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Dear Mr. Buffett_ What an Investor Learns 1,269 Miles From Wall Street Part 3

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Many hedge funds are small, undercapitalized shops that have an "investors only" Web site. If a fund rents offices, purchases computers, phone systems, reporting systems, trading systems, hires staff and retains accountants, it may not break even on the 2 percent annual fee unless it has several hundred million dollars under management. The trouble is, if a manager's results are not good, investors will run for the exits.

The strategy reminds me of a bridge saying I sent Warren about having a 50-50 chance your play will win while expecting it to work out 9 times out of 10.

The temptation is to lever up just for the sake of making a lucky bet so that the 20 percent fee on the upside kicks in to keep the fund solvent and keep investors happy. But can you trust that leverage is employed for the right reasons when the fund is feeling a cash crunch? Is it any wonder they want a waiting period to return your money?

Overcrowding makes most hedge fund strategies look very unattractive. Many hedge funds are merely shorting (selling) volatility to earn risk premiums, selling options in a low implied volatility environment and selling credit default protection in a skinny credit spread environment, or using investment banks' financing to make a bet on the market. In other words, underperforming hedge funds often resort to leverage in a gamble to inflate returns. In other words, underperforming hedge funds often resort to leverage in a gamble to inflate returns.

It is as if they are the young boy in D. H. Lawrence's story "The Rocking-Horse Winner," who gets visions of the winners of Ascot's horse races while madly riding his rocking horse. At first he wins enough money to pay off the family debts, but that is not enough, the household goes mad with greed and he must keep riding to produce winners until he dies of exhaustion. "Although they lived in style, they felt always an anxiety in the house. There was never enough money." After the boy's initial bet wins, the house seems to say: "There must be more money, there must be more money." When the boy wins even bigger, the voices become louder and more urgent: "There must be more money! There must be more money!" The boy asks his emotionally bankrupt yet greedy mother about luck and she responds: "I don't know. n.o.body ever knows why one person is lucky and another unlucky." The boy manically rides the rocking horse "Now! Now take me to where there is luck! Now take me!"The voices in the house rise to a frantic pitch: "There must be more money! Oh-h-h; there must be more money. Oh, now, now-w! Now-w-w-there must be more money!-more than ever! More than ever!" The boy eventually dies of nervous exhaustion and his uncle mourns: "eighty-odd thousand to the good . . . But, poor devil, poor devil, he's best gone out of a life where he rides his rocking-horse to find a winner."32 Warren avoids leverage. While it is true that Berkshire Hathaway's returns would have been much higher on average, both Buffett and Munger feel that it is their responsibility to shelter shareholders from leverage's swift and painful downside. Benjamin Graham counseled: "It should be remembered that a decline of 50 percent fully offsets a preceding advance of 100 percent."33 Some hedge funds are betting on leverage and luck as if they are rocking horses. Instead of relying on rocking horses, they look to their prime brokers, their investment banking and bank creditors. The hedge funds not only gain access to leveraged financing-there must be more money!-the investment banks also provide trading strategies.

Richard Heckinger ran into many hedge fund managers during his multiyear stay as managing director at Deutsche Boerse. He believes that many of them have no financial savvy:

I am amazed at how many of them don't understand the nuts and bolts of what they're trading. I've met . . . several dozen over the last several years who are not too clear even on the concept of an "exchange" . . . most deal with their prime brokers and order up their strategies much like calling Domino's and ordering a pizza.34 [image]

The barriers to entry into the hedge fund world are low, and there seems to be a philosophy in the global hedge world that "anyone can do it." It seems all it takes to go from zero to hero is swagger and loudly trumpeted self-reported claims.

In the late 1990s, there were only a few hundred hedge funds. By the summer of 2008, the number was estimated at around 8,000 globally, and hedge fund management had become a $1.87 trillion industry. Most of the money is concentrated in large funds. Funds that manage more than $5 billion have 60 percent of the market share; funds that manage $1 billion to $5 billion have another 26.7 percent of the market share. Put another way, less than 3 percent of hedge funds control 60 percent of the money, and somewhere between 6 percent to 9 percent of the funds control around 87 percent of the money.That means more than 90 percent of hedge funds are chasing the remaining 13 percent of market share.35 Hedge fund managers often claim they can beat the S&P 500, mutual funds, and just about any other investment available to individual investors. Some hedge funds state that their goal is to achieve positive returns in both bull and bear markets. Others claim to speculate with the (usually elusive) goal of highly volatile but ultimately high returns. Quant.i.tative funds or "quant" funds like LTCM claim their models help them outperform the market.

Survivorship bias distorts returns reported by hedge fund indexes since the low returns of failed hedge funds drop out of the equation. If anemic returns and total wipeouts disappear forever, then reported returns have a greater chance of creating an illusion of better performance than other investments.

Creation bias is an even bigger problem. In military terms, it is the strategy of is an even bigger problem. In military terms, it is the strategy of rapid dominance rapid dominance through through shock and awe. shock and awe. Only "successful" funds that show a track record of outperforming the market are sold to investors, while failed attempts to create a successful track record are never reported. The initial outperformance has a halo effect on later years since the long-term record will continue to carry its swelling effect, even if subsequent returns are mediocre. As more money flows in, the funds often cannot replicate outperformance, devolving into under-performers. Multiyear returns are rarely dollar weighted, so returns are overstated, because large slugs of new money are earning lower returns. As the funds grow, it is harder to make excess market returns, since it is harder to find those incrementally attractive new ideas and a.s.sets. Only "successful" funds that show a track record of outperforming the market are sold to investors, while failed attempts to create a successful track record are never reported. The initial outperformance has a halo effect on later years since the long-term record will continue to carry its swelling effect, even if subsequent returns are mediocre. As more money flows in, the funds often cannot replicate outperformance, devolving into under-performers. Multiyear returns are rarely dollar weighted, so returns are overstated, because large slugs of new money are earning lower returns. As the funds grow, it is harder to make excess market returns, since it is harder to find those incrementally attractive new ideas and a.s.sets.

