Search Results for: Personal Finance, Part

Another Dozen Notes on Our Manic-Depressive Credit Markets

Another Dozen Notes on Our Manic-Depressive Credit Markets

Posted on by David Merkel

This is what I sometimes call a “Great Garbage Post.”? I’ll cover a lot of ground, so bear with me.

1) How to do a bank/financial bailout: a) wipe out common and preferred equity and the subordinated debt (and offer some warrants to the debtholders).? Make the senior debt take a haircut of 50% (and offer warrants), and the bank debt a haircut of 20% (and offer warrants). Capital is offered in exchange for the equity interest, together with some senior financing pari passu with the banks.? If the management and other stakeholders do not like those terms (or something like them), then don’t bail them out.

Now, realize I’m not crazy about “lender of last resort” powers being in the hands of the government, but if we’re going to do that, you may as well do it right, and bail out depositors in full, while having others take modest to large haircuts.? There is no reason why the government/Federal Reserve should bail out common or preferred equityholders, and those that bought risky debt should pay part of the price as well.? This should only be done for institutions where significant contagion effects could affect other financial institutions.? The objective is to create a firewall for depositors, and the rest of the financial system.

2)? Bear Stearns.? Ugh, a bank run.? A testimony to leverage.? Book value is only fair if one can realize the value over time.? High leverage implies a haircut to book value in bad times, because the value of the assets can go down dramatically.? Will they get a buyer?? I don’t know, and I wouldn’t trust JC Flowers.? If what Jamie Dimon might be thinking is what the Bloomberg article states, then I think he has the right idea: keep the best businesses, dissolve the rest.

But remember, during crises, highly levered financial institutions are vulnerable, unless most of their financing is locked in long-term.? Most investment banks don’t fit that description, particularly with all of the synthetic leverage in their derivative books.

3) The downgrades on commercial bank credit ratings will continue to come, particularly for those that were too aggressive in lending to overlevered situations, e.g., home equity lending.? Home equity lending is very profitable in good times, but then it gets overcompetititive, and underwriting standards deteriorate.? Then a lot of money gets lost, as in 1998, where most of the main lenders went under.? In this case, most of the lenders are banks, and they aren’t concentrated in that line alone.

4)? Home builders are taking it on the chin.? Consider this article about joint venture failures of homebuilders.? It is my guess that we will see a few of the major homebuilders fail.? It will take us to 2010 to reconcile all of the excess inventory.? Personally, I would guess that the stable home ownership rate is still below the current level by maybe 2% of the households.? We tried to force homeownership on people that were not ready for it, people who didn’t have enough financial slack to make it through even a slight recession.

5) I find it amusing that Bob Rubin, the only guy in the Clinton Administration that I liked, says that few people anticipated this bubble. (Sounds like Greenspan, huh?)? Well, in a sense he’s right.? Probably fewer than 1% of Americans anticipated these results, but there were enough writers in the blogosphere that were saying that something like this would come (including me), that some could take warning.? As in the tech bubble, there were a number of notable commentators warning, but no one listens during the self-reinforcing cycle of the boom.

6) I am sticking with a 50-75 basis point move from the Fed in the coming week.? They want to move aggressively, but they don’t want to use up all of their conventional ammo, when they are so close to the “zero bound.”? They might disappoint the markets, but not on purpose.? They will tend to follow what the markets suggest.

7) This Fed is more willing to try novel solutions than in the Greenspan era.? Even so, I expect them to run into constraints on their ability to deal with the crisis, which will force the Treasury Department (yes, even in the Bush Administration) to act.

8)? The glory of “core inflation” is not that it excludes the most volatile classes of goods, but the ones for which there is the most excess demand.? Food price inflation is running.? Farmers can’t keep up with the demand.? Poetic justice for the hard-working farmers of our country, who have had more than their share of hard years.? Agriculture is one of the industries that makes America great.? Let the rest of the world benefit from our productivity there.

9)? This is one of those times where one can get a “pit in the stomach” from considering the possibilities from a financial crisis.? As leverage dries up, those with the most leverage on overvalued asset classes get margin calls, leading to forced liquidations.? As it stands now, many credit hedge funds are finding it difficult to maintain their leverage levels, and other hedge funds are finding their lending lines reduced.? This forces a reduction in speculation, and the prices of speculative assets.

10)? Be careful using the ABX indices.? They are too easy to short, and do not represent the values that are likely to be realized in the cash markets.? The same is true of the CMBX indices.? This would lead me to be a bull, selectively, in AAA CMBS, after careful analysis of the underlying collateral.? (CMBS was a specialty of minewhen I was a mortgage bond manager.)

