Portfolio Management – Page 118

Berkshire Hathaway — The Anti-Volatility Fortress

Posted on 1 March 2008 by David Merkel

I?ve commented on Buffett?s Shareholder letter now for the past five years.? Those who know me well know that I admire Buffett and Berky, but not uncritically.?? Also, I view Berky as primarily an insurance company, secondarily as an industrial conglomerate, and thirdly as an investment company.

Onto the letter:

From page 3:

You may recall a 2003 Silicon Valley bumper sticker that implored, ?Please, God, Just One More Bubble.? Unfortunately, this wish was promptly granted, as just about all Americans came to believe that house prices would forever rise. That conviction made a borrower?s income and cash equity seem unimportant to lenders, who shoveled out money, confident that HPA ? house price appreciation ? would cure all problems. Today, our country is experiencing widespread pain because of that erroneous belief. As house prices fall, a huge amount of financial folly is being exposed. You only learn who has been swimming naked when the tide goes out ? and what we are witnessing at some of our largest financial institutions is an ugly sight.

Buffett starts out with the cause behind most of our current problems in financial companies.?? There are too many houses chasing too few people, and inadequate underwriting of the financing, because of a misplaced trust in the rise of housing prices.

From page 4:

Though these tables may help you gain historical perspective and be useful in valuation, they are completely misleading in predicting future possibilities. Berkshire?s past record can?t be duplicated or even approached. Our base of assets and earnings is now far too large for us to make outsized gains in the future.? (emphasis his)

Buffett has been honest on this point for years.? As the business grows, it is unlikely to find opportunities as good in percentage terms as it did when it was smaller.? That?s normal, even for the best investors.

In our efforts, we will be aided enormously by the managers who have joined Berkshire. This is an unusual group in several ways. First, most of them have no financial need to work. Many sold us their businesses for large sums and run them because they love doing so, not because they need the money. Naturally they wish to be paid fairly, but money alone is not the reason they work hard and productively.

Buffett hits on what I think is one of the great secrets of good capitalism.? The best capitalists are not purely money-motivated, but are idealists, aiming for excellence as they serve others though their businesses.? In the best businesses that I have worked in, we did it because we loved what we did.? That?s a key for all good businesses, from the CEO down to the clerk.

From page 7:

Long-term competitive advantage in a stable industry is what we seek in a business. If that comes with rapid organic growth, great. But even without organic growth, such a business is rewarding. We will simply take the lush earnings of the business and use them to buy similar businesses elsewhere. There?s no rule that you have to invest money where you?ve earned it. Indeed, it?s often a mistake to do so: Truly great businesses, earning huge returns on tangible assets, can?t for any extended period reinvest a large portion of their earnings internally at high rates of return.

This is the core of Buffett the businessman.? He understands the need to redirect free cash flow to the opportunities that offer the best returns.? He knows that certain businesses will never be more than niches, and like a good farmer would, harvests his specialty crop each year, but doesn?t plant much more the next year.

He goes on for two pages on how he distinguishes between businesses, considering their long-term competitive advantage, return on investment, and capital intensiveness.??? It?s a good read, and very basic.? If it weren?t for the fact that many companies operate more for the good of management than shareholders, you might see this in operation more broadly.? (And you would see opportunities diminish for private equity as far as big deals go.? Private equity keeps public management teams on their toes, for the bigger deals.)

From pages 9-11, Buffett discusses his insurance businesses, and spends much less time on them than in prior years.? It is not as if there isn?t a good story to tell.? Are underwriting profits down?? Yes, but only by 10%.? The rest of the P&C insurance industry is struggling with the same problems, and is likely doing worse in aggregate.? I think that some major disasters will have to happen to re-energize earnings here.? Berky is an anti-volatility asset, and always does relatively better when the rest of the insurance industry is hurting.

On page 11, Buffett comments on his utility businesses.? Earnings are up in this line.? These are a natural fit for Berky, with their earnings yield considerably above Berky?s cost of float, and earnings that tend to do well when inflation is higher.? Expect Buffett to buy more here, but only during some significant pullback in utility stock prices.

From that page:

Somewhat incongruously, MidAmerican also owns the second largest real estate brokerage firm in the U.S., HomeServices of America. This company operates through 20 locally-branded firms with 18,800 agents. Last year was a slow year for residential sales, and 2008 will probably be slower. We will continue, however, to acquire quality brokerage operations when they are available at sensible prices.

From page 13:

Last year, Shaw, MiTek and Acme contracted for tuck-in acquisitions that will help future earnings. You can be sure they will be looking for more of these.

and

At Borsheims, sales increased 15.1%, helped by a 27% gain during Shareholder Weekend. Two years ago, Susan Jacques suggested that we remodel and expand the store. I was skeptical, but Susan was right.

From page 15:

Clayton, XTRA and CORT are all good businesses, very ably run by Kevin Clayton, Bill Franz and Paul Arnold. Each has made tuck-in acquisitions during Berkshire?s ownership. More will come.

Buffett understands that most good acquisitions are little ones that can be used to increase organic growth of the subsidiary. ?Same thing for intelligent capital spending, as at Borsheim?s.? He may keep a tight hold on free cash flow, but he listens to his subsidiary CEOs, and usually gives them enough to invest to improve the businesses.

Also look at the countercyclical nature of Buffett?s acquisitions.? He is willing to buy real estate sales franchises in this environment, if they come at the right price.? Much as I am a bear on housing, this is the right strategy, if you have a strong enough balance sheet behind it.

On pages 12 and 14, net operating income improved in Manufacturing, Service, and Retailing Operations, and fell in Finance and Finance Products.? He doesn?t discuss it, but there was a loss in life and annuity.? Berky mainly does life settlements there, a business I regard as somewhat malodorous because it undermines the life insurance industry, by weakening the concept of insurable interest.? Also, leasing didn?t do that well, as Buffett points out.

On page 15, I don?t have a strong opinion on his stock positions? they are a little more expensive than I like to buy, but he has to deploy a lot more money than I do, and has a longer time horizon.? His focus on long term competitive advantage is exactly right for his position in the market.

On page 16, Buffett discusses his derivative book:

Last year I told you that Berkshire had 62 derivative contracts that I manage. (We also have a few left in the General Re runoff book.) Today, we have 94 of these, and they fall into two categories. First, we have written 54 contracts that require us to make payments if certain bonds that are included in various high-yield indices default. These contracts expire at various times from 2009 to 2013. At yearend we had received $3.2 billion in premiums on these contracts; had paid $472 million in losses; and in the worst case (though it is extremely unlikely to occur) could be required to pay an additional $4.7 billion.

