Seth Klarman


"History never repeats itself but it rhymes"  Mark Twain

Studying history can provide an enormous edge in investing.  While history never exactly repeats itself I have witnessed plenty of examples over the last twenty plus years that leave me convinced that a lot of what happens we've seen before.  Hopefully this post will show that there is never much new in investing.

One of the most memorable examples for me was in late 2007 ahead of the financial crisis when the credit markets had slammed shut after the initial Bear Stearns Hedge Fund problems in June followed by a run on the UK lender Northern Rock in September.  Northern Rock was subsequently bailed out by the UK government.  I was in charge of the Hedge Fund advisory business at a global investment bank which had just IPO'd a 'shadow banking' home lender which relied on the wholesale credit markets.  The credit markets were effectively closed yet the equity market did not peak for another month afterwards [See chart below].  At the time I was reading about Jessie Livermore.  This paragraph about Jessie Livermore stood out to me at the time..

"While his tape-reading skills were still important, they were not as important as studying the fundamentals of each company and the credit conditions of the stock market and the economy.  His first successful “raid” on the stock market based on his sound, fundamental studies occurred during the Panic of 1907.  As credit conditions tightened and as a number of businesses and Wall Street brokerages went bankrupt during the summer, Livermore could sense that something was wrong – despite the hopes of the public evident in the still-rising stock market.  Sooner or later, Livermore concluded, there will be a huge break of epic proportions.  Livermore continued to establish his short positions, and by October, the decline of the stock market started accelerating with the collapse of the Knickerbocker Trust in New York City and Westinghouse Electric.  J.P. Morgan eventually stepped in to avert the collapse of the banking system and the New York Stock Exchange, but only after Livermore managed to make more than one million dollars by shorting the most popular stocks (and covering on a plea from J.P. Morgan himself) in the stock market."

At the time I wanted to learn more about this era and picked up the book 'The House of Morgan' by Ron Chenow which chronicled the history of J.P Morgan.  A few chapters provided an excellent summary of the boom stock market in the late 1920's ahead of the ensuing crash and great depression.  

During the 2009 Financial Crisis I wrote a note to my clients titled "How Will We Look Back on This Crisis".  The note was a compilation of quotes from this 1990 book and while they referred to the 1920's and 1930's they were just as apt to the modern times.  Consider the following ...

"Prophets of the age espoused an ideology of endless prosperity and talked of a new economic era"

The Fed's Greenspan and others, ahead of the Financial Crisis, were espousing the 'Great Moderation'. Greenspan presided over nearly two decades of prosperity and the lavish praise on the economy reflected the belief that Greenspan's deft changes in interest rates and crisis interventions stabilized the economy without rekindling inflation.

In his book 'The Most Important Thing' Howard Marks noted "On November 15, 1996 The Wall Street Journal reported on a growing consensus "From boardrooms to living rooms and from government offices to trading floors, a new consensus is emerging; The big, bad business cycle has been tamed."

"For many pundits, the sheer abundance of cash precluded any crash"

"There is a vast amount of money awaiting investment.  Thousands of traders have been waiting for an opportunity to buy stocks on just such a break as has occurred over the last several weeks.  The excess cash was viewed as a sign of wealth, not an omen of dwindling opportunities for productive investment".

Greenspan cut interest rates after the tech crash and left rates low which fuelled a rally in asset prices.

"Riding this cash boom, the American financial services industry grew explosively"

The American financial system also grew explosively ahead of the Financial Crisis.  During the peak of the housing boom, in October 2007, the S&P Financials sector reached 20.1% of the S&P 500.  Not even two years later in March 2009, that weighting had collapsed to 8.9%.  That’s the same level as all the way back in 1989.  The shadow banking market grew explosively also.

"There was a fad for foreign bonds, especially from Latin America, with small investors assured of their safety.  The pitfalls were not exposed until later on, when it became known that Wall Street banks had taken their bad Latin American debt and packaged it in bonds that were sold through their securities affiliates"

Let's rephrase that …  "There was a fad for mortgage backed bonds, especially from sub-prime borrowers with global investors assured of their safety.  The pitfalls were not exposed until later on, when it became known that Wall Street banks had taken their bad mortgage debt and packaged it in bonds that were sold through their securities affiliates"

"The 1920s were also a time of manic deal making.  As Otto Kahn recalled, there was a perfect mania of everybody trying to buy everybody else's property .. new organisations sprung up.  Money was so easy to get.  The public was so eager to buy equities and pieces of paper that money was .. pressed upon domestic corporations as upon foreign governments"

