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Harry Newton's In Search of The Perfect Investment Technology Investor. Harry Newton

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9:00 AM EST, Thursday, March 12, 2009. "Wall Street" are firms that sell you something and make a fee on the sale. You need to understand:

1. Wall Street creates products for the sole purpose of selling them to you. Examples include derivatives, auction rate securities, collateralized debt obligations (CDOs) and credit default swaps (CDSs).

2. Wall Street has zero interest in, or responsibility for the long-term worth of the product it sells you. Once you've bought, it's yours. Good or bad. Recently, mostly bad.

3. Wall Street creates "sales stories" -- reasons you should buy. Those "stories" have as much truth as diet foods that say you'll lose weight, (cosmetics that will remove your wrinkles, or (my recent favorite) Arm & Hammer's Age Defying toothpaste.

Wall Street's "sales stories" can be very creative -- like the price of housing will go up forever and ever, or alternative energy stocks are great because the new administration loves the industry. But the most creative was the idea that you can quantify risk and price it into a security, thus making the security (i.e. what Wall Street was selling you) risk-free. Once you quantify risk, you make selling the product easy. Hence you no longer need rocket scientists to sell your stuff. Anyone can sell it. And, in recent years, anyone and everyone did. Hence the explosion of weird securities.

Which is why I want you to read Wired Magazine's cover story, Recipe for Disaster: The Formula That Killed Wall Street. The story starts with a photo:

The photo's caption reads, "In the mid-'80s, Wall Street turned to the quants—brainy financial engineers—to invent new ways to boost profits. Their methods for minting money worked brilliantly... until one of them devastated the global economy."

Wired explains:

For five years, (David X.) Li's formula, known as a Gaussian copula function, looked like an unambiguously positive breakthrough, a piece of financial technology that allowed hugely complex risks to be modeled with more ease and accuracy than ever before. With his brilliant spark of mathematical legerdemain, Li made it possible for traders to sell vast quantities of new securities, expanding financial markets to unimaginable levels.

His method was adopted by everybody from bond investors and Wall Street banks to ratings agencies and regulators. And it became so deeply entrenched—and was making people so much money—that warnings about its limitations were largely ignored.

Then the model fell apart. Cracks started appearing early on, when financial markets began behaving in ways that users of Li's formula hadn't expected. The cracks became full-fledged canyons in 2008—when ruptures in the financial system's foundation swallowed up trillions of dollars and put the survival of the global banking system in serious peril.

Li tried to mathematically define risk and hence remove it from the investment decision, i.e. to get you the buyer not to think how risky what you were buying really was.

In finance, risk is the probability that an investment's actual return will be different than expected. This includes the possibility of losing some or all of your original investment.

The BIG problem is you can't mathematically define risk, because, to do it, you have to use past events and project them into the future. But nothing like 2008-2009 has ever happened before. (It was different in the Great Depression. )

So how do you measure probability? You don't. You can't. Risk is gut feel. Some of us are better at figuring it than others. Warren Buffett is the best. I'm not the worst, but only because I've hammered into my tiny brain some rules. The key one is "When in doubt, stay out." That one can be expanded to, "When I know nothing, stay out."

Stephen Yu has been reading Ben Graham’s investment classis Security Analysis recently when he came upon this paragraph:

It may be pointed out further that the supposed actuarial computation of investment risks is out of the question theoretically as well as in practice.There are no experience tables available by which the expected “mortality” of various types of issues can be determined. Even if such tables were prepared, based on long and exhaustive studies of past records, it is doubtful whether they would have any real utility for the future. In life insurance the relation between age and mortality rate is well defined and changes only gradually. The same is true, to a much less extent, of the relation between the various types of structures and the fire hazard attaching to them. But the relation between different kinds of investments and the risk of loss is entirely too indefinite and too variable with changing conditions, to permit of sound mathematical formulation. This is particularly true because investment losses are not distributed fairly evenly in point of time, but tend to be concentrated at intervals, i.e., during periods of general depression. Hence the typical investment hazard is roughly similar to the conflagration or epidemic hazard, which is the exceptional and incalculable factor in fire or life insurance.

It is a shame, writes Yu, that Ben Graham is not taught in business schools more often. Had the rating agencies had Ben Graham’s wisdom, there would have been fewer triple A-rated MBS and CDOs in the past few years. Had hedge funds and banks understood the limitation of mathematics in the field of finance, they would not have plunged so willingly into sub-prime mortgages and CDS; and we would not be in the pickle that we find ourselves today. Had foundations realized that the Modern Portfolio Theory is founded on narrow mathematical assumptions, they would have known that broad diversification does not guarantee safety; and their portfolios would be better endowed to fund their commitments now.

As Charlie Munger (Buffett's partner) has said, “People calculate too much and think too little.

Can Citigroup continue to lift the stock market? In as many words, the Wall Street Journal said that Citigroup's CEO, Vikram Pandit, was lying. It wrote:

Stocks soared Tuesday after Citi Chief Executive Vikram Pandit said the bank was profitable in the first two months of this year.

Citi is arguably the nation's sickest large bank, so any sign it can produce real earnings in this economic climate bolsters confidence. What's more, if Citi is on the road to profitability, there is a greater chance the government's bank-sector revival plan -- involving stress tests and possible equity injections -- will get financial firms through the downturn.

