I’ve been on both sides of the fence.  I’ve been a bond manager, with a large, complex (and illiquid) portfolio, and I have been a selector of managers.  Thus the current squabble between Jeffrey Gundlach and Morningstar isn’t too surprising to me, and genuinely, I could side with either one.

Let me take Gundlach’s side first.  If you are a bond manager, you have to be fairly bright.  You need to understand the understand the compound interest math, and also how to interpret complex securities that come in far more flavors than common stocks.  This is particularly true today when many top managers are throwing a lot of derivative instruments into their portfolios, whether to earn returns, or shed risks.  Aspects of the lending markets that used to be the sole province of the banks and other lenders are now available for bond managers to buy in a securitized form.  Go ahead, take a look at any of the annual reports from Pimco or DoubleLine and get a sense of the complexity involved in running these funds.  It’s pretty astounding.

So when the fund analyst comes along, whether for a buy-side firm, an institutional fund analyst, or retail fund analyst who does more than just a little number crunching, you realize that the fund analyst likely knows less about what you do than one of your junior analysts.

One of the issues that Morningstar had  was with DoubleLine’s holdings of nonagency residential mortgage-backed securities [NRMBS].  These securities lost a lot of value 2007-2009 during the financial crisis.  Let me describe what it was like in a chronological list:

  1. 2003 and prior: NRMBS is a small part of the overall mortgage bond market, with relatively few players willing to take credit risk instead of buying mortgage bonds guaranteed by Fannie, Freddie and Ginnie.  Much of the paper is in the hands of specialists and some life insurance companies.
  2. 2004-2006 as more subprime lending goes on amid a boom in housing prices, credit quality standards fall and life insurance buyers slowly stop purchasing the securities.  A new yield-hungry group of buyers take their place, with not much focus on what could go wrong.
  3. Parallel to this, a market in credit derivatives grows up around the NRMBS market with more notional exposure than the underlying market.  Two sets of players: yield hogs that need to squeeze more income out of their portfolios, and hedge funds seeing the opportunity for a big score when the housing bubble pops.  At last, a way to short housing!
  4. 2007: Pre-crisis, the market for NRMBS starts to sag, but nothing much happens.  A few originators get into trouble, and a bit of risk differentiation comes into a previously complacent market.
  5. 2008-2009: the crisis hits, and it is a melee.  Defaults spike, credit metrics deteriorate, and housing prices fall.  Many parties sell their bonds merely to get rid of the taint in their portfolios.  The credit derivatives exacerbate a bad situation.  Prices on many NRMBS fall way below rational levels, because there are few traditional buyers willing to hold them.  The regulators of financial companies and rating agencies are watching mortgage default risk carefully, so most regulated financial companies can’t hold the securities without a lot of fuss.
  6. 2010+ Nontraditional buyers like flexible hedge funds develop expertise and buy the NRMBS, as do some flexible bond managers who have the expertise in staff skilled in analyzing the creditworthiness of bunches of securitized mortgages.

Now, after a disaster in a section of the bond market, the recovery follows a pattern like triage.  Bonds get sorted into three buckets: those likely to yield a positive return on current prices, those likely to yield a negative return on current prices, and those where you can’t tell.  As time goes along, the last two buckets shrink.  Market players revise prices down for the second bucket, and securities in the third bucket typically join one of the other two buckets.

Typically, though, lightning doesn’t strike twice.  You don’t get another crisis event that causes that class of securities to become disordered again, at least, not for a while.  We’re always fighting the last war, so if credit deterioration is happening, it is in a new place.

And thus the problem in talking to the fund analyst.  The securities were highly risky at one point, so aren’t they risky now?  You would like to say, “No such thing as a bad asset, only a bad price,” but the answer might sound too facile.

Only a few managers devoted the time and effort to analyzing these securities after the crisis.  As such, the story doesn’t travel so well.  Gundlach already has a lot of money to manage, and more money is flowing in, so he doesn’t have to care whether Morningstar truly understands what DoubleLine does or not.  He can be happy with a slower pace of asset growth, and the lack of accolades which might otherwise go to him…

But, one of the signs of being truly an expert is being able to explain it to lesser mortals.  It’s like this story of the famous physicist Richard Feynman:

Feynman was a truly great teacher. He prided himself on being able to devise ways to explain even the most profound ideas to beginning students. Once, I said to him, “Dick, explain to me, so that I can understand it, why spin one-half particles obey Fermi-Dirac statistics.” Sizing up his audience perfectly, Feynman said, “I’ll prepare a freshman lecture on it.” But he came back a few days later to say, “I couldn’t do it. I couldn’t reduce it to the freshman level. That means we don’t really understand it.”

