Quantitative Methods – Page 41

What Might the Shape of the Treasury Yield Curve Tell Us?

Posted on 15 February 200815 February 2008 by David Merkel

There are many things that are unusual about the current Treasury yield curve. I’ve built a moderately-sized model to analyze the shape of the curve, and what it might tell us about the state of the economy, and perhaps, future movements of the yield curve. My model uses the smoothed data from the Federal Reserve H15 series, which dates as far back as 1962, though some series, like the 30-year, date back to 1977, and have an interruption from 2002-2005, after the 30-year ceased to be issued for a time.

So, what’s unusual about the current yield curve?

The slope of six months to three months (19 bp) is very inverted — a first percentile phenomenon.
The slope of two years to three months (38 bp) is very inverted — a third percentile phenomenon.
The slope of seven years to ten years is steep (57 bp – 5 bp away from the record wide) — a 100th percentile phenomenon.
The slope of five years to thirty years is steep (186 bp – 30 bp away from the record wide) — a 100th percentile phenomenon.
The slope of two years to thirty years is steep (274 bp – 97 bp away from the record wide) — a 97th percentile phenomenon.
The slope of ten years to thirty years is steep (82 bp – 29 bp away from the record wide) — a 98th percentile phenomenon.
The butterfly of three months to two years to thirty years is at the record wide (312 bp). (Sum of #5 and #2. Buy 3 months and 30-years, and double sell 2-years? Lots of positive carry, but the 30-year yield could steepen further versus the rest of the curve, and its price volatility is much higher than the shorter bonds.)

What prior yield curves is the current yield curve shaped like?

9/7/1993 — after the end of the 1990-1992 easing cycle to rescue the banks from their commercial real estate loans.
2/15/1996 — after the end of a minor easing cycle, recovering from the 1994 “annus horribilis” for bonds.
9/14/2001 — 60% through the massive easing cycle where Greenspan overshot Fed policy in an effort to reliquefy the economy, particularly industrial companies that were in trouble. Also days after 9/11, when the Fed promised whatever liquidity the market might need to stave off the crisis.

Okay, I’ve set the stage. What conclusions might we draw from the current shape of the yield curve?

The curve is forecasting a 2% Fed funds rate in 2008.
Fed policy is adequate at present to reliquefy the economy; the Fed doesn’t need to ease more, but it will anyway. Political pressure will make that inevitable. (If we really want an independent central bank, let’s eliminate the ~~pressure~~ oversight that Congress has over the Fed. Better, let’s go back to a gold standard; a truly private monetary policy. Oh, wait. I’m behind the times. We don’t want an independent central bank. Dos that mean we can now blame Congress for monetary policy errors?)
We could see a record slope for the yield curve (in the post Bretton Woods era) if the Fed persists in its easing policies.
One can sell sevens and buy tens, dollar-duration-weighted and have positive carry. Assuming one can hold onto the position, it would be hard to lose at these levels, if the last thirty years of history is an adequate guide to the full range of possibilities.
The Fed is planting the seeds of its next tightening cycle now. Every cut from here will make the tightening cycle that much more intense.
The curve can get steeper from here, but it is getting close to the boundaries where strange things begin to happen. The Fed is not omnipotent, and the steepening curve is evidence of that.
As I have said before, recently, the US Dollar is no longer a “sell” for now. The anticipation of Fed funds cuts is already factored in, and even if we get down to 2%, I suspect that we can’t go much lower because of negative real interest rates and rising inflation.

That’s where I stand for now. The Fed is trying to rescue the economy from asset deflation, much like 1990-1992, but will run into the buzzsaw of price inflation, and tighten a la 1994. Conditions in the real economy are not as weak today as they were in 2001, but the banks are in worse shape. That will drive further loosening by the Fed, until inflation is intolerable. Continue reading “What Might the Shape of the Treasury Yield Curve Tell Us?”

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

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.

Getting an Initial Read on a Deal

Posted on 1 February 2008 by David Merkel

I wrote at RealMoney.com today:

		David Merkel
		What Would Make More Sense to Me, Redux
		2/1/2008 10:14 AM EST

Nine months ago, I wrote this: Microsoft and Yahoo! are in several different businesses with modest synergies between them. Buried inside such a merger would be (at least):

An Internet advertising company

A web/(other media) content producing company

An operating system/applications software company

A consumer entertainment products company

A web search company, and

A web marketing company.

