David Merkel – Page 22 – The Aleph Blog

Surprise! Return to RT Boom/Bust

Posted on 1 March 2018 by David Merkel

After almost three years, I returned to RT Boom/Bust on Tuesday.? There are many changes at RT.? Many new people, and a growing effort to put together an alternative channel that covers the world rather than just the US or just the developed world.? They are bursting at the seams, and their funding has doubled, so I was told.

I get surprised by who watches RT and sees me.? My? congregation is pretty conservative in every way, but I have some friends working in intelligence come up to me and say, “Hey, saw you on RT Boom/Bust.”? And then there is my friend from Central Africa who says, “The CIA has you on their list.? Watch out!”? He’s funny, hard-working, but very earnest.

I’ve never seen anything in what I have done where there is any hint of editorial control.? Maybe it is there, but I think I would be smart enough to see it.

Anyway, the topic at hand was alternative monetary systems, and the thing that kicked it off was the Vollgelt in Switzerland, where they are trying to create a monetary system where the banks can’t lend against deposits.? Here were my notes for the show, with a little more to fill in:

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Mr. Merkel, what exactly is a sovereign money system?

The banks can?t lend against deposits.? Deposits are segregated, and wait for the depositor to use them.? The deposits no longer can be used by the bank but only the depositor.? There would be no need for deposit insurance, because deposits are off of the bank?s balance sheet.

What is the difference between a sovereign system and the way banks handle your money now?

You would have to pay for your transactional account, because the bank can?t make money off of lending against the deposits. Banks would no longer do ?maturity transformation? by lending long against short-term deposits.? Long-term lending would have to be other entities in the economy, such as insurance companies, pension funds, endowments, private individuals, foreign lenders, mortgage REITs, and banks funded by matching sources like CDs, bonds, and equity.

Switzerland is poised to vote on a sovereign money system, or Vollgeld in German. How likely is this vote to pass?

Not likely for three reasons.? First, the Swiss turned down a proposal to back the Swiss Franc with 20% gold.? Not one canton voted for it.? Only 22% of the electorate voted for it.? Second, things aren?t that bad now, and the financial system isn?t that levered.? ?If it ain?t broke, don?t fix it.?? Third, this is a total experiment with no real world precedents.? Many criticize economists for imagining what the world should be like and then proposing policy off their unrealistic idealized models.? This is another example of that.? We don?t know what the unintended consequences might be.

Some unintended consequences might be:

Transition would be difficult
Recession during the transition, because middle and small market lending would likely suffer
Pay for transactional accounts ? no interest even if inflation is high.
Increase in savings accounts, which might be short-dated enough to be transactional
Gives a lot of power to the SNB, which might be halfhearted about implementation (Regulators dislike change, and risk).
Could be subverted if Government becomes dependent on free money, leading to inflation
Moves monetary policy from rate targeting to permanent quantitative monetary adjustment. Unclear how the SNB would tighten policy; maybe issue central bank bonds to reduce money supply?

Could something like this rein in credit bubbles? Are we facing another credit bubble?

Yes, it could.? Most credit bubbles result from short-term lending funding long-term assets.? This would rein it in, in the short-run, but who could tell whether it might come back in another unintended way?? If some new class of lender became dominant, the threat could reappear.

We aren?t facing a credit bubble now, because the last crisis wiped away a lot of private debt, and replaced it with public debt.? Perhaps some weak nations with debts not in their own currency could be at risk, but right now, there aren?t any categories of private debt big enough and misfinanced enough to create a crisis.? That said, watch margin loans, student loans, and auto loans in the US.

Are there any modern day equivalents we can compare Vollgeld to?

None that are currently being used.? There are a lot of theoretical ideas still being tossed around, like 100% reserving, lowering bank leverage, strict asset-liability matching, disallowing banks from lending to financial companies, etc.? These ideas get a lot of press after crises, but fade away afterward.? Most of them would work, but all of them lower bank profits.? Concentrated interests tend to win against general interests, except in crises.

You mentioned there is a similar concept for derivatives that no one is talking about. How exactly would that work?

Derivatives are functionally equivalent to insurance contracts, but they are not regulated.? I believe they should be regulated like insurance contracts, and require that those seeking insurance have an ?insurable interest? that they are trying to hedge.? Only direct hedgers could initiate derivative transactions, and financial guaranty insurers would compete to fill the need.

This would prevent the unintended consequences of having multiples of protection written on a given risk, where a weak party like AIG is incapable of making good on all of the derivative contracts that they have written, which could lead to its own systemic risk if other derivative counterparties can?t absorb the losses.

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I know that is over-simplified, but I read through the papers of both sides in the debate, and I thought both overstated their cases significantly.

