Mike Kueber's Blog

October 13, 2011

The Buffett Rule – a Republican version

Filed under: Issues,Politics — Mike Kueber @ 5:33 pm
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Senator John Thune of South Dakota has been one of my favorite politicians in Washington.  Like people from my native state of North Dakota, people from South Dakota and the Great Plains tend to be thoughtful and modest.  (Sarah Palin is a glaring exception.)  Through the years, Senator Thune seemed to be a good reflection of Great Plains values, until last night.

Last night, Thune appeared on On the Record with Greta van Susteren to announce the introduction of a bill to enact the Buffett Rule.  As you may recall, Buffett thinks there should be an alternative minimum tax rate on the mega-rich so that the investors who live off capital gains and the hedge-fund managers who live off “carried interest” pay at a rate higher than their current rate of 15%, but less than the current maximum rate of 35% on regular salaries/earned income.  (Twenty-five percent has been informally suggested).  President Obama has informally endorsed the Buffett Rule.

I blogged about the Buffett Rule a few weeks ago, and suggested that it would be a good idea, especially in the context of comprehensive tax reform.  Any attempt to adopt the Rule on its own, however, would be doomed because both sides had already shifted into their demagoguery of a good idea – the Republicans claimed that it was class warfare while the Democrats claimed that the rich were getting off easy.

Because of my pessimism, I was mildly surprised to see Thune moving forward with the Buffett Rule.  Thune has become a player in the Senate, not by showboating, but by being a good team player.  Thune didn’t get very far into his interview with Greta, however, before he disabused me of any notion that he might be above petty politics.

Thune explained to Greta that his Buffett Rule wouldn’t accomplish what Buffett wanted, but rather it would accomplish what Mitch McConnell and several other demagogues wanted – i.e., it gave Buffett and any other mega-rich, if they thought there should be a minimum tax rate on the mega-rich, a streamlined process for voluntarily donating cash to the federal government.

Such a proposal, which fits the classic definition of demagoguery, makes no sense.  Under the Thune thought-process, legislators would never be able to require anything of the public because opponents of the requirements would simply argue that those who support the requirements should voluntarily comply while leaving everyone else alone.  You think the speed limit should be 55 mph?  Go ahead and comply, but leave me alone.  You think the sales tax should be raised to 9%?  Go ahead and pay it, but leave me alone.  You think we should re-institute the draft?  Go ahead, but leave me alone.

But that’s not the way government works.  Buffett wasn’t saying that he wanted to give more of his money to the government; he was making a policy argument that there should be a minimum tax rate that prevented his office staff from having a higher effective tax rate than many of the mega-rich.  Buffett’s argument is not demagoguery – instead of appealing to one’s baser side, it appeals to one’s higher side.

A blog posting in The Hill this week describes Thune’s proposal.  The title of the posting is “Thune introduces own version of ‘Buffett rule’, mockingly solicits donations from wealthy.”

Senator Thune, you may disagree with the Buffett Rule, but you should have better things to do that mock it.

Btw – the NY Times had an article today on the Buffett Rule and another Republican congressman from the Midwest, Tim Huelskamp of Kansas, who wants some time in the spotlight.  Ever since Buffett proposed his rule, Huelskamp has been demanding that Buffett release his tax return.  Is that the sort of harassment that concerned citizens are supposed to be subjected to?

Although Buffett decline to provide his tax return to Huelskamp, he did send him a letter stating that he paid $6.9 million in federal income taxes in 2010 and this amounts to 17.4 percent of his $39.8 million in taxable income.  According to the NY Times article, “Mr. Huelskamp, in a statement Wednesday, slammed Mr. Buffett’s letter as inadequate and again called on him to either release his full returns or voluntarily give more tax money to the federal government.”

Thune and Huelskamp are Midwestern Republicans from states that border Buffett’s Nebraska.  This week, they have not done their state, their region, their political party, or America proud.

September 18, 2011

The Buffett rule

Filed under: Issues,Politics — Mike Kueber @ 9:29 pm
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According to an article in the Washington Post, President Obama is planning on Monday to propose a new minimum tax rate for millionaires – a so-called Buffett rule because Warren Buffet recently said that the American tax system should ask more from the mega-rich.   The Post reports that, based on appearances by Lindsey Graham and Paul Ryan on Sunday talk shows, Republicans are expected to be united against the proposal.  They will argue that this is more class warfare by President Obama and that Americans are Taxed Enough Already.

