1) After reading a piece on Falkenblog yesterday, I decided to add up all of the profits from Fannie and Freddie over the last 20 years.  Ready for how much they made?  Ta-da!  They lost $114 billion.

When writing at RealMoney, I was always skeptical of the GSEs, and felt that they were too lightly reserved, because eventually they would run into a situation where real estate prices would fall.

2) Bruce Krasting comments on the solvency of the FHA.  I comment:

“I’ve argued that FHA would go negative for some time. Even the FDIC is engaged in a bit of chicanery by fronting future premiums forward to avoid borrowing from the Treasury.

We may avoid a banking crisis — at the cost of a sovereign crisis.”

3) I probably have a longer post coming on the paradox of thrift, that bogus concept that Keynes put forth.  But Paul Kedrosky crystallized it for me when he posted this.  And so I wrote:

The problem with the “paradox of thrift” is that it assumes there is only one way to save. Same for the “paradox of toil.” It assumes that all work is interchangeable and uniform.

The aggregation of all saving and all labor is necessary to make these models work mathematically, but isn’t valid in real life.

Yes, if everyone tries to do the same thing, stupid things happen, like bubbles from overinvesting. If there only a fixed possible number of tasks, and people work longer hours, it takes fewer people to do them.

But there are many opportunities, including ones that we don’t presently know about. Businesses that no one could imagine before the crisis can spring out of hard times.

This paper oversimplifies the economy. If the economy were that simple, he would be right. But the economy is not that simple.

4) I don’t know if the Volcker Rule will be eliminated or not, but I do know that the same ends could be achieved through changes in the risk-based capital formulas.  What I wrote:

The same ends of the Volcker Rule can be accomplished through adjusting the risk-based capital formulas — Equity-like risks should be funded through a 100% allocation of equity. Few banks would take on that level of speculation at that level of capital used.

If you need proof, look at the life insurance industry. Companies used to hold a lot more equities prior to the tightening of RBC rules. Now they hold little, except at a few mutual companies that are flush with capital.

For another off-the-wall idea: ban interstate banking, and let the states rule all depositary institutions. Results: No more too big to fail, and you get back “scaredy cat” regulators who don’t let banks deal in anything they don’t understand, which isn’t much.

That also has preserved the insurance business in this crisis, leaving aside mortgage and financial risks, where the state regulators still have no idea what they are doing — that a proper reserve level would leave most of the companies insolvent today, but had it been implemented ten years ago, would have preserved the companies, but eliminated much of their profits.

But Life and P&C insurers survive the process because of RBC, and “scaredy cat” state regulators. What a great system, which prior to the crisis, was criticized as behind the times.

PS — if we ever get a national regulator of insurance, there will be a big boom and bust, much as in banking at present. It is easier to corrupt one regulator than fifty.

5) Is the stock market overvalued?  Probably, but consider this article here.  I wrote:

truth, P/Es are best related to corporate yields, not deposit rates or government bonds. And, you have to flip them to be E/Ps. Current E/P on the S&P 500 is 5.4%. A dividend yield of 2.05% is 38% which is close to the long run average.

The longest corporate series that I have is the Moody’s Baa series — because of the growth inherent in stocks, for bonds to be the better deal versus stocks, Baa bonds need a 3.9% premium over the earnings yield, or a yield of 9.3% in the present environment.

So, I’ll take it back, because the present Baa yield 6.45% augurs in favor of stocks versus bonds. Not crazy about bonds in this environment — few categories offer good risk-adjusted yields. Now, maybe both are overvalued vs. commodities, but that one I don’t know.

6) Perhaps the phrase “Greek Banking System” will be a cuss word someday.  Fitch recently gave them a downgrade, and I wrote:

Rating agencies exist to be scapegoats. When they are proactive (yes there have been eras where they have been proactive) the bond buyers scream — “Ratings are supposed to be good over a full market cycle!” When they are reactive, which is most of the time, they get accused of being coincident indicators.

They can’t win, which is why institutional investors ignore the ratings, aside from the capital charges that they force, and instead, read what the rating agency analysts write. The true opinion is in the writing, not the rating.

7)  Barry comments on how Goldman Sachs bags clients.  Truth, almost all investment banks bag clients, selling complex products that they understand better than their clients do.  My comment:

I always advise retail investors not to buy structured notes — Wall Street offers an above-average yield, and has the buyer sell short some expensive option. You lose more in capital losses than you gain in interest on average.

This isn’t any different. It just that bigger players that should have known better are getting hosed.

There is no better defense than “buyer beware,” and “Don’t buy what someone else wants to sell you. Buy what you want to buy.”

Unless we want radical revisions to contract law, you are your own best defender.

8 ) One story with more sizzle than substance is put-backs, at least as far as it affects homeowners.  It was featured by Barron’s and picked up in a piece by Barry.  Investors that purchase a mortgage or any o=ther sort of loan have a limited window of time to give the mortgage back to those that they bought it from for full value.  My comment:

This seems to be useful for investors, but not for homeowners. Reps and Warranties claims can be enforced by investors that bought loans through securitizations. It does not help homeowners.

9) Jeff Matthews wrote a piece that was a little critical of splitting the “B” shares and Buffett’s logic on the Burlington Northern acquisition.  My comment:

I don’t always agree with Warren Buffett, but I do agree here. Index investors are passive investors. Individually, they are dumb. As a group they are smart, because they lower their investment costs.

Warren is also correct on Burlington Northern — it should be like his utilities, and throw off a growing inflation-protected return over time, allowing him to earn a spread over his cost of funds (negative) that his insurance enterprises generate.

He is still a bright man after all these years.

PS — I am a Calvinist Christian; the question asked regarding Jesus is not relevant to the short-term running of Berky, but is relevant to an Christian investor who cares about the ethics of the organization. Also, it is relevant to the long-term well-being of Mr. Buffett. The rest of us will have to face the results of that question one day as well.

10) The Developments blog at the WSJ hides in the shadow of better known blogs, but often puts up some really good pieces.  They recently did a piece on whether it is better to buy a home now or wait a while.  My comment:

Three years at The Aleph Blog?  Has it been that long?  Yes, the Shanghai crisis is that far in the past, which foreshadowed our current troubles, though I denied it at the time at my new blog.

