Search Results for: "dirty secret"

What is the Sound of One Hand Clapping?  What is the Right Price when there is no Market?

What is the Sound of One Hand Clapping? What is the Right Price when there is no Market?

No, this isn’t another discussion of SFAS 157, though there are some similarities.? There has been a bit of a brouhaha over repayment of TARP options.? Isn’t the government getting shortchanged?

Maybe.? Maybe not.? This one is tough to answer, because at least as yet, there is no active market available for really long-dated call options.? Let me give you an example from my own experience.

I used to run a reasonably large options hedging program for a large writer of Equity Indexed Annuities [EIAs].? Much as I did not like the product, still I had to do my job faithfully, and when we were audited by a third party, they commended us having an efficient hedging program.

But here was our problem:? the EIAs lasted for ten years, but paid off in annual installments, based on average returns over each year.? Implied volatility might be low today, and the annual options that we purchased to hedge this year might be cheap, but the product had many years to go.? What if implied volatility rose dramatically, making future annual hedges so expensive that the company would lose a lot of money?

Maybe there could be another way.? What if we purchased the future hedges today?? A few problems with that:

  1. We don’t know how much we need to purchase for the future — the amount needed varies with how much the prior options would finish in the money.
  2. But the bigger problem is once you get outside of three years, the market for options, even on something as liquid as the S&P 500, is decidedly thin.? There’s a reason for that.? The longer-dated the option, the harder it is to hedge.? There are no natural sellers of long dated options, and relatively few Buffetts in the world who are willing to speculate, however intelligently, in selling long-dated options.

There is an odd ending to my story which is tangential to my point, but I may as well share it.? Eventually, the insurance company wanted to make more money, and felt they could do it by hiring an outside manager (a quality firm in my opinion — I liked the outside manager).? But then they told them not to do a total hedge, which was against the insurance regs, given their reserving practices.? Not hedging in full bit them hard, and they lost a lot of money.? Penny wise, pound foolish.

So what about the TARP options?? Did the US Government get taken to the cleaners on Old National Bank?? Is Linus Wilson correct in his allegations and calculations?? Or is jck at Alea correct to be a skeptic?

It all boils down to what the correct long term implied volatility assumption is.? Given that there is is no active market for long-dated implied volatility / long-dated options for something as liquid as the S&P 500, much less a mid-sized bank in southern Indiana, the exercise is problematic.

In quantitative finance, one of the dirty secrets is that common parameters like realized volatility and beta are not the same if calculated? over different intervals.? Also, past is not prologue; just because realized or implied volatility has been high/low does not mean it will remain so.? It tends to revert to mean.? With the S&P 500, implied volatility tends to move 20% of the distance between the current reading and the long term average each month.? That’s pretty strong mean reversion, though admittedly, noise is always stronger in the short run.

Let’s look at a few graphs:

Daily Volatility for ONB:

Or weekly:

or monthly:

or quarterly?

Here’s my quick summary: the longer the time period one chooses, the lower the volatility estimate gets.? Price changes tend to mean revert, so estimates of annualized realized volatility drop as the length of the period rises.? Here’s one more graphic:

I’m not sure I got everything exactly right here, but I did my best to estimate what volatility level would price out the options at the level that the US government bought them.? I had several assumptions more conservative than Mr. Wilson:

  • In place of a low T-bill rate for the risk-free rate, I used the 10-year Treasury yield.? (Which isn’t conservative enough, I should have used the Feb-19 zero coupon strip, at a yield of 3.79%.)
  • I set dividends at their current level, and assumed they would increase at 5% per year.
  • I modeled in the dilution from warrant issuance.

But I was more liberal in one area.? I assumed that ONB would do an equity issuance sufficient to cut the warrants in half.? If the warrants were outstanding, the incentive to raise the capital would be compelling, and it would get done.

The result of my calculation implied that a 21% implied volatility assumption would justify the purchase price of the warrants.? That’s nice, but what’s the right assumption?

There is no right assumption.? Short-frequency estimates are much higher, even assuming mean reversion.? Longer frequency estimates are higher if one takes the present reading, but lower if one looks at the average reading .? After all, Old National is a boring southern Indiana bank.? This is not a growth business.? If it survives, growth will be modest, and the same for price appreciation.

