Personally, I did not have an outline when I began this series.  If I had decided to create a “story arc” it would ended with part six, which led to my becoming the corporate bond manager, but I will end this series on a different note, and with different lessons.

1)  After the merger, post 9/11, we decided on heresy.  We were going to sell a large amount of the CMBS I had acquired  over the prior three years for a large capital gain, and redeploy it into the bonds of hotels, airline EETCs, and every other area negatively affected by 9/11.  We did a huge down in credit trade.  Some of the tale is told here.

As far as mortgage bonds went, the sale was a stunning success.  The execution levels for the sales were great, and what we reinvested in were areas of the market that were dramatically oversold.  What could be better?  (A client who knew how use the results would be better.)

2) One day in 2000, the client came to me and said, “We’d like to do a bond indexed annuity.”  After reviewing product design, which allowed holders a one time option to increase their rate over the term of the annuity, and doing a little bit of game theory work, I said, “Here’s the good news: given what we know about policyholder behavior and what we know about bonds, this is a cinch to hedge.”  As I explained the dynamics to them they realized the risks were minimal, and they decided to proceed ahead.  Sadly, the product was not attractive enough, and it was killed.  Equity products got attention in that era, not income products.

3) In 2002, when I was a corporate bond manager, I had to do what a mortgage bond manager does on occasion: read thick prospectuses.  Bear markets in credit often offer the most interesting deals — as an example, the Prudential “C” bonds.  In this case I had to read through the prospectus of a Dominion subsidiary that had an Enron-like financing structure post-Enron.  If Dominion’s credit was downgraded, and its stock traded below a certain level for a certain number of days, the bonds would have to be redeemed at par-plus through an issuance of preferred stock.

We became one of the larger holders of those bonds. Enron-like structures are good for bondholders if they are a small part of the capital structure.  They are bad if they are big, because you can’t protect everything.

We bought the bonds at a significant discount to par for a 3-year bond.  Our research showed that Dominion the parent company was on the hook.  The larger holders negotiated (we were in the top 10), and eventually the bonds were tendered for a 10%+ gain, plus 7% of carry over the less than one year period.  I ended up sharing the the experience in real time with Cramer, who wrote a post about it in the midst of the furor.  Yes, bond markets can affect stock markets, and vice-versa.

4) There was a large debate in that era over what to do about Qwest / US West.  Amid corporate troubles, there was one easy play — buy long-dated US West bonds.  We all agreed on that.  But should we own Qwest bonds?  That was harder.

But then one day, because of our high yield contacts, we came into contact with the offering documents of a Qwest subsidiary, which had done badly.  It was a private placement, so when we inquired about it they asked for our documents, and we faxed a copy to them, though we had not been on the original deal (good thing).

As it was the debt was trading at under 50 cents on the dollar.  As I read through the prospectus, I realized that the debt was guaranteed by Qwest.  Given the short term of the debt, it made sense to trade our lower yielding Qwest positions for it.

And what did we do?  Nothing.  What happened to the debt two years later?  It was paid off at par.  To misphrase Mr T., “I hate it when a plan doesn’t come together!” (I am certain that comment dates me.)

5) (the end of the end) While I was the less-restricted manager of bond assets, both corporate and mortgage, for my client, I would sometimes meet with my former boss for lunch.  I would tell him what I was doing, and he would say, “Don’t you realize the risks you are taking?”  I would tell him, “Yes, but I have to evaluate risk and return relative to the other risks and returns available elsewhere in the market.  You have to pick the best of them.”

One thing I do know, I was far more willing to accept bond market risk than my boss, who had a strong teaching in the 90s, prior to hiring me, a neophyte.

There are two odd things here: why should an actuary turned bond manager take risk to make money amid panic?  Because he learned to be contrarian — this is something that must be experienced in order to teach it.  Second, why should I do far better than the guy who taught me?  I was more willing to take risk when it seemed to be rewarded.  Don’t get me wrong, when spreads and yields are narrow, I am not there.  I don’t take uncompensated risks.

There is wisdom in trying to understand the credit cycle.  It is one of the few constants in terms of economics.  If you follow credit, you will understand the economy in the short run.  If you follow the credit cycle, you will invest better than most.

The Negative Convexity Project

Me: We can’t buy the majority of Residential Mortgage Backed Securities [RMBS] anymore.

Boss: What! That is a staple asset class of ours.  There’s nothing illegal about life companies owning RMBS.

