July 2008 – Page 2 – The Aleph Blog

Not All Financials are Poision

Posted on 22 July 2008 by David Merkel

I am overweight financials, but I don’t own any banks, or entities where the primary business is credit risk.? I own a bunch of insurers, because they are cheap.? The first one to report came Monday after the close, Reinsurance Group of America.? They beat handily on both earnings and revenues.? They are the only pure play life reinsurer remaining.? Competition is reduced because Scottish Re is for all practical purposes dead.? They make their money primarily off of mortality, charging more to reinsure lives than they expect to pay in death claims.

This is a nice niche business, and a quality competitor in the space — well-respected by all.? And, you can buy it for less than book value.? Well, at least you could prior to the close on Monday.

Here are the financial stocks in my portfolio at present:

Safety Insurance? (Massachusetts personal lines)
Lincoln National (Life, Annuities, Investments)
Assurant (Niche lines — best run insurer in the US)
Hartford (Life, Annuities, Investments, Personal lines, Commercial Lines, Specialty Lines)
RGA (Life reinsurance)
Universal American Holdings (Senior Health Insurance — HMO, Medicare, etc.)
MetLife (Life, Annuities, Investments, Personal lines)
National Atlantic (waiting for the deal to close)

Now, I do have my worries here:

Even though asset portfolios are relatively high quality, they still take a decent amount of investment-grade credit risk, and even squeaky-clean portfolios like the one Safety has are exposed to Fannie and Freddie, unlikely as they are to default on senior obligations.
Those that are in the variable annuity and variable life businesses might have to take some writedowns if the market falls another 10% or so.? For those in investment businesses, fees from assets under management will decline.
Pricing is weak in most P&C lines.

Away from that, though, the companies are cheap, and I have a reasonable expectation of significant book value growth at all of them.? Also, a number of the names benefit from the drop in the dollar — Assurant, MetLife, Hartford, and RGA.

One final note before I close: diversification is important.? I have Charlotte Russe in the portfolio, and it got whacked 20%+ yesterday.? Yet, my portfolio was ahead of the S&P 500 in spite of it.? If Charlotte Russe falls another 5% or so, i will buy some more.? There is no debt, earnings are unlikely to drop much (young women will likely continue to buy trendy clothes), and there are significant assets here.? I don’t expect a quick snapback, but as with all of my assets, I expect to have something better 3 years from now, at least relative to the market.

Full disclosure: long SAFT LNC AIZ HIG RGA UAM MET NAHC CHIC

Thinking About Dividends

Posted on 20 July 200820 July 2008 by David Merkel

Dividends can be controversial.? Are they tax-efficient?? Not as good as compounding capital gains over a long period, and it will be worse when the Bush tax cuts expire.? There is no tax on buying back shares, but individuals get taxed on dividend payments.

Are they the best way to tilt value portfolios?? My guess is no.? There are many factors that drive the calculation of value, and dividends are one of them.? A multifactor model including dividends will probably beat a dividend yield only model.? It will definitely allow for a more diverse portfolio, rather than being just utilities, financials, LPs, etc.

Do dividend-yield tilted portfolios always do better than the indexes?? No, they don’t always do better.? Take the current period as an example.? These two notes from Bespoke are dated, but still instructive.? The total returns off of stocks with above average dividend yields has been poor recently.? Part of that is the current trouble in financials.? Part of it is the financial stress that is leading to cuts in dividends (again, mainly at financials).

Dividend paying stocks tend to lag when bond yields rise, also.? I remember an absolute yield manager who floundered in the early-to-mid ’90s when rates rose dramatically and bonds proved to be greater competition for the previously relatively high-yielding stocks.? They had a great time in the ’80s as yields fell but 1994 proved to be their undoing.

That said, dividends are an important part of total returns, probably one-third of all the money a diversified portfolio earns.? Also, on average, companies that pay dividends also tend to do better in the long run than companies that don’t pay dividends.? Why?

DIvidends have a signaling effect.? They teach management teams a number of salutary things:

Equity capital has a cash cost.
Be prudent risk takers, because we want to raise the dividend if possible, and avoid lowering it, except as a last resort.
Focus on free cash flow generation.? Be wary of projects that promise amazing returns, but will require continual investment.
Be efficient at using capital generated from free cash flow.? The dividend forces management teams to do only the most productive capital projects.? Increasing the dividend is alternative use of capital that must be considered.
Dividends keep management team honest in ways that buybacks don’t.? Buybacks can quietly be suspended, but in the American context, a dividend is a commitment.