Going back to our discussion of GE earlier this week, Microsoft does not need more businesses in its portfolio. It needs to focus its activities on what it does best. Same for Yahoo! but their problems are less severe unless they do this merger.

If I were Microsoft, I would accept defeat, and sell all web properties to Yahoo! If I were Yahoo!, I would spin off all content production in a new company to shareholders. You would end up with three focused companies that would be able to hit their markets with precision, in a business where scale matters inside your market, but not across markets. The ending configuration would be:

A software company for everything except the web — Microsoft, which would pay another huge special dividend with the proceeds from the sale.

A web search, advertising and marketing company — Yahoo!, which could focus on competing with Google, and

A web/(other media) content production company (would it make money?)

This to me would be rational, but corporate cash gets spent by self-aggrandizing folks with egos, so this is not likely to happen in the short run. But I think the eventual economic outcome will resemble something like this.

Microsoft has not shown a lot of competence in the areas that Yahoo! has focused on, and because of their long history of growth, I’m not sure they get how to run a company that is transisting into maturity. I would be bearish on the total concept.

The market has awarded an additional $3.7 billion to the combined valuations on Microsoft and Yahoo! off of this news. After some time, that premium should reverse, and it will come out of the valuation of Microsoft. But then, I only play in tech when it is trashed, so what do I know?

Position: none

=-=-=-=-=-=-=-=-=-

By the end of the day, that initial valuation premium of $3.7 billion turned into a deficit of $1.2 billion, and that was against a rising market. I’m not that kind of trader, but some deals make sense, and some don’t. When you find one that doesn’t make sense, and the market value of the package rises, one can short both the acquirer and the target, and wait for rationality to arrive.

That’s not to say that all deals are bad. Value can be added through synergies or improved management, or unlocked through expense savings and more leverage. Microsoft-Yahoo is unlikely to fit any of those descriptions in any major way.

An Anomalous View of Stock Investing

Posted on 17 January 2008 by David Merkel

I was impressed with what Charles Kirk had to say regarding AAII and Stock Screening.? I’m a lifetime member of AAII, and I’ve used their stock screening software for years, long before I was a professional.? I was also impressed to note in the recent issue that two of my four buys in the fourth quarter were buys in the shadow stock portfolio, which has done very well over the years.

Back to Charles Kirk, if I can quote a small part of his piece:

When looking over the information, among many things I noticed include the fact that 7 stock screens have posted gains for every year over the past 10 years. Screens with this amazing consistency include Graham’s Defensive Investor, Price-To-Sales, Zweig, PEG With Est Growth, PEG With Hist Growth, and two of O’Shaughnessy’s screens – Small Cap Growth & Value and Growth. Few screening strategies can produce gains year after year as these have and there’s something to be learned from them.

Looking through and comparing the criteria between all of these screens, in essence they were seeking four simple things: 1) growing earnings per share over various time frames, 2) strong sales growth, 3) an attractive valuation (often using price-to-sales), and 4) relative strength.

Though I may quibble with O’Shaughnessy’s methodology, this is consistent with what he found in his book What Works on Wall Street.?? That said, though I am more agnostic about market capitalization, as I looked across the shadow stock portfolio, which is a small cap deep value portfolio, it confirmed to me that there are a lot of cheap stocks to buy in this environment.? There are good gains to be had in the future, even if past performance has suffered.

Now to approach it from a different angle.? I mentioned how much I like the CXO Advisory blog.?? One page to visit is the Big Ideas page, if you like academic finance papers.? I want to give you my short synopsis of what seems to work:

Cheap valuation, particularly low price-to-book (though I like cheap price-to-everything… book, earnings, sales, dividends, EBITDA)
Price momentum
Low accrual accounting entries as a fraction of earnings or assets
Piotroski’s accounting criteria
Low net stock issuance
Positive earnings surprises
Low historical return volatility
Illiquidity, which is a proxy for size and neglect

There are other prizes on that page, including mean-reversion, an improved Fed Model, Dollar-weighted vs. Time-weighted returns, limitations on academic financial research, demography, etc.

