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Nine Notes and Comments

As I roll through the day, i often make comments on the blogs and websites of others.  I suppose I could gang them up, and post them here only.  I don’t do that.  Other sites deserve good comments.  Today, though, I reprint them here, with a little more commentary.

1) First, I want to thank a commenter at my own blog, Ryan, who brought this article to my attention.  I’ve written about all of the issues he has, but he has integrated them better.  It is a long read at 74 pages, but in my opinion, if you have 90 minutes to burn, worth it.  I will be commenting on the ideas of this article in the future.

2) My commentary on Dr. Shiller’s idea on Trills drew positive attention, but the best part was being quoted at The Economist’s blog.

3) Tom Petruno at the LA Times Money & Company blog is underappreciated.  He writes well.  But when he wrote Fannie and Freddie shares soar, but for no good reason.  I wrote the following:

From my comments to my report on financials yesterday —Federal Home Loan Mortgage Corp [FRE] and Federal National Mortgage Assn [FNM] Rise as U.S. Removes Caps on Assistance — this gives the GSE stocks more time, and hence optionality. I still think they will be zeroes in the end, but there will be a lot of kicking and screaming to get there. The government is engaged in a failing strategy to reflate the housing bubble, and they aren’t dead yet.

I write a daily piece on financials for my company’s clients.  The stock of the GSEs rose because the odds of them digging out of the hole increased.  You can’t dig out of the hole if you are dead, so when you are near that boundary, even small changes in the distance from death can affect sensitive variables lke the stock price.  Plus, the odds rise that the US will do something really dumb, like convert theor preferred shares to common.

4) Kid Dynamite put up a good post on CDOs, I commented:

KD, maybe we should play chess sometime. Spotting a queen and rook is huge. I have beaten Experts, though not Masters on occasion (except in multiple exhibitions), and I can’t imagine losing to anyone who has spotted me a rook and queen.

All that said, I never gamble, and as an actuary, I know the odds of most games that I play.

Now, all of that said, I never cease to be amazed at all of the dross I receive in terms of ideas that look good initially, but are lousy after one digs deep.

Good post. Makes me wonder how I would have done in the same interview. Quants need to have a greater consideration of qualitative data. When I was younger, I didn’t get that.

5) Then again, Yves Smith comments on a similar issue at her blog.  My comment:

I’m sorry, but I think jck is right. The risk factors were clearly disclosed. Buyers should have known that they were taking the opposite side of the trade from Goldman.

As I sometimes say to my kids, “You can win often if you get to choose your competition,” and, “Winning in investing comes from avoiding mistakes, not making amazing wins.”

As a bond manager, I was offered all manner of amazing derivative instruments. I turned most of them down. Most people/managers don’t read the prospectus, but only the term sheet. Not reading the prospectus is not doing due diligence.

Since we are on the topic of Goldman Sachs, in 1994, an actuary from Goldman came to meet me at the mutual life insurer where I worked. I wanted to write floating rate GICs which were in hot demand, and all of my methods for doing it were too risky for me and the firm.

Goldman offered a derivative instrument that would allow me to not take too risky of an investment strategy, and credit an acceptable rate on the GIC. So, as I read through the terms at our meeting, a thought occurred to me, and so I asked, “What happens to this if the yield curve inverts?”

He answered forthrightly, “It blows up. That’s the worst environment for these instruments.” Now, if you read the docs, it was there, and when asked, he told the truth. The information was not up front and volunteered orally.

But that’s true of almost all financial disclosures. You have to read the fine print.

As for the derivative instruments, in early 2005, many large financial institutions took billion dollar writedowns. All of my potential competitors in the floating rate GIC market left the market. I went back to buyers, and offered the idea that I could sell them the GICs at a lower spread, which would give them a decent return, but with adequate safety for my firm. All refused. They basically said that they would wait for the day when the willingness to take risk would return.

And it did, until the next blowup in 1998 around LTCM.

My lesson: the craze for yield drives many derivative trades. What cannot be achieved with normal leverage and credit risk gets attempted, and blows up during hard times.

Structure risks are significant; the give up in liquidity is significant. The big guys who play in these waters traded away liquidity too cheaply, and now they are paying for it.

=-=-=-=-=–=-==-=-Whoops, where I said 2005, I meant 1995. That loss I avoided for the firm was one of my best moves there, but we don’t get rewarded for avoiding losses.


6) Then we have CFO.com.  The editor there said they want to publish my comment in their next magazine.  Nice!  Here is the article.  Here is my comment:


Time Horizon is Critical
Yes, Wheeler did a good job, as did MetLife, including their bright Chief Investment Officer.

What I would like to add is the the insurance industry generally did a good job regarding the financial crisis, excluding AIG, the financial guarantors, and the mortgage insurers.

Why did the insurance industry do well? 1) They avoided complex investments with embedded credit leverage. They did not trust the concept that a securitized or guaranteed AAA was the same as a native AAA. Even a native AAA like GE Capital many insurers knew to avoid, because the materially higher spread indicated high risk.

2) They focused on the long term. The housing bubble was easy to see with long-term perception — where one does stress tests, and looks at the long term likelihood of loss, rather than risk measures that derive from short-term price changes. Actuarial risk analysis beats financial risk analysis in the long run.

