June 2008 – Page 2 – The Aleph Blog

Avoid Debt Unless it is to Purchase an Appreciating Asset

Posted on 18 June 200818 June 2008 by David Merkel

I’m generally against debt.? I’ve been debt-free for the past five years.? It allows me to take prudent risks with my investments.? So, when I read things like this in The Economist’s Free Exchange Blog, I shake my head.? Here’s the main quotation:

My friends who study humanities are shocked and do not believe me when I, a pension economist, tell them they should not be saving. Prudent advice has become: You should always save some fraction of your income. You should save not only for retirement, but also for adverse income shocks. But, Mr Becker points out, these new lines of credit help workers cope with income shocks.

The pension economist is wrong, mainly.? So is Dr. Becker.? It is reasonable to take on debt to gain an education for a career that is lucrative; it is not reasonable for something that does not pay well.? Following your heart into a career is a good thing, but if the field doesn’t pay well, don’t saddle yourself with debt to get there.? I know too many young people with large debts in their 20s with no reasonable way to pay them off.? They may be in the field that they love, but they are miserable due to the debt.

It is also reasonable to take on debt for an asset that will appreciate over time at a rate greater than the financing rate on the debt.? Note that I did not say housing here, though that is normally the case.

I counsel all of my kids, and all of my friends to avoid debt where it does not pay, particularly for consumption.? Pay off your credit cards in full each month.? If you can’t do that, cut up your credit cards, and learn to make do without them.

The advantage in life always comes to the man who has surplus, who receives a discount for paying upfront, rather than over time.? You should live below your means, and build up a buffer against the future.? Theoreticians like Dr. Becker essentially say, “Don’t worry, they’ll loan you the money.”? Ridiculous.? First, if they do loan, it is at horrendous rates.? Second, during a credit crunch, all cheap sources of financing disappear for all but the most creditworthy borrowers.? Credit disappears when you need it most.

Saving at young ages sets the tone for the rest of life.? The lifecycle saving hypothesis (of Milton Friedman) is wrong, because most people don’t possess the discipline to switch between being a borrower to being a saver.? Many do it, but not the majority. I saved money when I was a grad student, though most of my colleagues did not.

My advice to you is to develop careful spending habits, particularly if you are young.? What you do now will affect your ability to save for the rest of your life.? Borrow for things that have large long-term payoffs.? Delay purchases for short-term gratification.

National Atlantic Notes

Posted on 17 June 200817 June 2008 by David Merkel

The last several days have been interesting to me regarding National Atlantic. It started with a discussion with another person who worked for my former employer (no, not the same one as last time). It went something like this:

Friend: Did you see the filing by our old boss?

DM: Yes, but unless he files suit alleging fraud, it is unlikely to amount to much.

F: Good point. What do you think the odds are of the deal going through?

DM: The deal is more likely to go through than not, but if the deal does fail, the stock will fall to $4, and if the deal succeeds it will go to $6.25. The payoff is asymmetric. I think the odds are 65% that the deal goes through.

F: So why are you holding on if the odds are that poor relative to the rewards?

DM: Uh…

So, on Thursday of last week and yesterday, I sold away 70% of my position after voting “no” on the deal. My thoughts: it is quite possible that the deal will get voted down. Sure, it isn’t in the short term interest of stock holders to see the deal fail, but National Atlantic has so annoyed shareholders that many will vote against their short term interests because of the egregiousness of the deal.

As an aside, NAHC is the sort of stock that if you are not careful, a large order can disrupt the market; I ended up using discretionary reserve orders routing through Arca [NYSE Archipelago], which allowed me to show 100 shares with much more behind that, and have discretion to lift bids within a penny of the stated offer. I was able to sell a lot without disturbing the market.

If the deal does get voted down, I will buy back in, at much lower prices. If it succeeds, I will take the small gain and move on.

Full disclosure: long NAHC

A New CEO at AIG

Posted on 17 June 200817 June 2008 by David Merkel

Before I start this evening, I just want to say to new readers who are reading me because my piece, Ten Notes on Crude Oil: The Fixation made an unexpected splash, that my blog is a hodgepodge. I write about a wide variety of topics, but mostly it boils down to macroeconomics, stocks, bonds, portfolio management, value investing, insurance, speculation, real estate and mortgages, and structured products and derivatives. When I wrote more actively for RealMoney, I realized that I was probably the columnist with the widest field, including Cramer. I like to think that I am a good generalist, but I try not to push my expertise beyond its limits. Writing about energy fits into many of my posts, but it is not what I write about most of the time.