Although I didn’t see Graham or Ryan on the Sunday talk shows, I did see Senate Majority Leader Mitch McConnel on Face the Nation.  Ever since McConnel was a stick-in-the-mud obstructionist during the Bush administration, I have disliked this dour sourpuss, and my dislike grew today with his silly argument against the Buffett rule – i.e., if Buffett thinks the rich should pay more in taxes, there is nothing stopping them from sending personal checks to the federal government.  That is as nonsensical as a criticism I heard last week to the effect that Buffett’s company, Bershire Hathaway, shouldn’t be contesting an IRS tax ruling because Buffett thinks the rich should pay more in taxes.  What does one have to do with the other?

Remember that McConnell was the king of earmarks for years and was one of the last holdouts to capitulate to the TEA Party on this issue.  The next time he proposes spending money for some Kentucky boondoogle, we should ask him to fund it either with his millions or with the millions that his campaign has accepted from people and companies trying to bribe him.

Getting back to class warfare – last Tuesday, I blogged a suggestion to the Democrats about their continual class warfare – i.e., give it a rest.  In a response to a commentator, however, I agreed that higher rates for those who make $1 million or $10 million would be fair.  I also suggested that it was not fair that half of all Americans pay no income tax and that everyone who makes an income should pay some income tax.

Because of the partisanship in Washington, these changes can’t be implemented in a piecemeal fashion.  Fortunately, there is bipartisan agreement that comprehensive tax reform, which was last done in during the Reagan administration, is overdue and there appears to be reason for optimism that it can be accomplished before the 2012 election.  I’m keeping my fingers crossed.

July 11, 2014

Buffett, Gates, and Adelson weigh-in on immigration policy

Filed under: Issues,Politics — Mike Kueber @ 5:27 pm
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A few days ago, one of my favorite yogis posted on Facebook a photo of a sad-looking Indian (Native American), with the following caption:

  • “So you’re against immigration? Splendid, when do you leave?”

Although my brain told me to let the posting pass, I couldn’t stop myself from responding as follows:

  • “Conflating legal immigration with illegal immigration, which the liberal media does continually, is not helpful to understanding the issue. I haven’t heard of a single conservative against legal immigration.”

Fortunately for me, there was no resulting brouhaha, and one of my yogi classmates even said she agreed with me.

Today, the immigration issue again came to my attention when one of my heroes, Warren Buffett, along with two other billionaires, Bill Gates and Sheldon Adelson, authored an op-ed piece in the NY Times titled, “Break the Immigration Impasse.”  The piece is supposed to be significant because, while Gates and Buffett are liberals, Adelson is a conservative, and their ability to achieve a compromise suggests that Congress could do likewise if it focused on good policy instead political posturing. After looking closely at the op-ed piece, I disagree.

Perhaps the most constructive component of the op-ed piece is that, unlike the Indian posting in Facebook, Buffett and his gang distinguish between legal immigration and illegal immigration. They accurately describe America’s flawed immigration for kids educated in our universities (“talented graduate program”) and the “immigrant investor program” (EB-5). Those are programs where there is bipartisan support.

But sandwiched between these two programs, Buffett and his gang gloss over the insoluble part of the immigration problem – i.e., the eleven million illegal immigrants. About them, they spout pabulum:

  • “Americans are a forgiving and generous people, and who among us is not happy that their forebears — whatever their motivation or means of entry — made it to our soil? For the future, the United States should take all steps to ensure that every prospective immigrant follows all rules and that people breaking these rules, including any facilitators, are severely punished. No one wants a replay of the present mess.”

The first part of this paragraph is as shallow and trite as the Facebook posting. If they wish to compare the immigration in the 1800s and early 1900s with today’s immigration, they should make their case instead of simply implying that they are. They differences are so profound, beginning with the fact that immigration back then was legal, that any attempt to equate them requires more than a superficial reference.

The second part of the paragraph also requires elaboration. How can you talk about law-breakers being severely punished in the future when you are granting them amnesty this time? When Reagan granted amnesty in the 80s, he also said that future law-breaking would not be tolerated. Won’t America want to be humane to future law-breakers, too?

Seems to me that Buffett and Gates needed to contend with a stronger negotiator that Sheldon Adelson, who seems to have given away the conservative store.

September 30, 2011

Buffett’s perspective

Filed under: Economics,Issues,Politics — Mike Kueber @ 11:04 pm
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This morning, while watching Imus in the Morning on the FOX Business channel, I learned that Warren Buffett was going to be interviewed on the floor of the stock exchange by a FOX correspondent in a few minutes.  What a pleasant way to start the day!

