Buffett supposedly once said something like, “We’re paid to think about things that can’t happen.”  What would be examples of this?

  • The Housing Bust, and the ensuing funk with banks.
  • Hurricane Katrina, and the flood that it helped create.
  • The Tohoku Earthquake, with the surprising damage to the nuclear reactor
  • Four hurricanes hitting Florida in 2004.
  • The Fall of the Soviet Union
  • The Murderous effect of forced collectivization in the Ukraine, China, Cambodia, and other places.
  • The rise of Hitler
  • Chernobyl
  • Long US interest rates would fall below 5%.

This will be a short piece, but what I want to stress is that things that pundits say can’t happen sometimes do happen.  The application is that it is not impossible that the US Government defaults for political reasons.  Brinksmanship is a tough and heady thing, and it is possible for all parties to miscalculate and be intransigent.  Pride brings out the worst in mankind.

I’m not saying a default will happen, or that it is more likely to happen than not.  I am only saying the probability is non-zero, like rolling boxcars or snake-eyes at the craps table.  Thus credit default swaps [CDS] on a US default have risen considerably, because a few are hedging the possibility.

Personally, I think it would be interesting to see what would happen in a default, because we don’t have a lot of data points there, even for a short default.  That said, vain curiosity of mine should not be satisfied to the harm of many, so would prefer that the GOP and Dems would agree to a short-term extension of the debt ceiling combined with spending reductions.

But nothing is impossible among men.  Pride has often driven the otherwise sane to take courses of action that harm their enemies more, even as their friends are harmed also.

The Bible says, “An eye for an eye, and a tooth for a tooth.”  People look upon it as cruel, but it was meant as a limit.  You can’t force suffering at a greater level than you were harmed, and the threat of equal suffering would lead offenders to negotiate a monetary settlement to protect their eyes and teeth.

But when men will not restrain themselves, and seek to gain revenge, all manner of bad consequences occur.   There is something to having limits on political processes.  There is something to having manners in society.  There is something to having personal self-control.

We have lost a lot as a society as the Greatest Generation has handed power over to the Baby Boomers.  We agree far less on what society ought to pursue, and what is right and wrong.

That is why the fights in DC are so bare-knuckled.  Gerrymandered districts send ideologues to Congress, which have very different views on policy and ethics.

Back to the main point — when the two or three sides of the debate have widely different views should it be surprising that it is possible that we may end up with a stalemate leading to a temporary default?  A permanent default is another matter — I don’t think the politicians are that stupid, at least not yet.

Lo, how the mighty have fallen.

Let’s take a step back and see the full stock chart.

My, but Tower Group [TWGP] was a juggernaut in its time, but I never bought it or sold it.  Let me explain:

In 2005 my boss at the hedge fund came to me and said, “Why don’t we own Tower Group?  One of my friends owns it and says it is the greatest company in insurance.”

Me: “They are a new company underwriting in tough lines, with a weird reinsurance agreement from a small Bermuda company.  They are growing too fast, and I doubt they are as profitable as they claim.”

Boss: “Well, should we short them then?”

Me: “I don’t think shorting into strength is smart, so no.  We should do nothing here.” (After a little more, boss leaves, probably annoyed at me because I recommended no action.  He was a man of action!  I am a prudent risk-taker, and very selective about when I short.)

As an analyst of insurance stocks, I was always skeptical of Tower Group for three reasons:

  1. The acquisitive nature of Tower Group.
  2. The rapid growth in premiums, 52% per year over the last 10 years — no insurance company can successfully grow that rapidly in a mature market.
  3. Odd reinsurance agreements that made me wonder.

But by the time I ceased being a buy side analyst for a hedge fund in 2007, there was nothing to make me short Tower Group, much as I did not like it.  And so, I stopped following the company, because it is much easier to look only for companies to be long.  (TWGP remained on my “consider shorting” list till the end of 2007.)

I stopped following it.  Had I been following it, I would have noted the unusual strengthening of reserves for losses from prior year business (Page F-32, worth $69 Million) from the 10-K filed on 3/4/2013.  Someone selling on that day or soon after would have received something in the $18s/share vs. $4s/share now.  Large reserve strengthenings are often a harbinger of greater reserve strengthenings to come.

After their writedown, Tower Group was downgraded by the rating agencies to the degree that few will buy new insurance or reinsurance from them.  Further, they are seeking a buyer, and the buyers are skittish.

Thus, the company is probably in runoff. Runoff means there are no more new premiums, and the company aims to pay all legitimate claims until it closes its doors, hopefully leaving the equity investors a little.  Unless you are an expert, I would avoid taking any action here.  It is quite possible that reserves were set fraudulently, and that we have been given as much as the market can absorb in losses.  It’s also possible that the third-party actuaries have given a conservative view of reserves, and things get better from here.

I feature this company tonight to indicate how fraught with uncertainty it is to invest in insurance stocks, particularly those that grow premiums fast — that is usually a negative sign.

I have no idea where Tower Group goes from here, but they are a poster child for past fast growth and weak reserving.

I’ve written at least two significant pieces on endowment investing:

Recently, Cathleen M. Rittereiser, Founder of Uncorrelated, LLC, reached out to me to show me her whitepaper on endowment investing, The Portfolio Whiteboard Project.  This was partially in response to Matthew Klein’s excellent article, Time to Ditch the Yale Endowment Model. which came to conclusions similar to my articles above.

