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Good Until Reached For

Credit & debt derivatives remain a terrible risk say these 3 investment legends...

COUNT ME OUT, says Eric Fry of the Rude Awakening, summarizing recent comments from three investment legends about where the boom in credit derivatives trading is headed...

Charles Munger, at the Wesco Financial Corp. shareholder meeting:
   "One thing about accounting, the liabilities are always 100% good. It's the assets you have to worry about…

   "A modest amount of liquidity will service the true needs of a civilization. A large amount of liquidity will bring out the worst in human nature.

   "My nomination for the next crisis will be in the derivative books...I'm not sure when the denouement will come, but there will be one helluva mess in the derivatives books...When Berkshire [Hathaway, which Munger runs with Warren Buffett] bought General Re a few years back, it had a derivatives book. Gen Re needed a derivatives book like I needed a case of syphilis. When we went to sell these derivatives, we discovered that we couldn't get the prices that they were supposedly worth. They were Good-Until-Reached-for assets…

   "The Berkshire model is coming back into favor. The idea of buying a share of common stock for less than the underlying value of that stock is gaining favor."

James Grant
, at the Grant's Investment Conference:
"We Americans don't borrow so much because we are reckless, we borrow because we are adaptive. We tolerate more leverage than our forebears would have dared to do because we are more confident about the future than they generally could afford to be.

   "The economy has become more stable; cyclically the highs are lower and the lows are higher. [But] all of this begs the question – how do you get a depression from a financial crisis? The national hockey league shows the way.

   "Now, hockey is a violent sport. To reduce injuries, therefore, officials have armored the players with face masks and neck protectors...and therein lies the trouble, according to no less than Kevin Greenstein, editor-in-chief of 'With each passing innovation,' he says, 'the players feel as if they are more and more invincible, their armor protecting them from all perceived risk. And the recklessness with which they conduct themselves under that veil of invincibility only makes the sport even more dangerous for the participants.'

   "Does that remind you of anything? Potential safety benefits tend to get consumed as a performance benefit. For example, consider a case of a winding country road, and a safety-minded highway department. They straighten out the lines and improve the lanes.

   "But what then? There might be fewer accidents, but on account of people driving faster, there might be more fatal accidents...[and] so it is on Wall Street."

John Paulson
, president of Paulson & Co. – a hedge fund that, in the words of James Grant, "earned more in 2007 than the GDP of Kyrgystan or Rwanda" by betting on the falling prices of mortgage-backed securities:
   "There are a lot of people that are jumping in and buying mortgage securities today and providing capital to financial firms that are restructuring. So far, anyone that has done that has lost money.

   "Abu Dhabi, China Investment Corp, Singapore, Warburg Pinkus and many, many other investors...they all jumped in too early. Jumping in too early in the credit cycle can be a disastrous investment situation. Only time will tell if these investments will accrue.

   "The biggest factor which influences whether those investments turn out to be good ones or bad ones is really the direction of the economy at this point on. [And] I think that we're not over the crisis. The problems will get worst...

   "Our outlook for the economy is that house prices will continue to fall and consumer spending will decline, credit cost will rise, the recession will be worst than anticipated, and fiscal and monetary stimulus will not be enough to halt the decline. But that means for our own portfolio, in this environment, we would like to minimize our exposure to the equity market.

   "I think the stock market has further to fall. We continue to maintain a short credit bias."

Eric J.Fry has been a specialist in international equities since the early 1980s. A professional portfolio manager for more than 10 years, he wrote the first comprehensive guide to American Depositary Receipts, International Investing with ADRs. Today he reports on Wall Street from California for the renowned Daily Reckoning email service.

See full archive of Eric Fry articles

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