October 2009 – Page 2 – The Aleph Blog

On Dual Share Classes

Posted on 13 October 200913 October 2009 by David Merkel

My research sometimes takes me into the nooks and crannies of finance.? I know it is wonky, but I actually enjoy tearing into complex prospectuses in order get a sense of where value is.

One of my current projects is on large companies that have more than one share class.? Some easy questions:

How many companies are there in the US with more than $1.5 billion in market cap? 1,045.
How many of them have have more than one common share class?? 103, or roughly 10%.
How many of the 103 companies extra share classes trade more than one thousand dollars worth of volume per day?? 28.
How many of the 103 companies extra share classes trade more than one million dollars worth of volume per day?? 11.

Why are there dual share classes?? Usually, it is because a founder that prized control had a financing need for which equity was the right choice, but he decided that he did not want to give up control.? So, he issued equity with lesser voting rights at a discount to the shares with greater voting rights.

In most cases, there are covenants that protect dividend rights and liquidation rights of the lesser voting shares.? The difference in the share prices of different classes of stock often boils down to the value of what a vote is worth.

Now what of those 11 companies where liquidity is adequate in the dual shares?? There is the opportunity for arbitrage in synthetically buying votes cheap and selling them dear.

Now, this is not a large trade.? Indeed, this is not big enough to begin a hedge fund around.? But it could be of value to enhanced indexers that are trying to outperform their benchmarks by a small amount.? The lesser voting shares, particularly at an extreme discount offer higher yields, and a better return in a change of control.? The loss is a lesser degree of control — you are on the back of the bus and other investors

This presumes that there are covenants on the various share classes for equal treatment in a change of control, and/or that there are rules to govern dividend policy, giving the same or superior treatment to those with a lesser voice.? That is normally the case, but when I was younger, I ran into a case with a micro-cap stock (Cerbco, aptly named for the mythic three-headed dog of hell) where the supervoting share class received a higher price in an asset sale.

This isn’t going to be too much use to the average investor, except to say when you look at buying a company with dual share classes, do this:

Review the EDGAR filings to see the benefits of each share class.? Be wary of situations where lesser voting shares lack protection.
See whether the classes trade adequate volume (or at all) for the size of the position you want to have.
Review the price series for each share class, and review how wide or narrow the differential can be.? When near extremes in the values, shift to the class that is undervalued.? Sell votes dear, buy them cheap.? This works better in a tax sheltered account.

Where this has the most punch is for tax-sheltered index investors that want to enhance their indexing.? It won’t shoot the lights out, but using this on the 11 companies with decent volume, it would likely offer 5 basis points of outperformance versus a pure index portfolio, and more, if your trader is good.? My clients do/will get more specific advice on the eleven companies, but I put this out to my blog readers to give them a general idea of what to do as small investors when faced with multiple share classes.

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One final note: Berkshire Hathaway was an exception (isn’t it always?) with respect to why it has a second share class.? Buffett didn’t need more financing when he created the “B” shares.? He noticed that a small cottage industry grew up to allow investors to buy fractional shares of Berky.? What annoyed him was that the providers were taking a significant annual cut off of the fractional shares.? So, Buffett outcompeted them by creating a second class with lesser voting rights than the “A” shares, and 1/30th of the economic value of an “A” share.

This also allowed Berky investors to be able to gift shares under the gift tax limit.? (Thanks Dr. Bob, I did not know that, but it makes perfect sense.)

Now, for index investors, that doesn’t help, because Berky is not in any of the indexes (though I think it should be), aside from the NYSE Composite (no one follows that).? There’s still a smallish noisy arb there for those who want to play it.? Thanks, Climateer.

So it goes.? On to review some deal arbitrage…. enhanced indexing can be fun. 😉

Full disclosure: no positions in companies mentioned.

Book Review: Think Twice

Posted on 13 October 200913 October 2009 by David Merkel

Since I met him at a Baltimore CFA Society meeting in 2001, I have? appreciated the intelligence of Mike Mauboussin.? (My old boss was his roommate in college, so I was told, the name is pronounced “MOE-bus-son.”)? He was early to pick up on the value of behavioral economics and nonlinear dynamics (“chaos theory”).