I know fiat money has its problems, and so does fractional reserve banking, but if you are going to propose a solution, perhaps one that fits the basics of how a well-run bank at low leverage would work would be a good place to start.

Monitor Financial Accounts Regularly

Posted on 23 February 20188 August 2018 by David Merkel

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Fewer laws protect you now. In some ways, the laws are more virtual than real, and only apply to real situations, and not virtual ones.

Let me explain.

Though checks make up an increasingly smaller fraction of transaction volume in the US, they are still a lot higher here than in Europe.? As such, federal and many state legislators have not caught up with the effects of a hybrid system, where they attempt to regulate electronic banking transactions under the same rules as paper checks.

Many people like making mobile deposits, rather than going into the bank, or snail-mailing the deposits in.? But what happens if a check gets mobile-deposited to two banks?? Or, since many banks don’t actively check mobile deposits closely, what if someone repeatedly deposits a check to his bank, while altering the check number?

The latter scenario happened to me, and I am out a considerable amount of money because I was not following my accounts closely.

My soon-to-be former bank would not reimburse the losses, citing the account agreement, even though they facilitated the thefts by not checking the drafts against my account.
The same was true of the bank of the fraudster, which accepted the same altered check again and again.
The state of Maryland would not prosecute fraud charges against the person, because the crime was not committed inside a bank branch, and they could not conclusively prove that the perpetrator did the crime, even though all of the money went to his account.? And,that is even though the perpetrator admitted it to me, and I have it in writing.
Thus, I have an informal agreement with the perp to pay me back or face a tort claim.? His situation is not strong, and you can’t squeeze blood from a stone.? I could force him into bankruptcy, but what good would that for me?? I’m not vengeful.

So what is the best defense?? Check your transactional accounts weekly if not daily.? On that level, the banks will take the losses, if you identify them fast enough.

I began doing that recently, and found someone using one of my credit cards to pay his phone bill.? I have since reversed most of those charges.? GIven that many vendors try to induce you into payment plans that auto-renew, it is wise for that reason to do so, that you would cancel services that you no longer use.

So what can I say?? I could have not written this up, but I am not perfect in my personal money management… better that others learn from my mistakes.? Until the state and Federal governments get their acts together, you are your own best defender.? Check your transactional accounts frequently.? The money you save will be your own.

The Rules, Part LXIV

Posted on 6 February 2018 by David Merkel

Photo Credit: Steve Rotman || Markets are not magic; government economic stimulus is useless with debt so high

Weird begets weird

I said in an earlier piece on this topic:

I use [the phrase] during periods in the markets where normal relationships seem to hold no longer. It is usually a sign that something greater is happening that is ill-understood. ?In the financial crisis, what was not understood was that multiple areas of the financial economy were simultaneously overleveraged.

So what’s weird now?

Most major government running deficits, and racking up huge debts, adding to overall liability promises from entitlements.
Most central banks creating credit in a closed loop that benefits the governments, but few others directly.
Banks mostly in decent shape, but nonfinancial corporations borrowing too much.
Students and middle-to-lower classes borrowing too much (autos, credit cards)
Interest rates and goods and services price inflation stay low in the face of this.
Low volatility (until now)
Much speculative activity in cryptocurrencies (large percentage on a low base) and risk assets like stocks?(smaller percentage on a big base)
Low credit spreads

No one should be surprised by the current market action.? It wasn’t an “if,” but a “when.”? I’m not saying that this is going to spiral out of control, but everyone should understand that?The Little Market that Could?was a weird situation.? Markets are not supposed to go up so steadily, which means something weird was fueling the move.

Lack of volatility gives way to a surfeit of volatility eventually.? It’s like macroeconomic volatility “calmed” by loose monetary and fiscal policy.? It allows people to take too many bad chances, bid up assets, build up leverage, and then “BAM!” — possibility of debt deflation because there is not enough cash flow to service the incurred debts.

Now, we’re not back in 2007-9.? This is different, and likely to be more mild.? The banks are in decent shape.? The dominoes are NOT set up for a major disaster.? Risky asset prices are too high, yes.? There is significant speculation in areas?Where Money Goes to Die.? So long as the banking/debt complex is not threatened, the worst you get is something like the deflation of the dot-com bubble, and at present, I don’t see what it threatened by that aside from cryptocurrencies and the short volatility trade.? Growth stocks may get whacked — they certainly deserve it from a valuation standpoint, but that would merely be a normal bear market, not a cousin of the Great Depression, like 2007-9.

Could this be “the pause that refreshes?”? Yes, after enough pain is delivered to the weak hands that have been chasing the market in search of easy profits quickly.? The lure of free money brings out the worst in many.