The ten-minute interview reminded me why I like Buffett so much.  Most of the interview focused on the Buffett Rule, which has been proposed by President Obama.  The rule is really nothing more than a minimum income-tax rate (probably 25%) for people who make more than $1 million a year.  As Buffett pointed out, hundreds of these people currently pay less than 25% because the bulk of their earnings are taxed at the 15% rate for long-term capital gains.  This new minimum rate seems perfectly fair, and it does not raise the specter of a rate so high that it discourages entrepreneurs.

The other major issue discussed by Buffett was the lagging economy.  Buffett said that that things were improving, with most of Berkshire’s operational companies on schedule for record profits, except for his homebuilding companies.  When the FOX correspondent wondered what could be done to revive homebuilding, Buffett sagely told her that nothing needed to be done – i.e., he didn’t want to see more houses being built now.  He went on to explain that the bubble caused America to build more houses than it had households, and that resulted in an excess inventory of houses.  Today, America was creating more households than houses and this was slowly reducing the excess inventory.  It’s just a matter of time before homebuilding picks up.

When asked what American government should do from a macro-economic perspective, Buffett said that fiscal or monetary policy cannot supply the answer.  When pressed for an answer, Buffett said that we have already done as much as we can with fiscal and monetary policy, and that we need to give the economy some time.  Ultimately, the “natural regenerative juices of capitalism” will prevail.

What did Buffet think about stock market prices?  Berkshire was buying stocks every day, and in the 2nd quarter they had a net increase of $4 billion in the market.  Talk is cheap, but that’s his money talking.  I wish I had $4 billion to put in today’s market.

Regarding the recent retirement planning going on at Bershire, Buffett claimed that he was merely making sound precautions “should he drop dead tonight.”  But he had no plans to retire or slow down.

Long live Buffett.






January 25, 2012

Double taxation

Filed under: Business,Issues,Politics — Mike Kueber @ 4:44 am
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I confess that because I was preoccupied with a Happy Hour, I missed President Obama’s State of the Union address.  But prior to the address, I heard that a major part of the address was the so-called Buffett rule, which focuses on the fact that some secretaries paid taxes at a higher rate than their bosses.  I agree with this criticism of the American tax code.

Mitt Romney recently disclosed that his tax obligation was less than 14% even though he made about $20 million a year.  Based on news reports, President Obama was prepared to highlight that many secretaries not only paid taxes at a higher rate than 14%, but also had to pay social-security taxes of more than 7%, which the multimillionaires were not required to pay on the bulk of their income.

I agree that rich people should not be allowed to pay reduced income-tax rates simply because their income comes from capital gains.  The argument that such a tax amounts to double taxation doesn’t make sense.  Just because someone pays taxes on earned income doesn’t mean that additional income earned on that income shouldn’t be taxed.  America’s tax system is based on levying a tax on each transaction (e.g., sales tax is assessed every time your car is sold), and that is completely consistent with taxing a person on earned income and then taxing them again when those assets are used to generate capital gains.  The tax rate on capital gains should be at least at much, if not more, than the tax rate on earned income.  This concept would also work with estate taxes, where there is a tax on income earned and then another tax on the assets when they are tranferred to a beneficiary.  

To suggest that people will be reluctant to invest their capital because capital gains will be fully taxed is ludicrous.  That’s like saying you will decide to stop earning income above $250k just because the marginal rate on income over $250k is increased to 40%.

October 22, 2011

Sunday Book Review #50 – The Most Important Thing by Howard Marks

In my most recent book review – Islam, a short guide to the faith – I noted that the “little, highly readable” book reminded me of Harvey Penick’s Little Red Book on golf.  That description applies even more to Howard Marks’ book on investing – The Most Important Thing.

Marks describe his little book (180 pages) as a collection of insights (20) about investing that he has made over his 40-year career.  Each insight was initially a stand-alone comment that Marks might have fleshed-out in a memo to clients.  But over the years, as Marks’ insights gained critical mass, he began to realize that, although these insights could stand alone, they were more effective when considered as part of a package.  (Of course this alleged synergy justified consolidating the memos into book form.)  Although I have never heard of Marks, he is apparently famous as a value investor and the cofounder of Oaktree Capital Management, with $80 billion under management.

According to Marks in Chapter One, the most important thing is “second-level thinking,” which he describes as something a little deeper or more nuanced than the conventional wisdom. An investor needs
to focus on achieving second-level thinking because only with this ability can an investor consistently out-perform the market.