Why do I write here?  Is it for fame?  There isn’t much of that.  Money?  Sorry no, I make less than $3000/year off the blog; that does not justify my time.  My employer is pushing me?  Oh please, they would be happier if I did not blog, I think… eh, they like the notoriety, but would not want to pay for it.  Power?  What power?

Look, I write what I write because I believe it.  No other reason.  I write because I have had a strong impulse since the ’90s to find a way to give back to those who have/know less.  Everyone should do pro bono work in society.  It holds society together.

In general, I try to take a positive view of other bloggers, but I have no permanent favorites, though I have friends.  Politicians and regulators, not so.  They are almost all replaceable.  Our society needs change, and change will not happen without replacing the elites that govern us.  Vote out incumbents, and support third parties.  We need real change in America, not just the difference between the evil party (Democrats) and the stupid party (Republicans).

I write this partly from private criticism from other bloggers, who accuse me of writing for less than honorable motives.  Ugh, to quote that great moral philosopher Popeye, “I yam what I yam.”  There is nothing behind me.  I am not involved in politics in any deep way.  My blog does not make much money.  I write what I write for the sake of expressing my opinion.  That’s what I do.  I would rather that I lived in a less contentious era where I could spend more time on portfolio management issues.

So, what do I say after three years?  Thanks to my commenters, and thanks to my readers.  You are who I write for, and I thank you.  You have many things that you can do in life, but you deign to read me, and write about me.  Thanks ever so much; I do not deserve you.

To all of my readers: may the fourth year be the best of all!

David

PS — my apologies on e-mail; I get so much of it that I can’t get to it.  I want to reply, but am swamped.  Apologies.

The place that got the most snow during the recent storm was Howard County, Maryland.  Elkridge had 38″, Columbia 34″, and at Aleph Blog Global HQ we got a measly 30″.  Here are some photos:

looking out the front of the house

back deck from the inside…

and the back deck from the outside…

looking up the street…

icicles hanging from our house — eight feet long

some of my kids starting to shovel before the storm is over… and…

360 degrees after two feet

That should be an AVI file.  There were six inches to go after that.

Well, we have been busy bees, and we may be getting busier.  There is another storm coming.  Another 10-20 inches.  Wow.

Economic commentary on this?  It’s good to have boys — we have been helping out people where we can.  Neighborhood relationships have tightened as people have made efforts to help the elderly and infirm.

Maryland can’t afford storms like these — major roads are only half to 2/3rds plowed.  This may generate a political crisis here, but I am only surmising.  Even well-off Howard County can’t keep up.

All for now, gotta buy some more snow shovels and salt, if I can find them.

Before I start, I would like to toss out the idea of an Aleph Blog Lunch to be hosted sometime in January 2010 @ 1PM, somewhere between DC and Baltimore.  Everyone pays for their own lunch, but I would bring along the review copies of many of the books that I have reviewed for attendees to take home, first come, first served.  Maybe Eddy at Crossing Wall Street would like to join in, or Accrued Interest. If you are an active economic/financial blogger in the DC/Baltimore Area, who knows, maybe we could have a panel discussion, or something else.   Just tossing out the idea, but if you think you would like to come, send me an e-mail.

Onto the comments.  I try to keep up with comments and e-mails, but I am forever falling behind.  Here is a sampling of comments that I wanted to give responses on.  Sorry if I did not pick yours.

=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=–==-=–==-

Blog comments are in italics, my comments are in regular type.

http://alephblog.com/2009/12/16/notes-on-fed-policy-and-financial-regulation/#comments

Spot on David. I often think about the path of the exits strategy the fed may take. In order, how may it look? What comes first what comes last? Clearly this world is addicted to guarantees on everything, zirp, and fed QE policy which is building a very dangerous US dollar carry trade.

Back to the original point, I would think the order of exit may look something like:

1. First they will slowly remove emergency credit facilities, starting with those of least interest, which were aggressively used to curb the debt deflationary crisis on our banking system. The added liquidity kept our system afloat and avoided systemic collapse that would have brought a much more painful shock to the global financial system. Lehman Brothers was a mini-atom bomb test that showed the fed and gov’t would could happen – seeing that result all but solidified the ‘too big to fail’ mantra.

2. Second, they will be forced to raise rates – that’s right folks, 0% – 0.25% fed funds rates is getting closer and closer to being a hindsight policy. However, I still think rates stay low until early 2010 or unemployment proves to be stabilizing. As rates rise, watch gold for a move up on perceived future inflationary pressures.

3. Third, they can sell securities to primary dealers via POMO at the NY Fed, thereby draining liquidity from excess reserves. I think this will be a solid part of their exit strategy down the road – perhaps later in 2010 or early 2011. As of now, some $760Bln is being hoarded in excess reserves by depository institutions. That number will likely come way down once this process starts. The question is, will banks rush to lend money that was hoarded rather then be drained of freshly minted dollars from the debt monetization experiment. For now, this money is being hoarded to absorb future loan losses, cushion capital ratios and take advantage of the fed’s paid interest on excess reserves – the banks choose to hoard rather then aggressively lend to a deteriorating quality of consumer/business amid a rising unemployment environment. This is a good move by the banks as the political cries for more lending grow louder. The last thing we need is for banks to willy-nilly lend to struggling borrowers that will only prolong the pain by later on.

4. And finally, as a final and more aggressive measure, we could see capital or reserve requirements tightened on banks to hold back aggressive lending that may cause inflationary pressures and money velocity to surge. Right now, banks must retain 10% of deposits as reserves and maintain capital ratios set by regulators. Either can be tweaked to curb lending and prevent $700bln+ from entering the economy and being multiplied by our fractional reserve system.

I think we are starting to see #1 now, in some form, and will start to see the rest around the middle of 2010 and into 2011. The last item might not come until end of 2011 or even 2012 when economy is proven to be on right track and unemployment is clearly declining as companies rehire.

Thoughts????

