Before I start tonight, a reminder, those that want to follow me on Twitter can do so here.  I will be sharing posts and ideas that I find insightful, that I might or might not share on the blog.  I’m still working with it.  Thanks to all of those that tweeted and retweeted, and those that are following me now.

One more note, I disagree with Volcker and Sarkozy regarding supporting Greece, versus the Euro.  If Greece defaulted, Greece would lose the low cost funding of the Euro.  The Eurozone would lose a country, but the Euro would retain its strength, and marginal nations prone to cheating would come into line.  Tough love is the best policy; don’t bail others out if you care about the union as a whole.

On to tonight’s rule: Unless there is a natural purchaser of an exposure that one is trying to hedge, someone must speculate to a degree to allow you to hedge.  If the speculator is undercapitalized, risks to the financial system rise.

This rule is pretty simple.  There are few places in the financial markets where there are naturally offsetting exposures that have not been remedied by an institution created for that very purpose, such as a bank.  In most cases with derivatives, the one that wants to reduce exposure relies on a speculator.  There are rare cases where the risk of one is the benefit of another, but situations like that tend to create new firms to internalize the trade.

The trouble occurs when the speculator can’t make good on his obligations.  As with many speculators, he overcommits.  He is short of funds because many trades are going against him at the same time.  It is in these cases that those who hedge learn to evaluate counterparties for their riskiness.

That is why it is worth knowing who is at the end of the chain in this financial game of crack-the-whip.  The status of the ultimate speculators, and whether they can make good on promises or not is a huge thing.  After all, subprime mortgages were downplayed by many as the crisis was rising, but they were at the end of the financial game of crack-the-whip.  They were one of the main classes of marginal borrowers.


Taking this a different way, this argues against the academics that look for complete markets in the sense of Arrow-Debreu.  There are trades that no one wants to take at any price that a seller could live with.  There are securities that can be created that no one wants to buy, at prices that are unprofitable to the securitizer.    Complexity is a minus.  We can create securities that are the financial equivalent of toxic waste, but no one should pay much for them.  It is the price of creating safe securities.

No surprise: people pay a lot more for certainty, even if it is seeming certainty.  We see it in corporate bond spreads.  High quality borrowers borrow cheaply.  Low quality borrowers pay up. So what else is new?

What is new is the low-ish spreads for going down in quality.  This one could go either way; spreads are wide against history, but might be narrow against current difficulties.  The rebound has been rather sharp.

Note: this is reposted because of a system glitch.

Dear readers, I am now on Twitter — AlephBlog is my moniker if you want to follow me.

I have been somewhat reluctant to do this, but tonight’s post stems from a file on nonlinear dynamics on my computer that I developed between 1999 and 2003 for the most part.  Not so humbly, I called it “The Rules.”   This is the first in a series of what will likely be long set of irregular posts about what I call “The Rules.”  Please understand that I don’t want to make grandiose claims here.  After all, as I once said to Cramer (yes, that one): “The rules work 70% of the time, the rules don’t work 25% of the time, and the opposite of the rules works 5% of the time.”

My best recent example of the rules not working was when the formulas of the quants were blowing up in August 2007.  There were too many quants following the same strategy, and they had overbid the stocks that their models loved, and oversold the ones that they hated.  For a while, the quant models were poison.  Every investment strategy has a limited carrying capacity, and those that exceed the strategy’s capacity are prone for a comeuppance.

Here is today’s rule: There is no net hedging in the market.  At the end of the day, the world is 100% net long with itself.  Every asset is owned by someone, regardless of the synthetic exposures that are overlaid on the system.

There are many people, particularly dumb politicians, who think that derivatives are magic.  To them, derivatives create something out of nothing, and that something is strong enough to smash innocent companies/governments that have been behaving themselves, but have somehow found themselves caught in the crossfire.

First, if a company or government has a strong balance sheet, and has a lot of cash or borrowing power, there is nothing that speculators can do to harm you.  You have the upper hand.  But, if you have a weak balance sheet, I am sorry, you are subject to the whims of the market, including those that like to prey on weak entities.  Even without derivatives, that is a tough place to be.

With derivatives, for every winner, there is a loser.  It is a zero-sum game.  Yes, as crises arise there are always those that look for a way to make money off of the crisis.  And there are some parties willing to risk that the crisis will not be so bad, at a price.  Derivatives don’t exist in a vacuum.  Same thing for shorting — there is a party that wins, and a party that loses.  So long as a hard locate is enforced, it is only a side bet that does not affect the company whose securities are being played with.

