Month: January 2009

Industry Ranks for January

Industry Ranks for January

Posted on by David Merkel

I’m gearing up for the next change in my portfolio, but unlike prior reshapings, I am putting out my industry ranks first.? As I have mentioned before, the rankings can be used in value mode (green) or momentum mode (red).? That reflects two different philosophies on investment turnover and time horizons.

I am still negative on the banks, and think the present relative strength will reverse.? The same for housing-related industries… there is more weakness to come.

For those playing momentum, with a few exceptions, the industries in the red zone are industries with stable cash flows.? That is another sign of risk aversion in the present environment.

I will be putting out my replacement candidates later this week; at present, I’m not sure what way my portfolio will move.? These are unusual times, and I am focused on survivability, and after that, cheapness.? Safe and cheap, with the accent on safe.

Book Review: Dear Mr. Buffett

Book Review: Dear Mr. Buffett

Posted on by David Merkel

This is not your ordinary Buffett book.? In one sense, that is because it is not a Buffett book.? When I read other early reviews on the web, I concluded that they hadn’t read the book.? I read almost all of the books that I review at my blog.? If I have not read the book, but have skimmed it, I tell you so in the first few paragraphs.? I also purposely avoid reading the stuff that the PR flacks include with the books.? I find it fascinating how many reviewers rely on the crutches provided.

Why is this not an ordinary Buffett book?? Because it concerns how an expert on derivatives came to know Mr. Buffett, and how the current crises were seen in advance by both of them.? This book’s greatest strength comes from its ability to explain the messes we are currently in.? No solutions, mind you, and Mr. Buffett ain’t handing out any of those either, but understanding how we got to where we are is of value, and Janet Tavakoli is nothing if not a good writer on those points.

There is a second theme — how a derivatives expert came to appreciate value investing.? After all, when short term investing is focused on a variety of arbitrage situations, why not think long, and look for long term capital appreciation?

In the book, much of the current crisis gets examined up through September 2008.? Unlike many, she was right in advance on many of the topics that would eventually bite us:

  • CDOs
  • Subprime mortgages
  • Hedge fund underperformance
  • Failing Financial Guarantors
  • And more…

She also disses the overrated Nassim Taleb, saying that the current events are not a “black swan,” but predictable, given the overage of leverage.? I agree, having written about these thing before the bust hit, while still admiring Taleb’s focus on nonlinearity and feedback cycles.

Janet Tavakoli and Warren Buffett share a similar philosophy on derivatives.? That is what motivates this book.

  • How can they be a systemic hazard?
  • How might one use them properly?

I heartily recommend this book.? One reading this will understand our current crisis very well, and will gain in his understanding of how our markets work.? That said, the virtues of the book do not come from Mr. Buffett, but from one who intelligently admires his views on derivatives and other matters.

You can buy the book here: Dear Mr. Buffett: What An Investor Learns 1,269 Miles From Wall Street

PS — I write book reviews, and I hope you like them, because unlike other reviewers, I read the books.? I use Amazon because their service is good, and they offer a fair commision to those influencing those that buy through them.? My view is that if you need to buy something through Amazon, entering the site through one of my links will not increase your costs, and I will get a small commission.? Thanks to all who buy on Amazon through me.

Jargon

Jargon

Posted on by David Merkel

When I was an actuary interacting with the investment department inside a life insurance company, one of the things that I learned early was that there was an inpenetrable jargon on the part of the bond investors that neophytes had to learn.? My boss, the best actuarial businessman that I have ever known, insisted that we have a weekly meeting with the investment department, and in their offices.? Being on their own turf made them freer to talk their own lingo, and that helped us learn it.

When I went to work in an investment department years later, the shoe was on the other foot.? I was still learning investment lingo, but when the actuaries showed up, I was there to translate.? Not surprisingly, there is jargon on both sides, often with the same term having two different names, because it is used two different ways.

It was true until the day I left the firm, where I heard a bond term I had never heard before.? We have a lot of jargon in investing, whether it is fixed income or equities.? There is additional jargon in insurance.

Here’s my offer: I try to define what I write about, but if I fail to define something adequately, let me know in the comments, and I will add an entry to the new Jargon page.? Let me know; I live to serve.