The Portfolio Whiteboard Project, which seeks to take a fresh look at endowment investing came to some good conclusions.  If you are interested, it is worth a read.  The remainder of this piece expresses ways that I think their views could be sharpened.  Here goes:

1) Don’t Think in Terms of Time Horizon, but Time Horizons

2008-9 proved that liquidity matters.  The time horizon of an endowment has two elements: the need to fund operations over your short-term planning horizon, and the need to grow the purchasing power of the endowment.

Choose a length of time over which you think you have a full market cycle, with a boom and a bust.  I like 10 years, but that might be too long for many.   As I said in Managing Illiquid Assets:

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.

I include all risk assets in illiquid assets here.  The question of illiquid vs liquid assets comes down to whether you are getting compensated for giving up the ability to easily sell.  There should be an expected premium return for illiquid assets, or else, invest in liquid risk assets, and wait for the day where there is a return advantage to illiquidity.

2) Look to the Underlying Drivers of Value

Hedge funds aren’t magic.  They are just limited partnerships that invest.  Look through the LPs to the actual investments.  It is those actual investments that will drive value, not the form in which they are held.  Get as granular as you can.  Ask: what is the margin of safety in these endeavors?  What is the likely return under bad and moderate conditions?

3) Ignore Correlations

It is far more important to focus on margin of safety than to look at diversification benefits.  Correlation coefficients on returns are not generally stable.  Do not assume any correlation benefits from risky investments.  Far better to segment your assets into risky and safe, and then choose the best assets in each bucket.

4) On Leverage & Insurance

Unless they are mispriced, borrowing money or getting insurance does not add value.  Same for all derivatives, but as we know from the “Big Short,” there are times when the market is horribly wrong.

Away from that, institutional investors are not much different from retail — they borrow at the wrong time (greed), and purchase insurance at the wrong time (fear).

5) Mark-to-Market Losses Might Matter

Mark-to-Market losses only don’t matter if endowments don’t face a call on liquidity when assets are depressed.

6) Insource Assets

The best firms I have worked for built up internal expertise, rather than outsource everything.  The idea is to start small, and slow build up local expertise, which makes you wiser with relationships that you have outsourced.  As you gain experience, insource more.

7) Thematic Investing is Usually Growth Investing

Avoid looking at themes.  Unless you are the first on the scene, themes are expensive.  Rather, look at margin of safety.  Look for businesses where you can’t lose much, and you might get good gains.

8) Look to the Underlying Value of the Business, or Asset Class

Cash flows are what matter.  Look at he likely internal rate of return on all of your investments, and the worst case scenario.  Buy cheap assets with a margin of safety, and don’t look further than that.  Buying safe assets cheap overcomes all diversification advantages.

Those are my differences on what was otherwise a good paper.  I can summarize it like this: Think like a smart businessman, and ignore academic theories on investing.

At the CFA Institute at Baltimore, we had the pleasure of having Jeremy Siegel come speak to us this past Thursday.  He was lively, engaging, and utterly convinced of his theses.  Thanks to Wisdom Tree for helping fund the endeavor.

He openly asked us to poke holes in his theories.  This article is an effort to do that.

1) Stock tends to get bought in when it is undervalued, and sold via IPOs when it is overvalued.  Thus the time-weighted rate of return exceeds the dollar-weighted rates of return by a few percent.  This dents the main premise of “Stocks for the Long Run.”  Buying and holding is not possible, because valuable stocks are lost at the troughs, giving us cash, and we are forced to buy more near peaks, of overvalued stocks.

Dollar-weighted returns are what we eat, and they don’t vary much versus time-weighted returns when considering bonds or cash.

Also, in the present day, private equity plays a larger role, and they exacerbate the degree to which stocks get IPOed dear, and acquired cheap.

2) He spent a lot of time defending the concept of the CAPE Ratio, but not its execution.  He began a long argument about how accounting rules for financials were behind the drop in earnings for the S&P 500, and that AIG, Bank of America, and Citi were to blame for all of it.

Sadly, he seems not to know financial accounting so well.  What was liberal in the early and mid-2000s was corrected 2007-2009.  In aggregate the accounting was fair across the decade.  Remember that accounting exists to try to measure change in value of net worth across short periods, and net worth at points in time.

Really, if we were trying to be exact, when a writedown occurs, we would spread it over prior periods, because prior accounting was too liberal – the incidence of the loss occurred over many years prior to the writedown.

Thus I find his argument regarding specialness of financial company accounting to be bogus – he is just searching for a way to justify valuations off of current earnings, rather than off of longer term measures.

3) The longer–term measures agree with CAPE:

  • Q-Ratio
  • Market Cap/ GDP
  • Price-to-Resources
  • Financial Stress indexes
  • Eddy-Elfenbein’s Stock Market if valued like a bond measure

All of these point to an overvalued market.  But markets can be overvalued for a while.  Why might that be in this case?

4) Because profit margins may remain high for some time.  In an era where the prices for labor and resources are cheap, should it be surprising that profit margins are high?  Those conditions will eventually change, but not soon.

With that, I would simply say that:

  • Stocks do outperform bonds and cash over the long run, but not by as much as Dr. Siegel thinks.
  • Stocks are overvalued by long-term balance sheet-oriented measures at present.
  • But stocks may stay high because profit margins are likely to stay high – there will be regression to the mean, but not now.

Finally I would note that he was one of the most graceful and generous speakers to come speak to us in some time, took a long Q&A, staying longer than he needed to, and happily signing the books he had written.  I showed him my First Edition version of his book, signed by him after speaking to the Philadelphia AAII chapter in 1995, and said, “We were much younger then.”  He smiled and said, “Yes, we were.”

