February 2013 – Page 3 – The Aleph Blog

The Education of a Mortgage Bond Manager, Part VII

Posted on 10 February 2013 by David Merkel

1) One place where being an actuary and being a financial analyst melded well was with Affordable Housing and Historic Tax Credits.? In all of these investments, it made a great difference as to what the Statutory, Tax, and GAAP accounting bases.? When I described my methods of working through the free cash flows, AHIC [The Affordable Housing Investors Council] wanted me to speak to the whole regarding my methods.

I never gave the talk because we were full on tax credits, and I was too busy managing the portfolio of Fidelity & Guaranty Life.?? The moral is: watch free cash flow.

2) Probably the ugliest incident in managing money for Fidelity & Guaranty was when the management of F&G decided to try to buy the structured settlement liabilities of Confederation Life.? Big block, five potential buyers.?? St. Paul had a rule: we don’t outsource asset management.? Sadly, the chief actuary, against our admonitions allowed for reinsurance treaties that outsourced asset management.

During the conference call to legitimate the offer that we would make, several things happened:

a) F&G management accused St. Paul management of being bureaucrats, not businessmen.

b) St. Paul management told F&G management that they were ignoring the rules.

c) I informed both sides that we were all gentlemen here, and that the tone of discussion was not worthy of real businessmen.

d) The CEO of F&G eventually broke off the call, calling the St. Paul folks bureaucrats, rather than businessmen, and saying that they killed a good deal.

Personally, I think he said this to save face with his employees.? Also, the deal was marginal at best.? We would have had to take a lot of risk to make the deal work.? But F&G would not listen to us.

3) I liked buying seasoned bonds, because they were more predictable.? Problem: you could not buy them in size.? Buying bonds in the aftermarket is typically picking at scraps.? Face it — most bond buyer want to hold their bonds for a while.? Aside from the few that sell for a quick profit, most bond investors hold on for a long time.? But I would pick up scraps.? Enough scraps, and you have some decent positions.

If you do find a seasoned bond selling at a reasonable price, buy it in, subject to the advice of your credit analyst.

4) Regarding mortgage bonds, remember that default and prepayment are dual.? Debtors divide up into three groups: a) Very solvent, they will easily pay off their debts, and if there is an opportunity to refinance their debt, they will take it.? b) Solvent. They don’t have a lot of margin, but they can pay their debts if nothing serious goes wrong. c) We did not deserve the loan.? We will fail with high probability in the next year.

Ideally, if you want the best yield out of a bunch of consumer lending assets, you want a lot of the middle group.? Not the highest credit quality, but likely to pay off, and not so likely to prepay.? There is a hierarchy:

Best: pay,
Next best: prepay,
worst: don’t pay.

5) So as I learned about CMBS, I wondered about the interest only strip that many of the deals held — from my own testing, it had the credit properties of a BBB tranche at best, and a Single-B tranche at worst.? Sadly, because they had no principal to pay they were nominally rated AAA, and so the firm I worked for (not my area) crammed them into Stable value plans.? Because I had done the credit stress testing, I knew this, and resisted their use in my own portfolios.

But this is another example where accounting rules have led us afoul.? Nominal principal should be implied to “interest only” obligations.? “Principal only” obligations should have implied interest.

That’s all for now.? I will finish up in the last segment, probably on Monday.

Letters from Two Readers

Posted on 9 February 2013 by David Merkel

I wanted to drop you a line to commend you on your blog which I read with interest and almost universal agreement.

Your investment ideology and style is very similar to my own, and I enjoy the snippets of personal insight and glimpses of your life that you share.

I have worked in investment management for a number of life and general insurers in the UK and with a number of actuaries, some of these have been extremely able and had an outlook very similar to that which you hold. The more risk averse, countercyclical heads have tended to perform very strongly when given the time for their ideas to mature.

It is far easier to identify a good idea than to know when the market will come into line with your thinking!

Performance can be poor whilst you wait for the market to adjust, so you need have established your investment credentials beforehand. I have also seen a company destroyed by the unwillingness of a board to wait for investment performance switching managers and strategy at the peak of the TMT bubble, which ended up putting one of the strongest life funds into run-off.

Thanks for the words of encouragement.? It?s always challenging to strike the balance between earning returns and avoiding undue risk, much less having any sense of timing the risk cycle.? With bonds, it is a little easier, because you can tell when debt covenants, etc., and other terms of lending weaken.? We can see when incremental yield is most likely not going to be compensate for the risks involved.

The same applies to insurance ? stylistically, first pricing declines to technical levels, then terms and conditions deteriorate, then pricing declines further, until there is a disaster, capital reduces and pricing strengthens.

Thanks for writing.

I really appreciate the way you do twitter and blog. ?You always include your thoughts to some degree in your tweets, which I appreciate; and your blogging is great! ?I often read to hear about what your thinking and you do a good job of translating a lot of technical or specific information into applicable or at least thoughtful steps I can take.

I’m probably most amazed by your ability to find “truth” through mathematics due to your skills as an actuary. ?As a younger man in this business I’ve been from awed to disillusioned from the market and I still struggle to have a grasp. ?We use mutual funds predominantly so I don’t have to worry about knowing so much about the market and the individual goings-on but I still do a lot of asset allocation. ?Frankly, I think there is more risk in a poor asset allocation than a poor asset selection within that allocation.

