Actuaries are bright people.  Okay, present writer excepted.  That’s a danger when you give a talk to a bunch of them.  Every now and then you will end up with a questioner who is a bit of a crank.  Now, I have a soft spot in my heart for actuarial cranks, because I have done more than my fair share to question other presenters over the years.

At my talk yesterday, one actuary suggested turning the Social Security system into a defined benefit plan, and having it invest in stocks, which would provide cheap capital to corporations.  The Social Security system gets better returns. Everyone wins, right?

Well, no.  Here is what is amiss with the idea:

1. It would favor public companies over private companies.
2. Active managers would be useless, because the fund would be too big.  They would have to index.
3. Initially the stock market would shift up as the money began to be invested, but once fully invested, P/E multiples would be so high that future returns would be lousy.  Once the liquidation phase began, this fund would be so big that stocks would fall in advance of the liquidation, even if everything were indexed.
4. Marginal companies with lousy profitability would come public to take advantage of the cheap funds.
5. Corporate governance issues would be tough; how does the government vote its proxies?  How would activist investors get treated?  Which side would the government favor?  If they left this in the hands of active managers to take care of, could the managers stand up to all of the political pressure?
6. Do we really want the Socialism associated with the government owning 20% of every corporation?  What additional regulations might be put on corporations that are owned or not owned by the government?
7. Would we give the Fed a third mandate to try to improve corporate profitability, because it would have a greater effect on the economy?
8. Why limit the asset classes invested in?  Why not other bonds, loans, commodities, real estate (commercial and residential) and perhaps international investments?  At least if we liquidate international investments, we don’t hurt our own economy.
9. For that matter, the US government could contribute all of its property to a great big REIT, and use it to fund a small portion of Social Security.  Of course, the deficit would rise as the government made dividend payments.
10. Medicare is the tougher issue to solve; Social Security is small compared to it.  Solve that one first.

My last reason is that for the most part, stocks don’t care who owns them.  In the long run, they are weighing machines, and not voting machines.  They will produce the stream of cash flows as a group that will be pretty invariant to who owns them.  Activist investors may have an effect in the short run, but on the whole, the effects of activism on the index returns as a whole will be paltry at best.

This tired idea of investing the Social Security trust funds in equities came up during the Clinton Administration (hopefully there will not be a second one).  I view it as the ultimate “dumb money” for the stock market.  If it were ever implemented, you would invest into the wave of new money, and create IPOs to sop up money.  Then once the money flow was largely deployed, you would sell along with other smart investors, and invest overseas.

My own view is that Social Security and Medicare should be wound down over a 80-year period.  They were bad ideas to begin with, but getting us out of that business with fairness to promises made would have to take two generations or so to complete.  I know, that’s a non-starter, but most reasonable ideas regarding social insurance programs are.  The eventual “solution” will come through higher ages for benefit receipt, lower benefits, higher taxes, limitation of inflation adjustments (already done, and quietly) and means-testing.  Not that I like it, but we will have to face realities eventually.

The same issues will apply to Medicare.  Eventually we will have a two-tier healthcare system (we won’t call it that), because we can’t afford the promises made to Medicare recipients.  It will be “The government pretends to pay us, and we pretend to treat you.”  It will be a mess, and that one should begin to come into clear focus within ten years.

PS — My talk went well yesterday.  If there is ever a recording of it on the web, I will put a link at my blog.

Finishing off the presentation proved to be harder than I estimated, together with all of my other duties.  Well, it’s done now, and available for your review here.  For those looking at one of the non-PDF versions, you might be able to see the notes for my talk as well.

I’m writing this before I give the talk.  If I had it to do all over again, I would have made the talk less ambitious.  Then again, of the four topics that I offered them, they picked the most ambitious one.  When you look at the talk, you’ll see that it is a summary of the macroeconomic views that frame my investment decisions.  The presentation will run 40 minutes or so, plus Q&A.  Reading it is faster.

Enjoy it, give me feedback, and I’ll be back to normal blogging Monday evening.

