overindebted economy could deliver. Important here are the discount rates.

By asset class, relatively low discount rates relative to swap or Treasury yields indicate complacency. It is one thing if stocks move up because profits are rising rapidly, and another if the discount rate is declining. Similarly, it is one thing if stocks are rising because GD is growing rapidly, and thus revenues are rising, and another thing if it is due to profit margins rising, and profit margins are near record !e "ust happen to be the beneficiaries of a situation where we have simultaneously had bubbles in all three. Think of late #$$% & high values for residential and commercial real estate, low credit spreads, and high '(s )relative to future profits*. +arket participants e,pected far more growth than the overindebted economy could deliver. Important here are the discount rates. !e "ust happen to be the beneficiaries of a situation where we have simultaneously had bubbles in all three. Think of late #$$% & high values for residential and commercial real estate, low credit spreads, and high '(s )relative to future profits*. +arket participants e,pected far more growth than the overindebted economy could deliver. Important here are the discount rates. By asset class, relatively low discount rates relative to swap or Treasury yields indicate complacency. It is one thing if stocks move up because profits are rising rapidly, and another if the discount rate is declining. Similarly, it is one thing if stocks are rising because GD is growing rapidly, and thus revenues are rising, and another thing if it is due to profit margins rising, and profit margins are near record !e "ust happen to be the beneficiaries of a situation where we have simultaneously had bubbles in all three. Think of late #$$% & high values for residential and commercial real estate, low credit spreads, and high '(s )relative to future profits*. +arket participants e,pected far more growth than the overindebted economy could deliver. Important here are the discount rates. By asset class, relatively low discount rates relative to swap or Treasury yields indicate complacency. It is one thing if stocks move up because profits are rising rapidly, and another if the discount rate is declining. Similarly, it is one thing if stocks are rising because GD is growing rapidly, and thus revenues are rising, and another thing if it is due to profit margins rising, and profit margins are near record !e "ust happen to be the beneficiaries of a situation where we have simultaneously had bubbles in all three. Think of late #$$% & high values for residential and commercial real estate, low credit spreads, and high '(s )relative to future profits*. +arket participants e,pected far more growth than the overindebted economy could deliver. Important here are the discount rates. By asset class, relatively low discount rates relative to swap or Treasury yields indicate complacency. It is one thing if stocks move up because profits are rising rapidly, and another if the discount rate is declining. Similarly, it is one thing if stocks are rising because GD is growing rapidly, and thus revenues are rising, and another thing if it is due to profit margins rising, and profit margins are near record !e "ust happen to be the beneficiaries of a situation where we have simultaneously had bubbles in all three. Think of late #$$% & high values for residential and commercial real estate, low credit spreads, and high '(s )relative to future profits*. +arket participants e,pected far more growth than the overindebted economy could deliver.

Important here are the discount rates. By asset class, relatively low discount rates relative to swap or Treasury yields indicate complacency. It is one thing if stocks move up because profits are rising rapidly, and another if the discount rate is declining. Similarly, it is one thing if stocks are rising because GD is growing rapidly, and thus revenues are rising, and another thing if it is due to overindebted economy could deliver. Important here are the discount rates. By asset class, relatively low discount rates relative to swap or Treasury yields indicate complacency. It is one thing if stocks move up because profits are rising rapidly, and another if the discount rate is declining. Similarly, it is one thing if stocks are rising because GD is growing rapidly, and thus revenues are rising, and another thing if it is due to profit margins rising, and profit margins are near record !e "ust happen to be the beneficiaries of a situation where we have simultaneously had bubbles in all three. Think of late #$$% & high values for residential and commercial real estate, low credit spreads, and high '(s )relative to future profits*. +arket participants e,pected far more growth than the overindebted economy could deliver. Important here are the discount rates. profit margins rising, and profit margins are near record !e "ust happen to be the beneficiaries of a situation where we have simultaneously had bubbles in all three. Think of late #$$% & high values for residential and commercial real estate, low credit spreads, and high '(s )relative to future profits*. +arket participants e,pected far more growth than the overindebted economy could deliver. Important here are the discount rates. By asset class, relatively low discount rates relative to swap or Treasury yields indicate complacency. It is one thing if stocks move up because profits are rising rapidly, and another if the discount rate is declining. Similarly, it is one thing if stocks are rising because GD is growing rapidly, and thus revenues are rising, and another thing if it is due to profit margins rising, and profit margins are near record gn the system produces year by year. The value of e-uity is the capitali.ed value of the profit stream. The value of debt is the capitali.ed value of the interest stream. The value of property, plant and e-uipment is the capitali.ed value of the rent stream. The value of a slave'employee is the capitali.ed value of the wage stream.

