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Subprime Credit, Illiquidity, Leverage, Contagion and Concentration

Saturday, June 30th, 2007

There are two popular views that I am seeing among those that are in the media limelight at present regarding subprime mortgages. There may be more, but I will point at James Cramer’s assertions that this is an illiquidity event, and not a credit event, and the assertions of Bill Gross that this event heralds a wider credit event, and soon. Neither are correct in my opinion.

Cramer is in over his head on this topic; if you’ve never been a mortgage bond manager, but only an equity manager, you might view this in a way akin to a short squeeze. The hedge funds that got killed didn’t have enough equity to carry their positions through some market chicanery. There are no credit losses being allocated to the securities at present, and only the 2006 vintage stinks.

Plausible on the surface. My old boss at the Mt. Washington Investment Group would always say, “Liquidity follows credit quality.” Bonds with improving credit quality tend to become more liquid, and vice-versa for bonds with deteriorating credit quality.

One of my biggest professional investing mistakes was buying a gaggle of Manufactured Housing ABS bonds back in late 2001. I only bought bonds in vintages prior to mid-1997, because I knew later credit quality was horrid. I also stuck mainly to AA-quality mezzanine bonds. All of those bonds are still “money good” today, but when the market fell apart due to the horrid 1998 and after vintages, the bonds with relatively good underwriting got taken to the cleaners as well. Money good bonds trading in the 60s? It can happen.

Markets are discounting mechanisms; with asset-backed securities, if the projected losses make it virtually certain that a tranche of a securitization will lose principal, the tranche will quote like the losses have already happened. It doesn’t matter tht the losses won’t allocated for a few years; the tranche will trade at the discounted value of reduced future payments, at a high discount rate, if it trades at all.

The issues with the Bear Stearns funds are future credit issues, which produce present liquidity issues. It gets noticed there first because of the concentration of the risk in the fund, and the leverage employed. This is similar to what happened in 1994, when the prime mortgage market blew up over extension risk. There was no contagion there; many in the bond market absorbed losses from rising rates, but only a few notable players that took on the negative convexity risks in a big way got killed.

Derivatives are funny, or maybe I should say, people using derivatives are funny. Alan Greenspan thought that derivatives spread out the risk, making the system more stable. Nothing could be further from the truth, at least in terms of spreading out the risk. With derivatives, some market players, out of greed, concentrate the risk because they are trying to make a killing. When the negative part of the credit cycle hits, the speculators get destroyed. Contagion happens when the lenders to the speculators face major losses also. In 1998, that was the worry over LTCM.

With derivatives, speculators absorb the losses that previously might have been borne by the banking system. (Now, those speculators could be DB pension plans, endowments, or wealthy individuals, working through hedge funds.) If the banks overlend to these speculators, they can bear risk as well.

My view is that there are a small number of greedy players that hold most of the credit risk from subprime mortgages, and that their ultimate owners have enough capacity to bear losses that there is no significant contagion risk to the debt and equity markets, even if some players are wiped out, and the banks take modest losses.

That said, I would wait awhile to buy any subprime mortgage ABS, even at the AAA level. The market is dislocated, and has not fully realized the true level of losses that will be taken. The same goes for Alt-A loans, and make that a double!

In summary, this will not be a “piece of cake,” but the losses will be concentrated among a small set of investors. As for the CLO market, it will have its troubles, but not yet. Prudent investors will avoid it, but there may be some rallies there in the short run, away from subprime and Alt-A.

It was a Good Quarter; Also, my Favorite Managers

Saturday, June 30th, 2007

It’s good to be back home with my wife and kids. There truly is no place like home, particularly when things seem to be working well with my wife and kids.

Two quick notes, because I’m kind of tired:

  1. I wondered at many points this quarter whether I would beat the S&P 500 or not. Not counting my unpaid dividends and interest, I can say that I was ahead by 110 basis points for the quarter, bringing the year-to-date figure to 590 basis points. I don’t expect to win every quarter, and not every year either, but the streak is at six years now, and I hope to prolong it. Let’s see how I do at the next portfolio reshaping, which should come this week.
  2. One of my readers asked for my favorite mutual fund managers. Here they are: Marty Whitman at Third Avenue, Ron Muhlenkamp at the Muhlenkamp Fund, Don and Craig Hodges at the Hodges Fund, Ken Heebner at CGM, and Bob Rodriguez at FPA. (There are other value managers I like as well, Tweedy Browne, and Heartland Value, to name a few. I am a value guy, but I like rotating sectors.)

