February 2008 – Page 4 – The Aleph Blog

Five Thoughts on the Financial Guarantors

Posted on 6 February 2008 by David Merkel

The Financial Guarantors are receiving a lot of attention these days, and for good reason.? I want to offer a few observations to give my own take on the problem:

1) With structured finance, the initial choice is “Do we ask a financial guarantor to bring the credit up to AAA, or do we do it through a senior-subordinate structure?”? A senior-subordinate structure has classes of lenders with differing rights to payment.? The AAA, or, senior lenders only take losses after the subordinate lenders (who are receiving higher yields) have lost all of their money.? In the present environment, S&P and Moody’s have been downgrading subordinates, and even some senior bonds in senior-sub structures.

This should lead to downgrades of MBIA and Ambac, eventually.? The rating agencies can’t keep downgrading bonds that are similar to those guaranteed by MBIA and Ambac, without downgrading them as well.? Remember, MBIA and Ambac were late to the party; their bonds are disproportionately weak because later lending standards were weaker.

2) The main difficulty with a bailout of the guarantors is that most interested parties have different interests.? That said, the beauty of a bailout is that the guarantor can sit back and pay timely principal and interest, while waiting for better times to come.

3) Did the rating agencies force the guarantors into the CDO business?? I’ve heard rumors to this effect, but it would be pretty easy to prove or disprove.? Look at when MBIA and Ambac entered the business, and look at the commentary from the rating agencies around it; if they are trumpeting diversification, then it is likely that they pitched it to the guarantors.? If not, then the guarantors did it on their own.

4) Even in a bailout of financial guarantors, current shareholders may find themselves diluted beyond measure.? Given current political pressures, those risks are elevated; remember that management teams want to keep their jobs, and that regulators have some say in that.

5) As I noted today at RealMoney:

		David Merkel
		Considering the “Margin of Safety”
		2/5/2008 11:07 AM EST

Tim, I like your stuff, since I am a value investor. Be careful with XL Capital. The challenge is estimating what sort of guarantees they face from Security Capital Assurance. When I looked at them last, the potential payments could be huge — potentially larger than XL’s net worth, but hey, that’s the financial guarantee business. I looked at XL during my last portfolio reshaping — Finish Line also, and could not get past the potential risks. I had easier plays to go for, with less uncertainty, if also lower upside. I don’t try to hit home runs, so it makes it easier for me to not buy the stocks that are optically stupid cheap, but might have balance sheet issues. Cheap means that a company will have the capability to carry their positions through a downturn; it’s part of the “margin of safety” that we require.

Anyway, keep it up, and let’s see if we can’t make some money on our value investing.

Please note that due to factors including low market capitalization and/or insufficient public float, we consider Security Capital Assurance and Finish Line to be small-cap stocks. 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: none

?XL was downgraded recently as a result of those guarantees.? I would be cautious here.

-=-=-=-=-=-

Summary: there is still downside risk here.? Avoid the financial guarantors, and economic areas affected by the overleveraging of our credit markets. ? Stick with companies that have strong balance sheets.

An Economist at Last — Life Changes for David

Posted on 6 February 2008 by David Merkel

I started my business career as an actuary.? For an actuary, though, I had an unusual background — I wasn’t a math or a statistics major, I was an economics major, though admittedly, one with a lot of math.? You can’t get through the Ph.D. courses in econometrics without a lot of math.? In my business career, I’ve put my economics background to use, and added to it through studying finance.? Now, I studied much of the finance and economics of risk literature back in grad school, and developed a healthy dislike for MPT, the CAPM, and suchlike.

I grew up in a home where my self-taught mother used her head and picked stocks.? She did it quite well, too, and continues to do so today.? I figured that I could do it too, and over the past fifteen years, have done so.? Perhaps my major theme would be “hunt for value, and don’t be afraid to have a portfolio that looks weird.”? My studies of finance in my post-academic days were practical in nature, analyzing ways of beating the market, or reducing risk, realizing that any strategy can become overused, and useless.

