Your 2008/2009 Experience

[Uccmal]

Part of my experience in real time:

 

http://www.cornerofberkshireandfairfax.ca/forum/general-discussion/wfc-q1-results/

 

http://www.cornerofberkshireandfairfax.ca/forum/general-discussion/ge-cuts-dividend-to-10-from-31-cents/

 

http://www.cornerofberkshireandfairfax.ca/forum/general-discussion/what-to-do/

 

A.

 

[dcollon]

It's actually fun to look back at my notes and the comments/discussions that we were all having during the time. 

 

I particularly enjoyed looking back at the discussion on preferreds.  It's amazing to look back at some of the yields we were getting and the upside that came along with it.  What I'm most impressed with is that no one in the thread was panicking or acting irrationally.  We were just trying to systematically go through the facts as we knew them at the time. 

 

One thing I have done every year is keep a investment journal.  I have random comments, thoughts, feelings, etc...typed up in word documents since I started in the business.  I wish I could remember who told me to do it, but it's fun to look back on my behaviors/feelings/questions/opinions.

 

I also have binders for every year going back over 15 years now with print outs on economic data and market news.  It provides me a time stamp of topics/data/etc....that I thought was interesting at the time.  I'm trying to prevent any revisionist thinking from entering my process.

 

One of  the many reasons I enjoy this "community" so much is the ability to have a very rich data source to access over time.  It's truly priceless.

 

 

[Kraven]

It's actually fun to look back at my notes and the comments/discussions that we were all having during the time. 

 

I particularly enjoyed looking back at the discussion on preferreds.  It's amazing to look back at some of the yields we were getting and the upside that came along with it.  What I'm most impressed with is that no one in the thread was panicking or acting irrationally.  We were just trying to systematically go through the facts as we knew them at the time. 

 

One thing I have done every year is keep a investment journal.  I have random comments, thoughts, feelings, etc...typed up in word documents since I started in the business.  I wish I could remember who told me to do it, but it's fun to look back on my behaviors/feelings/questions/opinions.

 

I also have binders for every year going back over 15 years now with print outs on economic data and market news.  It provides me a time stamp of topics/data/etc....that I thought was interesting at the time.  I'm trying to prevent any revisionist thinking from entering my process.

 

One of  the many reasons I enjoy this "community" so much is the ability to have a very rich data source to access over time.  It's truly priceless.

 

Those are some really good ideas.  How great to be able to look back and have that kind of information and data.

[ERICOPOLY]

Original Mungerville played it well by having 100% notional Russell 2000 puts, and then having a 100+% long ORH position.  I think that is roughly right.

 

Instead, I had no cash and mostly FFH.  I quit my job in early January, 2008.  So I had nothing better to do than watch the daily events unfold.  FFH dropped from $285 range down to $218 or so around September 2008 -- somewhere near $230 and $220 I was selling common FFH purchasing $120 strike FFH calls.  Then out of the blue on a Friday the short selling ban was announced, FFH pre-announced a gain of roughly $400 million on AIG CDS the following Monday, and my (bruised at this point) net worth doubled by end of day Tuesday.  So that was completely random.  Because of that short selling ban (and due to the leverage I added soon beforehand), I finished 2008 up 20%. 

 

I would rather have been positioned like Original Mungervillle, but wasn't as smart/prepared.

 

I didn't have a very complicated strategy -- just blown by the wind.  It is somewhat amazing it worked out okay.

 

Eric,

Of course I have already said it many times, and you know very well my thought on the subject… But I repeat it once again: the reason to hold FFH today is not that the price of its stock will do fine in a market panic… Sincerely, I have no idea how it will behave… And I don’t see how anyone can predict such a thing… What I do know, instead, is that no other company I am aware of is so well positioned to take advantage of a market panic. This is the only reason I hold such a large investment in FFH today. Because it is a business led by opportunistic people, who are doing something I understand and like. Period. And because I think it is cheap. No idea what the stock price shall do. And don’t care.

You might say: well, I don’t like what they are doing… That’s perfectly fine! It is a business judgment. It is different from mine, but I understand and respect other points of view. And also find them useful. I think that’s what Packer is saying: he thinks this bull market will go on for years, therefore he feels no need to be invested in a business positioned to take advantage of a market panic. Very well! I can accept eventually to be wrong. (And don’t forget my firm’s equity is up 22% this year, the FFH’s investment notwithstanding! ;))

What I cannot relate to is the following thought: in a market panic FFH will go down with everything else, therefore I will buy it later at more advantageous prices… This is something I really don’t understand, because business is not done that way.