11)? Two interesting articles on character and capitalism.? This is a topic that I havea lot to say about, but every time I sit down to write about it, I am not satisfied with the results.? Let me make a down payment on an article here.? Capitalism is good, but Capitalists often abuse it.? Short-sighted capitalists play for short-term advantage, and end up burning up relationships.? Longer-term capitalists play fair, because they not only want deal one, but deals two, three, four, etc.? They play fair because they will do better in the long run, even if they are intelligent pagans.? (Christians should play fair anyway, because their Father in heaven looks at their deeds.? If we love Him, we will please Him.)

Economics isn’t everything.? Smart businessmen know that a good reputation is golden.? They also know that happy employees are more productive.? Suppliers that get paid on time are more loyal.? These are the benefits of ethical, long-run thinking.

12) In closing, a poke at quantitative analysis done badly.? Consider Paul Wilmott, or William Shadwick.? With bosses over the years, often they would ask me a seemingly simple quantitative question, and I would reply, “Here’s the standard answer: XXXXX.? But there are many reasons why that answer could be wrong, because the math makes too many assumptions about market liquidity, investor rationality, soundness of funding sources, etc.”? Most quants don’t know what they are assuming.? They are too good with the math, and not good enough at the human systems that inadequately lie behind the math.

As a quantitative analyst, I have generally been a skeptic.? At times like this, when the assumptions are breaking down, it gives me a bit of validation to see the shortfall.? That said, it’s no fun to be right when you are losing money, even if it is less than others are losing.

In Some Ways, The Municipal Bond Market Was Asking For It

In Some Ways, The Municipal Bond Market Was Asking For It

Posted on by David Merkel

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

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

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

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

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

Or, as I commented at RealMoney:


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

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

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

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

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

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

Ten More Odds & Ends

Ten More Odds & Ends

Posted on by David Merkel

I’m just trying to clean up old topics, so bear with me:

1) This blog is not ending because of my new job. Finacorp wants me to keep it going, and they may use the posts in PDF form for clients. Also, unlike my prior employer, Finacorp wants me to have a high degree of exposure, because it aids them. You may see me in more venues, which could include TV and radio.

2) In one sense, I had an unusually productive Saturday. I built two models — one for a critique of the PEG ratio, and one for a model of the Treasury yield curve. You will see articles on both of these, and I am really jazzed on both of them. It is not often that I get one impressive result in a day. Today I got two. I’ll give you one practical upshot for now, if you are an institutional bond investor: go long 10-year Treasuries and short 7-year. We are very near the historical wides. If you are like me, and can live with negative carry, dollar duration-weight the trade, so that you are immune to parallel yield curve shifts.

3) I didn’t read Barron’s, Forbes, or The Economist today, but I did read the Financial Analysts Journal. In it there were three articles that are worth a comment. There was an interesting article on fundamental indexation that comes close to my view on the topic. Fundamental indexation, when properly done, is nothing more than enhanced indexing with a value tilt. Will it make you more money than an ordinary index fund? Yes, it will, over a long enough period of time. Will it work every year? No. Is there one optimal way to fundamentally index? No. There is no one cofactor, or set of cofactors that optimally define value, if for no other reason than the accounting rules keep changing.

4) The second article went over the value of immediate annuities as risk reducers to retirees, something I commented on recently. The tweak here is buying annuities that start paying later in retirement, for example at 80 or 85, with the risk that if you die before then, you get nothing. Longevity insurance; a very good concept, but the execution is tough.

5) The third article was on Risk Management for Event-Driven Funds. Here’s my take: risk arb is like being a high yield bond manager. Anytime a deal is announced, you have to do a credit risk analysis:

  • How likely is it that this deal will go through?
  • How badly could I be hurt if it does not go through?
  • Am I getting paid more than a junk bond with equivalent risk?

But the portfolio manager must ask some more questions:

  • Are there any common factors in my risk arb book that could bite me? Sectors? Need for debt finance?
  • What if deal financing terms go awry all at the same time? How will that affect the worst risks in my book?
  • Am I getting paid more than a junk bond with equivalent risk? (Okay, it’s a repeat, but it deserves it.)

Risk arbs have been burned lately, with all of the deals that have been busted because financing is not available on easy terms. It’s tough but this happens. Most easy arbs tend to get overplayed before blowups happen. The lure of easy money brings out the worst in people, even institutional investors.

6) Naked Capitalism had an interesting post on GM. I made the following comment:

I took some criticism at RealMoney.com for writing things like this about GM, though the author here was a much better writer.

The thing is, there are enough levers here that GM can keep the debt ball in the air for some time, as can many of the financial guarantors, so long as they can make their interest payments.

The “Big 3” lose vitality vs. Toyota and Honda each year — in the long run GM and Ford don’t make it. Perhaps after they go through bankruptcy, and shed liabilities to the PBGC, and issue new equity to the current unsecured bondholders, they can exist as smaller companies that have focus. Maybe Ford could be a division of Magna, and GM a division of Johnson Controls. At least then there would be competent management.

