September 2009 – Page 3 – The Aleph Blog

On Life Settlements

Posted on 8 September 2009 by David Merkel

Well, thank you Rolfe Winkler and Reuters.? I go off-line on Sundays because it is the Sabbath, so I don’t review the web or catch e-mail, but when Rolfe e-mailed me and I saw it on Monday morning, I felt I had to give him a response.

Now, my response was a brief one, for me.? There was more to say, some of it of a personal nature, but I was busy this weekend.? We moved six of our children into different rooms, repainted two of them, and simplified our lives — I have more trash sitting outside than I have ever seen in my life.? The house is simpler and prettier than ever before, and our two oldest now both have their own rooms.

So, what I wrote was significant, but limited.? Let me fill in some gaps.

First, the efforts on life settlements have been going on for a long time.? This is not new, but has been happening for a little less than 20 years.? Over the last ten years I have been personally invited to be a part of three (maybe more) of these enterprises, and I have turned them all down early because of the ethical issues involved.? I genuinely believe in the concept of insurable interest.

Second, life insurance is for the most part sold, not bought.? I used to have trouble with that, but there are many people who will not save or seek protection unless someone goads them to do so.? Those who will not actively look out for themselves pay a price relative to those who seek coverage unbidden.

Surrender charges exist on life insurance policies to allow insurers to recover the cost of the commission that they have not amortized.? As GAAP accounting would suggest, all revenues and expenses are spread over the life of the policies.? The significant cost of acquiring a life insurance policygets recovered over the life of the policy.? If a policy owner wants to surrender early, the insurance company has a surrender value or cash value that reflects no loss to the insurer on average.

Pretend for a moment that you are a life insurer.? You want to make a profit, or if a mutual, break even.? You test/underwrite potential insured lives before the policy is issued to assign policies to the proper rating class for them.? The more accurate you are, the more polices you will write, and the fewer surrenders you will have.? But over time, people change.? After issue, insureds tend to get more sloppy in their lives, on average.? Also, things that could never have been caught in underwriting emerge.

Those doing life settlements aim at the policies where there have been negative health events since issue.? Death is considerably more likely, and so the value of the policy is worth more.

Think about it: you as the insurance company did your best job to estimate the risk involved. You did it assuming that policies could not be sold, whether really or synthetically.? You already knew that those who were healthy in the future would surrender and seek another carrier, but thought the those who were less healthy would persist to some degree.? Well, with life settlements, the unhealthy persist at a much higher level, which bites into profits.

This is the box that life insurers are in.? They can’t lock in policyholders, but policyholders can hang on, refinance (so to speak), or sell off their obligations.? That is a tough equation for life insurers to work through, and to the degree that life settlements are allowed, premiums will have to rise to compensate for the loss of profitability.

Waiting for the Death of the Chicago School, and the Keynesian School also, Redux

Posted on 5 September 20096 September 2009 by David Merkel

So Paul Krugman gets a lot of ink, and everyone goes gaga for it.? I don’t buy his arguments for two reasons:

He misdiagnoses the cause of the current crisis.? He thinks it is too much of the “free markets.”? Rather, it was predominantly profligate monetary policy.? Secondarily, it was poor banking regulation.? Monetary policy necessarily involves banking regulation in a fiat money system, because credit is what drives the economy.? A failure to limit the ability of regulated institutions to issue credit is just another form of loose monetary policy, whether it results in measured price inflation or not.
Keynesian economics and Neoclassical economics do not consider the debt structure of the economy to be relevant for policy purposes.? I’ve written about this already in this blog post: Waiting for the Death of the Chicago School, and the Keynesian School also. Debt structure is more relevant than any other factor at present.? Economies with high levels of indebtedness are inherently fragile, because booms and busts are amplified by the financial leverage.

Let me take this a different way.? If monetary policy had been conducted properly through the Greenspan era, what should he have done?? Let’s start with the crash in 1987.? Greenspan should have done nothing — no announcement at all.? Maybe a few small clearing firms would have failed, and maybe some minor investment banks, but so what?? The economy would remain sound.? There would be little danger of an increase in unemployment.