I would simply tell the fundamental investors in my audience to think about these issues.? Let me summarize them one more time:

Look for a cheap valuation.
Look for mean reversion, but don’t try to catch a falling knife.
Grab positive price momentum and earnings surprises.
Look for sound accounting, and management that is loath to dilute shareholders.
Avoid volatile stocks
Look for neglected stocks

That’s my my quick summary for what seems to work in stock selection.? I invite commentary on this.? I downloaded a lot of the papers cited, and will be reading them over the next few months.

How to Manage a Portfolio

Posted on 15 January 200827 March 2023 by David Merkel

Given the title above, I feel embarrassed to write, because the topic is too basic. I write because too few managers think clearly on the topic. The following analysis applies to long only funds and hedge funds; it also applies to equity and bond funds. The impetus to write this note arrived because the Fidelity Magellan Fund is reopening because cash inflows will make the life of the portfolio manager easier… not that he will get many inflows for now.

My view is that it should not be hard to manage a shrinking portfolio. It is much harder to manage a rapidly growing portfolio. (I have experienced that, and that is a topic for another day.) Here is the key concept: the portfolio manager must rank his portfolio by expected returns, adjusted for risk. This applies to both the longs and shorts. If there are cash inflows to a portfolio, assets should be allocated to the highest returning assets. If cash outflows, assets should be liquidated from the situations with the lowest expected returns. It is that simple, and I did that when I was a corporate bond manager. It worked well.

The reason why it will not be implemented at many asset management shops is that it takes work to do it, and we all avoid work if we can. But maintaining lists of long and short ideas ranked by likely risk-adjusted returns will yield better decision making, if one will do it.

What of the January Effect?

Posted on 15 January 2008 by David Merkel

I’m not feeling well this evening, so this will be a short post dealing with one simple issue.? (If I have strength, I may do one more.)

The January Effect is one of the best known calendar anomalies.? Stocks and high yield bonds tend to do well after the first day of the new year. This happens because these assets get oversold as some investors sell losing positions for tax reasons.? This tends to be more powerful for stocks that have done poorly over the past year, and for small companies, and value stocks.? This year it seemingly hasn’t happened.? Why?

First, all anomalies exist within a broader market environment.? When enough market players jump onto an anomaly, the anomaly outperforms in the short run, but peters out, because all interested parties have bought in.? If that were true of the January Effect, we would see the gains made in December, rather than January.? That’s not what happened this year.? (Anomalies tend to do best when they are ignored.)

Second, in a market where small value stocks may be overvalued, the January Effect could disappear for a year while small value stock valuations adjust back to normal, or below that.? That might be true this year.

We are in the winter season, not just for the calendar, but for small stocks and value investing. ? I feel the winter chill in all that I do at present, and no, I am not talking about the lack of insulation in my hovel.? I have the winter wind in my face now (much as I remember walking home from high school in Milwaukee), and yet I know that this is the time that my best purchases are likely to be made.? I have to focus on my core disciplines, and buy good long-term cash flow streams cheaply.

Before I close, I would say that a new favorite blog of mine is the CXO Advisory Group blog.? For quantitative investors, there is a wealth of knowledge there.

Industry Ranks and Additional Stocks

Posted on 12 January 200813 January 2008 by David Merkel

If I did not use a mechanical method for ranking replacement candidate stocks against my portfolio, I would not let so many stocks go onto my potential replacement list. Today I updated my industry model, and here it is:

Industry Groups January 2008

(If you have any difficulty downloading that, let me know. I’ve been having trouble with that.)

From that, I ran a bunch of screens, adding in some technology industries that have been hit of late. Here are the additional tickers that will be added to my candidates list: AMIE ASYT BBBY BC BELM BGFV BIG BNHN BRLC BWS CAB CBR CHRS CHUX CMRG CRH CTR CWTR DBRN DECK DFS DSPG DSW ESEA EXM EXP FHN FINL FRPT FSS GASS HGG HLYS HTCH HZO IDTI IKN IM IMOS JAS JNS KSWS KWD LF LIZ LNY LSI MIPS MRT NSIT NSTC NTY ODP OPMR OVTI OXM PERY PLAB POOL RCRC RENT ROCK RSC RT RUTH SAIA SHOO SIG SMRT SNA SNX SONC SSI TJX TOPS TUES VLTR VOXX ZQK

Now, the mechanical ranking system is supposed to be a simple way of prioritizing value stocks, and typically it does pretty well in directing my attention to the stocks that I should analyze, not necessarily the ones I should buy. That’s true of any screening method, no matter how simple or complex. You always find some companies that look really good initially, but got there because of data errors, accounting mis-characterizations, or a business situation that was vastly different when the accounting snapshot was taken.

