August 2010 – Page 2 – The Aleph Blog

One Dozen Comments on the Current Market Situation

Posted on 18 August 2010 by David Merkel

Here are my thoughts on the markets, in no particular order:

1) Momentum draws investors.? Long treasuries have run hard, and people like them now.? My view is, if you want to short them, wait until they rise 0.1% more in yield, then short.? There are a lot of weak longs to shake out.

2) That said, long rates are generally falling in the developed world.? Gives a real feel of global debt deflation.

3) Not that the yen sees any problem here for now.? This makes me more bullish on the yen; few nations are willing to allow their currency to appreciate.

4) Arguments over residential mortgages. Geithner sees room for a federal role. Gross want the Feds to make mortgages full-faith-and credit obligations of the US Government.? A shameful statement from a man who built his wealth through free markets, and now looks to protect it through Socialism. John Carney is far better, though he flounders over what to do.? To me it is obvious — take Fannie and Freddie through Chapter 11 after their debt guarantees are gone, and let the market buy up the pieces.? Fannie and Freddie have lost money for the US over their existence; they have served no useful function, any more than some misbegotten tax incentive might have done.? And, as Kid Dynamite has put it, “The problem is that home prices are too high.? We need more deflation, and more debt reduction.

5) Physics is the wrong analogy for economics.? Ecology is the right analogy.? Like ecologies, economies resist prediction and control.? People adapt, inanimate objects don’t.? So you might enjoy these articles from FT Alphaville and Bookstaber.

6) As I commented today on Twitter: “Get ready for the bookstore massacre http://bit.ly/cywtPT $BKS fiddles with its capital structure, while it gets outcompeted by $AMZN.”? I mean it.? The problems of Barnes & Noble are organic problems of competing against Amazon and losing.? Who controls B&N is less important than what strategy they take from here.? It is a lousy time for B&N to be consumed with a noneconomic issue, when they are getting killed.? And forget BGP… they are dead too.

7) Matthew Lynn hits the nail on the head.? Additional debt does not promote recovery.? If true in Europe, then true here as well.

8 ) The Dallas Fed questions whether we can stimulate our way to prosperity.? My answer: the more we place the decision in the hands of individuals the better the decisions will be.? We know what we need better than the government does.

9) Did we misunderstand the Fed’s recent FOMC non-action?? I don’t think we did , but Federal Reserve Bank of Minneapolis President Narayana Kocherlakota thinks that we did.? I think he has to understand the markets better — we work off of changes in expectations.? We expected the Fed to do nothing again.? Now that you are buying in more Treasuries, we know that the economy is weak, and we buy long fixed income as protection.? At least we are front-running you.

10) Hey, another blogger summit at the Treasury, and this one has three of the originals there (but not me).? Comments from Marginal Revolution as well.? One participant told me it wasn’t worth it to be there and the Treasury was not prepared to answer questions, but who can tell?? I have an idea: let the Treasury webcast the meeting.? I know from the first meeting that neither the Treasury nor the bloggers would have been dominant.? At least it would be transparent; isn’t transparency what the Obama Administration is about? 😉

11) Cramer has ten reasons that the market won’t blow up.? Good.? I am 80% invested.? All I will say is that the rules are different when debts are being deflated.? Things don’t behave the same way as when debts are growing.

12) TIPS are in an awkward spot here.? Negative yields on the short end imply that buyers are looking for more inflation.? I might think that in the long run, but would be reluctant to bet on that over the next five years.

Odds and Ends Stemming from a Question from a Friend

Posted on 17 August 201017 August 2010 by David Merkel

“How can I beat the Lehman Aggregate?” a bond manager friend recently asked me.? Tough question in this environment; I’m still musing about it.? It’s a tough market.

Start with Treasuries — they are the bedrock of the market.

Here is the Treasury yield curve at 4 polar moments in the last two years.? Two times where no one doubted that the economy was bouncing back: 6/10/2009 and 4/5/2010. One time where everyone thought the end was near: 12/18/2008.? Then there is now; the front five years of the curve is like the panic.? 7-20 years is like 75% of the panic.? 30 years is half of the panic, relative to the last two years.

So what to make of it?? Despite the Fed’s willingness to buy twos through tens, I think the thirties look attractive versus twenties and tens.? The curve typically peaks near 20 years, and that’s not true now.

Are things as bad as at the panic point in December 2008?? No, but the front-end thinks so.? I would be inclined to try a barbell where thirties and bills are overweighted, and twos through twenties are underweighted.? How big to make the bet?? That is up to your risk appetite.

Now remember, this is a trade, not a long-term investment.? Sometimes I think that government policy tends to turn us into speculators and traders… the first intentionally, the second by accident.

Now all of this is amid China lightening the boat on Treasuries.? That did not stop the rally.? As the article said:

For one thing, Japanese investors have steadily bought more U.S. debt as China has shrunk its portfolio. Japanese holdings rose to $803.6 billion in June and have increased by $82.7 billion since last July.

Domestic buyers have also helped fill the gap. U.S. household ownership of Treasurys in the first quarter was $795.7 billion, the highest in a decade, according to the latest Federal Reserve data available. Private pension funds, life-insurance companies and commercial banks have also raised their holdings to record or multiyear highs.

China favoring the Euro at this point is an interesting move, contrarian from an investment standpoint, but seeking European favor from a political standpoint.? Politics and economics go together in China, given the crude top-down planning they impose on the economy.

But what kind of market is it when both long Treasury bonds and gold rally at the same time?? It is a fear market that does not know what to fear.? “We fear ‘flation!!!”? Which kind of ‘flation, they are not sure, but things look bad.? Makes me want to short them both, but let the momentum die first…

Agency mortgages are problematic because of the weakness in home prices leading many mortgages to be not refinancable.? Thus the bonds trade at low interest rates, but high spreads to Treasuries.? Personally, I don’t think a mega-refinance is possible legally, but that makes the bonds a little cheap to Treasuries.? This would be an area to analyze collateral, and buy selectively.