Size has its disadvantages. Warren Buffett and Charlie Munger project they can achieve a tax-efficient average annual return of around 10 percent to 15 percent for the next five years-a very respectable return-but it isn't likely they will match the tax-efficient 27 percent plus average annual return of the past 30 years. Their strategy and projections are disclosed for anyone to read in annual reports.

In first quarter 2008, hedge funds reported their worst performance in nearly two decades according to Hedge Fund Research, Inc.36 Even those numbers may not represent reality because the lack of reporting controls tempt hedge fund managers to inflate their performance. Some academic studies "suggest hedge funds have been routinely dishonest, or at least economical with the truth." Even those numbers may not represent reality because the lack of reporting controls tempt hedge fund managers to inflate their performance. Some academic studies "suggest hedge funds have been routinely dishonest, or at least economical with the truth."37 Investment banks tightened credit terms for hedge funds. By the beginning of August 2008, year-to-date hedge fund performance was down 3.5 percent. Hans Hufschmid, a first-hand witness to LTCM's financing crisis, observed it was "much worse" than in 1998 when LTCM collapsed, because "hedge funds live on credit and leverage and the ability to finance esoteric positions for a long time." Investment banks tightened credit terms for hedge funds. By the beginning of August 2008, year-to-date hedge fund performance was down 3.5 percent. Hans Hufschmid, a first-hand witness to LTCM's financing crisis, observed it was "much worse" than in 1998 when LTCM collapsed, because "hedge funds live on credit and leverage and the ability to finance esoteric positions for a long time."38 I would have added that some hedge funds seem to extend their lives because of the ability to set the prices on their own esoteric positions. I would have added that some hedge funds seem to extend their lives because of the ability to set the prices on their own esoteric positions.

Academics seem late to wake up to this. Warren Buffett and Charlie Munger have publicly criticized (mis)representations of hedge funds for decades. Forbes Forbes has published article after article about hedge fund problems. Some hedge funds simply make things up. Even "legitimate" reporting is often materially misleading. In 2004, has published article after article about hedge fund problems. Some hedge funds simply make things up. Even "legitimate" reporting is often materially misleading. In 2004, Forbes Forbes said: "Fakery aside, hedge funds have returned less than stocks and bonds." said: "Fakery aside, hedge funds have returned less than stocks and bonds."39 If you took away various ways of plumping up performance such as creation bias (and a variety of other shenanigans) a Reality Check study showed: "Ta.s.s [the largest hedge fund tracking service] net returns drop from 10.7 percent to 6.4 percent annually for the six years through 2002.That compares with a 6.9 percent annual return for the S&P 500 and 7.5 percent for Lehman Brothers' intermediate bond index." If you took away various ways of plumping up performance such as creation bias (and a variety of other shenanigans) a Reality Check study showed: "Ta.s.s [the largest hedge fund tracking service] net returns drop from 10.7 percent to 6.4 percent annually for the six years through 2002.That compares with a 6.9 percent annual return for the S&P 500 and 7.5 percent for Lehman Brothers' intermediate bond index."40 Yet, poor relative average performance did not deter investors. Money continued to pour into hedge funds. Yet, poor relative average performance did not deter investors. Money continued to pour into hedge funds.

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Most hedge funds rely on borrowed money. Goldman Sachs, Credit Suisse First Boston, Merrill Lynch, Morgan Stanley and others lend money through hedge fund umbilical cords called prime brokers.Then they trade with the hedge funds and often supply research and other helpful information. Most of the time, the information sharing is legal.

If a hedge fund uses borrowed money to buy securities, it backs the loan with the a.s.sets it "bought" plus collateral plus collateral (margin (margin). For example, if a prime broker lends $100 million to a hedge fund to buy securities that the prime broker's investment bank is selling, it may ask a hedge fund to put up $10 million or 10 percent as additional collateral against the $100 million loan (so the a.s.sets plus margin are $110 million or 110 percent of the amount the hedge fund owes). That way, if the price of the securities falls a little (not more than 10 percent), the investment bank will have a cushion to make sure it gets back its money. If the price of the securities drops by 5 percent, or $5 million, the investment bank will ask the hedge fund to put up more money (approximately $5 million) to keep the percentage of margin roughly constant. When the investment bank calls for more collateral, it is known as a For example, if a prime broker lends $100 million to a hedge fund to buy securities that the prime broker's investment bank is selling, it may ask a hedge fund to put up $10 million or 10 percent as additional collateral against the $100 million loan (so the a.s.sets plus margin are $110 million or 110 percent of the amount the hedge fund owes). That way, if the price of the securities falls a little (not more than 10 percent), the investment bank will have a cushion to make sure it gets back its money. If the price of the securities drops by 5 percent, or $5 million, the investment bank will ask the hedge fund to put up more money (approximately $5 million) to keep the percentage of margin roughly constant. When the investment bank calls for more collateral, it is known as a margin call. margin call. One would think that investment banks only accepted cash or a cash equivalent such as a T-bill as margin (collateral). But sometimes they accept something very illiquid (while asking for a bit more of the illiquid stuff). Investment banks try not to think about the possibility that the value of the securities will drop by say, 50 percent, or that the hedge fund will not be able come up with the margin when asked (perhaps because One would think that investment banks only accepted cash or a cash equivalent such as a T-bill as margin (collateral). But sometimes they accept something very illiquid (while asking for a bit more of the illiquid stuff). Investment banks try not to think about the possibility that the value of the securities will drop by say, 50 percent, or that the hedge fund will not be able come up with the margin when asked (perhaps because everyone everyone is asking at the same time). That would probably mean the hedge fund is going bust. Prime brokers (affiliates of banks and investment banks) avoid thinking about this horrific scenario by comforting themselves with the thought of the high fees they charge the hedge funds. is asking at the same time). That would probably mean the hedge fund is going bust. Prime brokers (affiliates of banks and investment banks) avoid thinking about this horrific scenario by comforting themselves with the thought of the high fees they charge the hedge funds.

