Getting help in investing is a tough decision.? Who is worth the money that you will pay?? Precious few.? In equities, I could probably come up with a dozen “long only” managers that have real skill, and are worth their fees with decent probability.? With hedge funds and private equity, the questions are harder, and would have a harder tme judging who has a sustainable competitive advantage.
With bond funds, the answer is simple.? Go to Vanguard.? Almost all bond managers earn roughly the same amount before fees. Over a long period of time, fees make up most of the difference in performance.? In general, low fees work with equities, but with more noise.? With index funds, the lower the fees the better, they are generic.
Now there are a few places where additional money might help.?? Getting a good financial plan done can be worth the money.? For those that are wealthy, advice in limiting tax liabilities is usually worth it, though be careful when things get more complex than you can understand.? Also, insurance products can be useful, but don’t let someone sell you what is convenient for them.? Get advice from someone who won’t earn a commission, and then buy the products that you truly need.
Be careful, do your research, and buy what you want to buy.? Don’t buy what someone wants to sell you.
It seems that a number of Constant Proportion Debt Obligations are being downgraded or forced to delever.? This was something I thought would happen; it was only a question of when.? It’s a pity that S&P did not totally abandon its model framework for CPDOs; it is less liberal now, but not consistent with the way they rate other investments.? Here’s a trip through my thoughts on CPDOs over the last 16 months:
Periodically, I gain a sense of wonder from the derivative markets. This stems from the optimism of the markets vs. my knowledge of economic history. There are risks being taken that have not worked out in the past. My current wonder-generator is the CPDO [Constant Proportion Debt Obligation] market. With a CPDO, you leverage up a basket of investment grade credits, in an effort to earn a certain amount over the life of the CPDO. {Note: the CPDO is rated AAA, but the average of the underlying credits is rated weak single-A at best.
If the deal goes well, i.e. no defaults, it delivers early, and risk decreases. If defaults occur, the structure levers up more in an effort to make back what has been lost, up to a 15x leverage limit. After that, the CPDO rapidly takes on losses.
This structure is notable, because it attempts to achieve risk reduction for free, the same way the stock managers tried to do so in the mid-80s with dynamic portfolio management. It has no external guarantors, nor subordination.
The rumor at present is that these new CPDOs are leading to a tightening in the credit default swap market. Spreads are tight as a drum, so I can see the effect, if true.
Position: None, but I always get concerned when market players try to get risk control for free. Off-loading risk is never free on average.
Be sure and look at Tony’s blog post, “Default Insurance Costs at New Low.” I checked the other Dow Jones CDX North America Investment Grade Indexes, and yes, they also are at all time tight levels. Tony cites the spread from the newest one. Should we be worried? A little. As I noted in my post from this morning, some of this tightness is due to the CPDO market. They have to suck in a lot of long credit exposure to issue these, which puts downward pressure on spreads.
But bottoms in the stock market are an event. Tops are a process. Credit spreads are tight for long periods during the bull phase, and very fat for short periods during the bear phase. (Can I have BBB spreads in the 400s again, please?) Same for implied volatility… the VIX spikes during equity and credit market panics, but lolls around at low levels during the bull phase. This is complacency.
Trouble is, complacency can last a looong time, and many fixed income and equity managers don’t have the luxury of saying, “I think I’ll just stay in T-bills for now.” The greed of those they invest for (or their actuarial funding targets) force them into risk, often at bad times. The good times end when cash flow is insufficient to refinance marginal assets. Typically that’s three years after the issuance of debt deals that should never have been done, but in this environment, there is so much private equity amd vulture capital around that I don’t see many troubled assets not getting financing.
The party will continue a while longer. Oh look, there are the hedge fund-of-funds at the head of the Conga line, followed by the CDO equity managers, the investment banks, the credit hedge funds, and the cash bond market at the tail. What a party!
PS — I think it is irresponsible of the rating agencies to assign AAA ratings to securities like these CPDOs that are composed of BBB and single-A paper, and do not have any guarantor or subordination to protect the creditworthiness. This is akin to thinking that a martingale method, like doubling down, will protect you from loss in Vegas. It might most of the time, but you lose big when it doesn’t work.
I’ve gotten numerous pings since my initial posts on CPDOs [Constant Proportion Debt Obligations]. This post is designed to correct a few errors, and explain how we as equity investors might profit from a potential disaster here. My first posts were based off what I read in a few blogs. They got a few things wrong, so I am correcting what I wrote. The structure levers up investment grade credit fifteen times, allowing the purchaser to buy a bond with a coupon two percent (or so) higher than Treasuries, with a AAA rating. What a deal; it is difficult to find AAA bonds yielding 0.5% more than Treasuries. (Ignoring odd beasts like CMBS IOs, etc.) I have seen reports that $1.0-1.5 billion of these have been created in the recent past, which means around $20 billion of credit exposure has been absorbed, depressing credit spreads over the last month.
I suggested in my earlier writings that the structures could only allow for 15x leverage, but they can go higher if the deals go badly at first. They only unwind and take losses if the market value of the underlying assets would drop down to a threshold level, say, around 90%-94% of par. That’s not to say that losses are limited to 6%-10%. The losses could be worse if the market is moving against them as they liquidate.
Now, how to profit? There will be some sort of crisis from CPDOs; after all, the buying in order to establish these securities has been characterized by some as a panic. At some point, there will be a situation where there is a default on one or more of the companies in one of the CPDOs. If it is severe enough, at that time, the CPDOs will have to deliver, and that will push credit spreads wider, and stock prices lower.
Since the companies involved are all big capitalization companies, we can watch the price and volume patterns on the S&P 500 Spyder, and look for where volume is cresting, while price is trough-ing, and take a long position after the crisis. Watch the VIX. When it spikes in a situation like this, there will be profits from going long equity exposure.
