I have long said that the health of the states is a more valid measure of the health of the nation than looking at national statistics.  Why?

  • The states can’t print money, or force ask allow the central bank to buy their debt.
  • In general, the states must run balanced budgets.  (Would that we constrained the Federal government to do the same through amending the Constitution.  Somebody bring that up after the crisis is over, please?)
  • State statistics are more reliable than Federal statistics, because they serve fewer political goals.

So, what is going on with the states?  I invite readers to comment below on the affairs of their states; I am only going to cover a few big states tonight.  I will start with Illinois.

Illinois has gotten to the point where it is no longer paying its bills.  After years of deferring paying into their pension plans, and borrowing to cover shortfalls, there is no flexibility remaining in the Illinois budget.  The games that can be played accrual items have been played out, and the deficits in pension and retiree health plans are huge.

Rather than the legislature or the governor choosing what taxes to raise and what benefits to cut, well-meaning bureaucrats decide who will get paid and who won’t.  It is a haphazard way of setting priorities.

What will it take for Illinois to act? This isn’t so much an economic problem as a cultural problem.  Can the people of Illinois elect and direct their civil servants to do what is reasonable within taxation levels agreed to by the majority?  This crisis will test what it means to be the state of Illinois.

Then consider New York.  Governor David Patterson is vetoing 6,900 bills because the budget is out of balance.  What will the legislature do?  I can’t tell, but Patterson is showing some lame duck spine.  New York can’t manage with such large deficits.

California is notable, given Governor Schwarzenegger’s move to cut all government salaries to the minimum wage.  But can it be done?  Can the computers be reprogrammed to do it?  And is this the right way to balance California’s budget, or is it just a ploy to get the legislature to compromise?  The courts are going along with the move for now.

New Jersey has bitten the bullet in the short run, and has balanced its budget through shared sacrifice.  Here’s to the man who found courage when faced with the crisis, Chris Christie.  He did one of the hardest things in politics — get warring parties to compromise over budget priorities.  That is tough, as opposed to making decisions where the options are limited during a crisis, like 9/11.  There is little true heroism involved at such times, because the few courses of action are obvious.  That said, it makes the Bush Administration’s dealing with Katrina all the worse, because the options were also few.  (Yes, blame the Louisiana Governor as well, but really, what does it take to get real focus in a crisis?)  In a crisis, someone has to be ugly to get response.

All that said, the crisis in the states is likely to get worse over time, and the main reason is that the states have underfunded their employee benefit plans, and offered benefit increases which cost little in the short run, rather than fight unions over wages.  Perhaps the unions were too clever.  They are pushing the states toward a non-existent bankruptcy.  What if a state stops paying pensions and retiree healthcare?  What then?  The federal government orders them to do so.  But what if they ignore that?  The Feds have no right to order a state to do anything, outside of what the Constitution allows.

In a stylized way, this is what happened.  When states created pension plans, there was a path of expected benefit payments associated with them.  The path of funding the payments was more level than the rising curve of the payments, but states paid in less than the funding path, partly because the markets had done so well.  That led them to assume that the markets would continue to do so well, so their path of funding was reduced in the present, but higher in the future.  It also led them to bias negotiations in favor of offering higher future benefits, and less in current wages.

This worked well so long as the markets were doing really well, up through 2000.  But once that ceased to be true, the path of expected benefit payments was much higher then before, and steeper going into the future.

That is why it will be difficult for the states to get ahead of their funding path shortfalls.  In an era of low interest rates and low market returns, taxes must be raised to now pay real money into the plans, and an increasing amount each year.  It is not as if they are to the point where they have no assets in the plans and must make benefit payments out of cash flow, but the plans are distinctly underfunded on any basis that assumes fair investment returns over the next 30 years, which would be 5% per year, and not 7-9% per year.

So even for states that are presently virtuous like New Jersey, it will be hard to get out of their crises.  It will be even worse for states that are bargaining with the future and betting on a quick return to the false prosperity that was the product of an increasingly leveraged society, 1984-2007.

So watch the states.  The true picture of the nation is there; they don’t have a lot of wiggle room, and will have a difficult next two decades as the demographics catch up with the underfunding of employee benefit plans.

Working as the only analyst in a small broker dealer means you occasionally get some interesting projects.  There are many hucksters out there, and if they drop by your bitty broker-dealer to run their deal, skepticism, not hope, is the proper reaction.  “Why are we the lucky ones?” should be the skeptical question.

