Day: August 23, 2008

In Defense of the Rating Agencies — III

In Defense of the Rating Agencies — III

After writing parts one and two of what I thought would not be a series, I have another part to write.? It started with this piece from FT Alphaville, which made the point that I have made, markets may not need the ratings, but regulators do.? (That said, small investors are often, but not always, better of with the summary advice that bond rates give.? Institutional investors do more complete due diligence.)? The piece suggests that CDS spreads are better and more rapid indicators of change in credit quality than bond ratings.? Another opinion piece at the FT suggests that regulators should not use ratings from rating agencies, but does not suggest a replacement idea, aside from some weak market-based concepts.

Market based measures of creditworthiness are more rapid, no doubt.? Markets are faster than any qualitative analysis process.? But regulators need methods to control the amount of risk that regulated financial entities take.? They can do it in three ways:

  1. Let the companies tell you how much risk they think they are taking.
  2. Let market movements tell you how much risk they are taking.
  3. Let the rating agencies tell you how much risk they are taking.
  4. Create your own internal rating agency to determine how much risk they are taking.

The first option is ridiculous.? There is too much self-interest on the part of financial companies to under-report the amount of risk they are taking.? The fourth option underestimates what it costs to rate credit risk.? The NAIC SVO tried to be a rating agency, and failed because the job was too big for how it was funded.

Option two sounds plausible, but it is unstable, and subject to gaming.? Any risk-based capital system that uses short-term price, yield, or yield spread movements, will make the management of portfolios less stable.? As prices rise, capital requirements will fall, and perhaps companies will then buy more, exacerbating the rise.? As prices fall, capital requirements will rise, and perhaps companies will then sell more, exacerbating the fall.

Market-based systems are not fit for use by regulators, because ratings are supposed to be like fundamental investors, and think through the intermediate-term.? Ratings should not be like stock prices — up-down-down-up.? A market based approach to ratings is akin to having momentum investors dictating regulatory policy.

Have the rating agencies made mistakes?? Yes. Big ones.? But ratings are opinions, and smart investors regard them as such.? Regulators should be more careful, and not allow investment in new asset classes, until the asset class has matured, and its prospects are more clearly known.

With that, I lay the blame at the door of the regulators.? You could have barred investment in novel asset classes but you didn’t.? The rating agencies did their best, and made mistakes partially driven by their need for more revenue, but you relied on them, when you could have barred investment in new areas.

In summary, I still don’t see a proposal that meets my five realities:

  • There is no way to get investors to pay full freight for the sum total of what the ratings agencies do.
  • Regulators need the ratings agencies, or they would need to create an internal ratings agency themselves.? The NAIC SVO is an example of the latter, and proves why the regulators need the ratings agencies.? The NAIC SVO was never very good, and almost anyone that worked with them learned that very quickly.
  • New securities are always being created, and someone has to try to put them on a level playing field for creditworthiness purposes.
  • Somewhere in the financial system there has to be room for parties that offer opinions who don?t have to worry about being sued if their opinions are wrong.
  • Ratings can be short-term, or long-term, but not both.? The worst of all worlds is when the ratings agencies shift time horizons.

And because of that, I think that solutions to the rating agency problems will fail.

Clipping Coins, With No Added Inflation

Clipping Coins, With No Added Inflation

On Saturday, the Wall Street Journal had an article called Food Makers Scrimp on Ingredients In an Effort to Fatten Their Profits. Good article, but I’m here to draw a different conclusion than the article did.? How much impact does substituting cheaper ingredients in prepared food have on the CPI if the product price does not change?? No effect, but you are likely getting a lower quality good.

I don’t have troubles with the theory behind hedonic adjustment.? I have troubles with how it works in practice, and I wonder whether it can be done properly at all, as I wrote in my RM article Solid Foundation for Inflation Fears.

One requirement for doing hedonic adjustment right, is that both the new and old goods must be offered side-by-side for a while, and that people can clearly tell the differences between the old and new goods.? At that point, the economist can take the prices paid and quantities bought of both goods, and make a hedonic adjustment.

But typically, that doesn’t happen.? The old product disappears when the new product appears, and when features are upgraded, companies loudly announce the enhancements (and in a soft voice, the higher price).? When features/ingredients are downgraded, the companies say little to nothing.

But mere technical measurement of quality changes does not capture the perceived quality difference to the consumer.? Consider a soft drink company that changes its bottle size from 16 to 20 ounces (25% bigger), while raising the price 33%.? The consumers may say in their heads, “I only buy one bottle per day, and I don’t need the extra four ounces, but I have to buy one bottle of my favorite soda; I can’t buy 80% of a bottle, and this is it.”? The consumers aren’t 6.7% worse off in this example; the inflationary effect should be higher.

Same thing for computers.? Any comparison of features will overstate the perceived improvement, because for most needs of companies and individuals, computers run about the same — marginally improved hardware, and software that eats up a lot of resources, leading to little extra benefit.

With a little sympathy toward those who calculate the CPI, I will say that I think their job is tough.? Capitalist economies are diverse and dynamic.? They sample a smallish portion of what goes on, often on a static basket of goods that is infrequently updated, and try to generalize to the large, diverse, dynamic economy that we live in.? It is tough, and I know they have to do it for a wide number of reasons.? They use shortcuts.? They have to, in order to get their jobs done.? But those shortcuts bias the calculation of the CPI downward.

My advice would be this: aside from products where quality differences can be plainly figured (both goods trading side-by-side, with differences clearly identified), drop the hedonic adjustments.? This is one of the reasons why US inflation is so much lower than much of the rest of the world, and the government should be more honest about the value of our currency.

