Worth reading

[Peculiar_Investor]

Auditors can’t audit these contracts, and regulators can’t regulate them.

So do we ban futures and derivatives? How about their very useful functions in hedging risks? Do you tell the farmer, wanting to lock in now the price for September's wheat: "Sorry, that's too complex a transaction for our regulators; you'll just have to live with the risk"?

I count myself in the massive group that doesn't understand the complexities of derivatives. That said, I've heard a number of smart people make the claim the problem is not derivatives per say, it is the problem with specific derivatives such as CDS that allow third-parties unrelated to the underlying transaction to create and sell a derivative. This allows an infinite and untrackable set of derivatives on a single underlying transaction. This is quite different that the farmer hedging his/her production, or the oil and gas producer hedging their production.

My understanding is that CDS' are essentially insurance, but they were not called insurance because of the regulatory impact/burden that would have presented. This allowed the CDS market to grow exponentially and may have contributed to the problems that we are now seeing.

Of course, my simplified understanding may not be correct and other's on FWF will correct me. As I said, I include myself if the large group that doesn't understand this complex financial engineering. As Buffett said, "Beware of geeks bearing formulas."

[ghariton]

Did you read e.g. his analysis of the flaws in Black-Scholes on pp. 20-21?

Yes. He's quite right in pointing out that Black-Scholes is being abused in many ways. For example, it's madness to use short-term volatility to forecast long-term volatility.

Which suggests that he understands derivatives very well, and is just emphasizing his disagreement, not his confusion.

Note that, in my opinion, Black-Scholes has a much more fundamental problem that Mr. Buffett doesn't mention. The formula assumes that stock returns follow a Wiener process over time. In practice, that assumes that there are no "fat tails". But of course it's been well documented that most securities do have "fat tails". So use Black-Scholes at your peril, especially over extended periods of time.

George

[Peculiar_Investor]

Did you read e.g. his analysis of the flaws in Black-Scholes on pp. 20-21?

Yes. He's quite right in pointing out that Black-Scholes is being abused in many ways. For example, it's madness to use short-term volatility to forecast long-term volatility.

Which suggests that he understands derivatives very well, and is just emphasizing his disagreement, not his confusion.

Note that, in my opinion, Black-Scholes has a much more fundamental problem that Mr. Buffett doesn't mention. The formula assumes that stock returns follow a Wiener process over time. In practice, that assumes that there are no "fat tails". But of course it's been well documented that most securities do have "fat tails". So use Black-Scholes at your peril, especially over extended periods of time.

George

I think you've highlighted a problem with most formula based concepts. Most include a statement of assumptions that are required to make the formula(s) valid. However, the assumptions are usually quickly ignored and the formula just applied without testing if the necessary pre-conditions have been met.

Everyone just wants to have "a number", without understanding how the number is generated and under what circumstances the number can be applied. When I see things "simplified" in this manner, my inner radar goes off to warn me.

[Gus]

Auditors can’t audit these contracts, and regulators can’t regulate them.

So do we ban futures and derivatives? How about their very useful functions in hedging risks? Do you tell the farmer, wanting to lock in now the price for September's wheat: "Sorry, that's too complex a transaction for our regulators; you'll just have to live with the risk"?

Perhaps, at least for the more complex ones that have unclear links to the underlying assets, certainly not for simple futures contracts. In any case, after the recent bulimic binging on these things, I would expect that bankers' appetites will change to more stodgy fare, at least for a generation. So perhaps regulation will not be necessary, in practice.

It doesn't help that a regulator who has a good understanding of that business will be hired away by the private company, at a much higher salary.

Yes. The CEO of Fannie Mae was apparently paid more than the aggregate of the entire 236 member staff of its regulatory agency, OFHEO.

Anyway, Mr. Buffett shouldn't be reading reports on complex financial instruments on his own, without expert advice, and expect to understand the details. Does he expect to be able to read, say, a geologtist's report on his own and fully understand it? He should hire some experts (and help out the economy. )

Most of the reports I write should be readable to someone like Buffett (that's the point of them) and should also, of course, be in compliance with regulations such as NI 51-101 and non-codified but generally accepted geoscience standards. I think that the problem with some of the derivatives contracts (and some of the accounting, say, at Enron) is that the structures were designed to obscure rather than illuminate the underlying business fundamentals.