Now, after all of this work, I’m only trading 3-4 stocks into and out of my portfolio of roughly 35 stocks. But the idea is to end up with a portfolio with better offensive and defensive characteristics, such that the relative performance will be good, and should the market turn, I will be in the industries and companies with a lot of potential to outperform.

Pandora and the Fair Value Accounting Rules

Posted on 11 January 2008 by David Merkel

I’ve been involved in financial reporting for a large amount of my career, so even though I’ve never had an accounting course in my life, I’ve had to work with some of the most arcane accounting rules out there as an actuary, and later as an investor.? Over the years, the direction that the FASB and IASB have gone is in the direction of presenting the statement of financial position (balance sheet) on more and more of a fair market value basis.? (Please ignore the treatment of goodwill, advertising,? R&D, you get the idea though…)? To soften the blow on the income statement, changes in the value of many balance sheet items don’t get run through net income, but through accumulated other comprehensive income, so that income can reflect sustainable earnings power, in theory.? Now, I agree with Marty Whitman’s critique on these accounting issues.? We may be getting more accurate on individual companies (if the accounting is done by angels, for humans we are granting too much freedom), but we are losing comparability across companies.? What an item means on the balance sheet of one company may be considerably different than the value at another company.
The hot topic today is SFAS 157 and 159.? I would point you to Dr. Jeff’s article this evening on the topic.? I would like to give my perspective on this, becaue I have had to work with these accounting rules, and ones like them.

At one company that I managed money for, I originated a bunch of long duration high quality assets that did not trade.? At year end, our incentive payment was based on the total return that we generated.? Interest rates had fallen through the year, and so my high quality illiquid assets had yields well in excess of where new money could be deployed.? What were those assets worth?? Historic cost?? The cash flow streams were fixed.? As a conservative measure, though spreads over Treasury yields had fallen for those instruments, we kept the spreads from the issue, and accounted for the price change due to the move in Treasury yields.? (If spreads had risen, I would have argued that we move the spreads up as a conservative gesture.)? Now this was prior to SFAS 157, but it illustrates the point.? How do you calculate the value of illiquid instruments?? Worse, under SFAS 157, you can’t be conservative; you have to try to be realistic.

Now, that was a simple example.? Almost every moderate-to-large life insurance company has a variety of illiquid privately placed bonds for which there is no market.? What is the fair value?? Who can tell you?? Well, the broker(s) that brought the deal are supposed to provide continuing “color” on the bonds, and what few trades might transpire.? Typically, they don’t move the prices much as the interest rate and spread environments change, and third party pricing services are loath to opine on anything too illiquid.? Though the rating agencies night give a rating at issue, they might not update it for some time.? What’s the fair value?? The life insurer has a hard time determining that for that small minority of assets.

Now let’s take it to a yet more difficult level.? If we are talking about many asset-backed securities, they are generic enough that pricing models can determine a spread to Treasury or Swap yields for tranches with a given vintage, maturity, originator, and rating.? Yes, there will be many assets that “trade special,” but those are deviations from the model that the traders feel out.

With CDOs, things get more difficult, because aside from indexed CDOs, there is no generic structure.? The various tranches are bought and held.? They rarely trade.? Projecting the cash flows is a difficult talk, because there are many different bonds in the trust, with many different scenarios for how many will default, and what recoveries will be obtained.? The best a good simulation model can do is to illustrate what a wide variety of possibilities could be, and look at the average of those possibilities.? Even then, the modeler has an expected cash flow stream.? What’s the right discount rate to use?