A New Goal For TARP Money: Create Mutual Banks

A New Goal For TARP Money: Create Mutual Banks

Posted on by David Merkel

Call this a wild idea, but if the government wants to leverage its efforts in encouraging credit in the US economy, it should consider seeding mutual banks.? The US government would contribute money to 435 new banks (say $250 million to each), one for each congressional district, with the provision the government’s stake could be bought out at 1.5x what it put in.? The government would have a preferred dividend of 3 month LIBOR plus 5% or so.

The mutual banks would attract deposits, because the institutions would be healthy.? WIth the leverage from deposits, these new mutual banks would make loans that many current lenders would shun because their balance sheets are compromised.? They would be smaller institutions, not large like Fannie, Freddie and the FHLBs.? Depositors would own 2/3rds of the banks, with the government’s preferred stake getting 1/3rd of the votes.? These banks would pay dividends to depositors above any interest paid, in proportion to the profit earned on balances deposited.? (CDs being a higher cost source of funds would not get much of a dividend.)? The dividends would be paid out of profits in excess of what is needed to maintain the bank’s capital levels.

The mutual banks must remain mutual for 10 years, after which, they can be demutualized, with shares going to existing depositors in proportion to the cumulative profit earned off of each account for existing depositors.

That allocation system, similar to what is done with mutual insurers (“the contribution principle”) solves a lot of problems: people rushing to deposit when they hear about a demutualization, or, small depositors that think they will get a biggish slug of stock.? Sorry.? This is yet another area where the insurance industry is a lot brighter than the banking industry, and why?? We have actuaries, and you don’t. ;)? Actuaries are the best kept secret in business, at least, that is what the Society of Actuaries tells me. ;)? This insures fairness in who gets equity, and how much.

Now, this provides a much sweeter deal to depositors than what they currently have at their banks.? It is almost as good as a credit union, except these are subject to taxation.? (As the credit unions should be.)

This raises the objection: what of our current banks?? Will you let them go bust?? Why not prop them up?

This is one of the stupidities of how the current TARP was set up.? We reward incompetence.? Better we should allow the institutions to fail, wipe out the common, preferred, sub debt, etc.? After that, transfer the deposits and clean assets to the new mutual banks in the vicinity, and let the FDIC reconcile the crud through a new RTC.

This would set the incentives right.? Failure gets punished.? Depositors get rewarded for depositing in healthy institutions.? The government makes no big promises, but the interests of depositors are protected.

This puts the stick in front of existing banks.? No handouts, and more competition.? Show that you can delever and deliver, and you will survive.? Aside from that, we consolidate the failures into new healthy institutions.? With big failures the FDIC kicks additional funds into the affected mutual banks absorbing problems, but with an increased ownership interest to be bought out.

This is my idea of how the government and private industry could cooperate, with low ultimate costs to the taxpayer, while not subsidizing incompetence.? Such a deal.? Should I send it on to the Obama Administration?

Cramming Down on Whom?

Cramming Down on Whom?

Posted on by David Merkel

I favor cramdowns for now, becauseLike the recently departed Tanta at Calculated Risk, I also favor the concept of cramdowns in mortgage foreclosure proceedings.? It would bring balance to the negotiations, and discourage banks from making bad loans.? If a bank could be forced to compromise during? a foreclosure (odd because it is secured lending), the result could leave more homeowners in their homes, and with mortgages where the principal balances reflect current conditions.

In order for loan modifications to work, there has to be forgiveness of principal owed, though perhaps by granting the banks a part of the upside if the property is sold at a gain in later days.? Forgiveness of principal allows the LTV ratio to remain whole, while reducing the payment at the same time.

But what does that do to the banks?? The cramdowns cram immediate losses onto the banks.? What if the actions of judges lead to the insolvency of banks?? What if the possibility of future cramdowns lead mortgage rates to rise, in order to account for the risk?? This is not a costless exercise in fairness.

Articles on the cramdown proposal:

I favor cramdowns for now, because it can be a win-win for the borrowers and banks.? Leave the homeowner in place, who values the home, while making him pay something close to maximum sustainable monthly amount.

It makes the system more flexible, and at this point, that is a good thing.