Like it or not, the Morningstar folks have a job to do, and they will do it whether DoubleLine cooperates or not.  As in other situations in the business world, you have a choice.  You could task smart subordinates to spend adequate time teaching the Morningstar analyst your thought processes, or, live with the results of someone who fundamentally does not understand what you do.  (This applies to bosses as well.)

In the end, this may not matter to DoubleLine.  They have enough assets to manage, and then some.  But in the end, this could matter to Morningstar.  It says a lot if you can’t analyze one of the best funds out there.  That would mean you really don’t understand well the fixed income business as it is presently configured.  As such, I would say that it is incumbent on Morningstar to take the initiative, apologize to DoubleLine, and try to re-establish good communications.  If they don’t, the loss is Morningstar’s, and that of their subscribers.

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

Manufactured Housing Asset Back Securities — Mezzanine and Subordinated Certificates

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

[sigh]

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

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

What was my error?

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

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

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

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

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

Photo Credit: Matthias Ripp

Photo Credit: Matthias Ripp || Some bad ideas should be locked away…

Dan Primack of Fortune wrote in his daily email:

Saving unicorns from themselves? There was an interesting piece last week from Martin Peers in The Information (sub req), arguing that the private markets need some sort of shorting mechanism so that there is a check on unreasonable valuation inflation. It would make the market more efficient, Peers argues, even though implementation would require several structural changes (particularly to stock transfer rules). He writes:

“Private companies will probably resist the development of a short-selling market, given it would hurt valuations, which in turn can undermine the value of employee option programs, and give them less control over their shareholder group. But those risks are likely to be outweighed by the long term benefits of bringing more buyers into the market and ensuring the company’s valuation can be sustained outside of the constraints of the private market.”

Leaving out the technical difficulties — including the lack of ongoing price discovery — one big counter could be that shorts didn’t so much to stop the earlier dotcom bubble (which largely took place in the public markets).

Adam D’Augelli of True Ventures pointed me to a 2002 academic paper (Princeton/London Biz School) that found “hedge funds during the time of the technology bubble on the Nasdaq… were heavily tilted towards overpriced technology stocks.” They add that “arbitrageurs are concerned about attacking the bubble too early without support from their peers,” and that they’re more likely to ride the bubble until just a few months before the end.

That would seem to be too late to impose price discipline in private markets, but I’m curious in your thoughts. Does some sort of private shorting system make sense? And, if so, how would it be structured?

I’m going to take a stab at answering the final questions.  There is often a reason why the financial world is set up the way it is, and why truly helpful financial innovations are rare.  The answer is “no, we should not have any way of shorting private companies, and it is not a flaw in the system that we don’t have any easy way to do it.”

Two notes before I start: 1) I haven’t read the paper at The Information, because it is behind a paywall, but I don’t think I need to do so.  I think the answer is obvious.  2) I ran into this question answered at Quora.  The answers are pretty good in aggregate, but what exists here are my own thoughts to present the answer in what I hope is a simple manner.

What is required to have an effective means of shorting assets

  1. An asset must be capable of being easily transferred from one entity to another.
  2. Entities willing to lend the asset in exchange for some compensation over a given lending term.
  3. Entities willing to borrow the asset, put up collateral adequate to secure the asset, and then sell the asset to another entity.
  4. An entity or entities to oversee the transaction, provide custody of the collateral, transmit payments, assure return of the asset at the end of the lending term, and gauge the adequacy of collateral relative to the value of the asset.

Here’s the best diagram I saw on the internet to help describe it (credit to this Latvian website):

short selling

I’m leaving aside the concept of naked shorting, because there are a lot of bad implications to allowing a third party to create ownership interests in a firm, a power which is reserved for the firm itself.

The Troubles Associated with Shorting Private Assets

I can think of four troubles.  Here they are:

  1. The ability to sell, lend, or buy shares in a private company are limited by the private company.
  2. Lending over long terms with no continuous price mechanism to aid in the gradual adjustment of collateral could lead to losses for the lender if the borrower can’t put up additional capital.
  3. The asset lender can decide only to lend over lending terms that will likely be disadvantageous to the borrower.  Getting the asset returned at the end of the lending term could be problematic.
  4. It is difficult enough shorting relatively illiquid publicly traded assets.  Liquidity is required for any regular shorting to happen.

