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The Education of a Corporate Bond Manager, Part II

The Education of a Corporate Bond Manager, Part II

Part I is here.

For a new corporate bond manager with very little apprenticeship-type training, I had to learn some things on the fly.? Of my first tier brokers, roughly half of them took pity on me initially and explained to me the rules of the road.? That happened partly because I wanted to try some things that my old boss rarely did, and as I did that one of my brokers would explain to me, “If you’re going to do that, you have to do it this way…” which I would confirm with one or two of my major brokers.

If I wanted to buy a bond that was not presently being offered, I learned to find out who brought the deal and made a market in the bond issue, and told them, “If you find a few million bonds in a such and so spread context, I would be happy to pick some up.? Now, the less I knew about the price context, the more conservative I would be about price and size.? If I found a large amount offered to me at my level (rare), I would honor it by buying a small amount, and then backing up my price level to where I would not be offered so much, and try for more at better prices.

Price discovery is tough business, because some bonds trade rarely.? There are things to help you:

  • Comparable bonds in the same industry
  • Credit spreads across rating categories
  • Credit spreads across the maturity spectrum within rating categories
  • Spreads on credit default swaps on the same name.
  • Value of scarcity vs cost of illiquidity, and vice versa
  • Proper spread tradeoffs on premium vs discount bonds, call features, put features, off-the-run vs on-the-run issues, etc.
  • Calculating the spread on the last few trades, however dated, and then massaging the spread into what it is likely to be today.

My client was growing rapidly, and 30% of its liability structure was long because they wrote a lot of structured settlements.? [Geek note: structured settlements arise when a plaintiff wins a court case, and a stream of payments must be made by a defendant for the rest of the plaintiff’s life.? There are often inflation clauses, which makes the stream grow over time.? The defendant has insurance companies bid on paying the liabilities, and low bidder wins.]? I could buy a lot of long illiquid securities if my credit analysts liked the credit risk on the companies in question.

As such, I had a list of issues at various brokers that I wanted to buy if they became available.? Those ranged from moderately liquid to very illiquid.? I had a list that I sent out every now and then that I called the “Odd Duck” list; for fun, the last name on the list was the ultimate odd duck, AFLAC.? That got a few chuckles.

But with a rapidly growing client, much as I liked to source bonds that I fundamentally liked on the secondary market, I had to buy a lot of bonds in the new issue primary market.? Under normal conditions, the bond market has a lot of IPOs each day, as new bonds get issued, most often from companies that have issued before, but the characteristics of the new bond are different.

Now sometimes, when the corporate bond market is cold, or a deal is complex, it will take days for the deal to close, and sometimes a week or more.? But when things are hot, deals can close in seven minutes.? When I would see a new deal, the first thing I would do is analyze where we were in the speculation cycle for new deals.? As I said in my last piece, on average, new deals are brought a little cheap, because there is a price to gain liquidity that the issuer pays.

When deals were closing slowly, like say in half a day or more, I would send the deal terms to the analyst, and ask if she liked the credit.? If she said no, I would refuse the deal.? Otherwise I would put in for my normal allocation of bonds, subject to my limit for the company in question, and varying with the attractiveness of the deal, and how much cash I had to put to work.? When the market was rational, typically I would get good allocations, and deals would trade up a decent amount after issue.

But when the market was hot, and deals would close within an hour, I would work differently.? When the deal would come, I would put in for bonds, so that I would get some allocation.? I would ask for the high end of what I would normally ask for, knowing that I would get scaled back considerably.? Then I would send the details to my credit analyst, telling them that if they did not like the company, I would sell the bonds.

Eventually, most of my analysts during the times when the market was hot would come to me and say, “How can you put in for bonds without an opinion from us?”? First I would reassure them, and tell them that I valued their opinions, and that I would not hold onto a bond permanently unless they liked it.? I would sell all bonds they did not like, but when the technicals favored it, within a few months.

Second, I would tell them, “I do the one-minute drill,” which elicited the obvious question, “What’s the one minute drill?”? I then led them through a series of Bloomberg screens that would allow me to get a quick read on creditworthiness:

  • GPO – how has the stock price moved over the last year?? Down hard is a deal killer.
  • HIVG – how have option implied volatilities moves of late? Up considerably more than the market is a bad sign.
  • CH6 – how is operating cash flow doing?? If it is considerably worse than earnings, that ‘s a bad sign.
  • DES – what industry is it in?? Do I hate that industry?? If so, don’t play.
  • DES3 – all of the major financial ratios for the company.? What do the typical bond ratios look like?? Are they materially worse than those for the industry?
  • CH2 or ERN, are earnings declining?? If so beware.
  • CRPR – what are the credit ratings?

Then I would tell the credit analyst that if a company passes these tests, the odds of the company doing badly while I wait for the analysis of the credit analysts was slim.? Then I would get a smile from the analyst, who would go and do their analysis without fear of something going badly wrong while they do their analysis.

But there is one last complexity here.? When deals are running hyper-hot, and are closing in minutes, it is good to take a step back and ask on each deal if the yield spread is too tight. Bond syndicates price some deals too tight, and instead of the deals rising after issuance, something horrible happens.? I will bring that up, and other matters, in part III.

The Education of a Corporate Bond Manager, Part I

The Education of a Corporate Bond Manager, Part I

In 2001, I became a corporate bond manager by accident.? I had been the mortgage bond manager and risk manager of a unit managing the assets of a medium-to-large life insurer, when the boss left to take another job in the midst of a merger.

The staff and I got together, and the credit analysts told me that I should lead the organization during the merger.? When I asked why, they said they trusted me, appreciated my growing bond skills, that I was the only one who understood the client, and said that I had a better call on credit than the boss had.? I was surprised by that last comment, but upon meeting with the management of our parent company that was selling us, along with the life insurance company that we managed, they told me that yes, I should lead the unit until the merger closed, but rely on the high yield manager in our group to advise me for the duration, which was going to be three months.