After leaving my former employer, I’ve done a bunch of things — writing, consulting, etc.? Now it is time to focus.? I have taken a job as Chief Economist and Director of Research for Finacorp Securities, based in Irvine, California.? Their main focus is serving the investment needs of municipalities.? I have three main tasks:

Publish research that encourages clients to trade with us.
Provide research for internal staff and clients, enabling staff to serve clients better.
Build an asset management franchise for our clients around my value investing, and bond investing.

Beyond that, aid in the management of the firm where possible.? Now, I’m not changing locations; I am still based near Baltimore.? What I do can be done from anywhere, so long as I can connect to the Internet.
I have already produced a draft version of a newsletter for our institutional clients.? I am making preparations to?offer equity asset management services to clients.? What form that will take is still open.

That said, it is interesting at this point in my life to finally have the word “Economist” in my job title, as well as “Chief.”? In one sense, this dovetails well into my interests, as those who read my blog will know.? I write about the intersection of macroeconomics and investing.? That’s what I do.? It allows me to keep my interests broad, while solving a wide array of practical problems.? I have sometimes said that I am an investment omnivore.? That’s not quite true, but I like to wander across the investment wilderness, and gather disparate data, gaining good conclusions about the total investment landscape.

Anyway, that is what I am up to now.? To the extent that our newsletter or investment services might be open to individuals, I will let you all know.? I thank you all deeply for your support of me.

PS — I may be on FOX Business Wednesday between 12 and 2PM Eastern.? This is uncertain at present.? We will see.

All or Nothing at All

Posted on 5 February 2008 by David Merkel

I had some “down time” today (taking my third child to junior college), when I could sit and think about some of the issues in the markets, when all of a sudden, a weird correlation hit me.? Similarities between:

The near bankruptcy of the Equitable back in the early 90s.
Neomercantilism
The relationship of Moody’s and S&P to MBIA and Ambac.

Now, I write as I think, so at the end of this, I hope to have a theory that links all of these.? For now, let me tell a story.

When I was younger, I worked for AIG in their domestic life companies.? While I was there 1989-92, the life insurance industry was undergoing a lot of troubles from overinvestment in mortgages and real estate.? Many companies were under stress.? A few went bankrupt.? One big one was probably insolvent, and teetered in the balance — the Equitable.? I was the juniormost member of AIG’s team.? I have a lot of stories about what happened, and why AIG lost and AXA won.? If readers want to read about that, I’ll write about it.? For now though let me mention what I did:

Produced an estimate of value of the annuity lines in four days.
Estimated the “hole” in reserving for the Guaranteed Investment Contract line of business (accurate within 10%, according to the writedown they took later)
Wrote an analysis of AXA that indicated that we should take them seriously (probably ignored).
Analyzed the Statutory statement, the Cash Flow testing, and Guaranteed Separate Account filing (Reg 128), and came to the conclusion that the latter two were in error.? (Those filings, I later learned, forced the NY department to
tell Equitable that it had to find a buyer, because they could not believe the rosy scenarios.)
Analyzed the investment strategies that the Equitable employed in the late 80s.? (They doubled down.)

Two years after that, I was at the Society of Actuaries annual meeting, where I met a well-known actuary who had worked inside the corporate actuarial area of the Equitable during the critical years.? I.e., he watched and analyzed the assets and the liabilities as they arose.? The conversation went something like this:

David: What was it like working inside the Equitable during that period of fast growth?

Corporate Actuary: It was amazing.? It took everything we could do to stay on top of it, and still we fell behind.

D: Didn’t you think that perhaps you were offering guaranteed rates that were too attractive?

C: We wondered about it, but with money coming in, everyone felt great about the growth.? We simply had to find ways to productively deploy all of the cash flow.

