In An Uncertain World

I have another book recommendation to make: Robert Rubin’s In An Uncertain World.

Rubin was Bill Clinton’s Secretary of Treasury from 1995 to 1999. The reason why I really like the book has little to do with politics, and everything to do with investing.

Rubin worked on Wall Street at Goldman Sachs long before he became Treasury Secretary. While there, he learned the fundamental principles of investing, and put them to work doing risk arbitrage for Goldman.

He does an excellent job spelling out how he thinks in terms of probabilities, and how this thinking is equally applicable in investing, politics, and life. If you can consider the potential outcomes in a situation, and you can apply reasonable probabilities to each, it allows you to make good decision in any facet of your life.

The principles of probabilistic thinking in investing are simple, but the judgment and analysis required are hard. If you know a security has a 25% chance of going to zero, a 25% change of being flat, a 25% chance of going up 20%, and a 25% chance of going up 100%, then it’s easy to figure out whether it’s a good investment or not. The math of probability is easy, figuring out what the probabilities and outcomes will be is hard.

But, Rubin does a great job of describing this way of thinking. He even gives concrete examples to make it clear both in investing and in politics.

I must admit, it’s an enjoyable read, too. I don’t agree with everything he has to say, but you can’t help finishing the book and thinking that Rubin is a thoughtful, well meaning person. I highly recommend the book to anyone.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Mortgage market information

For those of you interested in gaining a better understanding of the mortgage market and what is going on recently, I’d like to recommend some great resources.

First is an extremely thorough report by CreditSuisse. It covers the mortgage market in detail and makes some predictions about how things may turn out. It’s 67 pages long, but there is a 10 page summary that will give you a flavor of their findings. http://www.billcara.com/CS%20Mar%2012%202007%20Mortgage%20and%20Housing.pdf

A more narrowly focused website that takes the subprime market to task is: www.lenderimplode.com. According to this website, 44 subprime lenders have exited the market.

A friend of mine, Bill Moyer, CFA, recommended the following blogs with additional information on lenders and the housing market:
http://calculatedrisk.blogspot.com
http://bigpicture.typepad.com
www.wallstreetexaminer.com

I found calculatedrisk to be particularly informative and thorough.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Failure = quitting

My father worked hard to convince me how important attitude is, but I didn’t do a very good job of listening. I’ve spent most of my life thinking attitude was a result, not a cause. But, now I know otherwise.

My dad is one of those really optimistic people. He expects good outcomes, and so they frequently happen. He’s one of the happiest people I know. He laughs easily, has strong relationships with family and friends, and has a good time doing even the mundane things.

When he had knee surgery last year, he was worried but also optimistic about the outcome. What happened? He’s taken to his new knee very well. This outcome is a result of his attitude, which led him to do the things he needed for the operation to be a success. He was a model patient and a model during physical therapy afterward. His outcome was assured because of his attitude.

You see, I’ve discovered that failure is not the result of things going poorly, it’s the result of quitting. No one can make you quit. You have to chose to quit. When things don’t work out the way you would like, it’s only feedback. You use this feedback to change your thinking and action, and that leads to success. As long as you keep trying, you can’t fail. As long as you keep taking that feedback and trying new approaches, you will eventually succeed.

It took me a long time to realize this, but now I see it clearly. Success happens because people go into things with the right attitude. The right attitude allows them to do the things necessary to succeed. If things don’t work out, they modify their thoughts and actions to get the outcomes they want. They don’t stop trying until they get the results they want. The only way to fail is to stop trying or to never try. The only person who fails is the one who quits.

Or, as more succinctly put by Napoleon Hill in Think and Grow Rich: ” A quitter never wins–and a winner never quits.”

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Low likelihood, high impact events

With an exciting title like that, you must be just glued to the screen right now! Probably not, but stay with me and you may see why I think this is important stuff.

One of the hardest concepts to grasp is how low likelihood, high impact events can really effect our lives. What do I mean by that? Think of winning the lottery. Now, I have your attention. That’s a low likelihood, high impact event. So is inheriting a million dollars from a distant aunt you’ve never met. But, so is getting struck by lightning or attacked by a shark. In other words, such events can be both good and bad, and their impacts are so great as to be really important to us.

The field of investing is filled with such events. According to finance theory, the likelihood of the 1987 stock market crash was statistically impossible, and yet it happened. That is an illustration of a low likelihood event, and an example of how low likelihood events occur much more frequently than theory predicts (fat tails for you statistical types out there).

The problem is that while most people eagerly seek out low likelihood, good impact events (playing the lottery), they also dismiss low likelihood, bad impact events. They think, “that’s so unlikely to happen, I’m just going to assume it never happens to me.” Not the right way to think about things, buster.