I may disagree with him on some points, but he is one very bright and personable guy.

US Government Shutdown


  • To Lead Is to Negotiate http://t.co/AJTjPESgiI Elements of an interview w/James Baker describing Reagan the pragmatic dealmaker $$ Oct 04, 2013
  • Pig Sales Fly Blind as Data Cut by Shutdown Hampers Firms http://t.co/MHHnn29XXH Guess what? That’s the way most markets operate $$ Oct 04, 2013
  • Troops Forage for Food While Golfers Play On in Shutdown http://t.co/Y9HV5IpF3A “the appropriations process has completely failed” $$ Oct 04, 2013
  • Obama Rewrites Debt-Limit History http://t.co/BIRNHLH7Pm D&R Congresses have used the borrowing limit as political leverage w/a president $$ Oct 04, 2013
  • US banks fearing default stock up on cash http://t.co/tYXMlQXcIe If money markets freeze, currency will be needed to mediate exchange $$ Oct 04, 2013
  • Loose monetary policy needed to counter Washington gridlock: Fed officials http://t.co/AmJqqcMQPQ Fed enables intransigence of congress $$ Oct 04, 2013
  • Republicans Are No Longer the Party of Business http://t.co/Vwa5U0pENS Case not proven; as if the Democrats think of any biz but big biz $$ Oct 04, 2013
  • Frustrated Republicans Pressure Boehner to End Shutdown http://t.co/m6eSEtXQ5n Likely endgame: Democrats & liberal GOP ally in House $$ Oct 03, 2013
  • US Stocks Rise as Investors See Limited Shutdown Impact http://t.co/nB5WCCcsd4 Will they say the same thing today off neg mkt action? $$ Oct 02, 2013
  • Behind the Noise, Entitlement Reform http://t.co/Ed2ug8HoCN This is the elephant in the room; the economic problem behind all the rest $$ Oct 02, 2013
  • More Than 800,000 Federal Workers Are Furloughed http://t.co/GP0XdAxugH Oddly, this helps point out what true priorities of the govt r $$ Oct 01, 2013
  • In Government Shutdown, Few Parallels With Most Recent One http://t.co/RmJ7X3iL0Q Maybe shutdown is an alternative mode of running govt? $$ Oct 01, 2013


Companies & Industries


  • Twitter Look-Alike Ticker Triggers 684% Advance in Penny Stock http://t.co/hLf2VRP6Hs Big difference btw Twitter $TWTR & Tweeter $TWTRQ $$ Oct 04, 2013
  • Mars Repays $4.4B of Berkshire Bonds Tied to Wrigley Deal http://t.co/U5uSgTXBd8 Now Buffett has tough job of redeploying capital $$ #cash Oct 04, 2013
  • Twitter Sends Different Message Than Facebook in Filing http://t.co/azMDDPHVwz 32 pages of risk factors, no classified stock, refreshing $$ Oct 04, 2013
  • Blackstone Opens Europe Spigot as Distressed Deals Surge http://t.co/yYQl2dwhzS As EU banks get reasonable, $BX sees opportunity 4 deals $$ Oct 04, 2013
  • Alcoa on “low risk financiers” and parallel metal markets http://t.co/ganjSH2aZg With low interest rates, cheaper to store metal $$ Oct 03, 2013
  • Beanie Baby Creator Pleads Guilty to Swiss Bank Tax Dodge http://t.co/V8PrsbKEAO He’ll make up the $$ w/a line of Ty the Jailbird dolls Oct 03, 2013
  • We Are Googling the New York Times to Death http://t.co/OLJ0XsSCRA Use Google 2get free access to the $NYT – broken media revenue model $$ Oct 02, 2013
  • OGX Upheaval Portends Deeper Bond Loss for Pimco http://t.co/m9Do3MALyM BK is tough on creditors in Brazil; long process, low recoveries $$ Oct 02, 2013
  • How BlackBerry blew it:The inside story http://t.co/4K7Kw4Y5bL Long article as $BBRY focuses on core biz, misses threat from new entrants $$ Oct 01, 2013
  • Schwarzman Says Selling BlackRock Was ‘Heroic’ Mistake http://t.co/G8ZKjxNOZ0 Missed out on 79%/yr returns compounded over 19 years! $$ $BLK Oct 01, 2013
  • BlackBerry Rare Breakup Fee Seen Deterring Bids http://t.co/uyo9Ra1zzA Watsa gets a free look, while others effectively locked out $$ $BBRY Oct 01, 2013
  • Why Anglo American Walked Away From Pebble Mine Gold Deposit http://t.co/QwqmjykuD9 Interesting, but only speculations on y $AAUKY left $$ Oct 01, 2013
  • Commodities ‘Super Cycle’ Is Seen Enduring by McKinsey http://t.co/Jnj1XwZNKO Marginal costs keep rising as lower costs ores deplete $$ Oct 01, 2013
  • Storage Wars Seize Metals Market http://t.co/WkX0fsOx3o Aiming 2end games that lock up metal in storage as collateral for loans, I think $$ Oct 01, 2013
  • Falcone’s Funds Sell Harbinger Group Shares to Leucadia http://t.co/2l8dSyEPKP $HRG funds sell shares 2 $LUK @ a 20% discount 2 mkt price $$ Oct 01, 2013
  • Of course $LUK has 2 hold onto the shares 4 a while, but still that’s a pretty stiff price 2 pay 4 liquidity $$ $HRG Oct 01, 2013


Finance, Pensions, Etc.


