Buffett Inflation has the "potential" to be worse than the 1970s

He added that inflation “has the potential” to be worse than the double-digit rates of the 1970s. “It depends on the wisdom of our policies, what we do with” new government spending. Buffett said that Republicans need to stand behind the Obama administration, but Obama and Democrats should not use the crisis “to roll Republicans.”

Other highlights:

• The economy "can't turn around on a dime" and a turnaround "won't happen fast."
• Five years from now, the economy will be running fine. The strength of the American system will pull it through, just as it has many times in the past.
  
• Democrats and Republicans should work together and not try to take advantage of the economic situation to achieve partisan goals.
• Inflation has the "potential" to be worse than the 1970s.
• Most banks are in "pretty good shape" and can "earn their way out" of the current problems given the low cost of funds. Banks, however, "need to get back to banking."
• Extremely important that the government make clear depositors won't lose their money if banks fail. Obama needs to make a "clear statement" in support of the banking system.
• Berkshire is restricted from buying more American Express stock, but that doesn't mean it is not a "hell of a buy" at $10 a share.
• Wishes he had written the New York Times "Buy American" piece a few months later, but stands by the basic argument that you'll do better over a ten-year period with stocks that you will with Treasuries. He said in the article he wasn't calling the bottom of the stock market, and he still isn't.
  
• Buffett says derivatives are not "evil" and to be avoided at all costs, but they are "dangerous" and should be used very carefully. He still expects to make money on the long-term "put option" equity derivative contracts Berkshire has written.
• Housing market could work through, or "sop up," its excess supply in as little as three years if new construction is reduced to a level below natural population growth
• The U.S. economy was not a "house of cards" over the past ten years, but mistakes were made when it came to borrowing money.
• Mark-to-market accounting should be retained, but regulators shouldn't use it so much to require insitutions to increase their reserves.
• "Probably the uptick rule" is a good idea.
• Mistake to "demonize" corporate executives for using private jets. Having a jet has helped Berkshire make deals in the past.
• Praises Ben Bernanke's leadership as Federal Reserve Chairman.

Warren Buffett to CNBC: Economy Has "Fallen Off a Cliff"

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Bob DeMarco is a citizen journalist, blogger, and Caregiver. In addition to being an experienced writer he taught at the University of Georgia , was an Asociate Director and Limited Partner at Bear Stearns, was CEO of IP Group, and is a mentor. Bob currently resides in Delray Beach, FL where he cares for his mother, Dorothy, who suffers from Alzheimer's disease. Bob has written more than 500 articles with more than 11,000 links to his work on the Internet. His content has been syndicated on Reuters, the Wall Street Journal, Fox News, Pluck, BlogCritics, and a growing list of newspaper websites (15). Bob is actively seeking syndication and writing assignments.

Betting Against the Doomsday Scenario

One of the hottest topics among investors is the volatility in the market and how to play it. The Chicago Board Options Exchange volatility index, the VIX, is the most often discussed measure of volatility in the market. The VIX traded at its highest levels ever during the hard down leg of this recent bear market.

It is not well known, but much of this volatility was caused by monster sized position that were built into the market during the bull market from 2002-2007. Traders were betting against a rise in volatility with all kinds of swaps and derivatives plays--hence they were short volatility. When volatility started to go up they were forced to buy volatility to cover their short positions.  They then found out they were part of a "herd"--they  all had the same positions. The extreme volatility levels we saw in the October-November period were exacerbated by smart investors who understood they could take advantage of the situation by buying volatility in front of these traders-- as the traders were trying to  cover and exit their short positions. This explains, in part, the extremes we saw in the VIX.

The VIX indicator, which acts as a reflection of the expectation for market swings in the future stood at 42.91 on January 30. This is down from peaks around 80 during October and November.

The big question now: is volatility high or low and how to play it?

Betting Against the Doomsday Scenario

Posted By David Gaffen On January 30, 2009

Rob Curran reports:

If you scoff at pundits and journalists pontificating on the possibilities of a second Great Depression, Credit Suisse says there’s a way you can put your money where your mouth is.

