Good Places to Short

We hope we 've dissuaded you from shorting, but if we haven 't, we 'd like to share some advice that Jim Chanos gave when we interviewed him in 2005 about the categories for his best short ideas 4 What are the broad categories your ideas tend to fall into JC The first and most lucrative are the booms that go bust. We've had our most success with debt-financed asset bubbles as opposed to just plain asset bubbles where there are ticking time bombs in terms of debt needing to be repaid, and where...

Overview of Berkshire s Businesses Insurance

Berkshire 's single most important business is insurance, consisting of Government Employees Insurance Company (GEICO), General Re, Berkshire Hathaway Reinsurance Group, and Berkshire Hathaway Primary Group. These four generated 58.5 billion in float as of year-end 2008 and during the year earned 25.5 billion in premiums and 2.8 billion in pretax profits. In general, insurance companies make money in two ways. First, like any other business, they can make an operating profit by charging more...

The Homeowner Affordability and Stability Plan

To some extent, all of our forecasts regarding the future of the housing market depend on what the government does. If the government wanted, it could borrow a few trillion dollars and save every troubled mortgage in the country. While this would be foolish from a policy perspective, it would make our estimate of future foreclosures look silly. After a series of ineffective attempts to address the tidal wave of foreclosures under the Bush administration, the Obama administration on March 4,...

The Government

Even the briefest study of the history of financial markets shows that they are prone to boom-and-bust cycles unless governments carefully regulate them. Thus, it's not surprising that the housing bubble was made possible by a complete failure of government at all levels to properly monitor and regulate many different areas. Here were some of the key events During the 1990s, the Clinton administration pushed Fannie and Freddie to support more lending in low-income communities and used the...

An Ill Fated Acquisition

Given that we covered our remaining short position in Wells Fargo at around 10 during the first week of March 2009 and are now long the stock you might wonder why we 're writing about it here. There are two answers first, because when we decided to write this book in early January 2009, it was one of our favorite short ideas because the stock was around 30 it 's truly stunning how quickly the stock fell in only two months. Second, because it's an interesting case study of how a company can be a...

What Caused the Bubble

It seems almost inconceivable that two-and-a-half years of reckless lending, the biggest part of it in the U.S. mortgage market, could create such an enormous bubble that its bursting would bring the world financial system to its knees and plunge nearly every economy in the world into a severe recession or worse . How did this happen The answer is that a confluence of factors created a perfect storm what Berkshire Hathaway's Charlie Munger calls Lollapalooza effects resulting in the greatest...

Perspectives from Buffett and Klarman

For further perspectives on this treacherous environment, let's turn to two of the greatest investors of all time Berkshire Hathaway 's Warren Buffett and Seth Klarman of the Baupost Group. On October 16, 2008, Buffett published an Op-Ed in the New York Times in which he highlighted the perils facing investors 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...

Arguments against Short Selling

Shorting looked easy in 2008, but in reality it's a brutally tough business. In many ways, it appears to involve nothing more than applying the same analyses one uses when determining whether to buy a stock On the long side, investors generally seek companies with good management, strong growth, high margins and returns on capital, little or no debt, clean balance sheets, and sustainable competitive advantages all at a low price. Conversely, short sellers look for weak or dishonest management...

Impact on the Broader Economy

Mortgage Meltdown Unemployment Rate

The train wreck in the U.S. housing market has triggered a credit crunch that has caused a severe economic decline worldwide. This, in turn, is exacerbating the problems in the housing market, creating a vicious circle. For example, if a business has difficulty borrowing Figure 3.15 Case Study California Home and Condo Resales Source MDA Dataquick. Note includes new construction. Figure 3.15 Case Study California Home and Condo Resales Source MDA Dataquick. Note includes new construction....

The Human Face of the Housing Bubble

So far, we've told the story of the mortgage meltdown with statistics, charts, and graphs, which makes it easy to forget that nearly every mortgage involves real people and families and their homes. Millions of Americans are struggling to pay their mortgages, and a meaningful percentage will lose their homes, which is often an economic and emotional catastrophe. Yes, some people were greedy and reckless or engaged in outright fraud and should lose their houses, but many others are vulnerable...

What Should the US Government Do to Save the Financial System

There 's universal agreement that putting the U.S. financial system on a sound footing is necessary to restore economic growth and improve employment, but there 's little agreement on exactly how to do this. We've long been believers that the only solution is for the U.S. government to assume temporary receivership of the many zombie banks in the system a view that became more mainstream in February 2009, though it remains unclear whether this course of action will be adopted. If it is we...

