Four Things For Investors to Consider and Four Policy Decisions Worth Noting

We like to keep things objective and impersonal.  For reasons that will be apparent, I would like to depart from that mode for today's article.  My objective is to provide the most immediate help both for investors and for traders.  I also hope to stimulate discussion.

My focus group often says that I sound too professorial.  That comes with sticking to what I know about and trying to educate readers.  A few of those commenting think that I place too much value on credentials.  Same answer.  Credentials frequently encompass knowledge.  Beware of thinking that shorthand methods are good answers.  And someone on Seeking Alpha even suggested that I was "long-winded."  Indeed!  (TM OldProf)

Let us just say that I like to explain fully.  Good writing is terse.  One way to start is by getting the ideas down and then editing.  For the moment, I am just trying to explain things.  This article is a typical example.

An Explanatory Anecdote

Here is a little story.  Many years ago I was a young aspiring student, trying to pass something called "prelims" so that I could begin my doctoral dissertation.  The prelims involved an oral examination covering everything you had learned in all of your courses.  It was an awesome task.  The courses we took typically involved several books and many articles in each of thirteen weeks for each of four courses.  Every year.  You were also fighting against time.  If you delayed too long, those teaching the courses (and therefore the topics of the prelims) would change.  There were many students who had a continuing need to audit the classes of the new professors so that they could pass prelims.  They often postponed their prelims, year after year.

I violated the norm.  I made a list of everything that I needed to read and know before taking my exams.  I scheduled the exams.  Each day I crossed something off of the list as I read it, and I also added any new topics that required review.  I took the exams on schedule without regard to the list.

Here is the question from this story:  At what point in my study did the list reach its apex?

Since I was reading and crossing off, an initial guess might be Day One.  The astute readership of this column is undoubtedly way ahead of the story.

The list was the longest on the day I took the examination!

The key takeaway is that the more you learn, the more you realize how much you do not know.

To be an authority, you should stick to what you really know about.  Look for your pitch.

Our Agenda

Since we are behind in a race with the market, we are going to do something a bit different.  Listed below are a number of propositions.  These are all conclusions we have reached based upon evidence we find convincing.  We hope and expect to write on each topic, so this is a preview, almost a data dump of thoughts in an effort to be timely with help.

Individual Investor Advice

We are getting plenty of calls and questions.  Here are the topics:

• Market reaction reflects plenty of unusual features, mainly "forced selling."  We will try to talk more about how to recognize this.  Meanwhile, Warren Buffett said (something like) if you don't know jewelry, know your jeweler.
• Most individual investors cannot figure this out for themselves and will make big mistakes if they try.
• The average investor should be cautious about making any big decisions.  There is no rush.
• My intelligent investors want to understand how this could have happened.  We have some articles planned.

Public Policy

There are plenty of opinions about what caused our problems and what solutions are best.  Most important for investors is the market implication.  Here are some topics:

• The original TARP plan was focused on what Bernanke called the "root cause."  That would be housing.  Counter-party risk forced the government to address immediate symptoms rather than the cause.
• A key question is the actual value of mortgage securities on the books of every financial institution.  Current methods of valuation range from a few cents on the dollar to the actual performing value of the loans.  Accounting rules favor the former, forcing financial institutions to shrink balance sheets at WARP speed.  A wise accounting expert recently wrote us that there would have been no problem if FAS 157 had been in place for ten or fifteen years before this crisis.  As we have said, it is a good idea, poorly implemented.
• The Treasury will create a working market for illiquid assets.  Nearly everyone thinks that this means that taxpayers will lose.  Wrong!  The test for this plan will be what we call "Win-Win-Win."  This means that the financial firms will no longer be stuck with a foolish and unrealistic price.  The taxpayer, qua taxpayer,  will enjoy the purchase of an asset that will probably appreciate.  The taxpayer, qua citizen, will benefit because a normal trading market in these securities will be established, creating a fair market value.  This means that the taxpayer will not lose in employment, government benefits, local services, and home values.  For a preview, read the insightful article from David Altig, one of our featured sources.
• The government actions will eventually restore normal credit markets for business and for home loans.  Most of those commenting on the housing market begin with a pre-conceived notion of the "correct" level of home prices.  The government plan will restore mortgage lending and facilitate actual price discovery.  No one knows for sure what this will be.

Pundit Pontification

For the moment, let us just say that many pundits are pontificating well outside of their happy zone.  In the shaded area of the Ted Williams picture, he explains that a good hitter becomes a 230 hitter if he swings at pitches even two inches outside of the strike zone.  The strike zone is increased by 37%.  We have too many pundits offering conclusions about things where they know nothing at all.  Their comments are what the average investor or trader reads every day.  This will be a theme for several articles, but the daily example is the insistence on "explaining" the stock market moves by some piece of news that would normally have a marginal effect.

Bonus Prediction

This is something you have not seen anywhere else.  In a few weeks, you will see it everywhere.  There is general consensus that the credit default swap market is flawed, unregulated, and possibly manipulated.

No one seems to have noticed that the ABX, the mortgage market index used to shrink the financial balance sheets and drive ratings downgrades, consists of only twenty securities -- all credit default swaps.

Connect the dots....

Do you think that these CDS's might have been manipulated by those seeking short sale profits on financial firms?  At some point we will see that the "marks" used by accountants were not only illiquid securities, but possibly manipulated securities.  If there is ever an SEC investigation, we will see some "perp walks."

You heard it here first.

If this is correct, we will see -- at some point -- a review of assets, an expansion of assets.  It requires a method that correctly prices mortgage securities, not the ABX.

Comments

[John Lounsbury:]

Thanks for an interesting article. I especially like two philosophical observations you made:

(1) "....the more you learn, the more you realize how much you do not know."

(2) "....many pundits are pontificating well outside of their happy zone."

I, too, endured "orals". In spite of being the top ranked student in my graduate program (based on grades), I miserably flunked the exam. I had not learned either of the above points until after experiencing that failure. Later, with not significantly more knowledge, I sailed through a second pass.

2008 Oct 17 10:50 AM

[BerkeleyBob:]

Interesting post, thank you. I am far from being an authority on accounting, but note the lenders/banks hated FAS 157 and some of the lassez-faire conservatives in Congress echoed this concern. The problem remains, given that many of the appraisals were phony, is how do you value a mortgage on a property which may be underwater? The problem remains, the securitization and packaging of large numbers of individual mortgages blessed by phony, probably fraudulent, endorsements by the rating agencies resulted in foreign central banks and institutional investors (pension funds) reluctantly holding the bag on toxic loans/CDO's. Added is the totally unregulated "not really insurance" credit default swaps scam. The cure is going to be long and expensive.

2008 Oct 17 02:41 PM

[Rumpole:]

Jeff, your philosophical points are well taken. But what is a method that correctly prices mortgage securities?? I'm interested to know your version of what is "correct" in this context because the implication is that the free market and current mark to market methods are not.

2008 Oct 17 04:56 PM

[Jeff Miller:]

Thanks to all for the comments. The next leg of the "rescue plan" is supposed to create a more realistic auction market for these securities. I am doing research and will write more. I'll try to show how some securities are valued below levels reflecting complete failure by the "toxic" portions.

I really constructive questions and comments. It helps to stay on course.

Jeff

2008 Oct 20 03:54 PM