  • More Than 5,000 Stockbrokers From Expelled Firms Still Selling Securities http://t.co/E5lczvdLJP Don’t buy what someone wants 2 sell 2u $$ Oct 04, 2013
  • How to Look Under a Hedge Fund’s Hood http://t.co/oKy6ZQWo1q There’s more 2ask than this, but these 7 questions r a good start $$ Oct 04, 2013
  • Hedge Funds Used Obscure Bond Bet to Win in GM Bankruptcy http://t.co/SaLKh7sg9Q They did hard work with their brains, & won $$ #distressed Oct 04, 2013
  • 8 Incredible Shares On StockTwits About Hedge Fund Market Wizard Ray Dalio http://t.co/tjQ9ecAF1A I added two more resources $$ Oct 04, 2013
  • Time to Ditch the Yale Endowment Model http://t.co/aYWfleXE7R Similar to an article I wrote 4 years ago http://t.co/2ox3Zzdaac $$ @M_C_Klein Oct 04, 2013
  • S&P 500 Pension Status Continues to Improve in September http://t.co/tyL1fqCivB Rising prices for risky assets & more contributions help $$ Oct 03, 2013
  • Peak-population investing http://t.co/0I5s49iBBC Demographics affect inflation – goods inflation w/many young asset inflation w/many old $$ Oct 03, 2013
  • 10 Terms Investment Pros Use to Raise Money @Reformedbroker http://t.co/cHivwK8uvh Points @ 10 buzzwords w/fuzzy meanings & little truth $$ Oct 02, 2013
  • Option-Selling Is Not Income http://t.co/zdiP91nKsK Well written,& it needs 2b said. Option “income” vs capital losses & opportunity costs $$ Oct 02, 2013
  • Eric Schneiderman, Wall Street Time-Machine Sheriff http://t.co/trSBh80ObO Dig deep enough in2 any multiparty trnsctn & u will find dirt $$ Oct 02, 2013
  • In multiparty transactions, u have 2b careful. Who has more info than u? How r incentives aligned? Y r u lucky one invited 2play w/them? $$ Oct 02, 2013
  • Student-Loan Straitjacket http://t.co/1keTvDykpV They should look at income-based repayment plans; in many cases they would pay far less $$ Oct 02, 2013
  • Fab Tourre Wants Another Chance to Explain http://t.co/X4H8b70hVi Did Tourre withhold mind-chging information deal players were entitled2 $$ Oct 02, 2013
  • Inter-dealer brokers’ inside information @FelixSalmon http://t.co/cCcVMM3foF What is fraud vs making/arbing a mkt? http://t.co/6aKN6t0Abw $$ Oct 02, 2013
  • Top 20 Films about Finance: From Crisis to Con Men http://t.co/nDv0Rz4P4P I added on the film “The Billion Dollar Bubble” Equity Funding $$ Oct 01, 2013
  • Gibraltar Seen as Europe-Beater for Finance Professionals http://t.co/YzHgQRv82A Perhaps more money per hectare than any other place $$ Oct 01, 2013
  • Commodity Trader Didn’t Really Believe in Market Prices http://t.co/qVEC4lQB8u Citi mismarked illiquid exchange-traded ethanol contracts $$ Oct 01, 2013
  • This Sociological Theory Explains Why Wall Street Is Rigged 4 Crisis http://t.co/ff6NWs1GOO Technological efficient w/odd feedback loops $$ Oct 01, 2013


PPACA / Obamacare


  • Overwhelming Demand 4 Obamacare Shows Potential Success http://t.co/4i3Kb6P8SN Success?? Show you what happened 2me http://t.co/vlrqUxFXzr Oct 04, 2013
  • How ObamaCare Wrecks the Work Ethic http://t.co/3U2z8PKPwR Saw this a month ago, subsidies raise marginal tax rates 4 lower middle class $$ Oct 03, 2013
  • The Republicans Fighting Obamacare Aren’t Crazy http://t.co/A61poB4ArU PPACA *can* b repealed, but would take a GOP swing in 2016 2do it $$ Oct 01, 2013
  • Why must the American people suffer when even so many Democrats don’t want Obamacare? http://t.co/uJfncEetS7 Congress exempts itself $$ Sep 28, 2013


Civil Liberties in Cyberspace


  • NSA chief admits misleading numbers, adds to Obama administration blunders http://t.co/wsS2qrIW74 Politicians overstate metadata value $$ Oct 04, 2013
  • NSA Involvement in NIST Encryption Standards Could Make Companies Less Competitive http://t.co/RzRVSYVtiv Does NSA demand backdoors? $$ Oct 03, 2013
  • On NSA’s encryption defeating efforts: Trust no 1 http://t.co/afq1Fjngzv Big companies r in cahoots w/NSA, can’t b trusted, r lying 2us $$ Oct 02, 2013
  • NSA Gathers Data on Social Connections of U.S. Citizens http://t.co/oVIYLWdHFi The NSA endangers our civil liberties; we need to end it $$ Sep 30, 2013


Monetary Policy


  • Will Unconventional Monetary Policy Be the New Normal? http://t.co/nN00ta4UIM Fed is hopeless; they don’t get they r inflating assets $$ Oct 04, 2013
  • Aluminum Prices: Blame It on the Fed http://t.co/kgjOTbNeqd Low interest rates lead to loans collateralized by aluminum $$ Oct 03, 2013
  • Don’t Cry for Me, Ben Bernanke http://t.co/unN01G8N8K Developing Countries should get ready for the eventual Fed tightening, if they can $$ Oct 01, 2013




