Ethics – Page 19 – The Aleph Blog

If Hedge Funds, Then Investment Banks, Redux

Posted on 14 December 200722 June 2017 by David Merkel

Every now and then, you get a reader response that deserves to be published.? Such was this response to my piece, “If Hedge Funds, Then Investment Banks.”? I have redacted it to hide his identity.

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I read your latest blog entry with interest because I have worked in the derivatives business and as a part of that helped to set up General Re’s financial subsidiary in 19XX – General Re Financial Products (GRFP). I was one of XX people that started that business from the ground up. I left shortly XXX Buffett arrived on the scene but I still knew a large number of people that remained and I have very good information about what happened there. I may be a bit biased so you should consider where I am coming from as you continue to read.

To be short about it, what happened at GRFP after Buffett took over was a complete mess. I can give you more information on that if you like but I will simply say that what Buffett writes about GRFP, has spin on it. Let me give you a somewhat quick example. Of that $104 million loss he refers to, how much of that could be attributed to salaries and operating expenses? How much of it was due to the forced unwinding of trades on the wrong side of the market? We know that there are high operational costs (these people are paid very well with nice offices, technology, etc.) and that one would expect to pay to get out of these transactions even if they are being marked perfectly correctly. It SHOULD cost money to unwind these trades. So why doesn’t Buffett, who normally gives us so much information, tell us how much of the loss was due to mismarking and how much was due to expected costs? I’ll let you guess at that answer. There’s a lot more to this story but let’s move on…

I am sure you felt safe quoting someone like Buffett – meaning he is likely to get things right almost every time, but even Buffett is not perfect and he has his blind spots. I believe that derivatives may be such a blind spot. I could go into detail about where I see holes in Buffett’s arguments however the bottom line is that I believe the vast majority of transactions done in the derivatives market are plain vanilla transactions that are extremely easy to mark. Did you know that the US Treasury market is now quoted as a spread off of swaps? That is how liquid the plain vanilla instrument is these days. These transactions will certainly not have two traders both booking a profit even though they are on opposite sides of a transaction. Bid/ask spreads in the plain vanilla market are less than 1 basis point per year in yield. I am certain there are exotic transactions that are mismarked for all the reasons that Buffett mentions but how many of these are really out there? My suspicion is that the total number is small enough to not be of any huge concern from a systematic standpoint.

Here is something interesting to consider. Why would the leader of a AAA-rated institution (a financial Fort Knox) that competes in many ways with other large financial institutions wish to lead people to believe that those other institutions may be engaged in a business that is particularly risky?

Just thought I would add my two cents (looks more like 25 cents now).
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For the record, both he and I are admirers of Buffett, but not uncritical admirers.? The initiator of a trade usually has to offer a concession to the party facilitating the trade.? Forced sellers or impatient buyers typically don’t get the best execution.? What my correspondent suggests here is at least part of the total picture in the liquidation of GRFP.? All that said, I still think there are deadweight losses hiding inside that swap books of the major investment banks.

If Hedge Funds, Then Investment Banks

Posted on 10 October 2007 by David Merkel

I’m still flooded by my workload, so just one comment this evening.? The Wall Street Journal posts an article on overly favorable (and smoothed) returns at hedge funds through securities that are mismarked favorably.? It was no surprise to naked capitalism, and no surprise to me either (point 26).? I’ve been writing about this issue off and on for three years now, because economic processes are messy, and tend to generate messy returns, not smooth returns, particularly once the easy arbitrages are glutted with yield-seeking investors.? Also, I know what the temptation is to mismark illiquid bond positions when incentive payments may be riding on the result (which is why we took the marking out of our hands at a prior firm).

Having been an actuary in financial reporting for twelve years, I know what the pressure is when someone above you in the hierarchy asks if your reserve is wrong.? It is rarely asked when the reserves are too low.? Few managements are so farsighted.? It is always asked when income is too low, and adjusting reserves downward is so convenient.? And who will notice?? Few, I’m afraid, but most actuaries I know are highly ethical, and resist these pressures.

My target here not insurance companies, though, but the investment banks.? Actuaries have detailed rules for setting reserves.? We have societies and ethics codes.? Those who work at the investment banks are not typically CFAs, which is more of a buy-side thing, so there is no industrywide ethics code there.? Also, the value setting rules for many investment banking assets and liabilities are far more squishy than for insurance liabilities.? Finally, investment banks frequently hold the same instruments as the hedge funds, and get their pricing marks from the same sets of sources.? I suspect that the positions are similarly mismarked, and they are big enough to hide it, because derivative books are never unwound.