Me: nothing illegal, yes, but because of new cash flow testing rules which our client is subject to, the negative convexity of RMBS will force our client to put up more risk-based capital than they would otherwise have to.  Most RMBS will require so much additional capital that the additional yield is uneconomic, and that assumes we get the yield when we want it, ignoring prepayment and extension risks.

Boss: I can’t believe that we can’t buy any RMBS… are there any exceptions?

Me: There are a few.  You know about the odd RMBS classes that have positive convexity, but little yield?

Boss: Yes, Yes… but why would we want to buy that?  Our client needs yield!

Me: I know that.  Would that they could do something other than need yield to sell yield.  There is one type of RMBS that still fits, and it is the NAS bond [Non-accelerating security], last cash flow structure.  Also, some of the credit-sensitive RMBS bonds rated less than AAA don’t affect the convexity issue, but we might not want to buy them, because the additional yield per unit risk is not compelling.

Boss: So what do we do?

Me: Buy NAS bonds when they are attractive, and buy CMBS that is attractive, after that look to corporates that our analysts like.

Boss: You are right, but I hate to lose a staple asset class.


What I wrote there took longer than a single conversation, and involved contact with the client as well.  The client was very conservative with capital, because they levered up more than most life insurers.  The results of detailed cash flow testing would affect large annuity writers like my client, and negative convexity would make them put up more capital, constraining the amount of business they could write.

Wait: negative convexity simply means your bond portfolio hates interest rate volatility — it does better when things are calm.  That is certainly true with residential mortgages, where people refinance easily when rates fall, and in that era, no one faced falling property prices.

It took some effort, but I made my case to the client and my boss, and we stopped buying most RMBS.  As an aside, it made asset-liability management tighter.

Alternative Investments

I was not totally hidebound with respect to derivatives.  I bought our first asset-swapped convertibles, and synthetic corporates.  If the risks associated with getting additional yield were small, I would take those risks.  In both cases, they converted other asset into straight corporate debt (plus counterparty risk).

But I wouldn’t do anything.  I grew to hate CDOs, as I saw how perverse the structure was. I remember one weird CMBS deal structure that added a note that combined the AAA, BBB & BB CMBS of the deal.  What a nice yield, but the riskiness was greater than my models would allow for the incremental yield.

Finally, for this piece, the “piece of work” broker that I have previously described pitched me a private placement debt deal for a power producer affiliated with his firm.  After hearing the initial spiel, I said, “Okay, soft-circle me for $25 million, subject to due diligence; send me all of the hard data via email and paper.”

My request should not have obligated me to buy the deal.  Indeed, when I got the hard data, and began estimating the counterparty risks, I thought the deal was a loser, so I contacted the “piece of work,” and said, “Sorry, but we are dropping out of the deal — it just doesn’t offer enough value for the yield.”  After some arguing, he eventually said, “Look, stay in the deal, and I promise you that I will get you out at par at minimum on deal day.  Okay?”

Sigh, even though he was number eight with us, he served an important firm that could potentially do a lot for us, so I agreed.  The day of the deal came, and indeed, he got us out at a teensy premium (I would have accepted par, maybe even a slight scrape).  The deal did horribly, at least initially, though I have no idea of what the eventual credit result was.

As my boss who taught me bonds would say, “On Wall Street, if you want a friend, get a dog.”  There are some honorable people on Wall Street, but the economics of Wall Street often leads to suboptimal results for clients, and indeed, the salesmen may be sweet enough, but they live to distribute paper; they don’t live to be your friend in any true sense.  Professional duty to company trumps friendship.


I sat down this evening, thinking that I would finish the series this evening, and realized that I had left out some significant things.  As such, I expect this series to have two more parts after this one.

Traveling to Annapolis

When you are an actuary, and a good one, you have elements of being a jack-of-all-trades.  Knowing the math is not enough, you have to understand the business processes that the math summarizes.  That also requires some knowledge of the law.  From early in my career, I realized that the insurance company lawyers would not help me with reserving, investing, contract provisions, and other legal questions, so I had to go to the law library and answer the questions myself.  Not fun, but I ended up learning a lot.

While working on another project one day, I made a copy of the Maryland life insurance investment code.  I took it back with me, saying to myself: “It’s only eight pages, written in 1955.  Don’t you think you should know the details of what your local regulator allows?”

