Even if Ambac and MBIA (the holding companies) survive, the business that used to be profitable for them will be occupied by others. I’ll throw this out as my next prediction in this space: they both go into conservation, and in runoff, claimants get paid off, senior debtholders get nicked, subordinated debtholders lose a lot, and the equity is a zonk.
One last note: the stocks rally after the downgrade. Probably short covering and other derivative-related activity, but you have to admit it is amazing for the stock to go up when the franchise gets destroyed.
Position: none
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Okay, after yesterday’s piece, there was a fast, opportunistic reaction by S&P. Moody’s action gave them cover to downgrade, and S&P took the ball and ran with it. Now that action gives Moody’s the cover to downgrade freely. There is no longer any reason for them to stay at Aaa. There is no money in it, and their reputation can only take further his from here. Rating agencies are like wolf packs — there is safety in the pack. Don’t be an outsider.
From one of my old RealMoney pieces (12/1/2004): Many of the conflict-of-interest problems still exist today. One more example: Could the ratings agencies downgrade MBIA (MBI:NYSE) or Ambac (ABK:NYSE) even if they wanted to? MBIA and Ambac rely on their Aaa/AAA ratings to the degree that they would have a difficult time operating without the rating. Much of the bond market relies on enhancement from MBIA and Ambac. The loss of a Aaa/AAA rating would be a jolt to the guaranteed bonds.
In addition, MBIA and Ambac structure their risks according to models provided by the ratings agencies. It is the models of the ratings agencies that tell the guarantors how much equity must stand in front of the debt that is being guaranteed. The ratings agencies are an inherent part of the business model of the financial guarantors. MBIA and Ambac can’t get along without them.
The ratings agencies derive so much income from these major financial guarantors that their own financial well-being would be affected by a downgrade. I’m not saying that either should be rated less than Aaa/AAA, but there is a cliff here, and I am wary of investing near cliffs.
Well, we came to the cliff, and S&P shoved MBIA and Ambac to the edge. Now Moody’s can push them over the edge. It should come soon. As with the rating agencies actions on the other financial guarantors, once a guarantor is pushed below AAA, the rating no longer matters as much. There are dedicated “AAA only” investors that care about this, and they will be forced sellers now, or, they will modify their investment guidelines. 🙁
Now, as I have mentioned before, stable value funds will have their difficulties here. Some have positioned themselves as “AAA only” funds, and that led to large holdings of MBIA- and Ambac-guaranteed debt. What they do now is beyond me. I suspect they try to modify their investment guidelines. 🙁
Well, at this point, we have to contemplate life without the old guarantors. They will shrink and disappear, while new guarantors, who are all currently skeptical of doing much more than Municipal bond insurance, will grow, and make it impossible for the old guarantors to return, because they are much better capitalized. Once you lose your AAA as a guarantor, you will rarely get it back.
Where were you while America aged? 😉 I’ve been following the issues in this book written by Roger Lowenstein for over 20 years. As an actuary (but not a pension actuary) and a financial analyst, I have written about the issues involved since 1992.
Roger Lowenstein motivates the issues surrounding pensions by telling three stories, those of General Motors, the New York City Subway, and the City of San Diego. He captures the essence of why we have pension problems in a way that anyone can appreciate. I sum it up this way: promises today, payments far in the future. Get through the present difficulty, at the price of mortgaging the future.
If you repeat that recipe often enough, you get into a tough spot, as GM is in today. Give GM credit though, a lesser firm would have declared bankruptcy long before now, and shed its pension liabilities to the Pension Benefit Guaranty Corporation [PBGC].
Given the softness of funding requirements for pension liabilities, the easy road for corporations and municipalities has been to skimp on funding pensions, leaving a bigger problem for others to solve 10+ years later. As for municipalities, review my recent post here.
Now, why didn’t the US Government insist on stricter funding standards for pension plans? Because of pushback from corporations and municipalities. The US Government hoped that their funding methods for corporations would encourage the creation of pension plans, and that corporations would be good corporate citizens, and not play it to the edge.
As for municipalities, which are not subject to ERISA, as corporations are, the government assumed that they would act in their best long-term interests. Alas, but governments are run by men, not angels.