According to Marks in Chapter Two, the most important thing is understanding market efficiency and its limits.  The efficient-market hypothesis generally posits that the market absorbs all available information and then generates pricing that reflects that information.  Marks’ position is that the market is incredibly efficient, but he defines efficient as “speedy, quick to incorporate information, not necessarily right.”

By now you should be understanding the format of this book.  It reminds me of MMA fighting.  Every few months, my son tells me about an upcoming fight that he invariably calls the fight of the century.  After a few such fights, I pointed out the ludicrousness of the claim, and he responded that I shouldn’t take everything so literally.  The same rule applies to Marks’ insights.  Each one may be the most important thing, but not really.

According to Marks in Chapter Four, the most important thing is value.  In this chapter, Marks briefly describes fundamental analysis, technical analysis, random-walk hypothesis, and momentum investing, and then focuses on the difference between value investors and growth investors.  He describes value investors as those who buy stocks because their current value is high relative to its current price.  By contrast, growth investors buy stock because its current value is likely to grow enough to cause substantial appreciation in the future price.  Marks endorses value investing because it is easier to consistently make profitable purchases.  Growth investing is more speculative.  According to Marks, “In my book, consistency trumps drama.”

Chapter Four describes the relationship between price and value.  According to Marks, no asset is of such good quality that price is not the dominant consideration.  Stating the obvious, Marks points out that
investment profits can be derived from (1) an increase in the intrinsic value of an asset, (2) selling an asset for more than it is worth, or (3) buying something for less than its value.  The last of these is the most reliable, but even that is not foolproof because “the convergence of price and intrinsic value can take more time than you have; as John Maynard Keynes pointed out, ‘The market can remain irrational longer than you can remain solvent.’”

Chapters Five, Six, and Seven deal with risk – understanding risk, recognizing risk, and controlling risk.  Marks suggests that the conventional thinking equates risk with volatility.  He disagrees.  He equates risk with the possibility of loss, or even more, the risk of permanent loss.  That makes sense.  Personally, I believe the market will inevitably recover before I need to cash-in most of my investment assets, and
therefore I don’t think the current volatility creates an inordinate amount of risk.  If the market is down significantly in 20 years, then I will have make a bad decision, and my estate and me will suffer the consequences.

Chapters Eight and Nine warn investors to be attentive to cycles and pendulums, with cycles referring to economic expansion and contraction and pendulums referring to investor optimism and pessimism.

Chapter Ten advises investors to combat the negative influences of human nature – e.g., greed, fear, a willing suspension of disbelief, a tendency to conform to the view of the herd, envy, ego, and capitulation.

Chapter Eleven endorses contrarianism, which makes sense for anyone trying to beat the conventional wisdom.  The trick is identifying what about the conventional wisdom is likely incorrect.  For example, when the market is crashing, most experts say, “We’re not going to try to catch a falling knife; it’s too dangerous.  We’re going to wait until the dust settles and the uncertainty is resolved.”  Marks
interprets this to mean that they are too frightened and unsure of what to do.  “The one thing I’m sure of is that by the time the knife has stopped falling, the dust has settled, and the uncertainty has resolved, there’ll be no great bargains left.”  If you know what you are doing, this is the time to do it.

Chapter Twelve recommends finding bargains.  These are usually unattractive assets that provide value because of their unreasonably low prices.  Because of their “unusual ratios of return to risk, they represent the Holy Grail for investors.”

Chapter Thirteen prescribes patient opportunism.  Marks credits Warren Buffett for articulating this concept in one of his annual shareholder letters.  Buffett taught the concept by first describing a baseball batter who is punished by baseball rules if he takes a juicy pitch right down the middle.  Pass on three such pitches and the batter is declared out.  By contrast, investors can take as many pitches as they want, even if the pitches are right down the middle.  Because of this unlimited opportunity, wise investors can wait until really good investments come along before pulling the trigger.

Chapter Fourteen warns about knowing what you don’t know.  Marks thinks most investing mistakes are made by persons who don’t know what they don’t know.  In this chapter, he contrasts actions taken
by investors in the “I don’t know” school vs. those in the “I know” school.