The first thing that I did was a bond swap, trading away an older bond of a company for a new issue.? There was some hurry in the matter, so I entered into the swap before I could consult the high yield manager.? After I could talk with him, he pointed out that I had offered terms more favorable than I should have.? On a $5M swap, I ended up losing $20K.? We worked through the swap a number of different ways, which solidified my knowledge of corporate bond pricing.? I did not make that error again.

In the corporate bond market, new deals come frequently.? My former boss would do almost all of his bond buying on new deals, and almost never in the secondary market, because he knew that new deals almost always came cheap.? There is a price to be paid by corporations to gain liquidity.? The life company that I managed money for was growing like a weed (their products were perpetually underpriced), so I had a lot of money to put to work.

But, I already had a large portfolio of corporate names.? I was familiar with many of them to some degree because of my stock investing.? How could I go through the whole portfolio to look for bombs that might be lurking? Ask the credit analysts to give me a review on every name?? I did not want to kill them, or me for that matter.

I took the idea home , and thought about it, and then it struck me.? Thinking of bonds as having sold a put option to the equity, why not look at the amount that the stocks of the companies issuing the bonds had fallen in price since issuance of the bonds?? I set a threshold of 50%, and that gave me a list of about 30 names to hand to the analysts.? Manageble.? Cool.? (Oh, and tell me briefly about these 20 private bonds where there is no stock price.)

The analysts came back with their opinions, and surprisingly they advised selling half of the bonds and keeping the other half.? That was more than I expected.? But I started selling away, and began to learn the art of price discovery.? When you want to sell a bond, you first have to look at what investment banks ran the books of the deal.? There is an unwritten rule that if they play that large role in origination, they have to make a market in the bonds thereafter.? So, I consulted the various investment banks and inquired about levels, and then said something to the effect of, “If there is a reasonable bid (naming the spread over Treasuries) we would be interest in losing a few million bonds.? If there is an aggressive bid, we could be induced into selling a few more.? We might even be willing to sell the whole wad if they make us the offer that we can’t refuse.”

If there were multiple banks that traded the bond, I would set the above up with just one bank.? You never wanted to make it look like there were two sellers out there, or bids would vanish.? Beyond that, it was bad etiquette to employ two banks without telling them that they were in competition with each other.? If not. you could end up with two orders to buy your bonds, and you would have a moral obligation to meet both orders, even if that was against your interests.

Usually the broker would ask for the total size of the wad available for sale.? The idea was to get the buyers to think economically.? Yes, they could get a small amount of bonds if they met the spread, but was it worth it to bid for more?? Also, if they bought the wad, they would know that there were likely no more bonds on offer, the selling pressure would be gone, and the bonds would likely trade up from there.

I sold away a decent amount of the bonds that the analysts wanted gone, and then 9/11 hit.? What a day.? Since we worked inside the insurance company that we manager money for, and we had two TVs on the corners of our trading floor, all of a sudden our area was flooded with people staring at the spectacle.? I almost felt like Crocodile Dundee as I had to maneuver my way around and over them.

I gathered my staff and told them to look at their portfolios, and e-mail me threat reports so that I could inform our client.? After that, take the rest of the day off, as there is nothing to do here; many of them wanted to mourn friends that might be dead (I lost two acquaintances).? I summarized the threat reports, and submitted them to the client by 4PM.? We repeated that process for the next eight business days, until the crisis was past.

I had worries over One Liberty Plaza, next to the former World Trade Center, which seemed to be leaning, and might fall.? We owned the AAA portion of the CMBS that contained the loan for that building.? As I scoured the web, I concluded there was no danger, the building only looked like it was leaning; the dark coloration was deceptive.

Eventually trading resumed.? If you remember Metcalfe’s Law, the value of a telecommunications network is proportional to the square of the number of connected users of the system.? Well, after 3 days, 2 of 12 major brokers were running, which meant that there was no trading.? After 4 days, 6 brokers were up, so I made an offer on some AA Manufactured Housing ABS, deeply below where there market was prior to the crisis.? I got hit, and I owned the bonds.? Some said to me, “Why not wait?? Why offer liquidity now?? I said that some had to make some bids to restart the market; my client had ample liquidity, and I was offering liquidity at a price; if someone was that desperate for liquidity, they could have it at my price.

After 5 days 8 of the 12 were up, and after 6, 10 of 12.? The last two took a while to re-emerge, but were back after 10 days.? Even so, things seemed sluggish.

I began to do the same with corporate bonds, doing a large auction offering liquidity, specifying bonds that I wanted at certain levels, and the amounts.? I ended up buying half of my list, and still my client had ample liquidity.? What a high quality problem to have.? More in my next segment.

The Rules, Part LXXII

Picture Credit: Kailash Gyawali || There are times when despair is rational

“There are two hard things in trading — buying higher, and selling lower.”

Currently I am selling out my position in an illiquid stock. I am patient, but I can tell that my selling is having an impact on the market.

Back when I was a corporate bond manager, I quickly learned that I had to scale in and out of positions. Even for the most commonly traded bonds, the market isn’t that liquid. While not lying to the brokers, learning to disguise your intentions, or at least frame them properly took some effort. One method I commonly used worked like this: “We need some cash. If you have someone wanting to buy $2-5 million, we will offer these at the 10-year Treasury + 150 basis points, $6-10 million T10 + 140 bps, and if they want to buy the whole wad (say 20-30 million), T10 + 125 basis points. Prices would ascend with size in selling. Prices would descend with size in buying, particularly for troubled bonds that we liked.

Usually the brokers appreciated the supply or demand curves that I gave them. Frequently I ended up selling the “the wad,” which we were usually selling because our credit analyst had a reason.

But life is not always so happy. Sometimes you have an asset that either you or the organization has concluded is a dud. Many people think it is a dud. How do you sell it? Should you sell it?