There is no good answer here.? One can try to infer a rate from what few trades have happened in the market with similar instruments, but that can be unreliable as well.? During a bear market, the sellers will be more incented than the buyers, particularly if they are trying to realize tax losses.? One can try to look at the scenarios across the tranches, and see which tranches have cash flows that behave like bonds, equities, and warrants, and apply appropriate discount rates like 6%, 20%, and 40% respectively.? Some explanation:

Bonds: pays interest regularly, and principal within a narrow window.? Few deferrals of interest.
Equities: high variability of payoffs.? Pays something in almost all scenarios, but the amounts vary a lot.? Timing and existence of principal repayment varies considerably.? Interest deferrals are common, but rarely last long.
Warrants: many scenarios have very low or zero payoffs.? Some scenarios have significant payoffs.? Interest deferrals last a long time, many never end.? Principal payments are rare.

Estimating fair value in a case like this is tough, if not impossible.? But a fair value must be estimated anyway.? Management teams may try to make the third party estimator come to a certain value that fits their accounting goals.? Given the squishiness of what the discount rate ought to be, management teams could say that once the market normalizes a low discount rate will prevail, and our models should reflect normalized, not panic conditions.

Well, good, maybe.? The thing is, once we open Pandora’s box, and allow for flexibility in valuation methods, subject to auditor sign-off (now, who is paying them?), our ability as third party investors to evaluate the value of illiquid assets and liabilities declines considerably.? There’s a great argument here for avoiding companies that own/buy complex assets in an era where fair value accounting reigns.? There is too much room for error, and human nature tells us that the errors are not likely to yield positive earnings surprises for investors.

I’m Not Afraid Of Derivatives

Posted on 10 January 2008 by David Merkel

In one state that I worked in, I managed to push a bill through the legislature that modernized that life insurance investment code, bringing it from the mid-50s to the late ’90s.? The bill had the D-word in it, and prominently: derivatives.? I had structured the bill so that derivatives could only be used for the purposes of risk reduction.? We had two investors and two lawyers on our team, and I was the “quant” who happened to have a good handle on economic history.? When testifying before the Senate, they asked us three questions:

How can you make sure that Procter & Gamble doesn’t occur?
How can you make sure that LTCM doesn’t occur?
How can you make sure that Orange County doesn’t occur?

Three derivative disasters.? I pointed to the protections embedded into the proposed law prohibiting speculation, and the detailed reports that the valuation actuary must submit on interest rate and investment risks, and that all transactions had to be reported to the insurance department, which could disallow transactions.

The bill passed unanimously.? Eight years later — no disaster yet.

This brings me to a piece by Bill Gross, and a critique by Felix Salmon.? As I have commented before, I am not horribly worried about counterparty risks at the investment banks.? Past history shows that they are very good at preserving their own hides while kicking their overleveraged customers over the edge.? Unless there are significant losses from counterparty risks, it is difficult to have large systemwide losses, because with derivatives, for every loser, there is a gainer.? It’s a zero-sum game.? I think Felix has the better part of the argument by a wide margin.? Also, PIMCO is a large user of derivatives; they write significant exposures that are the equivalent of out-of-the-money calls to enhance their returns.? If large losses are coming, what is PIMCO doing to limit losses, or better yet, profit?

That’s not to say that those that have taken risky positions won’t lose.? They very well might lose, but someone else will win.? That doesn’t make the analysis easy, because derivatives and securitization obscure what is going on with any one entity, even if the system as a whole is unchanged.? Even Moody’s is scratching their heads on the matter.? If the rating agencies which have inside information, are puzzled, the rest of us can feel better about being puzzled as well.

Two last notes: CDOs are ugly beasts, and there are really only two places to invest in them: at the most senior level, and at the most junior level.? At the senior level, you have some protection, and can control the deal in a crisis.? The most junior investors can make a lot of money if everything goes right.? Not generally true now, but in the right environment, it can be a winner.

Second, I don’t think CMBS market is as bad off as the CMBX indexes would indicate.? CMBS are more carefully underwritten and serviced than other securitized asset classes.? The only thing that gives me worry is that recent vintages have relied on rising rental rates, and property values that may temporarily have overshot.? Things aren’t great in CMBS-land, but there are other places more worthy of scrutiny.? Again, my comments about being senior or being junior (equity) apply here as well.

Securitization and derivatives are tools, and they can be used wisely or foolishly.? They can destroy individual companies, but not whole economies.