7) Barry Ritholtz had a good post called, 5 Historical Economic Crises and the U.S. The paper he cited went into five recent crises in the developed world, and how the current US situation stacks up against that.? Here was my comment on one of the areas where the US situation did not seem so dire, that of the run-up in government debt:

On the last point about the increase in the debt, what is missed is that a lot of the government debt increase is hidden by the non-marketable Treasury bonds held by the entitlement programs. Add that in, and consider the unfunded promises made at the Federal, State, and municipal levels, and the debt increase on an accrual basis is staggering.

We do face real risks here.? The rest of the world will not finance us in our own currency forever.? Oh, one critical difference between the US and the 5 crises — we are the worlds reserve currency, for now.

8 )? I like Egan-Jones on corporate debt.? They have quantitative models that follow contingent claims theory, and use market based factors to estimate likelihood and severity of default.? They are now trying to do models for asset backed securities.? Very different from what they are currently doing, and their corporate models will be no help.? They will also find difficulties in getting the data, and few market-based signals that inform their corporate models.? I wish them well, but they are entering a new line of business for which they have no existing tools to help them.

9) This article from Naked Capitalism pokes at the rating agencies, and the proposed reforms from the SEC.? My view is this: the financial regulators need a model on credit risk.? They need a common platform for all credit risks.? They need one set of ratings that allow them to set capital levels for the institutions that they regulate, or they need to bar investments that cannot be rated adequately.? The problem is not the rating agencies but the regulators.? How do they properly set capital levels.? They either have to use the rating agencies, or build internal ratings themselves.? Given my experiences with the NAIC SVO, it is much better to use the rating agencies.? They are more competent.

10)? Finally, on Friday, a UBS report stirred the pot regarding non-borrowed reserves.? You can see the H.3 report here. Both Caroline Baum of Bloomberg and Real Time Economics debunked the UBS piece.? But it was simpler than that.? The Fed published its own explanation at the time they put out the H.3 report.? UBS did not include the effect of the new TAF.? Whoops.? Oh well, I make mistakes also.? It’s just better to make mistakes when one doesn’t sound so certain.
Full disclosure: long MGA, HMC

The Press Release

The Press Release

Posted on by David Merkel

David Merkel to Join Finacorp Securities as Its Chief Economist and Director of Research

IRVINE, Calif., Feb. 8 /PRNewswire/ — In an ongoing campaign to provide targeted, value add services to its institutional client base,Finacorp Securities has hired David Merkel, formerly a Portfolio Manager for Dwight Asset Management, and an Equity Analyst for Hovde Capital Advisers. David is both a Chartered Financial Analyst, and a Fellow in theSociety of Actuaries.

Finacorp Securities today announced that David Merkel has joined as its Chief Economist and Director of Research. David has been a long time leading contributor to RealMoney.com, after being invited by Jim Cramer to write there. In addition to this he has acted as a Portfolio Manager to equity, corporate bond and structured product funds. He is also author and
owner of the popular finance weblog Alephblog.com. David’s focus has been equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues and corporate governance. As Chief Economist and Director of Research at Finacorp Securities, David’s chief responsibility will be to develop economic analysis with equity and
fixed income strategies and provide advice to the firm’s sales & trading staff and its client base.

“With the current credit crisis and ensuing market volatility we think it is imperative to offer additional support and insight to our client base. David is a proven professional that has analyzed, and created opportunities in many markets and will help do the same for our client base in this market and those in the future. David’s ability to analyze many of the complex and impaired assets in today’s marketplace including CDOs, SIVs, and Insurance Guarantors will create an immediate value add to our institutional clients. This is very much in line with our philosophy of bringing together the finest personnel in a collaborative environment,” said Ed Prado, President and CEO of Finacorp Securities.

This hiring comes after tremendous expansion by the company of personnel and infrastructure as it established a presence in: Seattle, Portland and Chicago.

About Finacorp Securities

Finacorp Securities is a full service broker/dealer focusing on servicing its institutional clients within the U.S. and select
international markets. The firm operates as a certified Minority-OwnedHispanic Broker/Dealer headquartered in California. Through a combination of its own proprietary systems and third-party partnerships, it provides seamless execution, settlement and custody to institutional fixed income and equity market participants. Finacorp has been built on a tradition of highly personalized brokerage services delivered by professionals harnessing the power of technology and strategic partnership to deliver value-driven securities execution, detailed portfolio analytics, and seamless settlement. Finacorp’s high-touch, high-tech business model represents a comprehensive set of fixed income and equity solutions for
today’s value driven, risk adverse investment professional.