UD, I think you have the Fed’s Order of Battle right.  The questions will come from:

1) how much of the quantitative easing can be withdrawn without negatively affecting banks, or mortgage yields.

2) How much they can raise Fed Funds without something blowing up.  Bank profits have become very reliant on low short term funding.  I wonder who else relies on short-term finance to hold speculative positions today?

3) Finance reform to me would include bank capital reform, including changes to reflect securitization and derivatives, both of which should require capital at least as great as doing the equivalent transaction through non-derivative instruments.

http://alephblog.com/2009/12/15/book-reviews-of-two-very-different-books/#comments

David,
A few years back you mentioned to me in an e-mail that Fabozzi was a good source for understanding bonds (thank you for that advice by the way, he is a very accessible author for what can be very complex material.)  In the review of Domash’s book you mention that he does not do a good job with financials. I was wondering, is there an author who is as accessible and clear as Fabozzi, when it comes to financials, who you would recommend.

Regards,
TDL

TDL, no, I have not run across a good book for analyzing financial stocks.  Most of the specialist shops like KBW, Sandler O’Neill and Hovde have their own proprietary ways of analyzing financials.  I have summarized the main ideas in this article here.

http://alephblog.com/2007/04/28/why-financial-stocks-are-harder-to-analyze/

http://alephblog.com/2009/12/05/the-return-of-my-money-not-the-return-on-my-money/#comments

Sorry to be a bit late to this post, but I really like this thread (bond investing with particular regard to sovereign risk). One thing I’m trying to figure out is the set of tools an individual investor needs to invest in bonds globally. In comparison to the US equities market, for which there are countless platforms, data feeds, blogs, etc., I am having trouble finding good sources of analysis, pricing, and access to product for international bonds, so here is my vote for a primer on selecting, pricing, and purchasing international bonds.

K1, there aren’t many choices to the average investor, which I why I have a post in the works on foreign and global bond funds.  There aren’t a lot of good choices that are cheap.  It is expensive to diversify out of the US dollar and maintain significant liquidity.

A couple of suggested topics that I think you could do a job with:  1) Quantitative view of how to evaluate closed end funds trading at a discount to NAV with a given NAV and discount history, fee/cost structure, and dividend history;   2) How to evaluate the fundamentals of the return of capital distributions from MLPs – e.g. what fraction of them is true dividend and what fraction is true return of capital and how should one arrive at a reasonable profile of the future to put a DCF value on it?

Josh, I think I can do #1, but I don’t understand enough about #2.  I’m adding #1 to my list.

http://alephblog.com/2009/12/05/book-review-the-ten-roads-to-riches/#comments

I see that Fisher’s list reveals his blind spot–how about being born the child of wealthy parents. . .

BWDIK, Fisher is talking about “roads” to riches.  None of us can get on that “road” unless a wealthy person decided to adopt one of us.  And, that is his road #3, attach yourself to a wealthy person and do his bidding.

I am not a Ken Fisher fan, but I am a David merkel fan—so what was the advice he gave you in 2000?

Jay, what he told me was to throw away all of my models, including the CFA Syllabus, and strike out on my own, analyzing companies in ways that other people do not.  Find my competitive advantage and pursue it.

That led me to analyzing industries first, buying quality companies in industries in a cyclical slump, and the rest of my eight rules.

http://alephblog.com/2009/11/28/the-right-reform-for-the-fed/#comments

“The Fed has been anything but independent.  An independent Fed would have said that they have to preserve the value of the dollar, and refused to do any bailouts.”

This seems completely wrong to me.  First, the Fed’s mandate is not to preserve the value of the dollar, but to “”to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.”  I don’t see that bailouts are antithetical to those goals. Second, I don’t see how the Fed’s actions in 2008-2009 have particularly hurt the value of the dollar, at least not in terms of purchasing power.  Perhaps they will in the future, but it is a bit early to assert that, I think.

Matt, even in their mandates for full employment and stable prices, the Fed should have no mandate to do bailouts, and sacrifice the credit of the nation for special interests.  No one should have special privileges, whether the seeming effect of purchasing power has diminished or not.  It is monetary and credit inflation, even if it does not result in price inflation.

¨Make the Fed tighten policy when Debt/GDP goes above 200%.  We’re over 350% on that ratio now.  We need to save to bring down debt.¨

David, I fully agree (as with your other points).
However, I do not see it happening.

I´d appreciate your, and other readers´, take on this.

Carol, you are right.  I don’t see a limitation on Debt to GDP happening.

As to nations rolling over each other’s debts for 10 more years, I find that unlikely.  There will be a reason at some point to game the system on the part of those that are worst off on a cash flow basis to default.

The rollover problem for the US Treasury will get pretty severe by the mid-2010s.

http://alephblog.com/2009/11/13/the-forever-fund/#comments

Any chance of you doing portfolio updates going forward? I’d be curious to see if you still like investment grade fixed incomes, given the rally.

Matt, I would be underweighting investment grade and high yield credit at present.

As for railroads, I own Canadian National – unlike US railroads, it goes coast to coast, and slowly they are picking up more business in the US as well.

Long CNI

http://alephblog.com/2009/11/10/my-visit-to-the-us-treasury-part-7-final/#comments

Did none of the bloggers raise the question of the GSEs? I can understand Treasury not wishing to tip their hands as to their future, but I would have expected their status to be a hot topic among the bloggers.

I also don’t buy the idea that the sufferings of the middle class were inevitable. Over the past 15 or so years the financial sector has grown due to the vast amount of money that it has been able to extract. Where would we be if all of those bright hard working people and capital spending had gone to the real economy? I’m not suggesting a command economy, but senior policymakers decided to let leverage and risk run to dangerous levels. Your comment seem to indicate that this was simply the landscape of the world, but it seems more to be the product of a deliberate policy from the Federal government.

Chris, no, nothing on the GSEs.  There was a lot to talk about, and little time.

