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Archive for August, 2008

Don’t Invest in the Company that You Work for

Friday, August 29th, 2008

My friend Cody put out a piece today on not investing in the company that you work for.  95% of the time, that is correct.  Since this blog is about reduction of risk, I advise all readers not to increase their risk by risking their retirement funds on the the company from which they derive their wages.  That said, here is the other 5%, from a RealMoney CC:


David Merkel
Right On, Roger!
12/12/2006 1:54 PM EST

Roger is dead right when he says to diversify. My broad market strategy has 35 stocks in it. Biggest position is Allstate (boring, huh?) at 5%. Most of the rest are around 2.5%, with about 15% cash.

There have only been two times that my wife has suggested that I do something with respect to our investments. Both were when I let a position grow too big. The first was the St. Paul, when I worked there. The other is my only private equity holding: a company which makes the best commercial lawn mowers in the world (my opinion). She was right both times, in my opinion.

The secret to investing is risk control. Don’t make a move that could knock you out of the game, and over the long run, you can make decent money as you compound your gains.

If I compare my investing to baseball, I would say that I try to hit singles. Playing home run ball leads to too many strikeouts, and the strikeouts hurt more than the home runs help. Not only do you lose money, you lose confidence to stay in the game.

So, play the game with a margin of safety. Diversify broadly, and maybe, just maybe, buy some bonds too, to even out the ride. (I have an article coming on my bond holdings in the next month…)

Position: long ALL

There are exceptions, though, and I will point three of them out.  1) Executives often have to buy company stock; but they are beiong paid to take risk for the good of the shareholders.  2)  Occasionally, when your company is out of favor, and you know it has a strong balance sheet, it may be time to buy.  That’s what I did with the St. Paul back in 2000, and it paid off well.  3) If you understand your business better than anyone else (very rare), and you are in a fast growing industry, the stock of your company can be a good deal if the general market has not discovered it yet, and bid the stock price to high P/E ratios.

Aside from that, do not invest in the stock of your company.  Why put your retirement at risk?

The Fundamentals of Residential Real Estate Market Bottoms

Friday, August 29th, 2008

This article was posted at The Big Picture this morning as I was guest-blogging for Barry.  That’s a first for me, and there is no better site to do it at.  I present the article here for those that did not see it at The Big Picture.

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This piece completes a series that I started RealMoney, and continued at my blog.  For those with access to RealMoney, I did an article called The Fundamentals of Market Tops, where I concluded in early 2004 that we weren’t at a top yet.  For those without access, Barry Ritholtz put a large portion of it at his blog.  I then wrote another piece at RM applying the framework to residential housing in mid-2005, and I came to a different conclusion: yes, residential real estate [RRE] was near its top.  Recently, I posted a piece a number of readers asked me to write: The Fundamentals of Market Bottoms, where I concluded we weren’t yet at a bottom for the equity markets.

This piece completes the series for now, and asks whether we are at the bottom for RRE prices. If not, when, and how much more pain?

Before I start this piece, I have to deal with the issue of why RRE market tops and bottoms are different.  The signals for a bottom are not automatically the inverse of those for a top. Tops and bottoms for RRE are different primarily because of debt investors.  At market tops, typically credit spreads are tight, but they have been tight for several years, while seemingly cheap leverage builds up.  There is a sense of invincibility for the RRE market, and the financing markets reflect that. Bottoms are more jagged, with debt financing expensive to non-existent.

As a friend of mine once said, “To make a stock go to zero, it has to have a significant slug of debt.”  The same is true of RRE and that is what differentiates tops from bottoms.  At tops, no one cares about the level of debt or financing terms.  The rare insolvencies that happen then are often due to fraud.  But at bottoms, the only thing that investors care about is the level of debt or financing terms.

Why Do RRE Defaults Happen?

It costs money to sell a home – around 5-10% of the sales price. In a RRE bear market, those costs fall entirely on the seller. That’s why economic incentives for the owners of RRE decline once their equity on a mark-to-market basis declines below that threshold. They no longer have equity so much as an option on the equity of the home, should they continue to pay on their mortgage and prices rise.

