Category: Public Policy

Plan for Failure

Plan for Failure

Imagine for a moment that you are managing a large corporate bond portfolio for a major institution.? One of the first things you should internalize is that you will be wrong.? You will buy bonds of companies that will get into unexpected trouble, and their prices will decline.? Or, you play it safe as a panic deepens, and then as the fog lifts, you underperform because you did not hold onto risky bonds that would recover.

Face it: in volatile times we get it wrong.? We panic at troughs, and chase the rabbit when the market runs contrary to our bearish expectations.? But what do you do when you are on the wrong side of a trade?

The first thing to do is sit down with all concerned parties and ask their opinions.? (If you are working on your own, this point is moot.)? If everyone who has an opinion agrees, and the position still worsens, the final step must be taken.? Look at all external analytical opinion, and find someone that disagrees.? Circulate the disagreeing opinions out, and ask all concerned parties what they think.? Or, simply ask, what arguments have they made that we haven’t heard?? Do those arguments make any sense?? If they make sense, close out the position.? If not, it may be time to add more amid the pessimism.

But it is better to prepare in advance for bad times than to react on the fly.? Good investment processes plan for failure.? They realize that not every investment will win, and so they limit the downside of possible bad investments through:

  • Diversification
  • Hostile review when the investment falls by a given amount.
  • Limitations on size of positions.
  • Holding safe assets

Good investment management considers where asset values could go in the short run, and the possibility that money could be pulled if performance is bad enough.? But it also looks to the long run value of the assets, and is willing to sell when values are too high, and buy when values are too low.

As a corporate bond manager, when I got on the wrong side of a trade, I would call my analyst to me and ask her for her unbiased opinion.? If she was certain that things were good, and gave good answers to my questions, I would add to my positions.? But if she gave me the sense that things were falling apart, I would take my losses.

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When I went to work for a hedge fund in 2003, one of the first questions I was asked was? how I would position the portfolio.? I found myself to be the lone bull.? When asked why, I said that we were in the midst of a liquidity rally, and that short positions were poison when liquidity was adequate to finance marginal companies.? My argument was not bought, but I focused my part of the portfolio on marginal insurance companies that would benefit most from the liquidity wave.

Today, there are many bearish hedge funds that are licking their wounds.? What to do?

1) First, assess your funding base.? Estimate how much assets will leave if the underperformance persists.

2) Look at your positions relative to your expectation of prices two years out.? Eliminate the positions with the lowest risk-adjusted expected returns, whether short or long.? Keep the positions on (or add to them) that offer the most promise.

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Bad times offer an opportunity to concentrate on best ideas.? Good times offer opportunities to avoid risk.? In this time of liquidity prompted by the Fed, take the opportunity to lessen risk, because eventually the Fed will have to shift its position, and suck liquidity out of the economy.

On Vanilla Products

On Vanilla Products

Though Congress may not mandate the sale of vanilla financial products to consumers, it is worth thinking about the concept in general. I have written two articles that argued that consumers should only simple products from insurers:

Life Insurance: A Bet You Don?t Want to Win
The Pros and Cons of Buying Annuities

Men (this includes women) are good at analyzing questions of more and less with one variable.? Stick to that, and most men do well.? When there are two or more variables, the rationality breaks down, because the average man does not know how to analyze the pricing tradeoffs.

Term insurance and deferred annuities are relatively simple; the markets are competitive because men can make simple price comparisons across similar products.? That’s why insurers try to sell unique combination products.? The more unique a product is, the harder it is to compare against products that might be cousins.

The same applies to banks.? I don’t believe that any bank should be forced to sell a product, but it would be smart for some banks to market themselves as “basic banks.”? No products are marketed as bundles, every product is sold separately.? Products are sold at cost plus risk-adjusted profit margin.

Some banks could bring in a lot of business if they did this.? I had a similar idea regarding variable annuities, where a life insurance company would charge a mere 40 basis points per year to wrap a variable annuity, with no guarantees.? It would create the generic tax-deferred mutual fund.

In the same way, some backs could win a lot of business offering generic credit cards, simple mortgages, etc.? The only difficulty is getting through gatekeepers, because the average American does not search for the best deal.? Gatekeepers often offer what compensates themselves best.

Aside from complex tax planning reasons, simple products are usually the best.? I encourage my readers to look over the financial services that they use, and aim for simplicity.

