Photo Credit: Fabio Tinelli Roncalli || Alas, there were so many signs that the avalanche was coming…


Ten years ago, things were mostly quiet.  The crisis was staring us in the face, with a little more than a year before the effects of growing leverage and sloppy credit underwriting would hit in full.  But when there is a boom, almost no one wants to spoil the party.  Yes a few bears and financial writers may do so, but they get ignored by the broader media, the politicians, the regulators, the bulls, etc.

It’s not as if there weren’t some hints before this.  There were losses from subprime mortgages at HSBC.  New Century was bankrupt.  Two hedge funds at Bear Stearns, filled with some of the worst exposures to CDOs and subprime lending were wiped out.

And, for those watching the subprime lending markets the losses had been rising since late 2006.  I was following it for a firm that was considering doing the “big short” but could not figure out an effective way to do it in a way consistent with the culture and personnel of the firm.  We had discussions with a number of investment banks, and it seemed obvious that those on the short side of the trade would eventually win.  I even wrote an article on it at RealMoney in November 2006, but it is lost in the bowels of’s file system.

Some of the building blocks of the crisis were evident then:

  • European banks in search of any AAA-rated structured product bonds that had spreads over LIBOR.  They were even engaged in a variety of leverage schemes including leveraged AAA CMBS, and CPDOs.  When you don’t have to put up any capital against AAA assets, it is astounding the lengths that market players will go through to create and swallow such assets.  The European bank yield hogs were a main facilitator of the crisis that was to come, followed by the investment banks, and bullish mortgage hedge funds.  As Gary Gorton would later point out, real disasters happen when safe assets fail.
  • Speculation was rampant almost everywhere. (not just subprime)
  • Regulators were unwilling to clamp down on bad underwriting, and they had the power to do so, but were unwilling, as banks could choose their regulators, and the Fed didn’t care, and may have actively inhibited scrutiny.
  • Not only were subprime loans low in credit quality, but they had a second embedded risk in them, as they had a reset date where the interest rate would rise dramatically, that made the loans far shorter than the houses that they financed, meaning that the loans would disproportionately default near their reset dates.
  • The illiquidity of the securitized Subprime Residential Mortgage ABS highlighted the slowness of pricing signals, as matrix pricing was slow to pick up the decay in value, given the sparseness of trades.
  • By August 2007, it was obvious that residential real estate prices were falling across the US.  (I flagged the peak at RealMoney in October 2005, but this also is lost…)
  • Amid all of this, the “big short” was not a sure thing as those that entered into it had to feed the trade before it succeeded.  For many, if the crisis had delayed one more year, many taking on the “big short” would have lost.
  • A variety of levered market-neutral equity hedge funds were running into trouble in August 2007 as they all pursued similar Value plus Momentum strategies, and as some fund liquidated, a self reinforcing panic ensued.
  • Fannie and Freddie were too levered, and could not survive a continued fall in housing prices.  Same for AIG, and most investment banks.
  • Jumbo lending, Alt-A lending and traditional mortgage lending had the same problems as subprime, just in a smaller way — but there was so much more of them.
  • Oh, and don’t forget hidden leverage at the banks through ABCP conduits that were off balance sheet.
  • Dare we mention the Fed inverting the yield curve?

So by the time that BNP Paribas announced that three of their funds that bought Subprime Residential Mortgage ABS had pricing issues, and briefly closed off redemptions, and Countrywide announced that it had to “shore up its funding,” there were many things in play that would eventually lead to the crisis that happened.

Some of us saw it in part, and hoped that things would be better.  Fewer of us saw a lot of it, and took modest actions for protection.  I was in that bucket; I never thought it would be as large as it turned out.  Almost no one saw the whole thing coming, and those that did could not dream of the response of the central banks that would take much of the losses out of the pockets of savers, leaving bad lending institutions intact.