The first one is the killer.  There are no advantages to a private company to allow for the mechanisms needed to allow for shorting. That is one of the advantages of being private.  Information is not shared openly, and you can use the secrecy to aid your competitive edge.  Skeptical short-sellers would not be welcome.

The second problem is tough, because sometimes successive capital rounds are at considerably higher prices.  The borrower will likely not have enough slack assets to increase his collateral, and he will be forced to buy shares in the round to cover his short because of that.  The lender could find that the borrower cannot make good on the loan, and so the lender loses a portion of the value his ownership stake.

But imagining the first two problems away, problem three would still be significant.  If the term for lending were not all the way to the IPO, next capital round or dissolution/sale, at the end of the term, the borrower would have to look for someone to sell shares to him.  It is quite possible that no one would sell them at any reasonable price.  They know they have a forced buyer on their hands, and there could be informal collusion on the price of a sale.

Perhaps another way to put it is don’t play in a game where the other team has significant control over the rules of the game.  One of the reasons I say this is from my days of a bond manager.  There were a lot of games played in securities lending, and bonds are not the most liquid place to short assets.  I remember it being very difficult to get a bond back from an entity that borrowed it, and the custodian and trustee did not help much.  I also remember how we used to gauge the liquidity of bonds we lent out, and if one was particularly illiquid, we would always recall the bond before selling it, which would often make the price of the bond rise.  Games, games, games…

What Might Be Better

Perhaps using collateralized options or another type of derivative could allow bets to be taken, if the term extended all the way to the IPO, the next capital round, or dissolution/sale of the company.  The options would have to be limited to the posted collateral being the most the seller of the option could lose.  Some of the above four issues would still be in play at various points, but aside from issue one, this would minimize the troubles.

What Might Be Better Still

The value of the shorts is that they share information with the rest of the market that there is a bearish opinion on an asset.  Short-sellers are nice to have around, but not necessary for the asset pricing function.  It is not unreasonable to live with the problem that some assets will be overvalued in the intermediate-term, rather than set up a complex method to try to enable shorting.  As Ben Graham said:

“In the short run, the market is a voting machine but in the long run, it is a weighing machine.”

The weighing machine will do its job soon enough, showing that the overvalued asset will never produce free cash adequate to justify its current high price.  Is it a trouble to wait for that to happen?  If you don’t own it, you shouldn’t care much.

If you want to short it, I’m not sure that will hasten the price adjustment process that much, unless you can convince the existing owners of the asset that it isn’t worth even the current price.  Given that buyers have convinced themselves to own the asset, because they think it will be worth more in the future, intellectually, convincing them that it is worth less is a tough sell.

In the end, only asset and liability cash flows count, regardless of what secondary buyers and sellers do.  Secondary trading does not affect the value of assets, though it may affect the perception of value in the short run.  Thus, you don’t need short sellers to aid in setting secondary market prices, but they are an aid there.  In the primary markets, where whole companies are bought and sold, the perceived cash return is all that matters.

Conclusion

Ergo, live with short run overvaluation in private markets.  It is a high quality problem.  Sell overvalued assets if you own them.  Watch if you don’t own them.  Shorting, even if possible, is not worth the bother.

Media Credit: Bloomberg

Media Credit: Bloomberg

I get fascinated at how we never learn. Well, “never” is a little too strong because the following article from Bloomberg, Meet the 80-Year-Old Whiz Kid Reinventing the Corporate Bond had its share of skeptics, each of which had it right.

The basic idea is this: issue a corporate bond and then package it with a credit default swap [CDS] for the same corporate bond, with the swap cleared through a clearinghouse, which should have a AAA claims-paying ability.  Voila! You have created a AAA corporate bond.

Or have you?  Remember that bond X guaranteed by Y has many similarities to bond Y guaranteed by X, because both have to fail for there to be a default.  I used to help manage portfolios that had many different types of AAA bonds in them.  Some were natively AAA as governments, quasi-governments (really, Government Sponsored Enterprises) like Fannie and Freddie, or corporations.  Some were created by insurance guarantees from MBIA, Ambac, FGIC, or FSA.  Others were created via subordination, where the AAA portion took the losses only if they were greater than a highly stressed level.  Lesser lenders absorbed lesser losses in exchange for the ability to get a much greater yield if there was no default.

