Weekly Insider (Lux Summit and Mortgage Math Made Easy)

If the website is busy, please try again on this link to join the crowd next month in Boston at the Lux Executive Summit.


Here’s simple way to look at stuff. First: a mortgage is LBO on a house. Or think of an LBO like mortgaging a company. Second, remember there’s a difference between say fire insurance and mortgage insurance. Third, a stone house less likely to burn then a wood house, and thus similarly a AAA rated mortgage is in theory less likely to burn than a BB-. Unless the stone in theory turns out to be wood. And the AAA in theory turns out to be BB-.



Imagine this: you buy a house. Then you buy fire insurance from AIG. If it burns down, you collect cash. AIG knows the chance of a scorched house: let's say 1 in 100 (1%). If your house is worth $1 Million, they wouldn’t price your premium below $10,000. (1%x1 Million). They would price your premium at something more like $20,000. And they'd be sure to insure a bunch of different homes in different areas, instead of 5 in a row which could all burn if 1 burns. AIG is pretty good at that.



But AIG was pretty bad at this scenario. You buy a house. A hedge fund buys a bunch of mortgages: your mortgage and other mortgages too. This is a CDO (collateralized debt obligation). Let’s say 10 of these mortgages have total value of $10 Million. The hedge fund manager buys insurance in case you don't pay. This is a CDS (credit default swap). Like the assumptions about your house burning down, AIG also makes assumptions about you not paying your mortgage. Let’s say they think there’s a 1% chance of someone a collection of 10 of these AAA rated mortgage not paying. That's would be (1% of 10 Million) or 100k premium--but remember they’re on the hook for an exposure of 10 Million. The chance of everyone not paying their mortgage is low, Moody’s says so. AIG trusts Moody’s. Moody’s trusts the models provided by the people who packaged the mortgages together. Everyone trusts the homeowner will pay his mortgage. But if the price drops, or the homeowner actually can't pay--well, the homeowner might not pay the mortgage. Others might not either. So a 1% chance of something bad happening zooms to 100%. It happens. And in aggregate, the odds of all those mortgages going bad may be around 20%. AIG is on the hook for $10 Million. Do this 8,500 times and that's $85 Billion!

Weekly Insider (Inches, Ounces, Rant on Rants)

A rant on all the rants: Remember this: as they say in my native Brooklyn: the one thing you can know for sure-- nobody knows nothin’.



Expectations and emotions rule the day. The market looks and feels like a skateboarder on a half-pipe: up-and-down and up-and-down, a few tricks that wow the crowd, eventually investors (the skateboarders) will adjust to (or tire of) volatility and things will settle down. High expectations give way to low expectations. Remember also: when climbing a mountain, good news adds a few feet, bad news send you off a cliff.



My friend and fellow investor Mike G wisely wrote, “Whatever the case, I stand proudly by my aversion to fiction — no writer’s imagination compares to the actual unfolding of history”.



Just check these two WSJ blurbs and remember: Do not act in desperation, else you’ll suffer gambler’s ruin. “On Monday night, after a day when stocks took their worst hit in years, Don Case bought a lottery ticket on his way home from work. Mr. Case, a 42-year-old data analyst in O'Fallon, Ill., is worried about the stability of the life-insurance policy he bought a few years ago from AIG…he's also concerned about his 401(k) and his…college savings plan. With a venerable institution like Lehman Brothers Holdings Inc. crumbling, "I'm sure all companies are vulnerable," he says. "If I win the lottery, I won't have to worry.”



The second headline read: “More Firms Tied to Tainted Formula”. It took me reading an inch of text to realize it was about ounces (ie. China baby formula) not equations (ie. flawed Black-Scholes, and all financial models based on normally distributed bell-curves). It ain’t what you don’t know. It’s what you know for sure that just ‘aint so.



Yes, it was the filling of a recipe for baby's food--not the falling of a recipe for disaster. When will the Nobel committee revoke an award for a failed theory? When will business schools stop teaching “professional” finance practitioners Black-Scholes and mean-variance theory as a measure of risk It’s like the doctor who teaches his medical students an outdated and incorrect procedure because its easy to teach: our financial businesses and our business schools teach incorrect formulas. 'Tis better to be roughly right than precisely wrong. Will someone –ahem, New York Times—please also hold Ben Stein accountable for being precisely wrong.



Here’s what you need to know: as a person or a business: if you spend or borrow more than you make or have you risk going broke. Nassim Taleb long ago called it. Bleed vs Blow-up. Make money, make money, makey money... file for bankruptcy. When banks were brokers they were fine. They were in the moving business, not the storage business. This business model is a "sold lottery ticket", an insurance claim or a sold-call on your equity and assets (remember Liabilities=Assets-Equity). Think of a lottery operator that sells you lotto tickets. Every day he collects a little bit--when the payday comes, you claim his stuff--all of it. All these banks were like a “7-11.”



VC is the inverse, we bleed a little everyday, spending, spending, spending...homerun.



Simply put: here's what's happening: credit contraction, asset deflation.



It’s the mirror image of what happened. Equity bubble, housing bubble, credit bubble. Capital was cheap. Lots of dollars. Residential construction boomed then peaked. Home prices boomed then dropped. Credit expanded then stopped. Profits rose, then fell. Employment rose, then stopped. Consumers spent then recessed. Lots of dollars meant cheaper dollar. That will change.



