Examiner: Lehman Torpedoed Lehman

A scathing report by a U.S. bankruptcy-court examiner investigating the collapse of Lehman Brothers Holdings Inc. blames senior executives and auditor Ernst & Young for serious lapses that led to the largest bankruptcy in U.S. history and the worst financial crisis since the Great Depression. In the works for more than a year, and costing more than $30 million, the report by court-appointed examiner Anton Valukas paints the most complete picture yet of the free-wheeling culture inside the 158 year-old firm, whose chief executive Richard S. Fuld Jr. prided himself on his ability to manage market risk.

Fuld's arrogance was boundless. He even told a House member to let him finish, when the politician had the temerity to interrupt his testimony before a Congressional committee. Fuld was used to such deference.


The document runs thousands of pages and contains fresh allegations. In particular, it alleges that Lehman executives manipulated its balance sheet, withheld information from the board, and inflated the value of toxic real estate assets. Lehman chose to "disregard or overrule the firm's risk controls on a regular basis,'' even as the credit and real-estate markets were showing signs of strain, the report said.

• Deals: Read the Lehman Examiner's Report
• Details of the 'Hail Mary' to Buffett
• Heard on the Street: Lehman's Racy Repo
• Deals: How Lehman Allegedly Manipulated Its Balance Sheet
• Deals: Lehman Senior VP Warned Auditors About Repo 105
• Deals: Dick Fuld's statement on the report
• MarketBeat: 'Hail Mary' to Warren Buffett
• Probe Yields Windfall for Legal Examiner

Getty Images - Lehman's top executives, including CEO Richard Fuld, were aware of accounting chicanery and failed to disclose it, the report said. Above, Fuld testifies before the House Oversight and Government Reform Committee in October 2008.


Mr. Valukas, chairman of law firm Jenner & Block, devoted more than 300 pages alone to balance-sheet manipulation, accusing Lehman of using accounting methods to move assets off its books.

Coincidentally, the firm is domicilied at 919 Third Avenue.


The examiner said that Lehman—anxious to maintain favorable credit ratings—engaged in an accounting device known within the firm as "Repo 105" to essentially park about $50 billion of assets away from Lehman's balance sheet. The move helped Lehman look like it had less debt on its books.

Seems misleading, to say the least.

In an ordinary repo transaction, Lehman would raise cash by selling assets with a simultaneous obligation to buy them back within days, according to the report. The transactions would be accounted for as financings, and the assets would remain on Lehman's balance sheet. In a Repo 105 transaction, Lehman did the same thing. But because the moved assets represented 105% or more of the cash it received in return, accounting rules allowed the transactions to be treated as "sales" rather than financings. The result: Assets shifted away from Lehman's balance sheet, reducing the amount of debt it showed to investors.

Misleading, and allowed. Nice.


"In this way, unbeknownst to the investing public, rating agencies, Government regulators, and Lehman's Board of Directors, Lehman reverse engineered the firm's net leverage ratio for public consumption," says the report.

Bloomberg News - Erin Callan, Lehman's former financial chief, in an April 2008 interview.

Lehman's own global financial controller, Martin Kelly, told the examiner that "the only purpose or motive for the transactions was reduction in balance sheet" and "there was no substance to the transactions." Mr. Kelly said he warned former Lehman finance chiefs Erin Callan and Ian Lowitt about the maneuver, saying the transactions posed "reputational risk" to Lehman if their use became publicly known.


In a November 2009 interview with the examiner, Mr. Fuld said he had no recollection of Lehman's use of Repo 105 transactions but that if he had known about them he would have been concerned, according to the report.

Plausible deniability?

One party singled out in the report is Lehman's audit firm, Ernst & Young, which allegedly didn't raise concerns with Lehman's board about the frequent use of the repo transactions. E&Y met with Lehman's Board Audit Committee on June 13, one day after Lehman senior vice president Matthew Lee raised questions about the frequent use of the transactions.

In a statement, Mr. Fuld's lawyer, Patricia Hynes, said, "Mr. Fuld did not know what those transactions were—he didn't structure or negotiate them, nor was he aware of their accounting treatment."

Difficult to believe that such a hands-on CEo didn't know a blessed thing about such an important matter. And if true, then he wasn't awatre of a very important matter.

As Lehman began to unravel in mid-2008, investors began to focus their attention on the billions of dollars in commercial real estate and private-equity loans on Lehman's books. The report said that while Lehman was required to report its inventory "at fair value," a price it would receive if the asset were hypothetically sold, Lehman "progressively relied on its judgment to determine the fair value of such assets."

To Slow Growth, China Raises an Interest Rate

Workers demolishing a house to make way for a residential area in Changzhi, Shanxi Province, last month. Real estate construction is rising briskly, thanks to a surge in lending by government-controlled banks.

China’s central bank raised a key interest rate slightly Thursday for the first time in nearly five months, in what economists interpreted as the beginning of a broader move to tighten monetary policy and forestall inflation.

After breaking stride a year ago during the global economic slowdown, the Chinese economy resumed galloping growth over the summer. Government investments, real estate construction and consumer spending are all rising briskly, thanks to a surge in lending by government-controlled banks.

Even exports have begun to recover despite continued economic weakness in the European Union and the United States, China’s two biggest overseas markets.

How? Other Asian markets?

More Photos

Victor Fung, the nonexecutive chairman of Li & Fung, a Hong Kong-based trading and supply chain management company that is one of the world’s largest, said that overseas demand had not been strong enough to sustain the strength in China's shipments seen last month. But he added that his own staff was somewhat more optimistic than he is, as are some investment bank economists.






Slide Show
A Booming Economy in China

Shorting China

James Chanos made his hedge fund fortune predicting problems at companies and shorting their stock.

James S. Chanos built one of the largest fortunes on Wall Street by foreseeing the collapse of Enron and other highflying companies whose stories were too good to be true.

Now Mr. Chanos, a wealthy hedge fund investor, is working to bust the myth of the biggest conglomerate of all: China Inc.

 The very next post (above) is a discussion of ginancial steps China took to slow growth.

As America’s pre-eminent short-seller — he bets big money that companies’ strategies will fail — Mr. Chanos’s narrative runs counter to the prevailing wisdom on China. Most economists and governments expect Chinese growth momentum to continue this year, buoyed by what remains of a $586 billion government stimulus program that began last year, meant to lift exports and consumption among Chinese consumers.

He thinks China might be overstating its growth rate ("cooking its books") , and that it has excess credit available ("Bubbles are best identified by credit excesses, not valuation excesses.")

Still, betting against China will not be easy. Because foreigners are restricted from investing in stocks listed inside China, Mr. Chanos has said he is searching for other ways to make his bets, including focusing on construction- and infrastructure-related companies that sell cement, coal, steel and iron ore.

 Uh-oh. Cemex.

Mr. Chanos, 51, whose hedge fund, Kynikos Associates, based in New York, has $6 billion under management, is hardly the only skeptic on China. But he is certainly the most prominent and vocal.

For all his record of prescience — in addition to predicting Enron’s demise, he also spotted the looming problems of Tyco International, the Boston Market restaurant chain and, more recently, home builders and some of the world’s biggest banks — his detractors say that he knows little or nothing about China or its economy and that his bearish calls should be ignored.

Easy to dismiss bears, when one wants to see sunshine.

“I find it interesting that people who couldn’t spell China 10 years ago are now experts on China,” said Jim Rogers, who co-founded the Quantum Fund with George Soros and now lives in Singapore. “China is not in a bubble.”

;Cowboy Jim had written that he'd be moving. He also predicted an unending bull market for commodities.

“The Chinese,” he warned in an interview in November with Politico.com, “are in danger of producing huge quantities of goods and products that they will be unable to sell.” In December, he appeared on CNBC to discuss how he had already begun taking short positions, hoping to profit from a China collapse.

In recent months, a growing number of analysts, and some Chinese officials, have also warned that asset bubbles might emerge in China.

The nation’s huge stimulus program and record bank lending, estimated to have doubled last year from 2008, pumped billions of dollars into the economy, reigniting growth. But many analysts now say that money, along with huge foreign inflows of “speculative capital,” has been funneled into the stock and real estate markets. A result, they say, has been soaring prices and a resumption of the building boom that was under way in early 2008 — one that Mr. Chanos and others have called wasteful and overdone.

“It’s going to be a bust,” said Gordon G. Chang, whose book, “The Coming Collapse of China” (Random House), warned in 2001 of such a crash.

2001? Guess he didn't get that one right.

Friends and colleagues say Mr. Chanos is comfortable betting against the crowd — even if that crowd includes the likes of Warren E. Buffett and Wilbur L. Ross Jr., two other towering figures of the investment world.

That is contrarian.

“His record is impressive,” said Byron R. Wien, vice chairman of Blackstone Advisory Services. “He’s no fly-by-night charlatan. And I’m bullish on China.”

Mr. Chanos often responds to critics of short-selling by pointing to the critical role they played in identifying problems at Enron, Boston Market and other “financial disasters” over the years.

“They are often the ones wearing the white hats when it comes to looking for and identifying the bad guys,” he has said.

Working the railroad

“This is all happening because my father didn’t buy me a train set as a kid,” Mr. Buffett joked in an interview.







America’s best-known investor, Warren E. Buffett, is making his biggest bet yet on the nation’s economic future by buying, of all things, a railroad.

After deftly capitalizing on the financial crisis with a series of bold deals, Mr. Buffett on Tuesday agreed to buy the 131-year-old Burlington Northern Santa Fe Corporation.

If I recall correctly, that Santa Fe part of the conglomerated name is th eold, renown Hutchinson, Topeka and Santa Fe.

Even as the credit markets have improved and banks have become less skittish about lending, few companies can muster Mr. Buffett’s financial firepower. Berkshire will borrow $8 billion to supplement $8 billion in cash from its books, paying off the debt in three annual installments.

Although it has the cash, Berkshire will borrow, presumably for tax advantages.

The Journal's article had these interesting details:

On Sunday afternoon, Burlington also hired Evercore Partners and its chairman, Roger Altman -- in part because of Mr. Altman's long relationship with Burlington lead board member Ed Whitacre. Both men worked on deals involving SBC Communications, where Mr. Whitacre was CEO, and General Motors, where Mr. Whitacre is lead independent board member.

Interlocking ties.

Greatest trade ever

Zuckerman, Gregory. (2009),
The greatest trade ever : the behind-the-scenes story of how John Paulson defied Wall Street and made financial history.
New York: Broadway Books.



Housing prices had climbed a puny 1.4% annually between 1975 and 2000, after inflation. But they had soared over 7% in the following five years, until 2005. The upshot: U.S. home prices would have to drop by almost 40% to return to their historic trend line. Not only had prices climbed like never before, but Mr. Pellegrini's figures showed that each time housing had dropped in the past, it fell through the trend line, suggesting that an eventual drop likely would be brutal.









By the middle of 2009, a record one in 10 Americans was delinquent or in foreclosure on their mortgages. U.S. housing prices had fallen more than 30% from their 2006 peak. In cities such as Miami, Phoenix, and Las Vegas, real-estate values dropped more than 40%. Several million people lost their homes. And more than 30% of U.S. home owners held mortgages that were underwater, or greater than the value of their houses, the highest level in 75 years.


















John Paulson was among the executives testifying on hedge fund regulation before the House Oversight and Government Reform Committee last November. From left, George Soros of Soros Fund Management, James Simons of Renaissance Technologies, Mr. Paulson, Philip Falcone of Harbinger Capital Partners, and Kenneth Griffin of Citadel Investment.

What do I think?

This is a perfect definition of a self-fulfilling prophecy: on page 1 of the Wall Street Journal today, this item appeared: "Stocks started September with a selloff led by financial issues, as investors worried that the summer rally could give way to a correction."

Well, yes: by selling, investors created a correction.

Pepsi Plans Big Mexican Investment

Soda in Mexico is far sweeter than in the US. I remember we had a Sprite when we were in Guadalajara; it tasted as if it were almost all sugar.

PepsiCo Inc. plans to spend as much as $3 billion in Mexico over the next five years, in its latest move to expand its snack and beverage businesses outside the U.S. as sales slow at home.

The Purchase, N.Y., maker of Pepsi-Cola, Lay's potato chips and other snacks and drinks said it will spend about $2 billion of the funds on local research and development, manufacturing, distribution, marketing and advertising for its Sabritas and Gamesa foods businesses.

The company's plans also include bringing some of its Mexican brands to the U.S. market, to grab a greater share of sales to the rapidly growing Hispanic population.

Congo Unrest Disrupts Critical Mine Reforms

This is one of the saddest stories I have ever read. The country has been a disaster since Mobutu Sese Seko, who was the US's darling: his anti-communism kept the Soviets out. Yet his corruption was flagrant, massive, and unchecked.

As rebel fighting in eastern Congo threatens to escalate into a regional conflict, government officials in Kinshasa have put on hold important decisions affecting the mining industry, a delay that likely pushes back international investment plans and undercuts the country's efforts to rebuild its shattered economy.

International companies have scrambled to secure mining rights in Congo, which has vast reserves of cobalt, copper, tin and diamonds. But the country has been racked by years of civil war and cross-border fighting. Elections in 2006, the country's first in 40 years, appeared to ease some of the instability.

View Slideshow

Refugees Struggle in Congo

It has vast resources, but has been racked with misery since the days of Belgian colonialism.

Congo needs the additional money. The country's central bank last week trimmed its annual growth forecast for next year to less than 10% from about 11%, citing waning demand for Congo's metals and unplanned violence-related spending. Craig Andrews, a World Bank analyst, said he would be surprised if growth topped 6% next year.

October Pain Was 'Black Swan' Gain

Not everybody lost money in October.

Separate funds in Universa's so-called Black Swan Protection Protocol were up by a range of 65% to 115% in October, according to a person close to the fund. "We're discovering the fragility of the financial system," said Mr. Taleb, who says he expects market volatility to continue as more hedge funds run into trouble.

I can only dream of making that kind of return at any time, let alone in one month.

Nassim Nicholas Taleb wrote a book entitled The black swan: the impact of the highly improbable, in which he wrote about black swans.

Buffett is buying

The Oracle of Omaha has turned into a buyer.

A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful. And most certainly, fear is now widespread, gripping even seasoned investors. To be sure, investors are right to be wary of highly leveraged entities or businesses in weak competitive positions. But fears regarding the long-term prosperity of the nation’s many sound companies make no sense. These businesses will indeed suffer earnings hiccups, as they always have. But most major companies will be setting new profit records 5, 10 and 20 years from now.

A long-term outlook. I own P&G, Goldman Sachs, and GE, 3 companies he has a stake in: I bought P&G four years ago, Goldman Sachs a year and a half ago, and GE just recently. All three are solid companies with a strong franchise, a good name, and a track record of success. I intend to keep them long-term.

Equities will almost certainly outperform cash over the next decade, probably by a substantial degree. Those investors who cling now to cash are betting they can efficiently time their move away from it later. In waiting for the comfort of good news, they are ignoring Wayne Gretzky’s advice: “I skate to where the puck is going to be, not to where it has been.”

I don’t like to opine on the stock market, and again I emphasize that I have no idea what the market will do in the short term. Nevertheless, I’ll follow the lead of a restaurant that opened in an empty bank building and then advertised: “Put your mouth where your money was.” Today my money and my mouth both say equities.

I'm in.

Warren Buffett: it's simple

In a WSJ story about Buffett investing in Goldman Sachs, there's this quote how simple things can seem to the Sage of Omaha:

Mr. Buffett received a call at 4:30 p.m. that Saturday from a private investment firm trying to assemble a group to buy the embattled financial giant. "I'm calling about Bear Stearns,'" the private investor began, according to Mr. Buffett. "Should I go on?'"

Mr. Buffett recalls thinking: "It's like a woman taking off half her clothes and asking, 'Should I continue?' Even if you're a 90-year-old eunuch, you let 'em finish." Mr. Buffett says he passed on the proposed deal. Bear Stearns was bought by J.P. Morgan Chase & Co. the following day.

Emphasis added. Gotta love it.

Behind the Boom and Bust in Real-Estate

This is a case of business people yelling ot the government: "save us from ourselves."

A firm that acted as a middle man in a popular real-estate-investment strategy has closed its doors, leaving investors scrambling to recover millions and pointing to flaws in the largely unregulated industry.

Emphasis added to make a point. Here's another point:

Vesta was founded in 2004 by Chicago businessman John Terzakis and his partner, Robert Estupinian. Prior to starting Vesta, Mr. Terzakis had a history of failed real-estate deals and soured relationships -- information Mr. Terzakis isn't required to disclose to potential clients.

Not required to disclose he had a history? Why? Should not that be considered material?

Californian Christina Pappas was seeking to carry out a 1031 exchange when, on the advice of her escrow company, she handed over $2.5 million to Vesta in April from the sale of a property. She soon found another building to purchase within the IRS-mandated 180-day time frame. But a Vesta representative failed to wire her money to complete the property exchange by the June 16 closing, and still hasn't done so, she says.

The 57-year-old Ms. Pappas filed suit against Vesta last month, but she fears she won't recoup the money, which accounted for much of her retirement savings. "If I would have known any of this, I would have paid my taxes instead" of attempting a 1031 exchange, she says.

If she had known? She handed over 2.5 million, and didn't know? Ouch.

Viva Mejico

Much as I like Mexico, the first part of this suprises me: Mexico now boasts the 12th-largest economy in the world and has the highest rating of long-term sovereign credit in Latin America. Even the second part surprises me; I would've guessed Brazil.

Grimple

A new one on me.

Got grimple in your portfolio? Remember when investors bet on 'Wintel'? Today the smart money is on 'Grimple.'

(Fortune Magazine) -- Back in the '90s, "Wintel" became shorthand for the seemingly unstoppable combination of Microsoft's Windows and Intel's chips. Wintel wasn't a bad investment thesis either. For years betting against either stock proved a sucker's game.

Lately hedge fund traders have started using a new term: "Grimple."

Grimple is a conflation of Google, RIM (the acronym for BlackBerry manufacturer Research in Motion (RIMM)), and Apple. Each company is the clear leader in one of tech's hottest areas: Google (GOOG, Fortune 500) for search advertising, RIM for wireless communicators, and Apple (AAPL, Fortune 500) for the convergence of computers, consumer devices, and recorded entertainment.

During market instability, owning three mega-cap market leaders (combined market value: $283 billion) is a comforting idea for some. "People think there's safety there because they're huge," says Douglas Whitman, a tech-focused hedge fund manager in Palo Alto. "The three have fantastic businesses, and none trade for ridiculously high valuations." (Especially now that Apple, Google, and RIM are off 39%, 37%, and 19%, respectively, from their all-time highs.)

Whether the term will spread beyond trading desks is no sure thing, though. Or as a Google spokesperson told Fortune, "I had not heard of 'Grimple' before your e-mail. Sorry about that."

Bottom, or a Bounce? The smart money saves WaMu

Private equity money moves into banks decimated by subprime disasters.

Investors are also hopeful that the smart money is ready at last to brave the financial sector, which has been in decline for the past nine months. Some investors are betting that the WaMu investment will pave the way for similar deals at other financial firms with hefty mortgage exposure, particularly in so-called speculator states such as California, Florida, Arizona and Nevada.

Roger Ehrenberg, a former Wall Street executive who writes the Information Arbitrage blog, expects to see much of the new money for hard-hit firms like National City coming from buyout shops, which have raised billions of dollars but have had little opportunity in recent months to deploy big chunks of money. "You will see more of this kind of deal because of the liquidity in private equity," he says.

That trend [to underestimate or understate foreseeable losses], along with continued housing slump nationwide, means that, for all of its expertise, TPG is buying into a highly uncertain environment. Further deterioration in housing industry fundamentals could leave the WaMu investment under water.

2 old pros assess the markets

When panic is spreading, investors with strong nerves and an eye for bargains step in and buy, for that is when opportunities and bargains are best. These are two savvy investors; their comments are fascinating, and wise.

First detail that strikes me is the connection they make between gambling at card tables and buying and selling on 'Wall Street'. Yes, both pursuits are betting against the odds, thinking that the other guy is either dumber or more apt to make mistakes.

Edward Thorp's tactic of counting card is not allowed in casinos; obviously, it works, and too well for the taste of the house.

Second detail that jumps out: "Mr. Thorp ran two hedge funds, Princeton-Newport Partners and Ridgeline Partners, which went nearly 30 years without a down year, and averaged 19%-20% annual returns, he says."

Next detail: Bill Gross saying, "I had $200, so I headed out to Las Vegas. I turned my $200 into $10,000. I didn't care about the money. I wanted to prove that you could beat the system. Then I thought about what I could do that takes the same skills. I realized it was investing.""

There is a similarity of skills between card playing and investing in stocks and bonds.

To manage risks, Thorp says, "You have to make sure that you don't over-bet. Suppose you have a 5% edge over your opponent when tossing a coin. The optimal thing to do, if you want to get rich, is to bet 5% of your wealth on each toss -- but never more. If you bet much more you can be ruined, even if you have a favorable situation."

Gross adds, "[Kelly's] basic thrust concerns the idea of gambler's ruin, where you lose everything by over-betting. In the context of blackjack, you can never bet more than 2% of your stake without the possibility of eventually losing your entire pot. Here at Pimco, it doesn't matter how much you have, whether it's $200 or $1 trillion. You'll see it throughout our portfolio. We don't have more than 2% in any one credit. Professional blackjack is being played in this trading room from the standpoint of risk management, and that's a big part of our success."

Conituing, Gross says, "You don't always [know you're safe]. That's why you stick to the highest-quality investments. We were recently a big buyer of municipal bonds, one-billion-plus. How did we know we paid the best price? We didn't. What we did know was that these are double-A quality credits that have very little chance of going bankrupt. We jumped in and crossed our fingers."

And Thorp winds it up this way: "Fear creates opportunities. So as Bill was saying, this is probably a great time."

Old Pros Size Up the Game

from Wall Street Journal of Saturday 22 March 2008

Thorp and Pimco's Gross Open Up on Dangers
Of Over-Betting, How to Play the Bond Market

By SCOTT PATTERSON
March 22, 2008; Page A9

from Wall Street Journal of Saturday 22 March 2008

About 50 years ago, a young math instructor at the Massachusetts Institute of Technology, Edward Thorp, created a strategy for wagering on blackjack that maximized winnings and effectively eliminated the chance of getting wiped out.

The strategy involved getting an edge over the dealer by counting cards, and never making especially big bets. He described the method in a 1962 book, "Beat the Dealer," then took on Wall Street in "Beat the Market."

Edward Thorp (left) and a now-famous follower, bond guru Bill Gross

Mr. Thorp ran two hedge funds, Princeton-Newport Partners and Ridgeline Partners, which went nearly 30 years without a down year, and averaged 19%-20% annual returns, he says.

One of his followers became Bill Gross, managing director of Allianz SE's giant bond-fund company, Pacific Investment Management Co., or Pimco. He read the books in college and still uses the risk-management techniques.

The Bear Stearns debacle shows that managing risk is more important than ever. Messrs. Gross and Thorp talked about risk management and markets -- and cards, of course -- in an interview at Pimco's Newport Beach, Calif., base:

Wall Street Journal: How did you get interested in blackjack?

Edward Thorp: I went to Las Vegas in 1958. I'd learned a strategy that would let you play just about even, so I decided to play with $10. My $10 lasted a lot longer than anyone else's at the table. I thought there had to be a mathematical way to beat the game, and that would be interesting mathematics. I figured it out and a few years later I wrote "Beat the Dealer."

WSJ: What about you, Bill?

Bill Gross: I picked up Ed's book in early 1966. I got in an automobile accident and had to go into the hospital and had time to practice the card-counting technique he discovered. And it worked! I had $200, so I headed out to Las Vegas. I turned my $200 into $10,000. I didn't care about the money. I wanted to prove that you could beat the system. Then I thought about what I could do that takes the same skills. I realized it was investing.

Mr. Thorp: He started out with $200 and now he manages nearly $1 trillion.

Mr. Gross: "Beat the Market" was even more fortuitous -- it was the reason I got hired at Pimco, or what was Pacific Mutual Life then. I had done a master's thesis on convertible bonds and "Beat the Market." The people who hired me said, 'We have a lot of smart candidates, but this guy is interested in the bond market.' So I got my job because of Ed.

WSJ: What can your blackjack strategy tell us about how to manage risk in today's markets?

Mr. Thorp: You have to make sure that you don't over-bet. Suppose you have a 5% edge over your opponent when tossing a coin. The optimal thing to do, if you want to get rich, is to bet 5% of your wealth on each toss -- but never more. If you bet much more you can be ruined, even if you have a favorable situation.

WSJ: Your key risk-management strategy is known as the Kelly Criterion. What is it?

Mr. Thorp: It's a formula Bell Labs scientist John Kelly devised in the 1950s for maximizing the long-term growth rate of capital. It tells you how to allocate your money among the choices available, and how much to invest as your edge increases and the risk decreases. It also avoids the over-betting that can ruin an investor who otherwise has an edge.

Mr. Gross: Ed's basic thrust concerns the idea of gambler's ruin, where you lose everything by over-betting. In the context of blackjack, you can never bet more than 2% of your stake without the possibility of eventually losing your entire pot.

Here at Pimco, it doesn't matter how much you have, whether it's $200 or $1 trillion. You'll see it throughout our portfolio. We don't have more than 2% in any one credit. Professional blackjack is being played in this trading room from the standpoint of risk management, and that's a big part of our success.

WSJ: Bill, you've compared what's going on in the credit markets today to another card game: Old Maid.

Mr. Gross: In Old Maid there's a card nobody wants: the old maid. In today's marketplace, there are quite a few old maids. The ones America knows about are subprime mortgages. And they've spread to, for goodness sakes, the municipal market and sacrosanct areas that presumably are default-free. In Old Maid, you try to pretend to your opponent that you don't have the maid, and you try to entice the other side to pick it up. That is happening extensively in today's market.

WSJ: How do you know what's safe?

Mr. Gross: You don't always. That's why you stick to the highest-quality investments. We were recently a big buyer of municipal bonds, one-billion-plus. How did we know we paid the best price? We didn't. What we did know was that these are double-A quality credits that have very little chance of going bankrupt. We jumped in and crossed our fingers.

WSJ: What's your assessment of the state of hedge funds today?

Mr. Thorp: In the last 15 years or so, there has been a large flow of capital into the hedge-fund world, from $100 billion in the early 1990s to $2 trillion now. But the amount of available investing opportunities hasn't increased that much. That has led to the over-betting phenomenon Bill and I were talking about, or gambler's ruin.

Hedge funds started using a great deal of leverage to increase returns. But you can get wiped out if you bet too aggressively. A classic example is Long-Term Capital Management [the huge hedge fund that blew up in 1998]. We'll probably be seeing more of that now.

Mr. Gross: It's true that the available edge has been diminished, and that led to increased leverage to maintain the same returns. It's the leverage, the over-betting, that leads to the big unwind. Stability leads to instability, and here we are. The supposed stability deceived people.

Mr. Thorp: Any good investment, sufficiently leveraged, can lead to ruin.

WSJ: Bear Stearns is another example.

Mr. Thorp: Using too much leverage seems to have taken down Bear Stearns, though it doesn't seem that the Bear executives feel any sense of responsibility for bringing this upon themselves.

WSJ: Is there more leverage in the system now than ever before?

Mr. Gross: Goodness yes. The critical jolt came through housing, through the real economy, when homeowners became so overly levered relative to the equity in their home -- in many cases there was no equity, which is like super-leverage. Ultimately, some level of interest rates, or some level of caution by lenders to extend further credit, meant we were going down. Now we are finding out the consequences.

WSJ: With all of the dislocations in the market, are you seeing opportunities crop up, Bill?

Mr. Gross: Six months has changed everything. We bought double-A municipals at 6.5% tax-free, vs. 3.5% Treasurys. That's witness to the extreme dislocations in this market. Risky assets, non-Treasury assets, are getting repriced swiftly. Six or 12 months ago, we were despairing in terms of finding good opportunities. But now the opportunities are enormous, and we're looking for places to jump in.

WSJ: But you must feel a little nervous.

Mr. Gross: We're treading cautiously, staying with a high level of quality. We're not going into high-yield or the subprime market. Is there blood on the streets? Yes. But there are strong-quality assets out there.

Mr. Thorp: Fear creates opportunities. So as Bill was saying, this is probably a great time.

Kelly Criterion for investing

The Kelly Criterion defined by one source:

John Kelly, who worked for AT&T's Bell Laboratory, originally developed the Kelly Criterion to assist AT&T with its long distance telephone signal noise issues. Soon after the method was published as "A New Interpretation Of Information Rate" (1956), however, the gambling community got wind of it and realized its potential as an optimal betting system in horse racing. It enabled gamblers to maximize the size of their bankroll over the long term. Now the system is used by many as a general money management system in not only gambling but also investing.

The Basics
There are two basic components to the Kelly Criterion:
• Win probability - The probability that any given trade you make will return a positive amount.
• Win/loss ratio - The total positive trade amounts divided by the total negative trade amounts.

These two factors are then put into Kelly's equation:
Kelly % = W – [(1 – W) / R]

Where:
W = Winning probability
R = Win/loss ratio

The output is the Kelly percentage, which we examine below.

Kelly's system can be put to use by following these simple steps:

1. Access your last 50-60 trades. You can do this by simply asking your broker, or by checking your recent tax returns (if you claimed all your trades). If you are a more advanced trader with a developed trading system, then you can simply back test the system and take those results. The Kelly Criterion assumes, however, that you trade the same way you traded in the past.
   
2. Calculate "W", the winning probability. To do this, divide the number of trades that returned a positive amount by your total number of trades (positive and negative). This number is better as it gets closer to one. Any number above 0.50 is good.
   
3. Calculate "R," the win/loss ratio. Do this by dividing the average gain of the positive trades by the average loss of the negative trades. You should have a number greater than 1 if your average gains are greater than your average losses. A result less than one is managable as long as the number of losing trades remains small.
   
4. Input these numbers into Kelly's equation: K% = W – [(1 – W) / R].
   
5. Record the Kelly % that the equation returns.

Interpreting the Results
The percentage (a number less than one) that the equation produces represents the size of the positions you should be taking. For example, if the Kelly percentage is 0.05, then you should take a 5% position in each of the equities in your portfolio. This system, in essence, lets you know how much you should diversify.

The system does require some common sense, however. One rule to keep in mind, regardless of what the Kelly percentage may tell you, is to never commit more than 20-25% of your capital to one equity. Allocating any more than this is carries far more risk than most people should be taking.

Is It Effective?
This system is based on pure mathematics. However, some people may question whether this math originally developed for telephones is actually effective in the stock market or gambling arenas.

By showing the simulated growth of a given account based on pure mathematics, an equity chart can demonstrate the effectiveness of this system. In other words, the two variables must be entered correctly, and it must be assumed that the investor is able to maintain such performance