Table of Contents Title Page Copyright Page Epigraph Preface Acknowledgements Chapter - An Unanswered Invitation Chapter - Lunch with Warren Chapter - The Prairie Princes versus the Princes of Darkness Chapter - The Insatiable Curiosity to Know Nothing Worth Knowing (Oscar Wilde Chapter - MAD Mortgages—The “Great” Against the Powerless Chapter - Shell Games (Beware of Geeks Bearing Grifts) Chapter - Financial Astrology—AAA Falling Stars Chapter - Bear Market (I’d Like a Review of the Bidding) Chapter - Dead Man’s Curve Chapter 10 - Bazooka Hank and Dread Reckoning (AIG, Fannie, Freddie, Lehman, Chapter 11 - Bond Insurance Burns Main Street Chapter 12 - Money, Money, Money (Warren and Washington) Chapter 13 - The Fogs of War, Religion, and Politics Chapter 14 - Finding Value Notes Bibliography Index Copyright © 2009 by Janet M Tavakoli All rights reserved Published by John Wiley & Sons, Inc., Hoboken, New Jersey Published simultaneously in Canada No part of this publication may be 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Congress Cataloging-in-Publication Data: Tavakoli, Janet M Dear Mr Buffet: what an investor learns 1,269 miles from Wall Street / Janet M.Tavakoli p cm Includes bibliographical references and index eISBN : 978-0-470-44273-9 Investments—Decision making Investment analysis Financial risk management Value Buffett,Warren Berkshire Hathaway Inc Tavakoli, Janet M I Title HG4521.T34 2009 332.6-dc22 2008035055 332.6—dc22 2008035055 Nobody was ever made by him [Claudius Maximus] to feel inferior, yet none could have presumed to challenge his preeminence He was also the possessor of an agreeable sense of humor —Marcus Aurelius Preface In 2003, I moved from London to Chicago, my original hometown, and founded a finance consulting firm,Tavakoli Structured Finance, Inc Sophisticated financial institutions call me when they have trouble understanding complex financial products, and in recent years, the products have exploded in size and complexity They also call me when they fight with each other over these products As a result, my firm is a lightning rod for the myriad problems facing the credit markets My client list is short and elite, and in one way or another, most of my business comes from my former employers I created a niche business at the right time Structured finance birthed a plethora of new products with acronyms such as ABS, MBS, CDO, and CMO, among other alphabet combinations Reporters and television networks frequently ask me to make sense of market madness I’ve made repeat television appearances—CNN, CNBC, BNN (Canada’s Business News Network), CBS Evening News, Bloomberg TV, and First Business Morning News—on where I’ve frequently predicted problems long before the market or even the Federal Reserve acknowledged them I’ve been quoted in major financial publications including the Wall Street Journal, the Financial Times, BusinessWeek, Forbes, Fortune and Investors Dealers’ Digest (among others) in which I was often the first to publicly and specifically challenge major financial institutions, the Federal Reserve Bank, and the major rating agencies: Moody’s Corporation (Moody’s); Standard & Poor’s (S&P), part of the McGraw-Hill Companies, Inc.; and Fitch, owned by France-based Fimalac SA Beginning in 1985, I worked for various Wall Street firms in New York and London These included Salomon Brothers (now part of Citigroup), Bank One and Bear Stearns (both now part of JPMorgan Chase), Goldman Sachs, Merrill Lynch, and others I chiefly worked on trading floors, and most of my colleagues were men My career travels took me to New York, Japan, continental Europe, and England I traded, structured and sold complex financial instruments Although I often held management jobs, I was chiefly a hired gun; I took the jobs others considered too new or too difficult I wrote finance books well known to users of esoteric financial products with tongue-twisting names such as credit derivatives and collateralized debt obligations Ten years ago, these products were limited to a small group, but now these products pose hot-button issues for investors ranging from very sophisticated banks to near-retail clients including local governments, small pension funds, and condominium associations I wrote articles for major financial publications explaining problems in structured finance and warned that it would not end well I predicted