Category: Portfolio Management

What Brings Maturity to a Market

What Brings Maturity to a Market

Some housekeeping before I start. My post yesterday was meant to be a “when the credit/liquidity cycle turns” post, not a “the sky is falling” post. Picking up on point number 4 from what could go wrong, I would refer you to today’s Wall Street Journal for two articles on LBOs that are not going so well, and the sustainability of private equity in the current changing environment. Please put on your peril-sensitive sunglasses before reviewing the credit metrics.

In the early 90s, as 401(k)s came onto the scene, savings options were the hot sellers to an unsophisticated marketplace. Because of the accounting rules, insurance contracts could be valued at book, not market, and so Guaranteed Investment Contracts [GICs] were sold to 401(k) and other DC plans.

The difficulty came when companies that issued contracts failed, like Executive Life, Mutual Benefit, Confederation, and The Equitable (well, almost). A market that treated all contracts equally was now exposed to the concept that there is such a thing as credit risk, and that the highest yielding contract is not necessarily the one that should be bought.

In the mid-90s, that was my first example of market maturation, and it was painful for me. I was running the Guaranteed Investment Contract desk at Provident Mutual, and making good money for the firm. We survived as other insurance companies went under or exited the business, but as more companies failed, the credit quality bar kept getting raised higher, until we were marginal to the market. Confederation’s failure was the last nail in my coffin. I asked my bosses whether I could synthetically enhance my GICs by giving a priority interest to the GIC-holders in an insolvency, but they turned me down, and I closed down an otherwise profitable line of business.
Failure brings maturity to markets, and market mechanisms. When a concept is new, the riskiness of it is not apparent until a series of defaults occurs, showing a difference between more risky and less risk ways of doing business. Let me give some more examples:

Stock Market Leverage: How much margin debt is too much, that it helps create systemic risk? In the 20s leverage could be 10x, and the volatility that that policy induced helped magnify the boom in the 20s, and the bust 1929-1932. Today the ability to lever up 2x (with some exceptions) is deemed reasonable. If it is not reasonable, another failure will teach us.

Dynamic Hedging: In the mid-80s, shorting stock futures to dynamically hedge stock portfolios was the rage. After all, wasn’t it a free way to replicate a costly put option?

When it was first thought up, it probably was cheap, but as it became more common the trading costs became visible. For small price changes, it worked well. Who could predict the magnitude of price changes it would be forced to try and unsuccessfully hedge? After Black Monday, the cost of a put option as an insurance policy was better appreciated.

Lending to Hedge Funds: I’m not convinced that this lesson has been learned, but if it has been learned, the crisis from LTCM started that process. After LTCM failed, counterparties insisted more closely on understanding the creditworthiness of those that they expected future payments from.

Negative Convexity: Through late 1993, structurers of residential mortgage securities were very creative, making tranches in mortgage securitizations that bore a disproportionate amount of risk, particularly compared to the yield received. In 1994 to early 1995, that illusion was destroyed as the bond market was dragged to higher yields by the Fed plus mortgage bond managers who tried to limit their interest rate risks individually, leading to a more general crisis. That created the worst bond market since 1926.
There are other examples, and if I had more time, I would list them all. What I want to finish with are a few areas today that have not experienced failure yet:

  1. the credit default swap market.
  2. the synthetic CDO market (related to #1, I know)
  3. nonprime commercial paper
  4. covenant-lite commercial loans, particularly to LBOs.

There is nothing new under the sun. Human behavior, including fear and greed, do not change. In order to stay safe in one’s investments, one must understand where undue risk is being taken, and avoid those investments. You will make more money in the long run avoiding foolish risks, than through cleverness in taking obscure risks ordinarily. Risk control triumphs over cleverness in the long run.

