Bonds – Page 111 – The Aleph Blog

What the Treasury Yield Curve is Telling Us About Corporate Bond Yields

Posted on 31 December 2007 by David Merkel

I learned from a dear friend of mine who manages high yield at Dwight Asset Management (one of the largest fixed income management shops that you never heard of), that with high yield bonds, spreads over Treasuries aren’t the most relevant measure for riskiness of the bonds.? Because they are more equity-like, high yield bonds have intrinsic risk that is independent of the level of yields in high quality bonds, the leading example of which are Treasury bonds.

In general, Treasury bonds can be thought of as a default-free debt claim (not perfectly true, but people think so), while other bonds must carry a margin for default losses.? As one moves down the credit spectrum, the riskiest corporate bonds act like equities, largely because as a company nears default, the equity of the firm is worthless, and true control of the firm is found in some part of the debt structure.
Spread curves of high yield bonds tend to invert when the Treasury yield curve is steeply sloped. ? The slope of the Treasury curve for that effect to be active now, particularly since high yield spreads have widened out from earlier in 2007.? The effect can be seen though, in higher quality investment grade bonds.? Given the lower spreads over Treasury yields on investment grade debt, the relative uncertainty in the present economic environment, and the lack of liquidity in the short end of the yield curve, it’s no surprise to find the spread curve inverted on Agencies, and flattish, but still positively sloped for single-A and BBB corporates.

What this means is that there are intrinsic levels of risk affecting the yields on high quality corporate debt, lessening the positive slope of their spread curves, or with agencies inverting the spread curves.? As the Treasury curve gets wider in 2008, those corporate? spread curves should flatten, and then invert, unless more macroeconomic volatility leads to still wider credit spreads, or a rise in short term inflation expectations causes the yield curve to stop widening.

Another way to say it is that if the short end of the Treasury yield curve falls dramatically, don’t expect the yields corporate debt to follow suit to anywhere near the same degree.

The Beauty of Broken Moats

Posted on 28 December 200728 December 2007 by David Merkel

When I wrote this post on Berkshire Hathaway, the main point I was going for was that the price of Berky was not unreasonable if one attributed value to what Berky could do in a crisis. When I trotted out the Ambac scenario, the idea was to illustrate how Buffett could if he wanted to, take advantage of a situation where values are depressed because the moats of competitors have been broken. (Think of what he did in manufactured housing finance after all the competitors were nearly destroyed. He bought the one healthy remaining company inexpensively.)

Now, had I been more thorough, I also would have pointed to pieces referencing Buffett and his experience with Gen Re Financial Products. The thing is, Buffett doesn’t like to be an external money manager or lender (for the most part), and
does not like structured finance exposure (even in its infancy, a la Salomon Brothers), he does recognize where there can be a clean, core business with defensible boundaries (a moat), where he can earn above average returns over time — insuring municipal bonds.

One key decision that any businessman must come to when entering a new field is build versus buy. Buy can be more attractive when there might be synergies between the acquirer and the target, or if the purchase price is sufficiently low. Build can be more attractive when the necessity of having something new that is unaffiliated with the old order is more attractive (no legacy liabilities), and where your competitors are viewed as being compromised, whether in balance sheet terms, or ethically. For the latter, think of the revenue lost by major insurance brokers after the Spitzer investigations. New players ate into the business models by avoiding conflicts of interest.

So, the announcement of Berkshire Hathaway Assurance Corp [BHAC] is no surprise here. Warren sees an opportunity, and he will pursue it.

Now here are three weaknesses of doing it this way. Buffett is not going to be the low cost provider, in a business where basis points matter as to who gets the business, and who does not. This strategy implies that he suspects that the major bond insurers have problems more severe than have been discounted by the equity and debt markets, and that their AAA bond ratings will remain under threat for some time. Second, it assumes that the managements of his competitors won’t take some action that significantly dilutes their equity in order to retain the solvency of their franchises, benefitting their own bondholders, those guaranteed by their firms, and management themselves (assuming they aren’t ousted). So far, the infusions to the financial guarantors have been significant, but not significant enough to remove doubt. The purpose of a AAA rating is that it is beyond doubt.