Name Your Poison

Name Your Poison

Last night I wrote a longish post, and the system ate it.? Probably I had not established a firm connection with the server, and when I hit the publish button, it disappeared.? My main point was to ask where the limits were for all of the borrowing and spending? going on from the Treasury, and all of the lending going on with the Fed.

I have talked about this before in articles like It is Good to be the World?s Reserve Currency.? Both China and?OPEC have their political reasons for lending to the US, and those keep the dollar afloat for now.

I began last night’s doomed post by declaring to readers that they were part owners in the largest hedge fund (or CDO) in the world — the US Government.? Very distant from the founders’ designs, the government lends to private enterprises in a big way, clipping a spread, while still being exposed to default.

The US government has absorbed many private debts into the government’s debt in exchange for many private debt and equity claims.? Given that the government is clipping a spread, and borrowers are obtaining better terms than the market could give, could there be any problem?

Yes, there are several problems:

  • The federal credit is not infinite — dare we risk the survival of our government to rescue special interests?
  • The ability of the Fed to stretch the currency is not infinite — price inflation has not come yet, but when it does come, it will likely accelerate from all of the promises made.
  • There is some degree of favoritism in who gets funds.? The larger banking firms have been bailed out at their holding companies, which is a travesty, because only regulated subsidiaries are to be protected, not the interests of holding company stock and bondholders.? Small banks have been left to fail.
  • Private lenders who would lend at higher rates are getting cheated by the government, who has no business being a lender.? (Yes, I know, they have been doing it for decades, but that does not make it right.)
  • There is little ability for the government to know whether they are offering fair terms or not as far as the taxpayer is concerned.? What is the right tradeoff between offering more loans, and taxing the populace more?
  • The FDIC trades on the creditworthiness of the US.? They offer guarantees using the Federal credit, rather than surcharge the banks to make up for losses.? Letting banks lend to them at Treasury rates is clever to replenish the reserve funds, but what happens when there are more large defaults?? The hole will be deeper, and the climb out more challenging.
  • So long as the productive capacity of the US is not expanding, arguing about how it is financed is not a fruitful endeavor.

Leaving aside the mutual suicide pact of those that own a disproportionate amount of US Treasuries, the risks that exist stem from an over-indebted economy, and the inability of consumers to resume their role of excess consumption, with accumulation of debt.

Aside from that, should we have a resumption in the decline of housing prices, an acceleration in corporate defaults, or commercial mortgage defaults that affect the big banks, it doesn’t matter that the government is clipping an interest spread, because the losses will be worse.

As a final note, let’s watch the end of the Quantitative Easing from the Fed.? Together with the Treasury they already own over 30% of all 30-year GSE-conforming mortgages, if not more.? What?? Do we want the government to absorb every bad debt?? Where is the responsibility to those that contracted the loans, expecting profit or pleasure?

This will not end well. The only question is whether it ends in inflation or greater taxation.? Name your poison.

