Photo Credit: Jason Wesley Upton || Of course this isn't China...

Photo Credit: Jason Wesley Upton || Of course this isn’t China…

I know this is redacted, but it is advice to a reader in a really remote area of the world.  You might find it interesting.

I am currently with the XXX team in XXX.  We are taking about trying to budget the [project] with the inflation of the past months being 50%. And September being 91%. I think XXX would appreciate your thoughts on the likely economic and inflation situation. They are trying to decide whether to move to working on dollars. And how to budget if they stay in the [local currency].

Dear [Friend],

One question that may not matter so much… is the inflation rate 50-91%/year, or 50-91%/month?  The reason I ask this is if that is the rate per month, then you should try to do as much business as you can in dollars, and/or treat the local currency like a hot potato… don’t hold onto it long – it is not a store of value.  It is normal in such a situation for another currency to become the practical currency when inflation gets that high… even if it is illegal.

If the rate is 50-91%/year, that’s not great to work with, but prices are still moving slow enough for you to have some degree of a planning horizon in the local currency.  Still, any big transactions should be done in dollars, unless you are certain that you are getting a favorable rate in the local currency.

As for budgeting, it could be useful to do the budget in both currencies.  This will help to raise the natural question of what happens if you don’t have the right currency.  Here’s what I mean: ask what currencies you would naturally use to transact to accomplish your goals – look at both revenues and expenses.  If you find your expenses are mainly in dollars or euros, but revenues are in the local currency, you will need to do one of two things.  Either a) try to charge in hard currency terms, or raise revenue rates regularly, or b) build in a significant pad in local currency terms for the things you would typically buy in a hard currency.

Feel free to send me a spreadsheet on this.  As an aside, you can tell XXX that I have little trust that the situation will improve rapidly.  The government is too corrupt, its budget way out of balance, and any revenue from oil is down.  It would take a hero willing to end the corruption, and then survive ending it, in order for the inflation to stop.

In closing, the following paragraph is illustrative, and not strictly relevant:

I realize that you all aren’t investing in the country, but if you were, I would give the following advice: invest in land.  In a nation where there are no securities market, and the government is the cause of the inflation, land is the only thing that retains value.  AIG used to do this all the time in countries, particularly when they couldn’t remit their earnings there back to the US.  As they say in Argentina, “The wealthy preserve their wealth by owning land.”  So long as land is not expropriated, it protects wealth against governments who steal via inflation.  Gold is similar, but where you are, something that light and valuable could easily be stolen.

Anyway, I missed you at XXX, and hope and pray that you are doing well.  If you or anyone else on the team has questions on this, just let me know.  I’ll make time for you.

In Christ,


A while ago I wrote two pieces called “Easy In, Hard Out.”  The main idea was to illustrate the difficulties that the Federal Reserve will face in removing policy accommodation.   In the past, the greater the easing cycle, the harder the tightening cycle.  I don’t think this time will be any different.

In the last two pieces, I showed three graphs to illustrate how the Fed’s balance sheet has changed.  I’m going to show them again now, updated to 11/11/2015.  Here’s the graph showing the liabilities of the Federal Reserve — i.e. what the Fed eventually has to pay back, occasionally with interest:

I’ve added a new category since last time — reverse repurchase agreements (“reverse repos”) because it has gotten big.  In that category, you have money market funds (etc.) lending to the Fed to pick up a pittance in interest.

As you might note — as the balance sheet has grown, all categories of liabilities have grown.  The pristine balance sheet composed mostly of currency is no more — it is only around 30% of the liabilities now.  The biggest increase in reserve balances at the Fed — banks lending to the Fed to receive a pittance in interest, because they have nothing better to do for now.

I’ve considered doing an experiment, and I might do it over the next few weeks.  I went to my copy of AAII Stock Investor, and pulled out the contact data for 336 banks with market capitalizations of over $100 million.  I was thinking of calling 10 of them at random, and asking the following questions:

  • What has the Fed’s ZIRP policy done to your business?
  • Do you have a lot of money on deposit at the Federal Reserve?
  • When the Fed raises the short-term interest rate, what do you plan on doing?
  • Then, the same questions asking them about their competitors.
  • Finally, who has the most to lose in this situation?

It could be revealing, or it could be a zonk.

One more interesting note: reverse repos and my “all other” category have become increasingly volatile of late.

Here’s my next graph, with the asset class composition of the Fed’s balance sheet:

The Fed has gone from a pristine balance sheet of 95% Treasuries to one of 60/40 Treasuries and Mortgage-backed securities [MBS].  MBS are considerably less liquid than Treasuries, particularly when you are the largest holder of them by a wide margin — I’ve heard that it is 25% of the market.  The moment that it would become public knowledge that you were a seller, the market would re-rate down in price considerably, until holders became compensated for the risk of more MBS supply.

