Beer - In the Clear
One of the nice aspects of trying to solve investment puzzles is recognizing
that even though I am not always going to be right, I don't have to be. Decent
portfolio management allows for some bad luck and some bad decisions. When
something does go wrong, I like to think about the bad decisions and learn
from them so that hopefully I don't repeat the same mistakes. This leaves
me plenty of room to make fresh mistakes going forward. I'd like to start
today by reviewing a bad decision I made and share with you what I've learned
from that error and how I am attempting to apply the lessons to improve our
At the May 2005
Ira Sohn Investment Research Conference in New York, I recommended MDC Holdings,
a homebuilder, at $67 per share. Two months later MDC reached $89 a share,
a nice quick return if you timed your sale perfectly. Then the stock collapsed
with the rest of the sector. Some of my MDC analysis was correct: it was less
risky than its peers and would hold-up better in a down cycle because it had
less leverage and held less land. But this just meant that almost half a decade
later, anyone who listened to me would have lost about forty percent of his
investment, instead of the seventy percent that the homebuilding sector lost.
I want to revisit
this because the loss was not bad luck; it was bad analysis. I down played
the importance of what was then an ongoing housing bubble. On the very same
day, at the very same conference, a more experienced and wiser investor, Stanley
Druckenmiller, explained in gory detail the big picture problem the country
faced from a growing housing bubble fueled by a growing debt bubble. At the
time, I wondered whether even if he were correct, would it be possible
to convert such big picture macro-thinking into successful portfolio management?
I thought this was particularly tricky since getting both the timing of big
macro changes as well as the market's recognition of them correct has proven
at best a difficult proposition. Smart investors had been complaining about
the housing bubble since at least 2001. I ignored Stan, rationalizing that
even if he were right, there was no way to know when he would be right. This
was an expensive error.
that I have learned is that it isn't reasonable to be agnostic about the big
picture. For years I had believed that I didn't need to take a view on
the market or the economy because I considered myself to be a "bottom
up" investor. Having my eyes open to the big picture doesn't mean abandoning
stock picking, but it does mean managing the long-short exposure ratio more
actively, worrying about what may be brewing in certain industries, and when
appropriate, buying some just-in-case insurance for foreseeable macro risks
even if they are hard to time. In a few minutes, I will tell you what
Greenlight has done along these lines.
But first, I'd
like to explain what I see as the macro risks we face. To do that I need to
digress into some political science. Please humor me since my mom and dad
spent a lot of money so I could be a government major, the usefulness of which
has not been apparent for some time.
said that, "Democracy is the worst form of government except for all
the others that have been tried from time to time."
As I see it,
there are two basic problems in how we have designed our government. The first
is that officials favor policies with short-term impact over those in our
long-term interest because they need to be popular while they are in office
and they want to be re-elected. In recent times, opinion tracking polls, the
immediate reactions of focus groups, the 24/7 news cycle, the constant campaign,
and the moment-to-moment obsession with the Dow Jones Industrial Average have
magnified the political pressures to favor short-term solutions. Earlier this
year, the political topic du jour was to debate whether the stimulus was working,
before it had even been spent.
was an unusual public official because he was willing to make unpopular decisions
in the early '80s and was disliked at the time. History, though, judges him
kindly for the era of prosperity that followed.
Bernanke and Tim Geithner have become the quintessential short-term decision
makers. They explicitly "do whatever it takes" to "solve one
problem at a time" and deal with the unintended consequences later. It
is too soon for history to evaluate their work, because there hasn't been
time for the unintended consequences of the "do whatever it takes"
decision-making to materialize.
The second weakness
in our government is "concentrated benefit versus diffuse harm"
also known as the problem of special interests. Decision makers help small
groups who care about narrow issues and whose "special interests"
invest substantial resources to be better heard through lobbying, public relations
and campaign support. The special interests benefit while the associated costs
and consequences are spread broadly through the rest of the population. With
individuals bearing a comparatively small extra burden, they are less motivated
or able to fight in Washington.
