Category: The Rules

The Rules, Part VIII

The Rules, Part VIII

Posted on by David Merkel

Illiquidity is a function of total transaction costs, which can be considered barriers to entry. (and exit…)

Not everything can be liquid; not everything should be liquid; not everything will be liquid.

I ran into the concept of complete markets for the first time while taking a graduate level economics of risk class at UC-Davis.? Lots of time spent on the Arrow-Debreu model. Quoting:

The Arrow?Debreu model applies to economies with maximally complete markets, in which there exists a market for every time period and forward prices for every commodity at all time periods and in all places[citation needed].

But as with many other economic models, the assumptions are unrealistic aside from some special cases like widely traded options and commodities markets.? For markets that are by necessity thin (which in the Arrow-Debreu sense as I read it is most markets) examples being buying or selling a certain house, an obscure bond, or offering/receiving credit default on a thin slice of a securitization, there is no way that complete markets could exist.

It takes effort to make a market in any commodity/security.? You have to know something about the commodity/security, and know about the buyers and sellers.? What motivates them?? What is their “bite size? (what their normal position size is)”? When should I be concerned that some market player knows something that I don’t?? How much can I bid and offer under normal conditions, and at how tight of a bid-ask spread?? How much must I offer under stressed conditions, and how wide of a bid-ask spread will the market players tolerate?

It costs money to make a market, and so, market-makers conserve on making markets, and only offer deep markets on widely traded instruments.? The same is true for markets that offer delivery at different times and places.? Things that many people want, over long periods of time, that are highly standardized, can develop into broad futures and options markets.

But what lends to illiquidity?

  • Specialness implies lack of information.? An obscure fixed income security might have a very high yield compared to its rating and likely maturity.? The costs of research, and the efforts that must be expended in bargaining drive many players away from unusual securities.
  • An asset subclass can be new, and there are few transacting in it.? That is another version of the former problem.
  • A security might be fungible but illiquid because of a large number of legal steps one has to go through in order to move the security.? Examples would include selling loans on the balance sheet, or selling real estate supported by tax credit, or credit tenant leases.
  • Lack of information can also relate to the size of the asset in question.? Big players with large research staffs focus on large and maybe mid-cap assets.? But few of size focus on micro-caps, they could not put enough money to work.

Now, when I was a bond manager, because my client had a large amount of long noncallable liabilities, I bought less liquid debts when I received adequate compensation to do so, but not more than my client’s balance sheet could tolerate.? That allowed me to make better money for my client, but without increasing risk.? Hey, use the advantages that you have.

But remember, even if you understand the illiquid security perfectly well, but you don’t understand your own liquidity situation, you might find yourself in a situation where you have to sell, but few others understand the security, and no good bids are offered.

I would add that even in liquid markets, there are large order sizes that render markets illiquid, at least for a time.? Having owned 10, 20, 30% (even 80% ugh) of a given bond issue, I knew that I could only accumulate and decumulate in dribs and drabs, and contented myself with being a pseudo market maker, who could buy if the price was attractive, hold under all conditions, and sell if a loony buyer or buyers showed up.

Phrasing it differently: we only hold illiquid assets, or illiquid amounts of assets when we know a lot more than the market.? We have paid the barrier to entry, and are the heavy hitter now.? We make money off of superior knowledge, though illiquidity means that trades will be infrequent.

The Rules, Part VII

The Rules, Part VII

Posted on by David Merkel

In a long bull market, leverage builds up in hidden ways within corporations, and does not get revealed in any significant way until the bear phase comes.

If I were to change that sentence, I would change the word “corporations” to “organizations.”? Why?? Everyone attributes greed to the corporate sector, but the same is true in different ways of governments and nonprofits.

Year to year, organizations measure progress.? Corporations look at profits.? Politicians look at whether they are still in office or not the success of programs passed.? Those that run non-profits look at how they have done on their missions, amid scarce resources.