If it means anything, I used strategies like this in 2001-2002 to generate profits when things were going crazy. These strategies will work again when the CPDOs fail. I can’t say they will fail soon; I just know they will fail, as Dynamic Portfolio Management did in 1987.
I’m not alone on not liking what Moody’s and S&P have done on constant proportion debt obligations [CPDOs]. Now a rival rating agency, Dominion, better known for rating Canadian debt, has weighed in on the issue with skepticism. I’m annoyed at the irresponsibility of Moody’s and S&P for two main reasons. A weak single-A, strong-BBB portfolio should have credit losses of 10-15 basis points per year on average. Unfortunately, losses tend to come in heaps for investment grade corporate debt. No losses for five years, and large losses for two years. Now these structures are levered up 9-15 times on average, so during the two loss years, we are talking about 9-10% losses of equity over a two year period. If that is not bad enough, spreads will widen during the loss period even on healthy debt, further adding to the problems.
In the old days, say, two years ago, Moody’s and S&P would have called a CPDO structure AAA once it had de-levered, not on the prospect that it is very likely to de-lever. Remember a AAA means it can survive the Great Depression, and pay principal and interest on a timely basis. I can say with certainty that a levered portfolio of weak single-A bonds can’t do what an unlevered AAA bond can do in a period of severe economic stress.
Can rating agencies be sued for malpractice? Perhaps the boards of Moody’s and S&P should spruce up their D&O coverage…
Position: none
Beyond these pieces, I had three posts here that followed the decline:
Now we may have an opportunity as some CPDOs are forced to delever, credit spreads are being forced higher.? I commented before (all too recently) that it was time to dip our toes into the waters of credit, and buy 25% of a full position, with carefully selected credits.? I think it is now time to raise that allocation to 50%.? It is time to begin taking some credit risks; spreads are discounting a lot of unfavorable future news, and it is time to take advantage of it.? Is the current news gloomy?? You bet, and I can tell you that at the end of many days in mid-2002, I would hold my head in my hands in disbelief at the carnage.? But good credit investors must invest when the spreads are wide, and give up income when spreads are tight.
As for the 2002 carnage, I sent Cramer e-mails on the bond market back then, and this CC post recounts one of them, where Cramer used one of my e-mails for a post (he did that twice in 2002):
If you haven’t read it yet, please read Cody’s piece, “The Nature of Feedback Loops.” I do a lot with this for two reasons. First my investment methods lead me to rotate sectors, and all mature businesses are cyclical; they just aren’t all on the same cycle. Second, the insurance industry is very cyclical. I spend most of my time analyzing trends in pricing power.At cycle peaks and troughs, I tend to stop looking at quantitative data, and look for anomalous behavior that might hint that the cycle is changing. No one rings a bell at the top or bottom, and you can never get tops and bottoms exactly, but sometimes people behave funny near turning points. Greed and fear get excessive, and then people do foolish things. As an aside, before I wrote for RealMoney, I would drop Jim Cramer notes on the corporate bond market. This article resulted from one of my missives. There was still five months of craziness remaining, but I kept my trading discipline in 2002, though I sometimes wondered if I was sane. At the turns in July and October, some of my best brokers called me in a panic, saying that there were no bids in the market and many sellers. Implied equity volatility had gone through the roof.
What to do? I got out the liquidity that I reserved for such occasions and put out lowball bids for medium-quality bonds. By the time I used up all my liquidity in the early afternoon, the market had turned. Nerve-wracking, but it really made for good performance in a horrible year.
1) I might not be able to post much for the next two days. I have business trips to go on. One is to New York City tomorrow. If everything goes right, I will be on Happy Hour with my friend Cody Willard on Tuesday.
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
3) More on AIG. As Cramer said yesterday: One last thought on the AIG issue: if President and CEO Martin Sullivan were to step down, the company might be more of a buy than a sale!
Maybe. Sullivan is a competent insurance executive with the biggest insurance job in the world. Breaking up the company, and letting the parts regain focus makes more sense. As an aside, M. R. Greenberg was known to be adamant about his ROE goal (15% after-tax on average equity), but he also liked the company to have bulk (high assets ? he liked asset-sensitive lines), which is why the ROA slid in the latter part of his tenure.
4) Some praise for Cramer on the same topic. As he said yesterday: AIG let me have it after I said last year that I couldn?t value the stock. They told me that there was a 92-page disclosure document and they wanted to know if I even looked at it. I shot back that not only did I look at it, but I had people comb it, including the forensic accountant I have on staff. The issue was always that despite the disclosure that they had CDO exposure, we couldn?t figure out what the real exposure was and we questioned whether THEY could.
Nothing gets a management more angry than being told that they don?t know what they are doing, but I was marveling at the certainty that they expressed. I told them they had tons of disclosure, but their estimation of possible losses seemed chimerical. I couldn?t figure out how THEY could value the stuff when no one else could with any certainty until it was off their books or written down. OF course, insurance companies aren?t held to the same standards of mark-to-market that banks are. They used mark-to-model, and the model, we learned today ? the Binomial Expansion Technique ? was totally wrong and dramatically understated the losses. All of this cuts to the incredible level of arrogance and stupidity on the Street, making judgments that were anti-empirical on data that could not be modeled but had to be experienced and examined nationally. In short, they were scientific and certain about something that couldn?t be quantified by science and certainly couldn?t be certain about.
Aside from the quibble that insurers for GAAP purposes are subject to the same rules as banks, Cramer got it right here. It is a major reason why I have been skeptical about AIG. Complexity in financial companies, especially financial companies that grow fast, is warranted. It is an unforgiving business where moderate conservatism works best.
5) Brief NAHC note: the CEO purchased more shares in the last few days. At least, it looks like it. Could he be acquiring shares to combat Hovde Capital? Honestly, I?m not sure, but this is looking more interesting by the day.