Redacted Version of the September FOMC Statement

Redacted Version of the September FOMC Statement

August 2009 September 2009 Comments
Information received since the Federal Open Market Committee met in June suggests that economic activity is leveling out. Information received since the Federal Open Market Committee met in August suggests that economic activity has picked up following its severe downturn. The FOMC thinks that the economy is growing.
Conditions in financial markets have improved further in recent weeks. Conditions in financial markets have improved further, and activity in the housing sector has increased. The FOMC thinks the residential housing market is improving.? The bond and stock markets are definitely better.
Household spending has continued to show signs of stabilizing but remains constrained by ongoing job losses, sluggish income growth, lower housing wealth, and tight credit. Household spending seems to be stabilizing, but remains constrained by ongoing job losses, sluggish income growth, lower housing wealth, and tight credit. Slightly more certainty that spending is stabilizing.
Businesses are still cutting back on fixed investment and staffing but are making progress in bringing inventory stocks into better alignment with sales. Businesses are still cutting back on fixed investment and staffing, though at a slower pace; they continue to make progress in bringing inventory stocks into better alignment with sales. Labor employment and capacity utilization are still falling, but less rapidly.? Inventory correction is still underway.
Although economic activity is likely to remain weak for a time, the Committee continues to anticipate that policy actions to stabilize financial markets and institutions, fiscal and monetary stimulus, and market forces will contribute to a gradual resumption of sustainable economic growth in a context of price stability. Although economic activity is likely to remain weak for a time, the Committee anticipates that policy actions to stabilize financial markets and institutions, fiscal and monetary stimulus, and market forces will support a strengthening of economic growth and a gradual return to higher levels of resource utilization in a context of price stability. The FOMC believes that current policy will strengthen an existing trend toward growth.
The prices of energy and other commodities have risen of late. However, substantial resource slack is likely to dampen cost pressures, and the Committee expects that inflation will remain subdued for some time. With substantial resource slack likely to continue to dampen cost pressures and with longer-term inflation expectations stable, the Committee expects that inflation will remain subdued for some time. Labor employment and capacity utilization are still falling, and the FOMC believes that that will contain inflation.? They also believe that expectations of inflation have stabilized.
In these circumstances, the Federal Reserve will employ all available tools to promote economic recovery and to preserve price stability. In these circumstances, the Federal Reserve will continue to employ a wide range of tools to promote economic recovery and to preserve price stability. They will no long use ?all available tools,? but instead ?a wide range of tools.?? They are looking at scaling back the range of quantitative easing.
The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period. The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period. No change.
As previously announced, to provide support to mortgage lending and housing markets and to improve overall conditions in private credit markets, the Federal Reserve will purchase a total of up to $1.25 trillion of agency mortgage-backed securities and up to $200 billion of agency debt by the end of the year. To provide support to mortgage lending and housing markets and to improve overall conditions in private credit markets, the Federal Reserve will purchase a total of $1.25?trillion of agency mortgage-backed securities and up to $200 billion of agency debt.? The Committee will gradually slow the pace of these purchases in order to promote a smooth transition in markets and anticipates that they will be executed by the end of the first quarter of 2010. No significant change.? This draws out the timing by one quarter ? perhaps they want flexibility to scale back if necessary.
In addition, the Federal Reserve is in the process of buying $300 billion of Treasury securities. To promote a smooth transition in markets as these purchases of Treasury securities are completed, the Committee has decided to gradually slow the pace of these transactions and anticipates that the full amount will be purchased by the end of October. As previously announced, the Federal Reserve?s purchases of $300?billion of Treasury securities will be completed by the end of October 2009. No big change.
The Committee will continue to evaluate the timing and overall amounts of its purchases of securities in light of the evolving economic outlook and conditions in financial markets. The Committee will continue to evaluate the timing and overall amounts of its purchases of securities in light of the evolving economic outlook and conditions in financial markets. No change.
The Federal Reserve is monitoring the size and composition of its balance sheet and will make adjustments to its credit and liquidity programs as warranted. The Federal Reserve is monitoring the size and composition of its balance sheet and will make adjustments to its credit and liquidity programs as warranted. No change.
Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; Elizabeth A. Duke; Charles L. Evans; Donald L. Kohn; Jeffrey M. Lacker; Dennis P. Lockhart; Daniel K. Tarullo; Kevin M. Warsh; and Janet L. Yellen. Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; Elizabeth A. Duke; Charles L. Evans; Donald L. Kohn; Jeffrey M. Lacker; Dennis P. Lockhart; Daniel K. Tarullo; Kevin M. Warsh; and Janet L. Yellen. No change.

PDF version with highlighting here.

Quick Hits:

  • The Fed is more bullish than I am.? I would be less certain about growth prospects.
  • I would also be wary of saying that residential housing is improving when the only improvement has? been transaction volume increasing on the low end.
  • In a global economy, I would not be so sanguine that price inflation can be kept under control through labor unemployment and low capacity utilization.? Remember the ’70s.
  • The Fed funds rate doesn’t mean anything at present.
  • They are looking at the end of quantitative easing, but are not yet considering the beginning of quantitative tightening.
  • There’s little policy difference between the August and September statements.? Maybe the FOMC will do less quantitative easing than they have stated, but that would surprise me.? They won’t stop easing until labor unemployment starts to decline significantly.
Two Notes

Two Notes

This was a horrible day for me.? I tried to fix my shaky internet connection, which troubled my access to Bloomberg.? After some time I had some success, but it pushed me into the late hours of the day, even for me.? For now, it seems stable, and for that, I am grateful.

A few notes:

1)? I’ve read Caroline Baum for about 15 years now, and have consistently benefited from her insight.? Her current piece makes the point that the Fed should not have entered into such policies of easing, because now we face the results of those policies, which include low interest rates, and little reason to borrow.? A liquidity trap, courtesy of the Fed.