Right now I’m thinking that high yield spreads are too tight and credit too frothy, but I read Third Avenue on high yield and they argue that we have a few years before that’s a problem. ?I guess what I’m asking for is advice on how to find the truth of where we are in the market cycle and how to take smart risks with my clients’ money. ?Should I be reducing or eliminating HY debt because of the “seemingly clear” overheated risk? ?If so, where do I find a decent return in fixed income or do I bite the bullet and stay short with little/no yield.

Especially for the more conservative investors who really need every penny to work out – it’s a hard balance to find right now. ?I don’t think I’m alone. ?Nevertheless, sorry for the long email. I hope to see something on your blog or a response if you find a minute of what must be a very busy life.

Yes, high yield is frothy, but it could get frothier.? Cramer had a saying, ?Absurd is like infinity.? Twice absurd is still absurd; twice infinity is still infinity.?? I read through the Third Avenue report? I generally like the way they do things though Marty Whitman got whacked in the financial crisis for owning too many low quality financials.

I learned early on from a junk bond manager who currently has five stars from Morningstar, that spreads are less critical to junk bond than dollar prices.? His view is that there is some irreducible risk in high yield, such that you need yield, not just spread, to guide your decisions.? Particularly when junk bond prices get so high that they are likely? to be called.? With such a steep yield curve for Treasuries, it is possible for option-adjusted spreads to rise as the bond price rises.

I can?t tell you what to do.? I can tell you what I am doing.? For my bond clients, I have assets? allocated half to emerging markets, both local currency and dollar denominated.? The governments of most emerging markets are run in a more orthodox manner than most of the developed markets, so I am comfortable with the risks.?? The rest is invested in short and longer investment grade corporate, and a small wager on the Swiss Franc appreciating.

I am happier getting yield from emerging markets than getting it from weak corporate credits. ?There are risks in the world today, and we could see high yield strategies fail.? After all, no one thinks about a moderate-sized war changing risk preferences.

That?s what I am doing.

-=-=-=-=-=-==-=-=-=-=–==-=-=–=-=–=-=-=-

To all my readers, risk is sometimes not obvious.? In this time of abnormal monetary policy and large budget deficits, it pays to be careful.

The Education of a Mortgage Bond Manager, Part VI

Posted on 9 February 2013 by David Merkel

1) One thing that impressed me about working in a life insurance investment department is how many ideas we kicked around and abandoned.? I did not experience that to the same degree working at a hedge fund.? I think that is true for two reasons: 1) we have a significant balance sheet, and can take on illiquidity. 2) we are conservative, and aren’t going to take on marginal risks.

2) Another thing that impressed me was how well the money was managed, and how poorly the liability writers thought it was managed.? I did a big study to analyze what we had earned for F&G Life over the prior seven years.? We beat single-A bond yields by more than 0.7%/year.? That’s huge.? That said, they kept asking for more.? I shake my head and wish that we were running a mutual fund; we would have gotten a lot of respect.

3) When I came, the client held no CMBS, after three years 25% of the assets were CMBS.? It made so much sense given the 10-year duration of the EIAs that were growing so rapidly.? Given my models, and the lack of yield from corporates, this was a big improvement.

CMBS, because it is noncallable, makes a lot more sense for longer-dated liabilities.? Hey, I was not only the mortgage bond manager, I was the interest rate risk manager.? I would not knowingly take bad risks.

4) When the merger happened, the boss decided to jump to another firm.? Unintentionally, I may have encouraged that, because when he asked me, ‘What would I do in this new organization?”? I said, “Let me draw it out for you,” showing that he would be CIO of insurance asset management.? He was crestfallen, and sought other avenues of employment.? When he announced his new job, there was a big change.

First, the St. Paul talked with me and the High Yield manager, and gave me authority to manage things, so long as the high yield manager agreed.? Basically, they trusted me, but knew I was inexperienced, so they wanted the high yield manager, who was far more experienced than me, to guide me.? There was an economic incentive here: the better we did, the less cash the St. Paul had to transfer to Old Mutual at the closing.

But after that, the analysts came to me and said “you be our leader.”? The high yield manager agreed.? When I asked why, they said, “We trust you. You have always had a better call on credit than the prior boss, and you understand our client better than anyone else!”

That led to something hard.? I called a meeting of the analysts and managers, but told the old boss, who was still with us, that he was not invited.? I almost cried.? He was our leader for so long, and a good one, but I had to take control.

Once I did so, I asked the analysts for reports on all companies where the stock price had fallen by more than 50% since bond purchase.? We began selling those bonds where it made sense.? Those sells were almost always good sells, and I wish I had not been countermanded by my new bosses on Enron (the greatest company in the world.)

I have more to say but that will have to wait for the next part.

How do Promoted Stock Scams Work?

Posted on 9 February 2013 by David Merkel

From a reader:

I’ve been following your blog for a little while and appreciate your analysis. I’ve been particularly interested in your coverage on the penny stock phenomenon and started doing some of my own digging. I’ve found a few “companies” that seem to share characteristics with the ones you have highlighted. Digging into the 10-Qs reveals all sorts of red flags around related party transactions, health of balance sheet, past history of management, etc. The question I’ve been trying to answer is how these companies continue to exist? In the cases I list below their sole purpose appears to be to move cash from unwitting investors to the management of the company.?