Think Twice is an effort to get all decisionmakers to take a step back and ask whether they are making decisions from shorthand rules, or from carefully analyzed data.? The book is full of examples of how people are easily fooled by irrelevant data.? Most of the examples I was aware of, becauseI have studied this stuff intensively.? There were a few surprises for me, though.

Did you know that at the craps tables in Las Vegas, on average, when someone wants a higher number, they throw the dice hard, and when they want a low number, they give it a gentle toss?? I found that to be an amusing example of the illusion of control in? a case where humans have no control.

This book helps answer a number of tough questions:

When are crowds better than experts, and vice-versa?
Why don’t we go get data, rather than listening to anecdotes?
Why does an initial estimate play such a large role in estimating the final value?? (Why don’t people ignore the estimates, and start from scratch?? It’s too much work!? Never underestimate the power of laziness.)
Can subliminal cues lead people to make different decisions?
Do I have to understand the whole system to understand the piece of the system that I am interested in?
When can you outsource production, and when does it not make sense?
When do catastrophic events occur, and why?
How does one sort out happenstance (so-called “luck”) versus skill?

The clear message of the book is don’t be lazy; do your homework on any task.? Try to be objective as possible, ignoring the opinions of others, and using as much data and cold logic as one possesses to confront the problem.? Be aware of the mental shortcuts that hinder good decisonmaking.

I recommend this book, but with a quibble.? It is not written in a truly user-friendly way.? There are technical terms used and not defined that many average people will blink at, and maybe get part of the meaning through context, but not get it in full.? If we Flesch-tested the book, it would come up at “college level” for reading.? (As for me, I am to be understood at a high school level.)

Who can benefit from this book?? Anyone who makes economic decisions could benefit.? It would help them be more self aware of the pitfalls involved in decisionmaking.? I found it to be a breezy read at 143 pages of main text, and the writing style is entertaining.

You can buy the book here: Think Twice: Harnessing the Power of Counterintuition.

Full Disclosure: Anyone entering Amazon through a link on my site, and buying something — I get a small commission.? Your costs remain the same.

To my readers, if you want me to review Mauboussin’s other book, Expectations Investing, I would be more than happy to, because I read it five years ago.? If you have other books you would like me to review, let me know… my time is limited, but if I get a lot of people asking for the same book, I will give it a shot.

PS — look at the book cover — what is the hidden message? (which never gets mentioned once in the book…)

Pension Apprehension

Posted on 10 October 200911 October 2009 by David Merkel

I have a bunch of pieces “ganged up” to go on real estate, international economics, government policies, market risks, and a book review on “Think Twice,” but tonight the topic is pensions, with a side order of Bill Miller.? Hopefully I will get to the other topics next week.

Defined benefit [DB] pension plans have run into the perfect storm: lousy equity returns and low high-grade bond yields.? It makes the last great pension crisis in the late ’70s look good — at least they had higher yields back then.? Thus this article from the Washington Post.? Many pension plans face almost impossible odds of catching up, raising the odds significantly of more plan terminations, where the two main losers are healthy defined benefit plans, who will have to pay higher amounts for PBGC coverage, and pensioners with high benefits, because those benefits will be cut.

That places pension plan sponsors in a bind.? What to do?? Take more risk, contribute more assets to bridge the funding gap, terminate the plan, or declare bankruptcy?? It is worse for US states, who can’t declare bankruptcy.? And municipalities don’t have the PBGC behind them; the pension liabilities are difficult to shake.

Why are there these problems?? Three reasons:

Actuarial funding methods were too optimistic for sponsors, and led them to underfund.
Investment assumptions were too generous, which also led to underfunding.
We have a cultural problem where we hide deficits/profit shortfalls through adjusting pension assumptions, or trading lower salary increases for pension benefit increases, which don’t hit the bottom line immediately, but increase funding needs for years to come.

