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Archive for March, 2008

Two Monetary Policy Graphs for the Evening

Saturday, March 29th, 2008

A few notes before I begin this evening. I tried posting twice, but my system failed twice, and the auto-save did not do its job faithfully. So, one reduced post, if I can get it out. Next week, I should publish a small primer on how monetary policy works. Also coming up is my next portfolio reshaping.

Well, there is certainly no more stigma in borrowing directly from the Fed. Just look at the discount window:

That’s a new record since the beginning of my data (1980), and more than doubles the last peak in 2001.

The following graph (look at the lower green graph) is the ratio of my M3 proxy (Total Bank Liabilities) to high-powered money (Total Fed Credit, the Monetary Base).

This ratio measures the willingness of the Fed to allow the banking system to lever up their deposit base relative to the size of the Fed’s own balance sheet. The data only goes back to 1980, but we are knocking at the door of a new high. The recent move up began in earnest at the beginning of the last tightening cycle, but has persisted into the loosening cycle, as the FOMC has not let the monetary base grow, but has permitted the banks to continue to gather deposits (banking, savings, CDs, money market funds). Some capital requirements have been loosened, and I suspect the bank examiners are not playing hardball at present, at least compared to the attitude 18 months ago.

After all, the banks don’t have to pay much interest to those who deposit money with them with a curve this low and steep, and many people are afraid of the equity markets, and are letting balances at the banks grow. The banks get cheap funding, and they use it to buy short-duration agency RMBS yielding 3-4%, which is a winner, at least for now.

Book Review: 7 Commandments of Stock Investing

Friday, March 28th, 2008

For those that read my book reviews, let me simply say that unless I say that I skimmed a book, I read every book that I review, and I don’t use the publishers notes to aid me, as many other reviewers do. I just give you my opinion straight, even if I didn’t like it, realizing that there will be no commissions at my Amazon Store from that review. And that is fine with me. I review new and old books — I just want to point my readers to what I think is good, and away from the bad stuff.

I would also add that my Amazon Store is my equivalent of the tip jar. If you value my writing, when you need to buy a book from Amazon, simply start by clicking on a book on my leftbar, and buy the books that you would buy anyway. It doesn’t increase your costs at all, and I get a small commission.

Anyway, onto tonight’s book review. I am genuinely not sure what to conclude on “7 Commandments of Stock Investing.”  There was much that I liked, and much I did not.  I know that Mr. Marcial wrote a column for Business Week for many years, but that was not something I followed closely.  This is my first real introduction to his thought.

Let me take his seven principles, and go in order:

Buy Panic –  Hey, I can go for that.  The difficulty for average investors, and even many seasoned investors is that they buy too soon in a panic.  One also has to focus on companies that are high credit quality in order to avoid big losses.  That got some attention in the book, but not enough for me.

Concentrate, Diversify Not — Ugh, I like having 35 companies in my portfolio, because I concentrate industries.  To the extent that you concentrate, you must have superior knowledge of the companies that you own.  Without that knowledge, the average investor should diversify more, and investors with no special knowledge should buy index funds.

Buy the Losers –  Again, I can go for this, but it takes a special person to separate out the companies that will crater from the companies that have a sustainable business model and will bounce.  Buying quality companies is a must here, or else you can lose a lot.

Forget Timing — I agree.  I keep roughly the same equity exposure all the time, and my rebalancing discipline helps protect me as well.

Follow the Insider –  That’s a good principle, but I’m not sure that it should rank so highly in a set of stock picking rules. Insiders do do better than the market as a whole, but using insider purchase and sale data takes discretion to interpret.

Don’t Fear the Unknown –  By this he means have some foreign equity exposure and biotechnology investments.  One of my rules is, “If you can’t understand it, you won’t know how to buy and sell it.”  Getting comfortable with any area of the market that is volatile takes study and effort.  This is not trivial.  As for biotech in particular, that takes a lot of incremental skill that I don’t have.  After reading what Mr. Marcial wrote, I would not feel confident investing there.

Always Invest for the Long Term: Seven Stocks for the Next Seven Years — He employs a multi-year holding period, like I do, and then points out seven stocks that he thinks will do well.  I’m not going to spoil that part of the book by mentioning any of the seven, but none of them interest me.  (Well, maybe one or two at the right level.)  All of them are large caps, and are quality companies.