One thing that is different from the panic in December 2008 is that corporate spreads are tighter now.? BBB bonds still look attractive, but with junk, you have to be selective.? I would focus on highest quality, and BBBs, and underweight the rest.? Consider buying the bonds of Moody’s.? Quite a spread at 3%, and unless something weird happens, it is still quite a franchise.

Beyond that there are always issue-specific bonds that seem to be undervalued.? Those are worth tossing in, and adusting the rest of the portfolio to adjust duration and credit quality.

Some closing notes:

Why is Google issuing commercial paper?? Please, tell me.? They have no lack of short-term liquidity.? Are they aiming for financial profits like a hedge fund would?? In some ways they are already– take note that they are doing securities lending to pick up additional yield (see my comment after the article). If this becomes a large part of Google, the P/E multiple on Google should come down, because financial entities arbing credit spreads do not deserve high multiples.? Better Google should pay out the excess cash to policyholders as a special dividend in 2010.
As an aside, I would add that the financialization of profits in general brings down the P/E multiples of industrial companies.? It looks so easy at the beginning.? Just finance the purchases of your own products through a captive subsidiary, and the extra profits roll in, with a small drop in the P/E.? That’s fine as far as it goes, but it usually doesn’t stop there; the division head of the finance sub seeks new vistas — if he can lend successfully in one area, he can do it in others.? We’ve got the infrastructure; why not use it?? The result at best is a GE or a Textron — two stocks that have gone nowhere over the last 14-15 years.
Many people in the US are selfish and want to decrease spending on others, but not themselves.? We see that through both of our clueless parties arguing over priorities, and people who want to see the deficit cut, but not in their prized areas.? The logic of shared pain has not yet arrived.? Things haven’t gotten bad enough to drive real spending or tax reform yet.
Last note: this is a period where people are demanding certain yield, thus bidding up bond prices versus stocks.? It reveals a lack of certainty about the future.? It makes some stocks look attractive — in many cases corporate bond yields are below stock earnings or cash flow yields, and even below dividend yields in some cases.? This article is an example of this phenomenon.? The key question is how long profit margins can remain elevated.? With labor plentiful relative to work, that could be a while, leaving aside risks in the financial system.

So, what should I tell my friend?? Maybe this:

Duration: emphasize short and long.
Credit: emphasize highest quality and some BBBs
Underweight financials with weak liability structures (I.e., the too big to fail banks) for now.
Mortgages: play carefully, but play.
If you don’t get a big yield premium for illiquidity, don’t play in illiquid bonds.
Can you do a little foreign? If so, diversify a little into the developed world fringe currencies outside of the US Dollar, Euro, UK Pound and Yen.

These are tentative conclusions that I would have to work out further — I don’t have my thoughts together on CMBS, Munis, etc.? That’s all for now.

Two Quick Notes on Investing

Posted on 14 August 201015 August 2010 by David Merkel

Insect bites, bruises, sore feet, tiredness, happy sons… I am back from backpacking.

Whenever a financial product is plentiful, it is usually time to avoid it.? Tonight’s poster child for such nuttiness is junk bonds.? If you are a speculator, you can own junk bonds, and the stocks of the companies that are issuing them, because the market is hot for now, but be ready to sell; have your stop orders ready.? Fundamental investors would need to be more careful.? Though default rates may be declining, there is no guarantee that that will continue to be so; given troubles at the banks, cautious stance is warranted.

If looking at individual issues, those aiming for organic growth are better candidates than those that are doing mergers, paying special dividends, or just levering up.? So be wary, and realize that conditions could change rapidly.? Stick to sounder credits, including investment grade issues.? There is more juice to be squeezed in the long end of investment grade, then in shorter junk issues.

My second point for the evening is avoid the equities of scale acquirers.? In general, acquirers of large entities overpay, and execution after the acquisition is tough because it is tough to integrate:

Management teams — different views are often incompatible, and the victor looks down on the company acquired.
Cultures — same thing.? Cultures encompass the ways that a broad body of people implement the views of management.? Incompatible cultures are tough to merge; usually that of the acquirer must die, much like ancient war that destroyed losing cultures.
Systems — rarely compatible.? It takes a lot of effort to make all of the critical computer systems speak the same language.
Marketing — different philosophies lead to a need for the best to remain, and the worst to die.
Finances — easy, except that differing practices must be integrated.? Accounting is often more liberal coming out of an acquisition, because of the need to make the acquisition look good.

The best acquisitions are small, incremental, and facilitate the organic growth of the acquirer.? They add new products that can be sold through existing infrastructure.? They add new markets to sell existing products to.

In an environment like this, focus on organic growth, and perhaps those companies likely to be acquired.? Organic growth because it shows where there is real and perhaps repeatable growth in the economy; targets because if capital is cheap, there may be future companies bought out by fools who serve themselves and not their shareholders.

All for now.? Back on Monday.

The Four Roads Ahead

Posted on 13 August 2010 by David Merkel

The last few days, I’ve been reading various opinions on the US Economy on the web, and thinking that they don’t really get the situation that we are in, both short- and long-term.? I am increasingly disappointed with those proposing Keynesian remedies, because those were what got us into this pickle in the first place, and they think that more of the “hair of the dog” will rescue us from our drunkeness.

Consider, when in the last 40 years has our government not run a deficit, excluding flows from entitlement programs?? I think the answer is has never been so.? Stimulus has been the rule, the only argument has been do we do more or less?

Think of monetary policy post-Volcker.? Who has been willing to allow a recession to harm marginal investments?? No one.? The punch bowl was removed slowly, but brought back rapidly, which brought the applause of politicians, and gave Greenspan the moniker “Maestro,” even though he was driving us into a liquidity trap.? (Maestro, yuck: I’m a gentleman; I can’t express what a disgrace it is to lionize a man who did us such harm.? Execution is out of the question, but can we send him to the North Koreans or the Iranians to have him run their monetary policy?)

Bernanke is little different, having learned the wrong lessons from the Great Depression, thinking that the response from the Central Bank and the Government was too weak.? Rather, they did too much, and prolonged the depression more than it would have otherwise gone.? Andrew Mellon was wiser than them all.