With life insurance reserving, we use assumptions that are conservative for reserves and capital.? Pension reserving is best estimate.? If a life insurance reserve is inadequate, it must be raised to adequacy.? Pensions have a lot more flexibility, even with the recent legal changes.? It should not have been that way — pension reserving should have required pre-funding and conservative reserving.

We had boom years in the ’90s, and most DB pension plans were overfunded for a while, but the boom gave the illusion that returns would be stupendous for a long time, and companies stopped contributing as much or at all to their DB plans.? Some of that was IRS policy; the IRS did not want companies hiding income by contributing to the employees’ DB plans.? Thus the IRS capped the degree of overfunding at the time when overfunding was needed.

The states have their own issues in that it was always easier to defer making payments to the DB plans, because no one wanted to raise taxes, or defer spending plans.? Now the true costs have come home to roost because of the financial crisis.? Not only are interest rates and asset values lower, but tax revenues are down significantly, and unlike the US government, the states can’t print their way out of it; there are no foreign buyers that think they have to buy the states’ debts.

I have said before that it is foolish to take more risk in order to try to get ahead of the pension promises.? Periods of debt deflation are not kind to those taking risks.

That applies to defined contribution [DC] plans as well.? This article in Time suggests that 401(k) plans be scrapped, which are a type of DC plan.? A few notes:

401(k) plans were an accident that got shoved into a piece of legislation for providing supplemental savings benefits.? It was probably design for a special interest, but was discovered by an then-obscure Ted Benna, who started a practice around it.
Whoulda thunk that it would get bigger than DB plans?? Few thought it possible until the early ’90s.
During the boom years, few questioned the abilities of plan participants to direct their own investing.? The bust years have made that inadequacy plain.? Average people don’t know how to allocate assets.? They are either too conservative or aggressive.? Few choose the middle ground of a Ben Graham 50/50, or a DB plan 60/40 (stocks/bonds).
Participants are also not well equipped for receiving and managing a lump sum of assets at retirement.? Few will buy an immediate annuity for part of their funding needs, smart as that is.? They also will not limit themselves to withdrawing only 4% of assets per year at most.

As for the Time article, I take issue with this phrase: “This isn’t how retirement was supposed to be.”

Oh please, retirement is a modern innovation that only the developed world achieved, and only because they had more than enough children (with technological development) to fund the economic growth of the entire system.? Now that developed countries are down to replacement rate or less, the only way these systems hold together is through tax subsidies or optimistic assumptions.

The world is not so bountiful that everyone can have an easy time after age 62, without taxing others to make it happen.

Now, the 401(k) was not a bad idea, but there were limitations:

People did not contribute enough.? They should have contributed to the max, but many only did it to the degree of the match, and and some did little to nothing.
They were too aggressive or too conservative, which led to greed, panic, and underperformance.? A middling allocation would have served most well, and could have been maintained through good times and bad.
Perhaps it would have been better to have had trustee-directed plans, where participants could have chosen the amount to save, but trustees would have invested for them.? One can’t easily tell when bad markets will come, thus it pays to have dispassionate advisors do he investoing for those that will give in to fear and panic.
People were poor at choosing how to distribute their 401(k) assets — few chose immediate annuities, for two reasons: it means the forfeiture of assets for a stream of cash for life, and insurance agents don’t want the money locked up; they want to earn multiple commissions.

Some of the large insurance companies are offering deferred income benefits, i.e., pay so much today, and we will give you an income of such and so at age 65, if you are still alive then.? They are not yet common, and will say that it is a tough benefit for insurers to fund.? Not many fixed income assets are not long enough to fund such a risk.

Regarding the termination of DB plans, and their replacement with DC plans, I predicted that 15+ years ago.? Why?? As the Baby Boomers got older, there would be no way that a corporation could afford the huge benefits, because the pension funding methods were back-end loaded, as I said before.? Corporations had to pony up a lot more to fund the retirement of a 60-year old than a 25-year old.? Corporations that did not terminate their DB plans would lose investors to those that did terminate, becausetheir profits would be a lot lower.

And, If the IRS had not made it tough to overfund DB plans, perhaps we would have more of them today.? Alas, it is not so.

