Opinion: General Motors becomes Government Motors

What seemed inevitable five months ago is finally about to occur. General Motors, once the largest corporation in America, the largest employer, and the first one to make $1 billion (1955), is about to enter bankruptcy. I always felt that bankruptcy was inevitable due to the conflicting interests of various parties (such as current employees, retired workers, shareholders, bondholders, auto dealers, and governments.)

Like most liberal governments, the Obama administration tried its best to avoid bankruptcy but was unable to do so. My Canadian government also pumped money into these failing enterprises with questionable results. I think what the US government attempted was fine, but I would have liked to see less heavy-handedness directed towards the bondholders (the GM bondholder situation doesn't seem so bad since all of them are supposedly unsecured creditors, but the Chrysler situation where the US government was playing hardball with secured bondholders hurts everyone in the long run.) Overall, contrary to what some critics on the right have suggested, even though the government was favouring retirees at the expense of bondholders, I don't think the government trampled property rights. The GM case, as well as Chrysler, will be ultimately decided by the courts so anyone (with resources) can challenge the government if they wanted to. Since I generally have faith in the independence of America's courts, I think the courts will rule against the government if it was genuinely violating property rights.

GM Has Support of Bondholders

The GM bankruptcy will essentially be a pre-packaged bankruptcy so it is likely to re-emerge within an year. The New York Times is reporting that GM has secured support from more than 50% of the bondholders:

Over the weekend, G.M. cleared a couple of obstacles to a court reorganization. Late Saturday, a majority of G.M. bondholders agreed to exchange their debt in exchange for an ownership stake as high as 25 percent in G.M.

Holders of about 54 percent of G.M.’s $27.2 billion in bond debt, agreed to support the plan by the Saturday afternoon deadline, according to Elliot Sloane, a spokesman for a committee representing some of G.M.’s largest bondholders, which negotiated the deal with the government. All told, 975 investors expressed support for the plan.

Mr. Sloane said that 20 percent of the support came from the ad hoc bondholders committee, another 15 percent came from bondholders who had backed earlier G.M. offers and 19 percent from investors who got on board between Thursday and Saturday.

But groups representing some of G.M.’s retail bondholders — individual investors who purchased the company’s bonds for as little as $25 a piece — said they still planned to contest the reorganization plan...It is not known how many of these individual investors there are, but some estimates place their holdings of G.M.’s $27.2 billion in bonds at more than 25 percent.

Retail investors—people like you and me—are not supporting the deal but I am not sure they have much of a case. You have to keep in mind that some people will complain just because they lost money—some would have purchased GM bonds 5 or 10 years ago assuming that there is no way GM would go bankrupt. We, as capitalists, should dismiss this argument. If someone loses money on their investments by misreading the future of a company, that's their problem. Ignoring that, there are two issues that are worth talking about.

First of all, some seem disgruntled that a big chunk is going to employees (specially health care trust for retirees). I'm not a lawyer and I could be completely wrong but my understanding is that retiree obligations (such as pensions or promised healthcare) have high precedence. A company cannot just ignore pension obligations (this case is really about healthcare obligations but I suspect it is similar to pension obligations.) GM has massive retiree obligations (not sure how much is unfunded) and I think a court of law would likely give a big chunk of the ownership of GM to cover these obligations. So, even though bondholders are unhappy, the payout to the retirees would likely have occurred anyway.

The second issue, and the one that is probably a legitimate concern, is the fact the bondholders are ending up with far less than anyone would have thought even 2 years ago. The reason, it seems, is because the government is taking a huge stake in the company. Instead of GM being divided up largely between the pensioners and the bondholders, a majority stake is going to the government. This has occurred because the government provided emergency funding that has high seniority compared to the unsecured bonds. If GM had gone straight into bankruptcy, the portion given away to the government (or anyone) providing emergency funding would likely have been smaller. If the government wasn't involved, it is also possible that the company would have been tougher with employees and possibly extracted more concessions. However, one of the key reasons the government involved in the first place is due to the concern that GM would end up liquidating itself rather than re-structuring due to lack of bankruptcy funding. The credit markets did lock up late last year, and it wouldn't have been easy to fund up to $50 billion, so maybe it was proper for the government to be the sole capital provider.

I, as an investor, would have made a mistake in the second point above. Like other retail investors, I never would have imagined that whoever that was providing bankruptcy funding would have to inject so much capital. Just goes to show how much of a newbie I am when it comes to bankruptcy (admittedly, part of the problem is the lock up in the credit markets and the collapse of auto sales and not many could have forecast the scope of such events.)

Post-bankruptcy Ownership Structure

The New York Times has the following on the ownership structure of the new GM that will emerge from bankruptcy:

In a regulatory filing last week, G.M. said the government, which is to provide bankruptcy financing of about $50 billion, initially would hold 72.5 percent of G.M., with the United Automobile Workers union receiving 17.5 percent, and bondholders 10 percent.

But the percentages held by the bondholders and the union could conceivably be larger because each are being offered warrants in the new G.M., which would be created in bankruptcy.

Under the terms of the plan, bondholders would initially receive 10 percent. They could then exercise their warrants for an additional 7.5 percent when the new G.M. rises to about $15 billion in value. The second set of warrants for the final 7.5 percent would be exercisable when new G.M. rises to $30 billion in value.

The union would initially receive a 17.5 percent stake to finance a health care trust for its retirees. It has also received warrants to raise that holding to 20 percent — but those warrants are exercisable only if new G.M.’s value hits $75 billion.

Once the union and bondholders achieve their full stakes, the government’s share would drop to 55 percent.

Well, it's Government Motors then ;) It looks like the government will own 72.5%, while the employee union owns 17.5% and the bondholders get 10%. However, the bondholders will own another maximum of 15% if the value of the company rises to $30 billion. The retiree trust run by the union will get warrants worth an additional 2.5% if the value of the company rises to $75 billion.

Cursory look seems to imply that current shareholders will get nothing. It is also not clear if the new company will be publicly listed (and if it is, I'm not sure who is going to sell their stake to the public.) It also remains to be seen if any of the warrants will be publicly traded (although it wouldn't surprise me if it shows up on the OTC Pink Sheets market.)

Government Ownership is Undesirable

The government owning General Motors is not a good thing for America (or even Canada.) Governments are inefficient by design—due to democracy—and they likely won't do a good job running a massive automaker like this.

Perhaps the worst impact of government ownership is the impact on competitors. Non-government automakers may have difficulties competing. On top of direct manipulation of laws that impact automakers, governments can severely hurt competitors by undertaking uneconomic decisions. For example, if GM introduces a car and it is not selling well, the government can simply get various branches of the government to buy them. The economies of scale provided by such large purchases by government divisions may turn the car into a profitable one. But how is Ford or Toyota supposed to compete against that? I'm not saying that is what is going to happen but just pointing out why it is preferable to have less government ownership, especially for consumer discretionary items.

Now, one can argue that manufacturing is rarely a true free market. Just like how the Chinese government manipulates the free market to favour its manufacturers, the same thing sort of happens in the auto industry. Toyota, for instance, doesn't pay healthcare costs whereas GM in America does (in Canada it doesn't pay either.) Obviously this is because healthcare is socialized in Japan, Canada, and most European countries (probably including big auto manufacturing countries like Germany.) It's not a coincidence that a big part of the problem for American auto manufacturers is healthcare costs. So, auto manufacturing is not exactly a true free market—nothing is a true free market. Nevertheless, America provides a beacon for capitalism and government ownership tarnishes the image.

A Looming Problem

There is another serious problem with government involvement in auto manufacturing. One will notice that almost every government out there is trying to protect every auto manufacturer out there. Those that are gravely affected—this indirectly includes people like me in Ontario since we depend on auto manufacturing for a big chunk of our economy—would prefer to keep the companies from disappearing. But the reality is that, crises are the symptoms of economic re-structuring.

I hope I'm wrong but I have a feeling that there is an overcapacity in auto manufacturing in North America (yes this is just a guess on my part.) Not only that, but we may also be looking at the start of a decline in auto consumption over the next few decades. As the baby boomers, who not only saw the emergence of the auto culture but also are wealthier than my generation or any of the younger ones, retire, I suspect car ownership will decline. It is possible that we may enter a slow, secular, decline in auto ownership. (However, note that there are many other factors that can influence this, including fuel costs, cost of a car, urbanization rate, and so on.)

Government actions are simply promoting the overcapacity problem. By keeping alive too many auto manufacturers, it is possible that the auto industry may end up like the airline industry—too many airlines with many ending up unprofitable and with poor service. (However, while overcapacity is bad for the owners and the industry in general, it's good for consumers since it will drive down prices.)