SOURCE Finacorp Securities

Relying on the Kindness of Strangers as an Investment Strategy

Relying on the Kindness of Strangers as an Investment Strategy

Posted on by David Merkel

In 2002, when many credits were troubled, I would look at some of troubled positions that we held and do a recovery analysis, to see what we might get if the company filed for insolvency. Often in that process, I would find that investors elsewhere in the capital structure had different motivations than we did. The bank might prefer to liquidate the stinker, while the bondholders, in a more junior position, would prefer it kept as a going concern. Or, the equity investors that have control of the company might pursue a unprofitable strategy that encumbers the assets of the firm, leaving the bondholders with a less valuable entity for their debt claims. Or, the company could issue secured debt, effectively subordinating bondholders, while providing cash that could be used to buy back stock. Another case is when you have a valuable company with a liquidity problem. The banks will be willing to lend against that trapped value so that the company can repay bondholders, right? Right?! (Sigh.) In most of these situations, a bond investor finds that he is implicitly relying on the kindness of strangers. That is rarely a good place to be. 🙁

Now, a few judicious debt covenants could partially level the playing field, but with investment grade bonds those are rare. (Covenants work a lot better than fraudulent conveyance lawsuits, etc….) My main point here is that it pays to analyze situations in advance to understand when your bargaining power is weak. Risk control is best done on the front end, not the back end. Equity/Management will always hold the “capital structure” option to some degree, and unsecured lenders will always have a weak hand there.

So when I read this article about ladies in Baltimore losing their homes because they didn’t do enough scrutiny of the mortgage documents, partly because they were deceived by people who were seemingly experts, who said that they would be able to refinance the rate when the reset date hit, I thought about relying on the kindness of strangers again. It would be one thing if guaranteed refinance terms were offered at the initial refinancing, but absent that, credit conditions are fickle, and it can be a short interval between loose credit and tight credit. Relying on the ability to refinance a debt is always risky.

Today, consumer credit terms are tight. A year ago, they were moderately loose. Two years ago, terms were stupid loose. Who knows, later this year, terms could become stupid tight, where even good quality borrowers with adequate security can’t get credit.

Again, in investing, and even in personal finance, strive to understand your bargaining position. Do you hold the options? If it’s not you or those with you in your position, then others hold the options to control the assets. Usually those are held by the equityholders (or management, who sometimes act in their own interest, not that of the shareholders), and senior or secured debtholders. Those with weak positions, like preferred stockholders, unsecured and junior debtholders must be compensated for the weak position with extra yield or covenant protections.

The same analysis applies to structured securities, whether the credit enhancement comes from a guarantor or a senior-subordinate structure. In the good times, the equity controls the deal. In the really bad times, control often slides to those who are most senior in the capital structure.

On a personal level, a house is controlled by the owner if he can stay current on the payments (if any). Absent that, the bank controls the situation, subject to the rights of other claimants (the taxman, home equity lenders, mortgage insurers, etc.)

If strangers are kind to you, that is a good thing. Be grateful for a society that encourages that kindness. But don’t rely on it in investing or personal finance.

PS — sometimes even a good analysis of your rights and options can go awry. The KMart bankruptcy was a good example of that, where KMart had assets worth more than their liabilities, and could have gotten financing to continue. But a bankruptcy judge allowed their petition, and they were able to give creditors and lessors the short end of the stick. Those that controlled KMart post-bankruptcy made out handsomely. It would be difficult to repeat that aspect of the success.

Thus, you might look at this good article on Sears Holdings (successor name for KMart) in a slightly different light. The financial engineering gains can’t be repeated. It now must make its money as a retailer. As the article gently points out, being a good investor and a good retailer don’t naturally go together.

Bringing this back to topic, does management of Sears act in the best interests of shareholders? Management has the incentives to do so, but sometimes the intellectual gratification of the CEO can get in the way of making good business decisions. Management has control, the outside passive minority investors do not. Their only options are to ride on the Sears bus, or get off. If an investor doesn’t think the management of Sears is doing it right, he would be foolish to trust them with his money.