Comparing the volatility implied by S&P 500 equity derivatives for the next ten years with other miserable economies, Credit Suisse strategist Edward Tom said the current scenario priced in is considerably worse than the “lost decade” of 1990s Japan. The current risk expectations on long-term equity derivatives line up with the realized volatility on the stock market during the “entire ten-year span following the Oct. 28th crash of 1929,” Mr. Tom says.

In other words, you could bet against long-term volatility and have a U.S. economy as bad as Japan’s for ten years, and still win the bet. That’s because volatility has been so high that expectations in turn are also very high, much higher than the norm. The Chicago Board Options Exchange volatility index, which reflects expectations for market swings in the coming month, is still trading at 42.91, which, excluding 2008, would be the highest expectations for swings in the S&P 500 since the depth of the tech bear market. Longer-term volatility — looking at futures contracts — remains even higher.

In the go-slow days of the 2002-2007 creeping bull market, one popular trade was to go short volatility. Traders bet against volatility using “variance swaps” or other derivatives , in the expectation that just about any increase in volatility was a short-term one, and that the market would remain quiet.

In the last several months, however, volatility has been off the charts. The realized volatility in the fourth quarter of 2008 was 64.9%, according to Credit Suisse. And so betting against long-term volatility need not even be a bet on a return to the staid trading of 2002 to 2007, but it’s just a way to bet against the doomsday scenario.

Credit Suisse recommends short-selling long-term volatility as part of a more nuanced hedging around stock positions. But some may be tempted to make an outright bet.

”The idea of shorting long-term vol is very compelling since it has basically never been this high, and quants keep getting excited about the fact that ‘the market can’t keep moving every day of the next 5 years as it has done in the last 5 months,’” said Lorenzo Di Mattia, manager of hedge fund Sibilla Global Fund. “One problem: the assumption is that the USA is going to be the same country as we know it.”

That’s the doomsday scenario. If there is a second Great Depression, Mr. Di Mattia says, all bets are off. And many of the assumptions built into financial markets during the last fifty years could be swept away. Of course, in that case, investors will have a few more problems than a volatility bet that didn’t work out.

Six Errors on the Path to the Financial Crisis

Alan Blinder wrote an interesting article in the New York Times last week. He spells out in easy to understand terms the six errors that led us into this financial mess. He points out that if simple choices has been made along the way the situation would not be as dire as it is today. He goes on to point out that the current situation is not the failure of capitalism but about human errors. By putting a clear, concise "frame" around the current situation he makes it easier to understand. A better basic understanding of the problem would help our politicians in Washington to make decisions about how "taxpaper" money should and could be used to exacerbate the current financial problems.  The real issue right 

now is whether or not the way taxpayer money is being used is helping or just delaying the inevitable.

My list of errors has six whoppers, in chronologically order. I omit mistakes that became clear only in hindsight, limiting myself to those where prominent voices advocated a different course at the time. Had these six choices been different, I believe the inevitable bursting of the housing bubble would have caused far less harm.

Six Errors on the Path to the Financial Crisis

By ALAN S. BLINDER

WHAT’S a nice economy like ours doing in a place like this? As the country descends into what is likely to be its worst postwar recession, Americans are distressed, bewildered and asking serious questions: Didn’t we learn how to avoid such catastrophes decades ago? Has American-style capitalism failed us so badly that it needs a radical overhaul?

The answers, I believe, are yes and no. Our capitalist system did not condemn us to this fate. Instead, it was largely a series of avoidable — yes, avoidable — human errors. Recognizing and understanding these errors will help us fix the system so that it doesn’t malfunction so badly again. And we can do so without ending capitalism as we know it.

My list of errors has six whoppers, in chronologically order. I omit mistakes that became clear only in hindsight, limiting myself to those where prominent voices advocated a different course at the time. Had these six choices been different, I believe the inevitable bursting of the housing bubble would have caused far less harm.

WILD DERIVATIVES In 1998, when Brooksley E. Born, then chairwoman of the Commodity Futures Trading Commission, sought to extend its regulatory reach into the derivatives world, top officials of the Treasury Department, the Federal Reserve and the Securities and Exchange Commission squelched the idea. While her specific plan may not have been ideal, does anyone doubt that the financial turmoil would have been less severe if derivatives trading had acquired a zookeeper a decade ago?