Thinking About What Might Blow Up

Thinking About What Might Blow Up

The credit cycle is kind of like a Monty Python skit where the humor has reached a point of diminishing marginal returns. At that point, they might blow something up, and move onto the next skit. Credit cycles end with a bang, not a whimper. Take a spin down the last few cycles:

  • 2000 — Nasdaq, dot-coms
  • 1997-98 — Asia/Russia/LTCM
  • 1994 — Mortgages/Mexico
  • 1989 — Banks/Commercial Real Estate
  • 1987 — Stock Market
  • 1984 — Continental Illinois
  • Early ’80s — LDC debt crisis

In each case, we had assets that were weakly financed.? When liquidity began to become scarce, the entities that were weakly financed faced sharply rising borrowing costs, and many defaulted.? The purpose of this piece is to muse about what entities in our world today are reliant on the presence of favorable financing, and would suffer if that financing ceased to exist.? Here’s my initial list.? Can you give me some more ideas?

  1. Too obvious: CCC-rated bond issuers.? We’ve had a lot of them issue debt over over the past three years.? Those that have not shored up their balance sheets and paid down debt will suffer if they need additional financing.
  2. Yield-seeking hedge funds.? When the credit cycle turns, yield becomes poison.? Those holding the equity of Collateralized Debt Obligations, and other levered forms of credit will have a rough time, particularly if their investors ask for their money back.
  3. Dodgy mortgages.? We’ve already seen the beginning with subprime mortgages, but there are more loans that will hit resets over the next twelve months.? The troubles with Alt-A lending will be more spread out, but it really hurts to have your financing rate jacked up at a time that the asset financed is experiencing weakness in price.
  4. Private equity over-borrowing.? Much of private equity relies on the idea that they can have an easy liquidity event five years from now.? What if interest rate are three percent higher then?? P/E and EV/EBITDA multiples will be lower, not higher, and then what do you do with all of the debt used to finance the purchase?
  5. Overly indebted cyclicals, and mergers that increase leverage.? Companies that presumed too much about the future get killed when the cycle turns.? The mergers and recapitalizations that looked so promising are horrid when the willingness to take risk drops.
  6. Mis-hedged investment banks.? This is a little more speculative, but in a credit crisis, investment banks without adequate liquidity are in the soup.? Lehman Brothers barely survived 1998; in a more severe crisis, who would get harmed?
  7. Sovereign nations with large current account deficits.? This is the most controversial category.? I am not talking about the main emerging markets here; I am talking about developed countries that lack discipline, like Iceland, New Zealand, and the United States.? The large emerging markets are in better shape than the derelict nations that they fund.? If the debt is in their own currency, the nation has more options than merely defaulting.? They can inflate, or create a two-tier currency system to give foreigners the short end of the stick.? (Think of Argentina, or South Africa back in the 80s.)


These are the weak entities that I can think of. ?There are more, I am sure, particularly as the demographic crises emerge over the next decade, but for now, if liquidity becomes scarce, these are the entities?that will suffer.

How to Sell a Securitization

How to Sell a Securitization

In securitizations, a series of assets, typically ones with well defined payoffs, such as fixed income (bonds and loans) and derivatives of fixed income get placed in a trust, and then the trust gets divided up into participations of varying riskiness. The risks can be ones of cash flow timing (convexity) and/or credit. Regardless of what the main risk is, the challenge for those issuing the securitization is who will buy the riskiest participations.

When the market is hot, and there are many players gunning for high income, regardless of the risk level, selling the risky pieces is easy, and that is what conditions are like today, with the exception of securitizations containing subprime loans.? When the market is cold, though, selling the risky pieces is hard, to say the least.? If market conditions have gotten cold since the deal began to be assembled, it is quite possible that the will not get done, or at least, get done at a much smaller profit, or even a significant loss.

In that situation, hard choices have to be made.? Here are some options:

  1. If there is balance sheet capacity, keep the risky parts of the deal, and sell the safer portions.? Then if the market turns around later, sell off the risky pieces.
  2. If there is a lot of balance sheet capacity, hold all of the loans/bonds and wait for the day when the market turns around to do your securitization.
  3. Sell all of the loans/bonds off to an entity with a stronger balance sheet, and realize a loss on the deal.
  4. Reprice the risky parts of the deal to make the sale, and realize a loss.