So it is worth parsing Mr. Pandit's comments. "We are profitable through the first two months of 2009 and are having our best quarter-to-date performance since the third quarter of 2007," he said in a memo to employees Monday. A Citi spokeswoman said Mr. Pandit's measure of profits was net income, according to generally accepted accounting principles. In other words, Citi was profitable even after all its expenses, including write-downs and provisions for credit losses in the period, which are expected to be large.

Investors, however, should treat the profit announcement carefully. First, Citi has assessed profitability for an arbitrary time period. Often banks don't know their true expenses until the end of a quarter. And the two-month profit is hard to square with analyst expectations that Citi will lose 32 cents a share in the first quarter, according to Thomson Financial.

It is possible that Citi's two-month net income got a boost from a low-quality source -- gains from marking up the value of its own debt as credit-default swaps on the bank reflected heightened fear.

Second, the timing of Mr. Pandit's comments looks opportune. His memo came the day after Sen. Richard Shelby of Alabama, the ranking Republican on the Senate banking committee, called Citi a "problem child." With the promise of profits, it might start to look less problematic on Capitol Hill and damp calls for more drastic (regulatory) approaches to the banks. ...

Another reason to be in the Coachella Valley:

Indian Wells Tennis TV Schedule -- PST times (I think)
Saturday, March 14
2 PM - 2 AM
Tennis Channel
Sunday, March 15
2 PM - 12 AM
Tennis Channel
Monday, March 16

4 PM - 7 PM
10:30 PM - 2:30 AM

Tuesday, March 17
4 PM - 7 PM
10:30 PM - 2:30 AM
Wednesday, March 18
4 PM - 7 PM
10:30 PM - 2:30 AM
Thursday, March 19
4 PM - 7 PM
10:30 PM -12:30 AM
Friday, March 20
4 PM - 7 PM
10:30 PM - 12:30 AM
Saturday, March 21
4 PM - 8 PM
Sunday, March 22
1 PM -5 PM

His just deserts? From Bloomberg this morning:

Bernard Madoff, scheduled to plead guilty today to masterminding the largest Ponzi scheme in history, may have to fight off prison inmates who want to squeeze him for money or blame him for the Wall Street crash.

Why do I think this is funny?

P.S. Madoff's Ponzi scheme is now up to $65 billion. A billion here, a billion there. It's beginning to add up to some real money.

The financial crisis explained in simple terms. Part 1.
Heidi is the proprietor of a bar in Berlin. In order to increase sales, she decides to allow her loyal customers - most of whom are unemployed alcoholics - to drink now but pay later. She keeps track of the drinks consumed on a ledger (thereby granting the customers loans).

Word gets around and as a result increasing numbers of customers flood into Heidi's bar.

Taking advantage of her customers' freedom from immediate payment constraints, Heidi increases her prices for wine and beer, the most-consumed beverages. Her sales volume increases massively.

A young and dynamic customer service consultant at the local bank recognizes these customer debts as valuable future assets and increases Heidi's borrowing limit.

He sees no reason for undue concern because he has the promissory notes of Heidi's customers as collateral.

At the bank's corporate headquarters, expert bankers transform these customer assets into DRINKBONDS, ALKBONDS and PUKEBONDS. These securities are then sold and traded on markets worldwide. No one really understands what these abbreviations mean and how the securities are guaranteed. Nevertheless, as their prices continuously climb, the securities become top-selling items.

One day, although the prices are still climbing, a risk manager of the bank, (subsequently fired due his negativity), decided that the time has come to start demanding payment from Heidi for the debts incurred by the drinkers at Heidi's bar.

Unfortunately Heidi's customers cannot pay back any of their debts to Heidi.

Heidi cannot fulfill her loan obligations to the bank and claims bankruptcy.

DRINKBOND and ALKBOND drop in price by 95 %. PUKEBOND performs better, stabilizing in price after dropping by only 80%.

The suppliers of Heidi's bar, having granted her generous payment terms and also having invested in the securities are faced with a new and desperate situation. Her wine supplier claims bankruptcy and her beer supplier is taken over by a competitor.

The bank is saved by the Government following dramatic round-the-clock consultations by leaders from the governing political parties. They came up with a miraculous rescue plan that saved the bank.

The funds required for this massive rescue are obtained by levying a new tax on all the non-drinkers.

The financial crisis explained in simple terms. Part 2.
Gone with the Wind fans observed the seventy-fifth anniversary of the Margaret Mitchell novel last week. Some people have never heard of it. Today people see Gone with the Wind in the bookstore and assume it's an investment manual.

Step back and smell the roses -- update 1:
Thus came the email: "You're an idiot, Harry. They're not hibiscus. They're bouganvillea."

I stand corrected. The history: In 1768 when Admiral Louis de Bougainvillea began his long journey to the Pacific Ocean and discovered the vine that now bears his name, it was a botanical highlight of the voyage.

Only 23%? Forbes’ annual list of the world’s richest got shorter and the average net worth of those on it fell 23 percent.

The Egypt Syndrome: Owners putting their houses up for sale in the Coachella Valley, California (where I am at present) are listing their homes at 2006 prices, i.e. 30% to 40% above where they should be. Real estate agents here say the owners suffer The Egypt Syndrome, namely the owners are in denial.

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.