 

Gio

 

The insurance operations hold them back -- I don't think they can go 100% into equities in a crisis... they have credit ratings and things like that which hold them back in a crisis -- I view those things as a hidden & very real cost of their float.

 

A better preparation for a crisis, IMO, is to just hold cash now instead of holding FFH.  Then fully deploy the cash when things are really cheap.

 

That approach would have worked a lot better in the last crisis of 2008/2009.  They have this really complicated approach of owning lots of insurance companies, the headaches that come along with that, and lots of hedges, but in the end they only double their equity in the crisis -- this is a result I'm sure those guys could individually outperform if they were not investing within an insurance company.

 

So given those shackles it puts on their investing freedom, one would hope the insurance operations would be extremely good in order to make up for this -- lots of underwriting profit.  Where is it?

 

 

[wachtwoord]

In hindsight I didn't know sh**t about financials.  And to this day I am scared to invest in financials because I just don't get it.

 

I wasn't around for the 2008 crisis since I started investing in 2011, but I've never bought a bank stock. Even though everyone here is saying that BAC and C  are great investments (and I'm sure they are) I don't  truly understand it and can't value it. Further, the moats of banks are provided by the state (basically being allowed to borrow very cheaply and handing out loans expensively) and could (potentially) be taken away if the public finds out what a great scam that really is. Banks without that monopoly would make far less money.

 

I also never owned insurers. I think those businesses are far more stable, but I've yet to investigate how to analyze both the safety and valuation.

[giofranchi]

The insurance operations hold them back -- I don't think they can go 100% into equities in a crisis... they have credit ratings and things like that which hold them back in a crisis -- I view those things as a hidden & very real cost of their float.

 

A better preparation for a crisis, IMO, is to just hold cash now instead of holding FFH.  Then fully deploy the cash when things are really cheap.

 

That approach would have worked a lot better in the last crisis of 2008/2009.  They have this really complicated approach of owning lots of insurance companies, the headaches that come along with that, and lots of hedges, but in the end they only double their equity in the crisis -- this is a result I'm sure those guys could individually outperform if they were not investing within an insurance company.

 

So given those shackles it puts on their investing freedom, one would hope the insurance operations would be extremely good in order to make up for this -- lots of underwriting profit.  Where is it?

 

Well, this I understand! You think they are not well positioned to take advantage of a market panic. Ok! No problem with that. It is a business judgment!

Now, the fact I have no problem to understand your judgment about how FFH has positioned its business... of course, doesn’t mean I agree with it! ;)

 

Gio

 

[ERICOPOLY]

 

Well, this I understand! You think they are not well positioned to take advantage of a market panic. Ok! No problem with that. It is a business judgment!

Now, the fact I have no problem to understand your judgment about how FFH has positioned its business... of course, doesn’t mean I agree with it! ;)

 

Gio

 

They are very well or extremely well positioned for an insurance company.

 

It's just that an insurance company is not the best vehicle in a market panic (due to the restrictions on the portfolio allocation).

[BG2008]

How did you aggregate all the data?  Just a binder with printouts/cutouts?  How would you track everything today? Just dump everything into a folder, world file etc?  I keep folders of companies that I look at.  So, it's good to look over my analysis at a later time.  I also will update my analysis/Excel files by naming using a new date.  That shows how my thoughts have evolved over time.  There are online tools such as basecamp.com that you can use to track all of the notes.  Any suggestion of a cloud solution would be appreciated. 

 

It's actually fun to look back at my notes and the comments/discussions that we were all having during the time. 

 

I particularly enjoyed looking back at the discussion on preferreds.  It's amazing to look back at some of the yields we were getting and the upside that came along with it.  What I'm most impressed with is that no one in the thread was panicking or acting irrationally.  We were just trying to systematically go through the facts as we knew them at the time. 

 

One thing I have done every year is keep a investment journal.  I have random comments, thoughts, feelings, etc...typed up in word documents since I started in the business.  I wish I could remember who told me to do it, but it's fun to look back on my behaviors/feelings/questions/opinions.

 

I also have binders for every year going back over 15 years now with print outs on economic data and market news.  It provides me a time stamp of topics/data/etc....that I thought was interesting at the time.  I'm trying to prevent any revisionist thinking from entering my process.