Eight Notes on Insurance, Economics, and Value Investing

Eight Notes on Insurance, Economics, and Value Investing

Posted on by David Merkel
  1. Doug Kass over at RealMoney made the following comment: “The next shoe to drop will be the failure of a public homebuilder and a private mortgage insurer. The latter concerns me more than the former, as the markets are not aware of the economic implications of my view.”? An interesting comment to be sure.? Unlike other insurers that benefit from state guarantee funds, the mortgage insurers do not so benefit.? That said, in a concentrated sub-industry that has only seven players (MTG, RDN, PMI, TGIC, GNW, ORI, and AIG), one advantage that poses is that failure of one company will not lead to assessments on the rest of the companies, leading to cascading failures.? So who would be affected?? Fannie and Freddie would get a lot of credit risk back, as would any private lender that used the mortgage insurers to reduce risks.? Even some of the mortgage originators with captive mortgage reinsurers would take some degree of a hit (most of the top originators had these).
  2. Some younger friends of mine asked me for advice recently, and the question came up, “Should I invest in the market, or pay down debt?”? Now, we weren’t talking about credit card debt, which they paid off in full every month.? They did have a home equity loan at 8.5% fixed.? My view was this: with 10-year Treasuries yielding 4.4%, and marginal investment grade corporate bonds yielding 6.0% or so, a reasonable return expectation for the equity markets as a whole would be in the 8-9% region.? Add 2-3% to the BBB-bond yield, and that should be a reasonable guess, given that I think the market is somewhere between lightly undervalued and fairly valued.? My advice to them was to pay down the home equity loan, and once it was paid off, invest in an index fund, or a diversified mutual fund.? Until then, better to earn 8.5% with certainty, than 8-9% with uncertainty.
  3. As can be seen from my recent reshaping, yes, I do buy sectors of the market that look ugly.? Shoe retailers and mortgage REITs have not done well of late.? Am I predicting no recession by buying the retailers?? No; so long as the shoe retailers aren’t too trendy, demand for shoes is relatively stable, and these stocks are already discounting a recession.? I chose two that had virtually no debt, so I am on the safer side of the trade, maybe.
  4. Does buying a mortgage REIT mean that I am betting on further FOMC loosening?? No.? The mortgage REITs that I hold embed a pretty nasty set of assumptions for the riskiness of the safest parts of the mortgage bond markets.? While a FOMC loosening would probably help, I’m not counting on that.
  5. My value investing is different than most value investors, because I spend more time on industries, either buying quality companies in beaten-up sectors, or companies with pricing power, where that power is underdiscounted by the market.
  6. If we are trying to estimate the central tendency of inflation and eliminate volatility, it is better to use a trimmed mean, or median, rather than toss out volatile components like food and energy, particularly when those components have led inflation for the last 5-10 years.? The unadjusted CPI is a better predictor of the unadjusted CPI than is the core CPI.
  7. Personally, I think the next ten years will be kinder to “long only” equity managers than hedged managers.? There is only so much room for shorting, which is an artificial overlay on the system.? We aren’t at the limits of shorting yet, but we are getting closer to those limits.? It would not surprise me to see ten years from now to find that balanced fund managers beat hedge fund managers on average (after correcting for survivor bias, which is more severe with hedge funds).? It’s much easier and more effective to do risk management in a long only mode, and I believe that the virtues of long only management, and balanced funds, will become more apparent over the next ten years.
  8. I’m thinking of doing a personal finance post on what insurance to buy.? Is that something that readers would like to read about?
Miscellaneous Notes

Miscellaneous Notes

Posted on by David Merkel

Well, look at the DJIA and Nasdaq Composite.? New 52-week highs.? I am still bearish on our credit markets, tepidly bullish on equities, particularly inflation-sensitive sectors (and insurance), and bearish on Real Estate and Real Estate finance.? This is a hard combo to hold together, but in some ways, I suspect that surplus capital that was making its way to the credit markets is now making its way to the equity markets.

I’m eclectic, what can I say?? I’m always trying to blend signals from the long-, intermediate-, and short-term, with greater emphasis to the longer cycle elements.? I’m not a trader.

Now, just a few notes to catch up on reader questions:

Why FSR and not VR or IPCR then?

I forgot about VR, and will have to consider it in the future.? I like IPCR, but it has run some recently, and their aggregate maximum loss discipline will limit their returns vs those companies that use probable maximum loss.

I think your post is very useful but that it raises some critical issues about successfully forecasting future inflation/real rates. Your study period includes a period where 3 major versions of CPI existing. There is the pre-Reagan CPI, the pre-Boskin CPI and the current. John Williams at shadow statistics calculates all three. The curren pre-Reagan CPI is running over 10% so ?real rates? based on that would be negative 6-7%! The pre-Boskin is I think 5-6% which would still produce negative real rates?.and the Fed is cutting rates!

I wish anyone luck trying to forecast 10 year hence real rates or inflation given this mix. My personal opinion is that due to fiat currencies they are likely to be much higher unless central banks allow a deflationary credit contraction to take force without trying to inflate. History suggests that they all try to inflate!

One thing that is different about my blog is that I will do different sorts of posts.? I’m hard to categorize. ? This comment makes some very good points, most of which I agree with.? I believe inflation is understated in the US, and I think that the idea is growing in the populace, while Ph.D. economists stay in lockstep with the guild, and deny it.? My main article on the topic, for those with access to RealMoney, can be found here.

Also, my main point was not to get people to try to forecast inflation and real interest rates.? It was to point out how changes in inflation and real interest rates disproportionately hurt equity investors compared to bond investors.? That said, it takes a large move in inflation rates to wipe out the ordinary advantage of equities.

Hi, how do you think i-bank incentive fees will effect EPS over the next year?

I worked for a technical trend following CTA in the 90?s that had a severe drawdown of -55% over the course of a year. It started with one bad day and the company was never even remotly profitable again and the owners closed it down 3 years later.