When there are troubles, it is because a company or government has overstretched its limits.  You can’t cheat an honest man (or country).  You can take advantage of countries and companies that have overreached on their balance sheets and cash flow statements.

Cash on the Sidelines, Market is Oversold/Overbought, Money is Moving into or out of…

Every bit of cash on the sidelines is matched by a short term debt obligation somewhere.  Now, that’s not totally neutral, as we learned in the money markets crises in the summers of 2007 and 2008.  If the money markets get too large relative to the economy on the whole, that means there is possibly an asset/liability mismatch in the economy, where too many are financing long assets short.  It costs more in the short run to finance long-life assets with long debt or equity, but in the short run you make a lot more if you finance short… do you take the risk or not?

GE Capital nearly bought the farm in early 2009 from doing that.  CIT did die.  Mexico in 1994.  When you can’t roll over your short term debts, it gets really ugly, and fast.  Think of the way we messed up housing finance in the mid-2000s; one of the chief signs that we were in a bubble was that so much of it was being financed on floating rates, or contingent floating rates with short refinance dates.  Initially, that gave people a lot more buying power, at a price of higher unaffordable rates later.  “The phrase, “You can always refinance,” is a lie.  There is never a guarantee that financing will be available on terms that you will like.

This is also a good reason to go for debt that fully amortizes (i.e., when you get to the end of the loan, the payments haven’t risen, and the loan pays off in full).  I’ve never been crazy about the way commercial mortgage loans don’t fully amortize.  I know why it happened this way.  A) in the late ’80s and early ’90s, insurance companies were issuing GICs by the truckload, and needed higher yielding debt with a 5-year maturity.  Voila, 5-year mortgage loans with a balloon payment.  For the real estate developers, the loans were cheaper, but they had to trust that they could refinance — an assumption sorely tested in the early ’90s.  After the death of many S&Ls, a few insurers and developers, and the embarrassment of a more, borrowers and lenders became a little more circumspect.

But the loss of the S&Ls left a void in the market.  The Resolution Trust Company created some of the first Commercial Mortgage Backed Securities [CMBS], that Wall Street then imitated, filling in the void left by the S&Ls.  But to make the securitizations more bond-like, for easy sale the loans were 10-year maturities with a balloon payment at the end.  That way the deals would closer at the end of ten years.  Maybe some of the junk-grade certificates would be stuck at the end with a some ugly loans to work out, but surely the investment grade certificates would all pay off on time.

And that is a big assumption that we are going to be testing for the next five years.  Will developers be able to refinance or not?

This has gotten long, and have more to say, but I’m going to a wedding of a friend, and must cut this off.  Let me close by saying there is a corollary to the rule above, and it is this:

Long-dated assets should be financed by non-putable long-dated liabilities or equity.  Don’t cheat and finance shorter than the life of the assets involved.  There is never an assurance that you will be able to get financing on terms that you will like later.

While on the Ron Smith show today, one caller asked, “So, where would you cut spending?”  Given my recent piece, The Virtue of a Big Bang, I was ready.  My view is that in a crisis, pain should be shared as evenly and broadly as possible.  Thus when someone claims that the schools or hospitals must be exempt, you come back with “No one is exempt.  There are lower priority projects and functions everywhere inside government.”

An aside: I live in Howard County, Maryland, which has the best school district in the state.  We homeschool anyway.  Unlike most places in the US where homeschoolers tend to be evangelical Christians, here most homeschoolers are purely secular.  We hear tales of those who have left the public schools decrying the sloppiness and waste in the system.  Also, we experience that the system demands more of homeschoolers than it asks of those that go to the public schools.

Earlier in my life, I have been on school boards — as a homeschooler, of course not now, that would be impossible.  No one would elect someone who homeschools to the school board.  But from my earlier work, and what I know from a basic understanding of the economics of public school systems, when counting in the fair value of pension accruals, teachers are very well paid.  We can freeze their pay, and freeze their benefits.

And, that is true for all government programs.  Cut an even amount everywhere; freeze them in nominal dollars at least.  Yes, that’s painful.  Pain needs to be shared as we cut back after years of growth beyond our ability to sustain it without additional debt.

Governors and mayors, ignore the screams.  People need to learn to make do with less.  If you lead, they will follow.  People love politicians that flout pandering, and stand for something, particularly during times of crisis.

