In order to do this book review, I have to compare the book to five others that I have reviewed.

  1. Trend Following, (2), (3), (4), (5)
  2. Beat the Market: Invest by Knowing What Stocks to Buy and What Stocks to Sell
  3. The Fundamental Index
  4. The Alchemy of Finance, and Soros on Soros
  5. What Works on Wall Street

I chose these five, because they deal with factors that affect stock performance.  With 1 and 4, you can learn a great deal about price momentum.  With 4, you learn how price momentum and mean reversion interact, and even get taste of why even fundamentalists should grab onto this.

Today’s book, Quantitative Strategies for Achieving Alpha, takes a mix of factors, including price momentum, and attempts to show how investors can achieve above average returns.  That is similar to what was posited in books 2 and 3 in rudimentary ways, and in book 5 in more sophisticated ways.  The book that is most similar to this book is What Works on Wall Street.  More on that later.

The author has seven “basics” that must be applied to all investments:

  1. Profitability
  2. Valuation
  3. Cash Flow
  4. Growth
  5. Capital Allocation
  6. Price Momentum
  7. Red Flags

These are the building blocks of good investment strategies, and the best strategies use 2 or more of the “basics.”  This is consistent with the book What Works on Wall Street.  The most important “basics” are Profitability, Valuation, Cash Flow, and Price Momentum.  Good strategies will look at most of them.


  • The data period for the analyses was short — a mere 20 years 1987-2006.  As time has gone on, data collection has gotten richer, but the 20 year period chosen was one of a big bull market, and not necessarily representative of the next 20 years.
  • Data mining — when testing a wide number of similar hypotheses, data snooping is a problem.  If theory A works well, why not test theories A’, A+, A-, A*, etc?  That happens in this book, but it does not make the error of What Works on Wall Street, because it does not make claims that the best strategies from the sample period will be the best strategies for the future.
  • Also on data mining, in the price momentum section, analyses are done to see which momentum strategies did best over the sample period, and then those strategies are applied.  Someone starting out in 1987 would not have had the benefit of that knowledge.
  • Strategies that favor increasing debt worked well, but that is a relic of the Greenspan era, where overages of debt were never punished.
  • Cash flow was an important variable, and there were variables for capital allocation, but there was not much discussion of earnings quality by itself, which has significant predictive powers.

The book is data and statistics heavy, but not equation heavy.  If your eyes glaze over from numbers and statistics, this is not for you.

Wrong way to use the book

Look for the strategies that gave the highest excess returns, Sharpe ratios, etc.  Follow those strategies religiously.  If you do this, you will mimic the excesses of the period 1987-2006.  Those won’t recur in the same way 2009-2028.

Right way to use the book

Use the book to guide your strategies.  Look at how you currently analyze stocks, and see if you aren’t missing significant factors that could improve your performance.  Look to balance your strategies such that all of the main factors get some representation.

Also, the summaries of each chapter are simple, and give the main thrust for those who get tired.  Tortoriello does a good job boiling it down for those needing a summary.  He also does not overpromise; the book is free from overselling, in my opinion.

If you want to buy it you can buy it here: Quantitative Strategies for Achieving Alpha (McGraw-Hill Finance & Investing)

Remember, I read the books that I review.  Not all do.  Those entering Amazon through my site, and buying anything, I get a small commission, and their prices do not rise at all.  This is my version of the “tip jar.”

1) I may as well start out the evening with some predictions. I’m not an expert on this, but Chapter 9 of the bankruptcy code applies to municipalities, but not states. Given the problems with state & municipal pensions, we will probably see chapter 9 modified over the next two decades to allows states to default. There will also be some modification to retirement funding laws as applied to municipalities, states, and maybe the US Government, to allow for retroactive negotiation of pensions and healthcare benefits for an insolvent government.

2) California will lead the parade of states in trouble.  They want the US to guarantee their municipal debt.  Schwartzenegger did all he could to try to pass the referenda that might partially close the budget gap, but from what I see now, it looks like most of the important ones have failed.  Having been a California resident for seven years, I went though my share of referenda; the referendum process makes the politicians of California lazy… they pass the tough stuff off to the electorate, who then get to decide off of voters’ guides and soundbites.

