The Aleph Blog – Page 284 – Helping Institutions and Ordinary People Invest Better by Focusing on Risk Control

Personal Finance, Part 8 ? Taxes

Posted on 18 December 2007 by David Merkel

I’m not a maniac on avoiding taxes.? Living through the 80s and 90s, I saw many cases where people bought financial products that made them less after-tax money than many fully-taxable products would have made them.? Limited partnerships, life insurance, annuities, etc… I never saw the value in focusing on what the government would not get.? I was more focused on what I would get after taxes.

That doesn’t mean there aren’t clever strategies to avoid taxes, particularly if you are rich.? For the rich, taxes can be more of a negotiation.? How much work will the IRS have to go through in order to drag incremental dollars out of me?? (The same logic applies to corporations… I have seen it in action.)? Perhaps Leona Helmsley had a point, even if she overstated it, “Only the little people pay taxes.”? Maybe it should be, “Only the little people pay sticker price on taxes.”

Now, as for me, I have a Health Savings Account, a Rabbi Trust, IRAs for me and my wife, and a Rollover IRA from all of the jobs I have worked at.? It’s not as if I don’t try to manage my tax position.? But I don’t let it drive my investment decisions on its own.? I own my house free and clear.? I enjoy the benefits of flexibility in my finances; I have not used 529 plans, for example.? Where the investment fits my overall goals and objective, then I will consider how it affects my tax position.? In general, the higher dividend stocks go into my Rollover IRA, the lower dividend stocks into my taxable account.? I also gift appreciated stock through my taxable account to charity.

At present, I don’t own any munis.? That’s something I’ll have to revisit.

Now, here are two things to be careful about.? If IRAs grow too big there can be additional taxes on them.? I’m not too clear on the rules, perhaps readers can more fully flesh that out.? The other is that taxes are likely to be higher in the future, so avoiding taxes today may lead to more taxes tomorrow.? Also, I would question whether our government will honor the concept of a Roth IRA.? Social Security benefits were not supposed to be taxed, but today they are mostly taxed.? The same might happen to Roth IRAs at some point in time. ? Congress giveth, and Congress taketh away.

My closing point here would be to not overcommit to any single tax strategy.? Congress changes the rules so often, that it is difficult to make long term decisions.? Stay flexible, and avoid taxes where it does not compromise your flexibility.

Booyah for Brainy Buybacks! (But not Brain-dead Buybacks.)

Posted on 18 December 2007 by David Merkel

Prior to the market hitting a spate of turbulence, for the last four years, I had rarely heard anyone say something bad about a buyback or a special dividend.? At that time, I tried to point out (at RealMoney) that buybacks are not costless:

They reduce financial flexibility.
They lower credit ratings and can raise overall financing costs, if overdone.
They can become a crutch for weak management teams that aren’t active enough in looking for organic growth opportunities.
They often don’t get completed, leading to some disappointment later, after the initial hurrah.
They can be a clandestine way of compensating employees, because they hide the dilution that occurs from shares received through incentive payments.? In a sense, shares are shifted from shareholders to management.? Buffett has the right idea here: pay cash bonuses off of exceeding earnings targets.? Nothing motivates like cash, there is no dilution, and managers don’t get compensated/punished for expansion/contraction in the P/E multiple.
A higher regular dividend could be more effective in some cases
Finally, does management want to make a statement that they don’t see any good incremental opportunities for their business on the horizon?? That’s what a large buyback implies.

But after reading a glob of articles criticizing buybacks, it makes me want to take the opposite side of the trade.? (Where were these writers during the bull phase?)? Buybacks can instill capital discipline, as regular dividends do.? A good management team, when considering an acquisition, should at the same time run the same numbers on their own common stock, to see whether the acquisition is an effective way to deploy capital.

The best buybacks are valuation-sensitive.? The company has an estimate of its private market value, and the buyback only goes on while at or below that value.? When a cheaper opportunity shows up to acquire a block of business, or a new line of business, or a whole business, the buyback stops, and the acquisition is executed.

Much of my thinking here boils down to how good the management team is.? A management team of moderate quality should not keep a lot of excess capital around, because they might make a dumb move with it.? A high quality management team can run with more excess capital.? In one sense, moderate quality managements should shrink their businesses, while high quality managements should try to grow their businesses organically, and through small in-fill acquisitions that enable? them to access new countries, markets, products, and technologies cheaply, that they can then grow organically.

There is no simple answer here.? Buybacks can be smart or dumb, depending on management talent, what external opportunities exist, and where the private market value of the company is.? We can entrust Berky and Assurant with excess capital; it will get used well eventually.? Other companies, well, there are some that should keep the capital tight, because the management teams are not good strategic thinkers.

For the less competent management teams, (and, no, you don’t know who you are, that’s part of being less competent), you can look at the problem this way: either you shrink your company through buybacks, or activists will come and try to force you to do it, ejecting you in the process.? That may not sound fair, but hey, this is the public equity markets.? Sink or swim.

Full disclosure: long AIZ, and a critical admirer of Buffett.? Ticker mentioned: BRK/A

Personal Finance, Part 7 — Debt

Posted on 15 December 200716 December 2007 by David Merkel

I was shopping this evening, and as I went to check out, the two checkers were discussing with a third party their financial woes.? One was making her payments after a workout, and would be free of her debts in a year.? The other had declared bankruptcy, and it would be eight years (or so) before things would normalize for her.? As for the one making payments, her parents had gone through bankruptcy two years ago.

I talked with them for a little while, and both had reverted to lifestyles where debt was not even an option.? Well, good for them, in the short run.? They are learning discipline (the hard way).

I’m not an ogre on debt.? It can be useful, but you have to be careful with it.? I have been debt-free for the past five years, and have enjoyed the freedom that it has brought me.? I take enough risk as it is, why should I magnify it through leverage?? Borrow for a home?? Fine in the right environment.? My advice would differ in 1998 vs. 2005.? Borrow to finance consumption?? No.? Never right.

I feel the same way about companies that I own.? I prefer companies that are less levered, and companies that borrow on a nonrecourse basis.? When we borrow, we are making a statement about the future — that we can presume that it will be good, hey, even better than today.? That’s a tough statement to make.? Avoid debt if you can, and save your debt capacity for times when assets have been crunched, like early 2003.

PS — One more note: because of the AMT the advantage of borrowing money to buy homes is diminishing, because the AMT erases mortgage interest deduction.

Not Dissing Warren the Wonderful

Posted on 15 December 200716 December 2007 by David Merkel

Look, Barron’s can say what they want about Warren Buffett, and his company Berkshire Hathaway, but I have just one thing to say here: Berky is the ultimate anti-volatility asset.? When the hurricanes hit in 2005, I told my boss that the easy money, low-risk, low-reward play was to buy Berky.? My boss liked to take risks, so that idea was shelved. Too bad, it was easy money.? After all, who could write retrocessional coverage (Reinsuring reinsurers) except Berky?? Every other writer was broke or disabled…

Now we have a different type of hurricane.? Prior bad lending practices are destroying lending/insurance capacity in mortgages and elsewhere.? This could be an investment opportunity for Berky.? Thing is, outside of the Sovereign Wealth Funds, Berky has one of the biggest cash hoards around, and during times of panic, where assets get sold at a discount, cash is valuable.

So during times of panic, we should expect Berky’s valuation to expand.? This is one of those times.

One final note: suppose Buffett, much as he doesn’t want to be an asset manager, decides to take Ambac private.? How would he do it?? Think of what he has done in other cases: he creates a nonguaranteed downstream holding company, capitalizes it to a level necessary for a AAA rating, and buys Ambac.? Warren never guarantees the debt of subsidiaries that he buys.? Why should he reward bondholders of his target companies?? Isn’t it enough that he pays the debts?

Well, yes, sort of.? Warren has never sent a subsidiary into insolvency, but he clearly reserves the right to do that.? Bondholders have given him that right, and I would not blame him for using that right under extreme circumstances.

That said, Berky’s excess cash offers opportunities at present, because Buffett can use that cash to snap up distressed assets when he chooses to do so, and at minimal risk to Berky if an acquisition fails.

Tickers mentioned: BRK/A, BRK/B, ABK

FOMC, Choose Your Poison

Posted on 15 December 2007 by David Merkel

We’re not there yet, but we are close.? The FOMC is likely facing inflation problems at the same time that it faces problems in the financial system.? Goods price inflation versus Asset price deflation.? There is a term for this, but it is easy to be marginalized if one uses the S-word too readily.? So I won’t.

On the other hand, I am almost done with James Grant’s Money of the Mind.? Several themes come to mind here regarding government policy in the late 20s and early 30s, most notable that the government tried to force credit onto an economy that had too much credit already.? First they tried to get the private sector to do their bidding.? When the private sector would not cooperate to the desired degree, the government entered the lending business itself.? This probably prolonged the Depression by not allowing bad debts to get liquidated on a timely basis.

But, if I use the D-word with respect to today, it is even worse than using the S-word as far as credibility goes.? So I won’t, except for historical reference purposes.

The thing is, though, the FOMC is running out of options.? Pretty soon, it will have to decide which pain is greater: goods price inflation, or asset deflation.? Given the current political demographics, I believe they will choose goods price inflation, while saying the exact opposite, or doing the intelligent equivalent of a mumble.

Final note: current FOMC policies are a bit of a joke.? The temporary nature of them (TAF), plus the reduction in T-bill holdings, particularly during year-end, when liquidity is needed for the “holidays” of some, is unusual to say the least.? If the Fed is serious about reflation of assets, they need to do a permanent injection of liquidity, and stop messing around with these temporary half-measures.

PS — All that said, if I were Fed Chairman, I would presently aim monetary policy to a yield curve that had a 1% spread between 2-years and 10-years, and then I would leave it there.? There would be screaming for a year, but the excesses would get bled out of the system.? After that succeeded, I would narrow the spread to 0.5%.? The economy would remain stable for a long time.

Reinsurance: The Ultimate Derivative

Posted on 15 December 2007 by David Merkel

Some housekeeping before I begin this evening. Here’s my progress on the blog:

RSS as far as I can test has no problems.? If you have problems with my feed, please e-mail me any details.? Before you do, try dropping my feed, and re-adding it through Feedburner.
My logo was anti-aliased for me by BriG.? Looks a lot cleaner.? Thanks ever so much, BriG!
The comment error problem is gone, and I suspect also the same one that I have when I post.? It was a bug in one of my WP plugins that was not 2.3.1 compliant.
My descriptive permalinks are still lost, though.

I still need to fix my left margins as well, and make my top banner clickable.? Still, that’s progress.

On to tonight’s first topic: my view on derivatives differs from that of other commentators because I am an actuary (as well as an economist and financial analyst).? In the late 1980s, the life insurance industry went through a problem called mirror reserving.? Mirror reserving said that the company reducing risk through reinsurance could not take a greater reserve credit than the reinsurer posted.

That’s not true with derivatives today.? There is no requirement that both parties on the opposite sides of an agreement hold the same value on the contract.? From my own financial reporting experience (15 years worth), I have seen that managements tend to take favorable views of squishy accounting figures.? The one that is short is very likely to have a lower value for the price of the derivative than the one who is long.

But can you dig this?? The life insurance industry is in this area more advanced than Wall Street, and we beat them there by 20 years minimum.? :D? Given the way that life insurers are viewed as rubes, as compared to the investment banks, this is rich indeed.

Now, as for one comment submitted yesterday: yes, counterparty risk is big, and I have written about it before, I just can’t remember where.? I would argue that the investment banks? have sold default on the counterparties with which they can do so.? That said, it is difficult to monitor true exposures with counterparties; one investment bank may not have the whole relationship.

Also, many exposures are hard to hedge because there are no natural counterparties that want the exposure.? When no party naturally wants? an exposure, either a speculator must be paid to bear the risk, or the investment bank bears it internally.

The speculators are rarely well-capitalized, and the risks that the investment banks retain are in my estimation correlated to confidence.? When there is panic, those risks will suffer.? Were that not so, there would be counterparties willing to take those risks on today to hedge their own exposures.

So, is counterparty risk a problem?? Yes, but so is deadweight loss from differential pricing.

If Hedge Funds, Then Investment Banks, Redux

Posted on 14 December 200722 June 2017 by David Merkel

Every now and then, you get a reader response that deserves to be published.? Such was this response to my piece, “If Hedge Funds, Then Investment Banks.”? I have redacted it to hide his identity.

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I read your latest blog entry with interest because I have worked in the derivatives business and as a part of that helped to set up General Re’s financial subsidiary in 19XX – General Re Financial Products (GRFP). I was one of XX people that started that business from the ground up. I left shortly XXX Buffett arrived on the scene but I still knew a large number of people that remained and I have very good information about what happened there. I may be a bit biased so you should consider where I am coming from as you continue to read.

To be short about it, what happened at GRFP after Buffett took over was a complete mess. I can give you more information on that if you like but I will simply say that what Buffett writes about GRFP, has spin on it. Let me give you a somewhat quick example. Of that $104 million loss he refers to, how much of that could be attributed to salaries and operating expenses? How much of it was due to the forced unwinding of trades on the wrong side of the market? We know that there are high operational costs (these people are paid very well with nice offices, technology, etc.) and that one would expect to pay to get out of these transactions even if they are being marked perfectly correctly. It SHOULD cost money to unwind these trades. So why doesn’t Buffett, who normally gives us so much information, tell us how much of the loss was due to mismarking and how much was due to expected costs? I’ll let you guess at that answer. There’s a lot more to this story but let’s move on…

I am sure you felt safe quoting someone like Buffett – meaning he is likely to get things right almost every time, but even Buffett is not perfect and he has his blind spots. I believe that derivatives may be such a blind spot. I could go into detail about where I see holes in Buffett’s arguments however the bottom line is that I believe the vast majority of transactions done in the derivatives market are plain vanilla transactions that are extremely easy to mark. Did you know that the US Treasury market is now quoted as a spread off of swaps? That is how liquid the plain vanilla instrument is these days. These transactions will certainly not have two traders both booking a profit even though they are on opposite sides of a transaction. Bid/ask spreads in the plain vanilla market are less than 1 basis point per year in yield. I am certain there are exotic transactions that are mismarked for all the reasons that Buffett mentions but how many of these are really out there? My suspicion is that the total number is small enough to not be of any huge concern from a systematic standpoint.

Here is something interesting to consider. Why would the leader of a AAA-rated institution (a financial Fort Knox) that competes in many ways with other large financial institutions wish to lead people to believe that those other institutions may be engaged in a business that is particularly risky?

Just thought I would add my two cents (looks more like 25 cents now).
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For the record, both he and I are admirers of Buffett, but not uncritical admirers.? The initiator of a trade usually has to offer a concession to the party facilitating the trade.? Forced sellers or impatient buyers typically don’t get the best execution.? What my correspondent suggests here is at least part of the total picture in the liquidation of GRFP.? All that said, I still think there are deadweight losses hiding inside that swap books of the major investment banks.

Post 400

Posted on 14 December 2007 by David Merkel

Time to take a moment to reflect on what?s happened over the last hundred posts (as WordPress counts them), together with what has been going on in my life, and what is in store for the future on my blog.? Ten months is a long time in blog terms.? Let’s start with what I have gotten right and wrong.

Right:

FOMC
Currencies
Credit markets
Super SIV
Personal Finance
SOA Presentation
Book Reviews

Wrong:

National Atlantic
Stock-picking generally
Blog programming

In general, my macro commentary has been pretty accurate.? At this juncture, being bearish on the dollar and credit have been winners.? No telling when that will change.? That said, my hand has gone cold in the market since value stocks went cold.? Beating the value index is not enough for me, thank you.? National Atlantic is a continuing problem, though it seems to have found buyers around $4.

Now, if someone had told me when I started this blog that more than one-third of my readers would be outside the US, I would not have believed it.? 19% of my readers are from Canada, 7% from the UK and 4% each from Uruguay and the Netherlands.? Hey, thanks for reading me; I hope what I write is relevant to you.? And thanks to the readers from China, Germany, France, Brazil, Singapore, Hong Kong, Australia, Japan, Spain, Italy, India, South Korea, Taiwan, and Bermuda.? I may not be a global traveler, but my blog gets around.

Where? do my readers come from?? In order, Abnormal Returns, The Kirk Report, The Big Picture, Stumble Upon, The Street.com, FT Alphaville, Random Roger, and VIX and More.? Most of the rest find me through search engines (Google) or RSS.? Seeking Alpha (Aleph — Shalom) is another source, and really don’t know how big that is, as well as other syndicators.

For the last four months, I have been trying to obtain work or build an asset management business.? Though the latter has been cold, I have received several job prospects, and I should have an announcement soon on what I will be doing.? I have sometimes said that this blog is an option on a business.? That has proven true for me.

Other improvements have been the continuing series on personal finance and book reviews.? Both of those came as a result of reader feedback.

On the negative side, the job hunt has left me little time to contribute to RealMoney.? Most of my blogging is at night, and RM is during the day, when I am trying to work.? I’ll see how much I can contribute to RM in the future.? I owe them a debt of gratitude for inviting me to write for them.? It sharpened my investment writing skills more than I would have expected.

Also on the negative side, I know that I have to do blog repairs.

My left margins aren’t quite right.
My top banner should lead back to the home page.
I need to anti-alias my banner.
An error message comes up when comments are posted (the comments do post, though).
The same is true when I post articles.
My descriptive permalinks are gone.
And more…

Anyone with a good lead on PHP programming should e-mail me.? I suspect the changes should not be too great.? Otherwise, I will? slog on, and do it myself.

In closing I want to thank referrers, syndicators, readers, blogs who link here, and especially commenters (even if you don?t agree, but keep it civil.? I end with a question for my readers.? What do you all want from my blog?

More on equities
More book reviews
More macro commentary
More personal finance
Something else
Or, the same mix that you are currently getting

Let me know.? It is a pleasure to write for all of you.

Full Disclosure: Long NAHC

The Nature of a Nervous Bull

Posted on 13 December 200713 December 2007 by David Merkel

Cast your bread upon the waters,
For you will find it after many days.
2 Give a serving to seven, and also to eight,
For you do not know what evil will be on the earth.
3 If the clouds are full of rain,
They empty themselves upon the earth;
And if a tree falls to the south or the north,
In the place where the tree falls, there it shall lie.
4 He who observes the wind will not sow,
And he who regards the clouds will not reap.
5 As you do not know what is the way of the wind,^[a]
Or how the bones grow in the womb of her who is with child,
So you do not know the works of God who makes everything.
6 In the morning sow your seed,
And in the evening do not withhold your hand;
For you do not know which will prosper,
Either this or that,
Or whether both alike will be good. [Eccelesiates 11:1-6, NKJV, copyright Thomas Nelson]

The point of Ecclesiastes 11:1-6 is that the farmer in Spring, much as he might be hungry, and want to eat his seed corn, instead has to cast his seed into the muddy soil, perhaps planting 7 or 8 crops, because he doesn?t know what the future may bring. If he looks at the sky, wondering if it will rain enough, or whether the winds might ruin the crops, he will never get a crop in Summer or Fall.

That?s the way that I view investing. You always have to have something going on. You can?t leave the market entirely, because it?s really tough to tell what the market might give you. Typically, across my entire set of investments I run with about 70% equity investments, and the rest cash, bonds, and the little hovel that I live in. Private equity is a modest chunk of my equity holdings, so public equities are about 60% of what I own. Domestic public equities are about 45%.

I don?t think of that as particularly bullish or bearish. Even with public equities trading at high price-to-sales ratios, my portfolio doesn?t trade at high ratios of sales, cash flow, earnings, or book value. Together with industry selection, modest valuations provide some support against bear markets.

