Month: April 2009

Two Boxes. Sixty Pounds. Tiny Type. What Are We? (The Answer)

Two Boxes. Sixty Pounds. Tiny Type. What Are We? (The Answer)

Posted on by David Merkel

I’m going to complete this article the way the first article began, incorporating the full text, and then interact with my friends, the boxes.

-==–==–=-==–==-=-=-=–=-==–==–==-=–=-==-=-

Box 1: Uh, pardon for the interruption, but we?re going to blog for David while he works on a research piece for Finacorp.

Box 2: Tireless, isn?t he?

1: I wouldn?t know, and neither would you.? We?ve only been here 14 hours.

2: True.? The UPS guy was a hoot when he brought the boxes: ?These are heavy, what are they??

1: Yes, but David had no idea what was going on either.? The expression on his face was priceless as he said, ?Uh, not sure.?? Then he took me inside.

2: And then walked out to get me, and he put me on top of you.? Then he scanned the writing on me, and seemed not to find much? then he roared with laughter.

1: Yeh, I heard him say to his wife, ?I NEVER thought they would send it.?

2: His wife gave him the usual polite expression of ?That?s nice dear,? as she went back to homeschooling one of the kids.

1: Precious, huh?? 22 years of marriage is comfortable like an old shoe.

2: Well, he opened me, and looked at some of the documents inside.? He even commented to one of his kids on the two colors on the documents inside me ? blue and yellow.? Perhaps we?re from Sweden, or maybe Ikea.

1: Hmph.? Well, the sender was once worth a lot more than that pipsqueak Ikea, but sadly, is worth a lot less now.

2: Is the sender worth less than ABBA?

1: At this point yes to that as well.

2: Too sad.? Hey, when David opened one of the documents in me, he commented, ?Hey, I know that guy.?? Then as he looked further, he commented on some financial data with words I can?t even remember now.? Very obscure.

1: He seems to be able to understand what is in us.

2: Yes, but there is a lot here.? I thought I heard him say, ?They could have put this on a DVD, couldn?t they??

1: I can?t answer that.? I?m related to a bunch of dead trees, and so are you.

2: I resemble that remark.? Wait, resent.? Hey, I am not paper, I am information!

1: You wish.? In all of our bulkiness, finding the important stuff is like finding a needle in a haystack.

2: Maybe David can do it?? He did comment that there was a story here after looking at one document.

1: Maybe.? A company created us, a statute created us, a phone call to investor relations created us.? I have no idea how talented David is, but I am rooting for him.

2: Me too.? Now to all our readers, we have given you enough clues that you might be able to identify the sender, and guess what we are.? What are we? ;)

The Boxes
The Boxes

David: Time for me to take over this discussion.

1: Go ahead.

2: You’re the boss.

D: I’m not the boss. It all started when my boss asked me about some AIG bonds, and I told him that a true analysis would be impossible without looking at the regulatory (statutory) books.? He told me to do my best without it, and give my best estimate, so I did.? But then, on a whim, I decided to call AIG Investor Relations, and ask for the statutory books for every US-domiciled insurance subsidiary of AIG.

1: Bold!

2: Wow!

D: Uh, I’m not sure, but you never get anything unless you try.? I put my odds at lower than 25%.? That said, after two days the AIG IR rep found the right person, who called me back and said that maybe I would get the documents.? I wasn’t holding my breath, though, because I had done the same thing at other insurers on a much smaller scale.? It’s expensive.

2: I knew we were important!

1: How expensive?

D: Well, they sent me around 60 books altogether, and preparation and printing take some doing — the shipping isn’t cheap either.? I estimate it cost $2000 for the whole thing.? I was shocked when I received it.? (For readers, as you look at the picture above, the yellow books on the left are P&C subsidiaries that were too small to deal with.? On top of them are variable account statements for life companies — little solvency risk there, so also ignored.? Hidden behind the blue and green upright books are the blue books for the life subsidiaries.? I have taken data from all of them.? The yellow books immediately next to me were bigger P&C insurers from which I took data.)

1: So, what are you going to do now?

2: Aside from pose with us?