Would be interested in your perspective.

Wanted to respond to you earlier, but time did not permit.? But thinking about it, I realized that for penny stocks, the most relevant statement to analyze is the Consolidated Statement of Changes in Stockholders’ Equity/Deficit.? You can see what prices they issued stock at.? Proceeds divided by shares gives you the internal valuation of where the company is willing to offer shares.? Few ask, but all should ask, “If the company is willing to issue stock at 30 cents per share for salaries, services, etc., why does the stock trade for $1 per share?”

Sometimes a merger, or a purchase of a business can inject money into a company; sometimes debts are settled for shares. That can temporarily grow the company, and combined with a reverse split, it can give it a share price and a market capitalization that seems respectable.

Number two is the hidden bidding up of the shares through sham transactions where related parties buy & sell at progressively higher prices (netting to no loss, aside from commissions) until some speculators see the microcap stock and start driving it higher, possibly supported by promotional paid research.

But here’s the hard part for me: Sometimes the companies are involved, sometimes not.? Sometimes I can tell how the promoters make money, sometimes I can’t.

This is what I suspect: Promoters have several shell corporations for promotion and trading.? Let’s say one has 4 shells.? When A promotes a stock, B, C, and D trade.? When B promotes a stock, A, C, and D trade.? When C promotes a stock, B, A, and D trade.? When D promotes a stock, B, C, and A trade.?? Then each promoter can say they have no economic interest in the stock mentioned that they are “advertising.”

This is an ugly space.? Supposedly you can get a borrow on these bits of financial trash (in order to short them) through Interactive Brokers.

Sorted Weekly Tweets

Posted on 8 February 2013 by David Merkel

Currency Wars

Battling the unknowns of currency devaluation | Reuters http://t.co/3kiN75eT A tough game to play, particularly w/changed policy in Japan $$ Feb 09, 2013
This is what a currency war looks like http://t.co/ibWgIZTg Japan is leading the #currencywar by no longer sterilizing monetary policy $$ Feb 08, 2013
The Dark Side of Japan’s Creating Inflation http://t.co/3O384dKU Risk is interest rates rise and Japan can’t finance itself. #tippingpoint Feb 07, 2013
Japan Inc.?s appreciation of the yen?s depreciation http://t.co/zdYFkcYR Japanese stocks rally as their exports get relatively cheaper $$ Feb 07, 2013
Falling yen set to spark renewed currency wars http://t.co/1QXtUFoA Japan has finally “thrown the hammer down.” No more sterilization $$ Feb 05, 2013

LBOs

Dell?s largest outside shareholder thinks it?s worth $10 more a share – Quartz http://t.co/1gr8dTZb Let Southeastern et al bid 4 control $$ Feb 09, 2013
The Three Scariest Letters for Bondholders: L-B-O | Fox Business http://t.co/wEEHVJUR Note: junk bonds r protected from this, not invt grade Feb 09, 2013
New Worry for Bondholders: LBOs http://t.co/KumxFjws Company is cheap & has good Bal Sheet, it could LBO, harming current bondholders $$ Feb 04, 2013

Pensions

Danger Seen in Pension Fund Cuts on Abe Inflation http://t.co/wDu6fWjE Guess what? Inflation can harm pensioners. Sad 4 them. $$ Feb 07, 2013
Pension Funds Cut Back On Commodity Indexes http://t.co/ZSvFgIoG Hoarding not a panacea, also, can get clipped on the roll $$ Feb 07, 2013
The Asset Mix (Stocks-Bonds) will make the Difference – 2 many Bonds Mr Abe? http://t.co/AOHm6p5X On pension asset allocation globally $$ Feb 07, 2013
Baby Boomers Sicker Than Parents? Generation, Study Finds http://t.co/Xy7VIs0n Will live longer too; big reason to reshape Medicare $$ Feb 05, 2013
Americans Rip Up Retirement Plans http://t.co/s5UARuld Nearly 2/3rds of Those Between 45 & 60 Plan Delays, Steep Rise From 2 Yrs Ago $$ Feb 05, 2013
Low Rates Force Companies to Pour Cash Into Pensions http://t.co/32JNXekQ Low long rates push pension liabilities higher, req $$ payment Feb 04, 2013

High Yield

US High Yield Bonds: HYG On the support http://t.co/Gcj35TAJ In order 4 HY 2 rally from here, need dumb buyers 2 apply leverage $$ Feb 08, 2013
Fed?s Stein: Signs of Overheating in Credit Markets http://t.co/TAT7QcwB Junk yields less than in June 2007. Replace CDO bid w/Fed $$ Feb 07, 2013
Two Things about High-Yield Bonds Investors Must Understand Today http://t.co/w3n4IODi Low yields & spread relatives & high $$ prices Feb 07, 2013
A Mad Rush Could Be Coming In The Corporate Credit Markets http://t.co/KFGkM3gQ Possible, but it depends on how levered investors are $$ Feb 05, 2013
No, there probably isn?t a bond bubble http://t.co/92p5SJBz Misses key question: how much debt is being issued to acquire other debts? $$ Feb 05, 2013
US Higher Yield Bonds: A Corrective Update http://t.co/RITd5UGl Corrections may be happening w/ both credit & high-quality long-duration $$ Feb 04, 2013

