Technology Investor 

Harry Newton's In Search of The Perfect Investment Technology Investor. Auction Rate Securities. Auction Rate Preferreds.

Previous Columns    Auction Rate Preferreds.
8:30 AM EST Monday, April 21, 2008: "Risk management" stinks. It's one of those polysyllabic words that Wall Street makes up to regularly to convince you to buy its latest, greatest new product. The words stick in my brain. Read on. This weekend's Economist talks about:

Reports from the IMF, the Financial Stability Forum, the Basel Committee on Banking Supervision and other august bodies have drawn attention in the past week to the appalling risk-management by many banks before the credit crisis.

And then Buffett talks about reading, reading and more reading, as though it's the universal investment panacea. And by God, he's right. Reading it yourself removes you from reliance on the joker (a.k.a. broker) who's trying to push it down your throat -- the broker selling you the auction rate security, the derivative, the mortgage in land deals, the sure-fire investment in a new startup.

Reading it ourselves gives us the strength to say ""NO, I don't want it.." Reading it gives us the strength to say, "I don't understand it." Here's a test. Do you know what a credit-default swap is? Me neither. Yet Wall Street issued $60 trillion of them last year...

Chart from the latest Economist.

Reading it ourselves finds the risks. We should list them. And then ask ourselves, "Does this bring the risk of losing all our money?" And if it does -- and remarkably many things do -- then we need to run 100 miles. Fast.

I'm harping on this reading thing because too many of us rely on our brokers, our financial advisers or someone else. If you don't believe me, I'll send you the hundreds of emails I've received from investors stuck in ARPS. Had we all read the prospectuses (which most of us never even received), we would be in much better shape today.

What Warren thinks... This week's Fortune has a featured piece with Warren Buffett.

Excerpts (my emphasis)::

Before we start in on questions, I would like to tell you about one thing going on recently. It may have some meaning to you if you're still being taught efficient-market theory, which was standard procedure 25 years ago. But we've had a recent illustration of why the theory is misguided. In the past seven or eight or nine weeks, Berkshire has built up a position in auction-rate securities [bonds whose interest rates are periodically reset at auction of about $4 billion. And what we have seen there is really quite phenomenal. Every day we get bid lists. The fascinating thing is that on these bid lists, frequently the same credit will appear more than once.

Here's one from yesterday. We bid on this particular issue -- this happens to be Citizens Insurance, which is a creature of the state of Florida. It was set up to take care of hurricane insurance, and it's backed by premium taxes, and if they have a big hurricane and the fund becomes inadequate, they raise the premium taxes. There's nothing wrong with the credit. So we bid on three different Citizens securities that day. We got one bid at an 11.33% interest rate. One that we didn't buy went for 9.87%, and one went for 6.0%. It's the same bond, the same time, the same dealer. And a big issue. This is not some little anomaly, as they like to say in academic circles every time they find something that disagrees with their theory.

So wild things happen in the markets. And the markets have not gotten more rational over the years. They've become more followed. But when people panic, when fear takes over, or when greed takes over, people react just as irrationally as they have in the past. ...

You don't want a capital market that functions perfectly if you're in my business. People continue to do foolish things no matter what the regulation is, and they always will.

How do you get your ideas?

I just read. I read all day. I mean, we put $500 million in PetroChina. All I did was read the annual report. [Editor's note: Berkshire purchased the shares five years ago and sold them in 2007 for $4 billion.]

What advice would you give to someone who is not a professional investor? Where should they put their money?

Well, if they're not going to be an active investor - and very few should try to do that - then they should just stay with index funds. Any low-cost index fund. And they should buy it over time. They're not going to be able to pick the right price and the right time. What they want to do is avoid the wrong price and wrong stock. You just make sure you own a piece of American business, and you don't buy all at one time.

How does the current turmoil stack up against past crises?

Well, that's hard to say. Every one has so many variables in it. But there's no question that this time there's extreme leveraging and in some cases the extreme prices of residential housing or buyouts. You've got $20 trillion of residential real estate and you've got $11 trillion of mortgages, and a lot of that does not have a problem, but a lot of it does. In 2006 you had $330 billion of cash taken out in mortgage refinancings in the United States. That's a hell of a lot - I mean, we talk about having $150 billion of stimulus now, but that was $330 billion of stimulus. And that's just from prime mortgages. That's not from subprime mortgages. So leveraging up was one hell of a stimulus for the economy.

The scenario you're describing suggests we're a long way from turning a corner.

