There’s no order to this post, so enjoy my reflections on broader trends that are affecting the markets.

  1. Corn-based ethanol is costly, and a mistake for our government to subsidize it, when we could buy sugar-based ethanol from Brazil. I’m no environmentalist, but even I can see the advantages of eliminating sugar subsidies and quotas here in the US. The only people hurt are some rich farmers that bribe Washington to keep the subsidies. With a little encouragement from the US, Brazil could adopt more environmentally friendly harvesting techniques, while not kicking up costs that much. Such a deal, better economics, and better for the environment.
  2. Stories like this always make me skeptical. Remember cold fusion? Maye there is a real innovation here that produces more energy than it consumes on net. I wouldn’t bet on it, though.
  3. Since the creation of the Earth, farming has been the dominant occupation of man, until now. More people are employed outside of farming, than inside it. This is not big news, except to confirm that what happened to the developed world 80 years ago is happening to the world as a whole now.
  4. ETFs are not open end mutual funds, where there is one price struck per day for liquidity. For small ETFs, the bid-ask spread can be quite wide on small funds. This shouldn’t be too surprising; the same is true of any small stock. If there is demand for an ETF concept, more units will get created as people bid for them, and the bid-ask spread will narrow.
  5. Rationality in markets is misunderstood. You can bring bright people to manage money, and they will still in aggregate become prey to the speculative aspects of the markets. Some will resist it, but most won’t. It is not a question of intelligence, but of discipline.
  6. Give Hersh Shefrin some credit. I think that behavioral finance is a much richer explanation of the markets than modern portfolio theory. MPT exists because it is easily mathematically tractable, which allow professors to publish, and not because it is a correct description of reality.
  7. It’s tough to be an orphan company. Much as I like investing in companies that have no analyst coverage, if they are cheap enough, when a company loses analyst coverage, the stock price typically declines, and often, the company disappears within a few years. Perhaps the lack of analyst coverage is a proxy for the demand for a company to be public, rather than private.
  8. Here’s a good article on why the market crashed in October of 1987. My quick summary for why it happened was that bonds were more attractive relative to stocks, and dynamic hedging left the market unstable, as many player were willing to sell on big down days.
  9. Will junk defaults triple from 2007 to 2008? Seems reasonable to me; given all of the CCC and single-B issuance over the last few years, the companies that have recently issued bonds seem weak to me.
  10. Can Thompson-Reuters give Bloomberg a run for its money? My guess would be no. Bloomberg is a much richer system, and for those that need that level of complexity, that is where you can get it with great ease.

Enough for the evening. More to come tomorrow.

I know why Sarbanes-Oxley [SOX] came into existence: to give one of America’s least productive Senators a fitting legacy.  I think the legislation was perhaps well-intended, but on the whole, it has perhaps imposed more costs than produced benefits.  Today I am faced with one of the costs: Lafarge SA has delisted, and now trades on the pink sheets.  Now, big institutional investors will buy and sell shares of this fine firm on the Paris bourse, but I’m not big, so I end up with an illiquid nonsponsored ADR.  This is the third time this has happened to me since the passage of SOX, because my investing travels the world in a cheap way, through ADRs.

It has been said in many ways, but I will summarize it in this way: there is price, quantity, and quality.  You can at most regulate two out of three, and usually, it’s not wise for a government to regulate more than one variable at a time.  Often, it is wisest not to regulate, unless there are material problems in quality that ordinary people cannot verify, and yet ordinary people have a common need for (think of food safety, and our government does well at that, but could do better).

Large companies are complex, and the accounting is more so.  The personal burdens placed on the CEO and CFO are misplaced, in my opinion, and the degree of auditing/testing prior to SOX was adequate to catch most abusive situations.  Are financial statements higher quality now?  Yes, but at a cost: Higher accounting costs, particularly for smaller firms, more firms going private, and fewer foreign firms listed in the US.  (Note to those pushing for unification of GAAP and IFRS.  If you’re trying to get more listings in the US, it would be better to aim for reform of SOX.  If GAAP and IFRS are the same, and I were a medium-sized US firm, maybe I would list in London.)