General Motors has become Government Motors... I hope it reverts back to General Motors sooner rather than later.


Sunday Spectacle XI

United States government bond — risk-free you say?

(Illustration by S. Kambayashi for The Economist. Not so risk-free. May 28th of 2009.)

Saturday, May 30, 2009 0 comments ++[ CLICK TO COMMENT ]++

Anyone know how the Japanese govt finances their debt at a lower rate than America?

Dave, in a post on his blog, wondered how the Japanese government manages to finance their debt at a lower yield than America, even though it has a lower credit rating and has a far higher debt as percent of GDP:

I've wondered for some time about why Japan has so much lower borrowing costs than the U.S., despite having a lower sovereign debt rating and a much higher ratio of debt to GDP, but I haven't heard a convincing explanation yet.

I'm not an economist and don't work in the industry but here is the guess I responded with (I added more here):

I suspect it is because something like 90% of the government debt is owned by individuals. As for why individuals choose to invest at such low returns, that's hard to say. I imagine it's because bonds have outperformed all other major assets (such as stocks and real estate). It should also be noted that Japan was experiencing a major bull market in bonds so retail investors had a huge incentive to own bonds.

Another thing to note is that real yields aren't that different in Japan. Given their near-zero, and indeed periodically negative, inflation, Japanese investors were probably earning the same real return as anyone investing in American bonds in the last decade. As a rough example, without me looking up actual numbers, a Japanese investor probably earned 2% real return (say 1.5% yield plus +0.5% from deflation) while an American bondholder may have been earning 2% due to a 4.5% yield and -2.5% from inflation (I'm ignoring fluctuations in currency here--if you are actually investing, you should think hard about potential currency movements.)

Anyway, enough with my guesses. Does anyone reading this know how the Japanese government manages to issue bonds at lower interest rates than the American government?


US stimulus plans becoming difficult as bond yields rise

There has been a huge rally in bond yields in the last few weeks. This will make the stimulus plans being initiated by the US Treasury and Federal Reserve more difficult (it will be even worse for other countries with weaker credit, such as Britain.) Perhaps the biggest impact of rising yields will be on the housing market (since mortgage rates will rise.) The corporate sector will also be impacted but so far things look good, with big appetite for junk bonds during the recent rally.

It'll be interesting to see what comes of all this. I personally have no idea if the bond sell-off is simply due to the improving economy (bonds are less attractive if economy is strong) or if it is due to bond investors signalling their displeasure with government policies (and potential for higher inflation.) Bloomberg has an article on the return of the bond vigilantes:

For the first time since another Democrat occupied the White House, investors from Beijing to Zurich are challenging a president’s attempts to revive the economy with record deficit spending. Fifteen years after forcing Bill Clinton to abandon his own stimulus plans, the so-called bond vigilantes are punishing Barack Obama for quadrupling the budget shortfall to $1.85 trillion. By driving up yields on U.S. debt, they are also threatening to derail Federal Reserve Chairman Ben S. Bernanke’s efforts to cut borrowing costs for businesses and consumers.

The 1.5-percentage-point rise in 10-year Treasury yields this year pushed interest rates on 30-year fixed mortgages to above 5 percent for the first time since before Bernanke announced on March 18 that the central bank would start printing money to buy financial assets. Treasuries have lost 5.1 percent in their worst annual start since Merrill Lynch & Co. began its Treasury Master Index in 1977.

“The bond-market vigilantes are up in arms over the outlook for the federal deficit,” said Edward Yardeni, who coined the term in 1984 to describe investors who protest monetary or fiscal policies they consider inflationary by selling bonds. He now heads Yardeni Research Inc. in Great Neck, New York.

Thursday, May 28, 2009 1 comments ++[ CLICK TO COMMENT ]++

Marc Faber interview with Bloomberg

Marc Faber is famous for saying controversial things. But since he is an obscure investor, no one really makes a big deal out of it, or even hears about it. Thanks for Naked Capitalism for originally mentioning a Bloomberg interview, which you can access here (approx 20 min interview.)

This time around he is quoted as saying there is a 100% probability of USA facing hyperinflation, just a tad bit below modern Zimbabwe. I don't always agree with what he saying and this is one comment that I disagree on.

Marc Faber also said earlier this year (or maybe last year) that the 'Warren Buffett way of investing' is dead (due to the bear market.) So value investors may want to skip him; but for others, check out my quick notes with my opinion thrown in...

  • Japan... "country of perfection"... some Japanese companies will do very well and be shareholder friendly... as a country, long term doesn't look so good... but Faber says he would go long for next 5 years and think it will outperform other countries... He also says that the low bond yields will help but my view is that Japanese companies haven't been able to use cheap financing to produce much shareholder wealth in the last 20 years. Perhas the most notable thing about Japan in business books of the future will be how businesspeople were unable to produce much profit even though they could literally borrow at 1%.
  • Says Asian region most attractive. I personally am not sold on Asia in the short to medium term. My conern is the potential for China to run into seriou problems.
  • (Not investment-related) A controversial view with nuclear weapons. He is in favour of no one having nuclear weapons or everyone having it... doesn't like the Western view that the West and a select few should have it but others should not... I agree that the only way to get rid of grave threats to humanity from weapons is to completely ban it everywhere or else it will never work. For instance, consider a hypothetical scenario in 50 years. If USA, acting for "the West", develops biological weapons while saying no one else, let alone so-called rogue nations, should have such weapons, will it happen? Of course not. China will develop the weapons as well, since USA is a threat to it. Then you will get India developing it too, since China is a threat. Then you will get Pakistan attempting to develop it as well, since India is a threat to it. Iran, which is generally hostile to Pakistan, will also attempt to develop it. And so on. The proliferation of nuclear weapons can only be stopped if everyone bans it. Then it will be considered "evil" by all humans and it can be dealt with--sort of like how slavery is considered evil and no state, including poor ones that may want to engage in it, do not (I will note, however, that non-state actor, such as criminal enterprises, do practice slavery (particularly in some parts of Africa; and sexual slavery is practiced in dark corners all over the world.)
  • (Not investment-related) Says next war may be biological and strategic terrorism such as poisoning water supplies. I personally don't think biological warfare is anywhere near reality. Nuclear weapons are still the biggest imediate threat. As for increased terrorism, it's possible. The "worst" result of mass terrorist incidents will not necessarily be the injured and lost lives. Instead, it will result in liberties being stripped. This will significantly curb immigration, as well as free trade. Flow of goods and trade will take a huge blow.
  • Doesn't think we'll make new lows this year... says government will print even more money if stocks come under pressure. I think it's misleading to say that governments are printing a lot of money. They aren't. Most of the capital injections and spending is coming from debt issuance. This isn't inflationary. However, it is possible that governments may start printing en masse if they can't issue debt. I actually don't think the problem will be in USA. USA is the richest (major) country and it is an attractive destination so it won't have any problems. But it may crowd out other countries and others may have to monetize debt. Countries like Britain can easily face financing problems. Others like Spain and Ireland may also face huge problems depending on whether EU will bail them out...
  • Thinks we are in a period of high volatility and will see huge moves every year.
  • Marc Faber says markets are not cheap.
  • US won't default but "100% sure US will go into hyperinflation". Not exactly Zimbabwe inflation but says close to it. Yikes :| Highly controversial comment and I wonder if Faber wishes he hadn't said it. This is going to bite him in the future. I definitely don't think USA is looking at somewhat-less-than-Zimbabwe hyperinflation. I don't even think such a probability is over 25% (except in a trade war with China or some similar scenario.)
  • In addressing deflation, which he obviously doesn't believe in, he says that if you are determined to create inflation, he implies it can be done. This is the view of Ben Bernanke as well. I, believe it or not, do not share this view. IANAE and I am not sure this is as easy as it seems.
  • Says gold not a great investment now; thinks equities will outperform. This is a major contrarian call. Goldbugs and those bullish on gold assume that high inflation, which is what Faber believes will occur, means that gold will skyrocket. Faber isn't so sure.
  • Australia will become more Asia-centric rather than the current US-centric nature
  • Believes in peak oil but says it doesn't necessarily mean this means prices will go up in the near term. Comment got interrupted and I'm not sure where he was going with this...
  • Natural gas very undervalued... I mentioned a few months (or maybe weeks) ago that natgas is attractive strictly from a contrarian point of view. However, the things to keep in mind about natgas are: (i) it is very localized, (ii) fundamentals seem bearish. On the first point, it should be noted that natgas is generally not transported across the planet, like oil is. What is produced in North America is consumed in North America and so on (there is some growth in LNG but that is still a small portion.) As for the fundamentals, natgas demand looks to remain weak given how industrial production is low (many manufacturers use natgas to some degree). Furthermore, LNG imports, which are a new thing, are increasing. Cost of production in places like Qatar or Russia are often lower than in North America. Having said all that, natgas is attractive strictly from a contrarian point of view. That is to say, natgas and natgas producers can rise even in the face of poor fundamentals if they are severely undervalued (for example, homebuilders (e.g. XHB, an ETF) are up 30% to 50% from the March low even though fundamentals are still horrible, simply because the market is betting that they are undervalued.)


