Pensions – Page 17 – The Aleph Blog

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 Collapse of Fixed Commitments

Posted on 16 August 2007 by David Merkel

I’ve begun portfolio triage here, and am debating what to sell, and buy, if anything.? More in my next post, if I have the strength tonight.? I’m feeling a little better, though the market is not helping.

Why the collapse of fixed commitments?? Consider what I wrote In RealMoney’s columnist conversation today:

		David Merkel
		Yielding Illiquidity
		8/15/2007 4:02 PM EDT

Liquidity is the willingness of two parties to enter into fixed commitments, which can be measured by yield spreads, option prices, and bid-ask spreads. At present, the willingness to be on the giving liquidity side of the trade is declining. Even the willingness to do repos, which is pretty vanilla, has dried up. Roughly double the margin needs to be put up now to hold the same position. That dents the total buying power for what are arguably high quality assets — agency RMBS and the AAA portions of prime whole loans. This means that prices fall until balance sheet players with unencumbered cash find it sufficiently attractive to take on the mortgage assets.

I thought this era of unwinding leverage would arrive, and arrive it has. (That said, I did not expect that mortgage repo funding would be affected. That was a surprise.) I could never predict the time of the unwind, though, and though I have a decent amount of cash on hand, it can never be enough at the time.

One of the few bright sides here is that most of the real risk is concentrated in hedge funds, and hedge fund-of-funds. (Some pension plans are going to miss their actuarial funding targets dramatically.) Hopefully the investment banks with their swap books have done their counterparty analyses correctly, and didn’t cross hedge too much.

I’m still up for this year, but not by much. Perhaps I liked being intellectually wrong better while I made money on the broad market portfolio. Sigh.

Position: none

Could Countrywide fail?? It’s not impossible.? I had an excellent banking/financials analyst when I was a corporate bond manager, and she taught me that if you are a finance company, your ratings must allow you to issue commercial paper on an advantageous basis in order to be properly profitable.? If not, the optimistic outcome is a sale of the company to a stronger party.? The pessimistic outcome is failure.? We last tested this late in 2002 when we accumulated a boatload of Household International debt on weakness after they lost access to the CP markets, but had announced the merger with HSBC.? If you can make 12% in two months on bonds, you are doing well.? Paid for a lot of other errors that year.

But if Countrywide fails, the mortgage market is dead temporarily.? It would be a help after a year because of reduction in new mortgages, but in the short run, the rest of the market would have to digest the remains of Countrywide’s balance sheet.

Shall we briefly consult with the optimists?? Exhibit A is William Poole, who is more willing to speak his mind than most Fed Governors, for good and for ill.? He doesn’t see any effect on the “real economy” from the difficulties in the lending markets.? At the beginning of any lending crisis, that is true.? Difficulties happen in the “real economy” when current assets have a difficult time getting financed, and consumer durable purchases and capital investments get delayed because financing is not available at reasonable prices.? By year end, Poole will change his tune.

Now, I half agree with the Lex column in the Financial Times.? The level of screaming is far too loud for a decline of this magnitude. ? But that’s just looking at the stock price action.? The action in the debt markets in relative terms is more severe, and bodes ill for the equity markets eventually.? Remember, the debt markets are bigger than the equity markets.? Problems in the debt markets show up in the equity markets with a lag, as companies need financing.

One more optimist: private equity funds buying back LBO debt.? The steps of the dance have changed, gentlemen.? It is time to conserve liquidity, not deploy it.? The time to deploy is near the end of a credit bust, not near its beginning.

How about the pessimists?? Start with Veryan Allen at Hedge Fund.? He tells us that volatility is normal, and that it often drags the good down with the bad.? The difference is risk control, and the good don’t die, and bounce back after the bad die.? Now let’s look at the rogues’ gallery du jour. Who is getting killed?? Pirate Capital, Basic Capital, and let’s mention the Goldman Sachs funds again because the leverage was higher than expected.? Toss in an Austrialian mortgage lender for fun, not.? Consider those that are trying to remove money from hedge funds.? It may not be as severe as possible, but it could really be severe.? Investors, even most institutional investors, are trend followers.

Five unrelated notes to end this post:

Could this be the end of the credit ratings agencies?? I don’t think so.? It might broaden the oligopoly, and weaken it, but ratings are an inescapable facet of finance.? Ratings go through cycles of being good and bad, but people need opinions that are standardized about the riskiness of securities.? Go ahead, ban all of the existing ratings agencies now.? Within five years, debt buyers and regulators will have recreated them.
What is funny about this article from the Wall Street Journal is that they mix some residential mortgage REITs into an article on commercial mortgage REITs.? DFR and FBR both are residential mortgage REITs.? There may be more there too, but I haven’t checked.
If you can’t trust your money market funds, what can you trust?? I was always a little skeptical about asset backed commercial paper [ABCP] when it first arrived, but it survived 2000-2003, and I forgot about it.? Now it comes back to bite.? Some programs will extend maturities.? Some backup payers will pay, and some won’t.? Fortunately, it is not ubiquitous in money market funds, but it is worth looking for, if you have a lot in money market funds.
How rapid has this 1,000 point decline in the Dow been?? Pretty fast, though 1,000 points is smaller in percentage terms than it used to be.
Sorry to end on a sour note, but the Asian markets are having a rough go of it, and will make tomorrow tough in the US as well.

It’s late, so I’m going to post on my portfolio tomorrow.? I’ll give you the skinny now.? I’m evaluating the balance sheets and cash flow statements of stocks in my portfolio, and I am starting with those I have lost the most on, and evaluating their survivability under rough conditions.? I have some good ideas already, but I fear that I am too late; some names are so cheap, though leveraged (DFR is a good example), that it is hard to tell what the right decision is.? I will be making some trades, though, no doubt.