I believe there have been policy errors made by our government – one the biggest being favoring debt finance over equity finance, but most bad policies of our government stem from a short-sighted culture that elects those that govern us.  That same short-sightedness has helped make us less competitive as a nation versus the rest of the world.  We rob the future to fund the present.

http://alephblog.com/2009/11/07/my-visit-to-the-us-treasury-part-6/#comments

it’s not clear from your writing whether the treasury officials talked to you about the GSEs or whether your comments (in the paragraph beginning with “When I look at the bailouts,”) are your own. could you clarify?

q, That is my view of how the Treasury seems to be using the GSEs, based on what they are doing, not what they have said.

http://alephblog.com/2009/10/31/book-review-nerds-on-wall-street/

“There are a lot of losses to be taken by those who think they have discovered a statistical regularity in the financial markets.”
David, take a look at equilcurrency.com.

Jesse, I looked at it, it seems rather fanciful.

http://alephblog.com/2009/10/27/book-review-the-predictioneers-game/#comments

David,
Just wondering if there’s an omission in this line:

“The last will pay for the book on its own. I have used the technique twice before, and it works. That said, that I have used it twice before means it is not unique to the author.”

Did you mean to write “that I have used it doesn’t mean it is not unique….”

In the event it is, I’ll look it up in the book, which I intend to buy anyway.
Otherwise, may I request a post that details, a la your used car post,your approach to buying new cars?

Saloner, no omission.  I said what I meant.  I’ll try to put together a post on new car purchases.

http://alephblog.com/2009/10/22/book-review-the-bogleheads-guide-to-retirement-planning/

thanks for the book review. it sounds like something that i could use to get the conversation started with my wife as she is generally smart but has little tolerance for this sort of thing.

> unhedged foreign bonds are a core part of asset allocation

i agree in principle — it would be really helpful though to have a roadmap for this. how can i know what is what?

I second that request for help in accessing unhedged foreign bonds – Maybe a post topic?

JK, q, I’ll try to get a post out on this.

http://alephblog.com/2009/10/20/toward-a-new-theory-of-the-cost-of-equity-capital-part-2/#comments

to the point above, basically just an IRR right?

JRH, I don’t think it is the IRR.  The IRR is a measure of the return off of the assets, not a rate for the discount of the asset cash flows.

When I was an undergraduate (after already having been in business for a long time), I realized that M-M was erroneous, because of all the things they CP’d (ceteris paribus) away. For my own consumption, I went a long way to demonstrating that quantitatively, but children, work and family intervened, and who was I to argue with Nobel winners.

But time, experience and events convince me that I was right then and you are right now. As you’ve noted the market does not price risk well. In large part this is due to a fundamental misunderstanding of value. The professional appraisal community has a far better handle on this, exemplified by drawing the formal distinction between “fair market value as a going concern”, “investment value”, “fair market value in a orderly liquidation”, “fair market value in a forced liquidation” and so on. One corollary to the foregoing is one of those lessons that stick from sit-down education, that “Book Value” is not a standard of value but rather a mathematical identity.

Without going into a long involved academic tome, the cost of capital (and from which results the mathematical determination of value per the income approach) has a shape more approaching that of a an asymmetric parabola (if one graphs return on the y axis and equity debt weight on the x.).

If I was coming up with a new theorem, risk would be an independent variable. So for example:

WAAC = wgt avg cost of equity + wgt avg cost of debt + risk premium

You’ll note the difference that in standard WAAC formulation risk is a component of the both the equity and debt variable – and practically impossible to consistently and logically quantify. Yes, one can look to Ibbottson for historical risk premia, or leave one to the individual decision making of lenders, butt it complicates and obscures the analysis.

In the formulation above, cost of equity and cost of debt are very straightforward and can be drawn from readily available market metrics. But what does risk look like? Again if you plot risk as a % cost of capital on the y axis and on the x axis the increasing debt weight, on a absolute basis risk is lowest @ 100% equity. From there is upwards slopes. However, risk however is not linear, but rather follows a power law.

The reason risk follows a power law is that while equity is prepared to lose 100%, debt is not. Also, debt weight increases IRR to equity (in the real world) contrary to MM. Again, debt is never priced well, because issuers don’t understand orderly and forced liquidation, whereby in “orderly”, e.g. say Chapter 11,recoveries may be 80 cents on the dollar, and forced, e.g., Chapter 7, 10 cents on the dollar. One really doesn’t begin to understand the foregoing until you’ve been through it more than a few times.

So in the real world, as debt increases, equity is far more easily “playing with house money.” A recent poster child for this phenomena is the Simmons Mattress story. In the most recent go round equity was pulling cash out (playing with house money) and the bankers were either (depending on one’s POV) incredibly stupid for letting equity do so, or incredibly smart, because they got their fees and left someone else holding the bag. I’m seen some commentators say that ‘Oh it was OK because rates were so low, the debt service (the I component only) was manageable.’ Poppycock; sometime it’s the dollar value and sometimes it’s the percentage weight and sometimes it is both.

But you’ve already said that: “company specific risk is significant and varies a great deal.” I would also add that – or amplify – that in any appraisal assignment the first thing that must be set is the appraisal date. Everything drives off that and what is ‘known or knowable’ at the time.

Gaffer, thanks for your comments.  I appreciate the time and efforts you put into them.  This is an area where finance theory needs to change.

http://alephblog.com/2009/10/10/pension-apprehension/

I have a DB plan with Safeway Stores-UFCW, which I’ve been collecting for a few years. I’m cooked?

Craig, not necessarily.  Ask for the form 5500, and see how underfunded the firm is.  Safeway is a solid firm, in my opinion.

Long SWY

http://alephblog.com/2009/09/29/recent-portfolio-actions/#comments

David, I am curious about your rebalancing threshold. Do you calculate this 20% threshold using a formula like this:

= Target Size / Current Size – 1

I have a small portfolio of twenty securities. A full position size in the portfolio is 8% (position size would be 1 for an 8% holding). The position size targets are based generally on .25 increments (so a position target of .25 is 2% of the portfolio and there are 12.5 slots “available”). I used that formula above for a while, but I found that it was biased towards smaller positions.

Instead I began using this formula:

= (Target – Current Size) / .25

So a .50 sized holding and a full sized holding may have both been 2% below the target (using the first formula), but using the second formula, they would be 8% and 16% below the target respectively. I found this showed me the true deviation from the portfolio target size and put my holdings on an equal footing for rebalancing.