Instead, he announces support for the markets, and debt levels increase as a result.? Bad debts are not liquidated, and new debts are incurred, because policy is favorable toward debtors.

Next came the commercial real estate crisis of the late ’80s to early ’90s.? What did the Fed do?? It cut rates from 9.75% to 3%.? What should it have done?? I have a basic rule that says that the Fed funds rate should never be more than 1% below the yield on the 10-year Treasury.? That means the Fed should have leveled out the Fed funds rate at 6-7%, and waited, and taken political heat for doing so.? If they had done this, there not would have been a residential mortgage convexity crisis in 1994, which ended up sinking Mexico as well.

Why not less than 1% below the 10-year Treasury rate?? Anything more leads to easy profits for the banks, with a large increase in the indebtedness of the economy.? Let the banks remain on a diet, and let savers get their due reward.? We don’t have to flood the economy with liquidity to get it to turn around.? Enough liquidity and willingness to wait will do it.? A policy approach like that will lead to a more stable and yet growing economy.

So what was the next crisis?? LTCM in 1998.? The Fed should have done nothing, and if any or all investment banks failed, it would have had little impact on the economy as a whole, because derivative exposures were small.? But no; they coerced the investment banks into a settlement, and loosened the Fed funds rate 0.75% when it should have kept policy tight, and not loosened at all, staying at 5.5%.

Perhaps the tech bubble would have been less virulent if liquidity had not been so plentiful.? Between the loosenings during LTCM and the extra build-up in liquidity for Y2k, the Fed put in the top of the equity market.? Then the Fed tightened significantly, bursting their new bubble.? After that, they went nuts, loosening Fed funds from 6.5% to 1.75% by the end of 2001.? It probably should have stopped at 3-4% and waited.? But no, not only did they go down to 1.75%, they went all the way down to 1% in June 2003, when it was obvious that a strong recovery was underway, and the FOMC left the rate there for a full year, while asset inflation springing from additional indebtedness coming from cheap financing ruled.

Instead of moving from 1% to 4% rapidly, the Fed chose a slow pace, a robotic pace for the next 17 meetings, increasing 0.25% each meeting.? Language dominated over policy as the market anticipated their actions.? They dared not surprise the market, but they overshot the 4% area that would have been closer to equilibrium.

If the Fed is unwilling to deliver surprises, it is unwilling to govern.? Give us what we need, not what we want.? At present, Fed funds should be in the 3% region, allowing a slightly positively sloped yield curve, which would allow most banks to do well in a normal environment.

What’s that you say?? It’s not a normal environment now, so why should the curve be flatter?? It is not a normal environment now precisely because the Fed was so loose for so long, allowing a huge buildup of debt that we are now fitfully trying to liquidate.? When that debt gets down to 1.5x GDP, we will have robust growth once again.? In the 3.0x+ position that we are now in, there is little hope for significant growth rates.? Our government should be aiding in liquidating zombie institutions, rather than keeping them undead with cheap financing.

Consider the position of David Walker.? He knows how bad the total debt crisis of the US is.? I’ve written about this many times before; this is the latest example.? Keynesianism does not address sovereign indebtedness, which is a huge flaw.? What if a country can’t make good on all of its promises?? Were the US? not the global reserve currency, that would be a big problem for us now.? Deficits are not helping the UK or Japan now.? But what happens when we go into perma-deficit in the next few years, where there is little to no hope to paying off debt, because excess revenues on social programs evaporate, and the elimination of deficits relies on the willingness of the US to raise personal income taxes across the board.? Soaking the rich will never be enough, and they always find ways of sheltering income.? Who will be willing to pick up the knife, and proudly say to constituents, “I did what was right for you and raised your taxes?” or, “I did what was right for you and cut social security payments by 30%, and created a 30% copay on Medicare.” or, “I helped create a new chapter in the bankruptcy code for states, with a modification to ERISA that allows for lowering of pension and healthcare benefits paid to former state employees for states under financial stress.”? No one will say any of that, obviously.

Perhaps there are simple solutions to all of this.? The only one I can think of is a large rise in taxes, which would be bitterly opposed, and might not result in that much additional taxes.? Any other bright ideas out there?