Let's rephrase that … "The years leading into the Financial Crisis were also a time of manic deal making.  There was a perfect mania of everybody trying to buy everybody else's property .. new organisations sprung up.  Money was so easy to get.  The private equity funds were so eager to buy equities and pieces of paper that money was .. pressed upon domestic corporations as upon foreign governments"

"Wall Street was being swept by new forms of leveraging… many brokerage houses, including Goldman Sachs, introduced leveraged mutual funds, called "investment trusts".  A second favourite device was the holding company.  Holding companies would take over many small operating companies and use their dividends to pay off their bond holders, who had financed the takeovers in the first place.  This permitted an infinite chain of acquisitions"

Wall Street was awash with new forms of leveraging before the Financial Crisis.  RMBS's, CDO's, CDS, SIV's, PIK loans and many other types of credit derivatives were growing exponentially.  In April 2007, The Economist noted "According to the Bank for International Settlements, the nominal amount of credit-default swaps had reached $20 trillion by June last year.   With volumes almost doubling every year since 2000, some reckon the CDS market will soon be worth more than $30 trillion.  The investment banks and private equity firms were up to their eyeballs in debt fuelled acquisitions.

"As masters of leverage, the Van Sweringens used each new purchase as collateral for the next.  Their holding companies took control of other holding companies in an endless hall of mirrors, all supported by little cash but powerful Morgan connections.  By 1929, the Van Sweringen railroads ruled America's fifth largest railroad system atop a forty story Cleveland tower and controlled trackage equal in length to all Britains railroads"

This was close to home for me.  It sounded very much like Babcock & Brown [which ultimately went bust], not to mention the investment banks and private equity firms.

"Leffingwell subscribed to the cheap-money theory of the crash, that is he blamed excessively low interest rates for the speculation in stock.  In 1927, Monty Norman had visited New York and asked Ben Strong [Governor of Federal Reserve] for lower interest rates to take pressure off the pound.  Strong obliged by lowering the discount rate.  Leffingwell believed this had triggered the stock market boom.  In early March 1929, when Leffingwell heard reports that Monty was getting 'panicky' about frothy condition on Wall Street he impatiently told Lamont "Monty and Ben have sowed the wind.  I expect we shall have to reap the whirlwind .. I think we are going to have a world credit crisis"

Many observers also blamed The Fed's Greenspan for keeping rates artificially low after the tech bubble for inflating the housing bubble and booming stock market.  It too ended in a world credit crisis.

"Were the increasing number of stock mergers grounds for concern? And should the federal government take action to stop speculation on Wall Street"

There was massive surge in mergers in the year before the Financial Crisis all funded with cheap debt and lax lending covenants.  Ahead of the crisis, the Fed's Greenspan was confident the stability and structure of the financial markets had improved and it was not the Fed's job to address asset bubbles.

"Both the market and public faith in bankers were collapsing"

The public at large and the publics faith in bankers collapsed after Bear Stearns was bailed out, Lehman went bust and the Fed had to bail out the banking system at large..

"Harrison [took over the Fed in 1928 after Strong's death] lowered interest rates and pumped in billions of dollars in credit to buoy banks with heavy loans to brokers"

Ben Bernanke, Harrison's equivalent, also aggressively lowered interest rates and the US Treasury pumped more than a trillion dollars into the financial companies via TARP, swap lines and other measures in an attempt to stabilise the system. 

"He bought up to $100 million in government bonds per day and made sure Wall Street banks had adequate reserves with which to deal with the emergency.  In scale and sophistication, his post crash actions made Pierpont's in 1907 look antediluvian in comparison, for he expanded credit as needed.  Harrison confirmed the principle of government responsibility in financial panics"

Bernanke also expanded the Fed's balance sheet and provided credit to financial institutions. He expanded the collateral accepted and his actions were on an unprecedented scale.  On numerous occasions in 2008 and 2009, the Federal Reserve Board invoked emergency authority to authorize new broad-based programs and financial assistance to individual institutions to stabilize financial markets.  Loans outstanding for the emergency programs peaked at more than $1 trillion in late 2008.

"The stereotype of bankers as conservative, careful, prudent individuals was shattered in 1929"

Certainly bankers reputations were decimated following the Financial Crisis.