The Same Idea on the Federal Level

Okay, much as I am not in favor of Obama’s plan for national health care, let me propose something like it.  It is time to tame Medicare.  The concept of a safety net means basic care, not extraordinary care.  News bulletin: every one of us will die, regardless of how much medical care we receive.  Too much money is spent in the last six months of life, for too little good.  If people want to spend their own money for extraordinary care to extend life, that is their own business, but it should not be the way the government spends, if it spends at all on health care.

Away from health care, let’s consider “Defense.”  To any who think me a slave of living near DC, pleazzze get it, even though if implemented, most of my friends would be hurt by what I am about to say, I will say it anyway.

There are bases overseas where soldiers face no real possibility of combat.  There is no real reason for the bases, aside from the US acting like an empire over the rest of the world.  We need to close bases in the US, and even more overseas.  They don’t benefit US interests.  We do not need to be the global policeman.

Also, many weapons programs fail.  They don’t produce anything useful, and yet a huge bureaucracy gorges on the cash from the US Government.

We need to focus on defense.  Defense, not dominating the rest of the world.  We don’t need a large military.  We don’t need to be in Iraq, and maybe not Afghanistan, and we don’t need legacy bases all over the world.  Cut “defense” spending, it is useless to the US.

If we didn’t try to dominate the Mid-East, we would not face many terror threats.  We get what we deserve.  Would we like it if outsiders tried to influence our leaders, and our selection of leaders?

Everything Must Be Cut

Fairness is paramount.  Americans have a strong sense of fairness.  If everything is being cut, then the sense of shared pain will reduce support for riots and demonstrations where people plead for their special interests.  Let the students that want lower tuition at the state University pay more.  Much more, but in rough proportion to the cuts in the rest of society.

If we cut Medicare by reducing our willingness to pay in the last six months of life, even so, let us make other cuts, such as reducing or eliminating Medicare Part D.  There is no good reason to have a Medicare drug benefit.  Please end this signature program created by George W. Bush.

I will say it again, cut everything.  Get your head around the idea that preserving the nation, state, or municipality is worth a lot more than preserving the stupid programs that venal ideologues are ranting must be kept.  There is nothing that must be kept, aside from police, fire, justice, and public health.  Even they should have wage cuts — the pain must be shared everywhere.

1) After reading a piece on Falkenblog yesterday, I decided to add up all of the profits from Fannie and Freddie over the last 20 years.  Ready for how much they made?  Ta-da!  They lost $114 billion.

When writing at RealMoney, I was always skeptical of the GSEs, and felt that they were too lightly reserved, because eventually they would run into a situation where real estate prices would fall.

2) Bruce Krasting comments on the solvency of the FHA.  I comment:

“I’ve argued that FHA would go negative for some time. Even the FDIC is engaged in a bit of chicanery by fronting future premiums forward to avoid borrowing from the Treasury.

We may avoid a banking crisis — at the cost of a sovereign crisis.”

3) I probably have a longer post coming on the paradox of thrift, that bogus concept that Keynes put forth.  But Paul Kedrosky crystallized it for me when he posted this.  And so I wrote:

The problem with the “paradox of thrift” is that it assumes there is only one way to save. Same for the “paradox of toil.” It assumes that all work is interchangeable and uniform.

The aggregation of all saving and all labor is necessary to make these models work mathematically, but isn’t valid in real life.

Yes, if everyone tries to do the same thing, stupid things happen, like bubbles from overinvesting. If there only a fixed possible number of tasks, and people work longer hours, it takes fewer people to do them.

But there are many opportunities, including ones that we don’t presently know about. Businesses that no one could imagine before the crisis can spring out of hard times.

This paper oversimplifies the economy. If the economy were that simple, he would be right. But the economy is not that simple.

4) I don’t know if the Volcker Rule will be eliminated or not, but I do know that the same ends could be achieved through changes in the risk-based capital formulas.  What I wrote:

The same ends of the Volcker Rule can be accomplished through adjusting the risk-based capital formulas — Equity-like risks should be funded through a 100% allocation of equity. Few banks would take on that level of speculation at that level of capital used.

If you need proof, look at the life insurance industry. Companies used to hold a lot more equities prior to the tightening of RBC rules. Now they hold little, except at a few mutual companies that are flush with capital.