/mm, that last one doesn0t sound right. !e no longer capitali.e people, as if one could legally own a person today. 1ontracts for labor are short2term, and employees typically can leave at will. But, there can be bubbles in property, debt and e-uity markets. !e "ust happen to be the beneficiaries of a situation where we have simultaneously had bubbles in all three. Think of late #$$% & high values for residential and commercial real estate, low credit spreads, and high '(s )relative to future profits*. +arket participants e,pected far more growth than the overindebted economy could deliver. Important here are the discount rates. By asset class, relatively low discount rates relative to swap or Treasury yields indicate complacency. It is one thing if stocks move up because profits

are rising rapidly, and another if the discount rate is declining. Similarly, it is one thing if stocks are rising because GD is growing rapidly, and thus revenues are rising, and another thing if it is due to profit margins rising, and profit margins are near record levels, as they are today. (,treme profit margins invite competition. (,treme profit margins tend not to last. In many asset classes, investors were fooled. /ome buyers bought thinking the prices could only go up. They ignored the high ratio of property value relative to what they would currently pay. 1ommercial real estate investors bought at lower and lower debt service coverage ratios. 1ollaterali.ed debt investors accepted lower and lower interest spreads at higher and higher degrees of leverage. !ith e-uity, investor assumed that growth in asset values in e,cess of growth in GD would continue. The stock market does grow faster than GD , but the advantage is less than double GD growth. Thus after the long rally, with no appreciable growth in the economy, I would be careful about e-uities, and corporate debt as well. Some yields are high relative to long run averages, but the risk is higher as well. The main point is to remember that the real businesses behind the financial markets drive performance in the long haul, even if ad"ustments to the discount rate do it in the short run. To be an e,cellent manager, focus on both factors & likely payments, and rate at which to discount. But who can be so wise3

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The Rules, Part XIII, subpart A

The need for income naturally biases a portfolio long. It is difficult to earn income without beneficial ownership of an asset positive carry trades will almost always be net long, absent major distress or dislocation in the markets. Those who need income to survive must then hope for a bull market. They cannot live well without one, absent an interest rate spike like the late 70s early !0s. "ut in order to benefit in that scenario, they had to stay short. +y paternal Grandfather invested in 1Ds through the interest rate spike of the late 4$s and early 5$s. /e looked pretty smart for a time, but he never shifted to take risk when there was a reward to do so. 1ontrast my +om, who had her 6$'6$ mi, of utility stocks and growth stocks )a clever strategy, which as far as I know, she thought up herself*. 7s she once said to me, 8+y utilities are my bonds.9 Though my +om0s strategy underperformed my Grandfather0s in the short run, in the intermediate term it soundly beat his strategy. :ong term3 ;o contest. There is something about yield. 7lmost everyone wants to have it, and have more than what would be average. +y own e-uity portfolio throws off more yield than the S< 6$$, even with =>? earning nothing in cash. There is something tangible about yield@ cash in hand, vs. uncertain capital gains, even if the dividend leads the stock price to drop.