  • The Bailout That Never Came http://t.co/cROhzGqjYB Bailout for homeowners was half-hearted at best; 4 banks it was a warm friendly hug $$ Oct 04, 2013
  • Banks abandon mortgage preapprovals http://t.co/ro6NE8T5Yb Makes the purchases of homes more complex b/c likelihood of financing down $$ Oct 03, 2013
  • Are Banks Forward-Looking in Their Loan Loss Provisioning? http://t.co/1V6ytChwB2 I would be more inclined to think it is a “cookie jar” $$ Oct 02, 2013
  • The JP Morgan apologists of CNBC http://t.co/HJgOH3NGvT Media often panders 2 power or they lose access to the powerful people $$ Oct 01, 2013




  • Duke to NYU Missteps Abroad Lead Colleges to Reassess Expansion http://t.co/1ZoHGD2CeP Have 2 make sure of a good cultural fit first $$ Oct 04, 2013
  • Freak Grape-Razing Hail Crushes Burgundy Winemakers’ Dreams http://t.co/rxSiKaRpvl 2years of hailstorms destroy the prospects of vintners $$ Oct 04, 2013
  • Migrant Ship Sinks Off Italian Island, Killing Dozens http://t.co/KCYgVt0Bx8 Europe is Elysium 4 these migrants; US is the same 4 others $$ Oct 03, 2013
  • NFL Free-Agent Lawyer to Unlock $16B in NCAA Athletes http://t.co/nfitchpsSt Free student labor may disappear; may hit big programs hard $$ Oct 03, 2013
  • Moon walker demo lets wannabe astronauts feel 0.17G http://t.co/BsenBrl8ck Cool. Could b used 4physical therapy after severe leg injuries $$ Oct 02, 2013
  • Educators in the art of life must have chance of their own http://t.co/HxiCZUOyP3 Certain college depts survive on low paid p/t academics $$ Oct 02, 2013
  • Worried About Cancer? Get Married http://t.co/PQFp8Q67SD A man & a woman who get & stay married tend to take care of each other $$ #healthy Oct 01, 2013
  • Gangnam-Style Nip and Tuck Draws Tourists to Seoul’s Beauty Belt http://t.co/2nC182RWtV Plastic surgery becomes a tourist draw 2 Seoul $$ Oct 01, 2013


US Politics & Policy


  • Small town, big impact: Supreme Court case could define religion’s role in public http://t.co/oD09WqaOaT Govt Ceremonial deism may end $$ Oct 04, 2013
  • Who Do You Believe: The White House and Wall Street — or the American People? http://t.co/ZIRZDU1i5p Economic Confidence continues 2drop $$ Oct 03, 2013
  • Bankrupt Stockton Plan Favors Retirees Over Creditors http://t.co/yZ80M5s5lz Will b difficult 2get thru BK city, unless emplyee benes cut $$ Oct 01, 2013
  • ‘Strings Attached’ Co-Author Offers Solutions for Education http://t.co/BMF9zPqMU6 I learned the most from teachers that were hard on me $$ Oct 01, 2013
  • Panel Finds Planes Can Handle Use of Electronic Devices http://t.co/hCnZNFfR98 At last, the bad science crumbles & freedom increases $$ Oct 01, 2013
  • The most predictable economic crisis? http://t.co/XAqVj9QZ9S Implicitly, entitlement reform lies behind almost all our problems in DC $$ Oct 01, 2013
  • Why I Am Cancelling My Documentary on Hillary Clinton http://t.co/oKxLjUwRDZ No openness from the Clintons dooms a documentary from CNN $$ Oct 01, 2013



Replies, Retweets & Comments


  • 2 all who follow me on Twitter, my account was hacked, & someone sent out a bunch of spam tweets & DMs that I would never send. My apologies Oct 01, 2013


  • @kltblom when the amount of range for premium variation is only three, it is not a workable system. Anti-selection will occur. Oct 05, 2013
  • @M_C_Klein I started out as an Asset-Liability Management actuary, and I have traded in illiquid securities, makes me think differently Oct 05, 2013
  • @kltblom Removed deduction for employer-paid healthcare. Encouraged HSAs, and try to move to predominantly first-party payer model Oct 05, 2013
  • @TheUncorrelated I willprobably write an article on this next week. Will sound like the one I cited b4 & like: http://t.co/Y8CA0LX9Qi Oct 05, 2013
  • @kltblom I’m an actuary; since the PPACA was proposed, the health actuaries I have talked with have said tht PPACA won’t work Oct 04, 2013
  • ‘ @JonathanWeil Say run rate EBITDA for 2013 is $50M. If Market Cap of $TWTR is $12B, that is an astounding EV/EBITDA of 240 $$ #nosebleed Oct 04, 2013
  • @_DM0_ I can confirm that, they have taken down the slides. Pity, quickest way to absorb the material Oct 04, 2013
  • @Kitsune808 It is not infrequent that @BloombergNews Headlines are misleading, or quirky. They march to the beat of a different drummer Oct 04, 2013
  • @PlanMaestro I know, but given attention to the video, I thought I would show the PDF that better fleshes out his position. and the slides Oct 04, 2013
  • Thanks @onlineawards @TightTalk @valuetakes for being top new followers in my community this week (insight via http://t.co/sern3wLA13) Oct 04, 2013
  • “”Spain’s public debt in 2014 is expected to be the equivalent of 98.9 percent of total economic…” — David_Merkel http://t.co/HPR50Rjijp $$ Oct 04, 2013
  • “Two more: 9) And for those that want to read Ray Dalio’s economic template book, it is free here:” — David_Merkel http://t.co/QLWdRs1odG $$ Oct 04, 2013
  • @ToddSullivan A computer could do it anywhere by minimizing the distance of internal boundaries subject to equal popoulations. Not hard. Oct 04, 2013
  • @ToddSullivan We need structural reform 2 end that given gerrymandered districts. A lot of people want change, but districts not competitive Oct 04, 2013
  • @kltblom If PPACA were mere risk pooling, I might agree. It is a messy ugly law that ignores basic actuarial principles & will not work well Oct 04, 2013
  • @volatilitysmile They give us different pieces of the puzzle (insight by http://t.co/sern3wLA13) Oct 04, 2013
  • #FollowFriday Thanks @ReformedBroker @pelias01 @researchpuzzler for being top influencers in my community this week 🙂 Oct 04, 2013
  • @ReformedBroker The Baby Boomers gray, and money socked away, let finance guys play, make dough every day. Thus so many wealthy $$ managers. Oct 04, 2013
  • Thanks @ToddSullivan @ReformedBroker for being top engaged members in my community this week (insight via http://t.co/sern3wLA13) Oct 03, 2013
  • Thanks @TightTalk @BabyFreshNuggz @X9T_Trading for being top new followers in my community this week (insight via http://t.co/sern3wLA13) Oct 01, 2013
  • Thanks @moneyscience @TopInvestBlogs for being top engaged members in my community this week (insight via http://t.co/sern3wLA13) Sep 30, 2013
  • @RexHuppke You are a real man, unlike many today. You may be stupid, but at least you are taking action, rather than compromising w/losers Sep 28, 2013