In closing, as an aside, can you imagine a question given at the Presidential debates that went something like this: “Senator, the leading bond manager of our country, and many leading financial writers (e.g. James Grant, Barry Ritholtz) have argued that the way that the government calculates the CPI is flawed, and understates the change in the cost of living.? If elected President, what would you do about this?? Further, how would it affect who you appoint to the FOMC?”

That one would probably even make Obama pause.? McCain? I like the guy, but I don’t know what he would say.? What it would point out, is how little scrutiny is really given to a core statistic that affects our lives in many ways, because it affect indexed payments, and helps define how fast the economy is really growing.? If I am correct in my assertion in the degree of understatement of the CPI, then we have been in recession for some time already.

And, for me, though I am doing well, all my friends are less well off than me.? From what I can gauge, I don’t see many whose standard of living is rising now.? So it goes.

Finance When You Can, Not When You Have To

Finance When You Can, Not When You Have To

“Get financing when you can, not when you have to.”? Warren Buffett said something like that, and it is true.? My biggest early investment loss was Caldor, which Michael Price lost a cool billion on.? A retailer that could not hold up to Wal-Mart, Target, and Sears, Caldor expanded in the early 90s by scrimping on working capital.? Eventually a cash shortfall hit, and their Investor Relations guy said something to the effect of, “We have no financing problems at all!”? The vehemence cause the factors that financed their investory to blink, and they pulled their financing, sending Caldor into bankruptcy, and eventually, liquidation.

Caldor had two opportunities to avoid the crisis.? It could have merged with Bradlees and recapitalized, leaving it stronger in the Northeastern US.? It also could have done a junk bond issue, which was pitched to them eight months before the crisis, but they didn’t do it.? In the first case, the deal terms weren’t favorable enough.? In the second case, they thought they could finance expansion on the cheap.

Caldor is forgotten, but the lessons are forgotten today as well.? Today, overleveraged financial companies wish they had raised equity or long-term debt one year ago, when the markets were relatively friendly and P/Es were higher, and credit spreads were lower.

I know I am unusual in my dislike for leverage in companies, but on average less levered companies do better than those with more debt.? Caldor went out with a zero for the equity.? A few zeroes can really mess up performance.

Capital flexibility has real value to good management teams.? I don’t mind exess cash hanging out on the balance sheets of good firms.? Hang onto some of it, and maybe during a crisis you can buy a competitor at a bargain price.

But for the financials today, who has the wherewithal to be a consolidator?? Most of the industry played their capital to the limit, and are now paying the price.? Either the door is shut for new capital, or they are paying through the nose.

I don’t see anyone large who fits that bill of being a consolidator.? Maybe some of the large energy companies that have been paying down debt would like to diversify, and buy a bank.? Hey, feeling lucky?!? Lehman Brothers!

Look, I’m being a little whimsical here, but the point remains — run your companies with a provision against adverse deviation.? Be conservative.? For those that invest, avoid companies that play it to the limit, unless you are an investor with enough of a stake that you can control the company.

Book Review: Investing By The Numbers

Book Review: Investing By The Numbers

I’m going to be reviewing a few books on quantitative investing.? Many of these will not be suitable for everyone, and as I do these reviews, I will try to indicate what level of math skills you will need in order to benefit from the book.? For today’s book, you can get most of it if you can remember your Algebra 1, and understand basic statistics.? Knowing regression helps, and a little calculus wouldn’t hurt, but this book is mainly qualitative.? It describes,and there are many graphs, but formulas are not on every page.

Investing By The Numbers has been out a while (1999), and though it is a good book in my opinion, it never sold big.? Oddly, a lot of investment actuaries bought the book because of a review in the Investment Section newsletter, Risk and Returns.? I have one of the few signed copies.? When I met Jarrod Wilcox when he gave a talk to the CFA Society of Washington, DC, he was genuinely surprised when I asked him to sign my copy of the book.

Jarrod Wilcox, Ph.D., CFA, held important roles at PanAgora Asset Management and Batterymarch Financial Management.? He runs his own shop now, focusing on liability-driven investing, something that I have written about at RealMoney, and at this blog.? What do I mean by liability driven investing?? Just that your asset allocation should reflect when you will most likely need the money.

This book does not have one big overarching idea to guide it.? Instead, it has many models to share from different situations in the market.? There is something for every quantitative equity investor here, and I will mention the areas where I benefited the most:

  • Along with a few other books, including some from the Santa Fe Institute, this book confirmed to me that one has to look at investment using an ecological framework.? Many strategies are competing for scarce returns.? Often the best strategy is the one that has few following it, and the worst one is the crowded trade.
  • Why do value methods tend to work?
  • How do you avoid traps in calculating models?
  • How do investors with different goals and expectations affect the market?? What happens when you get too many momentum investors?? Too many growth investors?
  • Difficulties with the Capital Asset Pricing Model [CAPM] and Arbitrage Pricing Theory [APT].
  • If the market tends toward equilibrium, the forces guiding it are weak.
  • Behavioral finance as a means of bridging investment theory and reality.
  • Market microstructure: how do we minimize total trading cost?? Minimize taxes?
  • How is the P/B-ROE model derived?
  • How to model market anomalies?
  • When do different valuation methods pay off well?
  • How does international diversification help?? (Bold in 1999, but a bit dated now.)
  • How to manage foreign currency risk in an equity portfolio?
  • How do neural nets work and what challenges are there in using them?

As a young investor using quantitative methods, I found the book useful, and still use a number of its findings in my current investing. Again, this is not a book for everyone — you have to want to do quantitative investing from primarily a fundamental mindset in order to benefit for this book.

Full Disclosure: Anytime anyone enters Amazon.com through any link on my site and buys anything there, I get a small commission.? This is my version of the tip jar, but best of all, it doesn’t cost you a thing, if you needed to buy it through Amazon already.

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