3) California is an exaggerated version of the troubles that other states are having.  Social program spending rises, while taxes on wages, corporate profits, real estate, real estate transfers, etc., all fall.  If you can’t print your own money, and must balance your budget, life is tough, kind of like it is for most Americans.

4) Another municipal issue — can financial guarantors split in two?  I have argued “no,” but who cares what I think?  We do care about those that use the courts, and banks are suing to prevent the MBIA split.  It is a simple issue of fraudulent conveyance.

5) One last municipal issue: pension placement agents.  This is very similar to what I experienced in Pennsylvania regarding municipal pensions there.  Pension consultants would gain business through campaign contributions, and the Democratic and Republican consultants would collaborate and share to control the profits jointly.  Insurance companies providing pension services would pay  compensation to the consultants in exchange for business.  It’s a dirty business, and when I raised ethical objections to it, I was told that I was naive.  Perhaps I have more company now.

Anytime you have opaqueness of compensation, politics, and uncertainty of results (investing), there is always room for corruption.

6) Asset allocation.  The belief in a large equity premium led many to overweight stocks.  I have argued against that.  Now there are many who are finding the they have to start over, after bad equity returns.  There is no magic in any asset class.  Yes, equities do better than bonds in the long run, but only by 1-2%/yr, not 5-7%.

As for the arguments of Ayres and Nalebuff, only the most emotionally dead investors can live with levering up 1.9 times perpetually.  Most people panic.  They can barely deal with the volatility of the S&P 500, much less double that.

7) Mmmm… is it time to take on Bill Miller again?  Yeh.  Overweighting financial stocks?  That is quite a bet, and probably irresponsible again.  Here is my free advice — analyze your estimates of intrinsic value with commercial real estate prices 30% lower than today.  Aside from short-tail insurers, I don’t think you want to be overweight financials.

8 ) On the same note, many small and intermediate-sized banks face troubles under stress, particularly from commercial real estate lending.

9) I think we are in the second inning for declines in prices for commercial real estate, but perhaps the seventh inning for residential real estate.  So long as residential properties sell for less than their mortgages there is downward pressure on prices, because negative events lead to foreclosures, not sales.

10) How will derivatives be regulated?  That is the question.  Will it be as transparent as TRACE?  I doubt it.  The market is not that liquid.

11) Will the US Government likely get full value back on TARP buyouts? No, because they lack expertise at analyzing these situations.  They don’t know what a warrant is worth.

12) Will low-rate mortgages rescue the economy?  No, but many middle class people with equity will breathe easier after they refinance.  Also, some will buy homes, but who will have the downpayment necessary to qualify now that underwriting has tightened?  Not many.

This completes the piece I wrote last week on the entitlements crisis.  Look at the following graph and table.

Those are trillions of dollars that we are looking at, and a 14% growth rate over the last eight years, significantly outpacing GDP growth.  Why did I not like Bush Jr., and why is Obama likely worse?  There is no concern for the long run effects of current policies.  Does it matter that current policy is unsustainable?  This does not count in state defined benefit pension plans and retiree healthcare.  Even without that, the deficit on an accrual basis is 3.5x GDP.  Another way to think of this is that we are at least ten years behind in tax collections.

We are viewing the slow failure of the US Government.  It may not be for years or decades, but the lack of willingness of the current administration to address the growing shortfall shows that they are more similar  to the Bush, Jr., administration, than different from it.  After all, who ran the biggest deficits?  Obama, by a long shot.

Since the last time I wrote about my portfolio, things have been volatile.  Here are my actions since then:

New Buys

  • National Western Life Insurance
  • Canadian National Railway

New Sells — Hartford Financial

Rebalancing Buys:

  • Assurant (brnging it up to a double-weight)
  • Dorel Industries

Rebalancing Sells:

  • Allstate (2)
  • Assurant
  • Companhia De Saneamento Basico
  • General Dynamics Crp
  • Genuine Parts
  • Hartford Finl Svcs Group Inc (3)
  • Industrias Bachoco SA (2)
  • Ishares Inc MSCI Brazil Index Fund
  • Noble Corporation
  • Safety Ins Group Inc
  • Shoe Carnival Inc
  • Vishay Intertech Inc (3)


After the plunge, and the run, I scaled out of Hartford three times, and then sold because of the high odds that they will take the TARP money.  Taking TARP money has led to underperformance in the past, and though it looks like cheap capital, it can be a very expensive set of handcuffs to cut off.

