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Shareholders and risk


Paul Kagan asks this question:

You won’t find the names of many of these funds in the published lists of banks’ largest investors, because they’re hidden behind the names of the money management firms they retain to make the actual investment and trading decisions. If nationalization destroys the common stock (and possibly preferred shares) of banks, the money managers may feel the pain, but their public service clients will be the ones wiped out. At year-end 2008, according to Bloomberg, the 100 largest of each of the top 10 banks’ institutional owners, held an average 60% of each bank’s common shares.

Take the case of the Teachers Insurance and Annuity Association-College Retirement Equities Fund

(TIAA-CREF).It manages some $800 billion for over 3.5 million members from more than 15,000 academic and medical institutions. At 12/31/08, TIAA-CREF owned 179 million shares of the Big 10 banks. On average, TIAA-CREF is the 19th largest holder of each of the Big 10 banks. At year-end, these shares were worth a total of $3.7 billion (plus $436 mil. worth of Goldman Sachs (GS) and Morgan Stanley (MS), which I did not include in the Top 10). TIAA-CREF may have lightened the load this year, but, encouraged by Washington’s largesse and lower bank stock prices, it may also have substantially increased several positions, putting it more firmly in the crosshairs of the Beltway’s bank bazooka.

Faculty and doctors, whose retirement funds might be seriously impaired by a “wipeout” of bank shareholders, are hardly alone in this crisis. The Vanguard Group, Capital Research, Wellington Management, T. Rowe Price and countless other caretakers of the public’s wealth have also loaded their portfolios with shares of the caretakers of the public’s savings and checking accounts. While the stockholders of broken companies are traditionally made to pay for the mistakes of their managements, a “mistake” of this scale calls for innovative planning. It makes no sense to sacrifice the nest-eggs of ordinary—and some extraordinary citizens in the name of arbitrary accounting rules. Which brings us to the rest of the story…

Somebody loses in the morass of unknowns of the downturn. The question becomes who, and are the assets so inscrutable that the ‘mark to market’ approach (would force or might force) ? Are any of the rules past and present NOT arbitrary in the sense of some mythical best approach and favoring some group over another? Is the choice more a matter of “economics” or more political preferred interests of one kind or another…there is no free in markets, just different rules.

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Warren Buffet’s annual letter to shareholders

Reader Donald sends us this note on Warren Buffet’s wisdom:

I’ve just finished reading through Warren Buffet’s annual letter to Berkshire-Hathaway shareholders I’ve extracted some general interest stuff below:

… “This debilitating spiral has spurred our government to take massive action. In poker terms, the Treasury and the Fed have gone “all in.” Economic medicine that was previously meted out by the cupful has recently been dispensed by the barrel. These once-unthinkable dosages will almost certainly bring on unwelcome aftereffects. Their precise nature is anyone’s guess, though one likely consequence is an onslaught of inflation. Moreover, major industries have become dependent on Federal assistance, and they will be followed by cities and states bearing mind-boggling requests. Weaning these entities from the public teat will be a political challenge. They won’t leave willingly. …

… “Though the path has not been smooth, our economic system has worked extraordinarily well over time. It has unleashed human potential as no other system has, and it will continue to do so. America’s best days lie ahead. …

… “Some years back our competitors [in purchasing companies] were known as “leveraged-buyout operators.” But LBO became a bad name. … Their new label became “private equity,” a name that turns the facts upside-down: A purchase of a business by these firms almost invariably results in dramatic reductions in the equity portion of the acquiree’s capital structure compared to that previously existing. A number of these acquirees, purchased only two to three years ago, are now in mortal danger because of the debt piled on them by their private-equity buyers. Much of the bank debt is selling below 70¢ on the dollar, and the public debt has taken a far greater beating. The private-equity firms, it should be noted, are not rushing in to inject the equity their wards now desperately need. Instead, they’re keeping their remaining funds very private.

… “Commentary about the current housing crisis often ignores the crucial fact that most foreclosures do not occur because a house is worth less than its mortgage (so-called “upside-down” loans). Rather, foreclosures take place because borrowers can’t pay the monthly payment that they agreed to pay. Homeowners who have made a meaningful down-payment – derived from savings and not from other borrowing – seldom walk away from a primary residence simply because its value today is less than the mortgage. Instead, they walk when they can’t make the monthly payments.

… “This unprecedented “spread” in the cost of money makes it unprofitable for any lender who doesn’t enjoy government-guaranteed funds to go up against those with a favored status. Government is determining the “haves” and “have-nots.” That is why companies are rushing to convert to bank holding companies, not a course feasible for Berkshire.

… [re why insured bonds will have different default characteristics than uninsured bonds] “Local governments are going to face far tougher fiscal problems in the future than they have to date. The pension liabilities I talked about in last year’s report will be a huge contributor to these woes. Many cities and states were surely horrified when they inspected the status of their funding at yearend 2008. The gap between assets and a realistic actuarial valuation of present liabilities is simply staggering.
When faced with large revenue shortfalls, communities that have all of their bonds insured will be more prone to develop “solutions” less favorable to bondholders than those communities that have uninsured bonds held by local banks and residents. Losses in the tax-exempt arena, when they come, are also likely to be highly correlated among issuers. If a few communities stiff their creditors and get away with it, the chance that others will follow in their footsteps will grow. What mayor or city council is going to choose pain to local citizens in the form of major tax increases over pain to a far-away bond insurer?

… “Clinging to cash equivalents or long-term government bonds at present yields is almost certainly a terrible policy if continued for long. Holders of these instruments, of course, have felt increasingly comfortable – in fact, almost smug – in following this policy as financial turmoil has mounted. They regard their judgment confirmed when they hear commentators proclaim “cash is king,” even though that wonderful cash is earning close to nothing and will surely find its purchasing power eroded over time.

… “Improved “transparency” – a favorite remedy of politicians, commentators and financial regulators for averting future train wrecks – won’t cure the problems that derivatives pose. I know of no reporting mechanism that would come close to describing and measuring the risks in a huge and complex portfolio of derivatives. Auditors can’t audit these contracts, and regulators can’t regulate them. …

… “Sleeping around, to continue our metaphor, can actually be useful for large derivatives dealers because it assures them government aid if trouble hits. In other words, only companies having problems that can infect the entire neighborhood – I won’t mention names – are certain to become a concern of the state (an outcome, I’m sad to say, that is proper). From this irritating reality comes The First Law of Corporate Survival for ambitious CEOs who pile on leverage and run large and unfathomable derivatives books: Modest incompetence simply won’t do; it’s mindboggling screw-ups that are required.”

There’s plenty more including some material on Black-Scholes pricing which I doubt I could summarize if I understood it — which I don’t. That’s on page 20-21 for the perusal of anyone who is interested. I think Buffett is saying that he is using Black-Scholes because he is expected to, but that some of the results seem pretty unlikely to him.

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