Dear Mr. Buffett: What an Investor Learns 1,269 Miles From Wall Street

by Janet M. Tavakoli

  In January 2007, I had lunch with Bethany McLean, coauthor of The Smartest Guys in the Room, a bestselling book about the Enron debacle. She was intrigued about my assertion that AAA and AA rated products were overrated. That meant that bond insurers such as Ambac, MBIA, FGIC that also insured municipal bonds would have substantial losses. It also meant pension funds, bank investment portfolios, mutual funds, and more were buying investments with a high-rated label, but in reality they had the risk of losing substantial principal. I told her: “No one believes the ratings have any value.”20

  Some AAA rated tranches traded around 95 cents on the dollar in the secondary market. Losses were already being absorbed by lower-rated, but still investment-grade, tranches, and first loss investors of conventionally structured deals were wiped out. Her article appeared on March 19, 2007, St. Joseph’s Day, the patron saint of the homeless.The rating agencies denied there was a problem: “All of the rating agencies say they have scrubbed the numbers, and slices of debt that are rated investment grade will mostly stay that way, even if the collateral consists of subprime mortgages.”21

  Investment banks kept up the front. None of them took the massive write-downs I expected in the first quarter of 2007. Instead, they cranked up the CDO machines.They offered toxic product to unwary investors.

  On March 22, 2007, I wrote Warren that John Calamos Sr., chairman and CEO of Calamos Investments, does not rely on the rating agencies, either:

  He mortgaged his house to start his fund, and he did not seek outside money. . . . Initially they tried using Moody’s and S&P ratings as benchmarks, and they got smoked a couple of quarters. They set up their own credit models and use those to the exclusion of ratings.

  The following year, on Tuesday, March 11, 2008, Bloomberg News reported that AAA subprime residential home equity loan backed bonds were not being downgraded despite having delinquencies exceeding 40 percent. As Bear Stearns gasped its last breaths, I appeared on Bloomberg TV that morning to discuss the structured finance ratings folly. The rating agencies were still in denial. Incapable of accurately measuring the present, the rating agencies provided no useful information for predicting future performance.The ABX indexes referenced 80 faux AAA bonds, and according to Bloomberg’s analysis, none of them merited that rating. According to its interpretation of S&P’s data, Bloomberg asserted that only six of the 80 AAA rated bonds in the ABX index would merit a rating above BBB-, the lowest possible investment grade rating.22 In other words, 90 percent of the bonds in the AAA index were not even investment grade.

  Contrary to the assertions of Nassim Taleb and the Talebites, the mortgage meltdown is not a black swan event (an unlikely occurrence—unless one lives in Australia or New Zealand). It is not even Benoit Mandelbrot’s gray swan, a flawed model that does not foresee disaster. 23 Those labels would have described the 1987 portfolio insurance catastrophe affecting around $60 billion in equity assets, when sophisticated mathematical models originated in academia failed to take into account what happens when a large crowd tries to sell at the same time.

  Portfolio insurance is a form of “dynamic” hedging that mimics a series of put options—as the stock price falls, the program automatically sells a given amount of stock and invests in cash. If the price falls further, the program sells more stock. In the week before the “Black October” crash of 1987, the Dow fell 250 points, and a large backlog of sell orders accumulated. The following Monday, portfolio insurance kicked in, and portfolio stock and index futures were sold. The market fell more.The market dropped around 500 points, the equivalent of around 2,500 points today. This was a classic liquidity crunch, brought on by model-driven selling, followed by the panic of general investors. The price at which managers were able to sell was much lower than the model’s price because they could not get out in time. To add insult to financial injury, the stock market as a whole was up 2 percent per year. If investors had simply held onto their positions during the “crash,” they would have been much better off. Instead, the models sold at lows, and then repurchased as prices rose. Portfolio insurance is a form of dynamic hedging, which I call death by one thousand cuts.