Unstable Value Funds? (II)

Unstable Value Funds? (II)

Posted on by David Merkel

Well, here’s a first crack in the foundation for stable value funds.? From the article:

The $235 million Lehman vehicle, though, lost 1.7% in value in December because bond prices fell and the insurance backing, called a “wrap” in financial parlance, ended after Lehman’s mid-September bankruptcy filing.

The reason is tied to the wrap agreements negotiated for at least two of the fund’s seven insurance providers, Pacific Life Insurance Co. and J.P. Morgan Chase & Co. Since the full coverage was no longer effective, Invesco severed the arrangements with them.

The 1.7% loss was subtracted from Lehman investors’ accounts, so fund investors ended up receiving about 2% in interest in 2008. The entire situation is causing a stir among stable-value investors, who fear that it may spread to their funds if more bankruptcies crop up. Of course, the shortfall doesn’t come close to the 39% decline in the Standard & Poor’s 500-stock index last year.

The Lehman fund’s 1.7% loss is a rare occurrence in the $416 billion stable-value industry, which has had few problems in its 35-year history. More than half of 401(k) plans in the U.S. now offer stable-value funds.

Stable value funds do have credit risk.? That credit risk is often spread among AAA and AA corporate names, and among the financial guarantors, MBIA and Ambac, and GSEs like Fannie and Freddie, back when they had those ratings.

Often, Stable value funds would purchase mortgage bonds guaranteed by Fannie, Freddie, or one of the guarantors.? They would then purchase a wrap to guarantee that benefit-responsive payments would be made at par, not at market value.? All fine, except that the wrap might not last as long as the mortgage bond in a rising interest rate scenario, or that the guarantor might default.? The former happened this time.

I’ve written about stable value funds before:

Stable value funds dodged bullets with Fannie and Freddie.? They still have issues with MBIA and Ambac, but the jury is out there.? There is one more major risk area for stable value funds: rapidly rising interest rates.

In a situation where short-term interest rates rise rapidly, the crediting rate of the stable value fund will lag the rise significantly, leading some to withdraw when the market value of the fund is less than the book value, leading to a possible run on the fund.? Now my proposal, A Proposal for Money Market Funds, and More, could deal with the problem, but that’s not in any of the contracts that I know of.

This is not to scare you out of stable value funds — after all, in a bad market, what does worse?? Stocks or stable value?? Stocks, of course.? But where you can move to other options that are more palatable, like short-term bond funds, money market funds, etc., it could be a good move.? Even a blanced fund or a corporate bond fund could work in this environment.

Be aware, and pressure your DC plan providers for more data on the stable value option.

Start a Rating Agency, Why Don’t You?

Start a Rating Agency, Why Don’t You?

Posted on by David Merkel

Many finger the ratings agencies for a portion of our current problems, and to be sure, they deserve blame.? Many of the recommendations call for eliminating the opinions of the ratings agencies from anything that might determine regulatory capital levels.? Let the regulators do it themselves, instead.

That’s a nice dream, or, for those in the insurance industry, a nightmare.? The insurance industry survived such an institution, the NAIC Securities Valuation Office, and lived to tell of it.

It is said that if you can’t get work as a credit analyst, go work for the rating agencies.? They always need people, because the competent would never stay around due to low pay.? Well, the NAIC SVO was if anything worse, and for those of us that interacted with it, we had no sorrow when they moved to the rating agencies.? In terms of speed, much better.? Even the opinions were more intelligent.

I’m not saying that the rating agencies didn’t make errors; of course they did.? Most often it was over asset sub-classes that were new, and had never been through a bust cycle.? They would always be too optimistic.

Now when the regulators blame the rating agencies, it is all too convenient.? Why not blame the regulators?? They can ban any asset class that they hate; in the past, regulators typically banned assets until they were seasoned enough for institutions with trust obligations? to buy them.

The rating agencies typically did well rating asset sub-classes that had experienced significant failure at some point in the past.? Ranking corporate bonds and corporate loans against each other — no one should argue that they did a bad job rating them in aggregate.? Structured products are another matter, and the rating agencies, through their conflicts of interest, got sucked into the boom-bust cycle.