I think so. I mean, it seems everybody says it'll be short and shallow, but it looks like it's just the opposite. You know, deleveraging by its nature takes a lot of time, a lot of pain. And the consequences kind of roll through in different ways. Now, I don't invest a dime based on macro forecasts, so I don't think people should sell stocks because of that. I also don't think they should buy stocks because of that.

Do you find it striking that banks keep looking into their investments and not knowing what they have?

I read a few prospectuses for residential-mortgage-backed securities - mortgages, thousands of mortgages backing them, and then those all tranched into maybe 30 slices. You create a CDO by taking one of the lower tranches of that one and 50 others like it. Now if you're going to understand that CDO, you've got 50-times 300 pages to read, it's 15,000. If you take one of the lower tranches of the CDO and take 50 of those and create a CDO squared, you're now up to 750,000 pages to read, to understand one security.

I mean, it can't be done. When you start buying tranches of other instruments, nobody knows what the hell they're doing. It's ridiculous. And of course, you took a lower tranche of a mortgage-backed security and did 100 of those and thought you were diversifying risk. Hell, they're all subject to the same thing. I mean, it may be a little different whether they're in California or Nebraska, but the idea that this is uncorrelated risk and therefore you can take the CDO and call the top 50% of it super-senior. It isn't super-senior or anything. It's a bunch of juniors all put together. And the juniors all correlate.

If big financial institutions don't seem to know what's in their portfolios, how will investors ever know when it's safe?

They can't, they can't. They've got to, in effect, try to read the DNA of the people running the companies. But I say that in any large financial organization, the CEO has to be the chief risk officer. I'm the chief risk officer at Berkshire. I think I know my limits in terms of how much I can sort of process. And the worst thing you can have is models and spreadsheets. I mean, at Salomon, they had all these models, and you know, they fell apart.

What should we say to investors now?

The answer is you don't want investors to think that what they read today is important in terms of their investment strategy. Their investment strategy should factor in that (a) if you knew what was going to happen in the economy, you still wouldn't necessarily know what was going to happen in the stock market. And (b) they can't pick stocks that are better than average. Stocks are a good thing to own over time. There's only two things you can do wrong: You can buy the wrong ones, and you can buy or sell them at the wrong time. And the truth is you never need to sell them, basically. But they could buy a cross section of American industry, and if a cross section of American industry doesn't work, certainly trying to pick the little beauties here and there isn't going to work either. Then they just have to worry about getting greedy. You know, I always say you should get greedy when others are fearful and fearful when others are greedy. But that's too much to expect. Of course, you shouldn't get greedy when others get greedy and fearful when others get fearful. At a minimum, try to stay away from that.

By your rule, now seems like a good time to be greedy. People are pretty fearful.

You're right. They are going in that direction. That's why stocks are cheaper. Stocks are a better buy today than they were a year ago. Or three years ago.

But you're still bullish about the U.S. for the long term?

The American economy is going to do fine. But it won't do fine every year and every week and every month. I mean, if you don't believe that, forget about buying stocks anyway. But it stands to reason. I mean, we get more productive every year, you know. It's a positive-sum game, long term. And the only way an investor can get killed is by high fees or by trying to outsmart the market.

I continue to love Australian mining stocks. The two biggest are BHP and Rio Tinto. They have everything going for them including China. I've banged the table for these two (and other Australian miners) on many occasions. Check out this piece from this weekend's Economist:

Diggers for China
The global reach of China's boom

TRY hailing a taxi or ordering a meal in a restaurant in Perth these days and you may be in for a long wait. The capital of Western Australia (WA) is suffering a labour shortage, as young people head north to make real money from a mining boom. China's insatiable demand for WA's minerals is driving it, and helping China displace Japan as Australia's biggest trading partner. But Australia has also to balance its mining windfalls against clashes with China over human rights.

The Pilbara, a desert region about 1,300km (800 miles) north of Perth, is the main focus. BHP Billiton and Rio Tinto, two of the world's biggest resource companies, roughly share the Pilbara's iron-ore deposits that feed China's flourishing steel industry. China takes about half their exports. They can barely dig it out fast enough to meet demand.

Rio Tinto plans to double its 2007 iron-ore production (160m tonnes) in four years. Last year iron ore earned the company $8.8 billion, mostly from the Pilbara. The region is rich in more than minerals. Archaeologists have reportedly found ancient aboriginal tools at Hope Downs. Rio Tinto jointly controls this iron-ore mine with Gina Rinehart, daughter of the late Lang Hancock, a pioneer Pilbara tycoon.

