Agora Financial’s Rude Awakening

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Laguna Beach, California

· Investigating the government-sponsored destruction of capitalism,
· From apocryphal $600 toilet seats to all-too-real squandering of public funds,
· What’s up with Warren? Berkshire shares trend in an unfamiliar direction and plenty more…

Eric Fry, reporting from Laguna Beach, California…

The S&P 500 Index tumbled 6.7% yesterday. Warren Buffett’s Berkshire Hathaway plummeted 7.7%. For this miserable year-to-date, the S&P and Berkshire have both lost about half their value. In this market, no one gets a “hall pass.” Not even the Oracle of Omaha.

At the end of yesterday’s blood-letting, the S&P 500 found itself at its lowest level since 1997. Berkshire hit its lowest level since 2003. What makes this comparison so interesting is that there was no comparison whatsoever between the two until very recently. At the end of September, Berkshire was down only 7% on the year, despite a 20% drop in the S&P.

But this stock market icon has been making up for lost time. Why? Because Warren Buffett engaged in some very un-Buffett-like activities. Several months ago, he sold an enormous quantity of naked put options against a smattering of equity indices, including emerging market indices. In other words, when global stock markets fall, Berkshire loses money. When they fall a lot, Berkshire loses lots of money, at least on a mark-to-market basis.

The options Berkshire sold don’t actually expire for more than 14 years. But that’s an irrelevant detail. These securities have a value that reflects the trend of global markets, and that value increases when global markets fall. Since Berkshire is short these securities, up in price means up in losses.

Berkshire has already booked a loss of $6.7 billion on this trade, and the markets have been tumbling anew since then. So the losses are clearly much larger now…which is probably most of the reason why Berkshire shares have come under such severe pressure of late. Meanwhile, bond investors have also become a bit skittish about Berkshire. The cost of insuring $10 million of Berkshire bonds against a default for the next five years has soared to about half a million dollars. That’s about the price an investor would typically pay to insure a near-junk credit!

Selling naked puts doesn’t seem very Buffett-like. For one thing, it has nothing to do with company analysis and everything to with market-timing. For another thing, the tactic employs leverage that increases as the bad bet gets “badder.”

The Buffett faithful are aghast. Why would their hero do such a thing? Your editors have no idea, but they have a couple of guesses. For starters, even geniuses believe their own press sometimes. Buffett is a billionaire. If that is an accident, it is an accident that occurred against astronomical odds. But just because he has been right most of the time does not mean that he is right all of the time. Nor does it mean that he is immune to occasional lapses of judgment.

This high-risk trade of his might still work out. But if it does, it would have worked out despite the fact that it contradicted some of Buffett’s investment tenets. For one thing, Buffett has referred to derivative contracts like the ones he is currently short as “financial weapons of mass destruction.” And so they are proving to be. In a related observation, Buffett recently remarked, “leverage [is] the only way a smart guy can go broke.”

Warren Buffett still has some pennies in his pocket, but fewer than he had just one month ago. Thanks to Berkshire’s sliding share price, Buffett’s net worth has decreased by a whopping $22 billion since the end of September.

Don’t weep for Warren just yet, however, he’s still got about $32 billion left. But his apparent misstep reminds us of a famous saying by John Maynard Keynes: “The markets can remain irrational longer than you can remain solvent.”

Buffett sowed the seeds of his fortune in the lows of the 1974 bear market. But if he had been old enough to attempt similar “opportunistic purchases” in the early days of the 1930 bear market, he would have lost everything and we would never have known his name.

Buffet is right to believe that stocks are cheap. But he is wrong to underestimate the possibility that they might get cheaper still. He is wrong to dismiss the possibility that significant portions of American capitalism may be broken and cannot be easily repaired.

Perhaps that’s why the stock market is falling…because American capitalism is broken. Because portions of it are rotten to the core. And instead of tearing out the rot and laying in a fresh lumber, we have decided to patch the cracks with spackle, slap on some fresh paint and hope that it holds up for a while longer.

There is simply no substitute for failure. Bankruptcies, like wildfires, clear the way for new growth. Without them – both bankruptcies and wildfires – the old, diseased growth crowds out the new growth and impedes revitalization.

The bailouts that are flooding out of the Treasury are merely nourishing the old growth…and that’s not going to produce prosperity for anyone.

Maybe THAT is why the stock market is falling.

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Bailout Fatigue Syndrome, Part II
Eric J. Fry

American capitalism is broken, at least a little broken.

Remember the Pentagon’s $600 toilet seat? Remember that appalling example of “government waste?”

Ignoring for the moment that the Pentagon did not, in fact, pay $600 for a $12 toilet seat, this apocryphal story from the early 1980s became a popular icon of governmental ineptitude and largesse. If our elected representatives would squander $600 on a toilet seat, the voting public reasoned at the time, how else would these good-for-nothing numbskulls squander taxpayer money?

Here’s how:
• $219,000 to fund a “curriculum package” to teach college students how to watch television.
• $1.2 million to study the breeding habits of the woodchuck.
• $150,000 to study the Hatfield-McCoy feud.
• $1,500,000 to buy a statue of the Roman god, Vulcan, in Birmingham, Alabama.
• $50,000 to fund a tattoo removal program in San Luis Obispo County, California.
• $26,000 to study how thoroughly Americans rinse their dishes.
• $90,000 to support the Cowgirl Hall of Fame in Fort Worth, Texas.
• $150,000 to promote “Therapeutic Horseback Riding” in Apple Valley, California.

