Quants have it tough.  Few in the investment world really understand what you do, and even fewer outside that world.  To many investment managers, quants are the guys nipping at their heels, clipping their returns, and questioning the need for fundamental analysis.  There comes a kind of schadenfreude when their models blow up, where qualitative mangers get to say, “See, I knew it was too good to be true,” and in the newspapers, a kind of bewilderment at eggheads whose models failed them.

I write this as a hybrid.  I am a qualitative investor that uses quantitative models to aid my processes.  As such, I was hurt, but not badly, but recent market troubles.  Any class of models can be overused, and the factors common to most quant models indeed became overused recently.  Truth is, the models don’t vary that much from quant shop to quant shop, because the market anomalies are well known.  Many of these funds held the same stocks, as seen in hindsight.  Should it surprise us that their results were correlated?

In a situation like this, success tends to breed more success, for a time, as more money gets applied to these strategies.  The statisticians should noticed the positive autocorrelation in excess returns, rather than randomness, which should have tipped them off to to much money entering the trade.  But no.  There was another calculation that could have been done as well, estimating the prospective return from new trades, which was declining as the trades got more popular.  My view is that a quant should estimate the riskiness of his strategy, and compare the returns to those available on junk bonds.  When the return is less than that available from a single-B bond, it’s time to start collapsing the trade.  (What, they won’t pay you to hold cash?  No wonder….)

On a different topic, consider mark-to-model.  I’ve said it before, but Accrued Interest said it better when it said that mark-to-model is unavoidable.  Most bonds in the market do not have a bid at any given time.  Most bonds are bought and held; beyond that, there are multiple bonds for a given company, versus one class of common stock.  The common stock will be liquid, and the bonds merely fungible.  It is even more true for structured securities, where the classes under AAA are very thin.  The AAAs may trade, classes with lower credit ratings rarely do.

Now the same argument is true when looking at a whole investment bank.  How do you mark positions that never trade, and here there is no readily indentifiable bid or ask?  You use a model that is built from things that do trade.  Sad thing is, there isn’t just one model, and there isn’t just one set of assumptions.  It is likely that the investment banks of our world, together with those they deal with, have marked illiquid securities to their own advantage.  Assets marked high, liabilities low.  Aggregate it across all parties, and the whole is worth more than the parts, due to mismarking.

Now for a tour of unrelated items:

1. There is something about a spike in volume that reveals weaknesses in back offices.  For derivative trading, where there is still a lot of paper changing hands, that is no surprise.
2. Prime brokerage is an interesting concept.  They bring a wide variety of services to hedge funds, but also compete in a number of ways.  At my last firm, I never felt that we got much out of our prime brokerage relationships for what we paid.  They provided liquidity at times, but not often enough.  Executions were poor as well.
3. The market sneezes, and we worry about jobs on Wall Street.  Par for the course.  What is unusual here is that few bodies were cut 2001-2003, so pruning may be overdue.  It may be worse because the structured product markets are under stress.
4. Catastrophe bonds are opaque to most, and Michael Lewis did us a favor by writing this.  That said, though this article begins by suggesting that 2007 will be an above average hurricane season, I ask, “What if it is not?”  It is rare for the hurricane season to shift halfway through the season.  It may be time to buy RNR, FSR, MRH and IPCR.  But regarding cat bonds, they are issued by knowledgeable insurers.  After issue, there are dedicated hedge funds that trade them, taking advantage of less knowledgeable holder, who only originally showed up for the extra yield.
5. A break in the market affects obscure asset classes as well.  If wealthy hedge fund managers are the marginal buyers of art, and they are getting pinched now, the art market should follow.
6. Message to Mish: If Bill Gross is shilling for a PIMCO bailout, we are all in trouble.  If the prime mortgage market and the agencies are in trouble, then I can’t think of anyone in the US that will not feel the pain.  I think Bill Gross is speaking his mind here, much as I think that Fed funds rate cuts are not needed, though I also think that they will happen, and soon.
7. Many emerging debt markets are in better shape than the US, because their current accounts are in better order.  Now, as for this article, Brazil might be okay, but Turkey is not in a stable place here because of their current account deficits, and I would be careful.
8. Finally we are getting real volatility.  I like that.  It helps keep us honest, and shakes out weak holders and shorts.

