In some ways the biggest risk that we face is unemployment risk, because the biggest asset that most people have is the stream of wages that they will earn from their jobs.
Twenty years ago, as a young actuary who had just gotten his ASA, I made a promise to myself that I would build up my investment knowledge base, and spend one hour a day improving my skills.? Why did I decide to do this?? I realized that few actuaries were good with investments (then, on this side of the Atlantic), and that most of the risks that life insurance companies faced were driven by assets, not liabilities (still true for now).? That was different than what the actuarial syllabus would lead one to believe, but nonetheless true.? I only know of one life company that failed from bad liability pricing (calculation of premiums).? All the rest died from bad asset strategies.
That “one hour a day” (six days a week) made me invaluable to many of the companies that I served, and opened a lot of employment doors for me.? It also allowed me to make a jump out of the insurance world, at least for now.? In a knowledge based economy, continually improving your skills is a great way to advance your career, and limit downside when the inevitable bumps happen due to M&A, etc.
Now, to the average person entering the work force, it pays to look at the underlying economics of the industry to see how stable employment prospects will be.? No one is perfect in making these judgments, but there are often industries to avoid.? Examples: certain traditional media companies are being destroyed by the internet.? During the tech bubble, it was cool to work for tech companies, but how much future is there if they don’t make any money.? Wall Street is wonderful, but periodic layoffs can knock out a lot of people on the margins of the business.
Also, understanding the underlying economics of your industry instantly makes you more valuable to your employer, since many only understand the technical craft that they pursue.
Finally, cultivate friends.? Be competent, but be warm.? Help others in need when they are looking for work.? Be willing to lend a sympathetic ear to colleagues in their job troubles.? Network at industry functions.? Start a blog to demonstrate expertise.? (Okay, nix that one. 😉 )? Treat vendors with kindness and respect; learn their business if you can.? Join industry task forces to solve larger problems.
We can’t control our employment futures in entire, but we can influence how well we bounce when things don’t go right. To repeat, three ways to mitigate unemployment risk:
I’m just trying to clean up old topics, so bear with me:
1) This blog is not ending because of my new job. Finacorp wants me to keep it going, and they may use the posts in PDF form for clients. Also, unlike my prior employer, Finacorp wants me to have a high degree of exposure, because it aids them. You may see me in more venues, which could include TV and radio.
2) In one sense, I had an unusually productive Saturday. I built two models — one for a critique of the PEG ratio, and one for a model of the Treasury yield curve. You will see articles on both of these, and I am really jazzed on both of them. It is not often that I get one impressive result in a day. Today I got two. I’ll give you one practical upshot for now, if you are an institutional bond investor: go long 10-year Treasuries and short 7-year. We are very near the historical wides. If you are like me, and can live with negative carry, dollar duration-weight the trade, so that you are immune to parallel yield curve shifts.
3) I didn’t read Barron’s, Forbes, or The Economist today, but I did read the Financial Analysts Journal. In it there were three articles that are worth a comment. There was an interesting article on fundamental indexation that comes close to my view on the topic. Fundamental indexation, when properly done, is nothing more than enhanced indexing with a value tilt. Will it make you more money than an ordinary index fund? Yes, it will, over a long enough period of time. Will it work every year? No. Is there one optimal way to fundamentally index? No. There is no one cofactor, or set of cofactors that optimally define value, if for no other reason than the accounting rules keep changing.
4) The second article went over the value of immediate annuities as risk reducers to retirees, something I commented on recently. The tweak here is buying annuities that start paying later in retirement, for example at 80 or 85, with the risk that if you die before then, you get nothing. Longevity insurance; a very good concept, but the execution is tough.
5) The third article was on Risk Management for Event-Driven Funds. Here’s my take: risk arb is like being a high yield bond manager. Anytime a deal is announced, you have to do a credit risk analysis:
How likely is it that this deal will go through?
How badly could I be hurt if it does not go through?
Am I getting paid more than a junk bond with equivalent risk?
But the portfolio manager must ask some more questions:
Are there any common factors in my risk arb book that could bite me? Sectors? Need for debt finance?
What if deal financing terms go awry all at the same time? How will that affect the worst risks in my book?
Am I getting paid more than a junk bond with equivalent risk? (Okay, it’s a repeat, but it deserves it.)