2)? Okay, so a Rep. Towns of New York proposes that we ease the terms on the bailout of AIG.? Why should the US do this?? There is no good reason — AIG has stabilized, though it has stabilized at a level where common shareholders will get nothing, eventually, unless valuations on financial asset rise even more.

Can’t the US government make up its mind?? It has voluntarily given up value from bailing out AIG twice.? Must it do so a third time?

No, it must not do so , but my odds that they will do so are 50/50.? The US government is given toward bailing out economically sensitive? institutions whether it makes sense or not.

That’s all for the night.? We are in a tough situation, and the US government leans toward politically sensitive institutions, and favors them versus other financial institutions.? It’s bad policy, but it can be good politics for some politicians.

In Defense of the Rating Agencies — IV

In Defense of the Rating Agencies — IV

I guess I am a glutton for punishment, but I am going to take the opposite side of the argument from what most have been saying of late regarding the rating agencies.? Those who want historical context can read my earlier three pieces:

And let me repeat my five realities:

  • There is no way to get investors to pay full freight for the sum total of what the ratings agencies do.
  • Regulators need the ratings agencies, or they would need to create an internal ratings agency themselves.? The NAIC SVO is an example of the latter, and proves why the regulators need the ratings agencies.? The NAIC SVO was never very good, and almost anyone that worked with them learned that very quickly.
  • New securities are always being created, and someone has to try to put them on a level playing field for creditworthiness purposes.
  • Somewhere in the financial system there has to be room for parties that offer opinions who don?t have to worry about being sued if their opinions are wrong.
  • Ratings can be short-term, or long-term, but not both.? The worst of all worlds is when the ratings agencies shift time horizons.

First, please understand that institutions own most of the bonds out there.? Second, the big institutions do their own independent due diligence on the bonds that they buy.? We had a saying in a firm that I managed bonds in, “Read the writeup, but ignore the rating.”? The credit analysts at the rating agencies often knew their stuff, giving considerable insight into the bonds, but may have been hemmed in by rules inside the rating agency regarding the rating. It’s like analysts at Value Line.? They can have a strong opinion on a company, but their view can only budge the largely quantitative analysis a little.

So there are systematic differences and weaknesses in bond ratings, but the investors who own most of the bonds understand those foibles.? They know that ratings are just opinions, except to the extent that they affect investment policies (“We can’t invest in junk bonds.”) or capital levels for regulated clients.

On investment policies, whether prescribed by regulators or consultants, ratings were a shorthand that allow for simplicity in monitoring (see Surowiecki’s argument).? Now, sophisticated investors knew that AAA did not always mean AAA.? How did they know this?? Because the various AAA bonds traded at decidedly different interest rates.? The more dodgy the collateral, the higher the yield, even if it had a AAA rating.? My mistake: I, for one, bought some AAA securitized franchise loan paper that went into default long before the current crisis hit.? Many who bought post-2000 AAA securitized manufactured housing loan paper are experiencing the same.? Early in the 2000s, sophisticated investors got burned, and learned.? That is why few insurers have gotten burned badly in the current crisis.? Few insurers bought any subprime residential securitizations after 2004.? But, unsophisticated investors and regulators trust the ratings and buy.

Recently, the rating agencies have lost some preliminary arguments in a court case where a defense they made is that ratings are free speech has been shot down.? I must admit, I never would have made such an argument, because it is dumb (See Falkenstein’s logic on the matter).? People and corporations cannot say what they want, and say that they are immune from prosecution because of free speech.? Fraud, and implied fraud from speech is prosecutable.

But what are rating agencies to do when presented with novel financial instruments that have no significant historical loss statistics?? Many of the likely buyers are regulated, and others have investment restrictions that depend on ratings, so aside from their own profits, there is a lot of pressure to rate the novel financial instrument.? A smart rating agency would punt, saying there is no way to estimate the risk, and that their reputation is more important than profits.? Instead, they do some qualitative comparisons to similar? but established financial instruments, and give a rating.

Due to competitive pressures, that rating is likely to be liberal, but during the bull phase of the credit markets, that will be hidden.? Because the error does not show up (often) so long as leverage is expanding, rating agencies are emboldened to continue the technique.? As it is, when liquidity declines and leverage follows, all manner of errors gets revealed.? Gaussian copula?? Using default rates for loans on balance sheet for those that are sold to third parties?? Ugh.