But, when things are good for a long time, institutional laziness sets in.? I remember being out at some party at a golf course in Philadephia in 1996, when our best salesman uttered the inanity, “Let the stock market pay your employees.”? Really, he was a decent fellow, and brighter than most who sold for us, but his statement reeked of the bubble logic that assumes that stock markets are magic.? They always go up.? Corporations and individuals come to rely on the stock market going up, because it always beats bonds and cash over long enough periods of time.? That is true, but less so than most think, and the time periods have to be longer than most can tolerate.

Back to topic.? Non-profits are slaves to the stock market.? Giving goes up considerably when there is appreciated stock to give.? People donate more from wages when they are secure in their homes, and they think their retirements will go well, (fools that they are).

Governments are also slaves to rising asset values.? When housing prices fall, sales drop, and transfer taxes plummet.? But real estate taxes fall as well.? My property taxes dropped by 30% — I can hardly believe it, even though I thought they overshot 3 years ago.

Governments also get used to the boom, and begin forecasting increases in wage taxes, capital gains, real estate, and all other taxes.? They rely on the increase, and borrow beyond that.? But more insidiously, since they run on cash accounting they begin to fudge accruals to make the cash accounting look good.

Tough negotiations with the public employees union?? Offer less of a wage increase, and a generous increase to the pension benefit. That will reduce the present cash costs, leaving others to deal with the costs shifted into the future.

Cash costs of paying your debts too high?? Wall Street has many derivatives that can lower your cash cost today, at a price of probably or certainly raising your cash costs in the future.? Ask Jefferson County, Alabama; they will tell you.? Greece and Italy did much the same to enter the Eurozone, amid winks from those that presently disapprove.

“Can’t we raise the spending rate on our endowment?” naive nonprofit board members ask.? Tell them to look at the 10-year Treasury yield — that is a reasonable proxy for sustainable distributions.? Most nonprofit board members don’t know up from down economically; they tend to favor the present over the future.

Corporations are the same, but they do it differently.? They run on accrual accounting, so they tend to tweak accounting to make net income look good, relative to cash flow.?? Also, they buy back stock, which increases leverage.? Even raising the dividend increases leverage, because it is like junior debt, corporations know their stock prices will fall if it isn’t paid or increased.

Buffett says something to the effect of, “Until the tide goes out, you don’t know who is swimming naked in the harbor.”? Bear markets reveal optimistic assumptions and accounting chicanery.? This is true for any organization, because we all rely on the same economy.? Yes, the wealthy support some organizations more than others, but many governments rely on taxes from the wealthy more than they realize.

This even applies to individuals.? Who paid attention to the increases in debts, especially junior debts like home equity lending during the boom?? My last firm did, and I wrote about it at RealMoney, but it felt lonely at the time.? Silent seconds, low LTV lending, mortgage insurance, and other means of getting people into housing that they couldn’t afford looked like like the pinnacle of success for US housing policy.? Now, with all of the wounds the banking system has taken, and all of the foreclosures, past, present and future, many are beginning to think differently, but you can’t see that in government policy.? Many people are not capable of bearing the fixed commitments associated with home ownership, and there is no way that government policy can materially change that.? But the government continues to encourage high home ownership and asset prices, merely delaying the inevitable reconciliation of bad debts and lower housing prices.

It’s the nature of a boom.? Free money brings out the worst in us, leading many to borrow more to get even more prosperity that seems to never end.? When the bust comes, it ends, with interest compounded.? The positive dynamic becomes a negative one, until sufficient debt is compromised, cancelled, or paid off.? There’s no way around it, but our government will fight on hopelessly.? They always do.

The Rules, Part VI

The Rules, Part VI

Posted on by David Merkel

History has a nasty tendency to not repeat, when everyone is relying on it to repeat.

History has a nasty tendency to repeat, when everyone is relying on it not to repeat.? Thus another Great Depression is possible, if not likely eventually.

When people rely on the idea that a Great Depression cannot occur again, they tend to overbuild capacity, raising the odds of another Great Depression.