Anyway, here are three responses that I gave to my bosses over a four month period on deals that were brought to them.  Names have been obscured where possible.

Project 1

This was a deal that attempted to securitize life settlements, i.e. life insurance policies where the owner has sold off his interests to a third party.  The biggest problem was all of the money sucked out of the deal that would not be invested to earn a return.  Here is what I wrote:

Dear Boss,

Notes on the deal

I have read the Overview and the Private Placement Memorandum [PPM], and have scanned everything else.  Here are the main points:

1. The key page of the entire document is page 18 of the PPM.  In it we learn: the zeros get a 4.07% return, but the collateral has to earn 11.72% net of fees in order to make this deal pay off.  Also, 65.52% of the proceeds go to other than investment purposes.  Why so large?  (As an aside, this yield is at a discount to Treasuries.  An equivalent length treasury zero yields 4.55%, AAA Aid to Israel – ~5%.)
2. The continuing fees are hefty – Servicing 1%/year of Face?  Origination – 1%/month of the Matured Policy Increase Amount [MPIA – essentially a measure of cash flow profitability]?  Administrative expenses as well to third parties.  I can’t tell how big those are, or how much the collateral would have to earn to make the bond pay off.
3. The residual value guarantor, AAACO, is not in good shape.  The central bank of CN has taken over the assets and liabilities for now, but it does not seem that they have guaranteed the liabilities permanently. They are rated “B” by AM Best – not a sound rating.  On taking over the group that owned AAACO, S&P said that it was a big enough rescue that they might have to downgrade CN from its A rating.  They have since reaffirmed the rating as stable, but Moody’s now rates CN as Baa1.
4. The residual value policy doesn’t do much if there is a modest deviation from perfect performance by the originator or servicer, the policy won’t pay.
5. We don’t have all of the documents, such as the Blocked Account Control Agreement.  But beyond documents, we don’t have any sort of cash flow analysis.  How are they going to earn so much on so little invested capital?
6. We don’t have any data on the life policies, insurers, etc.  Some insurers fight life settlements.
7. The Overview dramatically oversells the virtues of the deal.  Many of the things it lists as protections are weak.  Points 3 and 5 are the same points, but it makes them sound different.  Further, CN do not own AAACO, they have it in a form of semi-receivership.  If they did own it, AM Best would give it a better rating.
8. BBB is the actuary, but she owns the originator and the servicer. [Origco & Servco]  She is not bound to continue with the deal till maturity if it gets originated (she will be 75 herself then).
9. Servco and Origco have defaulted on prior deals, and they weren’t able to get enough interest on the first deal to make it work.
10. Origco is basically broke.  They have assets of $500K, and liabilities of $2 million.  The assets are receivables from Servco.  Servco owes $16 million that it can’t pay off either.
11. Origco and Servco do not use accrual accounting.  They could not pass a GAAP audit.  Even with accrual accounting, they would not be a going concern.
12. Origco and Servco have existing default judgments against them, and no way to pay them.
13. If Servco or Origco default, the residual value policy does not pay.
14. Servco and Origco have no significant staff.  If this gets originated, there will be a significant risk as they staff up.   They also don’t have licenses.  This is not a bond, it is seed stage venture capital.
15. They have had run-ins with the SEC, Texas Securities Commission, and Securities Division of North Carolina.
16. The notes are deemed equity for tax purposes, which seems aggressive to me.

If you want, read page 18, and scan the risk factors section of the PPM (pages 19-57).  It is my belief that this is something that we don’t want to get mixed up with, at any price.  I can understand why no underwriter wants to take this on, and why they are looking to smaller broker-dealers.  But if you want to look into this further, have them forward to me their cash flow analyses.  I can’t imagine how they get this to work.

I have this phrase that I use sometimes, “Holding my nose as I hit the delete key.”  That is when something smells so bad, the odor can even travel over the Internet.  This feels like the attempt of some desperate people who are deeply in debt, and need one “grand slam” to bail themselves out of debt
and have a happy retirement.

Postscript: this deal not only did not get done, but the boss apologized for bringing it to me.