So, what can I say?? Don’t blame 401(k) plans for broader societal trends.? Corporations would have had to terminate their DB plans simply due to demographics.? Also, understand that the economy is limited, and stocks are not magic.? Stock don’t guarantee a good return or even a positive return.? Also, don’t blame 401(k)s and other DC plans for people not investing enough.

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Okay, time for the side dish.? So Bill Miller has had a comeback over the year to date.? Big whoop.? He is still behind the S&P 500 over the last 10 years, though over the last 19 years, he is still ahead by 1-2%/year.? This is not as impressive as John Neff, by any means.

What has fueled the returns of Mr. Miller?? Low quality companies bouncing back from a crisis that the Government/Fed bailed them out of.? What Bill Miller does not do is value investing.? Value investing is not “buying them cheap,” but buying with a margin of safety.? Financials have not had a margin of safety for a long while.

Given that I think that companies with a lot of debt will underperform in the future, so do I think the Bill Miller will underperform as well.? That is an area where he he been sloppy in the past; given the weakness in the current economy, it will bite him again.

The Good ETF

Posted on 9 October 2009 by David Merkel

What makes a good ETF in the long term?? My, what a question, driven by the ETFs challenging the limits of what is prudent.? Maybe it is easier to start with what makes a bad ETF, then:

Headline risk can be eclipsed by credit risk.? All ETNs, Currency ETFs, and ETFs that use non-exchange-traded swaps, sometimes for commodity funds, take credit risk.? Did you know you were taking credit risk?
Roll risk — for commodity funds, trying to replicate the returns of the spot market using the futures market works only when there aren’t a ton of funds trying to do so.? The flood of funds into front month futures contracts incites other funds to front-run the activity, capturing the profits that the commodity funds were trying to make.? (For storable commodities, better to take delivery and store.)
Market size risk — an ETF can become too large relative to liquidity or regulatory constraints of the market, and it no longer tracks its benchmark well — again, mainly a commodity fund problem.
Irreplication risk — This is mainly a bond market theme, but once the ETF defines the index, only index bonds can be bought in proportion to the index.? I ran into this personally in 2002, when I ask ed why a certain bond traded rich.? The answer came that it was in a common index, but it was a small bond issue in proportion to its weight in the index.? Many investment banks were short the note to provide liquidity, but could not source the bonds to cover the short because most were in index funds.? I would keep an eye out for those bonds, and would sell them to those short for a small markup when I found them.? For ETFs, the trouble is that arbitrage can’t take place, because bond buyers can’t find certain rare bonds in order to create new units in exchange for expensive ETF shares.? That is one reason whey NAVs get stretched versus market prices.
Abnormal or faddish theme — the risk is that they become too dominant in the trading of less liquid companies in their ETFs.? But away from structural risks is the faddish investment risk.? The ETF only gets created as the fad is about to go into decline.

In one sense, the market can reward non-consensus views, particularly when they are small compared to their relative advantage in their sub-markets.? In the same way, the market can punish those that become too large for the pond that they swim in.? Growth will be limited or negative.? Even the efforts to create more capacity, create it at the cost of credit risk.

Good ETFs are:

Small compared to the pool that they fish in
Follow broad themes
Do not rely on irreplicable assets
Storable, they do not require a “roll” or some replication strategy.
not affected by unexpected credit events.
Liquid in terms of what they repesent, and liquid it what they hold.

The last one is a good summary.? There are many ETFs that are Closed-end funds in disguise.? An ETF with liquid assets, following a theme that many will want to follow will never disappear, and will have a price that tracks its NAV.

Seasonally Adjusting the Google Real Estate Index

Posted on 8 October 2009 by David Merkel

Barry did an interesting and short post on the Google Real Estate Index.? It measures the amount of search going on over real estate.? My question was: okay, are we over or under the trend at present, on a seasonally adjusted basis?