Quibbles

Under his first principle, he recommends buying the stock of the company that you work for when it gets hammered down (page 8).  Unless you are an industry expert here, be careful… you are compounding your risks, because your wage income derives from the health of the firm.  Don’t put your savings there too, unless you are dead certain.  (Full confession: I put one-third of my net worth on the line on my employer, The St. Paul, in March of 2000, selling in August of 2000.  Great trade, but no one else knew in the firm did it.)

On page 62, calling Primerica the predecessor firm to Citigroup is a bit of a stretch.  Yes, I know how the case could be made, but there were links in the chain where the smaller company was acquired by a larger one, and the smaller company came to dominate the management of the combined firm.

Under his third principle, he favored GM and Ford.  I can’t support buying such credit quality impaired investments under the rubric of “Buy the Losers.”  These are two companies that will have a hard time surviving in their present forms.  Motorola would be another example… a pity there is such a lag between writing and publication.

Summary

The book is intelligently written, and is short enough for an average person to read in 4 hours (188  pages).  He gives plenty of examples to illustrate his points.  I wasn’t usually enthused by the companies that he chose — I prefer to go further off the beaten path, and buy them cheaper.

His basic principles are good principals to follow, but they need to be tempered by a focus on risk control.  It’s one thing to serve up investment ideas as a writer — you can throw out a lot of promising ideas, and do it well.  What is tough is owning the companies, and trading through their troubles.  That’s a dirtier business; one where average investors will be more prone to fear and greed, and may not do so well, just because they can’t stomach the risks.

He also does not make clear how the seven principles work together. Need you follow all seven on every investment?  I think that’s what he is saying.

Away from that, you can’t use his principles on low quality stocks; that would be a recipe for regular large losses.  Buying panic, buying weakness, and concentrating requires a high quality approach to investing.

With that, I recommend the book to those that have enough maturity to know that they will have to bring their own risk control models to the game.  His methods presuppose a degree of ability in interpreting the fundamentals of companies, so I do not recommend this book to beginners; it would be a dangerous way to start out in investing.  Better to start with Ben Graham.

Full disclosure: If you buy this book, or any other book through the links on this page, then I get a small commission.

Our Not-So-Elastic Currency

Thursday, March 27th, 2008

Before I start this evening, I want to point to a blog post of Barry’s. I have never heard James Grant as agitated as he is in this Bloomberg interview. I’ve heard James Grant disappointed or discouraged, but not annoyed. It was interesting to listen to, and compatible with my views on the credit markets.

This small PDF file contains my summary of the Fed’s H.4.1 report at two points in time: early August 2007, and the latest. I chose early August, because it was prior to the FOMC being willing to advertise that they might consider unorthodox monetary policy solutions. How have things changed? Let’s start with what hasn’t changed. For the most part, the Fed hasn’t expanded its balance sheet. Total assets are up only 2.5%, or 3.8% annualized. The liability side of the balance sheet has expanded even less — 1.7% or 2.7% annualized. The issuance of Federal Reserve Notes has crept up 0.5%, or 0.7% annualized. For a loosening cycle, this is unusual.

But what has changed? The composition of assets on the balance sheet, and the level Fed net worth.

  • Treasury bills down $163 billion
  • Treasury notes and bonds down $18 billion
  • Repurchase agreements up $82 million
  • Term Auction Credit up $80 million
  • Other loans (direct lending to dealers) up $37 million
  • Fed net worth up $7 billion (21%, I will not annualize that)

What you are seeing is a substitution of T-bills and T-notes for short-term lending against collateral with greater credit risk (though with haircuts). If you net all of the changes that I highlighted on the asset side, it adds up to the change in assets less $3.5 billion. As for the net worth of the Fed, it is curious to see it rising so much. I need to look at that series over time to see how it changes.

In short, the FOMC is providing a little more credit to the economy as a whole through the expansion of its own balance sheet. In the process, it is changing the composition of its own balance sheet (at least for a little while) in order to induce more liquidity into the mortgage markets, while offering out T-bills that are in hot demand. Both aim to narrow the spread between mortgage bonds and Treasuries, particularly on the short end.

That said the bond market is big, making the $200 billion allocated by the Fed look small. Now, there are also the actions of the GSEs, which are perhaps another $300 billion. Is that enough to right the prime residential mortgage market? It looks small to me, though in the short-run, it can change market psychology.

