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Archive for August, 2010

Queasing over Quantitative Easing, Part IV

Tuesday, August 31st, 2010

In my last post on this topic, I went over the orthodox and unorthodox monetary policy responses to the crisis in the US.  Here were the orthodox options:

  • Lower the Fed funds rate into lower positive territory.
  • Offer language that says that the Fed Funds rate will be low for a long time.
  • Buy more long-dated Treasury bonds.

And the unorthodox options:

  • Lend directly to classes of private borrowers.
  • Create negative interest rates for Fed funds.
  • Debase the currency by expiration dates, lotteries, etc.

On orthodox policy: I’m not sure there is that much difference between Fed funds at 0.25% and 0.10%, except that money market funds will find themselves in further trouble, as yields are too low to credit anything. That the Fed will be on hold for a long time seems to be the default view of the market already, so an explicit declaration would likely prove superfluous.  On buying long-dated Treasury bonds, that will benefit the US Government by pseudo-monetizing the debt, but won’t help the real economy much.

Yes, some high-quality corporate and mortgage bond rates will be pulled down with it, but so will discount rates for liabilities.  The same applies to spending rules for endowments, and how much retirees can get if they go to buy an annuity.  The effects of QE are mixed at best, and on balance, might be depressing, not stimulating.  But what practical proof, if any, do we have that QE has ever worked?

We need policymakers to understand the bankruptcy of the theories they are working with.  So many macroeconomic models work with one interest rate.  But in the real world there are many rates, and duration and quality of lending make a huge difference in what rate is charged.  I would urge that every person who would be on the FOMC work at a buyside firm managing bonds and money market instruments.  Let them see how the markets really work, and it might disabuse them of their false neoclassical views of how the lending markets work.  Better still, if their P&L is less than the cost of capital, revoke their appointment.  It’s time to kick out the academics, with their failed ideologies, and let those who have worked in the markets successfully manage the economy.

Direct Lending

But then there are the unorthodox methods.  When Social Security came into existence, they argued over where the money would be invested.  It was decided that the only fair investment was in government bonds, because it was neutral.  Investing in other assets, like the S&P 500 would be unfair, because they would be favoring a sector of the economy.

The same argument applies to direct lending by the Fed, because it would smack of favoritism.   Going back to my last article, favoritism undermines confidence in the system, and makes people less willing to invest unless the government gives them an edge — cash for clunkers, $8,000 tax credit, etc.  We are Americans, after all.  Why buy from the retailer now, when you know that there will be another sale coming soon?  Economic policymakers should not rely on people to behave “as usual” when policy becomes unpredictable and unfair to the average person.

So I don’t see direct lending by the Fed, or buying high yield bonds, or offering protection on baskets of bonds as wise moves.  It may temporarily goose an area for a time, and make an area of the economy QE-dependent, or stimulus-dependent, but at best it is helping a few, while discouraging the rest.

Negative Fed Funds

I’ve been thinking about negative rates for Fed funds, and I think that they will have the following effects:

  • Banks will drop their excess reserves at the Fed to zero, and vault cash (or its short-term debt equivalents) will increase.
  • Banks will try to borrow from the Fed at negative interest rates, if they allow it, and just sit on the cash, park it in T-bills, Top-top CP — it’s free money, after all.  Of course, some point free money may be construed as valueless money, but that is another thing.

Required reserves are not a large percentage of liabilities.  Unless Fed funds goes deeply negative, it’s not going to affect bank profitability that much.  Banks may just view it as a cost of doing business, and pass it on to customers.

Destructive Creative Currency Debasement

With apologies to Schumpeter, who popularized the concept of creative destruction, I’ll try to define a new concept that is the opposite — destructive creativity.  Destructive creativity is when bureaucrats or regulators get too clever, and in an attempt to solve a lesser problem, end up creating a bigger problem.

I’ve heard proposals for further debasement of the currency via placing expiration dates on currency, or randomly canceling currency through lotteries based on the serial numbers on the bills.  The idea is that people will change their behavior: save less and spend more.

I can’t say that I can see every unintended consequence with these proposals, but according to Keynes, Lenin said, “The best way to destroy the capitalist system is to debauch the currency.”  These creative means of debasing the currency might do it.

Who gets to be the one holding the Old Maid card as expiry draws near.  How much time would be wasted scanning currency at registers as money is handed over and change is handed out?  Is the money cancelled or expired?  Close to expiration?  Quick, put it into the pile to give as change to the next customer.  There may be legal tender laws, but I can tell you that there would be fights over things like this.  Would all of the dollar bills used as a shadow currency overseas come trotting home?

If the Fed wanted to write its own death warrant, it should implement schemes like these.  The Fed is already viewed with enough skepticism by average people, that it wouldn’t take much to tip the scale from “Audit the Fed,” to “End the Fed,” where it gets replaced with the currency board tied to a commodity standard.

