Graham and Dodd Investor's  Instablog

In its simplest form, in the animal kingdom, it is called letting the fox guard the henhouse. That is to say, it consists of allowing regulation to be to designed by the very people that are supposed to be regulated.

One example of that was the repeal of the Glass Steagall Act in the late 1990s. This 1930s legislation was designed to separate investment banking from commercial banking, for good reasons, as we would soon find out. Who wanted it repealed? The investment bankers and and commercial bankers, who wanted to invade each others' turf. And specifically one commercial bank and one investment bank that wanted to merge?

And how did they get the regulatory approval? By offering the Secretary of the Treasury the third top job at the merged institution. This reflects the fact that apart from the two chairman, the Treasury Secretary was the third party, the midwife of the deal so to speak.

More recently, energy companies persuaded the SEC to change the process of evaluating reserves. It is an exact science that used to be performed by the engineers, to engineering standards. But now, the SEC has allowed the companies to estimate reserves using statistical, rather than engineering models. In essence, the statisticians, not the engineers now determined how oil companies will estimate reserves. And these are "stat arb" people like the ones who run hedge funds.

Meaning that the hedgies have captured the oil rating process, in much the same way that they (and the banks) captured the rating process, especially for exotic new instruments like CDOs and SIVs.

In economics, the greatest returns accrue to the scarcest factors of production. What is that scarce, high-returning factor in the stock market?

In our opinion, it's the long term view. Just about everyone is focused on squeezing the most out of today's trade, or this year's performance. Practically no one is looking at what a stock can do over the long term.

But it is the long term trade that can be the most rewarding. For instance, 30-year U.S. Treasuries sold to yield in the mid-teens in the early 1980s. This was more than the U.S. market had compounded over a period that long. What's more, the brokerage houses were eager to create zero coupon bonds by "stripping" the coupons, meaning that an investor could buy "stripped" bonds with no reinvestment risk. Capital gains exceeded the underlying cash flows, meaning that an investor could have reaped shorter term gains as well.

An investment compounding at 15% a year will double in five years, quadruple in 10, go up eight times in 15, and 16 times in 20. Even at 12%, the multiplication works out to something like three times in ten years, nine times in 20.

So Warren Buffett looks for the long term returns of 12%-15% in the Coca-cola's and Proctor & Gambles of this world. He has garnered even higher returns over shorter periods of time. But he is really looking over the longer term, using time as the ultimate form of leverage.

Richard Whitney and Richard Grasso. Both were head of the New York Stock Exchange. Whitney clearly committed a crime, embezzlement, and went to jail. Grasso was paid "obscenely," but apparently not illegally, and successfully resisted legal attempts to claw back his $192 million comp package.

Albert Wiggin and Cioffi and Tannin. One "panned" his Chase Manhattan bank by shorting its stock, and went to jail. The other two had negative things to say about their own hedge fund at Bear Stearns, specifically about the trouble that would ensue if their "in house" model was right. But apparently, there is no legal duty to act on one's own model; at least in making public statements.

Al Capone and Tim Geithner. Neither could be convicted for what they "really" did.. Both could have been convicted for the same (unrelated) action. But one was and one wasn't.

Carlo Ponzi and Bernie Madoff. Both ran "Ponzi" schemes of a type named after the first. Both were caught and sentenced to "hard time." This is the only real parallel between the two periods.

Elliot Ness and Eliot Spitzer. One nailed Al Capone. The other "went after" miscreants, and managed to win some civil judgments. But not criminal cases. The latter, was in fact, caught in what could have been characterized as a crime.

Ever wonder how the Dutch Tulip Bubble got started? It was actually not such a far fetched thing. It derived from the fact the SOME tulips were rare. Meaning that when there was a general prosperity in the Netherlands in seventeenth century, that they became collectors' items, driving up their prices.

When people observed this, they decided that ALL tulips were valuable, meaning that they bid up all the flowers, including the junky ones. A similar thing happened recently in the United States with real estate; the rise of high-end real estate provoked a general rise in property values.

BY DEFINITION, it is "hard" to value rare items. It is, however, not hard to value common items. They can be had just for the cost of replacing them. When the market price of such items is too much above replacement value, the bringing to the market of the new items (more tulips were planted, and harvested two years later), is by itself sufficient to burst the bubble.

Real estate "always" goes up, right? It is safe because it is "always" secured by the underlying property, right? The truth of the matter is that this ALMOST always holds. But it is important to note the exception to the rule.

There is no inherent value in real estate. It has value only because people are willing and able to pay for the right, in the form of "cash flows" to occupy it. If YOU occupy real estate that you own,  you derive value by not having to pay rent to someone else.

Nevertheless, real estate (almost) "always" goes up because the underlying cash flows (almost) always go up. And real estate values are "safe" as long as they bear a reasonable relationship to these cash flows.

These rules were violated in the past decade. Loose lending practices meant that people were "enabled" to buy houses that they really couldn't pay for. And the fact that they were included in the market meant that house prices went up for EVERYONE, including those who could pay. At their peak, they were about TWICE the net present value of the discounted rents. It was a double whammy. And a bubble that had to burst.

Boom and bust cycles are associated with a misallocation of resources. Booms occur when there is a known good, that attracts too much capital. That capital is withdrawn from productive uses elsewhere, in order to chase returns that are genuinely large, but ultimately insufficient relative to the capital expended.

An example was the tech boom. The advent of the Internet made possible more rapid communications. But the processes and protocols associated with it diffused slowly into society. As a result, too much capital went into the sector, initially fueling a boom, but ultimately creating a bust.

An example occurred when Bernie Ebbers of MCi/Worldcom told the FCC that internet usage was doubling every 100 days in 2000, or rising ten times for the whole year. (It actually doubled during the course of the year.) but companies like Global Crossing ramped up for a SIX fold increase in usage, and went bust when this failed to materialize.

The excesses of the tech bubble found its way into real estate. But that's another story, to be told in another post.