The proper choice will depend on the degree of balance sheet capacity that the securitizer has.? Balance sheet flexibility, far from being a waste, is a benefit during a crisis.? As an example, in 1994, when the residential mortgage bond market blew up, Marty Whitman, The St. Paul, and other conservative investors bought up the toxic waste when no one else would touch it.? Their balance sheets allowed them to buy and hold.? They knew that at minimum, they would earn 6%/year over the long haul, but as it was, they earned their full returns over three years, not thirty — a home run investment.? The same thing happened when LTCM blew up.? Stronger hands reaped the gains that the overly levered LTCM could not.

In this era of substituting debt for equity, maintaining balance sheet flexibility is a quaint luxury to most.? There will come a time in the next five years where it goes from being a luxury to a necessity.? Companies that must securitize will have a hard time then.? Those that can self-finance the assets they originate will come through fine, to prosper on the other side of the risk cycle.? Be aware of this factor in the financial companies that you own, and be conservative; it will pay off, eventually.

Listen to Cody on Risk Control

Listen to Cody on Risk Control

Cody has an point that everyone should listen to in his post, Cody on Your World with Neil Cavuto.? I still regard myself as a moderate bull here, but it is altogether wise to take something off the table here.? My methods have me forever leaning against the wind.? As an example, near the close yesterday I trimmed some Anadarko Petroleum as a rebalancing trade.? I still like Anadarko, but at a higher valuation, it pays to take something off the table.? Why?? Because we don’t know the future, and something could happen out of the blue that transforms the risk profile of the market in an instant.


So, what does this mean for me?? I’m up to 12% cash in my broad market portfolio, which is higher than the 5-10% that I like it to be, but not up to the 20% (or down to zero) where I have to take action.? My balanced mandates are taking on cash to a lesser extent.? A 5.25% yield is pretty nice.


Now, here’s where I am different (not better, but different) than Cody.? Cody advocated taking 20% off the table (in his Fox interview), whereas I am forever taking little bits off the table as the market runs.? My robotic incrementalism takes the emotion out of the selling and buying processes.? That said, I may leave something on the table versus someone making bigger macro adjustments.


Whatever you do, it has to be comfortable for you in order to be effective.? The market may go up further from here; on average, I expect it will do so, but I can imagine scenarios where it will not do so.? That’s why I take a little off the table each time my stocks hit upper rebalance points; my baseline scenario may not happen, and rebalancing to target weights protects against what is unexpected.? It is a modest strategy that guards against overconfidence, and will always allow you to stay in the game, no matter how bad the market gets.


I don’t have to be a raving bull or raving bear.? I just have to control my risks, and over the long run, I will do pretty well.? Cody will do well too; he just does it differently.

Full Disclosure: long APC

Going Through the Research Stack

Going Through the Research Stack

Once every two months or so, I go through my “research stack” and look at the broad themes that have been affecting the markets. Here is what I found over vacation:

Inflation

  1. Commodity prices are still hot, as are Baltic freight rates, though they have come off a bit recently. Lumber is declining in the US due to housing, but metals are still hot due to global demand. Agriculture prices are rising as well, partly due to increased demand, and partly due to the diversion of some of the corn supply into ethanol.
  2. While the ISM seemingly does better, a great deal of the increase comes from price increases. On another note, the Implicit Price Deflator from the GDP report continues to rise slowly.
  3. Interest rates are low everywhere, at a time when goods price inflation is rising. Is it possible that we are getting close to a global demographic tipping point where excess cash finally moves from savings/investment to consumption?
  4. At present, broad money is outpacing narrow money globally. The difference between the two is credit (loosely speaking), and that credit is at present heading into the asset markets. Three risks: first, if the credit ignites more inflation in the goods markets which may be happening in developing markets now, and second, a credit crisis, where lenders have to pull back to protect themselves. Third, we have a large number of novice central banks with a lot of influence, like China. What errors might they make?
  5. The increase in Owners Equivalent Rent seems to have topped out.