I found each of the three stories in the book to be interesting and instructive. They are tales of people aiming at short-term results, while letting the future suffer. In the case of the NYC Subways, the plan sponsors finally fought back. With GM, they accomodated until they were nearly dead. With San Diego, they compromised until it cost them their bond rating, and many people involved got sent to jail.
As any good author would, the book offers a few solutions at the end, but it recognizes as I do, that we are pretty late in this game — there are no “good” solutions. There are solutions that may aid future generations. An example is making municipalities subject to the funding requirements of ERISA. I agree, and add that we should apply that to Federal DB [defined benefit] plans, and Social Security too. This could be our own Sovereign wealth fund, investing overseas for the good of US retirees. (What, there is no money available to do that? What a shock.)
I would also add that the funding requirements specified in ERISA are weak. The standards for life insurance reserving are stronger. The weak standards were there to encourage the creation of DB plans. Well, you can encourage creation, but maintenance is another thing.
A certain level of overfunding is need in good times, hopefully, with discipline not to increase benefits. That overfunding is hard to achieve, because the IRS discouraged overfunding above a certain level, because it did not want companies to shelter income from taxation by contributing to the DB pension plans.
Now, I have also reviewed the book Pension Dumping. Which one is better? For the average reader, While America Aged motivates the topic better, but if you want to dig into some of the deeper issues, Pension Dumping does more.
Full disclosure: If you enter Amazon through a link on my site and buy something, I get a small commission. This is my version of the “tip jar.” Thanks to all who support me.
PS — In some ways, the actuarial profession comes out with a black eye in books like this, and I would say that it is deserved. I don’t believe in professions, per se. Self-regulating guilds/industries are a fool’s bargain. There are no guilds/industries where if you can’t explain it to a bunch of average folks, there should be no cause for discipline from society at large. What stinks to me, is that there is no hint of discipline to any of the actuaries, and other third party consultants from the actions that they took to support the actions of politicians and corporations where they bent and broke pension funding rules. The ABCD? What a joke.
Of the 35 stocks in my portfolio, only 4 lost money for me in May: Magna International, Group 1 Automotive, Reinsurance Group of America, and Hartford Insurance.? My largest gainer, OfficeMax, paid for all of the losses and then some.
I am only market-weight in energy, so that was not what drove my month.? Almost everything worked in May: company selection, industry selection, etc.? My other big gainers were: Charlotte Russe, Helmerich & Payne, Japan Smaller Capitalization Fund, and Ensco International.? I have often said that I am a singles hitter in investing — this month is a perfect example of that.
Now, looking at the year to date, I am not in double digits yet, but I am getting close — I am only 3.6% below my peak unit value on 7/19/07.? My win/loss ratio is messier: 15 losses against 32 wins.? It takes the top 5 wins to wipe out all of the losses.? The top 5: National Atlantic, Cimarex, Helmerich & Payne, Arkansas Best, and Ensco International.? Energy, Trucking, and a lousy insurance company that undershot late in 2007.
The main losers: Deerfield Triarc (ouch), Valero, Royal Bank of Scotland, Avnet, and Deutsche Bank.
I much prefer talking about my portfolio than individual stock ideas, because I think people are easily misled if you offer a lot of single stock ideas.? I have usually refused to do that here; I am not in the business of touting stocks.? I do like my management methods, though, and I like writing about those ideas.? If I can make my readers to be erudite thinkers about investing; I have done my job.
So, with that, onto the rest of 2007.? I don’t believe in sitting on a lead — I am always trying to do better, so let’s see how I fail or succeed at that in the remainder of 2007.
PS — When I have audited figures, I will be more precise.? You can see my portfolio, for now, at Stockpickr.com.
Full disclosure: long VLO AVT NAHC XEC HP ESV MGA GPI RGA HIG OMX CHIC JOF
1)? Let’s start out with my forecast.? I’ve given it before, but it has become the conventional wisdom — at the next FOMC meeting at the end of April, the Fed will cut by 25 basis points.? They will make the usual noises about both inflation and economic weakness, as well as difficulties in the financial system, and comment that they have done a lot already — it is time to wait to see the power flow.? The only difficulty is whether we get another blowup in the lending markets that affects the banks.? We could see Fed funds below 2% in that case, but absent another crisis, 2% looks like the low point for this cycle.? Now all that said, I think the odds of another crisis popping up is 50/50.? We aren’t through with the decline in housing prices, and there are a lot of mortgages and home equity loans that will receive their due pain.