Full Disclosure: long DFR

Speculation Away From Subprime, Compendium

Posted on 3 August 2007 by David Merkel

Subprime lending is grabbing a lot of attention, but it is only a tiny portion of what goes on in our capital markets.? Tonight I want to talk about speculation in our markets, while largely ignoring subprime.

I have grown to like the blog Accrued Interest.? There aren?t many blogs dealing with fixed income issues; it fills a real void.? This article deals with bridge loans; increasingly, as investors have grown more skittish over LBO debt, investment banks have had to retain the bridge loans, rather than selling off the loans to other investors.? Google ?Ohio Mattress,? and you can see the danger here.? Deals where the debt interests don?t get sold off can become toxic to the investment banks extending the bridge loans.? (And being a Milwaukee native, I can appreciate the concept of a ?bridge to nowhere.?? Maybe the investment bankers should visit Milwaukee, because the ?bridge to nowhere? eventually completed, and made it to South Milwaukee.? Quite an improvement over nowhere, right? Right?!? Sigh.)
Also from Accrued Interest, the credit markets have some sand in the gears.? I remember fondly the pit in my stomach when my brokers called me on July 27th and October 9th, 2002, and said, ?The markets are offered without bid.? We?ve never seen it this bad.? What do you want to do??? I had cash on hand for bargains both times, but when the credit markets are dislocated, nothing much happens for a little while.? This was true after LTCM and 9/11 as well.
I?ve seen a number of reviews of Dr. Bookstaber?s new book.? It looks like a good one. As in the last point, when the markets get spooked, spreads widen dramatically,and trading slows until confidence returns.? More bad things are feared to happen than actually do happen.
I?m not a fan of shorting, particularly in this environment.? Too many players are short without a real edge.? High valuations are not enough, you need to have an uncommon edge.? When I short, that typically means an accounting anomaly.? That said, there is more demand for short ideas with the advent of 130/30 and 120/20 funds.? Personally, I think they are asking for more than the system can deliver.? Obvious shorts are full up, and inobvious shorts are inobvious for a reason; they aren?t easy money.
From the ?Too Many Vultures? file, Goldman announces a $12.5 billion mezzanine fund.? With so much money chasing failures, the prices paid to failures will rise in the short run, until the vultures get scared.
Finally, and investment bank that understands the risk behind CPDOs.? I have been a bear on these for some time; perhaps the rapidly rising spread environment might cause a CPDO to unwind?
Passive futures as a diversifier made a lot of sense before so many pension plans and endowments invested in it.? Recent returns have been disappointing, leading some passive investors to leave their investments in crude oil (and other commodities).? With less pressure on the roll in crude oil, the contango has lessened, which makes a passive investment in commodities, particularly crude oil, more attractive.
Becoming more proactive on ratings?? I?m not holding my breath but Fitch may be heading that way on CMBS.? Don?t hold your breath, though.
When trading ended on Friday, my oscillator ended at the fourth most negative level ever. Going back to 1997, the other bad dates were May 2006, July 2002 and September 2001. At levels like this, we always get a bounce, at least, so far.
We lost our NYSE feed on Bloomberg for the last 25 minutes of the trading day. Anyone else have a similar outage? I know Cramer is outraged over the break in the tape around 3PM, and how the lack of specialists exacerbated the move. Can?t say that I disagree; it may cost a little more to have an intermediated market, but if the specialist does his job (and many don?t), volatility is reduced, and panics are more slow to occur.
Perhaps Babak at Trader?s Narrative would agree on the likelihood of a bounce, with the put/call ratio so high.
The bond market on the whole responded rationally last week. There was a flight to quality. High yield spreads continued to move wider, and the more junky, the more widening. Less noticed: the yields on safe debt, high quality governments, agencies, mortgages, industrials and utilities fell, as the flight to quality benefitted high quality borrowers. Here?s another summary of the action on Thursday, though it should be noted that Treasury yields fell more than investment grade debt spreads rose.
Shhhhh. I?m not sure I should say this, but maybe the investment banks are cheap here. I?ve seen several analyses showing that the exposure from LBO debt is small. Now there are other issues, but the investment banks generally benefit from increased volatility in their trading income.
Comparisons to October 1987? My friend Aaron Pressman makes a bold effort, but I have to give the most serious difference between then and now. At the beginning of October 1987, BBB bonds yielded 7.05% more than the S&P 500 earnings yield. Today, that figure is closer to 0.40%. In October 1987, bonds were cheap to stocks; today it is the reverse.
Along those same lines, if investment grade corporations continue to put up good earnings, this decline will reverse.
Now, a trailing indicator is mutual fund flows. Selling equities and high yield? No surprise. Most retail investors shut the barn door after the cow has run off.
Deals get scrapped, at least for now, and the overall risk tenor of the market shifts because player come to their senses, realizing that the risk is higher than the reward. El-Erian of Harvard may suggest that we have hit upon a regime change, but I would argue that such a judgment is premature. We have too many bright people looking for turning points, which may make a turning point less likely.
Are we really going to have credit difficulties with prime loans? I have suggested as much at RealMoney over the past two years, to much disbelief. Falling house prices will have negative impacts everywhere in housing. Still, it more likely that Alt-A loans get negative results, given the lower underwriting standards involved.
How much risk do hedge funds pose to the financial system?? My view is that the most severe risks of the financial system are being taken on by hedge funds.? If these hedge funds are fully capitalized by equity (not borrowing money or other assets), then there is little risk to the financial system.? The problem is that many do finance their positions, as has been seen in the Bear Stearns hedge funds, magnifying the loss, and wiping out most if not all of the equity.