Why I titled this “Our Not-So-Elastic Currency” is that the amount of stimulus to the economy as a whole is small; the action is focused on fixing the mortgage markets, and the broker-dealers. That M2 and other broader monetary aggregates are rising aggressively stems from a willing ness of the banks to take on leverage at present. For banks that are healthy, funds are cheap; they can expand.

TSLF Auction

I had earlier predicted that direct lending to broker-dealers would limit the need for the Term Securities Lending Facility. Well, that’s not true, but the need for the TSLF was not that great today. $75 billion of credit was offered, with only $86 billion of bids. The rate that the exchange of collateral priced at was only 33 basis points, which was only 8 basis points above the minimum acceptable. The auction was close to failing, except that failure would be a good thing. If bids had not been sufficient, it would have indicated a lack of need for the facility, which would indicate that conditions aren’t so bad after all.

My guess is that the TSLF will not be one of the new credit systems that survives the current crisis. The direct lending through the Primary Dealer Credit Facility may prove harder to discontinue because of its greater flexibility.

Ten Notes on Our Quasi-Government and the Financial System

Thursday, March 27th, 2008

Personal notes before I get started: I’ve been busy studying for the Series 7 (and also reviewing the compliance manual for my new firm — wow it is big). The two of them fit together, as I get to see how the regulations get applied. I’ve made through the study guide (what do you do when it is wrong — not that I found a lot of errors, maybe half a dozen?), and I am 20% through my first practice test. Went and got fingerprinted for the fourth time in my life yesterday. (The other three times were for adoptions.)

My links are back :) but I had to give up my descriptive permalinks. :( Maybe I’ll get them back when I upgrade the blog to WordPress 2.5.1. Beyond that, I am working on a book review for Gene Marcial’s forthcoming book, “7 Commandments of Stock Investing.”

Catching up on the markets:

Our Unorthodox Federal Reserve, GSEs and Government

1) Repo rates may not be negative now, but they were so recently. Fails (failures to deliver securities) become common, because of the lack of a penalty. Today we should see whether the TSLF has any impact on the scarcity of Treasuries. We should learn more about the direct landing program as well after the close today. It got off to a big start last week. Watch for the H.4.1 report after the close. Given all that is going on, it is becoming the critical weekly Fed document.

2) Now, because of all these actions on the asset side of the Fed’s balance sheet, some are calling the actions of the Fed, including the Bear Stearns bailout, revolutionary. Well, maybe. It’s certainly different than before, but there is a cost to doing business this way. Bit by bit the Fed loses flexibility as more and more of its highest quality assets become encumbered for a time.  The more that they do, also, the harder it will be to unwind, in my opinion.

3)  Greenspan…  If we turn off the spotlight, will he go away?  (Then again, he has enough money to buy his own spotlight.)  It is tough for anyone to defend a legacy, and I don’t blame him for trying, but the Fed became too integrated with the political establishment under his tenure, which made it too activist in avoiding short-term pain.  It made him look like a hero at the time, but now we are paying the price.  Overly loose monetary policy and financial supervision led to gluts of borrowing to finance assets that appreciated dramatically, until the ability to service the debt began to decrease.  I don’t think history will treat him kindly.  He said too much in the past that he is contradicting today.

4) Will the Fed buy agency MBS outright?  I think the answer to that one is yes, if the crisis persists. If housing prices drop enough further, like say 15%, the actions of the Treasury, Fed, FHLB, Fannie, Freddie, FHA, and whatever new lending monstrosity our imaginative Government comes up with will have to be closely coordinated.  At some level, if the Fed can’t trust the implicit guarantee of Fannie and Freddie, why should the rest of us?  That guarantee is as sound as a dollar! ;)

5)  It’s interesting to see the tide shift with respect to GSE involvement in the mortgage market:

6)  On a consolidated basis, our government, with its enterprises, are levering up.  This is a substitution of public debt for private, and more, just a lowering of capital standards for the GSEs.  (I wonder how comfortable the rating agencies are with this?)  This works while Treasury yields are low.  I wonder, though, how much impact this will have on the willingness of foreign buyers of Treasuries to continue their funding of our government?  One thing for sure, this will all get funded by the US taxpayers, together with those who lend to the US (dollar depreciation).

