2008 – Page 20 – The Aleph Blog

On Management Books

Posted on 31 July 2008 by David Merkel

I get e-mails from PR flacks asking me to review books on economics and finance.? I tell them, “No guarantee of a review, and if reviewed, no guarantee of a favorable review.”? I give them my address, and they send me a review copy.

I recently received and read a book on how to manage companies better.? After reading it, I was nonplussed.? On the whole, the book was vague and filled with platitudes.? The author claimed to have been a successful CEO of three companies, but he never named the companies, and what digging I did could not turn that fact up.? So, I’m not doing a review or naming the book.? I do know that giving advice to management teams is a career for the writer in his retirement.

Was the advice in the book bad?? Most of it is common sense stuff like how to manage your time, the time of your employees, developing employees, thinking long-term, communicating a vision to employees, etc.? I am reminded of many firms that I have worked for where the management was less than stellar, but it was usually for a pretty basic reason, which varied across the companies.

1) The management team had no idea of how much risk they were taking.? This book would have no relevance to that company, which went bankrupt.

2) The company was seemingly successful, but pressure from a results-oriented management team seemed to lead to compromises in accounting standards.? This book would have no relevance to that company, which is having its share of troubles now.

3) Senior management was insecure about their abilities, and would not listen to their mid-level staffers as problems arose.? This company has merged out of existence.? This book could have been helpful, but as with so many business problems, it is not know what to do, but being willing to do it.

4) The CEO was managing the company to maximize his own pay at retirement.? He succeeded, but the company did badly after his exit, and has merged out of existence.? This book would not have helped, but what management book could convince a man to give up greed, and look out the good of others?? Oh, yeah, the Bible.? But getting someone to read that is harder still.

5) Another seemingly successful company realizes that it needs critical mass outside of its home country, so it starts buying US financial firms.? They buy bargain assets after inadequate due diligence, and end up paying double what they should have.? This book would have been no use to that firm.

6) A rapidly growing asset manager does not realize that they are getting so large that the informal way that they do things isn’t quite cutting it so well, and they need to become more corporate, and less informal/personal.? This book would have given modest help.

7) A business grown from scratch has a strong leader who limits the organization because he has to be involved in everything.? This book would be useful to the organization and him.

8) An organization that excels in design and manufacturing is mediocre in marketing, and poor in financial management.? This book would not help.

So, when I think of how many organizations that I have been closely involved with could have been helped by the book, it is not that many.

Most management book writers don’t have the erudition of the late Peter Drucker, who has long been my favorite writer in this area.? Consider another popular book Good to Great, which still sells quite well.? I usually find the Guy who wrote Freakonomics to be somewhat tedious, but I agree with him on this.? The firms that went from good to great have not been great investments.? If you want to find good investments, it would be better to invest in companies that go from bad to good.? That is where money is made.? The cost of going from bad to good is small, usually, and the reward is high.? The costs are higher going from good to great, and the incremental rewards are not as great.

So, being great is not so great, but being good is pretty good.? If you need to think about management, read books by Drucker; they are classic, and will teach you more than management, they will help you think better.? Look at Buffett and Munger — they are intelligent men who understand people, and are always learning.? They are atypical, but effective CEOs.

There is no one perfect management style, it varies by the individual and the industry.? I would only say this, build up your people skills, industry knowledge, general knowledge, and ability to understand basic finance, and you can do better as a manager.? Most important, is that you have to want to become a better manager, and from my experience, most managers don’t want to do it.

I do have some more book reviews coming up, one on energy, and another few on quantitative finance.

Full disclosure: if you buy books/things from Amazon please consider doing so by entering Amazon through the links on my leftbar.? It will not increase your costs at all, but I will get a small commission.? This is my version of the “tip jar” and the best part of it is it doesn’t cost you a dime.

What are the Limits? Are there Limits?!

Posted on 30 July 200830 July 2008 by David Merkel

From 1995 to about 2004, I would imagine Federal Reserve Governors sitting around over dinner the night before the FOMC meeting, and because the mainstream view of monetarism hadn’t been discredited yet, and saying something to the effect of: “What would it take to create inflation? How fast could we move up the monetary aggregates and not get inflation?? We run a stimulative policy far more often than theory would demand, and we don’t get significant inflation.? We’re heroes! What a free lunch!”

(Note: the S&P 500 would look much more impressive if dividends were included.)? I’m not crazy about the way the CPI is calculated, for reasons listed in this article.? But there is a reason behind the lack of goods price inflation for that era.? The money wasn’t going into goods, it was going into assets, like stocks, bonds, venture capital, homes, etc.? There were too many dollars chasing too few assets.? Asset values inflated in the 80s and early 90s, leading to the “lost decade” 1998-2008, where the market went nowhere.

Part of that problem is that the ratio of savers to consumers was topping out 1998-2008, and the Baby Boomers as a whole were a lazy cohort with respect to saving money.