Investment bank prime brokers will even help sp.a.w.n hedge funds. Typical of most investment banks, Bear Stearns a.s.set Management (BSAM) offered a "turnkey" program, essentially a 50-50 economic split after expenses. BSAM became the general partner. In exchange for that, the hedge fund manager would get office s.p.a.ce, back office clearance, accounting, legal support, and marketing support, all of which is a top line expense. If BSAM accepted someone onto the platform they also invested seed capital of up to $25 million.41 Prime brokers provide hedge funds with a variety of services:They provide financing for leverage; they set up custody accounts for their a.s.sets; they act as a settlement agent; and they prepare account statements for customers. Smaller hedge funds often rely on their prime brokers for risk management and trade ideas. These smaller hedge funds also tend to drastically underestimate the cost of doing business. Fortunately for hedge fund managers, the fees fund managers charge can add up faster than the miscellaneous charges on a phone bill. If the hedge fund doc.u.ments allow loans to management, the lowest returning a.s.set in the hedge fund portfolio may be an invisible low-cost loan to management.

The investment bank symbiosis did not stop with hedge funds. Investment banks also provided loans, a.s.sistance, and even management staff to structured investment vehicles structured investment vehicles (SIVs), and (SIVs), and collateralized debt obligation collateralized debt obligation (CDO) managers, some of which also manage hedge funds. (CDO) managers, some of which also manage hedge funds.

Undercapitalized managers are easily influenced by an investment bank that set them up in business and trades with them. If an investment bank has a large inventory of overrated and overpriced mortgage loan or leveraged loan-backed securities that it needs to get off of its books, it is very convenient to have symbiotic relationships with structured investment vehicles, collateralized debt obligation managers, and hedge funds. As investment banks needed to get bad loans off of their balance sheets, inst.i.tutional investors became the prey of both hedge funds and investment banks.

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As General George S. Patton observed: "A pint of sweat saves a gallon of blood." Warren Buffett and Charlie Munger would not tolerate the kind of risk that would wipe out a lifetime of hard work, and look for a margin of safety when they make a purchase. Their decades-long track record beats all of the top hedge fund managers. Berkshire Hathaway does not promise to do well in both up and down markets. There are years when the value of the stock decreased or underperformed the S&P; but long-term value investors do not concern themselves with chasing a market return.Warren looks for value and for companies that he is happy to own even if the market closed for five years and he couldn't trade any of the shares.

As a disciple of Benjamin Graham, Warren Buffett does not distinguish between value and growth companies, since the concepts are Siamese twins. Why would you buy a fair company at a good price instead of a good company at a fair price? If possible, try to buy a good company at a good (cheap) price, and a good company has good growth potential.

Berkshire Hathaway defines value companies as those selling at or below a fair price-book value combined with earnings-that have high earnings growth potential relative to alternatives. The price has to make sense and the fundamental economics have to be good. A company (or hedge fund) could produce steadily rising earnings by investing in T-bills, and pa.s.sive compounding would cause capital earnings to steadily rise even if the company did nothing to generate additional shareholder value. Yet Warren would not consider this to be a value company.

Returns are not kept secret.They are available to the general public on Berkshire Hathaway's Web site. From 1965 to 2007, the S&P 500 (including dividends) has had a compound annual gain of 10.3 percent and an overall gain of 6,840 percent. For the same period, Berkshire Hathaway has shown adorable alpha; it had a compounded annual gain of 21.1 percent and an overall gain of 400,863 percent.42 In June 2008, Warren Buffett issued a challenge to hedge funds. He has bet Protege Partners LLC, a fund of hedge funds, that five hedge funds of its choosing will not produce averaged returns net of fees over the next 10 years above the S&P 500. Buffett and Protege each staked $320,000 to purchase a $640,000 treasury zero that will be worth $1 million in 10 years when the results are in (around a 4.56 percent annualized return-perhaps a better performance return than the hedge funds), and the $1 million will go the winner's charity. Warren chose Girls Inc. of Omaha, and I am sure they will be delighted when they receive the money.43

Chapter 5.

MAD Mortgages-The "Great" Against the Powerless The manufactured housing industry's business model centered on the ability . . . to unload terrible loans on naive lenders . . . The consequence has been huge numbers of repossessions and pitifully low recoverie[s].

-Warren Buffett, Berkshire Hathaway 2003 Annual Report

Berkshire Hathaway's 2003 annual report arrived in my mailbox in April 2004. Reading it, I learned that Berkshire Hathaway had acquired Clayton Homes, the largest U.S. manufacturer and marketer of manufactured homes. Unlike Oakwood Homes, a Berkshire Hathaway investment that lost money in 2002, Clayton Homes is well managed and practices sound lending through its Vanderbilt Mortgage and Finance Inc. affiliate. Clayton Homes is noted for the good character of its management in an industry rife with corrupt practices where buyers who could not afford homes were steered into fee-bloated loans created by lenders who should not have lent to them.Warren had learned about those practices the hard way after purchasing the distressed debt of Oakwood Homes, another manufactured housing company, which went bankrupt in 2002. Warren wrote: "Oakwood partic.i.p.ated fully in the insanity."1 Oakwood Homes (Oakwood) designed and manufactured modular homes and sold them either directly to home buyers or to independent retailers. Oakwood provided loans to buyers of its homes. On its own, Oakwood did not have money to lend. Oakwood got money through a line of credit from Credit Suisse First Boston (Credit Suisse). The credit line was similar to a credit card except that Oakwood had to put up the home loans as collateral. Credit Suisse earned fees for the loans and further fees when it packaged (securitized) Oakwood's loans. Credit Suisse (the "old investor") bought the securitized loans and then sold them to so-called sophisticated private and inst.i.tutional investors (the "new" investors).

Many of Oakwood's "home buyers" had not actually bought a home; they had a.s.sumed a mortgage loan they could not pay back. Sales declined. Loan delinquencies (late payments) and repossessions rose. Oakwood Homes had crushing debt and falling income for at least three years before it filed for bankruptcy in November 2002.