Third, a new startup will have higher fixed costs to amortize over the new business written. Mr. Buffett wants to charge more. Well, he will need to charge more, though perhaps that disadvantage is minimized because his competition faces higher costs in a different way from financial stress:

Distraction of management over structured finance exposure
Distraction with the rating agencies
Distraction over shoring up the capital structure
A much higher cost of capital than was previously available
Shareholder lawsuits (coming)

But, if I were in the seat of the competitors, I would tell my municipal divisions to ignore the problems of the company as a whole, and keep writing good business at pricing levels below that of BHAC. That will contribute to the value of the firm, and, the ratings agencies know that the marginal amount of capital needed to write that business against a mature block is almost zero. So keep writing, and protect the franchise.

Finally, it looks like this subsidiary is separately capitalized, and not guaranteed by Berky. It likely gets a AAA on its own, with only implicit support from the holding company. This gives Buffett the option to write a lot of business by providing more capital as needed, preserving flexibility at the holding company, while limiting downside if that subsidiary should ever run into trouble (very unlikely, given their business plan).Tickers mentioned: BRK/A, BRK/B, ABK

The Financing of Last Resort

Posted on 27 December 2007 by David Merkel

In 2002, we used to comment at the office that unless a company was dead, it could always get financing through a convertible bond offering.? The more volatile the situation (up to a point), the more the conversion option is worth, which can significantly reduce the effect of higher credit spreads, at a cost of possible dilution.

So, with the difficulties in getting financing at present, is it any surprise that we are having record issuance of convertible bonds?? I expect to see more of it, particularly for areas involved with housing, commerical real estate, mortgage finance, financial guarantee, and the investment banks.? High volatility and a need for financing begets convertible bond issuance.? That’s where we are now.

Depression, Stagflation, and Confusion

Posted on 26 December 2007 by David Merkel

I’m not sure what to title this piece as I begin writing, because my views are a little fuzzy, and by writing about them, I hope to sharpen them.? That’s not true of me most of the time, but it is true of me now.

Let’s start with a good article from Dr. Jeff.? It’s a good article because it is well-thought out, and pokes at an insipid phrase “behind the curve.”? In one sense, I don’t have an opinion on whether the FOMC is behind the curve or not.? My opinions have been:

The Fed should not try to reflate dud assets, and the loans behind them, because it won’t work.
The Fed will lower Fed funds rates by more than they want to because they are committed to reflating dud assets, and the loans behind them.
The Fed is letting the banks do the heavy lifting on the extension of credit, because they view their credit extension actions as temporary, and thus they don’t do any permanent injections of liquidity.? (There are some hints that the banks may be beginning to pull back, but the recent reduction in the TED spread augurs against that.)
Instead, they try novel solutions such as the TAF.? They will provide an amount of temporary liquidity indefinitely for a larger array of collateral types, such as would be acceptable at the discount window.
We will get additional consumer price inflation from this.
We will continue to see additional asset deflation because of the overhang of vacant homes; the market has not cleared yet.? Commercial real estate is next.? Consider this fine post from the excellent blog Calculated Risk.
The Fed will eventually have to choose whether it is going to reflate assets, or control price inflation.? Given Dr. Bernanke’s previous statements on the matter, wrongly ascribing to him the name “Helicopter Ben,” he is determined not to have another Depression occur on his watch.? I think that is his most strongly held belief, and if he feels there is a modest risk of a Depression, he will keep policy loose.
None of this means that you should exit the equity markets; stick to a normal asset allocation policy.? Go light on financials, and keep your bonds short.? Underweight the US dollar.
I have not argued for a recession yet, at least if one accepts the measurement of inflation that the government uses.

Now, there continue to be bad portents in many short-term lending markets.? Take for example, this article on the BlackRock Cash Strategies Fund.? In a situation where some money market funds and short-term income funds are under stress, the FOMC is unlikely to stop loosening over the intermediate term.