There is a lot of demand for AAA bonds if they have a high enough yield spread over Treasuries.  The amount of spread varies based on the structure, but greater complexity and greater credit risk tend to raise the spread needed.  Here are some simple examples: At one time, you could buy GE parent corporate bonds rated AAA, or GE Capital corporate bonds with an identical rating, but no guarantee from GE parent.  The GE Capital bonds always traded with more yield, even though the rating was identical.  AIG had a AAA credit rating, but its bonds frequently traded cheap to other AAA bonds because of the opacity of the financials of the firm (and among some bond managers, a growing sense that AIG had too much debt).

So how would one get a decent yield spread under this setup?  The CDS will have to require less spread to insure than the spread over Treasuries priced into the corporate bond.

How will that happen? Where does the willingness to accept the credit risk at a lower spread come from?  Note that the article doesn’t answer that question.  I will take a stab at an answer.  You could get a number of hedge funds trying to make money off of leveraging CDS for income, the excess demand forcing the CDS spread below that implied by the corporate bond.  Or, you could get a bid from synthetic Collateralized Debt Obligations [CDOs] demanding a lot of CDS for income.  I can’t think of too many other ways this could happen.

In either case, the CDS clearinghouse is dealing with weak counterparties in an event of default.  Portfolio margining should be capable of dealing with small negative scenarios like isolated defaults.  Where problems arise is when a lot of default and near defaults happen at once.  The article tells us what happens then:

ICE requires sellers of swaps to backstop their contracts with various margin accounts. If the seller fails to pay off, then ICE can tap a “waterfall” of margin funds to make the investor whole. In the event of a market crash, it can call on clearing members such as Citigroup and Goldman Sachs to pool their resources and fulfill swap contracts.

There’s still a danger that the banks themselves may be unable to muster cash in a crisis. But this shared responsibility marks a sea change from the bad old days when investors gambled their counterparties would make good on their contracts.

That shared responsibility is cold comfort.  Investment banks tend to be thinly capitalized, and even more so past the peak of a credit boom, when events like this happen.  Hello again, too big to fail.  Clearinghouses are not magic — they can fail also, and when they do, the negative effects will be huge.

Two more quotes from the article by those that “get it,” to reinforce my points:

The bond is a simple instrument with a debtor and creditor that’s proven its utility for centuries. The eBond inserts a third party into the transaction — the seller of the swap embedded in the security who now bears its credit risk.

Such machinations may be designed with good intentions, but they just further convolute the marketplace, says Turbeville, a former investment banker at Goldman Sachs.

“Why are we doing this? Is our society better off as a result of this innovation?” he asks. “You can’t destroy risk; you just move it around. I would argue that we have to reduce complexity and face the fact that it’s actually good for institutions to experience risks.”

and

“The way we make money for our clients is by assessing risk and generating risk-adjusted returns, and if you have a security that hedges that risk premium away, then why is it compelling? I would just buy Treasuries,” says Bonnie Baha, the head of global developed credit at DoubleLine Capital, a Los Angeles firm that manages about $56 billion in fixed-income assets. “This product sounds like a great idea in theory, but in practice it may be a solution in search of a problem.”

And, of course, fusing a security as straightforward as a bond with the notorious credit-default swap does ring a lot of alarms, says Phil Angelides, former chairman of the Financial Crisis Inquiry Commission, a blue-ribbon panel appointed by President Barack Obama in 2009 to conduct a postmortem on the causes of the subprime mortgage disaster. In September 2008, American International Group Inc. didn’t have the money to back the swaps it had sold guaranteeing billions of dollars’ worth of mortgage-backed securities. To prevent AIG’s failure from cascading through the global financial system, the U.S. Federal Reserve and the U.S. Treasury Department executed a $182 billion bailout of the insurer.

“When you look at this corporate eBond, it’s strikingly similar to what was done with mortgages,” says Angelides, a Democrat who was California state treasurer from 1999 to 2007. “Credit-default swaps were embedded in mortgage-backed securities with the idea that they’d be made safe. But the risk wasn’t insured; it was just shifted somewhere else.”