D: But wait.? Didn’t the investment department have a difficult time investing all of the proceeds?? With that much money coming in, the likelihood of making severe errors would be high.

C: Were you a bug on the wall at our meetings?? Yes, that is exactly what happened.? The money came in faster than we could invest it prudently.

D: Wow.? I thought that was what happened, but it amazes me to hear it confirmed.

They offered free options, and surprise, investors took them up on them.? They couldn’t make enough to fund the promises, and undertook a risky strategy in the late 80s that I called “double or nothing.”? The strategy failed, and they almost went broke, except that AXA bought them, pumped in a little capital, and then the real estate market turned.

What’s my point here?? Twofold: one, rapid growth in financial institutions is rarely a good thing; it usually means that an error has been made.? Two, there is a barrier in many financial decisions, where responsible parties are loath to cry foul until it is way past obvious, because the cost of being wrong is high.

So what of my other two cases?? With the neomercantilists, which I have written about more at RealMoney, they entered into the following trade: sell goods to the US and primarily take back bonds.? This suppressed inflation in the US, and lowered interest rates, because their bond buying reduced the excess supply of bonds.? In one sense, through export promotion, the neomercantilistic countries sold their goods too cheaply, and then had little current use for the US Dollars, since they did not want their people buying US goods.? So, they took the money and bought US bonds, probably too dearly.? Certainly so, after taking the falling US Dollar into account.

With the major rating agencies and the major financial guarantors, they are locked in a co-dependent relationship, one that I highlighted in a RealMoney article three years ago.? The financial guarantors are next to a cliff, and the rating agencies have a choice:

The guarantors are clearly in trouble, but how bad is it?? Do we push them over the edge to save our franchise, at a cost of a lot of forgone revenue in the short run?
Or do we sit, wait, and hope that things are not as bad as the equity markets are telling us?? This could preserve our ability to make money, and the government is giving us pressure to go this way, for systemic risk reasons.? Besides, someone could bail them out, right?

Ugh, I went through this back in 2001-2002, when the rating agencies changed their methodology to become more short-term in nature.? Funny how they always do that in bear markets for credit.

So, what’s the common element here?? Each situation has a major financial entity at the core.? Underpriced goods or promises were made in an effort to attract revenue.? When the revenues came too quickly, errors were made in deploying the revenues, whether into goods or bonds.? The faster and the larger the acquisition of the revenues, the larger the problem in deployment.

In each of these situations, then, there is a cliff:

Do the rating agencies push the guarantors over?
Does the NY department of insurance force Equitable to find a buyer?
Do neomercantilistic nations keep sucking down dollar claims in exchange for goods, importing inflation, or do they finally give up, and purchase US goods, and slow down their own economies, and the inflation thereof?

This is what makes practical economics tough.? Cycles that are self-reinforcing eventually break, and when they break the results can be ugly.? Why else are credit cycles long and benign in the bull phase, and short and sharp in the bear phase?

A Practical Reason to be Aware of ETF Activity

Posted on 2 February 20083 February 2008 by David Merkel

In investing, it is important to understand what industries the companies in which you invest are in.? There are several reasons for this:

Companies within an industry tend to face the same cost pressures.
Companies within an industry tend to face the same revenue drivers.
Companies within an industry tend to face the same regulators and political pressures.
Companies within an industry tend to face the same behavior from debt-financers and equity investors.

Now, some companies have competitive advantages that are difficult to replicate, but those are not plentiful.? It is no surprise then that equity performance within industries tends to be tightly correlated.

Now consider ETF activity.? The largest ETFs cover whole stock markets, or sectors containing many industries.? The trading can drive the prices of many stocks regardless of the fundamentals in the short run.? The ETFs allow for simple decisions to be made.? “Financials stink; sell the XLF.”? “Technology stinks; sell the XLK.”? “Energy and materials will do well here, buy the XLE and XLB.”