On to AIG. I write about AIG this evening, because businessweek.com cites my blog post as the source of “buzz” for breaking up AIG. (I like what I do in blogging, but my voice isn’t that big.)

Well, the dissident shareholders won. Martin Sullivan is out, Robert Willumstad is in. Whether having been part of Citigroup when it grew into a behemoth is an advantage here is questionable. He is clearly a bright guy, but so is Martin Sullivan. One thing is certain, and I wrote about it when Greenberg was shown the door in 2005, no one can replace Greenberg. He built AIG, and he is a bright guy who had his fingers on the pulse of a very complex operation. No one else can match his institutional knowledge, or the culture of fear that he ran.

This brings me to my controversial point for the evening: what if AIG did so well for so long by shading/shaving their reserves? A new CEO coming in to clean up would find a continual stream of assets marked too high, and liabilities markets too low. Martin Sullivan found that out the hard way. What then for Robert Willumstad?

If there are large holes on the balance sheet, the old mantra about eating elephants applies. How do you eat an elephant? One bite at a time. Much as the credit rating has fallen, AIG would not want to see it fall further. If I were in Mr Willumstad’s shoes, I would do a thorough scrubbing of every asset and liability on the balance sheet, and then do the following exercise:

If the restatement is small, take it all at once, declare victory, and make a splash to the media.
If the restatement is moderate, such that it would wipe out a year of earnings or so, take some writeoffs quarter by quarter, until the hole is filled.
If the restatement is large, such that it would wipe out 3-5 years of earnings, or wipe out a large amount of book value, I would create a plan for a turnaround, and then sit down with the rating agencies and the regulators. That would minimize the ultimate damage. The stock price would get killed when the problems are revealed, though.

I have a few other thoughts if the loss is larger still, but I will leave those to the side, because they would be too sensational. Now as to breaking up AIG, this WSJ article suggests that some units could be sold. That’s a good idea; as companies get huge, diseconomies of scale set in. It becomes more and more difficult to manage behemoth firms.

Perhaps AIG can get back to areas where they had a true sustainable competitive advantage: serving foreign markets where there is little/less competition. Maybe ILFC [International Lease Finance Corp]. Beyond that, what is truly distinctive about AIG? In my opinion, not that much.

The Bottom for the Banks

Posted on 14 June 200815 June 2008 by David Merkel

There are many people calling for a bottom to banking stocks, and I must admit, it is a tempting place to play. I never thought Fifth Third would trade so low. Or Keycorp. Royal Bank of Scotland, sorry, I sold you early in 2008; yes, I thought you would fall. When does the excessive leverage finally eliminate the CEO?

Here’s the challenge for investors: on the one hand, you have declining earnings per share in the near term, from losses and capital raises. But when have equity prices fallen enough to discount the future losses?

I am being cautious here. I own no banks.

Here’s another way to think about it — after all of the bad debts are written off, and bad banks eliminated, what kind of earnings stream will be attractive?

I’ll use the homebuilders as an example here — at troughs, they sometimes trade for half of written-down book value, The question becomes the final side of the book value after the writedowns.

I would still be cautious here, but markets are discounting mechanisms — we are getting closer to a bottom in the banks; we are not there yet.

Ten Notes on Crude Oil: The Fixation

Posted on 14 June 200815 June 2008 by David Merkel

In different economic eras, different things attract the attention of the media, investors, politicians, etc.? Today a leading attention grabber would be crude oil, and the energy complex.? It is a honeypot for conspiracy theorists and unscrupulous politicians (not quite an oxymoron).

1)? Fuel is subsidized across much of the world, particularly in countries where there is a large state owned oil company.? Current high prices are making it difficult to maintain those subsidies, so countries like Egypt and Indonesia are reducing subsidies.? Yet subsidies are not being eliminated everywhere yet.

2) Speculators — perhaps they need a new name, and a branding campaign.? Risk bearers, maybe.? I don’t know.? But discouraging speculation by raising margin requirements will not necessarily decrease the cost of crude — those who are short crude also face margin requirements.

Now, many commodities have no futures contracts.? On average their prices have increased more than those that have futures contracts recently. ? That indicates to me that those that have futures contracts are not in a bubble.

Some look at the dollar change in prices and think that speculation must be high.? Bespoke does a good job in breaking it down into percentage terms, which indicates that the oil market has been more volatile more than half a dozen times in the past.

Do speculators include the ordinary shmoes like you and me who use ETFs?? I’ve used currency and stock and bond index ETFs, but not commodities so far.? Amazing how the trading interest on commodities has grown through ETFs — here’s another good chart from Bespoke.

