Chapter 8. Bear Market (I'd Like a Review of the Bidding)


It's easy to put on leverage, but not as easy to take it off.

 --Warren Buffett (Wall Street Journal, April 30, 2007)

In 2007, both Warren and I thought many hedge funds were overleveraged. If the book value of Berkshire Hathaway stock falls 5 percent, investors have "lost" 5 percent for the moment, but Berkshire Hathaway's strong earning power (from subsidiaries and investments) will likely cause the price to rise satisfactorily again in the future. Berkshire Hathaway has value and its value is growing. A leveraged hedge fund that invests in collateralized debt obligations (CDOs) can only rely on those CDOs for "earnings." If the CDOs deteriorate due to, say, defaults on the loans backing them, there is permanent value destruction. There is no bouncing back from that. Furthermore, leverage magnifies the losses for investors. Bear Stearns Asset Management managed two hedge funds that provided classic examples.

On January 30, 2007, Jim Melcher of Balestra Capital (a $100 million hedge fund) and I appeared on CNBC to discuss hidden price deterioration in subprime CDOs. Diana Olick, CNBC's Washington-based real estate correspondent taped the segment. Olick may be the best reporter on any channel on this topic; she closely followed developments before the mortgage meltdown was big news. She reported that housing prices were softening and had risen only 1 percent the previous year for existing homes against the double-digit increases ...

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