You have to wonder when margin debt is high — short-term investors chasing the market, and Warren Buffett, Seth Klarman, and other valuation-sensitive investors with long horizons sitting on piles of cash.? That’s the grand asset-liability mismatch.? Long-term investors sitting on cash, and short-term investors fully invested if not leveraged… a recipe for trouble.? Have you considered these concepts:

Preservation of capital
Dry powder
Not finding opportunities
Momentum gives way to negative arbitrages.
Greater fool theory — “hey, who has slack capital to buy what I own if I need liquidity?”

Going back to where money goes to die, from the less mentioned portion on the short volatility trade:

Again, this is one where people are very used to selling every spike in volatility. ?It has been a winning strategy so far. ?Remember that when enough people do that, the system changes, and it means in a real crisis, volatility will go higher than ever before, and stay higher longer. ?The markets abhor free riders, and disasters tend to occur in such a way that the most dumb money gets gored.

Again, when the big volatility spike hits, remember, I warned you. ?Also, for those playing long on volatility and buying protection on credit default ? this has been a long credit cycle, and may go longer. ?Do you have enough wherewithal to survive a longer bull phase?

To all, I wish you well in investing. ?Just remember that new asset classes that have never been through a ?failure cycle? tend to produce the greatest amounts of panic when they finally fail. ?And, all asset classes eventually go through failure.

So as volatility has spiked, perhaps the free money has proven to be the bait of a mousetrap.? Do you have the flexibility to buy in at better levels?? Should you even touch it if it is like a knockout option?

There are no free lunches.? Get used to that idea.? If a trade looks riskless, beware, the risk may only be building up, and not be nonexistent.

Thus when markets are “weird” and too bullish or bearish, look for the reasons that may be unduly sustaining the situation.? Where is debt building up?? Are there unusual derivative positions building up?? What sort of parties are chasing prices?? Who is resisting the trend?

And, when markets are falling hard, remember that they go down double-speed.? If it’s a lot faster than that, the market is more likely to bounce.? (That might be the case now.)? Slower, and it might keep going.? Fast moves tend to mean-revert, slow moves tend to persist.? Real bear markets have duration and humiliate, making weak holders conclude that will never touch stocks again.

And once they have sold, the panic will end, and growth will begin again when everyone is scared.

That’s the perversity of markets.? They are far more volatile than the economy as a whole, and in the end don’t deliver any more than the economy as a whole, but sucker people into thinking the markets are magical money machines, until what is weird (too good) becomes weird (too bad).

Don’t let this situation be “too bad” for you.? If you are looking at the current situation, and think that you have too much in risk assets for the long-term, sell some down.? Preserving capital is not imprudent, even if the market bounces.

In that vein, my final point is this: size your position in risk assets to the level where you can live with it under bad conditions, and be happy with it under good conditions.? Then when markets get weird, you can smile and bear it.? The most important thing is to stay in the game, not giving in to panic or greed when things get “weird.”

NASDAQ Composite Hits an Inflation-Adjusted High

Posted on 20 January 2018 by David Merkel

Hey, it only took 18 years to eclipse the prior high in purchasing power terms! Better than the Great Depression!

This is an update of a post I did less than three years ago.? In that relatively short time, the NASDAQ Composite hit an all-time record in purchasing power adjusted terms.? Quite an ascent in the last two years.? I never would have predicted it.? If you took the other side of my advice you did better.

That said, the S&P 500 is forecast to return 3.4%/year prior to inflation for the next ten years.? Aside from one quarter during the go-go years (1968), the only period with lower anticipated returns was during the dot-com bubble.? The levels you see today will be revisited going the other way.

Are you too “chicken” to buy the NASDAQ Composite? Then you are like me.

The last time I wrote on this, I asked whether it would be better the NASDAQ Composite [IXIC] or Industrias Bachoco [IBA].? IBA is the second largest producer of chicken in North America, and is now expanding in the US.? From the time I wrote the last article it has returned 20%.? NASDAQ Composite? 47%.

That said, I still prefer IBA for the future.? Strong competitive position, little debt.? Intelligent tuck-in style of M&A, showing intelligent capital allocation.? 1.7x book.? 12-13x earnings.? If it weren’t a Mexican firm, it would be valued a lot higher.? IXIC’s valuation metrics are roughly double those.

All that said, IBA beat IXIC over the 12.5 years I have owned it.? 487% vs 401%.? And if you were measuring from the top of the dot-com bubble the return difference is 1460% vs 71%.

IBA still has a lot of room to expand, and is subject to less competition and antitrust threats than many large technology companies.