We are certain to make many more payments. But I believe that on premium revenues alone, these contracts will prove profitable, leaving aside what we can earn on the large sums we hold. Our yearend liability for this exposure was recorded at $1.8 billion and is included in ?Derivative Contract Liabilities? on our balance sheet.

The second category of contracts involves various put options we have sold on four stock indices (the S&P 500 plus three foreign indices). These puts had original terms of either 15 or 20 years and were struck at the market. We have received premiums of $4.5 billion, and we recorded a liability at yearend of $4.6 billion. The puts in these contracts are exercisable only at their expiration dates, which occur between 2019 and 2027, and Berkshire will then need to make a payment only if the index in question is quoted at a level below that existing on the day that the put was written. Again, I believe these contracts, in aggregate, will be profitable and that we will, in addition, receive substantial income from our investment of the premiums we hold during the 15- or 20-year period.

Two aspects of our derivative contracts are particularly important. First, in all cases we hold the money, which means that we have no counterparty risk.

Second, accounting rules for our derivative contracts differ from those applying to our investment portfolio. In that portfolio, changes in value are applied to the net worth shown on Berkshire?s balance sheet, but do not affect earnings unless we sell (or write down) a holding. Changes in the value of a derivative contract, however, must be applied each quarter to earnings.

Thus, our derivative positions will sometimes cause large swings in reported earnings, even though Charlie and I might believe the intrinsic value of these positions has changed little. He and I will not be bothered by these swings ? even though they could easily amount to $1 billion or more in a quarter ? and we hope you won?t be either. You will recall that in our catastrophe insurance business, we are always ready to trade increased volatility in reported earnings in the short run for greater gains in net worth in the long run. That is our philosophy in derivatives as well.

Okay, so Buffett is long high yield credit, and seemingly receiving a pretty reward for it (the numbers seem too good, what is he doing?), and is long the US and other equity markets by writing long-dated European puts.? Sounds pretty good to me on both, though I?d love to see the details on the high yield, and on the equity index puts, Berky will be vulnerable in a depression scenario (it would be interesting to know the details there also).

Buffett is behaving like a long-tail P&C insurer, and he is willing to take on volatility if it offers better returns.? Berky is almost always willing to take on catastrophe risks, if they are more than adequately compensated.? If you are uncertain about this, ask the financial guarantors, they will tell you.

On page 17:

There?s been much talk recently of sovereign wealth funds and how they are buying large pieces of American businesses. This is our doing, not some nefarious plot by foreign governments. Our trade equation guarantees massive foreign investment in the U.S. When we force-feed $2 billion daily to the rest of the world, they must invest in something here. Why should we complain when they choose stocks over bonds?

Indeed, what?s sauce for the goose is sauce for the gander.? Why should the rest of the world buy our depreciating bonds, when they can buy our companies, which in my opinion, often offer much better prospects?? As Buffett puts it later, we are force-feeding dollars to the rest of the world? the decline in value is to be expected.

Also on page 17:

At Berkshire we held only one direct currency position during 2007. That was in ? hold your breath ? the Brazilian real. Not long ago, swapping dollars for reals would have been unthinkable. After all, during the past century five versions of Brazilian currency have, in effect, turned into confetti. As has been true in many countries whose currencies have periodically withered and died, wealthy Brazilians sometimes stashed large sums in the U.S. to preserve their wealth.

Clever move, and emblematic of the shift happening in our world where resource- and cheap labor-driven nations grow rapidly, and build up trade surpluses against the developed world.? Their currencies have appreciated.

Also on page 17:

Our direct currency positions have yielded $2.3 billion of pre-tax profits over the past five years, and in addition we have profited by holding bonds of U.S. companies that are denominated in other currencies. For example, in 2001 and 2002 we purchased ?310 million Amazon.com, Inc. 6 7/8 of 2010 at 57% of par. At the time, Amazon bonds were priced as ?junk? credits, though they were anything but. (Yes, Virginia, you can occasionally find markets that are ridiculously inefficient ? or at least you can find them anywhere except at the finance departments of some leading business schools.)

The Euro denomination of the Amazon bonds was a further, and important, attraction for us. The Euro was at 95? when we bought in 2002. Therefore, our cost in dollars came to only $169 million. Now the bonds sell at 102% of par and the Euro is worth $1.47. In 2005 and 2006 some of our bonds were called and we received $253 million for them. Our remaining bonds were valued at $162 million at yearend. Of our $246 million of realized and unrealized gain, about $118 million is attributable to the fall in the dollar. Currencies do matter.

Though Buffett got scared out of many of his foreign currency positions over the last few years, intellectually he was right about the direction of the US dollar, and made decent money off it.? The Amazon position was a home run in bond terms.? Bill Miller benefited from that one as well.? (I also endorse the comment on occasional inefficient markets.)

On page 18:

At Berkshire, we will attempt to further increase our stream of direct and indirect foreign earnings. Even if we are successful, however, our assets and earnings will always be concentrated in the U.S. Despite our country?s many imperfections and unrelenting problems of one sort or another, America?s rule of law, market-responsive economic system, and belief in meritocracy are almost certain to produce ever-growing prosperity for its citizens.

This is one of America?s greatest sustainable competitive advantages.? We allow more flexibility and failure than anywhere else in the world.? We have a relatively open and free system of markets and government.? Woe betide us if we change this.

On pages 18-20, Buffett takes on employee stock option accounting and pension accounting.? He believes options should be expensed, and that companies should bring down their assumptions for investment earnings, because they are unrealistically high.? I agree on the latter, and on the former, I think full disclosure is good enough.? Accounting rules are important, but investors (like Buffett) look for long-term free cash flows, which are largely unaffected by accounting rules.

I don?t think the market is fooled in either case.? Companies with large stock option grants and high assumed earning on pension plans both tend to trade cheap.? Their earnings quality is light.

Finally, on page 20:

Whatever pension-cost surprises are in store for shareholders down the road, these jolts will be surpassed many times over by those experienced by taxpayers. Public pension promises are huge and, in many cases, funding is woefully inadequate. Because the fuse on this time bomb is long, politicians flinch from inflicting tax pain, given that problems will only become apparent long after these officials have departed. Promises involving very early retirement ? sometimes to those in their low 40s ? and generous cost-of-living adjustments are easy for these officials to make. In a world where people are living longer and inflation is certain, those promises will be anything but easy to keep.

Ummm? say it again, Warren.? I?ve been saying this for years.? Hey, throw in multiple employer trusts as well.

