21 February 2009 – The Aleph Blog

My, but the Left Tail is Large

Posted on 21 February 200922 February 2009 by David Merkel

Credit bets are asymmetric.? Leveraged bets more so.? A bondholder can lose all of his investment, and can optimistically receive principal and interest.? A leveraged bond investor can lose it all with greater probability and perhaps faster, but at least has the chance of making equity-like returns in the right credit environment.

Thus for Highland Capital Management the recent comeuppance with a recovery of zero is particularly severe.? I don’t care what you did in the past, but if you didn’t pay some income out, then losing it all drives total returns to -100%.? It doesn’t matter if you were once deemed brilliant:

As recently as October 2007, Barron?s magazine ranked Highland CDO Opportunity third among the top 50 hedge funds, with an average annual return of 44.12 percent during the three-year period ended that June. Its fortunes reversed last year, as the securities it invests in, known as collateralized debt obligations, plunged in value amid the credit crunch and downgrades by ratings firms.

When reviewing alternative investments, it is very important to understand the underlying drivers of performance.? With corporate debt instruments, it is the corporate credit cycle.? With corporate credit, it is normal to see 3-5 years of moderate favorable performance, followed by 1-3 years of horrendous performance.? Secondarily, it is choosing the debt of companies offering high yields relative to their likelihood of default.

Understand the cycle, and see if performance isn’t due to the cycle, rather than true skill.? With Highland, it seems that the cycle delivered, and then took it all away with high leverage.

When is a Financial Company Insolvent?

Posted on 21 February 2009 by David Merkel

Every now and then, I see a stupid post saying that a financial company is solvent if it is still making timely payments on its liabilities.? That is the Ponzi definition of solvency.? So long as there is an unclaimed dollar in the till, the financial institution is solvent.

To this I say “hooey.”? Financial institutions don’t have all that much to them.? They are just a bundle of promises.? “Parties I have lent to will pay me more than parties I have borrowed from.”? They are a bundle of longer-dated accruals.? The value of assets and liabilities can’t be firmly fixed in the same way that those of an industrial company can.? In that same sense, the current value of assets versus liabilities in a financial firm correlates highly with the trading value of its equity.

So when a financial company has a negative net worth on a fair market value basis, the odds of the common stock being wiped out is high.? Could the market come back?? Yes, but the odds are less than even.

This is my way of saying that regulators should take control of operating financial companies when the fair value of their net worth goes negative.? Like a good technical trader, honor the stop-loss.

Securitization Certificateholders Revealed

Posted on 21 February 2009 by David Merkel

In my continuing series on ideas to help resolve the crisis, here is an easy one: let Congress require that the servicer of every securitization disclose all of the parties that have an economic interest in the securitization trust.

Why would this be valuable?? Suppose some investor or government agency felt that the underlyng loans were worth more than what the certificates were valued at in the secondary markets.? The investor could then contact and bid for the certificates in an effort to gain the economic value of the assets in the trust cheaply.

This action would provide transparency in the markets, and would enable price discovery to take place.? What could be simpler?

What’s that, you say?? Many owners don’t want to be marked to market?? Shame on them.? Be big boys, and eat your spinach; after all, you want to survive this crisis, don’t you, that is, assuming that on a fair market basis, you are truly alive?