As RRE prices have fallen, a larger percentage of the housing stock has fallen below the 10% equity threshold. Near the peak in October 2005, maybe 5% of all houses were below the threshold. Recently, I estimated that that figure was closer to 12%. It may go as high as 20% by the time we reach bottom.

Defaults occur in RRE when there would be negative equity in a sale, and a negative life event occurs:

  • Unemployment
  • Death
  • Disability
  • Disaster
  • Divorce
  • Large mortgage payment rise from a reset or a recast

The negative life events, which, aside from changes in mortgage payments, can’t be expected, cause the borrower to give up and default. During a RRE bear market, most people in a negative equity on sale position don’t have a lot of extra assets to fall back on, so anything that interrupts the normal flow of income raises the odds of default. So long as there are a large number of homes in a negative equity on sale position, a certain percentage will keep sliding into foreclosure when negative life events hit. For any individual, it is random, but for the US as a whole, a predictable flow of foreclosures occur.

Examining Economic Actors as We near the Bottom

Starting at the bottom of the housing “food chain,” I’m going to consider how various parties act as we get near the RRE price bottom. At the bottom, typically Federal Reserve policy is loose, and the yield curve is very steep. Financial companies, if they are in good shape, can profit from lending against their inexpensive deposit bases.

This presumes that the remaining banks are in good shape, with adequate capacity to lend. That’s not true at present. Regulation has moved into triage mode, where the regulators divide the institutions into healthy, questionable, and dead. The bottom typically is not reached until the number of questionable institutions starts to shrink. Right now that figure is growing for banks, thrifts, and credit unions.

The Fed’s monetary policy can only stimulate the healthy institutions. Over time, many of the questionable will slow growth, and build up enough free assets to write off bad debts. Those free assets will come through capital raises and modest profitability. Others will fail, and their assets will be taken over by stronger institutions, and losses realized by the FDIC, etc. The FDIC, and other insurance funds, will have their own balancing act, as they will need to raise premiums, but not so much that it harms borderline institutions.

Another tricky issue is the Treasury-Eurodollar [TED] Spread. Near the bottom, there should be significant uncertainty about the banking system, and the willingness of banks to lend to each other. Spreads on corporate and trust preferreds should be relatively high as well. Past the bottom, all of these spreads should be rallying for surviving institutions.

Financing for purchasing a house in a RRE bear market is expensive to nonexistent, but the underwriting is strong. At the bottom, volumes increase as enough buyers have built up sufficient earning power and savings to put a decent amount down, and be able to comfortably finance the balance at the new reduced housing prices, even with relatively high mortgage rates relative to where the government borrows.

Many other players in RRE financing will find themselves stretched, and some will be broken. Consider these players:

1) Home equity lenders will be greatly reduced, and won’t return in size until well after the bottom is passed.

2) Many unregulated and liberally regulated lenders are out of business. The virtue of a strong balance sheet and a deposit franchise speaks for itself.

3) Buyers of subordinated RMBS have been destroyed; same for many leveraged players in “high quality” paper. Don’t even mention subprime; that game is over, and may even be turning up now as vultures pick through the rubble. This has implications for MBIA, Ambac, and other financial guarantors, since they guaranteed similar business. How big will their losses be?

4) Mortgage insurers are impaired. In earlier RRE bear markets, that meant earnings went negative for a while. In this case, one has failed, and some more might fail as well.

5) Do the GSEs continue to exist in their present form? That question never came up in prior bear markets, but it will have to be answered before the bottom comes. Will the FHLB take losses from their mortgage holdings? Will it be severe enough that it affects their creditworthiness? I doubt it, but anything is possible in this down cycle, and the FHLBs have absorbed a lot of RRE mortgage financing.