There are options: you could hold an auction, but I will tell you if you do that, play it straight. Your reputation is worth far more than if the auction succeeds or not. You can set a reservation price but if the auction doesn’t sell, you will lose some face.

Or you can test the market, selling in onesies an twosies ($1-2 million) seeing if there is any demand, and expand from there if you can.

What I tended to do was go to my most trusted broker on a given bond and say, “I don’t have to sell this, but we need cash. Could you sound out those who own the bonds and see what they might like to buy a few million?” If we get an interested party, we can sound them out on buying more a an attractive price.

But life can be worse, imagine trying to sell the bonds of Enron post default. Yes, I had to do that. And I had to sell them at lower and lower prices. (Kind of like the time I got trapped with a wad of Disney 30-year bonds.)

And there is the opposite. You want to have a position in an attractive company, and you can’t get them at any reasonable price. You could give up. You could “do half.” Or you could chase it and get the full position, only to regret it.

If you invest with an eye toward valuations, this will always be a challenge. All that said, if you focus on quality, these issues probably won’t hurt you as much.

In any case, do what must be done. If something must be bought, buy it as cheaply as possible. If something must be sold, sell it as dearly as you can. Hide your intentions, while offering deals. In doing so, you may very well realize the most value.

The Best of the Aleph Blog, Part 27

The Best of the Aleph Blog, Part 27

In my view, these were my best posts written between August?and October?2013:

I completed the last of my “Manager” series, on being an investment risk manager:

The Education of an Investment Risk Manager, Part VI

This is the bizarre story of how I pulled a win out of an impossible situation against my own management, and a major life insurer.

The Education of an Investment Risk Manager, Part VII

On the time that I correctly modeled a complex structured security, and the client wouldn’t listen to reason

The Education of an Investment Risk Manager, Part VIII

The time that I?did a competitive study of the most aggressive life insurers, and how it did not dissuade my client’s management team from trying to imitate them.

The Education of an Investment Risk Manager, Part IX (The End)

A bevy of little tales about odd investment tasks that I succeeded with, and how many of them did no good for my clients.

Ben Graham Did Not Give Up on Value Investing in Theory

With quotations and links to the source documents, I show what Ben Graham really said in the article commonly cited to say that he gave up on value investing.

On Avoiding Con Men

A summary article of many of my prior articles on how to avoid being defrauded.

On Alternative Investments

Alternative investments are like regular investments, but they are less liquid, more opaque, and have higher fees.

Should You Buy Shares of Stock or Not?

Where I answer Mark Cuban the one time he tweeted to me. ?Really!

Quiet Companies Are Better

Why companies should let their filings with the SEC speak for them, and abandon the media.

Two is Company, Three is a Crowd

On game theory, and how it affects politics and civil wars.

It Works, But It Doesn?t Work All The Time

On how good investment theories fail for periods of time, and then come roaring back when most people know they will never work again.

Value Investing when Debt Levels are High

On seeking a margin of safety, when very little seems safe

A New Look at Endowment Investing

I interact with a groundbreaking paper on endowment investing — a very good paper, and I give some ways that it could be improved.

Less is More

Do you want to do better in investing? ?Make fewer decisions, and make them count.

Taleb Versus Reality

In which I take on Nassim Taleb’s views on how to reduce risk in investing, and show which half of his valid, and which half are fantasy.

To Young Analysts

What I contributed to Tom Brakke’s project for young investment analysts — what do I think they should know?

The Rules, Part XLIX

In institutional portfolio management, the two hardest things to do are to buy higher than your last buy, and sell lower than your last sale.

The Rules, Part L

Countries are firms that produce claims on assets and goods

The Rules, Part LI

65% of the time, the rules work.? 30% of the time, the rules don?t work. 5% of the time, the opposite of the rules works.

The Rules, Part LII

ge + E/P > ilongest bond

The Rules, Part LIII

The tech market washes out about every eight years or so.? The broad market, which is a more robust beast, washes out far less frequently.? My question: are these variants of the same phenomenon?

The Rules, Part LIV

When do employee and corporate incentives line up?? Ideally, incentive schemes should reward people with a fraction of the additional profitability that resulted from the additional work that they did.? Difficulties: measurement impossible in many cases, people could receive a bonus when the firm is not profitable, neglects synergies (both positive and negative).

The Rules, Part LV

Financial intermediation reduces volatility.? In bull markets, demand for financial intermediaries drops.

The Rules, Part LVI

Leverage and risk eventually transfer to the least regulated

The Rules, Part LVII

The more that markets are united through derivatives, the more systemic risk is created.

The Shadows of the Bond Market’s Past, Part I

The Shadows of the Bond Market’s Past, Part I

Simulated Constant Maturity Treasury Yields 8-1-14_24541_image001

 

Source: FRED

Above is the chart, and here is the data for tonight’s piece:

Date T1 T3 T5 T7 T10 T20 T30 AAA BAA Spd Note
3/1/71 3.69 4.50 5.00 5.42 5.70 5.94 6.01* 7.21 8.46 1.25 High
4/1/77 5.44 6.31 6.79 7.11 7.37 7.67 7.73 8.04 9.07 1.03 Med
12/1/91 4.38 5.39 6.19 6.69 7.09 7.66 7.70 8.31 9.26 0.95 Med
8/1/93 3.44 4.36 5.03 5.35 5.68 6.27 6.32 6.85 7.60 0.75 Med
10/1/01 2.33 3.14 3.91 4.31 4.57 5.34 5.32 7.03 7.91 0.88 Med
7/1/04 2.10 3.05 3.69 4.11 4.50 5.24 5.23 5.82 6.62 0.80 Med
6/1/10 0.32 1.17 2.00 2.66 3.20 3.95 4.13 4.88 6.23 1.35 High
8/1/14 0.13 0.94 1.67 2.16 2.52 3.03 3.29 4.18 4.75 0.57 Low

Source: FRED ? ||| ? ? * = Simulated data value ?||| ?Note: T1 means the yield on a one-year Treasury Note, T30, 30-year Treasury Bond, etc.

