Stupid/brilliant investment move

Warren Buffet has some great guidance on stock investing: "Be fearful when others are greedy, and be greedy when others are fearful."

I'm pretty sure that the bank crisis is overstated, or, at least financial stocks are oversold. There will surely be more carnage like Bear Stearns, but I think there's a few companies with broad enough financial bases that with time will bounce back.

With that in mind, last week I took some fun money and invested it in extremely risky bank securities. I bought Jan 2010 LEAPs on Bank of America and AIG. My total investment in each is less than $750, but because of the nature of the options, I control 400 shares of stock in the two companies(total).

(Specifically, the Bank of America LEAPs (-WBAAA) have a strike price of $27.50. The options cost me $7.41 to buy, while BoA shares trade at $23.24. So, I win if BoA reaches $35/share by January, 2010. That would require a 50% increase in BoA's stock price, but consider that BoA was trading at $35 earlier this month, and was $50 a year ago.

I'm not sure if these specific investments will pay off. (They sure haven't yet, as they're already down 50% and 36%, respectively), but I intend to make a few more buys like this through the end of the year. My next purchases will be an S&P500 index, and a bank stock index.

I'm inspired to do this by two things:

1) the stories of folks who bought securities at the bottom of the Great Depression for pennies on the dollar. These turned out to be very prudent investments.

2) knowledge that while economic conditions are temporarily not favorable in America (and worse so in Europe), there are emerging markets where demand is increasing as locals escape poverty or climb the economic ladder. Whereas demand slumped worldwide during the Great Depression, there is no stopping the growth of the middle class in China. (For example.)

Plus, the American economy is still a good long term "buy and hold" opportunity. But don't take my word on it. Listen to Warren Buffet, who is buying.

Explaining the mortgage mess

Someone just asked me to try to explain the current mortgage mess. Here's my attempt at a neutral, simple explanation:


1. in order to underwrite (sell) a new mortgage loan security (a bond that is really a bundle of similar mortgages), sometimes the bankers behind them offer a default guarantee. An unguaranteed mortgage bond might have a 10% interest rate, but with a default guarantee, it might only need to be, say, 7%. It wasn't always the practice guarantee mortgage bonds, but banks like the fee income they could take from underwriting.

The biggest guarantors of mortgage loans are Fannie and Freddie. The positive spin is that by making guarantees, the cost of borrowing is lower for most Americans. The negative spin is that Fan and Fred have been gobbling risk for decades (with the US taxpayer underwriting their activities), while Fan and Fred shareholders received the profits. The Fan/Fred maneuver 2 weeks ago is basically the US taxpayer stepping up to pay for Fan/Fred's default guarantees.


2. The banks protected themselves from default by swapping their default guarantees among themselves. In other words, if Lehman made a guarantee on $100M in mortgage bonds, they might trade half of that guarantee to AIG, for a quarter of the default risk on their separate $200M car loan bond issuance. (They trade more than just $$$ amounts of risk. For example, a California mortgage bank might sell California home mortgage loan risk in exchange for NYC commercial mortgage loan risk, with the thought that spreading risk further insulates the loan originator.)

3. This whole system is dependent on things continuing as usual - that default rates stay within historical averages. That lets each risk swapper accurately price what's been swapped.

Turns out, in the rush to issue mortgages, some borrowers were given too much credit, and some rated much higher than they should have. These people have been unable to cover their mortgage loans, leading to defaults.


4. With mortgage defaults rising, all of the math underlying the default guarantees has gone to h3ll, and some bond guarantees are being called on. (some default guarantees aren't even being called and are still wreaking havoc, as accountants adjust the value on the books of troubled bonds down, and increase the (expected) liabilities of the guarantees. Banks need to keep a certain amount of capital in reserve for these situations, and the amount of required reserves is rising as a result. Money "reserved" by banks to meet requirements is money that really can't be used for investment. The result: less investment capital available for everyone. (Why this matters, pt. 1))

5. Some finance companies (Bear Stearns, Lehman) don't have the capital to make good on their guarantees, and they're going out of business. Other companies like AIG are feverishly trying to get more capital.

6. Why this really matters (pt 2.): in many ways, the finance world still operates on little more than a handshake (because the volume of transactions prohibits you from getting full legal paperwork done for every deal including regular settling of trades.). Many transactions rely on both sides believing that the other will still be around tomorrow, but now everyone is questioning everybody else, gumming up the system, and ultimately making transactions more expensive (in many different ways, including making a new mortgage for you or me more expensive), and hurting the economy.

7. If the problem described above were limited to a few companies or even just one sector (like home loans), the reaction would probably be "let 'em fail," but there's 2 larger issues that are also in consideration: 1) the mortgage default rate problem has creeped into other credit (financial) markets, such as auto loans and student loans. (As some consumers are swamped by their mortgage rate adjusting higher, they're defaulting on credit cards, car loans, etc.) The result of the problem creep: all financing is getting more expensive and more rare. Good companies with nothing to do with the financial mess are having a hard time getting loans and investment capital. and #2) investors (particularly foreign investors) are loosing faith in US markets, and demanding a risk premium on investments in the US. This hurts our economy in the short term, and makes it really hard to finance our national deficit. This difficulty is magnified by the weak dollar. (Though the dollar has been strengthening recently.)

Feel free to lob me any follow-up questions...