There is a sense that yield is free, like harvesting eggs from your chicken coop in the morning. +entally, that is the way that many view it. They may ad"ust the yield for risk of nonpayment, but there is a tendency to assume that the yield will come in. /ere0s an e,ample@ in =>>>2#$$$, +organ Stanley did a piece on some corporate bonds that they called, 8The Dirty Thirty.9 They were the worst of BBB2rated bonds, but they argued off of a limited period of past returns, that the widening in yield spreads over Treasuries was not "ustified, so but them because they survive and outperform. Aery bad timing, I must say. +any of the companies defaulted #$$$2#$$#, and enough came under severe stress, that those with weak balance sheets kicked them out at the wrong time, for fear of their possible insolvency. This was a prime e,ample of a brokerage providing advice that was technically correct off of history, but deadly wrong with respect to the situation at hand. ;ow, was +organ Stanley trying to lighten its inventory of Dirty Thirty bonds3 I don0t know, but I suspect not. +ost corporate bonds of large corporations are li-uid enough that they can be bought and sold easily. Truth is, if you are a bond manager, you get lots of sell side research telling you how to get a higher yield. To clients who report on a book value basis, like banks or insurers, that is manna, or pennies from /eaven. Bield goes straight to the bottom line. 1apital gains or losses can be deferred, at least until default or maturity, and even if they are reali.ed, analysts e,clude them from operating earnings. Thus the tendency for many regulated financial institutions to be yield hogs, unless the management team has religion regarding risk control. 7s for me, I held the uni-ue position of being risk manager and leading corporate bond manager at one "ob. There was a conflict of interest there, but for me, it enabled me to be more cautious, and more risk2taking at appropriate times. Gaining real market e,perience is something most risk managers never get, but it imparts knowledge of likely ways in which asset management can go astray. It can easily go astray. 7s !arren Buffett says, 8If you0ve been playing poker for half an hour and you still don0t know who the patsy is, you0re the patsy.9 Goes double for trading with the main desks on !all Street. They look for weaknesses, and the leading weakness is being a yield hog. They will more than happily dig up yieldy securities that are more risky than normal for such a client, because the client wants it, and it is easy to find those securities. The investment banker may think the client is dumb, but he is under no obligation to tell him so. 7nd besides, in investments, who knows3 The client may know things that the investment bank does not. To illustrate, I got cheated on my first corporate bond trade with 1SCB. It looked like a good trade to me. It would gain incremental yield on a seemingly similar security. +y boss was gone, so I, the new assistant, made the trade. Dn a E6+ trade, I lost E#$F instantly. +y boss was leaving for another "ob in a week, but he chewed me out anyway, and told me at some firms I would have been fired for what I had done. The 1SCB trader knew that I was a neophyte. 7 certain deal was coming to market on a bond that was close to a 8museum piece.9 They didn0t offer debt often. !e held some of their last deal, and we liked the credit, but we were close to the ma,imum amount that we could hold.

+y boss was gone, and nominally, trading authority was in my hands, but I had never done a corporate trade before & +BS, 1+BS, 7BS, yes, but not corporates. The broker encouraged me to swap our old bonds for the new ones. ;ow, I eventually became very good at relative value trades, but I had no idea of the nuances at that point, particularly for a bond that had few li-uid pricing comparisons. I entered into the trade for not enough incremental yield on the swap. I should have gotten E#$,$$$ more for the bond that I swapped. I went over it with the high yield manager afterward, and we independently concluded that we should have gotten E#$,$$$ more on the bond that I sold. I chalked it up to market tuition. Shame that the client paid the tuition, but I earned far more for them after that. Dne more note@ eventually that broker and I learned to work well together, and I did a lot of business with him.

I took it to heart, and hyperanaly.ed the trade to understand all of my errors. I did not make those errors again, and I was very diligent to be a skeptic regarding the trades that I did with the big firms. That did not mean that I did not trade, but that I drove the trades that I did, rather than accepting the trades that the Street suggested. Instead, I relied on our in2house analysts to do our digging, and I became persistent at pursuing what we wanted, and enlisted second2tier brokers that could help us. I would often do swap trades that gave up yield, if I saw a greater improvement in the risk profile. That is rare among bond traders. (ven among professionals, there is a bias toward more yield. I ended up preserving capital for our main client, allowing me to reinvest at favorable yields as the crisis was cresting. The bias for yield among individual investors is worse, and !all Street readily takes advantage of individual investors in order to hedge e,pensive options by offering seemingly high yields through structured products. The credit and interest rate risks take away what the yield offers, and more. That0s the business, and smart investors stay away. Don0t be the patsy at the investment poker game.