  Benjamin Graham was not a fan of market formulas or program trading: “Never buy a stock immediately after a substantial rise or sell one immediately after a substantial drop.”24 At least not for the sake of it. As more people rely on formulas, they become less reliable. For one thing, conditions change. Secondly, when a formula becomes very popular, it may cause the stock market herd to “stampede.”25 At the time, Warren also derided the models. If the price falls far enough, the model sells everything and the manager is 100 percent in cash; when prices rise, the model tells you to buy. Warren loves to buy more when the price of a good value stock falls and seeks to sell, if ever, at a profit.

  Instead, the mortgage meltdown was caused by Black Barts. Black Bart is said to have robbed California stagecoaches without ever firing a shot, and the mortgage meltdown involved some bloodless robbery. The risk was fully knowable, fully discoverable in the course of competent work. The mortgage meltdown had a direct cause and effect, and the result was predictable in advance. At the outset, symptoms of financial disease were as obvious as an advanced outbreak of mad cow. If one examined the loans they looked like downer cows, stumbling and sickly. Financial professionals including Warren Buffett, Charlie Munger, John Paulson, James “Jim” B. Rogers, William “Bill” Ackman, William “Bill” Gross, Whitney Tilson, Jim Melcher, David Einhorn (head of Greenlight Capital), myself, and others had been specific in sounding the alarm both verbally and in print for many years.

  Money market funds and pension funds often rely on ratings.The SEC is proposing that mutual funds should not rely on ratings, but the SEC is missing a piece.The SEC should not allow an investment below a previously required rating. For example, if an investor relied on an AAA rating before and it did not work out, that should not mean the investor should ignore the requirement and invest in something with a lower rating, either. Rather, the investor should still be required to have an AAA rating and should be required to understand that the value of the investment lives up to the rating.

  There is often a difference between an investor with a lot of money to manage and a sophisticated investor. For example, municipal funds usually lack the sophistication of Goldman Sachs Asset management. That is why many compliance departments at investment banks ask that brokers and institutional salespeople “know the customer.” The idea is to sell complex products to investors that have the ability to understand and analyze the risk.

  Or better yet, do as Warren does. Don’t make your investments unnecessarily complex and thoroughly understand the risk. That way, if you make a mistake, it is very unlikely it will be a big one.

  In spite of this wisdom, funds in Europe and the United States—including local government-run funds—often find they do not understand the risks of complex structured financial products they own, because they rely on AAA ratings for guidance. These Main Street government investors have no choice but to cut costs, aggressively go after back taxes, and—if the problem is bad enough—raise taxes. Main Street’s list of investors that feel burned is long and growing.

  For example, the Springfield (Massachusetts) Finance Control Board alleged that Merrill Lynch & Co. sold it AAA rated CDO products backed by subprime debt without fully disclosing the risk. State law limits Springfield’s investments to government securities and short-term liquid investments. Regarding Springfield, I told the Wall Street Journal: “Merrill has to know its customers and sell them what’s suitable and appropriate.These CDOs are not.”26

  Springfield was fortunate that its troubles received publicity. It seemed to own the chlorine trifluoride of CDOs. The AAA rated tranches were unstable and lethally toxic to portfolio value. The three CDOs Springfield originally purchased for $13.9 million in the summer of 2007 were valued by Merrill at around $1.2 million by January 2008. Merrill repurchased the CDOs for the full amount of $13.9 million.


  Vickie Tillman, executive vice-president at Standard & Poor’s defends its AAA ratings: “of the 26,000 structured securities originally rated AAA by S&P between 1978 and 2007, fewer than 0.1 per cent [sic] subsequently defaulted.”27

  That may be true. It may even be true that AAA ratings on securities that were imploding did not have ratings withdrawn to remove them from the data set. But that is not the point. When it counted, when the U.S. housing markets and municipal bond markets depended on the integrity of the ratings, the rating agencies failed. There were a lot of teeth marks in those “boxes” of CDOs backed by mortgage loans. Smart investors avoided CDOs and ate some See’s Candies.