The article rambles at times, touching on unrelated issues like index funds, capital structure arbitrage, and alternative liquidity structures for bonds.  On its main point the article leave behind more questions than answers, and the two big ones are:

  • Should a sufficient number of these bonds get issued, what will happen in a very large credit crisis?
  • How will these bonds get issued?  When spreads are tight, no one will want to do these because of the cost of complexity.  When spreads are wide, who will have the capital to offer protection on CDS in exchange for income?

I’m not a fan of financial complexity.  Usually something goes wrong that the originators never imagined.  I may not have thought of what will go wrong here, but I’ve given you several avenues where this idea may go, so that you can avoid losing.

Photo Credit: Chris Piascik

Photo Credit: Chris Piascik

Most formal statements on financial risk are useless to their users. Why?

  • They are written in a language that average people and many regulators don’t speak.
  • They often don’t define what they are trying to avoid in any significant way.
  • They don’t give the time horizon(s) associated with their assessments.
  • They don’t consider the second-order behavior of parties that are managing assets in areas related to their areas.
  • They don’t consider whether history might be a poor guide for their estimates.
  • They don’t consider the conflicting interests and incentives of the parties that direct the asset managers, and how their own institutional risks affect their willingness to manage the risks that other parties deem important.
  • They are sometimes based off of a regulatory view of what can/must be stated, rather than an economic view of what should be stated.
  • Occasionally, approximations are used where better calculations could be used.  It’s amazing how long some calculations designed for the pencil and paper age hang on when we have computers.
  • Also, material contract provisions that are hard to model/explain often get ignored, or get some brief mention in a footnote (or its equivalent).
  • Where complex math is used, there is no simple language to explain the economic sense of it.
  • They are unwilling to consider how volatile financial processes are, believing that the Great Depression, the German Hyperinflation, or something as severe, could never happen again.

(An aside to readers; this was supposed to be a “little piece” when I started, but the more I wrote, the more I realized it would have to be more comprehensive.)

Let me start with a brief story.  I used to work as an officer of the Pension Division of Provident Mutual, which was the only place I ever worked where analysis of risks came first, and was core to everything else that we did.  The mathematical modeling that I did in there was some of the best in the industry for that era, and my models helped keep us out of trouble that many other firms fell into.  It shaped my view of how to manage a financial business to minimize risks first, and then make money.

But what made us proudest of our efforts was a 40-page document written in plain English that ran through the risks that we faced as a division of our company, and how we dealt with them.  The initial target audience was regulators analyzing the solvency of Provident Mutual, but we used it to demonstrate the quality of what we were doing to clients, wholesalers, internal auditors, rating agencies, credit analysts, and related parties inside Provident Mutual.  You can’t believe how many people came to us saying, “I get it.”  Regulators came to us, saying: “We’ve read hundreds of these; this is the first one that was easy to understand.”

The 40-pager was the brainchild of my boss, who was the most intuitive actuary that I have ever known.  Me? I was maybe the third lead investment risk modeler he had employed, and I learned more than I probably improved matters.

What we did was required by law, but the way we did it, and how we used it was not.  It combined the best of both rules and principles, going well beyond the minimum of what was required.  Rather than considering risk control to be something we did at the end to finagle credit analysts, regulators, etc., we took the economic core of the idea and made it the way we did business.

What I am saying in this piece is that the same ideas should be more actively and fully applied to:

  • Investment prospectuses and reports, and all investment and insurance marketing literature
  • Solvency documents provided to regulators, credit raters, and the general public by banks, insurers, derivative counterparties, etc.
  • Risk disclosures by financial companies, and perhaps non-financials as well, to the degree that financial markets affect their real results.
  • The reports that sell-side analysts write
  • The analyses that those that provide asset allocation advice put out
  • Consumer lending documents, in order to warn people what can happen to them if they aren’t careful
  • Private pension and employee benefit plans, and their evil twins that governments create.

Looks like this will be a mini-series at Aleph Blog, so stay tuned for part two, where I will begin going through what needs to be corrected, and then how it needs to be applied.

Photo Credit: S@Z

Photo Credit: S@Z

I’ve been busier than ever of late — not much time to blog. Thus, a few notes:

1) Often the rate of change in a price can tell you something, particularly if the good in question is widely traded/held by a wide number of parties with different interests.  In this case, I am talking about crude oil prices, and the related set of prices that are cousins.

Overall demand for crude hasn’t shifted, and neither has supply.  Yes, there has been some buildup of inventories, and some key global players refuse to cut production in response to lower prices.  But the sharpness of the price move feels more like some large player(s) who were relying on a higher oil price finally hit their “stop loss” point, and their risk control desk is closing out the trade.

