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Market Miscalculates
by James Grant
Summary by Bill Erickson, Spring 2009

Mr. Market Miscalculates is a collection of articles from the past 10 years from James
Grant’s Interest Rate Observer, a twice-monthly journal. Grant was extremely bearish
during this period, and predicted many of the events that unfolded. He blames the Fed for
most of the problems, due to low interest rates and too much liquidity.

The book began with essays about “The Immortals” – successful capitalists that show us
how business should be done. I summarized two of The Immortals below. The rest of the
articles were organized around certain themes, which I also summarized.

The name “Mr. Market” was invented by Benjamin Graham to personify the irrational,
manic-depressive traits of the market that lead it to bubbles.

The Immortals - Henry Singleton

Henry Singleton was the chief executive of Teledyne Inc, and considered by Grant to be
"one of the greatest of modern American capitalists." Warren Buffett said he "has the best
operating and capital deployment record in American business." What did he do so well?
He was the master of recognizing when the market was over- or under-pricing his stock,
and took advantage of it. In the 60's when the company stock was sky high, he used it to
acquire about 130 companies. When the market turned and his stock went down, he
repurchased them. "Between 1972 and 1984, he ...reduced the share count (from high to
low) by some 90%." While many companies do stock acquisitions and buybacks, none
seem to time it as well as Singleton. In the ten year period following the buybacks, the
stock price remained multiples above the average price paid.

He also stood out for his openness to change. He "engag[ed] an uncertain world with a
flexible mind." He didn't have 5- or 10-year plans, because too much depends on events
and influences outside his control, which can't be predicted. "I like to steer the boat each
day rather than plan ahead way into the future."

The Immortals - Thomson Hankey

In 1866 there was a battle in the Bank of England on how to properly deal with a credit
crisis. The Bank of England was lending freely to banks that offered "good collateral",
which in this case was illiquid mortgages. Hankey argued against it for two reasons:

1. Moral hazard - "Let profit-maximizing people come to believe that the Bank of
England will bail them out, and they themselves will take the actions, and assume the
leverage, that will require them to be bailed out."
2. Fairness - If the banks have the right to be bailed out, what about the shipping,
construction, and railroad companies?

Against the advice of Hankey the central bank continued, and we can still see evidence of
this line of thinking in today’s central banks.
• 21% of Russian monetary reserves are parked in the obligations of Fannie,
Freddie, and the Home Loan Banks
• Over the past 12 months, the balance sheets of the Bank of England and European
Central Bank (ECB) have grown by 19.4% and 21%, respectively.
• Investment bankers who work in securitization are saying that their main business
now is structuring bonds that are eligible for ECB liquidity operations.

Investment and Speculation

Grant, provides an interesting take on investing. His thought: The theory that stocks excel
in the long term, regardless of how they are valued at the time one buys them, has
become “secular gospel.” It’s not the theory itself that bothers him, but the experience
that it is based on – the “almost unchecked, apparently unconditional returns of the S&P.”
What the theory should say is that over the long term, stocks are safer than Treasuries and
bonds because, unlike bond coupon income, dividends and cash flows tend to grow.

A lot of investing is really speculation. “An investment is a speculation to the extent that
its success is contingent on a forecast of uncertain events… an arbitrage between two
securities is an investment… but the outright purchase of the S&P 500 is speculation.”

This was especially evident during the tech bubble. In June of 1999, Grant described how
brokers “advise the purchase of Internet stocks without regard for price or valuation”
because it’s too risky NOT being invested in them.

Tech and telecom were just the most visible parts of the bubble. Its source was cheap
credit. “Artificially low interest rates induce extraordinary levels of borrowing.
Overborrowing stimulates overinvestment. Overinvestment elicits the kind of inflation
we call ‘a wonderful bull market.’”

War Against Deflation

It’s only recently (as in the past 60 years) that deflation has been seen as so destructive to
society and should be prevented at all costs. “From George Washington until the A-
bomb, prices alternately rose and fell. They rose in wartime and fell in peacetime.” There
was little net change in the price level between 1800 and 1929.

But, within two decades of abandoning the gold standard, consumer prices had doubled.
Four decades later, they had quintupled. “Monetary policy has allowed a persistent
overissuance of money.”

Grant argues that there ought to be deflation. “Free trade, globalization, and technological
advance have pushed the global supply downward and to the right. Prices should be
falling.” But in response, the Fed directed ultra-low interest rates, which led to a
consumption boom and pushed the US demand curve upward and to the right.
Figure I: Technological advancement increases supply and should lower prices.
Figure II: Cheap credit increases demand and raises prices.

During 1954-1955, the Consumer Price Index “registered 12 consecutive monthly year-
over-year declines.” But the deflation was benign. Commodity and stock prices zoomed,
and only five banks failed.

However, our deflation would be much worse because of our massive leveraging. “Heavy
debts work on borrowers in a deflation much as lead weights on a swimmer. Each has
trouble staying afloat.”