"The consequences of such an economic debauch are inevitable," said the Philadelphia Fed Governor.  "Can they be corrected and removed by cheap money? We do not believe they can." .. That fall Hoover complained to Lamont about bear raids, short selling and other unpatriotic assaults against national pride.  The following year would be the worst in stock market history"

The Fed certainly attempted to resolve the crisis with cheap money.  In 2008 the US's SEC banned short selling of financial companies to "protect the integrity and quality of the securities market and strengthen investor confidence". The U.K. FSA took similar action.

"The House of Morgan arranged a $10m line of credit.  Under Whitney's tutelage, the old Kidder, Peabody was folded"

On Friday March 14, 2008, Bear Stearns secured a 28-day loan from JPMorgan and thought it would receive access to the New York Federal Reserve’s discount window for additional funding. Those hopes were dashed before the weekend was out though, and by that Sunday the firm had been sold to JPMorgan for $2, a price that was ultimately raised to $10 two weeks later.

"A proposed rescue plan for the Bank of the United States got a cool reception on Wall Street, even after Leutenant Governor Herbert H. Lehman, the state banking authorities, and the new York Fed all pleaded for it.  The regulators wanted to merge the Bank of the United States with three other banks, backed by a $30 million loan from Wall Street Banks."

"At an emotional meeting, Joseph A Broderick, the state banking chief warned that if the bankers rejected the rescue plan, it might drag down ten other banks… As the Wall Street bankers sat stony-faced Broderick reminded them how they had just rescued Kidder, Peabody and how they had banded together years before to save Guarantee Trust."

"But they refused to save the Jewish bank, pulling out of their $30 million commitment at the last minute.  "I asked if their decision to drop the plan was final", Broderick recalled.  "They told me it was.  Then I warned them they were making a colossal mistake in the banking history of New York."  The biggest bank failure in American history, the Bank of the United States bankruptcy fed a psychology of fear that already gripped depositors across the country"

Let's rephrase that … "A proposed rescue plan for Lehman Brothers got a cool reception on Wall Street, even after Henry Paulsen, the US Treasury Secretary , and the New York Fed all pleaded for it.  The regulators wanted to merge Lehman Brothers with Barclays Bank or Bank of America."

"At an emotional meeting, Timothy Geithner, the NY Fed chief warned that if the bankers rejected the rescue plan, it might drag down ten other banks… As the Wall Street bankers sat stony-faced Geithner reminded them how they had just rescued Bear Stearns and how they  had banded together years before to save Long Term Capital Management."

"But the UK regulator refused to approve the deal with Barclays and save the bank at the last minute.  "I asked if their decision to drop the plan was final", Geithner recalled.  "They told me it was.  Then I warned them they were making a colossal mistake in the banking history of New York."  The biggest bank failure in American history, Lehman Brothers bankruptcy fed a psychology of fear that already gripped depositors across the country"

".. The banks failure shook confidence across America, It was a failure that could have been easily avoided by the proposed merger"

The failure of Lehman Brothers shook confidence across America.

"The Morgan-Hoover feud over debt was mild compared with their debate over short selling on Wall Street.. Hoover now shared the average American's view of Wall Street as a giant casino rigged by professionals"
"Now the crisis shifted to London, as investors traced financial ties between Germany and England.  During the summer of 1931, investors dumped sterling in massive amounts."
"Prime Minister Ramsay MacDonald and Philip Snowden knew the pound couldn't be defended without a foreign loan"
"Foreign bankers insisted that he close the budget gap as the pre-condition for a loan.  But any such austerity talk bought outcries from Labour ministers, who saw it as a betrayal of their followers to appease rich bankers".

Similarly, the crisis in the US travelled to Europe where the Euro came under pressure as a result of the PIGS [Portugal, Italy, Greece and Spain] economic turmoil and the inability to pay off their debts.  The German government demanded austerity measures as a condition of a bail-out.

The Global Financial Crisis and the early 1920's and 1930's had strikingly similar conditions.  Many of the issues that arose had been experienced before.  Most of what occurred certainly was not new.  The packaging of sub-prime loans ahead of the crisis was a replay of banks activities in the late 1920's.  One again, from the 'House of Morgan'..

"Pecora also studied the operations of the National City Company whose 1900 salesmen had unloaded risky Latin American bonds on the masses.  It emerged that in touting bonds from Brazil, Peru, Chile and Cuba to investors, the bank hushed up internal reports on problems in these countries.  After bank examiners criticised sugar loans made by the parent bank, the securities affiliates sold them as bonds to investors.