  In August 2008, a draft version of an SEC 38-page report on the rating agencies revealed that an S&P analyst emailed a colleague that they should not be rating a particular structured finance deal. The colleague responded that they rate every deal: “it could be structured by cows and we would rate it.”28

  Deal after CDO-squared deal brought to market in 2007 had AAA rated tranches downgraded below investment grade within months after the deals came to market. This is unprecedented. Deals brought in 2006 are similarly troubled as are deals brought in the last half of 2005. Dollar values involved are in the hundreds of billions. It is a travesty. Investors in AAA structured finance products are losing substantial principal. Some nominally, AAA bond insurers were downgraded from AAA to junk. The AAA ratings of others Slid lower. Municipal bond markets and student loan markets are in confusion. Investment banks sold auction-rate securities with long maturities as if they were money market instruments.They told customers that the coupons reset at regular auctions at short-term intervals, and if the auctions failed to find buyers, the investment banks would step in and buy back the securities. Investors could not get their money. Investors from large corporations to condominium boards investing members’ assessments held frozen assets. Yet they had been told the bonds are exactly like cash. By the fall of 2008, banks and investment banks were compelled to buy back auction rate securities from retail investors to settle claims with U.S. regulators that they improperly sold these bonds to uninformed customers. 2930 Larger investors are forced to settle their own disputes.31

  In the face of its contribution to enabling a cycle of shoddy home loans resulting in massive foreclosures, declining housing prices, deteriorating ratings of bond insurers, and lack of liquidity due to shaken confidence in the markets, Standard & Poor’s demonstrates a curious combination of arrogance and truthiness.

  The markets have nothing to replace the rating agencies other than individual initiative. Rating agencies are currently protected by government regulation, barriers to entry, institutionalized investor reliance, and the profit margin of approximately 40 percent that they make on their traditional business of rating corporate credits. As maddening as the recent actions of the rating agencies might seem, they are like a fellow who knowingly sells a horse to an investment banker named Black Bart. Without investors’ money funneled through investment banks to predatory mortgage lenders, the problems would have died an early death. It is very convenient for investment banks that Congress and the SEC are focused on the rating agencies, because investment banks—not the rating agencies—are the securities dealers obliged to perform due diligence appropriate to the circumstances.

  The rating agency business will probably pull in steady business in the future because the market has nothing to replace them. That does not mean, however, that the market is satisfied with the cartel’s performance. Warren Buffett avoids interfering with the management of the companies with which he invests but he made an unprecedented statement during his European excursion to find new investments. In May 2008, he said if Moody’s management did something wrong, “they should go.”32 Weeks earlier, Warren told me he is “not proud” of Moody’s. One could say the same for Standard & Poor’s and Fitch. Misleading ratings contributed to the global market meltdown, because many financial institutions used “high” ratings as a sign of “safety” to justify their use of excessive leverage.

  Chapter 8

  Bear Market (I’d Like a Review of the Bidding)

  It’s easy to put on leverage, but not as easy to take it off.

  —Warren Buffett

  (Wall Street Journal, April 30, 2007)

  In 2007, both Warren and I thought many hedge funds were overleveraged. If the book value of Berkshire Hathaway stock falls 5 percent, investors have “lost” 5 percent for the moment, but Berkshire Hathaway’s strong earning power (from subsidiaries and investments) will likely cause the price to rise satisfactorily again in the future. Berkshire Hathaway has value and its value is growing.A leveraged hedge fund that invests in collateralized debt obligations (CDOs) can only rely on those CDOs for “earnings.” If the CDOs deteriorate due to, say, defaults on the loans backing them, there is permanent value destruction. There is no bouncing back from that. Furthermore, leverage magnifies the losses for investors. Bear Stearns Asset Management managed two hedge funds that provided classic examples.

  On January 30, 2007, Jim Melcher of Balestra Capital (a $100 million hedge fund) and I appeared on CNBC to discuss hidden price deterioration in subprime CDOs. Diana Olick, CNBC’s Washington-based real estate correspondent taped the segment. Olick may be the best reporter on any channel on this topic; she closely followed developments before the mortgage meltdown was big news. She reported that housing prices were softening and had risen only 1 percent the previous year for existing homes against the double-digit increases of the prior few years. Subprime mortgage loans had reached around $1.3 trillion in outstanding loans of the total $11 trillion (at the time) U.S. mortgage market. The foreclosure rate was already 13 percent (in the years before the 2005 risky loan explosion delinquency rates were in the low to mid-single digits) and climbing fast and steeply for more recent (2006) vintages.