Chapter Fifteen compares three ways of dealing with inevitable cycles – (1) refuse to accept that cycles are unpredictable and try to predict them better than the average Joe, (2) ignore cycles and employ a
“buy and hold” strategy, or (3) instead of prediction or ignoring cycle, have a more limited objective of trying to figure out where we stand in the current cycle and what that implies for our actions.  We should be able to discern whether other investors are acting with reckless exuberance or undeserved caution, and that would suggest contrarian moves.  I think Warren Buffett said something like, “When others are fearless, I fear.  When others are frightened, I am emboldened.

Chapter Sixteen talks about appreciating the role of luck.  Although Bill Parcells is famous for saying a team is as good as its record, that is not necessarily true.  Some actions may look brilliant in hindsight, but the result was not pre-ordained.

Chapter Seventeen advises investing defensively.  There are old investors, and there are bold investors, but there are no old bold investors.

Chapter Eighteen says that the most important thing is to avoid pitfalls.  An investor needs to do very few things right as long as he avoids big mistakes – Warren Buffett.

Chapter Nineteen says the most important thing is to add value.  That value can be gaining more than the market when it goes up or losing less than the market when it goes down.  Marks, like Buffett, prides
himself in keeping up with the market in good years and then separating from the market (in a good way) in the bad years.

Chapter Twenty says the most important thing is to pull it all together.  This chapter contains 27 aphorisms that re-state the insights contained in the 19 previous chapters.  Among my favorites:

  • The relationship between price and value holds the ultimate key to investment success.  Buying below value is the most dependable route to profit.  Paying above value rarely words out as well.
  • The superior investor never forgets that the goal is to find good buys, not good assets.  (I wonder if Buffett agrees with this.)
  • Economies and markets cycle up and down.  Whichever direction they’re going at the moment, most people come to believe that they’ll go that way forever.  This thinking is a source of great danger since it poisons the markets, sends valuations to extremes, and ignites bubbles and panics that most investors find hard to resist.
  • Underpriced is far from synonymous with going up soon.  Thus, being too far ahead of your time is indistinguishable from being wrong.  It can require patience and fortitude to hold positions long enough to be proved right.
  • Never forget the six-foot-tall man who drowned crossing the stream that was five-feet deep on average.


March 5, 2011

Sunday book review #18 – The Little Book of Behavioral Investing by James Montier

The Little Book of Behavioral Investing is directed toward those investors whose investments underperform the market – i.e., just about everyone.  The author, James Montier, believes that investors are unsuccessful, not because they aren’t as smart as Warren Buffett, but because their decision-making process is prone to be based on emotion instead of reason.  Montier even quotes Buffett to support this proposition:

  • Success in investing doesn’t correlate with IQ once you’re above the level of 100.  Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble investing.”

Initially, I thought The Little Book would have little applicability to me because I am a firm adherent to Buffett’s buy-and-hold philosophy.  Montier warns of studies, however, that show virtually all investors concede that emotional behavior significantly affects investing decisions, but they also believe they are the exception to the rule. 

To persuade his readers that they aren’t an exception to the rule, Montier begins his book with a three-part brain teaser:

  1. A bat and a ball cost $1.10 in total.  The bat costs a dollar more than the ball.  How much does the ball cost?
  2. If it takes five minutes for five machines to make five widgets, how long would it take 100 machines to make 100 widgets?
  3. In a lake there is a patch of lily pads.  Every day the patch doubles in size.  If it takes 48 days for the patch to cover the entire lake, how long will it take to cover half the lake?

This test (Cognitive Reflection Task – CRT) is designed to reveal whether an individual’s brain operates with a lot of emotional thinking or logical reasoning.  Montier uses two characters from Star Trek to contrast this difference, with Dr. McCoy (Bones) epitomizing human emotion and Spock epitomizing dispassionate logic.  McCoy’s is an emotional approach to decision making (effortless, with mental shortcuts), whereas Spock’s is a more logical way of processing information (slow, step-by-step).  (All of which sounds a lot like my previous posting on intuition.)

According to psychologists, individuals tend to act like McCoy when (a) a problem is ill structured and complex, (b) information is incomplete, ambiguous, and changing, (c) the goals are ill-defined, shifting, or competing, (d) the stress is high, because either time constraints or high stakes are involved, or (e) decisions rely on interaction with others.  Montier points out that one of these factors applies to virtually all of our important decisions. 

Montier suggests that even if you correctly answered all three questions on the CRT test, you might still have “general vulnerability to a whole plethora of behavioral biases, such as loss aversion, conservatism, and impatience.  In addition to these biases, everyone has a problem with over-confidence, over-optimism (chapter three), and confirmatory bias (chapter eight).   