This leaves aside ideas like expiring/canceling a certain amount of monies in savings or checking accounts.  After all, why stop with the paper money?  Move onto the blips that we transfer day after day, silently, quietly choking the economic well-being of people, making them feel less safe, less secure, more paranoid.  Would we set up checking/savings accounts in other currencies to avoid this trouble?  Would that even work, such that we would have to set them up in foreign countries, and access funds that way?  What’s that you say?  Exchange controls?  Destructive creation indeed.  To “solve” a smaller problem, a dud economy, create a much larger problem…

Want to kill the economy/country?  Taxation is one thing, confiscation is another.  There are more than enough people who have question marks in their heads over what the government is doing with monetary policy and stimulus.  Aggressive actions to debase the currency can turn those question marks in to exclamation points.

This has gone longer than I thought.  Time to hit publish, and I will finish this tonight.

Tickers for the Current Portfolio Reshaping

Saturday, August 28th, 2010

I haven’t written about my portfolio management methods in a while.  I’ll be writing on this a few more times over the next week or so.  The eighth rule of my investing is:

Make changes to the portfolio 3-4 times per year. Evaluate the replacement candidates as a group against the current portfolio. New additions must be better than the median idea currently in the portfolio. Companies leaving the portfolio must be below the median idea currently in the portfolio.

First I have to get new ideas.  I have two sources for that:

  • My industry rank study.  Within those industries chosen, I run a screen that uses financial strength, valuation, and growth potential to highlight promising names.  Of the 34 current names in the portfolio, the screen chose 10 of them, out of 79 suggested names.
  • Trolling around on the web and talking to friends.  When I hear a promising idea, I print it out or write it down, and put it in a pile to wait for the next reshaping.  This helps me to forget who suggested it and why, so that I am forced evaluate it independently.  If I don’t fully understand it, I will not know when to buy more or sell it.  That generated 40 additional names.

Anyway, here are the tickers for the replacement candidates:

ABFS ACM AEP AFL AMGN APA APC APOL ATPG AXS BCE BDX BHI BRY BT CAG CALM CAM CDI CL CLX CNQ CPO CVS DFG DLM DO EGN ENR ESLT FDP FISV FLIR FRX FST FTO GD GLRE GMXR HAL HOGS HRL HSII IP JBL KELYA KEX KFT KHDHF LLL LNC LPX MDT MDU MET MMM MOG/A MOT MRO MUR MWV NBR NEMNLC NOV NVDA OCR OII OSG PCCC PG PRU PXD PXP RAH RDS/A RE REP RIG RNR RTN SJM SPR SU SUN SXT TDW TDY TEG THS TK TLM TMK TMO TRH TRP TSO TTI UNM V VZ WAG WAT WMT WPP WY YUM

I will run my quantitative model on these companies versus the current companies in the portfolio, and kick out companies I now own that score poorly and buy some the score well.  This procedure is not absolute; there are often bits of data  that the quantitative factors ignore.  But when all is said and done, I buy companies that I think are better than those that I am selling.

This also forces me to review the whole portfolio, and be dispassionate about what gets sold.  It also forces me to take things slow, and not make hasty decisions.

What factors exist in my scoring model:

  • Valuation – Earnings, Book, Sales
  • Momentum
  • Earnings Quality
  • Sentiment indicators — neglect, volatility, etc.

I change the weights over time.  I ask myself, “What is working now?” and, “What has or hasn’t been working for too long?”  What working now should get extra weight, while leaning away from ideas that are too popular, and leaning toward those that are unfairly tarred as dead.

But this is only an aid and a guide.  If I put something into the portfolio, it has to pass my qualitative reasoning tests, which admittedly are subjective, but encompass my reasoning as a businessman.

In short, that is what I do.  I hope to give you an update in a few days to explain how this practically worked out in this reshaping.  If you have other tickers that you think I should consider please let me know in the comments, and I will toss them into the mix.  Thanks.

Queasing over Quantitative Easing, Part III

Saturday, August 28th, 2010

I have a post on the futility of fiscal policy coming, but the hubbub over Jackson Hole has made me alter my publishing schedule.  I want to give one more shot on the idea that the Fed is out of ammunition, and that unorthodox moves are more likely to scare the public than result in increased real GDP.

I am better off than all of my friends, I think.  A common occurrence for me is a friend coming to me and saying, “How can the government borrow so much?  It doesn’t make sense.  Why do they spend money on this and not on me?”  I understand the paradox of thrift, but I don’t agree with it.  One reason is that because it is a paradox, ordinary people will react badly to actions of the government that they can’t do themselves.  Second, when the government or central bank does it, it seems like a form of theft, because no one should get something for nothing, and it degrades the ordinary person’s view of the honesty of the Government or Central Bank.  Third, what the money gets used for is viewed as a waste by some.

This consideration of the basic sense of fairness among average people should not be discounted by policymakers, nor the fear engendered when policymakers take such actions.  It is how average people think.  If you remember my review of the book Priceless, you might realize that people often act out of a sense of fairness, not out of economic interest.  When you think about the Paradox of Thrift through that prism, it is plain why government action doesn’t work — many people do nothing different when the government/central bank is making bold moves, because they are less certain about the future because the powers that be are dishonest in their view.