Risk arbs have been burned lately, with all of the deals that have been busted because financing is not available on easy terms. It’s tough but this happens. Most easy arbs tend to get overplayed before blowups happen. The lure of easy money brings out the worst in people, even institutional investors.
I took some criticism at RealMoney.com for writing things like this about GM, though the author here was a much better writer.
The thing is, there are enough levers here that GM can keep the debt ball in the air for some time, as can many of the financial guarantors, so long as they can make their interest payments.
The “Big 3” lose vitality vs. Toyota and Honda each year — in the long run GM and Ford don’t make it. Perhaps after they go through bankruptcy, and shed liabilities to the PBGC, and issue new equity to the current unsecured bondholders, they can exist as smaller companies that have focus. Maybe Ford could be a division of Magna, and GM a division of Johnson Controls. At least then there would be competent management.
7) Barry Ritholtz had a good post called, 5 Historical Economic Crises and the U.S. The paper he cited went into five recent crises in the developed world, and how the current US situation stacks up against that.? Here was my comment on one of the areas where the US situation did not seem so dire, that of the run-up in government debt:
On the last point about the increase in the debt, what is missed is that a lot of the government debt increase is hidden by the non-marketable Treasury bonds held by the entitlement programs. Add that in, and consider the unfunded promises made at the Federal, State, and municipal levels, and the debt increase on an accrual basis is staggering.
We do face real risks here.? The rest of the world will not finance us in our own currency forever.? Oh, one critical difference between the US and the 5 crises — we are the worlds reserve currency, for now.
8 )? I like Egan-Jones on corporate debt.? They have quantitative models that follow contingent claims theory, and use market based factors to estimate likelihood and severity of default.? They are now trying to do models for asset backed securities.? Very different from what they are currently doing, and their corporate models will be no help.? They will also find difficulties in getting the data, and few market-based signals that inform their corporate models.? I wish them well, but they are entering a new line of business for which they have no existing tools to help them.
9) This article from Naked Capitalism pokes at the rating agencies, and the proposed reforms from the SEC.? My view is this: the financial regulators need a model on credit risk.? They need a common platform for all credit risks.? They need one set of ratings that allow them to set capital levels for the institutions that they regulate, or they need to bar investments that cannot be rated adequately.? The problem is not the rating agencies but the regulators.? How do they properly set capital levels.? They either have to use the rating agencies, or build internal ratings themselves.? Given my experiences with the NAIC SVO, it is much better to use the rating agencies.? They are more competent.
Those that know me well know that I have been following the entitlements issue for over 15 years. I feel that the leadership of the American Academy of Actuaries has blown it royally over this whole period, and before, through and before the Greenspan commission (his worst legacy). We had a chance to warn the nation, and did not do it. We allowed actuaries who could do the math, but didn’t understand the politics, to write in our journals, and talk to Congress, and suggest that everything would be fine.
Well, things are fine now, and they might be fine for the next president, but they won’t be fine by the 2020 election.
I am talking about Medicare/Medicaid. Unless there are significant changes made, there is no way that we can afford the promises that have been made.? The graph from the Wall Street Journal (from this fine article), on the right, depicts spending excluding interest.? Including interest payments makes the graph worse, and more so as time goes on.? In general, Americans don’t like sending more than 20% of GDP to the Federal Government.? By 2020, that will no longer be possible to avoid, unless significant changes are made.
This is the same issue that faces every state in the nation (except Wisconsin) and the Federal Government over their retiree health care programs; they didn’t set aside money for the future payments, but decided to pay-as-it-goes.? Now, what choices are there to remedy the situation?? Not many good ones:
Raise taxes significantly.
Raise the age for Medicare eligibility to 75 or so (don’t phase it in).
Means-test eligibility (lousy incentives there, as it is for Medicaid)
Eliminate part D now, while there is no imperative to keep it.
Create a reimbursement system that forces the creation of a two-tier medical system.? For the elderly, it will mean limited help in their waning years.? Treatments for expensive prolonging of life will have to come out of private sources.? Call it the Federal Elderly HMO.
The likely solution will involve all five policy options in some form.? How it works out depends on how much political resistance the elderly Baby Boomers will put up.? Another political hurdle: much as I dislike National Health Care, that is a wild card in this mix.? That could be the de facto way that limits the benefit payments that seniors receive.
