finance

Warren Buffett: Embracing the 21st Century

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The news that Warren Buffett’s company, Berkshire Hathaway, bought a $10.7 billion stake in IB (64 million shares, a stake of roughly 5.5% of the company) surprised me this morning. This is a man who once explained “Technology is just something we don’t understand, so we don’t invest in it.”

What’s more? In his letter to his shareholders in 2000, Buffett wrote:

We have embraced the 21st century by entering such cutting-edge industries as brick, carpet, insulation and paint. Try to control your excitement.

So yes, let’s all collective welcome Warren Buffett to the 21st century.

I am skeptical on this purchase of IBM compared to other technology stocks such as Google and Apple. What has IBM done that’s really innovative lately? Yes, their Watson project was incredible (winning the Jeopardy! tournament against Brad Rutter and Ken Jennings was quite impressive), but nothing else that they are doing readily stands out, in my mind. What do you think?

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(hat tip: Dealbook)

On Moral vs. Contractual Obligations

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From a very good personal story in The New York Times, about a financial planner who ended up losing his house:

Borrowing that much had seemed to make sense when the value of the home was still rising substantially every year, taking our net worth higher with it. But at that point, there was no way we could sell the home for anywhere near what we owed. Some of my friends were already doing short sales, where the bank agrees to let you sell the house for less than your loan balance. I was also aware you had to be three months behind in your payments before the bank would talk to you about the possibility.

At first, I dismissed the idea of a short sale. Late that summer, I sat down with a really close friend in Las Vegas, someone I looked up to. He cut to the heart of the matter right away: Why, he wanted to know, were we still making the payments?

Because I have a moral obligation, I said. You pay your debts.

He proceeded to explain that I didn’t have a moral obligation to the bank. I had a moral obligation to my family. I had a contractual obligation to the bank, along with a clear moral obligation to be honest in my dealings. What he was asking was this: Which is more important? Your contractual obligation to the bank or your obligation to your family to preserve your ability to make a living?

I had never thought of it that way. But it made sense. I summed it up to myself like this: I have a contractual obligation to the bank (as well as a moral obligation not to skirt the consequences of breaking it: losing my house and wrecking my credit score). But my moral obligation to my family trumps the contractual obligation to the bank.

I found this paragraph particularly enlightening. Do not be quick to judge others’ financial habits:

For one thing, I am less quick to judge other people’s financial behavior. I’m also more inclined to take into account personal factors that determine how people behave around money.

I have a friend who is going through a tough time financially. He has a high income, but is burdened by debt from a few real estate deals that went south. He continues to take fairly expensive ski trips. That would seem irresponsible in his situation, and maybe they are.

But I now realize that it is not that simple. Maybe those trips are keeping the guy alive, or saving his marriage or keeping him sane enough to work.

The author of the piece, Carl Richards, is coming out with a book The Behavior Gap: Simple Ways to Stop Doing Dumb Things With Money early next year.

Nassim Nicholas Taleb on Banker Bonuses

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In today’s New York Times, Nassim Nicholas Taleb has a good op-ed decrying banker bonuses. He argues:

Instead, it’s time for a fundamental reform: Any person who works for a company that, regardless of its current financial health, would require a taxpayer-financed bailout if it failed should not get a bonus, ever. In fact, all pay at systemically important financial institutions — big banks, but also some insurance companies and even huge hedge funds — should be strictly regulated.

Critics like the Occupy Wall Street demonstrators decry the bonus system for its lack of fairness and its contribution to widening inequality. But the greater problem is that it provides an incentive to take risks. The asymmetric nature of the bonus (an incentive for success without a corresponding disincentive for failure) causes hidden risks to accumulate in the financial system and become a catalyst for disaster. This violates the fundamental rules of capitalism; Adam Smith himself was wary of the effect of limiting liability, a bedrock principle of the modern corporation.

Bonuses are particularly dangerous because they invite bankers to game the system by hiding the risks of rare and hard-to-predict but consequential blow-ups, which I have called “black swan” events. The meltdown in the United States subprime mortgage market, which set off the global financial crisis, is only the latest example of such disasters.

If you’ve never read The Black Swan, I highly recommend it. In it, Taleb goes into detail about the low-probability, high impact events that can derail individuals, institutions, and governments.

Taleb goes on to say:

What would banking look like if bonuses were eliminated? It would not be too different from what it was like when I was a bank intern in the 1980s, before the wave of deregulation that culminated in the 1999 repeal of the Glass-Steagall Act, the Depression-era law that had separated investment and commercial banking. Before then, bankers and lenders were boring “lifers.” Banking was bland and predictable; the chairman’s income was less than that of today’s junior trader. Investment banks, which paid bonuses and weren’t allowed to lend, were partnerships with skin in the game, not gamblers playing with other people’s money.

Of course, the big question is: how do we get banks to follow this no-bonus policy? Can it become a law?

The Perniciousness of “Buy Here, Pay Here” Car Dealerships

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I had no idea that there was a market for such things…

These dealerships focus on people who need cars to get to work, but can’t qualify for conventional loans. They sell aging, high-mileage vehicles at prices well above Kelley Blue Book value and provide their own financing. As lenders of last resort, they can charge interest at three times or more the going rate for regular used-car loans.