Well, almost never.? Buffett phrased it well in his 2005 Annual Report: (pp. 9-10)

Long ago, Mark Twain said: ?A man who tries to carry a cat home by its tail will learn a lesson that can be learned in no other way.? If Twain were around now, he might try winding up a derivatives business. After a few days, he would opt for cats.

We lost $104 million pre-tax last year in our continuing attempt to exit Gen Re?s derivative operation. Our aggregate losses since we began this endeavor total $404 million.

Originally we had 23,218 contracts outstanding. By the start of 2005 we were down to 2,890. You might expect that our losses would have been stemmed by this point, but the blood has kept flowing. Reducing our inventory to 741 contracts last year cost us the $104 million mentioned above.

Remember that the rationale for establishing this unit in 1990 was Gen Re?s wish to meet the needs of insurance clients. Yet one of the contracts we liquidated in 2005 had a term of 100 years! It?s difficult to imagine what ?need? such a contract could fulfill except, perhaps, the need of a compensation conscious trader to have a long-dated contract on his books. Long contracts, or alternatively those with multiple variables, are the most difficult to mark to market (the standard procedure used in accounting for derivatives) and provide the most opportunity for ?imagination? when traders are estimating their value. Small wonder that traders promote them.

A business in which huge amounts of compensation flow from assumed numbers is obviously fraught with danger. When two traders execute a transaction that has several, sometimes esoteric, variables and a far-off settlement date, their respective firms must subsequently value these contracts whenever they calculate their earnings. A given contract may be valued at one price by Firm A and at another by Firm B.

You can bet that the valuation differences ? and I?m personally familiar with several that were huge ? tend to be tilted in a direction favoring higher earnings at each firm. It?s a strange world in which two parties can carry out a paper transaction that each can promptly report as profitable.

I dwell on our experience in derivatives each year for two reasons. One is personal and unpleasant. The hard fact is that I have cost you a lot of money by not moving immediately to close down Gen Re?s trading operation. Both Charlie and I knew at the time of the Gen Re purchase that it was a problem and told its management that we wanted to exit the business. It was my responsibility to make sure that happened. Rather than address the situation head on, however, I wasted several years while we attempted to sell the operation. That was a doomed endeavor because no realistic solution could have extricated us from the maze of liabilities that was going to exist for decades. Our obligations were
particularly worrisome because their potential to explode could not be measured. Moreover, if severe trouble occurred, we knew it was likely to correlate with problems elsewhere in financial markets.

So I failed in my attempt to exit painlessly, and in the meantime more trades were put on the books. Fault me for dithering. (Charlie calls it thumb-sucking.) When a problem exists, whether in personnel or in business operations, the time to act is now.

The second reason I regularly describe our problems in this area lies in the hope that our experiences may prove instructive for managers, auditors and regulators. In a sense, we are a canary in this business coal mine and should sing a song of warning as we expire. The number and value of derivative contracts outstanding in the world continues to mushroom and is now a multiple of what existed in 1998, the last time that financial chaos erupted.

Our experience should be particularly sobering because we were a better-than-average candidate to exit gracefully. Gen Re was a relatively minor operator in the derivatives field. It has had the good fortune to unwind its supposedly liquid positions in a benign market, all the while free of financial or other pressures that might have forced it to conduct the liquidation in a less-than-efficient manner. Our accounting in the past was conventional and actually thought to be conservative. Additionally, we know of no bad behavior by anyone involved.

It could be a different story for others in the future. Imagine, if you will, one or more firms (troubles often spread) with positions that are many multiples of ours attempting to liquidate in chaotic markets and under extreme, and well-publicized, pressures. This is a scenario to which much attention should be given now rather than after the fact. The time to have considered ? and improved ? the reliability of New Orleans? levees was before Katrina.

When we finally wind up Gen Re Securities, my feelings about its departure will be akin to those expressed in a country song, ?My wife ran away with my best friend, and I sure miss him a lot.?

I could go on about this, but it’s late.? There are other weaknesses in the system as well.? A good rule of thumb is that whenever there is a lack of natural counterparties, there will be pricing difficulties.