That’s the prologue, my real puzzle is similar to what I posited above.? Dick Cheney has reportedly said, “Reagan proved that deficits don’t matter.”? Well, Reagan had the luxury of running the largest peacetime deficits we have seen, but at least it eventually bore the fruit of the “peace dividend,” that Clinton got to harvest.

I can see some leading officials at the Treasury having dinner together, and they about the budget deficit, and they say this: “How much money can we borrow from abroad?? We keep running larger and larger deficits, and the foreigners keep taking the paper down even as the US Dollar falls. That is great for us politically, because export industries get stimulated, and no one cares about imports (buy American), except crude oil.? There don’t seem to be any limits here.? What a great boon it is to be the world’s reserve currency!”

Yes, it is good to be King.? But, kings topple when they cannot control the amount they extract from their subjects.? I wrote a piece for RealMoney on how central banks would diversify out of the Dollar.? My main point was that those with the least to lose would do so first, and those with the most to lose would do so last.? I commented that diversification out of the Dollar would be “Led by smaller central banks, such as Singapore, Russia, or India.”

Well, India revalued the Rupee up since then, and Russia has diversified away from Dollars.? Singapore?? Their Dollar has had a significant rally against the US Dollar.

But other revaluations have not occurred yet.? The Gulf states, except Kuwait, have maintained their Dollar peg.? China is running a dirty crawling peg, rather than revalue its currency upward by 20%.

As a result, there has been no discipline, no constraint to the level of borrowing by the US Government.? They will borrow even more in future years.? Is there a time where they will find a lack of willingness of lend in Dollars to the US Government and other Dollar-denominated debt and force US interest rates up?? I think so, and it will happen by the time the demographic wave crests around 2015, give or take a few years.? At that point, future dissaving will overwhelm asset markets, as they anticipate the cash needs of the Baby Boomers as they retire.

Inflation is returning to the US, and will return in greater measure when foreign central banks diversify away from the US Dollar.? Until then, they will import inflation from the US, as they send us goods, and we send them paper.

Our position is precarious, and makes us reliant on the kindness of strangers, who might for economic or political reasons decide that the Dollar is not worth investing in.? Like any writedown, they would admit the loss that they knew was there, and move on.

In the long run, that is why I think the path of the Dollar is down, even though I think it could rally in the short run.? We are absorbing too much of the world’s goods and providing too little in return.

Covering Covered Bonds

Posted on 29 July 200829 July 2008 by David Merkel

Here’s a not-so-quick note on covered bonds.? What is a covered bond?? It is a form of secured lending, where a bank borrows money and offers a security as collateral.? That security remains on the bank’s books, but in a default the covered bondholder could claim the security in lieu of payment from the bank’s receiver.

It is not a passthrough, it is a bond.? The covered bond buyers do not receive the principal and interest from the security held by the bank, the bank receives it.? The covered bondholder (in absence of default) receives timely payment of interest at the stated rate, and principal at maturity.? Only in default does the value of the security for collateral matter.? If the collateral is insufficient to pay off principal and interest, the covered bondholders are general creditors for the difference.

Okay, so we’re talking about a type of secured lending, or secondary guarantee.? That exists in many places in different forms:

Credit Tenant Leases, which are secured first by the lease payments, and secondarily by the building.
Commercial and Residential Real estate loans are secured by property, and the ability of the debtor to service the loan.? Same for auto loans.
Utilities do a certain amount of first mortgage bonds where they pledge valuable plant and equipment, and receive attractive financing terms.
Enhanced Equipment Trust Certificates are how airlines and railroads do secured borrowing, pledging airplanes and rolling stock as collateral if they don’t pay.
Insurance companies in certain large states can set up guaranteed separate accounts.? If the insurance company’s General Account is insolvent, the separate account policyholders are secured by the assets of the separate account.? The separate account is tested quarterly for sufficiency of assets over liabilities.? If there isn’t enough of a positive margin, more securities must be added.? If those assets prove insufficient in an insolvency, they stand in line for the difference with the general account claimants.

That last example, obscure as it is, is the closest to the way a covered bond functions under the current Treasury Department’s statement on best practices for covered bonds.

Here is what collateral is eligible for the as the pool of assets securing the bonds (stuff from the Treasury document in italics):

Under the current SPV Structure, the issuer?s primary assets must be a mortgage bond purchased from a depository institution. The mortgage bond must be secured at the depository institution by a dynamic pool of residential mortgages.

Under the Direct Issuance Structure, the issuing institution must designate a Cover Pool of residential mortgages as the collateral for the Covered Bond, which remains on the balance sheet of the depository institution.

In both structures, the Cover Pool must be owned by the depository institution. Issuers of Covered Bonds must provide a first priority claim on the assets in the Cover Pool to bond holders, and the assets in the Cover Pool must not be encumbered by any other lien. The issuer must clearly identify the Cover Pool?s assets, liabilities, and security pledge on its books and records.