There is a logical balancing point to regulation, and SOX tipped the balance, imposing more costs than the value of improvements in quality.

Full disclosure: long LFRGY (not LR 🙁 )

Here’s a question from a reader a few weeks ago.

I consider myself to be a value investor and stick mainly to stocks
where I feel the asset to equity ratio is reasonable along with
consideration of other factors such as PE & share price to book value etc.
As a result, I am not panicking with the recent mkt downturn and expect
to hold most of my positions thru the major downturn when it happens.

Despite my resolve, I can’t help but feel uncomfortable with the recent
comments on subprime and liquidity etc. Again, I am a very inexperienced
amateur investor, but what I seem to be getting from the reports is that
there is so much leveraged investment in the markets these days that
even these mini downturns may force selling of stocks to cover leveraged
positions and could wash over the entire market. Reports of complete
funds being wiped out as a result of the necessity to cover leveraged
positions seem incredible to me.  I personally feel leveraging should be
left to very skilled, specialized traders and will only consider it when
I have a portfolio of sufficient size that I would be able to use it as
insurance and in turn cover a position if required.


Having said all of this, I have several questions, if you would be so
kind as to consider.


Is there a way to assess the volume of leveraged positions relative to
the whole market and likelyhood to tip the whole market and the average
% the market will retreat based on the amount of leveraging in the
markets and the historical data on the effects?


Are there not rules that govern funds, in order to protect the investors
in the funds from complete liquidation due to leveraging by the managers
and at any rate doesn’t someone review the activities of the fund managers?


Is this leveraging in the marketplace so widespread and common now that
small investors like me are tilting at windmills if don’t participate?


I realize that these questions may be rather uninformed and somewhat
equivalent to “the meaning of life” scenerio, however I have been
reading your blog quite faithfully and with my limited understanding of
some of the technical jargon, find it very interesting.

Thanks for asking your question, and sorry I didn’t get to it earlier.  There are several things to write about here:

  • How serious are leverage problems in the market?
  • There are certain forms of leverage that are well measured, and some that are not.
  • Some institutions have leverage rules, and some don’t, sort of.
  • Am I at a disadvantage as a small investor, particularly if I stay unlevered?

Let’s go in order.  The leverage problems in the market today are significant, though none are urgent at present.  The furor over ABCP and SIVs and other bits of short-term lending have largely passed.  Good collateral got rolled over, bad collateral got picked up by stronger institutions.  That said, there are other important problems in the market that are not at a crisis point yet:

  • Falling residential real estate prices, and the effect on mortgage default, and the effect on those that hold mortgage securities.
  • Private Equity’s ability to repay debt on new acquisitions.
  • The willingness of the investment banks to takes losses on prior LBO lending commitments.
  • Losses in the CDO market, and who owns the certificates with the most exposure to loss.
  • Losses from high-yield lending to CCC, and single-B rated firms.
  • Are any significant financial institutions overexposed to the above items, such that they might be impaired?

Now, some of the leverage is well measured, and some is not. We really don’t know with derivatives what the total exposure is, and whether the investment banks have been clean with their counterparty management.  (That said, so far it looks like it is working.  There may be a Wall Street rule, that if someone is near the edge, find a way to kick them over the edge, so that you can foreclose with more collateral.)

We also don’t know about lending to or from hedge funds, and hedge fund-of-funds.    Non-bank lenders, we know about what they securitize publicly, and that’s most of it, but the rest, we don’t know.  Foreign lenders to the US — the Treasury collects some data on them, but the detail is lacking.

All of these are areas where reporting requirements are limited to non-existent.  Regulated domestic finance — we know a lot about that, and that’s a large part of the system; the open question there, is how much the regulated part of the system has lent to the non-regulated part of the system.  Difficult to tell, but given the slackness of bank exams over the past five years, it could be significant, but I doubt perilous to the system as a whole.

