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.

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

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

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

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

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

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

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

That’s where I stand for now. The Fed is trying to rescue the economy from asset deflation, much like 1990-1992, but will run into the buzzsaw of price inflation, and tighten a la 1994. Conditions in the real economy are not as weak today as they were in 2001, but the banks are in worse shape. That will drive further loosening by the Fed, until inflation is intolerable. (more…)

1) I might not be able to post much for the next two days. I have business trips to go on. One is to New York City tomorrow. If everything goes right, I will be on Happy Hour with my friend Cody Willard on Tuesday.

2) As I wrote at RealMoney this morning:

		David Merkel
		Buy Other Insurers off of the Bad AIG News
		2/12/2008 2:54 AM EST

Sometimes I think there are too many investors trading baskets of stocks, and too few doing real investing work. I have rarely been bullish on AIG… I think the last time I owned it was slightly before they added it to the DJIA, and I sold it on the day it was added.Why bearish on AIG? Isn’t it cheap? It might be; who can tell? There’s a lot buried on AIG’s balance sheet. Who can truly tell whether AIG Financial Products has its values set right? International Lease Finance? American General Finance? The long-tail casualty reserves? The value of its mortgage insurer? I’m not saying anything is wrong here, but it is a complex company, and complexity always deserves a discount.

You can read my articles from 2-3 years ago where I went through this exercise when the accounting went bad the last time, and Greenberg was shown the door. (And, judging from the scuttlebutt I hear, it has been a good thing for him. But not for AIG.)

AIG deserves to be broken up into simpler component parts that can be more easily understood and valued. Perhaps Greenberg could manage the behemoth (though I have my doubts), no one man can. There are too many disparate moving parts.

So, what would I do off of the news? Buy other insurers that have gotten hit due to senseless collateral damage (no pun intended). As I recently wrote at my blog:

If Prudential drops much further, I am buying some. With an estimated 2009 PE below 8, it would be hard to go wrong on such a high quality company. I am also hoping that Assurant drops below $53, where I will buy more. The industry fundamentals are generally favorable. Honestly, I could get juiced about Stancorp below $50, Principal, Protective, Lincoln National, Delphi Financial, Metlife… There are quality companies going on sale, and my only limit is how much I am willing to overweight the industry. Going into the energy wave in 2002, I was quadruple-weight energy. Insurance stocks are 16% of my portfolio now, which is quadruple-weight or so. This is a defensive group, with reasonable upside. I’ll keep you apprised as I make moves here.

What can I say? I like the industry’s fundamentals. These companies do not have the balance sheet issues that AIG does. I will be a buyer of some of these names on weakness.

Position: long LNC HIG AIZ

3) More on AIG. As Cramer said yesterday: One last thought on the AIG issue: if President and CEO Martin Sullivan were to step down, the company might be more of a buy than a sale!

Maybe. Sullivan is a competent insurance executive with the biggest insurance job in the world. Breaking up the company, and letting the parts regain focus makes more sense. As an aside, M. R. Greenberg was known to be adamant about his ROE goal (15% after-tax on average equity), but he also liked the company to have bulk (high assets — he liked asset-sensitive lines), which is why the ROA slid in the latter part of his tenure.

4) Some praise for Cramer on the same topic. As he said yesterday: AIG let me have it after I said last year that I couldn’t value the stock. They told me that there was a 92-page disclosure document and they wanted to know if I even looked at it. I shot back that not only did I look at it, but I had people comb it, including the forensic accountant I have on staff. The issue was always that despite the disclosure that they had CDO exposure, we couldn’t figure out what the real exposure was and we questioned whether THEY could.