That said, the main reason I don’t agree with the solution to the paradox of thrift is that the government generally misspends money on cronies or projects of cronies.  It does not build the productive capacity of the economy, but only current consumption.  It does not aid growth.

Monetary Policy Now

Looking over a variety of articles on the options the Federal Reserve has, I would say that they are out of ammo that can do good.  They have plenty of ammo to destroy the economy, but little to build it.  What options does the Fed have left?

  • Lower the Fed funds rate into lower positive territory.
  • Offer language that says that the Fed Funds rate will be low for a long time.
  • Buy more long-dated Treasury bonds.

And the unorthodox options:

  • Lend directly to classes of private borrowers.
  • Create negative interest rates for Fed funds.
  • Debase the currency by expiration dates, lotteries, etc.

I will pick up on this tomorrow, and explain why the options that the Fed has are limited.

Industry Ranks August 2010

Thursday, August 26th, 2010

Industry RanksI’m working on my quarterly reshaping — where I choose new companies to enter my portfolio.  The first part of this is industry analysis.

My main industry model is illustrated in the graphic.  Green industries are cold.  Red industries are hot.  If you like to play momentum, look at the red zone, and ask the question, “Where are trends under-discounted?”  Price momentum tends to persist, but look for areas where it might be even better in the near term.

If you are a value player, look at the green zone, and ask where trends are over-discounted.  Yes, things are bad, but are they all that bad?  Perhaps the is room for mean reversion.

My candidates from both categories are in the column labeled “Dig through.”

If you use any of this, choose what you use off of your own trading style.  If you trade frequently, stay in the red zone.  Trading infrequently, play in the green zone — don’t look for momentum, look for mean reversion.

Whatever you do, be consistent in your methods regarding momentum/mean-reversion, and only change methods if your current method is working well.

Huh?  Why change if things are working well?  I’m not saying to change if things are working well.  I’m saying don’t change if things are working badly.  Price momentum and mean-reversion are cyclical, and we tend to make changes at the worst possible moments, just before the pattern changes.  Maximum pain drives changes for most people, which is why average investors don’t make much money.

Maximum pleasure when things are going right leaves investors fat, dumb, and happy — no one thinks of changing then.  This is why a disciplined approach that forces changes on a portfolio is useful, as I do 3-4 times a year.  It forces me to be bloodless and sell stocks with less potential for those wth more potential over the next 1-5 years.

I still like energy names here, some utilities, and reinsurers, particularly those that are strongly capitalized.  I’m not concerned about hurricanes for the strongly capitalized (it’s not likely to be a strong season anyway; if it hasn’t been strong yet, it likely will not be); they will be around to benefit from the increase in pricing power after any set of hurricanes.

I’m looking for undervalued and stable industries.  Human resources — sure, more part time workers.  Healthcare information?  A growing field, even with the new “health bill.”  Same for Biotech.

Even in a double dip, toiletries will still be purchased.  Phone calls will still be made, and the internet will still be accessed.  Perhaps life insurers are worth a look here; after all, the Bush tax cuts are expiring, and there will be more demand for tax avoidance.

I’m not saying that there is always a bull market out there, and I will find it for you.  But there are places that are relatively better, and I have done relatively well in finding them.

At present, I am trying to be defensive.  I don’t have a lot of faith in the market as a whole, so I am biased toward the green zone, looking for mean-reversion, rather than momentum persisting.  The red zone is more highly cyclical than I have seen in quite a while.  I will be very happy hanging out in dull stocks for a while.

Ten More Notes on the Current Market Scene

Tuesday, August 24th, 2010

11) I was surprised to read that there is not a perfect market in interest rate swaps.  They are so vanilla, but counterparty risk interferes.

12) There is always a skunk at the party, and who better than Baruch to dis bonds?  I half agree with him.  Half, because the momentum can’t be ignored entirely.  Half, because profit margins are wide.  But rates are low, and unless we are heading into the second great depression, stocks look cheap.  That’s the risk though.  Is this the second Great Depression? (Or the Not-so-great Depression that I have called it earlier.)

13) Housing is a mess.  The US government has been engaged in a delaying action on defaults, while calling it a rescue effort.  The sag in housing prices may lead to a recession.  The FHA is raising the costs of mortgages because their past loans have had too many losses.

14) Commercial Real Estate continues to do badly while some CMBS performs — no surprise that what is more secured does well.

15) The Fed gets whacked on its lack of transparency.  This could be a trend for the future.

16) In the current difficulties in the Eurozone, the ECB is beginning to suck in more bonds, presumably from peripheral Eurozone countries that are seeing their financing rates rise.  As central banks get creative, a simple question for currency holders becomes what backs the money?  It would seem to be governments, which will absorb losses if central banks generate them, and cover it with additional taxes or borrowing (some of which could eventually be monetized).  What a mess.