2) One interesting sideshow will be how loud the hawks will be opposing a 25 basis point cut.? We have comments from voting members Plosser and Fisher already. Price inflation is a real threat to them, and one that is closer to the Fed’s core mission than protecting the financial system.
3)? Okay, give the Fed some credit regarding the TSLF, which is now almost not needed.? The TAF is another matter — there is continuing demand for credit there.? It will be interesting to see when the Fed will stop the the TSLF, and what happens when they try to unwind the TAF.? As it seems, some banks still need significant liquidity from the TAF.
4) Indeed, if the Fed is lending to investment banks, it should regulate them.? I would prefer they didn’t lend to investment banks, though.? Better they should lend to commercial banks that are negatively affected by investment bank failures, and let the investment banks fail.? After all, there is public interest in the safety of depositary institutions, but I’m not sure that if the investment banks disappeared, and the commercial banks were fine, that the public would care much.? It certainly would teach the investment banks and the investing public a real lesson on overdoing leverage.
5)? Okay, so LIBOR rises after it seems that some bankers have been lowballing the rate in an effort to show that they are not desperate for funds.? Significant?? Yes, the TED spread has widened 12 basis points since then. ? I’m sure that borrowers with mortgages that float off LIBOR will be grateful for the scrutiny.
Having been in similar situations in the insurance industry regarding GIC contracts, I’m a little surprised that the BBA doesn’t have some requirement regarding honoring the rate quote up to some number of dollars.? On the other hand, can’t they track actual eurodollar trading the way Fed funds gets done, and then just publish an average rate?
6) Onto the last three points, which are the most controversial.? You know that I think the core rate of inflation is a bogus concept.? If you are trying to smooth the result, better to use a median or a trimmed mean, rather than throwing out classes of data, particularly ones that have had the highest rates of inflation.? Given the inflation that is happening in the rest of the world, I find it difficult to believe that we are the only ones with low inflation, unless it is an artifact of being the global reserve currency.
8 ) Finally, how do the actions of the Fed get viewed abroad?? Given the fall in the US Dollar, not nearly as favorably as the press coverage goes in the US.? Do I blame them? No.? They sense that they are losing economic value to the US, and that they are implicitly subsidizing us.? No wonder they complain.
I am writing to tell you that my firm is in very good financial condition. Normal market conditions would not require this correspondence. But I understand that many people are deeply concerned about the stability of their brokers at this time.
I have always tried to earn my clients? trust by running the firm conservatively, with clients? interests in mind. Today, 75% of the Company?s assets are in cash or cash equivalents and we have no debt. In addition, we have no investments in collateralized debt obligations or similar instruments. As a matter of policy, we do not carry positions or make markets.
Throughout the years, in making decisions about my business, I have always put the safety of my clients? assets first. This is one of the primary reasons my firm clears on a fully disclosed basis through DEF LLC (DEF), a GHI company. DEF clears our clients? trades and is in custody of their accounts. Their name appears with ours on monthly statements and confirmations. As of December 31, 2007, DEF had net capital in excess of $2.1 billion which exceeded its minimum net capital requirement by more than $1.9 billion.
In addition, when you do business at ABC, your account receives coverage from the Securities Investment Protection Corp. (SIPC) as primary protection for up to $500,000, including a limitation of $100,000 for cash. SIPC coverage is required of all registered broker-dealers. Since most ?cash equivalent? money market mutual funds are considered securities under SIPC, investments in money market mutual funds held in a brokerage account are protected by SIPC along with your other securities to a maximum of $500,000. Of course, there is no protection that will cover you for a decline in the market value of your securities. You may visit www.sipc.org to learn more about SIPC protection.
Furthermore, DEF has arranged for additional protection for cash and covered securities to supplement its SIPC coverage. This additional protection is provided under a surety bond issued by the Customer Asset Protection Company (CAPCO), a licensed Vermont insurer with an A+ financial strength rating from Standard and Poor?s. DEF?s excess-SIPC protection covers total account net equity for cash and securities in excess of the amounts covered by SIPC, for accounts of broker-dealers which clear through DEF. There is no specific dollar limit to the protection that CAPCO provides on customer accounts held at DEF. This provides ABC clients the highest level of account protection available in the brokerage industry to the total net equity with no limit for the amount of cash or securities. And, unlike many other brokers, there is no ?cap? on the aggregate amount of coverage for all of our customers? assets. You may access a CAPCO brochure about ?Total Net? Equity Protection? at ABC.com [deleted]?.