Above you see the seven yield curves most like the current yield curve, since 1953. ?The table also shows yields for Aaa and Baa bonds (25-30 years in length), and the spread between them.

Tonight’s exercise is to describe the historical environments for these time periods, throw in some color from other markets,?describe what happened afterward, and see if there might be any lessons for us today. ?Let’s go!

March 1971

Fed funds hits a local low point as the FOMC loosens policy under Burns to boost the economy, to fight rising unemployment, so that Richard Nixon could be reassured re-election. ?The S&P 500 was near an all-time high. ?Corporate yield spreads ?were high; maybe the corporate bond market was skeptical.

1971?was a tough year, with the Vietnam War being unpopular.?Inflation was rising, Nixon severed the final link that the US Dollar had to Gold, an Imposed wage and price controls. ?There were two moon landings in 1971 — the US Government was in some ways trying to do too much with too little.

Monetary policy remained loose for most of 1972, tightening late in the years, with the result coming in 1973-4: a severe recession accompanied by high inflation, and a severe bear market. ?I remember the economic news of that era, even though I was a teenager watching Louis Rukeyser on Friday nights with my Mom.

April 1977

Once again, Fed funds is very near its local low point for that cycle, and inflation is rising. ?After the 1975-6 recovery, the stock market is muddling along. ?The post-election period is the only period of time in the Carter presidency where the economy feels decent. ?The corporate bond market is getting close to finishing its spread narrowing after the 1973-4?recession.

The “energy crisis” and the Cold War were in full swing in April 1977. ?Economically, there was no malaise at the time, but in 3 short years, the Fed funds rate would rise from 4.73% to 17.61% in April 1980, as Paul Volcker slammed on the brakes in an effort to contain rising inflation. ?A lotta things weren’t secured and flew through the metaphorical windshield, including the bond market, real GDP,?unemployment, and Carter’s re-election chances. ?Oddly, the stock market did not fall but muddled, with a lot of short-term volatility.

December 1991

This yield curve is the second most like today’s yield curve. ?It comes very near the end of the loosening that the FOMC was doing in order to rescue the banks from all of the bad commercial real estate lending they had done in the late 1980s. ?A wide yield curve would give surviving banks the ability to make profits and heal themselves (sound familiar?). ?Supposedly at the beginning of that process in late 1990, Alan Greenspan said something to the effect of “We’re going to give the banks a lay-up!” ?Thus Fed funds went from 7.3% to 4.4%?in the 12 months prior to December 1991, before settling out at 3% 12 months later. ?Inflation and unemployment were relatively flat.

1991 was a triumphant year in the US, with the Soviet Union falling, Gulf War I ending in a victory (though with an uncertain future), 30-year bond yields hitting new lows, and the stock market hitting new all time highs. ?Corporate bonds were doing well also, with tightening spreads.

What would the future bring? ?The next section will tell you.

August 1993

This yield curve is the most like today’s yield curve. ?Fed funds are in the 13th month out of 19 where they have been held there amid a strengthening economy. ?The housing market is?doing well, and mortgage refinancing has been high for the last three years, creating a situation where those investing in mortgages securities have a limited set of coupon rates that they can buy if they want to put money to work in size.

An aside before I go on — 1989 through 1993 was the era of clever mortgage bond managers, as CMOs sliced and diced bundles of mortgage payments so that managers could make exotic bets on moves in interest and prepayment rates. ?Prior to 1994, it seemed the more risk you took, the better returns were. ?The models that most used were crude, but they thought they had sophisticated models. ?The 1990s were an era where prepayment occurred at lower and lower thresholds of interest rate savings.

As short rates stayed low, long bonds rallied for two reasons: mortgage bond managers would hedge their portfolios by buying Treasuries as prepayments occurred. ?They did that to try to maintain a constant degree of interest rate sensitivity to overall moves in interest rates. ?Second, when you hold down short rates long enough, and you give the impression that they will stay there (extended period language was used — though no FOMC Statements were made prior to 1994), bond managers start to speculate by buying longer securities in an effort to clip extra income. ?(This is the era that this story (number 2 in this article) took place in, which is part of how the era affected me.)

At the time, nothing felt too unusual. ?The economy was growing, inflation was tame, unemployment was flat. ?But six months later came the comeuppance in the bond market, which had some knock-on effects to the economy, but primarily was just a bond market issue. ? The FOMC hiked the Fed funds rate in February 1994 by one?quarter percent, together with a novel statement issued by Chairman Greenspan. ?The bond market was caught by surprise, and as rates rose, prepayments fell. ?To maintain a neutral market posture, mortgage bond managers sold long Treasury and mortgage bonds, forcing long rates still higher. ?In the midst of this the FOMC began raising the fed funds rate higher and higher as they feared economic growth would lead to inflation, with rising long rates a possible sign of higher expected inflation. ?The FOMC raises Fed fund by 1/2%.

In April, thinking they see continued rises in inflation expectation, they do an inter-meeting surprise 1/4% raise of Fed funds, followed by another 1/2% in May. ?It is at this pint that Vice Chairman McDonough tentatively realizes?[page 27] that the mortgage market has?now tightly coupled the response of the long end of the bond market to the short end the bond market, and thus, Fed policy. ?This was never mentioned again in the FOMC Transcripts, though it was the dominant factor moving the bond markets. ?The Fed was so focused on the real economy, that they did not realize their actions were mostly affecting the financial economy.

