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Q&A -The Answers, Part 1

Lots of questions.  Thanks.  I’ll break this up in two parts since there were so many.

How do you feel about P2P/marketplace lending (e.g. Lending Club, Prosper) as an asset class?

CR:  I have never used one of these services, but they’re basically unsecured personal loans.  The technology makes this useful and simple, but it’s still an unsecured personal loan at the end of the day.  Not exactly the least risky way to make a loan, but since it opens the credit network up to a wide scope of borrowers then it’s a nice service.  I don’t know what the figures are here, but my guess would be that P2P borrowers tend to be of lower credit quality which makes the whole structure of the business somewhat unstable.

Effem says:

I will assume you are a fan of “free markets” as a general statement. Why then are you in favor of the Fed (essentially a political body) setting the price of short-term money? Wouldn’t be be better off letting the market set the price, as it does most other prices?

CR:  I’m not really “for or “against” the Fed.  I describe the Fed for what it is – a great big clearinghouse that helps to smooth the interbank settlement process.  In general, this is a good and necessary thing and I don’t think the government could do it better (as in a nationalized banking system) or that the private sector could do it better (by having the clearinghouse be managed privately).

The key point in regards to interest rates is that we have a reserve system and because of this the banks will try to reduce their holdings of reserves in the interbank market unless they are incentivized not to.  This means that interest rates would decline to 0% without the Fed manipulating the rate higher at all times.  But this is only the overnight rate and while this is an important rate it is not all rates.  The “market” sets most other interest rates to a large degree (your credit card rate, mortgages, etc).

Curious says:

Do you think you could outrun an ostrich?

CR:  No.  An ostrich can sustain 35 mph according to the internets.  A Cullen Roche can sustain about 5-10 mph according to my extensive experience running with him.

Brian says:

Do you believe the suspension of mark to market accounting had everything to do with the market bottom or purely coincidental?

Also, just got your book. Looking forward to it.

CR:  There’s no doubt that the relaxation in accounting standards helped improve the overall situation.  I don’t think it’s unreasonable to say that this was an important turning point.  After all, it was essentially the point where the government stepped in and declared an all out war on the crisis.  Even to the point where they admitted they were willing to change the rules of the game in order to save the banks and the system.

Will the contrast in their Governors economics between Kansas and Cal. or Minnesota vs. Wisconsin get to affect policy?

CR:  I don’t know the specifics behind the different governors, but since governors determine policy to a significant degree I would assume that different political ideologies will lead to different outcomes.  But I can’t really answer the question without an extensive knowledge of the specific governors.

You mention that reserves don’t leave the banking system.

What about when reserves are collateralized as repurchase agreements which are then used as leverage to bid up stock, bond, and commodity markets?

Are those “reserves” still in the “banking system?”

CR:  A bank can always be thought of as leveraging its capital position to do various things.  But even if a bank were to collateralize reserves those reserves would still not “leave” the banking system in any practical sense.  It’s sort of like making a loan to someone with your Apple stock as collateral.  Your Apple stock doesn’t leave the secondary market where it trades.  Just like reserves don’t leave the interbank market.

Dan says:

OK. Really basic question compared to all we read on your blog. But my question comes from reading your book. From the chapter on investment vs savings:

1. Can a company have a policy of never paying dividends? If so, why would anyone ever buy such a stock either as an investment or as a way to allocate saving?

2. After the IPO, why does the company care about the value of the stock? Unless the company employees happen to own some of the stock, why would they care if the price goes up or down? I mean they already raised the money at the IPO and they don’t have to give the money back if the price goes to zero right? And if the stock values go way up a 100 times the price of their original purchase this doesn’t mean the company get more money right? It just means that “savers” are competing to own the stock and bidding up its value.

I am just curious about this after reading your book–which I’m enjoying.

CR:  Berkshire Hathaway has never paid a dividend.  When you buy a stock you are purchasing a claim on the company’s future cash flows.  That doesn’t mean that you must necessarily obtain part of the cash flows though.  You can literally trade that claim to someone else in the future because they believe that the future cash flows will be more valuable than they presently are.  Buying a stock that doesn’t pay a dividend is a little bit like buying gold.  You’re buying an asset that doesn’t pay you an income stream and you’re hoping that someone will believe that asset is more valuable in the future.  The difference, of course, is that a stock has a source of underlying output whereas a rock is, well, just a rock.

After an IPO the company is owned by its shareholders so management must answer to the shareholders.  If they don’t manage the company in a way that benefits the shareholders then management will be replaced.  The savers who own the stock demand that the company continue to grow in a way that helps protect them from purchasing power loss.  If the firm can’t achieve this then it has no value to its shareholders.  So the shareholders hold the firm accountable for increasing profits.

Andrew says:

What do you think of Josh Brown’s relentless bid theory?

CR:  There’s a lot of truth to it.  But I also think the stock market is simpler to understand than we often make it out to be.  The stock market is basically the summation of a whole bunch of poorly informed and irrational participants guessing about the future prices of stocks.  They move in herds, they act on emotion and they are programmed to think that they should be overweight stocks relative to everything else.  And so long as there’s no good reason to sell then the path of least resistance tends to be up.  And I think that’s been the story of the last few years driving this “relentless bid”.  It’s not that everything is so great or that asset managers are now buyers (they’re always net buyers), but that there doesn’t seem to be anything that is so worrisome at present that stocks sustain a downturn.  In other words, there hasn’t been a powerful trigger to send these irrational participants setting their bids lower and lower on a monthly basis….

dctodd27 says:

Would you ever utilize leverage in a client portfolio?

CR:  Depends on what you mean by leverage.  Would I implement a risk parity styled approach, buy options or utilize other strategies that implicitly utilize leverage?  Yes.  Would I leverage a portfolio, as in, buying 100% equities and then leveraging the account on margin by 20% through outright equity leveraging?  No.  Would I use these silly double or triple leverage ETFs?  Absolutely not.  I don’t think leverage is a necessary part of a portfolio and I think it adds the potential for uncontrollable tail risk type events.  Tail risk events are the biggest risk to the average investor’s portfolio so anything that substantially increases the odds of them occurring is generally a bad thing.

TheRealKess says:

Who would you rather get drunk with? Mark Cuban or Kim Jong Un.

CR:  Kim Jong Un.  Without a doubt.  Dennis Rodman described his parties as “7 star parties”.  DENNIS RODMAN SAID THAT.

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