A: How are you doing? Are you here for more enlightening banter?

Q: Not so well.  Have you heard of the Third Avenue Focused Credit Fund [TFCIX]?

A: Uh, the one that is in the news?

Q: Come on.

A: Yes, I know about it, but not much more than I have recently read.  Of all of Third Avenue’s Funds I know it least well.

Q: Weren’t you a bond manager who liked to take concentrated positions though?  You should be able to say something about this mess.

A: I dealt mainly with investment grade credit.  What’s more, I had a real balance sheet behind me at the life insurance company.  An ordinary open-end mutual fund has investors that can leave whenever they want — often at the worst possible time for them, or in this case, those that could not get out.

The main difference was that I could never be forced to sell, under most conditions.  I could buy and hold, and if the eventual credit of the borrower was good, my client would receive all that he expected.  TFCIX faced significant redemptions, and increasingly had mostly bonds that could not be quickly sold, and thus, were difficult to value.  That’s why they cut off redemptions — they couldn’t liquidate assets to give cash to customers on a favorable basis.  Personally, I think setting up the liquidation trust was the best that could be done.  That will allow Third Avenue to negotiate with interested buyers of the bonds without being rushed by redemptions.  The remaining fundholders should be grateful for them doing this now, though it would have been better to act sooner.

Q: But I own shares in TFCIX and need the money now.  What can I do?

A: Oh, my.  My sympathies.  You can’t do much.  There might be some off the beaten track lenders out there that might take it off your hands, but they wear “panky rangs,” as a mortgage borrower once said to me.

Q: Panky Rangs?

A: Pinky rings.  He was from the deep South.  I.e., no one is going to give you a decent bid for your shares, even if you could find someone willing to do so.  First, the value of the bonds is questionable, and the timing of the sales are uncertain.

In some ways, this reminds me a little of The London Whale incident.

Q: How is that relevant?

A: JP Morgan became too great of a part of the indexed credit derivatives market, and as a result, they lost the ability to value their positions, because they were too big relative to the market in which they traded.  Their very buying and selling had a huge impact on the pricing.  Though a value was placed on the positions, the entire situation was impossible to value accurately;  you couldn’t assemble a group to buy it all.

Some clever hedge funds took note of it, and began taking the opposite positions, thinking that they were overvalued, and fed JP Morgan more of what it was already bloated with.  Now maybe, if there hadn’t been so much press furor over it, together with the accounting questions that affected the financials of JP Morgan, they could have found a way out.  JP Morgan’s balance sheet was big enough, and if you left them alone, they would have all self -liquidated.  They might not have made the money they wanted that way, but it could have been done.  As it was, they were forced to liquidate more rapidly, and if I recall, they even called upon one of the opposing hedge funds to help them.

In any case, the forced liquidation led to losses.  Most forced liquidations do.

Q: So, what do think my shares are worth?

A: They are worth the liquidating distributions that you will receive.

Q: That’s no help.

A: Is the Federal Reserve willing to step up and buy the assets as they did with the Maiden Lane Trusts?  No one has a bigger balance sheet than they do, oh, oops.  Maybe they can’t do that anymore… who know where those emergency lending rules go…

Look, I’m sorry that you are stuck.  The Madoff “investors” were stuck also.  They had to wait quite a while.  In the end, they got paid more than most imagined they ever would.  Subject to credit conditions, I would suspect that the more time Third Avenue takes to liquidate, the more you will get.

Q: But that’s dribs and drabs over time, and I need it now.

A: Patience is a virtue.  Make other adjustments; sell something else; scale back plans… it’s no different than most people have to do when they have a loss.  It happens.

Q: I guess… but it would help to know what it was worth, so that I could estimate tradeoffs.

A: yes, it would, but the timing and amount of liquidations are uncertain, and the “market prices” don’t really exist for the underlying — they are too influenced by Third Avenue’s holdings.

Maybe they could have converted it into a closed-end fund,  but that would have cost money, and there still would have been the valuation issue.  People could have gotten paid now if that had happened, but I bet they would have blanched at the size of the unrealized losses.  I would just accept the payments as they come, that will probably give the best return, subject to future credit conditions.

Q: Do we have to modify your statement was true when we first started this discussion:

Q: What is an asset worth?

A: An asset is worth whatever the highest bidder will pay for it at the time you offer it for sale.