Many require customers to return to the lot to make their loan payments — that’s why they’re called Buy Here Pay Here dealerships.

If buyers default, as about 1 in 4 do, the dealer repossesses the cars and in many cases sells them again.

The dealerships make an average profit of 38% on each sale, according to the National Alliance of Buy Here Pay Here Dealers. That’s more than double the profit margin of conventional retail car chains like AutoNation Inc.

That 38% return is higher than anything you’ll see on Wall Street these days. And investors are paying attention. But here’s the rub:

Buy Here Pay Here is also being boosted by one of the sophisticated financial strategies that drove the nation’s recent housing boom and bust: securitization. Loans on decade-old clunkers are being bundled into securities, just as subprime mortgages were a few years ago. In the last two years, investors have bought more than $15 billion in subprime auto securities.

Although they’re backed mainly by installment contracts signed by people who can’t even qualify for a credit card, most of these bonds have been rated investment grade. Many have received the highest rating: AAA.

This is the same kind of thinking that led to AIG getting AAA rating and subsequently going bust. I can’t see this investment strategy working out in the long term. It will probably be another disaster.

Read the full story at The Los Angeles Times. This is predatory lending, but what can be done about it?

Europe and the Elephant in the Room

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Today’s quote of the day comes from John Lanchester, about the European debt crisis:

The difference between a safe euro and a euro on the verge of failure is the difference between that metaphorical elephant in the room, which you can ignore, and an actual elephant in the room with you, right now, filling the air with its hot, dank breath. That situation would be unignorable, and the source of a rising panic. The euro zone is already in the room with that elephant; unless some decisive steps are quickly taken, the rest of the world will soon be joining it.

More here.

Peter Thiel on Technology, Science, Politics

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Peter Thiel, the founder of PayPal, in his piece, “The End of the Future,” offers excellent food-for-thought regarding technology, science, innovation, politics, and the economy.

The state of true science is the key to knowing whether something is truly rotten in the United States. But any such assessment encounters an immediate and almost insuperable challenge. Who can speak about the true health of the ever-expanding universe of human knowledge, given how complex, esoteric, and specialized the many scientific and technological fields have become? When any given field takes half a lifetime of study to master, who can compare and contrast and properly weight the rate of progress in nanotechnology and cryptography and superstring theory and 610 other disciplines? Indeed, how do we even know whether the so-called scientists are not just lawmakers and politicians in disguise, as some conservatives suspect in fields as disparate as climate change, evolutionary biology, and embryonic-stem-cell research, and as I have come to suspect in almost all fields?

Not so sure about this statement. Nuclear engineering remains a strong major at Georgia Tech, for example:

 One cannot in good conscience encourage an undergraduate in 2011 to study nuclear engineering as a career. 

On the big pharmaceutical companies today:

In the next three years, the large pharmaceutical companies will lose approximately one-third of their current revenue stream as patents expire, so, in a perverse yet understandable response, they have begun the wholesale liquidation of the research departments that have borne so little fruit in the last decade and a half.

I think this is Thiel’s most important point in the piece.  Read it carefully:

If meaningful scientific and technological progress occurs, then we reasonably would expect greater economic prosperity (though this may be offset by other factors). And also in reverse: If economic gains, as measured by certain key indicators, have been limited or nonexistent, then perhaps so has scientific and technological progress. Therefore, to the extent that economic growth is easier to quantify than scientific or technological progress, economic numbers will contain indirect but important clues to our larger investigation.

The single most important economic development in recent times has been the broad stagnation of real wages and incomes since 1973, the year when oil prices quadrupled. To a first approximation, the progress in computers and the failure in energy appear to have roughly canceled each other out. Like Alice in the Red Queen’s race, we (and our computers) have been forced to run faster and faster to stay in the same place.

One interesting anecdote, in which Thiel quotes from the 1967 bestseller The American Challenge by Jean-Jacques Servan-Schreiber:

In 30 years America will be a post-industrial society. . . . There will be only four work days a week of seven hours per day. The year will be comprised of 39 work weeks and 13 weeks of vacation. With weekends and holidays this makes 147 work days a year and 218 free days a year. All this within a single generation.

And what does Thiel really think of John Maynard Keynes?

The most common name for a misplaced emphasis on macroeconomic policy is “Keynesianism.” Despite his brilliance, John Maynard Keynes was always a bit of a fraud, and there is always a bit of clever trickery in massive fiscal stimulus and the related printing of paper money. 

And I strongly agree with Thiel here. It’s a shame how science and engineering get passed over by our politicians:

Most of our political leaders are not engineers or scientists and do not listen to engineers or scientists. Today a letter from Einstein would get lost in the White House mail room, and the Manhattan Project would not even get started; it certainly could never be completed in three years. I am not aware of a single political leader in the U.S., either Democrat or Republican, who would cut health-care spending in order to free up money for biotechnology research — or, more generally, who would make serious cuts to the welfare state in order to free up serious money for major engineering projects.