There is a tendency with hedge funds to hedge away ?vanilla risks? (my phrase), while retaining the concentrated risks that have a greater tendency to be mispriced.? I want to get a copy of Richard Bookstaber?s new book that makes this point.? Let?s face it.? Most hedging is done through liquid instruments to hedge less liquid instruments with greater return potential.? Most hedge funds are fundamentally short liquidity, and are subject to trouble when liquidity gets scarce (which ususally means, credit spreads rise dramatically).
Every investment strategy has a limit as to how much cash it can employ, no matter how smart the people are running the strategy.? Inefficiencies are finite.? Now Renaissance Institutional is feeling the pain.? My greater question here is whether they have pushed up the prices of assets that they own to levels not generally supportable in their absence, simply due to their growth in assets?? Big firms often create their own mini-bubbles when they pass the limit of how much money they can run in a strategy.? Asset growth is self-reinforcing to performance, until you pass the limit.
I have seen the statistic criticized, but it is still true that we are at a high for short interest.? When short interest gets too high, it is difficult but not impossible for prices to fall a great deal.? The degree of short interest can affect the short-term price path of a security, but cannot affect the long term business outcome.? Shorts are ?side bets? that do not affect the ultimate outcome (leaving aside toxic converts, etc.).
I?ve said it before, and I?ll say it again, there are too many vulture investors in the present environment.? It is difficult for distressed assets to fall too far in such an environment, barring overleveraged assets like the Bear Funds.? That said, Sowood benefits from the liquidity of Citadel.
Doug Kass takes a swipe at easy credit conditions that facilitated the aggressive nature of many hedge funds.? This is one to lay at the feet of foreign banks and US banks interested in keeping their earnings growing, without care for risk.
Should you be worried if you have an interest in the equity of CDOs?? (Your defined benefit pension plan, should you have one, may own some of those?)? At present the key factors are these? does the CDO have exposure to subprime or Alt-A lending, home equity lending, or Single-B or lower high yield debt?? If so, you have reason to worry.? Those with investment grade debt, or non-housing related Asset-backed securities have less reason to worry.
There have been a lot of bits and bytes spilled over mark-to-model.? I want to raise a slightly different issue: mark-to-models.? There isn?t just one model, and human nature being what it is, there is a tendency for economic actors to choose models that are more favorable to themselves.? This raises the problem that one long an illiquid asset, and one short an illiquid asset might choose different values for the asset, leading to a deadweight loss in aggregate, because when the position matures, on net, a loss will be taken between the two parties.? For a one-sided example of this you can review Berky?s attempts to close out Gen Re?s swap book; they lost a lot more than they anticipated, because their model marks were too favorable.
If you need more proof of that point, review this article on how hedge funds are smoothing their returns through marks on illiquid securities.? Though the article doesn?t state that thereis any aggregate mis-marking, I personally would find that difficult to believe.
If you need still more proof, consider this article.? The problem for hedge fund managers gets worse when illiquid assets are financed by debt.? At that point, variations in the marked prices become severe in their impacts, particularly if debt covenants are threatened.
Regarding 130/30 funds, particularly in an era of record shorting, I don?t see how they can add a lot of value.? For the few that have good alpha generation from your longs, levering them up 30% is a help, but only if your shorting discipline doesn?t eat away as much alpha as the long strategy generates.? Few managers are good at both going long and short.? Few are good at going short, period.? One more thing, is it any surprise that after a long run in the market, we see 130/30 funds marketed, rather than the market-neutral funds that show up near the end of bear markets?
Investors like yield.? This is true of institutional investors as well as retail investors.? Yield by its nature is a promise, offering certainty, whereas capital gains and losses are ephemeral.? This is one reason why I prefer high quality investments most of the time in fixed income investing.? I will happily make money by avoiding capital losses, while accepting less income in speculative environments.? Most investors aren?t this way, so they take undue risk in search of yield.? There is an actionable investment idea here!? Create the White Swan bond fund, where one invests in T-bills, and write out of the money options on a variety of fixed income risks that are directly underpriced in the fixed income markets, but fairly priced in the options markets.? Better, run an arb fund that attempts to extract the difference.
Most of the time, I like corporate floating rate loan funds.? They provide a decent yield that floats of short rates, with low-ish credit risk.? But in this environment, where LBO financing is shaky, I would avoid the closed end funds unless the discount to NAV got above 8%, and I would not put on a full position, unless the discount exceeded 12%.? From the article, the fund with the ticker JGT intrigues me.
This article from Information Arbitrage is dead on.? No regulator is ever as decisive as a margin desk.? The moment that a margin desk has a hint that it might lose money, it moves to liquidate collateral.
As I have said before, there are many vultures and little carrion.? I am waiting for the vultures to get glutted.? At that point I could then say that the liquidity effect is spent. Then I would really be worried.
Retail money trails.? No surprise here.? People who don?t follow the markets constantly get surprised by losses, and move to cut the posses, usually too late.
One more for Information Arbitrage.? Hedge funds with real risk controls can survive environments like this, and make money on the other side of the cycle.? Where I differ with his opinion is how credit instruments should be priced.? Liquidation value is too severe in most environments, and does not give adequate value to those who exit, and gives too much value to those who enter.? Proper valuation considers both the likelihood of being a going concern, and being in liquidation.

That?s all in this series.? I?ll take up other issues tomorrow, DV.? Until then, be aware of the games people play when there are illiquid assets and leverage? definitely a toxic mix.? In this cycle, might simplicity will come into vogue again?? Could balanced funds become the new orthodoxy?? I?m not holding my breath.