All in all, the crisis had a lot of red lights flashing in advance of its occurrence.  Though many things have been repaired, there are a lot of people whose lives were practically ruined by their own greed, and the greed of others.  It’s a sad story, but one that will hopefully make us more careful in the future when private leverage rises, creating an asset bubble.

But if I know mankind, the lesson will not be learned.

PS — this is what I wrote one decade ago.  You can see what I knew at the time — a lot of the above, but could not see how bad it would be.

In my view, these were my best posts written between February 2015 and April 2015:

One Dozen Reasons Why the Average Person Underperforms In Investing, Part 1

One Dozen Reasons Why the Average Person Underperforms In Investing, Part 2

Most of this boils down to chasing past performance, neglecting fundamentals, and neglecting basic risk control.

Learning from the Past, Part 4

Learning from the Past, Part 5a [Institutional Bond Version]

In this series, I disclose my WORST investing mistakes ever.  Personal errors: cellular auctions, mistiming small cap value, and small deal arbitrage.  Professional error: Manufactured Housing Asset Backed Securities — Mezzanine and Subordinated Certificates.

Smell the burning money!

The “Secret” of Berkshire Hathaway

You can’t imitate what they do, because you would have to tear up everything you are doing now.

One Potential Weakness of Berkshire Hathaway

Reserving is weakening, new places to find float are few, and if policy on asbsetos settlements changed, BRK could be in a world of hurt.

From Stream to Shining Stream

How a stream of excess income during working years becomes a stream of income in retirement years.  It’s harder to do than you might expect.  Includes a list of strategies and pitfalls.

2000 More Points To Go; Look Elsewhere!

Even today, the NASDAQ Composite still hasn’t hit an inflation adjusted high.

On Bitcoin

I feel stronger about this than when I originally wrote this.  Bitcoin and the other cryptocurrencies are just a speculative crapshoot, and the attempt to have a currency without the legal structure of a government will fail, unless it is a commodity like gold.  Also, the blockchain is an overrated resource hog that lacks the flexibility possessed by life insurance company policy management systems.

On Negative Interest Rates

Explains why they exist, and what dangers could come from them.

An Idea Whose Time Should Not Come

Financial complexity should usually be avoided, particularly with financial guaranty schemes.

We Don’t Need To Be Able To Short Private Companies

Like the prior article, there are people with too much time on their hands thinking up nutty and useless ideas.  There is enough risk in the world already; we don’t have to add to it.

The Bond Market Tells The Fed What To Do, Not Vice-Versa

Sometimes we forget that the collective lending and borrowing decisions of the US bond market are more powerful than the Fed.

Index Investing is not Inherently Socialistic

I think active managers have to grow up and accept that passive investing isn’t evil; it just cuts against the economic interests of active managers like me, at least for now.  When it gets really big, the paradigm will shift…

On Being A Forced Seller in a Panic

Very few people want to panic, and fewer want to sell at the bottom — but many do just that.  How can you avoid it?

Why Life Insurers, Defined Benefit Plans, and Endowments Invest Differently

How investing differs for investors that have different types of long-duration liabilities to fund.

Fade High Price-Sensitivity Assets in Crude Oil

A short and lonely post where I told you in advance that crude oil would hang around $50/barrel “for a few years.”  And, my reasoning was on target as well.

Simple Stuff: On Bid-Ask Spreads

Do you have basic concepts that you want to have explained?  Shoot me an email, and if I think enough people would be interested, I will do it.

Photo Credit: Carl Wycoff || It is a long way to the end of retirement.  People are getting ready for it.  Are you?