I was curious how you calculated your threshold, or if it was less of an issue because you tended to have full sized positions. For me, I tend to start small and build positions over time. There are certain positions I hold that I know will stay in the .25-.50 range because they either carry more risk, they are funds/ETFs, or they are paired with a similar holding that together give me the weight I want in a particular sector.

Brian, you have my calculations right.  I originally backed into the figure because concentrated funds run with between 16-40 names.  Since I concentrate in industries, I have to run with more names for diversification.  I don’t scale, typically, though occasionally I have double weights, and rarely, triple weights.  The 20% band was borrowed from three asset managers that I admire.  After some thought, I did some work calculating the threshold in my Kelly criterion piece.

A fuller explanation of the rebalancing process is here in my smarter seller pieces.

http://alephblog.com/2009/09/04/tickers-for-the-latest-portfolio-reshaping/

Have you seen DEG instead of SWY?
Extremely able operator. Some currency diversification as well. I’d like to know your thougts.

MLS, I don’t have a strong idea about DEG – I know that back earlier in the decade, they had their share of execution issues.  It does look cheaper than SWY, though.

Long SWY

http://alephblog.com/2009/06/11/problems-with-constant-compound-interest-2/

I like your post and want to comment on a couple of items.  You point to the peak of the 1980’s inflation rates and the associated interest rates.

The reason that the yield spread exploded is well known.  Here is a snippet from Irving Fisher.  http://capitalvandalism.blogspot.com/2009/01/deflationary-spirals.html

CapVandal – Great comment.  A lot to learn from here.  I hope you come back to blogging; you have some good things to say.  Fear and greed drive correlated human behavior.

I like investing internationally, because of the diversification it offers, both in stocks and bonds.  Or, think of it as a hedge.  Will the American Experiment continue to prosper?  We have come a long way from the Founding Fathers, and more than half of it is not good.

But there are some place in our world that I will not invest in.  I have two requirements.

• Contract law must be close to that in the US, or better.
• Accounting practices must be close to the quality of the US, or better.

Sounds simple, but foreign tales are beguiling.  There is an exclusiveness about them, and a sense of greater knowledge for the one who has bothered to learn a trifle.  My acid test is watching over a long period and seeing how they treat foreign shareholders.  That is a good measure of the morality of management.  If they cheat foreign shareholders, they will eventually cheat domestic shareholders as well.

So, what don’t I invest in?

• Russia
• China
• Most of the Middle East.
• Venezuela
• And other places that do not protect foreign shareholders on a level that is at least close to that of citizens.

The idea is to avoid situations where your rights as a shareholder might be ignored.  It does not matter how cheap an asset is; if the ability of the asset to be liquidated is low, so should the valuation of the asset be low.  Don’t buy pigs in pokes.

This has application today with Dubai.  The Dubai government is telling creditors that it will not stand behind Dubai World, and nor will the UAE, but Abu Dhabi will stand behind UAE banks.  This is tough on foreign creditors because foreign creditor rights in Dubai have not been tested until now.  Even domestic rights are unclear.

A Note on Debt Risks

Much Islamic debt, because of the prohibition on interest, acts like an extremely volatile hybrid bond during times of stress.  This incident will prove instructive on how these bonds keep or lose value in a reorganization.  What happens here will probably have an impact on how much money will be willing to flow into these vehicles in the future.  Personally, I never found them compelling, and probably won’t in the future.  There is something compelling about straight senior unsecured debt that pays interest.  I think the guarantees involved, together with straightforward reorganization processes, create a fair game where it is easier to decide whether lending or borrowing makes sense.

Complexity in bonds is usually a loser for the lender — whether complexity of the borrower’s finances, complexity of holding company structures, complexity of the governing laws, or even enforcing a complex contract where the lender duped the less-knowledgeable borrower.

What applies to corporate debt — long term buy and hold investors do okay with investment grade debt, but less well with junk debt, and worse the junkier it gets.  Layer on top of that the difficulty of being able to psychologically buy and hold during a crisis.  Even if you personally have the fortitude to do so, there may be others that influence you that don’t.  (E.g., the rating agencies come along near the trough of the crisis, and tell the CEO that they will downgrade you if you don’t sell bonds with the risk du jour.  Or, your clients look at their statements, and see the unrealized losses and beg you to sell — it doesn’t matter, the screaming is always the loudest at the bottom (in hindsight).

A Final Note on Sovereign Risks

Sovereign and quasi-sovereign risks like Dubai World may play a larger role in overall credit risk as the broader crisis plays out.  When I was younger, I thought the great risk of the Euro was that it would be too weak.  Bite my tongue.  The risk is that it could be too strong, and marginal European countries (Greece, Iceland, Ireland, Spain, Portugal, and many Eastern European countries) that have too much Euro-denominated debt relative to their ability to tax and pay will find themselves pinched — and they can’t inflate their way out.

When I first came to bond investing (early 90s), sovereign risks were viewed  skeptically, excluding the large Western nations — bond managers had been taught by the greyheads who had seen sovereign defaults, and the difficult of recovering money in default, still had a bias against sovereign and quasi-sovereign risks.  That bias is largely gone today, after a period of few sovereign losses.  Yes, Mexico, Russia and Argentina have given their share of heartburn, but the significant growth in the emerging markets has made bondholders forgiving.  Add in the long term structural deficits of the US and Japan, and it makes for a really interesting investment picture.

Be aware.  If you hold sovereign debts, look at the ability of the government to tax and pay over the long haul.  On quasi-sovereigns, analyze the explicit guarantees, if any, and the governing law — as you can see with Dubai World, in a crisis, only the guarantees matter, and only to the degree that they are enforceable under law.  With Dubai World, it will be judged in Dubai courts by a judge appointed by the ruling family of the emirate, which owns the equity of Dubai World.  Not a strong bargaining position in my opinion.  The only thing worse than relying on the kindness of strangers, is relying on the kindness of adversaries.