Dangerous question, and it led to the following: under a strict interpretation of the law, we were in violation of the law.  Here is the key question: are asset-backed securities bonds?  They trade like bonds, but by the old Maryland statute, they are not bonds — they don’t fit any categories of permitted investments, and as such could only be held if we had sufficient surplus, which we did not, and probably most life insurers in Maryland did not.

Thus the problem.  I discussed it with my boss, and we had a conference call with the legal department, who confirmed my view of things.  A few days later we had a chat with the Maryland regulators.  That was a tough call, because at minimum we wanted them to accept asset-backed securities as bonds, which the the law did not admit.  We suggested, “Why don’t we adopt the NAIC [National Association of Insurance Commissioners] Model Investment law?”  The response was curt, “Oh, you mean the Illinois Investment Law?”

True, Illinois was the only state that adopted it verbatim, but several other major states had adopted >90% of it.  I said, “Tell me what you’d like to take out of the Model Investment Law.”  The main thing the Maryland department wanted was to avoid speculation through derivatives.  So I happily cut that out of my proposed law; I thought that was a good idea.  There were a few other minor things that they wanted, and I trimmed/added those as well.

After a lot of work between the lawyers and me, we sent the proposed bill to the Department of Insurance.  Then the conference call — would they go for it?  As it was they went for it.  They found it reasonable, and it codified what insurers were doing, and provided structure, such that present practices were approved, but bad extensions beyond that were forbidden.

But then we asked, “Are you not opposing us, or are you supporting us?”  They replied, “We are supporting you.  We know we need to modernize, but this statute meets our needs and yours.  Well done.”

(Note: all quotes here are summaries of what was said.  Most of it was not exactly the way I wrote it here.)

So, we hired an expert attorney who was skilled in getting bills through Annapolis.  He told us what we would need to do to get the bill passed.

So, a few weeks later, we were there in Annapolis, before the Assembly Finance Committee.  I can’t remember why, but I was not at the table before the Assembly Committee.  I sat a few feet behind my boss, our internal lawyer and our expert attorney.

The Assembly Finance Committee had a hard time with the bill.  Part of it was that there was no one to oppose the bill.  Opposition sharpens the minds of legislators.  As a result, the Committee remanded the bill to a study session, so that they could better understand the implications of the bill.

A week or so later, we appeared before the Senate Finance Committee, and I was on the panel this time.  Instead of the disorganized questions of the assembly, they asked three “simple” questions:

  • How will this law prevent Procter & Gamble?
  • How will this law prevent Orange County?
  • How will this law prevent Long Term Capital Management?

This was the reverse of the Assembly, because I answered all of the questions, and my partners were silent.  I could not have expected that.

As it was, I explained that P&G could not happen because the statute forbids using derivatives for speculation.  With Orange County, I explained that existing law required cash flow testing, so that we can’t invest in volatile mortgage derivatives or else we will fail our asset-liability management tests.

As for LTCM, I explained that the risk-based capital regulations would never allow us to take on that degree of leverage, and that the forbade speculation through derivatives.

And then, after a mercifully brief session, they let us go.  (Note: I had to sit through a couple sessions where we might be called, but weren’t.  Dull, but I brought work to do.  Also, I learned that Johns Hopkins, my Alma Mater, owns the state of Maryland.  Anything they ask for, they get.)

That left one more hurdle.  So on one early morning we met with the Assembly Finance Committee.  It was just my boss and I, because they were trying to understand what the bill meant.  (Technical subjects are tough for many state legislators.)  We met with them for two hours, and finally we convinced the Chairman of the committee that this was a good and honest deal.  (We both did good work here,  and the absence of the lawyers was a plus.)

That left the final voting, which was unanimous in both chambers.  And then, two months later, the signing ceremony with the governor, dressed like a Mafia Don, with a dark suit, and black shirt with thin white stripes.

So what did I accomplish here?  I reshaped Maryland’s Life insurance investment laws to be among the best in the nation.  I did it while working with many parties that had different goals.  I calmed and instructed many legislators that it was a good bill.  Finally, I set the company that I served on firm legal ground.  What could be better?

1) One place where being an actuary and being a financial analyst melded well was with Affordable Housing and Historic Tax Credits.  In all of these investments, it made a great difference as to what the Statutory, Tax, and GAAP accounting bases.  When I described my methods of working through the free cash flows, AHIC [The Affordable Housing Investors Council] wanted me to speak to the whole regarding my methods.

I never gave the talk because we were full on tax credits, and I was too busy managing the portfolio of Fidelity & Guaranty Life.   The moral is: watch free cash flow.