6) A new favorite blog of mine is Going Private. This post on insurance issues in Florida was unusual for that blog, but I thought it was perceptive. I wrote similar things at RealMoney:
Interesting note in the National Underwriter on a Towers Perrin Study (also try here) describing how much Floridians will have to pay if a 1-in-250 hurricane hits Florida. Cost per household: $14,000, or $467 per year for 30 years. On a 1-in-50 storm, the figures would be $5,640, or $188 per year. There would also be a higher initial assessment as well. Note that the odds are actually higher than stated odds would admit. The stated odds of the large losses from the 2004 and 2005 storms happening in consecutive years would have been considered astronomical, but it happened anyway.
The Florida legislature can determine how the pain is shared, but they can?t legislate that the pain go away. No free lunch.
P.S. As an aside, the state of Florida is subsidizing reinsurance rates through its catastrophe fund. Ostensibly, Florida homeowners get a cut in rates, but the insurers give that cut only because their reinsurance costs are lower. Who?s the loser? The citizens of Florida will have to reach into their pockets to recapitalize the Hurricane Catastrophe Fund if big losses hit, and at the very time that they won?t want to do it. (Note to S&P: why do you give this state a AAA GO bond rating?)
I don?t want to go on a rant here, but I do feel strongly about this. It ill-befits a state government to behave like a bunch of thugs, even if it pleases the electorate. For over two decades, the worst state to do business in as an insurer was Massachusetts. New Jersey was competitive for a while, and California was pretty bad on Worker?s Comp, but now we have a new state on the top of the heap: Florida.
The failure of the Florida property insurance market was due to the lack of willingness to allow rates to rise sufficiently to attract capital into the market. The partial socialization of risk drove away that capital. So what does the governor and legislature of Florida do to meet the crisis? Increase the level of socialization of risk, and constrain companies to a binary decision: accept profits that don?t fairly reflect the risks underwritten, or leave the state. (And, they might try to forbid insurers from leaving.)
In my opinion, if they bar the door to insurers leaving, or not being allowed to non-renew policies, it is an unconstitutional ?taking? by the state of Florida. No one should be forced to do business that they don?t want to do. Fine to set up the regulatory rules (maybe), but it?s another thing to compel parties to transact.
Okay, here?s a possible future for Florida:
1) By the end of 2007, many insurers leave Florida; the state chartered insurer now has 33% of all of the primary property risk.
2) Large windstorm damages in 2008-2009, $100 billion in total, after a surprisingly light 2006-2007.
3) Florida finds that the capital markets don?t want to absorb more bonds in late 2009, after the ratings agencies downgrade them from their present AAA to something south of single-A.
4) The lack of ability to raise money to pay storm damages leads to higher taxes, plus the high surcharges on all insurance classes to pay off the new debt, makes Florida a bad place to live and do business. The state goes into a recession rivaling that of oil patch in the mid-1980s. Smart people and businesses leave, making the crisis worse.
Farfetched? No, it?s possible, even if I give a scenario of that severity only 10% odds. What is more likely is a watered-down version of this scenario. And, yes, it?s possible that storm damages will remain light, and Florida prospers as a result of the foolishness of their politicians. But I wouldn?t bet that way.
Position: long one microcap insurer that will remain nameless
While I don?t pretend to be the insurance maven that you are, I don?t believe it?s quite as black and white as you portray.
First, let me preface my comments by saying that I believe in free markets and don?t agree with the Governor?s plan, although I stand to benefit. Secondly, my insurance rates, while higher than I?d like are not too bad compared to others in the state.
That being said, I think something had to be done. In one scenario that you lay out, you describe smart people leaving due to higher taxes. That was already happening due to high insurance rates. Some people with affordable mortgages suddenly found their insurance rates skyrocketing from $2,000 to over $6,000. Lots of seniors on fixed incomes also saw their rates jump.
One factor in the housing slump is that buyers are having a hard time finding insurance on a house they are ready to close on. I know that three years ago, we were scrambling at the last minute to find an insurer who would write a policy ? and that was before all of the storms.
I?m not sure what the answer is. I fear that in an entirely free market, there will be very few insurers willing to do business here if there?s another bad storm.
Maybe that?s an argument that we shouldn?t be building major population centers right on the coast, but that?s another story.
I understand the pain that many people in Florida are in. I know how much rates have risen. What I am saying is that the new law won?t work and will leave the people of Florida on the whole worse off. Florida is a risky place to write property coverage, and the increase in rates reflects a lack of interest of insurers and reinsurers to underwrite the risk at present rates and terms.
We don?t have a right to demand that others subsidize our lifestyle. But Florida is slowly setting up its own political crisis as they subsidize those in windstorm-prone areas, at the expense of those not so exposed. Commercial risks must subsidize coastal homeowners. Further, there is the idea lurking that the Feds would bail out Florida after a real emergency. That?s why many Florida legislators are calling for a national catastrophe fund.
They might get that fund too, given the present Congress and President, but Florida would have to pay in proportionately to their risks, not their population. Other proposed bills would subsidize Florida and other high risk areas. Why people in New York, Pennsylvania, Ohio should pay to subsidize Florida and California is beyond me.
The new law also affects commercial coverages; the new bill basically precludes an insurer from writing any business in Florida, if they write homeowners elsewhere, but not in Florida. If you want to chase out as many private insurers as possible, I?m not sure a better bill could have been designed. The law will get challenged in the courts; much of it will get thrown out as unconstitutional. But it will still drive away private insurance capacity.
I?m not writing this out of any possible gain for myself. I just think the state of Florida would be better served, and at lower rates, with a free market solution. Speaking as an insurance investor, I know of half a dozen or so new companies that were contemplating entering Florida prior to the new law. All of those ideas are now dead.
I hope that no hurricanes hit Florida, and that this bet works out. If there is political furor now in Florida, imagine what it would be like if my worst-case scenario plays out.
