The Big Short: What I Learned

I finished reading Michael Lewis’ book The Big Short a few weeks ago and it has really stuck with me. I have previously written about the book in a post dated June 19, 2010.

If you want to understand, in depth, about the sub-prime mortgage crisis and those few individuals and institutions that really predicted the implosion and made huge sums of money, this is a great read. The book is well-written and you’ll learn a lot at the same time.

What has had the most impact to me, after considering the book for a while, is the Big Picture of how these few players were successful. To me, this is the benefit of reading the book, and thus, for our clients.

These investors (some were individuals, some started as individual investors and then formed hedge funds, some were institutions; I’ll use the word investors to encompass them all) who were featured in the book were independent thinkers. They did not follow Wall Street. They followed their own thoughts. They were very disciplined and incredibly patient. They placed huge bets, in the hundreds of millions of dollars, which did not pay off for a number of years. This took a great deal of conviction, when many others, including their own fund investors, questioned their “wisdom.”

One hedge fund manager who was profiled had phenomenal returns for many years, so institutions were very willing to invest with him. As he invested more and more against the sub-prime markets, these investors grew very impatient with him. They demanded their funds back, but he would not allow them to (hedge fund rules). In the end, he made them all millions. But had they gotten their money back as they wanted, they would not have profited. If it was not for the manager’s forceful patience and insistence that he would be proven correct in the long run, these investors in his fund would have missed out on his tremendous thinking.

The lesson for us is that we should not follow what we hear on TV, in the papers and what market “experts” tell us. After years of careful research and thought, we have adopted and adhered to a disciplined investment philosophy which is fundamentally sound and rationale. It is academically based and not based on “predictions” and calls on what the market will do in the next week or few months.

It requires discipline and patience, but will be rewarded in the long run. With proper planning, it will provide our clients with a sense of security. It is a clear philosophy, which can be understood.

As we discuss with clients the ups and downs of the market in the future, the lessons of The Big Short will be a way to clarify why patience and discipline are so important. It is our role as your advisor to assist you in maintaining these qualities, which will lead to a more successful investment experience.

New FDIC Rules and Planning Opportunities

As a result of legislation enacted on July 21, 2010, FDIC insurance for bank deposits has been permanently increased to $250,000 per depositor, per insured bank.

This is great news for investors, as this permanent change extends the increase in coverage, which was to expire December 31, 2013. This means that investors who purchase CDs with maturities beyond 2013 will know their funds are insured.

There are very specific, and very beneficial rules that can greatly broaden this coverage far beyond $250,000 per individual. For example, if an investor has an account established using a Revocable Living Trust at an FDIC bank, and has 3 beneficiaries of the trust, the account will be insured up to $1,000,000. This is determined by combining the owner of the account and each beneficiary, so would total 4 times $250,000.

The maximum number of beneficiaries that are eligible for FDIC coverage would be 5, so the maximum coverage for an account established with a Revocable Living Trust is now $1,250,000.

This is of even greater relevance right now, given current interest rate conditions, as we are finding that CDs are good, secure investments, and even for taxpayers in high tax brackets, CDs may be safer and provide nearly the after-tax return of top quality municipal bonds.

If you have questions regarding how to structure your investments to gain the security of additional FDIC insurance, please contact our office.

Firm Updates

On a personal note, we would like to share with you that Keith and his family are expecting their fifth child later this year.

Brad’s oldest son, Daniel, recently graduated from high school and will begin college this fall at the University of Michigan.

We are also pleased to inform you that Brad was asked to join the Board of Directors of Fresh Air Society, the governing body of Tamarack Camps. This is one of many non-profit boards and committees that Brad serves on.

July 2010 Client Quarterly Letter

This is the quarterly letter that we sent to our clients during July, 2010:

Worldwide, stock markets during the second quarter of 2010 saw the return of market volatility, with wide daily swings and negative returns. Then, the first two weeks of July have seen positive returns, which erased these losses. We thought some perspective may help. Let’s look back, long term.

The year was 1960. The S & P 500 was at 60. The country would soon face the difficulties of Vietnam, the Civil Rights movement and the assassination of President Kennedy. It would also experience the Bay of Pigs crisis and land a man on the moon.