Speculation Away From Subprime, Part 3

Posted on 30 July 2007 by David Merkel

More on speculation, while avoiding subprime which is still over-reported.

How much risk do hedge funds pose to the financial system?? My view is that the most severe risks of the financial system are being taken on by hedge funds.? If these hedge funds are fully capitalized by equity (not borrowing money or other assets), then there is little risk to the financial system.? The problem is that many do finance their positions, as has been seen in the Bear Stearns hedge funds, magnifying the loss, and wiping out most if not all of the equity.
There is a tendency with hedge funds to hedge away “vanilla risks” (my phrase), while retaining the concentrated risks that have a greater tendency to be mispriced.? I want to get a copy of Richard Bookstaber’s new book that makes this point.? Let’s face it.? Most hedging is done through liquid instruments to hedge less liquid instruments with greater return potential.? Most hedge funds are fundamentally short liquidity, and are subject to trouble when liquidity gets scarce (which ususally means, credit spreads rise dramatically).
Every investment strategy has a limit as to how much cash it can employ, no matter how smart the people are running the strategy.? Inefficiencies are finite.? Now Renaissance Institutional is feeling the pain.? My greater question here is whether they have pushed up the prices of assets that they own to levels not generally supportable in their absence, simply due to their growth in assets?? Big firms often create their own mini-bubbles when they pass the limit of how much money they can run in a strategy.? Asset growth is self-reinforcing to performance, until you pass the limit.
I have seen the statistic criticized, but it is still true that we are at a high for short interest.? When short interest gets too high, it is difficult but not impossible for prices to fall a great deal.? The degree of short interest can affect the short-term price path of a security, but cannot affect the long term business outcome.? Shorts are “side bets” that do not affect the ultimate outcome (leaving aside toxic converts, etc.).
I’ve said it before, and I’ll say it again, there are too many vulture investors in the present environment.? It is difficult for distressed assets to fall too far in such an environment, barring overleveraged assets like the Bear Funds.? That said, Sowood benefits from the liquidity of Citadel.
Doug Kass takes a swipe at easy credit conditions that facilitated the aggressive nature of many hedge funds.? This is one to lay at the feet of foreign banks and US banks interested in keeping their earnings growing, without care for risk.
Should you be worried if you have an interest in the equity of CDOs?? (Your defined benefit pension plan, should you have one, may own some of those…)? At present the key factors are these… does the CDO have exposure to subprime or Alt-A lending, home equity lending, or Single-B or lower high yield debt?? If so, you have reason to worry.? Those with investment grade debt, or non-housing related Asset-backed securities have less reason to worry.
There have been a lot of bits and bytes spilled over mark-to-model.? I want to raise a slightly different issue: mark-to-models.? There isn’t just one model, and human nature being what it is, there is a tendency for economic actors to choose models that are more favorable to themselves.? This raises the problem that one long an illiquid asset, and one short an illiquid asset might choose different values for the asset, leading to a deadweight loss in aggregate, because when the position matures, on net, a loss will be taken between the two parties.? For a one-sided example of this you can review Berky’s attempts to close out Gen Re’s swap book; they lost a lot more than they anticipated, because their model marks were too favorable.
If you need more proof of that point, review this article on how hedge funds are smoothing their returns through marks on illiquid securities.? Though the article doesn’t state that thereis any aggregate mis-marking, I personally would find that difficult to believe.
If you need still more proof, consider this article.? The problem for hedge fund managers gets worse when illiquid assets are financed by debt.? At that point, variations in the marked prices become severe in their impacts, particularly if debt covenants are threatened.

That’s all in this series.? I’ll take up other issues tomorrow, DV.? Until then, be aware of the games people play when there are illiquid assets and leverage… definitely a toxic mix.? In this cycle, might simplicity will come into vogue again?? Could balanced funds become the new orthodoxy?? I’m not holding my breath.

The Five Pillars of Liquidity

Posted on 24 July 2007 by David Merkel

Liquidity, that ephemeral beast.? Much talked about, but little understood.? There are five pillars of liquidity in the present environment.? I used to talk about three of them, but I excluded two ordinary ones.? Here they are:

The bid for debt from CDO equity.
The Private Equity bid for cheap-ish assets with steady earnings streams.
The recycling of the US current account deficit.
The arbitrage of investment grade corporations buying back their own stock, or the stock of other corporations, because with investment grade yields so low, it makes sense to do it, at least in the short run.
The need of Baby Boomers globally to juice returns in the short run so that their retirements will be adequate.? With equities, higher returns; with bonds, more yield.? Make that money sweat, even if we have to outsource the labor that our children provide, because they are too expensive.

Numbers one and two are broken at present.? The only place in CDO-land that has some life is in investment grade assets.? We must lever up everything until it breaks.? But anything touched by subprime is damaged, and high yield, even high yield loans are damaged for now.

With private equity, it may just? be a matter of waiting a while for the banks to realize that they need yield, but i don’t think so.? Existing troubled deals will have to give up some of the profits to the lenders, or perhaps not get done.

Number three is the heavy hitter.? The current account deficit has to balance.? We have to send more goods, assets, or promises to pay more later.? The latter is what is favored at present, keeping our interest rates low, and making equity attractive relative to investment grade debt.? Until the majority of nations buying US debt revalue their currencies upward, this will continue; it doesn’t matter how much they raise their central bank’s target rate, if they don’t cool off their export sectors, they will continue to stimulate the US, and build up a bigger adjustment for later.

With private equity impaired, investment grade corporations can be rational buyers of assets, whether their own stock, or that of other corporations that fit their operating profiles. Until investment grade yields rise 1-2%, this will still be a factor in the markets, and more so for foreign corporations that have access to cheap US dollar financing (because of current account deficit claims that have to be recycled).