D: I have excerpted data from around 45 subsidiaries, with 20+ pieces of data from each.? My 48-year old eyes felt the strain as I did so.? After I did that, I realized that I left out a two critical variables, and so I am going back to get that data.? After I do that, I will publish a research piece for my employer, and two days later I will post it here.? There are several issues:

  • Continuing profitability
  • The bailout
  • Realized and unrealized capital losses (including the infamous securities lending program)
  • Reinsurance
  • Capital Stacking
  • Dodgy assets
  • Is this strictly an investment problem?
I’m not done with my analysis yet, but there is a good story to tell here.? Were all of the problems with AIG Financial Products, or were they more evenly distributed across the company?? My current guess is the latter, but I am really not sure yet.
Gentleboxes, some praise for the good guesses have received?
2: Second place goes to Anonymous
  1. April 3rd, 20091:57 pm at EditI know!! It?s David?s HR file from when he worked at AIG. :)
1: First place goes to rskbway
  1. April 4th, 20093:31 pm at EditRequested Freedom of Information Act documents on AIG, for sure, and perhaps Fannie and Freddie as well.
D: Well done both of you.? You caught the AIG strand in what the boxes were saying.? What firm would I know people in that could deliver a ton of data to me?? AIG.
Boxes?? Any final comments?

1: I am happy for your efforts, but I feel empty.

2: Me too.

D: Well, you are empty now, so there is some reality therapy for you.? As for me, I have more research to do.? I hope to publish my work on Thursday, and publish at my blog late on Saturday.? Until then.

1,2: Bye!!
Not All Bubbles Lead to Depressions

Not All Bubbles Lead to Depressions

Posted on by David Merkel

I enjoyed the opinion piece in yesterday’s WSJ, From Bubble to Depression? I want to clear up a few of their misconceptions.? Key quote:

Earlier, during the downturn in the equities market between December 1999 and September 2002, approximately $10 trillion of equity was erased. But a measure of financial system performance, the Keefe, Bruyette, & Woods BKX index of financial firms, fell less than 6% during that period. In the current downturn, the value of residential real estate has fallen by approximately $3 trillion, but the BKX index has now fallen 75% from its peak of January 2007. The financial sector has been devastated in this crisis, whereas it was almost completely unaffected by the downturn in the equities market early in this decade.

How can one crash that wipes out $10 trillion in assets cause no damage to the financial system and another that causes $3 trillion in losses devastate the financial system?

They almost get it in their later paragraphs, but the answer is simple.? In the first “crash,” the losses were mainly equity-based, so there were no knock-on effects on other entities.? No additional dominoes fell.? With housing in the late 2000s, a loss of $3 billion happened on assets that were usually levered with debt at 5x to 30x, probably averaging 10x.? And, these mortgages were held by leveraged banks that had borrowed in many other places in the overall financial system, and sometimes by even more leveraged speculators using CDOs.

Let me say it again — Bubbles are financing phenomena; depressions are financing phenomena.? They are opposite sides of the same coin.? The severity of bubbles differs with the amount of debt employed and the pervasiveness of the sectors of the economy affected.? The tech bubble did not have much debt, and it was contained.? The real estate bubble was the opposite.

The thing is, the amount of debt we have racked up as a fraction of GDP exceeds that of the Great Depression.? My view is that many debts will have to be liquidated before the US economy grows robustly again, whether through payoff, compromise or inflation.

Now, we had Michael Mayo today offering his opinions on the banks, (two, three) which are not all that much different than mine.? In an era of debt deflation, coming off record debt-to-GDP ratios, it is next to impossible for the US Government to make any significant difference against the deflation.? Better not to try at all.? An action big enough for the US Government to absorb the necessary amount of bad debt will kill the Dollar.

This last bubble has led to a depression, because of the debts incurred.? We must liquidate debts, but in the process, the economy will suffer.? I’m sorry, I like prosperity too, but there is no way out of this period of debt liquidation.? Just as the period of debt growth pushed asset prices up, so the period of debt deflation will push asset prices down.

My advice?? Avoid almost all banks, and other financial companies sensitive to the stock market or real estate, in terms of both equity and bond investments.

Replace the Car or Repair It?

Replace the Car or Repair It?

Posted on by David Merkel

It is a tough practical decision — when do you replace a car versus repairing it?? There isn’t an easy answer, but the intelligent way to approach it is to estimate the present value of the cost of continually repairing the old car versus the cost of buying a new one, net of the sales proceeds of the old car.