After all, if it is worth the liquidating distributions if I wait, maybe you should add, “or the cash flows you receive over time.”

A: I will do that, and that is part of what I have been arguing for here, but the price here and now is not that.  Just because you can’t sell it now doesn’t mean it doesn’t have value… we just don’t know what that value is.

Anyway, lunch is on me today, because there is another thing that you can’t sell that has value.

Q: What’s that?

A: Me.  A friend.

Q: Let’s go…

 

Photo Credit: Baynham Goredema || When things are crowded, how much freedom to move do you have?

Photo Credit: Baynham Goredema || When things are crowded, how much freedom to move do you have?

Stock diversification is overrated.

Alternatives are more overrated.

High quality bonds are underrated.

This post was triggered by a guy from the UK who sent me an infographic on reducing risk that I thought was mediocre at best.  First, I don’t like infographics or video.  I want to learn things quickly.  Give me well-written text to read.  A picture is worth maybe fifty words, not a thousand, when it comes to business writing, perhaps excluding some well-designed graphs.

Here’s the problem.  Do you want to reduce the volatility of your asset portfolio?  I have the solution for you.  Buy bonds and hold some cash.

And some say to me, “Wait, I want my money to work hard.  Can’t you find investments that offer a higher return that diversify my portfolio of stocks and other risky assets?”  In a word the answer is “no,” though some will tell you otherwise.

Now once upon a time, in ancient times, prior to the Nixon Era, no one hedged, and no one looked for alternative investments.  Those buying stocks stuck to well-financed “blue chip” companies.

Some clever people realized that they could take risk in other areas, and so they broadened their stock exposure to include:

  • Growth stocks
  • Midcap stocks (value & growth)
  • Small cap stocks (value & growth)
  • REITs and other income passthrough vehicles (BDCs, Royalty Trusts, MLPs, etc.)
  • Developed International stocks (of all kinds)
  • Emerging Market stocks
  • Frontier Market stocks
  • And more…

And initially, it worked.  There was significant diversification until… the new asset subclasses were crowded with institutional money seeking the same things as the original diversifiers.

Now, was there no diversification left?  Not much.  The diversification from investor behavior is largely gone (the liability side of correlation).  Different sectors of the global economy don’t move in perfect lockstep, so natively the return drivers of the assets are 60-90% correlated (the asset side of correlation, think of how the cost of capital moves in a correlated way across companies).  Yes, there are a few nooks and crannies that are neglected, like Russia and Brazil, industries that are deeply out of favor like gold, oil E&P, coal, mining, etc., but you have to hold your nose and take reputational risk to buy them.  How many institutional investors want to take a 25% chance of losing a lot of clients by failing unconventionally?

Why do I hear crickets?  Hmm…

Well, the game wasn’t up yet, and those that pursued diversification pursued alternatives, and they bought:

  • Timberland
  • Real Estate
  • Private Equity
  • Collateralized debt obligations of many flavors
  • Junk bonds
  • Distressed Debt
  • Merger Arbitrage
  • Convertible Arbitrage
  • Other types of arbitrage
  • Commodities
  • Off-the-beaten track bonds and derivatives, both long and short
  • And more… one that stunned me during the last bubble was leverage nonprime commercial paper.

Well guess what?  Much the same thing happened here as happened with non-“blue chip” stocks.  Initially, it worked.  There was significant diversification until… the new asset subclasses were crowded with institutional money seeking the same things as the original diversifiers.

Now, was there no diversification left?  Some, but less.  Not everyone was willing to do all of these.  The diversification from investor behavior was reduced (the liability side of correlation).  These don’t move in perfect lockstep, so natively the return drivers of the risky components of the assets are 60-90% correlated over the long run (the asset side of correlation, think of how the cost of capital moves in a correlated way across companies).  Yes, there are some that are neglected, but you have to hold your nose and take reputational risk to buy them, or sell them short.  Many of those blew up last time.  How many institutional investors want to take a 25% chance of losing a lot of clients by failing unconventionally?

Why do I hear crickets again?  Hmm…

That’s why I don’t think there is a lot to do anymore in diversifying risky assets beyond a certain point.  Spread your exposures, and do it intelligently, such that the eggs are in baskets are different as they can be, without neglecting the effort to buy attractive assets.