In the Financial Crisis the Investment Banks were also charged with unloading poor quality loans on unsuspecting buyers.  The rating agencies aided and abetted this process by placing AAA ratings on some of the sub-prime loan tranches.  That too had happened before in the junk bond crisis of the 1980's.  In Seth Klarman's 1991 book 'Margin of Safety' he notes..

"One of the last junk-bond-market innovations was the collateralized bond obligation [CBO]"

"What attracted underwriters as well as investors to junk-bond CBO's was that the ratings agencies, in a very accommodating decision, gave the senior tranche, usually about 75 percent of the total issue, an investment grade rating"
"The existence of CBO's was predicated on the receipt of the investment-grade credit rating on the senior tranche.  Greedy institutional buyers of the senior tranche earned a handful of extra basis points above the yield on other investment-grade securities.  
"The rating agencies performed studies showing the investment-grade rating was warranted.  Predictably these studies used historical default-rate analysis and neglected to consider the implications of either a prolonged economic downturn or a credit crunch that might virtually eliminate re-financings.  Under such circumstances, a great many junk bonds would default; even the senior tranche of a CBO could experience significant capital losses.  In other words, a pile of junk is still junk no matter how you stack it".

History repeats, it's deja vu all over again.  Spending the time to understand the history of financial markets will help you avoid some of the pitfalls investors can fall into.  Some of my favourite books that touch on the history of the markets include The Davis Dynasty [1930's onwards], A Decade of Delusions [Tech Crash and Financial Crisis],  Too Big to Fail [Financial Crisis] and the House of Morgan [great chapters on the 1920's and 1930's].  

Edward Chancellor in 'Capital Returns' notes "It's not true, however, to say nobody in the financial world saw it [the Financial Crisis] coming.  On the contrary, in the years prior to 2008 many serious investors and strategists were alert to the dangers posed by strong credit growth, dubious financial innovation and the appearance of various housing bubbles around the world".  Seth Klarman noted in 2008 "People say that what has happened recently was completely unpredictable and god knows how many sigma event, but that's just not right.  This was completely predictable and I could cite eight or ten people who in one way or another predicted it".    I concur.  In his 2005 Baupost Annual Letter he noted..

"Finally, as Northern Trust’s Paul Kasriel recently highlighted in the New York Times, household borrowing is out of control, and this debt is clearly propping up the U.S. economy. By way of example, in the third quarter of 2005, households spent a record annual rate of $531 billion more than their after-tax earnings. Historically, consumers regularly earned more than they spent; the recent binge in borrowing for consumption is truly unprecedented. It has (thus far) resulted in consumer spending at a record high 76% share of GDP.
"Consumers are using their increasingly valuable homes as quasi-ATMs, extracting $280 billion of cash through home equity borrowings in the second quarter of 2005 alone. This is a surprisingly new phenomenon; in the last three decades of the 1900s, there was virtually no net home equity extraction by consumers. While we cannot predict how these excesses will play out, it seems clear that such trends cannot continue indefinitely, and that a restoration of fiscal sanity will bring with it wrenching, largely unexpected, and painful adjustments.
The world could well be setting up for considerable upheaval and with it an avalanche of opportunity. As we have said, nearly every investment professional is fully invested, and many are leveraged. With massive trade imbalances and huge U.S. government budget deficits, tremendous leverage everywhere you look, massive and unanalyzable exposures to untested products like credit derivatives, still low interest rates, rising inflation, a housing bubble that is starting to burst, and record and unprecedentedly low quality junk bond issuance, there appears to be little, if any, margin of safety in the global financial system."

If you remain in doubt I suggest you read Frank Martin's excellent book "A Decade of Delusions" which contain his annual letters from before and during the crisis.  He laid out a prescient roadmap of the carnage that was to become the Global Financial Crisis.   The 2005 and 2006 annual letters include the following headers “The Perfect Storm?,” “The Blossoming of the Financial Economy: The Cataclysm in the Creation of Credit,” “Bubbles Are Indigenous to the Financial Economy,” and “If Housing Prices Roll Over.” Chapter 10 (2007 MCM annual report excerpts) included a draft of a letter to clients in 2007 proposing a strategy to buy put options on selected investment banks, as well as subtitles that included “Edging toward the Precipice” and “Credit-Default Swap Alchemy: Transmuting Junk into Gold.”