International

  1. Global economy strong, US is not shrinking , but is muddling along. US should do better in the second half of the year.
  2. The US is diminishing in importance in the global economy. The emerging markets are now 29% of the global economy, while the US is only 25%.
  3. Every dollar reserve held by foreigners is a debt of the US in our own currency. Wait till they learn the meaning of sovereign risk.
  4. Europe has many of the problems that the US does, but its debts are self-funded.
  5. The Japanese recovery is still problematic, and the carry trade continues.
  6. Few central banks are loosening at present. Most are tightening or holding.
  7. There is pressure on many Asian currencies to appreciate against the dollar rather than buy more dollar denominated debt, which expands their monetary bases, and helps fuel inflation. India, Thailand, and China are examples here.

Economic Strength/Weakness

  1. We have not reached the end of mortgage equity withdrawal yet, but the force is diminishing.
  2. State tax receipts are still rising; borrowing at the states is down for now, but defined benefit pension promises may come back to bite on that issue.
  3. Autos and housing are providing no help at present.

Speculation, Etc.

  1. When are we going to get some big IPOs to sop up some of this liquidity?
  2. Private bond issuers are rated one notch lower in 2007 vs 2000. Private borrowers in 2007 are rated two notches lower than public borrowers, on average. Second lien debt is making up a larger portion of the borrowing base.
  3. Because of the LBOs and buybacks, we remain in a value market for now.
  4. Volatility remains low ? haven?t had a 2% gain in the DJIA in two years.
  5. Hedge funds are running at high gross and net exposures at present.
  6. Slowing earnings growth often leads to P/E multiple expansion, because bond rates offer less competition.
  7. Sell-side analysts are more bearish now in terms of average rating than the ever have been.
  8. There are many ?securities? in the structured securities markets that are mispriced and mis-rated. There are not enough transactions to truly validate the proper price levels for many mezzanine and subordinate securities.

Comments to this? Ask below, and I’ll see if I can’t flesh out answers.

Still Another Boon from RealMoney.com

Still Another Boon from RealMoney.com

There are a number of articles that I wrote for RealMoney that fell into the “labor of love” category. So it was with my “If you get to Talk to Management” series. RM has republished the series at their TheStreet.com University. Enjoy it if you haven’t read it already.

Much as would like to post more, while I am in Bermuda it is unlikely that I will post much; look for me to be back on Wednesday.

One Dozen More Compelling Articles Around the Web

One Dozen More Compelling Articles Around the Web

1)? Picking up where I left off last night, I have a trio of items from Random Roger.? Is M&A Bullish or Bearish?? Great question.? Here’s my answer: at the beginning of an M&A wave, M&A is unambiguously bullish as investors seize on cheap valuations that have gone unnoticed.? Typically they pay cash, because the investors are very certain about the value obtained.

From the middle to the end of the M&A wave, the action is bullish in the short run, and bearish in the intermediate term.? The cash component of deals declines; investors want to do the deals, but increasingly don’t want to part with cash, because they don’t want to be so leveraged.

My advice: watch two things. One, the cash component of deals, and two, the reaction of the market as deals are announced.? Here’s a quick test: good deals increase the overall market cap of the acquirer and target as a whole.? Bad deals decrease that sum.? Generally, deal quality by that measure declines over the course of an M&A wave.

2) Ah, the virtues of moderation, given that market timing is so difficult. This is why I developed my eight rules, because they force risk control upon me, making me buy low and sell high, no matter how painful it seems.? It forces me to buy when things are down, and sell when things are running up.? Buy burned out industries.? Reshape to eliminate names tht are now overvalued.? These rules cut against the grain of investors, because we like to buy when comapnies are successful, and sell when the are failures.? There is more money to be made the other way, most of the time.

3) From Roger’s catch-all post, I would only want to note one lesser noticed aspect of exchange traded notes.? They carry the credit risk of the issuing institution.? As an example, my balanced mandates hold a note that pays off of the weighted average performance of four Asian currencies.? In the unlikely event that Citigroup goes under, my balanced mandates will stand in line with the other unsecured debtholders of Citigroup to receive payment.