With that, I would offer two observations about this letter from Warren.? First, it is shorter, and contains less data on the businesses, particularly the insurance businesses, but then, it was a quiet year.? Second, he had less in the way of ?soap box? issues this year.

In closing, Berky had a good year, and I have little to quibble with in this letter.? Another good job, Warren.

The Decision to Insource Asset Management

Posted on 29 February 2008 by David Merkel

There are real advantages to having someone else do the investing for you if you are not an expert on the subject.? Pity the poor 401(k) investor who has to struggle with the right asset allocation.? He typically does not have the constitution to control his emotions in investing; fear and greed overcome many institutional investors.? What can the poor guy do?

He could get some advice, and then, “set it and forget it,” with occasional rebalancing.
He could learn about investing and try to lean against the wind.
He could flounder — that’s the default option.
Even just investing in a balanced fund is better… one fund does it all.
Even a money market fund might beat the guy who naively tries to time the market.

But what of a local municipality?? I’m sure some municipal Treasurers look at Florida and ask, “What if that happened here?? What would I do?? Should I try to manage the money internally?”

That’s a tough decision, and one that should be approached slowly, having discussions with all interested parties.? One main idea that I would put forth here is that it is not an on/off decision.? Let me explain.

In general, the best mergers are little ones, where a larger company acquires a smaller one that gives them:

Access to a new market for existing products
Access to a new technology that makes existing products cheaper or better
A new complementary product
?A new geographic region to sell in.
Etc.

The same is true of deciding to insource investment management.? It does not have to be done all at once.? Start with something simple and near to you, like cash management.? It might require the hiring of one new person with expertise, or hiring one new firm that would do it in the place of the existing relationship.? That initial move can enable later moves in other asset classes.? The idea here is to be incremental, build up expertise slowly, and analyze competitive advantage.? It may that:

The existing investment pool is on net better than an external manager, or what could be done internally.
We are large enough to hire an internal professional to manage it, earning better returns after expenses.
The external manager has resources that the existing pooled arrangement can’t touch, and is better than an internal arrangement can do.

The answer will differ by municipality, but the question should be asked.? Now, there are spillover benefits from having investment professionals on staff; they can be internal consultants on other investing questions.? “Should we enter into this swap agreement, together with the municipal bond we are floating?”? “What do you think the best borrowing option is for us at present?” “What do you think about the managers of our defined benefit plan?”? And there are more questions like that.? You would not think to ask them unless you had someone on staff that you thought could answer it impartially, and competently.

As for my own experience, I have been that internal consultant at many of the firms at which I have worked.? And it helped the businesses, because they trusted someone that they knew.? With that, I simply close by saying look at your existing investment relationships, and test them against a different third party relationship, and managing internally.

Micro-stability versus Macro-instability

Posted on 28 February 200828 February 2008 by David Merkel

When I was a corporate and mortgage bond manager, I would have to look through prospectuses, if the bonds weren’t vanilla in nature. There was a division of labor — credit analysts would opine on the likelihood of whether a company was “money good,” and portfolio managers would try to decide relative value, analyze structure issues, and figure out whether the bond fit client needs.

The structure part didn’t come up often, but when it did, you’d have to read through a prospectus between a quarter of an inch to an inch thick. There were rewards to doing that. Sometimes I learned that protections weren’t what they seemed… I remember looking at an Enron privately placed bond, and after looking at the complex structure, asking what would happen if Enron’s stock price fell so hard that they couldn’t issue preferred or common equity to redeem the notes. I was told that Enron was a very successful corporation, and that wouldn’t happen. We didn’t buy the deal, and we let some of our existing Enron bonds mature. The protections might be valuable in a minor crisis, but not in a major one. In a major crisis, they would be the equivalent of unsecured debt.

After Enron blew up (and we took losses on the smaller amount of bonds still held — that’s another story), all Enron-like deals began to founder in the market. Dominion Utilities had a bond, Dominion Fiber Ventures, that was an Enron-like structure. It was only 3% of their capital structure, though, so unlike Enron, it wouldn’t kill them. We quietly bought as much as we could, after I read the prospectus, saw the protections (must issue preferred stock to redeem bonds if downgraded and stock price is below a certain price for so much time), and saw that Dominion guaranteed the debt. Dominion’s stock price did fall below the threshold, and a downgrade might come, so Dominion negotiated with bondholders to redeem the debt. We had a 10%+ gain plus interest in less than a year.

My point here is that protective measures in bonds must be adequate for the size of the issue involved, and must be capable of handling a big crisis to truly be effective. With Dominion, the protections were adequate, with Enron, they weren’t. Protective systems can work when they only have to take care of 3% of the capital structure — they will be inadequate at 50%.

Let me point you to a few other areas where this can be a problem. General American went under when they had ratings triggers on their floating rate GICs, as did ARM Financial. All it took was a downgrade, and when the money market funds exercised their puts, they couldn’t meet the redemptions, and they were insolvent. For GA, it was 25% of their capital structure. Metlife bought them for less than 75% of their net assets, and paid off the claimants. Mutual Benefit died for similar reasons. (I was a small part of trying to eliminate such triggers in property-catastrophe insurance.)

Or consider the financial guarantors. What if many different types of insured debt got into trouble at once? We may be seeing that now. If it’s not enough to see structured products in trouble, what of municipalities with soft real estate markets, like Vallejo? The rating agency models give some benefit to lack of correlation in the business mix, but in a systemic crisis, there is greater correlation. Insured obligations are AAA (or if you speak Moody’s Aaa) so long as the system is not overwhelmed. In normal times financial guarantors are money-spinners. There are few defaults, and nothing that is concentrated.

Or consider the auction rate securities markets, with all of the failed auctions of late. The dealers bought bonds when it was to their advantage, or, at least, not a big disadvantage. But when a tidal wave came, they protected themselves and not their issuers. Municipalities are working to refinance the high cost debt that they now have. The end result is bad but not horrid, but it will lead to steep yields in the long end of the muni curve for a while. (Also student loans and closed-end muni funds…)

Finally, think of the variable rate demand note (obligation/bond) market (Hi, Liz, another good article!). It is similar to the auction rate securities market, except there are banks that guarantee (for a time, sometimes to maturity, but usually for more like a year or two) to repurchase notes at par, so long as the municipality is still solvent, and the guarantor is still solvent, and not severely downgraded. The escape clauses have not been triggered, so now the banks that guaranteed repurchase at par must buy the bonds. What happens if the bank runs out of liquidity to make the purchases? The bonds will trade decidedly below par in most cases, even at the maximum interest rate payable.