If Allstate takes the TARP money, I will sell them as well, and buy a certain P&C reinsurer.  I suspect that they won’t take it — only the desperate take TARP money.

I replaced Hartford with National Western Life.  Little company, and illiquid.  If you follow me here, limit orders only.  It is a basic life an annuity company.  No debt.  Trades for half of book value.  Currently profitable, but future profits are uncertain.  One controlling investor, R. L. Moody, and the rest of the shareholder’s list reads like a “Who’s Who” of small cap value investing.  I have not reviewed the accounting in detail, but when I reviewed it in detail six years ago, I thought the accounting was more conservative than most insurance companies.

With all of the cash building up from rebalancing sales, I needed to add another name with a strong balance sheet.  I chose Canadian National.  Unlike US railroads, they go coast-to-coast — less need for loading and unloading.  Second, the valuation is not much higher than peers.  Third, the balance sheet is stronger than all peers.  Not that I think that any of the major North American railroads is at risk of failure, but it is unlikely that Canadian National will come under significant stress.

That’s all for now.  So far, it’s been a good year for me.  I’m running with cash at my upper 20% limit, so I am looking for safe and cheap ideas that would not get hit that badly in another pullback.


This week, amid everything else I was doing, I read the entirety of the newly released book, “Street Fighters: The Last 72 Hours of Bear Stearns, the Toughest Firm on Wall Street,”  written by Kate Kelly, Wall Street Journal reporter who covered Securities firms like Bear Stearns, and wrote three major articles as it declined.

Here is how the book works: it takes you from Thursday evening to Sunday evening during the crisis.  When a new topic or person is brought in in an important way, Kate Kelly does a flashback to give readers the needed background.  It detracts from the urgency of the rest of the story, but does flesh out how Bear Stearns came to this ugly situation.

Culture matters in an organization.  A well-run organization, such as existed under Ace Greenberg developed pride in the organization, because it worked so well.  But pride, once engendered, is a fickle mistress.  Under James Cayne, once he stopped checking the details, and even major issues like exposure to the mortgage markets, pride was destructive.  Alan Schwartz believed that Bear Stearns was a great institution, and it blinded him regarding raising capital.  They couldn’t need additional liquidity, until it was too late to raise it.

Kate Kelly interviewed many people extensively for her book, and includes footnotes where parties don’t agree with her renderings.  She does make  the  last 72 hours live, with all of the uncertainty and fear of the situation.  I liked the book, and would recommend it.  That said, there are other books out on Bear Stearns, and I have not read them.

It’s a Small World After All

Now, what are the odds that a kid I used to stand with at the bus stop to go to kindergarten would end up in this book that I am reviewing?  To an actuary, it boggles the mind.  There is a “bit player” who appears twice in the book, my old friend Pat Lewis.  He lived three doors down from me, and was the popular, tall athlete, while I was a short nerd who tried my best in athletics.  We were both long distance runners, but he was my better by far.

After many years, I came back into contact with him in 2000 or so, when he had gotten a job in risk control at Bear Stearns.  I met him for lunch during an actuarial conference in midtown Manhattan — what a place to meet for two guys from the Milwaukee suburbs.  We caught up on each other lives and careers.  Me, married with seven children (then — eventually eight) — he, unmarried, but still more handsome than me.  Both of us are risk managers — he at Bear, me at F&G Life.  As the book records, Pat and those working with him try to create mathematical models that will highlight the risks of Bear.  James Cayne, not understanding the value of them, kills the project.

There are other references to him in the book, but this is a tale where those more powerful would not listen to reason.  Pat Lewis is a standup guy, and stated what he believed, even when things were chaotic.


Though the book gives its own set of lessons, I want to give a few of my own.