In the context
of the recent economic crisis, a highly motivated and organized banking lobby
has demonstrated enormous influence. Bankers advance ideas like, "without
banks, we would have no economy." Of course, there was a public interest
in protecting the guts of the system, but the ATMs could have continued working,
even with forced debt-to-equity conversions that would not have required any
public funds. Instead, our leaders responded by handing over hundreds of billions
of taxpayer dollars to protect the speculative investments of bank shareholders
and creditors. This has been particularly remarkable, considering that most
agree that these same banks had an enormous role in creating this mess which
has thrown millions out of their homes and jobs.
with their parents away, financial institutions threw a wild party that eventually
tore-up the neighborhood. With their charge arrested and put in jail to detoxify,
the supervisors were faced with a decision: Do we let the party goers learn
a tough lesson or do we bail them out? Different parents with different philosophies
might come to different decisions on this point. As you know our regulators
went the bail-out route.
But then the
question becomes, once you bail them out, what do you do to discipline the
misbehavior? Our authorities have taken the response that kids will be kids.
"What? You drank beer and then vodka. Are you kidding? Didn't I teach
you, beer before liquor, never sicker, liquor before beer, in the clear! Now,
get back out there and have a good time." And for the last few months
we have seen the beginning of another party, which plays nicely toward government
preferences for short-term favorable news-flow while satisfying the banking
special interest. It has not done much to repair the damage to the neighborhood.
And the neighbors
are angry, because at some level, Americans understand that the Washington-Wall
Street relationship has rewarded the least deserving people and institutions
at the expense of the prudent. They don't know the particulars or how to argue
against the "without banks, we have no economy" demagogues. So,
they fight healthcare reform, where they have enough personal experience to
equip them to argue with Congressmen at town hall meetings. As I see it, the
revolt over healthcare isn't really about healthcare, but represents a broader
upset at Washington. The lack of trust over the inability to deal seriously
with the party goers feeds the lack of trust over healthcare.
On the anniversary
of Lehman's failure, President Obama gave a terrific speech. He said, "Those
on Wall Street cannot resume taking risks without regard for the consequences,
and expect that next time, American taxpayers will be there to break the fall."
Later he advocated an end of "too big to fail." Then he added, "For
a market to function, those who invest and lend in that market must believe
that their money is actually at risk." These are good points that he
should run by his policy team, because Secretary Geithner's reform proposal
does exactly the opposite.
reform on the table is analogous to our response to airline terrorism by frisking
grandma and taking away everyone's shampoo, in that it gives the appearance
of officially "doing something" and adds to our bureaucracy without
really making anything safer.
With the ensuing
government bailout, we have now institutionalized the idea of too-big-to-fail
and insulated investors from risk.
The proper way
to deal with too-big-to-fail, or too inter-connected to fail, is to make sure
that no institution is too big or inter-connected to fail. The test ought
to be that no institution should ever be of individual importance such that
if we were faced with its demise the government would be forced to intervene.
The real solution is to break up anything that fails that test.
The lesson of
Lehman should not be that the government should have prevented its failure.
The lesson of Lehman should be that Lehman should not have existed at a scale
that allowed it to jeopardize the financial system. And the same logic applies
to AIG, Fannie, Freddie, Bear Stearns, Citigroup and a couple dozen others.
years ago the government dismantled AT&T. Its break-up set forth decades
of unbelievable progress in that industry. We can do that again here in the
financial sector and we would achieve very positive social benefit with no
cost that anyone can seem to explain.
reform takes us in the polar opposite direction. The cop-out response from
Washington is that it isn't "practical." Our leaders are so influenced
by the banking special interests that they would rather declare it "impractical"
than roll up their sleeves and figure out how to get the job done.
have installed a great deal of moral hazard, which in the absence of radical
change will be reinforced and thereby grant every big institution a permanent
"implicit" government backstop. This creates an enormous ongoing
subsidy for the too-bigto-fails, as well as making it much harder for the
non-too-big-to-fails to compete. In effect, we all continue to subsidize the
big banks even though we keep hearing the worst of the crisis is behind us.
the now larger too-big-to-fails are beginning to take advantage of developing
oligopolies. Even as the government spends trillions to subsidize mortgage
rates, the resulting discount is not being passed to homeowners but is being
kept by mortgage originators who are earning record profits per mortgage originated.
Recently, Goldman upgraded Wells Fargo partly based on its ability to earn
long-term oligopolistic mortgage origination spreads.
reform does not deal with the serious risks that the recent crisis exposed.