I could go on from here, and talk about other protective structures that fail in disaster scenarios (Florida Hurricane Catastrophe Fund?), but you get the idea. Truth is, almost ant protective structure will fail, given a large enough crisis. Strong as the GSEs are, even they could fail in a large enough crisis, though the US government would likely stand behind senior obligations.

The important thing for fixed income investors is to evaluate the level of crisis that any protective structure/covenant might protect against, and how likely that crisis might be. During a period when many aspects of the credit markets are under threat, it’s too late to begin the analysis. Best to analyze when things are calm, and then ask the question, “What if?…”

Still More Odds & Ends (Twelve this Time)

Posted on 12 February 2008 by David Merkel

1) I might not be able to post much for the next two days. I have business trips to go on. One is to New York City tomorrow. If everything goes right, I will be on Happy Hour with my friend Cody Willard on Tuesday.

2) As I wrote at RealMoney this morning:

		David Merkel
		Buy Other Insurers off of the Bad AIG News
		2/12/2008 2:54 AM EST

Sometimes I think there are too many investors trading baskets of stocks, and too few doing real investing work. I have rarely been bullish on AIG? I think the last time I owned it was slightly before they added it to the DJIA, and I sold it on the day it was added.Why bearish on AIG? Isn?t it cheap? It might be; who can tell? There?s a lot buried on AIG?s balance sheet. Who can truly tell whether AIG Financial Products has its values set right? International Lease Finance? American General Finance? The long-tail casualty reserves? The value of its mortgage insurer? I?m not saying anything is wrong here, but it is a complex company, and complexity always deserves a discount.

You can read my articles from 2-3 years ago where I went through this exercise when the accounting went bad the last time, and Greenberg was shown the door. (And, judging from the scuttlebutt I hear, it has been a good thing for him. But not for AIG.)

AIG deserves to be broken up into simpler component parts that can be more easily understood and valued. Perhaps Greenberg could manage the behemoth (though I have my doubts), no one man can. There are too many disparate moving parts.

So, what would I do off of the news? Buy other insurers that have gotten hit due to senseless collateral damage (no pun intended). As I recently wrote at my blog:

If Prudential drops much further, I am buying some. With an estimated 2009 PE below 8, it would be hard to go wrong on such a high quality company. I am also hoping that Assurant drops below $53, where I will buy more. The industry fundamentals are generally favorable. Honestly, I could get juiced about Stancorp below $50, Principal, Protective, Lincoln National, Delphi Financial, Metlife? There are quality companies going on sale, and my only limit is how much I am willing to overweight the industry. Going into the energy wave in 2002, I was quadruple-weight energy. Insurance stocks are 16% of my portfolio now, which is quadruple-weight or so. This is a defensive group, with reasonable upside. I?ll keep you apprised as I make moves here.

What can I say? I like the industry?s fundamentals. These companies do not have the balance sheet issues that AIG does. I will be a buyer of some of these names on weakness.

Position: long LNC HIG AIZ

3) More on AIG. As Cramer said yesterday: One last thought on the AIG issue: if President and CEO Martin Sullivan were to step down, the company might be more of a buy than a sale!

Maybe. Sullivan is a competent insurance executive with the biggest insurance job in the world. Breaking up the company, and letting the parts regain focus makes more sense. As an aside, M. R. Greenberg was known to be adamant about his ROE goal (15% after-tax on average equity), but he also liked the company to have bulk (high assets ? he liked asset-sensitive lines), which is why the ROA slid in the latter part of his tenure.

4) Some praise for Cramer on the same topic. As he said yesterday: AIG let me have it after I said last year that I couldn?t value the stock. They told me that there was a 92-page disclosure document and they wanted to know if I even looked at it. I shot back that not only did I look at it, but I had people comb it, including the forensic accountant I have on staff. The issue was always that despite the disclosure that they had CDO exposure, we couldn?t figure out what the real exposure was and we questioned whether THEY could.

Nothing gets a management more angry than being told that they don?t know what they are doing, but I was marveling at the certainty that they expressed. I told them they had tons of disclosure, but their estimation of possible losses seemed chimerical. I couldn?t figure out how THEY could value the stuff when no one else could with any certainty until it was off their books or written down. OF course, insurance companies aren?t held to the same standards of mark-to-market that banks are. They used mark-to-model, and the model, we learned today ? the Binomial Expansion Technique ? was totally wrong and dramatically understated the losses. All of this cuts to the incredible level of arrogance and stupidity on the Street, making judgments that were anti-empirical on data that could not be modeled but had to be experienced and examined nationally. In short, they were scientific and certain about something that couldn?t be quantified by science and certainly couldn?t be certain about.

Aside from the quibble that insurers for GAAP purposes are subject to the same rules as banks, Cramer got it right here. It is a major reason why I have been skeptical about AIG. Complexity in financial companies, especially financial companies that grow fast, is warranted. It is an unforgiving business where moderate conservatism works best.

5) Brief NAHC note: the CEO purchased more shares in the last few days. At least, it looks like it. Could he be acquiring shares to combat Hovde Capital? Honestly, I?m not sure, but this is looking more interesting by the day.

6) A new favorite blog of mine is Going Private. This post on insurance issues in Florida was unusual for that blog, but I thought it was perceptive. I wrote similar things at RealMoney:

		David Merkel
		Move to Florida, Become a Reinsurer
		3/27/2007 3:30 PM EDT

Interesting note in the National Underwriter on a Towers Perrin Study (also try here) describing how much Floridians will have to pay if a 1-in-250 hurricane hits Florida. Cost per household: $14,000, or $467 per year for 30 years. On a 1-in-50 storm, the figures would be $5,640, or $188 per year. There would also be a higher initial assessment as well. Note that the odds are actually higher than stated odds would admit. The stated odds of the large losses from the 2004 and 2005 storms happening in consecutive years would have been considered astronomical, but it happened anyway.

The Florida legislature can determine how the pain is shared, but they can?t legislate that the pain go away. No free lunch.

P.S. As an aside, the state of Florida is subsidizing reinsurance rates through its catastrophe fund. Ostensibly, Florida homeowners get a cut in rates, but the insurers give that cut only because their reinsurance costs are lower. Who?s the loser? The citizens of Florida will have to reach into their pockets to recapitalize the Hurricane Catastrophe Fund if big losses hit, and at the very time that they won?t want to do it. (Note to S&P: why do you give this state a AAA GO bond rating?)

Position: none mentioned

		David Merkel
		The Worst Insurance State In The USA
		2/2/2007 3:52 PM EST

I don?t want to go on a rant here, but I do feel strongly about this. It ill-befits a state government to behave like a bunch of thugs, even if it pleases the electorate. For over two decades, the worst state to do business in as an insurer was Massachusetts. New Jersey was competitive for a while, and California was pretty bad on Worker?s Comp, but now we have a new state on the top of the heap: Florida.