I think I wrote those between 1999 and 2002.? I kept a MS-Word file at work and home, and when ideas would strike me, prior to my time of being asked to write at RealMoney, I would write them down, and later revise them, until I had something that I thought was worth keeping.? I eventually ended up with 6 pages.? At some point in time, I concluded that my musings needed to be more structured, and I reorganized them so that similar thought were near each other.? I am fairly certain I wrote the three phrases above at different times.

I have sometimes said that to be a good contrarian, you don’t analyze opinion, you analyze reliance.? How much have people invested in an idea?? Are those that have invested in an idea long-term holders with a strong balance sheet, or short term holders that are reliant on total returns?? Do those who have invested in an idea have to get returns in the short run in order to survive?

The idea may be right or wrong, in the long run or the short run.? But near turning points, short-term money seems to be near-unanimous in its opinion that “this is the best way to make money.”? Seemingly free money brings out the worst in us.? We were created to work, but we would rather speculate, if given the opportunity.? I criticize myself here as much as anyone else; maybe I should have been a Mathematician or a Chemist.? That’s what I started out as in College, before being seduced by the simple beauty of Economics 1 & 2, which hid the complexity, and lack of ability to estimate their models.

“It’s Different this Time.”? So say many investors during booms.? Following momentum is a great strategy when few are doing it, less good when many are doing it, and troublesome near market breaks.

The same is true of governments.? They happily accept credit for a good economy, and then during busts, they borrow from the future in order to make the present better.? The first few times they do it, is works amazingly well, and so they assume that it is a rule: let the government borrow, and let the central bank lower rates a lot, and voila! the recession ends.? They don’t notice the increases in debt, public and private, and that useless economic capacity is not disappearing, because it gets financed at lower and lower rates.? We tend to be lazy, and not think of better uses for resources until there is financial failure forcing us to do so.

The cost of eliminating recessions too quickly and prolonging boom cycles, is that the debts build up.? Consumers and investors lose fear, and take on more debts than is prudent.? Debt-based economies are more complex and fragile than economies with lower leverage.? Particularly when financial entities are highly levered, the odds of a crisis are high.

As my wise former boss once said, “We don’t make the mistakes of our parents, we make the mistakes of our grandparents.”? Our parents typically warn us of the problems they survived, but not those that their parents did.? Thus we fall into the forgotten problem, and why big busts tend to recur about once every two generations.

The knowledge is out there, but culturally, we don’t use it.? The past is irrelevant; this is a new era.? It’s different this time.? Alas, the hubris of man is one of the few infinite things that he has.? Few study economic history, particularly most economists.

As such, we build up productive capacity using debt, assuming that high compound growth will make it work, and fall into another bout of debt deflation.? It may not be the Great Depression, it might be like Japan for the last two decades, or, maybe… it could be another Depression.? Or, something entirely different… the US Government builds up so much debt, and is constrained politically from inflation or higher interest rates, that it decides to default on external obligations.? Not likely, I know, but hey, there are a lot of unusual things going on, and unusual tends to beget unusual, at least in the short run.

But, how many are truly invested for total disaster?? And which total disaster?

  • Depression.? Buy long Treasury bonds, sell gold.
  • High inflation.? Buy TIPS, foreign bonds, and commodities. Sell long bonds.
  • Hyperinflation. Buy Gold and Silver.? Sell bonds short, if it is still legal.? Look for alternatives for practical currency.
  • Civil unrest? Choose your home with care.? There is nothing to buy or sell here.? Survivalism would work for short periods, but almost all long-term solutions rely on a stable civil government.

My estimate is that few are invested for a crisis.? That does not mean that a crisis is coming, but that if a crisis comes, since most are not prepared, the selloff would be hard.

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Moving to the short run, there are many who say that the current rally is tapped out, and will fail soon.? That may be, but there is a lot of liquidity generated by the Fed’s low short rate policy, and many in the short run will borrow short to fund a long term asset, like a stock, which has a higher yield.? Eventually that will fail, but in the short run it is temporarily self-reinforcing.