With that, I put it back to the regulators.? You don’t want to depend on the rating agencies?? Fine, create your own rating agency, and staff it with top talent.?? Wait, you can’t afford that?? Okay, staff it with people that could work for the rating agenices.? You can’t afford that either?? Ugh.? Well, at least, limit your goals, and tell those you regulate that they can’t invest in complex products that you can’t understand and rate.? Wait, you’re getting pushback from politicians telling you that you’re killing those that you regulate? Tell them to jump of a cliff.? Wait, they are suggesting the same to you?

Now, many argue that a rating agency run by the regulators would be insulated from influence from Wall Street.? It’s not that easy.? If the ratings have a dominant effect on whether securitizations get done or not, you can bet that Wall Street will call to solicit their opinions in advance of issuance.? Once the ground rules are set, Wall Street will lobby the analysts, showing much the same approach that they did with the private rating agencies, in order to get them to change/loosen their opinions.? (I experienced this with the NAIC SVO; they would usually fall in line with the private rating agencies, because it made their life easy.)

I am not a defender of the private rating agencies as much as a explainer that it is difficult to avoid the problems that they face.? The problems exist in any situation where a third party tries to analyze a wide number of credit relationships.

This is why I am skeptical in the long run of any effort to replace the rating agencies by the regulators.? As a challenge, I say “Go ahead, try it.? Past efforts like this have failed, and you will as well.”? I say this not as a lover of the private rating agencies, because they have done me wrong as well.? The problems of the rating agencies are endemic to any third party evaluation of credit.? Better to be wise to their biases as an institutional investor, and avoid their weaknesses, than to be naively credulous, and complain that you got cheated because a rating was too high.

Book Review: Rich Like Them

Book Review: Rich Like Them

Posted on by David Merkel

Suppose you wanted to write a book about “how the other half lives.”? Well, make that how the 1-in-200 lives.? You could dig up statistics on the wealthy, chronicle those who are showy in our society, and write a book about the glamour of the well-to-do.

Now imagine that instead of doing that, you decided to start knocking on the doors of estates, and ask the owners how they achieved their august status.? For the one in four that humored your request you would learn some interesting truths that are pretty plebian.? That is the story told in “Rich Like Them.”

The author, Ryan D’Agostino spent time traveling through the 100 wealthiest zip codes in the US, getting stories from the wealthy that would give him time.? He tells the tales in the mode of a storyteller, loosely organized under five chapters, and teaching the following lessons:

  • Find opportunities that others don’t see.
  • So-called luck favors those who are prepared to profit from volatility.
  • Love what you do.? Do what you love.
  • Take risks.? If you work smart and hard, those risks will be reduced.
  • Be humble.? Realize what you can’t do, and work on what you can do.

The people he interviewed were in fairly ordinary businesses, but they conducted business in ways that added a lot of value to customers.? The interviews revealed many of them to be pretty ordinary people who were in the right place at the right time, but they put forth the effort that many would not, in order to build a successful business.

The book is discursive, structuring the story around his journeys, and around the lessons that he learned.? The author could have summarized more, as many books on business do, but given the way he decided to write the book, beating people over the head with the conclusions would not have fit the author’s style.

I liked the book, and would particularly recommend it to those that want to work for themselves, but have little idea of how to pursue that goal.

You can buy it here if you like: Rich Like Them: My Door-to-Door Search for the Secrets of Wealth in America’s Richest Neighborhoods

PS ? Remember, I don?t have a tip jar, but I do do book reviews.? If you enter Amazon through a link on my site and buy things from them, I get a small commission, and you don?t pay anything extra.? If you wanted to get it anyway, it is good for both of us?

Financial History is Valuable

Financial History is Valuable

Posted on by David Merkel

I’ve said it before, but I came into the investment business through the back door as a risk manager.? Unlike most quantitative analysts, I came with a greater depth of knowledge of economic history, and a distrust of the assumptions behind most quantitative finance models, because things can be much more volatile than most current market participants can imagine. As a result, I often ran my models at higher stress test levels than required by regulation or standards of practice.

Can countries fail?? Sure.? It has happened before.? Can leading countries fail?? Yes, and consider France, Germany and Japan.? Consider earlier history — the failure of a major power has significant effects on the rest of the world.