The last one is the one that can’t go away, at least not for another seven years as far as equities go, and maybe twenty years as far as debt goes.? There is incredible pressure to make the money do more than it should be able to under ordinary conditions, because the Baby Boomers and their intermediaries, pension plans and mutual funds, keep banging on the doors of companies asking for yet higher returns.? With debt, there is a voracious appetite for seemingly safe yet higher yielding debt.? The Boomers need it to live off of.

So where does that leave us, in terms of the equity and debt markets?? Investment grade corporates and munis should be fine on average; prime MBS at the Agency or AAA level should be fine.? Everything else is suspect.? As for equities, investment grade assets that are not likely acquirers look good.? The acquirers are less certain.? Even if acquisitions make sense in the short run, it is my guess that they won’t make sense in the long run. On net, the part of the equity markets with higher quality balance sheets should do well from here.? The rest of the equity markets… the less creditworthy their debt, the less well they should do.

Twenty-Five Ways to Reduce Investment Risk

Posted on 21 July 2007 by David Merkel

With all of the concern in the present environment, it is good to be reminded of the actions one should take in order to reduce risk in the present, should the investment environment turn hostile in the future.

Diversify by industry, country, currency, inflation-sensitivity, yield, growth-sensitivity and market capitalization
Diversify by asset class. Make sure you have liquid safe assets to complement risky assets. This is true whether you are young (tactical reasons) or old (strategic reasons).
Diversify by advisors; don’t get all of your ideas from one source (and that includes me). In a multitude of counselors, there is wisdom, which is something to commend RealMoney for — there is no “house view.”
Diversify into enough companies: better to have smaller positions in 15-20 companies, than 5 larger ones. When I began investing in single stocks 15 years ago, I started with 15 positions of $2,000 each. That made each $15 commission bite, but the added safety was worth it.
Avoid explicit leverage; don’t use margin.
Avoid shorting as well, unless you’ve got a profound edge; few are constitutionally capable of doing it well. Are you the exception?
Avoid implicit leverage. How much does the company in question rely on the kindness of the financing markets in order to continue its operations? Highly indebted companies tend to underperform.
Avoid balance sheet complexity; it can be a cover for accounting chicanery.
Analyze cash flow relative to earnings; be wary of companies that produce earnings, but not cash flow from operations, or free cash flow.
Avoid owning popular companies; they tend to underperform.
Avoid serial acquirers; they tend to underperform. Instead, look at companies that do little in-fill acquisitions that they grow organically.
Analyze revenue recognition policies; they are the most common way that companies fuddle accounting.
Focus on industries that are out of favor, and look for strong players that can withstand market stress.
Focus on companies with valuations that are cheap relative to present fundamentals, particularly if there are low barriers against competition.
Take something off the table when the markets run, and edge back in when they fall.
Analyze how any new investment affects your total portfolio.
Don’t use any investment strategy that you don’t fully understand.
Understand where you have made errors in the past, so that you can understand your weaknesses, and avoid acting out of weakness.
Buy only the investments that you want to buy, and not what others want to sell you. Use only investment strategies with which you are fully comfortable.
Find ways to take the emotion out of buy and sell decisions; treat investing as a business.
Match your assets to the horizon over which you will need the proceeds. Risky assets should not get a heavy weight when the proceeds will be needed within five years.
When you get a new idea, and it seems like a “slam dunk,” sit on it for a month before acting on it. More often than not, if it is a good idea, you will still have time to act on it, but if it is a bad idea, you have a better chance of discovering that through waiting.
Prune your portfolio a few times a year. Are there new companies to swap into that are better than a few of your current holdings?
Size positions inversely to risk levels.
Finally, think about risk before you need to; make it a positive component of your strategies.

Remember, risk preparation begins today. That way, you will be capable to invest in the bargains that a real bear market will produce, and not leave the investment game disgusted at yourself for losing so much money.

If I had a dollar for every person that I knew who ignored risk in the late 90s, and dropped out of investing in 2002, just in time for the market to turn, I could buy a nice dinner for you and me in DC, near where I work. So, analyze the riskiness of your portfolio today, and prepare now for the bad times that will eventually come, whether this year, or four years from now.

At The Periphery of Investing

Posted on 14 July 2007 by David Merkel

I have a friend who works for the Williams Inference Service.? Those who work for WIS spend their time looking for deep trends in our world that are underappreciated.? I dedicate a little of my time to that as well, and try to draw investable conclusions from odd bits of data that come across my radar.? But even without explicit conclusions, it richens my knowledge of our world, and perhaps with other data, will yield some return for me.? If nothing else, I love reading and writing, so join with me on this tour of articles around the web.

