go up in flames. Those who think an accident is likely pay insurance-like annual premiums to those willing to hold the opposite view. For a contract to come into existence there must be both a buyer of risk insurance and a seller who is willing to underwrite the risk. Although there is only one house at risk, the number of contracts outstanding is limited only by the number of parties willing to enter into a swap agreement related to that particular house. Unlike a conventional homeowner’s insurance policy with a limit of one per house, these synthetic policies have no such limits. When the speculative appetite is well nigh insatiable, they multiply like rabbits (but it’s hare today, gone tomorrow). Always thinking of new ways to make their money work harder, the swap sellers, those willing to underwrite the risk that the house will be destroyed, put their proceeds to work in the rising stock market. Likewise disposed, buyers pay their premiums with money borrowed at the local bank. Everyone knows that financial leverage amplifies returns (although they conveniently forget that it has the same effect on risk). Suddenly circumstances change. The house is sold and immediately a rumor spreads that the new owner is building a potentially explosive meth lab in the basement. As the perception of risk of fire rises sharply, the protection sellers are taking huge paper losses, while the buyers are racking up big gains. The buyers naturally want to cash in their gains and reduce their debt. But the sellers can’t close out their positions at the new price. And since this is a small and transparent market, other potential buyers have no interest, because the sellers are too weak a “counterparty.” And bankers are making collateral calls on their loans. Thus the buyers of the HDS contracts discover to their dismay the meaning of “counterparty risk.” Now, suppose there’s a modest stock market downturn, just as the HDS buyers’ banks are haircutting the nominal paper gains on their HDS. The bankers will start calling for more collateral for their margin loans, which many buyers can’t meet. The sellers, of course, are in even worse shape; they’re taking paper losses, and their stockbrokers have adopted much more aggressive tones. Both buyers and sellers may end up bankrupt. And so the fable ends with the meth lab madman in jail, the innocuous little house, the object of so much reckless risk taking, still standing. Though the structure didn’t collapse as expected, it was in a very real sense a house of cards—as the 50 speculators discovered to their chagrin. Left in the wake of the massive speculative episode where risk was created out of thin air are 50 financially and otherwise devastated families. The inebriate who insisted on smoking in bed, source of the comparatively insignificant original “risk” upon which the mania took root, never had a hint of what was going on in the neighborhood around him.

Market Ineffeciency

Value investing is based on the availability of mispricing of securities. It is important to understand the source of these inefficiencies. The financial market today is dominated by professionals that manage money for other individuals and institutions. It is the institutional imperative of these professionals that give rise to most of the market inefficiencies from time to time. One of the best explanations of this imperative I have read is by Jeremy Grantham at GMO in his letter to investment committee in Oct 2004:

Everything important about markets is ‘mean reverting’ or, if you prefer, wanders around a trend. Prices are pushed away from fair price by a series of “inefficiencies” and eventually dragged back by the logic of value.

In markets where investors hand over their money to professionals, the major inefficiency becomes career risk. Everyone’s ultimate job description becomes “keep your job.” Career risk reduction takes precedence over maximizing the clients’ return. Efficient career risk management means never being wrong on your own, so herding, perhaps for different reasons, also characterizes professional investing. Herding produces momentum in prices, pushing them further away from fair value as people buy because others are buying.

Prices are eventually pulled back to fair price by the need for the return of each asset class to relate sensibly to its risk. This is the force that exercises a persistent gravitational pull on inefficient prices and this force is generally described as ‘value’. An investor in equities in the ultra cheap markets of 1982 or 1945 who is receiving 10% or 20% a year real return for owning equities will sooner or later get a lot of company to bid down the returns. Conversely, all investors in 2000 faced with a market p/e of 33x, and an embedded return of under 3% a year while bearing full equity risk, will eventually lose heart and sell. A mix of behavioral inefficiencies and value based efficiencies means that bubbles will form and all of them will break.