Position: long a small amount of one microcap insurer with significant business in Florida
Florida had now dodged the bullet for two straight years. Hey, what might happen if we have a bad hurricane year during an election year? Hot and cold running promises; I can see it now!
7) One of the best common-sense writers out there is Jonathan Clements of the WSJ. He had a good piece recently on why houses are not primarily investments. Would that more understood this. There are eras where speculation works, but those eras end badly. You can be a landlord, with all of the challenges, if you like that business. You can own a large home, but you are speculating that demand for the land it is on will keep growing. That is not a given.
8 ) My favorite data-miner Eddy, at Crossing Wall Street comes up with an interesting way to demonstrate momentum effects. Large moves up and down tend to continue on the next day, and the entire increase in the market can be attributed to the days after the market moves up 64 basis points.
9) This is not an anti-Cramer day. I like the guy a lot. I just want to take issue with this article: ?Trading in CDOs Slows to a Trickle.?? The basic premise is that CDOs are going away because trading in CDOs is declining.? Well, the same is true of houses, or any debt-financed instrument.? Volumes always slow as prices begin to fall, because momentum buyers stop buying.
Short of outlawing CDOs, which I don’t think can be done, though the regulators should consider what financial institutions should be allowed to own them.? That would shrink the market, but not destroy it.? Securitization when used in a moderate way is a good thing, and will not completely disappear.? Buyers will also become smarter (read risk-averse) at least for a little while.? This isn’t our first CDO blowup.? The cash CDO vintages 1997-1999 had horrible performance.? Now we have horrible performance.? Can we schedule the next crisis for the mid-teens?
10) On Chavez, he is a dictator and not an oil executive.? Maybe someone could send him to school for a little while so that he could learn a little bit about the industry that he is de facto running?? As MarketBeat points out, take him with with a grain of salt.? Venezuelan crude oil needs special processing, much of which is done in the US.? If he diverts the crude elsewhere, who will refine it for sale?
11) I am really ambivalent about Bill Gross.? He’s a bright guy, and has built a great firm.? Some of the things he writes for the media make my head spin.? Take this comment in the FT:
That the monolines could shoulder this modern-day burden like a classical Greek Atlas was dubious from the start. How could Ambac, through the magic of its triple-A rating, with equity capital of less than $5bn, insure the debt of the state of California, the world?s sixth-largest economy? How could an investor in California?s municipal bonds be comforted by a company that during a potential liquidity crisis might find the capital markets closed to it, versus the nation?s largest state with its obvious ongoing taxing authority? Apply the same logic to the gargantuan size of the asset-backed market it has insured in recent years ? subprimes and CDOs in the trillions of dollars ? and you must come to the same logical conclusion: this is absurd. It is as if Barney Fife, television?s Sheriff of Mayberry in The Andy Griffith Show, promised to bring law and order to the entire country.
Most municipal defaults are short term in nature, even those of states, of which there have been precious few.? Ambac, or any other guarantor, typically only has to make interest payments for a short while on any default.? It is a logical business for them to be in… they provide short term liquidity in a crisis, while the situation gets cleaned up.? In exchange for guarantee fees the municipalities get lower yields to pay.
The muni business isn’t the issue here… the guarantors should not have gotten into the CDO business.? That’s the issue.
12) I try to be open-minded, though I often fail.? (The problem of a permanently open mind is that it doesn’t draw conclusions when needed.? Good judgment triumphs over openness.)? I have an article coming soon on the concept of the PEG ratio.? This is one where my analytical work overturned my presuppositions, and then came to a greater conclusion than I would have anticipated.? The math is done, but the article remains to be written.? I am really jazzed by the results, because it answers the question of whether the PEG ratio is a valid concept or not.? (At least, it will be a good first stab.)
I have to be careful as I write this post, because I have agreements with my former employer. I will stick with what is publicly understood, and avoid internal knowledge of what my former employer thought when I last worked with them.
Today, after the close, Hovde Capital filed a 13D, seeking to own more than 17% of National Atlantic, and asking for seats on the board of directors. Now, what I want to say to my readers might agree with what Hovde Capital might want. Don’t make too much out of this. First, the New Jersey Department of Banking and Insurance might turn Hovde down. Second, realize that any party acquiring 10% or more of any publicly traded company has to file two days after making any trade. That is the signal that I would be looking for.
National Atlantic is my largest holding, and I am aware of other parties considering buying National Atlantic, but they fail the urgency test for me. There’s lots of talk but no action. Don’t take any action off of Hovde’s SEC filing. There are too many uncertainties here, and wise investors will wait for favorable levels for investing.
Every now and then, valuation metrics in a market will get changed by the entrance of an aggressive new buyer or seller with a different agenda than existing buyers or sellers in the marketplace.? Or conversely, the exit of an aggressive buyer or seller.
Think of the residential mortgage marketplace over the last several years.? With an “originate and securitize” model where no one enforced credit standards at all, credit spreads got really aggressive, and volumes ballooned. Many marginal mortgage lenders entered the market, because it was strictly a volume business.? Now with falling housing prices, there are high levels of delinquency and default, and mortgage volumes have shrunk, leading to the failures/closures of many of those marginal lenders.? Underwriting standards rise, as capacity drops out.? Even prime borrowers face tougher standards.? In two short years, fire has given way to ice.
If you’ll indulge another story of mine, I worked for an insurer who had a well-run commercial mortgage arm.? Very conservative.? They did small-ish loans on what I would call “economically necessary real estate.”? See that ugly strip mall with the grocery anchor?? Everyone in the area shops there; that’s a good property.
Well, in 1992, the head of the Commercial Mortgage area had a problem.? The company had only three lines of business, and two lines representing 60% and 20% of the assets of the firm were full up on mortgages.? What was worse, was they didn’t want to even replace maturing loans, because the ratings agencies had told the company that commercial mortgage loans were a negative rating factor.? Never mind the fact that the default loss rate was 40% of the industry average.