Credit Default Swaps, which create large, correlated and asymmetric risks,
scared the authorities into spending hundreds of billions of taxpayer money
to prevent the speculators who made bad bets from having to pay.
CDS are also
highly anti-social. Bondholders who also hold CDS make a bigger return when
the issuing firms fail. As a result, holders of so-called "basis packages"
a bond and a CDS have an incentive to use their position as
bondholders to force bankruptcy triggering payment on their CDS, rather than
negotiate traditional out of court restructurings or covenant amendments with
troubled creditors. Press accounts have noted that this dynamic has contributed
to the recent bankruptcies of Abitibi-Bowater, General Growth Properties,
Six Flags and even General Motors. They are a pending problem in CIT's efforts
to avoid bankruptcy.
The reform proposal
to create a CDS clearing house does nothing more than maintain private profits
and socialized risks by moving the counter-party risk from the private sector
to a newly created too-big-to-fail entity. I think that trying to make safer
CDS is like trying to make safer asbestos. How many real businesses have to
fail before policy makers decide to simply ban them?
money markets were exposed as creating systemic risk during the crisis. Apparently,
investors in these pools of lending assets that carry no reserve for loss
expect to be shielded from losing money while earning a higher return than
bank deposits or T-bills. Mr. Bernanke decided they needed to be bailed out
to save the system. It is hard to imagine why this structure shouldn't be
fixed, either by adding them to the FDIC insurance program and subjecting
them to bank regulation, or at least forcing them to stop using $1 net-asset
values, which gives their customers the impression that they can't fall in
The most constructive
aspect of the Geithner reform plan is to separate banking from commerce. This
would have the effect of forcing industrial companies to divest big finance
subsidiaries, which would have to be regulated as banks. During the bubble,
companies like GMAC, AIG Financial Products and GE Capital, with cheap funding
supported by inaccurate credit ratings, took enormous unregulated risks. When
the crisis hit, GMAC and AIG needed huge federal bailouts. The Federal Reserve
set up the Commercial Paper Funding Facility to backstop GE Capital among
others, and GE became the largest borrower under the FDIC's Temporary Liquidity
Guarantee Program, even though prior to the crisis it wasn't even in the FDIC.
to the Geithner proposal, GE immediately let it be known that it had "talked
to a number of people in Congress" and it should not have to separate
its finance subsidiary because it disingenuously asserted that it hadn't contributed
to the crisis. We will see whether the GE special interest is able to stave-off
this constructive reform proposal.
deal with these simple problems with simple, obvious solutions, the official
reform plans are complicated, convoluted and designed to only have the veneer
of reform while mostly serving the special interests. The complications serve
to reduce transparency, preventing the public at large from really seeing
the overwhelming influence of the banks in shaping the new regulation.
In dealing with
the continued weak economy, our leaders are so determined not to repeat the
perceived mistakes of the 1930s that they are risking policies with possibly
far worse consequences designed by the same people at the Fed who ran policy
with the short-term view that asset bubbles don't matter because the fallout
can be managed after they pop. That view created a disaster that required
unprecedented intervention for which our leaders congratulated themselves
for doing whatever it took to solve. With a sense of mission accomplished,
the G-20 proclaimed "it worked."
We are now being
told that the most important thing is to not remove the fiscal and monetary
support too soon. Christine Romer, a top advisor to the President, argues
that we made a great mistake by withdrawing stimulus in 1937.
Just to review,
in 1934 GDP grew 17.0%, in 1935 it grew another 11.1%, and in 1936 it grew
another 14.3%. Over the period unemployment fell by 30%. That is three years
of progress. Apparently, even this would not have been enough to achieve what
Larry Summers has called "exit velocity."
our modern market, where we now get economic data on practically a daily basis,
living through three years of favorable economic reports and deciding that
it would be "premature" to withdraw the stimulus.
lesson from the double dip the economy took in 1938 is that the GDP created
by massive fiscal stimulus is artificial. So whenever it is eventually removed,
there will be significant economic fall out. Our choice may be either to maintain
large annual deficits until our creditors refuse to finance them or tolerate
another leg down in our economy by accepting some measure of fiscal discipline.
me to our present fiscal situation and the current investment puzzle.