The problem with bubbles breaking and going back to trend is that some do it quickly and some slowly. So at extremes you will always know what will happen but never when. You will know something certain about the indefinite future, but usually nothing material about the immediate future. This is why asset class prices resemble feathers in a hurricane – all certain to hit the ground, but lord knows when. If the timing was also knowable, it would be an arbitrageable situation: if you knew what would happen and when, then, like a Star Trek “paradox,” it would be anticipated and could, therefore, never occur.

But not knowing the timing creates critical career and business risk, which has molded the business of investing. If you are smarter than most and want to take no career risk, then anticipate other players and be quicker and slicker in execution, or as Keynes said, “beat them on the draw.” Refusing on value principles to buy in a bubble will, in contrast, look dangerously eccentric and when your timing is wrong, which is inevitable sooner or later, you will, in Keynes’s words, “not receive much mercy.”

The more the investment industry has become specialized and the more carefully benchmark deviations are measured, the greater the career risk of moving outside your narrow style. This has weakened the arbitrage mechanism and guaranteed increasingly larger and longer market distortions. Today the challenge is not getting the big bets right, it’s arriving back at trend with the same clients you left with, and GMO, for sure, has not solved this problem. The key investment task is to structure a firm where you can make more of these long-term mean reverting bets and live to tell the tale.

The good news is that human nature, which leaves its mark on all financial markets, will never change and we will always have these great opportunities to make money and have dangerous careers.

Or if you prefer serious brevity ...

Waiting for the Right Pitch

This discipline is one of the most important characteristic that distinguishes the value investors from other market participants and the value pretenders. Here is an extract from Seth Klarman's Margin of Safety Chapter 6. By now, you can tell that I am huge fan of this book. This is the equivalent of Ben Graham's Security Analysis updated for the current times, and the lessons I have learnt by reading and re-reading this book over and over again are invaluable.

Warren Buffet uses a baseball analogy to articulate the discipline of value investors. A long-term oriented value investor is a batter in a game where no balls or strikes are called, allowing dozens, even hundreds, of pitches to go by, including many at which other batters would swing. Value investors are students of the game; they learn from every pitch, those at which they swing and those they let pass by. They are not influenced by the way others are performing; they are motivated by their own results. They have infinite patience and are willing to wait until they are thrown a pitch they can handle-an undervalued investment opportunity

Value investors will not invest in businesses that they cannot readily understand or ones they find excessively risky

Most institutional investors, unlike value investors, feel compelled to be fully invested at all times. They act as if the umpire were calling balls and strikes - mostly stikes - thereby forcing them to swing at almost every pitch and forego batting selectively for frequency. Many individual investors, like amateur ballplayers, simply can't distinguish a good pitch from a wild one. Both undiscriminating individuals and constrained institutional investors can take solace from knowing that most market participants feel compelled to swing just as frequently as they do

For a value investor a pitch must not only be in a strike zone, it must be in "sweet spot." Results will be best when the investor is not pressured to invest prematurely. There may be times when the investor does not lift his bat from the shoulder; the cheapest security in an overvalued market may still be overvalued. You wouldn't want to settle for an investment offering a safe 10% return if you thought it very likely that another offering an equally safe 15% return would materialize soon.

An investment must be purchased at a discount from underlying worth. This makes it a good absolute value. Being a good absolute value alone, however, is not sufficient for investors must choose only the best absolute values among those that are currently available. This dual discipline compounds the difficulty of the investment task for value investors compared with most others.

Value investors continually compare potential new investments with their current holdings in order to ensure that they own only the most undervalued opportunities available. Investors should never be afraid to reexamine current holdings as new opportunities appear, even if that means realizing losses on the sale of current holdings. In other words, no investment should be considered sacred when a better one comes along.

Sometimes dozens of good pitches are thrown consecutively to a value investor. In panicky markets, for example, the number of undervalued securities increases and the degree of undervaluation grows. In buoyant markets, by contrast, both the number of undervalued securities and their degree of undervaluation declines. When attractive opportunities are plentiful, value investors are able to sift carefully through all the bargains they find most attractive. When attractive opportunities are scarce, however, investors must exhibit great self-discipline in order to maintain the integrity of the valuation process and limit the price paid. Above all, investors must always avoid swinging at bad pitches.