About a month ago, when the financial markets were more skittish, I saw a series of four articles on more interest in distressed debt investing (One, Two, Three, Four).  In this market, it didn’t surprise me much because we have too many smart people with too much money to invest.  It reminds me a bit of a RealMoney CC post that I made a year and a half ago:

		David Merkel
		Make the Money Sweat, Man! We Got Retirements to Fund, and Little Time to do it!
		3/28/2006 10:23 AM EST

What prompts this post was a bit of research from the estimable Richard Bernstein of Merrill Lynch, where he showed how correlations of returns in risky asset classes have risen over the past six years. (Get your hands on this one if you can.) Commodities, International Stocks, Hedge Funds, and Small Cap Stocks have become more correlated with US Large Cap Stocks over the past five years. With the exception of commodities, the 5-year correlations are over 90%. I would add in other asset classes as well: credit default, emerging markets, junk bonds, low-quality stocks, the toxic waste of Asset- and Mortgage-backed securities, and private equity. Also, all sectors inside the S&P 500 have become more correlated to the S&P 500, with the exception of consumer staples. In my opinion, this is due to the flood of liquidity seeking high stable returns, which is in turn driven partially by the need to fund the retirements of the baby boomers, and by modern portfolio theory with its mistaken view of risk as variability, rather than probability of loss, and the likely severity thereof. Also, the asset allocators use “brain dead” models that for the most part view the past as prologue, and for the most part project future returns as “the present, but not so much.” Works fine in the middle of a liquidity wave, but lousy at the turning points.

Taking risk to get stable returns is a crowded trade. Asset-specific risk may be lower today in a Modern Portfolio Theory sense. Return variability is low; implied volatilities are for the most part low. But in my opinion, the lack of volatility is hiding an increase in systemic risk. When risky assets have a bad time, they may behave badly as a group.

The only uncorrelated classes at present are cash and bonds (the higher quality the better). If you want diversification in this market, remember fixed income and cash. Oh, and as an aside, think of Municipal bonds, because they are the only fixed income asset class that the flood of foreign liquidity hasn’t touched.

Don’t make aggressive moves rapidly, but my advice is to position your portfolios more conservatively within your risk tolerance.

Position: none

We are still on the side of the demographic wave where net saving/investing is taking place, and that forces pension plan sponsors to find high-return areas to place additional monies.  Away from that, the current account deficit has to be recycled, and they aren’t buying US goods and services in size yet.  That’s why there will be vultures aplenty, outside of lower quality mortgages.  Even the debt market for new LBO debt is slowly perking up.  The banks pinned with the loan commitments may be able to get away with mere 5% losses.  Away from that, investment grade and junk grade corporate bonds are looking better as well.

Now, don’t take this as an “all clear.”  There are still significant problems to be digested, particularly in the residential real estate and mortgage markets.  CDOs still offer a bevy of credit issues.  There will be continued difficulties, and I don’t expect big returns.  But with so many willing to take risk at this point, I can’t see a big drop-off until they get whacked by worsening credit conditions.

In my continuing series where I try to look beyond the current furor of the markets, here are a number of interesting items I have run into on the web:

1) Asset Allocation

• Many people who want to stress the importance of their asset allocation services will tell you that asset allocation is responsible for 90% of all returns, so ignore other issues.  An article on the web reminded me of this debate.  The correct answer to the question, as pointed out by this paper, is that asset allocation explains 90% of the variability of the returns of a given fund across time, but only explains only 40% of the variability of a fund versus other funds.  Security selection matters.
• Two interesting papers on asset class correlation.  Main upshots: historical correlations are not fully reliable, because risky assets tend to trade similarly in a crisis.  Value tends to march to its own drummer more than other equity styles in a crisis.  The effects on correlation in crises vary by crisis; no two are alike.  Natural resources and globa bonds tend to be good diversifiers.
• In bull markets, risky asset classes all tend to do well.  Vice-versa in the bear markets.  My reason for this correlation is that you have institutional asset buyers all focusing on asset classes that were previously under-recognized, and are now investing in them, which raises the correlation level, not because the economics have changed, but becuase the buyers have very similar objectives.
• There are a few good states, but by and large, public pensions are a morass.  Most are underfunded, and rely on future taxation increases to support them.  When a public system realizes that it is behind, the temptation is to take more investment risk by purchasing alternative asset classes that might give higher returns.  This will end badly, as I have commented before… I suspect that some state pension plans are the dumping grounds for a lot of overpriced risk that Wall Street could not offload elsewhere.