My view: favor the momentum in the short run, but realize that most of this rally is anticipating profit margins in the economy that have never been obtained in the past.? Trim exposure, or be ready to do so.? Remember, bond yields are proving to be greater competition day by day.

The Rules, Part V

The Rules, Part V

Posted on by David Merkel

Tonight’s rule:? Massive debt issuance on a sector-wide basis will usually have a slump following it, due to a capacity glut.

If you are a bond manager, it pays to do what is difficult.? Buy proportionately less or none of the sector that is the heavy issuer.? Even? more, sell into it, and try to create a balanced portfolio without the hot sector.

When a sector as a whole borrows far more than in the past, it is often a mania, and the management teams are expanding capacity all at once, because conditions are so favorable.? I experienced this twice as a bond manager.? When I came on the scene in 2001, I tossed out all of my investment grade telecom bonds (aside from some of the Baby Bells), and auto bonds.? I could not see how they would make money over the long haul.

Those were two sectors heading for capacity gluts.? Yet there was a bigger capacity glut growing — that of the banks.? As 2005-2007 progressed, it was difficult to keep a balanced corporate bond portfolio, because almost half of all issuance was from financials.

Debt issuance is the option of optimists, and in an era where your competitors are issuing debt, it is hard to not imitate them.? But when everyone is optimistic in a sector, and levering up, that is often a time where subpar performance resides.

There is more than a hint of seeming success as a sector adds progressively more debt.? Pass on too many deals, and you begin to feel like a stick-in-the-mud.? There is a lot of pressure to change your strategy when things are running so hot.? Rather than change strategies in mid-stream, a good manager will sit down with colleagues and discuss:

  • What companies are misunderstood, and are safe to invest in.
  • What companies are misunderstood, and are definitely not safe to invest in.
  • Are there safe industries in the sector that aren’t adding so much debt?
  • On the scale from historic widest spreads over Treasuries, to historic lowest, where are we?? What inning of the tightening game are we in?
  • Stop looking at companies, and let’s create a model of the sector on the whole.? Is there enough business to justify all of the expansion that is going on?? What is happening to product pricing?
  • Who is the marginal buyer of the hot sector, and of yieldy paper generally?? Do they have strong or weak balance sheets?? How fast will they sell if things go wrong?
  • How fast are new deals completing?? Are the syndicates testing the waters to price deals too tight, in order to restore normalcy to bidding?
  • Are fools making money?? Have they been making money for a little while or a long time?? Are ordinarily risk-averse investors beginning to imitate them?
  • Where is the Fed?? Perhaps today it would be “What is the Fed?”? Are they getting ready to jerk the rug out from under the markets?? How complacent are expectations?
  • How long can we suffer underperformance before money begins to get pulled from us?? Are our clients educable or not?? Do they appreciate the risks in the market?? Why do we always get the dumb clients?? (Wait, don’t answer that, you get the clients that you deserve…)
  • And more, but you get the picture…

By the time you are done, you have a roadmap toward how you will add and subtract exposure in areas of the hot sector that you like and don’t like.? You will know your limits, and will maximize performance given those limits.? Finally, you will have an estimate of how long the hot sector will do well, and a trading strategy for the short run.

Capacity gluts are tough.? They have such an air of inevitable success as companies compete to dominate a promising area.? But ideas that are great if one company pursues the opportunity are only good when two do so, and average when three or four join the party.? But when a half dozen to a dozen join in, results will be poor.

This goes double for equity investors.? Avoid sectors that have high debt issuance.? At minimum, if you are a momentum investor, follow the mo, and decide in advance what sort of decline will cause you to make an exit.

Impractical Application for Today

This is all very nice, you might ask, but where are the debts building up today?? Need you ask?? We have just seen some of the biggest transfers of debt from the banking system and consumers to the government.? Government debt is the hot sector.

Wait, you might say.? How can this principle apply to governments?? They don’t go broke, at least, that what Walter Wriston told us.? Sorry, but Reinhart and Rogoff’s book says differently.? Government defaults are not unusual.? Also, banking crises are often followed by sovereign crises.