Closing comment: When I was at a Stable Value conference in 1994, I ran into some investment bankers and talked to them about this topic.? I asked them how they hedged their synthetic wrap exposures.? They said they didn’t hedge because it was riskless “free money.” I pointed out the scenario under which they could lose money, and asked how their auditor could sign off on the lack of the hedge.? Their comment went like this: “When we find an auditor capable of auditing our derivative books, we hire him and pay him ten times the salary.”

In a world like that, who knows what problems may lurk in the derivative books, because the auditors stand a better chance of figuring out the truth than the ratings agencies and regulators.

Tickers mentioned: BRK/A, BRK/B

Advertising Notes

Posted on 26 September 200722 June 2017 by David Merkel

I’m about to add advertising to my blog, and I’d like to ask a small favor from my readers.? If you happen to see an advertisement that is morally objectionable, please send me an e-mail.? Include the URL of the ad.? Examples would include:

Payday lenders
Gambling
Tarot Reading
Known Investment Scams

There are likely more, but that’s a start.? Google on ads is not “don’t be evil,” but rather, is amoral in their ad filtering, not allowing even for rudimentary category blocking.? One has to block ads URL by URL.? Klunky, if you ask me.

Again, thanks to all my readers for their help in making this a better site.

Private Equity Financing: Thinking Long-Term Versus Short-Term

Posted on 10 September 200711 September 2007 by David Merkel

Early on Monday, Cramer put up a piece called, “KKR: Cut the Hubris, Start the Healing.” Good piece generally, but it got me thinking. One reason I was an effective corporate bond manager was the way that I treated my brokers. I had a few rules:

My brokers must always be paid. Doing me favors is nice, but I want your long term loyalty, and confidentiality.
If a broker makes a mistake in your favor, give him back a portion of the error if he asks (20%-30% of the price difference).
Hold good on my commitments, even if it hurts.
If the broker is way out of the market context, tell him. It earns loyalty.
Use brokers to their highest ability levels. Know who is sharp in a given market, and use them there. Don’t waste their time on names they don’t know.
If their risk control desk is forcing them to kick out a position, try to help them. This is an Androcles and the Lion situation, so be a good Androcles. They will often offer you some good deals for helping them, beyond that, that will help you when you need it.
Don’t take advantage of them in obvious ways. If you must flip newly issued bonds, do it through the syndicate (with a polite explanation that your analyst doesn’t like the deal, or that your risk controls are forcing you), or through a quiet third party.
Be as transparent as possible without giving away the real secrets of what you are doing. You can get better execution if they know you are not acting on private information that they don’t possess.
Be sharp. Show them that they can’t take advantage of you, but don’t be arrogant about it. Let your performance speak for itself.

That was a long digression, but here’s the point: focus on the long term value of the business relationship. Most bond managers and traders are very short term in their orientation, and it keeps the Street wary of them. The Street holds them at arm’s length, and the handshake is not friendship, but a check for weapons up the sleeve, as in the old days.

So what does this have to do with private equity and the banks? The private equity firms that have financing guaranteed by the banks have the banks over a barrel. At the same time, their deals are delayed, because the banks are dragging their feet. The solution isn’t hard, but it means that the private equity firms must give up a little in the short run to get the long run. Give up 20-30% of the loss that the banks are taking in order to soften the blow. Do it in a way that allows the banks to spread the loss, if you are clever enough, by agreeing to covenants, or other non-interest-rate means of improving the position of the banks.
The banks will groan, but they know that this is the best that they will get, and will take the deal. The log jams will begin to break, and the market will return to “normal,” though with more covenants and fewer guarantees on future deals. That is, until the next craze hits.

Therefore, I wasn’t surprised when KKR agreed to a minimum EBITDA covenant (earnings available to pay the creditors). That’s what is needed to allow the banks to “save face,” and do the deal. There are a lot of pending commitments in the loan market, perhaps as high as $540 billion. If you are a major private equity firm, and you have multiple deals being held up, these small compromises will grease the skids for not only today’s deal, but all of the deals in the pipeline. For those few that don’t compromise, yes, the deal will get done eventually, but you will sour relationships on the Street.