Consider speeding up to make a yellow light. Suppose you make it through the light the first 999 times, but crash into someone and kill them on the 1,000th time. If you knew those were the chances you were taking, would you speed up to try to make the light? I sure wouldn’t.

One of the difficulties, here, is that it’s hard to know the probabilities. Will you t-bone someone else’s car 1 out of a thousand times, 1 out of a million times, or 1 out of a billion times? If you thought about it, you may decide never to take that chance because you don’t ever want to court such a disaster. The problem is that most people just decide not to think about it, and have no idea what risks they’re taking.

The same problem occurs with investing. Because most people don’t know the odds–and prefer never to think about it–they take chances that eventually lead to very negative outcomes. If you go to Vegas and gamble often enough, you will lose.

Think about a bank. The way a bank works is it borrows $900 from other people, puts it’s own $100 into the pot, and then makes loans of around $1,000. If 10% of those loans go south, then the bankers get wiped out. Would you want to be a banker and assume that 10% of your loans would never, ever go into default? What if I told you that credit cycles happen every 70 years and that bankers get wiped out when that happens? Makes you want to know the odds, doesn’t it?

And that’s the point with investing, too. It’s very important to know the odds of something bad happening, and what the impact will be if that bad event occurs. If you don’t know the odds, or if you can’t handle a bad event no matter what, you probably don’t want to play.

Everyone has to assume some risks, but there are many risks people take even when they don’t need to. Learning to avoid bad risks and take good risks is the art and science of investing. Surprisingly to most, it turns out avoiding bad risks is what most investment success is about.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Does the subprime meltdown indicate something bad for the economy?

Boy, oh boy, has the subprime market’s crash been making the news. I guess everyone loves a disaster movie, right?

But, a more important question to ponder is how the subprime meltdown may impact the broader economy. Some very smart people believe it’ll lead to the next recession. People like Merrill Lynch’s David Rosenberg and commodities investing great Jim Rodgers have made their predictions known.

I’d be a fool if I said I knew the answer, but I certainly have some thoughts of my own (you know what they say about opinions). I think a lot of the economy’s growth over the last 4 years has been due to the housing market. For example, much of the growth in jobs during this expansion has been due to housing (home building, mortgage finance, real estate brokers). And, mortgage equity withdrawals have certainly been fueling consumer expenditures.

So, if the a good chunk of the economy’s growth has been due to the housing market, what would happen if a few subprime loans defaulted? Those houses would come back on the market, and the bankers who ended up with them would be eager sellers. This could lower home prices at the margin. And, more homes on the market could lead to less home building. How might this impact all the jobs created over the last 4 years in home building, mortgage finance and real estate brokerage? Not for the better.

My fear is that this dynamic feeds on itself. More laid off builders, brokers and mortgage writers could lead to more defaults. Such defaults could lead to greater inventories, lower home prices, and more laid off workers related to the housing industry. Perhaps you can see the same spiral I do.

Added to this, Congress is worried that lenders have been taking advantage of consumers. Action on their part may restrict the mortgage market even further. This could be bad news, too, because folks with adjustable rate mortgages may need to refinance exactly when Congress restricts that market, further exacerbating the problem.

Betting against the US consumer any time since the depression has looked dumb, so I hesitate to spell out this worst case scenario. But, my fear about housing is exactly what kept me out of housing related investments even as they shot the lights out over the last 4 years.

People investing in the housing market now will end up looking brilliant if things don’t fall apart. But, because it’s almost impossible to forecast how bad things may get, I’ll wonder…were they lucky, or good.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Is the subprime crash a potential investment opportunity?

If you haven’t heard, the subprime market is having a tough go of it, lately. Somewhere between two and three dozen subprime lenders have closed their doors over the last several months. Even for those who haven’t gone belly up, yet, things are looking ugly. Subprime lender New Century Financial’s stock is down 93.8% from its peak. Accredited Home Lenders is better off, but still down 73.8%.

What is subprime lending? Basically, it’s the business of making loans to people who’ve been deemed less credit worthy. Such loans are provided at higher interest rates in hopes that the lender can make enough money off higher interest payments to make up for the inevitably higher level of defaults inherent with less creditworthy customers.

In normal economic conditions, these lenders make a ton of money. But, when economic conditions sour, such loans can turn out looking like earthquake insurance sold with insufficient premiums. But, wait, you may be thinking, the economy isn’t doing poorly and interest rates haven’t spiked. The things that usually make such loans go south aren’t happening.