Love beats fear… we need friends

Bear might have felt like a big swinging dick after LTCM, where they stiffed the rest of the securities industry by refusing to pony up capital, but that cemented the view of the rest of the industry: Bear was not a team player.  That cost them when their disaster hit.  My conclusion: love beats arrogance in the long run.  Better to have friends than to suffer alone.

Don’t take your eye off the ball

Cayne clearly took his eye off the ball thinking that the business would do fine without close attention — he could go off and play bridge and smoke pot.  Inattention destroys businesses.

Risk control wins in the long run.

Cayne ignored risk control.  He was happy with a high ROE, and did not look closely to see how it was generated.

Liquidity is lifeblood — consider the BONY box.

Goldman is the only securities firm to come through this crisis almost unscathed.  Rather than pressing it to the limit, they would add assets during good times to the BONY box.  That is, they would save safe assets to protect themselves in the long run.  What a wise strategy.  No wonder that they run our government.


This is a good book that deserves to be read by those that want a clear view of how Bear Stearns went down.  It is engaging and informative.

As For Me

Here are some posts that I wrote during the crises:

If you want to buy the book you can buy it through the link in my leftbar.    Or, you can buy it here:

Street Fighters: The Last 72 Hours of Bear Stearns, the Toughest Firm on Wall Street

For those that want to sponsor me, anytime that anyone buys at Amazon after entering through my my site, I get a small commission, and your price at Amazon remains the same.

At one point, I began restricting who could republish my articles, but I have decided that it is more in my interest, and in the interests of others, to allow a fuller republishing of what I write.  Anyone may republish articles at my website, so long as they give full credit to David Merkel and The Aleph Blog, with a link back to the original article.

It is appreciated if one contacts me in advance of publishing me, but if you cite this blog post, Iwill understand   presuming that I have not revoked this, which I find unlikely.  Nonetheless, read my blog news posts for further details.

When I heard the announcement on Tuesday about Social Security and Medicare, I emoted something between a grin and a grimace, and said, “A pity that I have been right on this.”  I’ve always felt that Social Security and Medicare  have had optimistic economic assumptions.  It does not surprise me that the year that Social Security revenues are exceeded by expenses has moved in by one year, from 2017 to 2016.  Medicare, we are already exceeding revenues in 2008 and now.

Many focus on when the trust funds will run out — now 2017 for Medicare, and 2037 for Social Security.  Consider this, the trust funds are invested in nonmarketable US Treasury Notes.  That’s safe, right?  Safe, yes, as safe as the US government.  They will pay with the dollars that they print via their stepchild, the Fed.

This is my advice to all who read me.  Given that these social insurance programs invest only in US government debt, on an accounting basis, it makes sense to unify their balance sheets with that of the US government.  Once we unify the balance sheets, it is easy to realize that the negative consequences will come when expenses exceed revenues, not when the funds go to zero. When expenses exceed revenues, the US government will either need to tax or borrow more in order to make ends meet.  The US Government bonds held are a convenient accounting fiction to show that the taxes paid have been spent for other purposes.  There are no “Trust Funds,” only nonmarketable bit of US debt, that will get repaid through higher taxes, or further borrowings.  China and OPEC, ready to fund US retirements in style? ;)

As for the economic assumptions that Social Security uses, I think they are still optimistic.  One thing I have learned about cash flow modeling is that though the averages matter, the early years matter the most.  There is more time for their results to compound with interest.

We could have two more bad years (flat/down GDP on average), and then face the total system revenue breakeven in 2013.  Even if their assumptions prove correct, total system breakeven will come in 2014-2015.

And the markets will react ahead of that, because it will be so well known.  The need for tax revenues will be significant, and more so as we proceed into the 2020s.  This will lead to the need for solutions — with Medicare, much sooner than Social Security.


