9 September 2011 – The Aleph Blog

Debt Relief

Posted on 9 September 2011 by David Merkel

The world yearns for debt relief.? There are many debts that will not be repaid at face value.? Better to recognize those realities now, and seek a compromise.? What’s that, you say?? Banks that lent the money won’t survive at the current market quote for the debts?? Best to take the bank into conservation NOW, and strike deals with their creditors.? Mark-to-market accounting should be the friend of regulators, letting them act to conserve institutions that have financed illiquid assets with liquid liabilities.

Where do we need compromises?

In Europe, Germany, France and the Netherlands need to realize they will not get full payment from Portugal, Ireland, Italy, Greece and Spain.
China and OPEC need to realize they will never get full payments from the US.
Japanese citizens need to grasp that their government will never make good on all of its obligations.
US citizens need to understand that Medicare is out of control and must be reduced, somehow.
US citizens need to get that promised benefits to municipal pension plans are too high.
Many mortgages are deeply under water, in the US and abroad.
Many loans made by Chinese banks to Party projects are not money good.

If the creditors will realize that the odds of getting par are close to nil, then a real negotiation can begin where the true value of the asset can be recognized.

Our world can be productive again, once we wipe clean all of the bad debts.? One thing that I admire about credit default swaps, when a credit event occurs, the process is clean and rapid, and relatively little cash changes hands.? Would that it could be the same for clearing debts in our more complex world.

In one sense, this is just recognizing reality before one is forced to do so, which is an admirable discipline.? The alternative is extend and pretend.? Loan more money, because for some reason unknown, it will recover.

That is no relief; it only increases the burden.? There needs to be reductions in principal, rather than rates.? Banks that don’t agree with this need to be handed over to the FDIC.

Don’t get me wrong, this is complex, but banks need incentives to shore up their balance sheets, so that they can lend once their position is solid.

As I have said from the beginning, if you want to solve this crisis, one must reconcile all of the bad debts.? Lenders need to take their hits.? Governments should liquidate bad banks, but make creditors as whole as possible.

Eat Your Own Cooking

Posted on 9 September 2011 by David Merkel

When I manage money for my clients, my own money is on the line along with them.? That’s the way it should be.? I try to give clients a clone of my portfolios whether on bonds or stocks.? This aligns my interests with theirs, because I want to make money over the long run on my assets.

This post is spurred by a post at the Wealthfront Blog, where he cites a Morningstar study where only 40% of mutual fund managers invest alongside their investors. Now, some of that is explainable because the asset class of their funds would not be a complete asset management strategy.? But it does not explain why they don’t have any significant amount invested there.

At one firm that I worked for, there was a rule: you could buy anything so long as the firm had first dibs on buying what you wanted to buy.? Once the firm was done buying, you could buy your idea.? Same thing for selling.? The firm must sell first, and only after that could any employee sell.? If you are not trading in lockstep with your clients, you must trade behind them.? No front-running.

But personally, I prefer managers that have the same incentive as investors.? Why? It makes them manage to normal risk levels.? Hedge fund incentives, unless there is some clawback for bad future performance, or that performance fees must be reinvested in the fund for a number of years, incent hedge fund managers to swing for the fences.? You can make a lot in a really good year, and receive your ordinary fees in bad years, without taking any losses.

My experience was when I was one who hired equity managers that the value shops tended to have large amounts of their personal wealth invested in their funds.? Why?? One, they believed in what they were doing.? Two, value investing tends to self-correct over time.? Three, value investors don’t trade as much.? They are typically holding investments they would be comfortable holding for a long time.? Four, there was an ethical idea of “we eat our own cooking.”? They wanted incentives aligned 1:1.? I win, you win.? You lose, I also lose.

This article is dated, but most of those that eat their own cooking are value-oriented managers.? This article is another example, but note that the excellent Vanguard does not require managers to invest in their own funds.? Part of that is the bond complex, and also that some of their equity funds are multiple manager funds.

As for me, I have over 60% of my net worth invested in my strategies, and over 80% of my liquid net worth.? I believe in what I do.? Granted, value investing has not been rewarded recently, but over the long haul, it is usually more than adequately compensated.