Now, if you are going to use dividend yields as a part of your strategy, you need to pay attention to two things:

Payout ratios, and
Growth of the dividend is more important than its size

Is the company earning the dividend?? Do they have enough left over to pay for capital expenditures for maintenance and growth??? Be careful with companies that have high dividends.? My belief is that companies with middling dividends tend to offer value, but the really high dividends portend trouble.? High dividends tend to be cut during periods of financial stress, as we are seeing today.? This article on newspaper stock yields does not convince me.? I have been a bear on the industry for the last ten years.? You can’t maintain high dividends in a industry with significant competition from new entrants (Internet destroying ad revenue, classified ad revenue, and sales revenue).

REITs have decent dividend yields, but the companies with the best total returns had low dividend yields, but they grew them more rapidly.? In general, growing dividend yields where payout ratios are not deteriorating are usually good stocks to own.? Think of it this way, the dividend yield plus its growth rate will approximate the total return of the stock in the long run (for dividend paying stocks).

Two more notes before I end.? FIrst, special dividends usually not a good idea; they signal reduced prospects for the company to deploy capital productively; better to do a dutch tender and buy back shares.? When Microsoft did their special dividend four years ago, I made the following comment at RealMoney:

		David Merkel
		Note From Fed Chairman: Don’t Worry, Be Happy
		7/21/04 12:46 PM?ET
Alan Greenspan completed his testimony slightly after noon today. The Q&A went quicker than usual. No real news from the affair; Dr. Greenspan tells us that inflation is not a problem, growth is not a problem, there is no systemic risk, the carry trade is reduced, a measured pace of tightening won’t hurt anyone, etc.Very optimistic; I just don’t go for the Panglossian thesis that everything can be fine after holding the fed funds target so low for so long. Bubbles develop when credit is too easy.And as an aside, I’d like to toss out a dissenting question on Microsoft (MSFT:Nasdaq). I know that the software business is not capital intensive, but if Microsoft disgorges a large amount of its cash, doesn’t it imply that they don’t see a lot of profitable opportunities to invest in it? Buying back $30 billion of Microsoft stock is a statement that they see no better opportunities (that the government will allow them to do), than to concentrate on current organic opportunities. It implies that additional organic growth opportunities are limited, no? No positions in stocks mentioned

TSCM quoted me in two articles at the time of the special dividend.? I was ambivalent about the buyback, and Microsoft stock has done nothing since then.

I also wrote this article to talk about the value of excess cash flow to management teams.? My view continues to be that excellent management teams should be given free rein to add value, while poor management teams should pay out excess cash to shareholders.

Also, there is a rule in the reinsurance business: buy back shares when the price-to-book ratio is under 1.3; issue special dividends when the price-to-book is higher, and you have slack capital.? But be careful.? Slack capital can be valuable.? I remember Montpelier’s special dividend before the 2005 hurricanes.? Ill-advised in hindsight.? The stock was a disaster, and is the only time in my career that I have flipped from long to short on a stock, post-Katrina.

Finally, I don’t look for dividends.? It is a factor in my models, but not a big one.? That said, 20 of 36 of the stocks in my portfolio pay dividends, and I receive a 2% yield or so on the portfolio as a whole.? I would rather focus on free cash flow, but dividends follow along behind free cash flow.

Bringing this back to the present, be wary.? High dividend yields, particularly on financial stocks, may be cut.? Analyze the payout ratios on stocks you own.? In general, dividends are good, but analyze the situation to determine the sustainability of the dividend.

Buy Agency Mortgage Bonds

Posted on 18 July 2008 by David Merkel

The above graph shows the difference in yields between a current coupon 30-year FNMA pass-through security, and a 10-year on-the-run FNMA senior note.? It is a good proxy for how much value is available in agency mortgages versus the debt that they issue.? Now, in mid-March, spreads were particularly high, because mortgage REITs and other leveraged holders of agency mortgages were forced to sell because of rising haircuts on repo financing.? Today, the furor is over the solvency of the agencies themselves.