All of these managers are willing to look for cheap assets, and sectors that are undervalued. That’s what I do, and my record is comparable to theirs, though I run a lot less money.
Here’s to a great second half of the year. Let’s make some money together, or, at least not lose more than the market.

Another Win for the Broad Market Portfolio

Thursday, June 28th, 2007

Well, score one more for my portfolios, Komag is being bought by Western Digital for $32.25/share. This was a remarkably quick win, given the initial purchase back in late March, and a rebalancing buy in late May.

Investments rarely work this quickly, but I am grateful when they do. In the last portfolio reshaping back in March, I put more weight on EV/EBITDA, and Komag scored well there. I’ll be selling Komag at the portfolio reshaping, which should take place in the next two weeks.

I sometimes mention that my investment methods allow me to be away without worrying too much; this closing week of the quarter is one more example of that, at least, so far.

PS — On another note, wasn’t it interesting today to see the market get excited about the supposedly dovish FOMC language, and then sell into the reality that nothing had changed?  I chuckled; people expect too much of the FOMC…

Full disclosure: long KOMG

Begging For A Rate Cut

Thursday, June 28th, 2007

Just a short editorial comment before the FOMC announcement.  There are many calling for the FOMC to cut the Fed funds rate.  Most of these players seem to be financial players seeking relief in their financial positions.  I don’t hear as much coming from real businessmen arguing that they need cheaper financing in order to survive, and/or grow their businesses.

The FOMC listens to the latter group more closely.  They listen to inflation signals more than both groups, though.

One of the investment implications is that the absence of a rate cut will continue to put pressure on leveraged investors that finance off the short rate.  No disasters now, but the pressure is growing.

Trailing E/P as a Function of Treasury Yields and Corporate Spreads

Wednesday, June 27th, 2007

As part of my 2-part project on the Fed Model, I want to give you the results of my recent investigation. This is the simpler of the two projects. A little while ago, Bespoke Investment Group published two little pieces on the relationship between the yield curve and the absolute level of the S&P 500 over short time periods. (You can see my comments below what they wrote.)

My data went from April 1954 to the present on a monthly basis. I regressed the yields on the three and ten-year treasuries, and a triple-B corporate bond spread series on twelve month trailing earnings yields for the S&P 500. The regression as a whole is highly statistically significant. Except for the t-statistic on the 10-year Treasury yield, the other regressors have t-statistics that are significant at a 95% level. I only did two passes on the data, because I didn’t realize until later that I had the spread series… in the first pass that did not have the spread series, the ten-year yield was significant.

Anyway, here are the statistics. What this says is that in the past trailing earnings yields tended to:

  1. decline when BBB spreads rose
  2. rise when three-year treasury yields rose
  3. rise when parallel shifts of the yield curve up
  4. rise when the yield curve flattens, with no adjustment in the overall height of the curve

The last three observations make sense, while the first one does not, at least not on first blush. Typically, I associate higher credit spreads with higher E/Ps, and thus lower P/Es, because tighter financing is associated with a lower willingness for equity investments to receive high valuations. I’m not sure what to do with that last observation; perhaps it is that my practical experience exists over the last 20 years which have been different than the whole data sample. Or, perhaps my readers will have a few ideas? :)

As for the main current upshot from this admittedly limited model is that current trailing E/Ps, and thus P/Es, are fairly valued against current treasury yields and bond spreads. Here are two graphs that illustrate this:

Clean yield slope graph

messy yield slope graph

The nice thing about these graphs is that they easily point out the stock market undervaluation relative to bonds in 1954, 1958, 1962, 1974, 1980, 1982, and September 2002, and overvaluation relative to bonds in 1969, early 1973, 1987, and March 2000 and March 2002. Now this model might have suggested staying in bonds for most of the 90s, but the 90s were a relatively good decade to be in bonds, though not as good as equities.

This is the first time I have done a post like this, and so I put it out for your consideration. Comments?