I decided to run a regression where each month would have a similar effect across years, and each year would have its own effect.? December 2009 was the baseline.? Here are the results:

Wow.? Very significant results.? As Barry said, “Go figure: Even the search pattern for Real Estate is highly seasonal;”? It’s not that surprising.? People don’t search in the fourth quarter, because they know the inflexibility derived from children and schools.? (Only 2% of the population homeschools and can act like turtles, taking their homes with them as they walk.? That said, homeschoolers don’t typically use that flexibility.)? But at the start of each calendar year, people look forward to the new year, and make new plans on real estate.

From the annual coefficients, there is also no surprise — 2005-2007 were great, 2008 was worse, and 2009 was horrible.

It should not them be surprising that with a 94% R-squared, that the following graph would be tight, actual versus expected:

But looking at the bottom, the purple line indicates when people have been more willing than normal to search for housing.? This is such a time — on the low end, from what I am seeing, many people are more interested in housing given the current lower prices.? Should we jump up and down about this?? Not sure, but it does point out what I have said recently, that housing on the low end has reached equilibrium with foreclosures.

Don’t get too excited by this, 2009 is still a bad year for real estate, but maybe a few things are starting to turn up.

PS — all of this assumes that search on Google has some correlation with actual intent to buy or sell real estate.? I think that is a reasonable assumption.

US Dollar: “I’m Not Dead Yet!”

Posted on 7 October 20097 October 2009 by David Merkel

Analyzing currencies is weird, and most people don’t get it.? Sometimes, I think I don’t get it.? There is nothing fixed in our economic world, no fixed measure of value.? Everything trades against everything else.? Currencies exist to make the trading easier.? Imagine a matrix that is millions by millions, with trillions of exchange rates for one good or asset against another.? With currencies, it simplifies.? Each nation prices out goods and assets in their own currency, and then currencies trade against each other, subject to arbitrage with commodities, and commodity-like assets.

Anyone who has read me for a while knows that I am not a bull on the US Dollar.? But where I part ways with the grizzly bears (call me a teddy bear 🙂 ), is that the fundamental accounting identities must be maintained.? Whatever country of our world has the status of reserve currency must issue debt, and a lot of it, that other countries can invest in to park their idle cash balances.

It does not matter what currency crude oil trading, or any other trading, is denominated in; it does matter in what currency the proceeds from the sale of crude oil is invested in.? So long as the US runs current account deficits, foreigners must acquire US assets in order to fill in the gap.? In the past that has mainly been bonds — agency, mortgage, corporate, but increasingly Treasury notes.

It is not that easy to abandon the US Dollar.? Where do you go?? The yen will suffer for years as Japan heads into demographic decline and large structural budget deficits. The Euro is still an experiment; there are many pressures on it; its survival is mot assured. Nothing else is large enough or stable enough, or mature enough to run the deficits necessary to have the debt markets, to be the global reserve currency.? As an example, China does not want to run deficits, nor is its financial system strong enough to bear the wear and tear of global use of its currency.

So, when reporters write pieces indicating the imminent demise of the US Dollar, I don’t buy their arguments:

Other parties disagree with the worry:

If the money is not invested in US Dollar investments, where will they invest? That is the question.

Now, there are other issues. China? could queer global trade by asserting that entities in China could default on obligations from derivative contracts and not worry about it.? Why is this big?? If a major country does not respect contract law, that country will not be respected in global trade.? Granted, China is a creditor, not a debtor on net, but the ability to transfer capital is paramount in the global economy, and if China will not honor contracts, that will bite them.

Away from that, I was fascinated by Australia’s interest rate hike.? It makes me bullish on the Australian Dollar, even after its significant rise.? That said, don’t move too aggressively, because eventually US Dollar rates will rise.

My view is that the US is in a Japan-like funk, which it will not rise out of for years.? I don’t think the Fed will move aggressively — they will be timid.? It is easier to argue to Congress that they did their best but conditions were severe, than to argue that they headed off inflation, but many people were unemployed.

Unless Europe moves to a full political union, or China frees its economy, there is no real competitor to the US Dollar.? Yes, the dollar will likely decline over the next decade, but it will not be likely to lose its reserve status, unless a commodity standard currency comes into being.

Profiting Over Lunch

Posted on 6 October 2009 by David Merkel

If I can pull this off, I’ll pay for lunch on this one.