He stared down the possibility that he would have to close down his division.? He had one last chance.? He called the actuary that ran the division that I was in (my boss), and pitched him on doing some commercial mortgages.? The conversation went something like this:
Mortgage Guy: I know you haven’t liked commercial mortgages in the past, but my back is against the wall, and if you don’t take my originations, I’ll have to shut down.? You’ve heard that the other two divisions won’t take any more mortgages at all.?
Boss: Yeah, I heard.? But the reason we never took commercial mortgages was that we didn’t like the credit spread compared to the risks involved.? 150 basis points over Treasuries just doesn’t make it for us.
M: Well, because many companies have reduced originations, the spreads are 300 basis points now.
B: 300?! But what about the quality of the loans?
M: Only the best quality loans are getting done now.? I can insist on additional equity, in some cases recourse, and faster amortization.? My loan-to-values are the lowest I’ve seen in years.? Coverage ratios are similarly good.
B: Well, well.? Perhaps I’ve been right in the past, but I’m not pigheaded.? Look, we could take our percentage of assets in mortgages from 0% to 20%, but no more.? At your current origination rate, that would allow you to survive for two years.? We will take them all, subject to you keeping high credit quality standards.? Okay?
M: Thank you.? We’ll do our best for you.
And they did.? For the next two years, our line of business and the mortgage division had a symbiotic relationship, after which, spreads tightened significantly as confidence came back to the market.? We had 20% of our assets in mortgages, and the other two lines of business now felt comfortable enough with commercial mortgages to begin taking them again — at much lower spreads (and quality) than we received.
It’s important to try to look through the windshield, and not the rear-view mirror in investing.? Analyze the motives of current participants, new entrants, and their likely staying power to understand the competitive dynamics.? I’ll give one more example: the life insurance industry was a lousy place to invest for years.? Why?? A bunch of fat, dumb, and happy mutual companies were willing to write life insurance business earning a minimal return on capital.? As another boss of mine once said, “It doesn’t take mere incompetence to kill a mutual life insurer; it takes malice.”? Well, malice, or at least its cousin, killed a number of insurers, and crippled others in the late 80s to mid 90s.? Investment policies that relied on a rising commercial real estate market failed.
But that was the point to begin investing in life insurers.? They began pricing capital economically, and the industry began insisting on higher returns as a group.? Many mutuals demutualized, and the remaining large mutuals behaved indistinguishably from their stock company cousins.? The default cycle of 2001-2003 reinforced that; it is one of the reasons that the life insurance industry has had only modest exposure to the current difficulties afflicting most financials.? After years of being outperformed by the banks, the life insurers look pretty good in comparison today.
I could go on, and talk about the CDO and CLO markets, and how they changed the high yield bond and loan markets, or how credit default swaps have changed fixed income.? Instead, I want to close with an observation about a very different market.? Who likes Treasury bonds at these low yields?
Well, I don’t.? At these yield levels the odds are pretty good that you will lose purchasing power over a 2-3 year period.? Then again, I’m a bit of a fuddy-duddy.? So who does like Treasury yields at these levels?
Players who are scared.
Players who have no choice.
There is a “fear factor” in Treasury yields now.? Beyond that, there is the recycling of the current account deficit, which is still large relative to the issuance of Treasuries.? The current account deficit is large, but shrinking, since the US dollar at these low levels is boosting net exports.? As the current account deficit shrinks, Treasury yields should rise, because foreign demand has been a large part of the buyers of Treasuries.? The Fed can hold the short end of the curve where it wants to, but the long end will rise as the current account deficit shrinks.
I think the current account deficit does shrink from here, because the cost of buying US debts, and not buying US goods is getting prohibitive.? Also, fewer retail buyers will take negative real yields.
That’s my thought for the evening.? Analyze the motives of other players in your markets, and don’t assume that the current state of the market is an equilibrium.? Equilibria in economics are phantoms.? They exist in theory, but not reality.? Better to ask where new entrants or exits will come from.
I had some “down time” today (taking my third child to junior college), when I could sit and think about some of the issues in the markets, when all of a sudden, a weird correlation hit me.? Similarities between:
The near bankruptcy of the Equitable back in the early 90s.
Neomercantilism
The relationship of Moody’s and S&P to MBIA and Ambac.
Now, I write as I think, so at the end of this, I hope to have a theory that links all of these.? For now, let me tell a story.
When I was younger, I worked for AIG in their domestic life companies.? While I was there 1989-92, the life insurance industry was undergoing a lot of troubles from overinvestment in mortgages and real estate.? Many companies were under stress.? A few went bankrupt.? One big one was probably insolvent, and teetered in the balance — the Equitable.? I was the juniormost member of AIG’s team.? I have a lot of stories about what happened, and why AIG lost and AXA won.? If readers want to read about that, I’ll write about it.? For now though let me mention what I did:
Produced an estimate of value of the annuity lines in four days.
Estimated the “hole” in reserving for the Guaranteed Investment Contract line of business (accurate within 10%, according to the writedown they took later)
Wrote an analysis of AXA that indicated that we should take them seriously (probably ignored).
Analyzed the Statutory statement, the Cash Flow testing, and Guaranteed Separate Account filing (Reg 128), and came to the conclusion that the latter two were in error.? (Those filings, I later learned, forced the NY department to
tell Equitable that it had to find a buyer, because they could not believe the rosy scenarios.)
Analyzed the investment strategies that the Equitable employed in the late 80s.? (They doubled down.)
Two years after that, I was at the Society of Actuaries annual meeting, where I met a well-known actuary who had worked inside the corporate actuarial area of the Equitable during the critical years.? I.e., he watched and analyzed the assets and the liabilities as they arose.? The conversation went something like this:
David: What was it like working inside the Equitable during that period of fast growth?