2) Probably the ugliest incident in managing money for Fidelity & Guaranty was when the management of F&G decided to try to buy the structured settlement liabilities of Confederation Life.  Big block, five potential buyers.   St. Paul had a rule: we don’t outsource asset management.  Sadly, the chief actuary, against our admonitions allowed for reinsurance treaties that outsourced asset management.

During the conference call to legitimate the offer that we would make, several things happened:

a) F&G management accused St. Paul management of being bureaucrats, not businessmen.

b) St. Paul management told F&G management that they were ignoring the rules.

c) I informed both sides that we were all gentlemen here, and that the tone of discussion was not worthy of real businessmen.

d) The CEO of F&G eventually broke off the call, calling the St. Paul folks bureaucrats, rather than businessmen, and saying that they killed a good deal.

Personally, I think he said this to save face with his employees.  Also, the deal was marginal at best.  We would have had to take a lot of risk to make the deal work.  But F&G would not listen to us.

3) I liked buying seasoned bonds, because they were more predictable.  Problem: you could not buy them in size.  Buying bonds in the aftermarket is typically picking at scraps.  Face it — most bond buyer want to hold their bonds for a while.  Aside from the few that sell for a quick profit, most bond investors hold on for a long time.  But I would pick up scraps.  Enough scraps, and you have some decent positions.

If you do find a seasoned bond selling at a reasonable price, buy it in, subject to the advice of your credit analyst.

4) Regarding mortgage bonds, remember that default and prepayment are dual.  Debtors divide up into three groups: a) Very solvent, they will easily pay off their debts, and if there is an opportunity to refinance their debt, they will take it.  b) Solvent. They don’t have a lot of margin, but they can pay their debts if nothing serious goes wrong. c) We did not deserve the loan.  We will fail with high probability in the next year.

Ideally, if you want the best yield out of a bunch of consumer lending assets, you want a lot of the middle group.  Not the highest credit quality, but likely to pay off, and not so likely to prepay.  There is a hierarchy:

  • Best: pay,
  • Next best: prepay,
  • worst: don’t pay.

5) So as I learned about CMBS, I wondered about the interest only strip that many of the deals held — from my own testing, it had the credit properties of a BBB tranche at best, and a Single-B tranche at worst.  Sadly, because they had no principal to pay they were nominally rated AAA, and so the firm I worked for (not my area) crammed them into Stable value plans.  Because I had done the credit stress testing, I knew this, and resisted their use in my own portfolios.

But this is another example where accounting rules have led us afoul.  Nominal principal should be implied to “interest only” obligations.  “Principal only” obligations should have implied interest.

That’s all for now.  I will finish up in the last segment, probably on Monday.


1) One thing that impressed me about working in a life insurance investment department is how many ideas we kicked around and abandoned.  I did not experience that to the same degree working at a hedge fund.  I think that is true for two reasons: 1) we have a significant balance sheet, and can take on illiquidity. 2) we are conservative, and aren’t going to take on marginal risks.

2) Another thing that impressed me was how well the money was managed, and how poorly the liability writers thought it was managed.  I did a big study to analyze what we had earned for F&G Life over the prior seven years.  We beat single-A bond yields by more than 0.7%/year.  That’s huge.  That said, they kept asking for more.  I shake my head and wish that we were running a mutual fund; we would have gotten a lot of respect.

3) When I came, the client held no CMBS, after three years 25% of the assets were CMBS.  It made so much sense given the 10-year duration of the EIAs that were growing so rapidly.  Given my models, and the lack of yield from corporates, this was a big improvement.

CMBS, because it is noncallable, makes a lot more sense for longer-dated liabilities.  Hey, I was not only the mortgage bond manager, I was the interest rate risk manager.  I would not knowingly take bad risks.

4) When the merger happened, the boss decided to jump to another firm.  Unintentionally, I may have encouraged that, because when he asked me, ‘What would I do in this new organization?”  I said, “Let me draw it out for you,” showing that he would be CIO of insurance asset management.  He was crestfallen, and sought other avenues of employment.  When he announced his new job, there was a big change.

First, the St. Paul talked with me and the High Yield manager, and gave me authority to manage things, so long as the high yield manager agreed.  Basically, they trusted me, but knew I was inexperienced, so they wanted the high yield manager, who was far more experienced than me, to guide me.  There was an economic incentive here: the better we did, the less cash the St. Paul had to transfer to Old Mutual at the closing.

