Agora Financial’s Rude Awakening

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Santa Barbara 

• Plenty of scandals and rot from the heart of the financial center,
• When liabilities are good, “it’s the assets you have to worry about,”
• Time to pack your chute…skydiving from a falling plane and plenty more…

Eric Fry, reporting from Santa Barbara, California…

“Include me out,” quipped Charlie Munger last week, referring to the seemingly revitalized financial sector. “A lot of rot has crept into the financial system…We’ve got plenty of scandals coming.”

“There is a lot of Gresham’s Law out there.  A lot of bad practices pushing out the good practices,” said Munger. “The amount of knavery and folly that has been revealed in the last nine months is unbelievable. How did it happen? Greed was part of it. Terrible accounting was part of it…

Munger, as most Rude readers would be aware, is the Vice-Chairman of Berkshire Hathaway, the legendary investment vehicle of Warren Buffett. But Munger is also the lone chairman of Wesco Financial Corp. (AMEX: WSC ), a lesser-known conglomerate based in Pasadena, California. (Berkshire owns about 80% of Wesco). Every year, the folksy Munger presides over the Wesco shareholder meeting, which is a MUCH smaller version of the Berkshire annual meeting.

I dropped in on last week’s Wesco meeting, mostly because my colleagues, Chris Mayer and Dan Amoss, dragged me along. Chris and Dan were concluding the tail-end of a three-stop investment tour that took them to the Berkshire Hathaway annual meeting in Omaha, Nebraska, then to the Value Investing Congress in Pasadena, California, and then to the Wesco meeting, also in Pasadena. I caught up with the two of them for the last two stops on the tour, both of which were a geographically desirable 60-minute drive from Laguna Beach.

Even though the Wesco meeting shared no connection whatsoever with the Value Investing Congress, one identical theme emerged from both events: The credit crisis is not over. In fact, this same theme also emerged repeatedly at last month’s Grant’s Investment Conference in Manhattan. (Chris, Dan and I also attended that conference. Hmmm…weird.)

Either my colleagues and I are seeking out like-minded individuals to corroborate our fringy perspective, or we just happened to stumble upon a few folks who also fail to understand how the Fed’s emergency lending facilities and panic interest rate reductions can cure a decade’s worth of credit excesses. Berkshire’s Charlie Munger numbered among the contrarians…

“Corporate officers are not held accountable for their actions,” Munger complained at the Wesco meeting. “That’s a serious problem…Philosopher Charles Frankel wrote a book called the ‘History of Philosophical Systems.’ And he observed that systems work to the extent that the participants in the system bear the responsibility of their actions. In Rome, for example, if you were the architect who designed a bridge, you stood under each arch while the scaffolding was removed. Or, in the same way, if you were a paratrooper in the U.S. Airborne, you packed your own chute.

“But we don’t have this system of responsibility today,” Munger sighed, “and that’s a big part of the reason we’ve got the mess we’ve got…Wouldn’t it be better if the officers of all public companies made money WITH the shareholders instead of OFF the shareholders? Is this ethos too much to ask?”

We think we know the answer to Munger’s question, but we don’t want to give it away. So instead, we would urge each reader to search his own heart – and the latest Wall Street Journal headlines – to find the answer to this troubling question.

Unethical corporate practices do not always produce dismal investment results. But they often produce imbecilic investment practices. For years, the imbecilic investment practices of Wall Street firms produced glittering results, especially for insiders. But sometime last summer, a tipping point arrived. Highly leveraged speculation in high-risk, illiquid assets was shown to be as stupid as it always was…even though it had seemed brilliant for a while.

And sometime last summer, finance companies across the land found themselves holding toxic assets they never wanted to own. And so now what?

Ben Bernanke and CNBC say the Fed has rescued the financial sector. The worst has passed, they say.

Charlie Munger, James Paulson and many, many other very brilliant investors fear that the credit crisis still holds a few ugly surprises. In the column below, we’ve complied a selection of quotes from three recent investment confabs: The Grant’s Investment Conference in early April, the Value Investing Congress on May 5th and the Wesco Financial annual meeting on May 6th.

