I concede defeat, on to Twitter

Turns out when I'm not ingesting oxycodone by the handful and flat on my back recovering from ACL surgery I don't have the patience to blog. I also happen to be terrible at proofreading which is glaringly apparent when I reread some of what I've written.

So, from now on I tweet and will only write a blog post when something thing really gets me going. Tweeting is highly conducive to people with short attention spans and many random thoughts.

Paulson and the Chinese Fraud

Over the past three weeks, Sino Forest Corporation, a Chinese company which "manages" forest land in China and produces various wood products through subsidiaries has fallen from $20 to less than $2 a share. A research and investment firm, Muddy Waters Research, which specializes in "shorting" Chinese stocks (betting that the share price will fall rather than rise over time) published an extensive report detailing what they believe to be a pervasive fraud committed by the company's management.

Caught in the middle of this was John Paulson, a hedge fund manager famous for making $3-4 billion shorting the housing market in 2007-2008. His firm, Paulson & Co., reportedly lost more than $750M when they exited their investment in the debt and equity of Sino Forest Corp. yesterday. Though this should make liberals and tea partiers alike estatic (just rewards for fat cat bankers and all that), I think there are two lessons to be drawn from this incident.

First, China is far from a developed nation in terms of accounting and capital controls. If Muddy Waters Research is correct, the fairly obvious fraud has existed since the mid-1990s. Further, Western accounting firms are easily fooled by Chinese management. Ernst & Young, one of the "Big Four" accounting firms was the company's auditor, and several former partners served on the company board. This fraud was not Enron-esque, it was fairly simple and it speaks volumes that the company board's oversight failed. Makes you wonder if they all knew and that's why the company was never listed in the United States in order to avoid potential criminal charges for the Western board members.

Second, Paulson & Co. seems to have grown so large that it is unable to conduct proper due diligence on its investments. With $30 billion under management and 8 separate funds, the former smarter guys in the room may just be unable to find and validate enough investments to made an adequate return. You see this same effect in mutual funds where performance begins to lag as the size of the fund grows. Yet another reason why the vast majority of Americans should be using ETFs for their investments. They are cheap and remove the investor from the business of trying to find a good manager for their money.

Update: Paulson actually lost $468M

Are Gold and Silver the New Beanie Babies?

I have a perverse interest in reading about crazy people, whether serial killers or end of the world types. One group which has interested me over the past 2.5 years are the gold and silver bugs. They fervently believe that fiat currencies around the world will collapse when hyper-inflation strikes leading to the re-introduction of the gold or silver standard.

The predictions for future gold prices are insane and arbitrary. One blogger/investor thinks $5000 an ounce is logical given the current price of $1500. Though old, this forum on burying gold in your backyard is good for a giggle.

All of that brings me to the conspiracy theory about the financial terrorists at J.P. Morgan being short 3.3 billion ounces of silver. While obviously a farce, the story is popular among gold and silver bugs. A blogger, Kid Dynamite, did a good job of explaining why the massive JP Morgan silver short was a hoax.

My own personal opinion is that people are going to lose their shirts on gold and silver. Gold has zero value beyond that which another buyer assigns to it. It pays no dividends and is not used for any industrial purpose. In fact, it's one of the few assets with a guaranteed negative cash flow (excluding sale) due to the costs of storage.

NY Times on paying off your mortgage

I wrote a post on this last year, but the New York Times did a much better job recently covering the story. Not surprisingly they have better writers on staff, even if they tend to report misleading or incorrect information occasionally.

I still don't understand the psychological value of paying off your home as the article talked about. It confuses me that people wish to have a significant portion of their wealth tied up in an asset which is very illiquid and and has historically low growth potential. (Click on the link for seasonally adjusted home price index levels)

Casino War

I recently finished a road trip to California, likely the last road trip involving driving through West Texas, New Mexico, Nevada, and Arizona I will ever do. We did, however, stop in Las Vegas where I made the monumental mistake of booking a room in a hotel off the strip. Redemption came in trying out a well-reviewed tapas restaurant in the Cosmopolitan Hotel and Casino next door to City Center.

After dinner I walked through the casino floor and stop to watch some inebriated people do their best to lose money playing War. Yes, that's right, can you bet on the game you used to play as a 5 year old when it was raining outside and your evil parents wouldn't let watch TV. Considering the odds, it's an even worse game to play than roulette.

Speaking of roulette, being in Vegas reminded me of one of my favorite human interest stories, Ashley Revell, who bet his life savings on a single spin of the wheel and won $135K in 2004.

