Baupost Group's Seth Klarman: "We Are in an Era of Leverage"

by: Eric Schleien

On October 27, 2007, Seth Klarman who manages the Baupost Group gave a speech as well as answered questions at the MIT Sloan Investment Management Conference. Klarman stressed tuning out daily market blips. He noted most investors can’t tune out the so called noise.

I would tend to agree with this assessment. Even so called “Buffett Followers” who preach his mantra of never looking at stock quotes – many of them do, it’s just not in vogue. His conservative and somewhat boring approach to investing has given him impressive returns by any measure. Not only has he significantly outperformed the market but he has made money for his limited partners 24 out of 25 years.

The key to this high yield investing approach is to first focus on downside risk before even considering the upside. He has also made his money without ever using leverage. Klarman makes the point that the market should not dictate you and using margin allows it to do just that. “It’s a slippery slope,” he said while referring to using leverage. “If you are on a small amount of leverage, why not use more?” Leverage is addicting.

“We are in an era of leverage,” he said to the crowd. Klarman noted that the last two generations of American have been using their homes as ATM machines and have been buying more goods on credit. He pointed out the problem wasn’t just amongst Main Street. Investment Banks have been pushing structured investment vehicles and exotic finances and the rating agencies have been labeling “toxic waste” as investment grade.

This situation has certainly become worse since October of 2007 and Klarman seems to have been very right on the severity of this theme which many pundits were calling trivial. Klarman noted last year that “Leverage is at record high levels…probably the beginning of a credit de-leveraging period.” He pointed out that the debt crisis is probably not near the end since people who owe money are taking out more debt to cure the problem. “This very ‘cure’ is what caused the problem in the first place”, he said.

In today’s environment credit receivables are ballooning. Perhaps the next round of defaults will take place in this arena. If you can’t take money out of your house anymore why not just swipe plastic? This type of mindset I believe is very prevalent in American society and while pundits such as Larry Kudlow will easily dismiss this rationale, I would be skeptical of this assessment.