Finally, here is the maturity graph for the assets owned by the Fed:

The pristine balance sheet of 2008 was very short in its interest rate sensitivity for its assets — maybe 3 years average at most.  Now maybe the average maturity is 12?  I think it is longer…

Does anybody remember when I wrote a series of very unpopular pieces back in 2008 defending mark-to-market accounting?  Those made me very unpopular inside Finacorp, the now-defunct firm I worked for back then.

I see three hands raised.  My, how time flies.  For the three of you, do you remember what the toxic balance sheet combination is?  The one lady is raising her hand.  The lady has it right — Illiquid assets and liquid liabilities!

In a minor way, that is the Fed now.  Their liabilities will reprice little as they raise rates, while the market value of their assets will fall harder if the yield curve moves in a parallel shift.  No guarantee of a parallel shift, though — and I think the long end may not budge, as in 2004-7.  Either way though, the income of the Fed will decline rapidly, and any adjustment to their balance sheet will prove difficult to achieve.

What’s that, you say?  The Fed doesn’t mark its assets to market?  You got it.  But cash flows don’t change as a result of accounting.

Now, there is one bit of complexity here that was rumored at the Cato Conference — supposedly the Fed doesn’t use a prepayment model with its MBS.  If anyone has better info on that, let me know.  If true, the average life figures which are mostly in the 10-30 years bucket are highly suspect.

As a result of the no-mark-to-market accounting, the Fed won’t show deterioration of its balance sheet in any conventional way.  But you could see seigniorage — the excess interest paid to the US Treasury go negative, and the dividend to its owner banks suspended/delayed for a time if rates rose enough.  Asking the banks to buy more stock in the Federal Reserve would also be a possibility if things got bad enough — i.e., where the future cash flows from the assets could never pay all of the liabilities.  (Yes, they could print money together with the Treasury, but that has issues of its own.  Everything the Fed has done with credit so far has been sterile.  No helicopter drop of money yet.)

Of course, if interest rates rose that much, the US Treasury’s future deficits would balloon, and there would be a lot of political pressure to keep interest rates low if possible.  Remember, central banks are political creatures, much as their independence is advertised.


Ugh.  The conclusions of my last two pieces were nuanced.  This one is not.  My main point is this: even with the great powers that a central bank has, the next tightening cycle has ample reason for large negative surprises, leading to a premature end of the tightening cycle, and more muddling thereafter, or possibly, some scenario that the Treasury and Fed can’t control.

Be ready, and take some risk off the table.

financial tales

This financial book is different from the 250+ other financial books that I have reviewed, and the hundreds of others I have read.  It tells real life stories that the author has personally experienced, and the financial ramifications that happened as a result.  Each of the 60+ stories illustrates a significant topic in financial planning for individuals and families.  Some end happy, some end sad.  There are examples from each of the possible outcomes that can result from people interacting with financial advice (in my rough large to small probability order):

  • Followed bad advice, or ignored good advice, and lost.
  • Followed good advice, and won.
  • A mixed outcome from mixed behavior
  • Followed bad advice, or ignored good advice, and won anyway.
  • Followed good advice, and lost anyway.

The thing is, there is a “luck” component to finance.  People don’t know the future behavior of markets, and may accidentally get it right or wrong.  With good advice, the odds can be tipped in their favor, at least to the point where they aren’t as badly hurt when markets get volatile.

The stories in the book mostly stem from the author’s experience as a financial advisor/planner in Maryland.  The stories are 3-6 pages long, and can be read one at a time with little loss of flow.  The stories don’t depend on each other.  It is a book you can pick up and put down, and the value will be the same as for the person who reads it straight through.

In general, I thought the author advocated good advice for his clients, family and friends.  Most people could benefit from reading this book.  It’s pretty basic, and maybe, _maybe_, one of your friends who isn’t so good with financial matters could benefit from it as a gift if you don’t need it yourself.  The reason I say this is that some people will learn reading about the failures of others rather than being advised by well-meaning family, friends, and professionals.  They may admit to themselves that they have been wrong when they be unwilling to do it with others.

I recommend this book for readers who need motivation and knowledge to guide themselves in their financial dealings, including how to find a good advisor, and how to avoid bad advisors.


The book lacks generality because of its focus on telling stories.  It would have been a much better book if it had one final chapter or appendix where the author would take all of the lessons, and weave them into a coherent whole.  If nothing else, such a chapter would be an excellent review of the lessons of the book, and could even footnote back to the stories in the book for where people could read more on a given point.

I know this is a bias of mine regarding books with a lot of unrelated stories, but I think it is incumbent on the one telling the stories to flesh out the common themes, because many will miss those themes otherwise.  In all writing, specifics support generalities, and generalities support specifics.  They are always stronger together.

An Aside

I benefited from the book in one unusual way: it gave me a lot of article ideas, which you will be reading about at Aleph Blog in the near term.  I’ve never gotten so many from a single book — that is a strength of reading the ideas in story form.  It can catch your imagination.