For another off-the-wall idea: ban interstate banking, and let the states rule all depositary institutions. Results: No more too big to fail, and you get back “scaredy cat” regulators who don’t let banks deal in anything they don’t understand, which isn’t much.

That also has preserved the insurance business in this crisis, leaving aside mortgage and financial risks, where the state regulators still have no idea what they are doing — that a proper reserve level would leave most of the companies insolvent today, but had it been implemented ten years ago, would have preserved the companies, but eliminated much of their profits.

But Life and P&C insurers survive the process because of RBC, and “scaredy cat” state regulators. What a great system, which prior to the crisis, was criticized as behind the times.

PS — if we ever get a national regulator of insurance, there will be a big boom and bust, much as in banking at present. It is easier to corrupt one regulator than fifty.

5) Is the stock market overvalued?  Probably, but consider this article here.  I wrote:

truth, P/Es are best related to corporate yields, not deposit rates or government bonds. And, you have to flip them to be E/Ps. Current E/P on the S&P 500 is 5.4%. A dividend yield of 2.05% is 38% which is close to the long run average.

The longest corporate series that I have is the Moody’s Baa series — because of the growth inherent in stocks, for bonds to be the better deal versus stocks, Baa bonds need a 3.9% premium over the earnings yield, or a yield of 9.3% in the present environment.

So, I’ll take it back, because the present Baa yield 6.45% augurs in favor of stocks versus bonds. Not crazy about bonds in this environment — few categories offer good risk-adjusted yields. Now, maybe both are overvalued vs. commodities, but that one I don’t know.

6) Perhaps the phrase “Greek Banking System” will be a cuss word someday.  Fitch recently gave them a downgrade, and I wrote:

Rating agencies exist to be scapegoats. When they are proactive (yes there have been eras where they have been proactive) the bond buyers scream — “Ratings are supposed to be good over a full market cycle!” When they are reactive, which is most of the time, they get accused of being coincident indicators.

They can’t win, which is why institutional investors ignore the ratings, aside from the capital charges that they force, and instead, read what the rating agency analysts write. The true opinion is in the writing, not the rating.

7)  Barry comments on how Goldman Sachs bags clients.  Truth, almost all investment banks bag clients, selling complex products that they understand better than their clients do.  My comment:

I always advise retail investors not to buy structured notes — Wall Street offers an above-average yield, and has the buyer sell short some expensive option. You lose more in capital losses than you gain in interest on average.

This isn’t any different. It just that bigger players that should have known better are getting hosed.

There is no better defense than “buyer beware,” and “Don’t buy what someone else wants to sell you. Buy what you want to buy.”

Unless we want radical revisions to contract law, you are your own best defender.

8 ) One story with more sizzle than substance is put-backs, at least as far as it affects homeowners.  It was featured by Barron’s and picked up in a piece by Barry.  Investors that purchase a mortgage or any o=ther sort of loan have a limited window of time to give the mortgage back to those that they bought it from for full value.  My comment:

This seems to be useful for investors, but not for homeowners. Reps and Warranties claims can be enforced by investors that bought loans through securitizations. It does not help homeowners.

9) Jeff Matthews wrote a piece that was a little critical of splitting the “B” shares and Buffett’s logic on the Burlington Northern acquisition.  My comment:

I don’t always agree with Warren Buffett, but I do agree here. Index investors are passive investors. Individually, they are dumb. As a group they are smart, because they lower their investment costs.

Warren is also correct on Burlington Northern — it should be like his utilities, and throw off a growing inflation-protected return over time, allowing him to earn a spread over his cost of funds (negative) that his insurance enterprises generate.

He is still a bright man after all these years.

PS — I am a Calvinist Christian; the question asked regarding Jesus is not relevant to the short-term running of Berky, but is relevant to an Christian investor who cares about the ethics of the organization. Also, it is relevant to the long-term well-being of Mr. Buffett. The rest of us will have to face the results of that question one day as well.

10) The Developments blog at the WSJ hides in the shadow of better known blogs, but often puts up some really good pieces.  They recently did a piece on whether it is better to buy a home now or wait a while.  My comment:

Anytime you have an artificial deadline for losing a benefit, as the deadline draws near, behavior can become more uneconomic — “gotta buy before the credit expires.” Since one can’t see what the price of the house would be in absence of the credit, the higher price doesn’t get factored in. People think, “If I want it, can I afford the monthly payment and make the down payment?”