The Solution

It would be a lot better for the US Treasury to get itself out of the warrant pricing business, and into the auction business, where it can be a neutral third party.? Let them auction off their warrants to the highest bidder, allowing banks to bid on their own warrants.? I’ll give the Treasury a tweak that will make them more money: give the warrants to the winning bidder at the second place price.

By now you are telling me that I am nuts — giving it to the winner at the second place price will reduce proceeds, not increase them.? Wrong!? We tell the bidders that we want aggressive bids, and that they will get some of it back if they win.? I’ve done it many times before — it makes them overbid.

So, with no market for these warrants, I am suggesting that the Treasury creates their own market for the warrants in order to realize fair value.? Is it more work?? Yeah, you bet it is more work, but it will realize better value, and indeed, it will be more fair.

Fifteen Notes on Our Troubled Global Economy

Fifteen Notes on Our Troubled Global Economy

1) It’s nice to see someone else recommend my proposal for partially solving housing woes.? Immigration made America great.? Kudos to my Great-great-grandparents.

2) Is there Any Such Thing as Systemic Risk? Surely you jest.? Systemic risk exists apart from klutzy governmental intervention, as noted in my article, Book Reviews: Manias, Panics, and Crashes, and Devil Take the Hindmost.

3) The Economist has another good post on the effect of past buybacks affecting companies today.? As for me, I criticized dividends in the past:


David Merkel
Buybacks Depend on the Management Team
1/5/2006 12:11 PM EST

I neither like nor dislike buybacks, special dividends, and other bits of financial engineering that extract limited value at a cost of increasing leverage. In one sense, these measures are a type of LBO-lite at best, merely covering the tracks of the dilution from options issuance mainly, or preparing to send the company to bankruptcy at worst.

A lot depends on what spot in an industry’s pricing cycle a given company is. It’s fine to increase leverage when the bad part of the cycle has played out and pricing power is finally returning. Unfortunately, unless they are careful, companies tend to have more excess cash toward the end of the good part of the cycle, at which point increasing leverage is ill-advised, but often happens because of pressure from activist investors and sell-side analysts.

My first article on RealMoney dealt with the concept of financial slack, and why it is particularly valuable for cyclical companies not to take on as much leverage as possible. One of the dirty secrets of investing is that highly-levered companies typically do not do well in the long run; they sometimes do exceptionally well in the short run, though, so if it is your cup of tea to speculate on highly-levered companies, just remember, don’t overstay your welcome at the party.

One final note: If a management team is talented, they should retain a “war chest” for the opportunities presented by volatility. Lightly-levered companies benefit from volatility, because they can buy distressed assets on the cheap. Highly-levered companies need volatility to stay low, because adverse conditions could lead to insolvency.

Leverage policy is just another tool in the bag of corporate management; it is neither good nor bad, but in the wrong hands, it can be poisonous to the health of a company. For most investors, sticking with strong balance sheets pays off in the longer-term.

Position: None

4) Financial accounting rules can work one of two ways: best estimate (fair value), or book value with adjustments for impairment.? Either system can work but they have to be applied fairly, estimating the value/amount of future cash flows.? Management discretion should play a small role.

5) Regarding Barry’s post on Bank Nationalization: I don’t like the term “nationalization.”? It’s too broad, as others have pointed out.? I am in favor of triage, which is what insurance departments (and banking regulators are supposed to) do every year.? Separate the living from the wounded from the dead.

The dead are seized and sold off, with the guaranty fund taking a hit, as well as any investors in the operating company getting wiped out.? The wounded file plans for recovery, and the domiciliary states monitor them.? The living buy up the pieces of the dead that are attractive, and kick money into the guaranty fund.? No money from the public is used.

We have made so many errors in our “nationalization” (bailout) that it isn’t funny.? We give money to them, rather than taking them through insolvency.? Worse, we give money to the holding companies, which does nothing for the solvency of operating banks.? We don’t require plans for recovery to be filed.? Further, we let non-experts interfere in the process (the politicians).? Better that the regulators get fired for not having done their jobs, and a new set put in by the politicians, than that the politicians add to the confusion through their pushing of unrelated goals like increasing lending, and management compensation.

The concept of the “stress test” is crucial here.? It could be set really low (almost all banks pass) or really high (almost all banks fail — akin to forcible nationalization).? Clearly, something in-between is warranted, but the rumors are that the test will be set low, ensuring that few banks get reconciled, and the crisis continues for a while more.