But beyond that, hold dry powder.  Think of cash, which doesn’t earn much or lose much.  Think of some longer high quality bonds that do well when things are bad, like long treasuries.

Remember, the reward for taking business risk in general varies over time.  Rewards are relatively thin now, valuations are somewhere in the 9th decile (80-90%).  This isn’t a call to go nuts and sell all of your risky asset positions.  That requires more knowledge than I will ever have.  But it does mean having some dry powder.  The amount is up to you as you evaluate your time horizon and your opportunities.  Choose wisely.  As for me, about 20-30% of my total assets are safe, but I have been a risk-taker most of my life.  Again, choose wisely.

PS — if the low volatility anomaly weren’t overfished, along with other aspects of factor investing (Smart Beta!) those might also offer some diversification.  You will have to wait for those ideas to be forgotten.  Wait to see a few fund closures, and a severe reduction in AUM for the leaders…

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Conclusion?

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

Be ready, and take some risk off the table.

Before I start on this tonight, let me say that I never begrudge any salesman a fair commission.  When I was a bond manager, I made a point of never letting my brokers “cross bonds” to me, i.e., at no commission.  I would raise my purchase price a little to compensate them.  Had my client known that I did that, he might have objected, but it was in his best interests that I did it.  As a result of that and other things that I did, my brokers were very loyal to me, and worked to give my client excellent executions whether buying or selling.  They were also more frank with me about bonds they thought I should sell.  Fairness begets fairness under most conditions, and suspicion and tightness also have their way of breeding as well.  Consider that in all of your dealings.

My main reason for writing tonight is to remind investors to think about how the parties you transact with are compensated.

  • If they are compensated on transactions, expect to see a lot of buying and selling.
  • If they are compensated on asset-based fees, expect them to try to get business, and then retain it.
  • If they are compensated on profits, they will try to get profits.  Be wary of how much control they might have over the accounting, they will be incented to be liberal if they have any control.  They will also be incented toward volatility, because volatile assets offer the best possibility of a big score, even if the probability is moderate at best.

The greater the potential compensation, the greater the tendency to act along the incentives offered.  As a result, if a life insurance salesman has a product offering a high commission, and one offering a low commission, he may act in the following way:

  • Figure out if you are price-sensitive or not.
  • Figure out if you are willing to accept a product that has a long surrender charge.  Long surrender charges lock in business, and allow for high commissions to be paid.
  • Also analyze how much complexity you are willing to accept — more complex permanent policies and especially ancillary riders are far more profitable because even external actuaries would have a tough time analyzing them.
  • If you are price-sensitive, bring out the low commission policy that is more competitive.
  • If you are price-insensitive, bring out the high commission policy that is less competitive.

(Note: there are state laws in every state that constrain this behavior for life insurance agents, but it can never be eliminated in entire.)

Now, many agents will act in your interests in spite of their own interests, but some won’t, so be aware.  Always ask a question like, “This seems expensive.  Don’t you have another policy that is less expensive that accomplishes only the main goal that I am shooting for?”

You could always ask them what commission is that they will earn.  Most won’t answer that.  First, it’s kind of offensive, and second, they will argue that it is not material to your decision.

But it is material to your decision.  Here’s why:

  • The size of the commission directly affects the size of the premium that you pay.
  • It also directly affects the length and size of the surrender charge that you would pay if you terminate the policy early.
  • After all, the actuaries or other mathematical businessmen are trying to avoid the risk of paying a commission that they can’t recover under ALL circumstances.  They will get their fees from you to recoup the commission cost.  They will either get it from you coming or going, but they WILL get it from you, at least on average.

If the salesmen disagree with you after mentioning this (or showing them this), you can say to them that every actuary knows this is true, don’t argue with the actuaries, they know the math.  (And its why we tend to buy term and other simple policies.  Shhh.)

I’ve seen more than my share of ugly products in my time.  I’m happy I never designed any.  I did kill a few of them.  That said, one of the most unpleasant duties I ever had as a life actuary was about 18 years ago when I inherited a department to clean up, and I got the responsibility of talking to the clients that were the most irate, demanding to talk to the man in charge.  I never created those products, but I was nominally in charge of the division as I cleaned up the pricing, reinsurance, reserving, accounting, and asset-liability management.

