CHAPTER SIX TWO EXAMPLES from the new book Price To Value Intelligent Speculation Using The
Decision Filters of Munger and Buffett ISBN: 978-0-557-31718-9 - by Bud Labitan Operations not promising safety of
principal and a satisfactory return are speculative.
In this chapter, I give one sparkling example of a
winning speculation and one tragic example of a losing
speculation. These two examples are framed inside the
simple “intelligent speculation model” proposed
earlier. We will look back at the losing
speculation of Long Term Capital Management (LTCM) and
the winning speculation of John Paulson’s Great
Housing Bubble Trade. How do they fit with our
model? Did they truly understand the odds and did
they have the discipline to bet only when the odds were
in their favor?[i] Examine
the basic framework of decision filter groups and you be
the judge. LTCM’s
Losing Speculation 1. Understanding
the Speculation Roger Lowenstein's book, “When
Genius Failed” is the tale of what happened when an
elite group of investors ran Long Term Capital Management.
LTCM was a company that tried to mathematically manage
risk and use high leverage to create wealth. The
founders included two Nobel Prize-winning economists,
Myron Scholes and Robert C. Merton. Scholes and Merton,
along with the late Fischer Black, developed the Black-Scholes
formula for option pricing. LTCM exploited small
arbitrage opportunities on a big scale. Scholes stated
that “LTCM acted like a giant vacuum cleaner sucking
up nickels that everyone else had overlooked.” The
strategy worked well for a couple of years before failing
dramatically. 2.
Advantages / Disadvantages Fancy mathematics from the Black-Scholes
option pricing model proved to be both an advantage and a
disadvantage. Early on, their formulas worked for
arbitrage. Later, a big event triggered a run of failure.
High Leverage proved to be catastrophic. LTCMplaced their
investors' money in a variety of trades simultaneously.
It was a volatile hedging strategy designed
mathematically to minimize the possibility of loss. When
a 1998 default in Russia set off a global financial storm,
Long-Term's models failed. 3.
People Involved In 1993, John Meriwether, a former
partner at Salomon Brothers, established a smart group of
bond arbitrage experts. This group included a pair
of Nobel Prize winners. LTCM had its origins in an
Arbitrage Group put together by Meriwether at Salomon
Brothers. He was a successful bond market trader with
prestige and influence within that firm. Although he was
a shrewd trader he was also good at choosing and managing
talented people. Meriwether recruited Eric Rosenfeld and
William Lasker from the faculty at Harvard. He also hired
Victor Haghani, who trained in finance at the London
School of Economics. Lawrence Hilibrand was trained
in finance at M.I.T. and Gregory Hawkins had a Ph.D. in
finance from M.I.T. While at Salomon, Meriwether's
Arbitrage Group was so successful at earning profits that
they were able to demand a change in the way they were
compensated. This created envy and resentment among
the other groups at Salomon. 4.
Price and Value of the Speculation At Long-Term Capital, Meriwether &
Co. believed that their computer software models could
manage risk with near mathematical certainty. [ii] Long-Term's
traders borrowed with little concern about the high level
of leverage. In raising funds Meriwether created
the category of Strategic Investors who invested at least
$100 million. He was successful in bringing in some of
the top financial organizations in the world into LTCM
despite expensive fees. The typical hedge funds
charged 20 percent of profits earned plus a one percent
of an investor's assets as fees. In contrast LTCM charged
25 percent of profits and levied a 2 percent fee on
assets. Despite the heavy fees and long term commitment
LTCM was able to raise $1.25 billion. At first, Long-Term's
models worked and both private investors and central
banks invested more money. Their system relied on a
high volume of trades, but it lacked the ability to
anticipate a sudden macro change. 5.
Catalysts and Conditions When a default in Russia set off a
global financial storm that Long-Term Capital's models
had not anticipated, its portfolios sank in market value.
In five weeks, the professors went from rich geniuses to
discredited failures. Global investors panicked about
risk. They wanted more certainty and they fled the
unpredictable markets for quality securities, ones with a
higher degree of certainty. Thus higher differentials for
the riskier securities did not stop the flight to quality
securities. For LTCM, whose models bet on the re-instatement
of equilibrium conditions, it was a ruinous time. The
firm began to lose hundreds of millions of dollars each
day. Events such as earthquakes, defaults,
political revolution and so forth do bring instantaneous
changes in prices. The models used by LTCM did not
allow for this type of risk. Although the LTCM traders took a large
number of separate positions, there was no benefit in
risk-reduction through diversification in this financial
crisis. Why? Because most of the separate
transactions were the same bet on the stabilization of
the markets and a return to equilibrium. With the firm
about to go under, its staggering $100 billion balance
sheet threatened to drag down markets around the world. Fearing
that the financial system of the world was in danger, the
Federal Reserve Bank summoned Wall Street's leading banks
to underwrite a bailout. On September 23, 1998, Goldman
Sachs, AIG, and Berkshire Hathaway offered to buy out the
fund's partners for $250 million. Plus, they offered to
add $3.75 billion and operate LTCM within Goldman's own
trading division. The offer was stunningly low to LTCM's
partners because their firm had been worth $4.7 billion
earlier that year. Buffett gave Meriwether one hour to
accept the deal and the time period lapsed before a deal
could be worked out. Seeing no options left the
Federal Reserve Bank of New York organized a bailout of $3.6
billion by the major creditors to avoid a wider financial
collapse. John
Paulson’s Winning Speculation[iii] 1.