Not that you should run out and buy IBA (caution: thin market), but what do you do if you are looking for ideas that could be good, but not as much in the spotlight as the companies that make up the bulk of the NASDAQ Composite?? I’ll quote the end of my last article, because the ideas are good, and will likely do better than buying hot ideas now.

…where are the good assets that few are looking at?

Tough question. ?I?ll give you a few ideas, but then you have to work on it yourself.

1)?Look at higher quality names in out-of-favor industries. ?The advantage of this approach is that your downside is likely to be limited, while the upside could be significant. ?I?ve seen it work many times. ?Note: avoid ?buggy whip? industries where the decline is final; the internet is eating a lot of industries.

2) Look at companies outside the US that act in the best interests of outside, passive, minority investors like you and me. ?There is less competition there from analysts and clever US-focused investors. ?Note: spend extra time analyzing how they have used free cash flow in the past. ?Is management rational at allocating capital, or even clever?

3) Look at firms that can?t be taken over, where a control investor seems savvy, and acts in?the best interests of outside, passive, minority investors. ?Many won?t invest in those firms because they are less liquid, and a takeover is very unlikely.

4) Look at smaller firms pursuing a growing niche in an otherwise dull industry. ?Or smaller firms that have good finances, but have some taint that keeps investors from re-examining it.

5) Look through 13F filings for new names that look promising, before too many people learn about the company. ?Or, IPOs and spin-offs in industries that are dull.

6) Analyze stocks that are in the lowest quartile of performance over the last 3-5 years.

7) Or, go to Value Line, and look at the stocks with the highest appreciation potential, with an adequate safety rank.

I use a variety of these ideas.? If I see somethings interesting, I will dig deep and sometimes I get a real gem.? Sometimes not.? But with an adequate margin of safety, I don’t get killed.

Full Disclosure: long IBA

On the Migration of Stock

Posted on 17 January 2018 by David Merkel

This should be a brief article.? I remember back in 1999 to early 2000 how P&C insurance stocks, and other boring slower-growth industries were falling in price despite growing net worth, and reasonable earnings.? I was working for The St. Paul at the time (a Property & Casualty Insurer), and for an investment actuary like me, who grew up in the life insurance business it was interesting to see the different philosophy of the industry.? Shorter-duration products make competition more obvious, making downturns uglier.

The market in 1999-2000 got narrow.? Few groups and few stocks were leading the rise.? Performance-conscious investors, amateur and professional, servants of the “Church of What’s Working Now,” sold their holdings in the slower growing companies to buy the shares of faster growing companies, with little attention to valuation differences.

I remember flipping the chart of the S&P 1500 Supercomposite for P&C Insurers, and laying it on top of an index of the dot-com stocks.? They looked like twins separated at birth, except one was upside down.

When shares are sold, they don’t just disappear.? Someone buys them.? In this case, P&C firms bought back their own stock, as did industry insiders, and value investors — what few remained.? When managed well, P&C insurance is a nice, predictable business that throws of reliable profits, and is just complex enough to scare away a decent number of potential investors.? The scare is partially due to the effect that it is not always well-managed, and not everyone can figure out who the good managers are.

So shares migrate.? Those that fall in the midst of a rally, despite decent economics, get bought by long-term investors.? The hot stocks get bought by shorter-term investors, who follow the momentum.? This continues until the gravitational effects of relative valuations gets too great — the cash flows of the hot stocks do not justify the valuations.

Then performance reverts, and what was bad becomes good, and good bad, but as with almost every investment strategy you have to survive until the turn, and if the assets run from the prior migration, it is cold comfort to be right eventually.

As an aside, this is part of what fuels dollar-weighted returns being lower than time-weighted returns.? The hot money migration buys high, and sells low.

Thus I say to value investors, “Persevere.? I can’t tell you when the turn will be, but it is getting closer.”

On a Letter from an Old Friend

Posted on 16 January 2018 by David Merkel

Photo Credit: jessica wilson {jek in the box}

David:

It’s been a while since we last corresponded.??I hope you and your family are well.

Quick investment question. Given the sharp run-up in equities and stretched valuations, how are you positioning your portfolio?

This in a market that seemingly doesn’t?go down, where the risk of being cautious is missing out on big gains.

In my portfolio, I’m carrying extra cash and moving fairly aggressively into gold.?Also, on the fixed income side, I’ve been selling HY [DM: High Yield, aka “Junk”] bonds, shortening duration, and buying floating rate bank loans.

Please let me know your thoughts.

Regards

JJJ

Dear JJJ,

Good to hear from you.? It has been a long time.