the mortgage meltdown, the global credit bubble, and the collapse of investments backed by unwise mortgage loans I warned about the risks of hedge funds using leverage including Long-Term Capital Management (LTCM).While the rest of the financial community tripped over themselves to extend LTCM credit (and later regretted it), I recommended cutting their credit Along the way, I acquired fans and a few groupies At a Washington D.C conference, a woman approached me in the ladies room to ask me to sign a blank sheet of paper, just to have my autograph At a New York conference, an attendee from the Netherlands asked me to sign an extra book he had packed for his absent colleague, a fan who could not make the trip to New York As I was finalizing paperwork at my doctor’s office in Chicago, a man standing at the counter said: “Tavakoli? Are you the lady who wrote the credit derivatives book?” I stumbled upon a career in finance My parents met near the end of World War II, during which my mother’s brother was killed after parachuting into Normandy My Wisconsin-born father was chief of surgical services tending wounded soldiers in the Central Europe and Rhineland campaigns My mother, who hailed from Buffalo, nursed burn victims in England They met through mutual friends and returned to Chicago to raise a large family My father had worked his way through medical school at Jesuit-run Loyola University during the first half of the last century, when well-educated adults were expected to be well-read polymaths He died when I was 12, and during the summers of my teenage years, I read his collection of books, including texts about medicine, mathematics, Greek philosophy, history, and poetry My father had read the Wall Street Journal every day, but after he died, my mother had not kept up the subscription I was interested in finance, but I did not yet know much about it I graduated with a B.S in chemical engineering from the Illinois Institute of Technology, and got married five days after graduation I worked as a chemical engineer, and a couple of years later (in 1978), I moved to Iran with my Iranian (and now ex-) husband Our timing couldn’t have been worse Six months after we arrived, Iranians deposed the Shah, and the Ayatollah Khomeini returned to lead an anti-American, repressive theocratic government I returned to the United States carrying one suitcase of clothing and $1,000 My husband remained in Iran with his wealthy family He returned to the United States a few years later to start a business with his father’s help, but by then, he was my ex-husband I had lost my possessions and savings, but my true wealth is portable and remained on my shoulders I worked as an engineer by day and received an MBA from the University of Chicago’s Graduate School of Business night program, where I later taught derivatives part time Just because one is an expert in complicated financial products like derivatives, it does not mean one is good at value investing (But it doesn’t mean one is bad at it, either.) Although I had read a lot on the subject of value investing, I had not really absorbed it, and I had not diligently practiced it when making investments for my personal portfolio Then I took a trip to a city 1,269 miles from Wall Street, and my perspective changed Harry Truman once said: “The only thing new is the history you don’t know.” I thought I knew a lot, until I met Warren Buffett In June 2005, I received a letter from Warren Buffett inviting me to visit him in Omaha A few years earlier, I had sent him a copy of a book I wrote on credit derivatives with a letter stuffed between the pages It was a pleasure to receive his invitation; but I delayed in business size collateral, usage employees, payment index investing capabilities investment bank bailout, impact investment strategy leverage/luck, bet location misrepresentations (Buffett/Munger) number, increase offshore location outcomes, uncertainty overleveraging proprietary model strategies, overcrowding (impact) structured products, usage wisdom Hedges, total return swaps (usage) Hedgie heroes Hennessee, Lee Highly rated products, Graham advocacy Hilder, David Historical data, statistical analyses (performing) Hockenberry, John Hoffman, Dustin Hold-to-maturity portfolios Home equity loans,Wells Fargo portfolio Homeowner equity (refinance encouragement), no-cost loans (usage) Hudson,Tom Hudson