6) Securitization gets done limitedly, if at all. This is already true for non-GSE-insured loans; the question is how much Fannie and Freddie will do. My suspicion is near the bottom, as loan volumes increase, banks will be looking for ways to move mortgages off of their balance sheets, and securitization should increase.

7) The losses have to go somewhere, which brings up one more player, the US Government. Through the institutions the US sponsors, and through whatever mélange of programs the US uses to directly bail out financially broken individuals and institutions, a lot of the pain will get directed back to taxpayers, and, those who lend to the US government in its own currency. It is possible that foreign lenders to the US may rebel at some point, but if the OPEC nations in the Middle East or China haven’t blinked by now, I’m not sure what level of current account deficit would make them change their policy.

That said, the recent housing bill wasn’t that amazing. Look for the US Government to try again after the election.

A Few More Economic Actors to Consider

Now let’s consider the likely actions of parties that are closer to the building and buying of houses.

1) Toward the bottom, or shortly after that, we should see an increase in speculative buying from investors. These will be smarter speculators than the ones buying in 2005; they will not only not rely on capital gains in order to survive, but they require a risk premium. Renting the property will have to generate a very attractive return in order to get to buy the properties.

2) Renters will be doing the same math and will begin buying in volume when they can finance it prudently, and save money over renting.

3) At the bottom, only the best realtors are left. It’s no longer a seemingly “easy money” profession.

4) At the bottom, only the best builders survive, and typically they trade for 50-125% of their written-down book value. Leverage declines significantly. Land gets written down. JVs get rationalized. Fewer homes get built, so that inventories of unsold homes finally decline.

As for current homeowners, the mortgage resets and recasts have to be past the peak at the bottom, with the end in sight. (In my piece on real estate market tops, I suggested that after the bubble popped “Short rates would have to rally significantly to bail these borrowers out. We would need the fed funds target at around 2%.” Well, we are there, but I didn’t expect the TED spread to be so high.)

5) Defaults begin burning out, because the number of the number of properties in a negative equity on sale position begins to decline.

6) Places that had the biggest booms have the biggest busts, even if open property is scarce. Remember, a piece of land is not priceless, but is only worth the subjective present value of future services that can be derived from the land to the marginal buyer. When the marginal buyers are nonexistent, and lenders are skittish, prices can fall a long way, even in supply-constrained markets.

For a parallel, consider pricing in the art market. Many pieces of art are priceless, but the market as a whole tends to follow the liquidity of the rich marginal art buyer. When liquidity is scarce, prices tend to fall, though it is often masked by a lack of trading in an illiquid market.

When financing expands dramatically in any sector, there is a tendency for the assets being financed to appreciate in value in the short run. This was true of the Nasdaq in the late ’90s, commercial real estate in the mid-to-late 1980s, lesser-developed-country lending in the late ’70s, etc. Financing injects liquidity, and liquidity creates confidence in the short run, which can become self-reinforcing, until the cash flows can’t support the assets in question, and then the markets become self-reinforcing on the downside, as buying power collapses.

The Bottom Is Coming, But I Wouldn’t Get Too Happy Yet

There are reasons to think that we are at or near the bottom now:

But I don’t think we are there yet, and here is why:

My best guess is that we are two years away from a bottom in RRE prices, and that prices will have to fall around 10-20% from here in order to restore more normal price levels versus rents, incomes, long term price trends, etc. Hey, it could be worse, Fitch is projecting a 25% decline.

Not all of the indicators that I put forth have to appear for there to be a market bottom. A preponderance of them appearing would make me consider the possibility, and that is not the case now.

Some of my indicators are vague and require subjective judgment. But they’re better than nothing, and keep me in the game today. Avoiding the banks, homebuilders, and many related companies has helped my performance over the last three years. I hope that I — and you — can do well once the bottom nears. There will be bargains to be had in housing-related and financial stocks.