Possible solutions (and their liabilities):

  • Nationalize the healthcare system and Medicare goes away.  (Medicare is solved, at the expense of creating a bigger problem.  Other cultures may fit nationalized healthcare, but American will chafe at it.)
  • Create a second parallel healthcare reimursement system that only serves Medicare clients with limited services to those that are terminally ill.  Ease the pain, but nothing radical and expensive.  (I like this one, so it can’t be a good idea.)
  • Raise taxes.  (lower the reasons to employ labor)
  • Raise eligibility ages, and quickly. (Listen to the screams.)
  • Lower reimbursement rates. (Also won’t work because fewer doctors will do Medicare medicine… and quality drops as well.)
  • Mandate that doctors must take Medicare clients at Medicare rates.  (Nasty.  But once rights of contract get violated in one place, they get violated in others.)
  • Eliminate plan D, the drug prescription benefit.  It’s young and too complicated, so just kill it.
  • Means-test eligibility for reimbursement.  (It would lose political legitimacy.)
  • Terminate the system, such that children born after 1/1/2010 don’t pay in, and would not receive benefits. (Doesn’t really solve the funding problem, unless mixed with some of the above.)

Social Security

Possible solutions (and their liabilities):

  • Means-test eligibility for reimbursement.  (It would lose political legitimacy.)
  • Raise taxes.  (lower the reasons to employ labor)
  • Raise eligibility ages, and quickly. (Listen to the screams.)
  • Lower benefit payments. (More screams.)
  • Remove the cost of living adjustments, and inflate the currency.  (At least this rates the problem back to the Baby Boomers, who would get hurt the worst over this… a generation that failed to save and produce enough kids.)
  • Terminate the system, such that children born after 1/1/2010 don’t pay in, and would not receive benefits. (Doesn’t really solve the funding problem, unless mixed with someof the above.)

“I’ll Gladly Pay You Tuesday for a Hamburger Today.”

The nature of the US government, the lower Federal governments, many of its corporations, and some of its people has been to promise/borrow today, and pay it off later, because tomorrow will be, much, much, better than today.  With the the debt overhang and the looming pension crises, we are beginning to see that much American prosperity was a debt-fueled illusion.  We are presently in stage 1 of dealing with the grief of this shattered illusion — denial.

If the Federal Social Insurance schemes (Social Security, Medicare, Veterans Pensions, Old Federal Employee Pensions) and most State Pensions and Elderly Medical Care are going to pay off, taxes will have to be raised significantly.  That will be one nasty political fight, which might result in the death of certain sacrosanct laws governing the inviolability of pension promises to state employees, and perhaps Federal employees.  Also note, you can raise tax rates, but if it harms the economy, you will get less taxes.

The Federal Government will try to borrow its way out of the problem, until foreign creditors finally rebel, realizing they are throwing good money after bad.  After that, taxes will have to be raised, or promises abandoned/reduced.

For underfunded private defined benefit and retiree healthcare plans, they will likely be terminated, and lesser benefits paid.  All three of the legs of the modern retirement tripod (social insurance, savings, and pensions) are under threat as the era of debt deflation progresses.

Now, realize that though I talk about the US, most of the rest of the developed world is in worse shape as the demographic crisis affects pensions and elderly healthcare globally — they had even fewer kids than in the US, which is close to replacement rate, and so the ratio of workers to those supported will fall even more than in the US, setting up many nasty political fights — all the more nasty, because the governments are much more heavily involved already.  Don’t even think about China, which will come to regret the one child policy that led to so many abortions, and so many beautiful Chinese girls coming to the US to be adopted.

So What’s a Year Worth?

A year can teach us a lot.  2008 showed us the limitations of our economy.  Future years will show us the limitations of the power of our governments.  Conditions for prosperity can be created, but prosperity can never created by governments.  That is up to the culture of those governed.

This has gotten a bit long, so I will do a follow-up piece within a few days.  Here are a few good articles to consider:


Something for nothing.

Intellectual and financial achievement.

We showed those losers.

Hey, it’s free money!


Possibly Right

Don’t play for the last nickel.  It may cost you a buck or more.

Shorting is not the opposite of being long, it is the opposite of being leveraged long.  You don’t control your trade in entire, and the margin desk, or fear of the margin desk can make you leave a trade prematurely.

Pride goeth before a fall.

Would you rather be right, make money, neither, or both?

Free money in the market exists until too many people start searching for it.

Whom God would destroy, He makes overconfident.


Though I do risk control different than many people, risk control is behind much of what I do in managing money.  Avoid risks that I am not being paid to take, and take risk where I am getting fair compensation or better.