I suspect that if/when the credit expires, prices will sag on the low end by more than the amount of the credit. We’ll have to look at Zillow to get some hint on that if/when it happens.

11) An interesting piece from the WSJ regarding the fight between wind power providers and natural gas power providers in Texas.  Wind is inherently variable, and so can’t offer guarantees, which other power providers have to. My comment:

The logical way to end this is to align interests — have the wind power producers own some natural gas peakers to offset their variability, and then compete by offering a base load type of power more cheaply.

Or, let them enter joint ventures together, and split the profits. If natural gas and wind can work together they can offer cheap clean power.

12) Another post in the WSJ, asking whether Economics deserves the title “Science” or not?  My answer today is different than if you had asked me 25-30 years ago, when I was a student.  My answer today would be “no.”  Mathematics has added a gloss of seeming science to economics, but the models do not work.  Macroeconomic models don’t forecast well.  Microeconomic models do not explain human behavior well, let alone forecast.  And, models of development economics common when I was a student actually retarded development of countries.  And don’t get me going on Modern Portfolio Theory.  Anyway, my comment:

More to the point, until the economics profession abandons their macroeconomic models, and moves to something closer to ecological models, they won’t have a shot at understanding how things work. Economics has physics envy when it should have ecology envy.

And then, they will realize that you can’t come up with good mathematical models there either, at least not those that allow for prediction and control. Then we can bring economics back to what it should be, a non-mathematical discipline that attempts to explain how men act to gain/create resources to pursue goals.

13) Felix had a good piece on Buffett’s recent shareholder letter.  My comments, edited, because they did not post right:

Felix, for what it is worth, if Berky wanted to issue debt today, they would have to issue at around 0.75% +/- 0.15% over agency yields. More around 5 years, less around 30.

While I’m here, here are 2 curiosities — Bloomberg’s DLIS function doesn’t work with Berky, which gives a list of maturities, probably because of all the nonguaranteed debt, and EETCs [enhanced equipment trust certificates] from BNSF.

But, using a download feature on Bloomberg off of [BRK Corp] a list is easily available. Sorting it by size of issue outstanding, what is fascinating is that most of the holding company debt has a short tenor. My estimate is an average maturity of 4.4 years and an effective duration of 2.8 years. 90% of it comes due by 2015.

Now, Berky doesn’t have that much debt at the holding company level, but it is remarkable that they are financing so much short. It is a negative arb, because he has a little more cash on hand than holding company debt.

It is a fascinating side of Berky.  Buffett could pay off all of his holding company debt with cash on hand but does not.  He pays a small price to stay flexible, in case he wants to make a big investment.
14) Finally, I’m going to be on the Ron Smith show today, talking about my recent piece on the finances of our Federal Government.  If you are not in the Baltimore area, you can listen here.  I will be on at 5PM Eastern.

If you are in the leadership of a municipality, or even a state, I have some advice for you, and it is worth many times more than you will pay to get this advice.  This is no time for half measures.  If you are just shaving here and there, and looking for the magic bullet that offends no one, let me say, “Sorry, that won’t work.  Better you should try ‘Steady as she goes for another year, borrow more, and see if the economy turns around for you.'”

But better still is to take charge, and deliver a Big Bang of pain everywhere.  If the pain hits everyone, and you put it in the language of shared sacrifice, where no one is really happy with the results, most of the electorate will respect it, and accept the reductions in services.  But make it deep, and challenge the municipal unions, whose pension plans have in the past gained exorbitant pension promises.  Don’t let anyone escape the cuts.  If everyone in the government is not hollering at you, you did not do it right.

Case in point: New Jersey.  Governor Chris Christie made draconian cuts to bring the budget into balance, and has gained respect for it.  Out of 378 possible reductions in the budget, he implemented 375 of them.  Everything got touched, and there was/is a lot of screaming.  Truth is, the government can work with fewer people, and with them paid less.  Services can be curtailed considerably.  Tell the schools they are getting less from the state/county/city.  Let them figure out what is least valuable in the system, and eliminate it.

But don’t count on help from governments above you.  They are strapped as well.  They will deliver “tough love” to those under them, much as Germany is doing to Greece.  What, you are surprised?  They are governments as well as you, and know that if they got aid, they would merely postpone action.  So they know it would do the same for you.  If you get extra aid, be grateful, but I would not count on it.