I would not be worried about the creditworthiness of agency mortgages.? The US Government is not going to let the senior liabilities of the agencies be questioned as to creditworthiness.? To do so would incite panic among investors in many financial institutions that own agency debt and agency guaranteed mortgages.

Here is a graph of the Lehman Brothers Swaption Volatility index:

Now, in March, there was panic in the mortgage market, leading to high implied volatilities.? Today, it is more quiet.

I don’t agree with everything El-Erian of PIMCO says, but I think he is right when he believes that the senior portions of capital structures at the agencies will not be harmed.? It sounds high to me, but according to the article, 61% of PIMCO’s Total Return Fund is in mortgage bonds.? I can support an overweight position in agency mortgage bonds, the yields seem attractive at current levels of volatility.

Musing Over Current Performance

Posted on 18 July 2008 by David Merkel

June was a good month for me, but in the middle of June, it felt like something was shifting in the markets, and it was showing up in my portfolio.? Then, July hit me like a ton of bricks.? The market was down, but I was way down.

Now, I have a number of disciplines that help me on average and over time as I manage equity money.? That doesn’t eliminate the “pit in the stomach” when nothing seems to be working.? It does give me something to do about it, though.? Evaluate poor performers (“what, down so much on no news!”), do some rebalancing trades (“ugh, cash is shrinking… will I have to move into concentration mode as I did in 2002?), and search for errors in my macro views (“why do I have so much cyclicality in the portfolio?”).

My performance versus the market as a whole tends to streak.? There are several reasons for that:

The portfolio has a value tilt.
Market capitalizations are smaller than the S&P 500.
I concentrate the industries that I invest in.
I turn over my portfolio more slowly than most investors.

But, as of Wednesday, as the market bounced back, my portfolio did even better.? I’m behind the S&P 500 by less than a percent now.? But this is what puzzles me here: ordinarily, I expect to outperform more in bear markets than in bull markets, but it seems to be flipped here.

I am overweighted in financials — though all of them are insurers, and none in the financial guarantee business.? Given all of the basket and ETF trading that goes on today, maybe my insurance names are getting dragged along with the banks.? In the short run, that can persist, but eventually industry performance emerges in stock prices.? That’s my best explanation for now.

Away from that, I did a rebalancing sale on YRC Worldwide today.? First rebalancing sale in a while.? Trucking is a volatile industry.? Then again, in cyclical industries, it is always a question of value over the cycle.? The stocks move more than the industry prospects do, so if you resist trends with companies strong enough to survive the cycle, you will make money in the long run.

Full disclosure: long YRCW, and many insurers? (full portfolio available at Stockpickr.com)

Free the Frozen Fed!

Posted on 18 July 2008 by David Merkel

I haven’t written about the Fed much recently, largely because little has changed.? The Fed is frozen in its position.? Can’t raise rates because the banking system is on edge (and now the Fed informally cares for the systemic risk created by the investment banks).? Can’t raise rates because labor unemployment is rising.? Can’t lower rates because inflation is moving up.? Can’t lower rates because the dollar will dive.? What a pickle!

This is my monetary aggregates graph over the last year.? Growth of the monetary base is anemic, but that is intentional.? Rather than let the monetary base grow through the purchase of Treasuries, the Fed is using its balance sheet to add liquidity to certain money markets.? When was the last time the Fed did a purchase of Treasuries?? 5/3/07.? I think this is the longest period in the Fed’s history without a purchase of Treasuries, and I have written the Fed to ask, but alas, no answer.? For comparison purposes, there is a tool at the NY Fed website that allow you to look at permanent open market operations after August 25, 2005.? How many purchases of Treasuries during the tightening/flat period from 8/25/05 to 5/3/07?? Fifty-nine.? Fifty-nine during a predominantly tightening period, and not one during a loosening period?

I point this out because the Fed is behaving very differently under Bernanke than any Fed Chair since the Great Depression.? Part of it is the situation in the capital markets.? Leverage got too high among a number of big capital markets players, and the SEC didn’t do diddly.

But under this new arrangement, liquidity goes out to the capital markets through the Fed’s new programs, but not out (at least not directly) to the commercial banking system and the general economy.? The balance sheets of some financial entities get relief, but not much stimulus makes it into the general economy.? What liquidity that is created gets extinguished by the Fed, because they sell/lend Treasuries to fund their lending programs.