The year was 1970. The S & P 500 was at 92. The country was still in the midst of the Vietnam War. It would face the Watergate crisis, the resignation of President Nixon, the Middle East crisis and the ensuing gas shortages. The prime rate rose to over 15% by 1979.

The year was 1980. The S & P 500 was at 108. The country would face unemployment and high interest rates. Chrysler would face bankruptcy, but recover. The prime rate would reach 20% in April, 1980. The later part of the decade saw the Savings and Loan crisis, which resulted in the closing of 296 financial institutions with total assets of $125 billion.

The year was 1990. The S & P 500 was at 353. By 1994, over 1,500 institutions were closed from the 1980s S&L crisis. The country grappled with health care reform, but it was not approved. Health care costs continued to skyrocket. The internet arrived and high technology stocks would go nowhere but up. The mantra was “this time was different.” But it wasn’t.

The year was 2000. The S & P 500 was at 1,469. The tech bubble was about to burst. 9/11 became emboldened in our memory. Wars began in Afghanistan and Iraq, which still continue. The housing market went up, then came crashing down. Major financial institutions and industrial companies went bankrupt, were taken over by the government or were struggling to survive by the end of the decade.

It is now 2010. The S & P 500 was 1,115 at the beginning of the year.

What can we learn from this information?

Note the increase, over the long term, in the S & P 500.

    • 1960: 60
    • 1980: 108
    • 2010: 1,115
  • If you focus on the day to day problems that face our cities, countries, specific companies or parts of the world, you would focus on the near term and probably be quite pessimistic about future prospects.
  • If you focus on the longer term, you become more positive. You realize how resilient the economy, companies and countries can be to resolve issues, innovate and these successes translate into positive stock market returns.
  • When we develop your investment plan, we focus on both the short term and the long term. We use very prudent fixed income strategies for the foundation of your portfolio, so you will have a solid base. For the long term, we structure a diversified global portfolio, which should provide for positive results over a longer time period.
    • It is our role as your advisor to assist you in reaching a balance, so that your portfolio can give you the comfort and security that the fixed income allocation provides, while providing the longer term perspective to achieve the greater potential returns that stocks can provide.
  • We are realistic and very cognizant that many states, municipalities and governments face significant issues. But looking back through history, each time period faced different challenges and problems.
    • As we assist you in building and monitoring your investment portfolio, and work with you to provide financial comfort and security, we rely on historical facts and academic information and research, not on the media or market forecasters. We do not have a crystal ball. No one else does either.
    • We will work with you, so that you will have the patience and discipline that is required to be a successful long-term investor.

If you are concerned about the economy or the markets, call us. Meet with us. That’s what we are here for.


Part of the reason for this blog is to share my feelings about current events. Part is that I enjoy writing. Part is that I hope it helps to inform others about our firm and our philosophy.

This morning I feel moved to write, as I am reading a book and various thoughts came together and became very clear…..and provided some real clarity.

I’m reading The Big Short, by Michael Lewis. He is a terrific writer, who has written a number of financial and non-financial books, many magazine articles, as well as wrote the book The Blind Side, which became the movie.

I am only part way through the The Big Short, which describes how a number of individuals placed huge financial bets against the home mortgage markets in the late 2000s, and made fortunes. The book is fast paced and very interesting, and as of now, I highly recommend it.

Yesterday, in a office meeting, as a result of a number of seminars that Keith and I attended in May, the word clarity was brought up. While reading this book this morning, I looked up the word clarity (in an old fashioned real dictionary): the state or quality of being clear; transparency; a difficult idea presented with clarity.

In The Big Short, it describes how Wall Street firms, mostly Goldman Sachs and AIG, combined and restructured residential home loans, most of very poor credit quality, into what later became AAA loans (top rated and considered very safe). Essentially, these investments/products were the complete opposite of “clarity,” to everyone except for the few individuals who are featured in the book, who truly understood what a sham these products were, and were willing to bet against them. As Lewis describes it, Goldman and others took lead and turned it into ore, and then turned it into gold, then sold the gold to investors. If a portion of the lead was not immediately turned into gold, they would take the residual lead, and then turn that into gold also (from page 76).