 

One of  the many reasons I enjoy this "community" so much is the ability to have a very rich data source to access over time.  It's truly priceless.

[giofranchi]

They are very well or extremely well positioned for an insurance company.

 

It's just that an insurance company is not the best vehicle in a market panic (due to the restrictions on the portfolio allocation).

 

I already hold both cash and some short positions… And I don't want to stay too much out of the game. Therefore, can you point me at a business, any business, not necessarily an insurance company, that is better positioned than FFH to take advantage of an hypothetical market panic? I would then gladly shift some capital from FFH to …

 

Gio

 

[ERICOPOLY]

They are very well or extremely well positioned for an insurance company.

 

It's just that an insurance company is not the best vehicle in a market panic (due to the restrictions on the portfolio allocation).

 

I already hold both cash and some short positions… And I don't want to stay too much out of the game. Therefore, can you point me at a business, any business, not necessarily an insurance company, that is better positioned than FFH to take advantage of an hypothetical market panic? I would then gladly shift some capital from FFH to …

 

Gio

 

Cash.  It didn't drop from $285 at the beginning of 2008 all the way down to $219 in March 2009.

 

That drop was "only" half as severe as the overall market.  Given the gains on the hedges, one might have thought the stock would go up, right?  Wrong.

[dcollon]

bg2008,

 

There are probably much more efficient and better ways of doing it.  However, I started out simply using binders with the year inserted in the sleeve on the outside for ease of reference.  I simply have printed everything out.  The problem I will have over time is storing the binders then worrying about them getting lost/damaged, so I will likely have to scan everything at some point and store it on a drive.  It will be much easier to access it.

 

You just need to figure out what works best for you.  I would definitely try to utilize the cloud and or a large external drive.  Unfortunately, when I started doing this those options weren't available.

 

 

[rjstc]

They are very well or extremely well positioned for an insurance company.

 

It's just that an insurance company is not the best vehicle in a market panic (due to the restrictions on the portfolio allocation).

 

I already hold both cash and some short positions… And I don't want to stay too much out of the game. Therefore, can you point me at a business, any business, not necessarily an insurance company, that is better positioned than FFH to take advantage of an hypothetical market panic? I would then gladly shift some capital from FFH to …

 

Gio

 

Cash.  It didn't drop from $285 at the beginning of 2008 all the way down to $219 in March 2009.

 

That drop was "only" half as severe as the overall market.  Given the gains on the hedges, one might have thought the stock would go up, right?  Wrong.

 

Good point Gio. I think that part of the problem is mental. With a cash position people think they are missing something. But as he says it was a better hedge.

[giofranchi]

Good point Gio. I think that part of the problem is mental. With a cash position people think they are missing something. But as he says it was a better hedge.

 

Well, but, as I have said, I already hold some cash… The problem with cash is plain to see: it will do well only if a market panic really unfolds! In any other scenario it will do terribly… FFH, instead, will do fine, even if the market keeps marching upward (at least, that's my business judgement...).

What I want is a portfolio of businesses (both private and publicly traded), that insulates me from what the market does (read what other people do) as much as possible. I don’t want the growth of my net worth “to depend on the kindness of others”. FFH has a very well defined place in this portfolio of businesses, and I don’t know of any other company that might replace it.

 

Gio

 

[twacowfca]

One question I have about 2004-2005-2006: Was it obvious that a bubble was forming in the financial sector? Was it as easy for a value guy to avoid banks then as easy it is to avoid today, say, facebook/twitter/netflix stocks?

 

Noooooooooooo, there was no agreement by investing guru's or us common folk that financials were going to blow. Sure I heard of people like Einhorn and Whitney, but there is always people on the fringe. Buffett didn't see it, Bernenke didn't see it, so how could I?

 

But you know, even Hollywood knows how wall street works. In the movie Margin Call, the head honcho says after the meltdown, "Nobody knows what's going on, we just react".  Buffett got rich from the crisis, because he had a cash cushion, that cash he always had on hand. So he could take advantage. The key is once you have a cash cushion, know to use it. I kept saying to anyone who would listen, this is a once in-a-lifetime opportunity. Because I looked at the DJIA of the last 100 years and I saw that 1932, 1974, 1982 were golden opportunities, I kept thinking man if I could get back to the 80's and bought MSFT. Well I can imagine myself saying the same thing about the market in 2009 if I don't act.