I’m in favor of the bank regulators doing their jobs, and the FDIC guiding the rationalization of bad banks, with an RTC 2 to aid them.? Beyond that, there isn’t that much to do, and there shouldn’t be that much money thrown at the situation.? We have wasted enough money already with too little in results.

One final comment — for years, many claimed that the banks were better regulated than the insurers.? Who will claim that now?

6) Equity Private rides again at Finem Respice (“look to the end”).? A good first post on how this all will not end well.

7) Whatever one thinks about mortgage cramdowns (I can see both sides), they will have a negative effect on bank solvency, and the solvency of those who hold non-Fannie and Freddie mortgage backed-securities.

8 ) What has happened to Saab is what should happen to insolvent automakers here in the US.? The companies will survive in a smaller form, with the old owners wiped out, and new owners recapitalizing them.

9)? Will the new housing plan work?? I’m not sure, but I would imagine that it would cost a great deal to support a large asset class above its theoretical equilibrium value.? There are also the issues of favoritism, and rewarding those less prudent.? We will see whether it doesn’t work (like Bush’s proposals), or works too well (my, but we burned through that money fast).? (Other thoughts: Mean Street, Barry, simple explanation from the NYT.)? As it is, many people will not be eligible for the help.

10) How do you eat an elephant?? One bite at a time. How well did Japan do in working through its leverage problem in the 90s and 2000s?? Reasonably well, though it took a while.? Deleveraging takes time when many balance sheets are constrained, and asset values are falling back to psuedo-equilibrium levels.? One person’s liability is another person’s asset; when a large fraction of parties are significantly levered, the reconciliation of bad debts can cascade, like a child playing with dominoes.

So, Japan took its time with a messy process rather than have a “big bang,” with less certain results in their eyes.? In America, we want to get this over with quickly, but not do a “big bang” either.? That’s where a lot of the cost comes in, because in order to reconcile private debts rapidly, the government must subsidize the process.? All that said, in the end we will have a lot of debt issued by the US Government, just in time to deal with the pensions/entitlement crisis from a position of weakness. And, that’s where Japan is today, facing a shrinking population with a lot of government debt, and rising demands for entitlement spending.? Japan may be a laboratory for the US, Canada, and Europe as we look at the same problems 5-20 years out.

11) If you want to search for prices and other data on bonds, look here.

12) Marc Faber makes many of the point that I have made about the crisis in this editorial.

13) Swiss bankruptcy?? I would never have thought of that possibility, but considering that it is a smaller country with a relatively large banking system, and those banks have made a decent amount of loans to weaker creditors in Eastern Europe.? Add Switzerland to the list with Austria on Eastern European lending troubles.

14) What is Buffett thinking in his recent sale of stocks?? Some criticize him for being inconsistent with his philosophy of long holding periods, but Buffett is a very rational guy.? He is getting some good opportunities in this market, and is selling opportunities that seem less good to him.? Could he be wrong?? Yes, but over the year, he has been pretty good at estimating the relative values of assets.? He’s made his share of mistakes recently, but 95% of investors have been in that same boat.? At least he has the insurance franchise to carry things along, and given the reduction in surplus across the industry from the fall in equitiues and other risky assets, pricing power should begin improving soon.? Berky is interesting here.

15) Mirroring the bubble, Anglo-Irish Bank rode the global liquidity wave up, then down.? Ireland was the hot place in the EU, and now the bigger boom, fueled by easy credit, has given way to a bigger bust.

Malthus, the False Prophet

Malthus, the False Prophet

For those with access to The Economist, I would advise reading Malthus, the false prophet.? In one sense, Malthus was a guy who ran afoul of the idea that you shouldn’t make predictions about the long term, or, assume that people can’t make changes to solve problems.

This is one reason that I rarely go in for “total disaster” scenarios.? Disaster, yes.? Big problems, sure.? But total collapse-type scenarios rarely happen because people act individually, corporately, and through their governments (which want to stay in power).? There are rare cases of failure — for a recent one, think of the fall of the Soviet Union after the failure of Chernobyl.? And, that was a relatively benign failure in aggregate.

To give another example, the Y2K problem was real, but the hysteria over it drove companies, politicians and bureaucrats to solve the problems, and the problems were largely solved with a year to spare.

The current worry is that high energy and food prices will get worse as our world continues to grow, and that poverty will increase as some can’t buy necessities.? Metal prices will rise as well as there will be more need for construction materials.? Who knows?? Perhaps timber and cement will come into short supply as well.