I’ll tell you, it is no fun talking to people who conclude that they have been had.  It is even less fun to be the one who has been had.  Thus I would tell you to view all salesmen of financial with skepticism.  It is hard to assure a good result with intangible products that are hard to compare.  Thus aim for simplicity and lower surrender charge and commission products.

Now, I used life insurance as my example here because I know it best, and it excels in complexity.  But this applies to all financial products, especially illiquid ones.  Be wary of:

  • Brokers who make money off of commissions
  • Those who sell private REITs and structured notes
  • Any product where you have a limited ability to liquidate or sell it.
  • Any product that you can’t understand how the company and salesman are making money off it.
  • Any product where you can’t understand what the legal form of the investment is (Stock, bond, mutual fund, partnership, derivative, insurance, etc.)

Here are some final bits of advice:

  • Look for advisers who are fiduciaries, and are responsible to look out for your interests (but still be wary)
  • Look at the fee structures, and look for lower cost alternatives.
  • Seek competing products, salesmen and companies.
  • Negotiate lower compensation where possible.
  • Remember that higher yields are almost never free… what yields more typically has more risk.  Yield is the oldest scam in the books.

Remember, regardless of what laws exist, you are your own best defender when it comes to your own economic interests.  Be aware of the economic incentives of those who seek your business with financial products, and be reasonably skeptical.

 

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Summary

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

Photo Credit: Kevin Dooley || At the Ice Museum, ALL of the assets are frozen!

Photo Credit: Kevin Dooley || At the Ice Museum, ALL of the assets are frozen!

This article is another experiment. Please bear with me.

Q: What is an asset worth?

A: An asset is worth whatever the highest bidder will pay for it at the time you offer it for sale.

Q: Come on, the value of an asset must be more enduring than that.  You look at the balance sheets of corporations, and they don’t list their assets at sales prices.

A: That’s for a different purpose.  We can’t get the prices of all assets to trade frequently.  The economic world isn’t only about trading, it is about building objects, offering services… and really, it is about making people happier through service.  Because the assets don’t trade regularly, they are entered onto the balance sheet at:

  • Cost, which is sometimes adjusted for cost and other things that are time-related, and subject to writedowns.
  • The value of the asset at its most recent sale date before the date of the statement
  • An estimated value calculated from sales of assets like it, meant to reflect the likely markets at the time of the statement — what might the price be in a deal between and un-coerced buyer and seller?

Anyway, values in financial statements are only indicative of aspects of value.  Few investors use them in detail.  Even value investors who use the detailed balance sheet values in their investment decisions make extensive adjustments to them to try to make them more realistic.  Other value investors look at where the prices of similar companies that went private to try to estimate the value of public equities.

Certainly the same thing goes on with real estate.  Realtors and appraisers come up with values of comparable properties, and make adjustments to try to estimate the value of the property in question.  Much as realtors don’t like Zillow, it does the same thing just with a huge econometric model that factors in as much information as they have regarding the likely prices of residential real estate given the prices of the sparse number of sales that they have to work from.

Financial institutions regularly have to estimate values for variety of illiquid assets in a similar way.  I’ve even been known to help with those efforts on occasion, though management teams have not always been grateful for that.

Q: What if it’s a bad day when I offer my asset for sale?  Is my asset worth less simply because of transitory conditions?

A: Do you have to sell your asset that day or not?

Q: Why does that matter?

A: If you don’t need the money immediately, you could wait.  You also don’t have to auction the asset if you think that hiring an expert come in and talk with a variety of motivated buyers could result in a better price after commissions.  There are no guarantees of a better result there though.

The same problem exists on the stock market.  If you want the the money now, issue a market order to sell the security, and you will get something close to the best price at that moment.  That said, I never use market orders.

Q: Why don’t you use market orders?

A: I don’t want to be left at the mercy of those trading rapidly in the markets.  I would rather set out a price that I think someone will transact at, and adjust it if need be.  Nothing is guaranteed — a trade might not get done.  But I won’t get caught in a “flash crash” type of scenario, or most other types of minor market manipulation.

Patience is a virtue in buying and selling, as is the option of walking away.  If you seem to be a forced seller, buyers will lower their bids if you seem to be desperate.  You may not notice this in liquid stocks, but in illiquid stocks and other illiquid assets, this is definitely a factor.