My tendency will be if the market moves lower from here to layer in slowly using my rebalancing discipline. That?s what I did in my worst period 6/2002-9/2002, and the stocks that I held at the end were ideally positioned for the turn in the market.

So, I never get very bullish, or bearish. I see the troubles in the markets, and I avoid most problem areas, such as in housing-related areas, but I continue to plug along, doing what I do best — trying to pick good stocks and industries (and occasionally, countries.)

Should the FOMC Statement have been a Surprise?

Posted on 13 December 2007 by David Merkel

Here?s the quick answer: no.? The Fed Statement was what I expected.? Read Dr. Jeff?s pieces on the reaction to the Statement; he hits the nail on the head.? No one should have been surprised at 25 bps, no differential change in the discount rate, and an evenhanded statement.? Real GDP is still growing, unemployment is low, and inflation is low also (pardon any differences on measurement issues).

There are too many people who are little better than cheerleaders for the equity markets, and think that the Fed should cater its policy for the good of public equity shareholders.? Forget what you think the FOMC should do.? I gave that up seven years ago, and it was amazing how much better my FOMC forecasting became.

The Fed only has three functions:

Keep inflation low (as they measure it)
Keep labor unemployment low (as they measure it)
Protect the security of the depositary financial system, particularly that which is affiliated with the Federal Reserve.

Three functions the Fed does not have:

The exchange value of the dollar, except as it affects inflation
Affecting the value of the bond market (though they occasionally mess around there trying to affect the shape of the yield curve)
Preserving the value of the stock market.

At some level of fall in the stock market, the Fed does care, but only because it affects soundness of the banking system and labor unemployment.? While the stock market is within 10% of record highs, it does not figure into the calculations of the FOMC.? Maybe at a decline of 30% it does matter to them.

Now, this doesn?t mean that the FOMC isn?t going to eventually lower the Fed funds rate to 3% at some point in 2008.? I believe they will still do that, largely because of the effect that falling housing prices will have on the credit of the residential mortgage market, and not just Subprime, but Alt-A, and Prime loans as well.

The thing is, the FOMC is off on a fool?s errand.? The cheap credit that they inject will overstimulate healthy assets, perhaps encouraging healthy US firms to level up using short-term finance, and buy back stock.? It?s one of the few areas of strength left.? What else could absorb the incremental credit?? The US government?? Maybe.

Cheap credit can?t reflate a sector in fundamental oversupply, like residential housing, unless the FOMC were willing to let inflation rip, perhaps leading the value of residential housing to rise, as it did in the ?70s.? More likely though, is that commodities that are in short supply globally would rise, like coal, steel, oil, gold, rare minerals, etc., and only after a while, would housing prices rise, as nominal incomes become large enough, and household formation great enough for the excess supply to disappear.

But inflation would lead mortgage rates to rise, which would cut against the ability to afford housing.? So, let this be a takeaway.? The FOMC is using their powers for other than there stated purposes, but grudgingly.? Their actions may preserve some marginal lenders, but will be inadequate to reflate housing, particularly in the short run.

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Now, I wrote the above while on a plane heading from LA to Baltimore, so I only found out about the Fed’s announcement about their term loan facility when I got home this evening.? Not to be a perpetual pessimist, but I think this idea is more show than substance.? The Fed can discontinue this program after two months.? The Fed has not done a permanent injection of liquidity since May 3rd, and growth in the monetary base is anemic.? All of the growth in broader monetary aggregates is coming from the banks stretching their balance sheets.

This may work in the short run to lower the TED spread, but unless the Fed makes a commitment that they will keep doing this until the market sees things their way, it will not have a major effect on the markets.? I don’t care how many different types of collateral they might take; if they won’t guarantee to take that collateral on favorable terms for a long time, it will amount to nothing by mid-2008.? For a clue to the market’s view, watch the change in 1-month LIBOR versus 12-month LIBOR.? True credibility will be measured by the change in the yield on 12-month LIBOR.