See you tomorrow, DV.

Tickers mentioned: IPCR, MRH, FSR, RNR

Earlier today I wrote at Realmoney:

Good Things Come in Small Packages

8/29/2007 11:49 AM EDT

Every now and then, the market serves up a bargain that is hard to realize, because trading liquidity is poor. I was acquiring this stock for just me, and it took ten days for me to do it. (If at the end of this, you want to buy some, use limit orders. Do not use a market order, and do your own due diligence, please.) National Atlantic Holdings is a small (primarily) personal lines insurer selling almost entirely in New Jersey. No debt. 6.9x 2007 and 2008 earnings, 69% of tangible book. It has relatively defensible boundaries in its lines of business, though no one is totally immune from the dangers of over-competition in the personal lines marketplace. I have met management, and I think that they are competent.

Risks:

There’s more, but these are the basic points that you can begin with as you do your own due diligence.

Please note that due to factors including low market capitalization and/or insufficient public float, we consider National Atlantic Holdings to be a small-cap stock. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.

Position: long NAHC

Now for the rest of the story: my average cost is $9.60, and I would not recommend buying above $9.75. There has been some big player liquidating his stake at prices under $10, and I am not sure that he is done. There are significant buyers underneath $9.60, but as with many traders they don’t automatically buy when the sellers arrive there. They let the market sag, and then slowly suck in shares at the bid, while letting the bid back up.

I mentioned the law of small numbers above. Well, that can work two ways. When the small numbers result in few claims in a quarter, the stock can pop, and it gets even better if it happens a few times in a row — then a pattern gets inferred by investors, and often wrongly so, but the price runs then.

There is another risk I did not mention above. They are entering a new state, Texas, and new lines (though not in a big way) in New Jersey. I always worry when insurers do that, because they tend to underestimate the risks involved. That said, NAHC tends to be conservative here, and that ameliorates the risk. That, and the CEO own 13% of the company; he has grown it himself, and doesn’t want to spoil what he has built.

Beyond that, their asset portfolio is clean, in my opinion. Their business in NJ depends on partner agents who primarily market to the wealthy of NJ, and try to cover their full insurance needs through package policies that cover their personal insurance needs, and sometimes their business insurance needs. This allows NAHC to compete away from Progressive and GEICO.

Again, there is more to this story, but please do your own due diligence, and if you do buy, be price-sensitive, and don’t use a market order.

Full disclosure: long NAHC

Tickers mentioned: NAHC, PGR

A personal note before I begin: My oldest daughter left for college today.  A bright girl who plays the harp beautifully, she is studying harp at the University of Maryland.  She is a true “people person” and an artist, and her good character is known by all of her friends.  She’ll be commuting, so I won’t lose her entirely yet, but we will miss her way with the other children.  She will be a natural mother, unlike her mother and I, who just try hard.

Well, two off to college in a single year.  Good thing I’ve got six left, or I’d be lonely.

It takes two to make a market.  During the panic, some bond managers increased their risk postures as the market sold off.  Here is another example.  I agree with this in principle, but I at this point, I would only have moved my risk posture from “most conservative” to 20% of the way to “most aggressive,” which I actually did get to in November 2001, and October 2002.  There is a lot of leverage to unwind, and so there is a lot of room for further widening.  Take for example, these graphs of lower investment grade, and junk spreads.  We are nowhere near the 2002 wide spreads, though for investment grade, I don’t see how we get there.  Credit metrics are pretty good, though banks are more opaque and questionable.