It’s a tough decision, with many squishy variables.? Nonetheless, it is the right way to frame the question.? It is also the right paradigm for a number of other questions.

  • When will the US give up on bailing out AIG (or any other firm)?
  • When will the US Government default, or decide to inflate massively?
  • When will China and the Arabs decide that “sunk costs are sunk” and abandon the US and the US Dollar?

After investing in an investment that proves to be bad, the question crops up, “Should I buy more?? If I liked it at 25, don’t I love it at 15?”? The same thing with govenment decisions, except that they are writ larger.

Eventually, there is a tipping point where the investor realizes that things are so bad, that it is better not to invest any more, because it would be throwing good money after bad.? Replace the car, repairing it will cost too much.

In this uncertain environment, that is what we are facing now:

  • What will the US do with marginal firms?? AIG or Lehman treatment?…
  • When would the US give up on issuing more debt?
  • When will foreigners give up on buying US debt?

None of these are necessarily second quarter 2009 issues.? Neither is a car replacement; I can just repair it for now.

My advice is to start thing ahead, and ask when parties that you rely on are likely abandon ship.? Then change your investment processes to avoid the likely path of disaster.? This is messy, but it is the best way to operate.

Nonidentical Twins: Solvency and Liquidity, Redux

Nonidentical Twins: Solvency and Liquidity, Redux

Posted on by David Merkel

Another post deserving a brief update: Nonidentical Twins: Solvency and Liquidity.? The accounting rules have changed on mark-to-market accounting, but it won’t help financials at all, because now the accounting will be distrusted.? Even Goldman Sachs, who covertly runs our government, 😉 believes that is so.? Cash flows talk, and estimates of future free cash flows drive stock prices.? Accounting rules do not affect free cash flows, and the best accounting systems try to make earnings approximate free cash flows.

Here’s one more difficulty with changing the accounting standards: companies have the choice when they buy an asset of labeling it held to maturity, available for sale, or a trading asset.? The accounting varies depending on the choice, but held to maturity means that there is no mark-to-market.? So why didn’t financial firms tag assets to be held to maturity?? Because if you sell too many assets so tagged, your auditors get annoyed, and would try to compel you to tag all of them as available for sale, at which point mark-to-market applies.

So, let’s take a trip to Bizarro-world, where companies never have to do asset impairment, ever.? You can hold a security at par even after it has declared bankruptcy.? Only when the bankruptcy settlement payment is made in cash or new securities, would the value change on the balance sheet.? How would investors in bank stocks operate in Bizarro-world?

For one, during times of credit market stress, they would significantly reduce the price-to-book multiples that they would be willing to pay for banks.? Book values aren’t trustworthy without impairment done on a good faith basis.

There is no free lunch with accounting rules.? Make them more liberal, and investors become more conservative.

Many bank managers might say, “It’s a money good asset; if I hold it long enough, I will get par.? Why should I be penalized today?”? They should be penalized for two reasons:

  • The probability of getting par back has declined.
  • The ability of the bank to hold the asset to maturity has declined.

The first reason is simple enough.? The second reason is not well-understood.? Those that argue against mark-to-market accounting implicitly assume that all financial institutions have the capability of holding until the asset matures (pays off in full).? But that is not always true.? Many seemingly strong financial institutions (rated AAA or AA!) — recently found they could not hold their assets to maturity.? If a bank has to raise liquidity prematurely, those mark-to-market prices (if done fairly, which I think is rare) reflect the true value of the assets.

This is why I believe that most liquidity problems are really solvency problems, but the banks are clinging to old prices, and don’t want to admit that things have changed.? As we joked at AIG domestic life companies back in the early 90s: “Oh, almighty actuary! Utter the weasel-words that allow this rusty tub to stay afloat so that we can continue to draw on our salaries!”? (Yeh, it was that bad in that unit then.? The rest of the company was better, supposedly.)

Substitute? the word accountant for actuary, and that is what the present fair value rules are creating.? What it means is that a company must break due to a lack of cash flows before it goes insolvent.? That puts our accounting on the level of Madoff and other Ponzi schemes.? No one is broke until there isn’t a dollar left in the till.