Index

ABFC Asset Backed Funding Corporation 2006-OPT2 Trust, 259-261 Acquisition accounting, 238 Adjustable-rate mortgages ARMs , 80-85, 277-278 Affordability of homes, 6-7, 88, 98-100, 104-106, 222 AIG American International Group , 37, 112, 115-116, 151 Ainslie, Lee, 145, 146 Allied Capital, 289-290 Alt-A loans mortgages, 31-32, 76-80 Altria, 130 Ambac Financial Group, 93, 95, 254-255 Ambassadors International, 131 American Express case study on, 179-197 cash trapping by, 191-192 challenges facing,...

Case Study American Express

Woolford Over the past 159 years American Express Amex has grown to be one of the most admired companies in the world and among the most recognized global brands, yet its stock price has plunged more than 80 percent from its peak less than two years ago, hitting a 14-year low below 10 on March 6, 2009, as shown in Figure 8.1. Is American Express yet another storied financial company doomed to fail amid the worst economic downturn since the Great Depression Or...

Losses

Wells Fargo, to its credit, did not become involved to any meaningful degree in toxic securitized products, as did so many of its peers, so the analysis of possible losses focuses on the loans Wells Fargo holds on its balance sheet. Table 13.6 shows the breakdown ofWells Fargo 's Table 13.6 Wells Fargo Loan Portfolio with Estimated Losses Wells Fargo Estimated Range Estimated Range 12 31 08 of Cumulative of Cumulative Bn Losses Losses Bn Commercial Real Estate Commercial Other real estate...

The Siren Song of Securitization

The mechanism by which Wall Street and the GSEs took mortgages and sold them to investors around the world is called securitization, which is simply a process by which a group of loans are pooled and then the pool is sliced into pieces called tranches the French word for slices . The most senior tranche gets the first cash earned by the loans in the pool and is the last to suffer losses, so it's typically rated AAA by the major rating agencies, whereas the most junior tranche usually called the...

Home Price Declines

All of these factors have led to a sharp decline in housing prices, which is measured in numerous ways. There is no right way, so we present three different measures. The most widely followed metric is the S amp P Case-Shiller 20-city composite home price index, which includes numerous bubble cities such as Las Vegas, Phoenix, Miami, and many in California. Thus, this index shows the greatest rise in prices during the bubble as well as the greatest decline, relative to other national home price...

How Payments Flow to the Tranches

Table 10.5 shows the status of the remaining tranches in the RMBS. Note that tranches M-5 through M-11 and the equity tranche have already been wiped out and there 's almost nothing left of the M- 4 tranche. This table shows that tranche IA has been paid down from 366 million to 223 million and the IIA1 tranche has been paid down from 323 million to only 52 million and no other tranches have been paid anything. A total of 413 million has gone to the top two tranches in this pool 253 million...

Notes

Chapter 1 What Happened during the Housing Bubble 1. Frank McKenna, Income Fraud Involving Stated and Full Document Loan Programs, . . 3. Clawing Your Way Out of the Subprime and Alt-A Market, www 4. The Giant Pool of Money, National Public Radio, This American Life, Program 355. Originally aired May 9, 2008. Produced by Chicago Public Radio and distributed by Public Radio International. This episode was a collaboration between This American Life and NPR News. Reported by Alex Blumberg and Adam...

The Collapse of Lending Standards

Loan Value Ratio Images

Lending standards collapsed to an almost unimaginable degree during the great bubble, to the point that in some areas if you had a pulse, you could get a mortgage. The collapse manifested itself in many ways. In 2001, the combined loan-to-value ratio for the average mortgage was 74 percent, meaning the buyer had put down 26 percent of the cost of the home see Figure 1.7 . When doing any kind of lending, it's critical that the borrower has meaningful skin in the game, so there is a strong...

MBIA s Business Model

MBIA 's business model is to collect a small amount of money up front insurance premiums in exchange for a promise to pay potentially large but unlikely-to-occur losses in the future in most cases, decades into the future. The best analogy for this business model is picking up pennies in front of a steamroller it's nicely profitable until something goes wrong, and then . . . splat This is a very different type of business model from, for instance, an auto insurer like GEICO, which collects...