Further collateral requirements:

Performing mortgages on one-to-four family residential properties
Mortgages shall be underwritten at the fully-indexed rate
Mortgages shall be underwritten with documented income
Mortgages must comply with existing supervisory guidance governing the underwriting of residential mortgages, including the Interagency Guidance on Non-Traditional Mortgage Products, October 5, 2006, and the Interagency Statement on Subprime Mortgage Lending, July 10, 2007, and such additional guidance applicable at the time of loan origination
Substitution collateral may include cash and Treasury and agency securities as necessary to prudently manage the Cover Pool
Mortgages must be current when they are added to the pool and any mortgages that become more than 60-days past due must be replaced
Mortgages must be first lien only
Mortgages must have a maximum loan-to-value (?LTV?) of 80% at the time of inclusion in the Cover Pool
A single Metro Statistical Area cannot make up more than 20% of the Cover Pool
Negative amortization mortgages are not eligible for the Cover Pool
Bondholders must have a perfected security interest in these mortgage loans.

Other major requirements (not exhaustive — stuff copied from the report in italics):

Overcollateralization of 5% must be maintained.? It must be measured each month.? If the test fails, there is one month to get the overcollateralization over 5%, else the trustee can terminate the covered bond program and return proincipal and accrued interest to bondholders.
For the purposes of calculating the minimum required overcollateralization in the Covered Bond, only the 80% portion of the updated LTV will be credited. If a mortgage in the Cover Pool has a LTV of 80% or less, the full outstanding principal value of the mortgage will be credited.? If a mortgage has a LTV over 80%, only the 80% LTV portion of each loan will be credited.
Currency mismatches between the collateral and the currency that the bond pays must be hedged.? Interest rate mismatches may be hedged.
Monthly reporting with a 30 day delay
If more than 10% of the Cover Pool is substituted within any month or if 20% of the Cover Pool is substituted within any one quarter, the issuer must provide updated Cover Pool
information to investors.
The depository institution and the SPV (if applicable) must disclose information regarding its financial profile and other relevant information that an investor would find material.
The results of this Asset Coverage Test and the results of any reviews by the Asset Monitor must be made available to investors.? The issuer must designate an independent Asset Monitor to periodically determine compliance with the Asset Coverage Test of the issuer.
The issuer must designate an independent Trustee for the Covered Bonds. Among other responsibilities, this Trustee must represent the interest of investors and must enforce the investors? rights in the collateral in the event of an issuer?s insolvency.
Issuers must receive consent to issue Covered Bonds from their primary federal regulator. Upon an issuer?s request, their primary federal regulator will make a determination based on that agencies policies and procedures whether to give consent to the issuer to establish a Covered Bond program. Only well-capitalized institutions should issue Covered Bonds.? As part of their ongoing supervisory efforts, primary federal regulators monitor an issuer?s controls and risk management processes.
Covered Bonds may account for no more than four percent of an issuers? liabilities after issuance.
Issuers must enter into a deposit agreement, e.g., guaranteed investment contract, or other arrangement whereby the proceeds of Cover Pool assets are invested (any such arrangement, a ?Specified Investment?) at the time of issuance with or by one or more financially sound counterparties. Following a payment default by the issuer or repudiation by the FDIC as conservator or receiver, the Specified Investment should pay ongoing scheduled interest and principal payments so long as the Specified Investment provider receives proceeds of the Cover Pool assets at least equal to the par value of the Covered Bonds.? The purpose of the Specified Investment is to prevent an
acceleration of the Covered Bond due to the insolvency of the issuer.
Not more than 10% of the collateral may be composed of AAA-rated mortgage bonds.

My Stab at Analysis

The four percent limitation takes a lot of wind out of the sails of this for now.? The regulators are taking this slow.? They want to see how this works before they let it become a large part of the financing structure of the banks.

So long as this remains small, there shouldn’t be any large effects on the yields for unsecured bank bonds, both of which are structurally subordinated by the new covered bonds.? In other words, if some more assets are off limits in an insolvency, particularly more of the better-quality assets, that means that much less is there to recover.? Now, discount window borrowing and FHLB advances are secured already, so this just makes the issue of what is left in an insolvency to the unsecured lenders tougher.? That doesn’t affect depositors under the FDIC limits, but if you have deposits or CDs exceeding the limits, you might want to watch this issue.

Acceptable collateral is generally high quality, which means the bank has to pledge some of its better mortgages, and accept a 5% minimum haircut on the amount received back.? This should provide some support to the jumbo loan market; I didn’t see any size limits.? It looks like it would be impossible to issue subprime loans because of the 80% LTV, income verification, no neg am, first lien, underwriting must be done at the fully indexed rate.? Maybe some Alt-A could be done, but I’m not sure.? With the requirement that you have to replace collateral if a loan goes 60-days delinquent, I’m not sure a bank would want to put in collateral with a high probability of replacement.