Where will the United States be in a year? In five years? In ten?

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(via Tyler Cowen)

Warren Buffett on Taxing the Super-Rich

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I really like Warren Buffett. He’s got a no-nonsense approach to investing, he speaks with charisma, and in today’s edition of the New York Times, he makes his voice heard loud and clear: tax the super-rich. And heavily.

In an op-ed titled “Stop Coddling the Super-Rich,” Warren Buffett explains how he paid the least amount in taxes from his office of twenty people (even when he made the most money):

Last year my federal tax bill — the income tax I paid, as well as payroll taxes paid by me and on my behalf — was $6,938,744. That sounds like a lot of money. But what I paid was only 17.4 percent of my taxable income — and that’s actually a lower percentage than was paid by any of the other 20 people in our office. Their tax burdens ranged from 33 percent to 41 percent and averaged 36 percent.

Some important statistics to digest (about income disparity in America):

Since 1992, the I.R.S. has compiled data from the returns of the 400 Americans reporting the largest income. In 1992, the top 400 had aggregate taxable income of $16.9 billion and paid federal taxes of 29.2 percent on that sum. In 2008, the aggregate income of the highest 400 had soared to $90.9 billion — a staggering $227.4 million on average — but the rate paid had fallen to 21.5 percent.

And his resilient conclusion:

But for those making more than $1 million — there were 236,883 such households in 2009 — I would raise rates immediately on taxable income in excess of $1 million, including, of course, dividends and capital gains. And for those who make $10 million or more — there were 8,274 in 2009 — I would suggest an additional increase in rate.

My friends and I have been coddled long enough by a billionaire-friendly Congress. It’s time for our government to get serious about shared sacrifice.

Bravo. Now, let’s make it happen.

Ray Dalio’s Richest and Strangest Hedge Fund

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In this month’s New Yorker, John Cassidy profiles Ray Dalio, the founder of Bridgewater Associates, said by some to be the strangest hedge fund in the world.

I found the piece interesting, though I did think Cassidy could have done a better job explaining the nuances of Dalio’s behavior, such as evidenced in this paragraph:

Dalio asked for another opinion. From the back of the room, a young man dressed in a black sweatshirt started saying that a Chinese slowdown could have a big effect on global supply and demand. Dalio cut him off: “Are you going to answer me knowledgeably or are you going to give me a guess?” The young man, whom I will call Jack, said he would hazard an educated guess. “Don’t do that,” Dalio said. He went on, “You have a tendency to do this. . . . We’ve talked about this before.” After an awkward silence, Jack tried to defend himself, saying that he thought he had been asked to give his views. Dalio didn’t let up. Eventually, the young employee said that he would go away and do some careful calculations.

Do you believe the world is mechanical? Do parts come together to work as a seamless whole? Ray Dalio thinks so:

Many hedge-fund managers stay pinned to their computer screens day and night monitoring movements in the markets. Dalio is different. He spends most of his time trying to figure out how economic and financial events fit together in a coherent framework. “Almost everything is like a machine,” he told me one day when he was rambling on, as he often does. “Nature is a machine. The family is a machine. The life cycle is like a machine.” His constant goal, he said, was to understand how the economic machine works. “And then everything else I basically view as just a case at hand. So how does the machine work that you have a financial crisis? How does deleveraging work—what is the nature of that machine? And what is human nature, and how do you raise a community of people to run a business?”

So who invests in Bridgewater Associates, exactly? Not wealthy invididuals:

Part of Dalio’s innovation has been to build a hedge fund that caters principally to institutional investors rather than to rich individuals. Of the roughly one hundred billion dollars invested in Bridgewater, only a small proportion comes from wealthy families. Almost a third comes from public pension funds, such as the Pennsylvania Public School Employees’ Retirement System; another third comes from corporate pension funds, such as those at Kodak and General Motors; a quarter comes from government-run sovereign wealth funds, such as the Government Investment Corporation of Singapore.

A surprise about Bridgewater’s investing tendencies (no U.S. markets?):

Is Bridgewater really any different? Although the firm trades in more than a hundred markets, it is widely believed that the great bulk of its profit comes from two areas in which Dalio is an expert: the bond and currency markets of major industrial countries. Unlike some other hedge funds, Bridgewater has never made much money in the U.S. stock market, an area where Dalio has less experience.

While the piece makes it sound like working at Bridgewater is quite the challenge, I appreciated this nugget:

Dalio insists that money has never been his main motivation. He lives well, but avoids the conspicuous consumption that some of his rivals indulge in. He and his wife, Barbara, to whom he has been married for thirty-four years, own two houses, one in Greenwich, Connecticut, and one in Greenwich Village, which he sometimes uses on weekends. (They are currently building a new house on the water in Connecticut.) Apart from hunting and exploring remote areas, Dalio’s main hobby is music: jazz, blues, and rock and roll. Recently, he joined a philanthropic campaign started by Bill Gates and Warren Buffett, pledging to give away at least half of his money.

Ray Dalio is a man I’d like to meet. We could talk about books and music and photography. And oh yes, the financial markets (I do have a degree in quantitative finance, after all, and work in the financial sector).