But after that, the analysts came to me and said “you be our leader.”  The high yield manager agreed.  When I asked why, they said, “We trust you. You have always had a better call on credit than the prior boss, and you understand our client better than anyone else!”

That led to something hard.  I called a meeting of the analysts and managers, but told the old boss, who was still with us, that he was not invited.  I almost cried.  He was our leader for so long, and a good one, but I had to take control.

Once I did so, I asked the analysts for reports on all companies where the stock price had fallen by more than 50% since bond purchase.  We began selling those bonds where it made sense.  Those sells were almost always good sells, and I wish I had not been countermanded by my new bosses on Enron (the greatest company in the world.)

I have more to say but that will have to wait for the next part.

Sometimes you have to do odd stuff for your client.  My boss and I were asked to come to a client meeting where there would be games (and a dopey speaker, I will leave that out).  As it was I found myself in a game where the one who moves his feet amid pushing loses.  I came in 4th (amid 60), I eventually lost to the tax guy… a very clever guy who should never be underestimated.  I ended up beating him in a game where we were all blindfolded, and those that were touched were out (we were the last two).

But the best part of the contest  was the square game.  We were blindfolded, and rope was around us, and they told us we had five minutes to form a square.  When the official said, “Go!” a marketing guy shouted out, “I know there has to be an actuary in our group.  What do we do?”

I shouted out, “I’m an actuary!”  “To the right of me, counterclockwise, count off, I am number one!” And so I heard, “two, three, four… fifteen.”

Fifteen? Uh-oh, that does not divide by four, so I shouted, “Okay, listen to me!  Five, Nine, and Thirteen, put your arms at right angles, and pull out.  You are the corners of the square.  Everyone else, put no pressure on the ropes.  Fourteen and Fifteen, make sure that you are not touching.”

After that, I shouted, “Has everyone complied with what I said!”  After agreement, I shouted to the judges, “Okay, we’re done!”

When we took off our blindfolds, behold, a square!  Way ahead of the other teams, who looked like blobs.

All actuaries are bright, but many lack courage.  I have courage, and a desire to learn more in areas where I am not an expert.

I needed all of my skills and my courage working for that difficult client. Here’s an example: I did not invest in a hedge fund structured note, with a guarantee from the AA insurer who was pushing it.  I said to them, “most hedge funds are short liquidity.  Why should I invest there?”  He disputed that hedge funds were short liquidity, but he dropped the case and we did not buy.

Here’s another example: A guy called me, asking me to let him pay at par a premium mortgage that we needed to fulfill our liabilities.  I said to him, “I can’t do that, we need the payment over time so that our shareholders are not badly affected.”  Then I said, “Why not get a second mortgage if you need to take money out?”  He said, “A second mortgage? Those guys wear ‘panky rangs.'”

I had the same experience on the most prominent building in Baltimore — the TransAmerica Building, which was the Legg Mason building when I was dealing with it.  Toward he end of my tenure at Dwight, they called me, asking to buy out the second mortgage, which was now the first mortgage.  They offered a slight premium to par, and I said no.  I told them that we needed 125% of par to make us whole, and we would be done.  They offered 110%, and I told them to go away; I would not counteroffer.

I had a strong position, and so I did not have to move.  Sadly, when I left, the company made a bad deal with the borrower, and lost a lot of money.

What can I say? I did my best, and they lost due to their stupidity.  They got more interest due to my intransigence at minimum.


I sat down this evening with my trading notebooks.  It was a reminiscence of 11-14 years in the past.  I may produce another chapter of “education of a corporate bond manager” from the books.  But it gave me a flavor of what I learned (rapidly) as a mortgage bond manager 1998-2001.  So let me share a few more bits of what I learned.

1) Avoid esoteric asset classes.  I am truly amazed at how many people believed that securitization created a lot of value, when it was more incremental.  There were many who proclaimed “Buy every new ABS structure,” because it had worked well in the past.

Sadly, that is a bull market argument, and many would lose a lot of money following that advice.  In 2008, it all came crashing down for unique structures.

2) Avoid volatile asset classes.  Collateralized Debt Obligations are volatile, and not worthy of being investment grade.  That said, when I was younger, I erred with CDOs and we lost money.  Never invest with those whose incentives are different from yours.

3) There was also a period where CDO managers would buy each others BBB tranches — it was a way of lowering capital costs, at least on a GAAP basis.  We did that with NY Life, but never got the benefit, because we never did our CDO.