Commercial Finance

REXI 's most valuable operation is its 85 percent stake in LEAF Financial LEAF 's management owns 15 percent , a small equipment leasing business. LEAF forms alliances with equipment vendors and investors and puts together investment pools limited partnerships that LEAF manages that do four-year-average-life leases on small-ticket items, with very wide diversification in terms of both the assets and the customers. LEAF generates three fee streams 1 income spread until leases are sold down 2...

Homes as ATMs

Another factor was at work as well As home prices rose and interest rates dropped, millions of Americans were able to refinance their mortgages at lower rates but also this is critical take out bigger mortgages, thereby converting the rising value of their homes into cash. Called a cash-out refinancing or refi, this practice soared during the bubble. In total, as shown in Figure 1.5, Americans pulled more than 2.5 trillion out of their homes from 2004 to 2007, fueling consumer spending and...

Introduction

It was a cold day in early February 2008 as we biked to the Peninsula Hotel in midtown Manhattan to meet Sean Dobson, the CEO of Amherst Securities. We were there because we were intrigued by this e-mail a friend had sent us a few days earlier Sean is the best mortgage technician I know and has developed a unique database that includes virtually all mortgages originated since 1998, sliced by month of origination, product type, and further stratified by a proprietary coding system that picks up...

Second Liens and Home Equity Loans

All of the mortgages we 've looked at so far, as toxic as they might be, are at least first mortgages or first liens , meaning that if the borrower defaults, the lender can foreclose on the house and sell it, thereby recouping some of the loss. But this isn' t so in the case of a home equity line of credit HELOC or a home equity loan, these loans are also known as a second lien, second mortgage, closed-end second CES , junior lien, or closed-end junior lien . A HELOC is a line of credit that a...

Good Bank Bad Bank

Mbia Inc Corporate Structure

Before we share our analysis of MBIA 's likely losses, we need to explain a recent restructuring of the company undertaken by management, which, if it stands, could change our analysis dramatically. MBIA has effectively been in a runoff mode for quite some time, having written minimal new business in 2008,' ' according to its Q4 2008 earnings release. In an attempt to get back into business, MBIA announced on February 18, 2009, that it was creating a separate public finance bond insurance...

Conclusion

In our entire careers, we have never seen a company as underreserved as MBIA without even considering the likely losses it will have in its nonstructured finance portfolio and guaranteed investment contract business. We think MBIA 's losses will significantly exceed the company 's reserves, and will far exceed the 944 million of equity at MBIA Inc., the holding company, and the claims-paying resources of the insurance subsidiary, MBIA Corp., even if one includes the money that was transferred...

The Money Being Made on Wall Street

Wage Proportion Economy

Wall Street firms were making a fortune from the bubble, which fueled their reported profits and share prices. Figure 2.4 shows the stock prices from 2003 to 2006 of the major Wall Street firms, Goldman Sachs, JPMorgan Chase, Morgan Stanley, Lehman Brothers, Merrill Lynch, and Figure 2.4 Stock Prices of Wall Street Firms vs. S amp P 500, 2003-2006 Source Yahoo Finance http finance.yahoo.com . Figure 2.4 Stock Prices of Wall Street Firms vs. S amp P 500, 2003-2006 Source Yahoo Finance http...

Look Through Earnings

Stock Price Intrinsic Value

Another way to value Berkshire is to simply put a multiple on its aftertax earnings the P E ratio just as one might do for any company. It's a little complex for two reasons, however First, Berkshire 's earnings need to be adjusted for investment and derivative gains losses, which from the 2008 annual report have no predictive value, and variations in amount from period to period have no practical analytical value. For example, in 2008 there were big mark-to-market losses on derivatives, and in...

What Happened during the Housing Bubble

Talk to your parents or grandparents about buying their first home and they'll tell you it was the fulfillment of the American dream, a long process that involved years of saving and sacrificing to gather enough cash for the 20 percent down payment. They'll tell you that the day they bought their first home was one of the greatest days of their lives, that it represented more than just a place to live. In fact, that home was the single biggest purchase most would ever make, and it represented...

Home Prices over Time

Historically, there was good reason to believe that homes represented stability, safety, and security. For more than half a century, home prices had marched steadily upward at a rate exceeding inflation by about one-half of 1 percent annually, with very little volatility, as shown in Figure 1.1. Figure 1.1 Real Home Price Index, 1950-2000 Source Robert J. Shiller, Professor of Economics, Yale University, Irrational Exuberance Second Edition, Princeton University Press, 2005. Figure 1.1 Real...