Sunday Spectacle X

(source: China Daily. November 15, 2007)


Articles for the week ending May 23, 2009

Some articles that you may find interesting, in no particular order:

  • Which economic indicators are important? (The Globe & Mail): A nice article that speculates on economic indicators that are useful, and those that may not be so. Even though I'm macro-oriented, I don't really pay regular attention to economic indicators. I think they are only useful in developing a rough idea of whether the world, or a country, or an industry is "good", "bad", or whatever. As for timing, or trying to pick sectors or stocks, they confuse me more than anything.
  • David Rosenberg Q & A (The Globe & Mail): David Rosenberg was the senior economist at Merril Lynch who recently moved to a firm in Canada. I used to have access to his reports through my discount broker (HSBC) but not anymore. He was pretty good IMO. He was mildly bearish—but not superbearish like Stephen Roach at Morgan Stanley—throughout the last few years and I'm sure he saved his clients some money. He maintains his reputation with an out-of-consensus bearish call on the economy. He thinks the economy won't recover as quickly as many imagine. If you share similar views, the thing to do is not to go and short sell stocks (unless you are good at that.) Rather, I think we should build more pessimistic estimates into company earnings, growth rates, and things like that.
  • Be careful with rare coins on E-Bay (Financial Post): I'm not that familiar with history but I can't think of another time period in human history when counterfeiting was so big. Particularly because of advances in technology and low manufacturing costs in China, almost anything is being counterfeited. This story deals with counterfeit rare coins bought on E-Bay. If you are buying coins, be careful; I'm not really sure how you can tell in advance.
  • Are the Chinese GDP numbers overstated? (The Economist): It's hard to say if the GDP numbers coming out of China are too high or not. I don't know about the current (or near-term) numbers but the long-term historical numbers don't make any sense to me (as I have mentioned before, it's hard to imagine a country that can grow around 9% to 10% real (probably 10% to 15% nominal) for a long period of time.) According to some private analysts the article references, the numbers may have been overstated in the past, but they seem more accurate now. If the past GDP is lower than official reported, it's actually bullish in my eyes (because it means that misallocation of resources or any bubble is likely to be smaller—instead of super-charged bubbly growth, it would be slower, more rational, growth.)
  • Citigroup quadrupling its share count (Fortune): Citigroup takes a page out of penny stocks and quadruples its common shares (by converting preferreds to common.) I wonder if this might set a record for a large-cap company (Citigroup's market cap is still $20+ billion.)
  • Obituary of the real estate bust - Florida residential golf resorts (New York Times): I didn't even know there were such a thing—I guess it's mostly for the wealthy—but it looks like residential golf resorts also seem to have been in a bubble and are bursting right now. NYT profiles a key player in the Florida region and goes over various problems faced by his network of companies. The story also touches on some unethical practices—denied by the accused actors—seemingly used to loot private equity investors. I have talked about the possibility of massive unrecognized losses at private equity funds but I wonder how many funds also involve unethical practices that allowed employees and advisors to profit at the expense of the investors. Private equity is not very transparent so it remains to be seen what comes of all this.
  • (recommended) A discussion among economists on the current crisis (The New York Review of Books; thanks to Conscience of a Liberal for pointing it out): I haven't read it yet but it looks a good discussion between economists on the current crisis. Although some look at the economics profession in negative light, given the collapse of the world economies and the financial crisis, I actually think it's great to see serious debate in economics. We are going to see revolutionary ideas come out of the current crisis.
  • Snowball plus two other books reviewed (The New York Review of Books): I have little interest in Snowball, the Warren Buffett biography, and have it near the bottom of my list. I'm just starting out and a slow-reader so I have a ton of other books to read first (it also shows how I'm not a hardcore Buffett fan ;)). But I do love reading reviews of books. This might strike some as the dumbest and most unproductive thing ever—why not spend the time reading the actual book instead—but there is some enjoyment in reading well-written essays (I'm probably one of the few who enjoys reading essays or long reviews of movies, many I still haven't seen :)). Well, this New York Review of Books piece pulls ideas from Snowball and essentially examines what made Buffett sucessful. Building on the notion of success, the review also looks at Malcolm Gladwell's views in his latest book, Outliers, as well as Geoff Colvin's Why Talent is Overrated. If you want an interesting read check it out; but if you are looking for something primarily dealing with investing, business, or economics, skip it.
  • Snowball review by Portfolio from last year (Portfolio; 4 parts): If you do want a good look at Snowball, especially if you are evaluating the merits of it, you should check out the multi-part review from Portfolio last year. As Felix Salmon, who writes the first part, mentions, the book is really more of a biography and doesn't really delve into why Buffett did what he did.
  • Mohnish Pabri lecture at Columbia Business School (Columbia Business School; thanks to ValueHuntr): Pabri had a horrible year but he is generally very transparent with his methods and his strategies. I'm still not sure how good of an investor he is. I put him in the camp as David Einhorn, William Ackman, Jim Rogers, and Marc Faber. That is, someone who is pretty good and much better than average, but with spotty record and question marks over their dependence on certain economic or business environment.
  • (Highly recommended) Notes from Value Investing Congress - West [part 1 - part 2 - part 3] (Cheap Stocks): Summary of various investment ideas and thoughts from up-and-coming value investors.
  • The saga of Porsche & Volkswagen (The Economist): The squeeze of short-sellers by Porsche was a risky strategy. I said it was one of the greatest investment actions last year but it is not for the faint of heart. It is still unclear if Porsche can successfully complete the takeover; failure may result it it destroying itself (In one of his best posts, John Hempton of Bronte Capital laid out, late last year, why the Porsche strategy was very risky and can end up bankrupting the firm if it fails.)
  • Outsourcing of a different type: agriculture (The Economist): The Economist asks, "Rich food importers are acquiring vast tracts of poor countries' farmland. Is this beneficial foreign investment or neocolonialism?" I'm free-market-oriented and think the idea of rich countries (like South Korea or Saudi Arabia) acquiring agricultural land in poor countries (like Ethiopia or Mozambique) is benefitial. However, the problem—a point most free marketers on the right seem to ignore—is that many poor countries have corrupt governments that do not benefit the poor, who tend to be reliant on agriculture. FDI (foreign direct investment) in poor countries' agriculture can revolutionize these countries like FDI in manufacturing has done to Asia. But how to do it without all the profits accruing solely to the corrupt governments (and the investors)?
  • Jeremy Grantham 1st quarter 2009 letter (GMO): I was thinking about commenting on it but didn't find anything worthwhile. He basically says that the market will rally much further but it may not be for fundamental reasons.
  • (Recommended) Berkshire Hathaway Q&A with the media(??) (GuruFocus): I haven't seen this before and I'm not sure what this is; I assume it's a media Q & A with Warren Buffett. In any case, the questions are very good and cut to the key points.

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Seth Klarman on investing

Seth Klarman doesn't conduct too many public interviews but I ran across a detailed interview conducted by TIFF Education Foundation (thanks to ValuePlays for referring to it.) A large chunk of the interview dealt with institutional issues, such as picking the right analyst or manager and retaining them, but the latter portion is likely to be useful for small investors. I don't follow Seth Klarman closely—he is not my style and virtually impossible to tell why his fund is purchasing or selling a security—but many value investors consider him to be one of the top investors around. Seth Klarman's record in the 90's is nothing spectacular but many claim he is very risk-averse and has done exceptionally well in the 2000's (I haven't seen anything to confirm this but it is probable that his record, if you include the last 9 years, is quite good.)

I will quote some of his thoughts, while injecting my views, in the rest of this post. Note that the text is not quoted in order and I'm actually going from, what I perceive as, least insightful to most insightful.

(source: Commentary. TIFF Education Foundation. 2009 Edition 2.)