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That’s all for now.  If anyone has any ideas on if, where, or how I should continue this piece, let me know in the comments, or send me an e-mail.  Thanks for reading.

 

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This is a story of triumph and tragedy.  Jesse Livermore is notable as one of the few people who ever made it into the richest tiers of society by speculating — by trading stocks and commodities — betting on price movements.

This is three stories in one.  Story one is the clever trader with an intuitive knack who learned to adapt when conditions changed, until the day came when it got too hard.  Story two is the man who lacked financial risk control, and took big chances, a few of which worked out spectacularly, and a few of ruined him financially.  Story three is how too much success, if not properly handled, can ruin a man, with lust, greed and pride leading to his death.

The author spends most of his time on story one, next most on story two, then the least on story three.  The three stories flow naturally from the narrative that is largely chronological.  By the end of the book, you see Jesse Livermore — a guy who did amazing things, but ultimately failed in money and life.

Let me briefly summarize those three aspects of his life so that you can get a feel for what you will run into in the book:

The Clever Trader

Jesse Livermore came to the stock market in Boston at age 14, and was a very quick study.  He showed intuition on market affairs that impressed the most of the older men who came to trade at the brokerage where he worked.  It wasn’t too long before he wanted to invest for himself, but he didn’t have enough money to open a brokerage account, so he went to a bucket shop.  Bucket shops were gambling parlors where small players gambled on stock prices.  He showed a knack for the game and made a lot of money.  Like someone who beats the casinos in Vegas, the proprietors forced him to leave.

He then had more than enough money to meet his current needs, and set up a brokerage account.  But the stock market did not behave like a bucket shop, and so he lost money while he learned to adapt.  Eventually, he succeeded at speculating on both stocks and commodities, leading to his greatest successes in being short the stock market prior to the panic of 1907, and the crash in 1929.  During the 1920s, he started his own firm to try to institutionalize his gifts, and it worked for much of the era.

After the crash in 1929, the creation of the SEC and all the associated laws and regulations made speculating a lot more difficult, to the point where he could not make significant money speculating anymore.

The Poor Financial Risk Manager

Amid the successes, he tended to aim for greater wins after his largest successes, which led to him losing much of what he had previously made.  One time he was cheated out of much of what he had while trading cotton.

Amid all of that, he was well-liked by most he interacted with in a business context.  Even after great losses, many wanted him to succeed again, and so they bankrolled him after failure.  Before the Great Depression, he did not disappoint them — he succeeded in speculation and came roaring back, repaying all of his past debts with interest.

In one sense, it was live by the big speculation, and die by the big speculation.  When you play with so much borrowed money, it’s hard for results to not be volatile.

A Rock Star of His Era

When he won big, he lived big.  Compared to many wealthy people of his era, he let spending expand far more than many who had  more reliable sources of income.  Where did the money go?  Yachts, homes, staff, wives, women, women, women…  Aside from the last of his three wives, his marriages were troubled.

His last wife was a nice woman who was independently wealthy, and after Livermore lost it all in the mid-’30s, he increasingly relied on her to stay afloat.  When he could no longer be the hero who could win a good living out of the market via speculation, his deflated pride led him to commit suicide in 1940.

A Sad Book Amid Amazing Successes

Sadly, his son and grandson who shared his name committed suicide in 1975 and 2006, respectively.  On the whole, the story of Jesse Livermore’s life and legacy is a sad one.  It should disabuse people of the notion that wealth brings happiness.  If anything, it teaches that money that comes too easily tends to get lost easily also.

The author does a good job weaving the strands of his life into a consistent whole.  The book is well-written, and probably the best book out there on the life of the famous speculator that so many present speculators admire.  A side benefit is that in passing, you will learn a lot about the development of the markets during a time when they were less regulated.  (The volatility of markets was obvious then.  It not obvious now, which is why people get surprised by it when it explodes.)

Quibbles

None.

Summary / Who Would Benefit from this Book

This is a comprehensive book that explains the life and times of Jesse Livermore, one of the greatest speculators in history.  It will teach you history, but it won’t teach you how to speculate.  If you want to buy it, you can buy it here: Jesse Livermore – Boy Plunger: The Man Who Sold America Short in 1929.

Full disclosure: I received a copy from a kind PR flack.

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

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

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

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

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

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

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

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

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

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

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

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.