But think of something even more pervasive.? For almost 20 years there were almost no losses on non-GSE mortgage debt.? How would you rate the situation?? Before the losses became obvious the ratings were high.? Historical statistics vetted that out.? No wonder the levels of subordination were so small, and why AAA tranches from late vintages took losses.

When prosperity has been so great for so long, it should be no surprise that if there is a shift, many parties will be embarrassed.? In this case both raters and investors have had their heads handed to them. And so it is no surprise that the rating agencies have no lack of detractors:

I may attend a meeting this Thursday on the rating agencies and the insurance industry, if my schedule permits.? If I get a chance to speak, I hope I can make my opinion clear in a short amount of time.

As for solutions, I would say the following are useful:

  • Competition (yes, more rating agencies)
  • Compensate with residuals and bonuses (give the raters some skin in the game)
  • Deregulation (we can live without rating agencies, but regulators will have to do a lot more work)
  • Greater disclosure (sure, let them disclose their data and formulas (perhaps with a delay).

In economics, where there are more than two players, easy solutions are tough.? I only ask that solutions to the rating agency difficulties be reasonably certain that they do not create larger problems.? Ratings have their benefits as well as problems.

No economic interest

Ten Notes on Current Market Risks

Ten Notes on Current Market Risks

1)? You hear me talk about this more than most, but liquidity risk needs more emphasis.? This is true whether you are a retail or institutional investor.? As the old saying goes, “Only invest what you can afford to lose.”? The basic operations of life require liquidity.

That even applies to the abstract mathematicians who developed much of modern finance.? The moment they assume a simple arbitrage argument, it implies that liquidity is free, or nearly so, in the markets.? I remember asking questions of my professors over Black-Scholes 25 years ago, because equity markets did not trade continuously, except for large companies.

My view is that introducing liquidity risk will be difficult for academic finance, because it will blow apart the simple models that they need in order to write their research.? Once markets do not trade continuously, the math gets tough.

2)? Insiders are selling, should you worry?? Perhaps a little, but I would wait until the price momentum starts to fail.? Like value investors, insiders tend to be early.

3)? What works in a time of rising leverage will not work well when leverage is decreasing.? Or, a strategy that requires liquid markets does not so well in a time of deleveraging.? Consider Citadel, then.? The period from 1991-2007 was pretty care-free.? What crises occurred were not systemic, and were quickly snuffed out by the Fed, as it edged us closer to a liquidity trap.? In 2008, the trap was sprung and Citadel had a lousy year.? Amid the carnage, they were forced to sell into? falling market.? Now they are running at reduced leverage, and planning products that would have been smart eight months ago.

4)? Average retail investors don’t understand regulated investments well enough to invest in them.? It would be stupid to allow them to invest in hedge funds, then.? If we would do such a thing, then deregulate the simpler investments first, telling people that they are on their own, the ineffective SEC is being disbanded, and that “caveat emptor” is the only risk control remaining.

I can’t see that happening in my lifetime.? The nature of American culture abhors implicit fraud, and thus we regulate most of those that take money and offer uncertain promises, when those offering the money don’t have much.? (The culture abhors little investors being fleeced by bigger institutions.)

5)? Auction rate preferred securities — when I was younger, I wondered how they worked.? By the time I figured that out, the market failed.? Now the lawsuits fly.? Yes, they were marketed as money market equivalents, but none of them made it into money market funds.? Now, having read many of the prospectuses, the risks that eventually emerged were disclosed in advance.? Few believed them because it had worked so well for so long.? My view is this — investors needed to read the “risk factors,” and did not.? ARPS were designed to be investment vehicles that could survive a storm, but not a tornado.? Tornadoes do happen, and those that assumed that such volatility would never happen lost.

6)? My, but the high yield market and lower investment-grade corporate markets have moved higher.? What observers miss is that yields for sensitive financials are a lot higher than they were in early 2007, about the time I started this blog.? Systemic risk is still high.

7)? Spreads have fallen for high yield; I have previous suggested to lose the overweight in credit.? I now suggest that credit be underweighted.? This is not a time to stretch for yield.

8 )? After many other crises, junior debt gets grabbed when seniors have rallied a great deal.? The need for yield is significant, much as I think it is premature to buy those junior debts.

9) The same is true for high yield.? When does the rally end? Now?? Typically near a market peak, there is confusion, and a diminution in volume.? I think we are close to the end, but as I usually say, honor the momentum.? If it is still going up, hold it.