I think that people don?t understand that in order to make incentive fees the hedge funds have to make new highs, just being flat doesn?t cut it. Unless they are constantly making new highs, the hedge fund business is the same model as the mutual fund biz but with much higher overhead.

Alternatively they shut their existing funds down and open new ones to reset the mark but its hard to replace the truely large capital pools.

Interested in your thoughts.

That’s an interesting question.? With respect to compensation from internal hedge funds, there will be some loss of EPS.? That said, investment banks have more true technical information than most hedge funds, and will benefit from trading against funds that are in bad situations.

In general, most hedge funds that lose 25% of capital go out of business.? At 50%, almost all of them do.

That’s all for the evening.? Let’s see if the S&P 500 hits a new high on Tuesday.

Full disclosure: long FSR

Tickers mentioned: VR IPCR

The Advantages of Being a Small Investor Amid Too Much Leverage

The Advantages of Being a Small Investor Amid Too Much Leverage

Posted on by David Merkel

Here’s a question from a reader a few weeks ago.

I consider myself to be a value investor and stick mainly to stocks
where I feel the asset to equity ratio is reasonable along with
consideration of other factors such as PE & share price to book value etc.
As a result, I am not panicking with the recent mkt downturn and expect
to hold most of my positions thru the major downturn when it happens.


Despite my resolve, I can’t help but feel uncomfortable with the recent
comments on subprime and liquidity etc. Again, I am a very inexperienced
amateur investor, but what I seem to be getting from the reports is that
there is so much leveraged investment in the markets these days that
even these mini downturns may force selling of stocks to cover leveraged
positions and could wash over the entire market. Reports of complete
funds being wiped out as a result of the necessity to cover leveraged
positions seem incredible to me. ?I personally feel leveraging should be
left to very skilled, specialized traders and will only consider it when
I have a portfolio of sufficient size that I would be able to use it as
insurance and in turn cover a position if required.

?

Having said all of this, I have several questions, if you would be so
kind as to consider.

?

Is there a way to assess the volume of leveraged positions relative to
the whole market and likelyhood to tip the whole market and the average
% the market will retreat based on the amount of leveraging in the
markets and the historical data on the effects?

?

Are there not rules that govern funds, in order to protect the investors
in the funds from complete liquidation due to leveraging by the managers
and at any rate doesn’t someone review the activities of the fund managers?

?

Is this leveraging in the marketplace so widespread and common now that
small investors like me are tilting at windmills if don’t participate?

?


I realize that these questions may be rather uninformed and somewhat
equivalent to “the meaning of life” scenerio, however I have been
reading your blog quite faithfully and with my limited understanding of
some of the technical jargon, find it very interesting.

Thanks for asking your question, and sorry I didn’t get to it earlier.? There are several things to write about here:

  • How serious are leverage problems in the market?
  • There are certain forms of leverage that are well measured, and some that are not.
  • Some institutions have leverage rules, and some don’t, sort of.
  • Am I at a disadvantage as a small investor, particularly if I stay unlevered?

Let’s go in order.? The leverage problems in the market today are significant, though none are urgent at present.? The furor over ABCP and SIVs and other bits of short-term lending have largely passed.? Good collateral got rolled over, bad collateral got picked up by stronger institutions.? That said, there are other important problems in the market that are not at a crisis point yet:

  • Falling residential real estate prices, and the effect on mortgage default, and the effect on those that hold mortgage securities.
  • Private Equity’s ability to repay debt on new acquisitions.
  • The willingness of the investment banks to takes losses on prior LBO lending commitments.
  • Losses in the CDO market, and who owns the certificates with the most exposure to loss.
  • Losses from high-yield lending to CCC, and single-B rated firms.
  • Are any significant financial institutions overexposed to the above items, such that they might be impaired?

Now, some of the leverage is well measured, and some is not. We really don’t know with derivatives what the total exposure is, and whether the investment banks have been clean with their counterparty management.? (That said, so far it looks like it is working.? There may be a Wall Street rule, that if someone is near the edge, find a way to kick them over the edge, so that you can foreclose with more collateral.)

We also don’t know about lending to or from hedge funds, and hedge fund-of-funds. ?? Non-bank lenders, we know about what they securitize publicly, and that’s most of it, but the rest, we don’t know.? Foreign lenders to the US — the Treasury collects some data on them, but the detail is lacking.

All of these are areas where reporting requirements are limited to non-existent.? Regulated domestic finance — we know a lot about that, and that’s a large part of the system; the open question there, is how much the regulated part of the system has lent to the non-regulated part of the system.? Difficult to tell, but given the slackness of bank exams over the past five years, it could be significant, but I doubt perilous to the system as a whole.

