I'm in Corsica for a wedding, where it's difficult to blog. Thank you all for the comments on my New Category post--and for the link, Mr. Salmon. I'll address them all as soon as I can.
Introducing a new category: the Family Foresight Thought Experiment
Suppose you're a family patriarch who just sold the business you've founded and nurtured, leaving you with proceeds of $1 billion or so. One night as you dream you're visited by a sentinel from the future. He informs you that one hundred years hence things are very bad: a dreaded virus threatens to kill a huge number of people. Your granddaughter, as yet unborn, will be the only one who can develop the cure to save civilization. She will be born with the brains, thanks to the genes you will pass down. She will develop the sense of virtue and duty, thanks to the values you will pass down. The only thing she will lack is the money needed to manufacture and distribute the cure, which will cost in the neighborhood of $5 billion in today's dollars.
Your task is simply to invest your current $1 billion such that in one hundred years its real value grows five-fold, an annual real return of only 1.6%. Suppose you are going to live another 50 years, during which you can actively oversee your portfolio, and then your handpicked successor will live another 50 years after he takes over.
The idea is not to earn the highest return, but to more or less preserve the value of the portfolio against whatever comes: war, revolution, taxes, inflation, etc. You must think of every possible calamity and take steps to avoid it. Like a modern Knight Templar guarding the Holy Grail, you must safeguard this vital pool capital through the years until it can save civilization.
Everything is on the table, including:
1) What companies do you invest in?
2) In which domicile do you hold your capital? What is the world's safest country in which to hold capital?
3) Who will be the custodian of your capital? Is there such thing as the world's safest bank?
4) In what form do you hold your capital? Do you trust paper money? Do you trust stock certificates? Do you trust the electronic system that we all rely on to tell us what we own? Or do you feel you have to invest in hard assets?
How hard is it to succeed at this task? Consider that if you'd started this experiment in 1908, you would most likely have failed if:
a) You held your capital in Germany, then probably the most scientifically advanced nation in the world.
b) You had your capital in British pounds, then the strongest currency in the world.
c) You were a member of any of the most noble families of Europe.
d) You had the equivalent of $10 billion and lived in Russia or what was then the Austro-Hungarian empire.
2) Paul Krugman likes the Dodd proposal, mostly because it gives Treasury equity in firms it rescues. This is one of my conditions for making the Paulson plan work. I was naive though: left to his own devices it's not clear Paulson would have pursued this. From his "quick and clean" language I doubt it. So I wasn't describing the Paulson Plan after all.
3) James Hamilton, via Brad DeLong
4) Calculated Risk, via James Hamilton
Question: At what point are you screwing the bankers so much--diluting their equity, cancelling compensation arrangements--that they say forget it and refuse to sell you the bad paper, which is the point of the exercise in the first place? Paulson's economist critics may underestimate this.
Now that so many businesspeople and professional investors are commenting on the economic crisis (I plead guilty), I thought it prudent to revisit an article written by Paul Krugman in 1996, in which he points out that for all their skills and wealth, businesspeople are not very good economists.
I can't get the direct link to work. Here's how to find it:
1) Go to http://www.pkarchive.org/
2) Click on the "International Trade" link on the left.
3) Find the article entitled "A Country is not a Company."
I told myself I have no expertise in this area and therefore should just keep my mouth shut. But I can't resist:
Having read through the criticisms I linked to in my previous post, I'd like to take a stab at defending the Paulson plan. I think it could work IF it acts as a catalyst for future positive events rather than being seen as the end in itself, AND if the Treasury, acting as a self-interested capitalist on behalf of taxpayers, exerts the pitiless leverage befitting a rescue financier. I see the favorable scenario as follows:
1) Treasury purchases toxic debt instruments from financial institutions at a not-crazy premium to their balance sheet values. 600 million fingers are then crossed in the hopes that it did not overpay, something that won't be known for years.
2) This has the effect of modestly increasing the stated book value of these financial institutions. More importantly, with the toxic waste off the books, it improves the likelihood that an outside investor--Treasury itself, a sovereign wealth fund, even our man in Omaha--now feels able to value the enterprise. Hold your nose and admit it: the relatively few franchises that manage the capital raising and M&A activities of Corporate America are worth a lot.
3) Said outside investors collectively have enough capital to recapitalize the major Wall Street insitutions via injections of new equity. Here comes the tricky part: In exchange for their largesse, both the outside investors and Treasury (e.g. via warrants struck at the same price as the outside investor) must be allowed to invest on very favorable terms. In a perfect world existing equity holders and stock options would be essentially wiped out, a la AIG. In an even more perfect world, existing debt holders (i.e. unsecured lenders to Morgan Stanley, Merrill, etc.) would also take a big haircut, just as they usually do when corporations declare bankruptcy.
4) Both liquidity and solvency are restored, credit starts to flow again, and the downward spiral of asset sales is prevented, allowing whatever pain will occur to occur over time, and to be spread widely.