For underwriting, an LTV of 80% or better is acceptable.? Other underwriting guidelines are left implicit to guidance given in the past on lending practices.? It’s possible that appraised values could be stretched to meet the 80% hurdle.? It’s happened before.

AAA-rated mortgage bonds are an interesting twist here as well.? I assume that it has to be AAA at every agency rating the bonds, first lien collateral, Prime or Jumbo collateral in order to be consistent with the intent of the document, but that is not explicitly defined.? Could a bank contribute a AAA home equity loan to the pool?? I doubt it, but…

Securitization is still getting done through Fannie and Freddie, but so long as the private mortgage securitization market is closed, this could be an attractive option for some banks to finance their mortgage loans.? When the securitization market comes back, covered bonds should reduce considerably as a financing source.? Overcollaterization for a securitization is less than the 5%+ that is necessary here, and it gets the loans off of your books, reducing capital requirements.? If I were a bank entering into a covered bond program, I would only borrow for the amount of time that I would expect the securitization market to be closed.? That could be years, but at some point, it will likely be cheaper to securitize, and the bank won’t want the mortgages trapped in the covered bond program then.

Beyond that, the bank would analyze whether it has better terms in securitized borrowing from the FHLB, or the newly non-stigmatized discount window of the Fed.? Even funding the loans through an ordinary deposit/MMMF/CD base would be most attractive under normal conditions, if the bank has the capital to support the loans.

Other collateral was proposed for use in covered bonds, but the regulators are taking it slow there as well.? They are starting with higher quality collateral; it might get expanded later.? The banks would probably like that.

Two final notes, and a tentative conclusion: this is a relatively complex solution for giving a new financing method to banks.? Only medium-to-large banks could be able to use it.? I’m not sure who a logical buyer of small transactions might be…. Hmm… maybe it could be a substitute for CD investors. 😉

Second, the inclusion of of a Specified Investment is interesting.? It further constrains what can be done with the proceeds of the bonds, which could be a big negative.? Are banks going to buy GICs from insurers?? BICs from other banks?? I don’t know.? Maybe I am misundstanding that part.

My conclusion, after all that, is that I don’t think this is going to be that big of a help to banks in the short run.? Why?

Small size of the program.
High overcollateralization.
Mostly (90%+) high quality mortgages can be pledged.
Capital requirements don’t change because the loans stay on the books.
Need for the Specified Investment.
Marginally increases the yields on unsecured debt.

But the benefit they get is a cheap-ish borrowing rate.? Would this get a AAA yield and rating?? Probably.? Is that enough to overcome the negatives?? Well, let’s watch and see, but I would expect it to have less impact than many expect.

PS — One other note: I read this elsewhere today, but Yves Smith points out that covered bond markets can have panics too.? Good to know; nothing is a panacea.

Credit Quality Cancer

Posted on 26 July 200827 July 2008 by David Merkel

With trends, I often try to answer the question, “Has the goat reached the end of the snake yet?”? (I got that phrase from a Canadian Investment Actuary with a quirky sense of humor.)? Another more common metaphor would be “What inning of the baseball game are we in?”? I’ll stick with the goat for now — but what I am considering is how far are we into the negative phase of the credit cycle, where:

bad debts develop
are realized
written off
new capital raised
capital calls fail at a few financial entities, leading to bankruptcies
contagion/ systemic risk worries multiply
moderate-to-weak capital structures come into question, perhaps a few fail…
increasingly, as failures happen, and marginal entities dilute the equity and raise capital, the number of zombie debts starts to decline
when the amount of zombie debts drop below a threshold, the credit markets realize that the rest is solvable, and the bull phase starts, usually with a roar.

Nine points?? Maybe I should get rid of the goat, and bring back the baseball analogy.? The nine points aren’t perfectly linear, though, and portfolio managers, both equity and debt, operate in a fog.? In 2002, when I was a corporate bond manager, I would sometimes take my head in my hands at the end of the day, and say to the more-experienced high yield manager who sat next to me, “This can’t go on much longer.”? When I would get that feeling, we were usually near a turning point.? The high yield manager would usually encourage me and tell me it was the nature of the market, and things change.

Part of the challenge is identifying the drivers of the credit bear market.? Is it the technology/CDO bubble (2000)?? LTCM (1998)?? Commercial real estate (1989)?? Here are two posts from the RealMoney CC:

		David Merkel
		Analogies for the Current Market Environment
		3/9/2007 10:13 AM EST

When I think of the current market environment, I don’t think analogies to Autumn 1987, Autumn 1998, or 2000-2002 are proper yet.

What do I think are reasonable analogies? Mexico/bonds in 1994, Cash flow Collateralized Debt Obligations [CDOs] 1999-2001, Manufactured Housing Asset-backed securities [ABS] 2002-2004, and the GM/Ford downgrade to junk crisis in May 2005 when the correlation trade went wrong.

