September 2011 – Page 2 – The Aleph Blog

Hand Banking Regulation Back to the States

Posted on 20 September 2011 by David Merkel

The insurance industry is badly regulated, but it is much better regulated than the banking industry.? Consumers have better protections under state regulation.? The states are closer to consumers, and further away from insurers.

In order to change policy in a given state, an insurer would have to develop leverage over legislators, and that is tough, unless you are an in-state insurer.? But at the federal level, there is only one target, and a lot of resources can be deployed, because the payoff will be big.

Beyond that, state regulators are not so smart, and that is a good thing.? That means they will resist sophisticated schemes for solvency and consumer protection on which a sophisticated national regulator would sign off.

It is a lot easier to beat one gorilla than 50 monkeys.? Regulatory capture is a lot harder at the state level, so my recommendation would be to hand banking regulation over to the states.? After that, we can reduce the Fed down to the FOMC and NY Fed, and break their stranglehold on macroeconomics given all that they fund in academia.? End the regional Feds; they don’t do much anyway.

The idea is to get the government out of the lending business, because they aren’t very good at it.

If we would be more radical, end interstate banking.? This is a simple solution to the too big to fail problem.? If JP Morgan becomes 50 banks tomorrow, guess what?? None of those 50 banks would be big enough to cause a systemic crisis.? Same for Citi and Bank of America.? Too big to fail would be solved instantly.

My main point is this: if you don’t want banking regulation corrupted by the banks, then decentralize regulation, making it much harder for banks to aim at a single target.

Beggar Thy Neighbor Correlation

Posted on 19 September 2011 by David Merkel

This should be a short post.? There are many reasons proffered for the increase in global equity market correlations — I would like to offer one more: competitive devaluation of currencies, a.k.a., the race to the bottom.? Almost all nations are looking to cheapen their currencies in order to encourage exports.? There is a a global “conspiracy” where consumers are discriminated against by producers and their governments.

The US is involved in this but is more willing to absorb foreign goods than most, making the US is the main reserve currency.? Send us you neomercantilistic goods and services, we will give you promises of future payment.

But when everyone wants to do the same thing, cheapen currencies to promote export-led growth at home, that same thing is impossible, because not all currencies can be cheap at the same time.

But as the process goes on, with so many of the world’s large countries engaged in similar policies at their Treasuries and Central Banks, it is no surprise that with one dominant global policy, there is one global market behavior, oscillating rapidly from panic to euphoria as stimulus measure go from less to more certain.

What do you do when you realize you are wrong?

Posted on 15 September 2011 by David Merkel

I have some sympathy for Bill Gross, who erred by selling, and even going net short Treasuries when they were about to go on one of their biggest runs ever.? He also went long credit risk at the wrong time.

But what to do as a manager when you realize your ideas are wrong? My answer is to first ask how long will the present trend likely continue, and what will likely happen after that?? If your view is that the trend will reverse soon, just wait.? But if you conclude that the trend has a long way to go, then make adjustments as rapidly as possible.

Some reading this will say, “Duh. If I only knew how long the trend would last I could make a ton of money.”?? You are right, but those who are immersed in the market and its cycles typically do have a sharp opinion of how long the cycle will last.?? That opinion is right more often than it is wrong, but is wrong often enough that it is not an easy path to riches.

So when wrong, analyze what is the best decision out to the intermediate horizon, and make the appropriate adjustments.

Value Investing and Financials

Posted on 15 September 2011 by David Merkel

Disproportionately, value managers are buyers of financial stocks.? This is a result of index construction, because financials trade at relatively low multiples of book value.? Financial stocks led the rally from 1987-2007, and for the most part, it was a good era for value investors.? Value investors tend not to focus on macro concerns; they just want to pick good stocks.

But what the value managers did not appreciate was that a lot of the outperformance of financials stemmed from the willingness of the Fed to engage in a reckless monetary policy that never allowed recessions to clear away the bad debt, and thus the debt/GDP ratio kept on building.? Along with that, poor bank regulation, led by the Fed, drove a decline in underwriting standards.