This post should be short and simple.  When there is a battle/negotiation between two parties, the one with that is stronger wins.  With three parties, unless one is stronger than the the other two combined, the negotiation may take some time until a coalition with a majority of power emerges.

In the present statement in the House of Representatives, I suspect the solution is that a faction of 20 or so liberal/moderate Republicans defect to the Democrats, and pass a clean bill that goes to the Senate.

Now, that’s not assured, and I think more broadly than many.  It is possible that the Republicans in the House will not raise the debt ceiling.  I’m not saying it would be a good thing, just that it is possible, and it might not be as bad as the worst outcomes of Y2K.

But think of Syria, and other places in the Arab Spring.  The calculations might be easier if it were simply this versus that.  But in Syria, you have the existing government versus two rebel groups, one of which is more doctrinare about Islam.  Such a situation will not be easy to solve, and US foreign policy will be challenged to choose a right and effective course of action.  (In this case, it probably means doing nothing.)

My main point here is that when there are multiple factions, results can be messy.

Because of gerrymandering, the US has mostly polarized their parties — that makes agreement difficult.  Gerrymandered districts produce ideologues.  Far better to set districts by computer, minimizing the length of internal boundaries, subject to substantially equal populations in each district.  That would produce fairer districts with more moderates.

I’ve written about this before, and better than this evening:

The main thing to remember is that reconciling multiple party disputes can be difficult; structural change, such as creating districts in a way that avoids polarization could help us avoid disputes like that in the House in the future.

As it applies to conflicts arising out of the Arab Spring, I would only say: think hard before rebelling, and analyze what other forces might be released by rebelling — there is no guarantee that you can beat the government, or the other forces you release.  Better the devil you know, than the devil you don’t.  Better negotiated change than change that springs from the chaos of war.

And, that’s all for now.

I’m bringing this series to a close with some odds and ends — a few links, a few stories, etc.  Here goes:

1) One day, out of the blue, the Chief Investment Officer walked into my office, which was odd, because he rarely left the executive suite, and asked something like: “We own stocks in the General Account, but not as much as we used to.  How much implicit equity exposure do we get from our variable annuities?”  The idea was this: as the equity markets go up, so does our fee stream.  If the equity market goes up or down 1%, how much does the present value of fees change?  I told him I would get back to him, but the answer was an easy one, taking only a few hours to calculate & check — the answer was a nickel, and the next day I walked up to the executive suite and told him: “If we have 20% of our liabilities in variable annuities it is the equivalent to having 1% of assets invested in the stock market.

2) This post, Why are we the Lucky Ones? could have been a post in this series.  At a small broker-dealer, all sorts of charlatans bring their ideas for financing.  The correct answer is usually no, but that conflicts with hope.  Sadly, Finacorp did not consult me on the last deal, which is part of the reason why they don’t exist now.

3) The first half of the post, The Education of a Mortgage Bond Manager, Part IX, would also fit into this series — the amount of math that went into the analysis was considerable, but the regulatory change that drove it led us to stop investing in most RMBS.

4) While working for a hedge fund, I had the opportunity to sit in on asset-liability management meetings for a bank affiliated with our firm.  I was floored by the low level of rigor in the analyses — it made me think that every bank should have at least one actuary to do analyses with the level of rigor in the insurance industry.

Now, this doesn’t apply to the big banks and investment banks because of their complexity, but even they could do well to borrow ideas from the insurance industry, and do stress testing.  Go variable by variable, on a long term basis, and ask:

  • At what level does this bring line profits to zero?
  • At what level does this bring company profits to zero?
  • At what level does this imperil the solvency of the company?

5) This story is a little weird.  One day my boss called me in and said, “There’s a meeting of corporate actuaries at the ACLI in DC.  You are our representative.  They will be discussing setting up an industry fund to cover losses from failures of Guaranteed Investment Contracts.  Your job is to make sure the fund is not created.”