Only 17% of respondents correctly answered all three questions; whereas 33% got all three wrong.  I quickly answered the first question and studied the second and third more closely.  Not surprisingly, I got the first wrong and the other two correct.  The first answer is five cents, the second is five minutes, and the third is forty-seven days. 

I love brain teasers like the CRT and there are several others in the book.  The most difficult is in Chapter Eight, and it is intended to show that we are all subject to a “confirmatory bias”:

  • Let’s imagine you have four playing cards laid out in front of you.  Each one has a letter on one side and a number on the other.  The four face-up symbols are E, 4, K, and 7.  I’m going to tell you that if a card has an E, then it should have a 4 on the reverse.  Which cards would you like to turn over to see if I am telling you the truth?”

 This teaser, which 95% of the people fail, shows that we tend to look for information that confirms our existing beliefs and we avoid disconfirming evidence. Most people answer E and 4.  The E is correct because if the face-down is not a 4, you will have learned that I lied.  However, turning over the 4 proves nothing, regardless of what the face-down symbol is.  The same is true of the K.  But you should turn over the 7 because if the face-down is an E, you will have learned that I lied.   Sometimes the best way to test a hypothesis is to look for all information that disagrees with it – “a process known as falsification.”  This is a particularly glaring weakness of mine.  I often look for a good explanation of something that I believe in and then don’t bother to look or study the contrary arguments.

Some of the various behavioral defects discussed in The Little Book include:

  • The empathy gap.  The “empathy gap” means that a person says or does one thing during calm and a different thing during the heat of the moment.  Because decision-making is usually better during calm, the author suggests that decisions be made during calm and then use discipline to ensure that you don’t change your mind during the heat of the moment.
  • Courage deficit.  The “courage deficit” describes the inability to act when the big bad market is terrifying.  As an example, Montier mentions the bottoming of the stock market in March 2009, at which time he presciently wrote, “Buy when it’s cheap – if not then, when?”  He brags, “Of course valuation isn’t a fail-safe reason for buying equities – cheap stocks can always get cheaper – but in March I was convinced that they offered a great buying opportunity for long-term investors.”  That sounds like Monday Morning Quarterbacking, which Montier lambastes later in the book.  With all of the Buffett quotes in this book, I am surprised that he didn’t use one of Buffett’s best in this chapter – “When others are fearful, be brave; when others are brave, be fearful.”
  • Over-optimism.  Montier describes over-optimism as one of the cognitive-ability-resistant biases.  To counter this, we must discipline ourselves to think critically and become more skeptical. 
  • Over-confidence.  This is another cognitive-ability-resistant bias that especially afflicts experts, who are even more over-confident than the rest of us.  Stop listening to them.
  • Forecasting.  Is almost always wrong.  Use it to help prepare, but don’t rely on it.
  • Information overload.  Humans are susceptible to information overload because, unlike computers, we cannot efficiently process limitless information.  At some point, the additional marginal information weakens our ability to make the correct, timely decision.
  • The good story.  There is a temptation to ignore facts when they conflict with a good story.  Value stocks usually have bad stories; IPOs usually have good stories.
  • Dealing with bubbles.  Normal people have an advantage over pros in dealing with bubbles because normal people don’t have to compete against artificial benchmarks.
  • Monday Morning Quarterbacking.  Investors are disposed to think, in hindsight, that everything that happened was obvious and predictable.
  • ADHD.  Many investors are afflicted with attention-deficit, hyperactivity disorder (ADHD).  They feel like they always should be doing something.  By way of contrast, Warren Buffett suggests the analogy of a baseball hitter without an umpire.  That batter can wait all day until he gets a fat pitch to swing at.  That’s what an investor should do.
  • Lemmings.  Instead of being a lemming, be a contrarian.
  • Status-quo bias.  There is a tendency to avoid buying or selling – like a deer caught in headlights.

Montier concludes by warning that we can’t control the outcome, but we can improve our chances by controlling our decision-making process.  Excellent advice; excellent book.

December 26, 2010

Sunday book review #6 – Chasing Goldman Sachs by Suzanne McGee

Goldman Sachs has become the fall guy for the 2007-08 worldwide financial meltdown.  Although there were eviler institutions – such as AIG, Countrywide, Washington Mutual, and Fannie Mae – those institutions were humbled and punished, albeit some inadequately.  By way of contrast, Goldman Sachs’ arrogance barely missed a beat (or a bonus) while accepting a multi-faceted government bailout.