Governments are bad allocators of capital.? They borrow money and allocate it to where the political return is the highest.? Those projects may bump up GDP in that year but do little for future GDP.? This is the lie of C+I+G=Y.? Yes, in the short run that works, but in the long run, money spent by consumers and investors yields far more for growth in the economy than government spending.? Our government is only interested in the short run, given their short-run fixation on the election cycle.

Consumers choose what helps them in the short-run, and Investors the long-run.? The government has non-economic motives — their actions merely harm the situation.? Better they should reduce taxes broadly than try to target certain areas that have clever lobbyists.

All that said, I believe government has a role in regulating commerce.? There have to be standards established so that that people can trust in what they buy, in areas that cannot be easily verified by ordinary people.

The Four Roads

There are four roads ahead for our economy, thought they are not all exclusive, aside from default.? Let me describe them:

Higher Taxes

This is the solution of the aftermath of the Great Depression.? After the huge debt buildup from the depression, the increase in taxes paid off the the debts in the 50s.? Problem: baby boomers and their children are more selfish, and won’t take the same abuse today.

All that said, be ready for higher taxes.

Inflation

At present the Federal Reserve will not stimulate goods-price inflation.? They will support asset inflation; consider how they supported the money markets when they were under stress.

But there may be a limit to their ability to control matters.

Default

The US Government could never default.? Well it did twice, under Roosevelt and Nixon, when it moved away from its gold-based obligations.

Government receipts would have to double to meet the future needs of entitlement programs.? I don’t think we can get there.? More likely we try to reduce payments, even if already agreed to.

Japan

The Japan scenario means survival.? Rather than taking a deserved depression, the economy is forced to support lousy companies that cannot survive otherwise.? They have done that for 20 years.

The Point

My view is that we are going to take deflationary pain anyway, so take it like men (are there men nowadays?). ? There may be institutions that fail; far better to deal with them at the most basic level, that of the debtor, than trying to prop up dud institutions.

I have more to say, but I have to go backpacking.? More later.

Redacted Version of the August 2010 FOMC Statement

Posted on 10 August 201010 August 2010 by David Merkel

Comments

Adds new paragraph for quantitative easing, round 2.? Will invest maturing Treasuries, Agencies and Agency MBS in longer term Treasuries.
Four months ago I wrote: The FOMC is overly optimistic on employment and housing issues.
Now the weakness is evident.? Hope has given way to modest pessimism, as they have shaded virtually all of their views of economic strength down.
Two months ago I wrote, ?Implicitly blaming the Eurozone is cheap, we have enough issues on our own for the weakness ? residential housing, commercial real estate, and over-indebted consumers.?
Now they have given up that evasion, and continue to shade down their views.
Hoenig still dissents; hasn?t gotten bored with it yet.? Fight on, Tom.
The key variables on Fed Policy are capacity utilization, unemployment, inflation trends, and inflation expectations.? As a result, the FOMC ain?t moving, absent increases in employment, or a US Dollar crisis.? Labor employment is the key metric.

Queasing over Quantitative Easing

Posted on 10 August 2010 by David Merkel

The world’s largest hedge fund, the Federal Reserve, is trying to decide whether it should expand its operations.? Unlike most hedge funds, the Federal Reserve has a big advantage in that it can fund itself cheaply, and for the most part, at its own discretion.

Unlike most hedge funds, it issues 0-day 0% Commercial Paper, which is accepted almost everywhere as a means of completing transactions.
Banks affiliated with them must place reserves with the Fed, on which they earn interest of around 0.25%
The affiliated banks, not finding as many opportunities as they would like to lend privately on a risk-adjusted basis, leave more money than they have to at the Fed, again earning about 0.25%.

What a cheap funding base.? They can buy almost any asset and make money, so long as equity/credit risk is limited, and so long as the yield curve doesn’t hit new records for steepness.? Given that the Fed does not have to mark most of its positions to market, and does not have to worry about margin calls in the conventional sense of the term, they make money year after year, and hand most of the profits over to the US Treasury, which keeps accounts for the Fed’s main owner, the US Congress.

Life is tough when you have to serve multiple conflicting interests.

They demand that you create conditions for full employment, something beyond your control.
They ask that you restrain inflation, which is possible.
They ask that you lend, because the banks affiliated with you are not lending, and an increase in lending is always a good thing, right?

So, like Keynes, the fools that think that a lower rate of interest is always better urge that the Federal Reserve should expand its balance sheet and buy up more Treasuries, Agencies and Agency MBS, forcing rates lower.? What good can come from forcing high-quality long rates lower?

My answer is, not much.? Existing debts if non-callable, will be worth more.? If debtors are solvent, and can refinance, they? can lower their debt service costs, though that is a minority of borrowers.? Beyond that, it will lead the favored debtors to borrow more — Treasury, Fannie, Freddie, etc.? We need more borrowing, right?

But a greater effect can be the speculative frenzy engendered by dropping the rate that savers earn to such a low level, leading them to invest more aggressively to meet their income targets.? As with any other sort of speculation, the game is over when people rely on the occurence of capital gains.

I think quantitative easing is a mistake; I also think it does not help matters much.? It transfers resources from creditors to debtors in a funky way.? That is not the right way to go if you want a country to grow.? (Which, contrary to the received wisdom, would mean that raising short term rates would be better for the US and Japanese economies than engaging in quantitative easing.? There would be short-term pain, but there will be pain regardless of how this policy is conducted.)

If the Fed makes a bow in the direction of quantitative easing on Tuesday, such as reinvesting the proceeds of MBS in more MBS, the markets will rally, but I would fade it, because it will have no long-term beneficial? impact on the economy.

There is no free lunch.? Any action that seems to cost nothing on the part of the Fed or the Federal Government will have no long-term effect on the economy.? Quantitative easing is one of those comforting fairy tales that is a fraud, whether intentionally so, or not.

The Education of a Corporate Bond Manager, Part XII (The End)

Posted on 7 August 20108 August 2010 by David Merkel

Tonight I pick up on the odds and ends.? Going along with last night’s theme of making mistakes, we had a saying in our office, “Great minds think alike.? Fools seldom differ.”? It helped us stay humble about our culture.? If we agreed, it might be because we were all bright, or all dumb.