A Final Aside

I knew about how dodgy the investments were that Dubai and its corporations were undertaking, so I was always a skeptic, though I never wrote about Dubai, because it is so far afield for me.  What I did not know was the near slavery of foreign workers tricked to go to Dubai, and then forced to work with little to no rights.  Read the story, it is not pretty, but reinforces a belief of mine that governments and corporations willing to cheat one group of people, will cheat other groups of people as well.  Character is important in any credit decision, and the government of Dubai does not have good character in my book.

I do a reflective piece every 100 posts, because I like to take a step back, and share my heart with those who read me.  It is fun for me writing this blog, even more than when I wrote for RealMoney.  Why better than RealMoney?  For what I liked to write, I did not feel that I fit well there.  One RealMoney editor told me, “You’re our most profitable columnist.”  Surprised, I asked how that could be.  The answer was simple.  I wrote lots of comments (no pay), and the articles I wrote were both high quality, and long lasting.  The half life of an average article at RealMoney is a day, if that.  My articles were perhaps a month or more.  And, as Cody (Willard) said (something like this) to me over dinner several years ago, “Many of your comments are better than the articles on the site.  I print them out and take them home so that I can think them over.”  I love Cody — a good friend.

Today’s piece is on Thanksgiving.  We all have  lot to be thankful for, but sometimes it is helpful to be prompted and consider all of the ways that we are blessed.

• Your health could be worse.  A wide number of accidents/infections could have harmed you and did not.  I can count on two hands the close scrapes that could have killed me.
• The food could be worse.  I don’t think that I have mentioned it before, but my hobby is cooking.  I am amazed at what supermarkets in the US offer today versus when I was a child.  The diversity is amazing, as are the places in the world that they come from.  It doesn’t hurt to have a large Asian market nearby.  (I am ready for my cooking event tomorrow — there will be 25 people here.)
• The health of your children could be worse.  Two of my eight children nearly died while they were young.  Health for children across the world has improved dramatically over the last century.
• Your economic situation could be worse.  Yes, there are problems, particularly today, but there have been markedly worse times and places to be alive in human history.  There are still dreadfully poor people in the world, but the lot of those worst off is still improving on average, though not everywhere.
• Your national politics could be worse.  Compare the freedom of today against other eras.  In most places, the level of freedom is higher now than in most of history.  We complain about politics being nasty in the US, but hey, a close look at history would tell you that it has almost always been nasty.  And, when it has not been nasty, some of the worst results have occurred.  We do best with divided government in the US.
• There could be more wars.  There are relatively few wars today, and what wars are going are relatively low intensity.

You name it — things could be worse, and across human history, things have been worse.  In most of the world. we would not want to go back to “Golden Eras” of the past.  They would be a step down (or more) from what we have today.

Against Complaining

The opposite of Thanksgiving is complaining.  I want to discourage complaining in a few areas.  First, if you are thankful, avoid complaining about government officials.  Complain about policies, fine.  It is proper to be principled; it is wrong to be acidic to those who hold an office, even if they hold a wrong opinion.  Basic respect must be maintained even with 180-degree disagreement.  The office means more than the person holding it that you disagree with.

There are many who are angry over the losses they have felt, and want restitution should it be available.  But with most things in life, most small-to-moderate losses aren’t recoverable.

There are those that are irascible, and complain no matter what.  They live to complain.  Time to repent, and gain a new perspective.  Yes, things aren’t what they ought to be.  When are they ever that way?  Grow up, and embrace what is good amid imperfection.

Avoid envy.  Yes, there are those who have it better than you, and they don’t deserve it.  Be happy for them; yes, they don’t deserve it, but neither do you.  There are people in developing countries as deserving as you that don’t have 10% of  what you do, and should they hate you?

No, they shouldn’t, and neither should you hate those who have done well in bad times.  Let the courts try those who have committed fraud.  There will always be those who get away, yet God will try them in the end, and find them wanting.

But truly, you don’t deserve what you have, and yet you have it.  It is time to be grateful.  We all have more than we deserve in a fallen world.

Toward God

Not that it is the most basic book of the Bible, but when we talk about thanksgiving, the book of Job is significant.  Read it if you get a chance.  It is the story of a wealthy, generous man who is put to the test.  Would he trust God if all of his riches were stripped away?  His two conclusions are that he needs a mediator, one who can go between God and man, and that no, his personal actions are nothing to God.  All that said, he trusted God, and God heard his prayers.  What more could one of us ask than to have God hear us?   (There is more that I could write about this, but it is beyond the scope of this blog.  All that said, what would a mediator be like, one that could relate to both God and man?  Who in history is like that?)

Gratitude

We have a lot to be grateful for, whoever we are, and whatever we are.  Grab hold of this, and be grateful to God on this day of Thanksgiving.  Your life will be richer when you give thanks to God for what you have, regardless of what others may have.

With this, I thank all of my readers around the world for reading me.  I don’t deserve your attention, and yet I appreciate it.  May the Lord Jesus Christ bless you amid the troubles that will afflict in 2010.

David

PS — you knew I was a Bible-believing Presbyterian Elder, didn’t you?  You didn’t?!  Well, aside from from my eight kids, and homeschooling, that is what I am.  Call me a Fundamentalist if you must, you will be partly right and partly wrong.  But my fundamental alliance is to Jesus Christ, who is still alive, and lives in his Church across the world.  Jesus is my Savior.

When I wrote What Stories Aren’t Being Told?, I did not expect a big response.  But I got 53 responses, more than double the responses of my next-most-responded-to article.  Many bloggers linked to it, and responses continued on for almost four days.

But after Dr. Jeff’s comment, I decided to write a second piece, What is Going Right? Now, part of that also sprang from an e-mail that Rolfe Winkler sent asking what is going right, but I did it as a kind of test to see if asking for optimism would yield a response.