Enjoy…

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Include Me Out
Edited by Eric J. Fry

Charles Munger, at the Wesco Financial Corp. shareholder meeting:

“One thing about accounting, the liabilities are always 100% good. It’s the assets you have to worry about…

“A modest amount of liquidity will service the true needs of a civilization. A large amount of liquidity will bring out the worst in human nature.

“My nomination for the next crisis will be in the derivative books…I’m not sure when the denouement will come, but there will be one helluva mess in the derivatives books…When Berkshire bought Generak Re a few years back, it has a derivatives book…Gen Re needed a derivatives book like I needed a case of syphilis. When we went to sell these derivatives, we discovered that we couldn’t get the prices that they were supposedly worth…They were Good-until-reached-for assets…

“The Berkshire model is coming back into favor. The idea of buying a share of common stock for less than the underlying value of that stock is gaining favor.”

James Grant, at the Grant’s Investment Conference:

“We Americans don’t borrow so much because we are reckless, we borrow because we are adaptive. We tolerate more leverage than our forebears would have dared to do because we are more confident about the future than they generally could afford to be…The economy has become more stable, cyclically the highs are lower and the lows are higher.

“All of this begs the question, how do you get a depression from a financial crisis? The national hockey league shows the way. Now hockey is a violent sport. To reduce injuries,  therefore, officials have armored the players with face masks and neck protectors…and therein lies the trouble, according to no less than Kevin Greenstein, Editor-in-chief of Insidehockey.com: ‘With each passing innovation, the players feel as if they are more and more invincible, their armor protecting them from all perceived risk. And the recklessness with which they conduct themselves under that veil of invincibility only makes the sport even more dangerous for the participants.’ Does that remind you of anything?

“Potential safety benefits tend to get consumed as a performance benefit. For example, consider a case of a winding country road, and a safety-minded highway department. They straighten out the lines and improve the lanes. But what then? There might be fewer accidents, but on account of people driving faster, there might be more fatal accidents.
..So it is on Wall Street.

John Paulson, president of Paulson & Co., a hedge fund that, in the words of James Grant, “earned more in 2007 than the GDP of Kyrgystan or Rwanda” by betting on the falling prices of mortgage-backed securities:

“There are a lot of people that are jumping in and buying mortgage securities today and providing capital to financial firms that are restructuring. So far, anyone that has done that has lost money. So there have been a lot of people that have jumped in…Abu Dhabi, China Investment Corp, Singapore, Warburg Pinkus and many, many other investors. They all jumped in too early…Jumping in too early in the credit cycle can be disastrous investment situation…Only time will tell if these investments will accrue. The biggest factor which influences whether those investments turn out to be good ones are bad ones is really the direction of the economy at this point on.

I think that we’re not over the crisis, the problems will get worst…Our outlook for the economy is that house prices will continue to fall and consumer spending will decline, credit cost will rise, the recession will be worst than anticipated, and fiscal and monetary stimulus will not be enough to halt the decline. But that means for our own portfolio, in this environment, we would like to minimize our exposure to the equity market…I think the stock market has further to fall. We continue to maintain a short credit bias.”

At the end of Paulson’s presentation, a conference attendee asked,  “Is the brokerage house business model broken?”

Paulson answered, “Is the model broken? I don’t know. I really don’t think it’s prudent.”

To be continued…

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Rude Endnote: A strong start to the week in the markets yesterday saw the Dow rally 1.02% to 12,876.31 points while the S&P poured on 1.1% to finish the day on 1,403.58 points.

A faux rally? Time will tell. The greenback slipped against Europe’s currency and will this morning buy you just 0.646 of a euro. It did rise slightly against the British Pound, however, and will buy you 0.5134 as of this writing.

Gold ebbed slightly too, down six bucks to close on $878.90 per ounce and oil to came off the boil a tad. Today you can buy yourself a barrel for June delivery for the bargain basement price of just $123.93.

Until tomorrow…

Cheers,

Joel Bowman
Managing Editor, Rude Awakening