Asset allocation is always a marriage between time horizon (when is the money needed for spending?) and expected returns, with some adjustment for risk.? I suspect that you are like me, and play for a longer horizon.

I’m at my lowest equity allocation in 17 years.? I am at 65% in equities.? If the market goes up another 4-5%, I am planning on peeling of 25% of that to go into high quality bonds.? Another 20% will go if the market rises 10% from here.? At present, the S&P 500 offers returns of just 3.4%/year for the next ten years unadjusted for inflation.? That’s at the 95th percentile, and reflects valuations of the dot-com bubble, should we rise that far.

The stocks that I do have are heading in three directions: safer, cyclical and foreign.? I’m at my highest level for foreign stocks, and the companies all have strong balance sheets.? A few are cyclicals, and may benefit if commodities rise.

The only thing that gives me pause regarding dropping my stock percentage is that a lot of “friends” are doing it.? That said, a lot of broad market and growth investors are making “new era” arguments.? That gives me more comfort about this.? Even if the FAANG stocks continue to do well, it does not mean that stocks as a whole will do well.? The overall productivity of risk assets is not rising.? People are looking through the rearview mirror, not the windshield, at asset returns.

I can endorse some gold, even though it does nothing.? Nothing would have been a good posture back in the dot-com bubble, or the financial crisis.? Commodities are undervalued at present.? I can also endorse long Treasuries, because I am not certain that inflation will run in this environment.? When economies are heavily indebted they tend not to inflate, except as a last resort.? (The wealthy want to protect their claims against the economy.? The Fed generally helps the wealthy.? Those on the FOMC are all wealthy.)

I also hold more cash than normal.? The three of them, gold, cash and long Treasury bonds form a good hedge together against most bad situations.

The banks are in good shape, so the coming troubles should not be as great as during the financial crisis, as long as nothing bizarre is going on in the repo markets.

That said, I would be careful about bank debt.? Be careful about the covenants on the bank debt; it is not as safe as it once was.? I don’t own any now.

Aside from that, I think you are on the right track.? The most important question is how much you have invested in risk assets.? Prudent investors should be heading lower as the market rises.? It is either not a new era, or, it is always a new era.? Build up your supply of safe assets.? That is the main idea.? Preserve capital for another day when risk assets offer better opportunities.

Thanks for writing.? If you ever make it to Charm City or Babylon, let me know, and we can have lunch together.

Sincerely,

David

Since 1950, the S&P 500 in 2017 Ranks First, Fourth, Tenth or Twenty-third?

Posted on 3 January 2018 by David Merkel

Credit: Roadsidepictures from The Little Engine That Could By Watty Piper Illustrated By George & Doris Hauman c. 1954

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I wish I could have found a picture of Woodstock with a sign that said “We’re #1!”? Snoopy trails behind carrying a football, grinning and thinking “In this corner of the backyard.”

That’s how I feel regarding all of the attention that has been paid to the S&P being up every month in 2017, and every month for the last 14 months.? These have never happened before.

There’s a first time for everything, but I feel that these records are more akin to the people who do work for the sports channels scaring up odd statistical facts about players, teams, games, etc.? “Hey Bob, did you know that the Smoggers haven’t converted a 4th and 2 situation against the Robbers since 1998?”

Let me explain.? A month is around 21 trading days.? There is some variation around that, but on average, years tend to have 252 trading days.? 252 divided by 12 is 21.? You would think in a year like 2017 that it must? have spent the most time where 21-day periods had positive returns, as it did over each month.

Since 1950, 2017 would have come in fourth on that measure, behind 1954, 1958 and 1995.? Thus in one sense it was an accident that 2017 had positive returns each month versus years that had more positive returns over every 21 day period.

How about streaks of days where the 21-day trialing total return never dropped below zero (since 1950)?? By that measure, 2017 would have tied for tenth place with 2003, and beaten by the years 1958-9, 1995, 1961, 1971, 1964, 1980, 1972, 1965, and 1963.? (Note: quite a reminder of how bullish the late 1950s, 1960s and early 1970s were.? Go-go indeed.)

Let’s look at one more — total return over the whole year.? Now 2017 ranks 23rd out of 68 years with a total return of 21.8%.? That’s really good, don’t get me wrong, but it won’t deserve a mention in a book like “It Was a Very Good Year.”? That’s more than double the normal return, which means you’ll have give returns back in the future. 😉

So, how do I characterize 2017?? I call it?The Little Market that Could.? Why?? Few drawdowns, low implied volatility, and skepticism that gave way to uncritical belief.? Just as we have lost touch with the idea that government deficits and debts matter, so we have lost touch with the idea that valuation matters.