I’m not into doom and gloom.? I manage money that is invested in stocks, and I have to look for advantage every day.? But we have put off real reform of entitlements for over 25 years, and we continue to do so.? Which of our six remaining presidential candidates is willing to talk about reforming Medicare?? I haven’t heard any of them go that way; it just loses votes.? But when it is hitting us between the eyes twelve years from now, younger people will be incented to vote in politicians that will curb benefits.
My investment implication is this: don’t rely on Medicare existing in its current form past 2020.? Plan today for the medical care you will need then.? Unless you have a funded private plan behind you, that means saving for the future costs.
When financial matters are opaque, there must be a large discount to prices representing clarity to interest people to buy.? Unfortunately, with 401(k)s and other defined contribution plans, it is sometimes akin to being limited to the “company store.”? I’ve written about these issues before, both here and at RealMoney.? Here’s a good example of one of them:
Pension Consultants: Watch Your 401(k) Expense Levels
9/27/2006 5:36 AM EDT
I want to point you to an article of John Wasik’s of Bloomberg. Having worked in the pension business while an actuary at a mutual life insurer, I had the experience of reviewing the pension services proposals of a number of competitors, and of complementary service providers. Most players were honest, but there were a number of players, while technically not breaking the law, would stretch ethics by finding ways to disguise fees by wending them into the change in unit value of the funds inside a deferred compensation plan. Why embed them in the unit value change? Slice up a fee over hundreds or thousands of participants, and over 365 days a year, and it is remarkable how little people notice it, because most people don’t bother to go and look at plan expenses as disclosed in the Form 5500. Even if everything were disclosed in detail there (some charges don’t get unbundled), an individual doesn’t see that the pro-rata expenses are coming out of his hide. Unless the plan sponsor goes the extra mile to try to minimize costs to participants, there is little that an individual can do.
We had a rule at our firm. We only take fees from one source, and we disclose them. We had a second rule: we only pay commissions once, and they can be disclosed to the ultimate client, or nondisclosed, but not both, but if nondisclosed, the ultimate client must know that.
Oe reason why we did not hire certain investment consultants was the potential for conflict of interest. We eventually hired a consultant to aid us in manager selection that took no fees from the managers, so we could get unbiased advice. There were other consultants that were less than scrupulous in that matter. Without naming names, we terminated our first investment manager consultant because we learned they would not recommend managers to us, unless they were receiving a fee from the manager. That fee would get built into the expenses would into the unit value, or, come out of my firms profit margins, which were for the good of the participating policyholders.
Now that was just my experience, so take that for what it’s worth, perhaps I’m just an investment actuary with a axe to grind. If you want a more general view of the problem, you can review this 2005 study of conflicts of interest done by the SEC. Now, as John Wasik notes, “The commission didn’t take any enforcement action after the report was issued, nor did it name any of the firms surveyed.” The problem is still there, and I’m afraid your only advocate is for you to appeal to your plan sponsor to watch out for the best interests of all participants, which is the duty of trustees under ERISA.
Position: none, but at the mutual life insurer, we had a saying, “We’re out to save the world for 25 basis points on assets, plus shipping and handling.” Beats a lot of other deals out there…
The difficulty here is that fees on small plans are sometimes high, and defined contribution plans don’t allow for easy examination of the total fee structures.? How much are the investment managers taking?? The recordkeeper? The custodian/trustee?? The marketer?? It is not always clear.? What can be worse is the manager selection, which are usually random on average (before fees) in terms of any outperformance versus indexes.
Now, in fairness, anytime you have a large number of small accounts, the costs will be high as a percentage of assets.? But there are limits.? Disclosure needs to be improved, but until then, ask your plan sponsor for all of the Form 5500 documents.? There are two classes of expenses.? Explicit: what the fund pays for directly.? Implicit: what gets deducted from investment returns.? Add the two together, because that is the total load.? Insist on as full of an accounting as the plan sponsor will give you.
If you are paying more than 1% of assets per year, then something is wrong, unless the asset classes are esoteric, which should not be the case for DC plans.? Remember, you have to be your own guardian with defined contribution plans.? No one will do it for you.? And, if a few of your colleagues complain at the same time, you will be amazed at how quickly it will be taken seriously, because the administrative staff of the plan sponsor usually doesn’t get that much feedback.