As I have commented before, I think the run-up in the price of oil is fundamental, not manipulation.? Ignore the futures, and just look at spot prices — it is hard to affect where the real buyers and sellers trade in a global commodity.? If prices get too high, like the last move of OPEC in the 1979, where they overshot, and supply eventually overwhelmed their too high price.

3) We could be in overshoot mode now; it’s hard to tell.? As I have said before, sustained high prices are necessary to create the investment in alternative technologies that save energy and produce energy
more cheaply.? I don’t think that it will happen quickly though… in the early 80s, oil prices edged down, and then came down rapidly in the mid-80s.? It took a while for the new supply to be developed, and for conserving technologies to be created and deployed.

If you want a current example, think of the new big oil field found off the coast of Brazil.? It will be three years or so until we see new production there.? Another example is that it is hard to ramp up additional production from existing fields.? If you try to force more oil out more rapidly than is prudent, you can destroy the long-term viability of the oil fields.

4) But, there are dissenting voices, whether wishful ones like this one from a Japanese Vice Minister, or this article from Fortune which is more nuanced.? His arguments sound like mine, but on a faster timetable, with less consideration for future depletion.? This article from the Dallas Fed is similar; though it says that it will be difficult for oil to stay over $100/barrel in 2008 dollars, they have a ten-year horizon on that forecast.? Hey, even I think that oil will drop below $100/barrel within 10 years.

5) Now, there is demand destruction.? We are already seeing it in the UK.? We are not seeing it in China, yet.? Part of the difference has to do with China subsidizing gasoline, which blunts the market effect.

From this article, within a year gasoline demand is pretty inflexible with respect to price.? Beyond one year, people adjust their behavior.

And, it is worth noting that OPEC thinks demand in the US and globally is shrinking.? They are probably right, though the effect on price is problematic, because many oil producers can’t produce what the used to — Mexico, Venezuela, Indonesia…

6) Now, this article indicates that changes in demand for oil have been more significant than changes in supply.? Whether that will be true in the future remains to be seen, but as the rest of the world gets better off, they will demand more energy.? A wealthy life is energy-intensive.

7) Inventories are light compared to average, but I’m not sure that is as big of a factor as many indicate.? At the edges when inventory is close to capacity, or when it is close to running out, that has a big impact, but in the middle zone, the impact should be modest.

8) When I read this summary of a speech by Donald Kohn, I concluded a few things:

The Fed is stuck.
Because the Fed is stuck, it will let things drift for a while.
A certain amount of idealism is waning inside the Fed, with a creeping suspicion that they aren’t wizards, but only sorcerer’s apprentices.

9) It has been a long term theme of mine that the oil that is easiest to refine would get relatively more scarce.? This article from Naked Capitalism is another demonstration of that.? And, for those who want a stock pick, that favors Valero, which can refine the heavy and sour crudes.

10) A large part of the US current account deficit is the increase in the price of crude oil.? Eventually, the decline in the US Dollar will stimulate exports, but for a while, the J-curve effect remains in place, and the Dollar takes a beating.? That beating isn’t happening at this instant, but it has gotten hit over the past several years.? I’m not sure that this recent rise is the reversal, but there will come a time when the current account normalizes.? Hopefully other nations will liberalize trade; that would do it in its own.

Full disclosure: long VLO

PS — I am market weight in energy stocks.

Book Review: The Wall Street Waltz

Posted on 13 June 200813 June 2008 by David Merkel

I’ve mentioned this before at RealMoney, but in early 2000, I was doing some serious thinking about investing. I decided to e-mail Ken Fisher a question that he had touched on in one of his Forbes pieces. That began an e-mail dialog that forced me to ask hard questions about how I did value investing. Personally, I was surprised how much time he was willing to waste on me, but I had read the three books that he had written up to that time, Super Stocks, 100 Minds that Made the Market, and The Wall Street Waltz. I had a good idea of how he approached investing.

He challenged me to throw away the CFA Syllabus and think independently — to focus on my own competitive advantage. That led me to analyze what had worked and failed in my prior efforts in value investing, and that led to what would become the Eight Rules. I did well in the prior era, but much better after my discussion with Ken Fisher.

One more note before I begin the book review. He told me that if something is known, it is not valuable for investing. I have modified that rule to be, “If something true is relied upon by many investors, it is not valuable for smart investors. If something false is relied upon by many investors, it is valuable for smart investors to bet against that.”

The Wall Street Waltz takes you on a graphic tour of economic and financial history. Using beautiful old charts created by multiple sources, he uses them to describe market action in the past, and what they might imply for the present. The original version, of which I have a copy, was written in 1987. The new edition updates Ken’s comments to 2007.