Well, no surprise that value managers did badly 2007 to the present.? And they will still do badly as debts are deflated, to the extent that they own banks.? There will come a time to own banks, but I think we have to go through one or two more macro-shocks before overall debt levels are reconciled.

I own no banks or REITs.? I own a number of insurers, all of which are conservatively managed.

The Best of the Aleph Blog, Part 11

Posted on 15 September 2011 by David Merkel

This era encompasses August through October 2009, as the market rallied.

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Avoiding the Tail Wagging the Dog

We need to regulate gambling in out country, and that means shutting down many derivative markets.

Earnings, Analyst Estimates, and Estimating Future Prospects

How to differentiate between future estimates and past results.

Waiting for the Death of the Chicago School, and the Keynesian School also, Redux

Points out the impotence of the Chicago and Neoclassical schools.? It is still true today.

On Life Settlements

Explains why agents should extra-cautious if they are thinking about buying life insurance policies in the illiquid secondary market.

The Dominance and Size of the Federal Reserve

The Fed is too large and powerful.? How to reduce it?

Fusion Solution: The Stable Value Fund Guide to Commodity ETF Management

A truly classic article that anticipated what some ETF providers would do, seeking out the best opportunities rather than trying to float at spot.

Alternative Investments, Illiquidity, and Endowment Management

A definitive article on the asset-liability mismatch involved in university endowment management.

In Defense of the Rating Agencies ? III

In Defense of the Rating Agencies ? IV

The rating agencies are fair dealers with occasionally bad models.

Plan for Failure

Don’t think about the present, think about what that the future is likely to be, and how you disagree with it.

Toward a New Theory of the Cost of Equity Capital

Toward a New Theory of the Cost of Equity Capital, Part 2

Replace modern portfolio theory with a model based on contingent-claims pricing.

Risks, Not Risk

Risk does not exist in abstract.? Rather, we face specific risks.? Wise managers evaluate the risks versus the rewards.

The Good ETF

Good ETFs are:

Small compared to the pool that they fish in

Follow broad themes

Do not rely on irreplicable assets

Storable, they do not require a ?roll? or some replication strategy.

not affected by unexpected credit events.

Liquid in terms of what they repesent, and liquid in what they hold.

Pension Apprehension

On why pension plans were likely to run into the difficulties they are presently in.

On Bond Investing, ETFs, Indexes, and the Current Market Environment

Why bond ETFs and index funds are more complex than those dealing with stocks.

The Best of the Aleph Blog, Part 10

Posted on 14 September 2011 by David Merkel

This era encompasses May through July 2009, as the market rallied.? As usual, I sold too soon, and did not benefit from the continuing rally.

Farewell to John Davidson

This is my only short story at my blog, about an honest insurance executive in the credit crisis.? I know many insurance executives like his adversary, but few like him.

Choose Two: Principal Protection, Liquidity, and Above-Market Returns

The main idea is simple: you can get two out of three at best.

The Zero Short

Shorting is a tactical discipline and not a structural discipline.? Don’t try to short stock to zero, or near it.

The First Priority of Risk Control

Can you assure liquidity under all reasonable possible futures, and a few unreasonable futures?

?Just Gimme the Answer, Will Ya??

Do you want to understand the situation fully, or do you want a soundbite answer to your question?

Problems with Constant Compound Interest

Problems with Constant Compound Interest (2)

Problems with Constant Compound Interest (3)

No tree grows to the sky.? Nothing can grow at above average growth rates forever.

Do you Want to be Proud, or do you Want to Make Money?

Humility is a core asset for investment managers.

Loss Severity Leverage

Structured securities have a higher probability of “losing it all.”? Also, the medium-sized insurer mentioned did not go insolvent, but did have to get a cash infusion from some other insurers that had joined with them into a greater entity.

Fruits and Vegetables Versus Assets in Demand (2)

Fresh produce is what it is, a perishable commodity, where quantity and quality are positively correlated, and pricing is negatively correlated.? Financial assets don?t perish rapidly, quantity and quality are negatively correlated, and pricing is often positively correlated to the quantity of assets issued, since the demand for assets varies more than the supply.? Whereas, with fresh produce, the supply varies more than the demand.