Alas, but only eleven responses came and a few were negative in nature.  I only received one link.  What should that tell me?  The most obvious answer to me is that people by nature are more inclined to complain than to praise.  Though I could resort to the Bible for proof here, instead I will cite two researchers I first bumped into 28 years ago (before they were cool), Daniel Kahneman and Amos Tversky.  They found that losses delivered roughly three times the pain, when compared to pleasures of an equal-sized gain.  (Side note: this has many applications, and in our day and age, most of them are politically incorrect.  As investors, though, we know it — avoiding losses is a better motivator than seeking gains.  At least, those that avoid losses stay in the game.)

Look, I see it in myself.  I tend toward the negative in this era, because I think it is under-told.  Would it surprise you if you knew that I was one of the more bullish guys in my last three firms (1998-2007)?  But even if under-told, there is something that always makes the bear case sound smarter.  Skeptics almost always seem smarter than optimists.  But, the optimists usually win, except when there is war on your home soil, famine, plague, or extreme socialism.

Where does that leave me?  It leaves me with rules.  I have trading rules.  I have asset allocation rules.  I can lean against something that I think is wrong, but I can’t put all of my weight on it.  I listen to the Sirens, but I tie myself to the mast.  Discipline trumps conviction.

So, to close, I offer an old CC post to illustrate:

		David Merkel
		I Listen to the Sirens, but Like Ulysses, my Hands Are Tied to the Mast
		12/27/2006 2:31 PM EST

When I had dinner with Cody two weeks ago, he asked me (something to the effect of): “If we have so many problems, why are you so net long?”

I told him about a hedge fund friend of mine who let his bearishness drive his macro bets over the last four years. The only thing that has bailed him out is that his analysts are really good stock-pickers… their fund has been in the plus column despite being an average of 25% net short, but not positive by much.

I tie my hands when it comes to asset allocation policy. After determining what I think the neutral policy should be for someone that I advise, I allow myself to tweak it by no more than 10% to reflect my overall levels of bullishness or bearishness. This keeps my emotions from taking over, and protects me and those that I manage for.

Besides, absent a major war on home soil, or a Communist takeover, markets have a tendency to eventually bounce back. (even if the bounce takes 25-odd years, as in the Great Depression). The question is whether one’s asset allocation is conservative enough to be around for the “bounce back.” So, it generally pays to play along with the optimists in the long run. Or, as Cramer has said, the bear case always sounds more intelligent. That can trap bright people who let legitimate fears of something that may happen a ways out get treated as a clear and present danger.

At present I am slightly bullish on the US markets and think that 2007 will produce moderate gains, 5-10%. There are things to worry about, but don’t let it blind you to opportunities that will emerge if disaster doesn’t happen. Instead, diversify. Stocks and high quality bonds. (Maybe even some municipal bonds.) Domestic stocks and foreign. There are ways to reduce risk that don’t cost that much in terms of performance. Use them, and don’t worry about the big, bad event. That event will happen, but it will usually be further out, and less bad than expected.

Position: none

Cramer wrote a piece two days later where he said:

I am always reminded when I see the myriad negative articles about macro issues that you must be like Ulysses — you have to tie yourself to the mast and plug your ears — if you are really going to make money. The parade of horrible worries is so loud and so seductive that the toughest thing to do is to stay the course. And the toughest thing to do is almost always the most lucrative.

I asked him via e-mail whether he had read my piece, and he said he had not. Quite a coincidence. Before I asked him, though, I wrote this response:

		David Merkel
		More Things Can Go Wrong Than Will Go Wrong
		12/29/2006 1:21 PM EST

I reflected on what I recently wrote when I read this bit of Jim’s piece this morning:

I am always reminded when I see the myriad negative articles about macro issues that you must be like Ulysses — you have to tie yourself to the mast and plug your ears — if you are really going to make money. The parade of horrible worries is so loud and so seductive that the toughest thing to do is to stay the course. And the toughest thing to do is almost always the most lucrative.

At my last firm, we conflated two maxims into: “Great minds think alike, but fools seldom differ.” Jim and I disagree on housing. In this case, though I still have many reasons to be bearish on housing, I don’t let it affect my investing to any great degree. For my broad market portfolio, I still own Cemex, Lafarge, and St. Joe. I even own a mortgage REIT, Deerfield Triarc. I’m not bullish on the consumer, but I still own Sonic Automotive and Lithia Motors.

The point is, it’s too easy to say “I’m too worried about the macro environment,” or, “I can’t find anything cheap enough to buy.” Will there be down years? Yes. Might the first decade of the 2000s have a negative total return? Possible, but unlikely. Like the farmer in Ecclesiastes 11, we have to cast the seed into the muddy spring soil, and not worry about the bad weather that might come. Diversification reduces risk, but not taking risk is possibly the biggest risk of all. The advantage belongs to those who take prudent risks.

Now, after all this, if you still want to worry, the biggest risks among the somewhat likely risks out there a breakdown in global trade and an error in Fed policy. I watch these things, but I’m not losing sleep over them.

PS — regarding Ulysses, he put wax in the ears of his sailors, but he tied himself up so that he could listen to the Sirens, but not do anything… it’s a tough discipline to maintain, but it helps me do better in the markets.

Position: Long CX LR JOE DFR SAH LAD

A very different era, that, but I am now bearish, and Cramer is still bullish.  I try not to change my positions often, and even then, I limit my behavior.  Discipline triumphs over conviction.

I did not start blogging in order to start a media career, but sometimes the media finds its way to my door.  I received a call today from a reporter for one of the major television networks, and after talking a while, she asked me, “What big stories aren’t being told?  Some of my best stories some from asking this question.”  I told her I needed to think, and would e-mail her back on the topic.  I decided I would review my last month of posts to look for out-of-consensus ideas, and I came up with these:

• China is overstimulating businesses through loans and they are buying up commodities that they don’t need now, leading to a possible correction in commodity prices.
• Western European banks are in trouble because of loans to Eastern European nations denominated in Euros.  With the rise in the Euro, defaults are likely.
• Water shortages in China and India.
• Most entities that the US Government has bailed out will have stocks that are zero eventually — GM, Chrysler, AIG, and maybe Fannie Mae and Freddie Mac.  For an opposing opinion on the GSEs, read the intelligent John Hempton at Bronte Capital.
• With dud residential mortgage loans, modifications don’t work well unless there is a forgiveness of some of the principal.
• The foreign funding base of the US is getting shorter in maturity — could this be a sign of trouble?  Is there a lack of confidence?
• If we marked the value of commercial real estate loans to market for banks, using data from the CMBS market, some banks would be insolvent.