S&P Lawsuit

State Lawsuits Could Add to S&P Exposure http://t.co/oQSwfYFR Attorneys General for states become profit centers; opportunistic thieves Feb 07, 2013
Wrong: Levitt Says McGraw-Hill ?Foolish? to Not Settle S&P Lawsuit http://t.co/dEL4g1ja There’s a good chance that S&P will win, y give up Feb 07, 2013
S&P Lawsuit Undermined by SEC Rules That Impede Competition http://t.co/GCUE01zz Will not be simple for the govt to win its case $$ #FTL Feb 07, 2013
S&P Lawsuit Portrays CDO Sellers as Duped Victims http://t.co/rAI69G1G Stretching truth; CDO sellers knew credit better than agencies $$ Feb 07, 2013
S&P feels Justice’s lash, but can law ever conquer greed? http://t.co/SVDZVZtG Diffcult 2 single out people/firms 2 prosecute in big crisis Feb 05, 2013

Companies

Top NY court throws Travelers asbestos award into question http://t.co/GAujEmCH Case started in 1948, when USF&G insured Western Asbestos Feb 08, 2013
Buffett?s Son Says He?s Prepared Whole Life for Berkshire Role http://t.co/xYWVlMu8 As Chairman, Howard will be “cultural guardian.” $$ Feb 08, 2013
San Francisco Gasoline Rises as Tesoro Seen Cutting Rates http://t.co/4Rmvbcz1 It’s tough when state governments discourage refineries $$ Feb 07, 2013
Bond insurers aren’t the only winners in Rakoff’s Flagstar ruling http://t.co/6A2IICLD All can rely on reps & warranties of mtge origin8rs Feb 07, 2013
Berkshire-Insured Muni Sees Good Demand http://t.co/yKX1lGPy Nothing amazing; some $BRK.B businesses r part of the development borrowing Feb 07, 2013
Life Insurer CFOs Say Their Financial Models Fall Short: Survey http://t.co/zJ3f2DJc Surprising, another reason 2b bearish on life ins Feb 07, 2013
BlackRock Cautious as Sales End Dollar Bond Rally: China Credit http://t.co/4LZDSoMf Questions over credit quality, maybe 2 much supply $$ Feb 04, 2013
Herbalife Drops After Report of Law-Enforcement Probe http://t.co/zC0a9GGv $HLF rises today. $$ Worries over being named “pyramid scheme” Feb 04, 2013
Was the AIG Rescue Legal? http://t.co/LUTVHQa9 Of course not. Gov’t should not play favorites; emergencies b a DIP lender of last resort Feb 02, 2013

US Politics & Policy

House Speaker: Washington Has to Address Spending http://t.co/lZcQcinD Yes it does, but will the Senate and President ratify that? $$ Feb 07, 2013
Party Eyes ‘Red-State Model’ to Drive Republican Revival http://t.co/qrlp6Zn5 First balance budget on an accrual basis; no state does $$ Feb 05, 2013
House Leaders Weigh US Spending Bill Below $1T http://t.co/0nBcoURd Good luck w/Senate & President on that, you will need it $$ Feb 05, 2013
Study Says States Lose Billions in Offshore Tax Avoidance http://t.co/qTnlUpTX Just an effect of federal tax policy, which needs change $$ Feb 05, 2013
The Fed?s Worst Fear http://t.co/nanNt52c Losing control of long interest rates; the bond market will eventually trump the Fed $$ Feb 04, 2013

Market Impact

Americans Are Tapping Into Home Equity Again http://t.co/gLLrlDEx Does this mean a return to the reckless equity withdrawals? Likely not $$ Feb 08, 2013
Banks Should Defer Bonuses for Up to 10 Years, Jenkins Says http://t.co/udabGhNT Better that banks become partnerships; creates caution Feb 08, 2013
Insiders now aggressively bearish http://t.co/vWogX2LF Last Fri: sell-to-buy ratio for NYSE-listed shares listed stood at 9.20-to-1 $$ Feb 08, 2013
SP500 Complacent Divergence – Risk Factors http://t.co/CPqaNYY4 Decelerating earnings growth threatens valuations. Econ surprises falling 2 Feb 08, 2013
Interdealer Brokers Emerge as Key Enablers in Libor Scandal http://t.co/bTgMtUOa & http://t.co/yBo7oxKJ Them & Rain Man Tom Hayes $$ Feb 08, 2013
Schwab Unveils Game-Changing Commission-Free ETF Platform http://t.co/yqCaunnJ Part of the ETF’s fees go to $SCHW . No free lunch here $$ Feb 07, 2013
H-P Aside, Corporate Splits Are Wholly Worth Investors? While http://t.co/e9dptR0E Managements gain new focus; Behemoths lack true mgmt $$ Feb 07, 2013
U.S. to Offer Floating-Rate Notes Within a Year http://t.co/eXCUd3Ni Money-market funds take heart; yield (w/spread duration risk!) $$ Feb 07, 2013
Small lenders ride US mortgage wave as big banks cut back http://t.co/KbACkvJk Interesting 2c little independent mortgage brokers return $$ Feb 04, 2013
America’s Baby Bust http://t.co/CaWPjZVU Heard on Radio C-SPAN yd http://t.co/Ow86Jsfs ?Economies don’t work well when popul shrinks $$ Feb 02, 2013

