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By Root 744 0

were so far removed from the source of action, they often failed to thoroughly check on what they were buying. Warren learned about the Ponzi-like business models in mortgage lending and securitization market fairly early on. He wrote shareholders (in the annual letter) about his disastrous experience and what he learned from it; then he posted the information on the Berkshire Hathaway Web site for the world to see.The financial industry had not behaved well.The problem was fueled by “buyers who shouldn’t have bought, financed by lenders who shouldn’t have lent.”3 If Wall Street read Warren’s shareholder letter, it either missed his message or walked away with an idea of how to expand on a bad theme.

No matter what hedge fund or investment bank one works for, no matter how lofty the title, no matter how successful the investor, they are all subject to My Theory of Everything in Finance:

The value of any financial transaction is based on the timing of cash flows, the frequency of the cash flows, the magnitude of cash flows, and the probability of receipt of those cash flows.

In finance, we make up a lot of fancy and difficult to pronounce names and create complicated models to erect a barrier to entry that keeps out lay people. High barriers tend to protect high pay. I’ve written books about some of the esoteric products: credit derivatives, CDOs, and more, but before I look at the latest hot label dreamt up, I look at the cash to find out what is really going on. I also ask a lot of questions.

Everything trades off the next most certain financial instrument, usually starting with U.S. treasuries as the risk-free benchmark.The price will fluctuate, going up as interest rates fall and going down as interest rates rise. U.S. Treasuries have the virtue of usually having a known coupon that will be paid on known dates and a known maturity date. If we all agree on how to discount those cash flows, the entire market will come up with the same price. With every other security, I will have an opinion about when and whether I will get my cash back. To form that opinion, I need to know if the company, consumer, hedge fund, investment bank, or other entity is good for the money.

Why would any diligent financial professional hand over money without asking tough questions of strangers in the marketplace? If a flaky brother-in-law who you wanted to help asked you for a large loan, you would probably grill him before you forked over thousands of dollars. There would be no point in letting him get in over his head since that wouldn’t be a loan, it would be something else: When will you pay me back? How much interest are you promising to pay? How often and when will those payments occur? Do you have any collateral? Do you have any other debts? What is the probability you will hang onto your job this time, so that you will have the money to pay me when it is due? You would probably come up with even more questions, and this is for someone you know. You know how to find him if he doesn’t pay, and you both have an interest in keeping the relationship going.

If it looks as if there will be a problem getting money back from a borrower, walk away. The most important part of My Theory of Everything in Finance is the Buffett Rule: Do not lend money to people who cannot pay you back.

During the South American debt crisis in the 1980s, U.S. banks warned it would be disastrous for South American governments if they did not pay back their debts. The banks got it partly right. If you are owed billions of dollars by a third world country, and it cannot pay you back, the third-world country is not in trouble, you are.

Investment bankers are astute worldly people, and they keep their fingers on the pulse of the global financial markets. However, they tend to run with the herd. After getting badly burned by making unsecured loans to those who couldn’t pay back the money, loans backed by assets were marketed as being a safe alternative. Loans backed by collateral such as homes and commercial property were viewed as particularly safe because