Project 2

This was a case where someone was willing to offer us $5 million in capital if we gave them $1 million.  What an altruist!  Not.  Yes, the value of shares if you could sell them all at the “last trade” was worth $5 million, but the company was basically a warrant on the success of a technology, and the balance sheet was horrendous.  This is what I wrote:

Dear Boss,

This doesn’t smell good.  Here’s my commentary, together with excerpts from their recent 10-K and 10-Q:

$6250 Stock Trading Volume per day

Negative earnings, cash flow, and net worth.  Little to no liquidity – huge negative net working capital.

1-100 reverse split

Auditors comment for 2008 10K: The accompanying consolidated financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 11 to the consolidated financial statements, the Company has a significant working capital deficit, has recognized significant operating losses in each of the years in the three year period ended December 31, 2008, and will need significant amounts of investment funds to fully develop its oil and gas leases. Management’s plans in regard to these matters are described in Note 11. The financial statements do not include any adjustments that might result from the outcome of this uncertainty.

The Company currently has three full-time employees.

Risk factor: The Company has incurred net operating losses since 1997. However, the Company currently has operations that provide working capital. The Company is also seeking further project based financing to develop its existing projects. There is no assurance that the Company will be able to secure adequate financing to fund those operations.

High compensation to management for not much of a company.  $5 million in 2008.

The Company failed to timely file a current report on Form 8-K upon the occurrence of the Default Notice and Acceleration Notice under the Credit Agreement with CCC, and the July 22, 2008 Limited Forbearance Agreement pursuant to which Gas Rock agreed to refrain from pursuing remedies for a limited time.

NOTE 7 – Note Payable – CCC CAPITAL LLC

The Company entered into an advancing term credit agreement for $30,000,000 on April 13, 2006 through its subsidiary DDDa, LLC with CCC Capital, LLC to fund the purchase of the EEE Field in GGG Oklahoma. This agreement was increased to $50,000,000 on April 2, 2007. The balance at December 31, 2008 was $13,423,221, net of debt discount of $41,077, and the Company paid interest of $1,957,294 for the year ended December 31, 2008. The note is secured by all of DDDa’s assets and certain personal assets owned by EEE, CEO of the Company. DDDa’s assets are cross-collateralized on a $3,469,000 loan made by CCC Capital, LLC to FFF, a related party. This loan is currently in default, with interest only payments being made.

On April 9, 2008, CCC delivered to the Company a Notice of Events of Default and Unmatured Events of Default (“Default Notice”) under the Credit Agreement. Due to these claimed Events of Default, interest under the Credit Agreement began accruing at the Default Rate of 15% and 100% of DDD’s Net Revenues were applied to Debt Service and other Obligations as of April 9, 2008. On April 16, 2008, CCC delivered to the Company a Notice of Acceleration (“Acceleration Notice”) under the Notes due to the continuing claimed Events of Default under the Credit Agreement. The Acceleration Notice declared the amounts due under the Note to be accelerated and due and owing in full as of April 16, 2008.

On July 22, 2008, CCC, DDDa and FFF (“FFF”, and together with DDDa, the “Borrowers”), entered into that certain Limited Forbearance Agreement, pursuant to which CCC agreed, subject to the terms thereof, to forbear from pursuing remedies under the Credit Agreement and Notes in respect of the Events of Default claimed as of that same date until the earlier of (i) November 15, 2008 and (ii) the date that CCC gives DDDa notice of any additional payment default under the Credit Agreement. FFF is controlled by the Company’s CEO and is a guarantor of the DDDa Obligations under the Credit Agreement. CCC is also a lender to FFF under an Advancing Term Credit Agreement (the “FFF Credit Agreement”, and together with the Credit Agreement, the “Credit Agreements”.

The Forbearance is subject to the following conditions to be fulfilled:

1) On or before November 15, 2008, (i) the Borrowers must repay all Obligations (as defined in the Credit Agreements) or (ii) DDD must have entered an agreement for the full or partial sale of the EEE Field, the proceeds of which would fully repay the Obligations owing under the Credit Agreements, and such sale shall close and repayment of the Obligations shall be made by December 31, 2008;

2) If the Obligations are not repaid by November 15, 2008, DDD must assign a 5.0% net profits interest in the EEE Field to CCC, effective as of November 1, 2008. The form of this assignment and the potential assignments discussed in paragraph 3, below, will be substantially in the form of the Conveyance of Net Profits Overriding Royalty Interests, attached as Exhibit A to the Forbearance Agreement;