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The Rules, Part XIII, subpart B

The need for income naturally biases a portfolio long. It is difficult to earn income without beneficial ownership of an asset positive carry trades will almost always be net long, absent major distress or dislocation in the markets. Those who need income to survive must then hope for a bull market. They cannot live well without one, absent an interest rate spike like the late 70s early !0s. "ut in order to benefit in that scenario, they had to stay short. To short bonds with success, you have to identify a tipping point. The one shorting a bond

borrows it and then sells it. 7fter that, he has to pay the interest on the bond, and maybe a little more, if the bond is hard to borrow, while he waits for the bond0s price to collapse. If the capital losses to a holder of the bond are not greater than the interest paid, the short loses money. )Bes, he makes some money off of interest on the proceeds from the sale, but let0s ignore that for now.* Bonds mostly have finite maturitiesG time can work against the short seller as the bond gets closer to maturity, because the bond will mature at par, and he will have to pay the par value. The same applies to credit default swaps H1DSI. The party buying protection must pay for the protection. /e looks for a disaster to happen, but as time elapses, and gets closer to the swap termination date, the odds of making money off of a failure declines. Thus being short any sort of fi,ed income, whether through shorting or 1DS involves paying money out regularly to support the position, with the possibility of incredible payoffs if default happens within the lifetime of the bond or 1DS. This mindset is the opposite of the way bond managers think. 7 common way they view things is to ma,imi.e e,pected yield over the e,pected lifetime of their liabilities. That is a simple way for bond managers at banks, insurance companies, pension funds and endowments to manage their bond assets. It is not so easy for total return mutual fund managers, because they can0t tell with accuracy how patient'"umpy their mutual fundholders will be. Typically, they pick an inde, of bonds, and mirror the most critical aspects of it & duration, conve,ity, credit -uality, etc. Jetail investors don0t care about that but they look at the return series, and analy.e whether the volatility is too great or too small for them, and if they have beaten many of their peers. To a good bond manager, he aims to add risk when he is well compensated for it, and reduce risk when it is not well compensated. That said, many bond managers have dumb clients. They want more yield, because they think that yield is free. I remember the 1hief 7ctuary of a client insurance firm saying to me, 8!hy can0t you earn the returns of 7J+ Cinancial, General 7merican, Kefferson ilot, and 1onseco3 )This was around early =>>>.* +y response was@ 8Bou want to take absurd risks3 ;ot only do these firms take asset risks, they are taking more risks than any large firm that I can find. They take asset risks everywhere. !orse, their liability structures are weak, and their leverage is high. 7 lot of their liabilities can run at will.9 It was not long before General 7merican and 7J+ Cinancial failed. 1onseco took a few more yearsG the ac-uisition of Green Tree helped kill them. Kefferson ilot wasn0t as bad as the others, but they sold out to :incoln ;ational while they could. It is foolish to be a yield hog. Bet, many institutional investors were yield hogs prior to the crisis. Someone had to buy the 111 "unk bonds. Someone had to sell protection in order to receive yield. The investment banks could not manufacture gains for those shorting the mortgage market on their own. There had to be yield hogs that wanted to receive yield in e,change for guaranteeing debts. Given the low interest rate environment that they faced, many parties felt they needed to earn more. 7IG in particular offered protection on many bonds in order to suck in e,tra income so that earnings estimates might be achieved. They were the ultimate yield hog, and like most hogs, they got slaughtered. 7s for the one offering protection, he must be sure that there is no tipping point over the life of

the swap. Then the e,tra yield would be safe. I have more to say on this, but let me summari.e for now. The need to earn income biases many bond investors to take too much risk. Jepeat after me@ 8Bield is not free.9 It e,ists because of perceived risksG the great -uestion is whether the perceived risks are underplayed, overplayed, or accurate. The good bond manager looks at the risks versus the incremental yields, and spreads his investments among a mi, of good risks.

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The Rules, Part XIII, subpart C