17) Bruce Krasting is almost always worth a read, and he digs up something that I had forgotten about how interest is credited on the Social Security Trust Funds.  It’s calculated this way:

The average market yield on marketable interest-bearing securities of the Federal government that are not due or callable until after 4 years from the last business day of the prior month (the day when the rate is determined). The average yield must then be rounded to the nearest eighth of 1 percent.

Krasting thinks that’s too high.  I think that is too low, given the true tradeoff that is going on here.  Think about it: when the government borrows from the SSTFs in a given year, a slice of the benefits incurred over that year don’t get “funded.”  The debt claim to back that should match the maturity profile of those future claims.  Medicare would have some short claims, Disability and Supplemental Security slightly longer, but Old Age Security develops most of the assets, and is a long claim.  Say the average person paying in is 40, and they will retire on average at 65.  That is a 25-year deferred claim that will last for maybe 20 years on average, with inflation adjustment.  The US offers no debt that is that long to back such a liability, so I would argue that the proper rate to use would be that of the longest noncallable debt offered by the Treasury.

But here would have been my second twist on this: they should have absorbed the longest marketable securities from the debt markets, and bought and held them.  That would have looked really ugly as the rates looked piddling against current interest costs.  But today, it would reflect the true costs of the borrowing from the SSTFs, and that cost would likely be greater than what was paid to the trust funds.  My guess is that the interest rate paid on the trust funds today would be higher than 5%, maybe higher than 6%, if a fair method had been used.

If there is enough interest, I could try to run the numbers, but the point is academic.  It would not change the total claims against the government plus SSTFs as a whole, but it might have changed the behavior of the government if it had tried to borrow on a long duration basis, competing for funds with private industry.  It would have revealed the true tradeoff earlier, and shown what a trouble we were heading for.

18) On retained asset accounts, this Bloomberg piece makes me say, “Yes, this is a big enough issue to deal with.”  For MetLife particularly, which has its own bank, it would be simple enough to set up a genuine bank account with all of the statutory protections involved.  If there are risks from forgery, that is big.  Even the risks of not being covered by the state guaranty funds is big enough.

My view is this: full cash payment should be the default, and a genuine bank account an option.  If you have one of these checkbooks now, and you want to minimize your risks, do this: write one check for the balance so that it is deposited in your bank account.  Simple enough.  You can protect yourself with ease here, even without legal change.

19) The yen will continue to rally until the Japanese economy screams.  Currency moves tend to last longer than we anticipate, and secular moves force needed economic changes on countries.

20) Consider what I wrote last week on long Treasuries:

I am not a Treasury bond bull, per se, but I am reluctant to short until I see real price weakness.  And some think that I am only a fundamentalist value investor.  With bonds, it is tough to catch the turning points, and tough to grasp the motivations of competitors.  Better to miss the first 10% of a move, than miss it altogether.

Now, I never expect to be right so fast, but with rates gapping lower on economic weakness — the 10-year below 2.5%, and the 30-year below 3.6%, I would simply say this: don’t fight it.  Let the momentum run.  Wait until you see a significant pullback in prices, and then short.  Don’t be a macho fool fighting forces much larger than yourself.  The markets can remain crazy for longer than you remain solvent.

Ten Notes on the Current Market Scene

Tuesday, August 24th, 2010

1) Start with the big one from yesterday.  On of my favorite monetary heretics, Raghuram Rajan, whose excellent book I reviewed, Fault Lines, pointed out how he had gotten it right prior to the crisis, versus many at the Fed who blew it badly.  Rajan suggests that Fed Funds should be at 2-2.25%, which to me would be a neutral level for Fed Funds.  That’s a reasonable level.  The economy needs to work its way out of this crisis, even if it mean failures of enterprises relying on a low short rate.  Entities that can’t survive low positive rates that give savers something to chew on should die.  Mercilessly.  Monetary policy at present is a glorified form of stealing from savers, who deserve more for their sacrifice.

2) Peter Eavis, an old friend, echoes my points on QE, in his piece Government Clouds Value of Investments.  When the government is actively trying to destroy the willingness to hold short-term assets, and engages in QE, it makes all rational calculations on investments a farce.

3) I agree with John Hussman in a limited way.  QE artificially lowers interest rates, which lowers the forward value of the US Dollar.  That doesn’t mean it will generate a collapse; I don’t think it could do that unless the Fed began to do astounding things, like monetize a large fraction of all debt claims.

4) The US Government is so dysfunctional that the baseline budget has increased 4.4 Trillion over the next 10 years.  This is the beginning of the end of the supercycle, and the reduction of America to the influence level of Brazil.  Earnings levels will converge as well, but more slowly.

5) While we are thinking soggy, think of Japan.  Years of fiscal and monetary stimulus have availed little.  Overly low interest rates have fostered an economy satisfied  with low ROEs.  Low interest rates coddle laziness, and encourage stagnation.

6) There are limits to stimulus, whether monetary or fiscal.  There is no magic way to produce prosperity by government fiat.  Stimulus, by its nature, will run into constraints of default or inflation, if taken far enough.  If not, why doesn’t the Fed buy up all debt?  (leaving aside laws) Isn’t QE a free lunch?