When I talk to professionals (and some amateurs) about the valuation model that I use for the market, increasingly I get pushback, suggesting that we are in a new era, and that my model might have been good for an era prior to our present technological innovations.? I simply respond by saying “The buying power has to come from somewhere.? Our stock market does not do well when risk assets are valued at 40%+ of the share of assets, and there have been significant technological shifts over my analysis period beginning in 1945, many rivaling the internet.”? (Every era idolizes its changes.? It is always a “new era.”? It is never a “new era.”)

If you are asking me about the short-term, I think the direction is up, but I am edgy about that.? Forecast ten year returns are below 3.75%/year not adjusted for inflation.? Just a guess on my part, but I think all of the people who are making money off of low volatility are feeding the calm in the short-run, while building up a whiplash in the intermediate term.

Time will tell.? It usually does, given enough time.? In the intermediate-term, it is tough to tell signal from noise.? I am at my maximum cash for my equity strategy accounts — I think that is a prudent place to be amid the high valuations that we face today.? Remember, once the surprise comes, and companies scramble to find financing, it is too late to make adjustments for market risk.

On Finding a Job in Finance

Posted on 19 December 2017 by David Merkel

I was approached by a younger friend for advice.? This is my response to his questions below:

Thank you for agreeing to do this for me. I would love to have an actual conversation with you but unfortunately, I think that between all of the classes, exams, and group project meetings I have this week it would prove to be too much of a hassle for both of us to try to set up a time.

1. What professional and soft skills do you need to be successful in this career and why?
2. What advice would you give to someone considering working in this field?
3. What are some values/ethics that have been important to you throughout your career?
4. I understand that you currently run a solo operation, but are there any leadership skills you have needed previously in your career? Any examples?
5. What made you decide to make the switch to running your own business?

Thanks again,

ZZZ

What professional and soft skills do you need to be successful in this career and why?

I’ve written at least two articles on this:

How Do I Find a Job in Finance?

How Do I Find a Job in Finance? (Part 2)

Let me answer the question more directly.? You need to understand the basics of how businesses operate.? How do they make money?? How do they control risk?

Now, the academics will show you their models, and you should know those models.? What is more important is understanding the weaknesses of those models because they may weakly explain how stocks in aggregate are priced, but they are little good at understanding how corporations operate.? The real world is not as ideal as the academic economists posit.

It is useful to read broadly.? It is useful to dig into a variety of financial reports from smaller firms.? Why smaller firms?? They are simpler to understand, and there is more variation in how they do.? ?Learn to read through the main financial statements well.? Understand how the income statement, balance sheet, and cash flow statement interact.? Look at the footnotes and try to understand what they mean.? Pick an industry and compare all of the companies.? I did that with trucking in 1994 and learned a boatload.? This aids in picking up practical accounting knowledge, which is more powerful when you can compare across industries.

As for soft skills, the ability to deal with people on a firm and fair basis is huge.? Keeping your word is big as well.? When I was a bond trader, I ate losses when I made promises on trades that went wrong.? In the present era, I have compensated clients for losses from mistaken trades.

Here’s another “soft” skill worth considering.? Many employers are aghast at the lousy writing skills of young people coming out of college, and rightly so.? Make sure that your ability to communicate in a written form is at a strong level.

Oral communication is also important.? If you have difficulty speaking to groups, you might try something like Toastmasters.

Many of these things come only with practice on the job, so don’t think that you have to have everything together in order to do well — the important thing is to improve over time.? Young people are not expected to be as polished as their older colleagues.

What advice would you give to someone considering working in this field?

It’s a little crowded in finance.? That is partially because it attracts a lot of people who think it will be easy money.? If you are really good, the crowding shouldn’t be much of a hurdle.? But if you don’t think that you are in the top quartile, there are some alternatives to help you grow and develop.

Consider developing your skills at a small bank or insurer.? You will be forced to be a generalist, which sets you up well for future jobs.? It also forces you to confront how difficult the economics of smaller firms are, and how costly/difficult it is to change strategy.? For a clever person, it offers a lot of running room if you work for a firm that is more entrepreneurial
Or, consider working in the finance area of an industrial firm.? Finance is not only about selling financial products — it is about the buyers as well.
Work for a government or quasi-governmental entity in their finance area.? If you can show some competence there, it would be notable.? The inefficiencies might give you good ideas for what could be a good business.

What are some values/ethics that have been important to you throughout your career?

Here are some:

Be honest
Follow laws and regulations
Work hard for your employer
Keep building your skills; at 57, I am still building my skills.
Don’t let work rob you of other facets of life — family, friends, etc.? Many become well-paid slaves of their organization, but never get to benefit personally outside of work.
Avoid being envious; just focus on promoting the good of the entity that you work for.
Try to analyze the culture of a firm before you join it.? Culture is the most important aspect that will affect how happy you are working there.

