1) A lament for Bill Miller.  Owning Bear Stearns on top of it all is adding insult to injury.  Now, living in Baltimore, I get little bits of gossip, but I won’t go there this evening.  I think Bill Miller’s problems boil down to lack of focus on a margin of safety, which is the main key to being a good value manager.  During the boom periods, he could ignore that and get away with it, but when we are in a bust phase, particularly one that hurts financials.  When financials get hit, all forms of accounting laxity tend to get hit, making the margin of safety more precious.

2) Now perhaps one bright spot here is rising short interest. Short interest is a negative while it is going up, but a positive once it has risen to unsustainable levels.  What is unsustainable is difficult to define, but remember Ben Graham’s dictum, that the market is a voting machine in the short run, and a weighing machine in the long run.  The value of stocks in the long run will reflect the net present value of their free cash flows, not short interest or leverage.

3)  Now, if you want the opposite of Bill Miller in the value space, consider Bob Rodriguez of FPA Capital.  Along with a cadre of other misfit value managers that are willing to invest in unusual long-only portfolios aiming for absolute returns while not falling victim to the long/short hedge fund illusion, he happily soldiers on with a boatload of cash, waiting for attractive opportunities to deploy cash.

4) Retirement.  What a concept amid falling housing and equity prices.  Though we have difficulties at present from the housing overhang, and the unwind of financial leverage, there will be continuing difficulties over the next two decades as assets must be liquidated and taxes raised to support the promises of Medicare, and to a lesser extent, Social Security.  My guess: Medicare gets massively scaled back.

5) I get criticism from both bulls and bears.  I try to be unbiased in my observations, because amid the difficulties, which I have have been writing about for years, there is the possibility that it gets worked out.  When there are problems, major economic actors are not passive; they look for solutions.  That doesn’t mean that they always succeed, but they often do, so it rarely pays to be too bearish.  It also rarely pays to be too bullish, but given the Triumph of the Optimists, that is a harder case to make.

6) Bill Rempel took me to task about a post of mine, and I have a small defense there, and perhaps a larger point.  Almost none of my close friends invest in the market. It doesn’t matter whether we are in boom or bust periods, they just don’t.  These people are by nature highly conservative, and/or, they are not well enough off to be considering investments in equities.  They are not relevant to a post on investing contrarianism, because they are outside the scope of most equity investing.  They are relevant to a discussion of the real economy, and where your wage income might be impacted.

7) To close for the night, then, a note on contrarianism.  When I read journalists, they are typically (but not always) lagging indicators, because they aren’t focused on the topics at hand. They get to the problems late.  But when I think of contrarianism, I don’t look for opinions as much as financial reliance on an idea.  Many opinions are irrelevant, because they don’t reflect positions that have been taken in the markets, the success of which is now being relied upon.  Once there is money on the line, euphoria and regret can do their work in shaping the attitudes of investors, allowing for contrary opinions to be successful against fully invested conventional wisdom.  But without fully invested conventional wisdom, contrarianism has little to fight.

I want to go back to an article that I wrote early in the history of this blog, when nobody read me except a few RealMoney diehard fans — Regulating Systemic Risk From Hedge Funds.  It was a critique of the “Agreement Among PWG And U.S. Agency Principals On Principles And Guidelines Regarding Private Pools Of Capital.”  Yes, the “shadowy” President’s Working Group on Financial Markets.  Some will call it the “Plunge Protection Team.”  Well, if they are that, they are certainly not playing up to their billing.  As an aside, I tend not to believe in conspiracy theories, because most bad plans of our government don’t require them.  As Chuck Colson pointed out regarding the Nixon Administration and Watergate leaks — he felt that information tightness in the Nixon White House was so effective, that if a conspiracy could work, it would have worked there.  (Since it didn’t work, and the information leaked out, it had a surprising effect on Colson’s life, as he concluded that the disciples of Jesus (Y’Shua) could not have conspired to steal the dead body, hide it, and fake a resurrection.  But that’s another story.)   Suffice it to say that I don’t think the government intervenes in the major financial markets of our country — there would be too many accounting entries to hide, and someone would have a real incentive to leak the information, or write a book about it.

Going back to my article, I tried to point out the difficulty of gathering data and analyzing it.  It was also somewhat prescient as I said, “Let me put it another way: if the government wants to reduce systemic risk, let them create risk-based capital regulations for investment banks, and let them increase the capital requirements on loans to hedge funds and investment banks. Or, let the Fed change the margin requirements on stocks. These are simple things that are within their power to do now. In my opinion, they won’t do them; they are friends with too many people who benefit from the current setup. If they won’t use their existing powers, why would they ask for new ones?

We will have to wait for the next blowup for the Federal Government to get serious about systemic risk. They might not do it even then. Upshot: be aware of the companies that you own, and their exposure to systemic risk. You are your own best defender against systemic risk.”

There is another reason why they would not act then, as I had pointed out at RealMoney over the years.  Bureaucrats are resistant to offering changes where if thy would get harmed if the changes led to a market panic.  Once the market panic starts, they can move with greater freedom, because no one will be able to tell whether changes imposed during the panic intensified the panic or not.

So, color me skeptical on efforts to monitor and control systemic risk.  It would be very hard to do effectively, and there are too many powerful interests against it.  Also, it would be difficult to get the gross exposure data necessary for inhibiting crisis, because many financial instruments would have to be split in two or more pieces.

As to the articles I have read on Treasury Secretary Paulson’s plan, they divide into credulous (one, two), mixed, and skeptical/hostile (one, two).  Let me simply observe that any plan for the control of systemic risk has to overcome:

• Political opposition
• Lack of effective data
• Lack of an effective model
• Lack of willingness to implement the conclusions generated by the staff/modeling
• Inter- and Intra-agency disagreements
• Data and action lags

If it is already difficult for the Fed to implement contracyclical monetary policy, just imagine how difficult it will be for them to deal with a problem that is far more tricky because of its multivariate nature.  Imagine them trying to analyze the effects from currencies, commodities, operating businesses, credit, ABS, RMBS, CMBS, equity-related businesses, counterparty risk, etc.  This is not trivial, and Paulson I suspect knows it all too well, which has led him to make a modest proposal that will likely not be effective, but will likely run out the shot clock for the Bush administration, leaving the issue for the next President to deal with.