The charts provide a springboard for Fisher to explain a wide number of concepts:

Why preferred stocks are suboptimal investments. (Chart 31 — learned that first hand a a little kid as I saw my Litton convertible preferred crater.)
How economically linked Canada is to the US (Chart 15)
The value of P/E ratios for the market (Charts 1&2)
Why you shouldn’t panic over bad political/disaster news. (Chart 24)
How inflation is correlated internationally (Chart 49)
Gold preserves purchasing power in the long run, but that is about it. (Chart 57)
Stocks create value in the long run, despite short/intermediate-term fluctuations. (Chart 88)

I could go on. I chose those pages randomly. There is a wealth of knowledge here. I would like to close with a timely page that I targeted, Chart 64 — Unemployment and the 1 Percent Rule. The stock market tends to rally after the unemployment rate rises 1%, though the challenge is timing when to sell, and I don’t know what the rule should be for that. After the last unemployment report, the rate is more than 1% over the recent low. If correct, it is time to be a buyer, though what is true on average is not always true in specific.

Most investors don’t benefit from an understanding of economic history, which gives a broader skill set for analyzing current problems. This book is an aid in gaining understanding of economic history.

Full disclosure: If anyone enters Amazon through my site and buys something, I get a small commission. Your costs are not increased. This is my equivalent of the “tip jar” and so, if you like what I write, and need to buy through Amazon, please enter Amazon through links on my site.

If You Want to Do Well, Study Math, Science, or Business, and Work Hard

Posted on 13 June 200813 June 2008 by David Merkel

I read the coverage of this academic paper with some amusement. Something not mentioned by the reviewers is that the data set came from just one college. Should that then be applicable everywhere? I don’t know.

Also, the idea of correcting for brightness of students strikes me as misguided. Smart students know to apply themselves to majors that will pay off. Also, the concept that high-paying careers require more hours is also misguided. Most of the graduates in lower earning professions can’t work more hours, even if they want to; there is no demand for that.

The paper was written to deal with how one statistically deals with non-responses in surveying. That it deals with education is a happy accident. I would be careful generalizing from this paper. To me, it is another example of advanced research that is highly intelligent, but may lack common sense.

As The Yield Curve Moves

Posted on 13 June 2008 by David Merkel

My, but haven’t we had interesting times in the short end of the yield curve lately. Have a look at this graph:

This covers the period from the final aggressive 75 basis point move by the FOMC, where there were expectations of a 1% fed funds rate by year end 2008, to now, where the rate at year end is between 2.5-3.0%.? Now look at this chart, which summarizes the yield curve moves:

The graphs and numbers tell a story.? My four datapoints represent:

3/17 – The sharpest point in the loosening cycle, prior to going to 2.25%.
4/25 – Anticipation of the end of the loosening cycle.
6/6 – FOMC jawboning that we must support the dollar and fight inflation.
6/12 – Now.

Let’s describe the moves, period by period.? In Period 1, the transition was from maximum FOMC accomodation to the end of the loosening cycle.? What happened?? Investors required more yield to invest for two years versus cash instruments, because they concluded that short rates would not go near record low levels.? The long end of the curve flattened, because inflation expectations were under control.

In period 2, things were quiet.? Three month rates rose to reflect the new consensus that the FOMC was on hold after the 4/30 meeting for the foreseeable future.? The rest of the curve did nothing.

In period 3, members of the FOMC began beating the inflation drum, particularly the hawks, including Plosser, Lacker, Fisher, and Bernanke.? The belly of the curve (twos to fives) rises the most, anticipating tightening moves by the FOMC, leading the long end to flatten, and the short end to steepen.? This implies that inflation will remain under control in the long run, an idea borne out by the TIPS market, where you can buy 20+ year inflation protection at a real yield of 2.3% — a pretty good bargain for investors that must own Treasuries and other high quality debt.

I’ll give the FOMC this.? In the last four trading days, they helped create the biggest move in the 2-year note yield that we have seen in a long time.? They managed to push up 30-year mortgage yields around 35 basis points, close to the move in the 10-year note.

Now, (to the FOMC) is that what you wanted?? Go ahead.? Start tightening monetary policy in August or September.? See what that does to the investment and commercial banks.? See how that affects weakening employment.? Do it during an election year, when politicians in 2009 might say, “Central bank independence hasn’t helped the nation.? Let’s clip the wings of the Fed.”

I see the FOMC tightening, and then abandoning the tightening early, and reverting to a weak policy, accepting more inflation for the sake of growth in the real economy, and leniency to banks that are facing tough market conditions.

