Year: 2008

Still Too Early For Banks

Still Too Early For Banks

Posted on by David Merkel

One thing about Jim Cramer, he is quotable.? Take this short bit from his piece, Graybeards Get It Wrong on Financials.

One of the loudest and most pervasive themes by a lot of the graybeards is that there is still much more pain ahead in the financials.Let me explain why that is wrong. First, the group is down from a year ago. It’s been hammered mercilessly.

More important, every time the stock market rallies is another chance for these companies to refinance.

Remember, as they go up, the companies are in shape to tap the equity market again because those who bought lower are being rewarded, psyching others to take a chance. In fact, other than the monoline insurance faux bailouts, people who pony up are doing pretty well.

Now, he might be right, and me wrong on this point (with my gray beard, though I am younger than he is).? But let me point out what has to go right for his forecast to be correct.

1) The inventory of vacant homes has to start declining.? Still rising for now, another new record.? Beyond that, you have a lot of what I call lurking sellers around, waiting to put more inventory out onto the market, if prices rise a little.? They will have to wait a while, and many will lose patience and sell anyway.? There is still to much debt financing our housing stock, and though most of the subprime shock is gone, much of the shock from other non-subprime ARMs that will reset remains.? Will prices drop from here by 20%?? I think it will be more like 12%, but if it is 20% there will be many more foreclosures, absent some change in foreclosure laws.? Foreclosures happen when a sale would result in a loss, and a negative life event hits — death, divorce, disaster, disability, and unemployment.

2) We still have to reconcile a lot of junk corporate debt issued from 2004-2007, much of which is quite weak.? Credit bear markets don’t end before you take a lot of junk defaults, and we have barely been nicked.? Yes, we have had a sharp rally in credit spreads over the last five weeks, but bear market rallies in credit are typically short, sharp, and common, keeping the shorts/underweighters on their toes.? You typically get several of them before the real turn comes.

3) We have not rationalized a significant amount of the excess synthetic leverage in the derivatives market.? With derivatives for every loser, there is a winner, but the question is how good the confidence in creditworthiness between the major investment banks remains.? Away from that, Wall Street will be less profitable for some time as securitization, and other leveraged businesses will recover slowly.

4) Credit statistics for the US consumer continue to deteriorate — if not the first lien mortgages, look at the stats on home equity loans, auto loans, and credit cards.? All are doing worse.

5) Weakness in the real economy is increasing as a result of consumer stress.? Will real GDP growth remain positive?? I have tended to be more bullish than most here, but the economy is looking weaker.? Let’s watch the next few months of data, and see what wanders in… I don’t see a sharp move down, but measured move into very low growth in 2008.

6) What does the Fed do?? Perhaps they can take a page from Cramer, and look at the progress from private repair of the financial system through equity and debt issuance.? It’s a start, at least.? But the Fed has increasingly encumbered is balance sheet with lower quality paper.? Two issues: a) if there are more lending market crises, the Fed can’t do a lot more — maybe an amount equal to what they have currently done.? b) What happens when they begin to collapse the added leverage?? Okay, so they won’t do it, unless demand goes slack… that still leaves the first issue.? There are limits to the balance sheet of the Fed.

Beyond that, the Fed faces a weak economy, and rising inflation.? Again, what does the Fed do?

7) Much of the inflation pressures are global in nature, and there is increasing unwillingness to buy dollar denominated fixed income assets.? The books have to balance — our current account deficit must be balanced by a capital account surplus; the question is at what level of the dollar do they start buying US goods and services, rather than bonds?

8 ) Oh, almost forgot — more weakness is coming in commercial real estate, and little of that effect has been felt by the investment banks yet.

As a result, I see a need for more capital raising at the investment banks, and more true equity in the capital raised.? Debt can help in the short run, but can leave the bank more vulnerable when losses come.? The investment banks need to delever more, and prepare for more losses arising from junk corporates and loans, housing related securities, and the weak consumer.

One Dozen Notes on Our Manic Capital Markets

One Dozen Notes on Our Manic Capital Markets

Posted on by David Merkel

1) I think Ambac is dreaming if they think they will maintain their AAA ratings. Aside from the real deterioration in their capital position, they now face stronger competition. Buffett got the AAA without the usual five-year delay because he has one of the few remaining natural AAAs behind him at Berky. (Political pressure doesn’t hurt either… many municipalities want credit enhancement that they believe is worth something.)