Margin of Safety

So, how exactly do we implement Buffet's Two Rules of Investing. This brings us to another important concept of value investing called "margin of safety". I am quoting from Chapter 6 of the book "Margin Of Safety" by Seth Klarman:

Benjamin Graham understood that an asset or business worth $1 today may be worth 75 cents or $1.25 in the near future. He also understood that he might be wrong about today's value. Therefore Graham had no interest in paying $1 for $1 of value. There was no advantage in doing so, and losses could result. Graham was only interested in buying at a substantial discount from underlying value. By investing at a discount, he knew that he was unlikely to experience losses. The discount provided a margin of safety.

Because investing is as much an art as a science, investors need a margin of safety. A margin of safety is achieved when securities are purchased at prices sufficiently below underlying value to allow for human error (of estimation of value), bad luck, or extreme volatility in a complex, unpredictable, and rapidly changing world. According to Graham, "The margin of safety is always dependent on the price paid. For any security, it will be large at one price, small at some higher price, nonexistent at some higher price."

Buffet described the margin of safety concept in terms of tolerances: "When you build a bridge, you insist it can carry 30,000 pounds, but you only drive 10,000-pound trucks across it. And that same principle works in investing."

Most investors do not seek a margin of safety in their holdings. Institutional investors who buy stocks as pieces of paper to be traded and who remain fully invested at all times fail to achieve margin of safety. Greedy individual investors who follow market trends and fads are in the same boat. The only margin investors who purchase Wall Street underwritings or financial-market innovations usually experience is the margin of peril

Buffet, in his 1990 letter to shareholders, says the following:

In the final chapter of the book The Intelligent Investor Ben Graham forcefully rejected the dagger thesis: "Contronted with a challenge to distill the secret of sound investment into three words, we venture the motto, Margin of Safety." Forty-two years after reading that, I still think those are the right words. The failure of investors to heed this simple message caused them staggering losses ...

Buffet's Two Rules of Investing

Once we understand how to think about the market using Ben Graham's Mr. Market analogy, the next important lesson, I believe, is to remember Warren Buffet's two rules of investing.
1) Never lose money.
2) Do not forget the first rule.

To appreciate these rules better, I am quoting from Chapter 5 of the book "Margin Of Safety". This book is rare and out-of-print. It is written by another legendary value investor, Seth Klarman. So here is what is says:

Avoiding loss should be the the primary goal of every investor. This does not mean that investors should never incur the risk of any loss at all. Rather "don't lose money" means that over several years an investment portfolio should not be exposed to appreciable loss of capital.

While no one wishes to incur losses, you couldn't prove it from an examination of the behavior of most investors and speculators. The speculative urge that lies within most of us is strong; the prospect of free lunch can be compelling, especially when others have already seemingly partaken. It can be hard to concentrate on losses when others are greedily reaching for gains and your broker is on the phone offering shares in the latest "hot" initial public offering. Yet the avoidance of loss is the surest way to ensure a profitable outcome.

Greedy, short-term oriented investors may lose sight of a sound mathematical reason for avoiding loss: the effects of compounding even moderate returns over many years are compelling, if not downright mind boggling. Table below shows the delightful effects of compounding even small amounts. Shown below is the compounded value of $1000 invested at different rates or return and for varying durations.

Rate	5 years	10 years	20 years	30 years
6%	1338	1791	3207	5743
8%	1469	2159	4661	10063
10%	1611	2594	6727	17449
12%	1762	31p6	9646	29960
16%	2100	4411	19461	85850
20%	2488	6192	38338	237376

As the table illustrates, perserverance at even relatively moderate rates of return is of utmost importance in compounding your net worth. A corollary to the importance of compounding is that it is very difficult to recover from even one large loss which could literally destroy all at once the beneficial effects of many years of investment success. In other words, an investor is more likely to do well by achieving consistently good returns with limited downside risk than by achieving volatile and sometimes even spectacular gains with considerable risk of principal. An investor who earns 16 percent annual returns over a decade, for example, will, perhaps surprisingly, end up with more money than an investor who earns 20 percent a year for nine years and then loses 15 percent the tenth year.