7) Now, it’s not as if the US is the only place in the world with central banking problems.  Consider the Eurozone, where there is still no lender of last resort.  How would they deal with a financial crisis?  I’m not sure; the ECB has quietly helped out some Spanish banks, but it is not really in their jurisdiction.  Under conditions of deflationary stress, it would not be impossible to see a nation whose financial system was in trouble either directly bail out the dud institutions, or even, exit the euro (last resort, but not impossible).

Or consider China, where inflation is getting a nice head of steam.  Their neomercantilism, with their crawling peg against the dollar is forcing them to import loose monetary policy from the US.  As the article cited points out, they need to significantly revalue their currency upward, which would would whack their exports, at least for a time.

8 )  For those that remember the files that I created for my piece, A Social View of the FOMC, it looks like I will have to update the file soon.  We have a successor to Bill Poole nominated, James Bullard.  When he is approved, I will update the file.  (I will miss Poole.  Though he was occasionally out of step with the rest of the FOMC, he always spoke his mind, which was usually more hawkish than the rest of the FOMC.)

9)  Now, Bullard is an Economics Ph. D.  (Surprise!)   In my earlier piece, Jeff Miller took note of a few of the things that I said, and perhaps attributed to me an anti-Academic bias.  I don’t have a bias against academics, per se.  (Hey, can we put Steve Hanke on the Fed?!  One of my professors…)  I do have concerns about not having enough real debate.  If the neoclassical view of monetary policy is correct, then we don’t have problems, because everyone on the FOMC is either a neoclassical economist, or a monetarist.

Now, I do know the difference between politics and policy formation, and if I hadn’t been trying to keep the number of pages down, I might have had two columns.  (Getting it down to 15 pages was hard.)  But most of the FOMC members had either one or the other, but not both, so I left it as one column.  Next time I change the column heading.  That said, even if one is in a policymaking capacity in the executive branch, there is typically some political affiliation that helps get that person the job.  Those are relevant bits of experience, just as I noted everyone that had foreign experience, or military experience.  But what worries me is a lack of real diversity in views of how economics works.  (Perhaps we could get someone from the Santa Fe Institute?)

10) Finally, there will be a lot of pressure in the future to re-regulate our financial system.  Personally, I don’t think it is possible to create a regulatory scheme that eliminates crises.  The regulator shapes the type of crisis that will come, and when it will come, but it is impossible to wipe out the boom-bust cycle.  (We put off this bust for a long time, and now we are getting it with compound interest for time delay.)  If a regulatory regime is too tight, the financial companies complain because their ROEs are too low.  To the extent that it can, capital begins to exit the industry, or, the stock prices languish, and financials trade at low multiples on book, because they can’t earn much off their net worth.

Financial companies find the weak spots in any risk-based capital formula.  They also lobby the executive branch and Congress effectively.  Unless we slide into Great Depression II, I don’t think things will change remarkably from here.

I  agree that we need to re-regulate, but perhaps after this crisis is done, we can consider systemic reforms, and not the piecemeal stuff we have been dished up in the name of crisis management.  My re-regulation would be to reduce the Federal Government’s role in the credit markets, but then, I am walking out of step, and realize that is not what is going to happen.

The Lost Decade

Wednesday, March 26th, 2008

I’ve written about “the lost decade” before at RealMoney.  A lost decade is where  the stock market goes nowhere, or loses money for ten years.  My purpose in doing so was to point out:

  • That it is normal for lost decades to occur.  Stock returns are weakly autocorrelated.  Good years tend to be followed by good years, and bad years by bad years.
  • Once a generation, you have to get a severe boom and a severe bust.  It is partly driven by monetary policy/financial regulation laxity, followed by tightness.  It is partly driven by the fear/greed cycle, because most people, even professional investors, chase performance.
  • This has a chilling effect on retirement planning.  Recall my recent article on longevity risk.  In that article, I tried to point out the similarities for retirement investment planning between Defined Benefit plans, and an individual with his own unique retirement circumstances, typically with defined contribution plans.

I’ll amplify the last point, because the WSJ doesn’t do much with it.  Nothing kills a DB plan’s funding level worse then a protracted flat/falling equity market, and low bond yields (showing not much alternative for reinvestment).  Same for an individual financial plan.  If a DB plan has an assumed earnings yield of 8%, and the stock market earns zero, and bonds earn 5%, with 60/40 stocks/bonds, than plan earns 2% when it needs 8%.  The funding deficits grow rapidly, and corporations finally bite the bullet, and begin making contributions to their DB plan, cutting earnings in the process.