3) If the Obligations are not repaid by December 15, 2008, DDD must assign an additional 1.0% net profits interest in the EEE Field to CCC, effective as of December 1, 2008, and will assign to CCC an additional 1.0% net profits interest each subsequent month if the Obligations are not repaid by the 15th of such month;

4) DDD shall escrow one 5% net profits interest conveyance and five 1% net profits interest conveyances to ensure it’s delivery of any potential obligations under paragraphs 2 and 3, above;

5) Any and all Net Proceeds (as defined in the Forbearance Agreement) from any equity issuance, refinancing, or asset sale will be applied first to outstanding fees and expenses of CCC, second to the accrued and unpaid interest on the Notes, and third to the outstanding principal balances on the Notes; and

6) The Borrowers must ensure that its hydrocarbon purchasers make payments relating to any of CCC’s overriding royalty interests in the EEE Field directly to CCC.

NOTE 11 – Going Concern

The Company has reported operating losses aggregating $9,877,016 for the two (2) year period ended December 31, 2008. At December 31, 2008, the consolidated balance sheet reported a working capital deficit of $23,887,172. The Company must raise significant amounts of cash to pay its current liabilities and to provide investment funds to continue development of its oil and gas leases. There can be no assurance the Company’s management will be able to secure funding.

David here: There is little assurance that an immature development stage company like this will ever be worth anything.  I am no expert on hydrocarbons but this company is overindebted, and it is likely that debtholders will own the assets within a year or two, and equityholders get nothing.

DDD shares would not, not, not be an asset to our firm.

Postscript: 6 months later, the stock worth $5 million is worth $300,000.  And will be worth zero soon.

Project 3

Another life settlements securitization.  The originator seems to be honest, but is using the securitization to get a cheap commercial mortgage loan.  What I wrote:

Dear Boss,

I’ve read through the whole document.  Here are my thoughts:

Summary Notes

The officers of the company have no experience at all with life settlements.  They do have some experience with multifamily housing.  They are using a life settlements securitization to facilitate loans for their multifaqmily housing expansion plans.  To me, that is pretty convoluted.  Why not simply go out and borrow the money?

I realize the offering memorandum is preliminary, but there are several things that need to be clarified:

  • Need to see the financials of the GGG enterprises
  • Correct address for their website.
  • Who is HHH Capital Management?  Can’t find them — the portfolio managers.
  • Need fees, policy data, and expected cash flows
  • What are they doing to source portfolio 2?
  • Need actuarial projections
  • Exactly what are the trusts receiving as collateral for the loans?  I need pro-forma financials on the property(ies) to be developed…
  • Where are the related party transactions?
  • If this deal is 3x overcollateralized, where does the excess money come from?  Who is the equity, and what are their motives?

That’s all for now.  Looking forward to more data.

After the response, I wrote:

Dear Boss,

I realize the offering memorandum is preliminary, but there are several things that need to be clarified:

I have three tentative conclusions (with questions):

1.      The largest asset is a 9 year fully amortizing 2.7% loan on the $40,000,000 to the sponsoring company.  It is a hidden source of profit to them, but the full amortization makes the loan more secure, it they can make the first few payments.  That said, they would need 12% cash flow on the loan to make the payment, and where will they get that?

2.      The deal would need a 6.1% return on the Life policies to get a Treasury yield on the certificates.  8.0% return to get T+100.  15.75% to get T+500.  What would it take to sell these notes?

3.      There is a low probability of full payment of principal.  A margin of $25 million on a $250 million principal payment is skimpy, and in my opinion, decidedly not investment grade.  I assume these aren’t going to be rated, right?

And I have additional data needs:

4.      Who is HHH Capital Management?  It looks like a new firm – do they have the ability to do their part?

5.      I need fees, policy data, and more detailed expected cash flows. Where is Appendix B?

6.      How were the life expectancies calculated?  That’s hard to do right.  Second opinions?

7.      I need actuarial projections, with considerable detail. That would mean a copy of the JJJ review.

8.      Exactly what are the trusts receiving as collateral for the $40 million loan?  Pro-forma financials on the property(ies) to be developed… And, I would need to see the financials of the GGG enterprises.

I think this deal will prove hard to complete.

Postscript: we went further with this group than the other two, but when faced with my data requests, the originator gave up.

After this happened to me, I talked with an investment banker who is local, and has many contacts like mine.  He commented on how small broker dealers get hit up with slick pitches, any one of which if accepted, could destroy the broker-dealer.  The trafficking of blocks of life settlements is endemic, and is a search for what lemming has the lowest discount rate — has mis-estimated the risks.