The popular conception of Goldman Sachs (GS) is that of an unproductive, money-grubbing leech, or in the famous phrasing of Matt Taibbi in Rolling Stone – “a great vampire squid, wrapped around the face of humanity, relentlessly jamming its blood funnel into anything that smells like money.”  But my hero Warren Buffett has said good things about GS and its chairman Lloyd Blankfein.  At Berkshire’s annual meeting last May, shortly after the SEC accused GS of fraud, Buffett described Blankfein as “smart” and “high grade” and rejected the possibility of trying to oust him – “If Lloyd had a twin brother, I would vote for him.”  Furthermore, I own 150 shares of GS (bought on May 3 for $149 after hearing Buffett’s recommendation, and it is currently selling for $167), so I need to do my due diligence before deciding whether to disown them.  I decided to do that by reading Chasing Goldman Sachs by Suzanne McGee.

Part I of the book – titled Dancing to the Music – consists of four chapters that describe how Wall Street devolved from a staid utility to an extremely risky player.  Among the things I learned in those chapters:

  • Fundamentally, GS and other investment banks play an invaluable role in what author McGee calls the world’s “money grid.”  She uses this term to describe the financial world because she likens it to a heavily regulated utility that delivers an essential service – just like water or electricity – to the economy.  The financial utility (investment bankers) is supposed to be a middleman who merely facilitates the transfer of capital from people who have a lot of money (investors) to those who need a lot of money (businesses).  That sounds like Economics 101.  While commercial banks obtain their money from deposits, investment banks raise their money through equity and bond transactions.  Investment bankers simultaneously serve two clients – buyers who need money and sellers who have money.
  • The problem with this “money grid/utility” analogy is that investment bankers like GS were dissatisfied with the low-risk returns that are generally the lot of utilities.  To generate a higher rate of return-on-equity (ROE), they ventured off into high-risk, highly-leveraged activities.  Instead of working to obtain capital for Main Street businesses (low-revenue work), investment banks started developing exotic financial products for hedge funds and private-equity firms.      
  • High-risk, highly-leveraged activities enabled investment banks to obtain incredibly high ROE rates in the last decade – between 15% and 40%., with GS usually leading the pack, and others jealously trying to catch up by leveraging their capital ever more riskily.  GS’s ROE from 1996 to 2008 was 24.4%, by far the highest in the industry.  Lehman was second at 19.2% and Morgan Stanley was third at 18.6%.  Everyone was “chasing GS.”    
  • The obscene bonus structure at investment banks shifted everyone’s focus to the next quarter’s financial results, with almost no concern for long-term financial soundness or reputation.  For example, in 2007 bonuses at GS averaged $661k per employee, while Lehman’s was $332k.  Although Lehman’s employees should have been happy, they were enviously “chasing GS.”
  • To raise more capital, all major investment banks transformed from partnerships to corporations, beginning with Donaldson, Lufkin & Jenrette in 1970 and ending with GS in 1999.  The partnership structure was especially conducive to restraining risk-taking because it created a feeling of personal responsibility whereas a corporate structure promotes a feeling of personal immunity.

Part II of the book – Greed, Recklessness, and Negligence; the Toxic Brew – consists of three chapters that provide a more technical description of the three major attributes of post-2000 Wall Street that caused the meltdown:

  1. Compensation policies.  Obscene bonuses and perverse incentives to increase revenues without any regard to risk.  This caused investment banks to drift away from their less-profitable utility function of moving capital from investors to Main Street business and toward the more-profitable function of creating exotic financial products for hedge funds and private-equity firms.
  2. Risk-management failures.  Fear (of being beaten by rivals) & greed (for more money) success caused companies to disregard risk; risk managers were marginalized.  In other words, “Chasing GS.”
  3. Regulatory shortcomings.  All federal regulators failed to do their job.  Ever since Reagan, the direction was toward deregulation.  The Office of Thrift Supervision (for thrifts) and the Office of the Comptroller of the Currency (for commercial banks) competed with each other to provide the least interference with their clients who were pushing sub-prime mortgages; derivatives escaped regulators.  The SEC was asleep at the wheel, but the book spends very little time discussing SEC failings.

Part III of the book – The New Face of Wall Street – consists of two chapters that describe how Wall Street needs to work if it is going to avoid another meltdown.  This part of the book seems like an afterthought – like author McGee was so caught up in describing the trees that she never developed a sense of what the forest needed.  Among her suggestions:

  • Foremost, Wall Street should return to its role as an intermediary – i.e., a utility that mere facilitates the movement of money from investors to businesses. 
  • Wall Street should be prohibited from making trades with its own capital, investing in hedge funds or private equity divisions.  This would minimize the conflicts of interest between Wall Street and its clients. 
  • And finally, there needs to be a regulator to monitor financial products, like derivatives. 

