Dear Mr. Buffett_ What an Investor Learns 1,269 Miles From Wall Street - Janet M. Tavakoli [65]
In January 2007, I had lunch with Bethany McLean, coauthor of The Smartest Guys in the Room, a bestselling book about the Enron debacle. She was intrigued about my assertion that AAA and AA rated products were overrated. That meant that bond insurers such as Ambac, MBIA, FGIC that also insured municipal bonds would have substantial losses. It also meant pension funds, bank investment portfolios, mutual funds, and more were buying investments with a high-rated label, but in reality they had the risk of losing substantial principal. I told her: “No one believes the ratings have any value.”20
Some AAA rated tranches traded around 95 cents on the dollar in the secondary market. Losses were already being absorbed by lower-rated, but still investment-grade, tranches, and first loss investors of conventionally structured deals were wiped out. Her article appeared on March 19, 2007, St. Joseph’s Day, the patron saint of the homeless.The rating agencies denied there was a problem: “All of the rating agencies say they have scrubbed the numbers, and slices of debt that are rated investment grade will mostly stay that way, even if the collateral consists of subprime mortgages.”21
Investment banks kept up the front. None of them took the massive write-downs I expected in the first quarter of 2007. Instead, they cranked up the CDO machines.They offered toxic product to unwary investors.
On March 22, 2007, I wrote Warren that John Calamos Sr., chairman and CEO of Calamos Investments, does not rely on the rating agencies, either:
He mortgaged his house to start his fund, and he did not seek outside money. . . . Initially they tried using Moody’s and S&P ratings as benchmarks, and they got smoked a couple of quarters. They set up their own credit models and use those to the exclusion of ratings.
The following year, on Tuesday, March 11, 2008, Bloomberg News reported that AAA subprime residential home equity loan backed bonds were not being downgraded despite having delinquencies exceeding 40 percent. As Bear Stearns gasped its last breaths, I appeared on Bloomberg TV that morning to discuss the structured finance ratings folly. The rating agencies were still in denial. Incapable of accurately measuring the present, the rating agencies provided no useful information for predicting future performance.The ABX indexes referenced 80 faux AAA bonds, and according to Bloomberg’s analysis, none of them merited that rating. According to its interpretation of S&P’s data, Bloomberg asserted that only six of the 80 AAA rated bonds in the ABX index would merit a rating above BBB-, the lowest possible investment grade rating.22 In other words, 90 percent of the bonds in the AAA index were not even investment grade.
Contrary to the assertions of Nassim Taleb and the Talebites, the mortgage meltdown is not a black swan event (an unlikely occurrence—unless one lives in Australia or New Zealand). It is not even Benoit Mandelbrot’s gray swan, a flawed model that does not foresee disaster. 23 Those labels would have described the 1987 portfolio insurance catastrophe affecting around $60 billion in equity assets, when sophisticated mathematical models originated in academia failed to take into account what happens when a large crowd tries to sell at the same time.
Portfolio insurance is a form of “dynamic” hedging that mimics a series of put options—as the stock price falls, the program automatically sells a given amount of stock and invests in cash. If the price falls further, the program sells more stock. In the week before the “Black October” crash of 1987, the Dow fell 250 points, and a large backlog of sell orders accumulated. The following Monday, portfolio insurance kicked in,