Then, there is the other side of this, for those that can legally do it: Chapter 9 bankruptcy.  More cities are considering it.  And, muni bond holders are beginning to fear it.  Those that lead municipalities are best off with a bold course.  If you are going for Chapter 9, then plan hard for how you will get compromises out of it and do it.  Otherwise, go for the draconian cuts.  These are not ordinary times where half measures will do.  The electorate will listen to the story that spending was way too high in the past, and we need to cut back for the survival of our municipalities.

Now, the same applies to the Federal Government, but the logic is trickier, because they will have to cut defense and entitlements, along with everything else.  But who aside from Paul Ryan (from my home state Wisconsin) would suggest such an idea?

We need to recognize that survival of our governments is more important than all of the programs within the governments.  Let the pain come as a “Big Bang,” and reduce funding everywhere.  The municipalities that do this will find that their funding costs will be far less than those who don’t.

Roughly three months later than originally scheduled, the fiscal year 2009 Financial Report of the United States Government came out.  I had predicted a few times (latest here) that the final total of debts and unfunded liabilities would be about 4x GDP.  Well, I was close:

OASDI (Social Security)


Medicare Part A


Medicare Part B


Medicare Part D


Unfunded Liabilities


Net Explicit Debt


Total Debt and Unfunded Liabilities


GDP 9/2009




As I commented in my piece The Biggest, Baddest Bubble of Them All:

This doesn’t take into account the value of land and certain less tangible assets that the U.S. Government has. It also does not take into account the considerable operating and capital lease liabilities, deferred maintenance, or liabilities for the GSEs, and other lending guarantee programs of the federal government.

That comment was originally written in October 2003.  As I commented at RealMoney a number of times, I felt that it was possible that the GSEs would fail — they held so little in reserve against mortgage losses.  Back then, the figure wasn’t $57 billion, it was $25 billion for fiscal year 2002, which would be 2.4x GDP.

The US Government has made a lot of promises to pay.  I have no idea how big the annual obligations for capital and operating leases are, but it would be cheaper for the Government  to borrow and buy their buildings, rather than hiding the debts through Credit Tenant Leases.  I also can’t quantify the full range of guarantees they have made, including implicit ones to bail out GSEs, big financials, allies, etc.

A reader wrote me asking: Would you please write a post on what will happen if the US goes bankrupt? This government spending continues to get worse and I am wondering what if anything I, a retired person, can do to get in front of this.

Okay, here goes.  Remember that the US Government has choices.  It can raise taxes, inflate, or default.  I don’t think default, even if it is only an external default, is the most likely option.  Also, the promises for Social Security and Medicare are not guaranteed — they can be reduced or canceled by Congress and the President.  Changing Social Security and Medicare would be political suicide, but suicide is an option.

An aside, why have I not mentioned cutting discretionary spending (or defense or entitlements)?  Because they aren’t that large a portion of the budget.  Defense and entitlements are large, but who could get a consensus on cutting those?  Our culture has a “more is better” mentality, even though spending money on “defense” has probably not made us more secure.

In order of highest likelihood, here is how I see the options:

    1. Borrow more
    2. Raise taxes
    3. Inflation
    4. Cut discretionary spending
    5. Cut defense spending
    6. External default
    7. Total default
    8. Cut entitlement spending
    9. Internal default

      Much as I would like to see the US Government reduced in size to only core functions, my views are not the consensus.  They will try to raise taxes, and failing that, inflate the currency.

      To the one who asked the question, I am not a tax expert, so consult one to limit your taxes.  On inflation, you probably know the drill: Money market funds, TIPS, commodities, and equities with hard assets or pricing power.

      The US government talks about cutting discretionary spending, but rarely does so.  Defense is worse; it always expands.  For the US to cut defense spending would be a mindshift requiring closing overseas bases, and a quiet surrender of the idea that the world is ours to guard/rule.  We think we are neutral, when we are genuinely self-interested.

      External default would not be enough to solve the problems the US faces, and, it would enrage the rest of the world.  We would find our assets abroad seized by foreign governments.  Say goodbye to goodwill and globalization.

      I don’t know what to say about total default, aside from depression everywhere, with many financial institutions failing in the US and abroad.  If the global reserve currency fails, well, those that rely on it will fail.

      I don’t view cutting entitlement spending or an internal default only as likely.  They are political suicide for whoever does it.

      My sense is when the ability to raise taxes fails, inflation will be the solution.  If/when the political outcry becomes too great against inflation, then the lesser remedies will be considered.