Wait, you might say again.? I have to limit my risks.? Governments will always be the safest credit in a currency because that can tax the other credits.? Maybe, but there are limits.? As tax rates get very high, they don’t produce incremental revenue.? Yes, I know this sounds like supply side economics, but there is a difference here — I believe higher tax rates would produce greater revenues at present.? But there is a tax level that governments cannot exceed before tax revenue goes down.? A sound business in a country with an unsound taxation policy might survive even if the government refused to pay on their debts.

I know, that government would likely try to inflate their way out, but indexing of benefits and political outcry might hinder them.? I don’t believe that it would be easy to inflate out of a debt crisis.? Too many economists derive simplified models of reality, and don’t consider how ugly the politics will be in the situation.? Sorry, men aren’t rational, particularly not as groups, and there would be a lot of sturm und drang, and delay.? Who could tell what foreign nations might do in response?

Still, I would underweight Treasuries relative to high quality bonds in other sectors.? Issuance is high as far as the eye can see — and beyond 2050, given all of the difficulties with entitlement programs.? Many high quality corporates won’t have much issuance over that same period; they will be scarce versus the massive amount of government debt to pay.? Beyond that, when the Fed tightens, debt costs for the government will rise dramatically.? Perverse, huh?? When you have so much to refinance, everything fights against you.

So, avoid the hot sector.? Suffer underperformance for a while, but decide in advance what mitigating actios you will take, lest you be a buyer out of insecurity near the peak, when losers capitulate prior to the bear market.

The Rules, Part IV

The Rules, Part IV

Posted on by David Merkel

Okay, here is tonight’s rule: Governments that scam the asset markets (and their citizens) take all manner of half measures to defend failed policies before undertaking structural reform.? (This includes defending the currency, some asset sales, anything that avoids true shrinkage of the role of government.)? The five stages of grieving apply here.

I know I wrote it 8+ years ago, but it feels very live now.? At present it is most obvious to apply the logic to the PIIGS, and American municipalities that have overextended themselves.

But consider New Jersey that has cut back considerably, and the Kansas City School District that has cut almost half of their schools.? Their backs were to the wall, and they took brave actions to cut back.

But many municipalities remain in denial.? They have long distinguished histories, they cannot fail.? They just need to tax (or borrow) a little more to make ends meet.? Maybe they should raise the rate they expect to earn on pension assets, or offer sweeter pensions instead of greater wage hikes.? This is a big part of the crisis now, and is biting hard.

When the taxes do not come in as expected, or budgets were underestimated, and there is more spending than expected (Snow, Flood, Hurricane) there is anger, and anger drives the hopeless negotiations (bargaining) over spending cuts, over which no one wants to budge.? Not only are there priorities in what interest groups want, there are things that are guaranteed by statute, and some guaranteed by constitution.? Consider the constitutional guarantees on public sector employee benefits in Illinois.? Just try to change the Illinois Constitution; that won’t be easy.

The next stage of grieving is depression, and there are some places like California, L.A., Harrisburg, PA, Greece, etc. that are close to the point where one might say, “There’s no hope.”

After that comes the final stage of acceptance, where finally the tough adjustments are made, and solvency restored, or, bankruptcy is entered, with all of the attendant costs.? Deals are made to reduce budget items that were previously sacrosanct, such as entitlements, public sector employee benefits and salaries, etc.? That is not happening today, not even in New Jersey.

One final note: just as the last refuge of scoundrels that run companies is to blame the shorts, so it is for scoundrels that run governments — they blame the speculators.

The Rules, Part III

The Rules, Part III

Posted on by David Merkel

Okay, here is tonight’s rule:

The assumption of normality for asset price changes is wrong in virtually every financial market setting.? The proper distributions are fatter tailed and more negatively skewed.

Normality allows researchers to publish, regardless of the truth.