Over the next
decade the welfare states will come to face severe demographic problems. Baby
Boomers have driven the U.S. economy since they were born. It is no coincidence
that we experienced an economic boom between 1980 and 2000, as the Boomers
reached their peak productive years. The Boomers are now reaching retirement.
The Social Security and Medicare commitments to them are astronomical.
When the government
calculates its debt and deficit it does so on a cash basis. This means that
deficit accounting does not take into account the cost of future promises
until the money goes out the door. According to shadowstats.com, if the federal
government counted the cost of its future promises, the 2008 deficit was over
$5 trillion and total obligations are over $60 trillion. And that was before
Over the last
couple of years we have adopted a policy of private profits and socialized
risks. We are transferring many private obligations onto the national ledger.
Although our leaders ought to make some serious choices, they appear too trapped
in short-termism and special interests to make them. Taking no action is an
In the nearer-term
the deficit on a cash basis is about $1.6 trillion or 11% of GDP. President
Obama forecasts $1.4 trillion next year, and with an optimistic economic outlook,
$9 trillion over the next decade. The American Enterprise Institute for Public
Policy Research recently published a study that indicated that "by all
relevant debt indicators, the U.S. fiscal scenario will soon approximate the
economic scenario for countries on the verge of a sovereign debt default."
As we sit here
today, the Federal Reserve is propping up the bond market, buying long-dated
assets with printed money. It cannot turn around and sell what it has just
There is a basic
rule of liquidity. It isn't the same for everyone. If you own 10,000 shares
of Greenlight Re, you have a liquid investment. However, if I own 5 million
shares it is not liquid to me, because of both the size of the position and
the signal my selling would send to the market. For this reason, the Fed cannot
sell its Treasuries or Agencies without destroying the market. This means
that it will be challenged to shrink the monetary base if inflation actually
Federal Open Market Committee members may not recognize inflation when they
see it, as looking at inflation solely through the prices of goods and services,
while ignoring asset inflation, can lead to a repeat of the last policy error
of holding rates too low for too long.
At the same
time, the Treasury has dramatically shortened the duration of the government
debt. As a result, higher rates become a fiscal issue, not just a monetary
one. The Fed could reach the point where it perceives doing whatever it takes
requires it to become the buyer of Treasuries of first and last resort.
even more vulnerable, because it is even more indebted and its poor demographics
are a decade ahead of ours. Japan may already be past the point of no return.
When a country cannot reduce its ratio of debt to GDP over any time horizon,
it means it can only refinance, but can never repay its debts. Japan has about
190% debt-to-GDP financed at an average cost of less than 2%. Even with the
benefit of cheap financing the Japanese deficit is expected to be 10% of GDP
this year. At some point, as American homeowners with teaser interest rates
have learned, when the market refuses to refinance at cheap rates, problems
quickly emerge. Imagine the fiscal impact of the market resetting Japanese
borrowing costs to 5%.
Over the last
few years, Japanese savers have been willing to finance their government deficit.
However, with Japan's population aging, it's likely that the domestic savers
will begin using those savings to fund their retirements. The newly elected
DPJ party that favors domestic consumption might speed up this development.
Should the market re-price Japanese credit risk, it is hard to see how Japan
could avoid a government default or hyperinflationary currency death spiral.
of Lehman meant that barring extraordinary measures, Merrill Lynch, Morgan
Stanley and Goldman Sachs would have failed as the credit market realized
that if the government were willing to permit failures, then the cost of financing
such institutions needed to be re-priced so as to invalidate their business
I believe there
is a real possibility that the collapse of any of the major currencies could
have a similar domino effect on re-assessing the credit risk of the other
fiat currencies run by countries with structural deficits and large, unfunded
commitments to aging populations.
I believe that
the conventional view that government bonds should be "risk free"
and tied to nominal GDP is at risk of changing. Periodically, high quality
corporate bonds have traded at lower yields than sovereign debt. That could
And, of course,
these structural risks are exacerbated by the continued presence of credit
rating agencies that inspire false confidence with potentially catastrophic
results by over-rating the sovereign debt of the largest countries. There
is no reason to believe that the rating agencies will do a better job on sovereign
risk than they have done on corporate or structured finance risks.