2) I read through the documents from the Senate hearings on the rating agencies, and my quick conclusion is that there won’t be a lot of change, particularly on such a technical topic in an election year. And, in my opinion, it would be difficult to change the system from its current configuration, and still have securitization go on. Now, maybe securitization should be banned; after all, it offers an illusion of liquidity liquidity in good times, but not in bad times, for underlying assets that are fungible, but not liquid.

3) I am not a fan of Fair Value Accounting. But if we’re going to do it, let’s do it right, as I suggested to an IASB commissioner several years ago. Have two balance sheets and two income statements. One set would be fair value, and the other amortized cost. It would not be any more work than we are doing now.

4) Now, some bankers are up in arms over fair value, and I’m afraid I can’t sympathize. If you’re going to invest in or borrow using complex instruments that amortized cost accounting can’t deal with, you should expect the accounting regulations to change.

5) Just because you can classify assets or liabilities as level 3 doesn’t mean the market will give full credibility to your model. Accounting uncertainty always receives lower valuations. It as if the market says, :These assets will have to prove themselves through their cash flows, we can’t capitalize earnings here. The same applies to the temporary gains from revaluing corporate liabilities down because of credit stress. If the creditworthiness recovers, though gains will be reversed, and good analysts should lower their future earnings estimates when bond spreads widen, to the degree that present gains are taken.

6) The student loan market is interesting, with so many lenders dropping out. This is one area where the auction-rate securities market initially hurt matters when it blew up, but there was a feature that said that the auction rate bonds could not receive more than the student lenders were receiving. So, after rates blew out for a little while, now some the auction rate bonds are receiving zero (for a while).

7) After yesterday’s post, I mused about how much the high yield market has come back, and with few defaults, aside from those that should have been dead anyway. With liquidiity low at some firms, there will be more to come. Personally, I expect spreads to eclipse their recent wides as things get worse, but enjoy the bear market rally for now.

8) Many munis are still cheap, but the “stupid cheap” money has been made. Lighten up a little if you went to maximum overweight.

9) What’s the Big Money smoking? They certainly are optimistic in this Barron’s piece. One thing that I can find to support them is insider buying, which is high relative to selling at present. And, even ahead of the recent run, hedge funds (and many mutual funds) had been getting more conservative. Guess they had to buy the rally. On the other side, there is a sort of leakage from DB plans, as many of them allocate more to hedge funds and private equity.

10) Does large private equity fund size lead to bad decision making? I would think so. Larger deals are more scarce, and so added urgency comes when they are available. Negotiating for such deals is more intense, and the winner often suffers the winner’s curse of having overbid.

11) I am not a believer in the shorts being able to manipulate the markets as much as some would say. It’s easier to manipulate on the long side. Here is a good post at Ultimi Barbarorum on the topic.

12) Financials are the largest sector in the S&P 500.? Perhaps not for long… they may shrink below the size of the Tech sector at current rates, or, Energy could grow to be the largest.? Nothing would make me more skittish about my energy longs.? The largest sector always seems to get hit the hardest, whether Financials today, or Tech in 2000, or Energy in the mid-90s.

Blog Notes

Blog Notes

Posted on by David Merkel

I just upgraded the blog and all of its software to WordPress 2.5.1. It should allow me to do more with the blog in terms of format flexibility and a few other things. It should improve the overall stability of the blog, as well as a few things that should make the blog harder to hack. Oh, I got my descriptive permalinks back. Yay! 🙂

If you notice anything going wrong, or if you have a suggestion for the blog, please let me know. I have tried to get clicking on the top banner to return to the front page, but I am afraid I can’t figure it out. On a positive note, I’ve never had a spam problem at my blog. Between Akismet and moderating all initial comments, I have been able to screen all spam. We’ll see how well that works in the future.

One more note: I get a lot of spammers that register for my blog from Russia and Poland. If you are based in Russia or Poland, and are a true reader of my blog, send me a note, because I am going to block certain domains from registering at my blog.

The Sea Change in Bonds

The Sea Change in Bonds

Posted on by David Merkel

The bond market has had quite a shift since the last Fed meeting. What are the common themes?