As for individuals, they should start to save more for their retirements after such a long bad market, in order to get their retirement funding back on track.  Oops, wait.  This is America.  We don’t save personally (particularly Baby Boomers), and our governments run deficits (even more on an accrual basis when we look at Medicare, Social Security, and other long-term inadequately funded programs.  Only our corporations save on net.

So, what to do?

  • Save more.
  •  Don’t materially increase or decrease allocations to stocks.  Things may be rough for a while longer, until excesses in the US financial system and in China are worked out, but positive returns will recur.
  • Avoid investing in companies with large pension funding deficits.
  • Avoid investments with high embedded leverage, whether individual companies, or ETFs.
  • Be wary of investing in esoteric asset classes this late in the performance cycle.  They may do well for a while longer, but their time is running out.  (It could be one year or another decade.)
  • Be ready for increasing inflation.  Even with the income giveup, it is probably wise to have bond durations shorter than the benchmark.
  • To the extent you can, push back retirement, or plan that you will do it in phases, where you slowly leave the formal labor force.

Of course, you could be a good stock picker, but that’s not a common gift.  The choices are hard when we have a “lost decade.”  There’s no silver bullet; only ways to mitigate the pain.

Book Reviews — The Alchemy of Finance, and Soros on Soros

Monday, March 24th, 2008

One trap you can fall into in life is to not learn from those that you disagree with, for one reason or another. George Soros would be an example of that. His politics are very different from mine, as well as his religious views. He’s a far more aggressive investor than I am as well. I am to hit singles with high frequency over the intermediate term. He played themes to hit home runs.

The Alchemy of Finance made a big impression on me 15 years ago. Perhaps it was a book that was in the right place at the right time. It helped to crystallize a number of questions that I had about economics as it is commonly taught in the universities of the US.

First, a little about me and economics. I passed my Ph. D. oral exams, but did not receive a Ph. D., because my dissertation fell apart. Two of my three committee members left, and the one that was left didn’t understand my dissertation. What was worse, I had moral qualms with my dissertation, because I knew it would not get approved.

My dissertation did not prove anything. All of my pointed to results that said, “We’re sorry, but we don’t know anything more as a result of your work here.” I have commented before that the social sciences would be better off if we did publish results that said: don’t look here — nothing going on here. But no, and many grad students in a similar situation would falsify their data and publish. I couldn’t do that. I also couldn’t restart, because I had put off the wedding long enough, so for my wife’s sake, I punted, and became an actuary.

That said, I was a skeptical graduate student, and not very happy with much of the common theories; I wondered whether cultural influences played a larger role in many of the matters that we studied. I thought that people satisficed rather than maximized, because maximization takes work, and work is a bad.

I saw how macroeconomics had a pretty poor track record in explaining the past, much less the present or future. In development economics, the countries that ignored the foreign experts tended to do the best. Even in finance, which I thought was a little more rigorous, I saw unprovable monstrosities like the CAPM and its cousins, concepts of risk that existed only to make risk uniform, so professors could publish, and option pricing models that relied on lognormal price movement.

Beyond that there was the sterility of economic models that never got contaminated by data. I was a practical guy; I did not want to spend my days defending ideas that didn’t work in the real world. And, I felt from my studies of philosophy that economists were among the unexamined on methodology issues. They would just use techniques and turn the crank, not asking whether the metho, together with data collection issues made sense or not. The one place where I felt that was not true was in econometrics, when we dealt with data integrity and model identification issues.

Wait. This is supposed to be a book review. :( Um, after getting my Fellowship in the Society of Actuaries, I was still looking for unifying ideas to aid me in understanding economics and finance. I had already read a lot on value investing, but I needed something more.

On a vacation to visit my in-laws, I ended up reading The Alchemy of Finance. A number of things started to click with me, which got confirmed when I read Soros on Soros, and later, when I began to bump into the work of the Santa Fe Institute.

I was already familiar with nonlinear dynamics from a brief meeting with a visiting professor back in my grad student days, so when I ran into Soros’ concept of reflexivity, I said “Of course.” You had to give up the concept of rationality of financial actors in the classical sense, and replace them with actors that are limitedly rational, and are prone to fear and greed. Now, that’s closer to the world that I live in!