The need for income naturally biases a portfolio long. It is difficult to earn income without beneficial ownership of an asset positive carry trades will almost always be net long, absent major distress or dislocation in the markets. Those who need income to survive must then hope for a bull market. They cannot live well without one, absent an interest rate spike like the late 70s early !0s. "ut in order to benefit in that scenario, they had to stay short. +ore with :ess. 7lmost all of us want to do more with less. Save and invest less today, and make up for it by investing more aggressively. !e have been lured by the wrongheaded siren song that those who take more risk earn more on average. Jather, it is true ='Lrd of the time, and in spectacular ways. +anias are -uite profitable for investors until they pop. 7s I have said many times before, the lure of free money brings out the worst in people. Cew people are disposed to say, 8Dn a current earnings yield basis, these investments yield little. I should invest elsewhere,9 when the price momentum of the investment is high. I will put it this way@ in the intermediate2term, investing is about buying assets that will have good earnings three or so years out relative to the current price. !hether one is looking at trend following, or buying industries that are currently depressed, that is still the goal. !hat good investments will persist3 !hat seemingly bad investments will snap back3 That might sound odd and nonlinear, but that is how I think about investments. :ook for momentum, and analy.e low momentum sectors for evidence of a possible turnaround. Ignore the middle. :ess with +ore. Doesn0t sound so appealing. I agree. 7s a bond manager, I avoided comple,ity where it was not rewarded. I was more than willing to read comple, prospectuses, but only when conditions offered value. 7way from that, I aimed at simple situations that my team could ade-uately analy.e with little time spent. That is one reason why I am not sympathetic to those who lost money on 1DDs. !e had two prior cycles of losses in 1DDs & a small one in the late 0>$s, and a moderate one around #$$=2 #$$L. 1DDs are inherently weak structures. That is why they offer considerably more yield relative to similarly rated structured assets.

So, for those buying 1DDs backed by real estate assets mid2decade in the #$$$s, I say they deserved to lose money. ;ot only were they relying on continued growth in real estate prices, but they were reaching for yield in a low yield environment. Goldman and other investment banks may have facilitated that greed, but the institutional investors happily took down the e,tra yield. ;o one held guns to their heads. The only -uestion that I would raise is whether they disclosed all material risk factors in their prospectuses. );ot that most institutional investors read those & they call it 8boilerplate.9* Jeaching for yield always has risks, but the penalties are most intense at the top of the cycle, when credit spreads are tight, and the Ced0s loosening cycle is nearing its end. It is at that point that a good bond manager tosses as much risk as he can overboard without bringing yield so low that his client screams. erhaps the client can be educated to accept less yield for a time. I suspect that is a losing battle most of the time, because budgets are fi,ed in the short2run, and many clients have long term goals that they are trying to achieve & actuarial funding targets, mortgage payments, college tuition, cost of living in retirement, endowment spending rule goals, implied cost of funds, etc. That0s why capital preservation is hard to achieve, particularly for those that have fi,ed commitments that they have to meet. It is impossible to serve two masters, even if the goals are preserving capital and meeting fi,ed commitments. Toss in the idea of beating inflation, and you are pretty much tied in knots & it goes back to my 8Corever Cund9 problem. This third subpart ends my comments on this rule. Bou0ve no doubt heard the !all Street ma,im, 8Bulls make moneyG Bears make moneyG /ogs get slaughtered.9 Bield greed is one of the clearest e,amples of hogs getting slaughtered. So, when yield spreads are tight )they are tight relative to risk now, but could get tighter*, and the Ced nears the end of its loosening cycle )absent a crisis, they are probably not moving until unemployment budges, more0s the pity*, be wary for risk. reserve capital. The peak of the cycle may not be for one to three years, or an unimaginable crisis could come ne,t month. lan now for what you will do so that you don0t mindlessly react when the ne,t bear market in credit starts. It will be ugly, with sovereigns likely offering risk as well. 7t this point, I wish I could give simple answers for here is what to do. !hat I will do is focus on things that are very hard for people to do without, and things that offer inflation protection. !hat I will avoid is credit risk.

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The Rules, Part XIV & Thoughts on Maiden Lane LLC, Part 1
#repayment and default are dual to each other. The less likely is default, the more likely is prepayment, and vice$versa. In a pool of loans, the critical distinction is the likelihood of loans to prepay or default. %ust