7) Deflation is tough; it weighs upon cities, states and other municipalities, who hide their true obligations.

8 ) Hoisington, the best unknown bond manager.  Where do they think long rates are going?  2% or so on the 30-year.  Makes the current buyers of bond funds look like pikers.  That’s over a 35% gain from here.  If they are right, their fame will be legendary.  Now, that could explain the willingness to fund ultra-long duration debt, because the gains will be bigger still.  What a great confusing time to be a bond investor, until something fails.

9) Or consider the Norfolk Southern 100-year bond deal yesterday.  Quoting the WSJ:

In what bankers hope will be the first in a new round of 100-year bond sales, Norfolk Southern Corp. raised $250 million Monday by selling debt that it won’t have to repay until the next century.

Investor interest was strong enough that the company increased the size of the new sale from $100 million. Market participants said investors had expressed an interest in buying at least $75 million of the debt before the company decided to announce the $100 million deal.

The interest rate on Norfolk Southern’s new debt is 6% for a yield of 5.95%, about 0.90 percentage points more than where the company’s outstanding 30 year debt was trading Monday. It was the lowest yield for 100-year debt bankers could recall, breaking through the 6% yield on the company’s 100-year issue in 2005.

“There is no question, obviously, that you are giving up a bit of liquidity, but you’re getting a pickup of 90 basis points to move out of the 30-year,” said Jeff Coil, senior portfolio manager at Legal & General Investment Management America. “But you’re getting good income on a stable cash credit in a sector where there are only a handful of rails left.”

Mr. Coil said the firm had a “sizeable” order in the deal. There were approximately 20 investors overall.

Moody’s Investors Service rated the new senior fixed-rate bonds Baa1, and both Standard & Poor’s and Fitch Ratings rated them BBB+.

Is 0.90%/year enough to compensate from going from 30 to 100 years?  I think so. The difference in interest rate sensitivity of a 30 versus a 100 are small at a yield of 5-6%, and if you have a liability structure that can handle it, as a life insurer might, it makes a lot of sense.  After all, a life insurer can’t economically invest in equities because of capital restrictions. You could compare it to investing in long dated preferred stock or junior debt, but then if there is a default, the losses are more severe than with a senior unsecured bond.

10) I’ve never found the yield curve model for recession/recovery compelling.  Limited data set, not covering the Great Depression, etc.

More to come.

Managing Illiquid Assets

Monday, August 23rd, 2010

Illiquidity is an underrated risk.  Most financial company failures are due to illiquidity, which usually takes the form of too many illiquid assets and liquid liabilities.  Adding to the difficulty is that it is generally difficult to price illiquid assets, because they don’t trade often.

So where do we see failures due to illiquidity?

  • Banks — too numerous to mention, though FDIC insurance restrains it now.
  • Life insurers, particularly those that write a lot of deferred annuities.
  • AIG and the GSEs — abominations all.
  • Bear and Lehman — waiving the leverage limit was one of the stupidest regulatory decisions ever.
  • Hedge funds – LTCM was the granddaddy of failures, but many have choked because redemptions forced liquidation of assets at unfavorable prices.
  • No colleges, though those college that were too aggressive on illiquid assets got whupped in 2008.  Some were forced to raise liquidity in costly ways.  Same for many overly aggressive pension plans, many of whom came late to the game with Venture Capital, Hedge Funds, Timber, Commodities, etc.

Face it.  Most alternative asset classes involve additional illiquidity.  That is an additional risk, and when evaluating those investments, the expected rate of return must be greater than that for liquid investments.

As an aside, there is another factor to be considered with alternative investments.  That factor is strategy capacity.  Alternative investments do best when they are new.  Here is my version of the phases that they go through:

  • New — few know about it except some business-minded investors.  Only the best deals get done.
  • Growing — a modest number know about it, and a tiny number of consultants.  Only very good deals get done.
  • Comes of age — many know about it, and most consultants pitch it to their clients as the way to go.  Good deals get done.
  • Maturity — almost everyone knows about it, and it is a standard aspect of asset allocation for consultants, who have their means of differentiating between different providers, based on metrics that will later be revealed to be useless.  All reasonable deals get done.
  • Post-maturity — Late bloomers make it to the party, and beg to get in, thinking that past is prologue, and do not realize that deal quality has eroded severely.
  • Failure, which brings maturity — deals fail, leading the market to scrutinize all investments, leading to true risk-based pricing.  Later adopters abandon the market, and take losses.  Earlier adopters sharpen practices, and prepare for a more normal asset class.

So, when looking at illiquid assets, how do you determine how much to invest?  First determine how much of your funding base will never leave over the next 10 years.  When I was a corporate bond manager, that was 25% of the assets that I was managing, because of structured settlements and immediate annuities.

For a pension plan or endowment, forecast needed withdrawals over the next ten years, and calculate the present value at a conservative discount rate, no higher than 1% above the ten-year Treasury yield.  Invest that much in short to intermediate bond investments.  You can invest the rest in illiquid assets, because most illiquid assets become liquid over ten years.