Full disclosure: no positions in companies mentioned

Accounting for Quality: the Quality of Accounting

Friday, August 29th, 2008

Accounting is esoteric.  :(  I say this as one who has never taken an accounting course in his life, but has written papers on accounting standards, and has had to implement them in the life insurance industry, which is possibly the industry with the most complex accounting of any industry.  (Okay, if we did the investment banks properly, they would be more complex.)

My post is prompted by Barry’s post.  I have known for a while, and commented here that the SEC is planning on abandoning GAAP for IFRS.  Why are they suggesting this?

  • IFRS is not that much different from GAAP.
  • They want to have every company in the developed world on a similar accounting basis, even if the basis is slightly worse than the existing standards.
  • Then perhaps, foreign companies will once again list their equities in the US.

You can get the same information in different ways from:

The latter two links do not directly address the issue, but they write intelligently about accounting.

This download is big, but it summarizes the differences between FAS and IFRS (in 77 pages).

My short take is this:

  • IFRS is a more liberal accounting standard.  Not by a lot, but significantly.
  • There will be a ton of retraining for accountants in the US, and financial analysts (ouch).
  • Earnings will rise, but P/E multiples will fall.  The intial net effect should be small.
  • Value investors will fare relatively better, as they spend more time on the balance sheet, income statement, and other earnings quality issues.
  • Exchanges in the US might get more foreign listings, if Sarbox were repealed.  Moving to IFRS is not enough.
  • If I were on the SEC, I would not care about global comparability, I would stick with GAAP, and stand alone if necessary, among the nations of the world.  Why move to a less informative, and more rubbery standard?  I don’t see a good reason.

IFRS is more flexible, which means that companies under it are less comparable.  I don’t see the advantage in our moving away from GAAP, which has its problems, but less than IFRS.  When I get the web address to post complaints, I will post it here, and I will be writing the SEC to stop this foolishness.

An Issue Where No One Wins

Thursday, August 28th, 2008

This is not a political blog.  That’s not to say that I don’t have opinions on politics, but I try to keep them off my blog for the most part.  But, as Bloomberg notes, why aren’t any of the major candidates talking about the credit crisis?  There’s a simple answer: no one has a solution to an intractable problem, and so they say nothing.

Part of this is the Faustian bargain that politicians of both parties have regarding the economy.  They like to provide the illusion that their policies produce prosperity, and take credit for it, while being quiet when the economy is poor, unless they can blame it on the other party.

Personally, if I were Obama or McCain, I would be concerned about what I would do about the problem if I were elected.  Wait, I would tell people there’s not a lot that can be done aside from increasing immigration on a controlled basis.  But that doesn’t get votes in the US, because we are biased toward action, even if it is useless or harmful.

Investing and Demographics, Redux

Wednesday, August 27th, 2008

My post last night attracted a number of intelligent comments.  I want to expand on what I said.

1) The Baby Boomers are different that other US generations.  They are less provident, willing to sacrifice the future for the present.  Not only do they save less, but they raid existing savings to fund current needs.  They are also more prone to investment scams.  When will Boomers realize that the amount that they can expect from investments with safety is not much higher than what long Treasuries yield?

2) My comment from last night, “The US is bad off demographically, but most of the rest of the world is worse off.  The US has a problem because it has not been saving, but that is largely because much of the rest of the world is neo-mercantilist, and is subsidizing export industries, and the US buys.” needs more explanation.

  • The US has its birth rate at replacement rate, which is unique among developed nations, and is largely due to the influence of Mormons, Muslims, Orthodox Jews, Evangelicals, recent immigrants (legal or not), and homeschoolers.  (Personal observation: even non-religious homeschoolers tend to have more kids on average.)
  • The rest of the world is worse off — China’s demographic problem is huge, but at least they save to compensate for it.  Europe is not quite as bad off, but nothing kills fertility quite so well as peace, moderate prosperity (meaning well-off with two working, not one working) and a decline in religious faith.

