Transcript of Remarks to Portfolio Management Research on April 21, 2020.

Introduction

Thank you, Mark, and welcome everyone. In the next ten minutes, I’ll accomplish three things. First, I’ll revisit the investment management lessons in the lead article that I wrote for the Spring 2019 issue of the Journal of Structured Finance. I titled the article “More than One Million Reasons to Lie about Structured Finance.” Second, I’ll explain how those lessons were profitably applied during the recent market upheaval caused by our reaction to the Wuhan virus. During this Bad Bat event, we were barraged by lies from the Chinese Communist Party. Third, I’ll offer my perspective on how those lessons can be applied to what may be coming next.

Financial Crisis of 2008

In the article for JSF, I wrote that before the 2008 meltdown, collateralized debt obligations were the fastest-growing segment of the financial markets. Securitization professionals were motivated by multi-million dollar bonuses and engaged in control fraud. The 2008 financial crisis was not a black swan or a swan of any color. The problem wasn’t data outliers; our problem was outright liars. In the run up to the 2008 financial crisis, the models were flawed, but the bigger problem was that the securitizations were riddled with fraud. Correlation models obscured the fact that many so-called “AAA” and “Super Senior” tranches were marketed as super safe but deserved junk ratings when they were created.

Fraud was discoverable and knowable in advance by doing a granular portfolio analysis, and I warned about permanent losses in advance. One had to do a granular analysis, a statistical sampling of the underlying portfolio, and that revealed grave issues with the underlying collateral and its documentation. Structure upon daisy-chained structure—combined with credit derivatives—amplified the problem. By 2007, CDO-squareds were simply vehicles to disguise losses.

Look for fraud, because trouble is opportunity. John Paulson and Dr. Michael F. Burry used credit derivatives to create leveraged shorts against tranches of value destroying securitizations. Fixed income securitizations come to market at par and only go down in value when fraud is part of the process. The price will eventually plummet, and there will be permanent value destruction.

One gen­erally considers three stochastic variables when calculating credit losses: default probability, recovery rates, and correlation. Of these three, correla­tion is the least important. Yet correlation trading raged through the financial markets like a highly contagious thought virus.

One problem was that most models estimated asset correlations instead of estimating default correlations. Modelers excused errors as spread convexity or used other obfuscation. They could give you the wrong answer to nine decimal places, but they couldn’t give you an accurate answer. They weren’t even in the ballpark.

Even if they had used default correlations, the overwhelming flaw in the methodology is that the only reason default correlation exists at all is if we pretend that default probability does not vary—but of course, it does vary.

Valuation and hedging should focus on default probability and re­covery rates. Instead of hiring quantitative analysts to write inaccurate mod­els that solve the wrong problem, hire people who can analyze a balance sheet and who can spot anomalies.

Correlation modelers counted huge losses as “unexpected losses” or even as “tail” risk. But in reality, these were all expected losses. There was no black swan; there was just a big turkey. Some securitizations were so bad, even the super senior tranches had little value when they were created.

If you cannot hedge due to statutory constraints, simply eliminating these so-called assets from your portfolio will markedly improve performance.

Jim Rogers shorted and profitably rode Citigroup’s share price down a steep slope. The point is that there is more than one way to make a leveraged bet on viral fraud. Jim Rogers shorted Citigroup stock in late December 2007. He covered his position in January 2009 at around $5.

You’ll recall that in 2011, Citgroup did a one-for-ten reverse stock split. It was just too depressing for regulators to see Citigroup trading in the single digits after we bailed it out with hundreds of billions of taxpayer dollars.

The Current Crisis

How can we apply what we know to our current crisis? The beauty of fundamental credit analysis is that even when there isn’t rampant fraud, if you do fundamental analysis and identify mispriced risk, you can leverage your views with credit derivatives.

We crashed our economy due to lockdowns in reaction to the virus that originated in Wuhan, China. Our reaction may have been more extreme than it otherwise would have been due to the Chinese Communist Party’s lies. The CCP lied about human to human transmission and enabled the global contagion by letting infected people board airplanes and other public transportation. The CCP’s cover-up has the rest of the world scrambling for reliable data about patient zero, the asymptomatic period, the contagion rate, and mortality rates.

Bill Ackman of Pershing Square hedged his equity portfolio with credit default swaps on credit indices. His analysis showed that credit spreads were near all-time tight levels on various investment grade and high yield credit default swap indices, after adjusting for near-default companies. He disclosed his hedging on March 3. The hedge offset his equity losses. Premiums and commissions cost Pershing Square $27 million. The proceeds were $2.6 billion. This leaves Pershing Square a little better than even but with a cash war chest.

Boaz Weinstein of Sabra also hedged tight credit spreads. His $2.2 billion of assets under management had an 82% gain as of March 20.

Fundamental credit analysis allowed both of them to initiate leveraged hedges that served their portfolios well.

What’s Next?

No one knows how our current crisis plays out. We already have a localized Depression. Twenty-five million people are out of work. Demand for oil is rock bottom. Banks are bracing for loan losses. Food supply insecurity is weeks away. Not months. Weeks.

The Fed is printing money and ballooning the nation’s debt. Historically, sovereigns have chosen the following methods for debt relief. We’ll probably try a variety of these techniques:

Sovereign Debt Relief

• Miraculous Growth
• Ban Overseas Investments
• Force Banks to Hold Government Debt
• Default on the politically cloutless and foreign unfriendlies.
• Currency Debasement and Inflation
• Negative Real Interest Rates

Of these choices, I far prefer growth.

Modern McKinley / Marshall Plan for the USA

• Rebuild USA’s Internal Supply Chain
• Made in America with American Labor
• Impose Protective Tariffs
• Invest in Productive Assets / Services

No one has seen anything like this before, not even the world’s most experienced and successful investors. I’ve lived through a brutal economic crash and currency debasement when the Shah of Iran was overthrown by Islamic extremists. Life went on, and incredibly, some adjusted and thrived. Correlation models are pretty darn useless in such scenarios. Spend all of your time on balance sheet analysis with an eye to productive well-managed assets that can generate cash.