But after that, there is an additional way of controlling illiquidity risk — time once again for the fusion solution! Money market funds run a ladder of maturities.  Stable value funds run a longer ladder, as should commodity ETFs, rather than floating at spot.  Then there are clever advisers who run municipal and other bond ladders for wealthy and semi-wealthy clients.  Running a ladder of maturities is one of the most robust management techniques as far as interest rate risk is concerned.  There is always money coming out and in every year, which slowly leads the portfolio yield in the direction of average rates.

Now, if these bonds are less liquid muni bonds, but the credit risk is low, you don’t care as much about the illiquidity, because the ladder produces its own liquidity as bonds mature.  The key question is sizing the length of the ladder, which comes down to a question of analyzing the liquidity/income needs of the client, combined with a forecast on the secular direction of rates.  The forecast is the least important item, because it is the toughest to get right.  (An aside: who has been right on bond yields consistently for the last 20+ years?  Hoisington, my favorite deflationists.  Wish I had listened more closely.)

The same principle applies to pension funds, endowments, life insurers with a few twists.  Divide your liabilities in two.  What obligations do you know cannot be changed, except at your discretion?  That group of liabilities can have illiquid assets to fund them.  Try to match the payout streams, but if not, try to match them in broad with a ladder, keeping in mind what mismatches you will likely face over the next 1-2 years in order to properly size your cash position.

The rest of the liabilities need more intensive modeling, analyzing what could make them change.  You can try to buy assets that change along with the liabilities, but in practice that is hard to do.  (That said, there are no end of clever derivative instruments available to solve the problem in theory.  Caveat emptor.)  The assets have to be liquid for this portfolio.  Other aspects of portfolio choice will depend on valuation parameters, credit spreads, yield curve shape, market volatilities, as well as macroeconomic factors.

Three Closing Notes

1) Now, all that said, just because you can take on illiquidity doesn’t mean that you should.  A good manager has a feel from history for what the proper liquidity give up is in valuations for stocks and other risk assets, and credit spreads for fixed income assets of all sorts.

Was it worth moving from the:

  • Relatively liquid AAA tranche to the illiquid AA, A or BBB tranche for 0.10%, 0.20%, 0.40%/year respectively?  As a bond manager at much larger insurance company said back in 2000 — “It’s free money.”  (That is almost always a dangerous phrase.) My view was there was more illiquidity and credit risk than we could consider.
  • Relatively liquid large-issue BBB bank bond to the relatively illiquid small-issue BBB bank bond for 1% more in yield?  Hard to say.  There are a lot of factors involved here, and your credit analyst will have to be at the top of his game.  It also depends on where you are in the speculation cycle.
  • Liquid public equities to private equity or hedge funds with lockups?  Tough question.  Try to figure out what the unlevered returns are for comparative purposes.  Analyze long-term competitive advantage.  Look at current deal quality and valuation metrics.  For hedge funds, look at how credit spreads moved over their performance horizon.  Anyone can make money when spreads are tightening, but who makes money when spreads are blowing out?  Analyze them over a full credit cycle.

2) Institutions that did not previously do more liquidity analysis because we had been in near-boom conditions for decades need to at least do scenario testing to assure that they aren’t overplaying their hands, such that they might be forced to make bad decisions if liquidity gets tight.  Safety first.  (This applies to governments and industrial corporations too, as we will experience over the next three years.)

3) Finally, if you decide to make a large illiquid purchase like Mr. Buffett did last year, make triple-sure of your logic and your liquidity positioning.  Nothing lives forever, but you can prolong the life of the institutions you serve by careful reasoning and planning, particularly regarding liquidity.  Get financing when you can, not when you need it. It takes humility to do so, but it yields the quiet reward of continued existence at a modest price.

Queasing over Quantitative Easing, Redux

Saturday, August 21st, 2010

People are good about making binary comparisons for the most part, leaving aside come of the more complex choices highlighted in the book, “Priceless.”  Would you like coffee or tea?  Do you prefer this room painted blue or white?

Where things get complex is when there are a zillion choices, and your quest is to pick the best one, particularly when there are multiple attributes to each possible choice.  Consider the problems of trying to choose the one best stock for the next ten days, months, or years.  The best solution is to redefine the problem and try to choose an excellent bunch of stocks for each period.  Give up on the impossible game to play the possible game.

I follow this logic when I make stock trades.  It is not possible to get the best companies consistently, but it is possible to look at the companies that you are buying, and the companies that you are selling, and conclude that the new portfolio is superior to the old portfolio.  Three or four times a year, it pays to freshen the portfolio, selling the companies with the weakest potential, and buying those with more potential.

Now, binary comparisons underlie many aspects of financial accounting and management.  Think of doing a net present value [NPV] calculation.  We do them frequently, but how often do we ask what they really mean?  The NPV calculation compares the after-tax cash flows of a project to a hypothetical investment, which is to shrink the asset base of the company by buying back stock and retiring debt.