The Fed is not by nature an activist institution, and it would have to become far more activist in order to effectively regulate the bulk of all financial institutions in the US.  I don’t see it happening.

As an aside, I am ambivalent about Federal regulation of insurance, and this RealMoney article of mine still expresses my views adequately.  Still, it would make sense to hand over oversight of financially sensitive insurers, such as the financial guarantee insurers and the mortgage insurers to the Feds, together with whoever oversees the ratings agencies.  An integrated solution is preferable.  (I still like my proposed name for the new regulator, “Federal Insurance Bureau” [FIB... well, it can't be the FBI].

As for some of the fog that a regulator of investment banks would exist in, consider these two articles on hedge fund distress.  What affects the hedge funds, affects the investment banks.  They are symbiotic.

As a joke, given that it is the first of April, if we do get a regulator for overall financial solvency and systemic risk, I believe it should be called the Federal Office for Oversight of Leverage [FOOL].  After all, I think it is taking on a fool’s bargain.

I’m not a fan of mark-to-market accounting, partially due to the loss of comparability across firms. It introduces a level of flexibility that can be gamed by the unscrupulous. That said, any accounting method can be gamed. Accounting attempts to assign the value of economic activity at and across points in time.

Now, with financial firms, there are typically several accounting bases going on at the same time. There’s GAAP, Regulatory, Tax, and then the accounting for special agreements, which may be different than any of the three major accounting bases.

Why has mark-to-market come up as an issue recently? Because it has seemingly created downside volatility in the financial statements, leading investors to panic, which pushes down security prices.

In my opinion, the greater problems are how a firm finances itself, how it is regulated, and negative optionality in its assets and positive optionality in its liabilities. I’ll give some examples to illustrate:

With Thornburg, the problem was over-reliance on short-term lending to finance long term assets. It doesn’t matter how you do the GAAP accounting here. The brokers will look at the day-to-day market value of the positions versus the capital supporting them. If the capital becomes insufficient to carry the position, the positions will be liquidated. Given that there were a lot of players with similar trades, and funding in the repo market, that created an ideal setup for the most levered to lose a lot as financing dried up.

Bear Stearns also relied on short-term financing. Bear ran with high leverage that made them vulnerable to attacks from those that bought credit protection in the credit default swap market… as those spreads went up, the willingness to extend credit went down. Ratings downgrades pushed up, and in some cases eliminated the willingness of lenders to extend short term credit. (Bear also lacked friends to help them in their time of need, a payoff for not helping on LTCM. Lehman had similar leverage, but the Street supports it.) Also, derivative agreements often specify a need for more collateral if downgrades occur, which is exactly the wrong time to have to provide more collateral. Again, this has nothing to do with GAAP accounting, but it has a lot to do with positive optionality in the liabilities of the firm. (I.e., the liability can get more onerous under conditions of stress.)

Consider PXRE, which recently merged with Argonaut Group. When the storms of 2005 hit, they claims against them were bad enough, but many of their reinsurance agreements had downgrade clauses, saying they would have to post collateral. Though it didn’t bankrupt them, it could have, and they had to find a buyer. Nothing to do with GAAP accounting.

General American wrote a bunch of floating rate Guaranteed Investment Contracts that had 7-day put provisions after a ratings downgrade. They wrote so much of them, that they comprised 25% of their liability structure. When they got downgraded, they could not meet the call on liquidity. They wen insolvent. Nothing to do with GAAP accounting.

CIT got downgraded and drew down their revolver because of a liquidity shortfall. The stock has fallen more then 80% in the past year. Mark-to-market accounting to blame? No, deteriorating assets and too much short-term financing.

I could go on. Regulators are under no obligation to use mark-to-market accounting, and they can set capital levels as they please. Optimally, regulators should look at risk based liquidity. How likely is it that a financial firm will have adequate liquidity in all circumstances? How safe and liquid are the assets? Is the liability structure long enough to support them? Can the liability structure dramatically shorten? (I.e., a run on the bank.)

Deterioration in the value of assets has to be addressed by accounting somehow. But regardless of the method, those that finance the company will look beyond the published GAAP financials, and will look at the cash generation capacity of the firm over the life of the loan, and how prone to change that could be. Even if a firm could take an asset worth 80 cents and mark it at $1.00, the sophisticated lenders would only assign 80 cents of value.

Along with The Analyst’s Accounting Observer, I don’t see mark-to-market accounting as a major threat to the solvency of firms. The companies that have gotten into trouble recently have held assets of dubious quality, and have financed themselves with too much leverage, borrowing short-term, and/or implicitly sold short options against their firms that weakened themselves during a crisis. Dodgy assets and liquid liabilities are poisonous to any firm, regardless of the accounting method.

My post yesterday on corporate bond spreads was received well.  I want to amplify one point that I did not make strongly enough.  During market crises, asset values cheapen not only in response to likely losses over the long run, but the possibility that there might be forced sellers due to:

• Reduction of leverage because of asset values declining
• Reduction of leverage because of brokers lending money get skittish
• Reduction of leverage because of rating agency downgrades
• Reduction of leverage because of client withdrawals
• Reduction of leverage because of an increased need for capital from the regulators
• Arbitrage from falling prices in related markets

This can temporarily self-reinforce falling asset prices, until unlevered (or lightly levered) buyers find the returns from the assets to be compelling.  Though my piece yesterday was more fun to write, this makes the argument plain.  Can you carry the asset through hard times?  What about the rest of the asset holders?

The concept of weak hands versus strong hands is a very real issue, and for those with a subscription to RealMoney, I recommend these four classic (Labor of love) articles of mine:

Managing Liability Affects Stocks, Pt. 1
Separating Weak Holders From the Strong
Get to Know the Holders’ Hands, Part 1
Get to Know the Holders’ Hands, Part 2

These articles are core to my thinking, and I spent a lot of time on them.