The thing is, in each of those sectors, there is a lot of variation.? Is there a reason to worry about financial companies that focus on mortgages?? Yes.? Does that have anything to do with insurers?? Aside from mortgage, financial and title insurers, no, it doesn’t.? What do chemicals have to do with base metals?? Not much.? Do refiners and E&P companies benefit similarly from a rise in the price of oil?? No, it is the opposite; one buys oil, the other sells.

ETF trading activity can be a benefit to the fundamental investor.? When your companies come under pressure from ETFs because ETF holders sell indiscriminately and the company that you own is not a party to the macro phenomenon that is leading to the selling, it is time to buy a little more.? When your companies rise because ETF buyers buy indiscriminately and the company that you own is not a party to the macro phenomenon that is leading to the buying, it is time to sell a little.

ETFs simplify decision-making for many investors.? Sophisticated investors will avoid the simplification and drill down the economics and the industries and companies that they own, leading to greater profits in the long run.

The Fiscal Elephant in the Room

Posted on 2 February 20083 February 2008 by David Merkel

Those that know me well know that I have been following the entitlements issue for over 15 years. I feel that the leadership of the American Academy of Actuaries has blown it royally over this whole period, and before, through and before the Greenspan commission (his worst legacy). We had a chance to warn the nation, and did not do it. We allowed actuaries who could do the math, but didn’t understand the politics, to write in our journals, and talk to Congress, and suggest that everything would be fine.

Well, things are fine now, and they might be fine for the next president, but they won’t be fine by the 2020 election.

I am talking about Medicare/Medicaid. Unless there are significant changes made, there is no way that we can afford the promises that have been made.? The graph from the Wall Street Journal (from this fine article), on the right, depicts spending excluding interest.? Including interest payments makes the graph worse, and more so as time goes on.? In general, Americans don’t like sending more than 20% of GDP to the Federal Government.? By 2020, that will no longer be possible to avoid, unless significant changes are made.

This is the same issue that faces every state in the nation (except Wisconsin) and the Federal Government over their retiree health care programs; they didn’t set aside money for the future payments, but decided to pay-as-it-goes.? Now, what choices are there to remedy the situation?? Not many good ones:

Raise taxes significantly.
Raise the age for Medicare eligibility to 75 or so (don’t phase it in).
Means-test eligibility (lousy incentives there, as it is for Medicaid)
Eliminate part D now, while there is no imperative to keep it.
Create a reimbursement system that forces the creation of a two-tier medical system.? For the elderly, it will mean limited help in their waning years.? Treatments for expensive prolonging of life will have to come out of private sources.? Call it the Federal Elderly HMO.

The likely solution will involve all five policy options in some form.? How it works out depends on how much political resistance the elderly Baby Boomers will put up.? Another political hurdle: much as I dislike National Health Care, that is a wild card in this mix.? That could be the de facto way that limits the benefit payments that seniors receive.

I’m not into doom and gloom.? I manage money that is invested in stocks, and I have to look for advantage every day.? But we have put off real reform of entitlements for over 25 years, and we continue to do so.? Which of our six remaining presidential candidates is willing to talk about reforming Medicare?? I haven’t heard any of them go that way; it just loses votes.? But when it is hitting us between the eyes twelve years from now, younger people will be incented to vote in politicians that will curb benefits.

My investment implication is this: don’t rely on Medicare existing in its current form past 2020.? Plan today for the medical care you will need then.? Unless you have a funded private plan behind you, that means saving for the future costs.

Back in the Black

Posted on 2 February 20082 February 2008 by David Merkel

No way. If you had asked me two weeks ago whether I would get back in the plus column for 2008, I would have said, “Yes, but in eleven months.” Well, my broad market portfolio is up on the year. Even now, I know that when I write next week, I could be on the other side of the line.