I’m not sure if pollution problems in China are any worse than the problems faced by the US or the UK at similar points in their development.? That said, one major constraint on their ability to grow is pollution.? These articles from the Wall Street Journal are an excellent example of that: heavy metals in the food supply, and lead in jewelry that they sell domestically and export, with the lead coming from US scrap metal.? These practices may allow businesses to survive in the short run, but soon enough, jewelry will get tested in the US, and importers sued for liability.? In China, there will be increasing pressure for change, perhaps even violent change.? In Chinese history, there is a tendency for change not happen, or to happen rapidly when troubles for average people become too great.
Demographics is a favorite topic of mine, particularly as the world slowly heads into a shrinking population.? For the most part, national economies don’t work so well when population levels shrink, which leads to pressure to import low skilled laborers from nations with surplus workers.? One nation that is at the front of the problem is Japan, where the population is shrinking pretty rapidly today.? Japan is now seeing that its pension system will be hard to sustain because of the lack of children being born.? Europe will face this problem as well.? The US less so, because of the higher birth and immigration rates; for us, the foreign debt will be our problem.
Is war with Iran a done deal in a few years?? I hope not.? Given the mismanagement of the Iranian economy in the hands of the cronyist mullahs that run the joint, and the genuine difficulty of producing effective nuclear weapons without a strong academic/technical/manufacturing base, my guess is that there will be another revolution there before a significant bomb gets made.? (We’re still waiting on North Korea; what a joke.)? Economically, Iran is a basket case.? As I have mentioned before, they have mismanaged their oil resources.? What is less noticed is their coming demographic troubles.? Not all Muslims are fanatics, and many are having small families, which will generate it’s own old age crisis thirty years out.? That said, if Iran is provoked, it’s leaders will not give in; they iwill fight, as the second article i cited points out.? Better to quietly hem the current Iranian leadership in by supporting their enemies, than to risk another war that the US does not have the resources to fight.? Iran is weaker and more divided than it looks; its government will fall soon enough.
Memo to all quantitative investors: are you ready for IFRS?? IFRS, the European accounting standard, particularly for financials will change enough things that older formulas of calculating value and safety may need to be severely modified.? The larger the importance of accrual items to an industry, the worse the adjustment will be.? All I say is, watch this.? If it changes, it will affect the way that we numerically analyze investments.? We are definitely losing foreign economies on our exchanges, mainly due to Sarbox, not accounting rules, but I think we are rushing through a compromise with IFRS to protect the interests of our exchanges, and I think that is a mistake.
Then again, maybe we don’t need the Europeans to mess up our accounting rules; we can do just fine ourselves.? Our accounting standards are a hodgepodge between amortized cost and fair value standards… we keep moving more and more toward fair value, but will the auditors be able to keep up?? Auditing amortized cost is one thing; there are different skills required when fungible but not liquid assets can be written up on a balance sheet. (Think about real estate or mortgage derivatives.)? Accounting will become less reliable in my opinion.
I wish we had a harder currency; why else do I buy foreign bonds?? Anyway, I appreciated this short partial monetary history of the US, from the Civil War onward, from Elaine Meinel Supkis.
When you can’t deliver the underlying, typically futures markets don’t work well.? It is no surprise then that a derivatives market on economic indicators closed.? Futures markets exist to allow commercial interests to hedge.? Where there is nothing to hedge, it is akin to mere betting, and without the extra thrill of a sports contest, that rarely attracts enough interest to be economic.? That said, aren’t the VIX futures and options contracts catching on?
Not sure what the second order effects will be here, but a rule is finally coming that will require the trade execution occur at the best price.? It will be extra work for the exchanges, but it will probably centralize exchanges in the intermediate term.? If you have to share data, why not merge?
One reason that Buffett was/is that best was his ability to learn from mistakes.? He kept his mistakes small and eventually found ways out of many of them.? US Air?? Salomon Brothers?? He eventually gets cashed out.? General Re?? The earnings from investing float bails him out. The “Shoe Group” and World Book?? Small, and you can’t win them all.
What do you do when the market has passed you by?? You got burned 2000-2002, and moved to a more conservative posture, only to find that the market ran like wild while you weren’t there.? What do you do now?? My advice: do half of what you would do if the market hadn’t run.? If you are at 20% equities, and you know that in normal times you should be at 60% equities, raise your investment level to 40% equities.? If the market rallies, you have more on, if it falls, you will have the chance to reinvest another 20% into equities at more attractive prices.
I usually agree with Eddy Elfenbein; he’s very common sense.? But here I do not.? Get me right here, Eddy is correct in all that he says.? I frame the problem differently.? You have someone sitting on cash, and the market has appreciated to where valuations are high-ish.? You can? 1) invest it all now, 2) dollar cost average, or 3) do nothing.? Eddy doesn’t consider that many will choose 3.? On average, 1 beats 2 by a small margin, but 2 beats 3 by a wide margin.? Dollar cost averaging is a way to get psychologically unprepared people into the market who would never risk putting it all in at once.? We use DCA to get inexperienced investors from a bad place to a “pretty good” place, because the best place is unimaginable to them.
Desalination is the wave of the future, even in the US.? Potable water is scarce globally (think of India and China), and the cost of potable water justifies the energy and other costs associated with desalination.? The article that I cited does not capture the environmental costs of desalination, in my opinion, but it gives a good taste of what the future will hold.

And, with that, that completes my tour of the periphery.? Next week, I hope to provide more color for you on our changing risk environment.

Thirteen Macroeconomic Musings

Posted on 7 July 20078 July 2007 by David Merkel

There are three great economic distortions in our world today that will eventually have to be unwound. All of them are temporarily self-reinforcing, so they will persist until something breaks. Here they are:

Recycling the US current account deficit.
Too much speculation in leveraged credit markets.
Too much speculation from private equity investors.