Disclaimer: David Merkel is an investment professional, and like every investment professional, he makes mistakes. David encourages you to do your own independent “due diligence” on any idea that he talks about, because he could be wrong. Nothing written here, or in my writings at RealMoney is an invitation to buy or sell any particular security; at most, David is handing out educated guesses as to what the markets may do. David is fond of saying, “The markets always find a new way to make a fool out of you,” and so he encourages caution in investing. Risk control wins the game in the long run, not bold moves.

Additionally, David may occasionally write about accounting, actuarial, insurance, and tax topics, but nothing written here or on RealMoney is meant to be formal “advice” in those areas. Consult a reputable professional in those areas to get personal, tailored advice that meets the specialized needs that David can have no knowledge of.

My disclaimer dates back five years.  It’s at the bottom of my blog, and is there for a reason: I get things wrong.  Now, I like to think that I get things right more often, but let’s just look at the gritty downside for a moment.  I wrote a series of articles at RealMoney on using investment advice.

Using Investment Advice, Part 1
Using Investment Advice, Part 2
Using Investment Advice, Part 3
Tread Warily on Media Stock Tips

I wrote these with Jim Cramer in mind.  Now, I like Jim Cramer; he says a lot of bright things.  But when you talk about so many things, and put out so much content, particularly on TV, you have to be careful.

I don’t have 0.1% of the exposure that Mr. Cramer has, but I care what happens to my readers.  (I think Jim does too, but the shell has to get hard when one is that exposed, or, you’ll give up speaking and writing.)  So, when I make notable errors, it hurts me double.  I usually have my cash on the line when I write, or at least, my reputation, which is more valuable (you only get one of those).

Today was my worst relative performance day in a long time.  Deerfield Capital, National Atlantic, and Gehl, all did badly.  I bought more Deerfield today, and I’ll put out a post on my thoughts soon.  That said, March is off to a bad start with me, after a tremendous first two months of the year.

So, I am eating my crow, lightly seasoned, and with humility.   Always do your own due diligence when you read me, because I get it wrong now and then, at least in the short run.

Full disclosure: long DFR NAHC GEHL

There are times where I feel the intellectual well is dry, and I come to my keyboard and say, “What do I write tonight?” This is not one of those times. I have too many things to write about, and not enough time. I’ll see how much I can say that is worth reading.

1) Jimmy Rogers (I’ve met him once – a nice guy) tends toward the sensational. There is a grain of truth in what he says, but the demographic situation in China is worse than that in Japan, which is why they Communist leadership there is considering eliminating the one-child policy:

I gave a talk last October, which included a lot on the effects of demographics on the global economy:

http://alephblog.com/society-of-actuaries-presentation/ (pages 15-23) (non-PDF versions have my lecture notes)

Now, eliminating the one-child policy won’t do that much, because most non-religious women in China don’t want to have kids. In developed societies, once women don’t want children or marriage, no level of economic incentive succeeds in changing their minds.

This isn’t meant to be social commentary. The point is that there is a global demographic shift of massive proportions happening where there will be huge social pressures on retirement/eldercare systems, because the ratio of workers to retirees will fall globally. China will be affected more than most, and the US less than most (if we can straighten out Medicare).

The economic effect will feel a little stagflationary, with wage rates improving in nominal terms, taxes rising to cover transfer payments, and assets being sold (to whom?) to fund retirements and healthcare. There need not be a crisis, like a war over resources, in all of this, but it won’t be an easy next 30 years. One thing for certain, when you look at labor, capital, and resources at present, the scarcest of all is resources. Again, resource price inflation. At present, capital is scarcer than labor, but that will flip in the next 30 years.

2) A few e-mailers asked for more data on how I view monetary aggregates. On monetary aggregates, my view of it is a little different than most, and I take a little heat for it. Ideally, the lower level monetary aggregates indicate a higher degree of liquidity; greater ease and shorter time of achieving transactions. The other way to view it is how sticky the liability structure is for the banks. Demand deposits, not sticky. Savings accounts, stickier. Money market funds, stickier still. CDs, even stickier.

As the Fed changes monetary policy, there are tradeoffs. Willingness of the public to hold cash, versus opportunity at the banks to make money from borrowing short and lending longer, versus banking regulators trying to assure solvency.

That’s why I look at the full spectrum of monetary measures. They tell a greater story as a group.

3) No such thing as a bad asset, only a bad price? No such thing as a bad asset, only a mis-financed asset? Both can be true. What we are experiencing today in many markets is that many assets were financed with too much debt and too little equity. In the process, because of the over-leverage allowed for high returns on equity to be generated from low returns on assets, the buyers of risky assets overpaid for their interests.

This has taken many forms, whether it was Subprime ABS, CDOs, SIVs, Tender Option Bonds, the correlation trade, etc. Also the borrow short, lend long inherent in Auction Rate Securities, TOBs, and other speculations that make wondeful sense occasionally, but players stay too long.

Rationality comes back to these markets when “real money buyers” appear (pension plans, insurance companies, wealthy dudes with nose for value), and these non-traditional buyers soak up the excess supply of investments that are out of favor, and do it with equity, at prices that make the unlevered return look pretty sweet. This is how excess leverage gets purged from the system, and how pricing normalizes, with losses delivered to the overlevered.

4) As I said in my post last night, there is value in the tax-free muni market for non-traditional buyers. Is this the bottom? Probably not, but who can tell? Smart buyers will put a portion of a full position on now, and add if things get worse. Don’t put a full position on yet. I eschew heroism in trading, in favor of a risk-controlled style, where one makes more on average, but protects the downside. It is possible that the drop in prices will bring out more sellers, but I think that there will be more buyers in the next week. That said, the leveraged buyers need to get purged out of the muni markets.