Assuming that you could throw stones on the financial internet, it would be hard to toss a stone and miss articles talking about how high the stock market is.  One good article from last week was Why Do U.S. Stocks Keep Hitting Records? Here Are Five Theories from the Wall Street Journal.  Here were the five theories:

  1. Stocks Reflect the Resurgent Health of American Corporations
  2. The Global Outlook Is Looking Brighter
  3. The U.S. Economy Is in a ‘Goldilocks’ Situation
  4. Passive Funds Are Propping Up Prices
  5. There Is No Alternative

Of this list, I think answers 1, 3 and 5 are correct, and 2 and 4 are wrong.  I have a few other answers that I think are right:

  1. Demographics are leading people to buy assets that will provide long-term cash flows. Monetary policy has led to asset price inflation, not goods price inflation.
  2. People are overestimating the resiliency of the political and social constructs that make all of this possible.
  3. The “Dumb Money” hasn’t arrived yet, but the sale of volatility by retail contradict that.

I disagree with point 2 from the WSJ article because a stronger global economy not only means that profits will rise, but also the cost of capital.  Depending on which factor is stronger, a stronger global economy can make stocks go up, down, or be neutral.

On point 4, I’ve written about that in Overvaluation is NOT Due to Passive Investing.  What matters more than the active/passive mix is the total shift in portfolio holdings into stocks versus everything else.  When people hold a lot of their portfolio in stocks, stock prices tend to be high.

The active/passive mix does have effect on the relative prices of securities in the indexes versus outside the indexes. The clearest place to see the impacts of ETFs and indexing is in bonds, where bonds that are in the indexes trade at lower yields and higher prices than similar non-index bonds.

With stocks, it is probably the same, but harder to prove; I wrote about this here.  In the short run, the companies in the popular indexes are getting a tailwind. That will turn into a headwind at some point, because the voting machine always eventually becomes a weighing machine.

Why are stocks high?

Profit margins are high because of productivity increases from the application of information technology.  Also, there is a lot of lower paid labor to employ globally which further depresses wage rates in developed countries.

Points 3 and 5 of the WSJ article are almost saying the same thing.  Interest rates are low.  They are low because inflation is low,, and general economic activity is not that robust.  As such, the cost of capital is low, people are willing to pay high prices for stocks and bonds relative to their cash flows.

Part of this stems from demographics, which was my first additional point.  For those that are retired or want to retire, there aren’t a lot of ways to transfer money earned in the present so that you can get the equivalent purchasing power or better far into the future.  There are a few commodities that you can store, like gold, but most can’t be stored.  Thus you can buy bonds if you don’t think inflation will be bad, or inflation-protected bonds if you can live with low real returns.  Money market funds will keep your principal stable, but also provide little return.  You can buy stocks if you are willing to get some inflation protection, and run the risk of a rising cost of capital at some point in the future.  Same for real estate, but substitute in rising mortgage rates.

A shift can happen when the marginal dollar produced by monetary policy shifts from being saved to being spent.  For now, monetary policy inflates asset prices, not goods prices (much).

My second point says that people are willing to spend more on stocks when they think that the system will remain stable for a long time.  That seems to be true today, but as I have pointed out before, it discounts the probability of trade wars, real wars, resurgent socialism, and bad future demographics.  Nations with shrinking populations tend to have poor asset returns.  Also, nations with unproductive cultures don’t tend to make economic progress.

My third point is equivocal.  I don’t see a lot of people yelling “buy stock!”  There’s a lot of disbelief in the market; this is what Jason Zweig was talking about in his most recent WSJ column.  That said, when I see lots of activity from people shorting volatility through exchange traded products in order to earn returns, it makes me wonder.  As I have said before, “Nothing brings out the financial worst in people like the lure of seemingly free money.”  Eventually those trades sting those that stay at the party too long.

So, where does that leave me?  The market is high, as my models indicate.  It may remain high for a while, and may get higher still.  That said, it would be historically unprecedented to remain in the top decile of valuations for more than three years.  It would be healthy to have the following:

  • A garden-variety recession
  • A garden-variety bear market
  • More varied sector/industry performance

Will we get any of those?  I don’t know.  I can tell you this, though.  For now, my asset allocation risk is on the low side for me, with stocks at around 70% (that is high for most people, but that is how I have lived my life).  If we get over the 95th percentile of valuations, I will hedge what I can.  For now, I reluctantly soldier on.