Day: December 15, 2007

Personal Finance, Part 7 — Debt

Personal Finance, Part 7 — Debt

I was shopping this evening, and as I went to check out, the two checkers were discussing with a third party their financial woes.? One was making her payments after a workout, and would be free of her debts in a year.? The other had declared bankruptcy, and it would be eight years (or so) before things would normalize for her.? As for the one making payments, her parents had gone through bankruptcy two years ago.

I talked with them for a little while, and both had reverted to lifestyles where debt was not even an option.? Well, good for them, in the short run.? They are learning discipline (the hard way).

I’m not an ogre on debt.? It can be useful, but you have to be careful with it.? I have been debt-free for the past five years, and have enjoyed the freedom that it has brought me.? I take enough risk as it is, why should I magnify it through leverage?? Borrow for a home?? Fine in the right environment.? My advice would differ in 1998 vs. 2005.? Borrow to finance consumption?? No.? Never right.

I feel the same way about companies that I own.? I prefer companies that are less levered, and companies that borrow on a nonrecourse basis.? When we borrow, we are making a statement about the future — that we can presume that it will be good, hey, even better than today.? That’s a tough statement to make.? Avoid debt if you can, and save your debt capacity for times when assets have been crunched, like early 2003.

PS — One more note: because of the AMT the advantage of borrowing money to buy homes is diminishing, because the AMT erases mortgage interest deduction.

Not Dissing Warren the Wonderful

Not Dissing Warren the Wonderful

Look, Barron’s can say what they want about Warren Buffett, and his company Berkshire Hathaway, but I have just one thing to say here: Berky is the ultimate anti-volatility asset.? When the hurricanes hit in 2005, I told my boss that the easy money, low-risk, low-reward play was to buy Berky.? My boss liked to take risks, so that idea was shelved. Too bad, it was easy money.? After all, who could write retrocessional coverage (Reinsuring reinsurers) except Berky?? Every other writer was broke or disabled…

Now we have a different type of hurricane.? Prior bad lending practices are destroying lending/insurance capacity in mortgages and elsewhere.? This could be an investment opportunity for Berky.? Thing is, outside of the Sovereign Wealth Funds, Berky has one of the biggest cash hoards around, and during times of panic, where assets get sold at a discount, cash is valuable.

So during times of panic, we should expect Berky’s valuation to expand.? This is one of those times.

One final note: suppose Buffett, much as he doesn’t want to be an asset manager, decides to take Ambac private.? How would he do it?? Think of what he has done in other cases: he creates a nonguaranteed downstream holding company, capitalizes it to a level necessary for a AAA rating, and buys Ambac.? Warren never guarantees the debt of subsidiaries that he buys.? Why should he reward bondholders of his target companies?? Isn’t it enough that he pays the debts?

Well, yes, sort of.? Warren has never sent a subsidiary into insolvency, but he clearly reserves the right to do that.? Bondholders have given him that right, and I would not blame him for using that right under extreme circumstances.

That said, Berky’s excess cash offers opportunities at present, because Buffett can use that cash to snap up distressed assets when he chooses to do so, and at minimal risk to Berky if an acquisition fails.

Tickers mentioned: BRK/A, BRK/B, ABK

FOMC, Choose Your Poison

FOMC, Choose Your Poison

We’re not there yet, but we are close.? The FOMC is likely facing inflation problems at the same time that it faces problems in the financial system.? Goods price inflation versus Asset price deflation.? There is a term for this, but it is easy to be marginalized if one uses the S-word too readily.? So I won’t.

On the other hand, I am almost done with James Grant’s Money of the Mind.? Several themes come to mind here regarding government policy in the late 20s and early 30s, most notable that the government tried to force credit onto an economy that had too much credit already.? First they tried to get the private sector to do their bidding.? When the private sector would not cooperate to the desired degree, the government entered the lending business itself.? This probably prolonged the Depression by not allowing bad debts to get liquidated on a timely basis.

But, if I use the D-word with respect to today, it is even worse than using the S-word as far as credibility goes.? So I won’t, except for historical reference purposes.

The thing is, though, the FOMC is running out of options.? Pretty soon, it will have to decide which pain is greater: goods price inflation, or asset deflation.? Given the current political demographics, I believe they will choose goods price inflation, while saying the exact opposite, or doing the intelligent equivalent of a mumble.

Final note: current FOMC policies are a bit of a joke.? The temporary nature of them (TAF), plus the reduction in T-bill holdings, particularly during year-end, when liquidity is needed for the “holidays” of some, is unusual to say the least.? If the Fed is serious about reflation of assets, they need to do a permanent injection of liquidity, and stop messing around with these temporary half-measures.

PS — All that said, if I were Fed Chairman, I would presently aim monetary policy to a yield curve that had a 1% spread between 2-years and 10-years, and then I would leave it there.? There would be screaming for a year, but the excesses would get bled out of the system.? After that succeeded, I would narrow the spread to 0.5%.? The economy would remain stable for a long time.

Reinsurance: The Ultimate Derivative

Reinsurance: The Ultimate Derivative

Some housekeeping before I begin this evening. Here’s my progress on the blog:

  • RSS as far as I can test has no problems.? If you have problems with my feed, please e-mail me any details.? Before you do, try dropping my feed, and re-adding it through Feedburner.
  • My logo was anti-aliased for me by BriG.? Looks a lot cleaner.? Thanks ever so much, BriG!
  • The comment error problem is gone, and I suspect also the same one that I have when I post.? It was a bug in one of my WP plugins that was not 2.3.1 compliant.
  • My descriptive permalinks are still lost, though.

I still need to fix my left margins as well, and make my top banner clickable.? Still, that’s progress.

On to tonight’s first topic: my view on derivatives differs from that of other commentators because I am an actuary (as well as an economist and financial analyst).? In the late 1980s, the life insurance industry went through a problem called mirror reserving.? Mirror reserving said that the company reducing risk through reinsurance could not take a greater reserve credit than the reinsurer posted.

That’s not true with derivatives today.? There is no requirement that both parties on the opposite sides of an agreement hold the same value on the contract.? From my own financial reporting experience (15 years worth), I have seen that managements tend to take favorable views of squishy accounting figures.? The one that is short is very likely to have a lower value for the price of the derivative than the one who is long.

But can you dig this?? The life insurance industry is in this area more advanced than Wall Street, and we beat them there by 20 years minimum.? :D? Given the way that life insurers are viewed as rubes, as compared to the investment banks, this is rich indeed.

Now, as for one comment submitted yesterday: yes, counterparty risk is big, and I have written about it before, I just can’t remember where.? I would argue that the investment banks? have sold default on the counterparties with which they can do so.? That said, it is difficult to monitor true exposures with counterparties; one investment bank may not have the whole relationship.

Also, many exposures are hard to hedge because there are no natural counterparties that want the exposure.? When no party naturally wants? an exposure, either a speculator must be paid to bear the risk, or the investment bank bears it internally.

The speculators are rarely well-capitalized, and the risks that the investment banks retain are in my estimation correlated to confidence.? When there is panic, those risks will suffer.? Were that not so, there would be counterparties willing to take those risks on today to hedge their own exposures.

So, is counterparty risk a problem?? Yes, but so is deadweight loss from differential pricing.

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