Why Isn t Everyone a Value Investor

If value investing sounds perfectly sensible which it is , you might wonder why everyone isn 't a value investor. A simple explanation is that you must be able to estimate the value of a business, which requires a great deal of skill and experience to do with reasonable accuracy. There are other explanations as well. James Montier has studied the subject and finds the reasons are deeply rooted in human nature and, therefore, unlikely to ever change. The first reason he cites is aversion to...

Avoiding Overconfidence

There are dozens of behavioral finance traps, but the single biggest one is overconfidence. One can 't be a successful investor without a healthy dose of confidence. To commit your own and others' hard-earned capital requires conviction, and conviction requires confidence. But as with fine brandy or coffee ice cream, too much of a good thing can be problematic. Social scientists have confirmed time and again that people generally overestimate their abilities and knowledge. More than 80 percent...

To the Bottom Subprime Loans

Delinquency Seasoning Mortgage

At the opposite extreme from prime loans are subprime ones, which are given to borrowers with very poor credit histories and low FICO scores, typically below 620 to 660, depending on whose definition you want to use the average FICO score for securitized subprime loans was 617 as of January 2009 . Such borrowers are generally poor, aren 't well educated, have spotty employment histories, and have frequently been late or defaulted on debts in short, precisely the people a lender should be very...

Performance of Long Beach Mortgage Loan Trust

The layering of risk factors is astonishing borrowers with very poor credit histories, high-interest adjustable-rate mortgages, lots of liar's loans, a concentration in bubble markets so it's not surprising that this Table 10.2 Information about the Mortgages in the Long Beach Mortgage Loan Trust 2006-8 Trust Statistics Total scheduled principal balance 1,380,727,000 Average scheduled principal balance 214,166 Weighted average gross coupon 8.46 Weighted average FICO score 639 Weighted average...

Option ARMs

Doc Mortgages Origination Volume

If one were to design a loan that would blow up the maximum number of borrowers the moment home prices stopped rising, an option ARM would be it. Also known as a pay-option ARM and sold under names like Pick-A-Pay and Pick-A-Payment, this is a 30- or 40-year adjustable-rate mortgage that, for the first five years, gives the borrower the option each month of paying 1 the fully amortizing interest and principal, 2 full interest only, or 3 an ultralow teaser rate typically 2 to 3 percent that...

The Spend Centric Model

Amex is the world 's largest issuer of charge and credit cards as measured by purchase volume, with over 90 million cards in force generating over 650 billion of annual spending. BusinessWeek ranks it 15th among the top 100 global brands, and Forbes ranks it 17th among the most admired companies in America. Amex's business model, which the company terms spend-centric, is focused on attracting premium card members who spend more per card, which in turn allows Amex to charge premium prices to...

Race to the Bottom

There was a race to the bottom among Wall Street firms, none of which wanted to lose business and profits to competitors. Mike Garner, who worked at the largest private mortgage bank in Nevada, called Silver State Mortgage, described what happened 3 Mike Garner Three of them mortgage brokers would show up at your door first thing in the morning and say, I lost 10 deals last week to Meritius bank. They 've got this loan. Look at the guidelines for this loan. Is there any way we can do this We...

Structure of a CDO

Credit Rating Cdo

In Chapter 10, we analyzed one RMBS in great depth. RMBSs were a money machine for Wall Street, as we explained in Chapter 2, but there was a problem It was easy to sell the AAA-rated tranches to the institutional investors of the world and to sell the lower-rated, high-yielding tranches to hedge funds and other yield-seeking investors also known as yield whores because they'd sell their mothers for an extra 50 basis points of yield , but the BBB and A tranches were harder to sell because they...

Jumbo Prime Loans

2011 Vintage Mortgage Delinquencies

Jumbo prime loans are those made to borrowers with good credit histories, but which are too big to be sold to the GSEs, which have a limit of 417,000 in some areas, 729,750 . In many ways, these loans have the same problems as option ARMs, the only difference being no negative amortization. Averaging 750,000, jumbo loans are most common in areas with high home prices like California and Florida in other words, the areas where the bubble inflated the most and that are now suffering the greatest...