The failure of the Florida property insurance market was due to the lack of willingness to allow rates to rise sufficiently to attract capital into the market. The partial socialization of risk drove away that capital. So what does the governor and legislature of Florida do to meet the crisis? Increase the level of socialization of risk, and constrain companies to a binary decision: accept profits that don?t fairly reflect the risks underwritten, or leave the state. (And, they might try to forbid insurers from leaving.)

In my opinion, if they bar the door to insurers leaving, or not being allowed to non-renew policies, it is an unconstitutional ?taking? by the state of Florida. No one should be forced to do business that they don?t want to do. Fine to set up the regulatory rules (maybe), but it?s another thing to compel parties to transact.

Okay, here?s a possible future for Florida:

1) By the end of 2007, many insurers leave Florida; the state chartered insurer now has 33% of all of the primary property risk.
2) Large windstorm damages in 2008-2009, $100 billion in total, after a surprisingly light 2006-2007.
3) Florida finds that the capital markets don?t want to absorb more bonds in late 2009, after the ratings agencies downgrade them from their present AAA to something south of single-A.
4) The lack of ability to raise money to pay storm damages leads to higher taxes, plus the high surcharges on all insurance classes to pay off the new debt, makes Florida a bad place to live and do business. The state goes into a recession rivaling that of oil patch in the mid-1980s. Smart people and businesses leave, making the crisis worse.

Farfetched? No, it?s possible, even if I give a scenario of that severity only 10% odds. What is more likely is a watered-down version of this scenario. And, yes, it?s possible that storm damages will remain light, and Florida prospers as a result of the foolishness of their politicians. But I wouldn?t bet that way.

Position: long one microcap insurer that will remain nameless

		Marc Lichtenfeld
		Florida Insurance
		2/2/2007 4:17 PM EST

David,

While I don?t pretend to be the insurance maven that you are, I don?t believe it?s quite as black and white as you portray.

First, let me preface my comments by saying that I believe in free markets and don?t agree with the Governor?s plan, although I stand to benefit. Secondly, my insurance rates, while higher than I?d like are not too bad compared to others in the state.

That being said, I think something had to be done. In one scenario that you lay out, you describe smart people leaving due to higher taxes. That was already happening due to high insurance rates. Some people with affordable mortgages suddenly found their insurance rates skyrocketing from $2,000 to over $6,000. Lots of seniors on fixed incomes also saw their rates jump.

One factor in the housing slump is that buyers are having a hard time finding insurance on a house they are ready to close on. I know that three years ago, we were scrambling at the last minute to find an insurer who would write a policy ? and that was before all of the storms.

I?m not sure what the answer is. I fear that in an entirely free market, there will be very few insurers willing to do business here if there?s another bad storm.

Maybe that?s an argument that we shouldn?t be building major population centers right on the coast, but that?s another story.

Position: None

		David Merkel
		My Sympathies to the People of Florida
		2/2/2007 4:45 PM EST

Marc,

I understand the pain that many people in Florida are in. I know how much rates have risen. What I am saying is that the new law won?t work and will leave the people of Florida on the whole worse off. Florida is a risky place to write property coverage, and the increase in rates reflects a lack of interest of insurers and reinsurers to underwrite the risk at present rates and terms.

We don?t have a right to demand that others subsidize our lifestyle. But Florida is slowly setting up its own political crisis as they subsidize those in windstorm-prone areas, at the expense of those not so exposed. Commercial risks must subsidize coastal homeowners. Further, there is the idea lurking that the Feds would bail out Florida after a real emergency. That?s why many Florida legislators are calling for a national catastrophe fund.

They might get that fund too, given the present Congress and President, but Florida would have to pay in proportionately to their risks, not their population. Other proposed bills would subsidize Florida and other high risk areas. Why people in New York, Pennsylvania, Ohio should pay to subsidize Florida and California is beyond me.

The new law also affects commercial coverages; the new bill basically precludes an insurer from writing any business in Florida, if they write homeowners elsewhere, but not in Florida. If you want to chase out as many private insurers as possible, I?m not sure a better bill could have been designed. The law will get challenged in the courts; much of it will get thrown out as unconstitutional. But it will still drive away private insurance capacity.

I?m not writing this out of any possible gain for myself. I just think the state of Florida would be better served, and at lower rates, with a free market solution. Speaking as an insurance investor, I know of half a dozen or so new companies that were contemplating entering Florida prior to the new law. All of those ideas are now dead.

I hope that no hurricanes hit Florida, and that this bet works out. If there is political furor now in Florida, imagine what it would be like if my worst-case scenario plays out.

Position: long a small amount of one microcap insurer with significant business in Florida

Florida had now dodged the bullet for two straight years. Hey, what might happen if we have a bad hurricane year during an election year? Hot and cold running promises; I can see it now!

7) One of the best common-sense writers out there is Jonathan Clements of the WSJ. He had a good piece recently on why houses are not primarily investments. Would that more understood this. There are eras where speculation works, but those eras end badly. You can be a landlord, with all of the challenges, if you like that business. You can own a large home, but you are speculating that demand for the land it is on will keep growing. That is not a given.

8 ) My favorite data-miner Eddy, at Crossing Wall Street comes up with an interesting way to demonstrate momentum effects. Large moves up and down tend to continue on the next day, and the entire increase in the market can be attributed to the days after the market moves up 64 basis points.

9) This is not an anti-Cramer day. I like the guy a lot. I just want to take issue with this article: ?Trading in CDOs Slows to a Trickle.?? The basic premise is that CDOs are going away because trading in CDOs is declining.? Well, the same is true of houses, or any debt-financed instrument.? Volumes always slow as prices begin to fall, because momentum buyers stop buying.

Short of outlawing CDOs, which I don’t think can be done, though the regulators should consider what financial institutions should be allowed to own them.? That would shrink the market, but not destroy it.? Securitization when used in a moderate way is a good thing, and will not completely disappear.? Buyers will also become smarter (read risk-averse) at least for a little while.? This isn’t our first CDO blowup.? The cash CDO vintages 1997-1999 had horrible performance.? Now we have horrible performance.? Can we schedule the next crisis for the mid-teens?

10) On Chavez, he is a dictator and not an oil executive.? Maybe someone could send him to school for a little while so that he could learn a little bit about the industry that he is de facto running?? As MarketBeat points out, take him with with a grain of salt.? Venezuelan crude oil needs special processing, much of which is done in the US.? If he diverts the crude elsewhere, who will refine it for sale?