2) Insurance

• When the premiums get too high, people tend to stop buying insurance, or reduce coverage severely. That’s happening for Southeast windstorm coverage now, particularly in Florida.  That might be a good bet this year, but I wouldn’t press my bet in 2008 even if 2007 ends loss free.
• Similarly, when reinsurance premiums are high, insurers buy less reinsurance, and more when prices fall.  Though Swiss Re is saying that 2007 will be worse from a loss standpoint than 2006, that’s not saying much.  Swiss Re can try to avoid premium decreases, but they will lose business in the process.

3) Investment Abuse of the Elderly

It’s all too common, I’m afraid.  Senior citizens get convinced to buy inappropriate investments.  Even the SEC is looking into it.  This applies to annuities as well, mainly deferred annuities, which I generally do not recommend, particularly for seniors.  The comment that a CEO doesn’t fully understand his own annuity products is telling.

Now fixed immediate annuities are another thing, and I recommend them highly as a bond substitute for those in retirement, particularly for seniors who are healthy.

The only real cure for these deceptive practices is to watch out for the seniors that you care for, and tell them to be skeptics, and to run all major investment decisions by you, or another trusted soul for a second opinion.

4) Accounting

• I am against the elimination of the IFRS to GAAP reconciliation for foreign firms.  What is FASB’s main goal in life — to destroy comparability of financial statements?  We may lose more foreign firms listed in the US, which I won’t like, but a consistent accounting basis is critical for smaller investors.
• Congress moves from one ditch to the other.  This time it’s sale of subprime loans.  Too many modifications, and sale treatment is at risk, so Congress tries to soften the blow for the housing market.  Let auditors be auditors, and if you want the accounting rules changed, then let Congress do the job of the FASB, so that they can be blamed for their incompetence at a complex task.
• As I’ve said before, I don’t like SFAS 159.  It will lead to more distortions in financial statements, because managements will tend to err in favor of higher asset and lower liability values, where they have the freedom to set assumptions.

5) Volatility

• Earn 40%/year from naked put selling?  Possible, but with a lot of tail risk.  I remember how a lot of naked put sellers got smashed back in October 1987.  That said, it looks like you can make up the loss with persistence, that is, until too many people do it.
• Here’s an interesting graph of the various VIX phases over the past 20 years.  Interesting how the phases are multiyear in nature.  Makes me think higher implied volatility is coming.
• I don’t think a VIX replicating ETF would be a good idea; I’m not sure it would work.  If we want to have a volatility ETF, maybe it would be better to use variance swaps or a fund that buys long delta-neutral straddles, and rebalances when the absolute value of delta gets too high.

That’s all for now.  More coming in the next part of this series.

1)  Start with the pessimists:

• It’s often thought that foreigners are the ultimate dumb money, entering near the end of a bull wave, because they are the last to notice, and chase performance.  Well, they are big investors now.
• Normal forward-looking assumptions about asset class returns don’t look that bullish either.  This is similar to my argument in this RealMoney article.

2)  Move to the optimists:

• When stocks trade like a herd, the past short-term price movements have been up on average.
• With the Dow Industrials, the dividend yield may be cheap relative to high quality bonds.  Hidden assumption: average future dividend growth or better.
• Insiders are buying.  Really, insiders are buying.
• P/Es are low in the eyes of some.  (Of course, profit margins are high…)
• The guy who said “Sell Sell Sell,” now says “Buy Buy Buy.”  (Of course, this is Europe, but equity markets are pretty correlated.)

3) Hedge funds are getting outflows at present (and here), and August performance was pretty bad (and here — look at  “Splutter”).  I began toting up a list of notable losers, but it got too big.  One positive note, many of the large quant funds bounced back from their mid-August stress.

4)  When muni bonds get interesting, you know it’s a weird environment.  It starts with the fundamental mismatch of muni bonds.  Muni issuers want to lock in long term financing, but most investors want to invest shorter.  Along come some trusts that buy long bonds and sell short-dated participations against them, and hedge the curve risk with Treasuries.  When credit stress got high, long munis were sold because they could be, and long Treasuries rallied, which was the opposite of what was needed for a hedge.  (Note: hedging with Treasuries can work in normal markets, but fails utterly in panics, as happened in 1998.)  When the selling was done, in many cases high quality muni yields were high than Treasuries even before adjusting for taxes.  That didn’t last long, but munis are still a good deal here.