He also mentioned how these groups toss around big names as those that will buy the senior certificates.  I experienced that myself.  Kuwaiti Investment Authority, indeed.

So, in four months time, I kept my firm from making dumb decisions three times, any one of which might have severely damaged or destroyed the firm.  What did I get get for my efforts?  The best thing of all: gratitude from my bosses, and knowing that I did my best for those that hired me, protecting the interests of all stakeholders of the firm.

Skepticism is a necessary aspect of investing, particularly as the complexity level rises.  Aim for simplicity, and put safety first in your investing.  It is easier to protect value than to try to earn back losses from mistakes.

To phrase it another way — in order to work through these deals, I had to read through over 1000 pages of data.  Don’t let the multiplicity of words dull you to the risks that exist.  Even for small investors I would say avoid complexity.   Where there is complexity, there is a much higher risk of loss, almost always.  Stick to simple investments, and let the complex stuff be bought by experts, who will turn away most of the charlatans.

To my readers: I am still in the process of blog repair.  I have heard from a few readers that I need larger type and more contrast.  I will fix that.  For now, use Ctrl-+ to expand the font.  I don’t want any of you going blind over me. 😉


Onto tonight’s topic: asset allocation.  So, we had a bad quarter for equities.  Not that I can predict things, but I pulled in my horns progressively over the last nine months, culminating in buying a bunch of utilities at the last portfolio reshaping.  I own mostly energy, insurance, utilities, and consumer nondurables stocks, with a little tech thrown in for fun.  At present, median P/E is around 9, and P/B around 90%, with strong balance sheets, and around 17% of the portfolio in cash.  I missed roughly half of the carnage of the last quarter, and this week, I put some money to work, cash falling by 1%.

So, when are equities cheap?  Next question: cheap relative to what?  It’s difficult to say when equities are absolutely cheap, but here are some ideas on cheapness:

  • Stocks are absolutely cheap when they trade in aggregate at less than book value, or less than 8x trailing earnings.  Think of Buffett getting excited back in 1974.
  • Stocks are relatively cheap to Baa bonds when the earnings yield of stocks plus 3.9% is above the yield on Baa bonds.  But this at present depends on very high profit margins continuing, and sales not shrinking, neither of which are guaranteed.
  • When there is significant debt deflation going on, determining cheapness is tough.  Better to ignore the market as a whole, and focus on survivability/cheapness.  Aim at companies in necessary industries with relatively little debt, strong accounting practices, and cheap to earnings/book/sales.
  • I don’t have a good metric for when equities are cheap/dear to commodities.  Ideas welcome.

With respect to bonds, credit spreads are not wide enough to make me yell buy, as I did in November 2008 and March 2009.  Beyond that, the spread on GSE debt and guaranteed mortgages is thin.  TIPS look attractive, as few care about inflation.  The US dollar has been strong lately, largely due to weakness in the Euro.  I would be light on non-dollar bonds for now.

What we have been experiencing is creeping illiquidity, where the prior stimulus from the Fed and US Government has been declining.  There isn’t enough private demand growth to drive the economy, because we need to pay off or compromise on debts.  Also, the private sector looks at the growing debts of the government, and gets concerned.  How will the government deal with it?  Higher taxes, inflation, default?  No good scenarios there.

When an economy is overleveraged, there are no good solutions.  If sales fall, then corporations will fire more people, and idle more capacity in order to maintain profits near prior levels.  High quality bonds do well, but stocks do poorly, until enough debts are paid of or compromised, and the economy can work without the fear of mass insolvency again.

I have written before on a new approach to asset allocation.  Broadly, I am looking at a system that:

  • Considers the credit cycle first.  Great returns typically happen after credit spreads are wide, and are lousy after they are tight.
  • Considers the slopes of the Treasury nominal and TIPS curves.
  • Looks at the cash flow yield of all asset classes relative to history, relative to other asset class yields, etc.
  • Factors in safety provisions for each asset class.  Stocks need the most, then junk bonds, then investment grade.
  • Looks at the short-run and the long-haul returns of each asset class, attempting to analyze when the short run is way above or far below long-haul trends.

At present, I am still happy playing conservative, because I am less confident about debt deflation than most investors are now.  There will come a time to be much more bullish, but it will come after earnings decline, and firms have delevered still further.