Taking a quick spin around the globe, inflation is viewed as a major threat, enough so that the ECB raised its policy rate to 4.25%.?? There may not be a lot more rises, but the likely direction of ECB policy is up not down.

China is having inflows of hot money, and much as the central bank keeps raising deposit requirements, it does little good.? Inflation keeps rising.

It’s an inflationary world, and one of the reasons that the US is not feeling it as bad is that we are the world’s reserve currency.? So long as China and OPEC keep buying US debts, the game can go on, but woe betide us if the music stops.

At present, Fed funds futures indicate a Fed that is frozen.? No more moves in 2008.? Using my “pain model” for the Fed (the Fed acts to minimize its political pain), I would concur.? When you don’t know what will work, doing nothing seems like a great plan.

A great plan for now, that is.? My guess is that the Fed can’t be out of step with the rest of the world for too long, and in 2009, they will begin tightening, even if the economy and the banks are weak.

Recent Portfolio Moves

Posted on 17 July 2008 by David Merkel

Over the last few trading days, I did rebalancing buys of Lincoln National, Gehl, Charlotte Russe, Group 1 Automotive and Anadarko Petroleum.? As the market has declined, so has my cash position, from 18% to 8%.

One reader has asked my opinion on stop loss orders, and I must admit, I have never used one.? I use the “economic sell rule,” which tries to look forward at the value of companies, rather than analyzing past price movements.? I sell when companies no longer offer me a good return on my money versus other investments.? I sell a little in rebalancing trades, because there is value in redeploying fundsafter quick moves up.

Do I take some losses from not having an automatic sell rule when prices fall?? Yes, but it is more than made up for from the gains on companies that I would have sold , but didn’t.

Don’t blindly adopt a sell rule, but use your head, and estimate the future value of the company, rather than agonizing over the paper loss.

Full disclosure: long LNC GEHL CHIC GPI APC

Fifteen Notes on the Current Market Stress

Posted on 16 July 2008 by David Merkel

1) Going back to one of my themes, be wary of companies that sell their best assets to bail out their worst assets.? Tonight’s poster child is GM.? How to get cash?? Borrow against the remainder of GMAC, foreign subsidiaries (most promising part of the corporation), etc.? Not a promising strategy.? As I have said many times before GM common is an eventual zero.? Same for Ford.? All the errors in labor relations over the years, compounded with interest, are coming back to bite, hard.

2) So where does GM cut expense?? White collar retiree medical care.? This is rarely guaranteed, except to unions, so it is legal to cancel it.? A word to those whose corporations or state/municipal employers presently have retiree medical care.? It is worth your while to find out whether there are guarantees of coverage or not.? If there aren’t, I can assure you that it will be terminated in the next ten years.? If there are guarantees, then you need to see whether there are standards of care guaranteed, and whether the plan sponsor has the wherewithal to make good on his promises.

One more prediction: many states and municipalities will devise clever ways to escape guarantees over the next 20 years.? That will include Chapter 9 of the bankruptcy code.

3) Note to the SEC, not that the powers-that-be read me: if you’re going to require a contract to borrow shares in order to short for a bunch of financial companies, then require it for every company, now.? Shorts are not the problem.? Failure to properly locate and borrow shares is a problem.? Let there be a level playing field in shorting, and let the investment banks that are lending out more than they have suffer.? (Ironic, huh, ‘cuz they are the ones complaining…)

4) Note to the new management of AIG: please do the following: a) locate lines of business with low ROAs and significant borrowing for funding in order to achieve high ROEs.? b) Close down those lines.? Possible areas include GIC-MTN programs, and life insurance generally.? c) Take a page out of Greenberg’s early playbook, and exit lines, or sell off divisions where it is impossible to achieve superior ROEs.? (I can see American General re-emerging, with SunAmerica in tow!)

5) File this under Sick Sigma, or Six Stigma — GE is finally getting closer to breaking up the enterprise.? It has always been my opinion that conglomerates don’t work because of diseconomies of scale.? As I wrote at RealMoney:

		David Merkel
		GE — Geriatric Elephant
		4/27/2007 1:16 PM EDT

First, my personal bias. Almost every firm with a market cap greater than $100 billion should be broken up. I don’t care how clever the management team is, the diseconomies of scale become crushing in the megacaps.