On Holding Cash

Seth Klarman is known for having sizeable cash positions. This is perhaps why is returns in the 90's don't look so good. In any case, I am starting to consider cash management as an essential tactic in investing (I didn't use to think this way.) Young investors, or those whose portfolio is very small compared to the amount of money they contribute every year (i.e. savings), probably can get away with poor cash management; others, however, should think of cash as an asset. A lot of people spend a lot of time thinking about how much to allocate to asset classes such as real estate, emerging market stocks, and so on, but they rarely think of how much cash to hold.

So I wouldn’t want the crowd here to think, “Well, we need to start going to 50% cash sometimes.” I don’t know what everybody should do. I just know that because I sit at a really interesting desk where a lot of really interesting bottom-up ideas cross my plate, I can tell very quickly, do we have no opportunities? Do we have a few sparse opportunities? Do we have a food of opportunities? If we have a flood, we probably want to raise the bar or we’re going to spend every nickel and then wonder what do we do with the next opportunity. There’s also something about the engine of creating opportunities that needs some cash to function. You’d hate to tell a great real estate partner or a great broker, “You know, that’s a really interesting opportunity; I’m glad you have this billion dollars of assets for sale at a ridiculously low price, but I’m sorry, we’re tapped out today.” That’s not a good answer. When you’ve worked really hard to cultivate relationships, you’d like to feed them, so you in some sense always want to have some buying power.

I think anyone who got killed in the current crash, which is almost everyone except short-sellers and certain macro investors (had to be long US Treasuries, Yen, or US$), can probably attest to the fact that valuations became cheap but they were already fully invested. There is going to be huge difference in the next few years between those who have cash versus those that don't. Those with cash can buy securities at much lower prices, while those with cash shortage have to start liquidating (generally with losses) in order to invest.

Of course, the downside to cash is that it is a drag on performance during bull markets. (This doesn't apply to small investors like us but institutional investors also have difficulties sitting on cash due to their business model.)

Warren Buffett is A Role Model

David [questioner]. Do you have a personal role model and a professional role model, if they’re in fact different?

Seth. I’m not used to black-and-white answers on these sorts of questions, but what I came up with on this was Warren Buffett. He has been a wonderful role model even though I know him only a very tiny bit. He was a role model long before I ever met him. What I think he’s done wonderfully, in the tradition of Benjamin Graham, is he is a brilliant investor, and he’s a teacher. He teaches us through his writings, through his interviews, and through his behavior. I think some of the best things that any investor today can read are his early partnership letters. The world is totally different, but there’s wisdom in them for the ages. As he says, an investor needs to be able to confront things they’ve never seen before. I think an investor today could learn a lot by seeing what the environment was like when there was less competition and when securities were of different kinds of companies, and to also understand the cycles of history. Virtually none of the companies that Buffett owned from the ’50’s and ’60’s, the little oddball things, are recognizable today. The eras pass and change but the fundamental principles don’t. Also, he has a thoughtful opinion on almost everything, which is a way of living in the world. It’s a way of asking, what do you want to read? What do you want to know about? What do you want to be an expert on? He seems very balanced in that way.

Warren Buffett is also a role model to me. I'm not a true Buffett fan but I do think he is one of the greatest Americans I have encountered. One of the impressive things about Buffett is that he generally made his money through ethical means. There are many others who became powerful, successful, wealthy, or influential, through dubious methods. Warren Buffett, like all humans, is flawed but he tries to avoid harming others. I am probably impacted more by Buffett's non-investing thoughts, such as his views on social issues, politics, and so forth, than most Buffett fans. Buffett has made me re-think the way I look at certain things in life.

Klarman suggests investors should read Buffet's early partnership letters. I haven't read many of his early letters but plan to do so over the next few years. You can access his early letters from ValueHuntr's resources page (scroll to the middle of the page.) ValueHuntr only seems to list letters starting in 1959 and I'm not sure if he published other letters before 1959.

I haven't read much of Buffet's writing—I would say I have read less than 20% of his shareholder letters and 100% of his newspaper/magazine articles—but, with my limited knowledge of his writing, I would say the best item Buffett has ever written is How Inflation Swindles the Equity Investor for Fortune in 1977. The PDF contained at Valuehuntr is very poor quality and hard to read but you can also access the article from ValueInvesting.DE. I don't know about his early partnership letters but this article is a must-read for investors. Even if you are macro-oriented, I highly recommend this article because it contains so many insightful ideas (as an example, I like how he says in one section that public shareholders own class D shares of companies, while governments own class A, B, and C shares.)

Is Investing an Art, Science, or Craft?

David [questioner]. The next question is one that I’ve asked other folks who’ve appeared on this stage over the years. I get asked the question a lot when I go out and talk to groups of college students or graduate students. They ask, “Is investing an art or a science or a craft?”, where craftsmanship is defned as the ability and willingness to come to work every day and do the same thing over and over again. How would you answer this question as it applies to what you do professionally? Art, science, craft: what’s the balance among the three?

Seth. I would say art first and foremost, craft second, science third. To me, the science of valuing things and of identifying when things sell at a discount is as straightforward as could be. It’s almost a commodity these days; when you hire business school kids, they all know how to do that. There are nuances and places they might make mistakes, but I think that’s the easiest part, albeit for a layperson it might seem like the hardest part. I think there is a big element of craft in showing up, especially for a value investor where part of the game is discipline. It’s like Warren Buffett says, you are in a game with no umpire and no called strikes so you can keep the bat on your shoulder for a long time. So the craft of showing up and saying, “Nope, nothing interesting today. Nope, still nothing interesting,” is really important. There are other parts that are also like a craft, such as hiring, which is tedious, as you know. One year we interviewed over 50 people and made no offers, so it was like waiting for a cheap stock. You’re waiting for something, and unless you have a massive hole that you have to fll, you have no urgency, so it forces you to have that long-term, craft-like perspective. I think, ultimately, the nuances I was talking about — the ability to distill two or three major themes out of an investment and get right to the heart of the matter — is truly an art. Some of our best analysts can get up to speed in a day or two on something they’ve never heard of before. This is a world where many people have chosen to specialize, to have silos, to have narrow areas of extreme expertise. That’s a legitimate choice, and many of the best long-short funds, for example, have their pharmaceutical analyst and their oil and gas analyst and their financial analyst. We respect that, but we think more value is added by being generalists and seeing opportunities from a broader perspective. If you have silos, you’re going to own things only within those silos. If you have the broader perspective, you can say, “I don’t even like stocks, I’m working on distressed debt,” or something like that.

An important question and an important answer. I wonder how someone like Charlie Munger or even Warren Buffett would answer the question.

I suspect what Seth Klarman says goes against what I, or many other newbies and amateurs, feel. I suspect most amateurs feel that the science part—determining the number, the value—is the hardest (Klarman even alludes to this possibility of amateurs and newbies having difficulty with this.) Many, including me, spend an inordinate amount of time on the science part. However, Klarman says that investing is, foremost an art, followed by the craft aspect.

I haven't given this question much thought and I'm not sure if I agree with his answer fully. I think the science part plays a bigger role than he implies—it might even be above the craft aspect. For instance, even the best & smartest on Wall Street were completely wrong with the valuation they placed on many securities in the last few years (particularly mortgage bonds and credit default swaps on almost anything—I'm not talking about fradulent mortgages; I'm referring to truly erroneous valuations.) In any case, there is some truth to what Klarman is saying.

The science part probably has the lowest barrier although it takes some minimal study (perhaps the amateurs have difficulties getting past the minimum barrier.) This is why professionals will likely beat the vast majority of newbies and amateurs. Even the below-average professional who spends 9 to 5 everyday on investing will likely have a better grasp of the science aspect of investing than above-average amateurs who have full-time jobs doing something else and can't learn anything to the same degree.

The craft aspect, which I think is less important than what Klarman thinks, actually gives a small edge to amateur investors. This has nothing to do with knowledge and is more of what you, as an investor actually chooses to do. For professionals, they are often forced to do something—anything—even if one should just stand still.

As far as the art of investing is concerned, I completely agree with Klarman. Investing really is an art. This is why you can't read books x, y, and z; work on it for n years; and become a successful investor. But the art aspect is probably the only area where an amateur investor may be able to develop a big edge over professionals. There really isn't any automatic advantage possessed by professional investors if you look at investing as an art. Because it is an art, there is no methodology or some system you can learn and become successful. I see many newbies trying to perfect a 'system' but there really isn't any; they would be better off trying to get a sense of what they are actually investing in, and how that fits into the world. If you look at many of the successful investments by Warren Buffett, you will notice that it has little to do with quantitive aspects and more to do with understanding the essence of a business and what it is trying to do in this world.