Clearly there are bad debts to be worked through, and the only way that they get worked out is through equity injections.? Think of the bailing out of money market funds and SIVs (not the Super-SIV, which I said was unlikely to work), or the Sovereign Wealth Fund investments in some of the investment banks.

Now, one of my readers asked me to opine on this article by Peter Schiff, and this response from Michael Shedlock.? Look, I’m not calling for a depression, or stagflation, at least not yet.? At RealMoney, my favored term was “stagflation-lite.”? Some modest rise in inflation while the economy grows slowly in real terms (as the government measures it).?? A few comments on the two articles:

?First, international capital flows from recycling the current account deficit provide more stimulus to the US economy than the FOMC at present.? Will they stop one day?? Only when the US dollar is considerably lower than now, and they buy more US goods and services than we buy from them.
Second, the Federal Reserve can gain more powers than it currently has.? If this situation gets worse, I would expect Congress to modify their charter to allow them to buy assets that it previously could not buy, to end the asset deflation directly, at a cost of more price inflation, and spreading the lending losses to all who hold longer-term dollar-denominated assets.? If not Congress, there are executive orders in the Federal Register already for these actions.
Third, in a crisis, the FOMC would happily run with a wide yield curve — they will put depositary institution solvency ahead of purchasing power.
Fourth, the Fed can force credit into the economy, but not at prices they would like, or on terms that are attractive.? In a crisis, though, anything could happen.
Fifth, I don’t see a crisis happening.? It is in the interests of foreign creditors to stabilize the US, until they come to view the US as a “lost cause.”? Not impossible, but unlikely.? The flexible nature of the US economy, with its relatively high levels of freedom, make the US a destination for capital and trade.? The world needs the flexible US, less than it used to, but it still needs the US.

One final note off of the excellent blog Naked Capitalism.? They note, as I have, that the FOMC hasn’t been increasing the monetary base.? From RealMoney:

		David Merkel
		The Fed Has Shifted the Way it Conducts Monetary Policy
		12/21/2007 11:56 AM EST

Good post over at Barry’s blog on monetary policy. Understanding monetary policy isn’t hard, but you have to look at the full picture, including the presently missing M3. I have a proxy for M3 — it’s total bank liabilities from the H8 report –> ALNLTLLB Index for those with a BB terminal. It’s a very good proxy, though not perfect. Over the last years, it has run at an annualized 9.4%. MZM has grown around 12.8%. The monetary base has grown around 3%, and oddly, has not been spiking up the way it usually does in December to facilitate year-end retail.

The Fed is getting weird. At least, weird compared to the Greenspan era. They seem to be using regulatory policy to allow the banks to extend more credit, while leaving the monetary base almost unchanged. This is not a stable policy idea, particularly in an environment where banks are getting more skittish about lending to each other, and to consumers/homebuyers.

This has the odor of trying to be too clever, by not making permanent changes, trying to manage the credit troubles through temporary moves, and not permanently shifting policy through adding to the monetary base, which would encourage more price inflation. But more credit through the banks will encourage price inflation as well, and looking at the TED spread, it seems the markets have given only modest credit to the Fed’s temporary credit injections.

I am dubious that this will work, but I give the Fed credit for original thinking. Greenspan would have flooded us with liquidity by now. We haven’t had a permanent injection of liquidity in seven months, and that is a long time in historical terms. Even in tightening cycles we tend to get permanent injections more frequently than that.

Anyway, this is just another facet of how I view the Fed. Watch what they do, not what they say.

Position: noneThe Naked Capitalism piece extensively quotes John Hussman.? I think John’s observations are correct here, but I would not be so bearish on the stock market.

After all of this disjointed writing, where does that leave me? Puzzled, and mostly neutral on my equity allocations.? My observations could be wrong here.? I’m skeptical of the efficacy of Fed actions, and of the willingness of foreigners to extend credit indefinitely, but they are trying hard? to reflate dud assets (and the loans behind them) now.? That excess liquidity will find its way to healthy assets, and I think I own some of those.