Regarding GE in specific, it is likely a better buy here than it was in early 1999, when the stock first breached this price level. That said, it doesn’t own Genworth, the insurance company that it had to jettison in order to keep its undeserved AAA rating. Which company did better since the IPO of Genworth? Genworth did so much better that it is not funny. 87% total return (w/divs reinvested) for GNW vs. 28% for GE. A pity that GE IPO’ed it rather than spinning it off to shareholders…

But here’s a problem with breaking GE up. GE Capital, which still provides a lot of the profits could not be AAA as a standalone entity and have an acceptable ROE. It would be single-A rated, which would push up funding costs enough to cut into profit margins. (Note: GE capital could not be A-/A3 rated, or their commercial paper would no longer be A1/P1 which is a necessary condition for investment grade finance companies to be profitable.)

Would GE do as well without a captive finance arm (GE Capital)? It would take some adjustment, but I would think so. So, would I break up GE by selling off GE Capital? Yes, and I would give GE Capital enough excess capital to allow it to stay AAA, even if it means losing the AAA at the industrial company, and then let the new GE Capital management figure out what to do with all of the excess capital, and at what rating to operate.

Splitting up that way would force the industrial arm to become more efficient with its proportionately larger debt load, and would highlight the next round of breakups, which would have the industrial divisions go their own separate ways.

Position: none, and I have never understood the attraction to GE as a stock

6) One to think about: if US Bancorp is having a bad time of it, shouldn’t most large banks be having a worse time of it?? I spent a little time this evening reviewing the prices of junior debt securities of marginally investment grade banks (and a few mutual insurers, also).? The pressure on marginal financial institutions bearing credit risk is huge.

7) Speaking of junior debt securities, Moody’s gave the GSEs, and the US Government a shot across the bow when it downgraded the preferred stock ratings of Fannie and Freddie.? With the fall in the common and preferred stock prices, any possiblity of private capital raising fades.? The Administration and Congress should realize that whatever flexibility/help they grant the GSEs will be taken, and quickly.? Budget for the worst case scenario.

8) Then again, Ackman’s plan to restructure the GSEs, which is similar to mine (given in the last week), is reasonable.? Leverage is reduced and a market panic is avoided.

9) But even if neither plan is implemented, the dividends may be cut for the GSEs common stocks.? Shades of GM.? What is more significant, is if the GSEs feel they can’t issue preferred stock at acceptable yields, maybe they will omit those dividends as well.

10) Now, in the midst of expensive bailout talk, is there a cost imposed on the US?? Yes.? The dollar is weak, and default swaps on US government debt are rising in yield.? (Thought: how do swaps on US government debt pay off?? Hopefully not in dollars…? Also, what qualifies as an event of default?? Inflation doesn’t count, most likely, and yet that is one of the main ways for a government to try to escape debt.

11) Socialism!? Is the bailout socialism? Even for a libertarian like me, I can justify a bailout like Ackman’s, because it hurts those that tried to profit from the public/private oligopoly.? But no, I can’t justify what Paulson is trying to do, and maybe, just maybe, the market is sending him a message that half-measures won’t work.

12) More on preferred stocks.? They have been crushed.? This reinfirces why I rarely recommend preferred stocks, or junior debt securities: the payoff is low in success, and losses are high when things go wrong.

13) Let me get this straight.? You trusted Wall Street on an implicit guarantee?? You didn’t get a formal guarantee in writing?? Oh, my, it happens every decade… implied promises fail, and the cold, hard, printed text governs.? “Yes, that could technically be called, but don’t worry, they never do that.” “AAA insurance obligations never fail.”? “Portfolio insurance will protect you; you don’t have to buy puts.”? Never trust implicit promises of Wall Street, because in a real crisis, they go away.

14) Looking over some of my indicators, it looks like we are close to a bounce.? It feels a lot like January of 2008.? So, is it time to buy??? I’m not sure, but I am adding little by little to my stockholdings.? I’m probably going to up the equity percentage in some of my accounts where I have few options (old job Rabbi Trusts).

15) Not that I am likely to liquidate 401(k) assets, or anything like it.? That some are doing so is a sign of the stress that we are under.? Don’t do it, if you can avoid it.? Better, perhaps, to take in a boarder.? It increases cash flow on an underused asset, and optimally, increases community relations.

