-In “The Black Swan,” Taleb wrote, “The government-sponsored institution Fannie Mae, when I look at its risks, seems to be sitting on a barrel of dynamite, vulnerable to the slightest hiccup.” Globalization, he noted, “creates interlocking fragility.” He warned that while the growth of giant banks gives the appearance of stability, in reality, it raises the risk of a systemic collapse — “when one fails, they all fail.” -
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One of the most important factors we consider in making investment decisions is a company’s ability to generate cash, and we believe the Fund’s portfolio is filled with companies that either have buckets of cash or are generating it. At the end of the third quarter, the Fund’s top five positions were Berkshire Hathaway, Apollo, Medtronic, Praxair, and Diageo—each one of these companies throws off significant free cash flow. When we are analyzing a company as a potential investment, we spend considerable time thinking about how a company is likely to use its cash, for example, whether in the form of increased investment in the business, potential acquisitions, or share repurchases and dividends—not whether or not a particular company is likely to generate cash. Cash generation is not the order winner, it is the order qualifier. -
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My second theory would be even harder to prove, and this is it: that CEOs are picked for their left-brain skills – focus, hard work, decisiveness, persuasiveness, political skills, and, if you are lucky, analytical skills and charisma. The “Great American Executives” are not picked for patience. Indeed, if they could even spell the word they would be fired. They are not paid to put their feet up or waste time thinking about history and the long-term future; they are paid to be decisive and to act now.
The type of people who saw these problems unfolding, on the other hand, had much less career risk or none at all. We know literally dozens of these people. In fact, almost all the people who have good historical data and are thoughtful were giving us good advice, often for years before the troubles arrived. They all have the patience of Job. They are also all right-brained: more intuitive, more given to developing odd theories, wallowing in historical data, and taking their time. They are almost universally interested – even obsessed – with outlier events, and unique, new, and different combinations of factors. These ruminations take up a good chunk of their time. Do such thoughts take more than a few seconds of time for the great CEOs who, to the man, missed everything that was new and different? Unfortunately for all of us, it was the new and different this time that just happened to be vital.
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THE financial world is a mess, both in the United States and abroad. Its problems, moreover, have been leaking into the general economy, and the leaks are now turning into a gusher. In the near term, unemployment will rise, business activity will falter and headlines will continue to be scary.
So ... I’ve been buying American stocks. This is my personal account I’m talking about, in which I previously owned nothing but United States government bonds. (This description leaves aside my Berkshire Hathaway holdings, which are all committed to philanthropy.) If prices keep looking attractive, my non-Berkshire net worth will soon be 100 percent in United States equities.
Why?
A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful. And most certainly, fear is now widespread, gripping even seasoned investors. To be sure, investors are right to be wary of highly leveraged entities or businesses in weak competitive positions. But fears regarding the long-term prosperity of the nation’s many sound companies make no sense. These businesses will indeed suffer earnings hiccups, as they always have. But most major companies will be setting new profit records 5, 10 and 20 years from now.
Let me be clear on one point: I can’t predict the short-term movements of the stock market. I haven’t the faintest idea as to whether stocks will be higher or lower a month — or a year — from now. What is likely, however, is that the market will move higher, perhaps substantially so, well before either sentiment or the economy turns up. So if you wait for the robins, spring will be over.
A little history here: During the Depression, the Dow hit its low, 41, on July 8, 1932. Economic conditions, though, kept deteriorating until Franklin D. Roosevelt took office in March 1933. By that time, the market had already advanced 30 percent. Or think back to the early days of World War II, when things were going badly for the United States in Europe and the Pacific. The market hit bottom in April 1942, well before Allied fortunes turned. Again, in the early 1980s, the time to buy stocks was when inflation raged and the economy was in the tank. In short, bad news is an investor’s best friend. It lets you buy a slice of America’s future at a marked-down price.
Over the long term, the stock market news will be good. In the 20th century, the United States endured two world wars and other traumatic and expensive military conflicts; the Depression; a dozen or so recessions and financial panics; oil shocks; a flu epidemic; and the resignation of a disgraced president. Yet the Dow rose from 66 to 11,497.
You might think it would have been impossible for an investor to lose money during a century marked by such an extraordinary gain. But some investors did. The hapless ones bought stocks only when they felt comfort in doing so and then proceeded to sell when the headlines made them queasy.
Today people who hold cash equivalents feel comfortable. They shouldn’t. They have opted for a terrible long-term asset, one that pays virtually nothing and is certain to depreciate in value. Indeed, the policies that government will follow in its efforts to alleviate the current crisis will probably prove inflationary and therefore accelerate declines in the real value of cash accounts.