Book Review: Obama's Wars

I read quite a bit, though my interest is highly concentrated in history, finance, current events, and derivations on those three subjects. I usually go through 1-2 books a week depending on my reading load for classes, and one of the challenges is remembering what the key points that I learn in each book. Since I've been a lazy blogger, I'll start trying to do a quick synopsis of each book here. 

I recently finished Obama's Wars by Bob Woodward. For those of you who don't know the name, he's one of the more famous investigative journalists of our era and was at the center of the Watergate scandal. The book is a narrative of the national security council's actions/thought process as they develop Obama's strategy for Afghanistan which was later announced in a speech at West Point on 01 December 2009.

As with any Woodward book, Obama's War does not seek to do more than simply record what happened. There's little analysis by the author, which may be just as well considering the subject matter. The most astonishing aspect of the Afghanistan saga is the degree of petty behavior exhibited among those who should represent the best of their respective fields. In every one of Woodward's books, senior military officers and Pentagon officials appear to consider their duty to country a distant second to their own parochial interests. General Petraeus, the former commander of CENTCOM and current commander of the fight in Afghanistan, as well as Admiral Mullen appear to brazenly defy the President's wishes on a number of key strategic issues, not least of which is providing neutral advise. 

The difficulty in evaluating in the actions of individuals within the story is that Woodward is well known for playing favorites. Certain individuals receive very complimentary portrayals based upon what appears to be their assistance to Mr. Woodward. That Petraeus is viewed in a less than positive light in this most recent book after Woodward's glowing reviews in four previous books should tell you something about the current administration's view of the general.

A new Chairman of the Joint Chiefs of Staff will be nominated this summer, I sincerely doubt that General Petraeus will be the one taped by the administration for the job. Far more likely it seems is the promotion of the current Vice-Chairman, Marine General James Cartwright. The only reason I would see this not occurring is that it would interrupt the otherwise steady rotation of the chairman's office from service to service, see here.

All in all, a good read. But if you're a current service member, this is yet another example of why the wars we fight seem to be run by a pack of schizophrenics.

What was getting out of the Army worth?

For the past 9 months I've been telling myself that I should do a financial analysis of my decision to leave the active duty Army to enter a full-time MBA program. This afternoon I finally sat down and finished it. The number was fairly astonishing. Leaving the Army for a career in the private sector is worth a minimum of several million dollars over the rest of my life. While I won't share the specifics or the excel model, it was a good exercise to at least do.

For those who are interested, I basically assumed that I would enjoy a fairly typical military career. Promotions would happen on schedule and I would retire after 25 years of service. After retiring I would begin a second career before retiring completely at age 60.

To estimate the civilian option I used my current job offer and some widely published statistics on post-MBA pay (see here). The chart presented is probably not a good representation of actual salaries, as MBA graduates tend to become quickly segregated into income brackets which vary considerably. The sample size and methodology that Bloomberg Businessweek used is dubious at best, but represents a good starting point.

I did this exercise for a couple reasons:
1. Many people see to make education choices with little analytical thought. While I'll perhaps write more on this later, I fundamentally believe that too many young people attend college/university and receive no financial benefit.
2. When I was resigning from the Army, my supervisors asserted (falsely) that it was a mistake financially. I believed then that this was a fallacious argument supported by some extremely naive assumptions around the value of a military pension. Unfortunately it's difficult to understand what your opportunity cost is when you haven't received a civilian job offer.

All that being said, money isn't everything. I know a great many peers who are still serving on active duty who would not leave their profession for any amount of money. There's certainly something to be said for being part of a profession with a noble calling.

Black-Scholes - Will they have to give back their Nobel Prize someday?

I've been delinquent in writing posts, mostly because I'm lazy. As a 2nd year MBA with a job offer in hand, my life is not that much different from an unemployed beach bum, much to my wife's chagrin.

Fischer Black, Myron Scholes, and Robert Merton are economists who developed a formula, now known as Black-Scholes, to value European style options.  A European style option gives you the right to buy or sell (known as exercising) a financial instrument at a fixed point in the future for a fixed price. Normally you must pay an upfront fee for this right, and Black-Scholes is what is used to calculate that fee. To keep this at a level which is understandable to the lay person, Black-Scholes uses the past prices of the asset, amount of time for which the option is available, and current borrowing rates to establish the price of the option. Black-Scholes makes a number of assumptions about each of these variables and a few others, and has been widely adopted by the finance community as the preferred method for valuing options. Scholes and Merton won a Nobel Prize for their work in 1997, Black was unfortunately dead and therefore ineligible for the honor.