Oakwood and Credit Suisse sued each other.These nice kids found each other in a dangerous playground; and they courted each other for years, long after the affection had gone. The court issued an opinion in June 2008.The doc.u.ments said Oakwood's aggressive lending practices led to the high number of repossessions and a debt load that Oakwood could not support; Oakwood's liquidator called the transactions it did with Credit Suisse "value destroying."2 The court said that Oakwood's own alleged wrongful conduct prevented it from recovering any money from Credit Suisse; there was equal fault. Basically, the court shrugged at the liquidator's claim: The court said that Oakwood's own alleged wrongful conduct prevented it from recovering any money from Credit Suisse; there was equal fault. Basically, the court shrugged at the liquidator's claim: lay down with dogs, wake up with fleas. lay down with dogs, wake up with fleas. An exception to this would have been if Credit Suisse were a corporate insider (say, if Credit Suisse had an officer on Oakwood's board-which it did not), but Oakwood's board and management made its own decisions. An exception to this would have been if Credit Suisse were a corporate insider (say, if Credit Suisse had an officer on Oakwood's board-which it did not), but Oakwood's board and management made its own decisions.

Warren Buffett learned that the manufactured housing industry's consumer financing practices were "atrocious," and securitization made the situation much worse. Investors in the securitizations supplied money to investment banks who lent to manufacturers and retailers, who then lent money to home "buyers" in the form of mortgage loans or real estate investment contracts. Since the ultimate so-called sophisticated investors, the buyers of the securitized loans, 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. 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 t.i.tle, 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 p.r.o.nounce 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 ent.i.ty 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. walk away. The most important part of My Theory of Everything in Finance is the Buffett Rule: 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. 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. 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 a.s.sets were marketed as being a safe alternative. Loans backed by collateral such as homes and commercial property were viewed as particularly safe because one could seize the property and sell it if the borrower could not pay.

After the late 1980s thrift crisis, during which savings and loans that made mortgage loans throughout the United States went bankrupt, the government took a more aggressive role in the U.S. housing market. A network of Federal Home Loan Banks makes low-cost loans to banks and financial inst.i.tutions so that they can lend money to mortgage borrowers. The Federal Housing Administration, FHA, part of the United States Department of Housing and Urban Development, or HUD, insures mortgage loans made by FHA approved lenders. These FHA loans are then sold to GNMA (or Ginnie Mae) a government agency that packages (securitizes) the loans for investors. Ginnie Mae "packages," known as agency pa.s.sthroughs (they pa.s.s through interest and princ.i.p.al payments to investors), are backed by the full faith and credit of the U.S. government, meaning U.S. taxpayers. Fannie Mae (FNMA) and Freddie Mac (FHLMC) were privately chartered United States mortgage giants regulated by HUD. While Fannie and Freddie were private and their securitizations were not guaranteed, the overall sense was that they were (1) too big to fail; and (2) had the implied moral obligation of the U.S. government (that would be you, the taxpayer). Freddie Mac and Fannie Mae are now so huge that many believed a default by either of them would cause a crisis of confidence and the global markets would collapse-they are too big to fail. Too big to fail means American taxpayers will pay for a bailout. Too big to fail means American taxpayers will pay for a bailout. It turns out this thinking was correct. In September 2008, both Fannie Mae and Freddie Mac were placed in conservatorship. A new regulator, the Federal Housing Finance Agency (FHFA) fired (and replaced) the CEOs, fired the former boards of directors, and took control in a form of nationalization. With so much at stake-meaning U.S. government funds obtained from taxpayer dollars-one would think that HUD, the FHA, Fannie Mae, Freddie Mac, and the 12 Federal Home Loan banks (plus the army of regulators that oversee them) would make sure that the lending is prudent, because if it is not, the U.S. government will have to pay. Sadly, that has not been the case, perhaps because the government feels it is dealing with other people's money-the money of the U.S. taxpayer. Mortgage lending practices in the United States are tightening up, but there is still a long way to go to get back to prudent lending. As for the new regulator, it is headed by James B. Lockhart, who also oversaw the old regulator (the Office of Federal Housing Enterprise Oversight or OFHEO). It seems to me that the new sheriff looks a lot like the old sheriff. It turns out this thinking was correct. In September 2008, both Fannie Mae and Freddie Mac were placed in conservatorship. A new regulator, the Federal Housing Finance Agency (FHFA) fired (and replaced) the CEOs, fired the former boards of directors, and took control in a form of nationalization. With so much at stake-meaning U.S. government funds obtained from taxpayer dollars-one would think that HUD, the FHA, Fannie Mae, Freddie Mac, and the 12 Federal Home Loan banks (plus the army of regulators that oversee them) would make sure that the lending is prudent, because if it is not, the U.S. government will have to pay. Sadly, that has not been the case, perhaps because the government feels it is dealing with other people's money-the money of the U.S. taxpayer. Mortgage lending practices in the United States are tightening up, but there is still a long way to go to get back to prudent lending. As for the new regulator, it is headed by James B. Lockhart, who also oversaw the old regulator (the Office of Federal Housing Enterprise Oversight or OFHEO). It seems to me that the new sheriff looks a lot like the old sheriff.

Fannie Mae and Freddie Mac purchase mortgage loans from mortgage lenders and earn fees for guaranteeing payments on other mortgage loans.To prevent losses, Fannie Mae and Freddie Mac have requirements for the types of loans they will buy. But, they came under pressure to relax those standards, and their risk increased as a result. Fannie Mae and Freddie Mac package up these loans and create securitizations known as conventional pa.s.sthroughs. Some mortgage lenders cannot keep going if Fannie Mae and Freddie Mac refuse to buy their mortgage loans. In this way, Fannie Mae and Freddie Mac are indirect mortgage lenders. indirect mortgage lenders.

Fannie Mae and Freddie Mac are highly leveraged, and they were extremely vulnerable to failure. If you are highly leveraged, you must keep the quality of the mortgage loans very high, because a small decrease in value is amplified by leverage. But if you have it in the back of your mind that you can have a colossal screw-up and someone will bail you out, it almost guarantees you will make lousy financial decisions. It is a crazy way for any investor to think. It is a crazy way for any investor to think. It is the ant.i.thesis of Benjamin Graham's philosophy. Warren told me that, as an investor, everyone makes mistakes, but you don't have to do a lot right as long as you It is the ant.i.thesis of Benjamin Graham's philosophy. Warren told me that, as an investor, everyone makes mistakes, but you don't have to do a lot right as long as you avoid big mistakes. avoid big mistakes.