Of Value Investing, Industry Rotation, and Selling

Posted on 15 July 200822 June 2017 by David Merkel

At RealMoney, I wrote two articles called “Become a Smarter Seller.”? Part 1 dealt with price targets, and part 2 dealt with reshaping/rebalancing.? Let me try to summarize the core ideas:

If an investment becomes so expensive that bond yields are more attractive, sell it.
If you find another investment significantly more attractive than a current investment, sell it, and buy the new investment.
Sell into price rises, and buy into price declines, if you can’t find economic reasons not to do it.

In other words, trade what you think will perform less well for what you think will do better over your time horizon.

Part of my philosophy in investing is simplifying investment decisionmaking.? Good corporate bond managers have an intuitive feel for when yield relationships justify a trade.? I have tried to do the same thing with equity investing, looking at when valuation relationships justify a trade.? My process where I add new companies four times a year aids the process, because it forces me to evaluate the whole portfolio versus contenders.

Now, many value investors have been hurt recently because financial stocks have done badly.? Included here are many investors that I admire.? I have not suffered along with them, but I offer no guarantee for the future.? I judged that credit-sensitive financials would be bad investments, and avoided them.? Most value investors have a large chunk of their portfolios dedicated to that area.? There were few ways to avoid the crisis.

As for non-insurance financials, we haven’t worked through the effects of all of the bad lending.??? Even with cheap “sticker prices” I am still reluctant to go there.

In closing, I completed my reshaping today.? I sold Helmerich & Payne and Alliance Data Systems.? I bought CRH plc and Kapstone Paper & Packaging.? I like both industries, and both companies are cheap and well-managed.

This takes me a step away from financials and energy, and into two softer materials related names.? There will be pricing power in each company before long.

Full disclosure: long KPPC CRH SAFT

PS — I have one more trade that I am likely to do in the future — trade Safety Insurance for Flagstone Reinsurance (or a similar name).? What I am waiting for is a greater development of the current hurricane year.? If we get near the end of August, and there are no significant damages, it is time to do the windstorm trade.? Sell SAFT, buy FSR, or something like that.

Watching the Leverage Collapse

Posted on 12 July 200813 July 2008 by David Merkel

Four notes for the evening: first, on Lehman Brothers: Deal Journal wrote a piece earlier this week on Lehman potentially selling their subsidiary Neuberger & Berman.? I generally agreed with the piece, and wrote the following response:

Be wary when managements sell their best/safest assets to stay alive. It means that the remaining firm is more risky, and that should the downturn persist, the firm will be in greater jeopardy.

Firms that sell their troubled assets (really sell them, not park the assets in affiliated companies) can survive the harder times. Trouble is, that requires taking losses, and sometimes the balance sheet is so impaired that that cannot be done.

So, selling the good assets may be a necessity, but it does not imply a good future for Lehman.

The same applies to Merrill regarding their stakes in Blackrock and Bloomberg.? Also, I am skeptical that Lehman was truly able to reduce its risk assets as rapidly as they claimed in the midst of a bad market.? I believe that if the tough credit markets persist into 2009, Lehman will face a forced merger of some sort.? Merrill Lynch has more running room, but even they could face the same fate.

Second, Alt-A lending worked when it was truly using alternative means to screen borrowers to find “A” credits.? It failed when loan underwriting ceased to be done in any prudent way.? Alt-A lending will return, but it is less likely that Indymac will see the light of day again.? Whether in insurance or lending, underwriting is the key to long-term profits.? Foolish lenders/insurers economize on expenses at the cost of losses.

Third, we have a possible deal that the US government may buy a convertible preferred equity stake in Fannie and Freddie.? This comes on the heels of news that no access would be granted to the discount window, but this deal would include discount window access.? (Ugh.? Is it going to take a Dollar crisis to make the Fed realize that only the highest quality assets should be on the balance sheet of the Fed?)

Now, this is not my favored way of doing a bailout, but it probably ruffles fewer political feathers, and many get to keep their cushy jobs for a while longer.? My question is whether $15 billion is enough.? It will certainly dilute the equity of Fannie and Freddie, but is it large enough to handle the losses that will come?

Now, reasonable followers of the US debt markets have shown some worry here, but in the short run, this will calm things down.