  • Outperformance of credit, especially high yield.
  • Return of the carry trade.
  • Tax-free Munis have run.
  • Underperformance of Treasuries (longer= worse), and foreign bonds, particularly carry trade currencies like the Yen and Swiss Franc.

The willingness to take risks in fixed income has returned, particularly in the last two weeks. I don’t want to tell you that this is a trend that won’t reverse… it might reverse. Remember that bear market rallies tend to be short and sharp, and that the credit bear market in 2000-2002 had several legs. Leg one may be over for this credit bear market, but that doesn’t mean the credit bear market is over; there are still too many unresolved credit issues in housing, builders and investment banks.

Now, to flesh out the changes, I looked at the total returns on 15 major ETFs in different sectors of the bond market. Here are the returns since 3/19:

  • HYG — High yield Corporates + 4.47%
  • DBV — Carry trade fund +2.83%
  • MUB — National Municipals +1.10%
  • LQD — Investment Grade Corporates +0.99%
  • FXE — Euro currency Trust +0.29%
  • BIL — Treasury Bills -.06% (Negative on T-bills?!)
  • AGG — Lehman Aggregate -1.03%
  • SHY — Short Treasuries -1.18%
  • TIP — TIPS ETF -2.85%
  • IEI — 3-7 yr Treasuries -3.41%
  • FXF — Swiss Franc Currency Trust -3.44%
  • BWX — Intl. Gov’t Bond Fund -3.49%
  • IEF — 7-10 yr Treasuries -3.74%
  • TLT — 20+ Treasuries – 4.87%
  • FXY — Yen Currency Trust -5.30%

What a whipping for safe assets. Perhaps the Fed will be happy that they helped engineer the whacking. Then again, the TED spread is still high, and the change might just be a normal shift in sentiment after the panic leading up to the last FOMC meeting. Interesting to see both the return of the carry trade and credit spreads outperforming the move in Treasuries.

For those that follow my sector recommendations, I would be lightening, but not exiting credit positions in the near term. I’m in the midst of considering my other sector recommendations, and will report on this soon. For more on this topic, refer to:

Before I close, one large negative area where there is excess supply: preferred stock of financial companies.? There is a lot floating around from balance sheet repair efforts where they didn’t want to dilute the common.? (That’s the next act.)? I would stay away for now, but keep my eyes on selected floating rate trust preferreds, to leg into on the next leg down.

Book Review: Beating the Market, 3 Months at a Time

Book Review: Beating the Market, 3 Months at a Time

Posted on by David Merkel

A word before I start: I’m averaging two book review requests a month at present. I tell the PR people that I don’t guarantee a review (though I have reviewed them all so far), or even a favorable review. They send the books anyway.

Included in every book is a 2-6 page summary of what a reviewer would want to know, so he can easily write a review. Catchy bits, crunchy quotes, outlines…

I don’t read those. I read or skim the book. If I skim the book, I note that in my review. Typically, I only skim a book when it is a topic that I know cold. Otherwise I read, and give you my unvarnished opinion. I’m not in the book selling business… I’m here to help investors. If you buy a few books (or anything else) through my Amazon links, that’s nice. Thanks for the tip. I hope you gain insight from me worth far more.

If I can keep you from buying a bad book, then I’ve done something useful for you. I have more than enough good books for readers to buy. Plus, I review older books that no one will push. I hope eventually to get all of my favorites written up for readers.

Enough about my review process; on with the review:

When the PR guy sent me the title of the book, I thought, “Oh, no. Another investing formula book. I probably won’t like it.” Well, I liked it, but with some reservations.

The authors are a father and son — Gerard Appel and Marvin Appel, Ph. D. They manage over $300 million of assets together. The father has written a bunch of books on technical analysis, and the son has written a book on ETFs.

Well, it is an investing formula book… it has a simple method for raising returns and reducing risks that has worked in the past. The ideas are simple enough that an investor could apply them in one hour or so every three months. I won’t give you the whole formula, because it wouldn’t be fair to the authors. The ideas, if spun down to their core, would fill up one long blog post of mine. But you would lose a lot of the explanations and graphs which are helpful to less experienced readers. The book is well-written, and I found it a breezy read at ~200 pages.

