So Berkowitz has released two case studies, and the investment theses are very simple. Both begin with some simple and similar points:

• trades at less than half or less than a third of book value
• fortress balance sheet
• leaders in respective markets
• potential for 20% return on investment

So with those simple facts would you take a serious look at investing in one or both of these companies?

See Case Study I and Case Study II.

According to Audit Analytics, a research firm in Sutton, Mass., 30% of the 1,000 leading U.S. companies have used the same firm to audit their books for at least a quarter-century. Fully 11% have used the same audit firm continuously for 50 years or more. Eight companies haven’t changed auditors in at least a century; the last time any of them hired a new accounting firm, William Howard Taft was in the White House.

Pretty shocking, right? Kinda makes you want to say that there needs to be a change. However, after reading through some of the comments to the article, the idea of term limits seems to be misguided and would likely not improve the chances of catching fraud. As one commenter put it, “Rotating the execution of a poorly designed process won’t fix anything. It might be time to go back to square one.” Also, there is already a requirement that the engagement partner of the auditing firm be rotated every five years. Furthermore, there already is a lot staff rotation with turnover, promotions and re-assignments.

So despite those attention-grabbing stats, it seems people should be always be hesitant to implement new laws or regulations, especially when there doesn’t seem to be any evidence that making a change would have net benefits.

There are many reasons for this, but I’ve looked at some interesting anecdotal evidence that suggests it will be very hard for Japan to make the necessary social and corporate changes to become more productive. For example, read this article about Sony Corporation, which details the rise and fall of the company. Stableboy Selections continues on this subject, arguing that its now Japanese companies (instead of American companies) that are making inferior style electronics. And then, given the recent scandal surrounding Olympus, you have to ask yourself whether there are more Japanese companies that have hidden losses through accounting tricks or fraud as opposed to admitting to mistakes and losses?

Further reading: the latest letter from Hayman Capital provides additional insight into the debt problems around the world.

So how would the SEC have known that LeCroy was a suspicious character a decade before it formally began its investigation of the sewer refinancings – in fact, before the infamous refinancings even took place?  In November 1997, Jefferson County Commissioner Bettye Fine Collins wrote the SEC asking for an investigation into the county’s swap transactions.  Collins argued that the county had been abused and that the transactions “raised the county’s expense by more than $1 million a year, and raised concern that the arrangement involved cronyism, patronage, excessive fees, and fraud.” (From examining the bond terms and swap confirmations, her numbers may have been accurate at the time.)

Why were these details left out of the SEC’s complaints?  Why did the SEC not acknowledge that the county had previous dealings with LeCroy?  Why would the SEC wait nine years to begin an investigation into the deals after being tipped off by a public official, of all people?  (I cannot imagine public officials are the SEC’s typical whistleblowers.)  Collins would have had access to any of the documents that the SEC would have required to determine if the pricing on the transaction was fair (marketing materials, swap confirmations, etc.).  If the SEC suspected her request was simply motivated by politics, they could have examined the deal to see if it was fair and moved on.  It is certainly not the SEC’s job to lecture governments about using swaps for speculative purposes rather than hedges, but if the SEC would have examined the deals, there would have been red flags immediately, such as the archaic commission structure on the swaps and the bizarre strategy that was being pitched to the county.  (The structure could have been appropriate in other sectors of the market, but certainly not for a county government.)  The original bond deals involved the same participants and modus operandi as the fraudulent deals that came later.

In the court filing there are lots of great examples of the lack of underwriting standards. One example of CS failing to fully investigate the borrower’s existing debt obligations: a re-underwriting of a $269,500 mortgage loan revealed that the borrower opened six mortgages totaling $1.7 million within 30 days of the subject mortgage loan’s closing date—a recalculation of the debt to income ratio yielded 135% which exceeds the max allowable DTI ratio of 60%.

Another excellent example is in regards to a failure to verify income. One borrower obtained a $479,900 mortgage loan claiming to be the owner of a maintenance and painting business with income of $358,800 per year. It turns out the actual income was $46,959 which gives a DTI ratio of 327%, exceeding the max allowable ratio of 60%—over 5 times the limit!

I suspect in the next 6–12 months there will be a settlement very similar in structure to the recent Bank of America/Countrywide settlement, meaning that AGO will likely receive about $1 billion in cash up front and another several hundred million later on along with some type of reinsurance or indemnity agreement.

I also used to play Magic a lot—I even came in 3rd place in a local tournament one time. Despite playing more than most people, I still did not approach it with quite the same amount of passion or seriousness as Finkel, and I eventually stopped playing to pursue other interests (and to save some money). But I think I developed some skills in a small way, such as improving my ability to pay attention to the details, gaining an understanding of how to weigh odds, and inadvertently learning about game theory.

What’s most interesting about Finkel is that he now is a partner in a hedge fund and I think the skills he developed as a Magic player have most likely helped give him an edge. When asked in an online forum about the links between Magic/gambling and the hedge fund, Finkel responded, “It’s a pretty natural progression really. They’re all advantage games that require logical thinking, discipline, and a willingness to take risks.”

I believe Finkel is correct. I also think everyone who is interested in improving their “game” should take Finkel’s advice to heart:

• Divorce your sense of self from your play. The key is to examine what you’ve done, in an unbiased way and critically, but not make yourself feel bad emotionally or crappy. Obviously, this is easier said than done.
• With anything in the world, find people who are better than you, but don’t forget the people who aren’t as good as you. Michael Jordan had a lot to learn from Phil Jackson, but he also had a lot to learn from Steve Kerr about shooting jump shots.
• Accept that if you want to be really good at something, you will need to do a lot of work. You look at people who are really good at Magic, they did it a real, real, real lot of times. They cared about it a lot, and they studied it a lot.

Even more recently, some financial analysts have journalists (namely Blodget, who I think made some utterly ridiculous claims) have suggested the need for BAC to raise more capital. Some have pointed out that another capital raise was imminent just by looking at the stock price.

Throughout this mess, I held no strong opinion about BAC. I felt that was and still is the weakest and most poorly run of the remaining big banks, but I have not felt that it needs another capital raise. I also felt that this pessimism was reaching an apex, and somehow there would be some event that make the shortsellers and naysayers reverse course.

And lo and behold, we have news today of Warren Buffett’s $5 billion investment in newly-issued BAC preferred shares. BAC stock is up about 18% as I write.

This brings me to the power of Buffett. It never ceases to amaze me the power Buffett can have over the stock price of a single company just by making an investment. There is little doubt this investment will work out great for Buffett. The terms of the investment are not as great as the Goldman Sachs and GE investments, but that is understandable. Those investments were made during a time of real financial crisis and when an investment from Buffett probably helped save those companies. The situation at BAC is not as dire, and thus the terms for Buffett’s investment are somewhat relaxed. Kudos to Buffett for another opportunistic investment.