So, what could be happening? When something is too good to last, it doesn’t. Such has been the case with making loans to folks who can’t make the payments. Unfortunately, loans have been made to people where little proof was required to indicate income, called no document or “liar loans.” And, loans were made at teaser rates that were set to adjust at preset times to much higher rates, and those loans are resetting. And, some companies, like Countrywide Financial, made loans where people only had to pay the interest on their loans, and even paying the interest was optional! Meanwhile, each of those lenders were booking profits as if the borrowers were paying interest and principal. What a mess.

Such situations seem to spell opportunity, at least usually. When headlines are screaming that the sky is falling, it usually means that opportunity is knocking. But, I must admit, I’m not sure this is such a good opportunity. How much of a mess is this? Will it spread to Alt-A and prime loans (the next two levels up in credit quality)? How would housing price declines affect this? Do the lenders have enough financial backing to survive a downturn?

If you can answer all these questions, I think you can invest in the subprime lender of your choice. I know a lot of smart value investors who are or have done just this. I’m not following them, though, because I can’t get my arms around the accounting and assumptions for such loans. I understand, theoretically, how such companies make money, but where the rubber meets the road is in knowing their lending, servicing, default assumptions are valid even in high-stress situations. I just don’t know enough to make that bet with conviction.

In addition, interest rates are still low and the economy hasn’t fallen into a recession. What if that were to happen over the next year or two? How would the lenders do if housing prices decline, as they have been, and unemployment goes up? Those are a bunch of tough questions to answer.

Investing in subprime lenders, or even undiversified home lenders, seems a little like selling flood insurance at premiums that won’t cover a 100 year flood. Its only a matter of time before lenders become over-zealous in lending to unworthy credit risks, and that leads to trouble when the credit market turns.

Investing in a subprime lender right now is like catching a falling knife. If you do it right, you make off like a bandit. If you don’t, you’re going to end up bloody.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Warren Buffett is looking for a successor

Every March, Warren Buffett (Chairman of Berkshire Hathaway) comes out with his annual letter to shareholders. For any true devotee of value investing, this is required and eagerly anticipated reading.

The letter came out last Thursday, and I poured over it with green pen in hand to underline important sections. One section in particular was particularly interesting to me. Buffett is going to pick a much younger successor to take over investing operations when he retires.

Buffett said,

“…I intend to hire a younger man or woman with the potential to manage a very large portfolio, who we hope will succeed me as Berkshire’s chief investment officer when the need for someone to do that arises. As part of the selection process, we may in fact take on several candidates.”

How will the greatest investor in the world go about picking the right person? Paying attention to how he looks for a money manager reveals important criteria we can all use in picking investment managers or even specific investments.

He goes on to say,

“Picking the right person(s) will not be an easy task. It’s not hard to find, of course, smart people, among them individuals who have impressive investment records. But there is far more to successful long-term investing than brains and performance that has recently been good.”

Right off, he highlights that a smart person with a good record isn’t enough. He’s emphasizing that brains and a nice 3 year record are insufficient criteria for choosing a money manager.

He continues,

“Over time, markets will do extraordinary, even bizarre, things. A single, big mistake could wipe out a long string of successes. We therefore need someone genetically programmed to recognize and avoid serious risks, including those never before encountered. Certain perils that lurk in investment strategies cannot be spotted by use of the models commonly employed today by financial institutions.”

He’s highlighting the irrational behavior of markets, and how big, wrong bets can tank a recently good-looking record. He’s looking for someone who avoids risks, not someone who can shoot out the lights. In avoiding risks, he wants a successor who doesn’t assume risk solely by looking in the rear view mirror at either past events or, even worse, statistical data which doesn’t capture and cannot capture future risks.

Some managers have great records because they’ve taken great risks. You don’t want to find out they were taking huge risks after your portfolio has been mauled. As Buffett puts it, you can’t tell who is swimming naked until the tide goes out.

Next, he says,

“Temperament is also important. Independent thinking, emotional stability, and a keen understanding of both human and institutional behavior is vital to long-term investment success. I’ve seen a lot of very smart people who have lacked these virtues.”

He’s looking for someone with the right temperament for investing, someone who is independent-minded, level-headed, and understands both individual and herd psychology.

Look at his criteria:

1) intelligence and a good record aren’t enough
2) he wants someone who avoids risks, not just a manager trying to shoot out the lights
3) he’s looking for someone who doesn’t just look at the past or statistical models in making decisions
4) he wants someone who is independent, level-headed, and understands human and group psychology

Is this the criteria that most financial planners or investment books and periodicals advise? Not in my experience. But, I think Buffett clearly understands what works, and most sellers of investment advice don’t.

What I think he’s saying is that it’s more important to pick a manager with the right attitude, process and temperament than a manager who is brilliant, seemingly confident and can show a stellar record. Now, that’s advice we can all use.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.