Do your clients need to hire a lawyer to read the reports they pay you to provide?

[ghariton]

I think that the problem with some of the derivatives contracts (and some of the accounting, say, at Enron) is that the structures were designed to obscure rather than illuminate the underlying business fundamentals.

I don't think that the derivatives were designed to confuse. But I agree that disclosure. i.e. explanation of what they were, and especially the assumptions on which they were evaluated, was woefully inadequate. I'm sure that's because the banks/financial institutions/others wanted to paint as attractive a picture as possible. But I suspect that lack of understanding by the people drawing up the disclosure was also a factor.

Do your clients need to hire a lawyer to read the reports they pay you to provide?

Sorry, I didn't mean to pick on geologists.

Law is not all that complicated, so I expect that any lawyer's opinion should be fully comprehensible to an intelligent lay person.

However, I also do reports on economic issues. At one time I used to spell out all my assumptions, etc, in the body of my report. But that annoyed most of my clients. (Indeed, I remember one CEO who was annoyed if there were any footnotes.) So I started putting the details of my analysis in an appendix. Eventually, I didn't even send the appendix, telling the client that it was available upon request.

The only time my economics reports get scrutinized in any detail is when I serve as an expert witness. The other side typically brings in their own experts and try to take my stuff apart. (I do the same to them.)

But that's a far cry from what shows up in the annual report. As a concrete example, when Bell wrote down several billion in 1997, I pulled together most of the analysis. We made a lot of assumptions and ran a lot of sensitivities. As a result, while I could stand behind the numbers as my best esimate at the time, I knew that they were very uncertain. But I doubt that anyone reading the public disclosures would get a sense of that -- except for depreciation experts.

George

[WishingWealth]

GHARITON: "(I do the same to them.)"

OMG, that must break your heart. Do you charge a duress praemium when this happens.

WW

[Peculiar_Investor]

I just finished Lowenstein's When Genius Failed, on the LTCM collapse. A fascinating read, with some relevance to the current sub-prime crisis.

The hubris of the firm was the belief that their models would always succeed. When liquidity dried up and the valuations were off more than the theory predicted, the leverage killed them.

I just finished the book and kept shaking my head at how relevant is was to the current crisis. From the epilogue,

The Long-Term crisis happened to involve a hedge fund, but the fathers of the crisis were the big Wall Street banks, which let their standards grow lax as their pocketbooks grew flush

This was published in 2000, but seems to apply to the current crisis.

A recommended read to all. Check out http://books.google.ca/books?id=-xgOQ6jnQooC Most of the epilogue is available for reading on-line.

[Gus]

The Financial Times has a new series on the Future of Capitalism. Registration may be required.

I have only read two articles so far but they are both surprising in how far away from free-market ideology and how far towards interventionist social policies the FT's writers are going. If these opinions, from a journal that hardly has had a history of left-wing bias, are in any way indicative of where mainstream thinking about the economy is heading, we really are in for a major shift away from free markets, every bit as dramatic as the swing towards economic liberalism after the collapse of the Soviet Union.

Another ideological god has failed. The assumptions that ruled policy and politics over three decades suddenly look as outdated as revolutionary socialism.

“The nine most terrifying words in the English language are: ‘I’m from the government and I’m here to help.’” Thus quipped Ronald Reagan, hero of US conservatism. The remark seems ancient history now that governments are pouring trillions of dollars, euros and pounds into financial systems.

“Governments bad; deregulated markets good”: how can this faith escape unscathed after Alan Greenspan, pupil of Ayn Rand and predominant central banker of the era, described himself, in congressional testimony last October, as being “in a state of shocked disbelief” over the failure of the “self-interest of lending institutions to protect shareholders’ equity”?

