Dear Mr. Buffett

Another very timely and thought provoking book from a very credible author; and a friend of Warren Buffett who endorses this authors ideas.


Janet M. Tavakoli, “Dear Mr. Buffett”, John Wiley & Sons, 2009, Pages 224

Janet Tavakoli is the President of Tavakoli Structured Finance, a Chicago-based consulting firm to financial institutions, institutional investors, and hedge funds. Warren Buffett read a book she wrote (“Credit Derivatives & Synthetic Structures”) and subsequently invited her to Omaha in 2005 to discuss the book. This started a friendship and collaboration. Both Janet and Warren saw the problems coming in the mortgage and credit markets, among others, but their warnings were ignored. Especially by the SEC who had regulatory authority. It appears too many regulators retire and go to work for the very firms they had been charged with regulating. I also believe political pressures caused much of the non-regulation but this is not dealt with in this book as the author has no knowledge in that area. Apparently even Warren Buffett underestimated the impact as his Berkshire fund is down 50% in the past 12 months. It will be interesting to read his annual letter to shareholders which will be online for viewing Saturday 2/28.

Notes:
Pg. 6: Leveraged bets are so popular that there is more money at risk in derivatives than in stocks or bonds. The problem with leverage-driven binge banking is that everyone tends to disgorge assets at the same time, depressing market prices. Financial leverage sometimes moves global markets, and if allowed to get out of hand, leverage can theoretically trigger a global market Chernobyl.

Pg. 36: By September 2006, more than 120 U.S. corporations were under investigation by U.S. regulators for backdating employee stock options, followed by many more. By September 2007, companies including Affiliate Computer Services, Apple Inc., Broadcom, United Health, and more had been subjects of the SEC probe, lost senior executives, and reported serious accounting issues related to backdating. In total, 85 U.S. companies made earnings restatements or took charges against earnings due to backdating.

Pg. 45: In 1990 there were a few hundred hedge funds with less than $50 billion in total assets under management. By the summer of 2008, there were around 8,000 hedge funds with $1.87 trillion in assets under management.

Pg. 110: Since many money managers cannot buy bonds that are not rated investment grade, and since some are required to sell bonds that fall below investment grade, ratings have a huge impact. This is why when Moody’s admitted that impairment rates show no difference in performance between CDO tranches with a junk rating of BB- and an investment grade rating of BBB, it should have been headline financial news. It was not. Moody’s, Standard and Poor’s, and Fitch have an NRSRO designation, meaning they are “Nationally Recognized Statistical Rating Organizations.” Yet, when they rate many securitizations, particularly mortgage-loan-backed securitizations, they fail to follow basic statistical principles.

Pg. 118: The mortgage meltdown was not a Black Swan event, instead it was an event whose risk was fully knowable and fully discoverable in the course of competent work. The mortgage meltdown had a direct cause and effect, and the result was predictable in advance. Financial professionals including Warren Buffett, Charlie Munger, John Paulson, James Rogers, William Ackman, William Gross, Whitney Tilson, Jim Melcher, David Einhorn (head of Greenlight Capital), the author, and others had been specific in sounding the alarm both verbally and in print for many years.

Pg. 168: Accountants allow corporations to put assets into three “levels.” The level indicates how easy it is for someone to check your work, with Level 1 being the easiest; it is simply mark-to-market (look up the stock price for the day on the internet and list it, it is transparent). Level 2 requires you to accept assumptions that you can supposedly recreate with enough hard work and data. Level 2 is mark to model. Prices are based on models using observable assumptions. You cannot easily find prices in the market on many CDOs. Since management can control the assumptions, even with “observable” inputs, Level 2 can be “mark to myth”. Level 3 is the same as Level 2 except unobservable inputs are used in the model. This is purely mark-to-myth. It is a black box. You have no evidence that management is leveling with you. You to trust management assumptions that you cannot see and they do not disclose.

Pg. 206: At its core, the mortgage lending crisis is no more sophisticated than a schoolyard swindle, and the SEC is the principal. Economists and pundits unhelpfully—and conveniently—focused on the Federal Reserve Bank and retired Chairman Alan Greenspan. Others blame the rating agencies. Yet neither the Federal Reserve Bank nor the rating agencies regulate the securities industry. That job belongs to the SEC. The SEC has broad authority over banks, too. The Office of the Comptroller, the OCC, examines the risk management of the capital markets areas of banks. The Federal Reserve Bank primarily looks at banks at the holding company level. The SEC has broader authority than either the OCC or the Fed for publicly traded companies. It is deceptive securitization practices at the root of the mortgage bubble, and the SEC had the authority to stop Hurricane Ponzi. Instead, it slumbered.