United, mortgage-backed CDO sale (attempt) Hufschmid, Hans Hughes, Howard I Immelt, Jeffrey (Sarbanes-Oxley complaints) Implode-o-Meter, usage Independent National Mortgage (IndyMac), Countrywide setup Indirect mortgage lenders Infiniti Capital, fund of funds Influence (Cialdini) Innumeracy (Paulos) Insurance companies, options (relationship) Intelligent Investor,The (Graham) Interest-only (IO) mortgage loans Interest rates, low level (Federal Reserve impact) International Monetary Fund (IMF), losses (estimate) International Swaps and Derivatives Association (ISDA), credit default swap documents (modification) Investment banking products, opacity probability Investment banks assets, market prices display (avoidance) losses prime brokers, hedge fund impact structured product prices, challenge trades underwriters, due diligence (responsibility) unsold CDOs write-downs Investors capital, manager self-interest (impact) safety, protection Iran Mohammed descendants tensions Iraq Study Group Report,The Iraq War, dollar cost Irrational hype Israel Lebanon, war tensions Israel III, Samuel (guilty charge) J Jain, Ajit Jefferson,Thomas James, LeBron Jenkins, Jr., Holman W Jesus Jones, A.W Jones, Paul Tudor (success) JPMorgan Chase Junk debt rating, rating agency problems Junk economics JWM Partners LLC, initiation K Kahneman, Daniel Kaplanis, Costas/Evi Kennedy,Ted (Edward Moore) Kernen, Joe Keynes, John Maynard Khameini, Ali Knight, Michael Khomeini, Ruhollah Khodorkovsky, Mikhail (imprisonment) Koch, Ed Kotok, David Kozlowski, Dennis L./Karen Kravis, Henry Kresa, Ken Krowne, Aaron Kurdistan Workers Party (PKK), insurgency L Ladreit de Lacharriere, Marc Lacker, Jeffrey M Lane, Jeffrey Laffer, Arthur Lampert, Edward Lawrence.H Lee, Jr., James Lehman Brothers Holding Inc accounting, Einhorn questions assistance, Fed refusal failure, Fed relationship financial report, examination losses, announcement money movement Leverage averages, problems usage Leveraged bets, popularity Leveraged Investment Group (LIG), conflicts of interest Levitt, Arthur (Consumer Deception Award) Levy, Harlan Lewis, Ken Lewis, Michael Liar’s Poker (Lewis) training class Lie, Eric Lipper Convertibles Investment Partnership, lawsuit Loans early post-signing defaults payments, servicer collection/ recordation problems, gravity Lockhart, James B problems Long position, short position, historical relationships Long-Term Capital Management (LTCM) bailout bid (Goldman Sachs/AIG) Buffett bid, refusal dollar investment excuse fundraising performance, Berkshire Hathaway performance (contrast) rejected bid (Buffett) Lowenstein, Roger Low-fee index funds, purchase (ability) M Madigan, Lisa (lawsuit) Major, John Mandelbrot, Benoit fractal finance gray swan Manufactured housing industry, consumer financing practices Marcus, Magen Margin call Marin, Richard blog writing Marino, Daniel (guilty charge) Markowitz, Harry Mark-to-management estimates Mark-to-market accounting, value Mark-to-model, usage Mark-to-myth, usage Marquez, James Martin, Judith Martin, Steve MBIA capital, raising securities McLean, Bethany McNamara, Robert Strange McVeigh,Timothy Mead, Scott Meissner,W Melcher, Jim CNBC appearance Merger and acquisition (M&A) opportunities Meriwether, John Merrill Lynch collateral, seizure O’Neal relationship Merton, Robert Miller, Bill Mindich, Eric (Eton Park Capital Management) Minority homeownership bad lending, excuse increase (Bush announcement) Mitchell, Edson Moffett, David Mohammed, Islam founder Molinaro, Sam (CNBC appearance) Money definition government, impact types Money market funds, ratings reliance Money market securities, pension fund investments Montag,Tom, Monte Carlo models, investment bank usage Monte Carlo simulation, usage Moody’s Corporation (rating agency) Berkshire Hathaway shares, ownership problems rating awards Morali,Veronique Morgan Stanley Mortgage borrowers (rights), defense (state inability) Mortgage broker, objectivity Mortgage companies, fees (problems) Mortgage lenders fees, siphoning loans, takebacks (obligation) Mortgage lending crisis, swindle Mortgage-related assets, Fed acceptance Mortgages direct/indirect taxpayer costs losses, increase meltdown modification, preference overdue, timing re-aging Moses, Jennifer Mozer, Paul Mozilo, Angelo lawsuit Mozilo, Eric Mr Market, manic depressiveness Mullins, David Munger, Charlie earnings Gen Re value, realization