29 May 2007 – The Aleph Blog

When Will the Goat Reach the End of the Snake?

Posted on 29 May 2007 by David Merkel

Speculation.? Rampant speculation.? This run in the market has to end soon, right?? Right?!

Look, I’m not so sure.? I have a lot to write on this topic, but not so much time.? Market trends have a nasty tendency to persist longer than fundamentally-based market observers would expect.? Let me give you the four things that could derail the markets, and tomorrow I can detail what I have seen in the markets concerning the four potential trouble spots (and more).

The recycling of US dollar claims from the trade deficit ends because the US dollar falls enough to make imports dear and US exports cheap.? US interest rates rise as a result, stopping the substitution of debt for equity, and in some cases, leading to the raising of new equity capital.? We have seen upward adjustments in many foreign currencies so far, but not enough to change the basic terms of trade.
Defaults in the bond and loan markets lead to a closing of the synthetic CDO market, which in turn leads to underperformance of many hedge fund-of-funds.??? Bond spread widen as risk returns to lending, and the substitution of debt for equity slows to a halt.
New supply comes to the equity market, overwhelming cash available.? This could come from private equity seeking to liquefy marginal asses at favorable prices.? Alternatively, this could come from private equity investments that are unable to pay their debt coupons.? It is less well known outside of fixed income investing that most insolvencies occur because companies can’t make a coupon payment, not that they can’t refinance a principal payment.
Rising inflation in countries providing capital to the US forces them to revalue their currencies higher, and not keep sucking in US dollar claims, which don’t provide any goods to their people who want to buy goods to support their lives.

Interest rates need to be around 1.5% higher to shut off the speculation with near-certainty (did not work in 1987… rates got much higher.).? Until then, the party can go on.? I have an article being developed on this topic, but I fear it is a “next week” item.

Bottom Left Hand Drawer Issues

Posted on 29 May 20076 January 2011 by David Merkel

Back in the saddle.? I have a lot to write about, but not so much time.? The insights developed over vacation will be spread out over the next week or so.

Just a quick one to get started.? In general, I think insurance companies with more than $100 million in assets should have their own investment departments, and not outsource the management of assets.? (Note: to any insurance CEOs reading this — would you like a chief investment officer with experience in all major fixed income classes, equity, and derivatives, and a knowledge of the actuarial side of investing as well?? E-mail me, and we can talk.)

I only know one insurance asset outsourcing larger than this, but Safeco has outsourced their asset management to Blackrock.? I think that it is a mistake.? Why?

Insurance companies excel at creating tailored liabilities, taking individual risks away, and pooling them.? The same should be done with assets.? Anyone can hire Blackrock (a very good firm), but an intelligent management will take the time and effort to develop in-house expertise, which is usually cheaper than most third party solutions.? It gives up what should be a profit center for the enterprise as a whole.
Third-party arrangements miss what I call “The Bottom Left Hand Drawer” issues.? I worked in insurance for 17 years, and I grew to love the competent but uncelebrated people in the company that did excellent work, but management thought were expendable.? Third-party relationships lack the freedom for customization that in-house management allows for.? Often because accounting systems don’t get it quite right, human intervention is needed.? Someone makes an adjustment off of a schedule that they keep in their bottom left hand drawer once a year, and that keeps the system running right.? In a third party solution, those issues can get lost; I have personally seen it fail.
Penny wise, pound foolish.? The explicit expense savings are easy to see, but the implicit losses from not having someone managing the investments that is totally on your side is hard to measure.? Though I can’t prove it, the soft costs are large.

If I served an insurance company again as an asset manager, I would want to serve that company only, and not run a third-party asset management shop.? The work of an insurance company is important enough that it deserves the undivided attention of professionals on staff.