5) In late 2004, I wrote a piece called Default Cycle Will Turn Nasty in 2007. Later I added the following comment:

		David Merkel
		A Low Quality Post by David
		3/27/2006 3:54 PM EST

Interesting to note on Barry’s blog that he has noted that the “low quality” trade has been so stunning over the past three years. I thought Richard Bernstein at Merrill and I were the only ones who cared about this stuff. But now for the bad news: the trade won’t be over until high yield spreads start blowing out, and presently, they show no sign of doing that. Why? There haven’t been many defaults, for one reason. The few defaults have been for the most part in auto parts and airlines. There’s no systemic panic.

Beyond that, there’s a lot of capital to finance speculative ventures, and to catch bad ones when they fall. That means that marginal ideas are getting forgiveness as they get refinanced.

The demand for yield is huge, which drives the offering of protection in the credit default swap market. Fund of funds encourage hedge funds to seek steady income, which makes them tend to be insurers against default risk, rather than speculators on possible default.

I know that I wrote “Default Cycle Will Turn Nasty in 2007;” I take my calls seriously, because I have money on the line, and many of you do too. I think the low quality trade, absent a market blow-up, won’t outperform by a lot in 2006, but will still outperform. Something needs to happen to make credit spreads not look like a free lunch.

My best guess of what will do that is the seasoning of aggressive corporate bond issuance in 2004 and 2005. Bad credit be revealed for what it is, and even the stocks of low quality companies that eventually survive will get marked down for a time, as strong balance sheets get rewarded once again.

Position: none

Then later, in early 2007, I wrote: I was wrong on underperformance of junk bonds. Tight levels got even tighter, with an absence of significant defaults. Junk bonds led the bond market in 2006. In 2007, I don’t expect a repeat, but I do expect defaults to start rising by the end of 2007, leading to a widening in spreads and some underperformance of junk bonds. The real fun will come in 2008-2009. Corporate credit cycles last four to seven years, and the last bear phase was 2000-2002. We’re due for a correction here.

Well, I got it close to right. Timing is tough.

6) Would you pay a high enough price to buy a short-dated TIPS with a negative real yield? Yes you might, if you were hedging against nominal Treasuries, with the CPI running ahead at 4%, and short-dated (5 years and in) nominal bonds at 2 1/2% and lower. As it is, the market seems to be hesitating at going negative, but in my opinion it will, until the concern of the FOMC changes to price inflation.

7) Wilbur Ross didn’t get rich by being dumb. He didn’t buy stakes in MBIA or Ambac, but in one of the two healthy firms, Assured Guaranty. Better to take a stake in the healthy firm in a tough market; they will survive, and write the business that their impaired competitors can’t. This just puts more pressure on MBIA and Ambac, and provides a lower cost muni insurance competitor to Berky.

8 ) MBIA and Ambac are playing for time, and I don’t mean that in a bad way. They are willing to shrink their balance sheets, and write little if any structured business, pay principal and interest in dribs and drabs, and pray that S&P and Moody’s give them the time to do this, and keep the AAA/Aaa intact. It could be three years, and stronger players (FSA, BHAC, AGO) will absorb their non-structured markets. But it could work. If I were Bill Ackman, I would take off half my positions here. Just a rule of thumb for me, when I am managing institutional assets and I become uncertain as to whether I should buy or sell, I do half, and then wait for more data.

Remember, many P&C insurers have been technically insolvent (in hindsight) during the bear phase of the underwriting cycle. They survived by writing better business when their balance sheet was in worse shape than commonly believed. The financial guarantors have a unique ability to wait out losses.

9) There have been all sorts of articles asking whether XXX institution is “too big to fail?” Well, let me “flip it” (sending my pal Cody a nickel for his trademark ) and ask, “Is the US too big to fail?” There’s a reason for my madness here. “Too big to fail” means that the government will bail out an entity to avoid a systemic crisis. Nice, maybe, but that means the government raises taxes to do so (nah) or issues debt that the Fed monetizes, leading to price inflation. Either way, the loss gets spread over the whole country.

What would a failure of the US look like? The Great Depression springs to mind. Present day Japan does not. They are not growing, but they aren’t in bad shape. Another failure would be an era like the 1970s, but more intense. That’s not impossible, if the Treasury Fed were to rescue a major GSE via monetary policy.

10) I have had an excellent 4Q07 earnings season. As of the end of February, I am still in the plus column for my equity portfolio. But, into every life a little rain must fall… after the close on Friday. Deerfield Capital reported lousy GAAP earnings, and I expect the price to fall on Monday. Now, to their credit:

• They reduced leverage proactively, and sold Alt-A assets before Thornburg blew.
• They moved to a more conservative balance sheet. It is usually a good sign when a company sells its bad assets in a crisis.

I would expect the dividend to fall to around 30 cents per quarter. I should have more to say after the earnings call. They are becoming a little Annaly with a CDO manager on board (might not be worth much until 2010).

I may be a buyer on Monday. Depends on the market action.

That’s all for this evening. Good night, and here’s to a more profitable week next week.

Full disclosure: long DFR

1) The blog was out of commission most of Saturday and Sunday, for anyone who was wondering what happened. From my hosting provider:

We experienced a service interruption affecting the Netfirms corporate websites and some of our customer hosted websites and e-mail services.

During scheduled power maintenance at our Data Centre on Saturday Feb. 23 at approximately 10:30 AM ET, the building’s backup generator system unexpectedly failed, impacting network connectivity. This affected several Internet and Hosting Providers, including Netfirms.

Ouch. Reliability is down to two nines at best for 2008. What a freak mishap.

2) Thanks to Bill Rempel for his comments on my PEG ratio piece. I did not have access to backtesting software, but now I do. I didn’t realize how much was available for free out on the web. He comes up with an interesting result, worthy of further investigation. My main result was that PEG ratio hurdles are consistent with a DDM framework within certain moderate values of P/E and discount rates. Thanks also to Josh Stern for his comments.

3) I posted a set of questions on Technical Analysis over at RealMoney, and invited the technicians to comment.