because prepayment has been high, does not mean the remainder won&t default under stress. I don0t have clear answers to +aiden :ane ::1, the bailout of Bear Stearns yet. The comple,ity of +aiden :ane ::1, as compared to +aiden :ane # or L, is enormous. I have a more work to do. But, at least, I have scrubbed the data, and figured our what the Ced released to us. In the Bear Stearns bailout, the Ced received a wide variety of securities, including@ 1ash 1DDs 1omm J( !:s 1J( ;otes 7gency pools 7gency +BS !: +BS 7BS Jes Je !:s Treasuries 1DS 1DDs 1+BM 1DS 1orporate 1DS 1J( Securities 1DS +unicipal 1DS !: +BS 1DS 7BS Interest Swaps +aiden :ane # < L were simple compared to this, and this had over =$, the securities of both combined. lus, this had 1DS transactions which would profit from failure of a wide variety of assets. 7dditional difficulties included a lot of coding difficulties on the 1DS. The Ced did not try to make things clear. I spent many hours trying to clarify the tranches in -uestion. 7 few of them are guesses, but >>? are reliable. The Ced0s principal figures were original principal figures not those for current principal. That

was another area of ambiguity. The current value of what is owed to the Ced is over E#5 billion. There is almost EN> billion in current principal, so why worry3 !orry because of all of the interest only securities. The principal for them is notionalG principal payments will never be made. !ith 1+BS, I know that ID securities are typically worth no more than 6? of the notional principal balance. Because most 1+BS protect against prepayment, the prices of interest only securities reflect the likelihood of default. Though they are rated 777, their creditworthiness is more like BB. !ith Jesidential mortgages, the -uestion is harder. /ow big is the interest margin, and when might it cut off due to default or prepayment3 Interest only securities are typically worth a lot less then the notional principal. Same for principal only securities. Their value is the likelihood of payment discounted by the length of time until payment. Beyond that, there are the residential and commercial loans made, with almost E=$ billion of principal, for which we have no idea of the creditworthiness. 7re there any statistics on the currency of the collateral3 The Ced had not deigned to tell us. I place the creditworthiness at BB, but who knows for sure3 I can tell you now that the securities involved were mostly originated #$$62#$$4, during the worst of the underwriting cycle. Is it any surprise3 Cew can escape the credit cycle. !ithin a given credit cycle, the credit -uality of securities originated declines all of the way till slightly past the peak of the credit cycle. I am going to do more analysis of the J+BS, so that I can get a better feel for the value there. It is not clear to me whether +aiden :ane ::1 is ade-uately funded or not. The high degree of "unk, whole loans, and interest only securities gives me doubt.

1omments 22 Todd 'ays( +ay #6th, #$=$>@#> am 8The current value of what is owed to the Ced is over E#5 billion. There is almost EN> billion in current principal, so why worry39 Kust for us neophytes in the audience, this is the collateral the Ced got for the loan they gave K +organ to buy Bear Stearns3 7nd really, it0s more like the Ced "ust bought these assets outright from K +organ for E#5 billion )plus the #.6? interest rate O which I guess is annual3* because it0s not like K +organ is actually going to pay them back that E#5 billion. The Ced will "ust be stuck with this stuff3

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The Rules, Part XV

) http( alephblog.com *0+0 0, +- the$rules$part$.v / 0hat if securiti1ation allows the economy to e.pand more rapidly than it would at a price of volatility, when intermediaries would prove useful2 'ometimes securiti1ation and tranching creates securities for which there is no native home. 3s the life insurance industry shrinks, it will be hard to find buyers for subordinated structured product. Securiti.ation is an interesting phenomenon. Take a group of simple securities, like commercial or residential mortgages, and carve the cashflows up in ways that will appeal to groups of investors. Do investors want ultrasafe investments3 (asy, carve off a portion of the investments representing the largest loss imaginable by most investors. The remainder should be rated 777 )7aa if you speak +oody0s*. Then find risk taking parties to buy the portion that could suffer loss, at ever higher yields for those that are willing to take reali.ed losses earlier. !hat0s that, you say3 !hat if you can0t find buyers willing to buy the risky parts of the deal at prices that will make the securiti.ation work3 (asy, he will take the loans and sell them as a block to a bank that will want them on its balance sheet. That said, securiti.ed assets are typically most li-uid near the issuance of the deal, with the short, simple and 777 portions of the deal retaining their li-uidity best. Suppose you hold a security that is not 777, or comple,, or long duration, and you want to sell it. !ell, guess what3 ;ow you have to engage in an education campaign to get some bond manager to buy it, or, take a significant haircut on the price in order to move the bond. It helps to have a strong balance sheet. If the credit is good, even if obscure, a strong balance sheet can buy off the beaten path bonds, and hold them to maturity if need be. 7nd yet, there is hidden optionality to having a strong balance sheet & you can buy and hold -uality obscure bonds, but if thing go really well, you can sell the bonds to an,ious bidders scrambling for yield, while you hold more higher -uality bonds during a yield mania. (ndowments, defined benefit pension plans, and life insurance companies have those strong balance sheets. They do not have to worry that money will run away from them. The promises that these entities make are long duration in nature. They have the ability to invest for the long2 run, and ignore short2term market fluctuations, even more than Buffett does, if they are so inclined. If there was a decrease in the buying power of institutions with long liability structures, we would see less long term investing in fi,ed income and e-uity investments. Investments re-uiring a lockup, like private e-uity and hedge funds, would shrink, and offer higher prospective yields to get deals done. 2PPOPP2P2P2P2POP2P2P2PP2P2POP But what of my first point3 There are securiti.ation trusts, and there are financial companies.