Rest of the World

Mind the Liquidity Gap – Credit Gap http://t.co/m2xTMEIs 3 factors: global monetary policy, global credit supply & global credit demand $$ Feb 08, 2013
German Hope French Despair and EU Rescue: PMIs http://t.co/qioLvblN Eurozone PMIs r rising, but economies r still contracting $$ #France Feb 07, 2013
Basel Seen Rotten in Denmark as Banks Bypassed http://t.co/HX9a6vOI Denmark has many covered mtge bonds; Basel doesn’t care much 4them $$ Feb 07, 2013
Shades of ’80s for Japan’s Stocks http://t.co/68rhfLmX What, Japanese stocks can go up after the demographic dividend has faded? Feb 07, 2013
Desperate Greeks scuffle at free food handout http://t.co/XpQUEBMM Total desperation. Democracy started there, and it may end there too $$ Feb 07, 2013
Canadians back2borrowing: avg consumer debt hits new hi http://t.co/wtSpy1pB overall debt low | cred: evergreen http://t.co/ndpBH0Ch Feb 07, 2013
Last tweet derives from this article http://t.co/wjSwNztf I believe in freedom, and small biz capitalism, with equality 4 all. $$ Feb 06, 2013
We need Obama/Hollande 2create economic barriers average people can’t surmount, so the clever rich can get richer. Cynical, but true $$ Feb 06, 2013
ECB Executive Board Member Asmussen: ‘German Interest Rates Will Rise Again’ http://t.co/oIJZtFtK Thinks *real* interest rates will rise $$ Feb 05, 2013
Top Iranians Trade Barbs in Rare Public Feud http://t.co/W1uR6M1p Corruption is endemic to Iran; rare 4 the mafiosi 2 fink on each other Feb 05, 2013

Other

An Insider’s Guide to Counterfeiting Wine – Businessweek http://t.co/SoVp0OrF 3 ways to counterfeit expensive wines & how to avoid them $$ Feb 09, 2013
Most Australian Wine Exports Ship in Giant Plastic Bladders http://t.co/jL1S9KLF ?We don?t ship glass around the world, we ship wine.? $$ Feb 09, 2013
Super Bowl Blackout Caused by Faulty Relay, Entergy Says http://t.co/GKd5619I That was what I guessed; weak spot in many power grids $$ Feb 08, 2013
Asteroid to Traverse Earth?s Satellite Zone, NASA Says http://t.co/ZnpmCxXD Interesting we only get one week’s notice on the near miss $$ Feb 08, 2013
What Abraham Lincoln Liked About Richard III http://t.co/oAp8PQjg Lincoln was Shakespeare buff; 1 controversial man’s thoughts on another Feb 08, 2013
Lease Surprise in Stuyvesant Town http://t.co/O7DQsILq “clause that allows landlord to increase the rent in the middle of the lease” $$ Feb 07, 2013
Nine Questions for Peter Levine, Andreessen Horowitz?s Enterprise Dude http://t.co/yiubWsqj How SDN commoditizes much special hardware $$ Feb 07, 2013
On Pins and Needles: Stylist Turns Ancient Hairdo Debate on Its Head http://t.co/RgrZqc80 Kinda of a quirky story, but interesting $$ Feb 07, 2013
‘They Owe It to Me’: FBI Identifies Top Email Phrases Used by Fraudsters – Compliance Week http://t.co/9FtlTkEH Set up filters, compliance Feb 06, 2013
Legacy of Benjamin Graham: http://t.co/GztBNt53 via @youtube In last minute, BG anticipates the Efficient Markets Hypothesis years ahead $$ Feb 05, 2013
Legacy of Benjamin Graham: http://t.co/GztBNt53 via @youtube Fascinating video w/Buffett, Kahn (2), Schloss, & other students of his $$ Feb 05, 2013
US Construction Jobs – A very Constructive Story http://t.co/Gqy8YIU0 Construction jobs coming back, looks like a dead cat bounce $$ Feb 04, 2013
Sending electronic money to friends catching on http://t.co/zRBh8tkT Creating next great avenue 4 money laundering; cheap & convenient $$ Feb 04, 2013
Hitler Awakes in 2011 Berlin, Becomes YouTube Hero http://t.co/ore3XtWB Hard 4 me 2 believe. Does humor have any limits anymore? Funny $$ Feb 04, 2013