The West is Australia's largest state, with just one-tenth of the country's population. Thanks to the mining boom, it now underwrites much of the country's economic growth. Last year the state's economy grew by 6.3%, almost double the national rate. Eric Ripper, WA's treasurer (finance minister), says his state “struggled” to post an A$9m ($8.3m) surplus seven years ago, before China's boom took off; the surplus last year was A$2 billion.

The “wild west”, as WA is sometimes known, has seen other booms end in tears. Alan Birchmore, a veteran of some, and on the board of United Minerals, a company with a Pilbara iron-ore lease, reckons this one is different: it has “depth”. “China”, he says, “is showing that it takes some stopping once people get a taste for consumption.” Some forecasts back him up. In a report for Rio Tinto and the Australian National University, Ross Garnaut and Ligang Song, two economists, argue that by 2020 China's demand for metals may increase by the equivalent of the industrial world's annual total demand now.

Meanwhile, the Pilbara's miners are wrangling with their biggest customer. After three years of successive price rises, BHP Billiton and Rio Tinto are reported to be seeking a 70% increase in contract prices this year. Chinese buyers are unhappy that both companies have made a killing selling some iron ore on the spot market; they are demanding that more be sold under lower-priced, long-term contracts. The Australian companies believe they have an advantage: their costs of shipping iron ore to China are about one-third those of Brazil, their main competitor.

Rather than jeopardise a huge trading relationship, Australian governments have tended to tread softly in their dealings with China over human rights. After nearly five months as Labor prime minister, Kevin Rudd was less constrained in a speech in Beijing on April 9th, referring to problems in Tibet. And he has banned Chinese security guards from accompanying the Olympic torch on its scheduled run through Canberra on April 24th.

China's bottomless need for Australia's resources is likely to override any political offence it may take from this. The boom's conflicts are closer to home. Mr Ripper says 500 people are arriving in WA each week to fill jobs for a bonanza whose scale took everyone by surprise. Rio Tinto's answer is a plan to move ore from mines to ports on a fleet of driverless trucks and trains, starting in 2010. But jobs will not disappear completely. People in Perth will give the “intelligent” vehicles their instructions by remote control.

A persuasive message

Impeccable logic
An old Italian Mafia Don is dying and he calls for his grandson to approach the bed; 'Lissin a me. I wanna for you to taka my chrome-plated 38-caliber revolver so you will always remember me.'

The grandson smiles weakly and replies; 'But grandpa, I really doana lika guns. Howzabout you leava me your ROLEX watch instead?'

Gasping for air the old man answers with a snarl in his voice; 'Shuddup an lissin. Somma day you gonna runna da business. You gonna have a beautifula wife, lotsa money, a biga home and maybe a couple a bambinos.'

After a slight pause to catch his breath he continues; 'Somma day you gonna comma home and maybe find you wife inna bed with another man. Whadda you gonna do then .. pointa to you watch and say 'Times up'?'

The Priest and Rabbi
A priest and a rabbi were sitting next to each other on an airplane.

After a while, the priest turned to the rabbi and asked, "Is it still a requirement of your faith that you not eat pork?"

The rabbi responded, "Yes, that is still one of our laws."

The priest then asked, "Have you ever eaten pork?"

To which the rabbi replied, "Yes, on one occasion I did succumb to Temptation and tasted a ham sandwich."

The priest nodded in understanding and went on with his reading.

A while later, the rabbi spoke up and asked the priest, "Father, is it still a requirement of your church that you remain celibate?"

The priest replied, "Yes, that is still very much a part of our faith."

The rabbi then asked him, "Father, have you ever fallen to the Temptations of the flesh?"

The priest replied, "Yes, rabbi, on one occasion I was weak and broke with my faith."

The rabbi nodded understandingly and remained silent, thinking, for about five minutes.

Finally, the rabbi said, "Sure beats a ham sandwich."

This column is about my personal search for the perfect investment. I don't give investment advice. For that you have to be registered with regulatory authorities, which I am not. I am a reporter and an investor. I make my daily column -- Monday through Friday -- freely available for three reasons: Writing is good for sorting things out in my brain. Second, the column is research for a book I'm writing called "In Search of the Perfect Investment." Third, I encourage my readers to send me their ideas, concerns and experiences. That way we can all learn together. My email address is . You can't click on my email address. You have to re-type it . This protects me from software scanning the Internet for email addresses to spam. I have no role in choosing the Google ads on this site. Thus I cannot endorse, though some look interesting. If you click on a link, Google may send me money. Please note I'm not suggesting you do. That money, if there is any, may help pay Michael's business school tuition. Read more about Google AdSense, click here and here.

Go back.