Summary / Who Would Benefit from this Book

You don’t need this book if you are an expert or professional in finance.  You could benefit from this book if you want to improve what you do financially, improve your dealings with your financial advisor, or get a good financial advisor.  if you want to buy it, you can buy it here: Financial Tales.

Full disclosure: The author sent a free copy to me directly.  Though we must live somewhat near to one another, and we both hold CFA charters, I do not know him.

If you enter Amazon through my site, and you buy anything, including books, I get a small commission. This is my main source of blog revenue. I prefer this to a “tip jar” because I want you to get something you want, rather than merely giving me a tip. Book reviews take time, particularly with the reading, which most book reviewers don’t do in full, and I typically do. (When I don’t, I mention that I scanned the book. Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website. Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites. Whether you buy at Amazon directly or enter via my site, your prices don’t change.


I’m still working through the SEC’s proposal on Mutual Fund Liquidity, which I mentioned at the end of this article:

Q: <snip> Are you going to write anything regarding the SEC’s proposal on open end mutual funds and ETFs regarding liquidity?

A: <snip> …my main question to myself is whether I have enough time to do it justice.  There’s their white paper on liquidity and mutual funds.  The proposed rule is a monster at 415 pages, and I may have better things to do.   If I do anything with it, you’ll see it here first.

These are just notes on the proposal so far.  Here goes:

1) It’s a solution in search of a problem.

After the financial crisis, regulators got one message strongly — focus on liquidity.  Good point with respect to banks and other depositary financials, useless with respect to everything else.  Insurers and asset managers pose no systemic risk, unless like AIG they have a derivatives counterparty.  Even money market funds weren’t that big of a problem — halt withdrawals for a short amount of time, and hand out losses to withdrawing unitholders.

The problem the SEC is trying to deal with seems to be that in a crisis, mutual fund holders who do not sell lose value from those who are selling because the Net Asset Value at the end of the day does not go low enough.  In the short run, mutual fund managers tend to sell liquid assets when redemptions are spiking; the prices of illiquid assets don’t move as much as they should, and so the NAV is artificially high post-redemptions, until the prices of illiquid assets adjust.

The proposal allows for “swing pricing.”  From the SEC release:

The Commission will consider proposed amendments to Investment Company Act rule 22c-1 that would permit, but not require, open-end funds (except money market funds or ETFs) to use “swing pricing.” 

Swing pricing is the process of reflecting in a fund’s NAV the costs associated with shareholders’ trading activity in order to pass those costs on to the purchasing and redeeming shareholders.  It is designed to protect existing shareholders from dilution associated with shareholder purchases and redemptions and would be another tool to help funds manage liquidity risks.  Pooled investment vehicles in certain foreign jurisdictions currently use forms of swing pricing.

A fund that chooses to use swing pricing would reflect in its NAV a specified amount, the swing factor, once the level of net purchases into or net redemptions from the fund exceeds a specified percentage of the fund’s NAV known as the swing threshold.  The proposed amendments include factors that funds would be required to consider to determine the swing threshold and swing factor, and to annually review the swing threshold.  The fund’s board, including the independent directors, would be required to approve the fund’s swing pricing policies and procedures.

But there are simpler ways to do this.  In the wake of the mutual fund timing scandal, mutual funds were allowed to estimate the NAV to reflect the underlying value of assets that don’t adjust rapidly.  This just needs to be followed more aggressively in a crisis, and peg the NAV lower than they otherwise would, for the sake of those that hold on.

Perhaps better still would be provisions where exit loads are paid back to the funds, not the fund companies.  Those are frequently used for funds where the underlying assets are less liquid.  Those would more than compensate for any losses.

2) This disproportionately affects fixed income funds.  One size does not fit all here.  Fixed income funds already use matrix pricing extensively — the NAV is always an estimate because not only do the grand majority of fixed income instruments not trade each day, most of them do not have anyone publicly posting a bid or ask.

In order to get a decent yield, you have to accept some amount of lesser liquidity.  Do you want to force bond managers to start buying instruments that are nominally more liquid, but carry more risk of loss?  Dividend-paying common stocks are more liquid than bonds, but it is far easier to lose money in stocks than in bonds.

Liquidity risk in bonds is important, but it is not the only risk that managers face.  it should not be made a high priority relative to credit or interest rate risks.

3) One could argue that every order affects market pricing — nothing is truly liquid.  The calculations behind the analyses will be fraught with unprovable assumptions, and merely replace a known risk with an unknown risk.

4) Liquidity is not as constant as you might imagine.  Raising your bid to buy, or lowering your ask to sell are normal activities.  Particularly with illiquid stocks and bonds, volume only picks up when someone arrives wanting to buy or sell, and then the rest of the holders and potential holders react to what he wants to do.  It is very easy to underestimate the amount of potential liquidity in a given asset.  As with any asset, it comes at a cost.