Now, the banks may get some help as they seek financing for the deals. This is one place where the vultures are lining up. Private equity, hedge funds, hedge fund-of-funds, and banks are setting up funds to take advantage of the dislocation. This “crisis” will likely resolve more easily than the troubles over in mortgage finance.
In closing, five more random bits on private equity:

When I look at the stock chart of Blackstone, it makes me want to find a black stone and toss it in to a pond to watch it sink. Quite an untimely stock offering.
The rise in financing rates will cost private equity on future deals, and as they try to harvest their existing deals when they come to maturity.
Now, private equity funds with uncommitted capital can benefit by purchasing deals cheaply from firms that are exiting.
Here is an excellent article from Going Private on the concept of liquidity within private equity financing. It’s long but good, and my commentary can’t improve on it, so enjoy it.
Finally, private equity is concerned about financing, but should be concerned the possibility of recession as well. After all, junk bonds and bank debt are very sensitive to slowdowns in economic activity.

As I said to a friend of mine once, it often pays to give up a little to get long term advantages. Private equity needs to show a little mercy here in order to do well in the long run. Investment banks are powerful friends to have, and they remember who has helped them, and who has hurt them.

Tickers mentioned: BX

The Longer View, Part 3

Posted on 3 September 20074 September 2007 by David Merkel

August wasn’t all that bad of a month… so why were investors squealing? The volatility, I guess… since people hurt three times as much from losses as they feel good from gains, I suppose market-neutral high volatility will always leave people with perceived pain.
Need a reason for optimism? Look at the insiders. They see more value at current levels.
Need another good investor to follow? Consider Jean-Marie Eveillard. I’ve only met him once, and I can tell you that if you get the chance to hear him speak, jump at it. He is practically wise at a high level. It is a pity that Bill Miller wasn’t there that day; he could have learned a few things. Value investing involves a margin of safety; ignoring that is a recipe for underperformance.
Call me a skeptic on 10-year P/E ratios. I think it’s more effective to look at a weighted average of past earnings, giving more weight to current earnings, and declining weights as one goes further into the past. It only makes sense; older data deserves lower weights, because business is constantly changing, and older data is less informative about future profitability, usually.
I found these two posts on the VIX uncompelling. Simple comparisons of the VIX versus the market often lead to cloudy conclusions. I prefer what I wrote on the topic last month. When the S&P 500 is below the trendline, and the VIX is relatively high, it is usually a good time to buy stocks.
What does a pension manager want? He wwants returns that allow him to beat the actuarial funding target over the lifetime of the pension liabilities. If long-term high quality bonds allowed him to do that, then he would buy them. Unfortunately, the yield is too low, so the concept of absolute return strategies becomes attractive. Well, after the upset of the past six weeks, that ardor is diminished. As I have said before, to the extent that hedge funds seek stable, above average returns, they engage in yield-seeking behavior which prospers as credit spreads and implied volatilities fall, and fail when they rise. Eventually pension managers will realize that hedge fund returns cannot provide returns over the full length of the pension liability, in the same way that you can’t invest more than a certain amount of the pension assets in junk bonds.
Is productivity growth slowing? Probably. What may deserve more notice, is that we have larger cohorts entering the workforce for maybe the next ten years, and larger cohorts exiting as well, which will decrease overall productivity. Younger workers are less productive, middle-aged most productive, and older-aged in-between. With the Baby Boomers graying, productivity should fall in aggregate.
This is just a good post on sector data from VIX and More. It’s worth looking at the websites listed.
Economic weakness in the US doesn’t make oil prices fall? Perhaps it is because the US is important to the global economy, but not as important as it used to be. It’s not hard to see why: China and India are growing. Trade is growing outside of the US at a rapid pace. The US consumer is no longer the global consumer of last resort. Now we get to find out where the real resource shortages are, if the whole world is capitalist in one form or another.
Calendar anomalies might be due to greater macroeconomic news flow? Neat idea, and it seems to fit with when we get the most negative data.
Is investing a form of gambling? I get asked that question a lot, and my answer is in aggregate no, because the economy is a positive-sum game, but some investors do gamble as they invest, while others treat it like a business. Much depends on the attitude of the investor in question, including the time horizon and return goals that they have.
Massachusetts vs. the laws of economics. Beyond the difficulty of what to do with expensive cohorts in a public insurance system, I’ve heard that they are having difficulties that will make the system untenable in the long run… most of which boil down to antiselection, and inability to fight the force of aging Baby Boomers.
Rationality is one of those shibboleths that economists can’t abandon, or their mathematical models can’t be calculated. Bubbles are irrational, therefore they can’t happen. Welcome to the real world, gentlemen. People are limitedly rational, and often base their view of what is a good idea, off of what their neighbor thinks is a good idea, because it is a lot of work to think independently. Because it is a lot of work, people conserve on hard thinking, since it is a negative good. They maximize utility where utility includes not thinking too hard. Any surprise why we end up with bubbles? Groupthink is a lot easier than thinking for yourself, particularly when the crowd seems to be right.
Is China like the US with 120 years of delay? No, China has access to better technology. No, China does not have the same sense of liberty and degree of tolerance of difference. Its culture is far more uniform from an ethnic point of view. It also does not have the same degree of unused resources as the US did in the 1880s. Their government is in principle totalitarian, and allows little true freedom of religious expression, which is critical to a healthy economy, because people work for more than money/goods, but to express themselves and their ideals.
As I have stated before, prices are rising in China, and that is a big threat to global stability. China can’t continue to keep selling goods without receive goods back that their workers can buy.
The US needs more skilled immigrants. Firms will keep looking for clever ways to get them into the US, if the functions can’t be outsourced abroad.
It’s my view that dictators like Chavez possess less power than commonly imagined. They spend excess resources on their pet projects, while denying aid to the people whom they claim to rule for their benefit. With inflation running hard, hard currencies like the dollar in high demand, and the corruption of his cronies, I can’t imagine that Chavez will be around ten years from now.
Makes me want to buy Plum Creek, Potlach, or Rayonier. The pine beetle is eating its fill of Canadian pines, and then some, with difficult intermediate-term implications. More wood will come onto the market in the short run, depressing prices, but in the intermediate term, less wood will come to market. Watch the prices, and buy when the price of lumber is cheap, and prices of timber REITs depressed.
Pax Romana. Pax Americana. One went decadent and broke, the other is well on its way. I love my country, but our policies are not good for us, or the world as a whole. We intrude in areas of the world that are not our own, and neglect the proper fiscal and moral management of our own country.
Finally, it makes sense for economic commentators to make bold predictions, because there’s no such thing as bad publicity. Sad, but true, particularly when the audience has a short attention span. So where does that leave me? Puzzled, because I enjoy writing, but hate leading people the wrong way. I want to stay “low hype” even if it means fewer people read me. At least those who read me will be better informed, even if it means that the correct view of the world is ambiguous.