      The pain has to go somewhere — we’ve been really good at ignoring the problem, delaying the payment, etc., but it has only had the effect of building up the eventual pain that will have to be taken.  Our leaders are seemingly opting for a Japan-style solution — stagnation for two-plus decades with debt shifted from private to public entities.  We have better much better demographics, but Japan has had better saving in the past — more of their explicit debts are internally funded compared to the US.

      The trouble with offering advice in a situation like this is that the right answer depends on what our officials do.  The best or worst investment could be long Treasury zero coupon bonds.  Or it could be gold.  Remember, many thought the Great Depression would end with inflation, but it didn’t, at least not to the degree that many feared.  Me?  I am invested in a mix of well financed businesses that generate a lot of cash and would be difficult to do without, and some money market funds, where I suffer the punishment of a saver, while retaining flexibility.

      There are no easy answers here.

      If you have to invest a lot of money, you have to think differently than the average investor.  The average investor thinks he can easily get in and out of positions.  Really large investors, if they are doing more than indexing, act like private equity investors, realizing that they are buying large chunks of nontradable businesses.  So, when I wrote the piece, The Forever Fund, I wrote it in view of the fact that Buffett’s job is a hard one — most of us have enough trouble generating returns off our small portfolios, but Buffett has to do it in size.

      My summary of what he is trying to do can be summarized in one sentence: “A business with a big moat, financed by cheap insurance float, will lead to book value growth.”  Moat — the business possesses sustainable competitive advantages that are significant.  It would be very difficult to reverse-engineer the competitive position of such a business.  Float — ordinarily, property-casualty insurers lose money on operations, but make it up on investing the funds that exist because of the delay in time between premium payments and claims.  Buffett calls that cost “float,” and indeed over the last seven years, Berky has made money on the insurance operations, far from it being a cost.  All the better as he invests the funds generated from insurance operations in businesses that will generate a growing stream of earnings in businesses that have sustainable competitive advantages, such as Burlington Northern and his utility investments.

      We hear too much about Buffett the investor, and too little about Buffett the businessman and insurance CEO.  In the old days he was the former — today he is the latter.  He is trying to create a stable of superior operating businesses that can benefit from the cheap financing that the insurance companies generate.

      That is a tough job — he is thinking about how he can preserve value forever.  I am reminded of King Solomon who wrote Ecclesiastes, because my family is reading it in family worship presently.  He agonized about how he could preserve what he had built in his life after his death and concluded in sorrow that there was no way to do that.  Again from Ecclesiastes 9:11 [NKJV]– I returned and saw under the sun that—

      The race is not to the swift,
      Nor the battle to the strong,
      Nor bread to the wise,
      Nor riches to men of understanding,
      Nor favor to men of skill;
      But time and chance happen to them all.

      Buffett is one among several billion, trying to fight the vicissitudes of this life after he dies.  Like Solomon, he wants what he has built to live a long and prosperous life.  Alas, we can assure nothing even while we live, how much less after we die?  Buffett is likely doing better than most who confront the problem, but the problem remains.

      Thus, my view of Berkshire Hathaway is that it is more critical as to who is the CEO/COO rather than who is the Chief Investment Officer.  The greater need is to manage the businesses, rather than manage slack cash for high returns.


      Among all the commentary regarding Berky’s annual report, there has been a dearth of comment about them entering life reinsurance.  Personally, I think their best move would be buying RGA at book value.  (Yes, I own some RGA.)  Why shouldn’t the best life reinsurer be a part of Berky?  There is a talented management team, and the best firm dealing with facultative life reinsurance.  Berky is already reinsuring some major life insurance risks, but who are they reinsuring?

      One thing I appreciate about Berky is that they don’t purchase reinsurance.  They size their appetite for a risk relative to their own balance sheet.


      On page 7 of the Berky Shareholders Letter, there is a joke about buying higher.  It is really tough to buy more of some stock that you have bought at a lower level.


      In the long run the risk for Berky is that it gets a manger that does not get  my summary, “A business with a big moat, financed by cheap insurance float, will lead to book value growth.” But in detail, there is the possibility of a loss of focus.  Can Berky motivate managers to perform?

      That is the tough question.  While Buffett lives, there is the “You don’t want to disappoint him” effect, but that will disappear after his death.


      It is impossible to assure  value permanently, but men will try to do it anyway, and fail mostly….

      Full disclosure: long RGA