When I started this irregular series on personal finance, I didn’t think it would live this long. Maybe it’s appropriate then that this piece deals with longevity risk. After all, my prior piece dealt the the concept of the PRIER [Personal Required Investment Earnings Rate].
One of the main ideas there is that you have to take enough risk so that you earn enough money to meet all of your goals. One of those goals would likely be having enough to live off of if you live to a ripe old age, like 100. 100 sounds old; after all, it serves our fascination with watching the odometer roll over. Old age mortality has been improving, though and the number of centenarians is growing rapidly. The same is true of those living into their 90s. Yet many people plan retirement as if they were only going to live to 85.
The destitute elderly definitely have it worse than those with resources. What if you could eliminate some of the risk of outliving your income? I have a product that could help you — the life-contingent immediate annuity. Life-contingent immediate annuities pay a stream of income for the life of the annuitant (or joint lives of two annuitants). They give an income that cannot be outlived. Today, a number of insurance companies do that one better, and offer inflation adjustments on the payments, with the trade-off being accepting a lower initial payment than the unadjusted annuity. The only remaining risk is insurance company solvency, but only buy from reputable firms. That said, remember that the state guarantee funds stand behind the companies, and the benefit payments they are least likely to cut off in an insolvency are death benefits, disability payments, and immediate annuity payments.
Immediate annuities are bought, not sold, unlike other life insurance products. Why? Because once they are bought, there are usually no ways to surrender the policy. You can only take payments over time. Agents don’t like selling immediate annuities, because they will never derive another commission from that money. They would rather sell a variable annuity with a living benefit rider, because it will be possible to roll the policy at a later date to a “better” policy (surrender charges are low), and earn another commission.
Though I am not crazy about variable annuities with living benefit riders, if you own one, be careful before you surrender it. You may have a valuable option to have the company pay a fixed amount for a long time that is worth more than your surrender value rolling into a new policy. In general, be careful in buying any deferred annuities, because the fees are stiff. Be most careful if the agent comes to you when the surrender charge is gone, and encourages you to “roll” to a new product. His interests are different than your interests. You are likely better off staying in your existing deferred annuity.
Are there any other solutions to longevity risk? There are a few. First, cultivate younger friends and family who will be advocates for you in your dotage. They are necessary for kind treatment on the part of the staff of any old age home that you might enter. Those that have no advocates don’t fare well. (For those who are really young, marry, and have more than two kids! Love them, and they will love you.) Second, have an investment policy that reflects the longer-term, realizing you might live longer than average for those that have attained your age. This means more risk assets (stocks) on average than what is commonly recommended, but I would temper this with two caveats:
1) Remember that the Baby Boomers are graying, and will need to liquidate assets to support their old age.
2) Sometimes the markets are overvalued, and it is time to preserve capital, not go for capital gains. Tweak you asset allocation to reflect asset valuations.
A long life is a blessing, and even more so when you have friends, family, good health, and peace with God. Plan now to live longer than you expect. Save more, invest wisely, and buy some longevity insurance.
PS — Don’t go “hog wild” with any single pecuniary strategy for your old age. This is another area where diversification pays, so don’t put all of your eggs in one basket.
PPS — Some of the larger insurers (Pru, Met, Hartford) allow you to buy future income streams should you be alive to receive them. They are an inexpensive way for younger people to put money away for retirement, though there are risks of early death, company insolvency and inflation.
Everybody has a series of longer-term goals that they want to achieve financially, whether it is putting the kids through college, buying a home, retirement, etc.? Those priorities compete with short run needs, which helps to determine how much gets spent versus saved.
To the extent that one can estimate what one can reasonably save (hard, but worth doing), and what the needs of the future will cost, and when they will come due (harder, but worth doing), one can estimate personal contribution and required investment earnings rates.? Set up a spreadsheet with current assets and the likely savings as positive figures, and the future needs as negative figures, with the likely dates next to them.? Then use the XIRR function in Excel to estimate the personal required investment earnings rate [PRIER].
I’m treating financial planning in the same way that a Defined Benefit pension plan analyzes its risks.? There’s a reason for this, and I’ll get to that later.? Just as we know that a high assumed investment earnings rate at a defined benefit pension plan is a red flag, it is the same to an individual with a high PRIER.