3) From a reader:

Can you please reconcile these two seemingly conflicting statements:

“[Boomers] will need to labor longer, and they should do so” and “To the extent that this causes labor shortages, the US will see greater employment prospects for its people”

Sorry that I wrote it that way.  There will be a balancing act that occurs in the economy around 2025 — wealthy Boomers retire, poor Boomers continue work.  The relative size of each cohort will determine what the effect is on the economy as a whole.  Beyond that, there is a third factor, immigration.  The US is more friendly than most places to legal and illegal immigration.  That helps solve our demographic problems, but it insures that my children learn Spanish.  If wages rise too much, immigration (and offshoring) will rise as well.  (It is akin to wealthy retired Boomers saying to their children, “You don’t have to care for us, we’ve found people who will do it more cheaply.”

4) Another reader comment:

Jeremy Siegel (Stocks for the Long Run) offers a pretty thorough and generally optimistic take on the Baby Boomer retirement issue in his latest book “The Future for Investors.” At the risk of oversimplifying a complex analysis, Siegel’s bottom line is that while there are not enough younger generation Americans to absorb the Boomers stock and bond assets at current prices, investors in emerging countries, like China and India, will more than make up for that and will end up buying the Baby Boomer’s paper assets as the Boomers sell them off to fund their retirements. The upshot is that foreigners will end up owning a lot of our companies by the year 2050. A potential snag, says Siegel, is whether America will be willing to let this happen, or will pass laws or adopt polices to discourage the transfer of US assets to foreign countries. This remains to be seen, but he is optimistic. On the other hand, the implications for the typical Baby Boomer’s most important asset, his or her house, is rather dire, because homes can’t be sold as readily  to foreigners, for obvious reasons. Siegel doesn’t provide an answer for the housing market, which is outside the scope of a book on stock investing in any event.

There is the political question around how much US corporations we would allow to be owned by foreigners.  I don’t know where the breaking point is there, but the answer will have an impact on the value of the US dollar.  As for homes, if we slow down the growth of the housing stock, and condemn more of the existing housing stock, we will eventually solve the excess housing problem.  As it is now, we have foreigners speculating on the value of residential US real estate.

5) One final note that I omitted last night.  Medicare is the big issue here, and we will begin to feel it over the next five years.  At least one election in the next decade will have Medicare as its top issue.  The Social Security problem is one-quarter the size of the Medicare problem.  No wonder Bush, Jr. did not try to deal with Medicare, but made the problem worse by adding the drug benefit.

6) I don’t see the emerging markets getting rich enough, fast enough, to do the wealth exchange necessary for the developed world on favorable terms for the developed world.

That’s all for now.  More comments, send them on.

Blog News and Recent Portfolio Moves

Tuesday, August 26th, 2008

Three notes on the blog itself.  1) I will be guest-blogging for one post at another site on Thursday.  Won’t say where, but watch for “The Fundamentals of Real Estate Market Bottoms.”  It will be reposted here Thursday evening.  2) I can’t paste certain bits of code in my blog because of a WordPress limitation introduced in version 2.5.  As of now, that won’t be remedied until version 2.9, which as far as I can tell, is a huge update, and is at least half a year off.  3) I have not left RealMoney, though I have not posted there in a while.  I started this blog so that I would have a site with my own distinct voice, and so that I could have greater creative freedom to write about things dearer to me that I felt would not fit the RM audience.  Also, I felt that I had run out of articles to write, simply because I held myself to a higher standard, and didn’t want to write articles just for the sake of putting something into print.  RM readers deserve better.  I will come back to posting at RM, I just don’t know when, amid my current busy-ness.

I last mentioned portfolio moves a little more than a month ago.  Here are my moves since then:

Rebalancing Buys:

  • Ensco International
  • Nam Tai Electronics
  • Cemex
  • Assurant
  • Industrias Bachoco
  • Charlotte Russe
  • Valero
  • Cimarex

Rebalancing Sells:

  • Universal American
  • OfficeMax
  • International Rectifier
  • Jones Apparel
  • Smithfield Foods
  • Group 1 Automotive
  • Shoe Carnival

For a six-week period, that ‘s a decent number of trades, at least for me.  My methods are designed to try to not trade frequently, but to trade to minimize risk and maximize return in a majority of situations.  For those not familiar with my rebalancing trades, I keep a fixed set of target weights in a largely equally-weighted portfolio.  When a security gets more than 20% away from its target weight, I buy (after review) to bring it back to target weight, or sell to bring it back to target weight (take some money off the table).

