So this is the first of (almost certainly) many posts detailing things I stuffed up.
The list for the first choice is long. How about these?
(a) Believing that regional banks of Credit Agricole (which are very good) would offset the losses at the investment bank (which is very bad). Stock is down from 36 to 12.
(b) Believing that the mortgage insurers would blow up this cycle but the bond insurers would probably be OK. Ambac is down 90 to and is no longer writing much business. MTG (which was my favourite short) is down from 60 to 6 but is writing plenty of business. Got the wrong shorts… and didn’t short the bond insurers…
(c) Believing that the (seemingly extreme) valuation difference between News Corp and other media stocks would solve itself by New Corp’s stock price rising. It didn’t as a stock price comparison of Viacom, Time Warner and News Corp will attest. (It was a wash – all the stocks lost a little.)
(d) Buying Origin Energy at under $2 and selling it at about $4 on the basis that the utility parts of the business were fully recognised. I sold it despite loving the management. It is currently under hostile takeover at $15.60 – and the Aussie dollar in which it is priced has almost doubled. I didn’t recognise just how good the gas assets were. This was non-trivial as the fund I worked for owned almost 5% of the company – and left more half a billion dollars on the table and it was my fault.
Against this it should be pretty hard to tell what the worst intellectual error I made in the past five years is. But I have a candidate. I thought that the interest rate risk in US banks would blow up before the credit risk.
For instance in most markets the difference between central bank fund rate and the average mortgage rate is less (often much less) than 200bps. In the
For this however the system as a whole takes an awful lot of interest rate risk. If short rates were to go to say 8 percent there would be 5-7 trillion in mortgages that yield less than that. Individual institutions might say they were hedged – but the system as a whole cannot be hedged.
I spent an awful lot of time looking for banks and other institutions that were particularly levered to interest rate risk. WestAmerica Bancorp (an otherwise pristine bank) stood out. If you look at the balance sheet I linked in my previous post you will see that it contains $1.5 billion in fixed rate securities financed floating. That number is very significant compared to pre-tax income of 120 million or tangible book value of about 270 million. And WABC is by no means the largest offender.
My back of the envelope calculation was that the system had about 400 billion of pre-tax profits. That included all brokers, all banks, all insurance companies, fund managers – the works.
The US system had 7 trillion of interest rate miss-match. Almost half the profits of the entire
And I thought with Alan Greenspan setting the tone of the Fed the stuff up on inflation and hence interest rates was inevitable. Greenspan never saw a problem he could not fix by pumping more liquidity into the system. I thought Helicopter Ben was even more likely to use a little inflation to get the
So I spent a couple of years getting completely obsessed about interest rate risk. It led to some OK shorts (eg Fannie and Freddie) but meant I underestimated the credit story.
The credit risk I thought had been passed pretty heavily to the non-bank sector. It existed in the Europeans (I sort of knew about UBS). It existed in the investment banks (including Citigroup). It existed in some regional banks (I knew about Bank United). But I was stunned it wound up quite so bad at Fifth Third. Just stunned.
I thus covered a Fifth Third short many years ago. (Ooops.) I was short a bunch of interest rate risk sensitive banks (such as
A few years ago the short end of the yield curve was at about 1%. The long end in the 4s and quasi-government guaranteed mortgages were in the high 5s. Borrowing short to buy Fannie Mae backed mortgages was the seeming no-lose trade. Everyone was on it. It didn’t even carry much credit risk because everyone knew the government backed Fannie.
However it carried – and still carries – massive interest rate risk. Everyone seemed to ignore that. My usual reaction – if everyone is doing something then it will probably lose you money. I would rather be on the other side.
Still I remain convinced that this is a theme that will play out. Warren Buffett says inflation is heating up – and he doesn’t stretch the duration of his assets.
There are good people who think inflation is highly unlikely. Paul Krugman (who I admire) suggests that Bernanke should ignore the inflation naysayers. Mish writes for ever on how inflation is not likely – see here and here for examples.
I will get back to this shortcoming one day soon.