Now, suppose at the end of the exercise one finds that the PRIER is greater than the yield on 10-year BBB bonds by more than 3%.? (Today that would be higher than 9%.)? That means you are not likely to make your goals.?? You can either:
Save more, or,
Reduce future expectations,whether that comes from doing the same things cheaper, or deferring when you do them.
Those are hard choices, but most people don’t make those choices because they never sit down and run the numbers.? Now, I left out a common choice that is more commonly chosen: invest more aggressively.? This is more commonly done because it is “free.”? In order to get more return, one must take more risk, so take more risk and you will get more return, right?? Right?!
Sadly, no.? Go back to Defined Benefit programs for a moment.? Think of the last eight years, where the average DB plan has been chasing a 8-9%/yr required yield.? What have they earned?? On a 60/40 equity/debt mandate, using the S&P 500 and the Lehman Aggregate as proxies, the return would be 3.5%/year, with the lion’s share coming from the less risky investment grade bonds.? The overshoot of the ’90s has been replaced by the undershoot of the 2000s.? Now, missing your funding target for eight years at 5%/yr or so is serious stuff, and this is a problem being faced by DB pension plans and individuals today.
While the ’80s and ’90s were roaring, DB plan sponsors made minimal contributions, and did not build up a buffer for the soggy 2000s.? Part of that was due to stupid tax law that the government put in because they didn’t want pension plans to shelter income from taxes for plan sponsors.? (As an aside, public plans did less than corporations, even though they did not face any tax consequences.)
But the same thing was true of individuals.? When the markets were good, they did not save.? Now when the markets are not good, the habit of not saving is entrenched, and now being older, saving might be more difficult because of kids in college, interest on a mortgage for a house larger than was needed, etc.
Now, absent additional saving, when investment earnings lag behind the PRIER, that makes the future PRIER rise, to try to make up for lost time.? Perhaps I need to apply the five stages of grieving here as well… trying to earn more to make up for lost time is a form of bargaining.? It rarely works, and sometimes blows up, leaving a person worse off than before.? Most aggressive asset allocation strategies only work over a long period of time, and only if a player is willing to buy-rebalance-hold, which only a few people are constitutionally capable of doing.? Most people get scared at the bottoms, and get euphoric near tops.? Few follow Buffett’s dictum, “Be greedy when others are fearful, and fearful when others are greedy.”? Personally, I expect the willingness to take investment risk over the next five years to rise, but over the next ten years, I don’t think it will be rewarded.
Now, as time progresses, and the Baby Boomers gray, unless the equity markets are returning the low teens in terms of returns, there will be a tendency for the average PRIER to rise, absent people realizing that they have to save more than planned, or reduce their goals.? This problem will be faced in the ’10s, bigtime.? The pensions crisis will be front page news, and I’m not talking about Social Security and Medicare, though those will be there also.? The demographics will be playing out.? After all, what drives the funding of retirement at a DB plan, but aging, where the promised expected payments get closer each day.
Well, same thing for individuals.? Every day that passes brings a slow weakening of our bodies and minds.? Dollars not saved today, or bad investment returns mean the PRIER rises, making the probability of attaining goals less achievable.
Now, is there nothing that can be done aside from increasing savings and reducing future plans?? In aggregate, no.? You will have to be someone special to beat the pack, because few do that.? Better you should take the simple solution, which is a humble one: save more, expect less.? For those that do have the talent, you will have to take the risks that few do, and be unconventional.? Note: for every four persons that think they can do this, at best one will succeed.? My own methods are always leaning against what is popular in the markets, and I think that I am one of those few, but it takes work and emotional discipline to do it.
Then again, I have done it, as far as my PRIER is concerned — it is below the rate on 10-year Treasuries.? Most of that is that my goals are modest, aside from putting my eight kids through college, and I am not planning on retiring.
With that, I leave to consider a post I wrote at RealMoney two years ago.? It’s kind of a classic, and Barry Ritholtz e-mailed me to say that he loved it.? Given what we are experiencing lately, it seems prescient.? Here it is:
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.