Grant argues not that deflation is good, but that we should consider the consequences of
our actions. Was the accumulation of huge amounts of debt through cheap credit better
than the deflation we sought to avoid?

“Falling prices are a natural byproduct of human ingenuity. Print money to resist the
decline, and the next thing you know, there’s a bubble.”

Real Estate Troubles – Consumer Side

The mortgage has changed from a “product used to buy one’s home … to a product
where people can leverage their home as a financial asset.” Interest-only, adjustable-rate
and other affordability loans accounted for 25% of all borrowing by dollar volume in
2004 and 2005.

Consumers were told “average US home prices rarely fall from one year to the next.” But
they weren’t told the other side of the statistic: they also rarely soar.
• Between 1890 and 2004, home prices (in real terms) rose by 0.4% a year.
• Between 1997 and 2005, home prices (in real terms) rose by 6.2% a year.
• Was it not foreseeable that, having broken from the trend on the upside, it could
also break from the trend on the downside?
It was said that home prices never go down nationally, and that real estate markets are
local. In the first quarter of 2008, housing prices in 43 states declined, and the nationwide
average home price was down by 3.1% in 2007.

Major causes of the inflated home prices include the availability of cheap credit, lax
lending standards, and the securitization of the mortgages.

Real Estate Troubles – Investor Side

Wall Street was busy turning these mortgages into financial securities. They take a
collection of sub-prime mortgages (higher risk, rated BBB or BBB-minus) into mortgage-
backed securities (MBS), which are then put together to create a Collateralized Debt
Obligation. The CDO “can be blessed with ratings roughly as follows: AAA, 75%; AA,
12%; A, 4%; BBB, 4%; equity, 5%.”

They’re able to do this because “rating agencies and investors share a belief in the risk-
attenuating powers of diversification.” They assume there is a low correlation between
the performances of the individual mortgages, and they won’t all default at the same time.

When the pool of mortgages pays the CDO, the profits go first to the AAA rated
securities and work their way down. If there are losses, they start at the lowest rated
securities and work their way up.

This is how Wall Street turns sub-prime mortgages into AAA rated ones. For it all to
work, housing prices need to continue to appreciate. If they go down, or even appreciate
slower than before, homeowners will default on their mortgages and these losses will
cascade through the system. The below table shows how fragile this system is:

Mortgage Schematic*
House prices, mortgage defaults, and CDO loss transmission mechanism
Home price** Mortgage pool Most senior Loss to CDO Most senior
appreciation cumulative loss MBS class CDO class
written off written off
+7% to +10% 2% None 0% None
+4% to +7% 4 BB 3 None
0% to 4% 6 BBB- 39 AA
0% to -4% 10 BBB+ 84% AAA (partial)
-4% to -7% 12 A 100 AAA
-7% to -10% 16 AA- 100 AAA

* assumes CDO constructed from BBB-rated tranches of subprime mortgage-backed securities; rough approximation of estimated
collateral losses and tranche write-downs
** cumulative appreciation over two years

“This scenario is not extreme. A flat to minus 4% house-price performance over two
years – this results in a 10% mortgage pool cumulative loss. This creates a wipeout of the
CDO AA tranche and a partial loss on the AAA tranche. Eighty-four percent of the
principal of the CDO – not just the BBBs – 84% of the whole principal is wiped out.”
That is one type of CDO, referred to as the cash variety. The second is a synthetic kind,
created by selling insurance against the default of the above kind, mirroring the exposure.
The abundance of synthetic CDO’s lowered the cost of protection, making a great
investment for those who wanted to bet against the CDO’s (with the expectation that
there would be mortgage defaults). The prices were incredibly low, ranging from 190
basis points a year for the better loans to 220 basis points a year for the riskier ones. A
buyer of protection would keep writing checks to the sellers until there is a “credit event.”

In December of 2006 the cost of protection was close to zero. “You can buy credit
protection on the AA slice of subprime mortgage exposure for a mere 13.8 basis points.
That is, the cost of insuring $10 million in notional value of the AA index will set you
back a mere $13,800 a year.”

In 2006, Grant asked a very pertinent question in regards to a CDO (Aquarius) that was
mostly synthetic: “Do you wonder if, by investing 90% in CDS [Credit Default Swaps]
and only 10% in cash CDO’s, you bear any additional credit risk – not only the risk of the
mortgages going bad but also the risk of a counterparty keeling over? Bulls insist not.”

CDO’s can be very confusing, and ignorance about CDO’s even “reaches far into the
population of CDO investors.” Most investors rely purely on ratings because they don’t
have the time or expertise to evaluate the underlying structure.

The Future
• Higher interest rates and higher inflation are coming
• Inflation is a world problem, not a localized one. “Domestic inflation [is]
increasingly sensitive to foreign…output gaps. Globalization…might explain why
inflation movements are so highly correlated across countries.”
• We’ve reached a point where individuals, businesses, and our government have
become too leveraged. A reduction in economic activity over the coming years
can be attributed to this deleveraging.