Banks, S&Ls, Mutual funds, Insurance companies, and margin accounts have leverage rules. ? Many non-regulated entities face leverage rules from the ratings agencies, which limit their ability to borrow and securitize.? Still other face limits on leverage from those who lend to them, in the form of debt covenants.? Almost everyone is limited in some way, but in a bull market, those limits often get compromised as a group.? The limits are not as wide as would be optimal for financial system stability.

So, there are some protections for those who lend to hedge funds and hedge fund of funds, but little protection to those who invest in them.? Hey, if you’re a big institution, and invest here, you are your only protector; no one is coming to rescue you in a crisis.

But onto the last question:? Am I at a disadvantage as a small investor, particularly if I stay unlevered??? You have many advantages as a small investor.? One? of the largest advantages is that no one can force you to be hyper-aggressive, except you yourself. If you are reasonable in your return goals, you can safely achieve better than your average levered competitor through a crisis.? An unlevered investor can’t be forced by anyone to take on or liquidate a position.? Levered investors, or those with return requirements from outside parties, do not fully control their own trades.

Second advantage: you can be more picky.? You can avoid trouble areas in entire if you want.? Many institutional investors face diversification or tracking error requirements, which force them to in vest some in areas that they don’t like.? As an example, I was one of the few investors that I knew that didn’t take some losses from the tech bubble popping.

Third advantage: you don’t have to take risk if you don’t want to.? If the market is too frothy, and shorting is not for you, just reduce exposure, and wait for a better entry point.? (Warning: that entry point may not come.)

A disciplined private investor may not have the same level of knowledge as the institutions, but he can have a longer time horizon, and play the out of favor ideas that might threaten job security of those who work inside institutional investors.? With that, I would advise you to take use your advantages, and invest accordingly.? Keep it up with the value investing!

For those with access to RealMoney, I advise reading these longish articles if you want more background on how I think here:

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

Post 300 (Mainly About Friends)

Post 300 (Mainly About Friends)

Posted on by David Merkel

Well, its that time again.? WordPress informs me that this is post 300.? For me, that means a time to stop and reflect, and let readers know what’s going on in my life.

The blog has been live now for about seven months, and it has seen growth.? Growth in readers at syndicated sites (I’ve lost count), growth in readers through Feedburner (RSS) and Feedblitz (e-mail), growth in the number of blogs linking to me, growth in comments, personal e-mails, and spam.? Since the blog started, I have screened out over 6000 spam comments.? It fascinates me how much effort goes into trying to penetrate the comments filter of this blog.? I review the spam filter periodically to rescue the 0.1% of captured posts that are genuine.

As in most of life, we don’t succeed purely on our own.? It helps to have friends.? My most personal support comes from my family and my church.? Beyond that, though, I don’t think this blog would have gotten where it is today with the aid of James Altucher at TheStreet.com, Abnormal Returns, Charles Kirk at the Kirk Report, Barry Ritholtz at the Big Picture, StumbleUpon.com (surprising how much traffic has come from there, and all recent), Roger Nusbaum of Random Roger’s Big Picture, Bill Luby at VIX and More, Seeking Alpha (Aleph – Shalom), and Jeff Miller at A Dash of Insight.? A special thanks to my friend Cody Willard who encouraged me to do this early on, and who has received the promotion of a lifetime recently by becoming an anchor at the new FOX business news channel.? The quality of insight in business journalism has just taken a turn for the better.

Speaking of friends, I’d like to talk a little about what I am up to now. ? No one has bitten yet on my equity management product, which has handily outperformed the market over the past seven years.? In one sense, that’s no surprise.? Doing well with a small asset base is not going to attract many takers, even if you have done in a liquid, disciplined, institutional way, as I have.? But I am still talking to people, and I have a four page synopsis of what I have done over the past seven years.? If any of my readers has an institution or a wealthy friend that you think might like to seed me (early investors get advantageous terms, permanently), please e-mail me.? Any real referral puts you in my “friend for life” category.

We’ll see where this leads. My dream is to manage money for others using my eight rules, and eventually set up a mutual fund so that smaller investors can join in.

But friends help in other ways also.? Two friends have decided to employ me as a consultant.? One for bond management advice at his bank, and management of two balanced funds, and another to analyze four insurance companies that he owns big stakes in to get a second opinion.? I am available for other consulting arrangements as well.? My wide (shallow?) skill set makes me particularly good for projects requiring knowledge of a broad range of subjects.? I’d like to say that no problem is too tough for me to take on, but that’s probably not true.? I have solved many tough problems for life insurers and investment firms, though.

Friends help in other ways also.? I have an article coming out in MoneySense magazine in November; an editor came to know me through RealMoney and my blog.? I am friends with a number of public insurance management teams.? One of them has granted me an interview in October; we will see where that leads.? My friends from my corporate bond management days are helping me as best they can; I need all the help I can get.

That’s what I am up to now, aside from seeking for venture capital for a friend, and aiding other friends in their business pursuits.? Oh, and seeking out other writing assignments.