 

 

 

Appreciate that insight - thanks.

 

Were financials, in any case, easy to avoid? Not because they were selling for P/E of 100, but more like dividend stocks today? Yielding a pittance for the risk taken. I think the biggest takeaway (even for those who avoided financials) is the blowback and the spillover effect the financials had on all other sectors of the economy.

 

I suppose the only lesson that can be drawn (especially for those running concentrated portfolios) is to have appropriate level of sector-based diversification.

 

Diversification would have made a difference but at what point would you have committed money to 10 year bonds or cash when the interest rates were so low. Sitting for 3 years with no income would have been torture.  I do recall a discussion well ahead of the meltdown on the old board about when the crash was going to happen but the magnitude, and the secondary, and worse crash, in March took everyone by surprise.  Hell, I had a small position in Washington Mutual in Sept/2008, thinking the worst had past.  There was literally only a handful of people still working on wall street who had ever experienced anything of this magnitude before (irving Kahn comes to mind).

 

Dont forget the homebuilders collapsing, and Bear Sterns two hedge funds in early 2007 all preceded the financial meltdown.  The mortgage meltdown preceded the liquidity crisis.  Nearly everyone thought it was contained.  The financials were the final chapter.  Everything else had gone to hell by the start of 2008, which incidentally is when the retrospectively dated. The markets kept on going as if very little had happened until rumours of the Lehman liquidity crisis.  Those who predicted it, such as FFH, Michael Burry, and the guys in the Big Short, predicted something but had no timing in place.  FFH and Burry were years early. 

 

Unless one is a permabear, and always in waiting for the next crash then there was no way to be right on that event.  The problem with the permabears is they missed the upturn as well, and the greatest bull run since forever. 

 

I was in Mexico on vacation during the March crash.  I would go to the paid internet service two or three times per day to sell stuff and buy other/better stuff cheaper.  I remember that Canadian idiot Kevin O'Leary on Tv saying that Ge broke $10 it was going to zero.  I bought GE Leaps that day. 

 

 

Addendum:

I will add that bravery would have looked like the ultimate stupidity had things not turned back up so quickly.  To that end I kept buying SPY puts to protect my gains for some time as the market recovered.  These lost money.

 

 

I saw everything coming, but not the extent of the panic, built up a very large cash position, and still blew a golden opportunity to make money.

 

Here are some good things I did and some not so good things  ( actually some really stupid things ).

 

The writing was on the wall in 2007.  The only question was when, and the answer to that question was almost certainly  : not long.  I kept pestering the managers of our largest holding to watch out for the big sell off of anything having to do with mortgage SPV's no matter how rated and anything else low rated.  They sailed through the crisis without any losses other than an insignificant half a percent loss in Q4 of 08, mainly thanks to their paranoia about losing money rather than my advice, despite the fact that their assets were almost entirely financial.

 

I bought FFH, but then sold it for a small profit and missed most of the run up during the crisis.  I had a large workout in HD's Dutch Auction that produced a small loss because large banks welched on their financing commitments for a sale of a subsidiary to a private equity company  that was to provide the funds for their share repurchase.  That was a bad omen of shakiness in the balance sheets of the financial sector so I bought a huge number of S&P 500 puts. But things took longer to unravel than I thought, so I closed out the puts at break even and missed the the market decline in January of 08.

 

The rest of 08 was like that.  I was right, although the magnitude of the panic surprised me, but either too early or too late to take advantage of my insights.  At the end of 08, my only consolation was the lame thought that I wasn't down nearly as much as the market averages.  ???

[giofranchi]

The rest of 08 was like that.  I was right, but either too early or too late to take advantage of my insights.  At the end of 08, my only consolation was the lame thought that I wasn't down nearly as much as the market averages.  ???

 

Ah! Another thing: I don't want timing to be part of the equation! I am terrible at timing! ;)

 

Gio

[ERICOPOLY]

Good point Gio. I think that part of the problem is mental. With a cash position people think they are missing something. But as he says it was a better hedge.

 

Well, but, as I have said, I already hold some cash… The problem with cash is plain to see: it will do well only if a market panic really unfolds! In any other scenario it will do terribly… FFH, instead, will do fine, even if the market keeps marching upward (at least, that's my business judgement...).