High prices will help solve these problems.? We have many bright businessmen that want to make money off this, who will drive scientists and applied technologists to find ways of meeting the needs at lower costs.? In the 1970s, once the drive to become less energy-intensive? got going, it was hard to stop.? The R&D kept going for a while even after energy prices started falling, leading demand to fall further.? Also, sustained high prices will lead old technologies like wind and solar to become economic.? I sort of predicted this on RealMoney two years ago:



David Merkel
Peak Oil, Socialistic Governments, and Crisis
5/9/2006 3:31 PM EDT

Now, I’m not an expert on energy like Chris Edmonds, so don’t take what I write here too seriously. I write this because of some things I read by some doom-and-gloomers on energy over the weekend. I thought the stuff was nonsense, so I’m not even publishing a link to the articles.

In general, I tend to agree more with the “peak oil” theory than disagree with it, mainly because there haven’t been a lot of new big oil finds, and depletion of old fields continues. “Peak oil” means that global output of oil will not increase beyond a certain level, which either has been reached, or will be reached in the next five years.

Beyond that, the behavior of socialistic governments like Venezuela and Bolivia tend to reduce oil output because they don’t manage the oil and gas deposits as well as those that they replaced. Beyond that, they reduce the incentive to search for new deposits, because the profit motive is reduced, if not eliminated.

So, I’m not optimistic about supply issues in energy, and I haven’t mentioned instability in other oil and gas producing nations. That said, I don’t believe that we are headed for a crisis, as some doom-and-gloomers forecast. If/when oil gets over $100/barrel and stays there, a combination of coal, nuclear, solar and wind will be used to generate electricity, and electric cars will become more common. Coal will be gasified as well. Ethanol will be a marginal contributor to the mix, because it takes a lot of energy to produce.

So, life will change some, and energy will become more expensive, but it won’t be the end of the world by any means. And, the scenario I posit above is a bearish one; things could end up better than that over the next two decades.

Position: none mentioned

Now, I’m not in the camp that says that the prices of food, energy and raw materials are coming down soon.? Changing the behavior of a culture takes time; changing technologies takes time.? The progress will likely come, though, and the process of meeting human needs as our world develops will persist, leading to better overall lives on our planet.

-==-=–==-=-=-=-=-=-=-=-=-=-

PS — It will be interesting to see how our world copes with zero population growth.? One of the dirty secrets of economics is that economies tend to do better with younger overall populations that are growing.? I can see governments, even China’s, adopting tax schemes that favor having large families.? I can also see governments becoming a lot more lenient about immigration for people under the age of 30, and families with children.

Now, this is utter heresy, because at present fertility projections our global population should top out at 9 billion around 2050.? My guess is that many governments will panic between 2020 and 2030, and promote fertility and immigration of the young.? Now, whether you can convince young women who have shed the idea that having and raising children is a large part of what life is about to change their minds is another matter… my guess is that the schemes will amount to little.? But who can tell?? Obviously, I haven’t fully learned from Malthus’ error: I’m on the other side of the debate, but still, I made long term guesses of what might happen.

PPS — Malthus was a minister, but unlike many ministers, he lacked confidence in the providence of God.? As an odd historical aside, that lack of confidence had a surprising effect — much later, another young man considering the ministry read the writings of Malthus, and doubted the goodness of God.? That man was Charles Darwin.? History is more complex than we could make up in a fictional work.

Insurance Earnings So Far 2Q07 ? Part V

Insurance Earnings So Far 2Q07 ? Part V

We’re not even midway through earnings season for insurance, and I have a dirty secret to share: Insurance stocks are down on the year on average. 🙁 What a scandal, particularly for an industry with little ties to the sectors in the market with the most credit stress.

Here’s the most recent file on insurance stock performance at earnings. Here are the main lessons, so far:

  • Beating earnings by 10% leads to beating the price performance of the index by about 1%.
  • Brokers and Commercial Lines are doing the best so far.
  • Positive price performance is associated with growing revenues, and rising guidance.
  • With the credit furor going on, it is no surprise that financial insurers are doing the worst of all of the subgroups.
  • Asset sensitive life insurers are faring badly in the face of good earnings, because with the fall in the equity markets, insurers might have lower asset based fees coming.
Theme: Overlay by Kaira