All of these were large enough in their own right to be minor crises, and they sent measures of systemic risk up for a while, but ultimately, they were self contained, because market players with strong balance sheets picked up the pieces from failed players, and earned a reasonable return off them after buying up the “toxic waste” at fire sale prices. What was a horrible idea buying at par ($100), can be an excellent idea buying at $30.

In general, my systemic risk proxies are falling. There is still systemic risk out there, a lot of it, but it will take a bigger crisis than Shanghai/subprime to unleash that. Just be careful; watch your balance sheets and your valuations — for long-term investors, that will reduce your losses in a crisis.

Position: none

		David Merkel
		Gradualism
		1/31/2006 1:38 PM EST

One more note: I believe gradualism is almost required in Fed tightening cycles in the present environment — a lot more lending, financing, and derivatives trading gears off of short rates like three-month LIBOR, which correlates tightly with fed funds. To move the rate rapidly invites dislocating the markets, which the FOMC has shown itself capable of in the past. For example:

2000 — Nasdaq

1997-98 — Asia/Russia/LTCM, though that was a small move for the Fed

1994 — Mortgages/Mexico

1989 — Banks/Commercial Real Estate

1987 — Stock Market

1984 — Continental Illinois

Early ’80s — LDC debt crisis

So it moves in baby steps, wondering if the next straw will break some camel’s back where lending has been going on terms that were too favorable. The odds of this 1/4% move creating such a nonlinear change is small, but not zero.

But on the bright side, the odds of a 50 basis point tightening at any point in the next year are even smaller. The markets can’t afford it.

Position: None

Add in the housing bubble, lousy credit quality in high yield issuance 2004-2008, mismarking of derivative books at investment banks, the troubles with CDOs, and growing problems in commercial real estate, and you have the main elements of the current financial crisis.? This crisis is broader than the previous crises.? Many players played it to the wire in a wide number of areas.

In this environment, the continuing fall of residential housing prices another 10-15% will lead to more bank failures, and failure of a few related institutions.? Commercial real estate has far to fall, and there is no telling what it might do to financial institutions.

So, we’re still in the middle innings.? The goat has only eaten one-third to one-half of the snake.? What this means to investors is to be careful of credit risk.? Avoid entities that need credit risk to improve for now.? And pray that we don’t get a negative self-reinforcing scenario where financial failures lead to more failures.

Be wary of credit risk particularly among financial stocks.

There are Libertarians, Even in Financial Crises

Posted on 26 July 200826 July 2008 by David Merkel

What a week.? I got whupped the last two days of the week, and am behind the S&P 500 by less than a percent for the month to date.? The moves of my portfolio relative to the S&P 500 have been unpredictably large compared to past experience.? I am down a little year to date.

My one brief note for the night is to say that there are libertarians, even in financial crises.? I am one.? To the degree that I recommend bailouts, they are painful, and meant to end the current government subsidy of the institutions.

After that, I will mention my acquaintance Caroline Baum, who favorably cites Jim Bunning.? He is one of the few, along with Ron Paul, who will uncover the follies of our monetary policies. Then I will mention George Schultz, who says we should avoid intervention in the GSEs (Fannie and Freddie).? He advocates that our government should be concerned with what it does not do — this is very out of step with the American psyche — action is always preferred to inaction, as opposed to the Hippocritean “First do no harm.”

Finally, I will mention Roger Lowenstein.? He is right; failure is a necessary part of capitalism.? Fascists (Crony Capitalists) and Socialists will protect favored industries, but failure gives important signals to all economic actors — what to avoid.

In one sense this is an essay on the short run versus the long run.? Our current economic policy is short-term laser-focused.? The “right” decisions to promote short-term prosperity reduce the prospects of long-term proserity.? A certain amount of fear of failure promotes long-term carefulness and prosperity.

We learned the wrong lessons from the Great Depression.? Yes, there will be instability in capitalist economies, and it can be severe.? But government action exacerbates that instability more often than not.? It is better to live with the occasional small crisis, than to have huge crises come because the monetary and fiscal authorities were too lenient.

The Fundamentals of Market Bottoms, Part 1

Posted on 25 July 2008 by David Merkel

A large-ish number of people have asked me to write this piece.? For those with access to RealMoney, I did an article called The Fundamentals of Market Tops.? For those without access, Barry Ritholtz put a large portion of it at his blog.? (I was honored 🙂 .) When I wrote the piece, some people who were friends complained, because they thought that I was too bullish.? I don’t know, liking the market from 2004-2006 was a pretty good idea in hindsight.

I then wrote another piece applying the framework to residential housing in mid-2005, and I came to a different conclusion? — yes, residential real estate was near its top.? My friends, being bearish, and grizzly housing bears, heartily approved.