During a boom phase, the securiti.ation trusts can finance assets cheaply. During a bust phase, the securiti.ation trusts have a lot of complicated rules for how to deal with problem assets. Cinancial companies, if they have ade-uate capital, are capable of more fle,ible and tailored arrangements with troubled creditors. /aving a real balance sheet with slack capital has value during a financial crisis. Securiti.ation trusts follow rules, and have no slack capital. :osses are delivered to the "uniormost security. P2P2P2P2P2P2P2P2P2P2P2PP2P2P2P2P2P2 Sometime around #$$N, a light went on in the life insurance industry regarding non2777 securiti.ed investments. In #$$6, with a few e,ceptions, the life insurance industry stopped buying them. 7IG was a ma"or e,ception. The consensus was that the e,tra interest spread was not worth it. Cortunately for the investment banks there were a lot of hedge funds willing to take such risks. There should be some sort of early warning system that clangs when the life insurance industry stops buying, and those that buy in their absence have weaker balance sheets. !hen risky assets are held by those with weak balance sheets, it is a recipe for disaster. 2P2P2P2P2P2P2P2P2P2P2P2P2PPP2P2P2P2P2 During the boom phase, securiti.ation trusts provide capital, cheaper capital than can be funded through banks. That allows the economy to grow faster for a time, but there is no free lunch. (ventually economic growth will revert to mean, when securiti.ations show bad credit results, and the economy has to slow down to absorb losses. In addition, when losses come, loss severities will tend to be higher than that for corporates. Qsually a tranche offering credit support will tend to lose all of its principal, or none. ):eaving aside early amorti.ation and the last tranche standing in the deal.* Cor years, the rating agencies and investment banks argued that losses on securiti.ed products were a lot lower than that for corporates, because incidence of loss was so low on 7BS, 1+BS and non2conforming J+BS. But the low incidence was driven by how easy it was to find financing, as lending standards deteriorated. Thus, securiti.ation allowed more lending to be done. Cirst, originators weren0t retaining much of the risk, so they could be more aggressive. Second, the originators didn0t have to put up as much capital as they would if they had to hold the loans on a balance sheet. Third, there were a lot of buyers for higher2rated yieldy paper, and 7BS, 1+BS and non2conforming J+BS typically offered better yields, and seemingly lower losses )looking through the rear2view mirror*. !hat was not to like3 !hat was not to like was the increased leverage that it allowed the whole system to run at. Debt levels increased, and made the system less fle,ible. Investors were fooled into thinking that assets were worth a lot more than they are worth today because of the temporary added buying power from applying additional debt financing to the assets. POP2P2P2P2P2PPOP2POPP2P2PPOPP2PP2P2P Securiti.ation has been a mi,ed blessing to investors. It is brilliant during the boom phase, and

e,acerbates trouble during the bust phase. 7nd so it is. 7s you evaluate financial companies, have a bias against clipping yield. Jegulators, as you evaluate risk2based capital charges, do it in such a way that securiti.ed products get penali.ed versus e-uivalently2rated corporates. Kust add enough JB1 such that it takes away any yield advantage versus holding it on balance sheet, or versus the e,cess yield on e-uivalently rated average corporates. It0s not a hard calculation to run.