I'm not saying there is only one way to invest but it is useful to think about what investing is, and what you, as an investor, is trying to master.

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One dissenting FedRes member sees inflation becoming a problem

MarketWatch reports that non-voting FedRes member, Charles Plosser, dissents with fellow FedRes members and thinks that inflation will be a threat. He suggests that the FedRes should start raising rates sooner rather than later.

Plosser's dissent from the mainstream view is based on a fundamental disagreement about the sources of inflation. In the mainstream view, inflationary pressures cannot build up when the economy has so many slack resources. With unemployment so high and so many factories, machines, stores and offices sitting idle, no one company could gain pricing power because its competitors could easily ramp up output to meet any surprise increase in demand that could lead to higher prices.

The nonpartisan Congressional Budget Office has estimated that the output gap -- the difference between what the economy is producing and what it could produce -- will be a massive 7% of gross domestic product in 2009 and in 2010, and that the output gap will not close until 2013.


But Plosser said the official story is flawed in two ways. First, the output gap is almost impossible to estimate accurately, and is probably much smaller than assumed. The economy is undergoing a massive structural change due to the shock of the housing and credit bubbles, he commented. Resources are flowing out of the housing and financial sectors. Those resources cannot be easily redeployed in other sectors.

In effect, the output-gap calculations presume the economy can produce as much as it did during the bubble, he said.

"The output gap is not likely to be as big as standard estimates suggest," Plosser added. "If so, the economy may be at greater risk of inflation than the conventional wisdom indicates."

Second, the Philly Fed president said the output gap model of inflation just doesn't work empirically.

We should be "highly suspicious of inflation forecasts that depend heavily on measures of 'gaps' and 'slack,'" according to Plosser. "Instead, if we look at inflation forecasts from a model that runs solely off historical correlations in the data and incorporates forward-looking expectations, we find inflation rising significantly over the forecast horizon."

In fact, Plosser's own economic model has inflation rising above 3% in 2010 and 4% in 2012 if the Fed doesn't act. Even if the Fed does act, Plosser sees inflation hitting 2.5% in 2011, significantly above its target.

The majority of the FOMC said the inflation rate in 2011 would be between 1% and 1.9%.

Quite a number of investors, with David Einhorn and John Paulson among them, are betting heavily on inflation by loading up on gold or gold stocks.

Thursday, May 21, 2009 0 comments ++[ CLICK TO COMMENT ]++

Bank of Canada considers changing banking policy

Bank of Canada is contemplating changing its policy. It's still in the early stages so nothing may come of it. IANAE (I am not an economist) and, quite frankly, I don't understand what is discussed in the article very well, but I like to cover potential events lurking far off in the distance so I thought others may find it interesting. It's certianly cutting-edge stuff so even if nothing happens now, it may be something that may be implemented 10 or 15 years from now.

The Bank of Canada pulled back the curtain on its internal debate over the future of policy making, revealing an institution that appears to be edging cautiously towards a new approach to setting interest rates.

Policy makers devoted their latest quarterly research publication to inflation targeting, publishing three articles that mostly back a shift to a new policy of “price-level targeting” and a fourth that seeks to damp the enthusiasm by arguing that there are still lots of questions about the largely untested strategy.

Price-level targeting, or PT, differs from the current policy regime of inflation-rate targeting, or IT, by letting prices rise to a certain level over a period of time, as opposed to aiming for a certain rate of inflation.

The Bank of Canada currently raises and lowers its benchmark interest rate to keep the consumer price index advancing at a pace of about 2 per cent a year, which is its mandate from the federal government.

That mandate is up for review in 2011, and Governor Mark Carney is considering suggesting a change, depending on the results of a vigorous research effort that began after the current inflation-targeting approach was renewed in 2006.

PT has “shown some promise in this research, as stabilizing tool and possible source of improved economic welfare,” John Murray, a deputy governor, said in the introduction to the spring edition of the Bank of Canada Review.


Sweden is the only country that has seriously tried linking interest rates to a future level of prices, and that was in the 1930s.

Proponents of PT argue that setting a goal for price levels over a certain period would enhance stability because consumers and investors would have a clearer idea of how to value purchases or longer term assets.

One positive identified by a team of three Bank of Canada economists led by Allan Crawford is that yields on longer term debt likely would fall under a PT regime, a boon for younger households and governments, both of which are big borrowers.

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S&P lowers UK's credit outlook to negative from stable

From MarketWatch:

Standard & Poor's on Thursday lowered its credit outlook on the U.K. to negative from stable for the first time ever in view of the country's swelling debt, which may expand even as the economy recovers.

The move by Standard & Poor's raises the prospect not only of a credit-rating downgrade in Britain but a lowering of the outlook in the U.S., which has taken a similar path of big spending and quantitative easing to escape the credit-led recession.

"I think there will be a downgrade on the U.K. and I think there will be a downgrade on the U.S. outlook from one of the Big Three" credit-rating firms, said Stephen Gallo, head of market analysis at Schneider Foreign Exchange.


S&P kept the country's AAA rating intact, but the outlook signals that the country's credit rating could be lowered within the next two years.

Rival agency Moody's Investors Service on Thursday said it is not reviewing the U.K.'s rating.

S&P already has lowered the ratings of other European countries, including those of Spain, Ireland, Greece and Portugal.

I have discussed how AAA-rated corporations were becoming an endangered species. Well, AAA-rated sovereigns may join the same list.

Any downgrade of Britain's rating will increase financing costs for the government and likely weaken the currency. However, the market generally tends to price in a lot of the sovereign rating changes well ahead of time.


Commercial real estate falling apart

Commercial real estate in America is nowhere as bubblicious ;) as residential real estate—or Japan circa 1989. Nevertheless, it is an area that will likely face stresses and probably end up with the biggest bust since 1990. The Globe & Mail picks up Reuters story that illustrates some of the fire-sales that have occured on prestigious buildings:

The 40-storey skyscraper sits on a prime corner in the country's wealthiest commercial market, steps from the Museum of Modern Art and a few blocks from Rockefeller Center and Central Park. It recently sold for $100,000 (U.S.).

The 1330 Avenue of the Americas building - which sold for close to $500-million three years ago - was auctioned last month for the minimum to a unit of the Caisse de depot et placement du Quebec after owner Harry Macklowe defaulted on a $130-million loan.

A month before that, the John Hancock Tower - Boston's tallest skyscraper - sold at auction for just over $20-million. The 33-storey Equitable Building in downtown Atlanta is set to go up for auction next month; its owners owe more than $50-million to the bank and have only half of the building leased. Loan defaults in the worst commercial real estate market in decades have created tens of billions worth of distressed properties across the U.S., forcing cut-rate auctions of landmark skyscrapers.

From these ashes, some investors will rise and make their name. I remember how Sam Zell went around and bought highly valuable properties for very low prices (usually $1), only to sit on them, cut operating costs, and wait until they turn around. The fact that a valuable skyscraper in a highly attractive part of town can be bought for $100,000—real cost is probably $130.1 million if the full loan had to be covered—and which traded hands for $500 million three years ago shows the state of affairs.

Small investors can't buy these things directly but anyone interested may want to start digging to see if there are REITs, publicly traded private-equity funds, and the like, with strong balance sheets that are attempting to purchase these distressed properties. I have little interest in real estate so I don't follow it, and I don't know much about it. But, similar to cyclicals such as autos, if you can buy at a low price during poor economic times, you may reap huge rewards later on.

Having said that, one needs to be extremely careful—similiar to anyone betting on consumer discretionary right now. I remember reading Jim Grant's Trouble with Prosperity and how most of the buildings in Manhattan, including a prestigious one covered in detail in the book, never recovered for more than a decade. Based on the wildly-inflated projections used to justify the project during 1929, some buildings never satisfied the original estimates for 20 or 30 years. So, the lesson here is that even if prices decline, they may still be too high.

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Warren Buffett...All Too Human

(Illustration by Alex Gross for The New Republic)

Thanks to Commodity at GuruFocus for bringing the Michael Lewis article in The New Republic, The Master of Money, to my attention. In it, Lewis reviews Snowball, the Warren Buffett biography by Alice Shroeder, and injects his interpretation of Buffett. To put it bluntly, Lewis skewers Buffett like few others ever have, and probably ever will. However, in doing so, we actually end up seeing how Warren Buffett is a flawed human just like any of us. Michael Lewis is not a fan of Warren Buffett but his respect of Buffett acutally increases in the end. I highly recommend this article, which provides an insight into the flaws of Warren Buffett.