I understand that you currently run a solo operation, but are there any leadership skills you have needed previously in your career? Any examples?

This is a cute story:?Learning Leadership.? I have also written three series of articles on how I grew in the firms that I worked for:

There’s a lot in these articles.? They are some of my best stories, and they help to illustrate corporate life.? Here’s one more:?My 9/11 Experience.? What do you do under pressure?? What I did on 9/11 was a good example of that.

I know I have a lot more articles on the topic on this, but those are the easiest to find.

What made you decide to make the switch to running your own business?

I did very well in my own investing from 2000-2010, and wanted to try out my investing theories as a business.? That said, from 2011-2017, it worked out less well than I would have liked as value investing underperformed the market as a whole.

That said, I proceed from principle, and continue to follow my investment discipline.? It follows from good business management principles, and so I continue, waiting for the turn in the market cycle, and improving my ability to analyze corporations.

Nonetheless, my business does well, just not as well as I would like.

I hope you do well in your career.? Let me know how you do as you progress, and feel free to ask more questions.

Favorite Aleph Blog Post of 2017?

Posted on 9 December 2017 by David Merkel

As you might recall, I was invited to participate in?The Best Investment Writing, Volume 1. Well, volume 2 is being discussed. This time, I thought I would let my readers offer their opinion on the matter. So, let me know, you can take this poll — oh, and can vote for as many as you like.

Thanks,

David

[socialpoll id=”2476711″]

Classic: Wrecking Ball Looms for Big Housing Spec

Posted on 8 December 2017 by David Merkel

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I thought this old post from RealMoney.com was lost, never to be found again.? This was the important post made on November 22, 2006 that forecast some of the troubles in the subprime residential mortgage backed securities market.? I favored the idea that there there would be a crash in residential housing prices, and the best way to play it would be to pick up the pieces after the crash, because of the difficulties of being able to be right on the timing of shorting could be problematic.? In that trade, too early would mean wrong if you had to lose out the trade because of margin issues.

With that, here is the article:

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I have tried to make the following topic simple, but what I am about to say is complex, because it deals with the derivative markets. It is doubly or triply complex, because this situation has many layers to unravel. I write about this for two reasons. First, since residential housing is a large part of the US economy, understanding what is going on beneath the surface of housing finance can be valuable. Second, anytime financial markets are highly levered, there is a higher probability that there could be a dislocation. When dislocations happen, it is unwise for investors to try to average down or up. Rather, the best strategy is to wait for the trend to overshoot, and take a contrary position.

There are a lot of players trotting out the bear case for residential housing and mortgages. I’m one of them, but I don’t want overstate my case, having commented a few weeks ago on derivatives in the home equity loan asset-backed securities market. This arcane-sounding market is no small potatoes; it actually comprises several billions of dollars’ worth of bets by aggressive hedge funds — the same type of big bettors who blew up so memorably earlier this year, Amaranth and Motherrock.

A shift of just 10% up or down in residential housing prices might touch off just such another cataclysm, so it’s worth understanding just how this “arcane-sounding” market works.

I said I might expand on that post, but the need for comment and explanation of this market just got more pressing: To my surprise, one of my Googlebots dragged in a Reuters article and a blog post on the topic. I’ve seen other writeups on this as well, notably in Grant’s Interest Rate Observer (a fine publication) and The Wall Street Journal.

How a Securitization Works (Basically)

It’s difficult to short residential housing directly, so a market has grown up around the asset-backed securities market, in which bulls and bears can make bets on the performance of home equity loans. How do they do this?

First, mortgage originators originate home equity loans, Alt-A loans and subprime loans. They bring these loans to Wall Street, where the originator sells the loans to an investment bank, which dumps the loans into a trust. The investment bank then sells participation interests (“certificates”) in the trust.

There are different classes of certificates that have varying degrees of credit risk. The riskier classes receive higher interest rates. Typically the originator holds the juniormost class, the equity, and funds an overcollateralization account to give some security to the next most junior class.

Principal payments get allocated to the seniormost class. Once a class gets its full share of principal paid (or cancelled), it receives no more payments. Interest gets allocated in order of seniority. If, after paying interest to all classes, there is excess interest, that excess gets allocated to the overcollateralization account, until the account is full — that is, has reached a value equal to the value of the second most junior class of trust certificates — and then the excess goes to the equity class. If there’s not enough interest to pay all classes, they get paid in order of seniority.