Reflexivity, as I see it, is that many financial phenomena become temporarily self-reinforcing.   We saw that in the housing bubble.  So long as housing prices kept rising, speculators (and people who did not know that they were speculators) showed up to buy homes.  That persisted until the  effective cashflow yield of owning a home was less than the financing costs, even with the funky financing methods used.

Now we are in a temporarily self-reinforcing cycle down.  Where will it end? When people with excess equity capital look at housing and say that they can tuck it away for a rainy day with little borrowing.  The cash on cash yields will be compelling.  We’re not there yet.

Along with that, a whole cast of characters get greedy and then fearful, with the timing closely correlated.  Regulators, appraisers, investment bankers, loan underwriters, etc., all were subject to the boom-bust cycle.

Expectations are the key here.  We have to measure the expectations of all parties, and ask how that affects the system as a whole.

In The Alchemy of Finance, Soros goes through how reflexivity applied to the Lesser Developed Country lending, currency trading, equities, including the crash in 1987, and credit cycles generally.  He gives a detailed description of how his theories worked in 1985-6.  He also gives you some of his political theorizing, but that’s just a small price to pay for the overall wisdom there.

Now, Soros on Soros is a series of edited interviews.  The advantage is that the interviewers structure the questioning, and forces more clarity than in The Alchemy of Finance.  The drawback (or benefit) is that the book is more basic, and ventures off into non-economic areas even more than The Alchemy of Finance.  That said, he shows some prescience on derivatives (though it took a long time to get to the promised troubles), though he missed on the possibility of European disintegration.

On the whole, Soros on Soros is the simpler read, and it reveals more of the man; the Alchemy of Finance is a little harder, but focuses more on the rationality within boom/bust cycles, and how one can profit from them.

Full disclosure: if you buy through any of the links here I get a small commission.

Blog Troubles

Monday, March 24th, 2008

Hello.  Sorry to anyone who is not able to read old posts in my blog.  Only the front page is working at present.  For those that have been following the small changes that I have been making, you might note that I have made some changes to my permanent pages to reflect my new employer.  Also, I have made my book reviews more prominent, because people have told me they like them.

I may be looking for a new hosting provider.  Ideas are welcome.

“Should I be worried about the economy?”

Saturday, March 22nd, 2008

Most of my friends don’t follow the economy or the markets that closely, so it has been interesting for a number of them to ask me recently, “Should I be worried about the economy?”  The answer isn’t a simple one.

Part of the answer depends on your line of work.  Stuff that’s economically necessary (utilities, staples, government, common services) will probably do okay, though there will be some slackening of demand at the edges.  For example, I visited  a hair salon recently, and asked how business was.  The answer was that customer numbers were unchanged, but that the average purchase level had dropped.  Even government positions, stable as they are will experience some pressure, because budgets have to balance, and tax revenues are starting to sag a bit.

Now if you work in an export-oriented sector, with the dollar down, you will probably do okay.  Demand for food, energy, raw materials, industrial goods, and some technologies will continue relatively strong.

But institutions that rely on credit risk, whether borrowing or lending, will have it tough.  During the boom phase, more and more bodies get added to service the cash flow.  At his point, bodies are coming out of banking, investment banking, real estate, homebuilding, etc.

You can also ask how well capitalized and profitable your current firm is.  This is not a time that rewards high degrees of leverage and short-term financing (unless you are very well capitalized). Volatility rewards firms that have excess capital; it is worth more when times are panicky.

Another part of the answer is how dependent you are on the need for continued external financing.  Can you meet all of your obligations, with some room for error over the next two years?  Do you have excess assets to aid you if you have a sudden crisis?

Finally, if you have investments, look them over.  Examine what investments are sensitive to worsening credit problems, and remove weakly financed companies from your portfolio.  You should have some investments that are inflation-sensitive, like stock in industries that have pricing power (precious few :( ), cash, TIPS, and foreign-currency demoninated bonds.  Now, carefully selected muni, mortgage and corporate bonds have value here, though don’t put on a full position at present.

In summary, it depends on your personal financial position, the firm and industry that you serve, and how much you have prepared to weather bad times in investing.  It’s not a pretty time as the leverage unwinds, but if you planned in advance for the possibility of trouble, then you should do adequately.