4) Bespoke Investment Group notices a negative correlation between good economic reports and stock price performance.? This should not be a surprise.? Good economic news pushes up both earnings and bond yields, with the percentage effect usually greater on bond yields, making new commitments to bonds relatively more attractive, compared to stocks.

5) From a Dash of Insight, I want to offer my own take on Avoiding the Time Frame Mistake.? When I take on a position, I have to place the idea in one of three buckets: momentum (speculation), valuation, or secular theme.? What I am writing here is more general than my eight rules.? When I was a bond manager, I was more flexible with trading, but any position I brought on had to conform to one of the three buckets.? I would buy bonds of the brokers when I had excess cash, and I felt the speculative fervor was shifting bullish.? If it worked, I would ride them in the short run; if not, I would kick them out for a loss.

Then there were bonds that I owned because they were undervalued.? I would buy more if they went down, until I got to a maximum position.? If I still wanted more, I would do swaps to increase spread duration.? But when the valuations reached their targets, I would sell.

With bonds, secular themes don’t apply so well, unless you’re in the mid-80s, and you think that rates are going down over the next decade or two.? If so, you buy the longest noncallable bonds, add keep buying every dip, until rates reach your expected nadir.? Secular themes work better with equities, where the upside is not as limited.? My current favorite theme is buying the stock of companies that benefit from the development of the developing world.? That said, most of those names are too pricey for me now, so I wait for a pullback that may never come.

6) I’ve offered my own ideas of what Buffett might buy, but I think this article gets it wrong.? We should be thinking not of large public businesses, but large private businesses, like Cargill and Koch Industries.? Even if a public business were willing to sell itself cheap enough to Buffett, Buffett doesn’t want the bidding war that will erupt from others that want to buy it more dearly.? Private businesses can avoid that fracas.

7) And now, a trio on accounting.? First, complaints have arisen over the discussion draft that would allow companies to use IFRS in place of GAAP.? Good.? Let’s be men here; one standard or the other, but don’t allow choice.? We have enough work to do analyzing companies without having to work with two accounting standards.

8) SFAS 159?? You heard it at this blog first, but now others are noticing how much creative flexibility it offers managements in manipulating asset values to achieve their accounting goals.? My opinion, this financial accounting standard will be scrapped or severely modified before long.

9) Ah, SFAS 133. When I was an investment actuary, I marveled that hedges had to be virtually perfect to get hedge treatment.? Perfect?? Perfect hedges rarely exist, and if they do, they are more expensive than imperfect ones.? Well, no telling where this one will go, but FASB is reviewing the intensely complex SFAS 133 with an eye to simplifying it.? This could make SFAS 133 more useful to all involved… on the other hand, given their recent track record, they could allow more discretion a la SFAS 159, which would be worse for accounting statement users, unless disclosure was extensive. Even then, it might be a lot more work.

10) ECRI indicates better growth and lower inflation coming soon.? I’ll go for the first; I’m not so sure about the second, with inflation rising globally.

11) What nation has more per capita housing debt then the US?? Britain. (And its almost all floating rate…)? With economics, it is hard to amaze me, but this Wall Street Journal article managed to do so.? Though lending institutions bear some blame for sloppy underwriting, it amazes me that marginal borrowers that are less than responsible can think that they can own a home, or that people who have been less than provident in saving, think that they can rescue their retirement position by borrowing a lot of money to buy a number of properties in order to rent them out.? In desperate times, desperate people do desperate things, but most fail; few succeed.? We have more of that to see on this side of the Atlantic.

12) I am not a fan of what I view as naive comparisons to other markets and time periods.? There has to be some significant similarity in the underlying economics to make me buy the analogy.? Thus, I’m not crazy about this comparison of the current US market to the Nikkei in the late 80s.? Japan was a much more closed economy, and monetary policy was far more loose than ours is today.? I can even argue that the US is presently relatively conservative in its monetary policy versus the rest of the developed world.? So it goes.