Bond management is a game where you are paid not to lose, because people are relying on you for safety, and then a modestly good return on their money.  Now, though the last article doesn’t treat Bill Gross well, in this article, he praises simplicity in investing, which I would heartily agree with.  The only thing that gives me a bit of pause there is that PIMCO is a quantitative bond management shop that has historically derived most of its excess returns from quantitative strategies that rely on the equivalent of selling deep out of the money options against their positions, and mean-reversion, and variety of other things.  When the ordinary relationships don’t work, PIMCO could be disproportionately hurt.

Though investment grade looks fine, junk is another thing; it could reach the 2002 wides.  As an example, aside from all of the high yield deals that would like to get done, and all of the LBO debt standing in line waiting to be funded, there are still entities like Calpine that want to emerge from bankruptcy.  Willingness to take risk is not what it was when the banks made their commitments, so they’ll have to take losses to move the loans off of their books.  That will help to back up spreads, as buyers will toss out other paper to buy the Calpine debt, if it comes at an attractive enough concession.

In situation like this, one would expect municipal [muni] bonds to be a haven, and largely, they are, partly because they are one of the few areas not touched by foreign capital.  But I was genuinely surprised when I read this article.  Muni arbitrage?  Okay, it comes from one simple insight muni investors want low volatility, which means short duration bonds, while most municipalities want to lock in long term funding.  After all, most of their projects are long term in nature.  Muni hedge funds (sigh) step in to fill the gap, buying long dated bonds, and selling short bonds against them to muni investors, clipping a yield spread in the process.  Worked fine for a while, but the hedge funds warped the market by their own participation, and played for yield spreads that were too low for the risks involved.  As the market normalized, they got hurt, and some aggressive selling of the long end happened.  Now, long munis are probably a good deal.  For taxable accounts, they make sense, if your time horizon is long enough.

During financial stress, financial journalists may get a little over the top.  Comparing Ken Lewis to JP Morgan is an example.  First, the rescue is not that big, relative to Countrywide’s total liquidity needs.  Second, Countrywide, even if it failed, would not have that big of an impact on the total US financial system; it’s just not that big.  Would it be inconvenient?  Yes.  A bother for the regulators?  Sure.  But it would not appreciably affect the average financial institution, and it would inject some needed caution into those that lend to less secure entities.  Third, in a real rescue, far more capital is hazarded; honestly, the Fed did more by opening the discount window, pitiful as that was… it offered unlimited liquidity to (ahem) “quality” assets at a price.  (Quality has been redefined for now.)

At a time like this, a bevy of survey articles come out to describe what has gone wrong.  Some tell of how aggressive players overplayed their hands as the willingness to take risk dried up.  In this case, they boil it down to bad lending models, whether subprime mortgages, bank debt for LBOs, or internal leverage inside hedge funds.  Other articles point at historical analogies, looking for something that might tell when the crisis will end.  The two years compared, 1987 (dynamic portfolio hedging) and 1998 (LTCM), do offer some help, but are not adequate to deal with an overall mortgage lending problem, and a large external debt, getting larger through the current account deficit.

Is information failure the best way to describe it?  I don’t know; there were a lot of savvy people (myself included) who could see this coming, but could not put a date on it.  Toward the end of almost any bull market, underwriting gets sloppy, and the mess that it leaves usually persists until early in the next bull phase.  That’s the nature of human beings, and the markets they create.

As I have stated before, central bank policy can help marginal entities refinance, but is no good at aiding balance sheets that are truly broken.  As you analyze your own assets, be sure to ask which entities need financing over the next two to three years, and how badly they need the help.  Don’t play with companies that are at the mercy of the capital markets.  Even if in the short run, after a volatility event, stocks tend to do well, there may be more volatility events than just one.  This first one is over financing; there will be defaults later.  Be ready for the volatility that will come from them.

Tickers mentioned: CPNLQ BAC CFC