What I want is a portfolio of businesses (both private and publicly traded), that insulates me from what the market does (read what other people do) as much as possible. I don’t want the growth of my net worth “to depend on the kindness of others”. FFH has a very well defined place in this portfolio of businesses, and I don’t know of any other company that might replace it.

 

Gio

 

For every share of BAC I hold, I have a matching put at $12 strike.

 

The stock is at $15.70 today.  Let's say we have a panic next month where the stock drops back to $12.

 

Those $12 strike puts which today cost $1, will rise to at least $2.40 (just based on experience I think it will go at least that high).  That means I have maximum near-term downside of 14.6%.

 

That's a lot less downside than I suffered holding FFH through the crisis.  Plus, I believe it holds greater upside in the case of non-crisis.

 

Anyhow, you asked what was better prepared for the next crisis and where you can't stand holding too much cash -- that's an answer, although it's not perhaps what you were looking for as BAC itself won't be scooping up any bargains in a crisis.

[giofranchi]

For every share of BAC I hold, I have a matching put at $12 strike.

 

The stock is at $15.70 today.  Let's say we have a panic next month where the stock drops back to $12.

 

Those $12 strike puts which today cost $1, will rise to at least $2.40 (just based on experience I think it will go at least that high).  That means I have maximum near-term downside of 14.6%.

 

That's a lot less downside than I suffered holding FFH through the crisis.  Plus, I believe it holds greater upside in the case of non-crisis.

 

Anyhow, you asked what was better prepared for the next crisis and where you can't stand holding too much cash -- that's an answer, although it's not perhaps what you were looking for as BAC itself won't be scooping up any bargains in a crisis.

 

That sounds like a very good strategy. The problem is I don’t master options half as good as you do… Half?! Try 1/5! Much better! ;)

And I wouldn’t dare following your strategy with much capital… Options clearly is a field where I still have a lot of room for growth and improvement! :)

 

Gio

 

[ERICOPOLY]

For every share of BAC I hold, I have a matching put at $12 strike.

 

The stock is at $15.70 today.  Let's say we have a panic next month where the stock drops back to $12.

 

Those $12 strike puts which today cost $1, will rise to at least $2.40 (just based on experience I think it will go at least that high).  That means I have maximum near-term downside of 14.6%.

 

That's a lot less downside than I suffered holding FFH through the crisis.  Plus, I believe it holds greater upside in the case of non-crisis.

 

Anyhow, you asked what was better prepared for the next crisis and where you can't stand holding too much cash -- that's an answer, although it's not perhaps what you were looking for as BAC itself won't be scooping up any bargains in a crisis.

 

That sounds like a very good strategy. The problem is I don’t master options half as good as you do… Half?! Try 1/5! Much better! ;)

And I wouldn’t dare following your strategy with much capital… Options clearly is a field where I still have a lot of room for growth and improvement! :)

 

Gio

 

People wouldn't dare purchase fire insurance for their homes right, because it's too risky?  I mean, so far I've lost money on fire insurance every single time I've purchased it.  Year after year, I've lost 100% of the premium.  It's too risky!

 

Fire insurance gets risky when you start purchasing insurance on homes that you don't own. 

 

Options work the same way.

[giofranchi]

People wouldn't dare purchase fire insurance for their homes right, because it's too risky?  I mean, so far I've lost money on fire insurance every single time I've purchased it.  Year after year, I've lost 100% of the premium.  It's too risky!

 

Fire insurance gets risky when you start purchasing insurance on homes that you don't own. 

 

Options work the same way.

 

I didn’t mean that! You should know by now, if there is someone who buys insurance (maybe too much of it!), it is just me!

Instead, what I meant is I don’t feel comfortable yet with the “technicalities” of options trading. That’s why I wouldn’t buy or sell options with much capital involved.

 

Gio

 

[ERICOPOLY]

People wouldn't dare purchase fire insurance for their homes right, because it's too risky?  I mean, so far I've lost money on fire insurance every single time I've purchased it.  Year after year, I've lost 100% of the premium.  It's too risky!

 

Fire insurance gets risky when you start purchasing insurance on homes that you don't own. 

 

Options work the same way.

 

I didn’t mean that! You should know by now, if there is someone who buys insurance (maybe too much of it!), it is just me!

Instead, what I meant is I don’t feel comfortable yet with the “technicalities” of options trading. That’s why I wouldn’t buy or sell options with much capital involved.