Replies & Retweets

@dpinsen 16x deteriorating free cash flow @ $24/sh. There’s some bluster there. Wouldn’t want to be a bondholder here $DELL $$ Feb 08, 2013
Commented on StockTwits: Wait, I’m wrong. Didn’t look far enough — they have 8.5% of shares, but 7.5% of votes. Onl… http://t.co/18jIZ94S Feb 08, 2013
Commented on StockTwits: Here: http://t.co/a3SdyNFq http://t.co/4OBGCIp0 Feb 08, 2013
‘ @ampressman Thanks, Aaron. Reading it now. http://t.co/aGpdRr8R Good stuff. SE recently bought more http://t.co/UGh12nkp $$ $DELL Feb 08, 2013 ?(This tweet was wrong, SE has been a seller of $DELL shares, and even recently?)
Owns 7.5%, what could they b thinking? $$ RT @BloombergNews: BREAKING: Dell holder Southeastern Asset plans ‘All Options’ to stop deal Feb 08, 2013
Worth the read RT @cate_long: Is the U.S. growing, or just issuing debt? – #MuniLand http://t.co/KLB1838k Feb 08, 2013
Seems reasonable to me $$ RT @TFMkts: @AlephBlog the high yield market is on cusp of some stop losses getting triggered Feb 08, 2013
@GaelicTorus Did not know that, thanks Feb 08, 2013
Small caps +7% http://t.co/ewRvffTb $$ RT @credittrader: Gentle Reminder Japan Nikkei 225 +0.75% YTD in USD http://t.co/cxxhjMoG Feb 07, 2013
@anatadmati Twitter is too small for this. Read: http://t.co/JDnLfhJ5 & http://t.co/yo7C05d0 Biggest problem isn’t capital, but liquidity $$ Feb 07, 2013
@Nonrelatedsense @credittrader Thanks, missed that Feb 07, 2013
@BlandDexter In a word, yes. Feb 07, 2013
@The_Analyst What floors me are professional investors that don’t read the prospectus the first time they analyze a new type of investment. Feb 07, 2013
@SapienQuis A lot of investment banks got pinned w/crud they could not sell whether due to secondary trading or origination Feb 07, 2013
@The_Analyst Yes, they did have staff. If u r a professional firm, you must independent vet out credit quality; ignore rating read writeup Feb 07, 2013
Well done! RT @jasonzweigwsj: 2 things about high-yield bonds investors should understand today, from @DavidSchawel http://t.co/EYo8KSEQ $$ Feb 07, 2013
@anatadmati A better idea would be double liability, where mgmt & directors lose their capital before shareholders do. Change incentives Feb 07, 2013
@anatadmati At current margins, banks could not earn their cost of capital w/30% E/A. Banks & credit would shrink a lot -> crisis Feb 07, 2013
@DavidSchawel Where will it be? Feb 06, 2013
Bondholders will get badly hurt $$ http://t.co/i7Fxa10p RT @DougKass: HPQ mulling a break up. $HPQ Feb 05, 2013
It’s starting $$ RT @LisaCNBC: The Japanese are going to overdo it and create an inflation problem. #Yen will spike in 2013. @PeterSchiff Feb 05, 2013
@TFMkts People made absurd predictions about capital mkts off of the experience 1982-2000, culmination ing tech bubble / lost decade $$ Feb 05, 2013
Mersenne Primes RT @motokorich: Largest Prime Number Discovered, and it’s 17,425,170 digits long. http://t.co/U8GzYFj1 via @sciam Feb 05, 2013
@TFMkts Would be interesting 2c a firm try that. The wind seems to still b blowing the wrong way there, w/discount rates so low. Feb 05, 2013
He was/is a bright guy $$ RT @munilass: Picking on S&P just isn’t as much fun without @EconOfContempt around. Feb 05, 2013
RT @LaurenLaCapra: “big exchanges therefore stand to gain tremendously from even a relatively small shift twd futures & away from sw … Feb 05, 2013
“I only want to add one thing: its not what pundits say that matters, it is what people rely on economically… http://t.co/zAPlxIHU $$ Feb 04, 2013
RT @moorehn: Pffft. MT @nycjim: Washington Post says it, too, was victim of hacking attack that appeared to originate in China. http://t … Feb 03, 2013
Good marketing kills bad ideas, people & products $$ RT @MattVATech: Marketing is never a substitute for substance. Feb 03, 2013
“Only if you think that by waiting a little while you might have higher yields to invest at. Can’t?” ? David_Merkel http://t.co/Vt16DKeU $$ Feb 02, 2013
“Hi, KD… my bond mandate is unconstrained, so I just aim for total returns. Right now I am pretty?” $$ David_Merkel http://t.co/4x41D4D2 Feb 02, 2013

FWIW

My week on twitter: 77 retweets received, 4 new listings, 86 new followers, 81 mentions. Via: http://t.co/SPrAWil0 Feb 07, 2013

The Education of a Mortgage Bond Manager, Part V

Posted on 8 February 2013 by David Merkel

Sometimes you have to do odd stuff for your client.? My boss and I were asked to come to a client meeting where there would be games (and a dopey speaker, I will leave that out).? As it was I found myself in a game where the one who moves his feet amid pushing loses.? I came in 4th (amid 60), I eventually lost to the tax guy… a very clever guy who should never be underestimated.? I ended up beating him in a game where we were all blindfolded, and those that were touched were out (we were the last two).

But the best part of the contest? was the square game.? We were blindfolded, and rope was around us, and they told us we had five minutes to form a square.? When the official said, “Go!” a marketing guy shouted out, “I know there has to be an actuary in our group.? What do we do?”

I shouted out, “I’m an actuary!”? “To the right of me, counterclockwise, count off, I am number one!” And so I heard, “two, three, four… fifteen.”

Fifteen? Uh-oh, that does not divide by four, so I shouted, “Okay, listen to me!? Five, Nine, and Thirteen, put your arms at right angles, and pull out.? You are the corners of the square.? Everyone else, put no pressure on the ropes.? Fourteen and Fifteen, make sure that you are not touching.”

After that, I shouted, “Has everyone complied with what I said!”? After agreement, I shouted to the judges, “Okay, we’re done!”

When we took off our blindfolds, behold, a square!? Way ahead of the other teams, who looked like blobs.