From the Top Prime Conforming Loans

The highest-quality loans are called prime or conforming, terms that are used interchangeably, though they don't have quite the same meaning conforming describes a loan that meets Fannie Mae and Freddie Mac guidelines and is typically sold to these GSEs. It can't exceed 417,000 except in certain high-cost areas, where the limit is 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 Figure 4.1 Mortgage Origination Volume by Product Type Source Inside Mortgage Finance, Inside Mortgage Finance...

Case Study Long Beach Mortgage Loan Trust

E are equity investors, but in mid-December 2008 we made our first debt investment when we bought a piece of a 2006 bubble-era subprime pool of mortgages suffering from catastrophic defaults. Were we crazy You decide. . . . The securitized pool of mortgages called a residential mortgage-backed security or RMBS is called the Long Beach Mortgage Loan Trust 2006-8, and it's a fairly typical pool of subprime mortgages from near the peak of the bubble in 2006. It contained 6,447 mortgages, valued at...

MBIA s RMBS Exposure

Default Rate 2006

Let 's turn our attention first to MBIA 's RMBS exposure. As noted earlier, MBIA had 31.8 billion of exposure to RMBSs at the end of 2008, broken down by sector and vintage in Figure 12.5 . Figure 12.5 MBIA RMBS Exposure, Sector, and Vintage Composition Source MBIA Q4 2008 investor presentation, March 3, 2009, p. 25. Figure 12.5 MBIA RMBS Exposure, Sector, and Vintage Composition Source MBIA Q4 2008 investor presentation, March 3, 2009, p. 25. Figure 12.5 provides a number of key pieces of...

MBIA s CDO Exposure

As noted earlier, MBIA has 124.9 billion of exposure to CDOs and has taken 1.2 billion of impairments, all against its 25.5 billion on multisector CDO exposure, broken down as shown in Table 12.4 . Let's focus on these three categories of multisector CDOs. Table 12.5 shows the exact securities that MBIA had guaranteed as of the end of 2007 MBIA has not disclosed this information since then, but the numbers haven 't changed much . Table 12.5 Details of MBIA's Multisector CDO Exposure Year Deal...

Sean Dobson Amherst

This book would not have been possible without Chris Woolford, who chased down endless amounts of data, created nearly every chart, and wrote the chapter on American Express. We 'd also like to thank Tim Melvin, who drafted parts of the book Jeannie Reed, who did invaluable editing and our office manager, Kelli Alires, who keeps things running smoothly. Special thanks also go to John Heins and John Schwartz, our partners, respectively, on Value Investor Insight and the Value Investing Congress....

Wells Fargo s Balance Sheet

Table 13.3 shows Wells Fargo 's balance sheet, which includes Wachovia, as it appears in the 2008 10-K. You might think it would be easy to determine Wells Fargo's stockholders' equity, the single most important element of the balance sheet -just read the second-to-last line at the bottom of the balance sheet, right But it 's not so easy. For more discussion of equity, see the appendix at the end of this chapter. What we, as investors, care about is Wells Fargo 's ability to weather the current...

An Analysis of One CDO

To show how significant MBIA's impairments are, let's drill into one CDO highlighted in Table 12.5, Longshore 2007-III. This is a 1.3 billion 2007 vintage high-grade CDO meaning that most of the tranches that comprise Longshore were originally rated A , A, or A , broken into seven tranches as shown in Table 12.7. We can see that Longshore had three AAA-rated tranches, comprising 94.2 percent of the CDO, and that the super-senior A1 tranche, Table 12.6 Vintage of CDOs Guaranteed by MBIA Table...

The Bull Case for Wells Fargo

There is much to admire about Wells Fargo. By all accounts it has a great management team and a very strong franchise that will likely become even stronger with the acquisition of Wachovia, which gives it a coast-to-coast presence and propels it to the top, or near the top, of U.S. banks. The combined company is number one in bank branches 6,610 , small business lending, middle market commercial lending, agriculture lending, commercial real estate lending and brokerage, and bank-owned insurance...

Wall Street Responds

Inside Mortgage Finance

With safe investments like Treasuries paying such low rates, the investors of that 70 trillion started taking more risk in search of higher yields and Wall Street was happy to oblige. Here s how Mike Francis, who helped build the U.S. residential mortgage trading desk at Morgan Stanley, described it when he was interviewed by This American Life 2 It was unbelievable. We almost couldn t produce enough to keep the appetite of the investors happy. More people wanted bonds than we could actually...