Understanding economic history can keep one from saying, “That can’t happen.”? Indeed when governments are pressed, they do their best to extract additional revenue out of those that will complain the least.? Qualitative analyses, if done properly, incorporate a wider amount of variation than the quantitative statistics will reveal in hindsight.? Do you incorporate the idea that all novel securities (new industries) go through a big boom bust cycle?? If so, you would have avoided most of the complex debt securities born in the last ten years, and would have been light on risky debt that was the building blocks for those securities.

Though the job should fall to regulators to bar institutions of trust from investing in novel instruments, and they used to do that, the legal codes and regulators, forgetting history, removed those restrictions, and left many financial institutions to their own wisdom in managing their risks.? Some of those institutions were careful and speculated modestly if at all.? Others went whole hog.

The speculators (not called that at the time) pointed to loss statistics that had been generated during the boom phase of the cycle.? They showed how the junk-rated certificates would even be money good under “stressed” conditions.? All of the way through the boom, they pointed to their backward looking statistics, as leverage levels grew, and underwriting quality fell in hidden ways.

We know how it has ended.? In some cases, even AAA securities will not be money good (i.e., principal and interest will not be repaid in full).? Alas for the poor non-US buyers who sucked down much of the junk securities.

This forgetfulness regarding booms and busts affects societies on a regular basis. It happens everywhere, but the freewheeling nature of the US makes it a model country for this exercise (boom period in parentheses):

  • Residential Housing (2002-6)
  • Commodities (2001-8)
  • Financial Innovation — hedge funds, securitization, credit default swaps (1995?-2007)
  • Cetes (1992-1994)
  • Commercial Real estate (20s, 80s, 2000s)
  • Guaranteed Investment Contracts (1982-1991)
  • Negative convexity trade in residential mortgages (think of Orange County, Askin, Bruntjen) 1990-1993
  • Stocks (20s, mid-to-late 60s “Go-go era,” 1982-1987, 1994-2000, 2003-2007)
  • Energy (1973-82)
  • Developing country lending (late 70s)

This list isn’t exhaustive, but it’s what is easy for me to rattle off now.? Cycles are endemic to human behavior.? Governments and central banks may try to eliminate the negative part of a cycle of cycles, but it is at a price to taxpayers, savers, and increased moral hazard.? Why limit risk when the government has your back?

All that said, relying on historical patterns to recur, or simple generalizations that say that “the current crisis will follow the same track as the Great Depression,” are too facile and subject to abuse.? The fine article by Paul Kedrosky that prompted this piece makes that point. Too often the statistics cited are from small data sets, or unstable distributions generated by processes that are influenced by positive and/or negative feedback effects.

Studying economic history gives us an edge by giving us wisdom to avoid manias, and avoid jumping in too soon during the bust phase.? I’m still not tempted by housing or banks stocks yet.

That’s why I write book reviews on older books dealing with economic history (among others).? As Samuel Clemens said, “History doesn’t repeat itself, but it does rhyme.”? It doesn’t give a simple roadmap to the future, but it does aid in developing scenarios.? As Solomon said in Ecclesiastes 1:9, “That which has been is what will be, That which is done is what will be done, And there is nothing new under the sun.”

I’ll close the article here, but I have an application of this for politicians and regulators that I want to develop in part two.

Bicycle Stability Versus Table Stability — II

Bicycle Stability Versus Table Stability — II

Posted on by David Merkel

An article in the New York Times quoted by Barry Ritholtz on risk management tells some very salutary lessons.? Value-at-Risk, and other systems that rely on liquid tradable markets fail when bid-ask spreads widen.

One of my main lessons on risk comes from the concept of “bicycle stability versus table stability.” As I said at RealMoney: “This emphasis on the size of monthly payments to the consumer reminds me of the 1920s. We have traded table stability for bicycle stability. A bicycle is stable if it continues to move forward; a table is stable regardless. In an effort to ‘lock in’ housing prices in markets that are rising rapidly, many people are doing things that are rational in the short run, but not necessarily in the long run.”

I’ve talked about the the difference between bicycle and table stability before at this blog, notably:

If your risk control methods require liquidity, then they won’t work when you need reduction of risk the most.? There are no free lunches in risk management.? In order to get “table stability” leverage has to be reduced, and in some cases, cash balances carried in order to assure that an enterprise can survive in all circumstances.? It implies a lower ROE in good times, in order to be sustainable in the worst times.

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