The thing that gives me some degree of confidence at this point relates to what I wrote at RealMoney earlier today:

		David Merkel
		Rebalancing Trade
		2/1/2008 2:56 PM EST

It’s not supposed to work this fast, but I did a rebalancing sale on Alliance Data Systems. Looked really cheap after the merger agreement blew; I guess it was cheap! Hanging onto the balance for more gains. It’s been a weird year so far. On the bright side, I am back to breakeven for 2008, and I have a better, cheaper, more financially sound batch of stocks than I did in mid-2007.

That means something to me. I even think my portfolio has more growth potential than the one I was running with in mid-2007, and I don’t pay up for growth. I do accept it if it is being offered gratis.

There is something different going on in the markets now. It is as if the wind has moved to my back and out of my face. That said, it could just be a bear market rally, or a brief spurt of mid- and small-cap value amid a market favoring growth investing.

Then again, I am grateful to God for the turn; I’ve made a number of good picks and sales lately, and they have paid off more rapidly than normal. With that, I am ready for some retrenchment here, but who knows? My philosophy is to play for maximum advantage; if I have made gains early in the year, I want to play for more. I always hated the idea of indexing if one had a good start to the year. Why cheat your clients? Do your best regardless, and most of the time, it will win.

Hey, I’m just grateful to have made money in 2008. Hope you make money too, and more than me.

Full disclosure: long ADS

Getting an Initial Read on a Deal

Posted on 1 February 2008 by David Merkel

I wrote at RealMoney.com today:

		David Merkel
		What Would Make More Sense to Me, Redux
		2/1/2008 10:14 AM EST

Nine months ago, I wrote this: Microsoft and Yahoo! are in several different businesses with modest synergies between them. Buried inside such a merger would be (at least):

An Internet advertising company

A web/(other media) content producing company

An operating system/applications software company

A consumer entertainment products company

A web search company, and

A web marketing company.

Going back to our discussion of GE earlier this week, Microsoft does not need more businesses in its portfolio. It needs to focus its activities on what it does best. Same for Yahoo! but their problems are less severe unless they do this merger.

If I were Microsoft, I would accept defeat, and sell all web properties to Yahoo! If I were Yahoo!, I would spin off all content production in a new company to shareholders. You would end up with three focused companies that would be able to hit their markets with precision, in a business where scale matters inside your market, but not across markets. The ending configuration would be:

A software company for everything except the web — Microsoft, which would pay another huge special dividend with the proceeds from the sale.

A web search, advertising and marketing company — Yahoo!, which could focus on competing with Google, and

A web/(other media) content production company (would it make money?)

This to me would be rational, but corporate cash gets spent by self-aggrandizing folks with egos, so this is not likely to happen in the short run. But I think the eventual economic outcome will resemble something like this.

Microsoft has not shown a lot of competence in the areas that Yahoo! has focused on, and because of their long history of growth, I’m not sure they get how to run a company that is transisting into maturity. I would be bearish on the total concept.

The market has awarded an additional $3.7 billion to the combined valuations on Microsoft and Yahoo! off of this news. After some time, that premium should reverse, and it will come out of the valuation of Microsoft. But then, I only play in tech when it is trashed, so what do I know?

Position: none

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By the end of the day, that initial valuation premium of $3.7 billion turned into a deficit of $1.2 billion, and that was against a rising market. I’m not that kind of trader, but some deals make sense, and some don’t. When you find one that doesn’t make sense, and the market value of the package rises, one can short both the acquirer and the target, and wait for rationality to arrive.

That’s not to say that all deals are bad. Value can be added through synergies or improved management, or unlocked through expense savings and more leverage. Microsoft-Yahoo is unlikely to fit any of those descriptions in any major way.

Book Review: The Volatility Machine

Posted on 1 February 2008 by David Merkel

There are some books that were important to forming the way I think about economic problems, but if I write about it, I feel that I can’t do justice to the quality of the book. The Volatility Machine, by Michael Pettis, is one of those books. Michael Pettis was a managing director at Bear Stearns, and an adjunct professor at Columbia University when he wrote it.