I could add a fourth, willingness of institutions to invest in weakly funded structures, like hedge funds, and anything else with liquid liabilities and illiquid assets, but that is for another day. Tonight, I want to focus primarily on the first of those issues, the consequences of the US current account deficit. Here goes:

Almost all bond managers love positive carry. It is the lure of free money, and it works most of the time. Borrow cheaply and invest the money in something that yields more. That simple idea lies behind most of the excesses in our debt markets globally, and fuels the three excesses listed above. With currencies, market player borrow in yen and Swiss francs, and invest in higher yielding currencies like the New Zealand Dollar. Even major corporations like Citigroup borrow in yen, because the rates are low.
When a country sends more goods to the US than it receives back, there is a natural inflationary effect. The local population buys goods and services, not US bonds, yet as banks accumulate the bonds, considering them to be part of their reserves, the balance sheets of the banks expand, because increased capital allows them to make more loans, which adds to the buying power of individuals and corporation, and can lead to more inflation. To resist the inflation, a country can let its currency rise versus the dollar, making exports less competitive, and increasing the willingness to import. This has happened in Thailand, India, and South Korea. Once this happens in enough nations, interest rates will rise in the US. We will send more goods to balance the accounts, and fewer bonds.
Here you can get a look at the dollar reserve levels of many nations. China has been absorbing a lot of dollar claims.
Thinking about inflation, wages are rising in China, particularly for those that work in export-oriented sectors. That is leading to rising prices for exports to the US. That will eventually have an upward impact on US price inflation.
Now, inflation is not a serious concern yet in Japan or Switzerland. But if it did become an issue, the carry trade would end rapidly. Interest rates would be forced up rapidly, and the cost of loans denominated in those currencies would rise as well, making the borrowing uneconomic. Personally, I think the yen is 20% undervalued; in a few years, the yen will correct, if not more.
On a more positive note, Jim Griffin suggests that the economies of Europe and Japan may be heading into classical recoveries. If true, good for all of us, particularly if they buy US goods.
Now, imbalances are not forever. The emerging markets ten years ago were fragile because they ran current account deficits. Today many of them have the high quality problem of surpluses (and the inflation they can engender). They are in a stronger position to deal with crises. The US, though is does not know it yet, is ina weaker position to deal with crises.
On the “dark matter” debate, my position has been that the US has a big debt to the rest of the world, but that since the US invests in higher yielding investments abroad than foreigners do in the US, until recently, the US earned more from foreign investments than foreigners earned off of US investments. This WSJ blog post supports my contention. On net, the US contains risk-takers, and the returns have been good so far, but the foreign debt has become so great, that the added yield is not enough to keep up with what we have to pay out.
The main thing that could go wrong here would be a trade war.? Now, one of those is not imminent, but the Doha round at the WTO has not been a success, and there is pressure in many nations to restrict trade, or foreign ownership of assets.? If one wants to destroy the gains from trade, that would be the way to go.
The 10-year Treasury yield has gotten jumpy in this environment, closing the week out at 5.18%.? I would expect the yield to muddle between 4.75 and 5.50% through the remainder of the year.? This is a finely balanced environment, with reason for rates to rise and fall.? Thus I expect the muddle.
Finally, three bits on debt and demographics.? The first is an article from the Wall Street Journal on how insurers are going after Baby Boomers.? This is just another factor in the yield seeking that I have been talking about.? Baby boomers want yield from their assets so that they can enjoy their retirement.? That yield-seeking is and will be a major force distorting the markets for years to come.? It is much easier to demand more yield from your assets than to save more.? In the long run, it is much harder to realize more yield from your assets than it is to save more.
Don’t trust US Government estimates of the deficit; instead, look at the change in net liabilities, the way a corporation might do it.? That would balloon the paltry $250 billion deficit to $1.3 trillion.? I have been writing about this since 1992.? The US government will not make good on all the promises it has made in money with today’s purchasing power.? The tipping point is not here yet for when this becomes obvious, but I believe it will become clear within the next ten years.? Pity the next three presidents.
Partly as a result of this, and greater labor competition from abroad, we are finally seeing some evidence that the current generation of young adults is not doing as well as their parents did.? This may be a case of increasing income inequality, so that the average can increase while the median decreases.? From my angle in society, this is happening.? A few motivated people are prospering, and many are muddling along.? Where my opinion differs here is that people are generally getting what they deserve; in a more competitive world, people have to compete harder than their parents did, in order to do better.? In general, people are not working harder, and so their results are falling behind those of their parents on an inflation adjusted basis.

Not to leave it on a down note, but that’s it for the evening.? Hope to write cheerier stuff next week.

Reasons For Short-Term Optimism

Posted on 4 July 20075 July 2007 by David Merkel

Bond investors and value investors tend to be cautious in investing. It is possible to be too cautious, though, and so sometimes it pays to lay out the bull case. Indirectly, I learned this after several years of sitting next to the high yield manager at Dwight Asset Management (a very good firm that few know about). He wasn?t unconcerned about negative developments, but knew that fewer bad things happen than get talked about, and that they tend to take longer to happen than most imagine. He knew that he had to take some risks, because if you wait for the market to correct before you enter, you will miss profits while waiting, and the correction could be a long time in coming.

Also, I fondly remember our weekly economic conference calls in 2002, where the high yield manager and I would take the bull side in the discussions. For me it was fun, because it was so unlike me (I tend to be a bear), and it helped me to learn to balance the risks, and not be a perma-bull or a perma-bear.

So with that, here?s my quick list on what is going right in this environment:

Earnings yields are higher than bond yields, particularly among many investment grade companies, fostering buybacks and occasional LBOs. Profit margins may mean-revert eventually, but it might be a while for that to happen, given the global pressures that are keeping wage rates low.
The financing of the US current account deficit is still primarily being done through the purchase of US dollar denominated debt securities, keeping interest rates low in the US. This may shift if enough countries experience inflation from the buildup of US dollar reserves that they do not need, and allow their currencies to appreciate versus the US dollar. That hasn?t happened in size yet.
ECRI?s weekly leading index continues to make new highs.
Money supplies are growing rapidly around the world. Most of the paper is creating asset inflation, rather than goods inflation so far.
Bond yields have moderated since the yield peak in mid-June. Spreads on corporate investment grade debt have not widened much. Financing is cheap for the creditworthy.
Short sales are at a record at the NYSE. Part of that is just the influence of hedge funds.
Vulture investors have a lot of capital to deploy. Marginal assets are finding homes at prices that don?t involve too much of a haircut. (I?m not talking about subprime here.)
On a P/E basis, stocks are 45% cheaper than when the market peaked in March 2000.
Sell-side analysts are more bearish than they ever have been.
Investment grade companies still have a lot of cash sitting around. The washout from 2000-2002 made a lot of companies skittish, and led them to hold extra cash. Much of the cash has been deployed, but there is still more to go.
The FOMC is unlikely to tighten before it loosens.
Yield-seeking on the part of older investors is helping to keep interest rates low, and the prices of yield-sensitive stocks high.
DB Pension plans and endowments are still willing to make allocations to private equity.
The emerging markets countries are in aggregate in better fiscal shape than they ever have been.
Trade is now a global phenomenon, and not simply US/Europe/Japan-centric.
The current difficulties in subprime are likely to be localized in their effects, and a variety of hedge funds and fund-of-funds should get hit, but not do major damage to the financial system.