A Trip to the Grocery Store

Saturday, March 22nd, 2008

My wife is a busy woman, given that she homeschools our children, so when time gets tight for her, say around eight times a year, I do the grocery shopping for her.  It was maybe four months since the last time, though, and the prices were an eye-opener for me.  Anything dependent on grain as an input was a lot higher in price than before.  Most meat was higher, cereals, bread, etc.  Not that this is a complete or scholarly answer, but I see the inflation rising in food and in energy.  (Heating oil, gasoline)

Good thing we have “core inflation” to explain this away.  Others may see things differently, but I was genuinely surprised at the price rises.

I would post more, but my site hosting was down for most of the evening.

Mark-to-Market Accounting Is not the Major Problem

Friday, March 21st, 2008

I’m not a fan of mark-to-market accounting, partially due to the loss of comparability across firms. It introduces a level of flexibility that can be gamed by the unscrupulous. That said, any accounting method can be gamed. Accounting attempts to assign the value of economic activity at and across points in time.

Now, with financial firms, there are typically several accounting bases going on at the same time. There’s GAAP, Regulatory, Tax, and then the accounting for special agreements, which may be different than any of the three major accounting bases.

Why has mark-to-market come up as an issue recently? Because it has seemingly created downside volatility in the financial statements, leading investors to panic, which pushes down security prices.

In my opinion, the greater problems are how a firm finances itself, how it is regulated, and negative optionality in its assets and positive optionality in its liabilities. I’ll give some examples to illustrate:

With Thornburg, the problem was over-reliance on short-term lending to finance long term assets. It doesn’t matter how you do the GAAP accounting here. The brokers will look at the day-to-day market value of the positions versus the capital supporting them. If the capital becomes insufficient to carry the position, the positions will be liquidated. Given that there were a lot of players with similar trades, and funding in the repo market, that created an ideal setup for the most levered to lose a lot as financing dried up.

Bear Stearns also relied on short-term financing. Bear ran with high leverage that made them vulnerable to attacks from those that bought credit protection in the credit default swap market… as those spreads went up, the willingness to extend credit went down. Ratings downgrades pushed up, and in some cases eliminated the willingness of lenders to extend short term credit. (Bear also lacked friends to help them in their time of need, a payoff for not helping on LTCM. Lehman had similar leverage, but the Street supports it.) Also, derivative agreements often specify a need for more collateral if downgrades occur, which is exactly the wrong time to have to provide more collateral. Again, this has nothing to do with GAAP accounting, but it has a lot to do with positive optionality in the liabilities of the firm. (I.e., the liability can get more onerous under conditions of stress.)

Consider PXRE, which recently merged with Argonaut Group. When the storms of 2005 hit, they claims against them were bad enough, but many of their reinsurance agreements had downgrade clauses, saying they would have to post collateral. Though it didn’t bankrupt them, it could have, and they had to find a buyer. Nothing to do with GAAP accounting.

General American wrote a bunch of floating rate Guaranteed Investment Contracts that had 7-day put provisions after a ratings downgrade. They wrote so much of them, that they comprised 25% of their liability structure. When they got downgraded, they could not meet the call on liquidity. They wen insolvent. Nothing to do with GAAP accounting.

CIT got downgraded and drew down their revolver because of a liquidity shortfall. The stock has fallen more then 80% in the past year. Mark-to-market accounting to blame? No, deteriorating assets and too much short-term financing.

I could go on. Regulators are under no obligation to use mark-to-market accounting, and they can set capital levels as they please. Optimally, regulators should look at risk based liquidity. How likely is it that a financial firm will have adequate liquidity in all circumstances? How safe and liquid are the assets? Is the liability structure long enough to support them? Can the liability structure dramatically shorten? (I.e., a run on the bank.)

Deterioration in the value of assets has to be addressed by accounting somehow. But regardless of the method, those that finance the company will look beyond the published GAAP financials, and will look at the cash generation capacity of the firm over the life of the loan, and how prone to change that could be. Even if a firm could take an asset worth 80 cents and mark it at $1.00, the sophisticated lenders would only assign 80 cents of value.

Along with The Analyst’s Accounting Observer, I don’t see mark-to-market accounting as a major threat to the solvency of firms. The companies that have gotten into trouble recently have held assets of dubious quality, and have financed themselves with too much leverage, borrowing short-term, and/or implicitly sold short options against their firms that weakened themselves during a crisis. Dodgy assets and liquid liabilities are poisonous to any firm, regardless of the accounting method.

Disclaimer


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


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


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

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