McGee is not very optimistic that Wall Street will change its ways.  She cites Citibank’s chairman Richard Parson as declaring that they are going back to their basics.  But his “basics” did not include any professional concern for Citi’s clients or the health of the banking industry.  Rather he was referring to Citibank’s core constituencies – employees and stockholders.  Of course, that is the same motivation that got Citi into all of its trouble – i.e., because its employees and stockholders are just as deserving as those of GS, then Citi should do whatever it can to match the financial results of GS (ROE and bonuses).  As a solution to these distorted values, author McGee suggests that the investment-banking world would be a better place if GS competitors tried to emulate, not GS’s financial results, but rather GS’s best features – i.e., strategic thinking and planning.  However, McGee fails to explain how that is going to come about.

McGee also is discouraged by a recent quote that came from Morgan Stanley’s chairman, John Mack.  He declared that Wall Street couldn’t stop itself from screwing up, that regulators need to “step in and control the Street… force firms to invest in risk management.”  Thus, vigorous regulation is needed, and this led to the Volcker Rule, endorsed by Barack Obama, which recommends a prohibition on speculative investments by investment banks that are not on behalf of their customers. 

Subsequent to the publication of Chasing Goldman Sachs, Congress enacted the 2,000-page Dodd-Frank Wall Street Reform and Consumer Protection Act in June 2010.  (Seems that 2,000 pages is becoming the standard length for major reform legislation.)  Among its major reforms:

  1. No more “too big to fail.”  Regulators were given the authority to seize and break-up troubled financial firms if the firm’s collapse would destabilize the financial system.
  2. Back to basics.  Severely restricts the ability of investment banks to invest in hedge and private-equity funds.  (No more than 3% of the bank’s Tier-1 capital.)
  3. Derivatives.  Extend comprehensive regulation to the heretofore unregulated, over-the-counter derivatives market.
  4. A new consumer protection agency.  Creates a new agency to protect consumers in the areas of credit cards, mortgages, etc. from hidden fees, abusive terms, etc.
  5. Federal Reserve audit.  Mandates a one-time audit of the Fed’s emergency lending programs from the financial crisis.
  6. Eliminates the Office of Thrift Supervision.  Its regulatory assignments are transferred to the Fed (holding companies), FDIC (state savings associations), and the OCC (thrifts).
  7. Securitization.  Requires banks that package mortgages to keep 5% of the credit risk.
  8. Credit-rating agencies.  Establishes a quasi-public agency to regulate conflicts of interest that are inherent in the rating business (after a study by the SEC); authorizes investors to sue and the SEC to fine the rating agencies for bad ratings.
  9. Hedge funds.  Hedge and private-equity funds are required to register with SEC and provide info trades to help regulators to monitor systemic risk.

After reading Chasing Goldman Sachs and other books on the financial meltdown, I find myself impressed with the Dodd-Frank bill.  The bill passed by highly partisan votes in the House and Senate (only three Republican senators supported it – two from Maine and one from Massachusetts), but I don’t know what the Republican objections were.  Perhaps it had to do with their historical opposition to the Democratic philosophy regarding regulating – as Ronald Reagan humorously captured – “If it moves, tax it.  If it keeps moving, regulate it.  And if it stops moving, subsidize it.”  Michelle Malkin called it “the Dodd-Frank monstrosity masquerading as financial reform.

Not discussed in Chasing Goldman Sachs, but something that I have read elsewhere, is the fact that GS is one of the most politically connected entities in America.  Former GS employees rotate in and out of virtually every important financial regulatory office.  Plus, they are not shy about spreading money around where it does the most good.  I was hugely disappointed a couple of weeks ago when I read that my newly elected, Tea Party Congressman Quico Canseco traveled to Washington, D.C. shortly after his election to pick up a $5,000 check from GS.  They obviously bet on the wrong horse before the election and were trying to make amends.  What makes this especially disappointing is the fact that Quico is a lifelong banker, and this might enable him to have outsized importance in future banking developments – just like I could have had with insurance-industry issues or candidate Will Hurd could have had with Afghanistan/Iraq issues.  This campaign contribution suggests that Quico will more likely be an outsized force for bad instead of a force for good.