Fannie Mae and Freddie Mac appeared to be careful back in the day. Loans had to "conform" by meeting lending guidelines so the borrower had a good chance of paying off the loan: the borrower's income had to be verified and doc.u.mented; total housing cost including insurance and fees-no more than 28 percent of borrower's gross income; total debt (including credit cards, auto loans, etc.) less than 36 percent of borrower's gross income; the borrower's payment history could not include too many late payments. The borrower's money for the down payments and closing costs should come from his own savings, not from, say, a "gift" (which may in reality be a loan) from a relative. The borrower should have a steady job for at least two years, and enough extra cash to cover at least two months of all living expenses and other obligations.This is called prudent lending, prudent lending, and it protects both the lender and the borrower. Prudent lending practices protect the United States economy from mischief makers whose actions, intended or otherwise, could upset the and it protects both the lender and the borrower. Prudent lending practices protect the United States economy from mischief makers whose actions, intended or otherwise, could upset the entire entire U.S. housing market. But as prudence gave way to politics born out of greed, HUD stopped being part of the solution and became part of the problem. U.S. housing market. But as prudence gave way to politics born out of greed, HUD stopped being part of the solution and became part of the problem.

For more than a decade, prudent lending seemed to a.s.suage the fear of losses; but "creative" investment banking ruined even that supposedly safe scenario. If you set up a countrywide system where you overstate the value of an illiquid a.s.set and then lend to borrowers who will have a hard time paying you back, you create bad loans on a ma.s.sive scale. Cheap money available for loans pushes the prices of homes well above the price of the underlying land and cost to build plus reasonable profit; the prices keep getting pushed upward based on imaginary value and paid for with loans for which few questions are asked. It is as if you created your own third-world country in a bubble.

In contrast, Warren Buffett's Clayton Homes (through Vanderbilt Mortgage) maintains prudent lending standards-that require a certain down payment, proof of income and employment, a reasonable debt to income ratio-the kind of standards that keep people in their homes and paying their mortgage.

Suppose there is an unemployed man with no source of other income other than his representation that he is a successful Internet day trader. Up until now, he has not been very successful at anything. He has a poor credit history, and he wants to buy a home he could not previously afford. Fortunately, he says he has a flair for gambling-I mean-day trading, on the Internet. He does not wish to provide doc.u.ments verifying his success, because the key to his successful formula is that is must remain confidential. Furthermore, he does not want to make a down payment on a home since his capital is tied up in his successful Internet day trading strategy, which he says is more profitable than the housing bubble-I mean housing investment. Why tie up money in a down payment when he can use that money to gamble-I mean-increase his fortune?

Fortunately, a mortgage broker, who is completely objective, since his income depends solely on the fees he generates by making mortgage loans, is willing to overlook the absence of doc.u.mentation. The Internet day trader can state his income, and that is good enough for the mortgage broker. The mortgage lender helpfully informs the day trader that there have been mortgages made to people who apparently cannot afford them other than the fact that they are willing to state an income which suggests they can make the payments-so climb on board.Warren Buffett would likely have asked whether or not the trader can pay him back. He would undoubtedly ask for doc.u.mentation.

After a few months, the mortgage broker calls the day trader with good news. The appraised value of homes in the day trader's area has gone up, so the day trader has equity in his home. The mortgage broker asks if the day trader would like to take out a home equity line of credit, which can then be used to make the payments on the mortgage of another home, an investment property.Yes? Great! (In contrast, Warren Buffett avoids investing in any business [in this case the loan from a shaky borrower] that has excessive leverage, that is, no equity left in the home.) The way the loans were made was bad enough, but some of the new risky loan products made it difficult for homeowners to pay back the loan, even if their house increased in value, and if the value of the home stayed the same or declined, the homeowner would have a huge incentive to default.

These dodgy loans were so laughable that the risk was an open secret. The market made up pet names with catchy tags for this trash. NINJA NINJA loan: no income, no credit, no job, no doc.u.mentation, no down payment, no problem. Get a loan and get in over your head. loan: no income, no credit, no job, no doc.u.mentation, no down payment, no problem. Get a loan and get in over your head. Liar loans Liar loans will let us take your homes.You will choke your credit trying to pay back will let us take your homes.You will choke your credit trying to pay back strangulation strangulation loans. loans. Vampire Vampire loans will suck your blood dry. loans will suck your blood dry.

In 2002, when Warren Buffett took losses due to Oakwood Homes' bankruptcy and was coming to grips with the credit derivatives losses in his Gen Re unit, President George W. Bush announced his intention to increase minority homeownership by 5.5 million by 2010. It sounded like a great idea-who isn't for home ownership? He lacked a sound plan to achieve it, and the regulatory policies of his administration enabled fraud fueled by greed. It sounded great to say in 2004 that homeownership had substantially increased. But by the beginning of 2008, homeownership was back down to 2002 levels, and minorities are most at risk for losing their homes-and their creditworthiness potentially ruined for years.4 Furthermore, the population is still growing as homeownership declined, so we have lost ground. Wealth transferred to the wealthy from the poor, and what cannot be wrung out of distressed borrowers is ultimately being subsidized by tax dollars as the Fed bails out investment banks, banks, and thrifts. Furthermore, the population is still growing as homeownership declined, so we have lost ground. Wealth transferred to the wealthy from the poor, and what cannot be wrung out of distressed borrowers is ultimately being subsidized by tax dollars as the Fed bails out investment banks, banks, and thrifts.

The national tragedy is that the Bush administration apparently neither read Berkshire Hathaway's shareholder letters nor sought Warren Buffett's advice.