		David Merkel
		Professionals are Overrated on Fundamental Analysis
		2/21/2008 5:19 PM EST

I’m not here to spit at technicians. I have used my own version of technical analysis in bond trading; it can work if done right. But the same thing is true of fundamental investors, including professionals. There are very few professional investors that are capable of delivering above average returns over a long period of time. Part of it is that there are a lot of clever people in the game, and that raises the bar.

But I have known many good amateur investors that do nothing but fundamental analysis, and beat the pros. Why? 1) They can take positions in companies that are too small for the big guys to consider. 2) They can buy and hold. There is no pressure to kick out a position that is temporarily underperforming. With so many quantitative investors managing money to short time horizons, it is a real advantage to be able to invest to longer horizons amid the short-term volatility. 3) They can buy shares in companies that have been trashed, without the “looks that colleagues give you” when you propose a name that is down over 50% in the past year, even though the fundamentals haven’t deteriorated that much. 4) Individual investors avoid the “groupthink” of many professionals. 5) Individual investors can incorporate momentum into their investing without “getting funny looks from colleagues.” (A bow in the direction of technical analysis.)

When I first came to RM 4.4 years ago, I asked a question of the technicians, and, I received no response. I do have two questions for the technicians on the site, not meant to provoke a fundy/technician argument, but just to get opinions on how they view technical analysis. If one of the technicians wants to take me up on this, I’ll post the questions — hey, maybe RM would want to do a 360 on them if we get enough participation. Let me know.

Position: none

		David Merkel
		The Two Questions on Technical Analysis
		2/22/2008 12:15 AM EST

I received some e-mails from readers asking me to post the questions that I mentioned in the CC after the close of business yesterday. Again, I’m not trying to start an argument between fundies and techies. I just want to hear the opinions of the technicians. Anyway, here goes: 1) Is there one overarching theory of technical analysis that all of the popular methods are applications of, or are there many differing forms of technical analysis that compete against each other for validity (and hopefully, profits)? If there is one overarching method, who has expressed it best? (What book do I buy to learn the theory?)

2) In quantitative investing circles, it is well known (and Eddy has written about it recently for us) that momentum works in the short run, and is often one of the most powerful return anomalies in the market. Is being a good technician just another way of trying to decide when to jump onto assets with positive price momentum for short periods of time? Can I equate technical analysis with buying momentum?

To any of you that answer, I thank you. If we get enough answers, maybe the editors will want to do a 360.

Position: none

I kinda thought this might happen, but I received zero public responses. I did receive one thoughtful private response, but I was asked to keep it private. Suffice it to say that some in TA think there is a difference between TA and chart-reading.

As for me, though I have sometimes been critical of TA, and sometimes less than cautious in my words, my guesses at the two questions are: 1) There is no common underlying theory to all TA, there are a variety of competing theories. 2) Most chart-readers are momentum players, as are most growth investors. Some TA practitioners do try to profit from turning points, but they seem to be a minority.

I’m not saying TA doesn’t work, because I have my own variations on it that I have applied mainly to bond investing. But I’m not sure how one would test if TA in general does or doesn’t work, because there may not be a commonly accepted definition of what TA would say on any specific situation.

4) One more note from RM today:

		David Merkel
		Just in Case
		2/25/2008 4:20 PM EST

Um, after reading this article at the Financial Times, I thought it would be a good idea for me to point readers to my article that explained the 2005 Correlation Crisis. Odds are getting higher that we get a repeat. What would trigger the crisis? A rapid decline in creditworthiness for a minority of companies whose debts are referenced in the relevant credit indexes, while the rest of the companies have little decline in creditworthiness. One or two surprise defaults would really be gruesome.

Just something to watch out for, as if we don’t have enough going wrong in our debt markets now. I bumped into some my old RM articles and CC comments from 2005, and the problems that I described then are happening now.

Position: none, and there are times when I would prefer not being right. This is one of them. Few win in a bust.

There are situations that are micro-stable and macro-unstable, and await some force to come along and give it a push, knocking it out of its zone of micro-stability, and into a new regime of instability. When you write about situations like that before the fact, it is quite possible that you can end up wrong for a long time. I wrote for several years as RM about overleveraging credit, mis-hedging, yield-seeking, over-investment in residential real estate (May 2005), subprime lending (November 2006), quantitative strategies gone awry, etc. The important thing is not to put a time on the prediction because it gives a false message to readers. One can see the bubble forming, but figuring out when cash flow will be insufficient to keep the bubble financed is desperately hard.

5) This brings up another point. It’s not enough to know that an investment will eventually yield a certain outcome, for example, that a distressed tranche of an ABS deal will eventually pay off at par. One also has to understand whether an investor can handle the financing risks before receiving the eventual payoff. Will your prime broker continue to finance you on favorable terms? Will your regulator force you to put up more capital against the position? Will your investors hang around for the eventual payoff, or will they desert you, and turn you into a forced seller? Can your performance survive an asset that might be a dud for some time?

This is why the price path to the eventual payoff matters. It shakes out the weak holders, and moves assets that should be financed by equity onto strong balance sheets. It’s also a reason to be careful with your own balance sheet during boom times, and in the beginning and middle of financial crises — don’t overextend your positions, because you can’t tell how long or deep the crisis might be.

6) I agree with Caroline Baum; I don’t think that the FOMC is pushing on a string. The monetary aggregates are moving up, and nominal GDP will as well… it just takes time. The yield curve has enough slope to benefit banks that don’t face a lot of credit problems… and the yield curve will steepen further from here, particularly if the expected nadir of Fed funds drops below 2%. Now, will real GDP begin to pick up steam? Not sure, the real question is how much inflation the Fed is willing to accept in the short run as they try to reflate.

7) Now, inflation seems to be rising globally. At this point in the cycle, the FOMC is ahead of almost all major central banks in loosening policy. I think that is baked into the US dollar at present, so unless the FOMC gets even more ahead, the US Dollar should tread water here. Eventually inflation elsewhere will get imported into the US. It’s just a matter of time. That’s why I like TIPS here; eventually the level of inflation passing through the CPI will be reflected in implied inflation rates.