I will summarize the approach, though. They use a positive momentum strategy on three asset classes — domestic equities, international equities, and high yield bonds, and a buy-and-hold strategy on investment grade bonds. They apply these strategies to open- and closed-end mutual funds and ETFs. They then give you a weighting for the four asset classes to create a balanced portfolio that is close to what I would consider a reasonable allocation for a middle aged person.

Their backtests show that their balanced portfolio earned more than the S&P 500 from 1979-2007, with less risk, measured by maximum drawdown. Okay, so the formula works in reverse. What do we have to commend/discredit the formula from what I know tend to happen when formulas get applied to real markets?

Commend

  • Momentum effects do tend to persist across equity styles.
  • Momentum effects do tend to persist across international regional equity returns.
  • Momentum effects do tend to persist on high yield returns in the short run.
  • The investment grade buy-and-hold bond strategy is a reasonable one, if a bit quirky.
  • Keeps investment expenses low.
  • Gives you some more advanced strategies as well as simple ones.
  • The last two chapters are there to motivate you to save, because they suggest the US Government won’t have the money they promised to pay you when you are old. (At least not in terms of current purchasing power…)

Discredit

  • The time period of the backtest was unique 3/31/1979-3/31/2007. There are unique factors to that era: The beginning of that period had high interest rates, and low equity valuations. Interest rates fell over the period, and equity valuations rose. International investing was particularly profitable over the same period… no telling whether that will persist into the future.
  • I could not tie back the numbers from their domestic equity and international equity strategies in the asset allocation portfolio to their individual component strategies.
  • I suspect that might be because though the indexes existed over their test period, tradeable index funds may not have existed, so in the individual strategy components they might be done over shorter time horizons, and then used indexes for the backtest. This is just a hypothesis of mine, and it doesn’t destroy their overall thesis — just the degree that it outperforms in the past.
  • They occasionally recommend fund managers, most of whom I think are good, but funds change over time, so I would be careful about being married to a fund just because it did well in the past.
  • If style factors or international regional return factors get choppy, this would underperform. I don’t think that is likely, investors chase past performance, so momentum works in the short run.
  • Though you only act four times a year, that’s enough to generate a lot of taxable events if you are not doing this in a tax-sheltered account.
  • It looks like they reorganized the book at the end, because the one footnote for Chapter 9 references Chapter 10, when it really means chapter 8.

The Verdict

I think their strategy works, given what I know about momentum strategies. I don’t think it will work as relatively well in the future as in the past for 3 reasons:

  • There is more momentum money in the market now than in the past… momentum strategies should still work but not to the same degree.
  • International investing is more common than in the past… the payoff from it should be less. There aren’t that many more areas of the world to go capitalist remaining, and who knows? We could hit a new era of socialism abroad, or even in the US.
  • Interest rates are low today, and equity valuations are not low.

Who might this book be good for? Someone who only invests in mutual funds, and wants to try to get a little more juice out of them. The rules on managing the portfolio are simple enough that they could be done in an hour or two once every three months. Just do it in a tax-sheltered account, and be aware that if too many people adopt momentum strategies (not likely), this could underperform.

Full disclosure: If you buy anything from Amazon after entering through one of my links, I get a small commission.

Eight Fed Notes

Eight Fed Notes

Posted on by David Merkel

1)? Let’s start out with my forecast.? I’ve given it before, but it has become the conventional wisdom — at the next FOMC meeting at the end of April, the Fed will cut by 25 basis points.? They will make the usual noises about both inflation and economic weakness, as well as difficulties in the financial system, and comment that they have done a lot already — it is time to wait to see the power flow.? The only difficulty is whether we get another blowup in the lending markets that affects the banks.? We could see Fed funds below 2% in that case, but absent another crisis, 2% looks like the low point for this cycle.? Now all that said, I think the odds of another crisis popping up is 50/50.? We aren’t through with the decline in housing prices, and there are a lot of mortgages and home equity loans that will receive their due pain.

2) One interesting sideshow will be how loud the hawks will be opposing a 25 basis point cut.? We have comments from voting members Plosser and Fisher already. Price inflation is a real threat to them, and one that is closer to the Fed’s core mission than protecting the financial system.