In 2003, while Warren Buffett was acquiring ethically run Clayton Homes after having taken the lesson of Oakwood to heart, the Office of the Comptroller of the Currency, the OCC, subverted the states' ability to defend the rights of mortgage borrowers against predatory lenders. The OCC examines national bank books and inquires about risk management practices in their capital markets areas. In an unprecedented move, it exercised an obscure power in the 1862 National Bank Act countermanding states' predatory lending laws over the unanimous objection of all 50 states.5 Ameriquest was alleged to be among the worst of predatory lending offenders. Forty-nine state regulators and the District of Columbia claimed it ran a boiler-room operation slamming borrowers with loans they could not pay back, hidden fees, and undisclosed escalating interest rates. The U.S. Senate delayed Ameriquest founder, Roland E. Arnall's, confirmation to the post of U.S. Amba.s.sador to the Netherlands, but approved it in February 2006, after Ameriquest paid a $325 million settlement.6 Fair Isaac Corporation developed a scoring system (FICO) as a rough guideline of consumers' ability to pay debts. Subprime borrowers have low credit scores; typically FICO scores are below 650. Lending problems were not limited to subprime borrowers, however. Risky mortgage products combined with overleveraging created problems for borrowers at all income levels, but subprime borrowers were hit the hardest. Subprime borrowers tend to be less sophisticated and include a higher percentage of minorities. Unscrupulous lenders prey on the relative naivete of these borrowers.

In the United States in the last part of the twentieth century, an illegal practice called redlining redlining denied sound mortgage products to eligible minorities. As we entered the twenty-first century, redlining was replaced with a perverse spin called denied sound mortgage products to eligible minorities. As we entered the twenty-first century, redlining was replaced with a perverse spin called reverse redlining. reverse redlining. This was supposed to help minorities buy homes, but instead Reverse Robin Hoods stole from the poor and gave to the rich. Since many subprime loans do not meet the standards of Fannie Mae and Freddie Mac, mortgage lenders borrowed most of the money from a handful of investment banks that packaged the loans and sold them to investors around the world (banks, mutual funds, insurance companies and more). The subprime loan disaster would have been headed off if sophisticated investment banks had stopped supplying money (through packaging and selling the ridiculous loans) to shaky mortgage lenders. This was supposed to help minorities buy homes, but instead Reverse Robin Hoods stole from the poor and gave to the rich. Since many subprime loans do not meet the standards of Fannie Mae and Freddie Mac, mortgage lenders borrowed most of the money from a handful of investment banks that packaged the loans and sold them to investors around the world (banks, mutual funds, insurance companies and more). The subprime loan disaster would have been headed off if sophisticated investment banks had stopped supplying money (through packaging and selling the ridiculous loans) to shaky mortgage lenders.

CNN's personal finance editor, Gerri Willis, exposed despicable lending practices. She told The Daily Show's The Daily Show's Jon Stewart that in 2007, " Jon Stewart that in 2007, "two million people (in the United States) went into foreclosure," people (in the United States) went into foreclosure,"7 and in a CNN segment in which she and I both appeared, she a.s.serted "the cards were exactly stacked against [the borrowers]." and in a CNN segment in which she and I both appeared, she a.s.serted "the cards were exactly stacked against [the borrowers]."8 I told her that some borrowers were "actively misled" and these loans on aggressively appraised homes: "were presented as gifts, but they were Trojan Horses you could ride to your financial ruin." I told her that some borrowers were "actively misled" and these loans on aggressively appraised homes: "were presented as gifts, but they were Trojan Horses you could ride to your financial ruin."9 Many minorities are stuck with an insurmountable mountain of debt and many have declared bankruptcy. Many minorities are stuck with an insurmountable mountain of debt and many have declared bankruptcy.

The net effect is a huge wealth transfer from minorities to builders, fee-earning mortgage lenders, and bonus seeking investment bankers.

Warren Buffett promoted affordable housing and sound lending practices; he runs a well-managed corporation that has increased in value thus benefiting shareholders; he has bequeathed most of his wealth to benefit those less fortunate. Meanwhile, mortgage lenders and the investment banks that enabled them stole from naive borrowers-and investors (such as munic.i.p.al governments).

Many people did not understand what they signed. Stretching funds to partic.i.p.ate in what appears to be a rising housing market is merely speculation. No one is ent.i.tled to credit for speculation, and credit was pushed on people with the promise of refinancing before interest payments rose, and low-money-down loans were touted as a way to wealth in an unsustainable market in which housing prices were propped up by temporarily cheap borrowing rates. Sign here, you want to own your dream house and get rich, don't you? Sign here, you want to own your dream house and get rich, don't you?

The idea that minority homeownership would increase was used as a justification for a lot of bad lending. Predatory lending practices were cloaked in a mantle of moral self-righteousness, as if steering borrowers into risky mortgage products was a public service instead of an act of malicious mischief by savvy financiers.

It is true that some borrowers knowingly overreached, but many were duped by confusing and risky loan products. More pain will come due to mortgage loans originated in 2005, 2006, and 2007. Mortgage brokers offered 40-year or 45-year adjustable rate mortgages (ARMs) in which homeowners built up virtually no equity in their homes in the early years of the mortgages. Approximately 80 percent of 2006 loan originations were ARMs of varying maturities with interest payments that reset sharply upward in two, three, or five years. For example, a 2/28 hybrid ARM has a fixed interest payment amount for the first two years, and then resets to an adjustable rate for the remaining 28 years. For a typical subprime 2/28 ARM, after low "teaser" rates of around 8 percent, many loans will reset to LIBOR plus 600 basis points, which as of summer 2008 would be around 8.46 percent.This borrowing rate, however, may be much higher by the time the actual reset occurs, particularly since the Fed will likely have to raise interest rates to head off inflation to avoid further depression of the dollar. For example, using June 2007's LIBOR rate, the interest payment would have been 11.32 percent. And here is the conundrum facing the Fed: If it raises rates, more bad loans will default and prolong a recession. But low rates fuel inflation, which leads to rising costs such as for gas and food, and the United States may slump into stagflation.

Some mortgage loans are interest-only interest-only (IO), meaning that the homeowner does not acc.u.mulate equity by paying down princ.i.p.al; the only way the home owner can build equity is if housing prices rise, but as a result of profligate lending, housing prices are falling. Some of these loans were made with very low (or no) down payment, so the homeowner would now lose money if the house were to be sold. (IO), meaning that the homeowner does not acc.u.mulate equity by paying down princ.i.p.al; the only way the home owner can build equity is if housing prices rise, but as a result of profligate lending, housing prices are falling. Some of these loans were made with very low (or no) down payment, so the homeowner would now lose money if the house were to be sold.