Gutfreund rescue intrinsic value, increase leverage, avoidance stock options, absence tax efficient average annual return Municipal bonds, bond insurer guarantees Murphy, Tom Mussaddiq Mohammad Mutually assured destruction (MAD) N Naked Shorts (Newton) National Recognized Statistical Rating Organizations (NRSRO) designation revocation Negative amortizing ARM, problems New Century Capital Corp Bear Stearns, relationship credit lines, disappearance loans shares, decline New Century Financial Corporation, fraud/bankruptcy Newton, Greg Ng, Serena NINA program NINJA loan No-cost loan, nonexistence Nonbank investment banks, protection Nonbank primary dealers, protection Non-Fannie Mae/Freddie Mac securitizations, purchase No-Ratio program Norris, Floyd O Oakwood Homes Berkshire Hathaway loss Credit Suisse lawsuits Off balance sheet vehicles, hidden risks Office of Federal Housing Enterprise Oversight (OFHEO) Office of Thrift Supervision (OTS), impact O’Leary, Kevin Old Lane Partners Olick, Diana O’Neal, Stan problems Wall Street Journal opinion piece O’Neill, Paul Onaran,Yalman Open Source, usage Operation Malicious Mortgage, mortgage fraud cases Option ARMs negative amortization, allowance product, toxicity Options holders, backdating advantage pricing model, corporation usage value manipulation Othmer, Donald/Mildred Outcomes, discovery Ownit Mortgage Solutions arms-length transaction implosion Merrill Lynch (part-owner) P Pahlavi, Reza Pallotta, James Pandit,Vikram Parmalat, scandal Parseghian, Greg Partridge-Hicks, Stephen Patel, Beejal Patton, George S Paulos, John Allen Paulson, Jr., Henry Merrit FNMA/FHLMC purchase request shares purchase, authority Paulson, John Bear Stearns credit default swaps statement collateral prediction U.S housing market bet Paulson Plan Pay option ARM, problems Peloton Partners ABS fund credit derivatives, usage failure demise Eurohedge, fixed income fund of the year award hedge fund, cessation leverage problems loans, delinquencies Multi-strategy fund contribution pledged assets, balance problems Pension funds, ratings reliance Pershing Square Foundation, personal gains donation Personal History (Graham) Personal returns, health Phallic narcissist (defined) Philadelphia Contributorship, Franklin initiation Pickens,T Boone Piggyback loans, principal losses Pimco Total Return Fund, default guarantees (sale) Planned Parenthood, Buffett support Plosser, Charles I Pluralistic ignorance Plus Funds Ponzi scheme Poole,William (St Louis Fed Reserve) statement Poor Charlie’s Almanack (Munger) Portfolio insurance catastrophe (1987) dynamic hedging Predatory loans, predatory securitization Premium money, usage Prime brokers, hedge funds services Prime loans, default rate Probabilities, human assessment (problem) Protége Partners LLC hedge funds, Buffett challenge Proxmire,William Prudent lending Publicly traded shares, sale Pulliam, Susan Q Quantitative hedge fund (quant fund) models claims usage Quick, Becky Quintanilla, Carl R Random events, explanation Rapid dominance, strategy Rappa, Ed Raptor Global Fund management Rating agencies financial astrology junk science, practice market foregiveness methodology, problems models, risk (moral hazard) problems reliance, absence replacement, problem Reagan, Ronald (Buffett similarity) Recession, definition Recovery rate, guess Redlining, illegality Regulators, ineffectiveness Reich, John Reilly, Dave Residential mortgage-backed securities (RMBSs) portfolio, loan purchases portfolio value, loss risk levels tranches, usage ResMae Mortgage Corporation, bankruptcy Revenue enhancement, leverage (usage) Reverse redlining, illegality Ricci, Matteo (memory palace) Ricciardi, Chris Rigas, John/Timothy (fraud/ conspiracy) Risk, underwriting (profit) Risk-free return, lockin Risk-neutral fully-hedged position “Rocking-Horse Winner,The” (Lawrence) Rogers, James B wealth, perspective Rose, Charlie Rosenberg, Jeffrey Rubinstein, David Lee, Jr., warning Russell, Bertrand R.W Pressprich & Co S Salomon Brothers, preferred stock Sandford C Bernstein, Inc (mutual fund performance results) Sarbanes-Oxley, business impact Savage, Sam Scalia, Antonin Scholes, Myron Schultz, George P Schumer, Charles E Schwartz, Alan CNBC interview Schwartzenegger, Arnold Securities, sale (backing) Securities Act of 1933, Regulation D, Securities and Exchange Commission (SEC) Securitization markets, fraud (potential) practices, deception SFAS 123R, FASB adoption Shareholders, executive duty (breach) Sheehan, John/Peggy Shenn, Jody Simonides, earthquake survivor Simons, Jim (earnings) Sinha, Gyan Smartest Guys in the Room,The (McLean/Elkind) Society of Jesus, founding Soft dollars, usage Soros, George South American debt crisis (1980s) Spanish Prisoner, The Spector,Warren Bear Stearns stock, sale job loss Speculator, Graham definition Spitzer, Eliot OCC attack scandal Springfield Finance Control Board, claims St Ignatius, psychobiography St Louis Federal Reserve Bank report Stagflation Stallone, Sylvester Standard & Poor’s (rating agency) CPDO ratings ratings, defense Stated income, stated assets (SISA) program Statistics Stempel, Jonathan Stewart, Jon Stock asset value, trading purchase, Graham advocacy Stock index fund portfolio, investment Stockman, David Stock market technology bubble, collapse Stock options (call options) backdaters, compensation backdating, data patterns benign intent corporation marking employee option exercise moral hazard strike price Strategos Capital Management default Structured finance ratings, problems Structured financial products, risk (misunderstanding) Structured investment vehicles (SIVs) collateral, downgrades Subprime-backed investments, shorting Subprime foreclosures, moratorium/ mortgage restructurings (advocacy) Subprime lenders, exposures (writedowns) Subprime loans, default rate Subordination Subprime mortgage loans, outstanding loans Subprime-related losses, Bloomberg tracking Subprime residential home equity loan, delinquencies/downgrading Subprime sector, recovery rates (overestimation) Sugrue, Chris Refco money, lending Suitability, application Super catastrophe (super-cat) business Survivorship bias, returns distortion Swartz, Mark Swensen, David Synthetic CDOs (hedging), credit derivatives (usage) Synthetic CDO-squared, toxicity Syron, Richard T Taleb, Nassim, Nicholas (black swan) (conditional probabilities) Tamraz, Cathy Baron Tannin, Matthew Cioffi electronic exchanges indictment TASS, net returns (decrease) Tavakoli, Janet M Buffett Rule critical mass Tavakoli’s Law, statement Theory of Everything in Finance Technology bubble Term Securities Lending Facility (TSLF), Carlyle creation Thain, John IPO origination, information Theory of Investment Value, The (Williams) Thermopylae, battle Third-party assumptions, usage Third-party valuations, occurrence Third World Conference Thrift crisis (1980s) Tillman,Vickie Tilson,Whitney Tobias, Andrew Total return BRKA, growth/value managers (contrast) Total return swaps, usage Tranches, trading Transparency, Sarbanes-Oxley promotion Tricadia Trust, restoration Tudor Investment Corporation, Pallotta management Tug of War (Erdman) Tversky, Amos 2/28 hybrid ARM, fixed interest payment amount U Undercapitalized managers, impact Union Fire Company, Franklin initiation United Nations Security Council, Resolution United States, Iran suspicions United States Department of Housing and Urgan Development (HUD) problems Unobservable inputs, usage Unwinding the position Upside down mortgage (defined) U.S subprime losses, IMF estimates V Value destruction, permanency Value opportunities, Buffett search Vanderbilt Mortgage Volatility, control W Wachovia Wald, Jonathan Waldorf, Michael Wall Street Journal, Buffett appreciation Washington Mutual (Wa Mu) Welch, Jack Wells Fargo West, Mae Wertheimer, Eitan Wertheimer, Ariel Wertheimer, Stef When Genius Failed (Lowenstein) Whim of Iron (Marin blog) Whitney, Meredith Why We Fight Wighton, David Williams, John Burr Willis, Gerri Winston, Harry WorldCom, scandal Wright, Kirk Y Yale Endowment, private equity investments Yield spread premium Young, Donald Z Zero subprime-backed investments, Gordian Knot purchase ... Cataloging-in-Publication Data: Tavakoli, Janet M Dear Mr Buffet: what an investor learns 1,269 miles from Wall Street / Janet M .Tavakoli p cm Includes bibliographical references and index eISBN : 97 8-0 -4 7 0-4 427 3-9 ... Chapter - Dead Man’s Curve Chapter 10 - Bazooka Hank and Dread Reckoning (AIG, Fannie, Freddie, Lehman, Chapter 11 - Bond Insurance Burns Main Street Chapter 12 - Money, Money, Money (Warren and... my Iranian (and now ex-) husband Our timing couldn’t have been worse Six months after we arrived, Iranians deposed the Shah, and the Ayatollah Khomeini returned to lead an anti-American, repressive