3)? Okay, give the Fed some credit regarding the TSLF, which is now almost not needed.? The TAF is another matter — there is continuing demand for credit there.? It will be interesting to see when the Fed will stop the the TSLF, and what happens when they try to unwind the TAF.? As it seems, some banks still need significant liquidity from the TAF.

4) Indeed, if the Fed is lending to investment banks, it should regulate them.? I would prefer they didn’t lend to investment banks, though.? Better they should lend to commercial banks that are negatively affected by investment bank failures, and let the investment banks fail.? After all, there is public interest in the safety of depositary institutions, but I’m not sure that if the investment banks disappeared, and the commercial banks were fine, that the public would care much.? It certainly would teach the investment banks and the investing public a real lesson on overdoing leverage.

5)? Okay, so LIBOR rises after it seems that some bankers have been lowballing the rate in an effort to show that they are not desperate for funds.? Significant?? Yes, the TED spread has widened 12 basis points since then. ? I’m sure that borrowers with mortgages that float off LIBOR will be grateful for the scrutiny.

Having been in similar situations in the insurance industry regarding GIC contracts, I’m a little surprised that the BBA doesn’t have some requirement regarding honoring the rate quote up to some number of dollars.? On the other hand, can’t they track actual eurodollar trading the way Fed funds gets done, and then just publish an average rate?

6) Onto the last three points, which are the most controversial.? You know that I think the core rate of inflation is a bogus concept.? If you are trying to smooth the result, better to use a median or a trimmed mean, rather than throwing out classes of data, particularly ones that have had the highest rates of inflation.? Given the inflation that is happening in the rest of the world, I find it difficult to believe that we are the only ones with low inflation, unless it is an artifact of being the global reserve currency.

7) I was quoted at TheStreet.com’s main site regarding the Fed. I think that the Fed is caught between a rock and a hard place, but I am not as pessimistic as this piece.

8 ) Finally, how do the actions of the Fed get viewed abroad?? Given the fall in the US Dollar, not nearly as favorably as the press coverage goes in the US.? Do I blame them? No.? They sense that they are losing economic value to the US, and that they are implicitly subsidizing us.? No wonder they complain.

Book Reviews: Manias, Panics, and Crashes, and Devil Take the Hindmost

Book Reviews: Manias, Panics, and Crashes, and Devil Take the Hindmost

Posted on by David Merkel


Sometimes we forget how bad it can be, and then we howl over minor bad times in the markets. We may be past a mania in residential housing, but we have not really experienced a panic or crash yet. People squeal over how bad the equity market is, but recently we haven’t had anything like the 2000-2002 experience, much less the 1973-1974 or 1929-1932 experience.

Two books come to mind when I think about disaster in a non-fear-mongering way: Manias, Panics, and Crashes, by Charles Kindleberger, and Devil Take the Hindmost, by Edward Chancellor. They take two different approaches to the topic, and those approaches complement each othe, giving a fuller picture. Chancellor takes a historical approach, while Kindleberger deals with the structures of financial crises.

From Chancellor, you will see that manias and their subsequent fallout are endemic to Western culture. Someone living a full life over the last 300+ years would see one or two big ones, and numerous small ones. Relatively free societies give people freedom to make mistakes. Given the way that people chase performance, we can all make mistakes as a group, with large booms and busts. Much as the regulators might want to tame it, they can pretty much only affect what kind of crisis we get, and not whether we get one. He is somewhat prescient in suggesting that the leverage inherent in derivatives post-LTCM could be the next crisis. This book is a better one if you like the stories, and don’t want to dig into the theories.

But if you like trying to place the manias, panics, and crashes on a common grid, to see their similarities, Kindleberger has written the book for you. In it he draws on a number of common factors:

  • Loose monetary policy
  • People chase the performance of the speculative asset
  • Speculators make fixed commitments buying the speculative asset
  • The speculative asset’s price gets bid up to the point where it costs money to hold the positions
  • A shock hits the system, a default occurs, or monetary policy starts contracting
  • The system unwinds, and the price of the speculative asset falls leading to
  • Insolvencies with those that borrowed to finance the assets
  • A lender of last resort appears to end the cycle

I liked them both, but I am an economic history buff, and a bit of a wonk. The benefit of both books is that they will make you more aware of how financial crises come to be, and what the qualitative signs tend to manifest during the boom and bust phases of the overall speculation cycle.