Tickers mentioned: PCH PCL RYN

The Longer View, Part 2

Posted on 1 September 2007 by David Merkel

When the market gets wonky, I write more about current events.? I prefer to write about longer-dated topics, because the posts will have validity for a longer time, and I think there is more money to be made off of the longer trends.? Before I go there tonight, I would like to say that at present the Fed says that it is ready to act, but it hasn’t done much yet.? As for the Bush Administration, and Congress, they have done nothing so far, and the few credible promises are small in nature.? My counsel: don’t be surprised if the markets stay rough for a while.

Onto longer-dated topics:

Perhaps this should go into my “too many vultures” file, but conservative players like Annaly can take advantage of bargains produced by the crisis.? My suspicion is that they will succeed in their usual modest conservative way.
Falling rates?? Falling equity prices?? Pension funding declines.? This issue has not gone away in the UK, and here in the US, the PBGC is still struggling.? As it is, FASB is facing the issue head on (finally), and the result will likely be a diminution of shareholders’ equity for most companies with defined benefit plans.
China is a capitalist country?? Eminent domain can be quite aggressive there.? At least now they are promising compensation, but who knows whether the government really follows through.
Any strategy, like quant funds, can become overcrowded.? As a strategy goes from little known to crowded, total returns rise and then flatten.? Prospective returns only fall as more and more compete for scarce excess returns.? As the blowout occurs, total returns go negative, and more so for the most leveraged.? Prospective returns rise as capital exits the trade.? Smart quants measure prospective return, and begin liquidating as prospective returns get too low.? Not many do that for institutional imperative reasons (investor: what do you mean cash is building up?? What am I paying you for?), but it is the right strategy regardless.
This is a useful graph of sector weights in the S&P 500.? If nothing else, it is worth knowing what one is underweighting and overweighting.? I am overweight Energy, Basic Materials, Staples, Utilities, and (urk) Financials, and underweight the rest.? My portfolio, right or wrong, never looks like the market.
I’ve written about SFAS 159 before.? Well, we may have a new poster child for why I don’t like it, Wells Fargo.? Mark-to-model is impossible to escape in fixed income, but I would treat gains resulting from changes in model assumptions as very low quality.? Watch SFAS 159 disclosures closely with complex financial companies.? If we wanted to repeat the late 90s headache from gain on sale accounting, we may have created the conditions to repeat the experience in a related way.
How dishonest is the P&C insurance industry?? It varies, as in most industries.? Insurance is a bag of complex promises, which leaves it more open to abuse.? This article goes into some of that abuse, and teaches us to evaluate a company’s claims paying record.? You may have to pay more to get Chubb or Stancorp, but they almost always pay.
China’s financial system is maturing slowly; one example of that is reduced reliance on bank finance, and issuing bonds directly.
I don’t care what regulations get put into place, capitalist economies are unstable, and that’s a good thing.? There are always information asymmetries, and always crowd behavior, such that risk preferences change precipitously.? That’s the nature of the system.? The only true protection is to be aware of this reality, and adjust your behavior before things get crazy.
A firm I was with had an early opportunity to invest in LSV and we didn’t do it.? The two members of our committee that read academic research thought we ought to (I was one), but the practical men of the committee objected to investing with unproven academics.? Oh, well, win some, lose some.
Speaking of academic research, here’s a non-mathematical piece on cognitive biases.? Economists believe that man is economically rational not because of evidence, but because it simplifies the models enough to allow calculations to be made.? They would rather be precisely wrong than approximately right.