I spent a lot of time trading illiquid bonds.  If I liked the creditworthiness, during times of market stress, I would buy bonds that others wanted to get rid of.  What surprised me was how easy it was to source the bonds and sell the bonds if you weren’t in a hurry.  Just be diffident, say you want to pick up or pose one or two million of par value in the right context, say it to the right broker who knows the bond, and you can begin the negotiation.  I actually found it to be a lot of fun, and it made good money for my insurance client.

5) It affects good things about mutual funds.  Really, this regulation should have to go through a benefit-cost analysis to show that it does more good than harm.  Illiquid assets, properly chosen, can add significant value.  As Jason Zweig of the Wall Street Journal said:

The bad news is that the new regulations might well make most fund managers even more chicken-hearted than they already are — and a rare few into bigger risk-takers than ever.

You want to kill off active managers, or make them even more index-like?  This proposal will help do that.

6) Do you want funds to limit their size to comply with the rules, while the fund firm rolls out “clone” fund 2, 3, 4, 5, etc?


You will never fully get rid of pricing issues with mutual funds, but the problems are largely self-correcting, and they are not systemic.  It would be better if the SEC just withdrew these proposed rules.  My guess is that the costs outweigh the benefits, and by a wide margin.

Photo Credit: Vinoth Chandar || Do you control the elephant, or does the elephant control you?

Photo Credit: Vinoth Chandar || Do you control the elephant, or does the elephant control you?

I’m currently reading a book about the life of Jesse Livermore.  Part of the book describes how Livermore made a fortune shorting stocks just before the panic of 1907 hit.  He had one key insight: the loans of lesser brokers were being funded by the large brokers, and the large brokers were losing confidence in the creditworthiness of the lesser brokers, and banks were now funding the borrowings by the lesser brokers.

What Livermore didn’t know was that the same set of affairs existed with the banks toward trust companies and smaller banks.  Most financial players were playing with tight balance sheets that did not have a lot of incremental borrowing power, even considering the lax lending standards of the day, and the high level of the stock market.  Remember, in those days, margin loans required only 10% initial equity, not the 50% required today.  A modest move down in the stock market could create a self-reinforcing panic.

All the same, he was in the right place at the right time, and repeated the performance in 1929 (I’m not that far in the book yet).  In both cases you had a mix of:

  • High leverage
  • Short lending terms with long-term assets (stocks) as collateral.
  • Chains of lending where party A lends to party B who lends to party C who lends to party D, etc., with each one trying to make some profit off the deal.
  • Inflated asset values on the stock collateral.
  • Inadequate loan underwriting standards at many trusts and banks
  • Inadequate solvency standards for regulated financials.
  • A culture of greed ruled the day.

Now, this is not much different than what happened to Japan in the late 1980s, the US in the mid-2000s, and China today.  The assets vary, and so does the degree and nature of the lending chains, but the overleverage, inflated assets, etc. were similar.

In all of these cases, you had some institutions that were leaders in the nuttiness that went belly-up, or had significant problems in advance of the crisis, but they were dismissed as one-time events, or mere liquidity and not solvency problems — not something that was indicative of the system as a whole.

Those were the warnings — from the recent financial crisis we had Bear Stearns, the failures in short-term lending (SIVs, auction rate preferreds, ABCP, etc.), Bank of America, Citigroup, credit problems at subprime lenders, etc.

I’m not suggesting a credit crisis now, but it is useful to keep a list of areas where caution is being thrown to the wind — I can think of a few areas: student loans, agricultural loans, energy loans, lending to certain weak governments with large liabilities and no independent monetary policy… there may be more — can you think of any?  Leave a comment.

Subprime lending is returning also, though not in housing yet…

Parting Thoughts

I’ve been toying with the idea that maybe there would be a way to create a crisis model off of the financial sector and its clients, working off of a “how much slack capital exists across the system” basis.  Since risky borrowers vary over time, and some lenders are more prudent than others, the model would have to reflect the different links, and dodgy borrowers in each era.  There would be some art to this.  A raw leverage ratio, or fixed charges ratio in the financial sector wouldn’t be a bad idea, but it probably wouldn’t be enough.  The constraint that bind varies over time as well — regulators, rating agencies, general prudence, etc…)

In a highly leveraged situation with chains of lending, confidence becomes crucial.  Indeed, at the time, you will hear the improvident squeal that they “don’t have a solvency crisis, but just a liquidity crisis! We just need to restore confidence!”  The truth is that they put themselves in an unstable situation where a small change in cash flows and collateral values will be the difference between life and death.  Confidence only deserves to exist among balance sheets that are conservative.

That’s all for now.  Again, if you can think of other areas where debt has grown too quickly, or lending standards are poor, please e-mail me, or leave a message in the comments. Thanks.

Too often in debates regarding the recent financial crisis, the event was regarded as a surprise that no one could have anticipated, conveniently forgetting those who pointed out sloppy banking, lending and borrowing practices in advance of the crisis.  There is a need for a well-developed model of how a financial crisis works, so that the wrong cures are not applied to the financial system.