11) I am really ambivalent about Bill Gross.? He’s a bright guy, and has built a great firm.? Some of the things he writes for the media make my head spin.? Take this comment in the FT:

That the monolines could shoulder this modern-day burden like a classical Greek Atlas was dubious from the start. How could Ambac, through the magic of its triple-A rating, with equity capital of less than $5bn, insure the debt of the state of California, the world?s sixth-largest economy? How could an investor in California?s municipal bonds be comforted by a company that during a potential liquidity crisis might find the capital markets closed to it, versus the nation?s largest state with its obvious ongoing taxing authority? Apply the same logic to the gargantuan size of the asset-backed market it has insured in recent years ? subprimes and CDOs in the trillions of dollars ? and you must come to the same logical conclusion: this is absurd. It is as if Barney Fife, television?s Sheriff of Mayberry in The Andy Griffith Show, promised to bring law and order to the entire country.

Most municipal defaults are short term in nature, even those of states, of which there have been precious few.? Ambac, or any other guarantor, typically only has to make interest payments for a short while on any default.? It is a logical business for them to be in… they provide short term liquidity in a crisis, while the situation gets cleaned up.? In exchange for guarantee fees the municipalities get lower yields to pay.

The muni business isn’t the issue here… the guarantors should not have gotten into the CDO business.? That’s the issue.

12) I try to be open-minded, though I often fail.? (The problem of a permanently open mind is that it doesn’t draw conclusions when needed.? Good judgment triumphs over openness.)? I have an article coming soon on the concept of the PEG ratio.? This is one where my analytical work overturned my presuppositions, and then came to a greater conclusion than I would have anticipated.? The math is done, but the article remains to be written.? I am really jazzed by the results, because it answers the question of whether the PEG ratio is a valid concept or not.? (At least, it will be a good first stab.)

Full disclosure: long AIZ HIG LNC NAHC

Ten More Odds & Ends

Posted on 9 February 200810 February 2008 by David Merkel

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.

6) Naked Capitalism had an interesting post on GM. I made the following comment:

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.

10)? Finally, on Friday, a UBS report stirred the pot regarding non-borrowed reserves.? You can see the H.3 report here. Both Caroline Baum of Bloomberg and Real Time Economics debunked the UBS piece.? But it was simpler than that.? The Fed published its own explanation at the time they put out the H.3 report.? UBS did not include the effect of the new TAF.? Whoops.? Oh well, I make mistakes also.? It’s just better to make mistakes when one doesn’t sound so certain.
Full disclosure: long MGA, HMC

Ten Odds & Ends

Posted on 8 February 2008 by David Merkel

I’ve wanted to post on a bunch of little things for a while, and while it won’t make for organized reading, maybe we can have some fun with it?? Here goes.

1) If Prudential drops much further, I am buying some.? With an estimated 2009 PE below 8, it would be hard to go wrong on such a high quality company.? I am also hoping that Assurant drops below $53, where I will buy more. ? The industry fundamentals are generally favorable.? Honestly, I could get juiced about Stancorp below $50, Principal, Protective, Lincoln National, Delphi Financial, Metlife…? There are quality companies going on sale, and my only limit is how much I am willing to overweight the industry.? Going into the energy wave in 2002, I was quadruple-weight energy.? Insurance stocks are 16% of my portfolio now, which is quadruple-weight or so.? This is a defensive group, with reasonable upside.? I’ll keep you apprised as I make moves here.

2) Reader Steve brought this to my attention: Mark Gilbert at Bloomberg brought attention to a monetary policy game at the San Francisco Fed’s website.? So did the estimable Marketbeat blog at the WSJ.? The game used to be found at this link.? Alas, no more.? Maybe all of the attention crashed the site, after all, the SF Fed can’t afford a heavy-duty website like mine.? Okay, sorry, they get 10x the traffic that I do, more like The Kirk Report.

Perhaps the game was removed over the embarrassment from Gilbert playing the game and applying the current Fed strategy to the game, and finding inflation going through the roof.? Now, for those that want to play a monetary policy game, my current favorite is this one from the Bank of Finland.? In a true American version of the game, we would replace the manic announcer with clips of who else, Jim Cramer.? Nobody does it better.? Oh and for true junkies looking for monetary policy games, here is a list of some of them.

3) Dig the falling long bond.? Worst day since 2004.? Echoing what I said yesterday, there’s a lot of fear in that part of the market, and a lot of foreign interest.? Well, at the 30-year auction, foreign interest was light at the lowest yield since regular auctions began in 1977.? A few strong economic numbers can make fear temporarily dissipate.

4) Here’s what I posted at RealMoney today:

		David Merkel
		Moody’s Downgrades XL Capital Assurance
		2/7/2008 3:34 PM EST

When the main rating agencies begin downgrading the lesser guarantors, the big guarantors are likely not far behind. Moody’s just downgraded XL Capital Assurance from Aaa to A3, and Security Capital Assurance From Aa3 to Baa3 (barely investment grade). Psychologically, the major rating agencies, Moody’s and S&P, have been taking baby steps toward downgrading Ambac, MBIA and FGIC. But first they have to do the lesser guarantors that are in trouble. As I have pointed out before, the major rating agencies are co-dependent with the major guarantors, and that will only throw the guarantors over the edge if hurts them more to leave the guarantors at AAA. That will cost them future revenues to cut the ratings of the major guarantors, but it might save their larger franchises. (Fitch, on the other hand, has less to lose and can downgrade with impunity.)

Now, the effects on the broader insured bond market are probably overestimated. There will be new entrants to take the place of the legacy companies that may have to go into runoff. The holding companies for the major guarantors could die, but a rescue of the operating insurance companies in runoff mode is more likely. Those who own equity in the holding companies or debt claims to the holding companies will not be happy with the results, though.

Watch for downgrades of the major guarantors. Unless a lot of new capital gets pumped into their operating insurance companies, the downgrades are coming, maybe within a month.

Please note that due to factors including low market capitalization and/or insufficient public float, we consider Security Capital Assurance to be a small-cap stock. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.

Position: none

Now after the close, MBIA offered stock at a 14% haircut to the closing price. ? Let’s see where the price closes tomorrow… it almost boils down to the number of buyers saying, “At a 14% haircut, there’s no way that it will close below that level.? We can buy and flip for an easy profit.”? In this case, though, there are 60%+ more shares after this issuance.? That’s some level of dilution.? MBIA may keep its AAA, but that says little for the value of holding company common stock.