How appalled we Americans were to lean that our Federal government had squandered so much money in so many absurd ways! We were utterly indignant.

But that was then and this, unfortunately, is now.

With the passage of time, these quaint examples of governmental waste recall a simpler era – an era when the US government sometimes balanced its budget, when Americans sometimes spent less money than they earned, when dysfunctional finance companies sometimes went bankrupt and when criminally negligent CEOs sometimes received pink slips rather than multi-million-dollar paydays.

In the modern era, the Pentagon might actually spend $600 for toilet seat, but no one would care. Indeed, most of us taxpayers would happily support buying $600 toilet seats for every commode in Washington, DC, if, in exchange, the Treasury Department would discontinue handing billions of dollars to companies that should be swirling down the drain of a commode.

The U.S. government no longer spends $600 on toilet seats; it showers billions of dollars on finance companies, which then spend hundreds of thousands of dollars on spa treatments for top executives.

But wait, that’s not all!

The same finance company executives who conducted the “Hiroshima-zation” of the American financial system by reducing it to a smoldering pile of toxic rubble are now lining up to receive billions of dollars of taypayer-funded bonuses.

This is epic audacity, even for Wall Street.

The Wall Street elite has spent so many years feeding at the trough of its clients and shareholders that it can’t seem to break itself of the habit. Of course, why would it want to break this delightful habit?

The folks on Wall Street who believe themselves entitled to a bonus fail to appreciate at least one important fact: they have already received a bonus – they still have their jobs. Thanks to taxpayer dollars, they still have their jobs. That’s an extraordinary bonus. How about a little gratitude…and maybe even a morsel of humility?…

And we won’t even begin to ask these folks to consider acts of charity…or to make reparations…but we shouldn’t rule it out.

“The executives in companies that get bailout money should have their base salaries reduced by 10 percent for 2009,” one disgruntled investor tells Bloomberg News, “and they should pay back a substantial portion of their 2007 bonuses to the government for the financial devastation they oversaw, fostered and, in some cases, directly caused. Their sense of entitlement is appalling.”

Paying back a portion of their bonuses?…Hmmm…Now that’s an interesting idea. What would that look like exactly?

For illustration purposes, let’s draw a random name out of a hat. Ah, here’s one: Chuck Prince. Let’s see, Chuck Prince, was CEO of Citigroup from 2003 until late last year. During that time, he presided over the construction of the house of cards that was Citi’s pre-bust balance sheet. As the first cards began ripping away from the fringes of Citi’s precarious financial structure, Prince took “full responsibility” for the initial capital losses, then took a $38 million severance check to the bank and cashed it.

Citi’s losses continue to escalate into the tens of billions of dollars. Chuck’s millions continue to earn interest. Something doesn’t feel right here. To be sure, Mr. Prince has not legal obligation to return the funds to Citi shareholders and/or employees…just a gigantic moral one. In other words, there’s no particular reason why Prince should hand the money back…except that didn’t deserve the money in the first place.

If so inclined, Prince could return the funds to the employees who are now losing their jobs. A quick, back-of-the-envelope calculation reveals that Prince could return his $38 million by handing a check for $730 to each of the 52,000 soon-to-be-fired Citi employees. Merry Christmas from Ol’ Saint Chuck!

Or he could just keep the money, like every other criminally negligent former CEO has done. To err is human, to keep money you obviously do not deserve is utterly inhuman. But who knows, maybe I’d keep the $38 million also. $38 million doesn’t goes as far as it used to, but it still buys a lot of golf balls.

One of my closest friends earns about $42,000 per year as a research scientist – working to find cures for diabetes. Her societal contribution is not absolutely essential, but it is valuable. In fact, I would submit that her contribution is of greater value than the collective societal contribution of the 50 highest paid individuals in every Wall Street firm…COMBINED.

In other words, if Wall Street’s top guns all joined the bread lines tomorrow – or at least the caviar-topped blini lines – the world would be no worse off. Of course, the same exact thing could be said of many professions, including my own.

But the difference between most of us gainfully employed individuals and most Wall Street top guns is that we did not create the debacle that destroyed the financial wellbeing of millions of individuals, and neither are we whining that our economy-destroying antics deserve multi-million-dollar bonuses.

“Please explain how miserable performance of biblical proportions warrants any bonuses, particularly using money from me the customer and taxpayer,” said Glenn Brown, 67, who recently retired after 21 years as a researcher in the department of surgery at Beth Israel Deaconess in Boston and as an adjunct assistant professor at Harvard Medical School. “I don’t understand how they can even conceive of doing that.”

Your editors at the Rude Awakening don’t understand either. But we don’t make the rules, we just ignore them.

American capitalism is broken, at least a little broken. So take your time wading back into the slop. In other words, preserve your capital first, risk your capital second.

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[Rude Endnote: Lastly, don’t forget to grab your free I.O.U.S.A. DVD/Personal Bailout Report before the complimentary pre-release stock runs out. If the publicly-funded bailout of moribund, criminally negligent companies and their CEOs has you livid, this package is a must. Check it out here.

Until next time…

Cheers,

Joel Bowman

The Rude Awakening
aussiejoel@the-rude-awakening.com