All that said, any correct cure will bring about a predictable response from the banks and other lending institutions.  They will argue that borrower choice is reduced, and that the flow of credit and liquidity to the financial system is also reduced.  That is not a big problem in the boom phase of the financial cycle, because those same measures help to avoid a loss of liquidity and credit availability in the bust phase of the cycle.  Too much liquidity and credit is what fuels eventual financial crises.

To get to a place where we could have a decent model of the state of overall financial credit, we would have to have models that work like this:

  1. The models would have to have both a cash flow and a balance sheet component to them — it’s not enough to look at present measures of creditworthiness only, particularly if loans do not fully amortize debts at the current interest rate.  Regulatory solvency tests should not automatically assume that borrowers will always be able to refinance.
  2. The models should try to go loan-by-loan, and forecast the ability of each loan to service debts.  Where updated financial data is available on borrowers, that should be included.
  3. The models should try to forecast the fair market prices of assets/collateral, off of estimated future lending conditions, so that at the end of the loan, estimates can be made as to whether loans would be refinanced, extended, or default.
  4. As asset prices rise, there has to be a feedback effect into lowered ability to finance new loans, unless purchasing power is increasing as much or more than asset prices.  It should be assumed that if loans are made at lower underwriting standards than a given threshold, there will be increasing levels of default.
  5. A close eye would have to look for situations where if the property were rented out, it would not earn enough to pay for normalized interest, taxes and maintenance.  When asset prices are that high, the system is out of whack, and invites future defaults.  The margin of implied rents over normalized interest, taxes and maintenance would be the key measure, and the regulators would have to have a function that attributes future losses off of the margin of that calculation.
  6. The cash flows from the loans/mortgages would have to feed through the securitization vehicles, if any, and then to the regulated financial institutions, after which, how they would fund their future liabilities would have to be estimated.
  7. The models would have to include the repo markets, because when the prices of collateral get too high, runs on the repo market can happen.  The same applies to portfolio margining agreements for derivatives, futures, and other types of wholesale lending.
  8. There should be scenarios for ordinary recessions.  There should also be some way of increasing the Ds at that time: death, disability, divorce, disaster, dis-employment, etc.  They mysteriously tend to increase in bad economic times.

What a monster.  I’ve worked with stripped-down versions of this that analyze the Commercial Mortgage Backed Securities [CMBS] market, but the demands of a model like this would be considerable, and probably impossible.  Getting the data, scrubbing it, running the cash flows, calculating the asset price functions, implied margin on borrowing, etc., would be pretty tough for angels to do, much less mere men.

Thus if I were watching over the banks, I would probably rely on analyzing:

  • what areas of credit have grown the quickest.
  • where have collateral prices risen the fastest.
  • where are underwriting standards declining.
  • what assets are being financed that do not fully amortize, including all repo markets, margin agreements, etc.

The one semi-practical thing i would strip out of this model would be for regulators to score loans using a model like point 5 suggests.  Even that would be tough, but even getting that approximately right could highlight lending institutions that are taking undue chances with underwriting.

On a slightly different note, I would be skeptical of models that don’t try to at least mimic the approach of a cash flow based model with some adjustments for market-like pricing of collateral and loans.  The degree of financing long assets with short liabilities is the key aspect of how financial crises develop.  If models don’t reflect that, they aren’t realistic, and somehow, I expect that non-realistic models of lending risk will eventually be the rule, because it helps financial institutions make loans in the short run.  After all, it is virtually impossible to fight loosening financial standards piece-by-piece, because the changes seem immaterial, and everyone favors a boom in the short-run.  So it goes.

This will be the post where I cover the biggest mistakes that I made as an institutional bond and stock investor. In general, in my career, my results were very good for those who employed me as a manager or analyst of investments, but I had three significant blunders over a fifteen-year period that cost my employers and their clients a lot of money.  Put on your peril-sensitive sunglasses, and let’s take a learning expedition through my failures.

Manufactured Housing Asset Back Securities — Mezzanine and Subordinated Certificates

In 2001, I lost my boss.  In the midst of a merger, he figured his opportunities in the merged firm were poor, and so he jumped to another firm.  In the process, I temporarily became the Chief Investment Officer, and felt that we could take some chances that the boss would not take that in my opinion were safe propositions.  All of them worked out well, except for one: The — Mezzanine and Subordinated Certificates of Manufactured Housing Asset Back Securities [MHABS].  What were those beasts?

Many people in the lower middle class live in prefabricated housing in predominantly in trailer parks around the US.  You get a type of inexpensive independent living that is lower density than an apartment building, and the rent you have to pay is lower than renting an apartment.  What costs some money is paying for the loan to buy the prefabricated housing.

Those loans would get gathered into bunches, put into a securitization trust, and certificates would get sold allocating cash flows with different probabilities of default.  Essentially there were four levels (in order of increasing riskiness) — Senior, Mezzanine, Subordinated, and Residual.  I focused on the middle two classes because they seemed to offer a very favorable risk/reward trade-off if you selected carefully.