Option ARMs allow negative amortization, negative amortization, meaning a homeowner's princ.i.p.al balance-the amount you'd pay if you pay off your loan right away-can potentially rise. Borrowers may have initial payments so low that the payments do not even cover interest costs. Unpaid interest increases the princ.i.p.al amount, the loan balance, resulting in meaning a homeowner's princ.i.p.al balance-the amount you'd pay if you pay off your loan right away-can potentially rise. Borrowers may have initial payments so low that the payments do not even cover interest costs. Unpaid interest increases the princ.i.p.al amount, the loan balance, resulting in negative amortization. negative amortization. What if you bought a home with no money down (no down payment), and home prices fall? You are in an "upside-down" mortgage. What if you bought a home with no money down (no down payment), and home prices fall? You are in an "upside-down" mortgage. You owe more than the house is worth, and the amount you owe grows bigger every day. You owe more than the house is worth, and the amount you owe grows bigger every day. As the song goes, you get "another day older and deeper in debt," and if you sell the house, all you have left is debt. As the song goes, you get "another day older and deeper in debt," and if you sell the house, all you have left is debt. You never bought a home, you simply signed for a loan that you cannot pay off. You are much worse off than you started. You never bought a home, you simply signed for a loan that you cannot pay off. You are much worse off than you started. These loans are These loans are vampire loans vampire loans because mortgage lenders who keep these loans in their portfolio find that they look better dead than alive. The princ.i.p.al balance increases; the loan value appears higher; but the reality is that the borrower may be about to default on a payment (or may have already defaulted on one or more payments). Sophisticated investment bankers knew this, but they bought these loans from shaky mortgage lenders, packaged them up, and sold them anyway. because mortgage lenders who keep these loans in their portfolio find that they look better dead than alive. The princ.i.p.al balance increases; the loan value appears higher; but the reality is that the borrower may be about to default on a payment (or may have already defaulted on one or more payments). Sophisticated investment bankers knew this, but they bought these loans from shaky mortgage lenders, packaged them up, and sold them anyway.

As Warren Buffett points out, if you lend money to people who cannot pay you back, it will not end well (and it hasn't).

Homeowners with equity in their homes are encouraged to refinance with "no-cost" loans. In my opinion, this term should be made illegal. There is no such thing as a no-cost loan, albeit this type of loan may make sense for homeowners planning to move in a year or two. Fees are buried deep in the mortgage doc.u.ments as a yield spread premium. yield spread premium. Usually a borrower pays around 2 percent of the loan amount in closing costs. On a $100,000 loan there are about $2,000 in closing costs. With a no-cost loan, the mortgage lender builds fees into the interest rate, and the borrower pays the fees over time. Since the lender sells the loan to an investment bank, the lender makes money because the loan paying a higher interest rate sells for a higher price, so the lender gets his money right away. Lenders Usually a borrower pays around 2 percent of the loan amount in closing costs. On a $100,000 loan there are about $2,000 in closing costs. With a no-cost loan, the mortgage lender builds fees into the interest rate, and the borrower pays the fees over time. Since the lender sells the loan to an investment bank, the lender makes money because the loan paying a higher interest rate sells for a higher price, so the lender gets his money right away. Lenders are not required are not required to tell a borrower how much this is worth, and most borrowers-even educated, intelligent, otherwise savvy homeowners-do not know where to find the yield spread premium in their loan doc.u.ments, which seems like pages of boring jargon, much less calculate what it is worth. to tell a borrower how much this is worth, and most borrowers-even educated, intelligent, otherwise savvy homeowners-do not know where to find the yield spread premium in their loan doc.u.ments, which seems like pages of boring jargon, much less calculate what it is worth. Warren counsels that you should not invest in something you do not understand, and that would also apply when taking out a loan to "invest" in a home. Warren counsels that you should not invest in something you do not understand, and that would also apply when taking out a loan to "invest" in a home.

The borrower may be getting a loan with a higher interest rate than he or she could get through another broker or through a traditional bank. Brokers doing this often raise the rate by 0.5 percent over and above the closing costs and what the borrower would otherwise pay elsewhere. For a $100,000 30-year fixed-rate loan, the extra charges mean additional interest payments of $11,500 above the closing costs already built into the interest rates. Honest brokers will run the math for a homeowner, show the borrower all of the fees, and calculate the breakeven ownership time period where the borrower will be indifferent between paying the closing costs upfront or paying the closing costs over time embedded in the monthly payments. Honest brokers will not fee slam by stuffing an extra 0.5 percent into the yield spread premium above and beyond the closing costs. There is no such thing as a no-cost loan. There is no such thing as a no-cost loan.

Some brokers of no-cost mortgages will only pay appraisers at closing (when borrowers sign doc.u.ments to buy the home).They claim the appraiser will otherwise not work as hard to fairly value the property, but the opposite is more likely. A higher appraisal makes it more likely the deal will close, and the appraiser only gets paid at closing. It creates a conflict of interest for the appraiser.The appraiser has an incentive to come up with a higher number to ensure there is additional value for the seller or for a homeowner refinancing a loan.

Mortgage brokers are responsible for about 70 percent of subprime loans. Many brokers make prudent loans, but a lot did not. According to Aaron Krowne's Internet-based Implode-o-Meter, from late 2006 to June 2008, 262 major U.S. mortgage lenders had gone "kaput."10 The number continues to climb.This is an unprecedented failure rate. The number continues to climb.This is an unprecedented failure rate.

The Alt-A mortgage market includes borrowers that have higher credit scores, but not high enough to qualify as "prime" borrowers. In both the Alt-A and prime markets, borrowers have purchased multiple dwellings with little or no money down. As housing prices drop, these borrowers find they have to sell property at a loss if the debt burden becomes too much for them.

Fraud on borrowers is a problem, but so is fraud on lenders. Borrowers, often in collusion with unscrupulous brokers, supplied phony doc.u.mentation or engage in ident.i.ty theft. Lenders have a right to complain about this type of fraud, but their own due diligence standards should certainly be tightened.