Normality allows risk managers and regulators to pretend that adequate reserves are held against disaster.? It also allows businessmen to achieve acceptable ROEs, while accepting a probability of ruin far in excess of what is prudent.

The normal distribution is a wonderful creation, because it is so simple.? All we need to know is the mean and the variance, which are very simple to calculate.? And… it seems close to fitting a large number of phenomena in nature where the behavior of one party does not affect the behavior of others.

But in economics and finance, the assumption of normality is perpetually violated.? I would guess that it is wrong more often than it is right.? Academics continue to drag out studies assuming normality because it allows them to publish.? academics get statistically significant results more often than they should, because they pursue specification searches, and get to results that they can publish via data mining (and ARIMA error terms — unless there is an a priori reason them, they facilitate specification searches).

And, lest I be accused of being merely biased against academics, this biases me against many businessmen as well.? Many bankers looked at their loss distributions over the prior 25 years in 2007, and assumed that risks were minuscule.? Yes, there were bad periods, but the Fed always rode to the rescue, and losses were low, aside from a few egregious offenders.

Bankers concluded that they could do no wrong, and underwriting suffered.? Rather than looking at more objective measures of risk, bank managements looked at the need to hit their earnings estimates.? Losses had not been large in the past, so the future should be equally good.

When I was a risk manager, I would look at the level of surplus, and would compare it to expected normalized annual losses — if I didn’t have at least 15x normalized annual losses, then I knew I could not survive a reasonably normal spike in defaults at the bottom of the credit cycle, though an assumption of normality, where losses don’t come in bunches, would have allowed me to lever up more.

And I have known my share of management teams that pushed at the risk manager, telling him he was too conservative.? The company couldn’t earn an adequate return on capital at such low levels of leverage.? Equity analysts expected constant growth out of financial stocks, which sadly are cyclical stocks — it is a mature industry, and mature industries are cyclical by nature.? So they added more leverage, and things worked well for a while, until things blew up.

So long as consumers felt that they could add more debt, the bet could go on, with occasional minor interruptions while the Fed mopped up the damage.? But that stopped when the Fed could not drop rates below zero.? Still, the Fed found new ways to subsidize the debts of privileged parties, by buying up their long term debts and holding them.

Look, if you want to regulate properly, you can’t rely on normality.? It does not work in finance and economics.? When looking at loss statistics, don’t look at the mean or the variance.? Instead look at the maximum 3-year loss, and gross it up by 20%.? The surplus of a company should be able to absorb the maximum amount of losses from 3 years, and then some.? I use this as an example rule; tailor it to your needs as you see best.? I used 3 years because the bust phase of when the credit cycle is rarely severe for more than 3 years in a row.

If you want to manage risk internally properly you should think similarly — look at the outliers, and ask whether you can survive something worse than that.? Here’s a personal example: if someone had come to me two months ago and asked me how likely it would be that my area near Baltimore could get 60+ inches of snow in a one week time span, I would have said, “That’s not impossible, but that is way beyond the prior record, which I think is around 30+ inches.? Very unlikely.”? Well, it happened, and five weeks of warmer weather later, my backyard is still half covered by snow.

Markets, like the weather, are far more variable than we would like to admit, and attempts to tame them often lead to suppressed volatility for a time, but with explosions of volatility later, as economic actors begin to presume upon the low volatility as their birthright, and begin to speculate more aggressively, building up progressively more leverage as they go.

So when analyzing risk look at the worst possible outcomes, and build a plan that can handle that.? Size your leverage to reflect that; in a really risky business, you might have no leverage, and extra bits of slack capital in high-quality short-term debt claims.

Finally, remember my analogy of bicycle versus table stability.? A bicycle has to keep on moving to stay upright. A table does not have to move to stay upright, and only a severe event will upend a large table.

I developed this analogy back when I was a corporate bond manager, because there were some companies that would only stay afloat if they kept moving, i.e., if operating cash flow continued at its projected pace. That is bicycle stability; they have to keep pedaling. There were other companies that could survive a setback in earnings, and even lose money for a time, and the debt would still be good. That is table stability.