In 2001, it was obvious that there was too much competition for lending to borrowers in Manufactured Housing [MH] — too many manufacturers were trying to sell their product to a saturated market, and underwriting suffered.  But, if you looked at older deals, lending standards were a lot higher, but the yields on those bonds were similar to those on the badly underwritten newer deals.  That was the key insight.

One day, I was able to confirm that insight by talking with my rep at Lehman Brothers.  I talked to him about the idea, and he said, “Did you know we have a database on the loss stats of all of the Green Tree (the earliest lender on MH) deals since inception?”  After the conversation was over, I had that database, and after one day of analysis — the analysis was clear: underwriting standards had slipped dramatically in 1998, and much further in 1999 and following.

That said, the losses by deal and duration since issuance followed a very predictable pattern: a slow ramp-up of losses over 30 months, and then losses tailing off gradually after about 60 months.  The loss statistics of all other MH lenders aside from Vanderbilt (now owned by Berkshire Hathaway) was worse than Green Tree losses.  The investment idea was as follows:

Buy AA-rated mezzanine and BBB-rated subordinated MHABS originated by Green Tree in 1997 and before that.  The yield spreads over Treasuries are compelling for the rating, and the loss rates would have to jump and stick by a factor of three to impair the subordinated bonds, and by a factor of six to impair the mezzanine bonds.  These bonds have at least four years of seasoning, so the loss rates are very predictable, and are very unlikely to spike by that much.

That was the thesis, and I began quietly acquiring $200 million of these bonds in the last half of 2001.  I did it for several reasons:

  • The yields were compelling.
  • The company that I was investing for was growing way too rapidly, and we needed places to put money.
  • The cash flow profile of these securities matched very well the annuities that the company was selling.
  • The amount of capital needed to carry the position was small.

By the end of 2001, two things happened.  The opportunity dried up, because I had acquired enough of the bonds on the secondary market to make a difference, and prices rose.  Second, I was made the corporate bond manager, and another member of our team took over the trade.  He didn’t much like the trade, and I told my boss that it was his portfolio now, he can do what he wanted.

He kept the positions on, but did not add to them.  I was told he looked at the bonds, noticed that they were all trading at gains, and stuck with the positions.

Can You Make It Through the Valley of the Shadow of Death?

I left the firm about 14 months later, and around that time, the prices for MHABS fell apart.  Increasing defaults on MH loans, and failures of companies that made MH, made many people exceptionally bearish and led rating agencies to downgrade almost all MHABS bonds.

The effects of the losses were similar to that of the Housing Bubble in 2007-9.  As people defaulted, the value of existing prefabricated houses fell, because of the glut of unsold houses, both new and used.  This had an effect, even on older deals, and temporarily, loss rates spiked above the levels that would impair the bonds that I bought if the levels stayed that high.

With the ratings lowered, more capital had to be put up against the positions, which the insurance company did not want to do, because they always levered themselves up more highly than most companies — they never had capital to spare, so any loss on bonds was a disaster to them.

They feared the worst, and sold the bonds at a considerable loss, and blamed me.


Easy to demonize the one that is gone, and forget the good that he did, and that others had charge of it during the critical period.  So what happened to the MHABS bonds that I bought?

Every single one of those bonds paid off in full.  Held to maturity, not one of them lost a dime.

What was my error?

Part of being a good investor is knowing your client.  In my case, the client was an impossible one, demanding high yields, low capital employed, and no losses.  I should have realized that at some later date, under a horrific scenario, that the client would not be capable of holding onto the securities.  For that reason, I should have never bought them in the first place.  Then again, I should have never bought anything with any risk for them under those conditions, because in a large enough portfolio, you will have some areas where the risk will surprise you.  This was less than 2% of the consolidated assets of the firm, and they can’t hold onto securities that would likely be money good amid a panic?!

Sadly, no.  As their corporate bond manager, before I left, I sold down positions like that that my replacement might not understand, but I did not control the MHABS portfolio then, and so I could not do that.

Maybe $50 million went down the drain here.  On the bright side, it helped teach me what would happen in the housing bubble, and my next employer benefited from those insights.

Thus the lesson is: only choose investments that your client will be capable of holding even during horrible times, because the worst losses come from panic selling.

Next time, my two worst stock losses from my hedge fund days.

Photo Credit: Thibaut Chéron Photographies

Photo Credit: Thibaut Chéron Photographies

I wish I could tell you that it was easy for me to stop making macroeconomic forecasts, once I set out to become a value investor.  It’s difficult to get rid of convictions, especially if they are simple ones, such as which way will interest rates go?

In the early-to-mid ’90s, many were convinced that interest rates had no way to go but up.  A few mortgage REITs designed themselves around that idea.  Fortunately, I arrived at the party late, after their investments that implicitly required interest rates to rise soon, fell dramatically in price.  I bought a basket of them for less than book value, excluding the value of taxes that could be sheltered in a reverse merger.