Monoline Malaise

Posted on 12 June 200812 June 2008 by David Merkel

Yves Smith at Naked Capitalism had a good post on the financial guarantors. It dealt with MBIA’s new refusal to make a capital contribution to its subsidiaries. Here’s the company’s take on the matter. And here was my comment at her (Yves’) blog:

David Merkel said…: Were I Dinallo, I would refuse to allow them to set up a new monoline. He has that authority for his own state. I might also take the existing companies into conservation. Then, let MBIA take their spare capital and try to set up a monoline in another state.The commissioners of the other states should refuse them as well, because they mismanaged an insurance company already. They are supposed to check these things when new insurance companies are formed.

Finally, I’m not sure how much good $1.1 billion will do them — If you look at the 2007 10K (page 161), and wipe out their investment in subsidiaries, and take the first quarter $2.4 Billion loss out… let them have the $1.1 Billion, their net worth is still negative.

Now, maybe the loss is at the subsidiaries, so their net worth at the holding company would be near zero. That would still cause them to violate the minimum net worth covenant on their bank debt, if they lost control of their subsidiaries.

The banks could force repayment, and if I were a leading bondholder (calling the major life insurers), I would have one of my lawyers make a courtesy call to MBIA’s lawyers, and suggest that any payment of bonuses could be viewed as fraudulent conveyance.

MBIA is in a bad enough spot, that I don’t see what good keeping the $1.1 billion does them in the long run. Thus, it has to be a short-term gambit.

June 11, 2008 5:56 PM

No, they didn’t promise to shareholders or bondholders that they would do it. It was only their intent.
But, they probably did make promises to the rating agencies and NY State insurance Commisioner Dinallo.

If I were in the shoes of the ratings agencies, not downstreaming the capital is worth at least another two notches in terms of downgrades. Can the management be trusted? Probably not, which calls into question all the non-verifiable data that they have from MBIA.

If I were in the shoes of Dinallo, I would not allow MBIA to support just one of its insurance companies. I would ask for the $1.1 billion to be contributed so that risk based capital ratios at the subsidiaries would be close to even.

Now, another analyst suggested that MBIA and Ambac should be junk rated. The idea here is that once a financial guarantor goes bad, it is likely that things are even worse. That is supported by the past behavior of the rating agencies and Moody’s own implied ratings as well.

Now, things could be worse. They are worse for Security Capital Assurance, which could not wriggle off the hook of their obligations to Merrill Lynch. This has negative implications on similar efforts of other insurers to not pay as promised. Even XL Capital, which owns a large portion of SCA, and has guarantees on parts of SCA’s business that was not part of the Merrill suit, fell. It fell because:

the value of their SCA stake fell
The value of their guarantees to SCA rose; harder to repudiate.
General malaise across all financial guarantors.

As a final note, the leverage that MBIA and Ambac had with respect to their market shares has evaporated with the regulators and the rating agencies. Who knows, maybe even with their GAAP auditors… The need to support MBIA and Ambac was greater when the alternatives were fewer, but when you have Berky, Assured Guaranty (give ACE some credit for discipline here), Dexia/FSA, and maybe other new entrants, you can turn your back on everyone else as a regulator. You don’t care about the exotic coverages, and you’re glad they are going away — you just have to clean up the mess. As for the rating agencies, they have reconciled themselves to the idea that all but the municipal enhancement business is dead. So, say goodbye to MBIA and Ambac writing new business. That is over.

Blog Notes

Posted on 12 June 200814 June 2008 by David Merkel

The following is going to sound a little sloppy, so please take it in stride. When I started this blog, I allowed a large number of entities to syndicate my content. I was a neophyte, so I did not keep a list. As of this post, no one, except Seeking Alpha and my employer, is allowed to republish my posts, whether taken via RSS or through a direct scrape of my blog.

Of course, fair use is permitted. Quote me if you like, but add value to my material through your commentary. I try to make my posts over 90% mine, perhaps you should as well. Linking is encouraged. I do that for a lot of sites, particularly those on my blogroll.

If you have registered at my site but never commented, and you are a legitimate reader of my site, e-mail me. I am going to delete a number of registrees who are simply likely spammers. They get caught by Akismet, but I want to tighten things up a bit.

Also, I try to be fair to readers, but any comment at my site can be deleted by me for any reason. I have not done this once yet, except for spam. I have edited a comment or two, but that’s all. Still, I reserve the right.

Finally, thanks for reading me. Your time is valuable, and there are many good blogs out there. Thanks also to those that link to me, and have me on their blogrolls.