4) The are many asset sub-classes that have “only been through a bull market cycle.”  That is the nature of new ideas that are introduced to applause.  But those are bull market babies.  Avoid sub-asset classes that have never seen failure.

5) There was the desire that we could originate our own commercial mortgages, with me doing the work of a full mortgage department.  I conveyed to my boss that this was impossible even if I dedicated 100% of my time to the process, and then he would not have me for the reasons he hired me.  This came up many times, and took a long time to die.

6) But at a later date, something better came up, doing credit tenant leases.  They are illiquid, but they have good protection.  The credit tenant guarantees the mortgage.  If there is non-payment, the property is yours.  I can get into securitized lending.  This was a great deal, but my colleagues in the firm overruled me, and foolishly.  Why give up protection, when you can’t get a safe yield at an equivalent spread.

7) I also learned that in the merger in 2001 that little things mattered.  So when they came to meet us in Baltimore in mid-2001, we took them to an Italian Deli that we liked.  They loved it, saying that there was nothing like it in Burlington.

I will continue this in the next part/episode.

In this irregular series, you can see that I wrestled with the concept of credit quality.  I built my own models.  I did not trust the rating agencies.

Why did I not trust the rating agencies in 1998-2001?  What great errors had they committed?  They had not created many errors at all… but I knew my job was to uncover value, and take risks where they were warranted.  Ratings will not help you there.

That said, many of the rating agency writeups and presale reports were quite erudite.  As our saying goes,”Ignore the rating, but read the writeup.”  After all, the rating agencies are “inside the wall,” unlike most, and often disclose bits of insider information that are no longer totally insider.  The rating agencies offer valuable information; the problem is that their ratings are less than golden.

In 2000, I remember going to a CMBS Conference where there was a young woman from Principal Financial, who ran their CMBS portfolio.  She said something to the effect of, “Because we know that defaults in CMBS are unlikely, we buy all of the mezzanine and subordinated tranches of most deals.  It’s free money.”  We had a different opinion.  We knew that liquidity had value, so we rarely bought non-AAA bonds.  You could not easily trade bonds that were not AAA.

Once I became the CIO in 2001, I decided that we would look at older deals where  wanted to sell BBB bonds.  I would subject them to my usual standards, and analyze the properties in depth.  I didn’t buy much, but what I did buy was quality.  Though markets were tough, all of them paid off.

An example was when JP Morgan did what they called a “kick-out” deal.  All of the properties that the B-piece cartel had refused to finance were in that deal.  The spreads were very wide, and I bought all of the AA & A-rated tranches.  I did a lot of due diligence, and I knew that the taint of the collateral was more than compensated for from the amount of subordination.

That was one of my lessons — be willing to buy things that are tainted in the eyes of many, so long as you have adequate protections, and a decent yield.

At the Life Insurance Conference

Though I was not a bond manager at the time that I went to a Life Insurance Conference in 2006, there were several themes in play.  Here are two of them.

1) Odd Types of Collateral: there was the sense that new and odd types of asset backed securities [ABS] should be bought with abandon because the past experience has been so great.

I did not buy that idea.  Most ABS requires a steady cash flow stream, and many industries don’t have that.

2) One guy said AAA bonds never default.  I stood up and told him  that AAA bonds that I had bought in franchise loans did default, so it was not true.  That said, losses were not large.

At the conference, I managed to speak to the CEO of Principal Financial, and tell him that he faced considerable credit difficulties in his CMBS book.  He was a big guy, tall and muscular, so he looked at me, average guy that I am, and told me he would consider it.  The look on his face disdained me, but I am used to that.  My appearance has never been my leading attribute.

Manufactured Housing ABS

In 2001, I came up with the idea that the Manufactured Housing ABS market was bifurcated.  Current deals were lousy in their credit metrics, so we stopped buying any current deals.  But older deals from GreenTree were seasoned and would likely deliver value.  Lehman Brothers shared with me their default database, and I built my model, and it told me that deals from 1998 would allow tranches A and above to get their money back.  It also told me that deals from 1997 and prior would allow tranches BBB and above to get their money back.

This proved to be true, but it meant that those that held the securities to maturity had to endure a time when the offered prices for the securities were far less than par, though all paid their principal and interest to maturity.  I don’t feel bad about my purchases, because I looked long-run, and knew I had a strong balance sheet behind me.