Three ideas taught in business schools have much to answer for. One is the theory of “efficient capital markets”, now clearly discredited. The second is “principal agent” theory, which says the agents will perform best under high-powered financial incentives to align their interests with those of the principal. This has led to excessive performance-related pay, which has often undermined the motive to work well for the sake of doing a good job and introduced unnecessary tension among colleagues. Finally, there is the macho philosophy of “continuous change”, promoted by self-interested consulting companies, which disregards the fundamental human need for stability – in the name of efficiency gains that are often not realised.

We do not want communism – as research shows, the communist countries were the least happy in the world and also inefficient. But we do need a more humane brand of capitalism, based not only on better regulation but on better values.

Values matter and they are affected by our theories. We do not need a society based on Darwinian competition between individuals. Beyond subsistence, the best experience any society can provide is the feeling that other people are on your side. That is the kind of capitalism we want.

[WishingWealth]

I often go through Wolf's and other FT articles comments and it's quite interesting to find some real 'heavy weights' amongst the commenters.
The article is sometimes just an appetizer to the real thing.

WW

FWIW: A recent Wolf interview@ Charlie Rose.
http://www.charlierose.com/view/interview/10058

[Jo Anne]

Finally, there is the macho philosophy of “continuous change”, promoted by self-interested consulting companies, which disregards the fundamental human need for stability – in the name of efficiency gains that are often not realised.

Hah! That is hilarious.

Back in the late '90s I had several contracts working for a dotcom that spent all of its time re-organizing, amalgamating, buying and selling companies, relocating head offices, hiring expensive executives, and upgrading its accounting/software systems. There was very little effort expended towards actual "work," and they never made a cent of profit as far as I know. Pulled in lots of investment capital though.

I once asked my boss (a consultant, also working on contract) why they did this, and she told me that a lot of people were making a lot of money from this. She and I included.

After 20 minutes of googling, I can find no trace of the company. It appears to have either disappeared or been absorbed by some other firm.

I'm once again reminded of this: Consulting. If you're not part of the solution, there's good money to be made in prolonging the problem.

[bailey]

Reminds me of this consulting joke:

A physician, a civil engineer, and a consultant were arguing about what was the oldest profession in the world.

The physician remarked, "Well, in the Bible, it says that God created Eve from a rib taken out of Adam. This clearly required surgery, and so I can rightly claim that mine is the oldest profession in the world."

The civil engineer interrupted, and said, "But even earlier in the book of Genesis, it states that God created the order of the heavens and the earth from out of the chaos. This was the first and certainly the most spectacular application of civil engineering. Therefore, fair doctor, you are wrong: mine is the oldest profession in the world."

The consultant leaned back in her chair, smiled, and then said confidently, "Ah, but who do you think created the chaos?"

[ghariton]

The Financial Times has a new series on the Future of Capitalism.

Terence Corcoran doesn't like the series (gosh, I never thought I would ever link to him, but it's on topic):

Nothing warms the bottoms of this crowd of power-seekers and regulators-in-waiting more than a good financial crisis.

FWIW, I think Corcoran is a clown, but I also think Wolf is too much of a pessimist. But he writes well, and has managed to attract some very heavy hitters to the FT.

I'm looking forward to concrete suggestions as to how the present system should be reformed.

George

[ghariton]

Speaking of left-wing economists, here's Amartya Sen. After due reflection, he concludes that capitalism will survive after all, but that it will have to be transformed.

Interestingly, he thinks that many arguments today are overly reliant on Keynes. He prefers to go back further, to Adam Smith himself, but also to A.C. Pigou, who he finds quite relevant to today. (Interesting how many economists are slaves to the ideas of dead economists.... or something like that.)

As to concrete details, he mentions better care of the environment, reform of the U.S. health care system, and more investment in public transport. That seems a very modest list. But then it's a lot more than most reformers offer.

In passing, here's what he has to say about reforming the U.S. health care system:

In US discussions of health reform, there has been an overconcentration on the Canadian system—a system of public health care that makes it very hard to have private medical care—whereas in Western Europe the national health services provide care for all but also allow, in addition to state coverage, private practice and private health insurance, for those who have the money and want to spend it this way. It is not clear just why the rich who can freely spend money on yachts and other luxury goods should not be allowed to spend it on MRIs or CT scans instead.

Does that mean that even the American left is to the right of the Canadian center?