A special thanks to the 22% of my audience that hails from outside of the US.? It surprises me that I have many readers in Canada, the UK, the Netherlands, China, Uruguay, France, Hong Kong, Switzerland, Singapore, Australia, Germany, Japan, Italy, Spain, South Korea, India and Taiwan.

Now, about future blog plans. ? Here’s what I have coming up:

  • Build out my books page, with book reviews, complete with a little Amazon store.
  • Articles: How markets and traffic are similar, When to be flexible versus rigid, hidden correlations in strategy, problems in academic finance, rescuing Capitalism from capitalists, and more.? Also more articles that answer reader questions.
  • My usual coverage of current topics, particularly when things are hot.
  • One more thing: a stock picking contest, akin to the Value Line contest done in the mid-1980s, with a prize to the winner.? This contest will test skill in picking stocks, rather than luck in trading, as so many contests do.? Sponsors are welcome to apply, otherwise the prize will come out of my pocket, which means it won?t be large.? A sponsor will receive free advertising on my site for the duration of the contest.

Finally, thanks to all my readers who take time to read what I write.? It is a pleasure to produce content for you, and I will do my best for you.

Fifteen Notes on the State of the Markets

Fifteen Notes on the State of the Markets

Posted on by David Merkel

1)? Start with the pessimists:


2)? Move to the optimists:

3) Hedge funds are getting outflows at present (and here), and August performance was pretty bad (and here — look at? “Splutter”).? I began toting up a list of notable losers, but it got too big.? One positive note, many of the large quant funds bounced back from their mid-August stress.

4)? When muni bonds get interesting, you know it’s a weird environment.? It starts with the fundamental mismatch of muni bonds.? Muni issuers want to lock in long term financing, but most investors want to invest shorter.? Along come some trusts that buy long bonds and sell short-dated participations against them, and hedge the curve risk with Treasuries.? When credit stress got high, long munis were sold because they could be, and long Treasuries rallied, which was the opposite of what was needed for a hedge.? (Note: hedging with Treasuries can work in normal markets, but fails utterly in panics, as happened in 1998.)? When the selling was done, in many cases high quality muni yields were high than Treasuries even before adjusting for taxes.? That didn’t last long, but munis are still a good deal here.

5) Large caps are outperforming small caps.? Foreign exposure that large caps have here is a plus.

6) Not all emerging markets are created equal.? Some are more likely to have trouble because they are reliant on foreign financing. (Latvia, Iceland, Bulgaria, Turkey, Romania)? Others are more likely to have trouble if the US economy slows down, because they export to us. (Mexico, Israel, Jordan, Thailand, Taiwan, Peru)? I would be more concerned about the first group.

7) Are global banks cheap?? Yes on an earnings basis, probably not on a book basis.? We need to see some writedowns here before the group gets interesting.

8) I’ve talked about SFAS 159 before, and you know I think it is a bad accounting rule.? This article from my friend Peter Eavis helps to point out some of the ways that it allows too much freedom to managements to revalue assets up.? What I would watch in financial companies is any significant increase in their need for financing, which could point out real illiquidity, even though the balance sheet might look strong; this one is tough because financials are opaque, and the cash flow statement is not so useful.? Poring over the SFAS 159 disclosures will be required as well.

9) As I have suggested, pension plans will probably end up with a decent amount of the hit from subprime lending, through their hedge fund-of-funds.

10) Hedge funds do better if the managers went to schools that had high average SAT scores?? I would not have guessed that.? Many of the best investors I have known were clever people who went to average schools.

11) My but bond trading has changed.? When I was a corporates manager, hedge funds weren’t a factor in trading.? Now they are 30% of the market.? Wow.? Surprises me that volatility isn’t higher.

12) Rich Bernstein of Merrill (bright guy) is getting his day in the sun.? His call for outperformance of quality assets seems to be happening.? Now the question is whether the cost of capital is going up globally or not.? If so, he says to avoid: “1) China, 2) emerging market infrastructure, 3) small stocks, 4) indebted U.S. consumers, 5) financial companies, 6) commodities and energy companies.“? Personally, I think the cost of capital is rising for companies rated BBB and below, which brings it back to the quality trade.

13) Econocator asks if markets have priced in a recession, and he says no. My problem with the analysis is that we would need 10-year Treasury yields in the 2.5% area to fully price it in by his measure, and that makes no sense, outside of a depression, and then, nothing is priced in.

14) Morningstar moves into options research.? Could be interesting, though Value line has had a similar publication, and I’m not sure that the market for publications like this is big enough.? They make a good point that most people use options wrong, and get the short end of the stick.

15) Oil is amazing, but wheat is through the roof.? I’ve seen articles about bread prices rising.? Fortunately, the cost of grain is a small part of the cost of foods that rely on grain.

With that, I bid you good night.

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