For some time, the stocks continued to fall, though not rapidly.  I became familiar with what it was like to go through coercive rights offerings from cash-hungry companies in trouble.  Bankruptcy was not impossible… and I burned a lot of mental bandwidth on these.  The rights offerings weren’t really good things in themselves, but they led me to buy in at a good time.  Fortunately I had slack capital to deploy.  That may have taught me the wrong lesson on averaging down, as we will see later.  As it was, I ended up making money on these, though less than the market, and with a lot of Sturm und Drang.

That leads me to my main topic of the era: Caldor.  Caldor was a discount retailer that was active in the Northeast, but nationally was a poor third to Walmart and KMart.  It came up with the bright idea of expanding the number of stores it had in the mid-90s without raising capital.  It even turned down an opportunity to float junk bonds.  I remember noting that the leverage seemed high.

What I didn’t recognize that the cost of avoiding issuing equity or longer-term debt was greater reliance on short-term debt from factors — short-term lenders that had a priority claim on inventory.  It would eventually prove to be a fatal error, and one that an asset-liability manager should have known well — never finance a long term asset with short-term debt.  It seems like a cost savings, but it raises the likelihood of insolvency significantly.

Still, it seemed very cheap, and one of my favorite value investors, Michael Price, owned a little less than 10% of the common stock.  So I bought some, and averaged down three times before the bankruptcy, and one time afterwards, until I learned Michael Price was selling his stake, and when he did so, he did it without any thought of what it would do to the stock price.

Now for two counterfactuals: Caldor could have perhaps merged with Bradlee’s, closed their worst stores, refinanced their debt, issued equity, and tried to be a northeast regional retail player.  It didn’t do that.

The investor relations guy could have given a more understanding answer when he was asked whether Caldor was having any difficulties with credit lines from their factors.  Instead, he was rude and dismissive to the questioning analyst.  What was the result?  The factors blinked and pulled their lines, and Caldor went into bankruptcy.

What were my lessons from this episode?

  • Don’t average down more than once, and only do so limitedly, without a significant analysis.  This is where my portfolio rule seven came from.
  • Don’t engage in hero worship, and have initial distrust for single large investors until they prove to be fair to all outside passive minority investors.
  • Avoid overly indebted companies.  Avoid asset liability mismatches.  Portfolio rule three would have helped me here.
  • Analyze whether management has a decent strategy, particularly when they are up against stronger competition.  The broader understanding of portfolio rule six would have steered me clear.
  • Impose a diversification limit.  Even though I concentrate positions and industries in my investing, I still have limits.  That’s another part of rule seven, which limits me from getting too certain.

The result was my largest loss, and I would not lose more on any single investment again until 2008 — I’ll get to that one later.  It was my largest loss as a fraction of my net worth ever — after taxes, it was about 4%.  As a fraction of my liquid net worth at the time, more like 10%.  Ouch.

So, what did I do to memorialize this?  Big losses should always be memorialized.  I taught my (then small) kids to say “Caldor” to me when I talked too much about investing.  They thought it was kind of fun, and I would thank them for it, while grimacing.

But that helped.  Remember, value investing is first about safety, and second about cheapness.  Cheapness rarely makes something safe enough on its own, so analyze balance sheets, strategy, use of cash flow, etc.  This is not to say that I did not make any more errors, but this one reduced the size and frequency.

That said, there will be more “fun” chapters to share in this series, because we always learn more from errors than successes.

Photo Credit: ~Sage~ || King of the Beasts, eh?

Photo Credit: ~Sage~ || King of the Beasts, eh?

It was winter in early 1995, and I was wondering if I still had a business selling Guaranteed Investment Contracts [GICs].  Confederation Life had gone insolvent the August prior, and I noticed that fewer and fewer stable value funds wanted to purchase my GICs, because our firm was small, and as such, did not get a good credit rating, despite excellent credit metrics.  The lack of a good rating kept buyers away.

Still, I felt I needed to try my best for one more year or so, despite my feelings that the business was dying soon.  With that attitude, I headed off in January to sunny Southern California, to attend GICs ’95, something my opposite number at AIG referred to as a Schmoozathon.

Schmoozathon?  Well, you took your opportunities to ingratiate yourself with current and potential clients, across four days and three nights of meetings, with a variety of parties going on.  I was not the best salesman, so I just tried to play it as straight as I could.

In the middle of the whole affair was a special lunch where Bill Gross was to be the Keynote Speaker.  Because I was talking with a client, I got to the lunch a little late, and ended up at a table near the back of the room.

Things were running a little behind, but Bill Gross got up and gave a talk that borrowed heavily from a recent Pimco Investment Outlook that he had written, comparing the current market opportunities to Butler Creek (see paragraph 6), a creek that he grew up near as a kid, which gently meandered, went kinda straight, kinda not, but didn’t vary all that much when you looked at it as a whole, rather than from a nearby point on the ground.