Investment banks funneled money to mortgage lenders by purchasing the mortgage loans and storing them in special purpose companies known as warehouses. Once there were enough loans, thousands of loans, in the warehouse, they packaged up the loans into residential mortgage-backed securities residential mortgage-backed securities (RMBS) and sold them to investors. As long as the banks could keep stuffing the loans into securitization packages and selling them, they did not have to keep the risk themselves. If you are ethically challenged and have reason to know you are building airplanes with defective parts, you will sell the airplanes as quickly as possible. That way, when the parts give out, someone else will fall out of the sky. Unfortunately for investment banks (and mortgage lenders that sold them the loans), they got stuck, and their earnings crashed. (RMBS) and sold them to investors. As long as the banks could keep stuffing the loans into securitization packages and selling them, they did not have to keep the risk themselves. If you are ethically challenged and have reason to know you are building airplanes with defective parts, you will sell the airplanes as quickly as possible. That way, when the parts give out, someone else will fall out of the sky. Unfortunately for investment banks (and mortgage lenders that sold them the loans), they got stuck, and their earnings crashed.

Mortgage lenders were obliged to take back loans that did not meet certain standards. Some of the loans made in 2006 and 2007 were so bad that they began defaulting before an investment bank could get rid of the risk (by selling packaged loans to investors like mutual funds and others). Shaky mortgage lenders could not buy back the bad loans without borrowing money from another another investment bank. When things got bad enough, investment banks stopped lending and the shaky mortgage lenders went bankrupt. Many investment banks were stuck with mortgage lenders' unpaid loans and with a warehouse full of bad subprime loans. investment bank. When things got bad enough, investment banks stopped lending and the shaky mortgage lenders went bankrupt. Many investment banks were stuck with mortgage lenders' unpaid loans and with a warehouse full of bad subprime loans.

One really can't say this enough: Warren advises that you shouldn't lend money to people who cannot pay you back. Investment banks-acting as indirect indirect mortgage lenders, bought up the mortgage loans and supplied money to shaky mortgage lenders.They kept the "party" going. mortgage lenders, bought up the mortgage loans and supplied money to shaky mortgage lenders.They kept the "party" going.

Before the party ended, mortgage lenders siphoned off fees and dividends. When everything unraveled, many mortgage lenders had no value to their shareholders and could not pay back their loans from investment banks ("old investors"), without the money provided by the "new investors," to whom investment banks sold the packaged dodgy loans. Perhaps your mutual fund. Perhaps your mutual fund. The only thing that kept the money train moving was the fact that money from "new investors" was used to generate the illusion of high returns for "old investors." That is a The only thing that kept the money train moving was the fact that money from "new investors" was used to generate the illusion of high returns for "old investors." That is a Ponzi scheme. Ponzi scheme. A Ponzi scheme raises money from "new investors" so "old investors" can be paid a return on their money even though the business model is a failure. When Ponzi schemes unravel, even "old investors" lose some of their money, and the "new investors" lose much more. Only "old investors," who get out very early, escape unscathed. A Ponzi scheme raises money from "new investors" so "old investors" can be paid a return on their money even though the business model is a failure. When Ponzi schemes unravel, even "old investors" lose some of their money, and the "new investors" lose much more. Only "old investors," who get out very early, escape unscathed.

In late 2006, I saw a prospectus for RMBS that took hundreds of mortgage loans, put them into a portfolio, and sold the risk to investors. The deal seemed targeted for foreign investors and showed a portfolio including first and second lien (piggyback) mortgages. Some were adjustable rate, some not. The portfolio included negative amortizing product and interest-only product.The loans were purchased from various mortgage lenders. More than 60 percent of the loans were purchased from New Century Capital, which in turn acquired them from New Century Mortgage Corporation, a subsidiary of New Century Financial Corporation, which filed a news release in February 200711 that it would have to restate its financials and filed for bankruptcy on April 2, 2007, under a cloud of fraud allegations. that it would have to restate its financials and filed for bankruptcy on April 2, 2007, under a cloud of fraud allegations.12 Investment banks had a responsibility to perform rigorous investigations into the quality of loans coming from mortgage lenders. Investment banks had a responsibility to perform rigorous investigations into the quality of loans coming from mortgage lenders.

One would expect investment banks that are obliged to perform due diligence appropriate to the circ.u.mstances to yell: Stop the money printing presses! Stop the money printing presses!

For example, Merrill Lynch (the previously mentioned deal was not a Merrill Lynch deal) was a part owner of California-based Ownit Mortgage Solutions. Mike Blum, Merrill Lynch's head of global a.s.set-backed finance, sat on the board of Ownit Mortgage Solutions. Revenue was up around 33 percent in the first three quarters of 2006, but Ownit was losing money. In November 2006, JPMorgan Chase told Ownit that its $500 million credit line would disappear on December 13. When Ownit imploded, Blum faxed in his resignation. Ownit made second-lien mortgages, issued 45-year ARMs, and originated no-income-verification loans. In the words of William D. Dallas, its founder and CEO: "The market is paying me to do a no-income-verification loan more than it is paying me to do the full doc.u.mentation loans."13 In this post Sarbanes-Oxley world, one might have expected Merrill's Mike Blum to insist on a fraud audit of Ownit instead of faxing in his resignation. Warren Buffett points out, "[T]here are worse things than Sarbanes Oxley." In this post Sarbanes-Oxley world, one might have expected Merrill's Mike Blum to insist on a fraud audit of Ownit instead of faxing in his resignation. Warren Buffett points out, "[T]here are worse things than Sarbanes Oxley."14 This is one of them. This is one of them.

Based on public information like this, the SEC should have taken immediate action and asked Merrill and other investment banks why they did not write down losses on mortgage loans and their securitization businesses. If the SEC was not alarmed by the newspapers, they should have been alarmed by an article that I wrote for risk professionals in first quarter 2007. There I emphatically stated that investment bank risk managers involved in securitizing subprime mortgages should get out and short the product, because the predators' fall was in full swing. It was career suicide to be in a position of supposedly overseeing risk if one did not have the authority to stop the insanity. If, however, one did have the authority to do something about it, the time for action was past due. The SEC may not care about my views, but it ignored many voices

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