Four Interesting Things I Have Seen Around the Web

Four Interesting Things I Have Seen Around the Web

1) In Grad School, one of my Ph. D. fields was econometrics. In general, I agree with this piece by Jeff Miller on the payroll survey, but I have a few things to add. My main problem with the birth-death model is that they use an ARIMA model. We only use ARIMA models when we don’t have sufficient cofactors to try to explain something structurally. At best, an ARIMA model is the reduced form solution to the broader structural model for which we do not have data. Second, I would simply add that the true error bonds on the month-to-month change are large, and I would advise everyone to look at year-over-year changes to get a better sense of the trend in the economy. As Morganstern showed over fifty years ago, economic data has so much noise that noise swamps signal until you look at year-to-year changes.
2) From the ever excellent Daniel Gross at the NYT, comes his piece questioning how important the US is the US to the global economy at present. I have written about the same thing over at RealMoney. With the US accounting for a shrinking fraction of global trade, it is hard to see how the role of the US is not diminishing here. We need to get used to the idea that we are “first among equals,” and make our policy requests as a part of coalition building among the nations that trade.
3) In general, I like John Hussman; I have learned a lot from him. We even live in the same city. That said, his commentary on share buybacks needs some clarification. Once a buyback is completed, the economics of the buyback are reflected in the diluted EPS. One should not count it as a dividend; the increment to book value reflects the change in value. But after the announcement, but prior to the buyback itself, investors analyze whether a management team is credible on the announcement. Does management follow though? Can the balance sheet handle it? Credible management teams can make the stock price rise with the mere mention of a buyback.

4) Calling John Henry and his modern counterparts: can traders be replaced by computer algorithms? Average traders, yes. The best traders, no. Good trading relies on a variety of factors that are difficult to turn into math. I learned that as a corporate bond manager/trader. Sensing when the speculative nature of the market is turning is touchy. There are many aspects of that that I think would be difficult to teach to a machine. It’s one thing for a computer to beat us at chess, which is a relatively simple game, but when will one beat us consistently at poker?

I have more, but I will publish now, and bring the rest back tonight.

Yesterday’s Trades

Yesterday’s Trades

Yesterday I swapped my holdings in Patterson-UTI for Noble Corp. I also reduced my holdings in SPX Corp, which has been a great turnaround play for me. I sold 20% of my position, which I do to rebalance to a target weight. This limits my risk, and given that nothing moves up in a straight line, it allows me to add 2-4%/year to my returns. For more information ion this sort of trade, for those that have access to RealMoney, see this article.


As for the swap, have a look at this article from Forbes. I see reason to swap to a cheaper name, when earnings trends are working in favor of deep water drillers. If oil prices rise a great deal, I will be proven wrong here, but at current oil prices, I like the swap.

Full disclosure: long NE SPW

Update: now, what should happen after I sell PTEN but that it puts up decent, but not stupendous numbers, and it goes up 5%. The relative return difference since the swap is -3%. I don’t play for days, so this does not bother me. My methods work on average over the intermediate term. The proper measurement period for this swap is over the next 1-3 years.

You Can Buy, But You Can’t Sell, And Vice-Versa

You Can Buy, But You Can’t Sell, And Vice-Versa

Be sure and check out this article from the Wall Street Journal.? Derivatives being private contracts between two parties, they can’t easily be traded.? To eliminate a position prior to maturity, one can do three things:

  1. Sell it back to the party you bought it from.
  2. Sell an equivalent contract to a third party.
  3. Sell your interest in the contract to a third party.

In situation 1, the exposure goes away, but the negotiation can be tough because they know they are the only ones that can eliminate the exposure in entire.? In situation 2, the exposure goes away, but one still has counterparty risk, in that they have bought and sold the same item to two different parties.? If one party defaults while owing money, the other obligation does not go away.

In situation 3, the exposure goes away if it can be done.? Sometimes the derivatives prohibit such a trade, because they don’t want the possibility of diminished creditworthiness.

So, as the WSJ points out: derivatives, even crdit and equity derivatives can’t be traded like stocks.

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