It’s a lousy way to do business, but investors will adjust, and lower valuations.

The Bonus Canard in Financials

The Bonus Canard in Financials

Posted on by David Merkel

It was 2000 when I received my first significant bonus check working for a financial company as part of an investment department.? Now don’t get me wrong, as an investment actuary at prior firms, I took on complex projects that no one else could do, and I did them not for any bonus that I might receive, but just to do my best.? My bonuses were maybe 3-5% of my pay, and I was happy with them.? That the NPV I created for the company was 5,000x that did not bother me.? I work to do my best.? I have turned down higher paying jobs that would hurt my family, but I love intellectual challenges, whatever they pay.? (I tell this story in greater detail to younger people in investments, in order to show them that we do our work to do our best, regardless of the compensation.)

Now, in 2000, when my boss gave me the check, I looked at it and thought there must be an error.? He told me that he was very happy with my work, and that we had all hit the top of the scale in our bonus formulas.? He told me to invest it wisely.? (How I invested it is another story, and one worth telling later.)? I thanked him, and then called my wife, telling her that I had a check for 105% of my salary.? We were amazed.

I didn’t get it, so I went back to my boss several days later, and asked him why the bonus was so large.? We had a good relationship, and at the time, I didn’t realize that I was slowly becoming his main assistant.? He told me, “The St. Paul wants its investment managers to focus on safety, not short-term returns.? But they compete for investment talent among other investment firm that do swing for the fences.? They want smart people, but they don’t want them to take undue risks.? That’s why they make the bonuses easy to get, unless we lose a lot of money.”

That made sense, but it made me think that my real pay was double what I signed up for.? Wow.? I did not realize what a good deal I had.? Double my pay to make money for the company, but keep it safe.? That’s a challenge I could love.

When we merged into another firm that had the opposite philosophy, my pay went up, but my bonus went down in percentage terms.? I would make more money if I took more risk, but I maintained the same behavior, because I serve a higher power than money.

At my next firm, my bonus was not predictable.? Whether I did well or badly, I could not figure out how I would receive a bonus.

My main point here is that there is no one correct bonus formula.? We can bonus for performance and/or safety, over short and/or longer horizons.? It is easy politically to criticize the bonuses at AIG, because why whould a losing firm give bonuses, but perhaps employees did the right thing in their area of the company, while other areas failed.? Some reward should come to those that did it well.

Corporate Anorexia

Corporate Anorexia

Posted on by David Merkel

As I looked at replacement candidates for my portfolio, I ran across many companies with negative tangible net worth.? Knowing that intangibles often have value, I looked for the gap that should exist between free cash flow (earnings, less depreciation, amortization, and capital expenditure) and earnings, and more often than not, it was not there.

Ugh, as a buyside insurance analyst, I often encouraged management teams to not buy back stock, but build up capital against contingencies.? It was a contrarian point of view, and not listened to for the most part.

I understand the troubles that come from managements that keep too much of a reserve on hand.? That’s not the problem now.? In the bust phase of the credit cycle, companies with more reserves do better.? The disciplines that minimize net working capital are worthless now in the bust phase.

As I have said before, the boom-bust cycle cannot be repealed.

Two Boxes. Sixty Pounds. Tiny Type. What Are We?

Two Boxes. Sixty Pounds. Tiny Type. What Are We?

Posted on by David Merkel

Box 1: Uh, pardon for the interruption, but we’re going to blog for David while he works on a research piece for Finacorp.

Box 2: Tireless, isn’t he?

1: I wouldn’t know, and neither would you.? We’ve only been here 14 hours.

2: True.? The UPS guy was a hoot when he brought the boxes: “These are heavy, what are they?”

1: Yes, but David had no idea what was going on either.? The expression on his face was priceless as he said, “Uh, not sure.”? Then he took me inside.

2: And then walked out to get me, and he put me on top of you.? Then he scanned the writing on me, and seemed not to find much… then he roared with laughter.

1: Yeh, I heard him say to his wife, “I NEVER thought they would send it.”

2: His wife gave him the usual polite expression of “That’s nice dear,” as she went back to homeschooling one of the kids.

1: Precious, huh?? 22 years of marriage is comfortable like an old shoe.