Another potential defense of the Paulson plan: as far as I can tell, the plan does not specify when Treasury is obligated to buy toxic assets, nor does it prevent Treasury from doing another AIG. Conceivably it could wait until the maximum moment of pain to get the best price possible for its assets. Or it could continue to do AIG-style bailouts followed by purchases of the toxic assets, in a sense bailing out itself. Suppose for instance that tomorrow Treasury buys AIG's entire CDS book at something close to market value--wouldn't it instantly make a lot of money on its $85 billion bailout, while over time perhaps making money on the CDSs?
Question: Above a certain level of size and complexity and unfairness, does it not become preferable for Treasury to chuck this plan and instead simply provide relief directly to people having trouble paying their mortgages (thus indirectly making whole the holders of mortgages, MBS and CDOs)? Could the government do a massive sale/leaseback of houses, buying mortgages and charging rent to former homeowners in lieu of foreclosing? The government as quasi-landlord, you say? I can see an example of this as I look out my window, and it's not that bad.
1) The text of the plan itself.
2) "Why Paulson is Wrong" by Luigi Zingales of the University of Chicago Graduate School of Business.
3) Obama Campaign Statement of Principles, via Brad DeLong.
4) "Why You Should Hate the Treasury Bailout Proposal" by Yves Smith.
5) Multiple posts from Paul Krugman.
6) "Concerns about the Treasury Rescue Plan" by Douglas Elmendorf of Brookings
1) I haven't posted anything in the last few days because, like many of you, I've been trying to keep track of events in the markets. My expertise is in selecting money managers and value investing, not in analyzing what's going on, so I should keep my mouth shut. The best I can do is link to the analysis of others who I think make sense and I can understand. Two quick examples:
2) Google just returned 80,800 hits for the term "worst financial crisis since the Great Depression." I've been hearing this phrase a lot, and something about it bothers me, especially when it's spoken by a money manager or Wall Street executive trying to excuse explain his/her firm's dismal performance and/or bankruptcy.
If you are responsible for the investment activities of a family office, you must not let this explanation give you any comfort. The Great Depression began almost exactly 79 years ago. To the rest of the investment world that's an eternity, but in the mind of the family office investor it's nothing--only two or three generations. Your job is to invest for the second and third generation to come. So if you pursue an investment strategy that does well for 78 years, only to go bust in year 79, you have in a sense failed your clients.
Of course you never know when that "year 79" will occur. It may occur earlier, in which case you're still a failure. A zero in investing, whenever it happens, means the game is over. So you have to be more careful than every other investor out there.
How careful do you have to be? More careful than you may think. Suppose you established a family office in 1930, right after the Great Crash, and were confident that your investment strategy had only a 0.5% of going bust in a given year--that is, a 99.5% chance of surviving until the next year.
What's the probability your family office makes it to 2009 intact? Only about 66%. That is, there's a one in three chance your capital goes to zero, equivalent to the probability a smoker will die from smoking. Now if you're like me, you would disinherit your grandchildren for being so stupid as to start smoking. But if you establish an investment strategy that's only capable of surviving until "the worst financial crisis since the Great Depression," there's an equal chance you'll end up doing the same thing via your own stupidity.
3) If you've been following the markets in recent days, you know all too well by now that money managers love to sound off about the macroeconomy, the best way to profit from the crisis, etc. This gives a money manager selector like me a good opportunity to evaluate who knows what they're talking about and who doesn't.
A special sub-category of this is the money manager who uses the media to tell us "what Warren Buffett is thinking/doing now." Exhibit A comes from this Reuters article, which contains the following quote from an oft-quoted Buffett watcher:
Mr. Betz may be an investing genius, and I give him credit as a marketer for his cleverness and for quoting Willie Sutton, but he is quite wrong here. Buffett does not "like banks," as this excerpt from his 1990 letter to shareholder makes clear:
Because leverage of 20:1 magnifies the effects of managerial strengths and weaknesses, we have no interest in purchasing shares of a poorly-managed bank at a "cheap" price. Instead, our only interest is in buying into well-managed banks at fair prices.
I hate to rant, but it's amazing that an insurance company, an entity charged with protecting others from the consequences of catastrophe, put itself in a position in which a mere downgrade could put it out of business:
The big insurance company, the American International Group, was seeking a $40 billion bridge loan Sunday night from the Federal Reserve, as it faces a potential downgrade from credit ratings agencies that could spell its doom, a person briefed on the matter said.
Ratings agencies threatened to downgrade the insurance giant’s credit rating by Monday morning, allowing counterparties to withdraw capital from their contracts with the company. One person close to the firm said that if such an event occurred, A.I.G. may survive for only 48 hours to 72 hours.
Coming soon: Why I bought AIG stock and lost a lot of money--and why I sold it in time to avoid losing a lot more money.