As an aside, one of the brighter associates at the main office pulled me aside to ask about the foolish behavior of the client.? Having worked for a much larger and more professional firm, he was shocked.? I simply said (regarding the client), “It may be a rusty tub, but its OUR rusty tub.”? He gave me the grim smile of understanding.

Timing Purchases and Sales

I developed my own view of technical analysis while trading corporates.? I wrote about it in this post, A Fundamental Approach to Technical Analysis.? Here is the most relevant excerpt:

But not every fundamental investor agrees on what the proper prices are for buying and selling. As the old saying goes, ?It takes two to make a market.? Sometimes, I will make it into the office and my trader will tell me that someone is aggressively selling a company that we own. I might ask him if our brokers have any feel for the size of the seller, and how desperate he is. The answer is usually ?no,? but if we do get an answer, that can help dictate our trading strategy. We would want to buy more as the big seller is closer to being done. In fact, we want to buy his last block of shares from him, if possible. Sometimes that can be arranged by talking to our broker; other times not.

As another aside, this is simpler to do in the bond market than the stock market. The large brokers generally know who is doing what. Be nice to your sales coverages, and you?d be amazed what they will tell you?. Here?s a stylized example.

Broker: ?You sure you want to buy that Washington Mutual bond??

Me: ?Yes, why??

Broker: ?Uh, there?s someone with size selling the name.?

Me: ?How much size??

Broker: ?Best indications are eight times your order size.?

Me: ?I can?t take that much down. Keep me in mind, and when he gets down to about double the size of my order, call me, and I?ll take the tail [everything that?s left].?

Broker: ?You got it.?

There were other rules that helped me. Keeping the VIX on my screen helped me accelerate or slow down purchases and sales in a given day. Yield spreads lag behind option volatility even though the two should be closely related. Momentum of spreads also helped — falling and rising spreads tended to persist, so be more aggressive when the market was hot, and not when it is not. Beyond that, there were credit default swap [CDS] spreads, which were just becoming a factor then. I came to the conclusion that credit spreads moved a lot slower than CDS, so I developed a rule that said, “Don’t buy if CDS is above the credit spread. Wait for the CDS to fall below, then buy.” Worked well, and kept me out of deteriorating situations.

These rules also left me more calm and capable when the market was falling apart.? I also tended to build up a cash buffer when things were going awry, waiting for the eventual turn in the market.

Time Horizons

If I had to summarize it, it boils down to managing three time horizons:

Daily — watch daily momentum and deal flow.
Weekly-Monthly — how is the momentum going?? Gauge the speculative nature of the market.
Credit cycle — where is the credit cycle in heading to the next peak or through?? How long till we get there, and what will it feel like as we near the peak or trough?

Thinking of it this way aids daily trading, and allows for clever trading in bear market rallies, and bull market pullbacks, while still watching the overall macroeconomic credit cycle.? You can’t get all three horizons in full; they fight each other at times.? Doing this means you can more intelligently weigh the costs of action and inaction, because the client needs income, and it helps you determine how long can you delay in providing income in order to avoid capital losses.

The client was growing like a weed.? That made my job easier and harder.? Easier because I could snap up every mispriced bond that was money good.? Harder, because during sharp rallies, I could not let cash build up too much.? I took the opportunity to buy AAA & AA bonds rather than A & BBB bonds, which gave up yield, but it was better than cash.

Scaling

One concept that aided me in trading was realizing that I did not have to be a big trader.? Moving in and out of positions slowly, as market conditions warranted was useful.? If the liquidity was available, and you were facilitating someone else’s bold move, that is another thing.? But the cardinal rule was, “Never demand liquidity unless it is an emergency, and you meet the strenuous test that you know something everyone else does not.? But, make others pay up for liquidity where possible.? You are doing them a service.”

Those ideas affect me today in my equity investing.? Most of the time I do small trades around core positions, and adjust my companies at a slow pace.? I make money while I wait.

Income Replacement

I was the risk manager as well as a corporate bond manager.? I understood that the policies written by the client had implied hurdle rates attached to them.? Selling a bond that was a good buy two years ago would realize a great capital gain, but would lead to a reduction in income most likely upon reinvestment of the proceeds.

The question was, and always will be, how to maximize the long-term well-being of the client.? Short-term gains matter little.? How can you build up a sustainable interest margin is the key.? Thus in my trading I looked at income replacement, adjusted for quality, maturity, liquidity, optionality, premium/discount, and a wide number of lesser variables.? Given that the client foolishly wanted me to trade aggressively, I did so, but matched off interest-rate related gains and losses, while building interest margins.

The End

No good deed goes unpunished.? The neophyte corporate bond manager that excelled was eventually told by his boss in early 2003 that they were losing manager searches because he was not in the home office (far away), and that fund management consultants told them that multi-city firms did not work.? (Those who can’t do, consult.)

I was offered a move to the main office, or be severed.? Hearing this, I went and called my wife, using my cell phone in an out-of-the-way place.? Little did I know that there was a betting line in the main office favoring that I would come by 3-1.? My gift to those who knew me in the main office was that little win, because in early 2003, investment jobs were hard to find, and would I just give my job up?

Well, yes.? I had enough confidence in my abilities (under God/Jesus), that I looked to the needs of my family first.? We had friends that we did not want to give up in our congregation for the first time, and I gave my family the benefit of the doubt, saying that I would try other possibilities in the area for a year or so.

Informally, I let my colleagues in my office know in advance; they were friends.? So on the last day for my decision, I announced that I would take severance.? Then something weird happened.? They left me with trading authority for the next two weeks.? Ordinarily that is cancelled, because the unscrupulous use that to reward friends at the expense of the client.? Rather than do that, I used the opportunity to sell down positions that I was comfortable with, but were too large forthose that would inherit the portfolio I built.? I managed to get all positions but one down to a reasonable level, leaving a clean portfolio for my successor.

Parties

My colleagues in my office took me out for lunch; they gave me a great time.? The analysts came and thanked me because I genuinely listened to them, and never blamed them.? They even told me that I was the only portfolio manager they knew who could be a credit analyst.