If you are concerned about the status of your assets at another brokerage firm, you might consider moving them to ABC. It is easy to transfer assets. If you have friends who are concerned about their brokers, you might consider referring them to us. We continue to offer free trades for asset transfer and referrals. If you have questions about anything in this letter, please feel free to call us at 800-xxx-xxxx from 7:30 a.m. –7:30 p.m. ET, Monday-Friday. Once again, thank you for your trust and your loyalty.
Sincerely,
President and Chief Executive Officer of ABC
I used to do business with ABC, and I presently do business with GHI. Both of them are good firms, doing business on a fair basis for their clients. To me, it is interesting to use financial strength as a marketing tool.
On another level, how many people actually check the solvency of their brokers before doing business with them? On a retail level very few, if any. On an institutional level, that’s a normal check for sophisticated investors.
That said, I would be surprised to see any major retail brokers go insolvent aside from those with significant investment banking exposure. Even there, accounts are segregated, and client cash typically has the option of being in a money market fund.
This is not something that I worry about in investing, but if I were worried about my broker, I would make sure that my liquid assets over $100,000 were in a non-commingled vehicle, most likely a money market fund.
What of Excess Insurance?
Now, I will add just one more note in closing. CAPCO is a nice idea, but I am always skeptical of small-ish insurers backing large liabilities with a remote possibility of incidence. There aren’t that many AAA reinsurers out there, and I am guessing that Berky is not one of them. Buffett does not like to reinsure financial risks, aside from municipal debt. That leaves the AAA financial guarantors — Ambac, MBIA, Assured Guaranty, and FSA (though I am open to a surprise here). I’m guessing it’s the first two, and not the last two. CAPCO is owned by many of the major brokers, but in a crisis, CAPCO has no recourse to its owners, but only to its reinsurers, should that coverage be triggered. The recent financial troubles have led S&P to place CAPCO on negative outlook, mainly because:
Standard & Poor’s assigns a negative outlook when we believe the probability of a downgrade within the next two years is at least 30%. The revised outlook reflects the challenging environment for broker/dealers and their parents. Deterioration in their credit quality and risk-management capabilities could affect CAPCO’s financial strength. In the past couple of months, Standard & Poor’s has revised the outlook on several of CAPCO’s members’ parents to negative. Also, the ratings on a couple of members are on CreditWatch with negative implications, which means there’s the potential for a more imminent downgrade. The capital of CAPCO’s members and–in some cases–their parents is an important resource for mitigating CAPCO’s potential payments for its excess SIPC (Securities Investors Protection Corp.) coverage.
It would be interesting to know for certain the underwriters and terms of CAPCO’s reinsurance. I’m not losing any sleep over it, though… there are bigger things to worry about, my personal broker is well-capitalized, and I have less than $100K at risk in cash, and that is in a money market fund. So long as accounts remain segregated, risks are small.
1)? A number of blogs pointed to this piece by Howard Marks of Oaktree, and I thought it was very well-thought out for the most part.? There are few people who think about history in the markets; they just follow present trends.? Learning how to see unsustainable trends and avoiding them not only reduces risk, but enhances long-term return.
4) To err is human, but to really mess things up, you need derivatives.? With Bear Stearns, different parties have different incentives regarding the firm.? Senior bondholders and derivative counterparties owed money by Bear are much, much larger than the teensy equity base of the small-cap firm.? It is my guess that they are protecting their interests by buying stock at prices over the terms of the deal.? They want the deal to go through.
5) How are the European investment banks?? My guess is that they have greater accounting flexibility, and things are better than US investment banks, but worse than currently illustrated.
6) Save our markets by risking our national credit?? I’m skeptical of many government solutions that bail out the markets, including those the Fed is pursuing.? Same for the GSEs… it seems like a free lunch to allow the GSEs to lever up further, but the losses are growing at Fannie and Freddie from all of the guarantees that they have written.? The US government backstops the whole thing implicitly, but even the capacity of the US government to fund these bailout schemes is limited.? Calling Fitch! — you often have more guts (or less to lose) than S&P and Moody’s.? Let’s have a shot across the bow, and downgrade the US to AA+.