Corporate Actuary: It was amazing.? It took everything we could do to stay on top of it, and still we fell behind.
D: Didn’t you think that perhaps you were offering guaranteed rates that were too attractive?
C: We wondered about it, but with money coming in, everyone felt great about the growth.? We simply had to find ways to productively deploy all of the cash flow.
D: But wait.? Didn’t the investment department have a difficult time investing all of the proceeds?? With that much money coming in, the likelihood of making severe errors would be high.
C: Were you a bug on the wall at our meetings?? Yes, that is exactly what happened.? The money came in faster than we could invest it prudently.
D: Wow.? I thought that was what happened, but it amazes me to hear it confirmed.
They offered free options, and surprise, investors took them up on them.? They couldn’t make enough to fund the promises, and undertook a risky strategy in the late 80s that I called “double or nothing.”? The strategy failed, and they almost went broke, except that AXA bought them, pumped in a little capital, and then the real estate market turned.
What’s my point here?? Twofold: one, rapid growth in financial institutions is rarely a good thing; it usually means that an error has been made.? Two, there is a barrier in many financial decisions, where responsible parties are loath to cry foul until it is way past obvious, because the cost of being wrong is high.
So what of my other two cases?? With the neomercantilists, which I have written about more at RealMoney, they entered into the following trade: sell goods to the US and primarily take back bonds.? This suppressed inflation in the US, and lowered interest rates, because their bond buying reduced the excess supply of bonds.? In one sense, through export promotion, the neomercantilistic countries sold their goods too cheaply, and then had little current use for the US Dollars, since they did not want their people buying US goods.? So, they took the money and bought US bonds, probably too dearly.? Certainly so, after taking the falling US Dollar into account.
With the major rating agencies and the major financial guarantors, they are locked in a co-dependent relationship, one that I highlighted in a RealMoney article three years ago.? The financial guarantors are next to a cliff, and the rating agencies have a choice:
The guarantors are clearly in trouble, but how bad is it?? Do we push them over the edge to save our franchise, at a cost of a lot of forgone revenue in the short run?
Or do we sit, wait, and hope that things are not as bad as the equity markets are telling us?? This could preserve our ability to make money, and the government is giving us pressure to go this way, for systemic risk reasons.? Besides, someone could bail them out, right?
Ugh, I went through this back in 2001-2002, when the rating agencies changed their methodology to become more short-term in nature.? Funny how they always do that in bear markets for credit.
So, what’s the common element here?? Each situation has a major financial entity at the core.? Underpriced goods or promises were made in an effort to attract revenue.? When the revenues came too quickly, errors were made in deploying the revenues, whether into goods or bonds.? The faster and the larger the acquisition of the revenues, the larger the problem in deployment.
In each of these situations, then, there is a cliff:
Do the rating agencies push the guarantors over?
Does the NY department of insurance force Equitable to find a buyer?
Do neomercantilistic nations keep sucking down dollar claims in exchange for goods, importing inflation, or do they finally give up, and purchase US goods, and slow down their own economies, and the inflation thereof?
This is what makes practical economics tough.? Cycles that are self-reinforcing eventually break, and when they break the results can be ugly.? Why else are credit cycles long and benign in the bull phase, and short and sharp in the bear phase?
1) Let’s start on a positive note: Doug Kass says it is time to buy the financials.? I may never be as successful or clever as Mr. Kass, but I think he is early by one year or so.? And this is from someone who is technically overweight financials — I own six insurers, two high-quality mortgage REITs, and two European banks.? When it comes time to own financials, I may have a portfolio with 50% financial stocks, and I will pare back the insurers.
2) What of the Financial Guarantors?? Forget that I said I would flip the 14% MBIA surplus note, I did not expect that it would do so badly so quickly.?? The rating agencies are all concerned to potentially downgrade MBIA, Ambac, and others.? Downgrades are death, and rating agencies would only consider such measures if they knew that other companies would step in to continue their AAA franchise if they kick the losers over the edge.? Berky, by entering the financial guarantee space, has signed a death warrant for at least one of MBIA and Ambac, and who knows, Berky might buy the loser.
3)? Away from that, PartnerRe, one of my favorite companies, has written off its entire stake in Channel Re, which provided reinsurance to MBIA.? Leave it to that classy company to write off the whole thing, which implies bad things for MBIA as it relies on reinsurance from Channel Re, which it also partially owns.
4) Though this is a test of the financial guarantors, it is also a test of the rating agencies, which are in damage control mode now.? My view is the Moody’s and S&P will survive the ordeal, and come back fighting.
6) Now, a lot of the subprime crisis is really a stated income crisis.? Think about it: income is such a standard metric for loan repayment.? If one lets borrowers or agents fuddle with income, should we be surprised that loan quality declines?
7)? Even the black humor of the credit crunch in residential real estate points out how much more residential real estate might fall in price, and with it the values of companies that rely on residential real estate.
8) The boom/bust nature of Capitalism can not be repealed.? As an example, at the very time that you want banks to want to lend more to support the real estate market, they insist on larger down payments.
9) At my last employer, and at RealMoney, I would often say that the biggest crater to come in residential housing was in home equity loans.? JP Morgan is a good example of this.? Should this be surprising?? I noted from 2004-2007 how much of the ABS market had gone to home equity loans, and felt it was unsustainable.? Now we are facing the music.
10) Now consider credit cards.? Even cards on the high end are reporting deteriorating loan statistics.? Unlike past history, many people are paying on their cards to maintain access to credit, and letting their home loans slide.? Worrisome to me, and to the real estate markets as well.
13) Now for long term worries, consider what will happen to the real estate market as the baby boomers age.? Houses in colder areas will get sold, and houses in warmer areas will be bought.? This article does not take into account reverse mortgages, which will also be prominent.? Aside from that, the idea that baby boomers will be able to cash out of their homes to fund retirement will be hooey, unless we let wealthy foreigners buy into the US.? There will not be enough buyers for all of the houses to be sold without immigrants buying them.