Nothing gets a management more angry than being told that they don’t know what they are doing, but I was marveling at the certainty that they expressed. I told them they had tons of disclosure, but their estimation of possible losses seemed chimerical. I couldn’t figure out how THEY could value the stuff when no one else could with any certainty until it was off their books or written down. OF course, insurance companies aren’t held to the same standards of mark-to-market that banks are. They used mark-to-model, and the model, we learned today — the Binomial Expansion Technique — was totally wrong and dramatically understated the losses. All of this cuts to the incredible level of arrogance and stupidity on the Street, making judgments that were anti-empirical on data that could not be modeled but had to be experienced and examined nationally. In short, they were scientific and certain about something that couldn’t be quantified by science and certainly couldn’t be certain about.

Aside from the quibble that insurers for GAAP purposes are subject to the same rules as banks, Cramer got it right here. It is a major reason why I have been skeptical about AIG. Complexity in financial companies, especially financial companies that grow fast, is warranted. It is an unforgiving business where moderate conservatism works best.

5) Brief NAHC note: the CEO purchased more shares in the last few days. At least, it looks like it. Could he be acquiring shares to combat Hovde Capital? Honestly, I’m not sure, but this is looking more interesting by the day.

6) A new favorite blog of mine is Going Private. This post on insurance issues in Florida was unusual for that blog, but I thought it was perceptive. I wrote similar things at RealMoney:

		David Merkel
		Move to Florida, Become a Reinsurer
		3/27/2007 3:30 PM EDT

Interesting note in the National Underwriter on a Towers Perrin Study (also try here) describing how much Floridians will have to pay if a 1-in-250 hurricane hits Florida. Cost per household: $14,000, or $467 per year for 30 years. On a 1-in-50 storm, the figures would be $5,640, or $188 per year. There would also be a higher initial assessment as well. Note that the odds are actually higher than stated odds would admit. The stated odds of the large losses from the 2004 and 2005 storms happening in consecutive years would have been considered astronomical, but it happened anyway.

The Florida legislature can determine how the pain is shared, but they can’t legislate that the pain go away. No free lunch.

P.S. As an aside, the state of Florida is subsidizing reinsurance rates through its catastrophe fund. Ostensibly, Florida homeowners get a cut in rates, but the insurers give that cut only because their reinsurance costs are lower. Who’s the loser? The citizens of Florida will have to reach into their pockets to recapitalize the Hurricane Catastrophe Fund if big losses hit, and at the very time that they won’t want to do it. (Note to S&P: why do you give this state a AAA GO bond rating?)

Position: none mentioned

		David Merkel
		The Worst Insurance State In The USA
		2/2/2007 3:52 PM EST

I don’t want to go on a rant here, but I do feel strongly about this. It ill-befits a state government to behave like a bunch of thugs, even if it pleases the electorate. For over two decades, the worst state to do business in as an insurer was Massachusetts. New Jersey was competitive for a while, and California was pretty bad on Worker’s Comp, but now we have a new state on the top of the heap: Florida.

The failure of the Florida property insurance market was due to the lack of willingness to allow rates to rise sufficiently to attract capital into the market. The partial socialization of risk drove away that capital. So what does the governor and legislature of Florida do to meet the crisis? Increase the level of socialization of risk, and constrain companies to a binary decision: accept profits that don’t fairly reflect the risks underwritten, or leave the state. (And, they might try to forbid insurers from leaving.)

In my opinion, if they bar the door to insurers leaving, or not being allowed to non-renew policies, it is an unconstitutional “taking” by the state of Florida. No one should be forced to do business that they don’t want to do. Fine to set up the regulatory rules (maybe), but it’s another thing to compel parties to transact.

Okay, here’s a possible future for Florida:

1) By the end of 2007, many insurers leave Florida; the state chartered insurer now has 33% of all of the primary property risk.
2) Large windstorm damages in 2008-2009, $100 billion in total, after a surprisingly light 2006-2007.
3) Florida finds that the capital markets don’t want to absorb more bonds in late 2009, after the ratings agencies downgrade them from their present AAA to something south of single-A.
4) The lack of ability to raise money to pay storm damages leads to higher taxes, plus the high surcharges on all insurance classes to pay off the new debt, makes Florida a bad place to live and do business. The state goes into a recession rivaling that of oil patch in the mid-1980s. Smart people and businesses leave, making the crisis worse.