2: Well, he opened me, and looked at some of the documents inside.? He even commented to one of his kids on the two colors on the documents inside me — blue and yellow.? Perhaps we’re from Sweden, or maybe Ikea.

1: Hmph.? Well, the sender was once worth a lot more than that pipsqueak Ikea, but sadly, is worth a lot less now.

2: Is the sender worth less than ABBA?

1: At this point yes to that as well.

2: Too sad.? Hey, when David opened one of the documents in me, he commented, “Hey, I know that guy.”? Then as he looked further, he commented on some financial data with words I can’t even remember now.? Very obscure.

1: He seems to be able to understand what is in us.

2: Yes, but there is a lot here.? I thought I heard him say, “They could have put this on a DVD, couldn’t they?”

1: I can’t answer that.? I’m related to a bunch of dead trees, and so are you.

2: I resemble that remark.? Wait, resent.? Hey, I am not paper, I am information!

1: You wish.? In all of our bulkiness, finding the important stuff is like finding a needle in a haystack.

2: Maybe David can do it?? He did comment that there was a story here after looking at one document.

1: Maybe.? A company created us, a statute created us, a phone call to investor relations created us.? I have no idea how talented David is, but I am rooting for him.

2: Me too.? Now to all our readers, we have given you enough clues that you might be able to identify the sender, and guess what we are.? What are we? 😉

First Quarter Portfolio Changes

First Quarter Portfolio Changes

Posted on by David Merkel

With all of the furor over the past quarter, I did not update my actions on my portfolio.? Today I do so.

New Buys

  • Archer Daniels Midland
  • Chevron Texaco
  • General Dynamics
  • Mosaic
  • Noble Energy
  • Oracle (can you believe it?)
  • iShares Brazil ETF

New Sells

  • Charlotte Russe
  • Cimarex Energy
  • Kapstone
  • CRH plc
  • Devon Energy
  • Tsakos Energy Navigation
  • Japan Smaller Capitalization Fund

Rebalancing Buys

  • AIZ (2)
  • CHIC
  • CRH
  • DVN
  • IBA (3)
  • LNT
  • NTE
  • NUE
  • RGA (2)
  • SAFT
  • SBS
  • SCVL (2)
  • VLO
  • VSH
  • XEC

Rebalancing Sells

  • AIZ
  • CHIC (3)
  • CRH
  • IBA
  • NUE
  • RGA (2)
  • SCVL
  • VLO
  • VSH
  • XEC (2)

Candidates List

My candidates list was smaller than usual, as I strictly limited candidates to be solvent in severe scenarios, such as we are facing now.? Nonetheless, here was my list of replacement candidates:

ABT ADM COL COV CVX FLR FMX GD INFY JNJ MCK MHP MOS MSFT NE ORCL PCP RTN SFG VAR

My favorite of those I did not buy was Stancorp.? If I could add more insurers, I would add them.? Stancorp is a? very well run firm.

I traded Brazil for Japan, and cleaned up my portfolio, trading away names with weaker balance sheets for those with stronger balance sheets, and aimed for industries that were not heading into reverse.

Full disclosure: long ADM CVX GD MOS NE ORCL EWZ AIZ IBA LNT NUE NTE RGA SAFT SBS SCVL VLO VSH

Legal Complexities as the Automakers Restructure

Legal Complexities as the Automakers Restructure

Posted on by David Merkel

When I became a corporate bond manager in 2001, one of the first things I began to do was sell away all of my automaker bonds.? A big bet I knew, even though I was a neophyte, but I thought it was the right thing to do.? I reduced my exposure from $100 million to $10 million.? ( I could not get a decent bid for bonds from Ford’s Dutch subsidiary.)? My view was that their fixed cost structures were too high, and they would lose to lower cost automakers.

In writing for RealMoney, I always took the tack of selling the automakers’ stocks.? I made an exception for their securitized auto loan receiveables, which had me on the other side of Cramer.? I always try to draw distinctions for what constitutes reasonable investments with respect to equities or debt; the question is not always the same.? But with the automakers, the distinction was somewhat moot, so I encouraged readers to sell all unsecured debts of the automakers maturing in less than three years.

Now, we are nearing the endgame, where GM and Chrysler stocks go to zero, and Ford may as well, as it comes under knock-on stress.