Both Scholes and Merton were part of an infamous hedge fund called Long-Term Capital Management, or LTCM. For those of you who are curious about a disaster that nearly became a prominent part of American history, you should read this book that details the story. I find it riveting, though you may find it a good way to fall asleep after a busy or stressful day. On a side note, many of the characters in the book came back to haunt us in this most recent financial crisis. The short story of LTCM is that they used many of the concepts that Black-Scholes developed, primarily the role of historical pricing in estimating future prices. LTCM failed miserably in 1998 when the Russian and East Asian financial crises occurred.

When I first heard about Black-Scholes as undergraduate economics major at West Point I considered it to be a intellectual gimmick. The difficulty is that Nobel Prize winners are likely to ask for your better idea when you point out that theirs is rubbish. Modern finance has spun this idea of using historical assets prices (or more accurately, volatility in those asset prices) to predict future prices into a frightening swirl of bullshit. While it may or may not be accurate in the very short term, in any period longer than a few weeks or months the validity of the model becomes questionable. A company's future profits are dependent on a myriad of factors, not least of which are the overall economy, individual market served, and company's operations. None of these factors are stagnant, rather they constantly evolve such that it is extraordinarily unlikely that the same set of variables which existed in the spring of 2011 may ever again exist. If these variables are not static, it becomes very difficult (I would say impossible) to use them in predicting future prices or volatility.

The recent financial crisis has put a bulls-eye on the back of adherents to this theory. It also raised very serious concerns about modern portfolio theory and the efficient market hypothesis which are the fundamental reasons that most Americans use something called index funds to invest for retirement. I don't believe that markets are efficient in the short or medium term or that index funds represent the best way to invest for retirement. That, however, does not translate to recommending that disinterested investors abandon their index funds. For most individuals, identifying market pricing failures is a task too difficult or boring to engage in and an index fund is the best option.

I've written this long-winded explanation as a lead-in to some interesting comments made by Warren Buffet. In his most recent letter to shareholders he made the following statement, "Both Charlie and I believe that Black-Scholes produces wildly inappropriate values when applied to long-dated options...More tangibly, we put our money where our mouth was by entering into our equity put contracts. By doing so, we implicitly asserted that the Black-Scholes calculations used by our counterparties or their customers were faulty." (paragraph 6, page 20, here).

I find the second part of the statement particularly amusing. Scholes and Merton received about $1 million and the undying love of their fellow academia's for their formula. Buffet is betting billions of dollars that they are full of it, and he's winning.

I've decided over the past year that my future investments will include a number of LEAPS. They are certainly risky, in most instances you must invest $1000s in each option and run the risk of the investment becoming worthless. You must be willing to lose on the vast majority of these bets, but one winner can make your year. I also love the risk, it's not unlike doubling down at the blackjack table if your two card total is 11. It doesn't matter what

Another Lesson In Contrarian Investing

Let me start this post by saying that I have shown myself to be, at least temporarily, very wrong on the subject of pricing in the municipal bond market. Having made a series of investments in mid-November, I am eating my words on the my original belief that I could make a quick profit. It now turns out it will take a little longer.

My original thesis was that the default risk for municipalities does not support the current prices. In December, a well known financial analyst named Meredith Whitney appeared on CBS's 60 minutes. The piece was entitled a State Budgets: The Day of Reckoning. In it she hypothesizes that hundreds of billions worth of municipal bonds will default in the near future. More knowledgeable investors who specialize in the bond market have stated that she is wildly overestimating the potential problem. Bill Gross, the legendary self-made billionaire bond investor, has been a buyer in the market as well as a critic of Whitney's analysis. The short explanation goes like this: municipalities (broadly defined as governments and gov. agencies other than states and federal gov) are facing lowered revenues (less property taxes, fees, etc) and increased costs (primarily benefits for employees), and many will have to restructure their existing debt because they can't make the payments.

In short, I agree that municipal debt issuers are in a rough place, however, it isn't that bad. Revenues can be adjusted upward as most issuers are normally monopolies (anyone ever call around to fire departments to get better pricing during a car accident/house fire?) and the defined benefits scheme which is now plaguing governments everywhere is going through a generational shift. I fundamentally believe a general obligation bond with a good credit rating (AAA/AA) is not priced correctly right now.

The difficult part remains investing while avoiding the avalanche of selling. Most investors don't do their own research and tend to be late to the party (selling or buying), so the question is how much longer they continue to push prices down. I'll keep my investment and lower the cost basis, but this will certainly take a while to work out. I really wish that I had the ability to buy individual bonds, I would be able to cherry pick. A few more million yet to go.