There have been three other actions during this time. 1) National Atlantic’s merger went through.  A loss for me, but I ain’t missing them at all.  2) After the buyback announcement, I traded my holdings in Anadarko for holdings in Devon Energy.  I like the valuation, and the Natural Gas exposure better at Devon.  3) I tendered all my MetLife shares for shares in RGA.  I like RGA a lot here and am willing to make it a double-weight in my portfolio. In the current tender offer, I should get approximately 10% more value in RGA shares for my MetLife shares, subject to a number of conditions listed in the prospectus.  Also, RGA is a unique company that makes its profit mainly from mortality, which is not correlated with other financials.  It is a well-run company, and deserves to be valued at a significant premium to book value.

Full disclosure: long RGA MET DVN SCVL GPI SFD JNY IRF OMX UAM XEC VLO CHIC AIZ IBA CX NTE ESV

Investing and Demographics

Tuesday, August 26th, 2008

I read your blog frequently, and I always find it very insightful and realistic, and without invective, which is refreshing. I’d like to pose a question to you, to which you can probably provide a good answer.

Given the current pessimistic mood of the U.S. economy and financial markets, I’ve been trying to figure out where the light at the end of the tunnel will be for U.S markets. But I get stuck at this point: Baby Boomers retiring. Their portfolios are the ones that have grown over the past 30+ years, and they will soon be drawing upon those savings as a source of income at a steady rate, and one that allows them to live at similar quality of life as when they retired. I have read plenty (I think) on the current state of Social Security, but I’ve seen nothing on the private pillar of retirement.

This future, steady drawdown must have some effect on U.S. equity markets, correct? Enough to keep markets moving sideways? Downwards for the long-term?

As an early 30-something who has been financially responsible (no consumer debt, no mortgage, high savings rate), I’m trying to figure out what might happen to my savings long-term, and how heavily a portfolio should be weighted with U.S. securities.

Could you possibly point me in the right direction where I can find some literature or statistics on how Boomer’s retirements will affect U.S. markets?

So went a recent question from one of my readers.  I’ve been studying this topic for 20 years, and writing about it for 15 years.  The questions are difficult, and the answers are not clear.  Let me point you to one thing that I have written on the topic: Society of Actuaries Presentation.

The US is bad off demographically, but most of the rest of the world is worse off.  The US has a problem because it has not been saving, but that is largely because much of the rest of the world is neo-mercantilist, and is subsidizing export industries, and the US buys.

Remember the lesson of the mercantilist era: the consumers won.  Those that tried to get gold got gold, and at a high cost in terms of other goods.  In the same way, the neo-mercantilistic nations are sucking in dollars that are worth less and less.  On page 32 of my presentation, it is amazing that the net debt position of the US has been flat, because our debts are worth less dur to the decline of the dollar.  What a boon it is to be the world’s reserve currency.

Now, as for the “retirement” of the Baby Boomers: there will be some stagnation in our equity markets to the degree that retirement causes liquidation of assets.  That said due to low savings rates, it is quite possible that retirement dates will be extended for most Baby Boomers.  They will need to labor longer, and they should do so, after all, at age 65 the average retiree is not within ten years of death.

To the extent that this causes labor shortages, the US will see greater employment prospects for its people.  In Japan that seems to be happening now.  But America welcomes immigrants (legal or illegal) in a greater way than most countries do.  That will mute any gains for unskilled labor in the US.

My advice for you is to look at global demand.  Rather than looking at investing with countries as a first screen, consider it through the lens of industries.  Look to which industries are benefiting from increased global demand, and if they are at reasonable valuations, buy them.