FOMC policy continued: Nothing in July, 1/2% rise in August, nothing in September, 3/4% rise in November, nothing in December, and 1/2% rise in February 1995, ending the tightening. In late December 1994 and January of 1995, the US Treasury and the Fed participated in a rescue of the Mexican peso, which was mostly caused by bad Mexican economic policy, but higher rates in the US diminished demand for the cetes, short-term US Dollar-denominated Mexican government?notes.

The stock market muddled during this period, and the real economy kept growing, inflation in check, and unemployment unaffected. ?Corporate spreads tightened; I remember that it was difficult to get good yields for my Guaranteed Investment Contract [GIC] business back then.

But the bond markets left their own impacts: many seemingly clever mortgage bond managers blew up, as did the finances of Orange County, whose Treasurer was a mortgage bond speculator. ?Certain interest rate derivatives blew up, such as the ones at Procter & Gamble. ?Several life insurers lost a bundle in the floating rate GIC market; the company I served was not one of them. ?We even made extra money that year.

The main point of August 1993 is this: holding short rates low for an extended period builds up imbalances in some part of the financial sector — in this case, it was residential mortgages. ?There are costs to providing too much liquidity, but the FOMC is not an institution with foresight, and I don’t think they learn, either.

This has already gotten too long, so I will close up here, and do part II tomorrow. ?Thanks for reading.

The Education of an Investment Risk Manager, Part IX (The End)

The Education of an Investment Risk Manager, Part IX (The End)

I’m bringing this series to a close with some odds and ends — a few links, a few stories, etc.? Here goes:

1) One day, out of the blue, the Chief Investment Officer walked into my office, which was odd, because he rarely left the executive suite, and asked something like: “We own stocks in the General Account, but not as much as we used to.? How much implicit equity exposure do we get from our variable annuities?”? The idea was this: as the equity markets go up, so does our fee stream.? If the equity market goes up or down 1%, how much does the present value of fees change?? I told him I would get back to him, but the answer was an easy one, taking only a few hours to calculate & check — the answer was a nickel, and the next day I walked up to the executive suite and told him: “If we have 20% of our liabilities in variable annuities it is the equivalent to having 1% of assets invested in the stock market.

2) This post, Why are we the Lucky Ones? could have been a post in this series.? At a small broker-dealer, all sorts of charlatans bring their ideas for financing.? The correct answer is usually no, but that conflicts with hope.? Sadly, Finacorp did not consult me on the last deal, which is part of the reason why they don’t exist now.

3) The first half of the post, The Education of a Mortgage Bond Manager, Part IX, would also fit into this series — the amount of math that went into the analysis was considerable, but the regulatory change that drove it led us to stop investing in most RMBS.

4) While working for a hedge fund, I had the opportunity to sit in on asset-liability management meetings for a bank affiliated with our firm.? I was floored by the low level of rigor in the analyses — it made me think that every bank should have at least one actuary to do analyses with the level of rigor in the insurance industry.

Now, this doesn’t apply to the big banks and investment banks because of their complexity, but even they could do well to borrow ideas from the insurance industry, and do stress testing.? Go variable by variable, on a long term basis, and ask:

  • At what level does this bring line profits to zero?
  • At what level does this bring company profits to zero?
  • At what level does this imperil the solvency of the company?

5) This story is a little weird.? One day my boss called me in and said, “There’s a meeting of corporate actuaries at the ACLI in DC.? You are our representative.? They will be discussing setting up an industry fund to cover losses from failures of Guaranteed Investment Contracts.? Your job is to make sure the fund is not created.”

His concern in 1996 was that it would become a black hole, and would encourage overly aggressive writing of GICs.? He didn’t want to get stuck with losses.? I told him the persuasion was not my forte, but I would do my best.? I said that my position was weak, because we were the smallest company at the table, but he said to me, “You have a voice at the table.? Use it.”

A few days later, I was on the Metroliner down to DC.? I tried to understand both sides of the argument.?? I even prayed about it.? Finally it struck me: what might be the unintended consequences from the regulators from setting up a private guaranty fund?? What might be the moral hazard implications?

At the meeting, I found one friend in the room from AIG.? We had worked together, and AIG didn’t like the idea either.? In the the early parts of the meeting it seemed like there were 10 for the industry fund, and 3 against, AIG, Principal, and us.? Not promising.? We talked through various aspects of the proposal, the three representatives taking the opposite side — it seemed like no one was changing their minds, but some opinions were weaker on the other side.

By 3PM the moderator asked for any final comments before the vote.? I raised my hand and said something like, “You have to think of the law of unintended consequences here.? What will be the impact on competition here?? What if one us, a large company decides to be more aggressive as a result of this?? What if regulators look at this as a template, and use it to ask for similar funds more broadly in life insurance??? The state guaranty funds would certainly like the industry to put even more skin into the game.”

The room went silent for a few seconds, and the vote was taken.

4-9 against creating the guaranty fund.

The moderator looked shocked.

The meeting adjourned and I went home.? The next day I told my boss we had won against hard odds.? He was in a grumpy mood so he said, “Yeah, great,” barely acknowledging me.? This is the thanks I get for trying something very hard?

6) In early 2000, I had an e-mail dialogue with Ken Fisher.? I wanted to discuss value investing with him, but he challenged me to develop my own proprietary sources of value.? Throw away the CFA syllabus, and all of the classics — look for what is not known.

So I sat down with my past trading and looked for what I did best.? What I found was that I did best buying strong companies in damaged industries.? That was the key idea that led to my eight portfolio rules. Value investing with industry rotation may be a little unusual, but it fit my new view of the world. I couldn’t always analyze changes in pricing power directly, but I could look at industries where prices had crashed, and pick through the rubble.

In Closing

My career has been odd and varied, which has led to some of the differential insights that I write about here.? In some ways, we are still beginning to understand investment risks — for example, how many saw the financial crisis coming — where a self-reinforcing boom would give way to a self-reinforcing bust?? Not many, and even I did not anticipate the intensity of the bust.? At least I didn’t own any banks, and only owned sound insurers.