I have a filing system that I designed to help me save time.? I have a box in my bedroom that I toss papers that I might need into.? Any paper with sensitive personal data goes in there as well.? Once or twice a year, I go into that box and sort through the papers.? I sort the papers into various piles:
Insurance
Bank Statements
Brokerage
Taxes, last year
Taxes, this year
Not needed
Not needed, and shred, due to sensitive data (SSN, address, monetary data, identifying information)
Art that my children have given me
Articles that I wanted to keep a permanent copy of
Other, etc.
Typically, I retain the year-end statements for mutual funds, and monthly statements for banks and brokerages.? The rest I shred.? Rather, my 9-year old shreds… she does a very good job, and does it happily. :)? Roughly half gets shredded, and one-quarter gets thrown away.? The rest gets filed.
I store the long term financial data in file folders until they get large, and I bind them into binders.? I retain tax data for personal reasons, though there is little reason to go beyond seven years.? About once every decade, I go through all of my files, and pitch stuff mercilessly, retaining only what is best.? I did that two years ago.? 2016 is a long way away.
The idea here is to minimize my time spent filing, retain critical data, shred data that would be harmful in the hands of data felons, and make sure that I know where to find something that is truly needed.? So far this system has worked very well for me, and I have been using it for about 20 years.
Anyway, I went through this process yesterday, and now it is great to have things organized again.? 2007 was a memorable year for me, and it was fascinating to consider all of the things that happened, including starting this blog.? (Yes, I found those papers as well.)
Hi David,? I really enjoy your blog very much.? Your recent post regarding AAA bonds brings up a question for me and I’ve seen several different answers in the press and on TV.
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I have?about 35% of my portfolio in triple AAA muni bonds–most insured, but not all.? My intention with insured AAA bonds was to not have to worry about them.
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I’m now reading about the potential bankruptcies of the muni insurers–AMBAC, etc.? I heard on the tube today that “we will?see a muni bond crash” if the ratings on these insurers are lowered.? After the close I saw where one was lowered to a AA rating.? This is not what I like to hear and I suspect with further reading that the comment was overblown, possibly irresponsible.?
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I hold my bonds to maturity with my principle concern of income generation. Is this something one should be worried about?? Anything specifically about the individual bonds that should raise read flags?? As I live in Arkansas, most are Ark. munis although I’ve got some from Puerto Rico.? Thanks for any insight on this.??And keep your great posts coming.
I don’t think you should be very worried.? Municipalities rarely default.? When they do default, it is typically for a little while, and then payment resumes.? So long as a municipal bond has an economic purpose behind it — a necessary city, county, state, or project, defaults are rare.
The financial guarantee is a way of making the bonds thought-proof.? Bond mangers don’t have to do credit analysis; the guarantee is enough.? The guarantors aren’t dumb (at least with respect to municipals), they know what doesn’t deserve a guarantee.
Without knowing exactly what you own, I can’t say it with certainty, but I can say it is likely that you will come out okay if all you hold are munis that have an economic purpose. ? (Be careful on the Puerto Rican issuers, I know little there.)? That said, the market value of your bonds have likely declined a little due to the possible loss of insurance protection.? If you are truly, buying and holding economically necessary issuers, you should end up fine.
One piece that I wrote three years ago for RealMoney has relevance today in a new way. Stable Value Funds often invest in AAA securities (some are solely invested in AAA securities), and some funds will have above-average exposure to securities credit-wrapped by the financial guarantors, and possibly, to some asset-backed securities that were rated AAA at issue, but don’t deserve that rating now. For those who have exposure to stable value funds through their defined contribution plans, it might be wise to check what exposures your funds have to the guarantors, and to AAA structured securities that are trading significantly below amortized cost. The summary statistic to ask for (not that they will give it to you) is the market-to-book ratio of the fund. If it gets lower than 97%-98%, I would avoid the fund.
Now for the good news: If a stable value fund breaks, the total loss is likely to be small, like that of a busted money market fund. The one exception would be if a stable value fund manager tried to meet withdrawals while facing a run on the fund, and ratio of the market value of the assets to the book value of the assets kept falling.
In such an event, better for the fund manager to stop withdrawals early and announce a new NAV that counts in the loss.
I don’t know of any stable value funds that are in trouble, so take this with a grain of salt. Most stable value funds are managed conservatively, so any testing will likely reveal that most of them are fine. There may be a few that aren’t fine, though, so a little testing is in order.