This is meaningful to me, and thus my clients, as I consider the evolution of my firm and our investment philosophy from day one. One the fixed income side of investing, we have completely avoided corporate bonds (debt), due to the academic research that showed that the risk of default, while relatively low, was not worth the risk. When first presented with these concepts and information in 2002 and 2003, I was skeptical. I followed the advice, but did not completely buy into it. But it was totally correct. With new clients, we almost always sell many of their fixed income investments, as we do not think they are safe enough. On behalf of a non-profit that I’m involved with, I had many discussions about these matters with a top leader many years ago, who has since passed away. Fortunately, they agreed with me and we restructured their investments. We have almost always purchased only CDs, and top-rated municipal bonds and governmental agency bonds for our clients. We can understand these. They are clear and transparent.

When it comes to alternative investing, a phrase for hedge funds (which are mutual funds that are private, not like public mutual funds, in which the investors really don’t know what the manager is investing in), we have also avoided these, for many reasons. Most importantly, if you can’t see what you are investing in, and can’t understand it, why would you invest in it?

So back to clarity. The investments we use for our clients, to implement their investment plans, are clear and straightforward. They are not hard to understand. The result of this is the comfort that the clarity provides. By knowing and understanding what you are invested in, and that you have an investment plan, we have provided clarity and comfort.

In Michael Lewis’ book, I’m reading about the products and actions that Goldman Sachs and AIG and others are doing (or were doing a number of years ago). While I do understand it, it is beyond comprehension, in terms of rationality. There was not clarity to the American public. There was not even clarity to many of the people and companies that were involved. There certainly was not full disclosure (and Lewis has some strong comments about Goldman Sachs!).

Did You Learn from the Past?

As Warren Buffet has said, the stock market can be a great teacher. While the Gulf Oil spill is certainly a terrible environmental disaster, it also provides another vivid reminder of the risks of concentrating your portfolio in a few stocks or allowing one stock to become a huge portion of your wealth.

This story has been repeated many times in the past. Many well known names, that were considered safe, incur huge declines, sometimes in a day or two or within months, without any prior warning and certainly not predicted or knowable in advance.

Think of:

Merck and the Vioxx legal issues (dropped almost 50% in very short time period)

British Petroleum (down almost 50% since the oil spill occurred)

General Electric lost 88% from its peak in 2008 to early 2009

United Health Group, which lost 40% during 2006 due to corporate options issues

The key is to structure your portfolio so it can withstand an event such as the BP oil spill. By owning a broadly diversified global portfolio, your lifestyle will not be dramatically affected by the events (or failure) of one company or one industry.

Isn’t that the goal anyway? To reach a level of financial comfort, by saving and investing, so that you can enjoy your life, regardless of the success or failure of one or a few companies in your portfolio. For our clients, that would be our goal!

Wealthy Thoughts – 2

A collections of thoughts and ideas about various things…..

“The US has discovered nearly $1 trillion in untapped mineral deposits in Afghanistan… enough to fundamentally alter the Afghan economy and perhaps the Afghan war itself…,” the New York Times reported on June 13.

These mineral deposits are so big that Afghanistan could eventually be transformed into one of the most important mining centers in the world, according to an internal Pentagon memo. It states that Afghanistan could become “the Saudi Arabia of lithium,” a key raw material in the manufacture of batteries for laptops and cell phones. The article states that Afghanistan’s current gross domestic product is only $12 billion.

A Federal Reserve research paper released Monday by the Federal Reserve Bank of San Francisco indicates that the Federal Reserve is likely to wait until 2012 before it starts to raise interest rates. This paper does not represent the official position of the Federal Reserve, but it is notable. The author based his research on the relationship between consumer price inflation and unemployment statistics over the past 20 years.

The authors stated that given these historical relationships, the Fed in theory should have lowered short-term interest rates by another 5% in 2009. That was already impossible, as the short-term interest rates that the Federal Reserve controls were already near zero.

We do not view this research as a direct indication of what the Federal Reserve will actually do. Although we do not make investment decisions based on predictions of when or by how much interest rates will change in the future, this certainly gives credence to the concept that interest rates in general may remain very low, on a historical basis, for the next year or two.