Bit by bit, the efficient markets hypothesis get chipped away.? Here we have a piece indicating persistence of excess returns of the best individual investors.? For those of us that have done well, and continue to plug away in the markets, this is an encouragement.? It’s not luck.

I have enough for two more pieces on longer dated data.? It will have to come later.

Tickers Mentioned: NLY WFC CB SFG

Tribunes are to Promote Justice among Common Men

Posted on 17 July 2007 by David Merkel

Bouncing off of Cramer’s lucid post regarding the Tribune deal (when Cramer is good, he is goooood), I wonder if it wouldn’t be better for all involved if the deal didn’t fail.? As I pointed out before, Zell doesn’t have a lot of skin in the game, and the workers get all of the downside and little of the upside.? Zell has a lot of upside, relative to his contribution, which means little downside.

Don’t get me wrong, the newspaper business is tough.? My view is that the ESOP should refuse to fund the deal, and let the equity price fall.? Someone will fund the deal at a lower price, and the remaining workers will get paid, if less than before.

One great lesson of all of this is that no matter what labor demands, it is impossible for labor to do well if the industry does not do well.

What Credit Deterioration Looks Like Prior to Defaults

Posted on 9 June 200722 June 2017 by David Merkel

There was a little stir over at RealMoney over an article printed in Friday’s Wall Street Journal regarding Leveraged Buy-out [LBO] quality. Both Jim Cramer (video) and The Business Press Maven, Marek Fuchs, disagreed with the premises of the article. So who was right? Let’s start with the case made by the Wall Street Journal. It can be summarized in three points:

There are a few LBOs in trouble. This is notable because it is happening early in the tenures of the deals. There are unique things going wrong in the each of the four deals mentioned.
Cash interest coverage ratios are at levels not seen since 1997.
Some of the bonds and loans used to finance the deals are trading below par.

So what do Cramer and Fuchs do with this? They attack the weakest part of the argument, that there are only four deals mentioned to be in trouble out of thousand or more deals. Now, before any credit crisis hits, typically credit metrics have deteriorated, but few deals seem to be in trouble. Why? The companies in question are usually in good shape at the time a LBO takes place, and if not, the financing obtained typically has additional cash to re-liquefy the company.

Typically, it takes 3 years from the time that loans/bonds are sold before defaults start happening. In years 1 and 2, defaults are few, and notable because they look incredibly dumb in hindsight. Point one of the WSJ article does not of itself prove that a crisis is coming. But if they couldn’t point at some bad deals, there would be no article to write.

The more serious issues are loan pricing and interest coverage. Interest coverage of 1.7 times cash flow is very low, and akin to what one gets on CCC-rated debt, except that the loans are typically secured by the assets of the company, which lessens the severity level of defaults. Further, for loans to trade below par when there is hot demand for loan collateral from Collateralized Loan Obligations, implies that something is amiss. Now, what do Cramer and Fuchs do with these issues? Not much. Cramer doesn’t deal with it, and Fuchs says:

“For an article that implies a turn in the pace and fate of LBOs (did I mention the graph titled “Less Breathing Room”?) there needs to be more and better evidence. To make a point in journalism, you do not need the rigors of a scientific sample. Daily journalism simply has to move faster than that.“

In short, he dismisses it without any significant comment.Now, I generally appreciate most of what Cramer and Fuchs write, but in this case, they didn’t seem to get the most significant points of the article (2 and 3 as I number them). That said, the WSJ emphasized point 1 the hardest, probably because they didn’t want to bore their audience, so perhaps they both can be excused.