7) Are mortgage rates finally falling?? I guess if the expectations of Fed policy get low enough, it will overcome the increase in swaption volatility.? Then again, PIMCO, Fannie, Freddie, and many others are buying prime mortgage paper again.
9) In terms of actual losses, Commercial Real Estate lending is not in as bad of a shape as residential lending.? That said, it’s not in great shape and the market is slowing dramatically.? What lending market is in good shape today? 🙁 We overlevered every debt market that we could…
10) When actual stock price volatility gets high, that is typically a sign of a bear market.? When it actual volatility peaks, that is often a sign of an intermediate term bottom.
11) Finally, an article on ETNs that mentions credit risk, if briefly.? Be wary of ETNs, they are obligations of investment banks, most of which have high credit spreads that you are not being compensated for in the ETNs.
12) Give the guys at Dexia some credit for being opportunistic during the crisis of financial guarantors… they had the balance sheet, conservative posture, and the team ready to take advantage of the dislocation in their subsidiary FSA.
13) Someone tell me otherwise if I am wrong, but I am not worried about the assets in my brokerage account.? In a crisis, there is SIPC and excess insurance.? Brokerages are prohibited from commingling client assets, and even if their are delivery failures from securities lending, those issues are solvable, given time and the insurance.
14) I worry about inflation in the US, because it is a global problem.? As the dollar declines, it slows foreign economies because they can’t export as much, and it raises prices here because imports cost more.
15)? This is an article that is just too early.? So the markets have rallied, and commodities have fallen?? It’s only one week, and that is no horizon over which to make the judgment that Fed policy is succeeding.? Look at it in 9-12 months, and then maybe we can hazard a good guess.
For most of my readers, this book may prove to be too basic, but we all have friends that are not “money people.” They don’t know how to take care of their finances, and they constantly get into money troubles. This book could be of help to them.
Now, as you can see from the picture, you can see that she refers to herself as, “The Internet’s #1 Personal Finance Expert.” I can’t vouch for that. I like to think that I am aware of a wide number of trends in investing and money management, and this was the first time I heard of her.
There were five main things that appealed to me about this book. First, it’s not a long book (173 pages in the main body of text), and it is simply written, so an average person not good with finances could make his way through it. Second, even though small, it is pretty comprehensive for the finances of an average person or family. Third, I think she gets most issues right for average people who have relatively simple financial problems. Fourth, it provides advice on where to get more data, without marketing herself directly. Fifth, it summarizes action points for each area of personal finance.
I do write about personal finance a little, but you will never get the detailed advice on cash management, budgeting, personal credit, hiring advisors, and shopping smart from me that you will get from this book. My contribution is a more savvy view of investing and insurance. On the latter topic, insurance, I thought she covered the bases well. (As an aside, she shares my bias against variable annuities.)
Now, was there anything that I wasn’t crazy about? I know she wrote a book on the topic, but I think it would have been worthwhile to briefly explain why keeping a high credit rating in this age is so important, because of the effect that it has on insurance premiums, and even employment, leaving aside how much you will pay in interest, and how onerous lenders and creditors will be with you if you ever make a mistake.
Now on investing topics, the book is good but not great. For the average person that doesn’t matter. For those wanting to take a step up, I would recommend The Dick Davis Dividend. She focuses on saving enough (most people don’t save enough), and asset allocation through passive investments. She is a little too bullish on real estate for my tastes. Someone following her advice in these areas will do better than most, if they have the discipline to avoid panic and greed.
But, leaving those quibbles aside, this is a solid book, and those following its advice will benefit.
Full disclosure: If you buy through Amazon.com on any of the books that I review through links on my site, I get a very modest commission.
Disclaimer: David Merkel is an investment professional, and like every investment professional, he makes mistakes. David encourages you to do your own independent “due diligence” on any idea that he talks about, because he could be wrong. Nothing written here, or in my writings at RealMoney is an invitation to buy or sell any particular security; at most, David is handing out educated guesses as to what the markets may do. David is fond of saying, “The markets always find a new way to make a fool out of you,” and so he encourages caution in investing. Risk control wins the game in the long run, not bold moves.
Additionally, David may occasionally write about accounting, actuarial, insurance, and tax topics, but nothing written here or on RealMoney is meant to be formal “advice” in those areas. Consult a reputable professional in those areas to get personal, tailored advice that meets the specialized needs that David can have no knowledge of.
My disclaimer dates back five years.? It’s at the bottom of my blog, and is there for a reason: I get things wrong.? Now, I like to think that I get things right more often, but let’s just look at the gritty downside for a moment.? I wrote a series of articles at RealMoney on using investment advice.
I wrote these with Jim Cramer in mind.? Now, I like Jim Cramer; he says a lot of bright things.? But when you talk about so many things, and put out so much content, particularly on TV, you have to be careful.
I don’t have 0.1% of the exposure that Mr. Cramer has, but I care what happens to my readers.? (I think Jim does too, but the shell has to get hard when one is that exposed, or, you’ll give up speaking and writing.)? So, when I make notable errors, it hurts me double.? I usually have my cash on the line when I write, or at least, my reputation, which is more valuable (you only get one of those).
Today was my worst relative performance day in a long time.? Deerfield Capital, National Atlantic, and Gehl, all did badly.? I bought more Deerfield today, and I’ll put out a post on my thoughts soon.? That said, March is off to a bad start with me, after a tremendous first two months of the year.
So, I am eating my crow, lightly seasoned, and with humility.?? Always do your own due diligence when you read me, because I get it wrong now and then, at least in the short run.
There are times where I feel the intellectual well is dry, and I come to my keyboard and say, “What do I write tonight?” This is not one of those times. I have too many things to write about, and not enough time. I’ll see how much I can say that is worth reading.
1)Jimmy Rogers (I?ve met him once ? a nice guy) tends toward the sensational.There is a grain of truth in what he says, but the demographic situation in China is worse than that in Japan, which is why they Communist leadership there is considering eliminating the one-child policy:
I gave a talk last October, which included a lot on the effects of demographics on the global economy:
Now, eliminating the one-child policy won?t do that much, because most non-religious women in China don?t want to have kids. In developed societies, once women don?t want children or marriage, no level of economic incentive succeeds in changing their minds.
This isn?t meant to be social commentary.The point is that there is a global demographic shift of massive proportions happening where there will be huge social pressures on retirement/eldercare systems, because the ratio of workers to retirees will fall globally.China will be affected more than most, and the US less than most (if we can straighten out Medicare).
The economic effect will feel a little stagflationary, with wage rates improving in nominal terms, taxes rising to cover transfer payments, and assets being sold (to whom?) to fund retirements and healthcare.There need not be a crisis, like a war over resources, in all of this, but it won?t be an easy next 30 years.One thing for certain, when you look at labor, capital, and resources at present, the scarcest of all is resources.Again, resource price inflation.At present, capital is scarcer than labor, but that will flip in the next 30 years.
2) A few e-mailers asked for more data on how I view monetary aggregates. On monetary aggregates, my view of it is a little different than most, and I take a little heat for it. Ideally, the lower level monetary aggregates indicate a higher degree of liquidity; greater ease and shorter time of achieving transactions. The other way to view it is how sticky the liability structure is for the banks. Demand deposits, not sticky. Savings accounts, stickier. Money market funds, stickier still. CDs, even stickier.
As the Fed changes monetary policy, there are tradeoffs. Willingness of the public to hold cash, versus opportunity at the banks to make money from borrowing short and lending longer, versus banking regulators trying to assure solvency.
That’s why I look at the full spectrum of monetary measures. They tell a greater story as a group.
3) No such thing as a bad asset, only a bad price? No such thing as a bad asset, only a mis-financed asset? Both can be true. What we are experiencing today in many markets is that many assets were financed with too much debt and too little equity. In the process, because of the over-leverage allowed for high returns on equity to be generated from low returns on assets, the buyers of risky assets overpaid for their interests.
This has taken many forms, whether it was Subprime ABS, CDOs, SIVs, Tender Option Bonds, the correlation trade, etc. Also the borrow short, lend long inherent in Auction Rate Securities, TOBs, and other speculations that make wondeful sense occasionally, but players stay too long.