 

Gio

 

I see.

 

Well, I can only say that it has been worth it for me to learn about them.  It's sort of nice the way you can write the $25 strike call and use the proceeds to purchase two $8 strike puts.  This way, you can put 100% of your present capital into the stock at $8 per share during a panic (by either purchasing the underlying common stock, or by flipping each $8 put into an $8 call).  So if it goes from $16, down to $8, and then back up to $16 you can double your money even though the stock never appreciated from present levels.  And instead if the stock doesn't go into a panic, but rather it goes from $16 to $25 over those same two years, you can make 56%.  That's not a horrible thing either way -- panic or no panic.

 

You get to preserve your buying power, and at the same time you don't have miss out on gains if there is no panic.

 

And really it costs nothing at all -- only gets expensive if the stock goes over $25... but if that is to be considered an expense, then you have a much bigger expense if you are instead in cash all that time.

[BG2008]

People wouldn't dare purchase fire insurance for their homes right, because it's too risky?  I mean, so far I've lost money on fire insurance every single time I've purchased it.  Year after year, I've lost 100% of the premium.  It's too risky!

 

Fire insurance gets risky when you start purchasing insurance on homes that you don't own. 

 

Options work the same way.

 

I didn’t mean that! You should know by now, if there is someone who buys insurance (maybe too much of it!), it is just me!

Instead, what I meant is I don’t feel comfortable yet with the “technicalities” of options trading. That’s why I wouldn’t buy or sell options with much capital involved.

 

Gio

 

I see.

 

Well, I can only say that it has been worth it for me to learn about them.  It's sort of nice the way you can write the $25 strike call and use the proceeds to purchase two $8 strike puts.  This way, you can put 100% of your present capital into the stock at $8 per share during a panic (by either purchasing the underlying common stock, or by flipping each $8 put into an $8 call).  So if it goes from $16, down to $8, and then back up to $16 you can double your money even though the stock never appreciated from present levels.  And instead if the stock doesn't go into a panic, but rather it goes from $16 to $25 over those same two years, you can make 56%.  That's not a horrible thing either way -- panic or no panic.

 

You get to preserve your buying power, and at the same time you don't have miss out on gains if there is no panic.

 

And really it costs nothing at all -- only gets expensive if the stock goes over $25... but if that is to be considered an expense, then you have a much bigger expense if you are instead in cash all that time.

 

Eric,

 

I'm assuming you're talking about Jan 2014 BAC calls and puts.  The $25 calls are 10-12 cents and the $7 (no $8) puts are 5-6 cents.  Seems like tiny % of the common.  Does seem to make sense to sell the upside here.  If buying the $7 puts only cost 30bps, seems to make sense to just pay up for them.  I really like the strategy of buying the commons and the ATM puts simultaneously.  Seems like a great way to sleep well at night knowing that you've paid the cost of the fire insurance on your "house" even if it cost 10% annualized.  It allows one to comfortably size a position at 20+% knowing that worst case downside is 2% of AUM.  Sizing trades large in a fund is harder to do than in your personal IRA.  This seems to resolve that issue.  If you want to size something at 20+%, the CAGR on that idea is likley above 10% anyway.  If you were to initiate a position in BAC today, which strike would you buy?  Would it be the $15, 12, or a mix of both with some deep OTM thrown in?  How do you think about the % premium vs OTM and duration?   

 

Regarding lending rates for shares like SHLD, can you implement a strategy where you can buy the ATM put and lend at a double digit rate that pays for the put?  I recall the cost of borrow for SHLD being close to 100% at one point.  Do you recall how much ATM BAC puts cost (% of common) when it was trading close to $5?

 

Great discussion on this thread.  I delayed the launch of my fund for 2 years because I couldn't figure out how to hedge a repeat of 2008/2009.  I've decided to borrow a page from Buffet by investing in workouts/special sits as an alternative to holding cash.  I believe that I can do >10% CAGR regardless how the market performs.  But your long commons coupled with long ATM puts is a great addition to my tool box of hedging against 2008/2009. 

 

 

[BG2008]

In trying to analyze the 2008/2009 experience come full circle, I want to share something that can hopefully answer the question of "when do you get back in?" 