Which brings us, oddly, to our present financial crisis. There has never really been a bad time in the last fifty years to be Warren Buffett, but just now would seem to be less favorable than most. If Buffett still measures his life by the book value per share of Berkshire Hathaway, then for the first time in forty years he must feel like a wasting asset. His share price is still off more than 40 percent from its highs, underperforming even the S&P 500. He railed against derivatives as weapons of mass destruction, and now turns out to have been sitting on a $68 billion pile of credit default swaps and exotic put options on various stock market indexes. And having vowed never again to become entangled in a big Wall Street investment bank, he has gone and sunk $10 billion into Goldman Sachs, a virtual re-enactment of his investment in Salomon Brothers--cash for reputation. The difference this time is that he has gotten himself a sweeter deal than not merely ordinary shareholders, but also the U.S. Treasury.

On the surface at least, he seems like a guy who has spent the last few years ignoring all of his own best advice...

(source: The Master of Money, by Michael Lewis. The New Republic. June 03, 2009)


Wall Street & Its Unemployed

I felt like I was playing a game of musical chairs where someone’s taken out half the chairs.
— David Roberts on searching for a Wall Street job

The above quote pretty much sums up the employment situation for financial workers in America—and probably Britain. A lot of financial jobs have dissapeared, likely forever, and the unemployed are fighting over the few remaining ones. The situation is similar to what technology workers faced after the dot-com bust.

Bloomberg Markets magazine has a profile of two couples who have lost their high-paying jobs and are struggling to find another job. The striking thing is how many of the Wall Street workers are highly paid—far more than I or 50% of Americans or Canadians would ever make in our life—and yet seem to be headed for financial difficulties. Ironically, I feel that someone who is closer to working class or middle class, and hence has a lower income, would probably handle their situation better than many of these Wall Street workers. One of the problems is that many high-paying workers are "stuck" in a higher-end lifestyle and have problems adjusting their lifestyles downward. I think David Robert's family is probably doing the right thing by moving elsewhere, which will be cheaper and will inject some fresh life.

In early 2008, David Roberts’s morning routine at the Ridgewood, New Jersey, train station was as unchanged as the view from its platform, which overlooks a downtown anchored by the Daily Treat diner and a 77-year-old movie theater. Roberts would sip coffee, eat a corn muffin, scan the Financial Times and step aboard the 7:50 train.

This was not the same trip he had made for the 14 years he worked for three Wall Street firms. This was a commute to nowhere.

Roberts, 61, was bound for an outplacement center on New York’s East 37th Street, where he pursued job leads and the dream of starting a consulting firm with former colleagues. Like many of his neighbors in Ridgewood, Roberts had been thrown out of work after the credit markets seized up last year, joining thousands of commuters in the competition for jobs that don’t exist anymore.

Roberts, an economist at Dominion Bond Rating Service until January 2008, was fired 13 months after he predicted in a published report the recession that would end his livelihood.

“You can see a train wreck coming,” Roberts says. “But that doesn’t mean you can get out of the way.”

Roberts has suffered through a chain of unanswered job applications, an ill-fated relocation to Washington, and depression. As of April, he had lost or spent more than half of his $1.4 million in savings.


Former Lloyds banker Matthew Tuck is still shaving--and still looking for work in banking. Since he was let go in September, he has applied for more than a dozen jobs and is a regular member of the Financial Executives Networking Group. He was one of 400 applicants for a post at the Office of the Comptroller of the Currency. It paid about $85,000, half his Lloyds base salary and two-thirds of his pay when he arrived in New York in 1995 with Barclays.


India...When was the last time a circuit-breaker tripped on the upside?

Traders and others who follow the markets daily may know the answer but I can't think of another time a circuit-breaker tripped on a bullish rally. It looks like the Indian stock markets were halted for the day after they rallied more than 17% in one day:

A deluge of buy orders greeted Indian shares Monday, propelling the country's benchmark stock indexes higher by more than 17% and triggering market circuit-breakers to force an early suspension of the day's trading.

Mumbai stocks leapt right off the blocks on optimism that the Congress Party-led alliance's victory in the just-concluded general election will result in a more market-friendly economic policy.

Within moments of the markets opening for trade, the Bombay Stock Exchange's 30-stock Sensex and the National Stock Exchange's 50-stock S&P CNX Nifty surged by nearly 15%, triggering a trading halt for two hours. Immediately at the resumption of trade, they surged further, prompting a trading suspension for the rest of the day.

That's a huge move even for an emerging market. Usually markets decline a lot but they rarely move up.

The strong market rally is due to the national election but I wonder if there is too much hype. Similar to the Chinese stock market and that of many other emerging markets, I believe the Indian stock market resembles more of a casino.

In the prior term, the government had to ally with far-left parties, such as the various incarnations of the Communist party, whereas they don't need their support going forward. The alliance with the Communists made it difficult to carry out some free-market-oriented reforms in the last term but it remains to be seen what can be accomplished given the economic slowdown.

My View of India Hasn't Changed

I have always been bearish on India, at least ever since I started investing (for real) 5 years ago. Initially my concern was valuation. Most Indian stocks seemed overvalued. India has capital controls so it's almost impossible for foreigners in invest in their local market. So one is typically limited to buying NYSE-listed stocks. But, on top of the valuations being high based on fundamentals, the NYSE-listed stocks used to trade at huge premiums to the Indian-listed ones (this was the case a few years ago but not sure now.)

Having said all that, I was probably wrong--not sure yet. Although valuations were high, the growth actually came through so the stock market has actually gone up quite a bit. Even after the crash over the last two years, it's still about 2x the 2004 levels (in nominal terms; real returns will be slightly lower but should still be a large positive number.)

This is an example of a situation that value-type investors will generally miss. Similar to growth stock investing, genuine emerging market growth can overcome seemingly high valuations. If anyone wonders why people invest in ridiculously high prices, it's because growth can overcome the valuations. Just like how people bet on tech stocks even with high P/E multiples, a lot of people do the same with emerging markets. If they are right, they will do well.

I'm still unsure of my incorrect view and am still maintaining my bearish view for another reason. I haven't check the numbers recently (I doubt they changed) but, as I have pointed out before, India runs a current account deficit (China doesn't; Brazil doesn't.) There is nothing wrong with a current account deficit per se. Those who defend current account deficits point to USA or Australia in the last few decades as examples of countries that have grown by utilizing foreign funding. But the long-term consequence is uncertain. One thing that is certain is that current account deficit countries are vulnerable to foreign capital flight. I'm not predicting this but there is a non-trivial probability of a credit bust unfolding in India. Similar to how many Eastern European countries are facing a credit bust because foreigners (basically foreign banks) are unwilling to finance their consumers and businesses, a similar thing may occur in India. However, since India is a developing country and the economy is still largely unsophisticated, the impact may be limited (e.g. most people are still poor and they have no access to credit; businesses also don't have easy access to credit and don't really borrow from foreigners.) But it's something to be wary of.


Conventional oil production to peak?

I'm not a Peak Oil Theory supporter but it's always useful to pay attention to what others are saying. Total, the French supermajor, recently said it thinks conventional oil production will peak within a decade so the Peak Oil Theorists shouldn't be dissmissed easily (but do note that people have been saying that for many years now—in fact, according to some of what was said a few years ago, the peak should have been in 2007 or 2008, yet that didn't happen.) The Toronto Star has an article interviewing former CIBC economist Jeff Rubin about his upcoming book, Why Your World Is About to Get a Whole Lot Smaller. The book is slated to be released on May 23rd and, given how Rubin is very outspoken and often has off-the-wall views, it will probably be a good read. If anyone wants to get an opinion of someone from the mainstream who thinks oil production will peak, check out the article:

Its basic premise is simple: Nearly everything we do, purchase and eat is "inextricably bound" to oil, and as the price of black gold increases, so too does the cost of growing, manufacturing, processing, packaging and transporting the goods we consume – whether they be apples from Australia or dollar-store trinkets from China.

In other words, the higher oil prices get, the more expensive distance becomes. And oil prices, argues Rubin, are going nowhere but up.

"The world's oil wells are running out of the stuff that keeps the whole system going," he writes, adding that the only supply available to replace it is dirty, hard to find, and for that reason increasingly expensive. The oil sands are a case in point. "We are getting closer to the bottom of the barrel."

Eventually, he says, the transportation costs of importing products from far-off countries will erase other advantages, such as low-cost labour. It will become, he argues, "the largest barrier to global trade."

This will lead to more dense communities, less driving, and a reliance on what we produce locally. World trade will revert back to the patterns we saw in the 1970s, when tariffs slowed the global movement of goods and trading was more regional. Economic growth will come to a crawl and inflation will rise.