10)? This article is a little unusual for me, but it points out something that I often talk about in different terms.? Trees don’t grow to the sky.? In almost any process, the results are not linear as one increases effort, but there comes diminishing returns because improvement is not costless.? Exponential growth meets the constraint that resources are not infinite, and so growth follows more of an S-curve.? So it is with business, and much of finance.

What is Liquidity? (Part III)

What is Liquidity? (Part III)

I have had a number of posts on liquidity over the past few years, in an attempt to explain an ill-understood phenomenon.? Here is a sampling:

Because of high frequency trading, I want to take another stab at what liquidity is.? Limit orders offer liquidity; an investor or market maker offers to buy or sell at a fixed price.? Market orders consume liquidity — they lift or hit limit orders, often forcing the bid-ask spread wider.

But not all limit orders are the same.? They vary because:

  • Some limit orders narrow the bid-ask spread, which aids liquidity.
  • Some limit orders bid/offer more shares, which increases liquidity.
  • Some limit orders hang out there for a long time, which also boosts liquidity.

Liquidity means being able to make a choice, and if possible to do it in size, at a price that you like.? Also, for many of us, it means that we have some amount of time to think about the price.? That is liquidity — the ability to buy or sell in size without having to “bust a gut” to do so.

High frequency traders claim to add liquidity, but their bids and asks are ephemeral.? They add little liquidity, because the average investor can’t act on them.? They are like market orders, because they are gone in a flash, consuming longer-dated liquidity.

I am not saying that high frequency trading should be illegal, but that investors and market makers should carefully consider the rules where they trade.? For investors: are you trading in a market where you have a disadvantage?? For market makers: you should be the heavy hitter here; don’t let anyone more powerful/fast in.? Operate your market for the best interests of all, and ignore those that want an advantage.? In some cases this may mean executing trades once every five seconds, or any such similar interval.

Level playing fields promote broad markets.? Let clever market makers so structure their businesses, that level playing fields dominate investing.

Alternative Investments, Illiquidity, and Endowment Management

Alternative Investments, Illiquidity, and Endowment Management

I am a risk manager first, and a profit maker second.? I tend not to trust solutions that are “magic bullets” unless there is some barrier to entry — why can you do it, and few others can?? Knowledge travels.

So, regarding the “endowment model” of investing, I have been partly a believer, and partly a skeptic.? A believer, because endowments do have the ability to invest for the long-term, and not everyone else does.? A skeptic, because many endowments were taking on too much illiquidity.

Liquidity is an underrated factor for investors who have charge over portfolios that have a long-term stable funding base.? I had that advantage once, as the main investment manager for an insurer the had a large portfolio of structured settlements.? In insurance liabilities, nothing is longer than a portfolio of structured settlements.

Buy long-dated debt?? Illiquid debt?? If the pricing is right, sure; you should have to pay to rent the strength of a strong balance sheet, where the funding is intact.? WHen managing that company’s portfolio I didn’t have to worry about a run on the portfolio, because I kept more than enough liquid assets to satisfy the demands of policyholders should they decide to surrender.

Pushing it Past the Illiquidity Limit

I decided to write about the endowment model after reading this article, of which I will quote the first paragraph:

There has been much written in the popular press lately about the failures and even the “death” of the endowment model. The discourse regarding this matter has been surprisingly simplistic, naive and exceedingly short sighted. As was the case with Mark Twain, reports on the death of the endowment model have been greatly exaggerated. Let’s start with the facts. The “endowment model” practiced by most of the big university endowments and many big foundations (but also by some astute smaller endowments and foundations) has overwhelmingly outperformed virtually all other models over any reasonable time period, and has done so for a very long time now. There is no single model, mode or manner of investing that outperforms in every environment and over every time period, and the endowment model of investing was never predicated on being the exception to this obvious reality. In fact, endowments’ time horizons are as long as any investor’s horizon, and hence are strictly focused on the long term. This is a huge advantage because there is clearly a significant liquidity premium to be captured by investing long term, not to mention the ability to better avoid the chaotic noise and behavioral finance mistakes that arise with a short term environment and outlook – especially in volatile markets.

The idea here is that you will obtain better returns if you can focus out to an almost infinite horizon — after all, endowments will last forever.? There is an edge to having a long investment horizon, but there are still reasons to be cautious, and not aim a majority of investments in such a manner that means that they cannot be touched for a long time.