When I left my prior employer, one of the first things I did was buy a new laptop from Dell. It was much slower than I expected, and I began experimenting to see if I couldn’t speed it up. Now, here are a few tips: a) install sysinternals process explorer — it gives you much more information than task manager, and will show you what programs are hogging system resources. b) shut off or cripple the many little programs that lurk in the background, many of which occupy a decent amount of resources while waiting for program updates to be released over the internet. Do the updates manually, say, once a quarter. c) Reduce the number of programs that load at startup. d) I turned off the advanced graphics that were kind of pretty from Windows Vista. e) all of these helped, but the big bopper was removing McAfee and replacing it with ZoneAlarm Security Suite. McAfee was a real resource hog, and after removing it and installing ZoneAlarm, everything is faster. Everything. There is a limit to security systems; if they are pressed too far, they kill productivity. Productivity and security must be balanced.
QBE’s gain is the Nasdaq’s loss. North Pointe, a not-all-that-well-known property-casualty insurer has sold out to QBE of Australia. Personally, I really liked NPTE’s management team, and thought they were on the right track. I appreciate insurance management teams that can focus on profitable niches, and are willing to let business go if they can’t make an underwriting profit. If QBE is smart, they will give prominent positions in their US operations to James Petcoff (the CEO) and Brian Roney (the CFO).
Just as an aside, I felt like republishing this off topic post from RealMoney:
When I was in college, I needed to make money, so I got a job working at a convenience store. The young lady who trained me showed me how to operate the popcorn maker. After adding the oil and the popcorn, she reached for the flavoring container and dumped the lot in. Her comment, “Just watch, the extra flavoring really creates sales.” She was right. As people walked in the door, a larger number than I would have expected bought popcorn. But there was a problem. The popcorn didn’t taste good. Too much salt and fake butter flavor. It led to few, if any repeat customers.
About a month later, when I was on the night shift, I tried an experiment where I cleaned out the popcorn maker, cleared out the old popcorn, and the popped a fresh batch using a little less than the instructions would indicate, much less the young lady who trained me. The smell was there, but it wasn’t overpowering. Since popcorn wasn’t usually done on the night shift, though, it would be noticeable.
The surprise: repeat customers for popcorn in the graveyard shift because it tasted good. Word of mouth spread, so I made popcorn regularly.
I believe in UPOD (underpromise, overdeliver) as Jim Cramer often points out. It applies to investing in two ways: first, buy companies whose managements do UPOD, and not OPUD. Positive surprises drive stocks higher, negative ones drive them lower.
That said, there is a second way that UPOD plays into investing. It’s what you tell your investing clients or readers. No strategy works all the time. No strategy is perfect even in the long run. No analyst is always right. Underselling your investment abilities, and demonstrating humility, may not attract as many clients in the short run, but it keeps them in the longer run, with continued diligent work.
And with that, I have to grab lunch; writing about the popcorn has made me hungry.
One of my maxims of the Fed is that it is better to watch what they do, and pay less attention to what they say. The markets are saying that they expect Fed funds at 3% sometime in 2008. The Fed governors see that also, and are being dragged there, kicking and screaming. They don’t want to do it; there is real risk to the US Dollar, and there are inflation risks as well. As they measure it, the economy is growing adequately, and labor employment is fairly full. But as Cramer and others point out, the financial system is under stress, manifesting most sharply in mortgage lenders and insurers. Secondary stress is in the investment banks and financial guarantors.
But what exactly has the Fed done so far? Most of the monetary easing has not come through growth in the monetary base, but from continued relaxation of reserve requirements. Given that the Fed is loosening, I would have expected a permanent injection of liquidity by now. As it is, the last one was May 3rd, when there was no hint of the loosenings coming.
So what then for future FOMC policy? The banks are increasingly incapable of levering up more. The monetary base will have to grow. With the Treasury-Eurodollar spread at over 170 basis points, the big banks don’t trust each other. Again, this measure points to 3.00-3.25% Fed funds sometime in 2008.
I see them getting dragged to cuts, kicking and screaming, until a combination of inflation and the dollar force them to change. Then the real fun begins.
Fed minutes out soon. Watch them make a fool out of me.
Okay, the FOMC minutes did not make a fool out of me.? Neither did the market action.? I’m in the weird spot of thinking that nominal economic activity is higher than expected, on both an inflation and real GDP basis.? I don’t like the mortgage and depositary financial sectors at present, two areas that are dear to the FOMC.? That’s where I stand.
One reader asked, what do you mean by, “Then the real fun begins.”?? Maybe I have to do a book review on James Grant’s, “The Trouble with Prosperity.”? James Grant is very often correct, but usually way too early, which is why it is hard to make money off of his insights.? The “real fun” is watching FOMC policymakers squirm as they balance off costs of inflation and economic growth on the negative side, as it was in the late 70s and early 80s.? It is also the fun of watching policymakers at the Treasury Department squirm as they realize that the the fiscal wind is in their face and not at their backs anymore, as the demographic winds spin 180 degrees.
Other readers e-mailed, asking the practical question of how to invest in such an environment.? First, don’t overdo it.? Invest for a normal market scenario, and then tweak it to add more short bonds, TIPS, Commodities, Foreign bonds, and stocks with good inflation pass-through.
I got a few questions asking me to justify my bearish view on the US Dollar.? On, a purchasing power parity basis, the US Dollar is fairly valued now.? (What goods can the Dollar buy versus other currencies?) Unfortunately, currencies react more to forward covered interest parity in the short run. (What will I be able to earn by investing my money in dollar denominated debt, instead of another currency?)? Low intermediate term interest rates in the US portend bad returns from investing in US Dollar denominated debt, so the US Dollar declines.? The rest of the world seems to be bracing for more inflation and more growth.? Because US policy is headed the other way, the US Dollar is weakening.