Rationality comes back to these markets when “real money buyers” appear (pension plans, insurance companies, wealthy dudes with nose for value), and these non-traditional buyers soak up the excess supply of investments that are out of favor, and do it with equity, at prices that make the unlevered return look pretty sweet. This is how excess leverage gets purged from the system, and how pricing normalizes, with losses delivered to the overlevered.
4) As I said in my post last night, there is value in the tax-free muni market for non-traditional buyers. Is this the bottom? Probably not, but who can tell? Smart buyers will put a portion of a full position on now, and add if things get worse. Don’t put a full position on yet. I eschew heroism in trading, in favor of a risk-controlled style, where one makes more on average, but protects the downside. It is possible that the drop in prices will bring out more sellers, but I think that there will be more buyers in the next week. That said, the leveraged buyers need to get purged out of the muni markets.
Interesting to note on Barry’s blog that he has noted that the “low quality” trade has been so stunning over the past three years. I thought Richard Bernstein at Merrill and I were the only ones who cared about this stuff. But now for the bad news: the trade won’t be over until high yield spreads start blowing out, and presently, they show no sign of doing that. Why? There haven’t been many defaults, for one reason. The few defaults have been for the most part in auto parts and airlines. There’s no systemic panic.
Beyond that, there’s a lot of capital to finance speculative ventures, and to catch bad ones when they fall. That means that marginal ideas are getting forgiveness as they get refinanced.
The demand for yield is huge, which drives the offering of protection in the credit default swap market. Fund of funds encourage hedge funds to seek steady income, which makes them tend to be insurers against default risk, rather than speculators on possible default.
I know that I wrote “Default Cycle Will Turn Nasty in 2007;” I take my calls seriously, because I have money on the line, and many of you do too. I think the low quality trade, absent a market blow-up, won’t outperform by a lot in 2006, but will still outperform. Something needs to happen to make credit spreads not look like a free lunch.
My best guess of what will do that is the seasoning of aggressive corporate bond issuance in 2004 and 2005. Bad credit be revealed for what it is, and even the stocks of low quality companies that eventually survive will get marked down for a time, as strong balance sheets get rewarded once again.
Position: none
Then later, in early 2007, I wrote: I was wrong on underperformance of junk bonds. Tight levels got even tighter, with an absence of significant defaults. Junk bonds led the bond market in 2006. In 2007, I don’t expect a repeat, but I do expect defaults to start rising by the end of 2007, leading to a widening in spreads and some underperformance of junk bonds. The real fun will come in 2008-2009. Corporate credit cycles last four to seven years, and the last bear phase was 2000-2002. We’re due for a correction here.
Well, I got it close to right. Timing is tough.
6) Would you pay a high enough price to buy a short-dated TIPS with a negative real yield? Yes you might, if you were hedging against nominal Treasuries, with the CPI running ahead at 4%, and short-dated (5 years and in) nominal bonds at 2 1/2% and lower. As it is, the market seems to be hesitating at going negative, but in my opinion it will, until the concern of the FOMC changes to price inflation.
7) Wilbur Ross didn’t get rich by being dumb. He didn’t buy stakes in MBIA or Ambac, but in one of the two healthy firms, Assured Guaranty. Better to take a stake in the healthy firm in a tough market; they will survive, and write the business that their impaired competitors can’t. This just puts more pressure on MBIA and Ambac, and provides a lower cost muni insurance competitor to Berky.
8 ) MBIA and Ambac are playing for time, and I don’t mean that in a bad way. They are willing to shrink their balance sheets, and write little if any structured business, pay principal and interest in dribs and drabs, and pray that S&P and Moody’s give them the time to do this, and keep the AAA/Aaa intact. It could be three years, and stronger players (FSA, BHAC, AGO) will absorb their non-structured markets. But it could work. If I were Bill Ackman, I would take off half my positions here. Just a rule of thumb for me, when I am managing institutional assets and I become uncertain as to whether I should buy or sell, I do half, and then wait for more data.
Remember, many P&C insurers have been technically insolvent (in hindsight) during the bear phase of the underwriting cycle. They survived by writing better business when their balance sheet was in worse shape than commonly believed. The financial guarantors have a unique ability to wait out losses.