Investment risk is elusive because it depends partly on the collective reactions of investors, and not on external shocks like wars, hurricanes, bad policy, etc.? We can create our own crises by moving together in packs, going from bust to boom and back again.

It is my hope after all these words that some will approach investing realizing that avoiding risks is as important as seeking returns, and sometimes, more important.? It is not what you earn, but what you keep that matters.

The Education of an Investment Risk Manager, Part VIII

The Education of an Investment Risk Manager, Part VIII

“So you’re the new investment risk manager?”

“Yes, I am,” I said.

CA: “Well, I am the Chief Actuary for [the client firm].? I need you to do a project for me.? We have five competitors that are eating our lunch.? I want you to figure out what they are doing, and why we can’t do that.”

Me: “I’ll need to get approval from my boss, but I don’t see why not.? A project like this is right up my alley.”

CA: “What do you mean, right up your alley?”

Me: “I’m a generalist.? I understand liabilities, but I also understand financing structures, and I can look at assets and after a few minutes know what the main risks are and how large they are.? I may not be the best at any of those skills, but when they are combined, it works well.”

CA: “When can you have it to me?”

Me: (pause) “Mmm… shouldn’t take me longer than a month.”

CA: “Great.? I look forward to your report.”

The time was late 1998, just prior to the collapse of LTCM.? Though not well understood at the time, this was the “death throes” of the “bad old days” in the life insurance industry for taking too much asset risk.? Yes, there had been bad times every time the junk bond market crashed, and troubles with commercial mortgages 1989-1992, but the industry had not learned its lessons yet.

The 5 companies he picked were incredibly aggressive companies.? One of them I knew from going to industry meetings came up with novel ways of earning extra money by taking more risk.? I thought the risks were significant, but they hadn’t lost yet.

So what did I do?? I went to EDGAR, and to the websites of the companies in question.? I downloaded the schedule Ds of the subsidiaries in question, as well as the other investing schedules.? I read through the annual statements and annual reports.? I had both my equity investor and bond investor “hats” on.? I went through the entirety of their asset portfolios at a cursory level, and got a firm understanding of how their business models worked.

Here were the main findings:

  • These companies were using double, and even triple-leveraging to achieve their returns.? Double-leveraging is a normal thing — a holding company owns an operating insurance subsidiary, and the holding company has a large slug of debt.? Triple leveraging occurs when a holding company owns an operating insurance subsidiary, which in turn owns a large operating insurance subsidiary.? This enables the companies to turn a small return on assets into a large return on equity, so long as things go well.
  • The companies in question were taking every manner of asset risks.? With some of them I said, “What risks aren’t you taking?”? Limited partnerships, odd subordinated asset-backed securities, high yield corporates, residential mortgage bonds with a high risk of prepayment, etc.

So, when I met with the Chief Actuary, I told hid him that the five were taking unconscionable risks, and that some of them would fail soon.? I explained the risks, and why we were not taking those risks.? He objected and said we weren’t willing to take risks.? As LTCM failed, and our portfolios did not get damaged, those accusations rang hollow.

But what happened to the five companies?

  • Two of them failed within a year — ARM Financial and General American failed because they had insufficient liquid assets to meet a run on their liquidity, amid tough asset markets.
  • Two of them merged into other companies under stress — Jefferson Pilot was one, and I can’t remember the other one.
  • Lincoln National still exists, and to me, is still an aggressive company.

Four of five gone — I think that justified my opinions well enough, but the Chief Actuary brought another project a year later asking us to show what we had done for them over the years.? This project took two months, but in the end it showed that we had earned 0.70%/yr over Single-A Treasuries over the prior six years, which is? a great return.? The unstated problem was they were selling annuities too cheaply.

That shut him up for a while, but after a merger, the drumbeat continued — you aren’t earning enough for us, and, in 2001-2, how dare you have capital losses.?? Our capital losses were much smaller than most other firms, but our main client was abnormal.

To make it simple, we managed money for an incompetent insurance management team who could only sell product by paying more than most companies did.? No wonder they grew so fast.? If they had not been so focused on growth, we could have been more focused on avoiding losses.

What are the lessons here?

  • Rapid growth with financials is usually a bad sign.
  • Analyze liability structures for aggressiveness.? Look at total leverage to the holding company.? How much assets do they control off of what sliver of equity?
  • If companies predominantly buy risky assets, avoid them.
  • Avoid slick-talking management teams that don’t know what they are doing.? (This sounds obvious, but 3 out of 4 companies that I worked for fit this description.? It is not obvious to those that fund them.)

And sadly, that applied to the company that I managed the assets for — they destroyed economic value, and has twice been sold to other managers, none of whom are conservative.? Billions have been lost in the process.

It’s sad, but tons of money get lost through some financials because the accounting is opaque, and losses get realized in lumps, as “surprises” come upon them.

Be wary when investing in financial companies, and avoid novel asset risks, credit risk, and excess leverage.

The Rules, Part XLIX

The Rules, Part XLIX

In institutional portfolio management, the two hardest things to do are to buy higher than your last buy, and sell lower than your last sale.

I’ll tell you about two former bosses that I had.? They are both good men, and I respect them both.? The first one taught me about bond management.? He had a difficulty though.? Typically, he did not like to trade.? When I stepped into his role, but with far less experience, I traded a lot more than he did.? Because I traded more, and liquidity in the bond market is sporadic, I came up with the rule listed above.

The boss had an interesting insight, though: he suggested when you get to large sizes, stocks and bonds are equally illiquid.? I tend to agree.? In my days, I have traded stocks and bonds where I was a disproportionate holder of them, more so with bonds than with stocks.? If you want to learn the microstructure of markets, there is no better training ground than with illiquid securities.? And if you hold a lot of any security, the position is illiquid.