Post 150

Saturday, June 23rd, 2007

Every now and then I do a post to talk about the blog itself, and my future plans for it.  While talking with an old friend of mine, who founded and majority owns a company that makes the best commercial lawn mowers in the world (full disclosure: I own a little less than 1%), I told him about my blog, and he thought it made perfect sense for me to do it.  Regardless of the eventual result, he said that I was building my brand.

I never thought of it that way before, and much as I like contributing to RealMoney.com, I am putting more of my thinking, and the better part of my thinking here.  So where am I going with the blog in the near term?

  • Finishing off the portfolio reshaping.  RealMoney will see the results of this second, and the blog first.
  • I have five news compendia posts coming on Economic Theory, Macroeconomics, Speculation, Derivatives (yes, Bear, subprime, and more), and Miscellaneous (the grab bag).
  • I also plan on improving some of the permanent pages, particularly my bio, fleshing out the investment books that I have learned from, and fleshing out my investment performance, so that I can publicly display it to readers (I’ve had a great last seven years).

Now, my ultimate goals are to either start an investment newsletter or start my own investment shop.  I have described what I would do on the following permanent pages (newsletterinvestment management).  So far, I have gotten about 20 bites on the newsletter, but I would need a minimum of 100 to make me quit my job to do that.  As for investment management, I am actively interested in any seed investor that would be willing to fund me.  Aside from that, I am still working with a fellow who is looking to revolutionize the health insurance industry, who if he gets funded, would like me to be his CIO.  We’ll see.

Because my main calling is to be a good husband and father, I can live with delays in my longer-term planning; things are going well.  I also have a calling to my church, which is having its annual meeting this coming week.  I can’t tell whether I will be posting more or less while I am at the conference; I’ll see what I can do.

Regardless, have a great week as the second quarter finishes up.

Portfolio Reshaping Mid-Year 2007, Part 2

Saturday, June 23rd, 2007

Here are my current industry ratings.  Using my Bloomberg Terminal, I  ran a screen looking for cheap companies in those industries.  The result yielded eight tickers:

ACO CONN GMRK HES NSIT PDE SMRT SSI

I also added in the top 12 tickers from the last time that didn’t make it into my portfolio, and aren’t on the current list.  Here are the tickers:

ABFS [DBK GR] FINL FL GGC HERO [NGX CN] PTSI RADN SNSA URI WIRE

If you have other stock ideas for me, let me know (post a comment!).  Remember that I am a value investor.  I like them cheap.

Aside from any names that readers might give me, my list of possible replacements is done.  All that is left is to run my valuations/technicals model, and think about what to but and sell.  Early next week, I will run those models, and make the decisions by Independence Day.

Portfolio Reshaping Mid-Year 2007, Part 1

Saturday, June 23rd, 2007

Well, the second portfolio reshaping of the year has begun. To refresh your memory on what I do here, you can review this short post. Here are the tickers from my initial stack, candidates to replace my current portfolio:

ABY ACI ACTU AFN APA ARLP ASEI BBG BHP BLX BMI BOW BTU BVN C CBE [CMB PE] CMC CNX CQB [CRY CN] CRZ CTHR CTL CVX CWEI CY DELL DNR DVN DVR EMR EOG EPEX EPL ERF ESV FCGI FCX FRD FRO FRX FSS FST FTO GIFI GMK GMR GSF GVHR GW GYI HHGP HNR IDCC IMMR IMOS INTX IO IR ITW IVAC KAR KEP LRCX LRW [LUN CN] MEOH MGS MKSI MLR MRO MTL MVC NAT NBL NBR NFX NR NRP OMM OPMR PCZ PH PRKR PTEN PVX PWE R RDC RDS RGS RIG RIO ROK RRC RSH S SHOO SPH SPI STZ SU SWKS TAP TLM TPL TSO TX TXI TYC UNT UNTD UPL WCC WDC WFC WIN XTO

If you have ideas, post them in the comment section of this post.  I’ll be running my industry model and an additional screen to generate a few more tickers, and then the comparison to my current portfolio. I should have more later today. Till then.