His concern in 1996 was that it would become a black hole, and would encourage overly aggressive writing of GICs.  He didn’t want to get stuck with losses.  I told him the persuasion was not my forte, but I would do my best.  I said that my position was weak, because we were the smallest company at the table, but he said to me, “You have a voice at the table.  Use it.”

A few days later, I was on the Metroliner down to DC.  I tried to understand both sides of the argument.   I even prayed about it.  Finally it struck me: what might be the unintended consequences from the regulators from setting up a private guaranty fund?  What might be the moral hazard implications?

At the meeting, I found one friend in the room from AIG.  We had worked together, and AIG didn’t like the idea either.  In the the early parts of the meeting it seemed like there were 10 for the industry fund, and 3 against, AIG, Principal, and us.  Not promising.  We talked through various aspects of the proposal, the three representatives taking the opposite side — it seemed like no one was changing their minds, but some opinions were weaker on the other side.

By 3PM the moderator asked for any final comments before the vote.  I raised my hand and said something like, “You have to think of the law of unintended consequences here.  What will be the impact on competition here?  What if one us, a large company decides to be more aggressive as a result of this?  What if regulators look at this as a template, and use it to ask for similar funds more broadly in life insurance?   The state guaranty funds would certainly like the industry to put even more skin into the game.”

The room went silent for a few seconds, and the vote was taken.

4-9 against creating the guaranty fund.

The moderator looked shocked.

The meeting adjourned and I went home.  The next day I told my boss we had won against hard odds.  He was in a grumpy mood so he said, “Yeah, great,” barely acknowledging me.  This is the thanks I get for trying something very hard?

6) In early 2000, I had an e-mail dialogue with Ken Fisher.  I wanted to discuss value investing with him, but he challenged me to develop my own proprietary sources of value.  Throw away the CFA syllabus, and all of the classics — look for what is not known.

So I sat down with my past trading and looked for what I did best.  What I found was that I did best buying strong companies in damaged industries.  That was the key idea that led to my eight portfolio rules. Value investing with industry rotation may be a little unusual, but it fit my new view of the world. I couldn’t always analyze changes in pricing power directly, but I could look at industries where prices had crashed, and pick through the rubble.

In Closing

My career has been odd and varied, which has led to some of the differential insights that I write about here.  In some ways, we are still beginning to understand investment risks — for example, how many saw the financial crisis coming — where a self-reinforcing boom would give way to a self-reinforcing bust?  Not many, and even I did not anticipate the intensity of the bust.  At least I didn’t own any banks, and only owned sound insurers.

Investment risk is elusive because it depends partly on the collective reactions of investors, and not on external shocks like wars, hurricanes, bad policy, etc.  We can create our own crises by moving together in packs, going from bust to boom and back again.

It is my hope after all these words that some will approach investing realizing that avoiding risks is as important as seeking returns, and sometimes, more important.  It is not what you earn, but what you keep that matters.

“So you’re the new investment risk manager?”

“Yes, I am,” I said.

CA: “Well, I am the Chief Actuary for [the client firm].  I need you to do a project for me.  We have five competitors that are eating our lunch.  I want you to figure out what they are doing, and why we can’t do that.”

Me: “I’ll need to get approval from my boss, but I don’t see why not.  A project like this is right up my alley.”

CA: “What do you mean, right up your alley?”

Me: “I’m a generalist.  I understand liabilities, but I also understand financing structures, and I can look at assets and after a few minutes know what the main risks are and how large they are.  I may not be the best at any of those skills, but when they are combined, it works well.”

CA: “When can you have it to me?”

Me: (pause) “Mmm… shouldn’t take me longer than a month.”

CA: “Great.  I look forward to your report.”

The time was late 1998, just prior to the collapse of LTCM.  Though not well understood at the time, this was the “death throes” of the “bad old days” in the life insurance industry for taking too much asset risk.  Yes, there had been bad times every time the junk bond market crashed, and troubles with commercial mortgages 1989-1992, but the industry had not learned its lessons yet.

The 5 companies he picked were incredibly aggressive companies.  One of them I knew from going to industry meetings came up with novel ways of earning extra money by taking more risk.  I thought the risks were significant, but they hadn’t lost yet.

So what did I do?  I went to EDGAR, and to the websites of the companies in question.  I downloaded the schedule Ds of the subsidiaries in question, as well as the other investing schedules.  I read through the annual statements and annual reports.  I had both my equity investor and bond investor “hats” on.  I went through the entirety of their asset portfolios at a cursory level, and got a firm understanding of how their business models worked.

Here were the main findings:

  • These companies were using double, and even triple-leveraging to achieve their returns.  Double-leveraging is a normal thing — a holding company owns an operating insurance subsidiary, and the holding company has a large slug of debt.  Triple leveraging occurs when a holding company owns an operating insurance subsidiary, which in turn owns a large operating insurance subsidiary.  This enables the companies to turn a small return on assets into a large return on equity, so long as things go well.
  • The companies in question were taking every manner of asset risks.  With some of them I said, “What risks aren’t you taking?”  Limited partnerships, odd subordinated asset-backed securities, high yield corporates, residential mortgage bonds with a high risk of prepayment, etc.

So, when I met with the Chief Actuary, I told hid him that the five were taking unconscionable risks, and that some of them would fail soon.  I explained the risks, and why we were not taking those risks.  He objected and said we weren’t willing to take risks.  As LTCM failed, and our portfolios did not get damaged, those accusations rang hollow.

But what happened to the five companies?