If you do find a need to move, money market and high quality bond funds are an excellent substitute for stable value funds. Be aware that you might have to leave funds in a non-competing fund option for 90 days to get there. In this market, the risks there could be as great as the losses on the stable value fund, so think out the full decision before making any change.
Position: none
That was my post at RealMoney today.? I wrote it with some degree of uncertainty, because stable value funds have a defense mechanism.? They can lower the crediting rate to amortize away the difference between book value and market value, and in a crisis, many will not argue with the credited rate reductions.? They are just happy to preserve capital.
Do I think this is a big problem?? No.? Do I think that no one is talking about this?? Yes.? The thing is, a lot of things can be hidden by the various wrap agreements that stable value funds employ.? If I were a stable value fund, I would not want to publish my market value to book value ratio.? If it’s above one, the fund will attract inflows, diluting existing investors.? If it’s below one, net outflows will increase, threatening a run on the fund.
Just be aware here, because if you can’t get a feel for the underlying economics of your stable value fund, you should probably seek another investment in the present environment.
1) Let’s start on a positive note: Doug Kass says it is time to buy the financials.? I may never be as successful or clever as Mr. Kass, but I think he is early by one year or so.? And this is from someone who is technically overweight financials — I own six insurers, two high-quality mortgage REITs, and two European banks.? When it comes time to own financials, I may have a portfolio with 50% financial stocks, and I will pare back the insurers.
2) What of the Financial Guarantors?? Forget that I said I would flip the 14% MBIA surplus note, I did not expect that it would do so badly so quickly.?? The rating agencies are all concerned to potentially downgrade MBIA, Ambac, and others.? Downgrades are death, and rating agencies would only consider such measures if they knew that other companies would step in to continue their AAA franchise if they kick the losers over the edge.? Berky, by entering the financial guarantee space, has signed a death warrant for at least one of MBIA and Ambac, and who knows, Berky might buy the loser.
3)? Away from that, PartnerRe, one of my favorite companies, has written off its entire stake in Channel Re, which provided reinsurance to MBIA.? Leave it to that classy company to write off the whole thing, which implies bad things for MBIA as it relies on reinsurance from Channel Re, which it also partially owns.
4) Though this is a test of the financial guarantors, it is also a test of the rating agencies, which are in damage control mode now.? My view is the Moody’s and S&P will survive the ordeal, and come back fighting.
6) Now, a lot of the subprime crisis is really a stated income crisis.? Think about it: income is such a standard metric for loan repayment.? If one lets borrowers or agents fuddle with income, should we be surprised that loan quality declines?
7)? Even the black humor of the credit crunch in residential real estate points out how much more residential real estate might fall in price, and with it the values of companies that rely on residential real estate.
8) The boom/bust nature of Capitalism can not be repealed.? As an example, at the very time that you want banks to want to lend more to support the real estate market, they insist on larger down payments.
9) At my last employer, and at RealMoney, I would often say that the biggest crater to come in residential housing was in home equity loans.? JP Morgan is a good example of this.? Should this be surprising?? I noted from 2004-2007 how much of the ABS market had gone to home equity loans, and felt it was unsustainable.? Now we are facing the music.
10) Now consider credit cards.? Even cards on the high end are reporting deteriorating loan statistics.? Unlike past history, many people are paying on their cards to maintain access to credit, and letting their home loans slide.? Worrisome to me, and to the real estate markets as well.
13) Now for long term worries, consider what will happen to the real estate market as the baby boomers age.? Houses in colder areas will get sold, and houses in warmer areas will be bought.? This article does not take into account reverse mortgages, which will also be prominent.? Aside from that, the idea that baby boomers will be able to cash out of their homes to fund retirement will be hooey, unless we let wealthy foreigners buy into the US.? There will not be enough buyers for all of the houses to be sold without immigrants buying them.
Those that know me well know that I have been following the entitlements issue for over 15 years. I feel that the leadership of the American Academy of Actuaries has blown it royally over this whole period, and before, through and before the Greenspan commission (his worst legacy). We had a chance to warn the nation, and did not do it. We allowed actuaries who could do the math, but didn’t understand the politics, to write in our journals, and talk to Congress, and suggest that everything would be fine.