Jeremy Grantham was right. Profits are mean reverting and we're in a secular bear or range bound market, with lower earnings, smaller P/Es, stock prices falling and people selling what they have to.



What will happen: Interests rates rise. Dollars rise. Jobs fall. Stocks fall. Fund of funds redeem. Hedge funds sell. Stocks fall more. Maybe, just maybe time horizons lengthen, attention spans lengthen, reporting periods lengthen (hundredths of a second tickers on CNBC, monthly redemptions, quarterly reporting add only noise). Distressed sellers sell. Some go to the hosptial, some the morgue. Cash-rich buyer buy. Others save-or start.



If you didn't think you had to save, you spent. If the stuff you owned went up, you could always sell it later--until you couldn't. Tech stocks, your house. Like the scene from Bronx Tale, "Now you's can't leave".



‘Global warming’ takes a back row to ‘global meltdown’. Investors in project finance lose shirts. Reputations fall. Oil and commodities fall. Decoupling is debunked. Emerging markets have emergencies. Radical Islam took root in Indonesia after '98 Asia collapse. Hitler took root after Germany's post WWI economic collapse. Castro as Battista looted Cuba. Attention will turn to new theaters of operations: Venezuela, Pakistan.



Here’s what worries me: Dictators and despots rise when economies fall. It is the desperation of the destitute, their hopeful ears and nodding heads, that fashions his sword and forms brigades behind him--and marches.For the long term, I'm less worried about "Fuld folding", than "Putin's Put" or the "Chavez Shuffle".



If you think there’s safety in the crowd, come join the crowd next month in Boston at the Lux Executive Summit:

http://www.regonline.com/Checkin.asp?EventId=618658

Weekly Insider (Will You Be There When...?)

Take note of what Google CEO Eric Schmidt just said:

"I could imagine a smart garage where I would plug in my car and the computer handles it. I could even make money by cost shifting. It sure sounds to me like a problem for the Internet...and personal computers. It's the largest opportunity I could possibly imagine. It solves energy security, energy prices and job creation."

Here’s why: in 4 weeks, I’ll be networking and learning at the annual Lux Executive Summit outside Harvard Square in Cambridge, MA. There are some very important speakers with some big announcements being made.



I’m fond of saying the best way to predict the future is to invent it. Here’s who’s inventing it and who you need to know:



Dean Kamen is an inventor extraordinaire. Watch him basically turn dirt into water. And if you haven’t heard Shai Agassi speak, you must. He was set to be CEO of SAP but threw it away to become founder of Better Place. Having raised hundreds of millions of dollars—he is mission-bent on making Israel the first all-electric car country. Other countries and states are signing up. You basically get the car for free and subscribe to it—like some cell phone plans. Shai will be featured at Lux’s event.



Now, if you believe water is the new oil, you must hear straight from CEO of GE Water, Jeff Garwood. It’s a $2 billion unit of GE. And of course: love him or hate him, but Lux will also host US Senator John Kerry weighing in privately on the high-tech economy and the Presidential election.



Meanwhile Roger Duncan will share the future of energy. He runs the 9th largest public power utilities in the country at Austin Energy. While Bob Metcalfe—he’s been turning algae into energy--and Genome Guru Craig Venter’s new company Synthetic Genomics will both be speaking too.



Nobel Prize winner Harry Kroto will be there and the Lux Research analysts will be releasing new market moving data. It’s nearly booked out. But register here to secure a seat!

Weekly Insider (Solar, Fancies, Facts & Flight of Icarus)

When opinions are not backed by facts, they’re fancies, speculations. But when they are—they’re analysis. First my fancy, then Lux’s facts.



My inkling and instinct—to which I'm trying to avoid anchoring, trying to collect supporting evidence and trying to not hold confirmation bias and ignore contrary data—was written here nearly six months ago:



Solar is to Africa as Global Crossing was to the world a decade ago. The latter helped do a great public good, connecting the world—by laying massive fiber with cheap capital provided on flawed (or fraudulent) assumptions. It was an invisible emerging market tax on speculators—that is: speculators subsidized massive infrastructure build-out. The local people in foreign lands ended up being the real winners. Solar too, at great expense to its private investors is doing a great good for the public. I predict Africa, with low or no base-load power will be the biggest beneficiary. As William Wordsworth wrote: “Pleasure is spread through the earth; In stray gifts to be claimed by whoever shall find.” Eventually, some years from now, some opportunistic entrepreneur will buy up excess panels and capacity and distribute distressed solar power assets to a distributed population (in Africa). As I’m so fond of quoting so often from Jim Surowiecki: “in greed and avarice lies the hope of progress.”



Now for the facts and the good news: the results of the most rigorous analysis I’ve ever seen on all things solar is out and in the private hands of top companies and institutional investors. Let me say this: some people playing in solar are set to be shocked, some to soar, some to get seared. The bad news: it’s not available to the public—only Lux Research clients. The worse news: I’ve been bound by secrecy from sharing it. The best I can do is share rare breadcrumb leaks left by the analysts in the press.



Lux Research’s Solar team was quoted just yesterday, in one investment publications, “The U.S. market is under pressure, though, as the industry frets over whether key federal tax incentives will be extended beyond 2008. Many analysts say that decision might have to wait until the new president takes office in January. Some analysts continue to see a big drop in prices next year. [Senior Analyst] Ted Sullivan of Lux Research says he fully expects declines of 15% to 20%. He says there's just too much supply. “



Stay tuned: As soon as I can share any of their controversial and groundbreaking analysis, I will.