I could be wrong here, but paper barrels of oil trade more rapidly than physical shifts in net demand, and risk control and margin desks will force moves that are non-economic.  Wait.  Surviving is economic, even at the cost of forgoing potential profits.

We’ll see how this shakes out over the next few months.  There’s a lot of pain for pure play producers, and those that aid them.  I particularly wonder at governments that rely on crude exports to support their budgets… they may not cut, but what will they do, if they don’t have reserves?  Cuts will have to come from economic players initially.  It make take a revolt to affect non-economic governmental entities.

All that said, sharp price moves tend to mean-revert, slow moves tend to persist, so be wary of too much bearishness here.

2) An article in yesterday’s Wall Street Journal was entitled Bond Funds Load Up on Cash.  This qualifies for the “Dog Bites Man” award, as it puts forth the conventional wisdom that interest rates must rise soon.

That drum has been banged so frequently that it is wearing out.  We’re not seeing the pickup in lending necessary to convince us that the economy needs higher real interest rates so that more savings would be available to be lent out.

Also, some managers may be running a barbell, holding more cash and long debt, and not so many intermediate securities.  This would be logical, because a barbelled portfolio does better in volatile markets — it’s ready for inflation and deflation, while giving up yield should times remain stable.

All for now.  Maybe when my busy time is done, I’ll write about it.

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Photo Credit: Ron

There’s a significant problem when you are a supremely big and connected financial institution: your failure will have an impact on the financial system as a whole.  Further, there is no one big enough to rescue you unless we drag out the public credit via the US Treasury, or its dedicated commercial paper financing facility, the Federal Reserve.  You are Too Big To Fail [TBTF].

Thus, even if you don’t fit into ordinary categories of systematic risk, like a bank, the government is not going to sit around and let you “gum up” the financial system while everyone else waits for you to disburse funds that others need to pay their liabilities.  They will take action; they may not take the best action of letting the holding company fail while bailing out only the connected and/or regulated subsidiaries, but they will take action and do a bailout.

In such a time, it does no good to say, “Just give us time.  This is a liquidity problem; this is not a solvency problem.”  Sorry, when you are big during a systemic crisis, liquidity problems are solvency problems, because there is no one willing to take on a large “grab bag” of illiquid asset and liquid liabilities without the Federal Government being willing to backstop the deal, at least implicitly.  The cost of capital in a financial crisis is exceptionally high as a result — if the taxpayers are seeing their credit be used for semi-private purposes, they had better receive a very high penalty rate for the financing.

That’s why I don’t have much sympathy for M. R. Greenberg’s lawsuit regarding the bailout of AIG.  If anything, the terms of the bailout were too soft, getting revised down once, and allowing tax breaks that other companies were not allowed.  Without the tax breaks and with the unamended bailout terms, the bailout was not profitable, given the high cost of capital during the crisis.  Further, though AIG Financial products was the main reason for the bailout, AIG’s domestic life subsidiaries were all insolvent, as were their mortgage insurers, and perhaps a few other smaller subsidiaries as well.  This was no small mess, and Greenberg is dreaming if he thought he could put together financing adequate to keep AIG afloat in the midst of the crisis.

Buffett was asked to bail out AIG, and he wouldn’t touch it.  Running a large insurer, he knew the complexity of AIG.  Having run off much of the book of Gen Re Financial Products, he knew what a mess could be lurking in AIG Financial Products.  He also likely knew that AIG’s P&C reserves were understated.

For more on this, look at my book review of The AIG Story, the book that tells Greenberg’s side of the story.

To close: it’s easy to discount the crisis after it has passed, and look at the now-solvent AIG as if it were a simple thing for them to be solvent through the crisis.  It was no simple thing, because only the government could have provided the credit, amid a cascade of failures.  (That the failures were in turn partially caused by bad government policies was another issue, but worthy to remember as well.)

Spot the failure

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Jason Zweig at the Wall Street Journal had a very good piece on whether to follow Bill Gross as he goes from Pimco to Janus.  Let me quote one paragraph:

Morningstar estimates that over the past five years, the average investor fell behind Pimco Total Return’s 5.6% annual gain by 1.6 points a year—largely as a result of buying high and selling low. That gap is among the widest of any large bond fund; at the Vanguard Total Bond Market Index Fund, for example, investors have earned returns only 0.4 point lower than those of the portfolio itself.