Now, behind each of these positives is a negative. (Every silver cloud has a dark lining?) What happens when these conditions shift? Profit margins fall, interest rates rise, inflation roars, risk appetites decrease, etc?

These are real risks, and I do not mean to minimize them. There are more risks as well that I haven?t mentioned. I continue to act as a nervous bull in this environment, making money where I can, and realizing that over a full cycle, my risk control disciplines will protect me in relative, but not absolute terms. So I play on, not knowing when a real disaster will strike.

Editing note — my apologies.? The second paragraph omitted the word “not” in the original publication.? What a word to omit, not. ??

Updating My Thoughts of Two Years Ago

Posted on 11 June 200712 June 2007 by David Merkel

Two years ago in the RealMoney Columnist Conversation, I wrote the following:

Yield curve be nimble, yield curve be quick, yield curve go under limbo stick.Okay, no great allusion in the song there, but I sit watching the long end of the yield curve rally as the short end falls slightly. Is the FOMC back in play that fast after yesterday? I don’t think anything has shifted, but Mr. Market is manic.

It’s times like this that make me want to review the full set of reasons why the long end is rallying:

The supply of long bonds is shrinking, and the Treasury hasn’t decided to reissue the 30-year bond yet.
Pension Reform is happening in Europe, and some Europeans are buying long U.S. debt together with currency swaps.
Pension reform might happen in the U.S. as well.
The PBGC is buying long investment grade debt (it likes to immunize, because it’s risk-averse), particularly Treasuries and Agencies like a madman, and it just got a new slug of cash in with the takeover of the UAL (UALAQ:OTC BB) plans.
Mortgage refinancing tends to depress rates as originators hedge.
Speculators that were previously short longer bonds are now long. (uh oh)
An aging population wants income and increasingly favors bonds.
Neomercantilistic economies buy U.S. bonds because they can’t find anything better to do with their export earnings.
Market players trust the FOMC (however misguidedly) to control inflation in the long run.
There aren’t a lot of other places to get incremental yield, so extending maturities is a temptation for bond investors.
The U.S. economy is anticipated to be growing at a slower rate.
The marginal efficiency of new capital is falling because of the introduction (in principle) of 2 billion laborers to the global capitalist labor pool.

This last point I covered in parts of the articles, “Implications of a Low-Nominal World,” and “The Economy, Seen From Many Angles.” When labor is abundant, more capital isn’t needed to produce a greater output, until labor is scarce again. The returns to the employment of additional capital fall, which leads market players to bid up the prices of fixed claims on the economic system, i.e., bonds, because they can’t find better places to assure a return for the future.

This also explains the increase in buybacks and debt reduction on the part of corporations, relative to increases in plant and equipment. That said, it’s a tough environment, but on the bright side, previously poor areas of the world are developing, and that bodes well for those countries, and the global economy 20 years out, once the labor that is new to the capitalist world is productively deployed.

What a difference two years makes. The above post was meant to justify low rates, and it did a fair job of making the case. Later I added a reason 13, that suggested that there was no other currency that could serve as the world’s reserve currency. Unless we move to a gold or commodity standard, that is probably still true.

So what among the above reasons are still valid? Let’s go through them:

30-year bonds are being issued now, though not in great abundance.
Still a factor, but small because the initial surge has worn off.
Only 40% complete in the US, but FASB may fix that within a year, which would intensify demand for long bonds as defined benefit plans attempt to match liability cash flows.
The bankruptcy wave is past. Not a factor now.
With rates higher, the mortgage hedging flows favor higher rates.
Kind of a wash. Speculators are long the 10-year and short the 30-year. Not a factor on rates now.
Still a factor. Yield seeking on the part of retirees is big, and Wall Street i catering to that search. (Hold onto your wallets.)
Still true.
Still true.
False; can’t get much incremental yield at all through extension of durations now.
True, but the degree of the slowdown is open to question, and foreign financial flows are a bigger factor.
Still true, though the marginal effect at present is probably smaller.

So where does that leave us on interest rates? Muddled. Most of the big demographic and international effects on rates still favor lower rates. A new factor that was only partially understood by me two years ago has become a bigger factor: rising inflation in countries that fund the US current account deficit. That favors higher rates, both here and abroad. The question is whether foreign countries bite the bullet and allow their currencies to rise against the dollar or not. To the extent that they allow their currencies to rise, so will rates in the US. But if they keep their currencies artificially weak by buying US dollar bonds with their own currencies, it will continue to depress US long interest rates.

Human nature being what it is, I would expect that most countries continue their policies of buying US fixed income until a crisis forces them to change. Those don’t come on schedule, so I will not try to predict timing. I continue to keep a large portion of my fixed income investments in foreign currencies, which has not been a winner in the last month, but has served me well over the last two years.