Now in late 2001, the new CIO came to me and said, “I’m taking over the CMBS, MBS, and ABS portfolios.”  I told him, “They are yours now, do what you like, do not care for my own preferences, do what you think is right.”  As it was, he panicked, and sold many things that would later be money good, and he blamed me, according to friends.

So what? I have my own share of blame here, because you never want to buy near par something that will test your willingness to hold it. Though what I bought went through the valley of the shadow of death and came out whole, there is a cost to making everyone worry; and many in the same situation would sell and take losses that they should not have.

All of the Big Boys know you should never trust a rating

When I was a mortgage bond manager, I did my own work.  I did not trust ratings, but did my own due diligence. I would analyze loss statistics where I had them, and some up with my own risk assessments.

This is why I don’t favor the prosecution of the rating agencies.  The rating doesn’t matter, and if people are willing to trust a ratings scale, rather than a description of the business of those that are rated, they deserve the bad result.

It is utterly puzzling to me why the government is going after the rating agencies, because they just did their jobs.  Yes, their models were flawed, but many ignored them in the insurance industry and elsewhere.  Ratings are not guarantees, they are opinions, and so the Supreme Court will rule eventually.

In much of my life, I have been thrust into situations for which I was not ready, and ended up rebuilding the wheel, or came up with an unorthodox approach that worked.  But a lot of the problem came down to the question of time horizon.  How long can you buy and hold, even if temporary market conditions make you squeamish?

I remember the first CMBS bond that I bought in 1998: it was the longest AAA tranche of a Nomura deal, which was out of favor at the time.  I did a lot of work analyzing the deal, and concluded that the bond was a lot safer than many competing bonds and offered more yield.  In early 1999, when I described this purchase to the investment committee of a charitable board the I was on, one said, “Only 7%, and you are locked in for 14 years?”  I said that stock valuations were high, and that 7% was a great return.  It was a great return, and far better than the stock market over the same time period, though I could not have known that at the time.

I became an advocate for CMBS in my firm as I realized that the hot product being offered would have the majority of its cash flows come at the 10-year maturity, but there would still be some level of withdrawals.  After some modeling, I realized that the best strategy was investing 80-85% of the money 10 years out, while leaving 15-20% of the money as pseudo-cash: 2 years out or shorter.  Of all of the mortgage bond categories, only CMBS offered assets with a ten-years or more duration, with minimal credit risk.

I used Charter/Conquest as my software.  It enabled me to set a consistent set of macroeconomic principles to evaluate a large number of properties in different economic areas.  The software would project the cash flows  of each property, given the assumptions that you fed it.

I spent time analyzing geography and property types.  I had a decent idea as to what areas of the country were doing badly, and with what property types.

I created what I called the black bucket.  Property types and geographic areas that I did not like were assigned to the black bucket, and if the  black bucket got big enough, we did not play in the deal.  It was a good method, and one CMBS expert at a bulge-bracket bank said to me that it was the most rigorous means of testing CMBS that he had run into.  Most buyers were far more trusting, and tended to buy quality issuers that were taking advantage of their reputation.

By having an independent standard of value where I worked, I did better than competitors.  I did not follow fads; I followed value to the greatest extent that I knew.

Brokers would be puzzled on why I turned down deals from good dealers, or why I bought deals from originators that were subpar.  My lesson was dig into the details, and ignore names.  Analyze the data, avoid the marketing.

Doing your own analysis is a lot of investing.  Ignore the puzzled expressions of your brokers, and buy what you have determined is valuable.  More in part 3.


You might remember my “Education of a Corporate Bond Manager” 12-part series.  That was fun to write, and a labor of love, but before I was a corporate bond manager, I was a Mortgage Bond Manager.  There is one main similarity between the two series — I started out as a novice, with people willing to thrust a promising novice into the big time.  It was scary, fun, and allowed me to innovate, because in each case, I had to rebuild the wheel.  I did not have a mentor training me; I had to figure it out, and fast.  Also, in this era of my career, I had many other projects, because I was the investment risk manager for a rapidly growing life insurer.  (Should I do a series, “The Education of a Financial Risk Manager?”)

One thing my boss did that I imitated was keep notebooks of everything that I did; if this series grows, I will go down to the basement, find the notebooks, and mine them for ideas.  When you are thrust into a situation like this, it is like getting a sip from a firehose.  Anyway, I hope to do justice to my time as a mortgage bond manager; I have been a little more reluctant to write this, because things may have changed more since I was a manager.  With that, here we go!