5) One reader wrote me, “mr. merkel — would you care at all to expound on point 2? it’s been the assertion of some that what makes the monoline threat a non-issue is specifically that there IS a harmony of interests in seeing ambac, mbia et al at least get to a point where they can run off their obligations. however, i must admit, i’ve not seen the case made with specificity — that is, what are the interests of the interested parties, and how do they conflict or coincide?”

Point 2 was the idea that a bailout would be tough to achieve, because of differing interests on the part of those being sought to bail out the guarantors. ? Here’s my rationale: different investment banks have differing levels and types of exposure to the credit risks covered by the guarantors.? Coming up with an equitable allocation of concessions would be tough, but not impossible.? Beyond that, you have all of the ways that the guarantors reinsured each other, which further tangles the web of promises.? A bailout could be done, given enough time, and enough angelic third-party experts to divide the pie perfectly.? Time is short here, and I suspect the rating agencies will lose patience, given their need to protect their franchises.

6) At present, the yield curve indicates a 2% Fed funds rate by mid-to-late 2008.? Uh, that’s not what I would do, but it seems pretty likely for now.? What kind of price inflation would get the attention of the Fed here?? Beats me; the slope of the yield curve today is adequate to allow banks to make money; if the Fed waits at these levels, the economy should recover over the next two years.

7) I liked the idea of this post at the American Prospect, but for a different reason.? Since I called the housing bubble very clearly over at RealMoney, and even subprime too, does that mean that I can criticize the Fed with impunity?? Constructively, of course.

8) From another reader, Bamboo: I have not seen much discussion of the statutory capital requirements of the financial guaranty insurers.? It seems that Article 69 of the New York Insurance Law is the critical statute.

Although the rating agencies do not consider mark to market losses in their evaulations of capital adequacy, do they affect statutory capital?

Is there a possibility that the financial guarantors will have to take a premium deficiency reserve for their structured finance business?

I would like to get a copy of article 69, but I can’t find one.? In general statutory regulations are less market-oriented than rating agencies and GAAP.? The problems usually show up faster on GAAP than Stat, leaving aside high growth situations.

9) Another reader, Bill Luby of VIX and More, writes: Hi David,

Once again, kudos for keeping up a consistently high quality of posting here.? Your thinking often sets my brain in motion — in a very good way.

If you don’t mind, I’d be interested to get your take on the current status of the bond insurer problem and how you think it might play out.? In addition to what happens to MBI and ABK, I am also interested in whether you think others with a stronger financial position (AGO?) might make significant gains in this space.

Cheers,

-Bill

Yes, AGO, Dexia (FSA), and Berky all do well from the turmoil.? Strong balance sheets benefit from increased volatility, even as weak balance sheets are harmed.

10) Finally, from Reader Scott, regarding Medicare and entitlements, “David, wondering your thoughts on how the situation gets addressed.? There is no question at all that the equation doesn’t solve, presently.? My current thoughts are that (1) taxes go higher – not even up for serious discussion; and (2) so do trade barriers.? we trade some protectionism, a la Europe, and reduced overall welfare, for a feel-good “leveling” of some of society’s current inequties.? our nation’s most influential demographic, old folks, who vote, are appeased. add to that, perhaps, some guest worker immigration policies.? second class citizens earning second-tier wages.? on balance, we begin looking a lot more like Europe, reversing the cherished myth of American exceptionalism, and staving off acceptance of the twenty-first being the China Century.? Care to comment?”

Americans are exceptional, and that is not always a good thing.? We have fewer presuppositions than most of the world, and that leads to innovative solutions, a certain amount of unnecessary chaos, and occasional hubris.? We are probably heading for an era of leveling, but that is not certain.? Historically, it is likely.? Trade may be another matter; we may be getting close to a point where the rest of the world sees the value of freer trade, even if the US goes the other way.? Organized efforts against free trade are weak compared to protectionist eras.

As for old folks that vote, yes, that’s what makes this problem tough.? I’m not into doom and gloom, but I can see a negative self-reinforcing cycle coming.? If Bush, Jr., got smacked over his all-too-cautious attempt at Social Security reform (it would have done almost nothing, but listen to the squeals), can you imagine what true reform of a much bigger problem might entail?? We would need a full blown panic in the debt markets to get focus there, and as for now, foreigners are still very willing to roll over US debt denominated in US dollars.

Full disclosure: long AIZ, LNC

Five Thoughts on the Financial Guarantors

Posted on 6 February 2008 by David Merkel

The Financial Guarantors are receiving a lot of attention these days, and for good reason.? I want to offer a few observations to give my own take on the problem:

1) With structured finance, the initial choice is “Do we ask a financial guarantor to bring the credit up to AAA, or do we do it through a senior-subordinate structure?”? A senior-subordinate structure has classes of lenders with differing rights to payment.? The AAA, or, senior lenders only take losses after the subordinate lenders (who are receiving higher yields) have lost all of their money.? In the present environment, S&P and Moody’s have been downgrading subordinates, and even some senior bonds in senior-sub structures.

This should lead to downgrades of MBIA and Ambac, eventually.? The rating agencies can’t keep downgrading bonds that are similar to those guaranteed by MBIA and Ambac, without downgrading them as well.? Remember, MBIA and Ambac were late to the party; their bonds are disproportionately weak because later lending standards were weaker.

2) The main difficulty with a bailout of the guarantors is that most interested parties have different interests.? That said, the beauty of a bailout is that the guarantor can sit back and pay timely principal and interest, while waiting for better times to come.

3) Did the rating agencies force the guarantors into the CDO business?? I’ve heard rumors to this effect, but it would be pretty easy to prove or disprove.? Look at when MBIA and Ambac entered the business, and look at the commentary from the rating agencies around it; if they are trumpeting diversification, then it is likely that they pitched it to the guarantors.? If not, then the guarantors did it on their own.

4) Even in a bailout of financial guarantors, current shareholders may find themselves diluted beyond measure.? Given current political pressures, those risks are elevated; remember that management teams want to keep their jobs, and that regulators have some say in that.

5) As I noted today at RealMoney:

		David Merkel
		Considering the “Margin of Safety”
		2/5/2008 11:07 AM EST

Tim, I like your stuff, since I am a value investor. Be careful with XL Capital. The challenge is estimating what sort of guarantees they face from Security Capital Assurance. When I looked at them last, the potential payments could be huge — potentially larger than XL’s net worth, but hey, that’s the financial guarantee business. I looked at XL during my last portfolio reshaping — Finish Line also, and could not get past the potential risks. I had easier plays to go for, with less uncertainty, if also lower upside. I don’t try to hit home runs, so it makes it easier for me to not buy the stocks that are optically stupid cheap, but might have balance sheet issues. Cheap means that a company will have the capability to carry their positions through a downturn; it’s part of the “margin of safety” that we require.