Once you are big, it is hard to trade in and out of positions rapidly.? You have to scale in and scale out, and do it in such a way that you don’t tip your hand to the market, which would then move against you.? Now, it would be easy if you had a fixed estimate of value for the securities, so that you knew whether a proposed buy or sell made sense, but corporate bonds and stocks improve and deteriorate.

Imagine for a moment that you hold five percent of a company’s bonds, and to your surprise, the situation is deteriorating.? Bid prices are falling.? What do you do?? First question: are the bonds money good?? Will they pay off, with high likelihood?? If so, bide your time, and maybe add some more if you have room.? If not, the second question: so what are the bonds worth?? If less than the current price, start selling, but avoid the appearance that you are desperate.? You have a lot of bonds to sell.? For the market to absorb them all will be a challenge.? I would say to brokers, that I was willing to sell small amounts of bonds at the current market, but if someone wanted to buy my full position, I might be willing to compromise a little.? Then you can have negotiations.

More often, in a deteriorating situation, you sell in dribs and drabs as the price of the asset falls.? There is psychological pain as you sell lower, but a good manager dismisses it, forgetting the past and focusing on the future.

Then there was the other boss.? At the interview he asked me, “What is one of the hardest lessons you have learned?”? I said, “In institutional portfolio management, the two hardest things to do are to buy higher than your last buy, and sell lower than your last sale.”

He appreciated the answer, though he had a hard time applying it personally.? He had a tendency to look to the past more than me.? Over the years I have learned to be forward-looking and try to analyze what securities will do the best, regardless of my cost basis.

I got the largest allocation of the Prudential “C” bonds when the deal was done. but I bought an equal amount 10% higher in price terms when it was a great deal in relative terms.? It was tough to buy more at a higher price, but it was still a great yield on a misunderstood bond.

Regret is native to mankind, but you can’t change the past.? You can try to estimate the future.? Don’t think about your cost bases.? Rather, think about what an asset is truly worth, and its trajectory, and manage your buys and sells relative to that.

Forward-looking management wins.? Look forward, and avoid regret.

PS — On Scottish Re (spit, spit) we went through this process.? We bought and bought more as it went down.? I erred in my judgment.? Had I looked at the taxable income, I would have realized that a lot of the profits weren’t real.

Before the company announced its reorganization plan, we doubled our position at a very low price, but then sold the whole thing into an astounding rally when the company announced its plans.? That cut our losses considerably, and we didn’t buy it back.? Eventually, it was worth nothing.? Focus on the future; ignore the past.

The Rules, Part XLII

The Rules, Part XLII

During a panic, it is useful to reflect on the degree to which the real economy has been driven by the financial economy.? In the Great Depression, the degree was heavy; in the seventies, it was light.? Today, my guess is that it is in-between, which makes it difficult to figure out the right strategy.

Again, this was written in 2002 or so.? As I posted last night, the banks were in relatively good shape then.? I made a lot of money for my clients buying bank floating rate trust preferred securities at ~$80.? There was no security that we did not clear at least $10 on, and most cleared $20 within a year.? One even went from $68 to $100, plus a healthy coupon.? In bond terms those were a series of home runs.? As an aside, as a bond investor, I focused more on net capital gains than most, and that helped us in a rocky era.? I often gave up current income to gain the potential for capital gains, which was the opposite of most of my competitors.

So in 2002 it was reasonable to buy banks as the willingness to supply of credit grew.? But there are limits to how much credit you can have in an economy without things getting screwy.? An economy with too many promises to pay becomes inflexible; far better to finance more of the economy with equity, but that requires a Fed that works properly, like it was under Eccles, Martin and Volcker.? Under men of less courage, like Bernanke, Greenspan, Burns, Miller, Crissinger, and Young, it simply paves the way for asset bubbles and price inflation.

In 1929 and 2008, though, it was relatively easy to know that the financial economy had grown too large for the real economy.? Total debt to GDP levels were at records.

Or think of it from this angle: in 2004, I was recruited by another financial hedge fund to be their insurance analyst.? I talked with them, but ultimately I refused, because I felt the boss was probably less competent than my current boss.? A major part of his presentation was how amazing the outperformance of financial stocks had been over the prior 10 years, implying that it would be the same over the next 10.? That outperformance was not repeatable because the capital of the banking and shadow banking industries had gotten so large that there was no longer any way that they could extract a high return out of the rest of the economy.? As it was, the effort to do so made them take on asset risks that killed many companies, and should have killed many, many more, had economic policy been handled properly.

This is one reason why my long only portfolio was so light on financials, excluding insurers, going into 2008.? I sold the last of my banks in 2007, realizing Europe would be no safe haven.? I retained one mortgage REIT that cratered as repo fell apart, teaching me a valuable lesson that I had bought something cheap, but not safe.? That was my only significant loss during the crisis starting in 2007-2008.? Repo funding is not a safe funding source during crises, and this is something that is not fixed from the last crisis, along with portfolio margining, and a few other weak liability structures.

With respect to the eras starting in 1929 and 2008, the key concept is debt deflation?? When there are too many debts, there will be too many bad debts.? That is the time to only only companies with strong balance sheets that will not need to refinance under any conditions.? That eliminates all banks and shadow banks.

I can’t guarantee that we are past the crisis, because we haven’t seen what will happen to the economy when the Fed starts to lessen policy accommodation, much less tighten.? As it is, for the most part, I not only own companies that are cheap, but primarily companies that are safe.? Value investing is “safe and cheap,” not just cheap.? This applies to financials as well, but many value investors lost a lot of money on financials because they ignored credit quality near the end of a credit boom.? Many credit-sensitive companies looked cheap near the end of the 2007, but they were cheap for a reason — they were about to get pelted by a ton of losses.

As an aside, do you know how hard it is to get a value manager to short something trading at 50% of book value?

I know how tough that is.? I’ve been through it.? He would not bite.