In Defense of the Rating Agencies — II

Posted on 25 December 2007 by David Merkel

It is easy to take pot shots at the rating agencies.? Barron’s did it this weekend.? What is hard is coming up with a systematic proposal for reform that will do more good than harm, as I pointed out on my last piece on this topic.?? Ordinarily, I like the opinions of Jonathan Laing, but not this time.? In my opinion, Barron’s failed the test of coming up with a systematic solution that recognizes market realities.

From my last article, I will repeat the market realities:

There is no way to get investors to pay full freight for the sum total of what the ratings agencies do.
Regulators need the ratings agencies, or they would need to create an internal ratings agency themselves.? The NAIC SVO is an example of the latter, and proves why the regulators need the ratings agencies.? The NAIC SVO was never very good, and almost anyone that worked with them learned that very quickly.
New securities are always being created, and someone has to try to put them on a level playing field for creditworthiness purposes.
Somewhere in the financial system there has to be room for parties that offer opinions who don?t have to worry about being sued if their opinions are wrong.
Ratings can be short-term, or long-term, but not both.? The worst of all worlds is when the ratings agencies shift time horizons.

From the Barron’s article:

MAKE NO MISTAKE: THE LATEST debacle dwarfs the rating contretemps earlier in the millennium. In all, $650 billion of 2006 subprime mortgages were securitized in the past year. Moody’s officials point out that only 15% or so of the dollar amount of that rated debt — counting all tranches — has gone bad, requiring downgrades. But the ripple effect of those downgrades has wreaked havoc throughout the global credit markets.

Having been a mortgage and corporate bond manager back then, I’m not sure I agree.? The ABS, CMBS and whole loan RMBS markets are about the same size as the corporate bond markets.? The degree of stress on the system was higher back in 2002.? To give one bit of proof, look at the VIX, which is highly correlated with corporate credit spreads. ? Why was the VIX in the 40s then, and around 19 now?? What’s worse, the banks were in good shape back then, and there are more questions about the banks now.? Most of the current problems exist in exotic parts of the bond market; average retail investors don’t have much exposure to the problems there, but only less-experienced institutional investors.

The Barron’s article suggests five areas for reform:

1. The SEC must encourage more competition by approving more rating agencies.? Rating fees would drop and diversity of opinion would lead to more accurate and timely ratings.

I’m all in favor of more rating agencies.? I don’t think rating fees would drop, though.? Remember, ratings are needed for regulatory purposes.? Will Basel II, and NAIC and other regulators sign off on new regulators?? I think that process will be slow.? Diversity of opinion is tough, unless a ratings agency is willing to be paid only by buyers, and that model is untested at best.

Regarding John Coffee, Jr. in the article:

Industry expert and Columbia Law School professor John Coffee Jr. has suggested an elegant solution to bolster rating-agency quality control, both to Barron’s and in recent congressional testimony. He wants the SEC to require raters that have been granted official status to disclose in a central database the historical default rates of all classes of financial products that they’ve rated. Regulators and investors would thus have an effective means of assessing the raters’ rigor.

Furthermore, Coffee argues, the SEC should discipline miscreant agencies by temporarily yanking their registration in areas where their ratings have been notably wrong.

And after that,

2. All rating agencies should be required to disclose default rates on all classes of securities that they’ve rated.? Agencies with bad results should have their SEC approvals yanked temporarily.

Disclosing default rates is already done, and sophisticated investors know these facts; this is a non-issue.? Yanking the registration is killing a fly with a sledgehammer.? It would hurt the regulators more than anyone else.? Further, what does he mean by “miscreant” or “notably wrong?”? The rating agencies are like the market.? The market as a whole gets it wrong every now and then.? Think of tech stocks in early 2000, or housing stocks in early 2006.? To insist on perfection of rating agencies is to say that there will be no rating agencies.

From the article:? One investor-subscription-based rating service, Egan-Jones, has been trying fruitlessly to win official agency status for more than a decade. In that time, the Philadelphia concern has been miles ahead of the established agencies in downgrading the likes of Enron and WorldCom and more recently the mortgage and bond insurers, mortgage originators and investment banks caught up in the subprime-mortgage crisis.