One final comment on the failure of macroeconomics — consider who did peg the crisis in advance.? Most were practical, business-oriented economists who saw the growth in leverage, and said, “This will not end well.”? The trouble is that timing and estimation of severity of the then-future crisis were problematic.? The moment that you say “This end badly,” in the midst of the bull phase, you can get labeled a perma-bear.? I hated that title, so I would tweak my language to avoid sounding too harsh.? Today that’s a pity, because the scenarios we privately talked about at my last employer are what are playing out now.

Why did macroeconomics fail us?? Bad theory in the two main schools of Neoclassical economics — Chicago and Keynesian.? There was an inability to appreciate the effects of overindebtedness on an economy.? Time to send both schools to the junkyard.

PS — I saw this in Barron’s.? If Henry Kaufman’s book is as good as it sounds, perhaps it will provide more insight into this situation.

Tickers for the Latest Portfolio Reshaping

Posted on 4 September 20094 September 2009 by David Merkel

Fortunately my portfolio management methods don’t revolve around? frequent trading.? One of my kids came up to me recently and said, “What did you do today, Dad?”? I said, “I made one trade, and I did a bunch of research.”? He then asked, “How often do you trade?”? I answered, “That was my first trade in a week, and I haven’t traded much in the last two months, but that’s not normal.? There is no normal for me. When the market is really volatile, I trade a lot more, selling when stocks are rising, and buying when they are selling off.? When the market is relatively placid, I don’t do much.” He looked at me, kind of smiled, and moved on.? Information overload from Dad.

Most people and investment managers trade too often.? They sell their winners too rapidly, and panic too soon on their losers.? Now, I’m not advocating “buy and forget,” or Buffett’s statement, “Our favorite holding period is forever.”? Buffett has had a huge opportunity loss on many of his “permanent” holdings.? Granted, when you are managing that much money, it is tough, so I give him a pass, not that he needs it from me.? (Rather, I am the needy one.? If you ever read me, Mr. Buffett, sir, would you send me an e-mail?? I have one favor to ask.)

Measure twice, cut once.? Risk control is best done on the front end, analyzing what you will buy, rather than having strict sell rules that limit losses.? Many who have strict sell rules die the death of a thousand cuts.? Careful selection matters more, in my opinion.? What should you aim for at present?

A strong balance sheet
Cheap price versus earnings and book
An industry that is needed even in bad times.
Earnings quality — low earnings from accrual entries.

Well, at least that is what I am aiming for.? The following tickers are my working list of buy candidates.? If you have other ideas for me or readers, please post them in the comments.? Thanks.

ABC ACE ACGL ACN ACS AEE AEP AGL AHL ALE AMGN APA APC ATI AWH BAX BCR BDX BG BHP BOBE BP CAH CB CNQ COO COV CPWR CSC CSL CTAS CVG CVS D DST DUK ECA ED EE EFX EIX ELNK EME ENH ETP EXC FE FIC FISV HELE HES HI HON HPQ HSC IMO IVC JNJ KCI MCK MDT MGEE MRO MUR NJR NOC NOK NPK NST NTRI OCR OGE PCG PCP PDCO RIG RLI SCG SJM SNPS SO SPR SPW SRE STJ SWY SYK T TCK TFX TGI TLM TOT TRV TYC UGI UL VAR VOD VZ WEC WGL WW XEL ZMH

Full disclosure: I don’t any of the above tickers, I am not short them either.

Book Review: Finding Alpha

Posted on 3 September 2009 by David Merkel

I found this book both easy and hard to review.? Easy, because it adopts two of my biases: Modern portfolio theory doesn’t work, and the equity premium is near zero.? Hard, because the book needed a better editor, and plods in the middle.? I don’t ordinarily do this, but I felt the reviews at Amazon were valuable, particularly the most critical one, which still liked the book.? I liked the book, despite its weaknesses.

One core idea of the book is that risk is not rewarded on net.? It doesn’t matter if you measure risk by standard deviation of returns, beta, or credit rating (with junk bonds).? Junk underperforms investment grade bonds on average.? Lower beta and standard deviation stocks overperform on average.