The company had asset risks as well as liability risks.? I extrapolated the liability cash flows to realize the long-term care? policies the company had written would likely bankrupt them.? But when the boss came to me pitching it as a long because one his buddies thought it was dirt-cheap, I uttered, “Gun to the head boss, I would tell you to short it.”? Reply: “But it’s trading at half of book value.” Me: “Book value is misstates true economic value.? Can’t say for certain, but I think this one goes out at zero.”

As it was, we did nothing, and the stock, Penn Treaty, did go out at zero. (There was one small positive out of this, I did convince the private equity arm not to fund a competitor in long-term care.)

Back to the main point.? Have a sense as to the financial economy.? This will probably only happen once in your life, but that time is crucial.? If there is a financial mania going on, move to safety, and reduce exposure to credit-sensitive financials.? It’s that simple, but to most value investors who invest in seemingly cheap financials that is a hard move.? Remember, safe comes before cheap in value investing, and that means questioning asset accrual items.? Financial companies have that in spades.

The Rules, Part XXXVII

The Rules, Part XXXVII

The foolish do the best in a strong market

“The trend is your friend, until the bend at the end.”? So the saying goes for those that blindly follow momentum.? The same is true for some amateur investors that run concentrated portfolios, and happen to get it right for a while, until the cycle plays out and they didn’t have a second idea to jump to.

In a strong bull market, if you knew it was a strong bull market, you would want to take as much risk as you can, assuming you can escape the next bear market which is usually faster and more vicious.? (That post deserves updating.)

Here are four examples, two each from stocks and bonds:

  1. In 1998-2000, tech and internet stocks were the only place to be.? Even my cousins invested in them and lost their shirts.? People looked at me as an idiot as I criticized the mania.? Buffett looked like a dope as well because he could not see how the enterprises could generate free cash reliably at any intermediate time span.
  2. In 2003-2007, there were 3 places to be — owning homebuilders, owning depositary financials or shadow banks, and buying residential real estate directly.? This was not, “Buy what you know,” but “Buy what you assume.”
  3. In 1994 many took Mexican credit risk through Cetes, Mexican short-term government debt.? A number of other clever investors thought they had “cracked the code” regarding residential mortgage prepayment, and using their models, invested in some of the most volatile mortgage securities, thinking that they had eliminated all risk, but gained a high yield.? Both trades went badly.? Mexico devalued the peso, and mortgage prepayments did not behave as expected, slowing down far more than anticipated, leading the most levered players to? blow up, and the least levered to suffer considerable losses.
  4. 2008 was not the only year that CDOs [Collateralized Debt Obligations] blew up.? There were earlier shocks around 2002, and the late ’90s.? Those buying them in 2008 and crying foul neglected the lessons of history.? The underlying collateral possessed no significant diversification.? Put a bunch of junk debt in a trust, and guess what?? When the credit cycle turns, most of those bonds will be under stress, and an above average amount will default, because the originators tend to pick the worst bonds with a rating class to maximize the yield, which allows the originator to make more.? Yes, they had a nice yield in a bull market, when every yield hog was scrambling, but in the bear market, alas, no downside protection.

I could go on about:

  • The go-go years of the ’60s or the ’20s
  • The various times the REIT market has crashed
  • The various times that technology stocks have wiped out
  • And more, like railroads in the late 1800s, or the money lost on aviation stocks, if you leave out Southwest, but you get the point, I hope.

People get beguiled by hot sectors in the stock market, and seemingly safe high yields that aren’t truly safe.? But recently, there has been some discussion of a possible “safety bubble.”? The typical idea is that investors are paying up too much for:

  • Dividend-paying stocks
  • Low-volatility stocks
  • Stable sectors as opposed to cyclical sectors.

A “safety bubble” sound like an oxymoron.? It is possible to have one?? Yes.? Is it likely?? No.? Are we in one now?? Gotta do more research; this would be a lot easier if I were back to being an institutional bond manager, and had a better sense of the bond market pulse.? But I’ll try to explain:

After 9/11/2001, institutional bond investors did a purge of many risky sectors of the bond market; there was a sense that the world had changed dramatically.? At my shop, we didn’t think there would be much change, and we had a monster of a life insurer sending us money, so we started the biggest down-in-credit trade that we ever did.? Within six months, yield starved investors were begging for bonds that we had picked up during the crisis.? They had overpaid for safety — they sold when yield spreads were wide, and bought when they were narrow.

But does this sort of thing translate to stocks?? Tenuously, but yes.? Almost any equity strategy can be overplayed, even the largest and most robust strategies like momentum, value, quality, and low volatility.? In August of 2007, we saw the wipeout of hedge funds playing with quantitative momentum and value strategies, particularly those that were levered.

Those with some knowledge of market? history may remember in the ’60s and ’70s, there was an affinity for dividends, with many companies borrowing to pay the dividend, and others neglecting necessary capital expenditure to pay the dividend.? When some of those companies ran out of tricks, they would cut or eliminate the dividend, and the stock would fall.? Now, earnings coverage of dividends and buybacks seems pretty good today, but watch out if one of the companies you own has a particularly high dividend.? You might even want to look at some of their revenue recognition and other accounting policies to see if the earnings are perhaps somewhat liberal.? You also compare the dividend to what the cash flow from operations is, less cash needed for maintenance capital expenditure.

I don’t know whether we are in a “safety bubble” now for stocks.? I do think there is a “yield craze” in bonds, and I think it will end badly when the credit cycle turns.? But with stocks, I would simply say look forward.? Analyze:

  • Margin of safety
  • Valuation, absolute & relative
  • Return on equity
  • Likely and worst case earnings growth

And then balance margin of safety versus where you have the best opportunities for compounding capital.? If relative valuations have tipped favorably to less common areas for stock investing that considers safety, then you might have to consider investing in industries that are not typically on the “safe list.”? Just don’t? compromise margin of safety in the process.

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