As a final note, I would simply like to say to all value investors out there that the key discipline of value investing is not cheapness, but margin of safety.? I write this not to sneer at those who have messed this up, because I have done it as well.? Pity Bill Miller if you will, but neglecting margin of safety and industry selection issues have been his downfall, in my opinion.? (And don’t get me wrong, I want to see Legg Mason prosper — I have too many friends in money management in Baltimore.)

I’m coming up on my next reshaping, and one thing I have focused on is balance sheet quality, and earnings stability.? Many value managers have been hurt from an overallocation to credit-sensitive financials.? They own them because the value indexes have a lot credit-sensitive financials in the indexes, and who wants to make a large bet against them?

Well, I have made that bet.? Maybe I should not have owned as many insurers, but they should be fine in the long run.? There is still more leverage to come out of the system, and owning companies that have made too many risky loans, or companies that need a lot of lending in order to survive are not good bets here.? Look at companies that can survive moderate-to-severe downturns.? If the markets turn, you won’t make as much, but if the markets continue their slump, you won’t get badly hurt.

In Large, Red, Friendly Letters it Reads, “Don’t Panic!” (GSE Edition)

Posted on 11 July 2008 by David Merkel

want to tread a fine line this evening.? I am going to argue that a government takeover of Fannie and Freddie would not be as costly as some imagine — it would likely be more expensive than the S&L bailout, but not in inflation-adjusted terms.? My post is driven by the New York Times article, as cited by Barry Ritholtz, and Yves Smith (as I was drafting this).

The first thing to say is that conservatorship may not happen.? The GSEs have many powerful political friends, and they won’t give up without a fight.? I rate the odds of conservatorship as less than 50/50 in 2008, and the next President/Congress may have a different opinion.

I want to rule out the idea that the Federal Reserve could save the GSEs.? Unlike Bear Stearns, the Fed is too small to materially affect the situation.? Sure, it can buy the senior paper of the GSEs, but that would not be enough to absorb more than 10% of the total senior financing base for the GSEs at maximum.

But suppose conservation of Fannie and Freddie takes place.? What then?

Most mortgages insured by Fannie and Freddie are good quality already.? They financed smaller loans, reasonable down payments, tilted away from the high cost areas that are under the most pressure.? For loans prior to 2006, losses should be small.? Also, Fannie and Freddie have been careful, even with pressure from politicians.

But some loans were done with mortgage insurance because of low down payments, and the mortgage insurers are in bad shape now.? True, and though Fannie and Freddie may not get full payment, they should get 80% payment on the 20% or so of the loan that was insured.? Mortgage insurers are worth something, even if not full value.? My scenario implies 4% losses on a small portion of their mortgage book.

Now the GSEs will continue to receive guarantee fees, and they still have embedded margins from the loans on their balance sheets.? Now, WIlliam Poole says that Freddie is insolvent on a fair value basis, and Fannie might be.? Still, the losses are small compared to the S&L bailout at present.

Thus, I argue that a guarantee of senior obligations of the GSEs would not be horrendously costly.? Let the preferred and common equity be wiped out.? Let the subordinated bondholders sweat.? The losses at the senior level should be small.

The benefits of such a guarantee would be big, though.? Who invests in Fannie and Freddie direct and guaranteed paper? Banks, insurers, stable value funds, foreign investors, and more.? Do we want a “domino effect” that might lead to further financial failures?? I think not.? Arresting the losses at the senior level, and eventually folding Fannie and Freddie into GNMA preserves many other financial institutions.

Two notes on the politics here: the Bush Administration wins, and loses.? Wins, because they end the dominance of the GSEs in a bigger way than they ever could have imagined.? Loses, because they can’t use them to support the mortgage market any more.? Can the FHLB pick up the slack without them?? I doubt it, at least not fully.? The FHA isn’t big enough either.

So, be careful here.? There are too many variables and political angles to make decisions easy.? I think I understand what is most likely here, but I would assume a conservative posture, unless the cost of achieving that posture was too high.? We are close to that “too high” level now.

PS — As a bond manager, aside from mortgage bonds, I rarely bought agency bonds because the spreads were too small to bother with.? I have a rule for avoiding small bond yield spreads; they are too narrow to waste time over, and the present distress illustrates why.? At present a barbell of Treasuries and high yield bonds is more attractive than agencies.

(These are my opinions, and not those of my employer.)