SKY-HIGH LEVERAGE The second error came in 2004, when the S.E.C. let securities firms raise their leverage sharply. Before then, leverage of 12 to 1 was typical; afterward, it shot up to more like 33 to 1. What were the S.E.C. and the heads of the firms thinking? Remember, under 33-to-1 leverage, a mere 3 percent decline in asset values wipes out a company. Had leverage stayed at 12 to 1, these firms wouldn’t have grown as big or been as fragile.

A SUBPRIME SURGE The next error came in stages, from 2004 to 2007, as subprime lending grew from a small corner of the mortgage market into a large, dangerous one. Lending standards fell disgracefully, and dubious transactions became common.

Why wasn’t this insanity stopped? There are two answers, and each holds a lesson. One is that bank regulators were asleep at the switch. Entranced by laissez faire-y tales, they ignored warnings from those like Edward M. Gramlich, then a Fed governor, who saw the problem brewing years before the fall.

The other answer is that many of the worst subprime mortgages originated outside the banking system, beyond the reach of any federal regulator. That regulatory hole needs to be plugged.

FIDDLING ON FORECLOSURES The government’s continuing failure to do anything large and serious to limit foreclosures is tragic. The broad contours of the foreclosure tsunami were clear more than a year ago — and people like Representative Barney Frank, Democrat of Massachusetts, and Sheila C. Bair, chairwoman of the Federal Deposit Insurance Corporation, were sounding alarms.

Yet the Treasury and Congress fiddled while homes burned. Why? Free-market ideology, denial and an unwillingness to commit taxpayer funds all played roles. Sadly, the problem should now be much smaller than it is.

LETTING LEHMAN GO The next whopper came in September, when Lehman Brothers, unlike Bear Stearns before it, was allowed to fail. Perhaps it was a case of misjudgment by officials who deemed Lehman neither too big nor too entangled — with other financial institutions — to fail. Or perhaps they wanted to make an offering to the moral-hazard gods. Regardless, everything fell apart after Lehman.

People in the market often say they can make money under any set of rules, as long as they know what they are. Coming just six months after Bear’s rescue, the Lehman decision tossed the presumed rule book out the window. If Bear was too big to fail, how could Lehman, at twice its size, not be? If Bear was too entangled to fail, why was Lehman not?

After Lehman went over the cliff, no financial institution seemed safe. So lending froze, and the economy sank like a stone. It was a colossal error, and many people said so at the time.

TARP’S DETOUR The final major error is mismanagement of the Troubled Asset Relief Program, the $700 billion bailout fund. As I wrote here last month, decisions of Henry M. Paulson Jr., the former Treasury secretary, about using the TARP’s first $350 billion were an inconsistent mess. Instead of pursuing the TARP’s intended purposes, he used most of the funds to inject capital into banks — which he did poorly.

To illustrate what might have been, consider Fed programs to buy commercial paper and mortgage-backed securities. These facilities do roughly what TARP was supposed to do: buy troubled assets. And they have breathed some life into those moribund markets. The lesson for the new Treasury secretary is clear: use TARP money to buy troubled assets and to mitigate foreclosures.

Six fateful decisions — all made the wrong way. Imagine what the world would be like now if the housing bubble burst but those six things were different: if derivatives were traded on organized exchanges, if leverage were far lower, if subprime lending were smaller and done responsibly, if strong actions to limit foreclosures were taken right away, if Lehman were not allowed to fail, and if the TARP funds were used as directed.

All of this was possible. And if history had gone that way, I believe that the financial world and the economy would look far less grim than they do today.

For this litany of errors, many people in authority owe millions of Americans an apology. Richard A. Clarke, former national security adviser, set a good example when he told the commission investigating the 9/11 attacks that he wanted victims’ families “to know why we failed and what I think we need to do to ensure that nothing like that ever happens again.” I’m waiting for similar words from our financial leaders, both public and private.

Alan S. Blinder is a professor of economics and public affairs at Princeton and former vice chairman of the Federal Reserve. He has advised many Democratic politicians.

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