My firm recently
met with a Moody's sovereign risk team covering twenty countries in Asia and
the Middle East. They have only four professionals covering the entire region.
Moody's does not have a long-term quantitative model that incorporates changes
in the population, incomes, expected tax rates, and so forth. They use a short-term
outlook only 12-18 months to analyze data to assess countries'
abilities to finance themselves. Moody's makes five-year medium-term qualitative
assessments for each country, but does not appear to do any long-term quantitative
or critical work.
Their main role,
again, appears to be to tell everyone that things are fine, until a real crisis
emerges at which point they will pile-on credit downgrades at the least opportune
moment, making a difficult situation even more difficult for the authorities
I can just envision
a future Congressional Hearing so elected officials can blame the rating agencies
for blowing it, as the rating agencies respond by blaming Congress.
Now, the question
for us as investors is how to manage some of these possible risks. Four years
ago I spoke at this conference and said that I favored my Grandma Cookie's
investment style of investing in stocks like Nike, IBM, McDonalds and Walgreens
over my Grandpa Ben's style of buying gold bullion and gold stocks. He feared
the economic ruin of our country through a paper money and deficit driven
hyper inflation. I explained how Grandma Cookie had been right for the last
thirty years and would probably be right for the next thirty as well. I subscribed
to Warren Buffett's old criticism that gold just sits there with no yield
and viewed gold's long-term value as difficult to assess.
recent crisis has changed my view. The question can be flipped: how does one
know what the dollar is worth given that dollars can be created out of thin
air or dropped from helicopters? Just because something hasn't happened, doesn't
mean it won't. Yes, we should continue to buy stocks in great companies, but
there is room for Grandpa Ben's view as well.
I have seen
many people debate whether gold is a bet on inflation or deflation. As I see
it, it is neither. Gold does well when monetary and fiscal policies are poor
and does poorly when they appear sensible. Gold did very well during the Great
Depression when FDR debased the currency. It did well again in the money printing
1970s, but collapsed in response to Paul Volcker's austerity. It ultimately
made a bottom around 2001 when the excitement about our future budget surpluses
gold should do fine unless our leaders implement much greater fiscal and monetary
restraint than appears likely. Of course, gold should do very well if there
is a sovereign debt default or currency crisis.
A few weeks
ago, the Office of Inspector General called out the Treasury Department for
misrepresenting the position of the banks last fall. The Treasury's response
was an unapologetic expression that amounted to saying that at that point
"doing whatever it takes" meant pulling a Colonel Jessup: "YOU
CAN'T HANDLE THE TRUTH!" At least we know what we are dealing with.
When I watch
Chairman Bernanke, Secretary Geithner and Mr. Summers on TV, read speeches
written by the Fed Governors, observe the "stimulus" black hole,
and think about our short-termism and lack of fiscal discipline and political
will, my instinct is to want to short the dollar. But then I look at the other
major currencies. The Euro, the Yen, and the British Pound might be worse.
So, I conclude that picking one these currencies is like choosing my favorite
dental procedure. And I decide holding gold is better than holding cash, especially
now, where both earn no yield.
same lines, we have bought long-dated options on much higher U.S. and Japanese
interest rates. The options in Japan are particularly cheap because the historical
volatility is so low. I prefer options to simply shorting government bonds,
because there remains a possibility of a further government bond rally in
response to the economy rolling over again. With options, I can clearly limit
how much I am willing to lose, while creating a lot of leverage to a possible
For years, the
discussion has been that our deficit spending will pass the costs onto "our
grandchildren." I believe that this is no longer the case and that the
consequences will be seen during the lifetime of the leaders who have pursued
short-term popularity over our solvency. The recent economic crisis and our
response has brought forward the eventual reconciliation into a window that
is near enough that it makes sense for investors to buy some insurance to
protect themselves from a possible systemic event. To slightly modify Alexis
de Tocqueville: Events can move from the impossible to the inevitable without
ever stopping at the probable.
we can't change the course of events, but we can attempt to protect capital
in the face of foreseeable risks.
Of course, just
like MDC, there remains the possibility that I am completely wrong. And, personally,
I hope I am. I wonder what Stan Druckenmiller thinks.