9) There have been all sorts of articles asking whether XXX institution is “too big to fail?” Well, let me “flip it” (sending my pal Cody a nickel for his trademark 😉 ) and ask, “Is the US too big to fail?” There’s a reason for my madness here. “Too big to fail” means that the government will bail out an entity to avoid a systemic crisis. Nice, maybe, but that means the government raises taxes to do so (nah) or issues debt that the Fed monetizes, leading to price inflation. Either way, the loss gets spread over the whole country.
What would a failure of the US look like? The Great Depression springs to mind. Present day Japan does not. They are not growing, but they aren’t in bad shape. Another failure would be an era like the 1970s, but more intense. That’s not impossible, if the Treasury Fed were to rescue a major GSE via monetary policy.
10) I have had an excellent 4Q07 earnings season. As of the end of February, I am still in the plus column for my equity portfolio. But, into every life a little rain must fall… after the close on Friday. 🙁 Deerfield Capital reported lousy GAAP earnings, and I expect the price to fall on Monday. Now, to their credit:
They reduced leverage proactively, and sold Alt-A assets before Thornburg blew.
They moved to a more conservative balance sheet. It is usually a good sign when a company sells its bad assets in a crisis.
I would expect the dividend to fall to around 30 cents per quarter. I should have more to say after the earnings call. They are becoming a little Annaly with a CDO manager on board (might not be worth much until 2010).
I may be a buyer on Monday. Depends on the market action.
That’s all for this evening. Good night, and here’s to a more profitable week next week.
Sometimes I think there are too many investors trading baskets of stocks, and too few doing real investing work. I have rarely been bullish on AIG… I think the last time I owned it was slightly before they added it to the DJIA, and I sold it on the day it was added. Why bearish on AIG? Isn’t it cheap? It might be; who can tell? There’s a lot buried on AIG’s balance sheet. Who can truly tell whether AIG Financial Products has its values set right? International Lease Finance? American General Finance? The long-tail casualty reserves? The value of its mortgage insurer? I’m not saying anything is wrong here, but it is a complex company, and complexity always deserves a discount.
You can read my articles from 2-3 years ago where I went through this exercise when the accounting went bad the last time, and Greenberg was shown the door. (And, judging from the scuttlebutt I hear, it has been a good thing for him. But not for AIG.)
AIG deserves to be broken up into simpler component parts that can be more easily understood and valued. Perhaps Greenberg could manage the behemoth (though I have my doubts), no one man can. There are too many disparate moving parts.
So, what would I do off of the news? Buy other insurers that have gotten hit due to senseless collateral damage (no pun intended). As I recently wrote at my blog:
If Prudential drops much further, I am buying some. With an estimated 2009 PE below 8, it would be hard to go wrong on such a high quality company. I am also hoping that Assurant drops below $53, where I will buy more. The industry fundamentals are generally favorable. Honestly, I could get juiced about Stancorp below $50, Principal, Protective, Lincoln National, Delphi Financial, Metlife… There are quality companies going on sale, and my only limit is how much I am willing to overweight the industry. Going into the energy wave in 2002, I was quadruple-weight energy. Insurance stocks are 16% of my portfolio now, which is quadruple-weight or so. This is a defensive group, with reasonable upside. I’ll keep you apprised as I make moves here.
What can I say? I like the industry’s fundamentals. These companies do not have the balance sheet issues that AIG does. I will be a buyer of some of these names on weakness.
Position: long LNC HIG AIZ
Look, back when AIG had a AAA rating, there was a reason to hold the whole thing together, because of cheap financing.? Today, AIG suffers from a conglomerate discount, because no one can understand the balance sheet.? (Can anyone inside AIG understand all the exposures that they face?)
Simpler is better.? Simple companies get better valuations, and the managers are sharper at financial controls, because they don’t have to cover as much ground.? They can focus.? So it should be for AIG, if they want to unlock value.? (Perhaps AIG is the Citigroup of the insurance industry…)
Where were you while America aged? 😉 I’ve been following the issues in this book written by Roger Lowenstein for over 20 years. As an actuary (but not a pension actuary) and a financial analyst, I have written about the issues involved since 1992.
For most of my readers, this book may prove to be too basic, but we all have friends that are not “money people.” They don’t know how to take care of their finances, and they constantly get into money troubles. This book could be of help to them.