As for my longer-run negative view on US Bonds, US government policies are designed to undermine bonds.? They have made more future promises than they can keep.? Who will they renege on their promises?? Bond investors are the easiest target; they don’t vote in large numbers.? It will be harder to turn their backs to those receiving social insurance payments, at least in nominal terms.? They have a lot of votes.
I consider myself to be a value investor and stick mainly to stocks
where I feel the asset to equity ratio is reasonable along with
consideration of other factors such as PE & share price to book value etc.
As a result, I am not panicking with the recent mkt downturn and expect
to hold most of my positions thru the major downturn when it happens.
Despite my resolve, I can’t help but feel uncomfortable with the recent
comments on subprime and liquidity etc. Again, I am a very inexperienced
amateur investor, but what I seem to be getting from the reports is that
there is so much leveraged investment in the markets these days that
even these mini downturns may force selling of stocks to cover leveraged
positions and could wash over the entire market. Reports of complete
funds being wiped out as a result of the necessity to cover leveraged
positions seem incredible to me. ?I personally feel leveraging should be
left to very skilled, specialized traders and will only consider it when
I have a portfolio of sufficient size that I would be able to use it as
insurance and in turn cover a position if required.
?
Having said all of this, I have several questions, if you would be so
kind as to consider.
?
Is there a way to assess the volume of leveraged positions relative to
the whole market and likelyhood to tip the whole market and the average
% the market will retreat based on the amount of leveraging in the
markets and the historical data on the effects?
?
Are there not rules that govern funds, in order to protect the investors
in the funds from complete liquidation due to leveraging by the managers
and at any rate doesn’t someone review the activities of the fund managers?
?
Is this leveraging in the marketplace so widespread and common now that
small investors like me are tilting at windmills if don’t participate?
?
I realize that these questions may be rather uninformed and somewhat
equivalent to “the meaning of life” scenerio, however I have been
reading your blog quite faithfully and with my limited understanding of
some of the technical jargon, find it very interesting.
Thanks for asking your question, and sorry I didn’t get to it earlier.? There are several things to write about here:
How serious are leverage problems in the market?
There are certain forms of leverage that are well measured, and some that are not.
Some institutions have leverage rules, and some don’t, sort of.
Am I at a disadvantage as a small investor, particularly if I stay unlevered?
Let’s go in order.? The leverage problems in the market today are significant, though none are urgent at present.? The furor over ABCP and SIVs and other bits of short-term lending have largely passed.? Good collateral got rolled over, bad collateral got picked up by stronger institutions.? That said, there are other important problems in the market that are not at a crisis point yet:
Falling residential real estate prices, and the effect on mortgage default, and the effect on those that hold mortgage securities.
Private Equity’s ability to repay debt on new acquisitions.
The willingness of the investment banks to takes losses on prior LBO lending commitments.
Losses in the CDO market, and who owns the certificates with the most exposure to loss.
Losses from high-yield lending to CCC, and single-B rated firms.
Are any significant financial institutions overexposed to the above items, such that they might be impaired?
Now, some of the leverage is well measured, and some is not. We really don’t know with derivatives what the total exposure is, and whether the investment banks have been clean with their counterparty management.? (That said, so far it looks like it is working.? There may be a Wall Street rule, that if someone is near the edge, find a way to kick them over the edge, so that you can foreclose with more collateral.)
We also don’t know about lending to or from hedge funds, and hedge fund-of-funds. ?? Non-bank lenders, we know about what they securitize publicly, and that’s most of it, but the rest, we don’t know.? Foreign lenders to the US — the Treasury collects some data on them, but the detail is lacking.
All of these are areas where reporting requirements are limited to non-existent.? Regulated domestic finance — we know a lot about that, and that’s a large part of the system; the open question there, is how much the regulated part of the system has lent to the non-regulated part of the system.? Difficult to tell, but given the slackness of bank exams over the past five years, it could be significant, but I doubt perilous to the system as a whole.
Banks, S&Ls, Mutual funds, Insurance companies, and margin accounts have leverage rules. ? Many non-regulated entities face leverage rules from the ratings agencies, which limit their ability to borrow and securitize.? Still other face limits on leverage from those who lend to them, in the form of debt covenants.? Almost everyone is limited in some way, but in a bull market, those limits often get compromised as a group.? The limits are not as wide as would be optimal for financial system stability.
So, there are some protections for those who lend to hedge funds and hedge fund of funds, but little protection to those who invest in them.? Hey, if you’re a big institution, and invest here, you are your only protector; no one is coming to rescue you in a crisis.
But onto the last question:? Am I at a disadvantage as a small investor, particularly if I stay unlevered??? You have many advantages as a small investor.? One? of the largest advantages is that no one can force you to be hyper-aggressive, except you yourself. If you are reasonable in your return goals, you can safely achieve better than your average levered competitor through a crisis.? An unlevered investor can’t be forced by anyone to take on or liquidate a position.? Levered investors, or those with return requirements from outside parties, do not fully control their own trades.
Second advantage: you can be more picky.? You can avoid trouble areas in entire if you want.? Many institutional investors face diversification or tracking error requirements, which force them to in vest some in areas that they don’t like.? As an example, I was one of the few investors that I knew that didn’t take some losses from the tech bubble popping.
Third advantage: you don’t have to take risk if you don’t want to.? If the market is too frothy, and shorting is not for you, just reduce exposure, and wait for a better entry point.? (Warning: that entry point may not come.)
A disciplined private investor may not have the same level of knowledge as the institutions, but he can have a longer time horizon, and play the out of favor ideas that might threaten job security of those who work inside institutional investors.? With that, I would advise you to take use your advantages, and invest accordingly.? Keep it up with the value investing!
For those with access to RealMoney, I advise reading these longish articles if you want more background on how I think here:
