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WISDOM From SETH KLARMAN

Excellent compilation on Seth Klarman's thinkings and principles. Many thanks to Distressed
Debt Investing for the sharing.

Wisdom from Seth Klarman - Part 1

Seth Klarman and Baupost are in the news lately regarding the CIT Group Inc (CIT) bailout.
While I do not want to delve into specifics, I will say that, outside the chance of fraudulent
transfer / conveyance / some other quirky bankruptcy ruling dealing with the rescue
financing, I would buy the new L+1000 loan (3% floor) all day long...especially if I was
getting a 5 point advance fee. Currently in the grey market (when-issued) it is trading at
104-105 without the fee.

As we have not discussed Klarman or Baupost in the past few months, I thought I would take
a few moments to pull out some of the more educational quotes from his fund letters
through 2004-2007 (note: I do not have the fund letter from 2008...just the portions that
were posted in a recent issue of Value Investor Insight).

Before I start pulling out some of my more favorite Seth Klarman quotes, I want to point our
reader to a post by Sivaram Velauthapillai, at his contrarian investment blog, where he
discusses Seth Klarman's performance in relation to Warren Buffett (WEB). Now admittedly,
Sivaram admits he does not know much about Seth Klarman, and really was pulling
information from a document I alerted readers to a while back: old Seth Klarman Fund
Letters. A few comments have already corrected him, but just to reiterate: As of the end of
2007, Klarman was CRUSHING the S&P since the inception of the fund. The lowest return of
the three classes of his funds, from inception, was 5903.7% cumulative return (10434.2% for
the largest inception return). And no I did not place the decimal in the wrong point. The S&P
in the same period return came in at 1828.4%. So despite lagging the S&P in the go/go
years of the 90s, he maintained his capital base when the market gave a lot back in 2000-
2002 and the rest is history. In 2008, press reports stated that Klarman was down low
double digits. I can neither confirm nor deny this. Nonetheless, the S&P was down ~38.5% ...
further extending Baupost's lead.

In response to the blog post specificially: I understand the point about Klarman under-
performing the S&P in the go-go years. I get it. But, the problem in looking at any one's
record at any one point in time is that the past is the past. If you had looked at John
Paulson's merger arbitrage flagship fund in the beginning of 2007 you may say to yourself:
"Well, this fund...you know, it has been just doing OK" ... and then he goes out and throws a
+50% net to investors year in 2007 versus a nearly flat market. On the flip side you could
look to any number of funds that were putting up annualized returns in the high 20s to low
30s up to 2008 and were down 50-60% last year bringing their cumulative returns to mere
marginal levels.

Extending this to fundamental analysis, take a guess who's returns these are:

1991: 14.9%
1992: 28.1%
1993: 27.7%
1994: 22.3%
1995: 11.3%
1996: 21.2%
1997: 22.1%
1998: 19.2%
1999: 16.1%
2000: 15.9%
2001: 11.7%
2002: 15.7%
2003: 17.7%
2004: 17.0%
2005: 15.2%
2006: 18.3%
2007: 1.8%

They are the reported return on equity of Bear Stearn (as reported from Bloomberg)...right
up until the very end. As Seth Klarman writes in his 2004 letter, "While others attempt to win
every lap around the track, it is crucial to remember that to succeed at investing, you have
to be around at the finish."

Now onto some more Seth Klarman wisdom. I am going to a few quotes from each letter
(2004-2007) that I find particularly insightful regarding the investment and portfolio
management process.

From the Baupost 2004 letter:

"By holding expensive securities with low prospective returns, people choose to risk actual
loss. We prefer the risk of lost opportunity to that of lost capital, and agree wholeheartedly
with the sentiment espoused by respected value investor Jean-Marie Eveillard, when he said,
"I would rather lose half our shareholders...than lose half our shareholder's money..."

That is just a spectacular quote (both Klarman's and Eveillard's). It's also why, as my readers
are more than aware, I prefer current paying, senior-secured bank debt. Risk of permanent
capital is low, I am getting paid to wait, there is a definite catalyst in emergence, and I have
some control over the process. More quotes from the 2004 letter:

"We continue to adhere to a common-sense view of risk - how much we can lose and the
probability of losing it. While this perspective may seem over simplisticor even hopelessly
outdated, we believe it provides a vital clarity about the true risks in investing."

Another great quote from Seth Klarman. Risk is not beta or standard deviation...it is how
much you can lose on an investment and what the chance is that "loss" scenario is going to
play out.

And finally, from the 2004 letter (I am going to jump around on this one for full effect):

"Markets are inefficient because of human nature - innate, deep-rooted, permanent. People
don't consciously choose to invest with emotion - they simply can't help it.

"So if the entire country became securities analysts, memorized Benjamin Graham's
Intelligent Investor and regularly attended Warren Buffett's shareholder meetings, most
people would, nevertheless, find themselves irresistibly drawn to hot initial public offerings,
momentum strategies and investment fads...People would, in short, still be attracted to
short-term, get rich quick schemes.

"In short, we believe market efficiency is a fine academic theory that is unlikely ever to bear
meaningful resemblance to the real world of investing."

Wisdom from Seth Klarman - Part 2

Last week, we posted some quotes and commentary on the Baupost 2004 Letter to Investors
penned by Seth Klarman. We continue our wisdom / quotes from the Baupost 2005 letter.

First of all, they posted a return of 11.22% for the year, with 3.32% of the gain coming from
"non-performing debt." Further this position represented ~15% of the NAV at year end.
When the odds are in your favor, you bet big. Most people in the distressed debt can guess
what this position is...My personal guess is Enron. There was a video floating around on the
interweb, where Seth Klarman gave a speech to Columbia business school students, where
he mentions Enron. From Gurufocus (via Alex Bossert's Value Investing Blog):

"Baupost invested in Enron’s senior debt and he said that would be an example of his
favorite type of investment. The situation had a lot of complexity, hard to analyze, a lot of
litigation, uncertainty and no one wanted to be associated with anything Enron creating a
huge mispricing. Baupost bought the debt for 10-15 cents on the dollar. It comes down to
assessing assets minus liabilities. After a few years most of Enron’s assets were cash $16-18
billion but the liabilities were extremely complicated, with over 1,000 subsidiaries. Baupost
had one analyst focus solely on Enron for over 4 years and try to figure out its liabilities and
how much they would get back on the bonds. Baupost believed that the people liquidating
Enron were low balling what they would get back on the bonds. The people liquidating Enron
were very pessimistic and they originally estimated that the bonds would get back 17 cents
on the dollar at the same time the debt traded for 14-15 cents, Baupost estimated that the
debt would recover 30-40 cents and as of now they believe it will be more then 50 cents."

My old fund had a large position in Enron, in which I was the analyst, and the time frame
pretty much matches with the movements of the bonds. We owned the Class 4's with S (if
you do not know what that means, don't worry about it). I do not know the exact vehicle
Baupost would of invested, but it looked like they made a nice chunk of change (as many
distressed funds did).

Back to the Baupost letter now.

"For most investments, much can go wrong, including numerous factors beyond an
investor's control: the economy, the markets, interest rates, the dollar, war, politics, tax
rates, new technology, labor problems, competition, litigation, natural disasters, fraud,
dilution, accounting gimmicks, and corporate mismanagement. Some but not all of these
risks can be hedged, often only imprecisely and always at some cost. Other factors are
under an investor's control, but are not always controlled: discipline; consistency; remaining
within your circle of competence; matched duration of client capital with underlying
investments; prudent diversification; reacting rationally to news or market developments;
and of course, not overpaying"

One of the characteristics that has impressed from reading Klarman is how consistent he
seems. He does not seem to waver from his strategy. I know he has used options and very
tight CDS (specifically sovereigns) to hedge his portfolio. Those factors where he
commented that are under our control...well we should spend 90% of our time thinking
about them and not worrying if the market will finish higher a month from now. For our next
quote, Klarman discusses Baupost's investment returns:

"Is or past success the result of skill or luck? Is it replicable, or merely a lengthy run of good
fortune? We are confident that our success has not been the result of a favorable spin of a
roulette wheel or a timely roll of the dice. It has been truncated, not heightened, risk. Our
gains over the years have been earned, banked, redeployed into the next advantageous
investment, and thereby compounded, again and again. With sound investment principles, a
committed and dedicated investment organization, a healthy and vigilant awareness of what
can go wrong, and a strong sell discipline, investing is more akin to a high-yielding,
periodically volatile, and non-guaranteed bank account than a game of chance. Can gains
be lost? Of course they can, through laziness, sloppiness or hubris. Buck such a reversal is
hardly inevitable, especially when one is aware of these risks. We work assiduously to
maintain our gains, emphasizing as always the preservation of capital and, only when
attractive opportunities become available, its enhancement."

One of the reasons I like this quote is because it pretty much puts to rest the buy and hold
argument. Klarman buys, and when the offered return vs downside risk is against him, he
banks the gain and waits for another attractive opportunity. Too many times, hedge fund
managers get sucked into a story of a never ending bullish sentiment on a particular stock.
Yes, intrinsic value changes throughout the life of an investment. But when a stock is trading
at 125% of your IV target, it's hard not to bank some of those gains. And in the final
sentence, Klarman again differentiates the return of capital vs return on capital, something
that I talk about way too much on this medium.

A few other sets of quotes I really liked:

"While you know that our investments often stand apart from those of the crowd, you may
not be aware of how deeply this contrarianism permeates our activities. Our investments
can be remarkably contrary; we regularly search the "new low" list for investment ideas,
while shunning names on the "new high" list. We purchase what the crowd is dumping. We
typically buy stocks in the face of Wall Street "sell" recommendations, and reduce positions
in their "buys" We eagerly assess financially distressed companies for opportunity while the
world experiences revulsion. For us, analytically complex, litigious, stigmatized, and
shunned situations bought at the right price form the backbone of a limited risk portfolio of
opportunity."

Contrarian for the win. Some more nuggets:

"Rather than ratchet up risk, our approach has been to hold cash in the absence of
opportunity, accepting a minor diminution in expected return where, and only where, the
historic returns have been particularly out sized for the risk. There was never any logic, for
example, behind the consensus industry annual return targets of 20% or more on bankrupt
bonds or private investments. At times, an expected 15-18% return is ample, given the
qualify of the underlying assets, the conservative nature of the assumptions made, and the
limited spectrum of things that can go wrong. Other times, even a projected 25-30% return
might be inadequate, where the quality of the assets is suspect, the return is earned in a
risky and unhedged currency, and the downside risk is larger than usual. The quality of
management must be factored in. The expected duration of an investment may also play a
role; a short-dated investment earning inadequate return is over soon, and one can move on
to better opportunity. Long duration mistakes are the gifts that keep on taking, locking you
in to low returns, or significant capital losses if you exit early."

And finally:

"We believe that while investors need to focus great attention on the fundamentals, they
must simultaneously answer the question: What's your edge? To succeed in today's
overcrowded environment, investors need an edge, an advantage over the competition, to
help them allocate their scarce time. Since most everyone has access to complete and
accurate databases, powerful computers, and well-trained analytical talent, these resource
provide less and less of a competitive edge; they are necessary but not sufficient. You
cannot have an edge doing what everyone else is doing; to add value you must stand apart
from the crowd. And when you do, you benefit from watching the competition at work."

This 2005 Letter may need a second post. Seth Klarman offers many more nuggets of
wisdom. Stay tuned.
Wisdom from Seth Klarman - Part 3

If you remember, in the beginning of August, we grabbed some quotes from the Baupost
letter from 2005. We continue with that same letter, as it provided a number of fantastic
investing gems.

"...Investors operate within what is for the most part a zero-sum game. While it is true that
the value of all companies usually increases over time with economicout performance by
one investor is necessarily offset by another's under performance. Consequently, you keenly
watch your competitors to see not only what they are doing right, but what they are doing
wrong. You observe carefully to identify their investment constraints and limitations, their
time horizon and liquidity requirements, areas that they ignore and areas that they avoid. It
is in these areas that opportunity is often greatest; that is where bargains regularly surface,
with your best competitors not only failing to compete but sometimes serving as the seller.
It is here, where others panic, sell mindlessly, neglect, or fear to tread that investors have a
chance to develop and sustain an edge." growth, market

From a speech that Seth Klarman gave to a group of Professor Greenwald's Value Investing
Class, we know that he has analysts that just focus on spin offs, changes in indexing,
bankruptcy etc. These create vacuums where force sellers rule the day due to investment
constraints. In the example of an index fund trade, imagine a somewhat illiquid stock
dropping from an index. Index funds across the board need to sell the holding to maintain
their index match which creates a situation of uneconomic selling which in turn may create a
dispersion between price and intrinsic value. It is also rumored that Baupost's investments in
MLPs in late 2008/early 2009 stemmed from the fact that Lehman brothers held 20% of the
float of the companies and were forced sellers as their prop desk unwound.

"The single greatest edge an investor can have is a long-term orientation. In a world where
performance comparisons are made not only annually and quarterly but even monthly and
daily, it is more crucial that ever to take the long view. In order to avoid a mismatch
between the time horizon of the investments and that of the investors, one's clients must
share this orientation. Ours do."

It is a sad, but true fact in the investment industry that limited partners and general
partners, specifically in the context of a hedge fund, have different investment and liquidity
time constraints. Many analysts reading the blog today will have experienced a situation
where an investment looks particularly compelling, but the idea was kibashed, or sold early,
because the portfolio manager had to raise cash, or was painting the monthly numbers.
Despite their obviously strong investment skills, an advantage of Baupost is how sticky the
capital is as opposed to a number of other funds that have had to put the gates up. I do not
know who said it, but I remember hearing a quote: "You deserve the capital you attract."
Unfortunately, for a small manager, any capital is good to get the ball rolling. And that
creates a mismatch which is one of the fundamental flaws of this business.

"We are able and willing to concentrate our capital into our best ideas. These days, other
investors' idea of "risk control" is to own literally hundreds of small positions while making
no size able bets, a strategy that might also be labeled "return control". It is clearly an
advantage, but by no means without risk, to be able to concentrate our exposures. We work
exceptionally hard to ensure that our largest positions are indeed our most worthwhile
opportunities on a risk-adjusted basis."

What is interesting, is that this quote somewhat ties in with the previous two. Having a large
diversified book helps when capital it quick to exit. Further, a massive position in two or
three stocks when limited partners are redeeming can cause returns to become even worse
as you put pressure on the stock. The opportunistic investors should see this and buy the
stock you are selling (uneconomically I might add) on the cheap. But they will wait until you
are fully out, further depressing returns, and inciting more limited partners to redeem.

This is where portfolio management becomes so important. Managing the book to allow for
sufficient liquidity in case of redemptions, but at the same time placing your bets in a way to
maximize risk return. This is where people discuss the Kelly Formula...or better yet, the
modified Kelly Formula. As has been reported in many places, Monish Pabrai moved his
allocations to 10% per position to a smaller number. I think this makes sense, but there will
be times (like Enron for example) where a 10% position makes sense.

Now remember, Klarman wrote these words in early 2006:

"The world could well be setting up for considerable upheaval and with it an avalanche of
opportunity. As we have said, nearly ever investment professional is fully invested, and
many are leveraged. With massive trade imbalances and huge U.S. government budget
deficits, tremendous leverage everywhere you look, massive and unanalyzable exposures to
untested products like credit derivatives, still low interest rates, rising inflation, a housing
bubble that is starting to burst, and record and unprecedented low quality junk bond
issuance, there appears to be little, if any, margin of safety in the global financial system. "

Take about having a crystal ball.

Stay tuned for the next part of the Seth Klarman series where we dig into the 2006 Baupost
annual letter.

Wisdom from Seth Klarman - Part 4

In this edition, we will take a look at Baupost's 2006 Annual Letter. And before I get to it,
thank you to Andy for his donation (for those so inclined, a donation link is on the right rail,
lower in the page). More donations = the better.

In 2006, Baupost's various funds ended the year up between ~21.4 to 22.8%. This is in
comparison to the S&P which was up 15.8% that year. Gains were made from a number of
categories with approximately 7% of absolute gain coming from performing and non
performing debt - with the largest gain coming from "unnamed non-performing debt" which I
speculated in last post was a position in Enron. These results are even more impressive
given that cash/cash equivalents were 48% of the fund at year end. ROE therefore was over
40% during the year.

After discussing the party that was 2006, Klarman writes:

"We maintained our discipline throughout the year: disciplined buying when bargains
emerged, and disciplined selling when prices approached full value. Despite fairly expensive
markets, robust competition, and a near complete dearth of distressed debt opportunity, our
tireless, highly capable, and experience team was able to fairly regularly uncover new
opportunities. Considerable fundamental progress in many of our holdings, along with our
strong selling discipline, triggered realizations during the year that were approximately
equal to new purchases, resulting in relatively flat cash balances that masked substantial
underlying activity.

One adverse in evidence during the year is that the markets proffered fewer extreme
mispricings, and a relatively greater number of moderate ones. Beneficially, the velocity of
the correction of these mispricings accelerated. In other words, fewer investments become
really inexpensive, more become somewhat inexpensive, and the correction of these
smaller mispricings happened faster than usual, enabling a particularly favorable overall
result for us and for many value-oriented investors. It is impossible to know if this paradigm
will continue, although the proliferation of ever-vigilant and opportunistic hedge funds and
increasingly private equity pool suggest that it could.

The old saw reminds us never to confuse genius with a bull market. Anyone can become
"expert" at buying the dips, and recent market conditions have amply rewarded dip-buyers
with quick gains. It will not always be so easy; slight bargains don't always compliantly rally.
Sometime minor bargains become major ones, and sometimes great bargains turn out to be
not as cheap as you thought. Eras of quite low volatility and general prosperity are often
followed by periods of disturbingly high volatility and economic woe. Meanwhile, for the
undisciplined, "buy the dips" can drift mindlessly into "buy anything"; a rising tide that is
lifting all boats often proves irresistible."

This guy must have a crystal ball. Remember he wrote this in January 2007. He is also
somewhat pointing the finger (I am sure unintentionally) to many of the value investors that
kept buying and buying all throughout 2nd quarter of 2007 - 2008. I remember reading an
interview with a prominent value investor saying that Freddie Mac was one of the cheapest
stocks he had ever seen - and he just kept buying and buying it.

After talking about the sheer magnitude of capital flowing into alternative investments
(hedge funds, venture capital, and private equity), fueled by demand from institutions and
pensions:

"Many of today's institutional asset allocators are not evidently worried about the enormous
amounts of capital surging into alternative investments. They are now asking the relevant
bottoms-up question: Where are today's bargains? They are not following that thread to
build, investment by investment, or one carefully chosen fund at a time, a diversified
portfolio of undervalued investments. Instead, they are typically focused on the answer to
three questions, each of which demonstrates a reluctance to think for themselves:

1. What has worked lately?


2. How can I diversify my way to investment success?
3. How can I invest like the institutional thought leader of this era; in other words, like Yale?

Here's why these questions range from remarkably foolish to largely irrelevant.

Investing is mean reverting. What has outperformed lately will not, and cannot, grow to the
sky. Sustained out performance in any particular sector of the markets is eventually
borrowed from the future, to be given back either slowly through sustained under
performance or quickly through price declines. What has worked lately is popular, widely
owned, and bid up in price, and therefore generally anathema to good future results. But
human nature makes it extremely difficult for people to embrace what has recently fared
poorly."

And further down the letter...

"The idea that you should own a little bit of everything is a concept rooted in market
efficiency. If the markets are efficient, you cannot outperform anyway, so by owning a bit of
everything in just the right proportions, you stand to reduce portfolio volatility, what at least
avoiding under performance. This is the best that you can hope to do in an efficient market.

For any fundamental-based investor, this is complete hogwash. Investment come in the
following varieties: undervalued, fairly valued, and overvalued. Price is everything, and
every investment is undervalued at one price, fairly valued at a higher price, and overvalued
at some still higher price. You buy the first, avoid the second, and sell the third. Having a
goal of diversification, rather than owning value, causes investors to take their eye off the
ball. It is a refuge of investment wimps, owning a little bit of everything to avoid being
wrong, but thereby ensuring never being really right either."

I love it. Too many times, each of us get caught up trying to look at some many things that
our heads spin. A number of value investors suffer from a problem I fondly dub "Everything
is cheap syndrome" ... after you study Buffet, Graham, and Klarman you start looking at
everything, and lots of the things you look at you think are cheap. Any investor can
rationalize a price target for any asset. The goal is to be patient and swing at those once in a
lifetime opportunities, and then not dilute those returns with mediocre value traps.

"Given how hard it is to accumulate capital and how easy it can be to lose it, it is astonishing
how many investors almost single-mindedly focus on return, with a nary of thought about
risk. Lured into their slumber by the 'Greenspan-now Bernake-put', an investment mandate
of relative and not absolute returns, as well as a four-year period of generally favorable
market conditions, investors seem to be largely oblivious to off the radar events and worst-
case scenarios. History suggests that a reordering of priorities lies in the not too distant
future."

The first rule of investing is to not lose money. And the second rule is to not forget the first
rule. When approaching situations, always look to the possibility and magnitude of
permanent capital loss. I remember watching Alice Schroeder (author of The Snowball) at an
event a year or so ago and she mentioned that Warren Buffett will not invest in a situation
where there is even a remote chance of permanent capital loss.