A few days before that, Legg Mason took me out to dinner with a few of my colleagues.? I was mystified as to why.? Yes, I had traded with them a lot, but they had given me good value on my trading.? In the middle of the dinner, I said, “This is really nice, guys, but why so much for me?”? They looked at my sales coverage and said, “Didn’t you tell him?”? They picked up and said, “What you don’t know is that your willingness to trade with us allowed us to build up our corporates coverage; without you we would not have a business today.? Also, you were honest with us and kept us from mistakes when we were out of the market context.”

I was floored.? Really?? I did that much for you?? They said, “Whatever we can do for you, just ask.”? I asked for an interview with Bill Miller.? That probably exceeded their notional credit line, because that never happened.

As it was, I landed a job with a wonderful hedge fund, Hovde Capital, in two months, and was very grateful to them for hiring me.

Postscript

There is one story that I left out from the beginning, which still needs to be told.? When our little money management firm was being acquired by an arm of Old Mutual, the CEO of that firm balked at paying our credit analysts the salaries they were receiving, and was really annoyed at the bonus structure.? He said to me and the high yield manager, “Look, the only people I need are the two of you, and we can hire other analysts.”? The two of us knew that our analysts/friends were golden — analysts that would be hard to replace.

The prospective buyer of our little firm called the two of us to a phone conference.? Somehow it leaked to the analysts what was being proposed and when.? As we headed off to the meeting, one analyst who was Jewish, called out to me, “David, don’t forget you are a Christian!”? Surprised, I turned and said, “I won’t.”? What determination I had doubled.

The high yield manager and I went into the teleconference and held our ground.? Then the counterproposal came, “If you want to protect your analysts, are you willing to put your bonuses on the line?”? We looked at each other.? I nodded; he nodded.? I said, “If we don’t meet your expectations as a group, you hit our bonuses first.”

As it was, we did well, and we all got our bonuses.? But it was never lost on the analysts that we put them first, both as colleagues and friends.? It was one big reason why we continued to do great business together.

Though I was only a corporate bond manager for two very special years, where I did well against a tough market, the way I did business helped us to do well, by being ethical above all else.? In a bad environment, that can really help.? Even Wall Street differentiates between who keeps their word and who does not.

I would have loved to continue in that business.? It was a lot of fun, but jobs like that are not handed out willy-nilly.? All that said, I went out knowing that I had done my best, and was ready to do more for my next employer.

The Education of a Corporate Bond Manager, Part XI

Posted on 7 August 2010 by David Merkel

I appreciate my readers.? That doesn’t mean that I am the fastest to respond to e-mails, but I appreciate what they write, even when I don’t agree.? But here is an e-mail very relevant to tonight’s piece:

Great series, David.

If you have more posts planned, it would be interesting to know what the biggest mistake you’ve made that you learned from the most.

In my short tenure as a corporate bond manager, I had a very good run in the midst of a bad environment.? Sometimes I think my lack of formal training was a plus for analyzing a situation where little was going well.

But I did make my mistakes. One was Enron — don’t get me wrong, I urged the sale of Enron bonds, but was countermanded.? Could I have argued the cause better?

Fast-growing company in a slow-growing industry.
Management that could not take criticism.
Growing profits, shrinking cash flow.
We had a peek inside the veil, because we had financed some of their private deals.? The complexity was astounding.
Opaque balance sheet.

I made all of those points and still lost; my new bosses were not deep when it came to corporate credit; they were skilled in other areas of the bond market.? I eventually ended up selling the Enron bonds at an unfavorable price.? Would that I had sold on the date of the default, rather than a month later.

Then there was the Teleglobe situation, where I erred in many ways.? BCE, Incorporated had a unregulated subsidiary called Teleglobe.? Think of Global Crossing, and other marginal telecom ideas.? BCE was a sound company, and they offered verbal support for their subsidiary, but would not put it into writing, and formally guarantee their debt.

I did not know the company well, and I had no stock price to give me aid.? Stock prices are more sensitive than bond prices, and can give warnings before bond prices move dramatically.? My analyst went off to a telecom/technology conference, where the S&P analyst disclosed over dinner that she was likely to downgrade Teleglobe because of the lack of explicit support from the parent company.

Now given the broader picture, this should have been obvious.? There were too many situations where implicit support did not translate into real support, and Teleglobe, most than most, needed support.

My analyst called me after the comment from the S&P analyst, and I asked, “Should I sell?”? He said I should wait; he wanted to gather a little more data.? We had our opportunity to sell at $90, and waiting missed that.? By the time he returned, the S&P analyst indicated that a downgrade was likely, and the pseudo-price fell to $70.? But, we were now determined to sell.

So I called my favorite broker, who was at the only firm making a market in Teleglobe bonds.

DM: “What’s the market in Teleglobe bonds?”

FB: “$68/$72.”

DM: “Very good.? I sell you $XX Milllion of Teleglobe bonds at $68.”

FB: “I’m sorry, that’s not a real market, that is an indicative market.”

DM: “So where is the real market?”

FB: “We’ll take an order from you.”

DM: “You mean there is no real market?? You brought this deal to market, you have to maintain a market.”

FB: “We’ll take an order from you.”

DM: (Pause) You have an order for $XX million Teleglobe bonds at $65.

FB: “We will do our best for you.”

To this day, I have no doubt that she was serious with me.? Teleglobe bonds after that point traded in the $50s, but never at the main broker.? As I learned later, they had 10+ times more Teleglobe bonds than I did, and were trying to minimize their own exposure.? They lost a lot more than I did.

When BCE sent Teleglobe into bankruptcy several weeks later, we sold the bonds at $20.? The eventually went out as a zonk.? No value.

Lesson learned: bonds are asymmetric.? You are paid to be cautious regarding failure.? When in doubt, sell.? Also, don’t take your broker at face value always.

The fallout from the Teleglobe failure was twofold.? 1) the client accused us of incompetence, because we had missed on Enron, KMart, and Teleglobe. 2) My boss asked me how I could have missed it, and I said, “I was following it and did the best I could.? But I am following over 500 credits.”

Sadly, he made the wrong decision, and hired another corporate bond manager, and we split the portfolio.? It led to poorer portfolio management.