Banks, S&Ls, Mutual funds, Insurance companies, and margin accounts have leverage rules.   Many non-regulated entities face leverage rules from the ratings agencies, which limit their ability to borrow and securitize.  Still other face limits on leverage from those who lend to them, in the form of debt covenants.  Almost everyone is limited in some way, but in a bull market, those limits often get compromised as a group.  The limits are not as wide as would be optimal for financial system stability.

So, there are some protections for those who lend to hedge funds and hedge fund of funds, but little protection to those who invest in them.  Hey, if you’re a big institution, and invest here, you are your only protector; no one is coming to rescue you in a crisis.

But onto the last question:  Am I at a disadvantage as a small investor, particularly if I stay unlevered?   You have many advantages as a small investor.  One  of the largest advantages is that no one can force you to be hyper-aggressive, except you yourself. If you are reasonable in your return goals, you can safely achieve better than your average levered competitor through a crisis.  An unlevered investor can’t be forced by anyone to take on or liquidate a position.  Levered investors, or those with return requirements from outside parties, do not fully control their own trades.

Second advantage: you can be more picky.  You can avoid trouble areas in entire if you want.  Many institutional investors face diversification or tracking error requirements, which force them to in vest some in areas that they don’t like.  As an example, I was one of the few investors that I knew that didn’t take some losses from the tech bubble popping.

Third advantage: you don’t have to take risk if you don’t want to.  If the market is too frothy, and shorting is not for you, just reduce exposure, and wait for a better entry point.  (Warning: that entry point may not come.)

A disciplined private investor may not have the same level of knowledge as the institutions, but he can have a longer time horizon, and play the out of favor ideas that might threaten job security of those who work inside institutional investors.  With that, I would advise you to take use your advantages, and invest accordingly.  Keep it up with the value investing!

For those with access to RealMoney, I advise reading these longish articles if you want more background on how I think here:

Managing Liability Affects Stocks, Pt. 1
Separating Weak Holders From the Strong
Get to Know the Holders’ Hands, Part 1
Get to Know the Holders’ Hands, Part 2

Here was a reader question from yesterday:

I’ve been reading your blog for awhile, and I appreciate all the hard work you put into it. I especially like how you comment on intermarket relationships, and it’s helping to quicken my ever so slowly growing knowledge of the markets.

I read your comments that higher quality bonds should perform better than lower quality, because of a probable rising cost of capital for lower quality companies. In a different environment, or for financially secure companies, is it ever a good idea to make a leveraged buy of higher yielding bonds, where the bond sells at a discount and the coupon is greater than the margin interest rate?

I realize that junk bonds are called such for a reason, and that if reaching for yield was a no-brainer prospect then everyone would be doing this. But I notice that a company like Alltel with a 7/01/2012 maturity has a 7% coupon and 9.156 YTM, and a borderline investment grade rating. While a lot more research would need to go into a bond before buying, would something like this, in theory, be safely bought with any leverage?

Lastly, is debt issued by companies acquired by private-equity firms worth looking at, or is it to be avoided at all costs?

Thank you very much for any help you could provide, and I apologize for the long length of my email,

Yes, in a different environment, a leveraged purchase of lower quality bonds can be a great idea, though I tend to purchase the equity instead. Starting about the time of the Iraq war, we hit a period where low quality bonds outperformed for four years. Since then it has been tough; it goes in cycles. Typically, the time to buy low quality bonds is when everyone is scared to death, the VIX is over 40, and realized defaults are high. This scares everyone away.

Now, with Alltel, this reminds me of an “Ask Our Pros” question that was asked of me on RealMoney, back when they had that feature. (I think I got asked the most, because of my unconventional skill set, but I don’t know that for sure…) A read asked about Toys ‘R Us bonds. Here’s what I wrote back then:

Toys R Us Debt
4/4/05 7:26 AM EDT

Reader: What do you think of buying debt of Toys R Us (TOY:NYSE) now that they are being acquired, I don’t see KKR buying a company and defaulting on its debt. I am specifically looking at the 7 5/8 2011 trading at about 95. – G.S.

David Merkel: I think you ought to be careful here. Buying the debt of a junk-rated company owned by private investors is not trivial.