Equities will almost certainly outperform cash over the next decade, probably by a substantial degree. Those investors who cling now to cash are betting they can efficiently time their move away from it later. In waiting for the comfort of good news, they are ignoring Wayne Gretzky’s advice: “I skate to where the puck is going to be, not to where it has been.”
I don’t like to opine on the stock market, and again I emphasize that I have no idea what the market will do in the short term. Nevertheless, I’ll follow the lead of a restaurant that opened in an empty bank building and then advertised: “Put your mouth where your money was.” Today my money and my mouth both say equities. -
The last few weeks witnessed the greatest panic I’ve ever seen, as measured by its severity, the range of assets affected, its worldwide scope and the negativity of the accompanying tales of doom. I’ve been through market crashes before, but none attributed to the coming collapse of the world financial system.
It’s worth noting that few of the recent sharp price declines were associated with weakness in the depreciating assets or the companies behind them. Rather, they were the result of market conditions brought on by psychology, technical developments and their interconnection. The worst of them reflected a spiral of declining security prices, mark-to-market tests, capital inadequacy, margin calls, forced selling and failures.
It was readily apparent that such a spiral was underway, and no one could see how or when it might end. That was really the problem: no scenario was too negative to be credible, and any scenario incorporating an element of optimism was dismissed as Pollyannaish.
There was an element of truth in this, of course: nothing was impossible. But in dealing with the future, we must think about two things: (a) what might happen and (b) the probability it will happen.
During the crisis, lots of bad things seemed possible, but that didn’t mean they were going to happen. In times of crisis, people fail to make that distinction. Since we never know much about what the future holds – and in a crisis, with careening causes and consequences, certainly less than ever – we must decide which side of the debate is more likely to be profitable (or less likely to be wrong).
For forty years I’ve seen the manic-depressive cycle of investor psychology swing crazily: between fear and greed – we all know the refrain – but also between optimism and pessimism, and between credulity and skepticism. In general, following the beliefs of the herd – and swinging with the pendulum – will give you average performance in the long run and can get you killed at the extremes. -
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There is broad agreement among economists that what the financial system needs right now is not only an injection of liquidity but also a recapitalization. The essence of the current financial crisis is that many firms bet that housing prices would not fall; the prices fell nonetheless; and now these firms have too little capital to perform the crucial function of financial intermediation.
(As an aside, one might ask, why did these firms make such bad bets? Essentially, it was a result of poor judgment among various private decision makers, encouraged by equally poor judgment of various public policymakers, many of whom were more interested in promoting homeownership among questionable borrowers than in the preserving the safety and soundness of the financial system. But this is not the time for recriminations. We have to face up to the problem sitting in our laps.)
The question for the moment is, How can we get capital back into the financial system? Ideally, it would be great if more Warren Buffetts would step up to the plate and recapitalize financial firms with private money. Unfortunately, that might not happen fast enough to prevent a major economic downturn.
Some economists have proposed forcing these firms to go raise more capital from private sources. But how exactly can the government do that? It is not entirely clear how, as a legal matter, that can be accomplished. Perhaps regulators can twist the arms of the financial institutions. Call it the Tony Soprano approach. “Nice bank you have here. I wouldn’t want anything bad to happen to it.”
Other economists have suggested that the government inject capital itself. That raises several questions. First, which firms? The government does not want to put taxpayer money into “zombie” firms that are in fact deeply insolvent but have not yet recognized it. Second, at what price should the government buy in? Third, isn’t this, kind of, like socialism? That is, do we really want the government to start playing a large, continuing role running Wall Street and allocating capital resources? I certainly don't.
Here is an idea that might deal with these problems: The government can stand ready to be a silent partner to future Warren Buffetts.
It could work as follows. Whenever any financial institution attracts new private capital in an arms-length transaction, it can access an equal amount of public capital. The taxpayer would get the same terms as the private investor. The only difference is that government’s shares would be nonvoting until the government sold the shares at a later date.
This plan would solve the three problems. The private sector rather than the government would weed out the zombie firms. The private sector rather than the government would set the price. And the private sector rather than the government would exercise corporate control.
Why would an undercapitalized financial firm take advantage of this offer? Because it would need to raise only half as much capital from private sources, that financing should be easier to come by. With Warren Buffetts in scarce supply, the government can in effect replicate them, by pigging backing on what they do.
I believe that Treasury has the discretion to use some of the $700 billion recently approved by Congress to make these equity injections. I would recommend that the Treasury announce an upper limit, say, $300 billion, allocated on a first-come, first-served basis. The limit would encourage financial institutions to act quickly to get in before the door closed. Given how fast matters are deteriorating, the sooner capital gets back into the financial system, the better. -
Robert Shiller and Jason Zweig were guests on last week's Consuelo Mack WealthTrack: Video - 10/3/08.-Interestingly, they both recommended TIPS as their "One Investment."-
We are in a vicious cycle: falling housing values cause losses on securities, which reduce bank capital, thereby tightening lending and causing house prices to fall further. The cycle has spread beyond housing, but housing is the place to fix it.