The book was written in 1999-2000, and published in 2001. It explains how economic activity in the developed world travels into the smaller markets of the developing world, amplifying booms and busts. Coming off the Asian/Russian crises of 1997-1998, it was a timely book. During boom periods, capital flows from the developed countries to the developing countries; during bust periods, capital gets withdrawn. There is a kind of “crack the whip” effect, where the tail feels the change in direction the most.

Borrowing short is a weak position to be in, as the Mexican crisis in 1994 showed us, as the Fed raised rates and the tightening spilled into Mexico, which was financing with short-term debt, cetes. The same is true of corporations that finance with short debt; they are ordinarily less stable than firms that finance long. The Volatility Machine explains why the same forces apply to both situations.

Buffett has said, “It’s only when the tide goes out that you learn who’s been swimming naked.” Rising volatility is that tide going out, and it reveals weak funding structures and bad business/government plans. Booms set up the overconfidence that leads some economic parties to presume on future prosperity, and choose financing terms that are less than secure if the market turns.

Countries that are small and reliant on continued capital inflows are vulnerable to volatility. In the 1970s-1990s, that was the developing countries. Today, the developing countries vary considerably. Some have funded themselves conservatively, some have not, and a number are net capital providers. The US is the one reliant on capital inflows. So what would Michael Pettis have to say in this situation?

You don’t have to look far. Today, Michael Pettis is a professor at Peking University’s Guanghua School of Management. He is studying China from the inside, and writes about it at his blog (I read it every day, and will add it to my blogroll the next time I update it), China financial markets. Among his most interesting recent posts:

China’s latest batch of numbers aren’t good

Chinese pro-cyclicality makes predictions so difficult

More on why high share prices don?t mean Chinese banks are in good shape

The new China-Europe-US world order

Things have gotten grimmer in China

His views are complex and nuanced, and reflect the sometimes asymmetric incentives that politicians and policymakers face.? When I read his writings on China, I am simultaneously impressed with the rapid growth, and with the potential fragility of the situation.

So, enjoy his blog if that is your cup of tea.? If you want to learn how international finance affects developing economies, buy his book.

Full disclosure: if you buy the book through the link above, I will receive a pittance.

Could Have Been a Lot Worse…

Posted on 1 February 2008 by David Merkel

One month down, eleven to go?? Can we stick our heads out of the foxhole yet?

Personally, I was off just a little in January.? Comparing myself against a bunch of value indexes, which did better than growth indexes in January, I did better than all of them.? We’ll see what the future brings, though, these things can turn on a dime.

So what worked for me?? Arkansas Best, National Atlantic (not out of the woods yet), Charlotte Russe, Gehl, YRC Worldwide, Alliance Data Systems, Reinsurance Group of America, and Honda.

What hurt?? Nam Tai, Gruma, Valero, Deutsche Bank, Royal Bank of Scotland, and Anadarko Petroleum.

Common factors:

Financials with complexity got hurt
Energy was lackluster at best
Industrials, Retail, and Trucking did well
Value took less pain
What got whacked before went up

One final note here.? Look at this graph from Bespoke.? The “sea change” there mirrors my own turn in performance.? What does that tell me?? Perhaps it tells me that in late 2007 there were a lot of hedge funds liquidating positions that value managers liked to own.? After the end of the year, the selling pressure ebbed, and value seekers came in.? At RealMoney today, both Cramer and Marcin were commenting on they could find stuff to buy when the market was down in the morning.? I agreed; I haven’t seen this many good values since 2002.? I’m not counting on anything here, but I think my portfolio has attractive valuations and prospects.? Much as I am not crazy about the macro environment in many ways, I have some confidence that my portfolio should do better than the S&P 500 in 2008.

Full disclosure: long NTE GMK VLO DB APC RBS ABFS NAHC CHIC GEHL YRCW ADS RGA HMC