Mortgage rates again near all-time lows
For the week ended June 11, Freddie Mac reported that interest rates on 15 and 30 year mortgages fell to their lowest level of 2010 and were just barely above their all-time lows.

The average for a 30 year fixed mortgage was 4.72% and 15 year mortgages averaged 4.17%, the lowest since this began to be reported in 1991. (per, 6/11/10)

The New York Times, US Identifies Vast Mineral Riches in Afghanistan, June 13, 2010
The New York Times, Fed Study Suggests Rates Will Stay at Record Lows until ’12, June 14, 2010

The Value of Real Research

Most traditional Wall Street research is based on an analyst making a prediction on a particular stock, usually by providing a rating on the stock and a future price target.

Our firm does not use this type of strategy. We focus on a client’s long-term goals, meeting their needs and determining an appropriate asset allocation. To implement their investment strategy, we rely on sound financial principles and academic data. Hopefully the following will clearly contrast this difference.

The Wall Street Journal reported on June 11 that Goldman Sachs was suspending coverage of many high-tech companies, after the departure of their lead analyst. This means “our current investment ratings and earnings estimates for the stocks are no longer in effect and should not be relied upon.”

The Journal stated: “clients have had reason to wonder whether they should have relied upon some of Goldman’s calls in the IT hardware sector. We previously highlighted the fact that Goldman’s stuck with its neutral rating on Apple from December 2008 to the present.” Goldman actually downgraded Apple in December 2008 to “neutral.” The shares are up more than 150% during this period. In changing its rating on December 15, 2008, Goldman cited weakening consumer demand for Apple’s products. This analyst could not have been more wrong in his analysis and future “prediction” (my term) for Apple.

When we implement a client’s stock portfolio, we generally utilize a fund manager that focuses on broad, global diversification. Their investment management is based on many years of rigorous academic research, not on predictions about specific stocks. As a result of their continuous research, they recently informed us that they will be excluding a certain segment of stocks from their small stock mutual fund.

This small cap strategy would currently hold about 2500 eligible stocks. Based on the new research, they will exclude approximately 240 stocks, which they have identified as “the worst of the worst.” They have identified the stocks to exclude based on specific financial criteria, not on the future predictions of the specific company. Over a 30 year period, from 1979 to 2009, this change would have resulted in an improvement of nearly 1.4% annually. This strategy would have had a return of 13.30% annually, versus the Russell 2000 index of 11.26%.

While we focus on meeting with clients, understanding their needs and determining an investment policy to help them reach their goals, we rely on the strength of this type of academic stock market research to implement the investment plan that we develop. As we don’t know of anyone who has an accurate crystal ball of the stock market, this is the most rational way of investing that we know of.

If you would like to know more about this topic, or our investment methodology, please contact us.

Sources: Wall Street Journal, June 11, 2010 “After Missing Apple’s Surge, Goldman Cuts Coverage” and April 21, 2010, Goldman on Apple: Yes, We’re Stickin’ to that “Neutral ” Rating

What we are getting asked about

The most common questions that we are being asked about in client meetings are about municipal bonds, interest rates and inflation (fixed income investments in general).

Interest rates: They are currently at all time lows, based on the past 5-10 years or over a much longer time period, such as 30-50 years. However, predicting the short term direction of interest rates (such as will they be higher 3 months from now), is nearly impossible to predict.
Implication: When we structure our client’s fixed income portfolio’s, we do not make investment decisions based on our “predictions” about future interest rates. We make purchasing decisions on the current rates that are available, with the intention to hold the investments to maturity (not buying them to trade them in 6 months or 2 years, based on our “bet” of the direction of interest rates).

Municipal bonds:
We view fixed income investments as an area to minimize risk. This should be the foundation of your portfolio, with the objective of preserving your investment, while getting a safe interest rate return.

Due to the greater rate of defaults, we do not purchase corporate bonds. The risk of default and not getting your principal back is not worth the additional small amount of annual interest that you would receive. Others may disagree with this philosophy, but it has enabled our clients to sleep well.