I admire two organizations: the Hussman Funds and CrossingWallStreet.com.? Both live near me.? They have different views on whether the market is overvalued or undervalued.

Take these two posts:

The first was Eddy’s post indicating that the market is cheap on a forward earnings basis.? After I read this, I prompted my Bloomberg Rep to show me data on market-wide Price-to-Sales ratios, because profit margins could be unsustainable.? While I did that, William Hester, who I have met at a BCFAS meeting, commented on the very item I was looking for — if the profit forecasts occur, profit margins will be unusually high.

Having been burnt on unusually high profit margins before, I am inclined to be more conservative about future profit margins now.

But for fun, Eddy and William (and if you can bring along your bright boss John), I am willing to have a lunch discussion of these issues at a nice restaurant in Howard County.? Let me know if you have interest.

Risks, Not Risk

Posted on 3 October 20094 October 2009 by David Merkel

While at our last denominational meeting, I made the offer to the pastors of my denomination that if they needed investment advice, they could contact me for advice.? Out of eighty or so pastors that that could have asked for advice, one e-mailed me.? (The pastors and elders did elect me to the pension board, to help manage the relationships with the defined contribution fund managers.? I’ll do my best for them.) The pastor is young-ish, with a wife and six kids.? He had 60% invested in a broad bond fund which had a high exposure to investment grade corporates and high yield (and AAA CMBS), and 40% in a stable value fund. This is a redacted version of what I wrote to him:

You’ve been playing it conservatively.? At this point conservative is good.? If I were not tardy in responding to you (my apologies), I might have suggested taking a little more risk at the time when you wrote.

This is the way that I view asset allocation:? look at the risk factors in the investment markets, and look at the funding needs of the person or institution that owns the assets.? (I.e., so what are we saving for?)

Most people don’t save enough.? The $4000 per year is good, but most people need to put more of a buffer aside than that, whether in IRAs (for retirement) or in a taxable account (for emergencies, future coollege aid to children, etc.)? You have six little liabilities that may need some help starting out as they reach adulthood.? Consider saving more.

Now for the risk factors:

Equities — somewhat overvalued at present.? (US and foreign)
Credit — Investment grade credit is slightly overvalued, and high yield is overvalued.
Real Estate — the future stream of mortgage payments that need to be made is high relative to the present value of properties.? There will be more defaults, both in commercial and residential.
Yield Curve — Steep.? It is reasonable to lend long, so long as inflation does not take off.
Inflation — Low, but future inflation is probably underestimated.
Foreign currency — One of my rules of thumb is that when there is not much compensation offered for risk in the US, it is time to look abroad, particularly at foreign fixed income.
Commodities — the global economy is not running that hot now.? There will be pressures on resources in the future, but that seems to be a way off.
Volatility is underpriced — most have assumed a simple V-shaped rebound but there are a lot of problems left to solve.

What this leads me to is this: I don’t know all of the bond and stock funds you can use at present, though I will after the next pension board meeting.? The bond fund you are using was a great play over the last 9 months, but is probably overvalued now.? If there is a more conservative bond fund, you might want to shift some funds there.? If not, use the fixed fund.? I don’t think we have an international bond fund, or an inflation protected fund?available, but if we do I would add some there.

On a pullback in the stock markets, I would look to add some stock into the mix.? I would add some with the market 10% lower, and would add considerably with the market 30% lower.? If there are international stock funds, I would use them 30/70 with US funds.

Consider this a start of a discussion.? I’m not bullish on much right now.? This is a time to preserve capital, not make returns.? Let me know what you think, and sorry for being so slow to get back to you.

If I were talking to an institutional investor, I would have added illiquidity as a risk factor, which I think is fairly priced right now. I might have also added that I would be bullish on GSE-sponsored mortgage bonds and carefully selected CMBS.

Aside from that, I was pleasantly surprised in Barron’s to see Mark Taborsky of Pimco thinking about asset allocation the way I do.? There is no generic risk.? There are many risks.? Are you getting fair compensation for the risks that you are taking?? If not, invest in other risks, or if there are few risks worth taking, invest in cash, TIPS, or foreign fixed income.