Here is my example: Harvard.? At the end of fiscal 2008, those that managed Harvard Management Company were heroes.? The largest university endowment, stupendous returns, etc.? Who could ask for more?

The risk manager could ask for more.? With an endowment of nearly $37 billion in June of 2008, only $16 billion was liquid assets.? Of that $16 billion, $11 billion was spoken for because of commitments to fund limited partnerships.? Harvard also had $4 billion in debt, not all of which was directly attributable to the endowment, but still would be a drag on the total Harvard entity.?? If this is representative of the endowment model, let me then say that the endowment model accepts illiquidity risk more than most strategies do.? Even after their great investment successes, Harvard did not have enough liquidity.

Then Came Fiscal 2009 — We’re out of liquid assets!

My guess is that sometime in the fourth quarter of calendar 2008, the powers that be at Harvard concluded that they were in a liquidity bind — negative net liquid assets, and there is a need for liquidity at Harvard, to pay for ordinary operations, as well as expansion.? Thus they moved to sell illiquid investments, and take a haircut on them.? They reduced their forward commitments by $3 billion.? They also raised $1.5 billion in new debt, $500 million worth of 5-, 10-, and 30-year debt each.

This is clear evidence of a panic, and an indication that the portfolio was too illiquid.? What else might indicate that?? Well, Harvard had to scale back capital projects, and had a round of layoffs of ancillary personnel.

The idea of an endowment is that you can run your institution without fear of the future.? But that also implies that those endowed will not make abnormal demands on the endowment.? That applies to the amount disbursed and the liquidity of the underlying investments.

Now at the inception of fiscal 2010, Harvard is much in the same place as it was in 2009.? Net of debt and commitments, Harvard’s endowment does not have liquid assets on net.? (My estimates: $12.5 billion of liquid endowment funds, $8 billion of funding commitments, and $5.5 billion of debt.)? Granted, it was wise to move the endowment’s cash policy target from -5% to -3% to +2% over the past two fiscal years.? Even if cash doesn’t return anything, it is still valuable.? You can’t pay professors with shares of a venture capital partnership.

The Horizon Isn’t Infinite

This brings me to my penultimate point, which is that the investment horizon for endowments is different for other investors in degree, but not in kind.? The horizon for an endowment is infinite only under conditions of permanent prosperity.? Well, anyone can invest forever under conditions of permanent prosperity.? The forever-growing investments can be borrowed against.

The investment horizon must take into account the possibility of a depression, or at least a severe recession or war, if you want to have an endowment that will truly last forever.? There has to be cash and high quality liquid debt adequate to provide a buffer of a few years of expenses.? That will give the institution more than adequate time to adjust to the new economic conditions.

Most college endowments that have not gone overboard on illiquid investments and don’t have a boatload of debt probably don’t have to worry here.? But for those that bought into the alternative investments craze, the idea of invest for forever must at least be tempered into something like 20% of our investments exist to buffer the next 5 years, and the other 80% can be invested to the infinite horizon (maybe).? That’s a more realistic approach to endowment investing, akin to a speculator paying off his mortgage and having a year of savings in the bank before beginning a trading career with capital beyond that.

Alternative Investments are not Alternative Anymore

There is another reason, though, to be cautious about illiquid investments.? With any new alternative investment class, the best deals get done first, and wow, don’t they provide a thundering return!? Trouble is, knowledge travels, and success breeds imitators.? The imitators typically bring deals that will have lower returns or higher risks than the original deals.? But the pressure of additional money into the alternative illiquid investments force progressively more marginal ideas to get done as deals.? Also, mark-to-market returns of earlier investments get marked up, giving them an even more impressive return, which attracts more capital to the investment class.

Eventually deals get done that make no sense, but the momentum of demand carries the asset class until returns of newer deals prove to be negative.? That? gets the mark-to-market process moving in reverse, and demand for the “no longer new” investment class declines.? In some cases, investors will try to get out of funding commitments, and even try to sell their interests to a third party, usually at a significant concession to the hard-to-define fair market value.

Eventually enough capital exits the class, inferior deals get written down, and the once new investment class might still be labeled “alternative,” but has entered the mainstream, because it has been around long enough to go through a failure cycle.? The now mainstream but still illiquid investment class is near a normal size versus the investment universe, and should possess forward-looking returns that embed a risk premium to reflect the disadvantages of illiquidity.? Also, the now mainstream investment becomes more correlated with risk assets generally, because the actions of institutional investors chasing past returns is common to much of what qualifies for asset allocation.