So, a number of people came to me and asked if I would write “The Fundamentals of Market Bottoms.”? Believe me, I have wanted to do so, but some of my pieces at RealMoney were “labor of love” pieces.? They took time to write, and my editor Gretchen would love them to death.? By the way, if I may say so publicly, the editors at RealMoney (particularly Gretchen) are some of their hidden treasures.? They really made my writing sing.? I like to think that I can write, but I am much better when I am edited.

Okay, before I start this piece, I have to deal with the issue of why equity market tops and bottoms are different.? Tops and bottoms are different primarily because of debt and options investors.? At market tops, typically credit spreads are tight, but they have been tight for several years, while seemingly cheap leverage builds up.? Option investors get greedy on calls near tops, and give up on or short puts.? Implied volatility is low and stays low.? There is a sense of invincibility for the equity market, and the bond and option markets reflect that.

Bottoms are more jagged, the way corporate bond spreads are near equity market bottoms.? They spike multiple times before the bottom arrives.? Investors similarly grab for puts multiple times before the bottom arrives.? Implied volatility is high and jumpy.

As a friend of mine once said, “To make a stock go to zero, it has to have a significant slug of debt.”? That is what differentiates tops from bottoms.? At tops, no one cares about debt or balance sheets.? The only insolvencies that happen then are due to fraud.? But at bottoms, the only thing that investors care about is debt or balance sheets.? In many cases, the corporate debt behaves like equity, and the equity is as jumpy as an at-the-money warrant.

I equate bond spreads and option volatility because contingent claims theory views corporate bondholders as having sold a put option to the equityholders.? In other words, the bondholders receive a company when in default, but the equityholders hang onto it in good times.? I described this in greater measure in Changes in Corporate Bonds, Part 1, and Changes in Corporate Bonds, Part 2.

Whew!? For an introduction to an article, that’s a long introduction.? Tomorrow, I will pick up on the topic and explain how one sees market bottoms from a fundamental perspective.

You Can Sue, But You Won’t Win

Posted on 24 July 2008 by David Merkel

Now, I’ve never been a great fan of the financial guarantee insurers, or the rating agencies.? Consider my post dealing with then over at RealMoney, Snarls in Insurance Investigation, Part 2.? In it, three-plus years ago, I suggested that Eliot Spitzer should investigate the relations between the rating agencies and the financial guarantors.

Now the City of Los Angeles is bringing a suit against the financial guarantors for forcing them to buy unnecessary municipal bond insurance.? Oh, please.? Did the armies of MBIA and Ambac surround LA City Hall, threatening violence if you didn’t give in to their protection racket?? This suit almost makes the failed efforts of regulators to split the guarantors into separate municipal and non-municipal insurers seem intelligent.

First, the real value of the municipal bond insurance was not for credit enhancement.? Municipal bonds rarely default, and when they do, they often become current again.? It was liquidity insurance.? Now, for a city like Los Angeles, maybe that’s not needed, but most municipalities are small issuers, and there is not enough manpower at bond managers to analyze them all.? The rating agencies fill part of the gap with their ratings.? For most municpalities, they are the only analytical coverage at all.

Now, the municipalities had the choice of issuing insured or uninsured bonds.? Insured bonds could be sold at AAA rates, and bond managers would buy them more easily because they were more liquid.? The question to an issuer boiled down to which is cheaper?? Pay AAA rates plus the guarantee fees and have an easy sale, or, pay at the rates that managers demand for lower-rated municipal bond?? For many munipalities they chose an insured sale because it was cheaper, or not much more expensive.

Any yield premium paid could possibly be attributed to their investment bankers, who did not want the extra work of having to actually sell the bonds.? With the AAA, they would fly out the door with no questions.? A lower-rated bond would cause some bond managers to sit on their hands; even though they could look at the rating from the agencies, they would not trust the rating without further analysis, and that takes time and effort.? (I know from my time as a bond manager, you can’t push your credit staff too hard, or they start making mistakes, because they can’t do quality work.)

The municipalities had another choice as well.? They could have borrowed less money, and raised more taxes, bringning their credit profiles up to AAA.? I know, the rating agencies should have rated municipalities higher, but that’s not who they are suing.? (That said, credit ratings are only moderately related to the yield spreads paid.)

A suit like this would have a better chance if it alleged implicit collusion between the rating agencies and the financial guarantors, and sued them both.? I still don’t think the City of Los Angeles would win such a suit, but the real flaw was not the insurers, but the ratings, including the ratings the financial guarantors themselves, which in my opinion, were always somewhat liberal.? (Hint: with financials, don’t just look at the rating, but look at the implied rating from the spreads on their debt.? The rating agencies holding company debt always traded at wider yields than their stated ratings would imply.)