Liquidity for a Moment

In any vanilla corporate bond deal, when it comes to market for its public offering, there is a period of information dissemination, followed by taking orders, followed by cutoff, followed by allocation, then the grey market, then the bonds are free to trade, then a flurry of trading, after which little trading occurs in the bonds.

Why is it this way?  Let me take each point:

  1. period of information dissemination — depending on how hot the market is, and deal complexity, this can vary from a several weeks to seven minutes.
  2. taking orders — you place your orders, and the syndicate desks scale back your orders on hot deals to reflect what you ordinarily buy and even then reduce it further when deals are massively oversubscribed.  When deals are barely subscribed, odd dynamics take place — you get your full order, and then you wonder, “Why am I the lucky one?”  After that, you panic.
  3. cutoff — it is exceedingly difficult to get an order in after the cutoff.  You have to have a really good reason, and a sterling reputation, and even that is likely not enough.
  4. allocation — I’ve gone through this mostly in point 2.
  5. grey market — you have received your allocation but formal trading has not begun with the manager running the books.  Other brokers may approach you with offers to buy.  Usually good to avoid this, because if they want to buy, it is probably a good deal.
  6. bonds are free to trade — the manager running the books announces his initial yield spreads for buying and selling the bonds.  If you really like the deal at those spreads and buy more, you can become a favorite of the syndicate, because it indicates real demand.  They might allocate more to you in the future.
  7. flurry of trading — many brokers will post bids and offers, and buying and selling will be active that day, and there might be some trades the next day, but…
  8. after which little trading occurs in the bonds — yeh, after that, few trades occur.  Why?

Corporate bonds are not like stocks; they tend to get salted away by institutions wanting income in order to pay off liabilities; they mature or default, but they are not often traded.

By this point, you are wondering, if the title is about mortgage bonds, why is he writing about corporate bonds?  The answer is: for contrast.

  1. period of information dissemination — depending on how hot the market is, and deal complexity, this can vary from a several weeks to a few days.  Sometimes the rating agencies provide “pre-sale” reports.  Collateral inside ABS, MBS & CMBS vary considerably, so aside from very vanilla deals, there is time for analysis.
  2. taking orders — you place your orders, and the syndicate desks scale back your orders on hot deals to reflect what you ordinarily buy and even then reduce it further when deals are massively oversubscribed.  When deals are barely subscribed, odd dynamics take place — you get your full order, and then you wonder, “Why am I the lucky one?”  After that, you panic.
  3. cutoff — it is exceedingly difficult to get an order in after the cutoff.  You have to have a really good reason, and a sterling reputation, and even that is likely not enough.
  4. allocation — I’ve gone through this mostly in point 2.
  5. grey market — there is almost no grey market.  There is a lot of work that goes into issuing a mortgage bond, so there will not be competing dealers looking to trade.
  6. bonds are free to trade — the manager running the books announces his initial yield spreads for buying and selling the bonds.  If you really like the deal at those spreads and buy more, you can become a favorite of the syndicate, because it indicates real demand.  They might allocate more to you in the future.
  7. no flurry of trading — aside from the large AAA/Aaa tranches very little will trade.  Those buying mezzanine and subordinated bonds are buy-and-hold investors.  Same for the junk tranches, should they be sold.  These are thin slices of the deal, and few will do the research necessary to try to pry bonds out of their hands at a later date.
  8. after which little trading occurs in the AAA bonds — yeh, after that, few trades occur.  Same reason as above as for why.  Institutions buy them to fund promises they have made.

Like corporate bonds, but more so, mortgage bonds do not trade much after their initial offering.  The deal is done, and there is liquidity for a moment, and little liquidity thereafter.

Again, if you’ve known me for a while, you know that I believe that liquidity can’t be created through securitization and derivatives.  Imagine yourself as an insurance company holding a bunch of commercial mortgage loans.  You could sell them into a trust and securitize them.  Well, guess what?  Only the AAA/Aaa tranches will trade rarely, and the rest will trade even more rarely.  The mortgages are illiquid because they are unique, with a lot of data.  You would have a hard time selling them individually.

Selling them as a group, you have a better chance.  But as you do so, investors ramp up their efforts, because the whole thing will be sold, and it justifies the analysts spending the time to do so.  But after it is sold, and months go by, few institutions have a concentrated interest to re-analyze deals on their own.

And so, with mortgage bond deals, even more than corporate bond deals, liquidity is but for a moment, and that affects everything that a mortgage bond manager does.  More in part 2.