This is why stress-testing beats value-at-risk in a crisis, and why the insurers came through the crisis so much better than the banks.? When liquidity disappears, strategies that require continued liquidity can cause their companies to disappear.

Better safe than sorry.? Banks should run their businesses using stress tests that will cause them to have lower ROEs because of the additional capital needed to assure solvency.? The regulations have been too loose for too long.

The Rules, Part II

The Rules, Part II

Posted on by David Merkel

Before I start tonight, a reminder, those that want to follow me on Twitter can do so here.? I will be sharing posts and ideas that I find insightful, that I might or might not share on the blog.? I?m still working with it.? Thanks to all of those that tweeted and retweeted, and those that are following me now.

One more note, I disagree with Volcker and Sarkozy regarding supporting Greece, versus the Euro.? If Greece defaulted, Greece would lose the low cost funding of the Euro.? The Eurozone would lose a country, but the Euro would retain its strength, and marginal nations prone to cheating would come into line.? Tough love is the best policy; don?t bail others out if you care about the union as a whole.

On to tonight?s rule: Unless there is a natural purchaser of an exposure that one is trying to hedge, someone must speculate to a degree to allow you to hedge.? If the speculator is undercapitalized, risks to the financial system rise.

This rule is pretty simple.? There are few places in the financial markets where there are naturally offsetting exposures that have not been remedied by an institution created for that very purpose, such as a bank.? In most cases with derivatives, the one that wants to reduce exposure relies on a speculator.? There are rare cases where the risk of one is the benefit of another, but situations like that tend to create new firms to internalize the trade.

The trouble occurs when the speculator can?t make good on his obligations.? As with many speculators, he overcommits.? He is short of funds because many trades are going against him at the same time.? It is in these cases that those who hedge learn to evaluate counterparties for their riskiness.

That is why it is worth knowing who is at the end of the chain in this financial game of crack-the-whip.? The status of the ultimate speculators, and whether they can make good on promises or not is a huge thing.? After all, subprime mortgages were downplayed by many as the crisis was rising, but they were at the end of the financial game of crack-the-whip.? They were one of the main classes of marginal borrowers.

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Taking this a different way, this argues against the academics that look for complete markets in the sense of Arrow-Debreu.? There are trades that no one wants to take at any price that a seller could live with.? There are securities that can be created that no one wants to buy, at prices that are unprofitable to the securitizer.??? Complexity is a minus.? We can create securities that are the financial equivalent of toxic waste, but no one should pay much for them.? It is the price of creating safe securities.

No surprise: people pay a lot more for certainty, even if it is seeming certainty.? We see it in corporate bond spreads.? High quality borrowers borrow cheaply.? Low quality borrowers pay up. So what else is new?

What is new is the low-ish spreads for going down in quality.? This one could go either way; spreads are wide against history, but might be narrow against current difficulties.? The rebound has been rather sharp.

Note: this is reposted because of a system glitch.

The Rules, Part I

The Rules, Part I

Posted on by David Merkel

Dear readers, I am now on Twitter — AlephBlog is my moniker if you want to follow me.

I have been somewhat reluctant to do this, but tonight’s post stems from a file on nonlinear dynamics on my computer that I developed between 1999 and 2003 for the most part.? Not so humbly, I called it “The Rules.”?? This is the first in a series of what will likely be long set of irregular posts about what I call “The Rules.”? Please understand that I don’t want to make grandiose claims here.? After all, as I once said to Cramer (yes, that one): “The rules work 70% of the time, the rules don’t work 25% of the time, and the opposite of the rules works 5% of the time.”

My best recent example of the rules not working was when the formulas of the quants were blowing up in August 2007.? There were too many quants following the same strategy, and they had overbid the stocks that their models loved, and oversold the ones that they hated.? For a while, the quant models were poison.? Every investment strategy has a limited carrying capacity, and those that exceed the strategy’s capacity are prone for a comeuppance.