Look no further than the current recession for proof, he says. In chapter 7, Rubin lays out in detail how high oil prices, which peaked near $150 in July 2008, led to inflation and rising interest rates that triggered the U.S. mortgage crisis and sent the economic dominoes, including global trade, falling.

The last paragraph is a bit weak. Although I have seen it being mentioned by a few others, I don't really think oil prices played the key role in the current economic collapse. Yes, the higher energy costs started harming consumers and producers but what really caused the economy to collapse was the credit crisis--essentially a run on investment banks. Higher oil prices would have caused a recession at some point but it didn't get enough time in this case, in my opinion.

"You can liberalize trade all you like, but it won't make a difference if no one can afford to ship the things you want to sell," he writes.

His prediction: Manufacturing jobs are going to return to North America over time. There will be a revival in regional agriculture. Urban farmers' markets will become more plentiful. Travel will be local and certainly not by plane. Dining out will be replaced by cooking in.

No one can predict the future but we all try to. So, it remains to be seen how many of these predictions come true. Some of these predictions seem kind of extreme. As investors, what I would do is to think about these possibilities and simply avoid getting surprised by them. If you are macro-oriented, you may want to give it deeper thought (maybe even buy the book) and see if there is an investment thesis here.


Book Summary: In the Market: The Illustrated History of the Financial Markets

In the Market: The Illustrated History of the Financial Markets
by Christopher Finch

Published in 2001
Abbeville Press

Quick Description:
Colourful coffee-table book covering the history of various markets (not just the stock market); Visually appealing reference book

Recommended For:
Anyone interested in business/investing/economics/economic history

My Rating: 91%
(anything over 25% is worth considering; over 50% is recommended; over 90% is highly recommended)

As anyone continuously following this blog would know, this isn't a typical investment blog. Most blogs are focused on certain aspects of investing—fundamental analysis, technical analysis, macroeconomics, trading, value investing, dividend stocks, and so forth—whereas I tend to write about anything. I'm sure this is frustrating to some and it will probably keep my readership very low forever (for instance, I haven't analyzed any stocks, other than special situations, in more than an year—anyone looking for investing ideas may have been dissapointed, although, by complete fluke, it would have prevented one from buying stocks during a crash and suffering massive losses.) Well, the reason I don't focus on anything is because my interests are diverse and it gets boring to do the same sort of thing over and over again. In a similar vein, the books I read are also generally different from what you see on most sites. In the Market is one such book.

I purchased In the Market: The Illustrated History of the Financial Markets a few months ago. Written by Christopher Finch, it is a large-format coffee-table book suitable as a reference for anyone's home or office. I did some research before buying and this is the best coffee-table-type book (on this topic) I could find anywhere. As to be expected in coffee-table type books, there are a ton of pictures with some spanning one and a half pages of the large book.

In the Market covers markets of all sorts—not just the stock market—from several thousand years ago to the present. Most of the book, though, deals with the last century. The early history is quite weak and is mostly a general overview. I suspect this is because most of the early innovations and advanced civilizations were in the Middle East or Asia and historical records are hard to come by—this is especially true before the invention of writing on paper. The early European period, pre-British, from 1500 to 1800 starts getting interesting. But the real detail starts with the establishment of Wall Street under a buttonwood tree.

While the history of various markets is covered in the background, there are "inserts" on various topics. These tend to be a few pages, often with pages full of pictures, but enough to introduce the topic. I actually found these topics more interesting than the main chapters in the book. Some of the topics include venture capitalists; state and local finance; investment in private companies; emerging markets; blue chips; agricultural commodities futures; and so on. If you are intersted in a particular topic, it's fun to read through it.

At the back of the book, there are very brief biographies of important businesspersons, investors/financiers, policymakers, and so on. There is also a timeline of important events that occurred over the years.


Abbeville Press, the publisher, has a PDF containing some sample pages from the book. You may want to check out the PDF (7MB) or their site if you are interested. I have extracted some images to give you an idea of what is in the book.

Note: All images belong to their respective owners: Christopher Fince and Abbeville Press (except publi domain images.) I cropped some of the images from the full page.

The following image depicts one of the insert sections, with this one being emerging markets. As is common throughout the book, there is a large image that spans more than a page, along with some text introducing the topic.

The following is another insert section—this time the one on private companies:

You are not going to become an expert reading this stuff but it will introduce you to the topic and broaden your knowledge base.

I chose the following cropped image from the main body to illustrate how In the Market contains historical pictures that are not easily found. Although these historical images are freely available, one may have a hard time finding them. In this case, the sketch is of Black Friday in 1869.

The following image is to make the libertarians and other extreme free market proponents keep coming back to my site—although I don't really make any money off this site :). It is a privately issued bank currency.

Once upon a time in America, banks were issuing their own currencies in California. Since they were on the gold standard, the note above promises to pay back in gold. Letting the banks issue their own currencies is closer to a free market than only having the government do it. Extreme free-market supporters, which includes most American libertarians, generally suggest that it is better to let anyone issue their currency rather than let the government have a monopoly on currency. However, such a system is unstable and most banks end up bankrupt.

The final image I extracted is the original 'greenback', which was issued during the Civil War and wasn't backed by gold or silver.

As the caption mentions, critics accused the currency of having nothing backing it other than the green ink. Nowadays, the negative connotation has been lost and greenbacks simply refer to the US dollar.

What's Not to Like?

This isn't a big deal for me—I bought the book after all— but here is something some may find wanting.

This is more of a pop book suitable for the general reader so it isn't an in-depth reference for experts. Likewise, investors would likely disagree with some of the ideas in the book (ideas may seem a bit too simplistic to some.) If you want an in-depth understanding of a topic, say venture capitalism, you are better off finding a book that specializes in venture capitalism. I don't fault the book because such a book has to be written for the general audience but just warning anyone interested in buying this.

I will also mention that all the content in the book can be found freely on the Internet. You can Google for a topic and find some websites that educate you on the topics covered in the book. You can also hit Wikipedia and read up on the material.

What's to Like?

Even though the material can be found online or in several other books, it's good to have them all located in one book. Instead of you trying to read many different articles or websites, this book ties it all down for you.

In particular, I really love the illustrations, historical photos, paintings, and the like. As the samples I showed above illustrate, you will see some interesting stuff. There are political sketches criticizing robber barrons in the 1800's; there are paintings of panics and manias; there are large photos of workers; there are old photos of the excesses of the Roaring 20's, such as the famous tennis match on the wings of an airplane.

If you are like me and have diverse interests, you will probably like reading about topics that won't help with your investing; won't help with your love life; won't help with your family; and won't help with your career. But it's fun to read when you have time to kill :)

Final Comment

I recommend In the Market to anyone that is interested in economic history, investing, or business in general. It is an easy-to-read book that one can flip through when they are in a mood to discover something. Want to learn something about the markets during the Victorian era? Flip to page 126. Feel like reading some basics about privately-held companies? Starting on page 134, you would learn that Cargill is the largest private company in America followed by Koch Industries (I think these two flip around quite a bit because I vaguely remember reading that Koch was the largest.) Also, did you know that Ford was a private company during its high growth phase during its Model T days? Ford wasn't public until the 1950's.


Sunday Spectacle IX


Stanford International Bank short $6 billion

As initially suspected, it looks the Stanford International Bank was indeed a Ponzi scheme. It looks like the bank's liabilities exceed assets by $6 billion:

The Caribbean offshore bank at the centre of an alleged Ponzi scheme by a wealthy Texas businessman has a $6-billion (U.S.) shortfall between assets and liabilities, a court-appointed liquidator reported Friday, confirming fears that investors will likely get little of their money back.

Stanford International Bank Ltd. in Antigua, run by financier R. Allen Stanford, owed about $7.2-billion, including interest, when regulators closed it in February after the U.S. Securities and Exchange Commission alleged it was offering fraudulent certificates of deposit, the liquidators said in a letter to investors.

But the liquidators said they have found less than $1-billion in assets, including just $46-million in cash at accounts in Antigua, Canada, the U.S. and the United Kingdom.

The cause of the “very significant shortfall” is unknown at this time but the records “indicate that a Ponzi scheme ... had been in operation,” the liquidators, Nigel Hamilton-Smith and Peter Wastell of Vantis Business Recovery Services, said in the report.

If it weren't for the Madoff Ponzi scheme, this may actually be the biggest Ponzi scheme in history. Truly unfortunate for the victims. The Madoff scheme only directly impacted wealthy investors or institutional investors, whereas this one likely impacts the average person. Since the main bank is in the Carribean, I'm not sure if any of the deposits or the issued CDs are insured (The Texas, as well as Canadian and other operations, will be insured but not sure about the main Carribean headquarter bank.)