Suppose you source the bonds at $95, for a yield to maturity in about 6 1/2 years of 8.66%. The best thing that could happen is that the private buyers turn around and sell Toys R Us to an investment-grade buyer who foolishly decides to guarantee the debt. Less good, but still good, is that the spread compression in the market continues, your bonds get bid up and you sell for a profit. Still less good is that it matures and you make your 8.66%. Now for the bad scenarios.

When the Toys R Us bond in question was issued, it was an investment-grade bond. Toys R Us won’t file financial statements. There are no covenants to protect you. In principle, the private buyers could sell a profitable division like Babies R Us and pay themselves a special dividend with the proceeds. You just lost security as a result. Granted, a case could be made for fraudulent conveyance, but try proving that in the courts against the private buyers’ legal team. Also, you could be structurally subordinated by bank debt at Toys R Us. The private buyers could borrow at the bank with Toys R Us as the borrower and pay themselves a special dividend (if the bank lets them). You now have less security.

Or, they could use the money to grow the business. If things go well, they win big, and you get principal and interest. If things go badly, you both could end up with zeroes, but remember, they are private buyers; they probably got some level of dividends out of the deal. Their objective is to skate on a thin equity base to make the highest return on equity that they can. They don’t care about bondholders, unless they are selling bonds.

Their interests and yours are not perfectly aligned. The spread on the bond is weak single-B, which is fair in my opinion for the risks that you would be taking on relative to other securities like it in the market. Those risks are real, and not ones that I typically like to play.

No positions

With Alltel, you are similarly facing a private equity buyout, which will get done if the LBO debt market normalizes (not holding my breath). It is junk-rated by two agencies, and investment grade by two. Unless the deal fails, it is junk grade, with all of the problems listed in my note above for Toys ‘R Us.

There is a time in the cycle to buy debts like this, but it is not now. The level of panic is too low. Wait until we see significant defaults in high yield borrowers, and then revisit this question. Spreads have widened on high yield names, but not as much as they will when defaults start coming through.

One final note, when the cycle turns, you don’t want to mess around with AT paper maturing in 2012. You would want the stuff maturing in 2029 or 2032. If you’re going to play it, play it to the hilt, but only once the cycle has turned.

Tickers mentioned: AT

What a day.  We’ve had too many “What a days” lately, and its late.  Over at RealMoney today, I posted this:

David Merkel
Watching the Maple Leaves Rise as Fall Approaches
9/20/2007 12:49 PM EDT

It brings a lump to my throat, but the Canadian dollar briefly traded over parity to the U.S. dollar today. My guess is that it decisively moves above the U.S. dollar, and stays there for a while. Why not? Their economy is in better shape.Oh, and to echo one of Doug’s points, watch the 10-year swap yield. Nothing correlates better with the prime 30-year mortgage rate. It’s up 13 basis points since the FOMC move.

Looking at slope of the yield curves 10-years to 2-years, the Treasury curve has widened 20 bp and the swap curve 23 bp. If all Bernanke is trying to do is calm the short-term lending markets, that’s fine, but the long-term markets are getting hit.

Even in the short-term markets, things aren’t that great. We’re past the CP rollover problem, but the TED [Treasury-Eurodollar] spread is 135 bp now, and that ain’t calm.

I’m not a bear here, but there are significant risks that we haven’t eliminated yet… most of them stemming from the need for residential real estate to reprice down 10%-20% in real terms. Hey, wait. Hmm… what if the FOMC doesn’t really care about inflation anymore? They could concoct a rise in the price level of 20% or so, which would presumably flow through to housing, bailing out fixed-rate borrowers with too little margin (ignore for a moment that floating and new financing rates will rise also).

Okay, don’t ignore it. It will be difficult to inflate our way out of the problem. Even as the dollar declines, it will cause our trading partners to decide whether they want to slow their export machines by letting their currencies rise or buying more eventually depreciating dollar assets.

I would still encourage readers to be cautious with real-estate-related assets and those who finance them. Beyond that, just be wary of firms that need financing over the next two years. It may not be available on desirable terms.

Position: none, but who is not affected by this?