 

He mentioned that when you start seeing net-nets (excluding Chinese frauds) that actually have a good underlining business, it is time to tip back into the market.  A good example is Tellular was trading at liquidation value, the company was buying back stock, and the underlining alarm business is a very high quality with recurring revenue.  When you can find those for sale, just buy a basket .  If there is a drawn out recession/depression, the buyback in shares and the growing cash balance will serve as a catalyst to drive the price higher.  There were a handful of companies that exhibits these characteristics during the darkest days.

 

 

[ERICOPOLY]

People wouldn't dare purchase fire insurance for their homes right, because it's too risky?  I mean, so far I've lost money on fire insurance every single time I've purchased it.  Year after year, I've lost 100% of the premium.  It's too risky!

 

Fire insurance gets risky when you start purchasing insurance on homes that you don't own. 

 

Options work the same way.

 

I didn’t mean that! You should know by now, if there is someone who buys insurance (maybe too much of it!), it is just me!

Instead, what I meant is I don’t feel comfortable yet with the “technicalities” of options trading. That’s why I wouldn’t buy or sell options with much capital involved.

 

Gio

 

I see.

 

Well, I can only say that it has been worth it for me to learn about them.  It's sort of nice the way you can write the $25 strike call and use the proceeds to purchase two $8 strike puts.  This way, you can put 100% of your present capital into the stock at $8 per share during a panic (by either purchasing the underlying common stock, or by flipping each $8 put into an $8 call).  So if it goes from $16, down to $8, and then back up to $16 you can double your money even though the stock never appreciated from present levels.  And instead if the stock doesn't go into a panic, but rather it goes from $16 to $25 over those same two years, you can make 56%.  That's not a horrible thing either way -- panic or no panic.

 

You get to preserve your buying power, and at the same time you don't have miss out on gains if there is no panic.

 

And really it costs nothing at all -- only gets expensive if the stock goes over $25... but if that is to be considered an expense, then you have a much bigger expense if you are instead in cash all that time.

 

Eric,

 

I'm assuming you're talking about Jan 2014 BAC calls and puts.  The $25 calls are 10-12 cents and the $7 (no $8) puts are 5-6 cents.  Seems like tiny % of the common.  Does seem to make sense to sell the upside here.  If buying the $7 puts only cost 30bps, seems to make sense to just pay up for them.  I really like the strategy of buying the commons and the ATM puts simultaneously.  Seems like a great way to sleep well at night knowing that you've paid the cost of the fire insurance on your "house" even if it cost 10% annualized.  It allows one to comfortably size a position at 20+% knowing that worst case downside is 2% of AUM.  Sizing trades large in a fund is harder to do than in your personal IRA.  This seems to resolve that issue.  If you want to size something at 20+%, the CAGR on that idea is likley above 10% anyway.  If you were to initiate a position in BAC today, which strike would you buy?  Would it be the $15, 12, or a mix of both with some deep OTM thrown in?  How do you think about the % premium vs OTM and duration?   

 

Regarding lending rates for shares like SHLD, can you implement a strategy where you can buy the ATM put and lend at a double digit rate that pays for the put?  I recall the cost of borrow for SHLD being close to 100% at one point.  Do you recall how much ATM BAC puts cost (% of common) when it was trading close to $5?

 

Great discussion on this thread.  I delayed the launch of my fund for 2 years because I couldn't figure out how to hedge a repeat of 2008/2009.  I've decided to borrow a page from Buffet by investing in workouts/special sits as an alternative to holding cash.  I believe that I can do >10% CAGR regardless how the market performs.  But your long commons coupled with long ATM puts is a great addition to my tool box of hedging against 2008/2009.

 

I was actually thinking of the 2016 expirations when I wrote that -- the short terms expiring in 2014 don't provide adequate time to recover to the upside.

 

So if you get 2016 expiry $8 puts, and the shares crash back to that level, you can either buy more common (hedged at $8), or you can sell the put and buy the call.  So the long-dated call here gives you a lot of time for market recovery.  This is if you are willing to hold the BAC shares to expiration of the calls you write -- it will get annoying if the stock goes to $25 by end of next year and you have this (by then) really expensive $25 strike call standing in the way.  But, that's the tradeoff if you want the $8 strike puts to come at "no" cost.

[BG2008]

Yeah, that makes sense.  I actually meant to say 2015. 

[original mungerville]

Original Mungerville,

 

How did you know that there were impending doom?  I think many of us realize that the US RE market exhibited bubble like characteristics.  But it was hard to time.  Many were too early.  Were there particular signs?  Was it expensive for you to put on your Russell 2000 put strategy?  How much OTM were the puts?  How much did it cost at the time? 