George

[Gus]

FWIW, I think Corcoran is a clown, but I also think Wolf is too much of a pessimist. But he writes well, and has managed to attract some very heavy hitters to the FT.

Agreed on both counts, although I always enjoy reading Corcoran and it's nice to see him ranting about junk economics rather than junk science.

I also think that some of the predictions about social disorder as a result of this crisis are overdone (eg, Niall Ferguson's recent articles) especially in Democratic societies where the pissed-off masses get a chance to throw the rascals out every few years. But things could easily get ugly in China if the government there acts clumsily.

I'm looking forward to concrete suggestions as to how the present system should be reformed.

Yes, this whole area seems to be a heck of a lot easier to talk about than to take action in. I am pessimistic that the boom-bust economic cycle can be changed by regulation or other measures such as transparency. The hard lessons of economic crises get learned but are soon forgotten as a newer, smarter generation games the old rules and makes a claim that it's really different this time; which is often just a rationalization for wilful blindness. Proposals such as narrower banks and escrowing employee bonuses for five years would help slow the cycle time down and mitigate some of the worst effects, but would not prevent booms and crashes, which seem to be inevitable consequences of mixing people and money.

Still, it means we might have a new bubble to look forward to soon!

[Peculiar_Investor]

Here is an out-of-print value financial book, currently featured in Business Week, that I have never heard of ...

Seth Klarman's 1991 work, Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor

Has anyone here read it?

Not me, but I think that $700 is a decline from last time a similar story surfaced

I do know that a partial scanned version is making the rounds on the internet. But I don't have a copy. The best, and morally correct, thing to do is to get it from a library.

Klarman is out of print and, for all we know, will remain out of print forever. If it does remain out of print, then is reading a scanned copy remarkably more immoral than reading a library copy? (As far as I can tell, exactly one copy exists among all public libraries in BC.)

This is, IMO, one of the best, or perhaps the best, book on common stock investing written to date.

You have to download it because you can't get it from the library, except in very rare cases. This book is a prime example why a library cannot loan out (for very long) highly valuable works. Too great an incentive for people to 'lose' (ie steal the book) and pay some trivial fine. You think Archivists would maintain some sort of master databank (say all OOP books selling on Amazon for > $200) and then valuable works could remain in reference for all to enjoy but unfortunately, that isn't how things seem to work. So.....Bit Torrent, not because it's free, because it's the right thing to do:
http://isohunt.com/torrent_details/4724 ... &babelfish

A more recent Klarman article from www.valueinvestorinsight.com ($$$), The Value of Not Being Sure (link to a free version, looks like a scan). A financial advisor sent me a PDF copy.

[Bylo Selhi]

(link to a free version, looks like a scan). A financial advisor sent me a PDF copy.

I'm not a financial advisor (although I do play one on FWF) but I can send everyone an "original" PDF copy

[FinEcon]

Peculiar Investor and Bylo.....many thanks for the heads up on the latest Klarman article.

[Gus]

I have just finished reading The Long and the Short of it: A Guide to Finance and Investment for Normally Intelligent People Who Aren't in the Industry.

Of the few investment books I have read, this is by far the best and, although it is designed for the general reader, it's not always a very easy read, since he deals with some tough subjects. John Kay is an academic economist and a businessman, he has sat on the boards of major financial corporations and has run the investment fund of an Oxford college. He's also a journalist for the Financial Times.

The overall message of the book is: do-it-yourself; keep costs low; index but diversify beyond indexing by making contrarian, out-of-fashion, value stock and sector picks. He discusses and describes many of the models and methods of modern finance, such as the Efficient Markets Hypotheses, the Capital Assets Pricing Model, Expected Value Calculations and Subjective Expected Utility. Typically, he comments that such models are "illuminating but not true".

The book is written for a British audience and about 10% of it is not directly applicable for Canadians, since it refers to the British equivalents of RRSPs, UK income taxes and the City instead of Wall/Bay Street. For the majority of FWF members, that should not be a big drawback.

By my reckoning, he rather downplays the role of bonds and overstates the importance of investing in real property. I have lent my copy to Norbert and asked for him to post a professional's review here when he's done.