I know this is not a full answer, but it is the best medium-to-short answer that I can give you.

The Answer, My Friend, Is Blowing In The Wind…

Monday, August 25th, 2008

Gusty Hurricane Gustav

That said, my question is: do I buy the property reinsurers here?  My initial guess is yes, because it has been a weak hurricane season so far, and the beginning and end of the seasons tend to be correlated.  But, it is too early to take action.  What I am more likely to do is wait until my next reshaping at the end of September, and make some shifts then.  Perhaps Gustav and some other hurricanes will prove my thesis wrong by then.

So, how are valuations for the reinsurers?  Cheap, but pricing is weak, because capital is plentiful.

Source: Yahoo Finance, Bloomberg

Source: Yahoo Finance, Bloomberg

If I were looking to move tomorrow, I would consider IPC, Flagstone, and Validus among the “pure play” property reinsurers. Among the diversified players, I would consider PartnerRe, Endurance, Allied World, and Aspen. Note that the book value of PartnerRe is understated because they don’t discount their loss reserves. For conservative players, PartnerRe is compelling because of their strong balance sheet, very diversified book of business, and strong management. PartnerRe, Endurance, Flagstone, IPC and Allied World score some extra points in my book because of their conservative cultures.

I’m not doing this trade tomorrow, but with good weather, and continued pessimism over financials, this trade could look very good near the end of September.

Full disclosure: no positions

In Defense of the Rating Agencies — III

Saturday, August 23rd, 2008

After writing parts one and two of what I thought would not be a series, I have another part to write.  It started with this piece from FT Alphaville, which made the point that I have made, markets may not need the ratings, but regulators do.  (That said, small investors are often, but not always, better of with the summary advice that bond rates give.  Institutional investors do more complete due diligence.)  The piece suggests that CDS spreads are better and more rapid indicators of change in credit quality than bond ratings.  Another opinion piece at the FT suggests that regulators should not use ratings from rating agencies, but does not suggest a replacement idea, aside from some weak market-based concepts.

Market based measures of creditworthiness are more rapid, no doubt.  Markets are faster than any qualitative analysis process.  But regulators need methods to control the amount of risk that regulated financial entities take.  They can do it in three ways:

  1. Let the companies tell you how much risk they think they are taking.
  2. Let market movements tell you how much risk they are taking.
  3. Let the rating agencies tell you how much risk they are taking.
  4. Create your own internal rating agency to determine how much risk they are taking.

The first option is ridiculous.  There is too much self-interest on the part of financial companies to under-report the amount of risk they are taking.  The fourth option underestimates what it costs to rate credit risk.  The NAIC SVO tried to be a rating agency, and failed because the job was too big for how it was funded.

Option two sounds plausible, but it is unstable, and subject to gaming.  Any risk-based capital system that uses short-term price, yield, or yield spread movements, will make the management of portfolios less stable.  As prices rise, capital requirements will fall, and perhaps companies will then buy more, exacerbating the rise.  As prices fall, capital requirements will rise, and perhaps companies will then sell more, exacerbating the fall.

Market-based systems are not fit for use by regulators, because ratings are supposed to be like fundamental investors, and think through the intermediate-term.  Ratings should not be like stock prices — up-down-down-up.  A market based approach to ratings is akin to having momentum investors dictating regulatory policy.

Have the rating agencies made mistakes?  Yes. Big ones.  But ratings are opinions, and smart investors regard them as such.  Regulators should be more careful, and not allow investment in new asset classes, until the asset class has matured, and its prospects are more clearly known.

With that, I lay the blame at the door of the regulators.  You could have barred investment in novel asset classes but you didn’t.  The rating agencies did their best, and made mistakes partially driven by their need for more revenue, but you relied on them, when you could have barred investment in new areas.

