Day: August 20, 2013

The Rules, Part XLIX

The Rules, Part XLIX

In institutional portfolio management, the two hardest things to do are to buy higher than your last buy, and sell lower than your last sale.

I’ll tell you about two former bosses that I had.? They are both good men, and I respect them both.? The first one taught me about bond management.? He had a difficulty though.? Typically, he did not like to trade.? When I stepped into his role, but with far less experience, I traded a lot more than he did.? Because I traded more, and liquidity in the bond market is sporadic, I came up with the rule listed above.

The boss had an interesting insight, though: he suggested when you get to large sizes, stocks and bonds are equally illiquid.? I tend to agree.? In my days, I have traded stocks and bonds where I was a disproportionate holder of them, more so with bonds than with stocks.? If you want to learn the microstructure of markets, there is no better training ground than with illiquid securities.? And if you hold a lot of any security, the position is illiquid.

Once you are big, it is hard to trade in and out of positions rapidly.? You have to scale in and scale out, and do it in such a way that you don’t tip your hand to the market, which would then move against you.? Now, it would be easy if you had a fixed estimate of value for the securities, so that you knew whether a proposed buy or sell made sense, but corporate bonds and stocks improve and deteriorate.

Imagine for a moment that you hold five percent of a company’s bonds, and to your surprise, the situation is deteriorating.? Bid prices are falling.? What do you do?? First question: are the bonds money good?? Will they pay off, with high likelihood?? If so, bide your time, and maybe add some more if you have room.? If not, the second question: so what are the bonds worth?? If less than the current price, start selling, but avoid the appearance that you are desperate.? You have a lot of bonds to sell.? For the market to absorb them all will be a challenge.? I would say to brokers, that I was willing to sell small amounts of bonds at the current market, but if someone wanted to buy my full position, I might be willing to compromise a little.? Then you can have negotiations.

More often, in a deteriorating situation, you sell in dribs and drabs as the price of the asset falls.? There is psychological pain as you sell lower, but a good manager dismisses it, forgetting the past and focusing on the future.

Then there was the other boss.? At the interview he asked me, “What is one of the hardest lessons you have learned?”? I said, “In institutional portfolio management, the two hardest things to do are to buy higher than your last buy, and sell lower than your last sale.”

He appreciated the answer, though he had a hard time applying it personally.? He had a tendency to look to the past more than me.? Over the years I have learned to be forward-looking and try to analyze what securities will do the best, regardless of my cost basis.

I got the largest allocation of the Prudential “C” bonds when the deal was done. but I bought an equal amount 10% higher in price terms when it was a great deal in relative terms.? It was tough to buy more at a higher price, but it was still a great yield on a misunderstood bond.

Regret is native to mankind, but you can’t change the past.? You can try to estimate the future.? Don’t think about your cost bases.? Rather, think about what an asset is truly worth, and its trajectory, and manage your buys and sells relative to that.

Forward-looking management wins.? Look forward, and avoid regret.

PS — On Scottish Re (spit, spit) we went through this process.? We bought and bought more as it went down.? I erred in my judgment.? Had I looked at the taxable income, I would have realized that a lot of the profits weren’t real.

Before the company announced its reorganization plan, we doubled our position at a very low price, but then sold the whole thing into an astounding rally when the company announced its plans.? That cut our losses considerably, and we didn’t buy it back.? Eventually, it was worth nothing.? Focus on the future; ignore the past.

The Fed Needs Valuation Actuaries (and More Steel in the Spine)

The Fed Needs Valuation Actuaries (and More Steel in the Spine)

I reviewed the following report from the Federal Reserve to Congress today, and found it disappointing.? From my prior experience as an actuary, and the time that I spent on the asset-liability committee of a small bank, I know that? the banking industry is far behind the life insurance industry on risk control.? The Fed would have done far better to have studied the works of the Society of Actuaries and the National Association of Insurance Commissioners, and learned from their efforts.

Now, I know that the contingencies of banks are far less predictable then those of life insurers.? Further, life insurers have long liabilities, whereas the liabilities of banks are short, and thus, they are more subject to runs.? But liquidity risk management does not play a large role in their document — and this is a severe defect in what they write.? Almost all failures of financial firms are due to loss of liquidity.? The word liquidity only appears once in the document, on page 15.? This shows the amateurish work of the writers.

The Fed focuses on a lot of process issues that don’t matter as much as the substantive issues of discovering forward-looking measures of risk, and changing business processes to reflect those risks.

Here are some examples:

1) Internal controls matter, but it is a rare internal control auditor that can truly analyze a complex mathematical process.? They don’t have the capacity to review those processes, or they would be doing it and earning far more.

2) Risk identification is important, but the Fed document would have not helped in 2007-2009.? How do you detect risks that have (seemingly) never happened before?? Further, if you do detect a major problem that has happened before, and it would impair some very profitable businesses, why do you think management will kill profits to appease your lunacy?

3) Governance is important, but the board gets data so late that it is useless.? This is not worth bothering with.? Management has to do the job here.

4) The language on capital targets is weak, and allows the banks way too much latitude in performing their own calculations.? The Fed needs to be far more specific, and prescribe the scenarios that need to be tested.? It need to prescribe the loss severities, asset class by asset class.? It needs to prescribe the correlations, if any, that can be used in the models.

5) The document does not speak of ethics.? Valuation Actuaries do the same work on a higher level, and they have an ethics code.? That may occasionally make them oppose the management team that pays them, but it is a necessary check against managements trying to manipulate results.

6)? The piece spends too much time on the dividend policies of bank holding companies, and no significant time on the abilities of the subsidiaries ability to dividend to the bank holding companies.? The proper focus of a bank regulator is on the health of the operating subsidiaries.? Who care if the holding company goes broke?? Big deal, at least we protected depositors.

Banking regulators should adopt the same policy as insurance regulators.? Outside of ordinary limits, they can deny any special dividends from subsidiaries to the holding company.

7) The piece does not get forward-looking estimates of risk.? On new classes of assets, you don’t have historical data to aid in estimates of risk.? At such a point, one must look at similar businesses that have gone through a failure cycle, or do something even more difficult: do a cash flow model to estimate where losses will fall if asset values decline for an unspecified reason (okay, no more ability to buy…)

8 ) Macroeconomic factors rarely correlate well with the factors that lead to losses on assets.? Most of that effort is a waste.

9) As Buffett said (something like): “We’re paid to think about things that can’t happen.”? This is why the Fed has to specify scenarios, and be definite.? The mealy-mouthed language of the document can be gainsayed.? Life Actuaries have better guidance.

10) So all of the banks did not pass the mark.? With the vagueness of the guidelines, no surprise.? Let the Fed put forth real guidelines for bank stress tests, and let the banks scream when they get them.? Better to have slow growth in the banking sector than another crisis.

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