Now, I can think of several companies where I think the common is an eventual zero.  Fannie, Freddie, AIG, GM, and Ford (I am less certain about the last one).  My calls on GM and Ford were ones made long ago.  The same for Fannie and Freddie.  AIG is more recent.

Now, I rarely short, because my risk control methods are not designed to work with shorting.  But one thing I would almost never do is try to “zero short” — short a stock to zero.  As I have said before, seemingly free money brings out the worst in people, and makes them play more aggressively than they should.

Don’t underestimate the power of control.  There is an optionality there that is underappreciated.  With the right offer management can sell assets, change the capital structure, get a bailout, etc.

Don’t overestimate the uniqueness of the reasoning involved.  Zero shorts attract parties wanting to short to the bitter end; they think that zero is inevitable.  No risk here.  One decision.

I would look at the borrow.  Can I borrow a lot more stock easily, without paying a premium either directly, or indirectly through the cost of some derivative instrument? (options, swaps, etc…)  If I can, perhaps I don’t have to worry so much about losing control of the trade.  If not, it may be time to close out the trade (for a little while, then re-evaluate), or at least evaluate how high the price could go in a short squeeze.  As we have seen recently, some lousy companies in a short squeeze can double or triple.  Would I have enough capital to carry the trade under such adverse conditions?

At least I should estimate short-term upside versus downside for that position versus others in the portfolio.  After a successful short, it may not employ a lot of capital; perhaps I should close it out.

What’s that you say?  The borrow is plentiful, and I should short more?  After all, it is going to zero.  I would not do it because the upside/downside ratio is worse than when the  trade began.  Figuratively, playing for that last nickel could cost me several bucks.

What if the position moves against me and the borrow is plentiful?  Should I short more?  After all, it is going to zero.  Sigh.  Review the thesis.  I might look for someone who doesn’t always agree with me, and ask him what he thinks.  If the thesis does not change, I would short a little more once the momentum against the position has stopped.

One more note: I review pricing across the capital structure.  Where does the bank debt trade?  Where are Credit Default Swaps [CDS] trading?  Yields of senior unsecured notes across the maturities?  Junior debt, trust preferreds, hybrids, preferred stock, etc…  These are all relevant bits of data to tell whether the common stock will indeed zero out.  If the next most senior class of capital to the common is trading above 50% of par, I would do more research on my thesis.  If it is over 80% of par, the zero short is not a good idea.

Risk control wins in the long run.  To me shorting all the way to zero is a risky way to do business, and so I am very unlikely to do it.  There is a pride element involved, and all good investing relies on having control over your attitude.  If you decide to zero short, be very careful.  It is not as easy as it looks, even if in the end, it does go to zero.

The Committee on Oversight and Government Reform has asked Ed Liddy and the AIG trustees  to testify Wednesday.  Here are the questions that I would ask, given my recent piece on AIG.

  • Are you going to be able to use all of your deferred tax assets? What level of sustained profitability does that imply, and how are you going to get there?
  • Are you going to destack your Life and P&C subsidiaries to avoid double counting of subsidiary capital on a statutory basis?
  • If relatively clean and simple subsidiaries like Hartford Steam Boiler and 21st Century got sold for bargain prices near where AIG bought them, and below book value, what hope does that offer for the value of the rest of AIG?
  • You’ve lost a lot of money recently. What do you project to be your level of annual sustainable profitability to be over the next three years?
  • There are rumors that AIG is slashing pricing to stay alive in the short run on a cash flow basis. Many competitors are alleging this. Is this true?
  • What have happened to your efforts to sell AIA and your asset management arm?
  • What has happened to your efforts to sell International Lease Finance?
  • How is United Guaranty going to survive amid mounting residential mortgage losses?
  • As you wind down AIG Financial Products are you finding “deadweight losses” where the subsidiary was fundamentally mishedged?
  • How are you dealing with defections of key personnel, and bad employee morale?
  • How are you dealing with increased surrender activity in your domestic life subsidiaries? Will you need more capital as a result?
  • Are you going to try to sell Alico?
  • Are you going to try to sell AIU?
  • What are the core businesses that you are going to keep, and why are they worth keeping?
  • How will AIG repay the US Government in full?
  • How have you reduced risk in your asset portfolio?