Farfetched? No, it’s possible, even if I give a scenario of that severity only 10% odds. What is more likely is a watered-down version of this scenario. And, yes, it’s possible that storm damages will remain light, and Florida prospers as a result of the foolishness of their politicians. But I wouldn’t bet that way.

Position: long one microcap insurer that will remain nameless

		Marc Lichtenfeld
		Florida Insurance
		2/2/2007 4:17 PM EST

David,

While I don’t pretend to be the insurance maven that you are, I don’t believe it’s quite as black and white as you portray.

First, let me preface my comments by saying that I believe in free markets and don’t agree with the Governor’s plan, although I stand to benefit. Secondly, my insurance rates, while higher than I’d like are not too bad compared to others in the state.

That being said, I think something had to be done. In one scenario that you lay out, you describe smart people leaving due to higher taxes. That was already happening due to high insurance rates. Some people with affordable mortgages suddenly found their insurance rates skyrocketing from $2,000 to over $6,000. Lots of seniors on fixed incomes also saw their rates jump.

One factor in the housing slump is that buyers are having a hard time finding insurance on a house they are ready to close on. I know that three years ago, we were scrambling at the last minute to find an insurer who would write a policy — and that was before all of the storms.

I’m not sure what the answer is. I fear that in an entirely free market, there will be very few insurers willing to do business here if there’s another bad storm.

Maybe that’s an argument that we shouldn’t be building major population centers right on the coast, but that’s another story.

Position: None

		David Merkel
		My Sympathies to the People of Florida
		2/2/2007 4:45 PM EST

Marc,

I understand the pain that many people in Florida are in. I know how much rates have risen. What I am saying is that the new law won’t work and will leave the people of Florida on the whole worse off. Florida is a risky place to write property coverage, and the increase in rates reflects a lack of interest of insurers and reinsurers to underwrite the risk at present rates and terms.

We don’t have a right to demand that others subsidize our lifestyle. But Florida is slowly setting up its own political crisis as they subsidize those in windstorm-prone areas, at the expense of those not so exposed. Commercial risks must subsidize coastal homeowners. Further, there is the idea lurking that the Feds would bail out Florida after a real emergency. That’s why many Florida legislators are calling for a national catastrophe fund.

They might get that fund too, given the present Congress and President, but Florida would have to pay in proportionately to their risks, not their population. Other proposed bills would subsidize Florida and other high risk areas. Why people in New York, Pennsylvania, Ohio should pay to subsidize Florida and California is beyond me.

The new law also affects commercial coverages; the new bill basically precludes an insurer from writing any business in Florida, if they write homeowners elsewhere, but not in Florida. If you want to chase out as many private insurers as possible, I’m not sure a better bill could have been designed. The law will get challenged in the courts; much of it will get thrown out as unconstitutional. But it will still drive away private insurance capacity.

I’m not writing this out of any possible gain for myself. I just think the state of Florida would be better served, and at lower rates, with a free market solution. Speaking as an insurance investor, I know of half a dozen or so new companies that were contemplating entering Florida prior to the new law. All of those ideas are now dead.

I hope that no hurricanes hit Florida, and that this bet works out. If there is political furor now in Florida, imagine what it would be like if my worst-case scenario plays out.

Position: long a small amount of one microcap insurer with significant business in Florida

Florida had now dodged the bullet for two straight years. Hey, what might happen if we have a bad hurricane year during an election year? Hot and cold running promises; I can see it now!

7) One of the best common-sense writers out there is Jonathan Clements of the WSJ. He had a good piece recently on why houses are not primarily investments. Would that more understood this. There are eras where speculation works, but those eras end badly. You can be a landlord, with all of the challenges, if you like that business. You can own a large home, but you are speculating that demand for the land it is on will keep growing. That is not a given.

8 ) My favorite data-miner Eddy, at Crossing Wall Street comes up with an interesting way to demonstrate momentum effects. Large moves up and down tend to continue on the next day, and the entire increase in the market can be attributed to the days after the market moves up 64 basis points.