 

From what I hear about China on the ground, I think it's due for some sort of correction.  Overall, there's a prevailing sense of "you can't lose money buying real estate" and the government will save us all.  But, I've felt that way since 2009.  The kind of euphoria in China now is very similar to the euphoria we experience here in the US when the meatheads at the gym talks about flipping houses for $50k profit.

 

 

I felt the US RE market (as well as the stock market and bond market) exhibited bubble like behaviour for some time (quite a few years). RE started turning down I guess in 2006, then by early 2007 those Bear Stern funds were showing signs of distress. Ackman's "Who's Holding the Bag" powerpoint presentation really had an effect on me - this was spring/summer 2007. By August 2007, many securitisation structures were starting to breakdown. Around August, the bond market dropped 20% I believe, I think the stock market turned down as well in summer 2007.

 

Then in September 2007, the stock market recovered back to its highs. At that point, the bond market spreads may have come in a bit, but they were not recovering. RE continued to decline and the securitisation structures continued to breakdown. Further, all the financials were levered 30-40x to equity. My thinking at the time was simple: We have the 3 major asset classes in a bubble. Bonds and real-estate were already down 10-20%. Securitisation was deteriorating rapidly and about to blow up, and was linked to both the bond and RE markets...the financials were levered 30x... so a 3% after-tax loss wipes the system out. All this was going on with stocks trading at their highs in late September 2007. Stocks are junior to bonds, so basically either the bond/securitisation markets were going to recover or, in my view, the stock market would join the bond and RE market and decline in price - by more than 20% (ie more than the bonds) so something like 30-60%. My view was that was going to happen imminently because securitisations were blowing up and that was kindof the trigger, but not only that, a persistent trigger, a festering flame that would be difficult to put out - and that would ensure bonds/RE would not recover on their own. If that happens, stocks were going to joint, and then we have all 3 major asset classes in the tank with the financial system levered 30-40x. Given this, the financial system was going to collapse in my view in the coming months.

 

So, for example, years earlier, I had a friend I had provided my view on regarding which mutual fund to put his money in, and he took my advice. I felt morally obliged to warn him of my view. So in late September 2007, I called him and told him to take ALL of his money out of the stock market because it was going to crater soon. With my money I went to a fully hedged position (see below). Also at work I began warning people of the impending doom (which I had never done before).

 

Ericopoly is right. In the middle of the crisis, I was 100% ORH I believe with calls at strike of 30 with the stock trading at 37. It was the biggest no brainer long I knew of no matter what happened / how bad things got. I was also hedged with similarly in the money puts on the Russell 2000 representing 100% notional. At times I think I went to over 100% notional and both the long ORH and short Russell. Through 2007 - 2009, I did not want anything long other than ORH. At the time buying ORH was like say buying into Chou Funds - not at NAV but at 80% of NAV because ORH was at 80% of forward book at 37. Furthermore, because Watsa bought most of the municipal bonds guaranteed by Berkshire and stuck a big chunk in ORH, these things along with the treasuries they held etc, and with ORH's historic underwriting profit, together meant that you can have income of (if I remember) 8% almost guaranteed (ie treasuries plus BRK guaranteed municipals with any equity exposure in the ORH investment portfolio fully hedged - so BRK has to go down for ORH not to pay me off basically; if the crisis got worse, I think BRK would have felt it big time but would not have failed...). So anyway, ORH was like buying at 80% of NAV with an 8% almost certain annual yield to NAV (and of course, layer on top of that any Alpha Watsa would produce on his hedged equity book and other investments). Imagine if you could buy a mutual fund at 80% of NAV, 8% guaranteed, with the investment manager who manages the rest of the assets being one of the best out there. 80% with an 8% floor yield - WITH upside - was a hell of a deal in a crisis. So ORH was trading below 50 cents and was very secure. Anyway FFH ended up taking out ORH at 60-65 or so...so it worked out although ORH was worth at least 85 in my opinion. So Watsa low-balled the take-out...but then again, I should not expect anything less from a good value investor. 37 to 65 or whatever was an OK return, then on top of that my hedge made me money.

 

I did not want an industrial, or a financial at the time - I did not want BRK, I wanted ORH because it was safer than anything out there.