3) The state insurance regulators did a better job than the Federal banking regulators — the state regulators did not get captured by those that they regulated, and were more natively risk averse, which is the way regulators should be.

4) Having long term funding, rather than short term funding is critical to surviving crises. The banks were only prepared to maximize ROE during fair weather.

I know of some banks that prepared for the crisis, but they were an extreme minority, and regarded by their peers as curmudgeonly. I write this to give credit to the insurance industry that I used to for, and still analyze. By and large, you all did a good job maneuvering through the crisis so far. Keep it up.

7) Then we have Evan Newmark, who is a real piece of work, and I mean that mostly positively.  His article:  My comment:

Good job, Evan. I don’t do predictions, except at extremes, but what you have written seems likely to happen — at least it fits with the recent past.

But S&P 1300? 15% up? Wow, hope it is not all due to inflation. ;)

8 ) Felix Salmon.  Bright guy.  Prolific.  His article on residential mortgage servicers.  My response:

Hi Felix, here’s my two cents:

I think the servicers are incompetent, not evil, though some of the actions of their employees are evil. Why?

RMBS servicing was designed to fail in an environment like this. They were paid a low percentage on the assets, adequate to service payments, but not payments and defaults above a 0.10% threshold.

Contrast CMBS servicing, in which the servicer kicks dud loans over to the special servicer who gets a much higher charge (over 1%/yr) on the loans that he works out. He can be directed by the junior certificateholder (usually one of the originators) on whether to modify or foreclose, but generally, these parties are expert at workouts, and tend to conserve value. The higher cost of this arrangement comes out of the interest paid to the junior certificateholder. Pretty equitable.

Here’s my easy solution to the RMBS problem, then. Mimic the CMBS structure for special servicing. An RMBS special servicer would have to be paid a higher percentage on assets than a CMBS special servicer, because he would deal with a lot of small loans. The pain of an arrangement like this would get delivered where it deserves to go: to those who took too much risk, and bought the riskiest currently surviving portions of the RMBS deal.

The underfunded RMBS servicers may be doing the best they can. They certainly aren’t making a bundle off this. As a former mortgage bond manager, I always found the RMBS structures to be weaker than the CMBS structures, and wondered what would happen if a crisis ever hit. Now we know.

9) But then Felix again through the back door of Bronte Capital.  My comments:

I don’t short. Short selling is socially productive though. Here is how:

1) Sniffs out bad management teams.

2) Sniffs out bad accounting.

3) Adds liquidity.

4) Defrays the costs of the margin account for retail investors. Institutional longs get a rebate. Securities lending programs provide real money to long term investors, with additional fun because when you want to sell, you can move the securities to the cash account if the borrow is tight, have a short squeeze, and sell even higher.

5) Provides useful data for longs who don’t short. (High short interest ratio is a yellow flag in the long run, leaving aside short squeeze games.)

6) Allows for paired trades.

7) Useful in deal arbitrage for those who want to take and eliminate risk.

8) Other market neutral trading is enabled.

9) Lowers implied volatility on put options. (and call options)

10) And more, see:

http://alephblog.com/2008/09/19/governme nt-policy-created-too-hastily/Short selling is a good thing, and useful to society, as long as a hard locate is enforced.

=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-

That is what my commentary elsewhere is like.  I haven’t published it here in the past, and am not likely to do it in the future, but I write a lot.  Amid the chaos and economic destruction of the present, the actions are certainly amazing, but consistent with the greed that is ordinary to man.






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Bonds, Currencies, Ethics, Fed Policy, Insurance, Macroeconomics, public policy, Real Estate and Mortgages, Speculation, Stocks, Value Investing | RSS 2.0 |

4 Responses to Nine Notes and Comments

  1. Dale Simmons says:

    David,

    Happy New Year to you and your family.

    That is what my commentary elsewhere is like. I haven’t published it here in the past, and am not likely to do it in the future

    I wish you would rethink this comment. There are several very informative links in this article and it would be interesting to follow your “tracks” to other quality sites.
    Dale Simmons

  2. I am not sure what you mean, Dale. I included links to every article. Did I say something to offend you, because it is not obvious to me what I did or didn’t do that I now need to rethink.

  3. Dale Simmons says:

    No, you certainly did not offend me, your writing has been a great help to me for many years. I go back to your early days with Real Money.

    My request is that you post more of the commentary on Aleph Blog that you post elsewhere. That leads me to sites I would not find on my own.
    Dale Simmons

  4. I get it, Dale. Thanks.

Disclaimer


David Merkel is an investment professional, and like every investment professional, he makes mistakes. David encourages you to do your own independent "due diligence" on any idea that he talks about, because he could be wrong. Nothing written here, at RealMoney, Wall Street All-Stars, or anywhere else David may write is an invitation to buy or sell any particular security; at most, David is handing out educated guesses as to what the markets may do. David is fond of saying, "The markets always find a new way to make a fool out of you," and so he encourages caution in investing. Risk control wins the game in the long run, not bold moves. Even the best strategies of the past fail, sometimes spectacularly, when you least expect it. David is not immune to that, so please understand that any past success of his will be probably be followed by failures.


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