But is it Legal?

I am dismayed at the enthusiasm that many display for giving the US Treasury draconian powers, allowing them to effectively destroy contract law.? I don’t care if the Treasury saves the economy or not, what will our society be like when it is done?? I have already laid out a simpler proposal where change is incremental, Add a New Chapter to the Bankruptcy Code, which leaves most of the powers in the hands of the courts.

We don’t need to get it done quickly, if the government added a “too big to fail” section to the bankruptcy code.? Obligations would be honored, and the courts could sort through an equitable division of the property, or cram it down, if agreement is not rapidly reached.

Even if Congress passes a law allowing the Treasury Department to have incredible discretion in reorganizing financial companies, that does not mean that the actions are exempt from judicial review.? The Supreme Court could rule that the infringement on the rights of bondholders constitute an illegal “taking.”? I’m no lawyer, so I write this with some trepidation.

My main point is that the US government does not have the power to eliminate the basics of contract law, without making the government itself lose legitimacy.? Contract law is basic to all civilized societies, and is a major component of the wealth, which relies on stability.

Beyond that, any plan that creates a good company / bad company should be doomed, because it essentially becomes government sponsored fraudulent conveyance, where valuable assets that the bondholders were relying on disappear.

Don’t get me wrong, I think the bondholders should take a sizable hit here.? I just believe that the result should come through the courts, not through the US Treasury.? The courts do well at this sort of thing.

It is dangerous to tamper with contract law in such ways.? Bond financing for other entities that are anywhere near the bankruptcy cliff will dry up, pushing other firms into insolvency.? The Treasury could well save some firms through these powers, should they get them, but at a cost of destroying many others.

The rush should not be this big.? Let the government temporarily be a DIP-lender to “too big to fail” firms, but then let the court handle it.? They were designed for questions of equity, and they have worked well at that for several centuries.? Discretion on the part of bureaucrats at the Treasury will be far less competent (as we have seen so far) and far less fair (ditto).

Slow, Veeeery Slow…

Slow, Veeeery Slow…

Posted on by David Merkel

I did a post like this before, and got some criticism because it was “ad hoc” and not generalizable to the economy as a whole.? Fine, I admit that.? Let me tell you what I have been seeing.

My wife and I informally divide the duties of shopping.? She does about 60%, and I do 40%.? I like this, because it allows me to keep my feet on the ground as regards the economy.? I may have a very traditional marriage, but this is one place where I want to have more play.

After playing “pickle” with my youngest four children (the oldest four were elsewhere), we went to Home Depot and Sears on Tuesday evening.? We needed some gardening supplies and a few miscellaneous items.? At the Home Depot, I saw three other customers.? Compared to two years ago, I would have expected dozens (say 30).? There were so few customers that we got instant help from staff (astounding), with the staff freely commenting that my two youngest (girls wearing matching dresses) were pretty as can be.? (Aw, I think so too.)? At Sears, we were the only customers there.? It is a converted KMart, so maybe that makes a difference.? The staff outnumbered us 3-1.? The merchandising is far better than the old KMart, but the prices are higher as well.? Even my children felt things were deserted at both stores.? (For a homeschooler, this was time for a few basic economics lessons.)

The Wal-Mart near my house seems normal, and on weekends, above normal.? The local Asian food market is more crammed than ever.? I go there to buy produce and Asian specialty items.? (Did you know that I am a decent cook?)? I suspect it is the same as the Wal-Mart effect.? As times get tighter, more people look for cheap deals.? The prices at the Asian market are way below those of local competitors, but it is not as inviting, because the produce is of varying quality, the music is unusual to the average Westerner, and you have to be comfortable dealing with people whose first language is not English.? I find it fun, but not everyone else does.

My wife’s favorite store, Safeway, is much slower.? People are cutting expenses, even in relatively wealthy Howard County, and Safeway is suffering.? They are offering far more specials than I am used to seeing.

But my biggest suprise was my local 7-11.? I know that staff there pretty well, and they tell me that thiongs are a lot slower.

These observations were made over the last two months, and are fascinating to me.? Just six months ago, the Home Depot had unchanged volume, but now it is considerably lower.? Only places known for low prices have volume consistent with the past.? What a tough retail environment.

Theme: Overlay by Kaira.