Book Review - Mr Market Miscalculates by James Grant

8/14/2019 Book Review - Mr Market Miscalculates by James Grant

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Mr. Market Miscalculatesby James Grant

Summary by Bill Erickson, Spring 2009

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

The book began with essays about The Immortals successful capitalists that show ushow business should be done. I summarized two of The Immortals below. The rest of thearticles 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 SingletonHenry 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 bestoperating 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 toacquire about 130 companies. When the market turned and his stock went down, herepurchased them. "Between 1972 and 1984, he ...reduced the share count (from high tolow) by some 90%." While many companies do stock acquisitions and buybacks, noneseem to time it as well as Singleton. In the ten year period following the buybacks, thestock price remained multiples above the average price paid.

He also stood out for his openness to change. He "engag[ed] an uncertain world with aflexible mind." He didn't have 5- or 10-year plans, because too much depends on eventsand influences outside his control, which can't be predicted. "I like to steer the boat eachday 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 creditcrisis. 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 ofEngland will bail them out, and they themselves will take the actions, and assume theleverage, 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 ofthis line of thinking in todays central banks.


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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 EuropeanCentral 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 excelin the long term, regardless of how they are valued at the time one buys them, hasbecome secular gospel. Its not the theory itself that bothers him, but the experiencethat 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 andbonds 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 thatits success is contingent on a forecast of uncertain events an arbitrage between twosecurities 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 howbrokers advise the purchase of Internet stocks without regard for price or valuationbecause its too risky NOT being invested in them.

Tech and telecom were just the most visible parts of the bubble. Its source was cheapcredit. 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

Its only recently (as in the past 60 years) that deflation has been seen as so destructive tosociety 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. Therewas 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 persistentoverissuance of money.

Grant argues that there ought to be deflation. Free trade, globalization, and technologicaladvance have pushed the global supply downward and to the right. Prices should befalling. But in response, the Fed directed ultra-low interest rates, which led to aconsumption boom and pushed the US demand curve upward and to the right.


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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. Heavydebts work on borrowers in a deflation much as lead weights on a swimmer. Each hastrouble 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 betterthan the deflation we sought to avoid?

Falling prices are a natural byproduct of human ingenuity. Print money to resist thedecline, and the next thing you know, theres a bubble.

Real Estate Troubles Consumer Side

The mortgage has changed from a product used to buy ones home to a productwhere people can leverage their home as a financial asset. Interest-only, adjustable-rateand other affordability loans accounted for 25% of all borrowing by dollar volume in2004 and 2005.

Consumers were told average US home prices rarely fall from one year to the next. Butthey werent 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 couldalso break from the trend on the downside?


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It was said that home prices never go down nationally, and that real estate markets arelocal. In the first quarter of 2008, housing prices in 43 states declined, and the nationwideaverage 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 acollection 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 DebtObligation. The CDO can be blessed with ratings roughly as follows: AAA, 75%; AA,12%; A, 4%; BBB, 4%; equity, 5%.

Theyre 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 wont all default at the same time.

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

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

Mortgage Schematic*House prices, mortgage defaults, and CDO loss transmission mechanismHome price**appreciation

Mortgage poolcumulative loss

Most seniorMBS classwritten off

Loss to CDO Most senior CDO classwritten 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 estimatedcollateral losses and tranche write-downs** cumulative appreciation over two years

This scenario is not extreme. A flat to minus 4% house-price performance over twoyears this results in a 10% mortgage pool cumulative loss. This creates a wipeout of theCDO AA tranche and a partial loss on the AAA tranche. Eighty-four percent of theprincipal of the CDO not just the BBBs 84% of the whole principal is wiped out.


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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 CDOs lowered the cost of protection, making a greatinvestment for those who wanted to bet against the CDOs (with the expectation that

there would be mortgage defaults). The prices were incredibly low, ranging from 190basis points a year for the better loans to 220 basis points a year for the riskier ones. Abuyer 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 creditprotection 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 youback a mere $13,800 a year.

In 2006, Grant asked a very pertinent question in regards to a CDO (Aquarius) that wasmostly synthetic: Do you wonder if, by investing 90% in CDS [Credit Default Swaps]

and only 10% in cash CDOs, you bear any additional credit risk not only the risk of themortgages going bad but also the risk of a counterparty keeling over? Bulls insist not.

CDOs can be very confusing, and ignorance about CDOs even reaches far into thepopulation of CDO investors. Most investors rely purely on ratings because they donthave 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 foreignoutput gaps. Globalizationmight explain why

inflation movements are so highly correlated across countries. Weve reached a point where individuals, businesses, and our government have

become too leveraged. A reduction in economic activity over the coming yearscan be attributed to this deleveraging.

Book Review - Mr Market Miscalculates by James Grant

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