Another error: I am not politics-sensitive.? I am more interested in doing what is right for clients, than what looks best.? So when the client proposed value destroying ideas that would benefit them directly, I argued against them.? The asset manager took me out of direct client contact, aside from actuarial risk management, but asked me to tell them what was up, because the client asked for weird things.? The same applied inside the asset manager, where my willingness to take or avoid risk was in sync with opportunity, but out of sync with the firm.

I had learned to avoid undue pessimism from the high yield manager who sat next to me, and that often made me more optimistic amid gloom than others in the firm.? I was not a pea in the pod, and perhaps that made those that had acquired my firm wonder about me.? I never did anything more than make my opinions known, but that is enough for some to take umbrage.

Maybe the point is this: you can be right in the long run, but wrong in the short run.? What eventually happened to the client?? Well, I mentioned all of the dismissals before, but as God would have it, the client was sold yesterday to hedge-fund manager Phil Falcone.? The new CEO of Old Mutual said:

But just to remind you of the background of the transaction, we bought US Life in 2001 with the aim of building a Life business in the United States. This has proved to be a poor acquisition for the Group, and we acknowledge it, largely due to taking excessive credit risk, the impacts of which came to a head in the 2008 global financial crisis. So we said in March we intended to explore the sale of the business.

Old Mutual pumped in hundreds of millions in capital, in addition to what they paid for it.? They lost badly.? But they did not list the real reason why they lost, which gives me little confidence that they will do better in the future.? They lost because their US life division sold policies at levels that did not cover the cost of capital.? In order to avoid the inevitable losses from selling policies too cheaply, they pushed those who invested for them to try to make it up by taking much more risk.? The risk didn’t come first; what came first was a bad management culture that pushed sales growth at the expense of everything else.

Hopefully, Mr. Falcone will see that and realize that sales aren’t everything, and dial back investment risk.? But who can tell?

My main errors came from mis-estimating people.? I was not strong enough to change the culture, and I should have realized that, and tried to be more incremental.? As it was, I was right, but frozen out from being able to effect change.

Final episode tomorrow, most likely…

The Education of a Corporate Bond Manager, Part X

Posted on 6 August 20106 August 2010 by David Merkel

“We’re doing a CDO.”? So said the head of investments.? A few days later, the staff of an investment bank crashed the branch office where I worked, and told us what they would like us to do.? We would buy a lot of their distressed inventory of utility bonds and financial bonds, add in some bonds of our own design, and sell a CDO.

I thought the idea stunk.? I also thought we should do it.? Why?? Get your foot in the door.? You can only do deal #2 if you have done deal #1.? Investment banks were not banging on our door to help us create a CDO, and the collateral wasn’t horrible.? It wasn’t what I would have chosen if I had discretion, but it wasn’t horrible.? Besides, we would own the equity, so who would take the first losses?

Unfortunately, the deal meant a trip to Wall Street, or at least midtown Manhattan. Now, some find that a lot of fun, and I do as well, because I like meeting bright people, and exploring new ideas.? Often my brokers wanted to introduce me to some of their “thought leaders.”? I found that to be a lot of fun.

But much as I like wine and good food, I sometimes found the schmoozing to be a burden.? I try to be an ethical guy.? I’m out to serve my client within the scope of the law, and within extra-legal ethical codes (I am an actuary and I hold the Financial Analysts’ Charter.)? I’m also a “cheap date.”? I don’t have to have an expensive steak… a good burger will do.

We had a practice in my office, that we would take visiting brokers from Wall Street to Victor’s Cafe, which was a 3 minute walk from our office.? Not very expensive, and good food.? We could get back to work quickly.? The brokers would look at the bill and say, “How am I going to explain this cheap tab to my boss?”? I told them that it was our way; we enjoy people, not spending.

On that two-day trip to Wall Street to talk with brokers and cement the CDO deal, the meal on the second night would be at a certain five-star restaurant.? One problem: no reservations were made.? So, at the beginning of the second day, a competitor broker (the piece of work featured in part nine) asked what we were doing that evening, and we mentioned the other broker, the restaurant, and that we did not have a reservation.? He said, “I am close friends, with the manager of [that restaurant].? If you want I can get you reservations this evening.? The only thing I ask is that your coverage at [the competitor] send me a thank-you note.”? We said sure.? He called them up, and BAM! Reservations for twelve on the spot.

The guy was a piece of work, but he could get things done.? The evening was great; I made the bright move of ordering a Russian beer, which was so bitter that I drank little.? The food was rich, for the nth time on this trip, and as I went home on Amtrak, I said to myself, “You can’t do this to your body — too much rich food over two days.”? I felt horrible.

And, as God would have it, the CDO deal blew up within a week.? Management did not want to do a deal that they did not shape.? As for me, I could go either way.? Deal one for shops that don’t have a big name is typically a compromise.

But, I learned from my times visiting in Manhattan, enjoy it, but not too much.? The best parts were learning how the brokers worked.? In the times that I visited the trading floors, Wall Street completed moving the cash guys next to the derivative guys, to share information effectively.

I also learned that we were up against organizations that were so much more clever than those that they served (us!), that we were better off cooperating with them than competing against them.? It was fascinating to watch the flow of information ripple across the trading floor.

-==–=-=-==-=–=-=-==-=-=-=-=-=-=-=-=-

Making Money

Merger arbitrage was an area I was surprised to find had value as a manager of bonds.? I trust my analysts; if they said a deal will go through, it will go through.? I would analyze the downside, and see if it was not acceptable.? In that era, the incremental yield on swapping acquirer bonds for target bonds was 40% annualized.? Woo-hoo!? Given all of the credit losses in 2002, I was able to make up for it all and more with some of these trades.

There was one big deal where my analyst said that the deal was a lock, and so I traded all of my shorter bonds, and bonds in the acquirer, for 30-year non-deal-protected bonds, and went up to my credit risk limit.? To my surprise, I got a call from the chief investment officer.

“Hey.”

DM: “What’s up?”

“What are you doing?”

DM: “Making money, and you?”

“Not funny.? You are messing with all of our credit risk limits here.? What if the deal doesn’t go through?”