5) Large caps are outperforming small caps.  Foreign exposure that large caps have here is a plus.

6) Not all emerging markets are created equal.  Some are more likely to have trouble because they are reliant on foreign financing. (Latvia, Iceland, Bulgaria, Turkey, Romania)  Others are more likely to have trouble if the US economy slows down, because they export to us. (Mexico, Israel, Jordan, Thailand, Taiwan, Peru)  I would be more concerned about the first group.

7) Are global banks cheap?  Yes on an earnings basis, probably not on a book basis.  We need to see some writedowns here before the group gets interesting.

I’ve talked about SFAS 159 before, and you know I think it is a bad accounting rule.  This article from my friend Peter Eavis helps to point out some of the ways that it allows too much freedom to managements to revalue assets up.  What I would watch in financial companies is any significant increase in their need for financing, which could point out real illiquidity, even though the balance sheet might look strong; this one is tough because financials are opaque, and the cash flow statement is not so useful.  Poring over the SFAS 159 disclosures will be required as well.

9) As I have suggested, pension plans will probably end up with a decent amount of the hit from subprime lending, through their hedge fund-of-funds.

10) Hedge funds do better if the managers went to schools that had high average SAT scores?  I would not have guessed that.  Many of the best investors I have known were clever people who went to average schools.

11) My but bond trading has changed.  When I was a corporates manager, hedge funds weren’t a factor in trading.  Now they are 30% of the market.  Wow.  Surprises me that volatility isn’t higher.

12) Rich Bernstein of Merrill (bright guy) is getting his day in the sun.  His call for outperformance of quality assets seems to be happening.  Now the question is whether the cost of capital is going up globally or not.  If so, he says to avoid: “1) China, 2) emerging market infrastructure, 3) small stocks, 4) indebted U.S. consumers, 5) financial companies, 6) commodities and energy companies.“  Personally, I think the cost of capital is rising for companies rated BBB and below, which brings it back to the quality trade.

13) Econocator asks if markets have priced in a recession, and he says no. My problem with the analysis is that we would need 10-year Treasury yields in the 2.5% area to fully price it in by his measure, and that makes no sense, outside of a depression, and then, nothing is priced in.

14) Morningstar moves into options research.  Could be interesting, though Value line has had a similar publication, and I’m not sure that the market for publications like this is big enough.  They make a good point that most people use options wrong, and get the short end of the stick.

15) Oil is amazing, but wheat is through the roof.  I’ve seen articles about bread prices rising.  Fortunately, the cost of grain is a small part of the cost of foods that rely on grain.

With that, I bid you good night.

1. 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.
2. Need a reason for optimism? Look at the insiders. They see more value at current levels.
3. 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.
4. 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.
5. 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.
6. 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.
7. 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.
8. This is just a good post on sector data from VIX and More. It’s worth looking at the websites listed.
9. 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.
10. 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.
11. 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.
12. 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.
13. 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.
14. 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.
15. 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.
16. 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.
17. 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.
18. 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.
19. 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.
20. 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

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:

1. 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.
2. 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.
3. 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.
4. 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.
5. 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

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.

1. 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.)
2. 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.
3. 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.
4. 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.
5. 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.
6. 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?
7. 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.
8. 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.
9. 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.
10. 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.
11. Perhaps Babak at Trader’s Narrative would agree on the likelihood of a bounce, with the put/call ratio so high.
12. 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.
13. 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.
14. 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.
15. Along those same lines, if investment grade corporations continue to put up good earnings, this decline will reverse.
16. 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.
17. 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.
18. 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.
19. 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.
20. 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).
21. 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.
22. 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.).
23. 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.
24. 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.
25. 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.
26. 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.
27. 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.
28. 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.
29. 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?
30. 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.
31. 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.
32. 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.
33. 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.
34. 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.
35. 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.

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

1. 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.
2. 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).
3. 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.
4. 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.).
5. 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.
6. 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.
7. 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.
8. 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.
9. 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.
10. 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.

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:

1. The bid for debt from CDO equity.
2. The Private Equity bid for cheap-ish assets with steady earnings streams.
3. The recycling of the US current account deficit.
4. 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.
5. 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.