Now, with the added fun in the space since Moody’s moved Assured Guaranty and FSA to negative watch, something I did not expect, this leaves Berky as the last man standing in the space.? But one seller does not a market make.? What this means, if Moody’s follows through, and S&P follows suit, is that muni bond insurance is likely dead for some time.? Who loses?? Small municipalities primarily.? They will face higher debt issuance costs.? Even large issuers have found the new issue market less than inviting recently.

In closing, could this come at a worse time for municipalities?? Revenue bases are eroding even as demands for services rise.? (Housing price will be a drag here for a few more years.)? They can’t print money or issue debt at whim to solve the problem, so they have to make painful cuts.? I will add this, even more painful cuts will come over the next 10-20 years as the pensions/ retiree healthcare crisis descends on the municipalities.? Not a fun time for anyone… and I’m sure there will be more lawsuits over the whole shebang, most of them bogus.

The Nature of a Crowded Trade

Posted on 23 July 2008 by David Merkel

Let me start off with two Columnist Conversation posts that talk about crowded trades:

		David Merkel
		When Is a Trade Crowded?
		8/9/2006 9:35 AM EDT

At the end of every day, every asset is owned by somebody. If you want to count in the shenanigans that occur as a result of shorting (naked or legal), those are a series of side bets that do not change the total number of shares/bonds outstanding. (I.e., if legally, shares get borrowed. Naked shorting creates a liability at the brokerage for the shares that should have been borrowed.)

So how can a trade be crowded? It comes down to the character of investors in the given stock or bond. A trade will be crowded if those owning the asset have a short time horizon that they are looking to make money over.

My example of the day is the run-up in financial stocks while waiting for the Federal Open Market Committee to pause. Financial stocks ordinarily don’t do well when the FOMC tightens, but from the time of the first tightening until now, they have returned 10%-11% annualized. There still are a lot of people betting that things will get a lot bettr for depositary institutions now that the FOMC is (in the eyes of some) done tightening.

Even if the FOMC is done tightening, as Bill Gross thinks (Who cares that he has been wrong since tightening number 5?), the yield curve needs to steepen by about 75 basis points from twos to tens before the lending margins of banks are no longer under pressure from the shape of the yield curve.

Maybe once we get our first loosening, I’ll be more constructive on lending institutions, but as for now, I am steering clear. There are too many parties that believe that the FOMC is done and too many trying to profit from the rebound that “has to happen” in lending-based financials when the FOMC is “done.”

Position: None.

		David Merkel
		Make the Money Sweat, Man! We Got Retirements to Fund, and Little Time to do it!
		3/28/2006 10:23 AM EST

What prompts this post was a bit of research from the estimable Richard Bernstein of Merrill Lynch, where he showed how correlations of returns in risky asset classes have risen over the past six years. (Get your hands on this one if you can.) Commodities, International Stocks, Hedge Funds, and Small Cap Stocks have become more correlated with US Large Cap Stocks over the past five years. With the exception of commodities, the 5-year correlations are over 90%. I would add in other asset classes as well: credit default, emerging markets, junk bonds, low-quality stocks, the toxic waste of Asset- and Mortgage-backed securities, and private equity. Also, all sectors inside the S&P 500 have become more correlated to the S&P 500, with the exception of consumer staples.

In my opinion, this is due to the flood of liquidity seeking high stable returns, which is in turn driven partially by the need to fund the retirements of the baby boomers, and by modern portfolio theory with its mistaken view of risk as variability, rather than probability of loss, and the likely severity thereof. Also, the asset allocators use “brain dead” models that for the most part view the past as prologue, and for the most part project future returns as “the present, but not so much.” Works fine in the middle of a liquidity wave, but lousy at the turning points.

Taking risk to get stable returns is a crowded trade. Asset-specific risk may be lower today in a Modern Portfolio Theory sense. Return variability is low; implied volatilities are for the most part low. But in my opinion, the lack of volatility is hiding an increase in systemic risk. When risky assets have a bad time, they may behave badly as a group.

The only uncorrelated classes at present are cash and bonds (the higher quality the better). If you want diversification in this market, remember fixed income and cash. Oh, and as an aside, think of Municipal bonds, because they are the only fixed income asset class that the flood of foreign liquidity hasn’t touched.

Don’t make aggressive moves rapidly, but my advice is to position your portfolios more conservatively within your risk tolerance.

Position: none

The concept of a crowded trade is simple.? Trades are crowded when those that hold the assets in question have short time horizons.? This can happen for a variety of reasons:

The trade could have negative carry, i.e. you have to pay to keep the trade going (e.g., shorting a high-dividend stock).
The investors holding the assets are predominantly momentum-driven.
The investors bought the assets using borrowed money. (or, sold short…)
There is an event expected to take place that will provide liquidity (e.g., a buyout); woe betide if it doesn’t happen.

Now, some will look at crude oil and other hydrocarbons and say that the trade is crowded.? Though I am now finally underweight the energy sector for the first time in seven years, I’m not sure it is a crowded trade.? The financing of the sector is pretty strong, and valuations are reasonable, discounting an oil price of around $80 or so.