That’s all for me, or now.  Now, I don’t watch television, listen to radio much, and I don’t subscribe to anything aside from the WSJ.  I don’t see everything.  That is why I am asking my clever readers to answer the question that the reporter asked me — what significant economic stories aren’t being told?  These can be small issues as well as big issues.  Please let me know in the comments below.  Thanks.

Since the first time I read him, I have been a fan of James Grant.  He helped to sharpen my focus on how money and credit work in the long run, and how they affect the economy as a whole.  Reading one of his early books, Minding Mr. Market: Ten Years on Wall Street With Grant’s Interest Rate Observer, I gained perspective on the increasingly complex financial world that we were moving into.

But not all have shared the opinion of Mr. Grant’s wisdom.  When I worked for Provident Mutual, the Chief Portfolio Manager (at that time new to me, but eventually a dear colleague) said to me, “feel free to borrow any of the publications we receive.”  For a guy who likes to read, and learn about investments, I was jazzed. But, when I came back and asked whether we subscribed to Grant’s Interest Rate Observer, I got the look that said, “You poor fool; what next, conspiracy theories?” while she said, “Uh, noooo. We don’t have any interest in that.”

Now the next two firms I worked for did subscribe, and I enjoyed reading it from 1998 to 2007. But now the question: why buy a book that repeats articles written over the last fifteen years?

I once reviewed the book Just What I Said: Bloomberg Economics Columnist Takes on Bonds, Banks, Budgets, and Bubbles, by another acquaintance of mine, the equally bright (compared to James Grant) Caroline Baum.  This book followed the same format, reprinting the best of old columns, with modest commentary.  In my review, I cited Grant’s earlier book as a comparison, Minding Mr. Market.

As an investor, why read books that will not give an immediate idea of where to invest now?  Isn’t that a waste of time? That depends.  Are we looking to become discoverers of investment/economic ideas, or recipients of those ideas?  Books like those of Grant and Baum will help you learn to think, which is more valuable than a hot tip.

Here are topics that the book will help one to understand:

• How does monetary policy affect the financial economy?
• Why throwing liquidity at every financial crisis eventually creates a bigger crisis.
• Why do value (and other) investors need to be extra careful when investing in leveraged firms?
• What is risk?  Variation of total return or likelihood of loss and its severity?
• Why financial systems eventually fail at compounding returns at rates of growth significantly above the growth rate of GDP.
• Why great technologies may make lousy investments.
• Why does neoclassical economics fail us when trying to understand the financial economy?
• How does one recognize a speculative mania?
• And more…

The largest criticism that can be leveled at James Grant was that he saw that he would happen in this crisis far sooner than most others.  Being too early means you eventually get disregarded.  The error that the “earlies” made, and I knew quite a few of them, was not recognizing how much debt could be crammed into the financial economy in order to juice returns on fixed income assets with yields lower than likely default losses.  That’s a mouthful, but the financial economy had not enough good loans to make relative to the amount of loans needed to maintain the earnings growth expectations of the shareholders of financial companies. Thus, the credit bubble, facilitated by the Fed and the banking regulators.  You can read all about it in its many facets in James Grant’s book.

You can buy the book here: Mr. Market Miscalculates: The Bubble Years and Beyond.

Who would benefit from the book?

• Those that have assumed that neoclassical economics adequately explains the way our economy works.
• Those that want to understand how monetary policy really works, or doesn’t.
• Those that want to learn about equity or fixed income value investing from a quirky but accurate viewpoint.
• Those that want to be entertained by intelligent commentary that proved right in the past.

As with other James Grant books, this does not so much deal with current problems, as much as educate us on how to view the problems that face us, through the prism of how past problems developed.

Full disclosure: If you buy anything through the links to Amazon at my blog, I get a small commission,  but your costs don’t go up.   Also, thanks to Axios Press for the free review copy.  I read the whole thing, and enjoyed it all.

I lost an 800-word post last night, and WordPress did not keep a backup as it usually does.  Occasionally, I have also rescued posts by grabbing the post from the RSS feed, but the RSS feed was a blank as well.  So, no post from last night.  If it’s any consolation, a large part of the post dealt with the rating agencies, and my views are well-known there — most of the so-called solutions fail to serve the market as intended, because:

• ratings are needed for regulatory capital levels
• there is no concentrated interest to pay for ratings aside from the issuer
• sophisticated investors do their own analyses and ignore ratings
• creation of a public rating agency will suffer the same fate as the the NAIC SVO — if one thinks the analysts were weak at S&P, Moody’s, and Fitch, they were weaker at the NAIC SVO.
• regulators were asking the impossible of the rating agencies in asking them to rate immature securities that never been through a “bust” in the credit cycle.
• At the bust in the credit cycle, there is always some embarrassing error that causes the rating agencies to whipsaw.  It may be CMBS today; it was ratings triggers and covenants in 2002.
• It is rough for anyone relying on ratings during the bust of the cycle, because the philosophy shifts from “ratings are made over a full credit cycle” to “ratings should last until lunchtime, maybe, uh, look the stock price is down 5%, post a downgrade.”

That’s why I think that most of the solutions will fail.  The present system has its problems, but the problems are well-known and sophisticated investors know how to deal with them.  New systems will have new problems that we don’t immediately know how to deal with, particularly if they don’t reflect the realities that I listed above.

Okay, there’s one-third of the post back, but I can’t remember the rest.  I delete bookmarks after I do links, and Firefox does not send them to the recycle bin; they just disappear.  Maybe I should do my posts in a word processor, and then post them at the end.  Trouble is, when I do that, the formatting often doesn’t work out right.

Odd Question

Enough of my troubles.  I do have one odd question for my readers before I close off here.  Does anyone know of any financial institution actively lending to churches today?  My congregation is in the midst of a building project.  10,000 minds are better than one, and I hope one of you has some knowledge here that  I don’t.