Full disclosure: if you buy anything through Amazon after entering their site by clicking on one of the links here, I get a small commission. That’s my version of the tip jar.

I Don’t Get It

I Don’t Get It

Posted on by David Merkel

1) Liberty Mutual buys Safeco?? Pays 1.75x book, and 11x estimated earnings?? Mutual companies have limited access to the credit markets, and have no equity to pay with, so it is mainly a cash deal.? They must have had a lot of cash lying around — might we wonder why they might not have enhanced policyholder dividends instead?? This is not an economic use of capital in my opinion. Kudos to those who owned Safeco — it was cheap, though in the negative part of the underwriting cycle.

I know this diversifies Liberty Mutual geographically and from a line of business standpoint, but I don’t expect there are a lot of costs to take out here. Intellectually, it is harder to grow organically, but at this point in the underwriting cycle, it is definitely preferred to acquisitions.? There are no equity investors in Liberty Mutual, but I would not lend them money on a trust preferred or a surplus note at present.? There are better places to put money at interest — remember, acquirers usually underperform.

But for those with a RM subscription, check out Cramer.? Off of Safeco, he likes Chubb.? Okay, I like Chubb too.? Great company, and cheap.?? I prefer Allstate, HCC, or Safety, and if I wanted to speculate, maybe Affirmative.? Lots of cheap P&C names out there, but it is the wrong side of the underwriting cycle — premiums falling, losses coming in unabated.

2) I don’t get fundamental weighting on bonds.? With bonds, the best one can do is get paid interest and principal, if one is buy-and-hold.? With stocks, a buy-and hold investor can do better in the long run by buying better earnings streams (value), rather than accepting market value weightings.? With bonds, there is no such upside, so I don’t get the fundamental weighting, except perhaps in foreign currency denominated bonds, and using purchasing power parity, which is still a weak tool.? I wouldn’t go there.

3) I don’t get Bill Miller.? I’m a value investor.? I like companies that trade at modest multiples of book and earnings.? I agree in principle with the concept of deferred performance that he mentioned in his quarterly letter:

My friend Jeremy Hosking, who has delivered around 400 basis points per year of excess return over two decades at Marathon (in London), corrected me recently when I spoke about our underperformance. “You mean, your deferred outperformance,” he said. I thought it a clever line, but it contains an important point. For investors who are trend followers, or theme driven, or who primarily build portfolios around forecasts, or who employ momentum strategies, price is dispositive. When they do badly, it is because prices moved in a direction different from what they thought. For value investors, price is one thing, and value is another. When prices move against us, it usually means that the gap between price and value is growing, and our future expected rates of return are higher.

With stable, cheap businesses, this definitely applies, but as you step out onto the growth spectrum, it no longer applies.? Check out the beginning of the letter, he is only 41 basis points ahead of the S&P 500 on a ten-year basis.? At this rate next year, he might be behind the S&P over ten years.? Quite a flameout for one who was so lionized.? Could he be fired?? Yes, but not by Chip Mason.? They are too close.? If one succeeds unconventionally, there is less tolerance for failure, because they weren’t sure why it worked in the first place.

4) I’ll take the opposite side of this trade.? Financial literacy is a good thing, and most people would be better off knowing more about finances, so long as they can mix it with humility.? I’m a professional, and I think humility is a key virtue in handling money.? As I say in my disclaimer:

David Merkel is an investment professional, and like every investment professional, he makes mistakes. David encourages you to do your own independent “due diligence” on any idea that he talks about, because he could be wrong. Nothing written here, or in my writings at RealMoney is an invitation to buy or sell any particular security; at most, David is handing out educated guesses as to what the markets may do. David is fond of saying, “The markets always find a new way to make a fool out of you,” and so he encourages caution in investing. Risk control wins the game in the long run, not bold moves.

People who are educated will still make mistakes with their money, but they will make fewer mistakes on net.? Hey, I’ve paid market tuition, and it is painful.? But boy, I learned a lot, and I don’t repeat mistakes often.? (Repeating mistakes sometimes is bad enough… 😉 )

Full disclosure: long SAFT (not SAF)

Book Review: Pension Dumping

Book Review: Pension Dumping

Posted on by David Merkel

I?m an actuary, but not a Pension Actuary. I don?t understand the minutiae of pension law; I only know the basics. Where I have more punch than most pension actuaries is that I understand the investing side of pensions, whereas for most of them, they depend on others to give them assumptions for investment earnings. I?ve written on pension issues off and on for 15 years or so. I remember my first article in 1992, where I suggested that the graying of the Baby Boomers would lead to the termination of most DB plans.