What I do think is a crowded trade is residential housing, and commercial property as well.? A little over three years ago I wrote a piece called, Real Estate’s Top Looms. It had all the marks of a crowded trade:

Lots of leverage, with much of it short-dated (Option ARMs, 2/28, etc.)
Momentum buyers (and the get rich quick books)
Negative carry for investors (capital gains must happen in order for the purchase to work)
Much reliance on the “greater fool” that would buy the property from the new owner.
A high proportion of investors to owner-occupiers

It is still a crowded trade today.? There are excess homes.? Investors still face negative carry.? Buying power of prospective buyers is reduced because of higher lending standards.? Then, there’s dark supply.

Dark supply are the homes that will come onto the market if it looks like prices have stabilized.? There are owners who want to sell, but they don’t want to take a large loss, or, they can’t afford to, because they would go bankrupt.? So, they feed the mortgage for now, and wait for the day when the market will have life again.

I experienced things like this in the corporate bond market in 2001-2003.? Whenever a bond would fall sharply and not die, the recovery would be fitful, because there would be market players who were burned, wanted out, but could only justify a certain level of loss.? Dealers would tell me when I expressed interest in some of the damaged names that there would be supply a short bit above the price where I could buy today, so, I should be careful.? I had a longer time horizon, so I would often buy, and watch the struggle as fundamentals improved, but prices went up more slowly due to selling pressure.

Oh, here’s another area of dark supply:? Real estate owned by the GSEs.? They can probably be a bit more patient than commercial banks, but as prices begin to firm, they will start to unload properties.

I have been reading estimates of the size and duration of further declines in residential housing prices.? My view is that we have another 10% down, and that in two years, we should be at the bottom.? How long it takes to burn through the dark supply is another matter, and one that I don’t have a good guess for.

When investors can make a good return off of buying and renting (but there aren’t many of them), and many people have reconciled themselves to the losses they have incurred, then the trade will no longer be crowded, and we will have a normal residential real estate market once again.

For those that want to read some of my older articles on market structure, have a look at these five articles at RealMoney:

The Fundamentals of Market Tops
Managing Liability Affects Stocks, Pt. 1
Separating Weak Holders From the Strong
Get to Know the Holders? Hands, Part 1
Get to Know the Holders? Hands, Part 2

The latter four were a series, but not labelled as such.

Asking for Help

Posted on 23 July 200822 June 2017 by David Merkel

This post is a little different, so bear with me for a moment.? I’m in the midst of taking my value investing and turning into a product that will enable me (and the firm I work for) to manage separate accounts. I figure a few of my readers may manage firms that manage separate accounts.? If you do that, I’m just looking for pointers, particularly regarding difficulties to avoid in starting up such an operation.? E-mail me at the address listed on this page if you think that you can help.? Thanks.

Oh, one more thing.? Today was my best relative performance day in a long time.? I’m back in the plus column (barely) year-to-date, and ahead of the S&P 500 for the month, after having been behind by more than 5% earlier this month.? What a manic, nutty month!? And now, watch it all shift because of Cemex’s earnings miss.? Can’t win them all.

Full disclosure: long CX

Ten Notes and Comments on the Current Market Fracas

Posted on 22 July 200822 July 2008 by David Merkel

1) How to control your emotions when the market is nuts?? Develop a checklist, or at least a strategy that makes you re-evaluate the fundamentals, rather than buying/selling indiscriminately.

2) What, one standard for revenue recognition?? Impossible! Great!? Revenue recognition is probably the most important issue in accounting, and whatever comes out of this will be important to investors.? (If the standard is bad, value investors that watch the quality of earnings will gain additional advantages.)

3) America is too big to fail?? You bet, at least to our larger creditors.? As it stands now, our economy is partly propped up by foreign creditors.? Remember, the mercantilists lost more than they gained.? The same will happen here.

4) Tom Graff is a bright guy, and I respect him.? He disagrees with my view on buying agency mortgage backed securities.? He is worth a read.

5) Dark supply.? There are many people who want to sell homes who have them off the market now waiting for better prices.? There are investors buying properties hoping to flip them.? These are reasons I don’t expect housing prices to come back quickly.

6) When I read this piece on Countrywide, I was not surprised by the existence of special deals, but only by their extent.

7) HEL and HELOC experience will continue to decline.? Face it, on most home equity loans in trouble, the losses will be 100%.? This will only burn out one year after the bottom in housing prices.

8) Fannie and Freddie have their concerns:

Their books are being reviewed again.
They are too big to fail, but they are in trouble.
The Government is pressing them to lend more, but their capital bases say the opposite.

9)? Loser rallies rarely persist, but that is what we have had recently.

10) Along with Barry, I do not believe that banks have bottomed yet.? There are more credit losses to be taken, particularly as housing prices fall another 10%.