The reviews on the Amazon site linked above are worth reading.

[adrian2]

By my reckoning, he rather downplays the role of bonds and overstates the importance of investing in real property.

Having spent a couple of months around year 2k in Australia, I was surprised that generally accepted financial wisdom Down Under puts real estate on a high pedestal, somewhere closer to stocks (aka shares in their lingo).

[Bylo Selhi]

Actively Mismanaged Funds

Mutual fund managers are paid lavishly in good markets and bad. In the current bad one, a lot of them aren't earning their keep...

[Bill Miller's] Value Trust is an exceptional case of outsize gains followed by outsize losses, but the phenomenon of active managers creating wealth only for themselves is no fluke. What makes this especially searing to investors these days is the implication by many active funds that they're worth a premium because they'll rescue you from nasty bear markets while "dumb" index funds abandon you to a mauling.

The facts indicate otherwise. Last year, during the worst stock market drubbing since 1931, the average active stock fund lost 40.5%, versus a 37% loss for the market-tracking Vanguard S&P 500 Index, according to Morningstar. Stretch out the time frame and active management looks no better. According to Standard & Poor's, 69% of actively run large-company funds, 76% of funds buying midsize companies and 79% of funds buying small companies underperformed their indexes in the five years through last June.

"Investors have been willing to subordinate their own economic interests to the fund managers'," sighs Vanguard founder John Bogle, who has devoted his life to popularizing passive funds. He hopes the declines will force investors to hold their fund managers to account: "At some point there's going to be a comeuppance."

[Taggart]

I thumbed through the following book at the library many years ago. From what I've read elsewhere on the internet, I'm pretty sure the investing techniques displayed in it are outdated. Although I found the book fascinating, I can't pretend to have understood everything written in it, I couldn't. For those who have a mathematical bent though, you may find the book of interest in historical terms.

Beat the Market: A Scientific Stock Market System

You can find more about one of the authors, Edward O. Thorp here.

The book was originally published in 1967 and you can read what looks to be the entire book, available free on the web here.

[skepticus]

New Rules of Reirement--What Your Financial Advisor Isn't Telling You--by Warren Mackenzie and Ken Hawkins.

Well-written, concise retirement advice which applies not only to finances but lifestyle as well.

While you are focusing on financial matters, you can easily overlook some of the other important elements that give meaning and enjoyment to life.

[parvus]

Junk bond king Michael Milken on capital structure:

The late Nobel laureate Merton Miller and I, although good friends, long debated whether this kind of capital-structure management is an essential job of corporate leaders. Miller believed that capital structure was not important in valuing a company's securities or the risk of investing in them.

My belief -- first stated 40 years ago in a graduate thesis and later confirmed by experience -- is that capital structure significantly affects both value and risk. The optimal capital structure evolves constantly, and successful corporate leaders must constantly consider six factors -- the company and its management, industry dynamics, the state of capital markets, the economy, government regulation and social trends. When these six factors indicate rising business risk, even a dollar of debt may be too much for some companies.

Over the past four decades, many companies have struggled with the wrong capital structures. During cycles of credit expansion, companies have often failed to build enough liquidity to survive the inevitable contractions. Especially vulnerable are enterprises with unpredictable revenue streams that end up with too much debt during business slowdowns. It happened 40 years ago, it happened 20 years ago, and it's happening again.

[ghariton]

parvus, thanks for the link.

Now let me see if I have this right.

On the one hand we can have deregulation of financial institutions and markets, because after all, capital markets are efficient, and robust, and don't really need supervision -- or if they do, it is of the most rudimentary sort.

On the other hand, wall street bankers need huge compensation because only they can make the financial markets run properly. Implied is the idea that these markets are terribly fragile, and if you don't have the very best people involved, the whole thing will come crashing down.

Speaking of the sorry plight of the wall street bankers who have lost their jobs and are struggling to make ends meet: Did these clowns build up a nest egg against a rainy day? And if they didn't do that, why should we entrust them with risk management of any kind? And if they did build up a nest egg, what is their problem now?

George

[NormR]

And if they did build up a nest egg, what is their problem now?

Their TARP is leaky?