DM: “It will go through.? The target will not survive well without it, though the bonds are money good, and the acquirer has its reputation on the line.”

“No more trading in this name, got it?”

DM: “Got it.” (I was done anyway.)

That ended up being our largest single capital gain for the year.? A close competitor was when I began buying the junior debts of banks in late 2002, particularly of the floating rate variety, which offered more upside.? After putting 2% of the client’s assets into the floating-rate trust preferreds, I got the call.

“Hey.”

DM: “What’s up?”

“What are you doing?”

DM: “Making money, and you?”

“Not funny.? You are messing with all of our credit risk limits here.? What if the banks don’t do so well?”

DM: “These are major, solid banks, where there is little risk of insolvency.? You’ve bought some outright preferred stock of some of these banks for portfolios, and this is safer.”

“Forget that. This trade is done, no more, got it?”

DM: “Got it.”? Again, the trade was done, and spreads had begun to collapse in, rapidly.? One broker who dominated the sub-market, but who I had done few trades through, told me that there was a buyer in the market, and so spreads were falling fast.? I wonder who that buyer was? 😉

Anyway, the smallest capital gain they cleared on that trade was 10%, and in bond terms, those were home runs.

I had other notable trades, such as credits tainted with Brazil exposure, where the company would be fine even if the Brazil exposure defaulted in entire — we loaded the boat, and sold after Lula was elected.? (Remember how worried people worried about Lula?? Another reason to remember that stability usually triumphs over discontinuity.)

If you give your bond managers enough rope, they may work wonders for you, or they might hang themselves.? We had our share of losses and gains in what was a horrible period 2001-2003.? On the whole, it was well above average, but our client was tough, and we got little appreciation for what we did.

If you work for money, you will be disappointed.? If you work for praise, the same.? If you work for excellence, you can only disappoint yourself.? I was happy with what I achieved for the client, even though the client didn’t like me much. More in the next piece.

PS — the broker did not send the thank-you note, and “the piece of work” got after him until he did.? What an episode!

The Education of a Corporate Bond Manager, Part IX

Posted on 5 August 2010 by David Merkel

You aren’t supposed to act like a market-maker as a bond manager.? That is the role of a broker-dealer, and should they know that you aspire to making the risk-free profits that they do, they may use their power to harm you, notably:

Give you lower allocations on new deals.
Be tougher with you on haggling.

There are exceptions, though, and both tales are instructive.? One time, I received an offer that had a lot of spread on a bank bond that I had never heard of (given my memory, that was rare).? It was from a third-tier dealer that I rarely traded with.? I called over my new banking analyst (NOTE: She is a stupendous corporate bond analyst for banks, and is looking for a job now… if you need such an analyst e-mail me.? You won’t be sorry.) and asked her about the company.? She commented, “Solid franchise, boring.? Credit metrics are fine.? Go ahead.”? So I bought the bonds.? Remember, I trust my analysts, but if the trade works out badly, it is my fault.? The buck stops here.

On that day, the new corporate bond manager, with whom I would divide the portfolio (because it had gotten so big) was there for the first time.? We met and chatted for a while, but while we met, I got a phone call from a different third-tier dealer who wanted the exact same bonds that I had just bought.? He asked be where I would sell them, and I named a spread level 50 basis points tighter than where I had bought them minutes ago.? To my surprise, he bought the bonds at the level.? The new portfolio manager asked where I had bought them, and when he heard that I had cleared $3 per $100 on a 15 minute trade, he gave me a big “high five” and told me that I was the best.

Now, for those that know me well, in person, I get embarrassed with too much attention.? Writing, that’s another thing because it is somewhat anonymous to sit in front of a screen and write to people that you don’t know personally, like now.? I was surprised at his reaction, and it proved to be an indicator of what he was like as a trader.? He liked to take advantage of the Street where he could, and he had a bit of a greedy reputation, as some of my brokers told me later.

Most corporate bonds I traded had three basis points between the bid and the ask.? I would try to shrink that to two, or even one where I could, without being rude.? This was common after the new guy was hired:

DM: “Could I get the bonds one basis point wider?”

Broker: “Let me talk to the trader.”? (Fainter: “could he have them a basis point wider?”)? Pause, indecipherable.

Broker: “Let me try again.” (Fainter: “It’s XXX.” naming my firm)? Pause, indecipherable.

Broker: “Let me try again.” (Fainter: “It’s Merkel.”)? Pause, indecipherable.

Broker: “You are done at your level.”

DM: “Thanks! You’re the best!”

Reputation matters.? There was another example where I crossed bonds where it was legitimate — if it was done to help a broker in distress.? One day, someone offered me a rare type of Capital One bonds at a normal level, and I asked whether the bonds in question were the ones that were in a major bond index, without saying that per se.? After figuring that out, I bought them at the level, and called a broker that was likely to be short the bonds to see if he wanted them.? He certainly did, and offered them at a three basis point concession to where I bought them, as opposed to ripping the eyeballs out (as the technical term went).

The whole set of two transactions took 15 minutes, and made $15,000 for my client.? What was funnier, was that my whole family came to visit me that day, my wife and at that time, seven kids.? They heard the two transactions, though I had to explain it to them later. To the second broker, I had each of the kids say “Hi,” ending with the then three-year old girl who squeaked “Hi.”? He said something to the effect of, “I knew you had a large family, but it only really struck me now.”

Underwriting Your Brokers

Just as I said in an earlier part about underwriting your credit analysts, the same was true of brokers.? It paid to analyze what they would say, and what they would do, and compare them.? Over time, I gravitated secondary trading business to those the “walked the walk.”? So, one day, one of the brokers of a big firm who did not “walk the walk” called me and asked, “Of all of your brokers, where am I in your ranking of getting trades done?”? I told him that I didn’t know, but asked him to call back tomorrow.? With my computer expertise, I ran a few analyses, and got the answer.? When he called back the next day, I told him that he was number eight.

“EIGHT! I am number three at worst with the rest of my clients, and you are my smallest client! Who is ahead of me with you?”

DM: “Salomon, B of A, Chase, Wachovia…”

“What!”