All actuaries are bright, but many lack courage.? I have courage, and a desire to learn more in areas where I am not an expert.

I needed all of my skills and my courage working for that difficult client. Here’s an example: I did not invest in a hedge fund structured note, with a guarantee from the AA insurer who was pushing it.? I said to them, “most hedge funds are short liquidity.? Why should I invest there?”? He disputed that hedge funds were short liquidity, but he dropped the case and we did not buy.

Here’s another example: A guy called me, asking me to let him pay at par a premium mortgage that we needed to fulfill our liabilities.? I said to him, “I can’t do that, we need the payment over time so that our shareholders are not badly affected.”? Then I said, “Why not get a second mortgage if you need to take money out?”? He said, “A second mortgage? Those guys wear ‘panky rangs.'”

I had the same experience on the most prominent building in Baltimore — the TransAmerica Building, which was the Legg Mason building when I was dealing with it.? Toward he end of my tenure at Dwight, they called me, asking to buy out the second mortgage, which was now the first mortgage.? They offered a slight premium to par, and I said no.? I told them that we needed 125% of par to make us whole, and we would be done.? They offered 110%, and I told them to go away; I would not counteroffer.

I had a strong position, and so I did not have to move.? Sadly, when I left, the company made a bad deal with the borrower, and lost a lot of money.

What can I say? I did my best, and they lost due to their stupidity.? They got more interest due to my intransigence at minimum.

Is High Yield Expensive?

Posted on 8 February 2013 by David Merkel

Event	Date	AAA	AA	A	BBB	BB	B	CCC
CDO Trough	6/5/2007	5.62	5.68	5.90	6.21	6.74	7.34	9.12
Recent Trough	1/25/2013	2.09	2.09	2.47	3.34	4.51	5.64	9.57
Now	2/6/2013	2.10	2.12	2.50	3.42	4.73	6.10	9.80

Yes, I think high yield is expensive, and stocks as well.? We have replaced a set of maniacs who were creating CDOs, with a single maniac, the Federal Reserve.? The Federal Reserve has less effect on junk bonds because they directly affect Treasuries and Agency MBS.? Those are far more similar to AAAs than junk bonds.

When CDOs were bidding for every yieldy bond, they compressed relative yield spreads to unbelievable levels.? Today, those unbelievable yields come from the Fed.? They bid for MBS and Treasuries, leaving others to seek yield in riskier notes.

There is real risk here, and the Fed will get whacked when normal yield relationships, and real yields re-emerge.

On Operating Company Defaults

Posted on 8 February 2013 by David Merkel

From an e-mail from a reader:

Hi, David. I hope this e-mail finds you well. I am a long-time reader of your blog and have learned an immense amount about markets from your writings.

I am a stock analyst and am just starting to learn the nuances in the operating vs. holding co. relationship.

I saw your brief explanation here:

http://alephblog.com/2009/03/25/holding-and-operating-companies/

Could you point me to any websites, books, or articles that really delves into this? Specifically, there are lots of bonds issued on both the opco and holdco levels ( EIX, CZR, and many others).

I know distressed guys do this all day and I’ve already read Stephen Moyer’s Distressed Debt Analysis. ?I understand structural vs. contractual subordination, cross guarantees, and other basics, but, I’d like to know how it would impact the publicly traded shares at the holdco level.

?For example, if holdco A has publicly traded shares and has opcos B and C. B is a profitable company while C is loss-making company. B and C both have publicly traded debt.

What would happen if C defaults? ?Nothing is clear cut but I’m trying to find a good way think about these things.

I have been here already.? If company C defaults, company A has no obligation to make you whole.? In my case with Teleglobe, the bondholders got zero.? The parent, BCE, is still doing well.

This is a major aspect of being a bondholder.? You must analyze the relationships, so that you do not rely on those that do not legally need to pay you.? Implicit support is always suspect.? In a crisis, it goes away.

The Education of a Mortgage Bond Manager, Part IV

Posted on 7 February 2013 by David Merkel

I sat down this evening with my trading notebooks.? It was a reminiscence of 11-14 years in the past.? I may produce another chapter of “education of a corporate bond manager” from the books.? But it gave me a flavor of what I learned (rapidly) as a mortgage bond manager 1998-2001.? So let me share a few more bits of what I learned.

1) Avoid esoteric asset classes.? I am truly amazed at how many people believed that securitization created a lot of value, when it was more incremental.? There were many who proclaimed “Buy every new ABS structure,” because it had worked well in the past.

Sadly, that is a bull market argument, and many would lose a lot of money following that advice.? In 2008, it all came crashing down for unique structures.

2) Avoid volatile asset classes.? Collateralized Debt Obligations are volatile, and not worthy of being investment grade.? That said, when I was younger, I erred with CDOs and we lost money.? Never invest with those whose incentives are different from yours.

3) There was also a period where CDO managers would buy each others BBB tranches — it was a way of lowering capital costs, at least on a GAAP basis.? We did that with NY Life, but never got the benefit, because we never did our CDO.

4) The are many asset sub-classes that have ?only been through a bull market cycle.?? That is the nature of new ideas that are introduced to applause.? But those are bull market babies.? Avoid sub-asset classes that have never seen failure.