  Based on my projections, foreclosure rates for subprime loans made in 2006 could reach 30 percent and recovery rates would probably be only around 30 cents on the dollar. This was based on my experience during other times of severe mortgage loan stress combined with poor underwriting standards. This meant that recent subprime loan securitizations were in trouble. Most investment-grade-rated residential mortgage-backed securities were in serious trouble at the lower levels, and the AAA tranches did not have enough protection to merit that rating. CDOs compounded the problem and CDO-squared products amplified it further. For those deals, even the AAA tranches had significant risk of substantial losses.

  I told Olick that investors who bought non-Fannie Mae and non-Freddie Mac securitizations should be very worried. Deals were overrated and overpriced, and prices would plummet. Jim Melcher was short the ABX index, the ABX HE 2 06 BBB- series, to profit on overrated and overpriced subprime-backed CDOs. He had tripled his money the prior two months and was one of the few hedge fund managers willing to publicly discuss the trade. He hung on anticipating further profits. I explained to CNBC that one didn’t even need to own the securitizations, you could have a gain “if the price in someone else’s portfolio takes a hit.”1

  Ralph Cioffi, a senior managing director of Bear Stearns Asset Management and a former colleague, had seen the segment and gave me unsolicited feedback.“You sounded good,” he said,“and you looked mahvelous as Billy Crystal used to say.”When his leveraged hedge funds failed a few months later, I wondered if he had listened to the content.

  In early February 2007, the shares of aggressive subprime mortgage lender, New Century Financial Corp., then the second largest subprime in the United States, plummeted after it alerted that it was short of cash. London-based HSBC Holdings Plc, the largest bank by market value in Europe, unexpectedly reported that it had $1.8 billion of losses due to subprime lending.2

  Bear Stearns’ fixed income research gave the horrific news a positive spin indicating that the worst might be over and recommended customers go long—the opposite of Jim Melcher’s short money-making position.3 ResMae Mortgage Corporation went bankrupt
on February 13, 2008, the day after Bear Stearns Fixed Income Research issued its report. ResMae was selling assets for mere pennies on the dollar.4

  By the end of February 2007, New Century was trading at around $15 per share, after its share price fell around 50 percent during the prior three weeks. Rumors circulated that the lender was in its death throes. Perhaps Bear Stearns didn’t get the memo, even though it had a “longstanding”5 relationship financing New Century’s mortgage operation. On March 1, 2007, Scott R. Coren, a Bear Stearns stock analyst, upgraded New Century, saying that $10 per share would be the downside risk, if New Century needed rescuing. About a week later, New Century announced it had probably been unprofitable during the last six months of 2006 and needed to restate its earnings. Lenders yanked their credit lines. In April 2007, New Century filed for bankruptcy, joining more than 100 failed mortgage lenders. Countrywide, the nation’s largest mortgage lender, also showed signs of strain.

  Hidden leverage threatened the global markets. Many hedge funds used CDOs’ artificially high ratings as an excuse to leverage their “safe highly rated” investments. It is an extremely risky proposition. Debt purchased near full price has little or no price upside, but there is a lot of room for the price to go down when things go wrong. Combine that with leverage, and you have a very risky strategy.

  What if prices drop because everyone finds out that the assets are overrated? What if prices drop because of defaults by overextended homeowners, defaults due to a collapse in housing prices, or permanent value destruction due to fraud? There is no other income to give you upside potential, and a leveraged position has no hope of springing back. If a fund does not have gobs of liquidity in reserve, investor capital is quickly wiped out. Investors take a stomach-churning toboggan ride straight down risk’s icy slope. Creditors that lent the fund money to buy assets are lucky if they do not lose money, too.