Eleven Articles on Residential Real Estate

Friday, June 22nd, 2007

Those who have read me at RealMoney know that I have been bearish on residential real estate for the last 2-3 years, and on commercial real estate for the last year.  I have found it fascinating to see both markets move to situations where current income is exceeded by what can be earned in Treasury securities, much less mortgage funding costs.  Take it as a rule, when one must depend on rental growth and property appreciation to make a profit, it’s time to sell.  Anyway, here are the articles:

  1. I guess I have to start with Bear Stearns’ hedge funds.  An ugly situation where Bear might have to tap $3.2 billion of liquidity to stem the crisis.  Bear can afford the money, but it might bite into their credit rating, and their ability to earn money off of their spare capital.  As I commented on RealMoney yesterday, it is not likely, but possible that this turns into a wider crisis.
  2. Though this article is about Collateralized Debt Obligations [CDOs] generally, much of the excess yield that allowed the CDOs to be sold came from subprime CDOs.  Now who holds the risk?  From what I can tell, a bunch of hedge funds, hedge fund-of-funds, and pension plans.  The lure of easy yield beings out the worst in institutional investors stretching to make a certain total return target.  The low-paid managers of public funds are particularly drawn to these investments because of the political pressure to keep taxes low.

    As an aside, the principal-protected versions are a sham; it is the same as investing a small amount in the volatile stuff, and a large amount in Treasuries.  That one can’t lose money on the package is meaningless; look at the two investments separately, and ask if they both make sense.  Lesson: don’t but investments that you don’t fully understand.

  3. Little of the current troubles in residential real estate could have gone on without optimistic appraisals.  That’s putting it kindly; before the end of this crisis the appraisers are going to face some degree of additional regulation.  Will it be the right solution?  Probably not, but read the article, and watch a profession in need of tough ethical requirements, or perhaps, means of eliminating shady operators.
  4. I’m not sure how one can rent out credit scores.  It would be fraud if done without the consent of the one whose score is borrowed.  With consent, it would be a stupid form of co-signing a loan.  I never recommend co-signing.  You have more protections loaning the person the money yourself, even if you have to take out a loan to do it.
  5. I’ve followed this statistic for a while.  With a few conservative assumptions, it means that the average indebted homeowner has only 30% equity in his home.  Not a safe place to be.
  6. Buying foreclosures?  Wait a year, okay?  Look, foreclosure, and other forms of distressed investing only work when the ratio of vultures to carrion is low.  It’s not low now.  Let the dumb vultures overspend now; come back when you hear of former vultures having to raise liquidity.
  7. Barry Ritholtz and I have long been on the same page on residential real estate investing.  This article has some of the best charts I have seen in some time.
  8. Here’s an alternative view of residential real estate pricing.  Rather than listen to the shills at the NAR, this might be a fairer take on the market.  Note that it has been lower and higher than NAR forecasts; I like that, because reality is almost aways more volatile than we would admit.
  9. My view of the residential real estate markets is bifurcated.  The Midwest and the South suffered the worst initial foreclosures because housing prices did not rise much there, and refinancing was not an option.

      Tight finances + bad event = default.

    But the pain will shift to the formerly hotter coastal markets, where subprime financing was more prevalent, as the ARM resets hit, and now prices are falling, and interest rates rising.

  10. Excess supply is the rule; we have a little less than one year’s supply of housing vacant and ready to sell at present.  That is a record by almost double the long term average.  This will take years to clear up, particularly with the builders still constructing homes.  Perhaps we can solve the problem by selling all the excess homes to wealthy foreigners.  Kill two birds with one stone; fund the current account deficit, and reduce the the housing supply overhang in one fell swoop.
  11. Interest rates are the silent killer here.  It would be wise for many people to refinance to prime fixed-rate loans, but with interest rates rising, the bar is getting raised for even creditworthy borrowers.

We are stopping at a butcher’s dozen here.  Not a great time to own residential real estate on leverage.  When I went to work for the hedge funds that employ me, I paid off my mortgage because my earnings would be less certain than what ai earned as a bond manager for an insurance company.  Would that more people were conservative with their finances in the same way.  As it is, I expect the residential real estate price slump to persist into 2009.

Nine Notes on Speculation

Thursday, June 21st, 2007

Recently I have been clipping articles, and arranging them by category, so that I can comment on them as a group more easily.  Tonight’s topic is speculation again, but these articles are all of the odd bits that don’t follow any particular theme.