If there are loan losses from nonpayment of the mortgages or home equity loans, the losses get funded by the overcollateralization account. If the overcollateralization account gets exhausted, losses reduce the principal balances of the juniormost certificates — those usually held by the originator — until they get exhausted, and then the next most junior gets the losses. There’s a little more to it than this (the prospectuses are often a half-inch thick on thin paper), but this is basically how a securitization works.

From Hedging to Speculation

The top class of certificates gets rated AAA, and typically the lowest class before the equity gets rated BBB-, though sometimes junk-rated certificates get issued. Most of the speculation occurs in securities rated BBB+ to BBB-.

The second phase of this trade involves credit default swaps (CDS). A credit default swap is an agreement where one party agrees to make a payment to another party when a default takes place, in exchange for regular compensation until the agreement terminates or a default happens. This began with corporate bonds and loans, but now has expanded to mortgage- and asset-backed securities.

Unlike shorting stocks, where the amount of shorting is generally limited by the float of the common stock, there can be more credit default swaps than bonds and loans. What began as a market to allow for hedging has become a market to encourage speculation.

With CDS on corporate debt, it took eight years for the notional size (amount to pay if everyone defaulted) of the CDS market to become 4 times the size of the corporate bond market. With CDS on home equity asset-backed securities, it took less than 18 months to get to the same point.

The payment received for insuring the risk is loosely related to the credit spread on the debt that is protected. Given that the CDS can serve as a hedge for the debt, one might think that the two should be equal. There are a couple reasons that isn’t so.

First, when a default happens, the bond that is the cheapest to deliver gets delivered. That option helps to make CDS trade cheap relative to credit spreads. But a bigger factor is who wants to do the CDS trading more. Is it those who want to receive payment in a default, or those who want to pay when a default occurs?

How It Impacts Housing

With CDS on asset-backed securities, the party writing protection makes a payment when losses get allocated to the tranche in question. Most protection gets written on tranches rated BBB+ to BBB-.

This is where shorting residential housing comes into the picture. There is more interest in shorting the residential housing market through buying protection on BBB-rated home equity asset-backed securities than there are players wanting to take on that risk at the spreads offered in the asset-backed market at present. So, those who want to short the market through CDS asset-backed securities have to pay more to do the trade than those in the cash asset-backed securities market receive as a lending spread.

One final layer of complexity is that there are standardized indices (ABX) for home equity loan asset-backed securities. CDS exists not only for the individual asset-backed securities deals, but also on the ABX indices as well. Those not wanting to do the credit work on a specific deal can act on a general opinion by buying or selling protection on an ABX index as a whole. The indices go down in quality from AAA to BBB-, and aggregate similar tranches of the individual deals. Those buying protection receive pro-rata payments when losses get allocated to the tranches in their index.

So, who’s playing this game? On the side of falling housing prices and rising default rates are predominantly multi-strategy and mortgage debt hedge funds. They are paying the other side of the trade around 2.5% per year for each dollar of home equity asset-backed securities protection bought. (Deals typically last four years or so.) The market players receiving the 2.5% per year payment are typically hedge and other investment funds running collateralized debt obligations. They keep the equity piece, which further levers up their returns. They are fairly yield-hungry, so from what I’ve heard, they’re none too picky about the risks that they take down.

Who wins and who loses? This is tricky, but if residential real estate prices fall by more than 10%, the buyers of asset-backed securities protection will probably win. If less, the sellers of protection probably win. This may be a bit of a sideshow in our overly leveraged financial markets, but the bets being placed here exceed ten billion dollars of total exposure. Aggressive investors are on both sides of this trade. Only one set of them will end up happy.

But how can you win here? I believe the safest way for retail investors to make money here is to play the reaction, should a panic occur. If housing prices drop severely, and home equity loan defaults occur, and you hear of hedge fund failures resulting, don?t act immediately. Wait. Watch for momentum to bottom out, or at least slow, and then buy the equities of financially strong homebuilders and mortgage lenders, those that will certainly survive the downturn.

If housing prices rise in the short run (unlikely in my opinion), and you hear about the liquidations of bearish hedge funds, then the best way to make money is to wait. Wait and let the homebuilders and mortgage finance companies run up, and then when momentum fails, short a basket of the stocks with weak balance sheets.

Why play the bounce, rather than try to bet on the success of either side? The wait could be quite long before either side loses? Do you have enough wherewithal to stay in the trade? Most players don?t; that?s why I think that waiting for one side or the other to prevail is the right course. Because both sides are levered up, there will be an overshoot. Just be there when the momentum fails, and play the opposite side. Personally, I?ll be ready with a list of homebuilders and mortgage lenders with strong balance sheets. Though prospects are not bright today, the best will prosper once the crisis is past.