9) This is not an anti-Cramer day. I like the guy a lot. I just want to take issue with this article: “Trading in CDOs Slows to a Trickle.”  The basic premise is that CDOs are going away because trading in CDOs is declining.  Well, the same is true of houses, or any debt-financed instrument.  Volumes always slow as prices begin to fall, because momentum buyers stop buying.

Short of outlawing CDOs, which I don’t think can be done, though the regulators should consider what financial institutions should be allowed to own them.  That would shrink the market, but not destroy it.  Securitization when used in a moderate way is a good thing, and will not completely disappear.  Buyers will also become smarter (read risk-averse) at least for a little while.  This isn’t our first CDO blowup.  The cash CDO vintages 1997-1999 had horrible performance.  Now we have horrible performance.  Can we schedule the next crisis for the mid-teens?

10) On Chavez, he is a dictator and not an oil executive.  Maybe someone could send him to school for a little while so that he could learn a little bit about the industry that he is de facto running?  As MarketBeat points out, take him with with a grain of salt.  Venezuelan crude oil needs special processing, much of which is done in the US.  If he diverts the crude elsewhere, who will refine it for sale?

11) I am really ambivalent about Bill Gross.  He’s a bright guy, and has built a great firm.  Some of the things he writes for the media make my head spin.  Take this comment in the FT:

That the monolines could shoulder this modern-day burden like a classical Greek Atlas was dubious from the start. How could Ambac, through the magic of its triple-A rating, with equity capital of less than $5bn, insure the debt of the state of California, the world’s sixth-largest economy? How could an investor in California’s municipal bonds be comforted by a company that during a potential liquidity crisis might find the capital markets closed to it, versus the nation’s largest state with its obvious ongoing taxing authority? Apply the same logic to the gargantuan size of the asset-backed market it has insured in recent years – subprimes and CDOs in the trillions of dollars – and you must come to the same logical conclusion: this is absurd. It is as if Barney Fife, television’s Sheriff of Mayberry in The Andy Griffith Show, promised to bring law and order to the entire country.

Most municipal defaults are short term in nature, even those of states, of which there have been precious few.  Ambac, or any other guarantor, typically only has to make interest payments for a short while on any default.  It is a logical business for them to be in… they provide short term liquidity in a crisis, while the situation gets cleaned up.  In exchange for guarantee fees the municipalities get lower yields to pay.

The muni business isn’t the issue here… the guarantors should not have gotten into the CDO business.  That’s the issue.

12) I try to be open-minded, though I often fail.  (The problem of a permanently open mind is that it doesn’t draw conclusions when needed.  Good judgment triumphs over openness.)  I have an article coming soon on the concept of the PEG ratio.  This is one where my analytical work overturned my presuppositions, and then came to a greater conclusion than I would have anticipated.  The math is done, but the article remains to be written.  I am really jazzed by the results, because it answers the question of whether the PEG ratio is a valid concept or not.  (At least, it will be a good first stab.)

Full disclosure: long AIZ HIG LNC NAHC

I have to be careful as I write this post, because I have agreements with my former employer. I will stick with what is publicly understood, and avoid internal knowledge of what my former employer thought when I last worked with them.

Today, after the close, Hovde Capital filed a 13D, seeking to own more than 17% of National Atlantic, and asking for seats on the board of directors. Now, what I want to say to my readers might agree with what Hovde Capital might want. Don’t make too much out of this. First, the New Jersey Department of Banking and Insurance might turn Hovde down. Second, realize that any party acquiring 10% or more of any publicly traded company has to file two days after making any trade. That is the signal that I would be looking for.

National Atlantic is my largest holding, and I am aware of other parties considering buying National Atlantic, but they fail the urgency test for me. There’s lots of talk but no action. Don’t take any action off of Hovde’s SEC filing. There are too many uncertainties here, and wise investors will wait for favorable levels for investing.

Full disclosure: long NAHC