Interesting Times

We are within a half percent of taking out the all time low (1992) on the Dollar Index [DXY].  Since the move by the FOMC the ten-year Treasury has moved up 21 basis points.  That’s not stimulative.  Then again, maybe the FOMC wants to address the short term lending crisis, but could care less about stimulating the economy as a whole.  If this is their goal, let’s stand up and applaud their technique, but perhaps not their goals.

All that said life has returned to the investment grade bond market, and may be returning to the junk market, and maybe even the LBO debt market, if the banks will take enough of a loss to get things moving.  What I am finding attractive currently in fixed income right now is prime residential mortgage paper (this is rare — I usually hate RMBS).  Implied volatilities in are high, just look at the MOVE index, but they will eventually come down, at which point, the prices of mortgage bonds should improve (on a hedged basis).

Beyond that, I like foreign bonds, but am uncertain as to what currencies to go for; I still like the Canadian dollar, yen and the Swiss franc, but beyond that, I don’t know.  Aside from that, keep it short and high quality, because the long end isn’t acting well, and the junk credit stress is starting to arrive.

Away from that, I also still like inflation protected bonds, but they have run pretty hard since April.  TIPS overshot on the FOMC announcement, and have undershot since.  What a whipsaw.

So where would that leave me if I were a bond manager?  Foreign, mortgages, inflation-protected, and short duration high quality.  Sometimes the game is about capital preservation, and nothing more.

Well, its that time again.  WordPress informs me that this is post 300.  For me, that means a time to stop and reflect, and let readers know what’s going on in my life.

The blog has been live now for about seven months, and it has seen growth.  Growth in readers at syndicated sites (I’ve lost count), growth in readers through Feedburner (RSS) and Feedblitz (e-mail), growth in the number of blogs linking to me, growth in comments, personal e-mails, and spam.  Since the blog started, I have screened out over 6000 spam comments.  It fascinates me how much effort goes into trying to penetrate the comments filter of this blog.  I review the spam filter periodically to rescue the 0.1% of captured posts that are genuine.

As in most of life, we don’t succeed purely on our own.  It helps to have friends.  My most personal support comes from my family and my church.  Beyond that, though, I don’t think this blog would have gotten where it is today with the aid of James Altucher at, Abnormal Returns, Charles Kirk at the Kirk Report, Barry Ritholtz at the Big Picture, (surprising how much traffic has come from there, and all recent), Roger Nusbaum of Random Roger’s Big Picture, Bill Luby at VIX and More, Seeking Alpha (Aleph – Shalom), and Jeff Miller at A Dash of Insight.  A special thanks to my friend Cody Willard who encouraged me to do this early on, and who has received the promotion of a lifetime recently by becoming an anchor at the new FOX business news channel.  The quality of insight in business journalism has just taken a turn for the better.

Speaking of friends, I’d like to talk a little about what I am up to now.   No one has bitten yet on my equity management product, which has handily outperformed the market over the past seven years.  In one sense, that’s no surprise.  Doing well with a small asset base is not going to attract many takers, even if you have done in a liquid, disciplined, institutional way, as I have.  But I am still talking to people, and I have a four page synopsis of what I have done over the past seven years.  If any of my readers has an institution or a wealthy friend that you think might like to seed me (early investors get advantageous terms, permanently), please e-mail me.  Any real referral puts you in my “friend for life” category.

We’ll see where this leads. My dream is to manage money for others using my eight rules, and eventually set up a mutual fund so that smaller investors can join in.

But friends help in other ways also.  Two friends have decided to employ me as a consultant.  One for bond management advice at his bank, and management of two balanced funds, and another to analyze four insurance companies that he owns big stakes in to get a second opinion.  I am available for other consulting arrangements as well.  My wide (shallow?) skill set makes me particularly good for projects requiring knowledge of a broad range of subjects.  I’d like to say that no problem is too tough for me to take on, but that’s probably not true.  I have solved many tough problems for life insurers and investment firms, though.