There is an understandable, albeit uneconomic, appeal to the latter pattern of returns, however. The second investor will outperform the former nine years out of ten, gaining considerable psychic income from this apparently superior performance. If both investors are money management professionals, the latter may also have a happier clientele (90 percent of the time, they will be doing better) and thus a more successful company. This may help to explain why risk avoidance (and hence value investing) is not the primary focus of most institutional investors.

Ben Graham's Mr Market

This is my first post on this blog. I hope to use this blog to put in written words lessons I am learning about finance, investing, economics, and multi-disciplinary thinking. No better place to start than with one of the most important lessons, in my opinion, of investing.

Warren Buffet, the legendary value investor, in his 1987 letter to shareholders has said the following:

Whenever Charlie and I buy common stocks for Berkshire's insurance companies we approach the transaction as if we were buying into a private business. We look at the economic prospects of the business, the people in charge of running it, and the price we must pay. We do not have in mind any time or price for sale. Indeed, we are willing to hold a stock indefinitely so long as we expect the business to increase in intrinsic value at a satifactory rate. When investing, we view ourselves as business analysts, not as macroeconomic analysts, and not even as security analysts.

Our approach makes an active trading market useful, since it periodically presents us with mouth-watering opportunities. But by no means is it essential: a prolonged suspension of trading in the securities we hold would not bother us any more than does the lack of daily quotation. Eventually our economic fate will be determined by the economic fate of the business we own, whether our ownership is partial or total.

Ben Graham, my friend and teacher, long ago described the mental attitude toward market fluctuations that I believe to be most conducive to investment success. He said that you should imagine market quotations as coming from a remarkably accommodating fellow named Mr. Market who is your partner in a private business. Without fail, Mr. Market appears daily and names a price at which he will either buy your interest or sell you his.

Even though the business that the two of you own may have economic characteristics that are stable, Mr. Market's quotations will be anything but. For, sad to say, the poor fellow has incurable emotional problems. At times he feels euphoric and can see only the favorable factors affecting the business. When in that mood, he names a very high buy-sell price because he fears that you will snap up his interest and rob him of immenent gains. At other times he is depressed and can see nothing but trouble ahead for both the business and the world. On these occasions he will name a very low price, since he is terrified that you will unload your interest on him

Mr. Market has another characteristic: He doesn't mind being ignored. If his quotation is uninteresting to you today, he will be back with a new one tomorrow. Transactions are strictly at your option. Under these conditions, the more manic-depressive his behavior, the better for you.

But, like Cindrella at the ball, you must heed one warning or everything will turn into pumpkins and mice: Mr. Market is there to serve you, not to guide you. It is his pocketbook, not his wisdom that you will find useful. If he shows up some day in a particularly foolish mood, you are free to ignore him or to take advantage of him, but it will be disastrous if you fall under his influence. Indeed, if you aren't certain that you understand and can value your business far better than Mr. Market you don't belong in the game. As they say in poker, if you've been in the game 30 minutes and you don't know who the patsy is, you're the patsy.

Following Ben's teachings, Charlie and I let our marketable equities tell us by their operating results - not by their daily, or even yearly, price quotations - whether our investments are successful. The market may ignore business success for a while, but eventually will confirm it. As Ben said: In the short run, the market is a voting machine but in the long run it is a weighing machine. The speed at which a business's success is recognized, furthermore, is not that important as long as the company's intrinsic value is increasing at a satisfactory rate. In fact, delayed recognition can be an advantage: It may give us the chance to buy more of a good thing at a bargain price.