The Benefits of Dumb Regulation

In short, why regulators have to have some spine, and just say no to fancy ideas.? Implied in this is that state regulation of insurance, dumb as it is, is more effective than Federal regulation of banks.

It Takes Two to Tango

Why simple explanations of market phenomena are frequently wrong.

Sorry, Doctor Shiller, not Everything can be Hedged

“The concept that everything can be hedged assumes deep markets everywhere, which is not the case.”

Toward a New Concept of Asset Allocation

An attempt to flesh out what a better concept on asset allocation would look like.

To Control Bubbles, the Fed Must First Control Itself

Why the Fed should be the systemic risk regulator.

The Equity Premium is No Longer a Puzzle

Why stocks are slightly better than bonds in the long, long run.

Central Bank Independence is Overrated

If the independence of the Central Bank is never used to resist that desires of the politicians to goose, then that is not independence, but a sham.

The Best of the Aleph Blog, Part 9

Posted on 12 September 2011 by David Merkel

This era covered February-April 2009, the nadir and the recovery.? What a time.

Financial Versus Actuarial Models of Risk

Cashflow-based models are superior to complex models relying on unstable correlations.

Who Do You Work For?

Do you act on what gives you immediate advantage, or do you try to act on what is best for all?

On Animal Spririts

An essay on Keynes lame idea that businessmen are irrational, when it is reasonable to assume that they take risk when it is warranted, and they don’t when it is not.

The Bane of Broken Balance Sheets

An essay at the nadir of the crisis trying to point out the problems when so many entities have borrowed too much.

They Voted For Change, They Got Bush-Plus

A simple summary of the Obama Administration.? Still true today.

Translation: We Really, REALLY, Hate You Guys!!

Explains why China can’t destroy the US, but the US could harm China.

Sell Stocks, Buy Corporate Bonds (II)

Good timing for anyone that wanted to buy high yield bonds, though it was a great time to buy stocks also.

Nonidentical Twins: Solvency and Liquidity, Redux

Points out why solvency and liquidity are closely related, and why we should be doubtful when someone says, “This is a liquidity problem, not a solvency problem.”

Ancient and Modern: The Retirement Tripod

Explains why we should be distrusting of modern retirement systems.

?Do Half?

Explains how to mange assets wisely when one is less than certain.

Book Review: Trend Following

I lock horns with Michael Covel, and much as I try to be reasonable over five articles, he treats me as a Cramer-wannabe.

This was the paper that had me talk before the SIGTARP staff.? Buffett read it, and from reports, liked it.? The New York Times commented on it.

The Best of the Aleph Blog, Part 8

Posted on 10 September 201111 September 2011 by David Merkel

November 2008 through January 2009 was a rough period.? The markets were in chaos.? My best posts I will categorize for your benefit:

Criticism of Government and Central Bank Policy

As the crisis hit, the government was not willing to reconcile bad debts, but insisted on on putting off pain.? Though Depression was staved off, it came with a price, which includes a future depression.

The Crisis

As many grasped at straws, the crisis was best understood as too much debt, and because that was not a part of the neoclassical economists’ playbook, they floundered, having no idea of why the crisis was occurring.

Investment Ideas

Many good ideas for how to play the market in a depressed state.? The call to buy junk bonds was a very good call.

Debt Relief

Posted on 9 September 2011 by David Merkel

The world yearns for debt relief.? There are many debts that will not be repaid at face value.? Better to recognize those realities now, and seek a compromise.? What’s that, you say?? Banks that lent the money won’t survive at the current market quote for the debts?? Best to take the bank into conservation NOW, and strike deals with their creditors.? Mark-to-market accounting should be the friend of regulators, letting them act to conserve institutions that have financed illiquid assets with liquid liabilities.

Where do we need compromises?