“It’s tremendously liberating to just work for investors and not worry about angering the issuer community,” partner Sean Egan tells Barron’s. “Not only have we been able to give investors earlier warnings of corporate frauds and other negative credit situations, but in many cases we’ve led the industry on upward credit revisions of worthy recipients.”

I like Egan-Jones, so it is with pleasure that I mention that they have achieved NRSRO [nationally recognized statistical rating organization] status.? That said, their model that I am most fmailiar with only applies to corporate credit.? Could they have prevented the difficulties in structured credit that are the main problem now?

3. Agencies must be encouraged to make their money from investor subscriptions rather than fees from issuers, to ensure more impartial ratings.

If this were realistic, it would have happened already.? The rating agencies would like nothing more than to receive fees from only buyers, but that would not provide enough to take care of the rating agencies, and provide for a profit.? They don’t want the conflicts of interest either, but if it is conflicts of interest versus death, you know what they will choose.

4. Agencies no longer should have exclusive access to nonpublic information, to even out the playing field.

Sounds good, but the regulators want the rating agencies to have the nonpublic information.? They don’t want a level paying field.? As regulators, if they are ceding their territory to the rating agencies, then they want he rating agencies to be able to demand what they could demand.? Regulators by nature have access to nonpublic information.

5. Agencies must say “no” to Wall Street when asked to rate exotic types of debt instruments that lack historically relevant performance data.

Were GICs [Guaranteed Investment Contracts] exotic back in 1989-1992?? No.? Did the rating agencies get it wrong?? Yes.? History would have said that GICs almost never default.? As I have stated before, a market must fail before it matures.? After failure, a market takes account of differences previously unnoticed, and begins to prospectively price for risk.

Look, the regulators can bar asset classes.? Let them do that.? The rating agencies offer opinions.? If the regulators don’t trust the ratings, let them bar those assets from investment.? The ratings agencies aren’t regulators, and they should not be put into that role, because they are profit-seeking companies. Don’t blame the rating agencies for the failure of the regulators, because they ceded their statutory role to the rating agencies.? But if the regulators bar assets, expect the banks to complain, because they can’t earn the money that they want to, while other institutions take advantage of the market inefficiency

Look, sophisticated investors don’t rely on the rating agencies.? They employ analysts that do independent due diligence.? Only rubes rely on ratings, and sophisticated investors did not trust the rating agencies on subprime.? My proof?? Look how little exposure the insurance industry had to subprime mortgages.? Teensy at best.

There will always be differences in loss exposure between structured securities and corporate bonds at equivalent ratings.? Structured securities by their nature will have tiny losses for long periods of time, and then large losses, relative to corporate bonds.? The credit cyclicality is even bigger than that of corporate bonds.

Let’s get one thing straight here.? The rating agencies will make mistakes.? They will likely make mistakes on a correlated basis, because they compete against one another, and buyers won’t pay enough to support the ratings.

Barron’s can argue for change, but unless buyers would be willing to pay for a new system, it is all wishful thinking.? Watch the behavior of the users of credit ratings.? If they are unwilling to pay up, the current system will persist, regardless of what naysayers might argue.

The Virtue of Lunch with Friends

Posted on 21 December 200721 December 2007 by David Merkel

I really enjoyed being an investment grade corporate bond manager.? I enjoyed interacting with credit analysts and sales coverages, and the hurly-burly of price discovery in markets that were thinner than optimal.? My credit analysts were professionals, and I never went against them; at most, I would explain to them why market technicals favored a delay in the action they proposed.? But I would never permanently disagree.? What they wanted to buy I would buy, and sell I would sell, eventually.? The level of communication evoked greater effort from them.? Machiavelli was wrong.? It is better to be loved than feared, at least in the long run.? I have gotten more out of associates and brokers by being altruistic than through transactional constraint.? People will give far more to someone that cares for them, than someone that threatens them, in the long run.? (The short run is another matter…)

Now, this is not my character.? I tend to be shy, and constant interaction pushes me out of my comfort zone.? But when others are depending on me, I push myself harder, and do what needs to be done for the good of others.? I can’t let down those who rely on me.

