Thoughts on a Chaotic Market

Today I choose to write about something that I don’t know.

I cannot, nor can anyone, predict what this turbulent market will do in the short term. The nonsense that is going on in the lending industry may turn in to a complete catastrophe, or it may blow over and we will be able to return to our normal everyday investing lives. Nobody knows. That much I do know.

It has been an unusually wild and unpleasant ride recently and this will undoubtedly cause some to panic. I am not among those. I have a portfolio of very strong companies that, barring any widespread contagion of historic proportions, are completely removed from the subprime lending market. Nonetheless, as all the worrywarts are reminding us, the problem could spread to other areas of the economy, credit could dry up and I may indeed suffer severe losses as a result. But I have no business selling my stakes in such strong businesses merely on this speculation.

However there is one specific and valuable lesson I have gleaned from this mess: Judging the strength of a financial institution is extremely difficult, if not impossible, for an individual to do well. In fact, many analysts and institutions probably face the same difficulty. Moreover, before I invest in any business, I must understand it. And if you can’t understand it, you shouldn’t be investing in it. I suggest that the investors who have gotten burned the most did not understand their businesses well enough. They couldn't have.

How was I to know the vulnerability of New Century Financial’s loan portfolio to a sudden adjustment of ARMs? I wasn’t. How could I have known that American Home Mortgage would suddenly announce it was liquidating? I couldn’t. Anyone who did know was on the inside. Consequently, everyone on the outside – not just the little guys but big institutions as well – got slammed in one brutal press release.

The truth is that banks, mortgage REITs, and even insurance companies have very opaque financials. Unless I am the loan officer that sees the credit report and 1040 of the nice couple that walked in to my office wanting to buy a house, how am I to know, realistically, the likelihood that they will default? I claim that I really cannot. Nor can I really gauge the underwriting discipline of an insurer with the information available to me. Sure, banks have standards and algorithms on which they base lending decisions. And the holding companies have historical default rates and CAMELS ratings to report to their regulators, but how well does this convey to the investor how strong the loan portfolio really is? I claim that it doesn’t do it very well.

And so, as I see it, the investor is left with three options. We can rely on management reports and judge the company on the basis of those reports. Taking this approach devastated the AHM investor, and I guess that is the one piece of wisdom to take away from this fiasco. Or, the investor could invest in only huge banks, i.e. Citigroup, JP Morgan etc., whose mere size all but guarantees adequate diversification.

Alternatively, we can take the faith approach. Investing in a bank with well-respected and responsible management, say perhaps Wells Fargo, would have left the WFC investor unscathed. If I really trust these folks to do what is best for the company in the long-term, then I needn’t worry quite so much.

I realize this is a simplification of the issue, since all such financial institutions are inescapably intertwined and they all rely on each other for liquidity, but the choice among these approaches could mean the difference between complete disaster and only moderate losses. And judging management is no easy task itself. So I guess I haven’t really provided any sort of solution to this fiasco, but that’s because I don’t have one. Just a few thoughts for consideration.

FD: I have no position in any company mentioned in this post.