Agora Financial’s Rude Awakening

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Laguna Beach, California

• Selling risk and complexity, buying caution and simplicity,
• America’s financial motto: Look good until you perish,
• “Stay-cationing” in sunny Laguna Beach and plenty more…

Eric Fry, reporting from Laguna Beach, California…

As your editor jogged along the sun-drenched sands of Laguna Beach yesterday, he observed a wide variety of tourists from near and far. In the “far” category, he saw a few Middle Eastern tourists playing volleyball. Some of the women on the court were actually wearing veils while they played…This volleyball fashion might be a little slow to catch on with the locals.

In the “near” category, a large sampling of American accents issued from passersby on the boardwalk. Accents from the South would amble along the boardwalk, followed by accents from the Northeast, followed by accents from I’m-not-really-sure-where. Each group of tourists seemed to be enjoying the brilliant sunshine, and a few of them seemed to be enjoying too much sunshine. During the evening hours, these same sunburned tourists keep the bars and restaurants humming.

These are the “stay-cation” tourists of 2008. Rather than jetting off to distant, foreign locales like Paris or Phuket, they are seeking a few days of R&R right here at home. During your editor’s recent trip to France, he rarely encountered a fellow American. Instead, languages like Russian, Italian, Farsi and Chinese filled the air. During his earlier trips to France, a conspicuously large number of fanny-pack-wearing, water-bottle-toting American tourists would clutter the sideways of the Champs-Elysee and the cobblestones of the Latin Quarter. But this time, nada, nunca, rien. The dollar’s frail physique puts a serious crimp in oversees travel.

Blame the finance sector!

If not for the crazy games that America’s largest banks and brokerage companies played during the last few years, the housing bubble might never have seen the light of day. And if we never had a housing bubble, we would never have gotten a housing bust, or a credit crisis, or a financial sector meltdown, or a bunch of dollar-debasing rescue plans from the Treasury and the Federal Reserve.

But the financial sector DID play its game…and a credit crisis did ensue…and the dollar did plummet. And so, very few vacationing Americans go to Paris, but lots of stay-cationing Americans go to Laguna Beach. So now we ask ourselves, “Is America’s historic credit-crisis-cum-dollar crisis drawing to a close…or will it be writing more history still?”

If we had to guess, we’d guess that there will be a lot of history left to write. The credit crisis is probably not over, at least not for the shareholders of American bank and brokerage stocks. During last month’s Agora Wealth Symposium, your editor took the podium for 40 minutes and offered a few guesses about the history of the credit crisis that remains to be written – the history that lies somewhere in the near future.

In today’s edition of the Rude Awakening, we present a lightly edited excerpt from that presentation.

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The End of Peak Greed – Preparing for the Era of Caution
By Eric J Fry

The Era of Peak Greed is over; the Era of Caution is upon us. That’s not such a bad thing. Caution sounds boring, but it’s not nearly as boring as it sounds. In fact, I think being cautious is kind of an uncelebrated virtue. It’s a little bit like being free of venereal disease. You can’t really brag about it at a cocktail party, but it’s still a pretty darn, good thing at the end of the day…

To illustrate the virtues of caution, allow me to cite the example of Warren Buffett. There’s a story that some of you might know about him. He operated a partnership from the late 1950s until 1969. And that partnership during those 13 years delivered almost a 30% annualized return and made him his first $25 million. What some of you might not know is that he just shut it down one day. He said that he couldn’t find any opportunities to invest in that appealed to him. So he just shut it down and he sent the money back.

He said at the time, “I didn’t know how to be a hero anymore…I had been a Niagara Falls of new ideas. But I became an eyedropper.” Not knowing what to do, he did nothing…and that was brilliant.

This is a slide I showed last year. In fact, I ended my speech last year with this slide:

“Risk comes from not knowing what you’re doing.” – Warren Buffett

I think this quote is more germane this year. In an era of caution, you want to make sure you know what you’re doing. As it turns out, it was very important to HAVE known what you were doing twelve months ago.

The Era of Peak Greed was not so much an era of greed; it was an Era of Peak Stupidity. Lots of people did lots of stupid things. Not just that, they leveraged up their stupid things. So American finance companies embarked on a frenzied borrowing binge and they levered up big time in order to fulfill their corporate mandate, which was to maximize returns to management.

Here’s how bad it got:

A few of us were at a Grant’s Conference in New York in April and David Einhorn spoke. He’s been in the press a lot lately for being negative on Lehman Brothers. And he said: “A few weeks ago, the financial world was presented with the imminent failure of Carlyle Capital Corporation. It had leveraged itself more than thirty to one. The press scoffed about what kind of insanity this was. Who in their right minds would take on such leverage?”