Here is today’s rule: There is no net hedging in the market.? At the end of the day, the world is 100% net long with itself.? Every asset is owned by someone, regardless of the synthetic exposures that are overlaid on the system.

There are many people, particularly dumb politicians, who think that derivatives are magic.? To them, derivatives create something out of nothing, and that something is strong enough to smash innocent companies/governments that have been behaving themselves, but have somehow found themselves caught in the crossfire.

First, if a company or government has a strong balance sheet, and has a lot of cash or borrowing power, there is nothing that speculators can do to harm you.? You have the upper hand.? But, if you have a weak balance sheet, I am sorry, you are subject to the whims of the market, including those that like to prey on weak entities.? Even without derivatives, that is a tough place to be.

With derivatives, for every winner, there is a loser.? It is a zero-sum game.? Yes, as crises arise there are always those that look for a way to make money off of the crisis.? And there are some parties willing to risk that the crisis will not be so bad, at a price.? Derivatives don’t exist in a vacuum.? Same thing for shorting — there is a party that wins, and a party that loses.? So long as a hard locate is enforced, it is only a side bet that does not affect the company whose securities are being played with.

When there are troubles, it is because a company or government has overstretched its limits.? You can’t cheat an honest man (or country).? You can take advantage of countries and companies that have overreached on their balance sheets and cash flow statements.

Cash on the Sidelines, Market is Oversold/Overbought, Money is Moving into or out of…

Every bit of cash on the sidelines is matched by a short term debt obligation somewhere.? Now, that’s not totally neutral, as we learned in the money markets crises in the summers of 2007 and 2008.? If the money markets get too large relative to the economy on the whole, that means there is possibly an asset/liability mismatch in the economy, where too many are financing long assets short.? It costs more in the short run to finance long-life assets with long debt or equity, but in the short run you make a lot more if you finance short… do you take the risk or not?

GE Capital nearly bought the farm in early 2009 from doing that.? CIT did die.? Mexico in 1994.? When you can’t roll over your short term debts, it gets really ugly, and fast.? Think of the way we messed up housing finance in the mid-2000s; one of the chief signs that we were in a bubble was that so much of it was being financed on floating rates, or contingent floating rates with short refinance dates.? Initially, that gave people a lot more buying power, at a price of higher unaffordable rates later.? “The phrase, “You can always refinance,” is a lie.? There is never a guarantee that financing will be available on terms that you will like.

This is also a good reason to go for debt that fully amortizes (i.e., when you get to the end of the loan, the payments haven’t risen, and the loan pays off in full).? I’ve never been crazy about the way commercial mortgage loans don’t fully amortize.? I know why it happened this way.? A) in the late ’80s and early ’90s, insurance companies were issuing GICs by the truckload, and needed higher yielding debt with a 5-year maturity.? Voila, 5-year mortgage loans with a balloon payment.? For the real estate developers, the loans were cheaper, but they had to trust that they could refinance — an assumption sorely tested in the early ’90s.? After the death of many S&Ls, a few insurers and developers, and the embarrassment of a more, borrowers and lenders became a little more circumspect.

But the loss of the S&Ls left a void in the market.? The Resolution Trust Company created some of the first Commercial Mortgage Backed Securities [CMBS], that Wall Street then imitated, filling in the void left by the S&Ls.? But to make the securitizations more bond-like, for easy sale the loans were 10-year maturities with a balloon payment at the end.? That way the deals would closer at the end of ten years.? Maybe some of the junk-grade certificates would be stuck at the end with a some ugly loans to work out, but surely the investment grade certificates would all pay off on time.

And that is a big assumption that we are going to be testing for the next five years.? Will developers be able to refinance or not?

This has gotten long, and have more to say, but I’m going to a wedding of a friend, and must cut this off.? Let me close by saying there is a corollary to the rule above, and it is this:

Long-dated assets should be financed by non-putable long-dated liabilities or equity.? Don’t cheat and finance shorter than the life of the assets involved.? There is never an assurance that you will be able to get financing on terms that you will like later.

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