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Pigs Get Slaughtered



September 16, 2010 – Comments (0)

On my metro ride into work this morning I was reading Margin of Safety by Seth Klarman of the Baupoust Group. Klarman is a "go where they aren't" value investor who preaches a "safety first" philosophy. You may have never heard of him because he is not active in the press. Nevertheless, he is incredibly respected and has an investment track record among the best.

The book was slow in the beginning, but this morning's reading was absolutely captivating. In fact, I was reading so intently that I missed my stop and had to reverse course.

Deja vu All Over Again

The section that had me hooked began on page 76 and was on Collateralized Junk-Bond Obligations. These instruments came about in the 80's as a way to please institutional investors who wanted extra yield "without taking on extra risk." Mmmmm hmmmm.

Long-story short, the pigs got slaughtered and CJBOs exacerbated the junk bond meltdown. I was so enthralled by this topic because just a few short years later (ahem 2000-2006) Collateralized Debt Obligations were viewed as a vehicle for institutional investors to use to pick up extra yield without taking on extra risk. Sound familiar?

In both cases, ratings agencies blessed some of the tranches of the products with coveted AAA ratings and had the models (based on rosy historical projections) to back it up. Well, pigs caught holding Collateralized Mortgage Obligations (a type of CDO) again got slaughtered and the product exacerbated the mortgage crisis.

Will We Ever Learn?

A reader of Klarman should have had the wherewithall to notice that something was wrong during the lead up to the mortgage crisis. I realize hindsight is 20/20, but the similarities are eerie.

Klarman goes on to say:

"It can be hard to concentrate on the potential losses while others are greedilly reaching for gains and your broker is on the phone offering shares in the latest 'hot' public offering. Yet the avoidance of loss is the surest way to ensure a profitable outcome."


"Investors must be willing to forego some near-term return, if necessary, as an insurance premium against unexpected and unpredictable adversity."

Warning: Don't Be a Pig

So in these times of remarkably low interest rates, don't chase yield and ignore potential loss.

Fool on,

Bryan (TMF42)

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