Summary

  • Liquidity is valuable, and should not be surrendered without proper compensation.
  • Alternative investment classes eventually go through a mania phase, and then go through a failure cycle.
  • After failure, they tend to be more correlated with other risk assets.
  • Endowments can indeed invest for a long horizon, but should keep sufficient liquid assets on hand to deal with significant market corrections.
  • Harvard’s endowment would be vulnerable if we had a repeat in the near term of what happened in fiscal 2009 because of its low net liquidity.

Investing is a business where the smarter you are, the more it pays to be humble and recognize risk limits.? Major universities and colleges (and defined benefit plans) should review their asset allocations and stress-test them on scenarios where liquidity is in short supply.? Better safe than sorry.

Articles on the Harvard Endowment

6:46 PM Update — So I write this, and Morningstar comes out with a good piece like this one.? So it goes.

QUEASY — QUantitative Easing Aids Speculators Yields

QUEASY — QUantitative Easing Aids Speculators Yields

Okay, I am going out on a limb here, so please understand that what I am saying is a bit of an experiment.? When quantitative easing was originally done in Japan, it was after:

  • a credit-fueled expansion that pushed the stock and real estate markets to new heights, which have not been seen for 19 years.
  • productive capacity was built up that the rest of the world would not need.
  • anticipated returns on equity for investment projects were in the low single digits.

Now, during the time of quantitative easing, the following things happened:

  • money market rates were near zero.
  • relatively few private investors wanted to borrow money for investments to expand productive capacity.
  • government deficits expanded dramatically in a futile attempt to simulate an over-indebted economy.
  • Speculators borrowed money in yen in order to do carry trades.? They borrowed the surplus yen from the quantitative easing, and used the leverage to speculate on higher-yielding debt.? This had little benefit for the average person in Japan, though many played the carry trade game internally, buying investments denominated in Australian, New Zealand, or US Dollars.

Back to the present, and back to the US.? Short-term borrowing rates have been falling, as there is a lack of demand to borrow short-term.? Contrast that with one year ago, where there was no lack of demand to borrow short-term, but no willingness to lend.

An amazing change indeed, but much of it stems from a lack of demand for short-term borrowing. Some attribute the low TED (3-month Eurodollar less Treasury yield) spread to risk-seeking, but I think that banks don’t have many uses for surplus cash now.

As it is, with low US Dollar LIBOR lending rates, it makes the US Dollar a honeypot for speculators.? Borrow in Dollars, invest in your favorite higher yielding currency, or in higher credit risk instruments.? For the foreign currency trade, the added kick is that the US Dollar may decline in value.? That said, many said the same would happen to the yen; that it would decline in value, and it did not.? I have many reasons to think why the Dollar will decline, but the carry trade argument goes the other way for me.

Now, maybe the excess liquidity is fostering day traders as well.? We saw the same phenomenon in 1999-2000.? The liquidity should not have leaked out, but it did, and to those that would only speculate.

So what is the Fed doing?? Is it ending quantitative easing?? It seems not.? They will buy mortgages until they reach their preannounced limit, most likely.? That said, the Treasury might reduce funding to the Fed.? They see less need to fund the Fed, though that will force the Fed to decide how large it wants its balance sheet to be in a time of crisis.

Here’s my concern — having carry traders absorb excess liquidity that the Fed has put out is a waste of Fed resources, and indicates that Fed policy is too loose.? Don’t buy more mortgages and agencies, and consider selling bonds back in to the market.? Let short-term rates rise to reflect the true scarcity of short-term ways to profit.? Let savers earn some money — there is no benefit to having monetary policy so loose.

To summarize: Japan did not benefit from many years of quantitative easing, but it provided a lot of fuel for carry trades around the world until most of them blew up over the last two years.? It seems to me that excess liquidity created by the Fed is going the same way now, because consumers and businesses don’t want to borrow to the same degree as they did during the boom phase.

It will take a long time for balance sheets to heal.? It depends upon the rates of debt forgiveness/compromise, and paying it down.? During the Great Depression, Debt/GDP peaked several years after the Depression started, and after the peak it took about ten years for it to come down to a more normal level in 1941.? I suspect that we will go through this same process again, before the economy grows robustly as it did post-1941, regardless of what the Fed and Treasury do.

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