IEA forecasts oil demand contraction... biggest decline since 1982

IEA is forecasting oil demand to contract this year. The contraction is expected to be the largest since 1981:

World oil demand this year will post the sharpest annual decline since 1981 as the economy struggles to bounce back, the International Energy Agency (IEA) said on Thursday.

Demand will contract by 2.56 million barrels per day (bpd) in 2009, the agency, which advises 28 industrialized countries, said in a monthly report. It previously forecast demand would contract by 2.4 million bpd this year.

As is obvious now, oil equities are down in the last year mainly due to this demand contraction. There were some who have suggested that there was irrational sell-offs in oil equities last year but it seems fundamentals back up the decline. Oil has rallied recently but IEA thinks it isn't based on physical demand:

The agency added a rise in oil prices, which topped $60 a barrel for the first time in six months this week, was due to sentiment and oil fundamentals remained weak.

Prices fell below $57 (U.S.) after the report was released.

“The oil price seems to have moved a bit higher in the past month largely on the basis of equity markets and sentiment about potential economic recovery,” David Fyfe, head of the IEA's Oil Industry and Markets Division, told Reuters.

“But we're not seeing it in terms of the preliminary demand data for early 2009.”

Like most analysts, IEA cannot predict the future and is often wrong with their long-term forecasts. However their near-term forecasts, as well as their historical views, are worth paying attention to.

One question is whether this decline in demand is temporary or not. I think it doesn't matter much anymore. There is so much excess capacity on the sidelines with Saudi Arabia alone supposedly having 3 mmbd to 4.5 mmbd spare capacity by end of this year—consider this against Canada's total production of around 3.4mmbd—that price increases will be muted. If there is excess capacity, consumption growth may not matter. Oil consumption rarely ever declines on a worldwide basis, even during recessions. Except for the early 80's, oil demand never declined thoughout the bear market in oil from the mid-80's to 2000. Oil companies were cutting production and many went bankrupt in the late 80's to 2000, while consumption growth was positive but oil prices didn't really go up.

Wednesday, May 13, 2009 1 comments ++[ CLICK TO COMMENT ]++

Banks sue MBIA over split

Bloomberg is reporting that 18 banks have sued MBIA over its split:

Bank of America Corp., JPMorgan Chase & Co., UBS AG and 15 more of the world’s largest financial companies sued MBIA Inc., saying the biggest bond insurer’s split of its guarantee business illegally cut their odds of getting paid on policies.

MBIA stripped $5 billion of assets out of its MBIA Insurance Corp. division to fund a new unit amid “an ongoing financial crisis that has made it increasingly likely that MBIA Insurance will have to pay out billions” of dollars, according to the complaint filed today in New York State Supreme Court in Manhattan.

The case adds to two previous lawsuits filed by funds over the February restructuring by Armonk, New York-based MBIA, which New York State Insurance Superintendent Eric Dinallo approved. Banks concerned that the split of the business hurt them had met with state regulators in March, David Neustadt, a spokesman for the New York State Insurance Department, said at the time.

The decision to move assets from the unit and “render it effectively insolvent was a blatant attempt to enrich MBIA Inc. and its management at the expense of MBIA Insurance and its policyholders,” Vince DiBlasi, a lawyer who represents the group at Sullivan & Cromwell LLP, said in an e-mailed statement.

The group also includes Barclays Plc, HSBC Holdings Plc, Citigroup Inc., Canadian Imperial Bank of Commerce, BNP Paribas, Royal Bank of Canada, Morgan Stanley, Sumitomo Mitsui Financial Group Inc., Societe Generale, Credit Agricole SA and Wells Fargo & Co. or their units.

MBIA decided to split itself into a business that writes muni bond insurance and another that, in the past, wrote structured finance product insurance. The split is thought to strengthen the muni bond business at the expense of the other. Banks and various other sophisticated parties seem to be the only buyers of the structured product insurance. The lawsuits aren't a surprise but it remains to be seen what comes of all this. The insurance regulator approved the split but I'm not sure what the courts will think of this.

Funds such as Martin Whitman's Third Avenue Fund has also sued MBIA over the split. In this case, the concern by Third Avenue is that the debt-like notes purchased by Third Avenue will have less assets backing it.

In the same article, MBIA says it is vigorously pursuing lawsuits against various banks and others involved in packaging mortgage securities:

Brown said on a conference call yesterday that about 66 percent to 80 percent of his insurer’s losses on second-mortgage bonds and mortgage-related collateralized debt obligations, its two worst insurance categories, are tied to collateral that was “ineligible” to be included in the deals, and so its guarantee payouts may be recouped, either through negotiations or suits.

Again, it's not clear how the courts will rule. A lot of the court rulings related to the monolines will likely have huge ramifications for the entire real estate securitization industry, going all the way from the mortage lenders, to banks, to investors. For instance, if a monoline wins a court case by showing fraudulent actions during secrutization (admittedly a tall order,) it's possible—I'm not a lawyer and this is pure layperson speculation—that investors who purchased similar securities may be able to sue banks arguing that the securities they purchased were misrepresented. Most mortage lenders are bankrupt or defunct now, so the ones that may be vulnerable to damage claims will be the packagers of mortgage securities, who were mostly investment banks and very large commercial banks. Overall, any damage payments, assuming any of this even happens, is likely to be limited since the two biggest real estate securities players, Bear Stearns and Lehman Brothers, aren't alive anymore (I'm not sure if JP Morgan has exposure to Bear Stearns' legacy operations or if it is shielded.)

Not to be outdone, MBIA has also offered to buy back its insurance company preferred shares for 10 cents on the dollar.


Mathstar receives unsolicited bid

GreenBackd reported yesterday that PureChoice is offering to buy Mathstar for $1.04. This is way below the liquidation value—my guess is around $1.3—and I hope management and other shareholders don't pursue this deal. There is no reason to accept anything widely below the liquidation value given how there is very little to liquidate and most of the value is residing as cash. The share price has jumped and is trading close to the offered price. I had been trying to increase my stake in the last few weeks but haven't had much success (maybe I'm too greedy and bidding too low of a price?).


Ambac posts a loss of $392.2m for first quarter; MBIA posts a profit of $696.7 million

I didn't get much time to review the results but Ambac announced its quarterly results today--MBIA announced after market close as well.

Ambac posted a loss $392.2 million:

Ambac Financial Group, Inc. (NYSE: ABK) (Ambac) today announced a first quarter 2009 net loss of $392.2 million, or a net loss of $1.36 per share. This compares to the first quarter 2008 net loss of $1,660.3 million, or a net loss of $11.69 on a per share basis. The first quarter 2009 results reflect pre-tax net income amounting to $279.7 million resulting primarily from a positive net change in fair value of credit derivatives. The unrealized gain in credit derivatives was partially offset by loss and loss expenses primarily related to the residential mortgage-backed securities (RMBS) portfolio and other-than-temporary impairment write downs of RMBS securities in the investment portfolio. During the quarter Ambac increased its deferred tax asset valuation allowance by approximately $600 million, causing the after-tax net loss. The first quarter 2008 results reflected a net change in fair value of credit derivatives amounting to ($1,708.2) million as a result of deterioration in certain insured CDO of ABS transactions and loss and loss expenses amounting to $1,042.8 million related to RMBS securities.

You can access the presentation here, the conference call here, and conference transcript (via SeekingAlpha) here.

Cursory look does not signal anything positive. Things still look ugly and Ambac's balance sheet keeps deteriorating.

On another note, MBIA announced its results after the bell:

The Company recorded net income available to common shareholders of $696.7 million, or $3.34 per share, for the first quarter of 2009, compared with a net loss of $2.4 billion, or $12.92 per share, for the first quarter of 2008. Net income in the first quarter of 2009 was primarily driven by $1.6 billion in pre-tax unrealized net gains (mark-to-market) on insured credit derivatives.

The Company’s first quarter results include $693.7 million in pre-tax loss and loss adjustment expenses on insured exposures, primarily on second-lien mortgage exposures and $169.0 million in pre-tax realized losses in the Company’s Asset-Liability Management (ALM) asset portfolio reflecting the continued deterioration and stress in the credit markets.

Because of accounting complications, one needs to read through to figure out the details. A profit is not what one thinks of generally as a profit; similarly, a loss is not what it seems. It seems the situation is still deteriorating, which shouldn't be news to anyone following the markets.

If I get some time, I'll read through them in more detail and post something.

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