  1. Sometimes I think that the major financial press that covers Wall Street should send chocolates to Jim Cramer for creating TheStreet.com.  Where else would they get high quality journalists the understand the markets?  Writing for RealMoney, Matthew Goldstein would occasionally e-mail me with a question.  He was the one who covered financials in the news group for TSCM.  Financials are harder to learn than industrials, and I thought he would go far.

      Well, he has gone far, to Business Week.  The advent of hedge funds has created a great demand for shorting stock, and there are concerns on the part of some with naked shorting, where one does not borrow the shares before they are sold.  This article describes the probe into stock lending, and what may come of it.  Personally, I wonder why investment banks don’t create single-name total return swaps.  E.g., receive three month LIBOR plus or minus a spread, pay IBM total return.  That would allow the same economics of shorting, without the stock borrow, and no charges of naked shorting.  Why not?

  2. Brave new world; the uptick rule is history.  Well, that should provide more liquidity to buyers.  I’m indifferent on this one, though I would warn anyone doing a death-spiral convert that the elimination of the uptick rule means there is no way that the short sellers won’t win.
  3. Once you have derivatives, almost anything is possible.  Insider trading can be hidden through derivative instruments, because they are not publicly reported.  Now, in practice, it may not be that simple, because derivatives are a zero sum game, and the counterparty loses what the one with information wins, unless they are hedged.  Whoever bears the loss after the takeover is announced has a concentrated interest to find the one who ended up winning, because they might get back what they lost.
  4. I think it is inevitable that there will be different ways of trading large and small blocks of stock.  Most industries have different distribution methods for wholesale and retail.  Dark pools of liquidity don’t surprise me; when I was a bond trader, if I wanted to trade a large fraction of some bond deal, quietness and anonymity were crucial.  My view: have the SEC serve as trading apprentices a large equity or bond shops, and see why large trading is different from small trading.
  5. Fitch gets it, maybe.  They see why hedge funds might be weak holders during a crisis.  I’m not sure what Fitch will do with it, but that skepticism will make for a better rating agency.
  6. 130/30 seems to be coming along at the wrong time.  There is too much pressure on the borrow from hedge funds already.  My opinion is that short-selling is getting close to useless on average, given the high level of shorting.  When the bad event happens, the covering keeps the stock afloat.
  7. No more earnings guidance? Yay!!  Let analysts be real analysts, and not just take what management has fed them.  I like it when companies I follow eliminate earnings guidance, because it increases the advantage of analysts who really understand what is going on.
  8. Investing in commodities was a great idea until players started to invest in an indexed manner on the front month.  This has forced the front month to be low versus future months, and the continuing roll depresses returns.  If I were running such a fund, I would invest in a ladder of contracts similar to the pro-rata ladder of contracts currently traded; that would minimize the antiselection.
  9. Finally, be wary of funky ETFs that don’t actually own the underlying assets in a direct way.  There are too many ways for those vehicles to go wrong.  Good ETFs have direct ways of hedging that keep the prices in line with what they are trying to replicate.

That’s all for now.  My own investing has gone well so far this week, but who can tell what the future will bring?

Disclaimer


David Merkel is an investment professional, and like every investment professional, he makes mistakes. David encourages you to do your own independent "due diligence" on any idea that he talks about, because he could be wrong. Nothing written here, at RealMoney, Wall Street All-Stars, or anywhere else David may write is an invitation to buy or sell any particular security; at most, David is handing out educated guesses as to what the markets may do. David is fond of saying, "The markets always find a new way to make a fool out of you," and so he encourages caution in investing. Risk control wins the game in the long run, not bold moves. Even the best strategies of the past fail, sometimes spectacularly, when you least expect it. David is not immune to that, so please understand that any past success of his will be probably be followed by failures.


Also, though David runs Aleph Investments, LLC, this blog is not a part of that business. This blog exists to educate investors, and give something back. It is not intended as advertisement for Aleph Investments; David is not soliciting business through it. When David, or a client of David's has an interest in a security mentioned, full disclosure will be given, as has been past practice for all that David does on the web. Disclosure is the breakfast of champions.


Additionally, David may occasionally write about accounting, actuarial, insurance, and tax topics, but nothing written here, at RealMoney, or anywhere else is meant to be formal "advice" in those areas. Consult a reputable professional in those areas to get personal, tailored advice that meets the specialized needs that David can have no knowledge of.

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