Friends help in other ways also.  I have an article coming out in MoneySense magazine in November; an editor came to know me through RealMoney and my blog.  I am friends with a number of public insurance management teams.  One of them has granted me an interview in October; we will see where that leads.  My friends from my corporate bond management days are helping me as best they can; I need all the help I can get.

That’s what I am up to now, aside from seeking for venture capital for a friend, and aiding other friends in their business pursuits.  Oh, and seeking out other writing assignments.

A special thanks to the 22% of my audience that hails from outside of the US.  It surprises me that I have many readers in Canada, the UK, the Netherlands, China, Uruguay, France, Hong Kong, Switzerland, Singapore, Australia, Germany, Japan, Italy, Spain, South Korea, India and Taiwan.

Now, about future blog plans.   Here’s what I have coming up:

  • Build out my books page, with book reviews, complete with a little Amazon store.
  • Articles: How markets and traffic are similar, When to be flexible versus rigid, hidden correlations in strategy, problems in academic finance, rescuing Capitalism from capitalists, and more.  Also more articles that answer reader questions.
  • My usual coverage of current topics, particularly when things are hot.
  • One more thing: a stock picking contest, akin to the Value Line contest done in the mid-1980s, with a prize to the winner.  This contest will test skill in picking stocks, rather than luck in trading, as so many contests do.  Sponsors are welcome to apply, otherwise the prize will come out of my pocket, which means it won’t be large.  A sponsor will receive free advertising on my site for the duration of the contest.

Finally, thanks to all my readers who take time to read what I write.  It is a pleasure to produce content for you, and I will do my best for you.

I intend to get back to answering more reader questions, and doing it through posts.  I’ve been somewhat derelict in responding to comments, and I want to do it, but time has been short.  Here is a start, because I think the answer would be relevant to a lot of readers.

From a reader in Canada:

I enjoy your writing as many of your comments generate a wider perspective than my own.  There is always something to learn.

I was too young to appreciate the last stagflationary period.  Yet, I need to manage my portfolio.  My approach is more ETF based, whereas, I see that you prefer specific stocks.

I struggle in anticipating the currency impact on my foreign holdings.  I’m a Canadian based investor.  The simple solution is to pull in my exposure and be more Canada centric.  This idea conflicts with my goal to have my portfolio weighted in similar fashion to the global markets (i.e., Canada is a very small percentage relative to the total).  I also do not subscribe to the excessive weighting in gold as a major investment theme.  To me, it’s insurance to help offset risk elsewhere.

I’m not asking for specifics as you are not familiar with my situation.  Do you have any recommended reading or suggestions to help me test my thoughts and to identify options, so that I can arrive at a better decision?

Well, I’m not that old either.  During the last stagflation, I was aged 13 to 22, from junior high through my Master’s Degree in Economics at Johns Hopkins.  That said, I have read a lot on economic history, so I understand the era reasonably.  I also spent many of my Friday evenings as a teenager watching Wall Street Week with my first teacher on investments.  (Hi, Mom! 🙂 )  Another thing I remember is being the student representative to the school board for two years 1977-1979, when our district in Brookfield, Wisconsin decided to do a wide number of capital improvements in order to save energy, at the peak of the “energy crisis.”  I remember that the payback periods were 15 years or so, not counting interest that they would have to pay on the munis that they issued.  No way that project saved money on a net present value basis.  (And it was depressing to see 2/3rds of the windows covered up.)

During the last Stagflation, bonds were called “certificates of confiscation” by many professionals in fixed income.   It paid to have your fixed income assets as short as possible.  Money market funds, a new invention at the time, were the optimal place to be until about 1982, when the cycle shifted, and the longest zero coupon bonds were the new best place to be.  Timing the shift between cycles is difficult, so don’t try to time it exactly, but add more longer bonds as long rates rise.  Right now, I would stay in money market funds, inflation protected bonds, and foreign currency denominated bonds.  You have enough Canadian exposure, so aside from you money market funds, consider bond investments in the yen, Swiss franc and Euro.