We believe in holding individual municipal bonds or certificates of deposits, as long as they are FDIC insured. When selecting municipal bonds, we are extremely particular about what sectors the bond is in. As much of our investment philosophy is based on academic data and research, so to is our fixed income strategy. For municipal bonds, sectors such as housing, healthcare and industrial development have far greater default rates than other areas, such as school districts, highways, and public transportation. You may have never even heard of these statistics or had it brought to your attention by another financial advisor. In our purchasing criteria, we only buy top rated municipal bonds in certain sectors, that have the lowest historical default ratio.

We also advise our clients to diversify nationally, and not hold bonds in just one state. While this may cost some small amount of additional state taxes, the benefit of diversifying your fixed income investments is well-worth the cost. Again, this helps you to sleep well at night.

Inflation, interest rates and bond funds:

As discussed in this and other posts, we cannot predict future inflation rates or interest rates. We do know, however, that interest rates are at a historical low, and it is very likely that inflation will rise at some point in the future. If either of these events occur, the value of bond funds will decrease, and for some bond funds dramatically. If you are holding intermediate or long-term bond funds, of corporate, government or municipal bonds, and interest rates rise, you’ll be faced with a permanent loss in the value of your bond fund.

For this reason, we feel it is critical that investors be very selective and hold only individual fixed income investments, not bond funds. We feel there is the potential for huge bond fund losses, at some point in the future, when interest rates rise. These losses could be similar to losses incurred in the tech bubble. This would be almost more tragic, as bond fund holders feel that their investments are intended to be safe. However, interest rate risk will negate the perceived safety of these fixed income investments.

If you have significant bond fund holdings, we would be pleased to review them and provide you with our thoughts and recommendations.

What’s Going On?

The stock markets have dropped significantly in recent weeks. What are our thoughts?

Through the end of April, 2010, there had been a significant difference between the performance of US stocks markets (positive) and International stock markets (negative). The difference, depending on the asset class, was between 5-20% (meaning the best performing US asset class may have had a 20% better return than a poor performing international asset class).

Quick thoughts on that? Diversification is always working. It is impossible to know which asset class will outperform another. These are themes that we continuously focus on.

Other events have further caused significant gyrations in the worldwide stock markets and commodities. The economic crisis in Greece and potentially other countries in Europe are certainly the root of much of the markets’ declines during 2010. While in late 2009 indications of problems in Greece were beginning to appear, it is events such as these that provide further evidence of how difficult it is to make accurate market predictions and investment decisions based on “having a crystal ball.”

Late in 2009, most forecasters were predicting greater inflation in the US, based on governmental spending that was causing even greater budget deficits. So…..the Wall Street Journal blared last week in a huge headline that the most recent inflation statistics were at a 42 year low!

Most economists predicted rising interest rates and higher mortgage rates for 2010, to correspond with the expected rise in inflation along with the Fed’s moves to stop purchasing mortgage backed securities in spring, 2010. So….interest rates have declined during 2010 and mortgage rates have decreased, not increased.

Gas prices have dropped, based on expected declines in economic activity, stemming from the problems in Europe. Few would have predicted this decline, as no one could have predicted the oil spill. One would think the oil spill would cause reduced oil supplies, which would increase the price of gas. For now, that has not happened. At the same time, the reduction in gas prices will help to limit or reduce other inflationary factors.

The impact to our clients and our investment strategy?

We are focused on long term investing, not short term market predictions and reactions to short-term market activity. We are not changing our investment strategy based on these market movements. As part of a client’s long term investment plan, we may view the market decline as an opportunity to BUY stocks, if a client’s allocation to stocks has decreased below their planned allocation to stocks. In other words, as disciplined investors, we would recommend buying low (even though we don’t know whether the market will go higher or lower in the short term).

The key are the discussions that we have with our clients, both when we develop their investment plan and possibly now, when they may be concerned about the recent market declines. As we did during the declines of 2008 and 2009, we talk and discuss the markets. We listen. We counsel our clients to focus on their goals. As part of the plan we developed, the money that is allocated to stocks is not expected to be needed for many years. If this is so, then the movements of today become less of an issue.

Although we clearly are concerned about many of the economic problems throughout the world and in the US, we remain optimistic and positive for the long term. Our economy and the world are resilient and that solutions and innovations continue.