Catching falling knives

One of the most difficult tasks in investing is to buy things as they go down. Psychologically, its no fun.

Hence, some investors refer to this as catching falling knives: you may do it right, but you may also get cut.

The payoff in investing can be huge. Buying companies that most people think will go bankrupt can be very profitable–if they don’t go bankrupt. There’s the rub, as Shakespeare put it.

How do you know the company in question won’t go bankrupt? There are very smart people out there who know enough about certain businesses, bankruptcy, etc., who can pull this off. But it’s not for the faint of heart any more than catching literal falling knives.

This question occured to me because a lot of very smart value investors are looking hard at mortgage and bond insurance companies (which I wrote about here and here).

Mortgage guarantee companies like Triad and Radian and bond insurers like Ambac and MBIA have been taken out to the woodshed recently, in terms of their stock prices. This seems justified considering they seem to insure a lot more than they could pay out.

Such investments were great as long as you assumed a housing recession or deep economic recession never hit. That doesn’t seem like a very wise bet, now, nor did it beforehand.

The question is how will these investments do going forward? It seems hard to imagine the government will let the rating agencies downgrade their insurance ratings, for this would surely put them out of business and leave the financial markets in one heck of a mess (tons of investors have their money insured by these entities and would lead to a major dislocation).

But, do you want bet on that? That’s the question. Will the government save these entities? Should their shareholders get off scott-free instead of bearing the risk they took? Will this encourage moral hazard (I can answer that last one–YES)?

Although I believe a ton of money could be made by investing in bond and mortgage insurers at these prices, I’m not expert enough to catch these falling knives. Do I know enough about the risks they’ve assumed and the capital they can use to support claims and the cozy relationship between rating agencies/the government/such insurers?

I don’t. And not many do.

Perhaps that’s why it might be best to leave catching falling knives to the experts.

As Warren Buffett put it, I don’t try to find 7 foot fences to jump, I look for 1 foot fences to step over. Bond and mortgage insurers look like a 7 foot fence to me.

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.

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