As for equities, pricing power is critical.  Who can raise prices more than the cost of their inputs?  Producers of global commodities like oil, metals, etc., typically do well here.  Financial companies with short duration assets or exposure to hard assets should do better here.  Staples should do better versus durables.  Growth investing should beat value investing (uh, oh, what do I do?  All of my processes are geared toward value investing).   Cyclical names may beat them both.

If inflation really takes off, hard assets will offer some shelter though housing will lag until the inflation of real estate exceeds the deterioration of the debt.  I occasionally like gold, but it’s not a panacea.  I’d rather own the economically necessary commodities.

But what if stagflation does not become a reality?  That’s why we diversify.  I don’t tie my whole portfolio to one macroeconomic view.  Instead, I merely tilt it that way, leaving enough exposure elsewhere to compensateif my economic forecast is wrong.  I am a value investor, and almost always have a a few companies that will do well even if my economic forecast fails.

In summary: keep your domestic bonds short.  Diversify into foreign currency bonds.  Keep a diversified equity portfolio, but focus on companies that are immune to, or can benefit from inflation.

Earlier today at RealMoney, I responded to a question in the Columnist Conversation. It was a longish post that tried to be complete, so I reprint it here:

David Merkel
Mark-to-Management Assumptions
9/18/2007 1:50 PM EDT

Bob, Joe is essentially correct, but I’d like to add a little. From the Office of Thrift Supervision Examination Handbook (pages 137 & 138):

Observable Inputs – market participant assumptions developed based on market data obtained from sources independent of the reporting entity

Level 1 Inputs – Unadjusted quoted prices in active markets for the identical assets and liabilities that the reporting entity has the ability to access at the measurement date. Examples: Treasury bonds and exchange traded securities.

Level 2 Inputs – Other than quoted prices included in Level 1 that are observable for the asset or liability, either directly or indirectly. Level 2 inputs include quoted prices for similar assets or liabilities in active markets and quoted prices for identical or similar assets or liabilities in markets that are not active. Examples: loans traded within the secondary market and plain vanilla interest rate swaps.

Unobservable Inputs

Level 3 Inputs – Entity specific inputs to the extent that observable inputs are unavailable. Because there is little to no market activity, these inputs reflect the entity’s supposition about the assumptions of market participants based on the best information available in the circumstances. In those situations, the reporting entity need not undertake all possible efforts to obtain information about market participant assumptions. However, the reporting entity must not ignore information about market participant assumptions that is reasonably available without undue cost and effort. Examples: credit enhancing I/O strips and private equity securities.

Another way to phrase it is this:

  • Level 1 – publicly observable data
  • Level 2 – derived almost entirely from publicly observable data, and a commonly-used model
  • Level 3 – significant use of private firm-specific data, or public data not derived from the markets (think of a life insurance industry standard mortality table)
  • Now, I’m not a fan of SFASs 157 & 159, or any of the current statements dealing with intangibles. Even level 1 is subject to problems when markets are less liquid. I’ve known of situations where a bond manager found himself holding a disproportionate share of the market of a publicly tradable bond, where it almost never trades because he owns so much of the issue. Where do you mark that? That’s just level one!

    Aside from AAA securities, most asset backed bonds never trade. Level 2 comes into play here, because the dealers estimate a pricing grid from what few transactions take place. with “fair value” accounting, there is no way to avoid mark-to-model, but there are significant possibilities for error.

    The classic case of level 3 is how one estimates the changing value of private equity investments over time. Discounted cash flow anyone?

    As a result of the changes, we have to be a lot more careful in how we interpret the financial statements of financial companies. The game just got a lot more complex given the new fair value accounting rules.

    Position: none

    After I wrote that, a friend of mine e-mailed me saying that Private Equity accounting was for the most part conservative at present, but that there was some pressure to use fair value accounting to smooth results. He also thought the use of these methods wouldn’t make private equity correlate more closely with public equities. I think he is onto something there, and that could affect that amount allocated by pensions and endowments to private equity. On the flip side, if the returns are smoothed through these accounting methods, the standard deviation of returns would drop, which is a bigger effect than the correlation effect. So allocations might go up, and some Private Equity managers, believing the smoother returns, might be tempted to lever up more.