A second core idea is that some people are so risk averse that they only accept the safest investments, which leaves investment opportunities for those that are willing to compromise a little with credit quality or maturity.? Moving from money markets to one year out is an almost riskless move for most, and usually adds a lot of excess return.? Bond ladders do the same thing, though Falkenstein does not discuss those.

Also, the move from high investment grade to low investment grade does not involve a lot more investment risk, but it does offer more yield on a risk adjusted basis.

A third core idea is that equities, though more risky than high quality bonds, have not returned that much more than bonds when the returns are measured properly.? See this post for more details.

A fourth core idea is that people are more willing to take risks to be wealthy than theory would admit.? Most of those risks lose money on average , but people still pursue them.

A fifth core idea is that alpha is hard to define.? Helpfully, Falkenstein defines alpha as comparative advantage.? Focus on what you can do better than anyone else.

A sixth core idea is that leverage, however obtained, does not add alpha of itself.? This should be obvious, but people like to try to hit home runs.

A seventh core idea is that when an alpha generation technique becomes well-known, it loses its potency.

An eighth core idea is that people are more envious than greedy; they care more about their relative position in this world than their absolute well-being.

One idea he could have developed more fully is that retail investors are easily deluded by yield.? They underestimate the amount of yield needed to compensate for illiquidity, optionality, and default.? Wall Street makes money out of jamming retail with yieldy investments that deliver capital losses.

Another idea he he could have developed is that strategies that lose their potency lose investors, and tend to become less efficiently priced, leading to new opportunities.? Investment ideas go in and out of fashion, leading to overshooting and washouts.

How one achieves alpha is not defined — Falkenstein leaves that blank, because there is no simple formula, and I respect him for that.? He encourages readers to devise their own methods in areas where there is not a lot of competition.? Alpha? comes from being better than your competition.

Summary

What this all says to me is that investors are too hopeful.? They look for the big wins and ignore smaller ways to make extra money.? They swing for the fences and get an “out,” rather than blooping singles with some regularity.? I like blooping singles with regularity.

I recommend this book for quantitative investors who can find a way to buy it for less than $40.? The sticker price is $95, though it can be obtained for less than $60.? Try to find a way to borrow the book, through interlibrary loan if necessary — that was how I read Margin of Safety by Seth Klarman.? Klarman’s book is not worth $1000.? Falkenstein’s book is not worth $95.? Falkenstein’s very good blog will give you much of what you need to know for free, and even more than he has covered in his book.

This book would also be valuable for academics and asset allocators wedded to Modern Portfolio Theory and a large value for the equity premium, though some would snipe at aspects of the presentation.? Parts of the book are more rigorous than others.

If you still want to buy the book at the non-discounted price, you can buy it here: Finding Alpha: The Search for Alpha When Risk and Return Break Down (Wiley Finance)

PS: Unless I state otherwise, I read the books cover-to-cover, unlike most book reviewers.? The books are often different from what the PR flacks encourage reviewers to think.? If you enter Amazon through my site and buy anything, I get a small commission.

Ten Points on Commercial Real Estate Lending

Posted on 2 September 2009 by David Merkel

Before I begin this evening, I would like to give a big praise to Calculated Risk.? CR and his readers do a great job of highlighting stories in economics and real estate; I get a lot of data from that blog.? Some articles cited this evening have sprung from links on a CR post; my non-citing of CR is not a lack of respect for what CR does.

1)? We are at the beginning of seeing large commercial properties slide into default where equity sponsors have concluded that there is no use throwing good money after bad.? Recourse typically does not exist on commercial loans, aside from the smallest loans.

The last article is interesting to me, in that the ability of the US Postal Service to walk away from leases is greater than I previously thought.? It is also interesting to contemplate the economics of a collapsing postal service.? Will the postal service charge a differential rate to serve rural areas?? It would align revenues with costs, but politically I can’t imagine it is feasible given the US Senate.

2)? Of course, those defaults have large negative implications for large and small banks, as well as CMBS and Commercial REITs.