In Europe, Germany, France and the Netherlands need to realize they will not get full payment from Portugal, Ireland, Italy, Greece and Spain.
China and OPEC need to realize they will never get full payments from the US.
Japanese citizens need to grasp that their government will never make good on all of its obligations.
US citizens need to understand that Medicare is out of control and must be reduced, somehow.
US citizens need to get that promised benefits to municipal pension plans are too high.
Many mortgages are deeply under water, in the US and abroad.
Many loans made by Chinese banks to Party projects are not money good.

If the creditors will realize that the odds of getting par are close to nil, then a real negotiation can begin where the true value of the asset can be recognized.

Our world can be productive again, once we wipe clean all of the bad debts.? One thing that I admire about credit default swaps, when a credit event occurs, the process is clean and rapid, and relatively little cash changes hands.? Would that it could be the same for clearing debts in our more complex world.

In one sense, this is just recognizing reality before one is forced to do so, which is an admirable discipline.? The alternative is extend and pretend.? Loan more money, because for some reason unknown, it will recover.

That is no relief; it only increases the burden.? There needs to be reductions in principal, rather than rates.? Banks that don’t agree with this need to be handed over to the FDIC.

Don’t get me wrong, this is complex, but banks need incentives to shore up their balance sheets, so that they can lend once their position is solid.

As I have said from the beginning, if you want to solve this crisis, one must reconcile all of the bad debts.? Lenders need to take their hits.? Governments should liquidate bad banks, but make creditors as whole as possible.

Eat Your Own Cooking

Posted on 9 September 2011 by David Merkel

When I manage money for my clients, my own money is on the line along with them.? That’s the way it should be.? I try to give clients a clone of my portfolios whether on bonds or stocks.? This aligns my interests with theirs, because I want to make money over the long run on my assets.

This post is spurred by a post at the Wealthfront Blog, where he cites a Morningstar study where only 40% of mutual fund managers invest alongside their investors. Now, some of that is explainable because the asset class of their funds would not be a complete asset management strategy.? But it does not explain why they don’t have any significant amount invested there.

At one firm that I worked for, there was a rule: you could buy anything so long as the firm had first dibs on buying what you wanted to buy.? Once the firm was done buying, you could buy your idea.? Same thing for selling.? The firm must sell first, and only after that could any employee sell.? If you are not trading in lockstep with your clients, you must trade behind them.? No front-running.

But personally, I prefer managers that have the same incentive as investors.? Why? It makes them manage to normal risk levels.? Hedge fund incentives, unless there is some clawback for bad future performance, or that performance fees must be reinvested in the fund for a number of years, incent hedge fund managers to swing for the fences.? You can make a lot in a really good year, and receive your ordinary fees in bad years, without taking any losses.

My experience was when I was one who hired equity managers that the value shops tended to have large amounts of their personal wealth invested in their funds.? Why?? One, they believed in what they were doing.? Two, value investing tends to self-correct over time.? Three, value investors don’t trade as much.? They are typically holding investments they would be comfortable holding for a long time.? Four, there was an ethical idea of “we eat our own cooking.”? They wanted incentives aligned 1:1.? I win, you win.? You lose, I also lose.

This article is dated, but most of those that eat their own cooking are value-oriented managers.? This article is another example, but note that the excellent Vanguard does not require managers to invest in their own funds.? Part of that is the bond complex, and also that some of their equity funds are multiple manager funds.

As for me, I have over 60% of my net worth invested in my strategies, and over 80% of my liquid net worth.? I believe in what I do.? Granted, value investing has not been rewarded recently, but over the long haul, it is usually more than adequately compensated.

Month: September 2011

Hand Banking Regulation Back to the States

Beggar Thy Neighbor Correlation

What do you do when you realize you are wrong?

Value Investing and Financials

The Best of the Aleph Blog, Part 11

The Best of the Aleph Blog, Part 10

The Best of the Aleph Blog, Part 9

The Best of the Aleph Blog, Part 8

Criticism of Government and Central Bank Policy

The Crisis

Investment Ideas

Other Topics:

Debt Relief

Eat Your Own Cooking