As a young actuary, I was fascinated by how much a small change in interest rates could change the present value of a policy.  I worked with two companies in the structured settlement business, both of which had the same philosophy on asset management — write short policies and long policies, and invest to the middle of them.  Though, with the second one, I took the opportunity to buy ultra-long bonds when they were attractive.

In an interest-spread management business like life insurance, the binary comparisons were in many ways more obvious, as I would swap bonds relatively worse for those relatively better.

Wait, how does this relate to quantitative easing?

The Fed can create liquidity in two ways — it can send the liquidity out to the general economy, raising prices.  Or, it can use the liquidity to buy assets, in most cases, government or high quality bonds, which lowers interest rates in that area, raising the prices of assets so bought.

Quantitative easing has a direct impact and an indirect impact.  The direct impact is that those that issue the bonds that have  been bought face lower yields and are inclined to issue more.  More Agency MBS, more Treasury issuance.  It is an obscure and indirect means of monetizing government debt and Agency MBS.  The government likes nothing better than to have a captive, non-economic buyer of its securities, particularly in a period of extreme deficit spending.

The indirect impact is that as Treasury yields fall, the yields on other debts fall to a lesser degree.  There are many investors out there who need yield, and as safe yields fall, they take more risk in order to achieve their desired income.  The conundrum of QE is that people get torn between income and losing capital by taking too much risk.

This helps to explain why stock valuations are low relative to high-quality bond yields.  The high-quality bond yields, affected by QE are not indicative of the true risks faced in the high quality lending.  Stocks and lower quality bonds are affected to a lesser extent — as it is harder get yield out of quality instruments, most will dip to lower quality instruments.

I learned as a corporate bond manager that every now and then I had to fly the “Jolly Roger,” but for different reasons.  When yield lust consumed the market, I would do painful up-in-credit lose-not-much-yield trades.  When there was panic, I would wave in yieldy bonds that were more than adequately protected.  In one sense, I was doing the market a favor, even though I was trying to make gains for my client.  I was always on the other side  of the money that was panicking.

So, what does QE do?  It lowers the cost of government debt (for now), and drags lower the cost of high quality debt, because there isn’t as much government debt available to buy because of QE.  As for high-yield bonds, and stocks, the effect is weak.

So, will QE improve economic prospects?  In my opinion, no.  Unless QE begins buying high yield debt and stocks (please don’t ever do this), it will not a have any impact on real businesses.  Government should be neutral, and beyond bias — buying the securities of a non-government enterprise should be forbidden — there should be no favorites to the government.  (What’s that you say, we have already had favorites via the rescues of 2008-2009?  Sad but true, but no reason to repeat the error!)

QE leaves investors in an awkward spot.  There are no safe places to place money with any yield.  So, you can earn zero, or take risks that seem uneconomic to gain yield.  Almost makes me want to be a trader, because there is little logic to where I invest. There is no obvious place for me to invest.

If the government thinks that QE will force investors to invest, I have news for them — yes, some will take more risks, but they will lose through their investing. Risky assets are only good at a fair or fear price, not at one where yields or risk margins are dragged low by QE.  Trying to tweak our psyche as a whole is ridiculous, and deserves only scorn by voters and investors.

Go, take your QE with you and destroy the economies of other nations.  Let interest rates rise here, and allow savings to grow, that will be deployed into the businesses of the future, not QE, that invests to protect the past.  We don’t need more homes, autos, and banks.  We don’t need AIG or the GSEs.  Just leave our economy alone, we can live with the booms and the busts, unamplified by central banks and federal governments.

A Baker’s Dozen Of Economic Items

Friday, August 20th, 2010

1) Kind of like my thesis that the States give a better picture of the economy than the Federal Government, I agree with the idea that small banks better represent that health of the US economy.  Most small an medium-sized businesses rely on small banks.  Growth in employment relies on small and medium-sized businesses, because they typically have more room to expand.

2) I’ve been arguing for a weak economy before the double dip concept was derided.  Not that I make the Philly Fed survey a big part of my analysis, but the weak report is consistent with my view that the US economy is weak.

3) All developed markets where there is still confidence are finding long government yields hitting new lows.  No surprise, with so many investors and nations scared, that many would focus on sovereign governments for repayment.

4) So there are failures to deliver in the MBS market.  Part of it is due to the Fed sucking up a large part of the market.  Part due to the low cost of short term funds.  My question to anyone reading, are there any significant costs?

5) A crisis like this is divisive.  In the US, it separates the strong versus the weak states.  In the EU, it separates the strong versus the weak countries.  That is the nature of financial crises — they divide the healthy from the sick,with some slight tweaking from government action.  As it is now, there is a divergence where countries with some flexibility fight to maintain their independence.

6) Jake makes the argument that one would pay a lot for certainty of return of principal in this environment. SO, don’t sniff at low short term rates.

7) Ordinarily I agree w/Jesse.  For example, I agree that there could be a lot more extracted from the rich in taxes.  But I don’t think it would succeed.  There are too many holes in the tax code, and the wealthy would hire bright people to make the tax obligation go away.  I speak as one that has seen this in action.  Rich people are much smarter than poor people when it comes to money. It would take radical tax reform to change matters.