8 ) Okay, MBIA will split in 5 years? That is probably enough time to strike deals with most everyone that they wrote coverage for structured products, assuming the losses are not so severe that the entire holding company is imperiled. If it’s five years away, splitting is a possibility, but then are the rating agencies willing to wait that long? S&P showed that they are willing to wait today. Moody’s will probably go along, but for how long?

9) I found it interesting that AQR Capital has not been doing well in 2008. When quant funds did badly in the latter half of 2007, I suffered along with them. At present, I am certainly not suffering, but it seems that the quants are. I wonder what is different now? I suspect that there is too much money chasing the anomalies that the quant funds target, and we reached the end of the positive self-reinforcing cycle around mid-year 2007; since then, we have been in a negative self-reinforcing cycle, with clients pulling money, and the ability to carry positions shrinking.

10) Now some graphs tell a story. Sometimes the story is distorted. This graph of the spread on Fannie Mae MBS is an example. Not all of the spread is due to the creditworthiness of Fannie Mae. Those spreads have widened 30 basis points or so over the past six months for Fannie’s on-the-run 5-year corporate bond, versus 50 basis points on the graph that I referenced. So what’s the difference? Increased market volatility makes residential MBS buyers more skittish, and they demand a higher yield for bearing the negative optionality inherent in RMBS. Fannie and Freddie are facing harder times from the guarantees that they have written, and the credit difficulties at the mortgage insurers, but it would be difficult to imagine the US Government allowing Fannie or Freddie to default on senior obligations.

That’s another reason why I like agency-backed RMBS here. You’re getting paid a decent spread to bear the risks involved.

11) I would be cautious about using prics from CMBX, ABX, etc., to make judgments about the cash bonds that they reference. It is relatively difficult to borrow and short small ABS and CMBS tranches. It is comparatively easy to buy protection on the indexes, the only question is what level does it take to induce another market participant to sell protection to you. When there is a lot of pressure to short, prices overshoot on the downside, and stay well below where the cash bonds would trade.

12) One last point, this one coming via one of our dedicated readers passing on this blurb from David Rosenberg at Merrill Lynch:

A client sent this to us last week

It was a New York Times article by Louis Uchitelle in December 1990 on the housing and credit crunch. In the article, there is a quote that goes like this – “This is different from the experience of the Great Depression, but something related to the 1930’s is beginning to happen”. Guess who it was that said that (answer is at the bottom of the Tidbits).

Answer to question above

“Ben Bernanke, a Princeton University Economist” (and future Fed chairman, but who knew that then?).

My take: it is a very unusual time to have a man as Fed Chairman who is a wonk about the Great Depression. That makes him far more likely to ease. The real question is what the FOMC will do if economic weakness persists, and inflation continues to creep up. I know that they want to save the day, and then remove all policy accomodation, but that’s a pretty difficult trick to achieve. In this scenario, I don’t think the gambit will work; we will likely end up with a higher rate of price inflation.

It seems that a number of Constant Proportion Debt Obligations are being downgraded or forced to delever.  This was something I thought would happen; it was only a question of when.  It’s a pity that S&P did not totally abandon its model framework for CPDOs; it is less liberal now, but not consistent with the way they rate other investments.  Here’s a trip through my thoughts on CPDOs over the last 16 months:

		David Merkel
		Having A Sense Of Wonder
		11/7/2006 2:09 AM EST

Periodically, I gain a sense of wonder from the derivative markets. This stems from the optimism of the markets vs. my knowledge of economic history. There are risks being taken that have not worked out in the past. My current wonder-generator is the CPDO [Constant Proportion Debt Obligation] market. With a CPDO, you leverage up a basket of investment grade credits, in an effort to earn a certain amount over the life of the CPDO. {Note: the CPDO is rated AAA, but the average of the underlying credits is rated weak single-A at best.

If the deal goes well, i.e. no defaults, it delivers early, and risk decreases. If defaults occur, the structure levers up more in an effort to make back what has been lost, up to a 15x leverage limit. After that, the CPDO rapidly takes on losses.

This structure is notable, because it attempts to achieve risk reduction for free, the same way the stock managers tried to do so in the mid-80s with dynamic portfolio management. It has no external guarantors, nor subordination.

The rumor at present is that these new CPDOs are leading to a tightening in the credit default swap market. Spreads are tight as a drum, so I can see the effect, if true.

Position: None, but I always get concerned when market players try to get risk control for free. Off-loading risk is never free on average.

		David Merkel
		Call It Complacency
		11/7/2006 3:58 PM EST

Be sure and look at Tony’s blog post, “Default Insurance Costs at New Low.” I checked the other Dow Jones CDX North America Investment Grade Indexes, and yes, they also are at all time tight levels. Tony cites the spread from the newest one. Should we be worried? A little. As I noted in my post from this morning, some of this tightness is due to the CPDO market. They have to suck in a lot of long credit exposure to issue these, which puts downward pressure on spreads.

But bottoms in the stock market are an event. Tops are a process. Credit spreads are tight for long periods during the bull phase, and very fat for short periods during the bear phase. (Can I have BBB spreads in the 400s again, please?) Same for implied volatility… the VIX spikes during equity and credit market panics, but lolls around at low levels during the bull phase. This is complacency.

Trouble is, complacency can last a looong time, and many fixed income and equity managers don’t have the luxury of saying, “I think I’ll just stay in T-bills for now.” The greed of those they invest for (or their actuarial funding targets) force them into risk, often at bad times. The good times end when cash flow is insufficient to refinance marginal assets. Typically that’s three years after the issuance of debt deals that should never have been done, but in this environment, there is so much private equity amd vulture capital around that I don’t see many troubled assets not getting financing.

The party will continue a while longer. Oh look, there are the hedge fund-of-funds at the head of the Conga line, followed by the CDO equity managers, the investment banks, the credit hedge funds, and the cash bond market at the tail. What a party!

PS — I think it is irresponsible of the rating agencies to assign AAA ratings to securities like these CPDOs that are composed of BBB and single-A paper, and do not have any guarantor or subordination to protect the creditworthiness. This is akin to thinking that a martingale method, like doubling down, will protect you from loss in Vegas. It might most of the time, but you lose big when it doesn’t work.