Yesterday I had lunch with three friends and a new friend.? Two were sales coverage, and two from the firm that I used to work for.? It was fascinating to hear the tales of woe in the structured securities markets (worse than I expected, and I am cynical).? It was also fascinating to consider why investors for a life insurance company, which has a liability structure that would allow them to buy and hold temporarily distressed assets, does not do so. ? A lot depends on how short-term the investment orientation of the client is, and this client is definitely short-term oriented.

I talked about my new CDO model, and about what I write about for all of you who read this blog.? The summary of our discussions is that it is a tough environment out there, and one that is particularly not kind to complex securities.? After the lunch, which the sales coverages generously paid for (at present, I don’t know what I can do for them), I went back to the office of my old friends, and reacquainted myself with one of the best consumer/retailing credit analysts period, who is a very nice woman.? I also talked with my former secretary, who is sweet, and was always a real help to me and all of the staff.

Friends.? I am richer for them.? I am richer for being one.? Beyond that, it is excellent business to live life in such a way that your business dealings leave people happy for having dealt with you.? I am truly blessed for all the business friends that I have gained.

Options as an Asset Class

Posted on 20 December 200720 December 2007 by David Merkel

Well, my CDO model is complete for a first pass. There is still more work to do. Imagine buying a security that you thought would mature in ten years, but two years into the deal, you find that the security will mature in twenty years from then, though paying off principal in full, most likely. Worse, the market has panicked, and the security you bought with a 6.5% yield is now getting discounted at a mid-teens interest rate. Cut to the chase: that is priced at 40 cents per dollar of par. Such is the mess in some CDOs today.

Onto the topic of the night. There have been a number of articles on volatility as an asset class, but I am going to take a different approach to the topic. Bond managers experience volatility up close and personal. Why?

Corporate bonds are short an option to default, where the equity owners give the company to the bondholders.
Mortgage bonds are short a refinancing option. Volatile mortgage rates generally harm the value of mortgage bonds.
Even nominal government bonds are short an inflation option, should the government devalue the currency. (Or, for inflation-adjusted notes, fuddle with the inflation calculation.)

Why would a bond investor accept being short options? Because he is a glutton for punishment? Rather, because he gets more yield in the short run, at the cost of potential capital losses in the longer-term.

Most of the “volatility as an asset class” discussion avoids bonds. Instead, it focuses on variance swaps and equity options. Well, at least there you might get paid for writing the options. Bond investors might do better to invest in government securities, and make the spread by writing out-of-the-money options on a stock, rather than buying the corporate debt.

I’m not sure how well futures trading on the VIX works. If I were structuring volatility futures contracts, I would create a genuine deliverable, where one could take delivery of a three month at-the-money straddle. Delta-neutral — all that gets priced is volatility.

Here’s my main point. Volatility is not an asset class. Options are an asset class. Or, options expand other asset classes, whether bonds, equities, or commodities. Whether through options or variance swaps, if volatility is sold, the reward is more income in the short run, at the cost of possible capital losses in asset classes one is forced to buy or sell at disadvantageous prices later.

Over the long term, in equities, unlike bonds, being short options has been a winning strategy, if consistently applied. (And one might need an iron gut to do it.) But when many apply this strategy, the excess returns will dry up, at least until discouragement sets in, and the trade is abandoned. For an example, this has happened in risk arbitrage, where investors are short an option for the acquirer to walk away. For a long time, it was a winning strategy, until too much money pursued it. At the peak you could make more money investing in Single-A bonds. Eventually, breakups occurred, and arbs lost money. Money left risk arbitrage, and now returns are more reasonable for the arbs that remain.

Most simple arbitrages are short an option somewhere. That’s the risk of the arbitrage. With equities, being perpetually short options is a difficult emotional place to be. You can comfort yourself with the statistics of how well it has worked in the past, but there will always be the nagging doubt that this time it will be different. And, if enough players take that side of the trade, it will be different.