Modern Portfolio Theory has done everyone a gross disservice.? It is not as if we can predict the future, but the use of historical values for average returns, standard deviations, and correlations lead us astray.? These figures are not stable in the intermediate term.? The past is not prologue, and unlike what Sallie Krawcheck said in Barron’s, asset allocation is not a free lunch.? With so many people following strategic asset allocation, assets have separated into two groups, safe and risky.

To this end, it is better to think in terms of risk factors rather than some generic formulation of risk.? Ask yourself, am I getting paid to bear this risk?? Look to the risks that offer the best compensation, and avoid those that offer little or negative compensation.

At Last, Death!

Posted on 3 October 2009 by David Merkel

Alas, but all good things in the human sphere come to an end.? Penn Treaty is the biggest insurer failure since 2004.? Now, don’t cry too much.? The state guaranty funds will pick up the slack.? The banks are jealous of an industry that has so few insolvencies.? Conservative state regulation works better than federal regulation.

Or does it?? In this case, no.? The state insurance regulator allowed a reinsurance treaty to give reserve credit where no risk was passed.? The GAAP auditor flagged the treaty and did not allow credit on a GAAP basis, because no risk was passed.? No risk passed? No additional surplus; instead it is a loan.? I do not get how the state regulators in Pennsylvania could have done this.? Yes, they want companies to survive, but it is better to take losses early, than let them develop and fester.

A prior employer asked me about this company as a long idea, because it was trading at a significant discount to book.? I told him, “Gun to the head: I would short this.? Long-term care is not an underwritable contingency.? Those insured have more knowledge over their situation than the insurance company does.”? He did nothing.? He could not see shorting a company that was less than 50% of book value.

It was not as if I did not have some trust in the management team.? I knew the CEO and the Chief Actuary from my days at Provident Mutual.? Working against that was when I called each of them, they did not return my calls.? That made me more skeptical.? It is one thing not to return the call of a buyside analyst, but another thing not to return the call of one who was once a friend.

Aside from Penn Treaty, the only other company that I can think of as being at risk in the long term care arena is Genworth.? Be wary there.? What is worse is that they also underwrite mortgage insurance.? I can’t think of a worse combo: long term care and mortgage insurance.

The troubles at Penn Treaty are indicative of the future for those who fund long term care.? Be wary, because the troubles of the graying of the Baby Boomers will overwhelm those that try to provide long term care.? That includes government institutions.

Financial Versus Real

Posted on 2 October 2009 by David Merkel

I wrote the following this morning for Finacorp clients:

“One of the keys to understanding the current environment is that there is a lot of financial liquidity, which obscures a lack of demand for products that are not staples. With unemployment so high, and perhaps worsening, it is difficult to invest in new plant and equipment, but easy to build up excess liquid assets as protection against further decay. It is also then easier to refinance debts, or buy high yielding debt, and clip a spread, hoping things don?t blow up again.”

Let me phrase it another way.? So the Fed comes in and offers cheap liquidity to financial institutions.? Does that mean the financial institutions will now offer loans to industrial corporations?? More of the loans will go to those that are buying “cheap” high yield debt, until the yields make no sense versus the bad default climate for companies that have issued high yield debt.

Most of what the Fed has done has been to raise? the prices of financial assets for now.? Unfortunately, the the Fed is not big enough to do that for most residential housing in America.? For those that have mortgages, sorry, half of you are under water, where under water is defined as higher than a 90% LTV.? Once sale costs are counted in, a 90% LTV is a close to a breakeven.

For the US government, together with the semi-independent Fed, it is relatively easy to lower interest rates, which percolates through the lowest risk sectors of the economy, so long as the dollar does not fall apart.

The Fed can manufacture financial speculation easily, but has a harder time encouraging investment in plant and equipment.? Much of that depends on the rest of the world.? There are no strong economies now, and most countries need to pay down debts.? Debt-based financial systems are more fragile than equity based systems.? Things may be weak for a while as we head back to an equity-based system.