Position: none

		David Merkel
		More Information on CPDOs
		11/9/2006 12:25 AM EST

I’ve gotten numerous pings since my initial posts on CPDOs [Constant Proportion Debt Obligations]. This post is designed to correct a few errors, and explain how we as equity investors might profit from a potential disaster here. My first posts were based off what I read in a few blogs. They got a few things wrong, so I am correcting what I wrote. The structure levers up investment grade credit fifteen times, allowing the purchaser to buy a bond with a coupon two percent (or so) higher than Treasuries, with a AAA rating. What a deal; it is difficult to find AAA bonds yielding 0.5% more than Treasuries. (Ignoring odd beasts like CMBS IOs, etc.) I have seen reports that $1.0-1.5 billion of these have been created in the recent past, which means around $20 billion of credit exposure has been absorbed, depressing credit spreads over the last month.

I suggested in my earlier writings that the structures could only allow for 15x leverage, but they can go higher if the deals go badly at first. They only unwind and take losses if the market value of the underlying assets would drop down to a threshold level, say, around 90%-94% of par. That’s not to say that losses are limited to 6%-10%. The losses could be worse if the market is moving against them as they liquidate.

Now, how to profit? There will be some sort of crisis from CPDOs; after all, the buying in order to establish these securities has been characterized by some as a panic. At some point, there will be a situation where there is a default on one or more of the companies in one of the CPDOs. If it is severe enough, at that time, the CPDOs will have to deliver, and that will push credit spreads wider, and stock prices lower.

Since the companies involved are all big capitalization companies, we can watch the price and volume patterns on the S&P 500 Spyder, and look for where volume is cresting, while price is trough-ing, and take a long position after the crisis. Watch the VIX. When it spikes in a situation like this, there will be profits from going long equity exposure.

If it means anything, I used strategies like this in 2001-2002 to generate profits when things were going crazy. These strategies will work again when the CPDOs fail. I can’t say they will fail soon; I just know they will fail, as Dynamic Portfolio Management did in 1987.

Position: None

		David Merkel
		Dominion & CPDOs
		12/20/2006 12:47 AM EST

I’m not alone on not liking what Moody’s and S&P have done on constant proportion debt obligations [CPDOs]. Now a rival rating agency, Dominion, better known for rating Canadian debt, has weighed in on the issue with skepticism. I’m annoyed at the irresponsibility of Moody’s and S&P for two main reasons. A weak single-A, strong-BBB portfolio should have credit losses of 10-15 basis points per year on average. Unfortunately, losses tend to come in heaps for investment grade corporate debt. No losses for five years, and large losses for two years. Now these structures are levered up 9-15 times on average, so during the two loss years, we are talking about 9-10% losses of equity over a two year period. If that is not bad enough, spreads will widen during the loss period even on healthy debt, further adding to the problems.

In the old days, say, two years ago, Moody’s and S&P would have called a CPDO structure AAA once it had de-levered, not on the prospect that it is very likely to de-lever. Remember a AAA means it can survive the Great Depression, and pay principal and interest on a timely basis. I can say with certainty that a levered portfolio of weak single-A bonds can’t do what an unlevered AAA bond can do in a period of severe economic stress.

Can rating agencies be sued for malpractice? Perhaps the boards of Moody’s and S&P should spruce up their D&O coverage…

Position: none

Beyond these pieces, I had three posts here that followed the decline:

Speculation Away From Subprime, Compendium

Stressing Credit Stress

Ten Notes on Our Crazy Credit Markets

Now we may have an opportunity as some CPDOs are forced to delever, credit spreads are being forced higher.  I commented before (all too recently) that it was time to dip our toes into the waters of credit, and buy 25% of a full position, with carefully selected credits.  I think it is now time to raise that allocation to 50%.  It is time to begin taking some credit risks; spreads are discounting a lot of unfavorable future news, and it is time to take advantage of it.  Is the current news gloomy?  You bet, and I can tell you that at the end of many days in mid-2002, I would hold my head in my hands in disbelief at the carnage.  But good credit investors must invest when the spreads are wide, and give up income when spreads are tight.

As for the 2002 carnage, I sent Cramer e-mails on the bond market back then, and this CC post recounts one of them, where Cramer used one of my e-mails for a post (he did that twice in 2002):

		David Merkel
		Cycling Through Cycles
		2/1/05 2:54 PM ET
If you haven’t read it yet, please read Cody’s piece, “The Nature of Feedback Loops.” I do a lot with this for two reasons. First my investment methods lead me to rotate sectors, and all mature businesses are cyclical; they just aren’t all on the same cycle. Second, the insurance industry is very cyclical. I spend most of my time analyzing trends in pricing power.At cycle peaks and troughs, I tend to stop looking at quantitative data, and look for anomalous behavior that might hint that the cycle is changing. No one rings a bell at the top or bottom, and you can never get tops and bottoms exactly, but sometimes people behave funny near turning points. Greed and fear get excessive, and then people do foolish things. As an aside, before I wrote for RealMoney, I would drop Jim Cramer notes on the corporate bond market. This article resulted from one of my missives. There was still five months of craziness remaining, but I kept my trading discipline in 2002, though I sometimes wondered if I was sane. At the turns in July and October, some of my best brokers called me in a panic, saying that there were no bids in the market and many sellers. Implied equity volatility had gone through the roof. What to do? I got out the liquidity that I reserved for such occasions and put out lowball bids for medium-quality bonds. By the time I used up all my liquidity in the early afternoon, the market had turned. Nerve-wracking, but it really made for good performance in a horrible year. For more of my thoughts on applying cycles to investing, you can read my piece, “Evolution of an Investment Style.” None

Anyway, buying credit now is a “pain trade.”  It is time to selectively take advantage of wide spreads if your investment mandate allows for it.