DM: “Hey, he covers me like a glove; you don’t often call. Lehman, Goldman Sachs…”

“No one does corporate business with Goldman!”

DM: “I do corporate business with Goldman, and I get a lot done because my coverage is earnest and looks out for me.? Merrill, Legg Mason…”

“LEGG MASON!!!? You’re &*^*&^ kidding me, they are nobodies!”

DM: “but they talk to me daily, and the broker I deal with there is honest, and we get trades done.? They may be nobodies, but I deal with those who will deal with me, and we care about the fixed income community of the city we are in.? You are next, do you want to hear who is after you?”

“NO! You are a TOTAL EMBARRASSMENT to me.? I don’t need to have you as a client.? You are my smallest client, and I have other clients who treat me with the respect the I deserve.”

DM: “Do what you want.? Other brokers send me ideas every day, but you don’t.? If you want to be a big broker with me; I am open to that, but you have to spend time on me.”

The conversation ended soon after that, but there were two results: I began to get more trade ideas from him, and he handed me off to a junior broker who worked for him who spent more time on me.? Business went up.

I have described some people I have worked with to my kids, but he was the first that I described as “a piece of work.”

There was a time that I had lunch with him in Midtown, with my old boss there as well, where he described the travails of his wife with two nannies, for his two kids.? My boss got angry on my behalf: my wife dealt with seven, home schooling, with no help, and he talked of the troubles of his wife.? Me?? I give people room.? What is hard for one is tough for others.

But what this touches on is the schmoozing that goes on with clients, and how that affects business decisions.? More on that in the next part.

June 2010	August 2010	Comments
Information received since the Federal Open Market Committee met in April suggests that the economic recovery is proceeding and that the labor market is improving gradually.	Information received since the Federal Open Market Committee met in June indicates that the pace of recovery in output and employment has slowed in recent months.	Shades down their views on production and labor.
Household spending is increasing but remains constrained by high unemployment, modest income growth, lower housing wealth, and tight credit.	Household spending is increasing gradually, but remains constrained by high unemployment, modest income growth, lower housing wealth, and tight credit.	Shades down their view on consumer spending.
Business spending on equipment and software has risen significantly; however, investment in nonresidential structures continues to be weak and employers remain reluctant to add to payrolls.	Business spending on equipment and software is rising; however, investment in nonresidential structures continues to be weak and employers remain reluctant to add to payrolls.	Shades down their view on business spending on equipment and software.
Housing starts remain at a depressed level.	Housing starts remain at a depressed level.	No change.
Financial conditions have become less supportive of economic growth on balance, largely reflecting developments abroad. Bank lending has continued to contract in recent months.	Bank lending has continued to contract.	Gives up the ?We?re fine, this is a foreign problem? idea.
Nonetheless, the Committee anticipates a gradual return to higher levels of resource utilization in a context of price stability, although the pace of economic recovery is likely to be moderate for a time.	Nonetheless, the Committee anticipates a gradual return to higher levels of resource utilization in a context of price stability, although the pace of economic recovery is likely to be more modest in the near term than had been anticipated.	Finally accepting that their forecasts were too optimistic.
With substantial resource slack continuing to restrain cost pressures and longer-term inflation expectations stable, inflation is likely to be subdued for some time.	Measures of underlying inflation have trended lower in recent quarters and, with substantial resource slack continuing to restrain cost pressures and longer-term inflation expectations stable, inflation is likely to be subdued for some time.	Toots the ?At least inflation is low? horn.? Not a popular instrument at the moment.
The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period.	The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period.	No change.? Fed funds are useless at this point.
	To help support the economic recovery in a context of price stability, the Committee will keep constant the Federal Reserve’s holdings of securities at their current level by reinvesting principal payments from agency debt and agency mortgage-backed securities in longer-term Treasury securities.¹ The Committee will continue to roll over the Federal Reserve’s holdings of Treasury securities as they mature.	New paragraph for quantitative easing, round 2.? Will invest maturing Treasuries, Agencies and Agency MBS in longer term Treasuries.? May be avoiding Agency MBS in order to stop problems with the rolls.
The Committee will continue to monitor the economic outlook and financial developments and will employ its policy tools as necessary to promote economic recovery and price stability.	The Committee will continue to monitor the economic outlook and financial developments and will employ its policy tools as necessary to promote economic recovery and price stability.	No change.? A meaningless statement.
In light of improved functioning of financial markets, the Federal Reserve has closed all but one of the special liquidity facilities that it created to support markets during the crisis. The only remaining such program, the Term Asset-Backed Securities Loan Facility, is scheduled to close on June 30 for loans backed by new-issue commercial mortgage-backed securities; it closed on March 31 for loans backed by all other types of collateral.		Paragraph removed.? The programs are gone, leaving behind a legacy of increased moral hazard risks.
Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; James Bullard; Elizabeth A. Duke; Donald L. Kohn; Sandra Pianalto; Eric S. Rosengren; Daniel K. Tarullo; and Kevin M. Warsh.	Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; James Bullard; Elizabeth A. Duke; Donald L. Kohn; Sandra Pianalto; Eric S. Rosengren; Daniel K. Tarullo; and Kevin M. Warsh.	No change.
Voting against the policy action was Thomas M. Hoenig, who believed that continuing to express the expectation of exceptionally low levels of the federal funds rate for an extended period was no longer warranted because it could lead to a build-up of future imbalances and increase risks to longer run macroeconomic and financial stability, while limiting the Committee?s flexibility to begin raising rates modestly.	Voting against the policy was Thomas M. Hoenig, who judges that the economy is recovering modestly, as projected. Accordingly, he believed that continuing to express the expectation of exceptionally low levels of the federal funds rate for an extended period was no longer warranted and limits the Committee’s ability to adjust policy when needed. In addition, given economic and financial conditions, Mr. Hoenig did not believe that keeping constant the size of the Federal Reserve’s holdings of longer-term securities at their current level was required to support a return to the Committee’s policy objectives.	Hoenig continues his dissent.? Thinks economy is improving, and that quantitative easing should roll off.
	1. The Open Market Desk will issue a technical note shortly after the statement providing operational details on how it will carry out these transactions.	Footnote added to QE paragraph.