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By Root 844 0

and portfolio stock and index futures were sold. The market fell more.The market dropped around 500 points, the equivalent of around 2,500 points today. This was a classic liquidity crunch, brought on by model-driven selling, followed by the panic of general investors. The price at which managers were able to sell was much lower than the model’s price because they could not get out in time. To add insult to financial injury, the stock market as a whole was up 2 percent per year. If investors had simply held onto their positions during the “crash,” they would have been much better off. Instead, the models sold at lows, and then repurchased as prices rose. Portfolio insurance is a form of dynamic hedging, which I call death by one thousand cuts.

Benjamin Graham was not a fan of market formulas or program trading: “Never buy a stock immediately after a substantial rise or sell one immediately after a substantial drop.”24 At least not for the sake of it. As more people rely on formulas, they become less reliable. For one thing, conditions change. Secondly, when a formula becomes very popular, it may cause the stock market herd to “stampede.”25 At the time, Warren also derided the models. If the price falls far enough, the model sells everything and the manager is 100 percent in cash; when prices rise, the model tells you to buy. Warren loves to buy more when the price of a good value stock falls and seeks to sell, if ever, at a profit.

Instead, the mortgage meltdown was caused by Black Barts. Black Bart is said to have robbed California stagecoaches without ever firing a shot, and the mortgage meltdown involved some bloodless robbery. The risk was fully knowable, fully discoverable in the course of competent work. The mortgage meltdown had a direct cause and effect, and the result was predictable in advance. At the outset, symptoms of financial disease were as obvious as an advanced outbreak of mad cow. If one examined the loans they looked like downer cows, stumbling and sickly. Financial professionals including Warren Buffett, Charlie Munger, John Paulson, James “Jim” B. Rogers, William “Bill” Ackman, William “Bill” Gross, Whitney Tilson, Jim Melcher, David Einhorn (head of Greenlight Capital), myself, and others had been specific in sounding the alarm both verbally and in print for many years.

Money market funds and pension funds often rely on ratings.The SEC is proposing that mutual funds should not rely on ratings, but the SEC is missing a piece.The SEC should not allow an investment below a previously required rating. For example, if an investor relied on an AAA rating before and it did not work out, that should not mean the investor should ignore the requirement and invest in something with a lower rating, either. Rather, the investor should still be required to have an AAA rating and should be required to understand that the value of the investment lives up to the rating.

There is often a difference between an investor with a lot of money to manage and a sophisticated investor. For example, municipal funds usually lack the sophistication of Goldman Sachs Asset management. That is why many compliance departments at investment banks ask that brokers and institutional salespeople “know the customer.” The idea is to sell complex products to investors that have the ability to understand and analyze the risk.

Or better yet, do as Warren does. Don’t make your investments unnecessarily complex and thoroughly understand the risk. That way, if you make a mistake, it is very unlikely it will be a big one.

In spite of this wisdom, funds in Europe and the United States—including local government-run funds—often find they do not understand the risks of complex structured financial products they own, because they rely on AAA ratings for guidance. These Main Street government investors have no choice but to cut costs, aggressively go after back taxes, and—if the problem is bad enough—raise taxes. Main Street’s list of investors that feel burned is long and growing.

For example, the Springfield (Massachusetts) Finance Control