The point? Sell volatility.  Buy mortgage bonds.  Take convexity risk.  Clip yield.  Take a few chances, the environment should be gentle, and you can’t go too wrong.

After the horrible investment environment for bonds of 1994, this was a notable shift.  So he came to the end of his talk, and it was time for Q&A.  Suddenly, the moderator stormed up to the front of the room and said, “I’m really sorry, but we’re out of time.  We’ve got a panel waiting in the main meeting room to talk about the Confederation insolvency.  Please head over there now.”

Everyone got up, and dutifully headed over to the Confederation panel.  I was disappointed that I wouldn’t get a chance to ask Bill Gross a question, so as I started to leave, I looked to the front of the room, and I saw Bill Gross standing there alone.  It struck me. “Wait.  What don’t I know about Confederation? The best bond manager in the US is standing up front.”

So I walked up to the front, introduced myself, told him that I was an investment actuary, and asked if I could talk with him about mortgage bonds.  He told me that he could until his driver showed up.  As a result, for the next 15 minutes, I had Bill Gross to myself, asking him how they analyzed the risks and returns of complex mortgage securities.  His driver then showed up; I thanked him, and he left.

Feeling pretty good, I wandered over to the Confederation panel.  As I listened, I realized that I hadn’t missed anything significant.  Then I realized that the rest of the audience had missed a significant opportunity.  Oh, well.

As it turned out, I made many efforts in 1995 to resuscitate my GIC business.  It survived for one more year, and collapsed in 1996, with little help from senior management.  It was for the best, anyway.  It was a low margin, capital intensive business, and closing it enabled me to focus on bigger things that improved corporate profitability.  I never went to another Schmoozathon as a result, but the last one had a highlight that I would not forget: meeting Bill Gross.

Photo Credit -- Javier || Buffett believes in America

Photo Credit — Javier || Buffett believes in America

Yesterday there was an article where Buffett was quoted on getting mortgages to buy houses. Let me quote the most relevant portion:

“You would think that people would be lining up now to get mortgages to buy a home,” Buffett said today at a conference hosted by Fortune magazine in Laguna Niguel,California. “It’s a good way to go short the dollar, short interest rates. It is a no-brainer. But so far home construction pickup has been slower than I had anticipated.”

Now, when I read the comment stream on the article, I was not surprised at the level of disagreement, but the vitriolic nature of the the disagreement.  Buffett is certainly not made of Teflon anymore, and fame has led to its share of detractors.

Now, I don’t think that Buffett is giving the right advice to everyone here, but I also don’t think that he is talking his book because has has investments in firms that sell:

  • Real estate
  • Manufactured housing
  • Building materials
  • Mortgages
  • Etc.

Indeed, Buffett has enough investments that almost anything he says could be talking his book.  I think his character is such that he does not talk his book — his firm is one that is built on “low hype” attitudes, at least, low hype for a company of its size and complexity.

Should everyone run out and get a mortgage because it is a cheap time to be borrowing money?  That is an individual question, hinging on how secure and high your income is versus the likely payment on the mortgage, and other housing-related expenses.

The interest rate may indeed be low relative to history, but how well will the economy do in the future?  Maybe residential housing is too expensive in some areas to get a lot of people excited about buying.

Buffett also said:

“Household formation falls off dramatically in a recession, at least initially,” he said. “But that doesn’t last long. Hormones kick in and in-laws get tiresome, too.”

Unless something changes in US culture, there have been changes to the demand for homes, driven by the following factors:

  • People are marrying later and less frequently
  • They are having fewer kids
  • Urban areas are more attractive for many people to live in, reducing commute time and costs.  Even car-buying is affected.
  • There are fewer move-up buyers because of the financial crisis.
  • The ability of lower middle class people to afford homes has been reduced, particularly in high cost of living areas.
  • The financial crisis has ruined the illusion that residential real estate is an investment that can’t lose money.

There may be more reasons, but even though the 30-year mortgage is the cheapest long-term financing that an average person can get, there are more people than before who are not interested in buying a home.  Renting suits their goals fine.

As such, I think Buffett is wrong here, and that borrowing to buy residential housing will not be as prominent as it was in the past.  But I don’t think he has any bad intentions in what he said — he believes in America, and thinks that we will return to the consumption patterns of the past, which relied on too much debt in my opinion.

Final note: I’m getting tired of reading comment streams.  The people there are often too cynical, and too loose with the truth.  Their expectations for what they deserve in this life are also inflated beyond what is reasonable.  Some turn to conspiracy theories to keep themselves from blaming their bad fortune on their own actions.

Buffett is generally a good guy, and a good example as far as businessmen go — he does not deserve the abuse.  I don’t agree with Buffett’s politics, but I don’t think that he is not sincere.

Full disclosure: long BRK/B and WFC