In the short run, this offers a reason to follow Bill Gross to Janus.  He is starting with a clean slate, and will be able to implement positions that seem attractive to him that would not have been attractive at Pimco because they would have been too small.  Managing less money lets Bill Gross be more choosy.

Second, in the short run, growth in bond assets at Janus will temporarily push up the prices of bonds held by Janus.  Those that get in early would benefit from that if bond assets grow under the management of Bill Gross.  Just keep your eye on when assets stop growing if you are buying for that speculative reason.

A third potential reason to follow Gross depends on how much Pimco continues to use his quantitative strategies.  If Pimco abandons them (unlikely, but not impossible), Janus would get the chance to use them on much less money, which would make the excess returns greater.  If I were considering this as a reason, I would watch the turnover in Pimco’s main funds, and see if certain classes of assets disappear.

My last point here is that the abilities of Bill Gross will do better managing less money, but the effect won’t be so great if he is competing with Pimco to implement the same strategies.  At minimum, he’s not likely to do worse than at Pimco, and in the short-run, there are some reasons why he will likely do better.

PS — please remember that Bill Gross has two hats: the showman and the quant.  The quant makes money for clients while the showman entertains them.  The showman opines about the Fed, politics, etc.  That can get investors interested because it sounds clever, but that is not how Bill Gross makes money.

This brings up one more point.  If you do decide to invest with him at Janus, review the prospectus to see what degree of flexibility with derivatives Gross will have.  If it similar to what he had at Pimco, he is likely following the same strategy.

Photo Credit: Matt Cavanagh

Photo Credit: Matt Cavanagh

There is a saying in the markets that volatility is not risk. In general this is true, and helps to explain why measures like beta and standard deviation of returns do not measure risk, and are not priced by the market. After all, risk is the probability of losing money, and the severity thereof.

It’s not all that different from the way that insurance underwriters think of risk, or any rational businessman for that matter. But just to keep things interesting, I’d like to give you one place where volatility is risk.

When overall economic conditions are serene, many people draw the conclusion that it will stay that way for a long time. That’s a mistake, but that’s human nature. As a result, those concluding that economic conditions will remain serene for a long time decide to take advantage of the situation and borrow money.

When volatility is low, typically credit spreads are low. Why not take advantage of cheap capital? Well, I would simply argue that interest rates are for a time, and if you don’t overdo it, paying interest can be managed. But what happens if you have to refinance the principal of the loan at an inopportune time?

When volatility and interest spreads are low for you, they are low for a lot of other people also. Debt builds up not just for you, but for society as a whole. This can have the impact of pushing up prices of the assets purchased using debt. In some cases, the rising asset prices can attract momentum buyers who also borrow money in order to own the rising assets.

This game can continue until the economic yield of the assets is less than the yield on the debt used to finance the assets. Asset bubbles reach their breaking point when people have to feed cash to the asset beyond the ordinary financing cost in order to hold onto it.

In a situation like this, volatility becomes risk. Too many people have entered into too many fixed commitments and paid too much for a group of assets. This is one reason why debt crises seem to appear out of the blue. The group of assets with too much debt looks like they are in good shape if one views it through the rearview mirror. The loan-to-value ratios on recent loans based on current asset values look healthy.

But with little volatility in some subsegment of the overly levered assets, all of a sudden a small group of the assets gets their solvency called into question. Because of the increasing level of cash flows necessary to service the debt relative to the economic yield on the assets, it doesn’t take much fluctuation to make the most marginal borrowers question whether they can hold onto the assets.

Using an example from the recent financial crisis, you might recall how many economists, Fed governors, etc. commented on how subprime lending was a trivial part of the market, was well-contained, and did not need to be worried about. Indeed, if subprime mortgages were the only weak financing in the market, it would’ve been self-contained. But many people borrowed too much chasing inflated values of residential housing.  As asset values fell, more and more people lost willingness to pay for the depreciating assets.

We’ve had other situations like this in our markets. Here are some examples:

  • Commercial mortgage loans went through a similar set of issues in the late 80s.
  • Lending to lesser developed countries went through similar set of issues in the early 80s.
  • The collateralized debt obligation markets seem to have their little panics every now and then. (late 90s, early 2000s, mid 2000s, late 2000s)
  • During the dot-com bubble, too much trade finance was extended to marginal companies that were burning cash rapidly.
  • The roaring 20s were that way in part due to increased debt finance for corporations and individuals.

At the peak some say, “Nobody rings a bell.” This is true. But think of the market peak as being like the place where the avalanche happened 10 minutes before it happened. What set off the avalanche? Was it the little kid at the bottom of the valley who decided to yodel? Maybe, but the result was disproportionate to the final cause. The far more amazing thing was the development of the snow into the configuration that could allow for the avalanche.

This is the way things are in a heavily indebted financial system. At its end, it is unstable, and at its initial unwinding the proximate cause of trouble seems incapable of doing much harm. But to give you another analogy ask yourself this: what is more amazing, the kid who knocks over the first domino, or the team of people spending all day lining up the huge field of dominoes? It is the latter, and so it is amazing to watch large groups of people engaging in synchronized speculation not realizing that they are heading for a significant disaster.

As for today, I don’t see the same debt buildup has we had growing from 2003 to 2007. The exceptions maybe student loans, parts of the energy sector, parts of the financial sector, and governments. That doesn’t mean that there is a debt crisis forming, but it does mean we should keep our eyes open.

The dirty truth is that some investments in this life are sold, and not bought.  The prime reason for this is that many people are not willing to learn enough to save and invest on their own.  Instead, they rely on others to corral them and say, “You ought to be saving and investing.  Hey, I’ve got just the thing for you!”

That thing could be:

  • Life Insurance
  • Annuities
  • Front-end loaded mutual funds
  • Illiquid securities like Private REITs, LPs, some Structured Notes
  • Etc.

Perhaps the minimal effort necessary to avoid this is to seek out a fee-only financial planner, and ask him to set up a plan for you.  Problem solved, unless…

Unless the amount you have is so small that when look at the size of the financial planner’s fee, you say, “That doesn’t work for me.”

But if you won’t do it yourself, and you can’t find something affordable, then the only one that will help you (in his own way) is a commissioned salesman.

Now, to generate any significant commission off of a financial product, there have to be two factors in place: 1) the product must be long duration, and 2) it must be illiquid.  By illiquid, I mean that either you can’t easily trade it, or there is some surrender charge that gets taken out if the contract is cashed out early.

The long duration of the contract allows the issuer of the contract the ability to take a portion of its gross margins over life of the contract, and pay a large one-time commission to the salesman.  The issuer takes no loss as it pays the commission, because they spread the acquisition cost over the life of the contract.  The issuer can do it because it has set up ways of recovering the acquisition cost in almost all circumstances.

Now in some cases, the statements that the investor will get will explicitly reveal the commission, but that is rare.  Nonetheless, to the extent that it is required, the first statement will reveal how much the contractholder would lose if he tries to cash out early.  (I think this happens most of the time now, but it would not surprise me to find some contract where that does not apply.)

Now the product may or may not be what the person buying it needed, but that’s what he gets for not taking control of his own finances.  I don’t begrudge the salesman his commission, but I do want to encourage readers to put their own best interests first and either:

  • Learn enough so that you can take care of your own finances, or
  • Hire a fee-only planner to build a financial plan for you.

That will immunize you from financial salesmen, unless you eventually become rich enough to use life insurance, trusts, and other instruments to limit your taxation in life and death.

Now, I left out one thing — there are still brokers out there that make their money through lots of smallish commissions by trading a brokerage account of yours aggressively, or try to sell you some of the above products.  Avoid them, and let your fee-only planner set up a portfolio of low cost ETFs for you.  It’s not sexy, but it will do better than aggressive trading.  After all, you don’t make money while you trade; you make it while you wait.

If you don’t have a fee only planner and still want to index — use half SPY and half AGG, and add funds periodically to keep the positions equal sized.  It will never be the best portfolio, but over time it will do better than the average account.

One final note before I go: with insurance, if you want to keep your costs down, keep your products simple — use term insurance for protection, and simple deferred annuities for saving (though I would buy a bond ETF rather than insurance in most cases).  Commissions go up with product complexity, and so do expenses.  Simple products are easy to compare, so that you know that you are getting the best deal.  Unless you are wealthy, and are trying to achieve tax savings via the complexity, opt for simple insurance products that will cover basic needs.  (Also avoid product riders — they are really expensive, even though the additional premiums are low, the likely benefits paid are lower still.)