8 ) The ultimate stories on GM and AIG, as well as FNMA and FHCC, is that the government loses money on the deals, but spins them positively, in saying, “look, they are operational again.” Truth, better that they all failed, but the government aims at fixing things, even when it can’t.

9) This piece gets it right on Social Security in minor, blows it in major.  Yes, the bonds built up over the last 20 years will be paid out of current tax revenues, but will the US Government be able to bear the total burden as Medicare expenses go through the roof?

10) What a fight on stocks vs. bonds.  I favor bonds in the short run, stocks in the long run.  Where I disagree with both is that government action is needed to preserve value.

11) Are we turning into Japan? I have argued yes for some time because we are following the same government actions that Japan did.

12) How bad is the economy?  Bad enough that average people are liquidating 401(k)s.

13) China might finally be getting smart on population policy.  But getting women to have more kids once you have convinced them of the short-term value of not doing it — you will have a better career, and the long-term benefit of not doing it — we have too many people for the planet already; it’s pretty tough.  They take the easy road of not having kids, and it doesn’t matter how many economic incentives get kicked up — once women decide they don’t want to have children, there is no amount of economic policy that will change their minds.

But, there are other ways to do it: show reruns of happy families with many kids.  Waltons, Brady Bunch, Eight is Enough, etc.  We had eight kids, (we adopted five) and there is a lot of value in the many relationships that exist in a large family.

Okay, enough for now.  Time for sleep.  Just don’t go shorting bonds thinking I told you to do it.

Eight Notes on 8/19

Thursday, August 19th, 2010

1) I am not a Treasury bond bull, per se, but I am reluctant to short until I see real price weakness.  And some think that I am only a fundamentalist value investor.  With bonds, it is tough to catch the turning points, and tough to grasp the motivations of competitors.  Better to miss the first 10% of a move, than miss it altogether.  And consider this teardown of the past bear case here.  Or look at the bull case here.  Or, look at Japan supporting us as China sells.

But are there enough buyers out there for Treasury notes on the current path of deficits? At present interest rates, the answer is likely “no,” after some time.  The US is going to have to change its behavior, and shrink deficits, especially expenses from defense and entitlements.

2) To Narayana Kocherlakota: Yo, man, time to grow up.  Markets are what they are.  They react to what you say, not what you mean.  But beware the the day that you say what you mean, lest the market go bonkers.  What, you say that is unfair? Feh, sir, welcome to the markets.  We understood what you meant.  There is no document so analyzed as the FOMC statement.  If it is misanalyzed in your view, it is your fault for sloppy language.

3) Hitting a 10 out of 10 on the “Hooey scale,” this piece at Martin Wolf’s forum rings the bell. Quantitative easing has lowered rates in Japan, but has not helped employment to any degree.  The same will be true for the US.  Hint: lowering discount rates raises the value of existing enterprises, but does little for new enterprises because new enterprises need equity finance.  There is no evidence that lower interest rates, of themselves, will lower unemployment.

4) If someone had said to me that I would say something nice about Basel III soon, I would have growled.  But I was wrong, Basel III limits short-term leverage.  Very nice, would that Dodd-Frank had been equally useful.  (I wrote about this many times.) The thing that still gores me about the Basel standards is that it is wrong to rely on companies for credit analysis.

5) When the debt reacts bad on a merger, so do I.  So it is for American General Finance.  Fortress may want to buy it, but do they really get the lending to AIG?  The bad experience on subprime lending, etc.

6) We have already had one lost decade, the question that we have is whether we will have two decades. We may have recognized some losses faster than Japan, but the policies that we are pursuing of stimulus, running deficits, and forcing high quality interest rates lower is the same strategy that failed in Japan.  The government needs to stop hogging the liquidity through QE, and let private markets allocate liquidity.

7) Corporations act to protect their interests, regardless of those who follow them.  Google aside, few CFOs want to take risk with their excess short term assets. Flexibility is a real asset in volatile times, so good CFOs keep their powder dry rather than stretch for yield.

8 ) Saw this cute piece on residential real estate prices in the US.  There is still room for prices to fall.  A house is a place to live; under ordinary circumstances it is not an investment.  That said, though low rates aren’t stimulating a lot of buying, they are leading to a decent amount of refinancing.

That’s all for now.  Gotta go help my oldest daughter move out.

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.


Also, though David runs Aleph Investments, LLC, this blog is not a part of that business. This blog exists to educate investors, and give something back. It is not intended as advertisement for Aleph Investments; David is not soliciting business through it. When David, or a client of David's has an interest in a security mentioned, full disclosure will be given, as has been past practice for all that David does on the web. Disclosure is the breakfast of champions.


Additionally, David may occasionally write about accounting, actuarial, insurance, and tax topics, but nothing written here, at RealMoney, or anywhere else is meant to be formal "advice" in those areas. Consult a reputable professional in those areas to get personal, tailored advice that meets the specialized needs that David can have no knowledge of.

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