Summer Reading

August 15, 2008

I had a chance to catch up on some reading while in South America. Two books that may be of interest to readers of this blog include Roger Lowenstein’s new book While America Aged on the various pension crises facing America and Martin Mayer’s older book The Greatest-Ever Bank Robbery on the collapse of the savings and loan industry in the late 80s.

Lowenstein is the author of the best biography of the best investor: Warren Buffet. He also wrote When Genius Failed, a fantastic book chronicling the collapse of hedge fund Long Term Capital Mgmt. This last, a story of trading hubris mixed with poor risk management and obnoxious leverage, is particularly relevant today.

As regular readers of this blog know, the pension crisis in America is close to my heart. Earlier this year I interviewed (now former) Controller General David Walker, who is on a crusade to warn the public about the pending bankruptcy of the federal government. I thought Lowenstein would offer some interesting new angles on the topic. In fact, he doesn’t even address the federal pension crisis. His subjects are local: GM, the NYC subway and San Diego. Canaries in the coal mine you might call these three.

Pensions are easy to promise, yet hard to pay for. Politicians and chief executives, interested above all in making it through the next election or meeting next quarter’s earnings target, buy off their labor constituencies with lavish future benefits that will, theoretically, be paid for later. The problem of actually finding the funding to pay for promised benefits they leave to their successors.

To give you a sense of the problem, municipal pension systems like San Diego’s are $1 trillion in the hole. That’s the amount of underfunding relative to the promises they’ve made to future retirees. And that’s just pension obligations. It excludes retiree health care.

Corporate pension plans are themselves hundreds of billions in the hole. Over the last 15 years, GM has scraped together $100 billion to get current on its retiree pension and health care liabilities. With all that cash going to workers, and none to shareholders, it’s no wonder that GM stock is trading at levels not seen since the 1960s.

Mayer’s book is a fascinating, impeccably-researched look at the last major banking crisis we faced in the United States. He describes in detail how moral hazard, i.e. privatizing profits while socializing risk, can wreak havoc in the financial system. Think Fannie and Freddie today.

Perhaps the most quotable paragraph from the book is this one:

The root problem of politics in a modern society is the control of professional performance….What makes the S&L outrage so important a piece of American history is not the hundreds of billions of [taxpayer] dollars [lost] but the demonstration of how low our standards for professional performance have fallen in law, accounting, appraising, banking, and politics—all of them. We are farther along than anyone thought on our road to a Hobbesian society: these days you can’t trust anybody. Americans really don’t want to live this way. But they have forgotten that there are other ways.

He wrote that in 1990, but no truer statement could be made regarding the present crisis. All you’d need to do is update his list of professional incompetents with the rating agencies, investment banks, and mortgage brokers/lenders. As the crisis deepens, I’m sure we’ll add a few overlevered hedge fund managers and private equity investors.

Ironically, on my boat in the Galapagos there was an amiable chap working in mortgage-backed securities for UBS in New York. He’s helping to clean up the mess UBS made of its own balance sheet. We had a few long conversations and he made the point, frequently, that investors should stop bitching about taking losses on toxic mortgage securities. They should have known what they were buying and shouldn’t hold the investment banks accountable.

True, investors should indeed know what they are investing in. But absolving the investment banks is a total whitewash. Financial advisers are supposed to be experts regarding the products they sell to clients. Moreover, ethical ones are required to put their clients interests above their own. They should be aware of their clients’ return objectives and, more importantly, their risk tolerances, and never market products to them that don’t fit these criteria. But of course, investment banks do this all the time. It’s how they make money.

Still, the higher-ups at the investment banks do know there have been ethical lapses. Just last week UBS, Merrill and Citigroup announced they will spend $36 billion to buy back totally illiquid auction-rate securities. These they had misleadingly marketed to investors as cash equivalents on par with money market funds.

But of course, at this point, they are still merely promising to pay back $36 billion. Enough said.

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