I am here to recommend to you the book Pension Dumping. It is a very good summary of how we got into the mess we in today with respect to Defined Benefit [DB] pension plans. Now, much of the rest of this review will quibble with some aspects of the book, but that does not change my view that for those interested in the topic, and aren?t experts now, they will learn a lot from the book. The author, Fran Hawthorne, has crammed a lot of useful information into 210 pages.

The Balancing Act

One of the things that the book gets right is the difficulty in setting pension regulations and laws. In hindsight, it might have been a good idea to give pensioners a higher priority claim in the bankruptcy pecking order. But if that had been done, many companies might have terminated their plans then and there, because of the higher yields demanded from lenders who would have been subordinated.

She also covers the debate on the ?equity premium? versus immunization well. Yes, it is less risky to immunize ? i.e., buy bonds to match the payout stream. Trouble is, it costs a lot more in the short run. With equities, you can assume that you will earn a lot more.

She also notes how many companies were deliberately too generous with pension benefits, because they did not have to pay for them all at once. Instead, they could put up a little today, and try to catch up tomorrow.

Things Missed

  • ? Individuals aren?t good at managing their own money. Even if a participant-directed 401(k) plan is cheaper than a DB plan in terms of plan sponsor outlay, the average person tends to panic at market bottoms and get greedy at market tops. DB plans and trustee-directed DC plans are a much better option for most people. That said, most people prize the illusion of control, and will not choose what is best for them.
  • ? Technological progress was probably a bigger factor in doing in the steel industry, and other unionized industries, than foreign competition. Nucor and its imitators did more damage to the traditional steel industry than did foreign competition. With commodity products, low price wins, and Nucor lowered the costs of creating steel significantly.
  • ? In the analysis of what industries could face pension problems next, she did not consider banks and other financial institutions. Most of those DB plans are very well-funded. Why? They understand the compound interest math, and the variability of the markets. But what if the current market stress led to financial firms cutting back on their plan contributions?
  • ? She gets to municipal pensions at the end, and spends a little time there, but those face bigger funding gaps than most private plans. Also, she could have spent more time on Multiple Employer Trusts, where funding issues are also tough, and plan sponsor failures leave the surviving plan sponsors worse off.
  • ? She also thinks that if you stretch out the period of time that companies can contribute in order to fund deficits, it will make things better. In the short run, that might be true, but in the intermediate term, companies that are given more flexibility tend to get further behind in funding DB pensions.
  • The book could have spent more time on changes in investing within DB pension plans, which are drifting away from equities slowly but surely, in favor of less liquid investments in private equity and hedge funds. How that bet will end is anyone’s guess, but pension investors at least have a long time horizon, and can afford the illiquidity. My question would be whether they can fairly evaluate the skill of the managers.

Summary

This book describes the motives of all of the parties in DB pension issues very well, and why they tend to lead to DB plan terminations. There are possible solutions recommended at the end, but in my judgment they might save some plans that are marginal, but not those that are sick. If you are interested in the topic of pensions, buy the book, and if you buy it through the links above, I get a small commission. (If you buy anything through Amazon after entering from a link on my site, I get a small commission. That?s my tip jar, and it doesn?t raise your costs at all.)

Blog Outage

Blog Outage

Posted on by David Merkel

Apologies for no post last night.? It is rather disconcerting to find the database of my website corrupt, and wonder whether I will have anything of it left.? If anyone has any recommendations on good hosting providers, I am all ears.

In the “what is coming up” file, I have the following ideas that I am working on:

  • Several book reviews.
  • A piece on ETFs
  • Monetary policy 101
  • Fundamentals of Market Bottoms
  • Intraday trading — does not seem to follow a random walk
  • What of strategies that need continuous liquidity?
  • Fixing the title of my blog, so that clicking it takes one to the home page

That’s all for now.? Thanks for reading my posts, and interacting with me, even though I find it difficult to keep up with the flow of e-mails.

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