5) There was the desire that we could originate our own commercial mortgages, with me doing the work of a full mortgage department.? I conveyed to my boss that this was impossible even if I dedicated 100% of my time to the process, and then he would not have me for the reasons he hired me.? This came up many times, and took a long time to die.

6) But at a later date, something better came up, doing credit tenant leases.? They are illiquid, but they have good protection.? The credit tenant guarantees the mortgage.? If there is non-payment, the property is yours.? I can get into securitized lending.? This was a great deal, but my colleagues in the firm overruled me, and foolishly.? Why give up protection, when you can’t get a safe yield at an equivalent spread.

7) I also learned that in the merger in 2001 that little things mattered.? So when they came to meet us in Baltimore in mid-2001, we took them to an Italian Deli that we liked.? They loved it, saying that there was nothing like it in Burlington.

I will continue this in the next part/episode.

The Education of a Mortgage Bond Manager, Part III

Posted on 6 February 2013 by David Merkel

In this irregular series, you can see that I wrestled with the concept of credit quality.? I built my own models.? I did not trust the rating agencies.

Why did I not trust the rating agencies in 1998-2001?? What great errors had they committed?? They had not created many errors at all… but I knew my job was to uncover value, and take risks where they were warranted.? Ratings will not help you there.

That said, many of the rating agency writeups and presale reports were quite erudite.? As our saying goes,”Ignore the rating, but read the writeup.”? After all, the rating agencies are “inside the wall,” unlike most, and often disclose bits of insider information that are no longer totally insider.? The rating agencies offer valuable information; the problem is that their ratings are less than golden.

In 2000, I remember going to a CMBS Conference where there was a young woman from Principal Financial, who ran their CMBS portfolio.? She said something to the effect of, “Because we know that defaults in CMBS are unlikely, we buy all of the mezzanine and subordinated tranches of most deals.? It’s free money.”? We had a different opinion.? We knew that liquidity had value, so we rarely bought non-AAA bonds.? You could not easily trade bonds that were not AAA.

Once I became the CIO in 2001, I decided that we would look at older deals where? wanted to sell BBB bonds.? I would subject them to my usual standards, and analyze the properties in depth.? I didn’t buy much, but what I did buy was quality.? Though markets were tough, all of them paid off.

An example was when JP Morgan did what they called a “kick-out” deal.? All of the properties that the B-piece cartel had refused to finance were in that deal.? The spreads were very wide, and I bought all of the AA & A-rated tranches.? I did a lot of due diligence, and I knew that the taint of the collateral was more than compensated for from the amount of subordination.

That was one of my lessons — be willing to buy things that are tainted in the eyes of many, so long as you have adequate protections, and a decent yield.

At the Life Insurance Conference

Though I was not a bond manager at the time that I went to a Life Insurance Conference in 2006, there were several themes in play.? Here are two of them.

1) Odd Types of Collateral: there was the sense that new and odd types of asset backed securities [ABS] should be bought with abandon because the past experience has been so great.

I did not buy that idea.? Most ABS requires a steady cash flow stream, and many industries don’t have that.

2) One guy said AAA bonds never default.? I stood up and told him? that AAA bonds that I had bought in franchise loans did default, so it was not true.? That said, losses were not large.

At the conference, I managed to speak to the CEO of Principal Financial, and tell him that he faced considerable credit difficulties in his CMBS book.? He was a big guy, tall and muscular, so he looked at me, average guy that I am, and told me he would consider it.? The look on his face disdained me, but I am used to that.? My appearance has never been my leading attribute.

Manufactured Housing ABS

In 2001, I came up with the idea that the Manufactured Housing ABS market was bifurcated.? Current deals were lousy in their credit metrics, so we stopped buying any current deals.? But older deals from GreenTree were seasoned and would likely deliver value.? Lehman Brothers shared with me their default database, and I built my model, and it told me that deals from 1998 would allow tranches A and above to get their money back.? It also told me that deals from 1997 and prior would allow tranches BBB and above to get their money back.

This proved to be true, but it meant that those that held the securities to maturity had to endure a time when the offered prices for the securities were far less than par, though all paid their principal and interest to maturity.? I don’t feel bad about my purchases, because I looked long-run, and knew I had a strong balance sheet behind me.

Now in late 2001, the new CIO came to me and said, “I’m taking over the CMBS, MBS, and ABS portfolios.”? I told him, “They are yours now, do what you like, do not care for my own preferences, do what you think is right.”? As it was, he panicked, and sold many things that would later be money good, and he blamed me, according to friends.

So what? I have my own share of blame here, because you never want to buy near par something that will test your willingness to hold it. Though what I bought went through the valley of the shadow of death and came out whole, there is a cost to making everyone worry; and many in the same situation would sell and take losses that they should not have.

All of the Big Boys know you should never trust a rating

When I was a mortgage bond manager, I did my own work.? I did not trust ratings, but did my own due diligence. I would analyze loss statistics where I had them, and some up with my own risk assessments.

This is why I don’t favor the prosecution of the rating agencies.? The rating doesn’t matter, and if people are willing to trust a ratings scale, rather than a description of the business of those that are rated, they deserve the bad result.

It is utterly puzzling to me why the government is going after the rating agencies, because they just did their jobs.? Yes, their models were flawed, but many ignored them in the insurance industry and elsewhere.? Ratings are not guarantees, they are opinions, and so the Supreme Court will rule eventually.