In summary, I still don’t see a proposal that meets my five realities:

  • There is no way to get investors to pay full freight for the sum total of what the ratings agencies do.
  • Regulators need the ratings agencies, or they would need to create an internal ratings agency themselves.  The NAIC SVO is an example of the latter, and proves why the regulators need the ratings agencies.  The NAIC SVO was never very good, and almost anyone that worked with them learned that very quickly.
  • New securities are always being created, and someone has to try to put them on a level playing field for creditworthiness purposes.
  • Somewhere in the financial system there has to be room for parties that offer opinions who don’t have to worry about being sued if their opinions are wrong.
  • Ratings can be short-term, or long-term, but not both.  The worst of all worlds is when the ratings agencies shift time horizons.

And because of that, I think that solutions to the rating agency problems will fail.

Clipping Coins, With No Added Inflation

Saturday, August 23rd, 2008

On Saturday, the Wall Street Journal had an article called Food Makers Scrimp on Ingredients In an Effort to Fatten Their Profits. Good article, but I’m here to draw a different conclusion than the article did.  How much impact does substituting cheaper ingredients in prepared food have on the CPI if the product price does not change?  No effect, but you are likely getting a lower quality good.

I don’t have troubles with the theory behind hedonic adjustment.  I have troubles with how it works in practice, and I wonder whether it can be done properly at all, as I wrote in my RM article Solid Foundation for Inflation Fears.

One requirement for doing hedonic adjustment right, is that both the new and old goods must be offered side-by-side for a while, and that people can clearly tell the differences between the old and new goods.  At that point, the economist can take the prices paid and quantities bought of both goods, and make a hedonic adjustment.

But typically, that doesn’t happen.  The old product disappears when the new product appears, and when features are upgraded, companies loudly announce the enhancements (and in a soft voice, the higher price).  When features/ingredients are downgraded, the companies say little to nothing.

But mere technical measurement of quality changes does not capture the perceived quality difference to the consumer.  Consider a soft drink company that changes its bottle size from 16 to 20 ounces (25% bigger), while raising the price 33%.  The consumers may say in their heads, “I only buy one bottle per day, and I don’t need the extra four ounces, but I have to buy one bottle of my favorite soda; I can’t buy 80% of a bottle, and this is it.”  The consumers aren’t 6.7% worse off in this example; the inflationary effect should be higher.

Same thing for computers.  Any comparison of features will overstate the perceived improvement, because for most needs of companies and individuals, computers run about the same — marginally improved hardware, and software that eats up a lot of resources, leading to little extra benefit.

With a little sympathy toward those who calculate the CPI, I will say that I think their job is tough.  Capitalist economies are diverse and dynamic.  They sample a smallish portion of what goes on, often on a static basket of goods that is infrequently updated, and try to generalize to the large, diverse, dynamic economy that we live in.  It is tough, and I know they have to do it for a wide number of reasons.  They use shortcuts.  They have to, in order to get their jobs done.  But those shortcuts bias the calculation of the CPI downward.

My advice would be this: aside from products where quality differences can be plainly figured (both goods trading side-by-side, with differences clearly identified), drop the hedonic adjustments.  This is one of the reasons why US inflation is so much lower than much of the rest of the world, and the government should be more honest about the value of our currency.

In closing, as an aside, can you imagine a question given at the Presidential debates that went something like this: “Senator, the leading bond manager of our country, and many leading financial writers (e.g. James Grant, Barry Ritholtz) have argued that the way that the government calculates the CPI is flawed, and understates the change in the cost of living.  If elected President, what would you do about this?  Further, how would it affect who you appoint to the FOMC?”

That one would probably even make Obama pause.  McCain? I like the guy, but I don’t know what he would say.  What it would point out, is how little scrutiny is really given to a core statistic that affects our lives in many ways, because it affect indexed payments, and helps define how fast the economy is really growing.  If I am correct in my assertion in the degree of understatement of the CPI, then we have been in recession for some time already.

And, for me, though I am doing well, all my friends are less well off than me.  From what I can gauge, I don’t see many whose standard of living is rising now.  So it goes.

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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