  • Two of them failed within a year — ARM Financial and General American failed because they had insufficient liquid assets to meet a run on their liquidity, amid tough asset markets.
  • Two of them merged into other companies under stress — Jefferson Pilot was one, and I can’t remember the other one.
  • Lincoln National still exists, and to me, is still an aggressive company.

Four of five gone — I think that justified my opinions well enough, but the Chief Actuary brought another project a year later asking us to show what we had done for them over the years.  This project took two months, but in the end it showed that we had earned 0.70%/yr over Single-A Treasuries over the prior six years, which is  a great return.  The unstated problem was they were selling annuities too cheaply.

That shut him up for a while, but after a merger, the drumbeat continued — you aren’t earning enough for us, and, in 2001-2, how dare you have capital losses.   Our capital losses were much smaller than most other firms, but our main client was abnormal.

To make it simple, we managed money for an incompetent insurance management team who could only sell product by paying more than most companies did.  No wonder they grew so fast.  If they had not been so focused on growth, we could have been more focused on avoiding losses.

What are the lessons here?

  • Rapid growth with financials is usually a bad sign.
  • Analyze liability structures for aggressiveness.  Look at total leverage to the holding company.  How much assets do they control off of what sliver of equity?
  • If companies predominantly buy risky assets, avoid them.
  • Avoid slick-talking management teams that don’t know what they are doing.  (This sounds obvious, but 3 out of 4 companies that I worked for fit this description.  It is not obvious to those that fund them.)

And sadly, that applied to the company that I managed the assets for — they destroyed economic value, and has twice been sold to other managers, none of whom are conservative.  Billions have been lost in the process.

It’s sad, but tons of money get lost through some financials because the accounting is opaque, and losses get realized in lumps, as “surprises” come upon them.

Be wary when investing in financial companies, and avoid novel asset risks, credit risk, and excess leverage.

In late 2007, I was unemployed, but had a line on a job with a minority broker-dealer who would allow me to work from home, something that I needed for family reasons at that point.  The fellow who would eventually be my boss called me and said he had a client  that needed valuation help with some trust preferred CDOs that they owned.

Wait, let’s unpack that:

  • CDO — Collateralized Debt Obligation.  Take a bunch of debts, throw them into a trust, and then sell participations which vary with respect to credit risk.  Risky classes get high returns if there are few losses, and lose it all if there are many losses.
  • Trust preferred securities are a type of junior debt.  For more information look here.

I got to work, and within four days, I had a working model, which I mentioned here.  It was:

  • A knockoff of the KMV model, using equity market-oriented variables to price credit.
  • Uncorrelated reduced discrepancy point sets for the random number generator.
  • A regime-switching boom-bust cycle for credit
  • Differing default intensities for trust preferred securities vs. CMBS vs. senior unsecured notes.

It was a total scrounge job, begging, borrowing, and grabbing resources to create a significant model.  I was really proud of it.

But will the client like the answer?  My job was to tell the truth.  The client had bought tranches originally rated single-A from three deals originated by one originator.  There had been losses in the collateral, and the rating agencies had downgraded the formerly BBB tranches, but had not touched the single-A tranches yet.  The junk classes were wiped out.

Thus they were shocked when I told them their securities were worth $20 per $100 of par.  They had them marked in the $80s.

Bank: “$20?! how can they be worth $20.  Moody’s tells us they are worth $85!”

Me: “Then sell them to Moody’s.  By the way, you do know what the last trade on these bonds was?”

B: “$5, but that was a tax-related sale.”

Me: “Yes, but it shows the desperation, and from what I have heard, Bear Stearns is having a hard time unloading it above $5.  Look, you have to get the idea that you are holding the equity in these deals now, and equity has to offer at least a 20% yield in order attract capital now.”

B: “20%?! Can’t you give us a schedule for bond is worth at varying discount rates, and let us decide what the right rate should be?”

Me: “I can do that, so long as you don’t say that I backed a return rate under 20% to the regulators.”

B: “Fine.  Produce the report.”

I wrote the report, and they chose an 11% discount rate, which corresponded to a $60 price.  As an aside, the report from Moody’s was garbage, taking prices from single-A securitizations generally, and not focusing on the long-duration junky collateral relevant to these deals.

In late 2008, amid the crisis, they came back to me and asked what I thought the bonds were worth.  Looking at the additional defaults, and that the bonds no longer paid interest to the single-A tranches, I told them $5.  There was a chance if the credit markets rallied that the bonds might be worth something, but the odds were remote — it would mean no more defaults, and in late 2008 with a lot of junior debt financial exposure, that wasn’t likely.

They never talked to me again.  The bonds never paid a dime again.  I didn’t get paid for running my models a second time.

The bank wrote down the losses one more time, and another time, etc.  How do you eat an elephant?  One bite at a time.  It did not comply well with GAAP, and eventually the bank sold itself to another bank in its area, for a considerably lower price than when they first talked to me.

So what are the lessons here?

  • Ethics matter.  Don’t sign off on an analysis to make a buck if the assumptions are wrong.
  • Run your bank in such a way that you can take the hit, rather than spreading the losses over time.  (Like P&C reinsurers did during the 1980s.)  But that’s not how GAAP works, and the CEO & CFO had to sign off on Sarbox.
  • A model is only as good as the client’s willingness to use it.  There are lots of charlatans willing to provide bogus analyses — but if you use them, you know that you are committing fraud.
  • Beware of firms that won’t accept bad news.

I don’t know.  Wait, yes, I do know — I just don’t like it.  This is a reason to be skeptical of companies that are flexible in their accounting, and that means most financials.  So be wary, particularly when financials are near or in the “bust” phase — when the credit markets sour.