Housing starts are at their lowest level since the early 1980s, while there are more vacant houses than at any time since the Census Bureau started keeping such data in 1960. Millions of homeowners owe more on their mortgage than their house is worth. Foreclosures are accelerating. House prices continue to fall, weakening household balance sheets and the balance sheets of financial institutions.
But this can stop. The price of a home is partially dependent on the mortgage rate -- a lower mortgage rate raises house prices.
We propose that the Bush administration and Congress allow all residential mortgages on primary residences to be refinanced into 30-year fixed-rate mortgages at 5.25% (matching the lowest mortgage rate in the past 30 years), and place those mortgages with Fannie Mae and Freddie Mac. Investors and speculators should not be allowed to qualify.
The historical spread of the 30-year, fixed-rate conforming mortgage over 10-year Treasury bonds is about 160 basis points. So a rate of 5.25% would be close to where mortgage rates would be today with normally functioning mortgage markets. One of us (Chris Mayer) recently published a study showing that -- assuming normally functioning mortgage markets -- the cost of buying a house is now 10% to 15% below the cost of renting across most of the country. Rising mortgage spreads and down-payment requirements are what's still driving down housing prices. We need to stop this decline.
The direct cost of this plan would be modest for the 85% of mortgages where the homeowner owes less on the house than it is worth. Lower interest rates will mean higher overall house prices. The government now controls nearly 90% of the mortgage market and can (and should) act on this realization. Remove the refinancing option and you can have lower rates without substantial cost to the taxpayer. Homeowners would have to give up the right to refinance their mortgage if rates fall, although homeowners could pay off their mortgage by selling their home. For borrowers with lower credit scores, the mortgage rate would be greater than 5.25%, but it would be less than their current rate.
Now, what about mortgages on homes that are worth less than the total amount of the loan? These mortgages could be refinanced into a 30-year fixed-rate loan to be held by a new agency modeled on the 1930s-era Homeowners Loan Corporation. New mortgages would be made of up 95% of the current value of a home.
The government might use two approaches to mitigate its losses. It could offer owners and servicers the opportunity to split the losses on refinancing a mortgage with the new agency. Servicers would have to agree to accept these refinancings on all or none of their mortgages, to avoid cherry-picking. Or the government should take an equity position in return for the mortgage write-down so that the taxpayers profit when the housing market turns around.
Our calculations based on deeds and Census data suggest that the total amount of negative equity for all owner-occupied houses is $593 billion. However, capping an individual's write-down to $75,000 would reduce the government's total liability to $338 billion and cover 68% of individuals with negative equity. Even this loss will be reduced as the proposal spelled out here raises housing values and economic activity, and contemplates loss sharing with lenders, hopefully matching the experience of the old Homeowners Loan Corporation.
While the net cost is modest compared with many plans on the table, it would require that the government could assume trillions of dollars of additional mortgages on its balance sheet. But we have already crossed this bridge with the explicit "conservatorship" of Fannie Mae and Freddie Mac. In any event, these mortgages would be backed by houses and the verified ability to repay the debt by millions of Americans. In addition, by putting a floor under house prices, this proposal would raise the value to taxpayers of trillions of existing home mortgage assets already owned or guaranteed by the FDIC, the Fed, the Treasury, Fannie Mae and Freddie Mac, among others.
Improvements in household and financial institution balance sheets will increase investment and consumer spending, which will mitigate the extent of the current downturn. Americans, on average, spend about 5% of the equity of their homes on consumer goods and services. So if home prices increased 10% above where they would have been without government intervention, we estimate consumers will have an additional $100 billion annually to spend.
In addition to focusing on the very real problem in the housing market, the plan could be implemented immediately. As a result of the U.S. government's conservatorship of Fannie Mae and Freddie Mac, origination of new mortgages can be financed quickly. Congress would have to raise the overall borrowing limit and approve the new federal purchases of negative equity loans. But it will likely take the Treasury much longer to buy troubled assets than Fannie and Freddie, and it would have to seek the involvement of many additional private actors, as opposed to using vehicles already in place.
The decline in housing prices remains the elephant in the room in the discussion of the credit market deterioration. Let's start there.
Mr. Hubbard, dean of Columbia Business School, was chairman of the Council of Economic Advisers under President George W. Bush. Mr. Mayer is a professor of finance and economics and senior vice dean of Columbia Business School.