There are a variety of interested parties with an interest in keeping the guarantors in one piece, as is pointed out in this article from Bloomberg. Downgrading half a trillion of asset-backed bonds if a split happens? Yes, that is the price, and that is why there will be many lawsuits to contest any split, as pointed out by naked capitalism. The discussion of that post is worth reading, because it got me thinking about the differences between swaps and insurance. There are two ways to go here:

1. A swap that mimics the nature of an insurance contract is an insurance contract. After all, that is the way their regulators have been behaving, at least up until now.
2. A swap is a side agreement between the operating company (the actual insurer, not the parent holding company MBIA or Ambac), and the counterparty. In liquidation, they would be treated at general creditors, behind the policyholders in liquidation preference.

I looked at a few of the relevant state legal codes yesterday, and if the state regulators want to play hardball, they would go with the second interpretation, and pull the rug out from under the feet of those who were relying on the first interpretation. They could argue that swaps are a different class of business than insurance, and try to make the case that if an insolvency occured, those with with swap contracts would face a much lower recovery than those with insurance contracts, so let’s make it formal and do a split.

Now, most of the business done was by insurance contracts, and the laws on rehabilitation, conservation and liquidation indicate that similar parties are to be treated equitably within each class of claimants. Policyholders are all in the same class. Splitting the companies into municipal insurance and everything else would not treat all policyholders equally. Thus the lawsuits.

Now for a few links:

• Roger Ehrenberg at Information Arbitrage sees the issues clearly.
• FT Alphaville features my comments, and adds to them.
• Good interview by Chris Whalen of David Kotok discussing the furor in municipals at present.
• For wonks only: from Stroock & Stroock & Lavan, a discussion of how derivatives are treated in insurance insolvencies. Yes. I actually got out my old insurance law books this afternoon, but they were no help. Interesting article that would support the hardball case.

As I’ve said before, I would not be bullish on the equities of the compromised financial guarantors. They may survive, but only after much dilution. Now we have Ambac trying to raise $2 billion. What will they use? A rights offering? A PIPE? Mandatorily convertible debt? Surplus notes at their operating insurance companies? In order to get cash today, they have to give up a lot of the potential profits of the business. And what, will they take the $2 billion to try to buy off the structured securities claimants? Not enough, I think, if that half-trillion figure is correct, with $35 billion of mark-to-market losses for the market as a whole (Ambac’s portion would be big).

Two last notes: legally, I don’t see how splitting the guarantors gets done. It flies in the face of decades of contract law regarding insurers. Second, wouldn’t it be a troubling unintended consequence if the regulators managed to protect the municipalities, and in the process, ended up destroying the investment banks, leading to a bigger catastrophe?

What do municipalities want from their bond market? Low long-term financing rates. In and of itself, that’s not a bad goal to pursue. The question is how you do it.

What prompted this post was an article from The Bond Buyer (via Google cache). The need for short-dated tax-free muni bonds drives hedge funds (typically) to buy long munis and sell short term debt to finance the bonds, which tax-free money market funds buy. For more on Variable Rate Demand Structures, look here. (Thanks, Accrued Interest. The article was prescient to the current troubles.) The Wall Street Journal also anticipated the current troubles in this article. The hedge funds could only take the pain for so long. As perceived risks rose with the sagging prospects of the financial guarantors, fewer market players wanted to buy the short term debt, because the collateral underlying the short term debt no long had high enough ratings. That led to the hedge funds having to collapse their balance sheets, selling the long munis, and repaying the short term debts, taking losses in the process.

Now, many of the same difficulties apply to auction rate bonds (another article from Accrued Interest), no matter who the obligor (entity that must pay on the bond) is. As I commented recently:

Part of the difficulty here is that auction rate structures are unstable. They can handle 30 mph winds, but not 60 mph winds. Auction rate structures deliver low rates when things are calm, but can be toxic when short term liquidity dries up. A sophisticated borrower like the NY Port Authority should have known that going in. Small borrowers are another matter, their investment banks should have explained the risks.

Yes, the explanations are all there in the documents, but a good advisor explains things in layman’s terms. That said, it is usually the shortsightedness of local governments wanting low rates and long term funding at the same time that really causes this. You can have one or the other, but not both with certainty.

Or, as I commented at RealMoney:

		David Merkel
		Failed Muni Auctions are not the End of the World
		2/14/2008 2:50 PM EST

Most of the municipalities with the failed auctions are creditworthy entities that don’t need bond insurance. Bond insurance is “thought insurance.” The bond manager doesn’t have to think about the credit if he knows the guarantor is good. If the guarantor is not good, then the bond manager has to get an analyst to look at the underlying creditor. That takes work and thought, and both of those hurt. Daniel Dicker is on the right track when he says the municipalities are racing refinance. Well, good. Auction rate structures are stable under most conditions, but under moderate stress, like the lack of confidence in the guarantor, they break. I would like to add, though that auction rate structures are kind of a cheat. Why?

1) The municipality gets to finance short, which usually reduces interest costs, but loses the guarantee of fixed-rate finance. 2) This is driven by investors who want tax-free money market funds. Most municipalities don’t want to issue the equivalent of commercial paper. They want long term financing. 3) The auction rate structure seems to give the best of both worlds: long term financing at short rates, without having to formally issue a floater. 4) For minor hiccups, an interested investment bank might take down bonds, but in a crisis, they run faster than the other parties from a failed auction.

The municipalities could have issued fixed or floating-rate debt over the same term, but they didn’t because it was more expensive. Well, now they will have to bear that expense, and yes, as Daniel points out, that will make the muni yield curve steepen.

Pain to municipalities, which will mean higher taxes for debt service. Fewer auction rate securities to tax free money market funds. It’s a crisis, but not a big crisis.

Position: none
Let me put it another way. No one complained when hedge funds levered up the long end of the muni market, allowing municipalities to finance more cheaply than they should have been able to. But now that the leverage is collapsing, and municipalities that did not prudently lock in their rates, but speculated on short rates are getting hurt, should it be a major crisis? I think not. Personally, I think the wave of auction failures will give way to refinancing long, and a new group of speculators buying auction rate securities at higher yields than the prior short-term equilibrium yield.