Like any other strategy, options as an asset class has merit, but there is a limit to the size of the trade that can be done in aggregate. Once enough players pursue the idea, the excess returns will vanish, leaving behind a market with more actual volatility for the rest of us to navigate.

Crunchy Credit

Posted on 19 December 2007 by David Merkel

My head feels like mush.? I have been struggling over creating a CDO pricing model with the following features:

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

Makes my head spin, but at least the credit model is complete.? The rest of the model can be done tomorrow.

Ugh, so what was I going to talk about?? Oh yeah, the short term lending markets.? So the ECB makes a splash by showering temporary liquidity on the short end of the market.? That will reduce Euribor-based rates, but not US dollar-LIBOR based rates.? Check with Dr. Jeff for more on that.? Now, Dr. Jeff and I might not agree on the significance of this move, because I discount temporary injections of liquidity.? What will happen to liquidity conditions when the temporary injection goes away?? My view is that they will go back to how they were before the temporary injection.? The only way that would not be so is if the temporary injection somehow changes the willingness of parties to take risk, and I think most large investors can see through the temporary nature of the injection.? The ECB can keep short-term Euribor down for a while, but unless they make some of the injection permanent, conditions will revert.? People and institutions can’t be fooled that easily.

Topic two: the WSJ article on the credit crunch.? The author posits two disaster scenarios:

A financial guarantor going down, or
Many money market? funds? “breaking the buck.”

Here’s my view:? The financial guarantors have been too profitable for too long.? There will be parties wiling to recapitalize them, though not necessarily at values that make current equityholders happy.? They are not going broke; the major firms will be recapitalized.

Regarding the second fear, a few money market funds will break, but the wide majority of money market funds won’t.? Most short term debt managers are highly conservative, and don’t take inordinate risks.? To do so would threaten their franchise, which would be stupid.

Things are not good, don’t get me wrong, but it would be very difficult to destroy most of the investment markets on the short end of the yield curve.? Away from that, the actions of the ECB will only have modest impacts on USD-LIBOR.

Not Dissing Warren the Wonderful

Posted on 15 December 200716 December 2007 by David Merkel

Look, Barron’s can say what they want about Warren Buffett, and his company Berkshire Hathaway, but I have just one thing to say here: Berky is the ultimate anti-volatility asset.? When the hurricanes hit in 2005, I told my boss that the easy money, low-risk, low-reward play was to buy Berky.? My boss liked to take risks, so that idea was shelved. Too bad, it was easy money.? After all, who could write retrocessional coverage (Reinsuring reinsurers) except Berky?? Every other writer was broke or disabled…

Now we have a different type of hurricane.? Prior bad lending practices are destroying lending/insurance capacity in mortgages and elsewhere.? This could be an investment opportunity for Berky.? Thing is, outside of the Sovereign Wealth Funds, Berky has one of the biggest cash hoards around, and during times of panic, where assets get sold at a discount, cash is valuable.

So during times of panic, we should expect Berky’s valuation to expand.? This is one of those times.

One final note: suppose Buffett, much as he doesn’t want to be an asset manager, decides to take Ambac private.? How would he do it?? Think of what he has done in other cases: he creates a nonguaranteed downstream holding company, capitalizes it to a level necessary for a AAA rating, and buys Ambac.? Warren never guarantees the debt of subsidiaries that he buys.? Why should he reward bondholders of his target companies?? Isn’t it enough that he pays the debts?

Well, yes, sort of.? Warren has never sent a subsidiary into insolvency, but he clearly reserves the right to do that.? Bondholders have given him that right, and I would not blame him for using that right under extreme circumstances.

That said, Berky’s excess cash offers opportunities at present, because Buffett can use that cash to snap up distressed assets when he chooses to do so, and at minimal risk to Berky if an acquisition fails.

Tickers mentioned: BRK/A, BRK/B, ABK

Personal Finance, Part 5.1 ? Inflation and Deflation 2

Posted on 7 December 2007 by David Merkel

I wish that I had more time to respond to readers both in the comments and e-mail.? Unfortunately, I am having to spend more time working as I am in transition as far as my work goes.? I’ll try to catch up over the next week or so, but I am behind by about 50 messages, and I hate to compromise message quality just to clear things out.

