2007 Year in Review

2007 was a very satisfactory year for me.

I generated significant market out-performance, and that came mostly by avoiding the things that did badly this year.

After waiting since 2004, this was finally the year when the mortgage bankers, mortgage insurers, bond insurers and other financial institutions reaped the consequences of their poor business practices. Although I did not short these investments, I was able to generate significant out-performance simply by avoiding the group.

Unfortunately, several of the Real Estate Investment Trusts (REITs) I invested in were also taken to the woodshed this year. In each case, I think the REITs I’ve chosen are the babies getting thrown out with the bathwater, and will almost certainly be market out-performers in the years to come.

I look forward eagerly to 2008 and beyond, when I think my out-performance will be generated not just by avoiding bad investments, but also because I’ve chosen great investments.

I believe 2008 will be another volatile year, as uncertainty about the economy and slowing corporate profits will lead to significant market moves both up and down. It should be a good year to be a bottom-up stock picker.

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.

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.

Graham and Dodd on guaranteed real-estate mortgages and mortgage bonds

I recently re-read–with pleasure–chapter XVII of the 1934 Edition of Security Analysis by Benjamin Graham and David Dodd. The chapter addresses guaranteed real-estate mortgages and mortgage bonds.

I re-read the section because I think it highlights the problems of mortgage insurance companies and other insurance companies that enter the business of guaranteeing the payment of mortgages and mortgage securities (such as surety businesses like bond insurers).

You see, the real estate boom of the 1920’s led to a terrible real estate crash in the 1930’s. It basically wiped out the mortgage insurance industry and many of the surety companies that ended up guaranteeing mortgage bonds. The history is illustrative for what can happen and what may be happening today.

I quote liberally from the text below (starting on page 184).

“The idea of underlying real-estate mortgage guarantees is evidently that of insurance.”

“It is within the province of sound insurance practice to afford this protection in return for an adequate premium, provided of course, that all phases of the business are prudently handled. Such an arrangement will have the best chance of success if:
1. The mortgage loans are conservatively made in the first instance.
2. The guaranty or surety company is large, well managed, independent of the agency selling the mortgages, and has a diversification of business in fields other than real estate.
3. Economic conditions are not undergoing fluctuations of abnormal intensity.
The collapse in real-estate values after 1929 was so extreme as to contravene the third of these conditions.”

“In the first place a striking contrast may be drawn between the way in which the business of guaranteeing mortgages had been conducted prior to about 1924 and the lax methods which developed there-after, during the very time that this part of the financial field was attaining its greatest importance.”

“The amount of each mortgage was limited to not more than 60% of the value, carefully determined; large mortgages were avoided; and a fair diversification of risk…was attained.” [loan to value ratios run very high today: 80%, 90% and even 95%]

“It is true also that the general practice of guaranteeing mortgages due only three to five years after their issuance contained the possibility, later realized, of a flood of maturing obligations at a most inconvenient time.”

“The building boom which developed during the new era was marked by an enormous growth of the real-estate-mortgage business and of the practice of guaranteeing obligations of this kind.”

“Great emphasis was laid upon the long record of success in the past, and the public was duly impressed….”

“The weakness of the mortgages themselves applied equally to the guarantees which were frequently attached thereto for an extra consideration.”

“The rise of the newer and more aggressive real-estate-bond organizations had a most unfortunate effect upon the policies of the older concerns. By force of competition they were led to relax their standards of making loans.”

“…the face amount of the mortgages guaranteed rose to so high a multiple of the capital of the guarantor companies that it should have been obvious that the guaranty would afford only the flimsiest of protection in the event of a general decline in values.”

“When the real-estate market broke in 1931, the first consequence was the utter collapse of virtually every one of the newer real-estate-bond companies and their subsidiary guarantor concerns. As the depression continued, the older institutions gave way also.”

“During the 1924-1930 period several of the independent surety and fidelity companies extended their operations to include the guaranteeing of real-estate mortgages for a fee or premium.”

“…surety companies began the practice of guaranteeing real-estate-mortgage bonds only a short time prior to their debacle….”

“In most cases the resultant losses to the suretor were greater than it could stand; several companies were forced into receivership, and holders of bonds with such guarantees failed to obtain full protection.”

Perhaps the real estate boom of the early 2000’s was similar to that of the 1920’s. If that is the case, and I believe it is to some degree, then Graham and Dodd’s historical lesson served as a potent warning for investors in mortgage and bond insurance companies. Maybe that is why they have sold at such seemingly cheap prices over the years….

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.

Beware the Black Swan

I’ve been babbling for several months now on this blog (and, as my wife can attest, for several years before that) about the risk of low probability, high impact events–what Nassim Taleb refers to as Black Swans–particularly related to the housing market.

It seems that chicken may finally be coming home to roost in the housing market and the markets that rely strongly on the housing industry.

Before I crow too loud about the malaise that is occurring, I must freely admit that I did not place any money-making bets on this decline. Quite the contrary, all I did was try to stay away from such a risk.

In staying away, I missed out on the huge run-up that has occurred in mortgage lenders, mortgage insurers, bond insurers, home builders, etc. This made me look pretty stupid in the short run, but right now I’m quite happy I don’t own any companies in these industries.

Will these industries face a total collapse or a financial crisis? I have no idea. The odds are against it. But, like all Black Swans, I want to avoid such negative, low likelihood, high impact events.

I don’t have to be able to predict when they will happen or how bad it will get, I simply have to stay away from risks I cannot accurately assess or that do not provide sufficient compensation for their risk.

I will be very interested to see how bad such housing related markets get, but I still don’t think I’ll be participating there for quite some time. After all, because it seems to be a Black Swan, I don’t know how bad it will get, and so I’m staying away until I understand what’s going on.

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.

Continued ripple effects

It’s been interesting to watch how the fallout in credit markets has rippled across other markets.

The initial indication of credit market stress showed up as subprime problems during late winter and early spring of this year. At the time, many market commentators were saying it was isolated and contained.

Then, as expected, credit tightening continued to ripple across other markets as it became more difficult to raise high yield debt. This, too, was described as a short term and isolated situation.

Now, it sounds like prime home equity loans are having trouble as are auto loans. The ripples keep showing up in more and more places. And, the market commentators continue to declare that it’s contained and short term.

Is this unusual? Not at all. This is exactly the type of thing that happens every time credit markets get too loose. As the credit market gets further and further away from its most recent problems, lower quality borrowers are loaned more and more money, or money is lent to borrowers at a rates not high enough to compensate for the risk involved.

At some point in time (forecasting if it will happen is easy, forecasting when is extraordinarily difficult), credit markets tighten again as lenders realize they have made bad loans.

This usually takes several years to unfold and almost always includes a large and “unexpected” crisis such as Long Term Capital Management in 1998, the Saving and Loan Crisis in the late 80’s and early 90’s, or the corporate credit squeeze in 2002.

I expect greater difficulties for banks (especially mortgage banks) that made bad loans, bond insurers that insured AAA tranches that were much more risky than they assumed, and mortgage insurers who looked only at recent data when pricing their insurance premiums.

At a later point in time, the market will become so disgusted that great buying opportunities will occur. I don’t think that time is here, yet, but I also assume that smart investors will start buying long before the bottom is reached. I just may be in that group, too.

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.