Well, as it turns out, no one in their RIGHT minds would take on such leverage, but everyone on Wall Street took on that kind of leverage. Every investment bank was leveraged more highly than Carlyle, against assets that were inferior to Carlyle’s. So somehow, these highly leveraged balance sheets, offset by various versions of toxic waste, passed for normalcy, passed for prudent investing, passed for prudent stewardship. Everyone was doing it.

But it turns out that operating an insanely leveraged balance sheet is not such a good idea. It turns out that leverage is not a great thing at all in extreme applications…And all of this leveraged stupidity of the last several years was nurtured by the ratings agencies. By Moody’s primarily, and by S&P.

The analysts at Moody’s, despite all their advanced degrees, and their whiz-bang quant models, weren’t any more capable of determining the credit-worthiness of a CDO than a monkey with an abacus. They were unable to quantify what was essentially non-quantifiable. The stuff was just too complicated. And that’s why I never bought a CDO…knowingly…and that’s why I was afraid to buy a banking stock. I just wasn’t smart enough to buy a banking stock. I always kept Buffett’s phrase in my mind that “risk comes from not knowing what you’re doing.”

So to illustrate that point, I also presented this slide last year. It’s from Chuck Prince, the former CEO of Citigroup:

This quote is one of the most remarkable mementoes of the era. Prince uttered these words just a few weeks before last year’s Vancouver conference and he was booted out within three months. I displayed this quote last year and I said, “This is all you really need to know about Citigroup. This is all you need to know about finance in America. This quote!”

And that’s why I urged people one year ago to avoid financials and that’s why I urge people now to avoid the temptation to bottom-fish in this sector…unless you REALLY know what you’re doing. There’s still too much complexity; too many unknowns; and too much downside, potentially, remaining.

I would refer to this recent quote from Charlie Munger:

“Include me out!…A lot of rot has crept into the financial system. We’ve got a lot of scandals coming.”

This is why we are now entering the Era of Caution – not because of what happened during the last twelve months, but because we do not know what will happen during the NEXT twelve months.

What we KNOW is that we are in a period of de-leveraging. DE-leveraging. We are going to reverse what has been happening for the last several years. And this de-leveraging will occur at every level. It will occur in the derivatives markets; it will occur on personal balance sheets; and it will occur on financial balance sheets.

America lives on credit and without it, we will have a hard time. The hard time will be even harder than normal because we have already piled up liabilities that we now have to deal with. The banks are struggling to deal with them. So are a lot of individuals. Here’s another wonderful quote from Charlie Munger:

“One thing about accounting, the liabilities are always 100% good.”

So we’ve got to pay off the liabilities, but without any new credit. That means banks will sell whatever they can, including parts of themselves. Individuals will sell whatever they can, including the roofs over their heads. And both of these activities will depress asset values. We Americans are prepared for no such thing.

We’re dressed in string bikinis, financially speaking. Now I admit, I love string bikinis, but I don’t wear one very often and I certainly wouldn’t wear one on a polar ice-fishing expedition.

This image here is not simply gratuitous, it is also [a metaphor for] the approximate economic model of modern America: Look good until you perish.

So what do we do?

There are a lot of ways to describe the same general idea. I’ll mention a few of them:

Sell risk, buy caution. Sell complexity, buy simplicity. Sell the beneficiaries of discretionary spending, buy the beneficiaries of necessary spending.

To be continued…

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[Rude Endnote: Last, but far from least, remember that Addison and Short Fuse's film, I.O.U.S.A., premiers tomorrow. We had the pleasure of catching the trailer at the inaugural Society of Austrian Economic Thought conference a couple of months back in Vienna. We might have been the only person in the room without a PhD in economics, but we surely were not the only one floored by the sneak preview of the movie. [You can actually see that trailer for yourself right here.]

Then, last month in Vancouver, we caught the entire film at the Agora Financial Investment Symposium. The joint was packed to the rafters and, as you might expect from a group of Agora’s Reserve members, the response was amazing.

Still, getting Rude readers and economics enthusiasts into the theater to see the flick is not enough. The crushing weight of debt in the U.S. (as Addison explained a couple of days ago in a radio interview on WYPR) has reached epic proportions and is something every American needs to be aware of. So, in addition to getting yourself along to see the premier, make sure to grab a mate or two for the ride. You can click here to find a theatre near you.

As an added bonus, Addison has agreed to give each ticket holder a complimentary subscription to Strategic Investment, our flagship investment newsletter usually valued at $99/year.

A few of the smartest guys I know were blown away by this documentary, so I highly recommend you get out and have a look.

Until tomorrow…

Cheers,

Joel Bowman
Rude Awakening

aussiejoel@the-rude-awakening.com