That said, my inflation/deflation piece yesterday attracted two comments worthy of response.? The first was from James Dailey, who I would recommend that you read whenever he comments here.? We may not always agree, but what he writes is well thought out.? He thinks I attribute too much power to the Fed.? He has a point.? From past writings, I have suggested that the Fed is not all-powerful.? What I would point out here is that the Fed controls more than just the monetary base.? They control (in principle) the terms of lending that the banks employ.? With a little coordination with the other regulators, the Fed could restrict non-bank lenders by raising the capital requirements that banks (and other regulated institutions) must maintain in lending to non-bank lenders.? So, if credit is outpacing the growth in the monetary base, it is at least partially because the Fed chooses to allow it.? Volcker reined in the credit card companies in the early 80s, which was not a normal policy for the Fed; it had a drastic impact on the economy, but inflation slowed considerably.? (Causation?? I’m not sure.? Fed funds were really high then also.)

The other comment came from Bill Rempel.? He objected more to my terminology than my content, though he disliked my comment that “Inflation is predominantly a monetary phenomenon.”? I think we are largely on the same page, though.? I know the more common phraseology here, “Inflation is purely a monetary phenomenon,” and I agree with it, but with the following provisos:

If we are talking about goods, services, and assets as a group, or,
If the period of time is sufficiently long, like a century or so, or,
If we are talking about monetary inflation.? (Who disagrees with tautologies? 🙂 Not me.)

Part of my difficulty here, is that when we talk about money, we are talking about something that lies on the spectrum? between currency and credit.? By currency I am talking about whatever physical medium can be commonly deployed to effectuate transactions.? By credit, anything where the eventual exchange of currency is significantly delayed, and perhaps with some doubt of collection.? Because of the existence of credit, over shorter periods, the link between monetary inflation and good price inflation is more tenuous, which leads people to doubt the concept that “Inflation is purely a monetary phenomenon.”? My post, rather than weakening that concept, strengthens it, because it broadens the concept of inflation, so that the pernicious effects of monetary inflation can be more clearly seen.? I wrote what I wrote to distinguish between monetary, goods and asset inflation.? I think it is useful to make these distinctions, because most people when they hear the word “inflation” think only of goods price inflation, and not of monetary or asset inflation.

Now, onto today’s topic: how to protect ourselves from inflation and deflation.? With goods price deflation (should we ever see that under the Fed), the answers are simple: avoid debt, lend to stable debtors, and make sure you are economically necessary to the part of the economy that you serve.? You want to make sure that you have enough net cash flow when net cash flow is scarce.? You can use that cash flow to buy distressed assets on the cheap.? Economically necessary and low debt applies to the stocks you own as well.

On goods price inflation, take a step back and ask what is truly in short supply, and buy/supply some of that.? It could be commodities, agricultural products, or gold. ? As a last resort you could buy some TIPS, or just stay in a money market fund.? You won’t get rich that way, but you might preserve purchasing power.? In stocks, look for those that can pass through price inflation to their customers.? In bonds, stay short, unless they are inflation-protected.

This is not obscure advice, but there is an art to applying it.? There comes a point in every theme where prices of the most desirable assets discount or even over-discount the scenario.? Safe assets get overbought in a deflation toward the end of that phase of the cycle.? Same thing for inflation-sensitive assets during an inflation.? As for me at present, you can see my portfolio over at Stockpickr; at present, I split the difference, though my results over the last five months have been less than stellar.? I have companies with relatively strong balance sheets, and companies with a decent amount of economic sensitivity, whether to price inflation or price inflation-adjusted economic activity.

I don’t see the global economy heading into recession; I do see price inflation ticking up globally, and also asset inflation in some countries (China being a leading example). ? But we have a debt overhang in much of the developed world, so we have to be careful about balance sheets.

I may have it wrong at this point.? My equity performance over the last seven-plus years has been good, but the last five months have given me reason for pause.? Well, things were far worse for me 6/2002-9/2002; I saw that one through.? I should survive this one too, DV.