The difficulty for banks is different because they do not hold their Commercial Real Estate [CRE] loans at fair value.? So long as the loan is performing, it can be held at par.? The accounting does not require anticipating failure, no matter how likely on average that failure would be.

The banks have writeoffs to take which the CMBS market is already anticipating.? Absent a larger rally in CMBS, there will be significant writeoffs at the banks eventually.

For a broader look at the troubles the banks face, look at this article: Q2 2009 Bank Stress Test Results: The Zombie Dance Party Rocks On.

3)? When the price of properties are down 36% from the peak, it implies that most recent lending, 2006 and beyond, is under water, and 2005 is iffy.

4) $165 Billion in Commercial Loans are Due in ?09.? Banks will extend the loans, whereas CMBS special servicers will foreclose on some and extend others — the balance sheet of a CMB Securitization is not as flexible as that of a bank.

5) “What evil lurks in the heart of Commercial Real Estate loans?? The Shadow Supply knows.”? Whether it is condos in Manhattan, or apartments in the same, the problem of underemployed real estate weighs on the market, waiting for a moment to sell, and making the recovery that much longer.

6)? Goldman Sachs is the key component of the oligarchy that controls the US Government and sucks the blood of the American taxpayer for profit. ;)? Now they are planning to repeat their clever pillage of residential housing in the commercial sector.

Look, GS is clever, and they will make money they can.? I never supported any of the bailouts, but if the government sets the rules inadequately, and GS finds holes to profit off of, where does the blame go, but to the government who set loose rules.

7)? Goldman also sees hard times ahead for Commercial REITs, as I do.? Prices are too high relative to NAVs.? There will be significant loan defaults.? Shall I mention that Deutsche Bank agrees?

8) At such a time, as is normal, underwriting standards rise, and loan volumes decline.? It adds insult to injury, but banks have to protect their balance sheets.

9) This is also affecting pension plans, which are large investors in commercial real estate, both equity and mortgages.

10)? And looking at the architectural billings index, any turn in commercial real estate will not be soon.

I will be considerably more bullish when these problems are half solved.? Until then, I am still a bear on financials.

Animal Spririts Eating Green Shoots

Posted on 1 September 2009 by David Merkel

I have never liked Keynes concept of “animal spirits.” (I reread that piece, and though it is long, I think it is worth another read.? I try not to say that about my own stuff too often.)? Businessmen are generally rational, and take opportunities when they see them.? As for those that invest in the stock market, perhaps the opposite is true — panicking near bottoms, and buying near tops.

Most businessmen are risk-averse.? They do what they can to avoid insolvency.? But debt capital is cheap during the boom phase of an economic cycle, and businessmen load up on it then.? During the bear phase of the cycle, overly indebted businessmen pull in their horns and try to survive.? At bottoms, deals are too attractive for businessmen with spare cash to ignore — businessmen are rational, and seek deals that offer profitability with reasonable probability.

Unlike this article, I’m not convinced that the news does that much to affect behavior.? Movements in asset values are self-reinforcing not because of crowd opinion, but because of the accumulation and decumulation of debt and other financial claims.? As businessmen get closer to insolvency, they trim activity.? As their financial constraints get looser, they are willing to consider more investments with free cash.

As for the current situation, I am less confident of the “green shoots.”? Yes, inventory decumulation has slowed down.? So has the increase in unemployment, maybe.? Yes, financing rates have fallen.? We still face a situation where China is force feeding loans for non-economic reasons into its economy, and where the financial sector of the US is still weak due to commercial real estate loans, bank loans to corporations, and weak financial entities propped up by the US government.? Even residential real estate is not done, because of the number of properties that are inverted, and the increase in unemployment, which I think is likely to get worse.

Applications: I think it is more likely than not that there will be another crisis with the banks, and another round of monetary rescue from the government.? I also think that many speculative names like AIG have overshot, and the advantage now rests with the shorts for a little while.? Real money selling is overcoming day traders.

Be cautious in this environment.? After I put out my nine-year equity management track record, the next project is to dig deeper in the risks in my own portfolio, and make some changes.