Wisdom from Seth Klarman - Part 5

We continue today discussing Baupost's 2006 Annual Letter to Investors. As discussed


previously on this blog, Seth Klarman is arguably our favorite investor and we hope to
enlighten readers with some of his wisdom and "Klarman quotes."
"When people ask us about Baupost's risk controls, we have no glib answer. We have no risk
control group we can trot out with a PowerPoint presentation. Risk control to us is a careful
aligning of interests, a proper balance in our investing between greed and fear, experienced
and collaborative senior management and investment teams that have worked together for
quite some time, a consistent and disciplined investment approach where every opportunity
is individually and meticulously evaluated on its fundamentals, a strict sell discipline, a
willingness to hold cash when opportunity is scarce, a complete avoidance of recourse
leverage, and a healthy level of fear."
Read that last sentence one more time. If that is not the way to run an investment
partnership, then I don't know what is.

On discussing Baupost's edge (see some of our previous posts on this):


"...in today's competitive world, these edges do not ensure long term success. Our best
ideas sometimes look a lot like other firms' best ideas and, at times, may even be identical.
Yet our approach, if successfully executed, may enable us to outperform the crowd even if
we have the exact same idea flow as everyone else. How might this be possible?

The answer is that we have worked hard to create an environment that lends itself to good
decision-making. Simply put, we strive to make the most of each opportunity we have at
hand. One way to do this, as mentioned earlier, is to avoid over-diversifying. Talking full
advantage of our best ideas is a real no-brainer. The search for new opportunity is often
times quite challenging; buying more of what we already know and like requires minimal
additional effort. The teach approach that we have adopted at Baupost maximizes the
probability that our best ideas will be effectively identified as such, and that a healthy
overallocation of capital will be made to them. A firm that exploits its best ideas has
superior returns, happier clients, better rewarded employees, and greater profitability."
Many people in the distressed debt world know circles exist among funds. Many people know
which fund will put on positions just because another fund has the same position on. The
problem is that only a few funds have the discipline to put a large portion of its capital in
Enron or in 2007 sub-prime RMBS shorts. Those are the winners in my opinion.

A quick point on selling:

"Selling, in particular can be a challenge; many investors are tempted to become more
optimistic when a security is performing well. This temptation must be resisted; tax
considerations aside, when a security reaches full valuation, there is no longer a reason to
own it."

On hedging the portfolio - and remember this was in early 2007 (read: GO GO GO market)
"In today's fully valued financial markets, one area remains quite inexpensive: disaster
insurance. In general, disaster insurance is intended to offset portfolio losses from positions
that are expected to suffer during or in the aftermath of extreme adversity or dislocation.
Like any insurance, it usually expires worthless when the disaster fails to occur - but that
doesn't mean it's not worth having. Financial disaster insurance can take many forms,
including out-of-the money put options on individual stocks, baskets of stocks, or market
indices. Call options on gold (a hard metal that has served as a store of value for centuries)
or inexpensive out of the money options on interest rates or currencies, where a dramatic
fluctuation could adversely affect our situation, are other forms of disaster insurance."
I remember watching an interview with Seth Klarman where he said he was buying credit
protection on sovereign nations. It cost him approx 5-10bps a year. This was an incredible
opportunity at the time as sovereigns blew out 100-300 bps depending on the country. And
sub prime RMBS (whether the ABX or single-name) were a similar sort of trade...no real
downside (cheap carry) and MASSIVE upside.

Speaking of Subprime:
The sub prime market is the canary in the coalmine of housing; a minor downward tremors
in home prices could be felt with seismic force here, especially in the priced-almost-to
perfection lower investment grade debt tranches. These tranches offer far too miserly a
yield given the rather significant risk of principal impairment. Holders expect the real estate
markets of tomorrow to closely resemble those of yesterday, and for Joe Sub prime to
behave just like the average Joe. Should conditions worse, as they lately have been doing,
and should the yield on these narrow slices of marginal credit risk to reflect this risks, as it
currently happening, the financial Cuisinart that churns out sub prime tranches could
become incapacitated. Then, then junior tranche trail could end up wagging the sub prime
dog, causing the sub prime mortgage window to slam shut and thereby begin to restore
sanity to the home lending market.

Stay tuned later in the week when Distressed Debt Investing finishes its analysis of the 2006
Baupost Annual Letter.