Understanding the Speculation Paulson & Co., Inc. profited from
the subprime mortgage crisis. It had assets under
management of $12.5 billion in June of 2007. Most
of this was raised from institutions. This amount
climbed to $36 billion by November 2008 because Paulson
& Co. capitalized on the problems in the foreclosure
and mortgage backed securities (MBS) markets. 2.
Advantages / Disadvantages Paulson was not a mortgage or real
estate expert. He did not have much of a background
in the derivatives, the credit-default swaps (CDS) that
he used to make the big bets. His advantage was to
believe, learn, wait, and act on his variant perception. 3.
People Involved John Paulson spent a career on Wall
Street underappreciated as an investor. He had
slowly built up his hedge fund. By 2005 he started
getting nervous about the overpriced housing market and
the proliferation of subprime mortgages. Subprime
mortgages were bundled into complex derivative
instruments known as MBS, mortgage backed securities.
Paulson and others started to think about how to bet
against this price and value mispricing. Paolo Pellegrini
helped John Paulson make this great trade. His study of
the data helped reveal the changing indicators to them.
In 2007, Paulson made $15 billion for his firm. In 2008,
he transformed the trade into a bet against financial
firms. This generated another $5 billion. 4.
Price and Value of the Speculation The oversupply of lower grade subprime
mortgages fed a house building frenzy and home price
inflation. While one needs to get the timing right in
order for a bet for change to be profitable, there is
usually no incentive to bet against a bubble. In
the middle of '06, Paulson and others started making such
trades. To this select few, they sensed that the
conditions were favorable for a massive downturn in the
housing market and subprime securities. The derivatives
known as MBS or mortgage backed securities were complex
and dangerously overvalued. 5.
Catalysts and Conditions When was the catalytic moment of change?
This group of successful traders started having worries
about the state of the economy and the housing market in
2005. [iv] They
wanted to buy puts on the S&P 500, but found them too
expensive. So they started buying these CDS contracts,
which are basically insurance policies on debt. The CDS
prices were perceived to be very cheap. So, Paulson
and Pellegrini studied these CDS contracts. They decide
that they wanted to raise a fund to do this trade on a
large scale. If Paulson could raise a specific hedge fund
dedicated to betting against housing, he could make a
fortune. Others had interesting arguments against
this perception. The contracts were hard to trade,
and the government might act quickly to stop a broad
financial collapse. Paulson and others started their bets
in the middle of 2006, and they did not work out well
early on. However, in the winter and spring of 2007
the indexes Paulson was betting against start to move
downward dramatically. His biggest gains were in '07, but
in 2008, he was still bearish on housing. He
switched to buying credit-default swaps on the
institutions that were peddling subprime mortgages, like
Bear Stearns. Others soon accepted this variant
perception and followed. Now, Bear Stearns is
history. Paulson made a brilliant bet shorting
subprime. The Bear Stearns Companies, Inc. was a
global investment bank and securities trading firm until
its collapse and sale to JPMorgan Chase in 2008. Bear
Stearns pioneered the securitization and asset-backed
securities markets. Interestingly, as investor
losses mounted in 2006 and 2007, the company actually
increased its exposure to mortgage-backed derivatives.
In March 2008, the Federal Reserve Bank of New York
provided an emergency loan to try to stop a sudden
collapse of the company. The company could not be saved,
and it was sold to JPMorgan Chase. In January 2010,
JPMorgan discontinued use of the Bear Stearns name. Can a “margin of safety” be
built into a speculative decision? Successful
speculators would say that some “safety belts”
can be added to intelligently made speculations. Having
important controllable factors on your side can favor the
probabilities for a good outcome. If the macro economy
was not in a recession, and there was no oversupply of
houses, land developers would be thinking of ways to
develop and build “spec” homes. In normal
economic conditions, they would design and sell such spec
homes with an ideal mix of product features, price, place,
and promotions. Understanding the economics, advantages,
disadvantages, people, prices, values, and catalysts
involved in framing a speculative decision is the
foundation of making a risk-minimizing decision. Speculator beware! Be aware to
not invest nor speculate if the odds are not in your
favor. Charlie Munger believes in this tactic.
He had enlisted in the Army a year after Pearl Harbor.
Alice Schroeder wrote that Munger augmented his army pay
by playing poker. “He found he was good at it. It
turned out to be his version of the racetrack. He said he
learned to fold fast when odds were bad and bet heavily
when they were good, lessons he would use to advantage
later in life.” [v] A thoughtful investment operation, on
thorough analysis, promises safety of principal and a
satisfactory return. Operations not promising safety of
principal and a satisfactory return are speculative. In
either operation, I believe that Charlie Munger’s
statement is appropriate: “You have to understand
the odds and have the discipline to bet only when the
odds are in your favor.”[vi]
Even if the odds seem to be in your
favor, remember the warning Benjamin Graham gave us in
The Intelligent Investor: “In most
periods the investor must recognize the existence of a
speculative factor in his common-stock holdings. It is
his task to keep this component within minor limits, and
to be prepared financially and psychologically for
adverse results that may be of short or long duration.”
[i] Charlie Munger talk at [ii] When Genius Failed. The
Rise and Fall of Long-Term Capital Management. by Roger
Lowenstein. Random House Inc. 2001. [iii] The Greatest Trade Ever.
The Behind-The-Scenes Story of How John Paulson Defied
Wall Street and Made Financial History, Gregory Zuckerman,
Broadway Business, 2009. [iv] The Greatest Trade Ever.
Book Review. By Daniel Gross | Newsweek Web Exclusive.
http://www.newsweek.com/id/221924
Nov 10, 2009. [v] Charlie Munger talk at [vi] Charlie Munger talk at |