Saturday, March 8, 2008 0 comments ++[ CLICK TO COMMENT ]++

Newbie Lesson: When Good Guys Finish Last

Some superinvestors like Walter Schloss avoid debt like the plague. I can see why. Schloss likely is mainly referring to industrial companies with debt but my thought is about financial companies in a similar predicament.

One of the lessons to be learned from the current credit crunch is that having good assets may mean almost nothing. If you are leveraged too much, and dependent on lenders, you can go up in flames quite easily. Two current examples are the Tequesta hedge fund and Thornburg Mortgage, mortgage REIT. Both of these seem to be well-run operations that completely avoided risky subprime assets. Thornburg originates and services high-quality jumbo mortgages targetted at higher-income borrowers. Tequesta is an investment fund that invests in high-quality super-jumbo mortgages. Fundamentally, the jumbo mortgages have not deteriorated like subprime mortgages, and the default rate is not worrisome.

Yet, both of these, the mortgage REIT and the hedge fund, are on the verge of collapse because of margin calls. The problem is that, although the assets held by these companies are solid, they used leverage. Furthermore, although the underlying assets seem to be solid, their markets are illiquid and the mark-to-market prices are deteriorating (similar problem as monolines except monolines only pay out real losses and don't use margin or much debt). When you borrow money, you are at the mercy of lenders. The banks and investment banks who loaned the money are facing credit problems on their own so they are getting strict. Ironically, one might be better off with poor assets than good assets in this case. The lenders are less likely to call the loan and sell off your assets if they are not worth much; whereas they are likely to seize high quality assets.

This is one reason even Warren Buffett avoids margin. Buffett has said the only time he thinks it makes sense to use margin is when doing risk arbitrage. I will note, however, that Buffett has used long-term debt to finance his investments in the past. Avoiding leverage is also why Buffett has seemingly lower returns than many hedge funds or even amateur investors. I was initially surprised to see that some hedge funds, not to mention amateur investors posting on message boards or blogs, have returns of 30%+ per year for 5+ years. I wondered how they can be better than Buffett (even during his better days a few decades ago). Well, the reason I realized is that they are leveraging their returns. Someone leveraging a 10% return to 30% may be floating on air during the good times; but when dark clouds gather, they can fail spectacularly.

My impression is that both Thornburg and Tequesta, which seem to have successfully navigated past the subprime problems, are on their deathbed partly due to by mark-to-market accounting. Mark-to-market accounting is going to be the one of the big casulties of the current credit crisis (I'm not the only one that shares that view either).

To sum up, one takeaway from all this is to be careful with leverage. The other key thing is that it doesn't matter how good your company or its assets are. If lenders/bondholders/creditors/etc come knocking, what matters is how liquid your assets are.


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