    One other note: I expect that companies with high percentages of level 3 assets will trade at discounts to relative to their peers. Accounting complexity and opaqueness always have valuation discounts. I see it in insurance for financial insurers, reinsurers, and long-tailed commercial lines. Uncertain assets and liabilities should always get lower valuations. Thus, aggressive users of fair value will wonder why their P/Es and P/Bs are so low. It’s because of the lack of ability of investors to verify the asset and liability figures used.

    1. My broad market portfolio trailed the market a little today. I’ve been a little out of favor over the past three months; I’m not worried, because this happens every now and then. That said, we are coming up on another portfolio rebalancing, where I will swap out 2-3 stocks, and swap in 2-3 others. Watch for that in the next few weeks.
    2. Every group in the S&P 1500 was up today. I can’t remember when I have seen breadth like that before. Financials and Energy led the pace. Names like Deerfield Triarc flew on the Fed cut. They will benefit from cheaper repo rates, and the excess liquidity injected the system should eventually ease repo collateral terms.
    3. If the US dollar LIBOR fix at 6AM (Eastern) tomorrow follows the move in the US futures markets today, then we should see LIBOR drop by 27 basis points or so. Given the smaller move down in T-bill yields, 14 basis points, that would leave the TED spread at 132 basis points, which is still quite high, and higher than the 10-year swap spread. (LIBOR would still be higher than the 10 year swap yield.) This indicates that there is still a lack of confidence among banks to lend to each other on an unsecured basis. Things are better than they were two weeks ago, but still not good.
    4. The short term crunch from the rollover of CP, especially ABCP is largely over. The good programs have refinanced, the bad programs have found new ways to finance their assets, or have sold them, or used backup guarantors, etc.
    5. Watch the slope of the yield curve. It is my contention that the slope of the yield curve changes relatively consistently through loosening and tightening cycles. In the last tightening cycle, the curve flattened dramatically through the cycle, making the word “conundrum” popular. This is only one day, but the yield curve slope, measured by the difference in yields between 10-year and 2-year Treasuries, widened 10 basis points today. (The curve pivoted around the 7-year today.) If I were managing bonds at present, I would be giving up yield at present by selling my speculative long bond positions that served me well over the past few months in my model portfolio. I would be upping my yen and Swiss Franc positions.
    6. We learned some new things about the FOMC today: a) They don’t talk their book publicly, so don’t take their public comments too seriously. b) They are willing to risk more inflation for the sake of the non-bank financial system (which is under threat), or economic growth (which may not be under threat). c) They are flagging the Fed funds rate changes any more by letting rates drift nearer the new target in the days before the meeting. d) Beyond that, we really can’t say yet whether this is a “one and done” or not yet. We just don’t have enough data. e) The FOMC really isn’t interested in transparency.
    7. It would be historically unusual for this to be a “one and done.” Fed loosenings are like potato chips. It’s hard to stop at one. Just as there is a delay in the body saying, “that’s enough,” with the potato chips, the in the economy in reacting to monetary policy is slow as well, often leading policy to overshoot, as the FOMC reacts to political complaints to do more because things aren’t immediately getting better. It’s hard to sit in front of the short-term oriented Congress, or listen to the manic media, and say, “But the FOMC has done enough for the economy. It doesn’t look good now, but in 18 months, our policy will take effect and things will be better. Just trust us and wait.” That will not fly rhetorically; it will take a strong-headed man to not overshoot policy. On that Bernanke is an unknown.
    8. To me, it’s a fair assumption then that this cut will not be the last. Investment implications: in fixed income stay in the short to intermediate range, and remain high quality. Buy some TIPS, and have some foreign bonds as well. I like the Yen, Canadian Dollar, and the Swiss Franc. In equities, think of high quality sectors that can use cheap short-term credit, and sectors that benefit from inflation and a weaker dollar. So, what do I like? High quality insurers, mortgage REITs that have survived, (maybe trust banks?), basic materials, energy, goods transportation, staples, some areas in healthcare and (yes) information technology (if I can find any more cheap names there that I like).

    Full disclosure: long DFR