That’s all, and I hope Mr. Liddy, who I have met and I think he is a bright guy, will do well.   He is a bit of a bagholder in the AIG mess.

Perhaps we have it easy in the life insurance industry.  Solvency is defined on two criteria: risk-based capital, and a variety of cash flow testing schemes, both contingent and noncontingent.  Truth is, it’s not that easy, but the life insurance industry has been more proactive on risk management than the banks.

I have not talked much, if at all about the “bank stress tests” for one major reason:  in life insurance, there are detailed rules for performing cash flow analyses.  With the bank stress tests, the adverse scenario posited higher unemployment, lower residential housing prices, and lower real GDP than “baseline” estimates.

Okay, that’s nice, but as is often said, the devil is in the details.  Did the banks get relief from the scenarios?  It seems so.  Why?  When I first saw the adverse scenario, I said to myself, “Not adverse enough.  Aside from that, how do you translate the adverseness into actual credit losses?”

The latter question is a critical assumption, particularly for complex financial institutions.  There is no immediate good answer, so how did the US government simplify matters?  We do not know, but we do know that the financial institutions pushed back.

What concerns me the most is that the stress scenarios did not explicitly consider weakness in commercial mortgage pricing.  This is a process that is in its early phases.  Much as REIT stock prices have fallen, and CMBS prices have fallen, the impact has yet to be realized on commercial whole loans on bank balance sheets.

It is very difficult to transform the macroeconomic assumptios of the stress test into usable credit loss data.  Reasons:

  • Differences in bank lending practices makes uniformity tough.
  • Attempts at getting accurate on a company-specific basis introduces the ability of the company to tilt the analysis their way.  Also, company specific loss estimates lack credibility.
  • Loss estimates on new lending classes also lack credibility.
  • Estimates of how sensitive loss estimates are to unemployment, GDP and residential housing prices lack credibility for most lending classes.  We don’t have enough data.

Now I have done stress tests at life insurance companies.  You estimate how much you can take in credit losses without having to dip into surplus assets over a 1, 3, 5, 10, etc-year periods.  You compare those statistics to worst few credit losses over 1, 3, 5, 10, etc-year horizons to get an idea of the likelihood of such large losses.  That has its troubles, but it is better than nothing.  The life insurance industry keeps pretty extensive statistics on its asset losses.

I didn’t get too encouraged by the results of the stress tests.  They were easy tests to pass for many because:

  • The stress scenario isn’t that severe.  I give it better than 50% odds of occurring.  A real stress test has perhaps a 5% chance of occurring.
  • The stress scenario isn’t very prolonged, like the Great Depression.
  • Creating the models that connect the economic assumptions to the loss costs is problematic.  Errors are unlikely to be on the conservative side — both the banks and the regulators are incented to be aggressive, because they don’t want to cause specific panic over their company, or general panic over the banks.  Remember, their is a large  number of people who think this panic is merely confidence/liquidity, and not solvency.   (Then why are we raising capital or selling assets?)
  • There are many new lending classes that have not gone through a full asset default cycle, so their default loss properties in an era of debt deflation won’t be calculable.  We don’t have the data.

When I look at the modest cost of $75 billion of capital to raise, I think of all the capital raised prior to this — and now a measly $75 billion will assure the future solvency of the system.  This is only an opinion, but I think that number is too low, particularly with the troubles in commercial real estate being so early in its cycle.  Remember 1989-92?  The degree of overbuilding now is greater than then.  The losses should at least be proportionate.

My simple bit of investment advice is to underweight the securities (bonds, preferred and common stocks), of the companies that failed an easy test.  That means underweighting:

  • Bank of America
  • Citi
  • Fifth Third
  • GMAC (debt, there is no public common)
  • Keycorp
  • Morgan Stanley
  • PNC
  • Regions Financial
  • SunTrust
  • Wells Fargo

At least, this will be worth watching as a basket from 5/8 on.  It may give us clues to the economy as a whole.  I expect that it will underperform, but I am more certain that it will covary very highly with the market as a whole.  Let’s see what happens.