The Guest Blog

Farrell: Dumb Moves on Both Sides of the Atlantic


Just how dumb can you be?

The guys that took the other side of the Fabulous Fab-concocted CDO-Squared whatever it was weren't stupid because they bet wrong on the housing market.

Most of us did.

I certainly didn't see it coming, but then I can probably fill a book thicker than War and Peace with the mistakes I have made in the close to 40 years that I have been in the investment business. And my pal Doug Kass (Lola Jane Farrell's honorary uncle) saw it and even warned me! No, they're stupid because they took such enormous risk for so little potential gain.

John Alfred Paulson, president of Paulson & Co., Inc.
TimSloan | AFP | Getty Images

Paulson and Co. wanted to bet that the housing market was going to implode.

If they were right (and of course they were), their gains could be/were enormous, but the risk they took was very small.

Since the package that Goldman created was not a portfolio of actual bonds but rather it "referred" to a package of bonds, Paulson & Co. had the obligation to pay to the issuer of the insurance policy they were buying (called a swap in this case) an interest rate. I presume the interest rate was the rate on the mortgages that were in the referred package. If it wasn't, I'm not wrong by a lot. So Paulson paid a modest rate of interest and stood to gain, as we found out, a billion dollars.

That is a remarkable risk-reward ratio.

On the other side of the trade, the two banks that sold the insurance policy stood to gain only the interest payments. For a modest rate of interest, they assumed the risk of losing a billion dollars. In all the stupid things I've done in my investment career, at least I never took on such a ridiculous one-sided bet. Weighing risk vs reward is the most important thing a manager of money can do.

It's remarkable how that was forgotten in the crazy, final days of the mortgage blow-off.

I think it's equally remarkable how the European Union is driving its fancy European sports car right over the cliff. What started as a project to assist Greece is rapidly turning into a fiasco. I've been traveling a lot, so I'm in a very lazy mood. I'm going to borrow from a few friends who state the case very well.

Debtor Nations

Dave Rosenberg, who is now at Gluskin Sheff in Toronto, wrote the other day (hoping the EU would realize what they are contemplating and turning away), "Look, Greece is not going to 'fail.' They are going to default. There will be a debt restructuring and there will be some recovery. Bondholders will take a haircut - why shouldn't they?....Greece has been in default in its recent 200 year history almost half the time."

"So Greece defaults, bondholders who knowingly bought these instruments went for the yield and simply do not deserve a taxpayer-supported bailout of any kind. To actually come to the aid of Greece (especially after all the accounting gimmickry) would send a signal to investors that the best way to make money is buy the debt of the most risky and highest-yielding enterprise because there will always be a bailout. Rewarding bad investment decisions is a huge mistake."

Kevin Ferry of Cronus Futures weighed in the other day as well. You see Kevin all over CNBC, and I usually need the English translation of what he says, but that's what makes him so much fun. Kevin wrote the other day, "European Union countries outside Germany and France are the Government-Sponsored Enterprises (Fannie and Freddie) of Europe, and implied backing morphs into a crisis. The concept of implied backing and shared credit worthiness is a recipe for disaster. The idea of socialized credit is the root cause of these meltdowns. Europe and subprime share a flawed premise that a social good can be financed at [artificially] low interest rates." (Watch Ferry's most recent appearance on CNBC right here.)

The NY Times had an article the other day that stated Greece will need 90 billion Euros, Portugal 40 billion and Spain 350 billion. That's 480 billion Euros, if I added correctly. The IMF doesn't have that, and are German workers going to delay retirement to pay off the profligacy of the Club Med partiers? It's time for responsibility and accountability to come back into the spotlight.

I am apolitical.

If I wasn't, half of you would hate me and the other have wouldn't, and then sides would be swapped. But President Obama said something the other day that I would like all of us to consider. "We don't begrudge success fairly earned." (So far, so good.) "I do think at a certain point you've earned enough money." Okay- what's enough, who decides, and do you tax everything above that? The tax marginal tax rate towards the end of the Depression hit 80%. But it didn't help to end the Depression. And if you had cut off the Rockefellers, for example, we wouldn't have Rockefeller University, the University of Chicago, the Cloisters in upper Manhattan, the Museum of Modern Art in midtown, and any number of other national treasures, including a whole lot of conservation land.

There was a rally of union workers in lower Manhattan Thursday. Among other things, they were protesting the bailout of banks that went on to pay enormous bonuses. Richard Trumka, the AFL-CIO leader, noted that 25 hedge fund managers earned what 680,000 teachers earned last year. A stunning observation. Senator Levin went after Goldman in Washington-speak the other day and Lloyd Blankfein spoke Wall Street back to him. Smart men all, but all talking past each other and not to each other.

Something has to change.

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Vincent Farrell, Jr. is chief investment officer at Soleil Securities Group and a regular contributor to CNBC.