Anyway, keep it up, and let’s see if we can’t make some money on our value investing.

Please note that due to factors including low market capitalization and/or insufficient public float, we consider Security Capital Assurance and Finish Line to be small-cap stocks. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.

Position: none

?XL was downgraded recently as a result of those guarantees.? I would be cautious here.

-=-=-=-=-=-

Summary: there is still downside risk here.? Avoid the financial guarantors, and economic areas affected by the overleveraging of our credit markets. ? Stick with companies that have strong balance sheets.

An Economist at Last — Life Changes for David

Posted on 6 February 2008 by David Merkel

I started my business career as an actuary.? For an actuary, though, I had an unusual background — I wasn’t a math or a statistics major, I was an economics major, though admittedly, one with a lot of math.? You can’t get through the Ph.D. courses in econometrics without a lot of math.? In my business career, I’ve put my economics background to use, and added to it through studying finance.? Now, I studied much of the finance and economics of risk literature back in grad school, and developed a healthy dislike for MPT, the CAPM, and suchlike.

I grew up in a home where my self-taught mother used her head and picked stocks.? She did it quite well, too, and continues to do so today.? I figured that I could do it too, and over the past fifteen years, have done so.? Perhaps my major theme would be “hunt for value, and don’t be afraid to have a portfolio that looks weird.”? My studies of finance in my post-academic days were practical in nature, analyzing ways of beating the market, or reducing risk, realizing that any strategy can become overused, and useless.

After leaving my former employer, I’ve done a bunch of things — writing, consulting, etc.? Now it is time to focus.? I have taken a job as Chief Economist and Director of Research for Finacorp Securities, based in Irvine, California.? Their main focus is serving the investment needs of municipalities.? I have three main tasks:

Publish research that encourages clients to trade with us.
Provide research for internal staff and clients, enabling staff to serve clients better.
Build an asset management franchise for our clients around my value investing, and bond investing.

Beyond that, aid in the management of the firm where possible.? Now, I’m not changing locations; I am still based near Baltimore.? What I do can be done from anywhere, so long as I can connect to the Internet.
I have already produced a draft version of a newsletter for our institutional clients.? I am making preparations to?offer equity asset management services to clients.? What form that will take is still open.

That said, it is interesting at this point in my life to finally have the word “Economist” in my job title, as well as “Chief.”? In one sense, this dovetails well into my interests, as those who read my blog will know.? I write about the intersection of macroeconomics and investing.? That’s what I do.? It allows me to keep my interests broad, while solving a wide array of practical problems.? I have sometimes said that I am an investment omnivore.? That’s not quite true, but I like to wander across the investment wilderness, and gather disparate data, gaining good conclusions about the total investment landscape.

Anyway, that is what I am up to now.? To the extent that our newsletter or investment services might be open to individuals, I will let you all know.? I thank you all deeply for your support of me.

PS — I may be on FOX Business Wednesday between 12 and 2PM Eastern.? This is uncertain at present.? We will see.

A Practical Reason to be Aware of ETF Activity

Posted on 2 February 20083 February 2008 by David Merkel

In investing, it is important to understand what industries the companies in which you invest are in.? There are several reasons for this:

Companies within an industry tend to face the same cost pressures.
Companies within an industry tend to face the same revenue drivers.
Companies within an industry tend to face the same regulators and political pressures.
Companies within an industry tend to face the same behavior from debt-financers and equity investors.

Now, some companies have competitive advantages that are difficult to replicate, but those are not plentiful.? It is no surprise then that equity performance within industries tends to be tightly correlated.

Now consider ETF activity.? The largest ETFs cover whole stock markets, or sectors containing many industries.? The trading can drive the prices of many stocks regardless of the fundamentals in the short run.? The ETFs allow for simple decisions to be made.? “Financials stink; sell the XLF.”? “Technology stinks; sell the XLK.”? “Energy and materials will do well here, buy the XLE and XLB.”

The thing is, in each of those sectors, there is a lot of variation.? Is there a reason to worry about financial companies that focus on mortgages?? Yes.? Does that have anything to do with insurers?? Aside from mortgage, financial and title insurers, no, it doesn’t.? What do chemicals have to do with base metals?? Not much.? Do refiners and E&P companies benefit similarly from a rise in the price of oil?? No, it is the opposite; one buys oil, the other sells.

ETF trading activity can be a benefit to the fundamental investor.? When your companies come under pressure from ETFs because ETF holders sell indiscriminately and the company that you own is not a party to the macro phenomenon that is leading to the selling, it is time to buy a little more.? When your companies rise because ETF buyers buy indiscriminately and the company that you own is not a party to the macro phenomenon that is leading to the buying, it is time to sell a little.

ETFs simplify decision-making for many investors.? Sophisticated investors will avoid the simplification and drill down the economics and the industries and companies that they own, leading to greater profits in the long run.

Back in the Black

Posted on 2 February 20082 February 2008 by David Merkel

No way. If you had asked me two weeks ago whether I would get back in the plus column for 2008, I would have said, “Yes, but in eleven months.” Well, my broad market portfolio is up on the year. Even now, I know that when I write next week, I could be on the other side of the line.

The thing that gives me some degree of confidence at this point relates to what I wrote at RealMoney earlier today:

		David Merkel
		Rebalancing Trade
		2/1/2008 2:56 PM EST

It’s not supposed to work this fast, but I did a rebalancing sale on Alliance Data Systems. Looked really cheap after the merger agreement blew; I guess it was cheap! Hanging onto the balance for more gains. It’s been a weird year so far. On the bright side, I am back to breakeven for 2008, and I have a better, cheaper, more financially sound batch of stocks than I did in mid-2007.

That means something to me. I even think my portfolio has more growth potential than the one I was running with in mid-2007, and I don’t pay up for growth. I do accept it if it is being offered gratis.

There is something different going on in the markets now. It is as if the wind has moved to my back and out of my face. That said, it could just be a bear market rally, or a brief spurt of mid- and small-cap value amid a market favoring growth investing.

Then again, I am grateful to God for the turn; I’ve made a number of good picks and sales lately, and they have paid off more rapidly than normal. With that, I am ready for some retrenchment here, but who knows? My philosophy is to play for maximum advantage; if I have made gains early in the year, I want to play for more. I always hated the idea of indexing if one had a good start to the year. Why cheat your clients? Do your best regardless, and most of the time, it will win.

Hey, I’m just grateful to have made money in 2008. Hope you make money too, and more than me.

Full disclosure: long ADS