Credit metrics deteriorate before defaults happen, and it takes three years afteer the peak of issuance to see how bad it will be. We are seeing record loan issuance combined with deteriorating fundamentals at present. It may be as late as 2010 before we see the bad results of this in full, but I would not cavalierly dismiss the problem simply because there are few distressed situations now. Within three years, we will have more than enough distress to overwhelm the sizable resources of vulture investors.

A Modest Proposal to Raise Taxes on Mr. Buffett (and me)

Posted on 2 May 2007 by David Merkel

I doubt that it will go anywhere, but there is a proposal on Capitol Hill to tax private equity funds more.? As usual with Congress, we can criticize this from two angles.? The first is that they are creating a discriminatory rule that will create more clever structuring, but not result in significantly more taxes.? Private equity funds might float stubs of their holdings on the public equity markets in order to avoid taxation.? There are other ways they could deal with it as well.

The other criticism is that the proposal is not broad enough.? We need to tax everyone on the appreciation of their assets every year, whether they have sold them or not. Granted, this modest proposal would require a substantially larger IRS, but as for real estate, the Feds could piggyback off of what is done at the state level, with suitable massaging to create comparability.

This would whack the life insurance industry, certain tax-efficient mutual funds, etc.? It would lead to many abandoning their holdings on which they wanted to avoid taking the tax hit.

With the money raised here, the AMT could be easily eliminated.? What’s more, we could lower the top marginal tax rates, still bring in excess revenue.? We could have a flat tax, and the rich would pay a lot more than today.? No more shelters; everyone pays on the increase of their beneficial income, whether they have received it in cash or not.? This would create greater liquidity and volatility in the markets as stock that was locked away comes out for sale to create liquidity for tax payments.

Do I want this system?? If it is part of radical simplification and flattening of the tax code, yes.? Those who benefit from the system would pay their fair share, rich and poor alike.? I might end up paying more, but it would be more equitable.

PS — private businesses would still be difficult to apply this to, but I would tax them on their EBITDA.

Another Boon from RealMoney.com

Posted on 12 April 200720 June 2017 by David Merkel

Well, my RealMoney column from April 9th got republished on the free site, and got syndicated out to Yahoo! as well. When I write a piece where I mention a company, like Assurant, it’s fun to see the piece appear on the Yahoo! news. But when I don’t mention a ticker, I know that if they put it on the free site, I know they also syndicate it out to Yahoo!, and a number of other places as well. I get amazed at times where my stuff ends up. Well, I hope it makes money for them, and most of all, I hope it benefits those who read it.

That’s particularly true for this piece, because it focuses on risk control in a very direct way. Too many market players don’t realize that risk control is a way to make more money on average over the long term. How does that work?

It keeps you in the game. Absent war on your home soil and aggressive socialism, being an owner in society is a winning strategy over the long haul.
Rebalancing allows you to pick up an incremental 2-3% annually on average. It forces you to buy low and sell high.
There will be drawdowns. You will get drawn down less, and if you stay with strong companies in industries that have previously underperformed, when the bottom arrives, you will outperform the market.

I view risk differently than most market players, and than almost all academics. Risk means trying to avoid loss on every name in my portfolio, not avoiding loss on the portfolio as a whole, and certainly not standard deviation of returns, or even worse, beta.

“Don’t keep all your eggs in one basket.” True enough. “Keep all your eggs in one basket, and watch that basket carefully.” Also true. “Watch every egg.” That’s what I try to do. I’m a singles hitter, not a home-run hitter with attendant strikeouts. I try to make money on every company, by following my eight rules. That doesn’t guarantee success, but my losers over the last 6.5 years have been less than 10% of the names that I invested in. And, in each case where I lost, the error of judgment came from neglecting one of the eight rules.

All that said, I encourage you to focus on risk control. It’s a lot easier to make money if you don’t lose it.

Full disclosure: long AIZ