David Merkel – Page 260 – The Aleph Blog

Recent Portfolio Moves, and Insurance Company Musings

Posted on 7 June 20088 June 2008 by David Merkel

On Friday, toward the end of the day, I added to my position in Cemex, just to rebalance the portfolio and take advantage of undue weakness in the Mexican stock market.

Earlier in the day, though my timing was good, it could have been better, I swapped my exposure in Japan Smaller Capitalization Fund [JOF] for the SPDR Russell/Nomura Small Cap Japan ETF [JSC]. Given that I like JOF, why did I trade? The premium to NAV got too high — it was 10% on an intraday basis by my calculations, so, I traded. Eventually it will go back to a discount of -5% or so, and I will reverse the trade. I still like Japanese Small caps, but I have my limits when it comes to NAV premiums.

Away from that, I am still considering trading away some/all of my RGA for some MetLife, since I think it will be a cheap way to acquire more RGA. I’m glad the separation has finally come for MetLife and RGA; it was only a question of when. RGA is a unique company; unless Swiss Re, or Munich Re, or Aegon wants to spin out their Life Re business, there are no other pure play life reinsurers out there. Reinsurance of mortality in the present environment is a cozy oligopoly, with one former main player, Scottish Re (spit, spit), badly damaged. (Though I lost badly on Scottish Re, I am still grateful that when I figured out what was going on, I was able to sell at $6+/sh. Current quote: 14 cents/sh, and I hope that MassMutual and Cerberus are enjoying themselves. I took enough lumps for my patronage of Scottish Re, so anyone who sold when I did is at least that much better off.)

Pricing power isn’t anything amazing here, because the life insurers in general have enough capital, and are not ceding as much business to the reinsurers. But it is a steady business, and one with barriers to entry — ACE and XL will try to get into the business, and Scor will try to improve its position, but RGA, Swiss Re and Munich Re will be tough to dislodge.

I am looking forward to the next reshaping, and considering industry trends… I’m really not sure which way the portfolio will go, but I am gathering tickers and industry data, and preparing for the next change.

One last note: did you know that I am overweight financials? Yes, but only insurance companies, and Alliance Data Systems. (I still don’t trust the banks, and particularly not the investment banks.) The insurers that I own are cheap to the point where earnings don’t need to grow much to give me good value over the long run, and are largely insulated from any hurricane activity this year. Now, if the winds blow, you can expect that I will do a few trades to take advantage of mispricing among reinsurance companies. That said, Endurance, Aspen, Flagstone, and PartnerRe look cheap to me at present. Endurance looks very cheap… I have owned all four in the past, and will probably own some of them again in the future. But, no major commitments until the wind starts blowing (hurricanes), or if we get to the middle of the hurricane season (say, mid-September), and nothing has happened. Then it would be time to buy. Damage from windstorm tends to be correlated within years — bad years start early, and are very bad. Good years are quiet, and continue quiet with a few storms doing low levels of damage.

Anyway, that’s what I am up to. Got other ideas? Share them with my readers!

Full disclosure: Long CX JSC RGA ADS

Everyone is a Critic!

Posted on 6 June 200822 June 2017 by David Merkel

It’s bad enough that nobodies like me criticize the Fed, but what do you do when members of the FOMC criticize?? Two hawks, Lacker and Plosser, criticize the recent efforts to alleviate difficulties in the lending markets because of the potential for moral hazard.? In this case, moral hazard means to banks: “Don’t worry about bad lending as a group.? If you make mistakes, the Fed will rescue you.”

Give Bernanke some credit, because unlike Greenspan, he lets the members of the FOMC speak their minds.? Hopefully the disagreement will sharpen the Fed, and not lead to paralysis or confusion.? For more background on the individuals who are part of the FOMC, please refer to my piece, A Social View of the FOMC.

I agree the the moral hazard is a live issue here.? The real question is whether growing weakness in the lending markets can be tolerated, which might be worse than moral hazard.

The Amazin’ Ragin’ Contagion

Posted on 6 June 200822 June 2017 by David Merkel

When I wrote more over at RealMoney, I commented on how falling real estate values would eventually affect prime lending.? Here’s an example:

		David Merkel
		Hear Cody on Housing
		8/24/2007 1:25 PM EDT

Much, but not all of the upset in the lending markets (which, if you look at swap spreads, the current manifestation of the crisis seems to be passing — down 4 basis points today), is from deflating values in housing. My estimate for how much further real estate has to decline on average in the US is 10-20%. We need to find owners for about 4% of the US housing stock that is vacant. The pain that has been felt in subprime and Alt-A loans will get felt in prime loans, and possibly conforming loans as well. Fannie and Freddie won’t get killed, but they will take credit losses.

So, listen to Cody. Residential real estate markets do not clear as rapidly as a futures exchange. The illiquidity and variations in lending standards tends to lead to markets that adjust slowly, and autocorrelatedly. I.e., if it went up last period, odds are it will go up next period, and vice-versa.

It will take a while for the residential real estate market to clear. When the inventory gets down to 3% it will be time to start speculating on homebuilders and mortgage lenders again, but real estate prices won’t start rising in aggregate until the inventory of unsold homes gets below 1.5-2.0%.

Position: none

Well, the chickens are now coming home to roost.? Residential real estate values have fallen enough that it has eaten through much of the equity of prime borrowers, leading to distress on prime mortgage collateral.? If that is not bad enough, the banks are also staring down falling commercial property prices.? Even Fed Governor Kohn is telling us to expect more loan losses, which I expect will cause monetary policy to be confused amid rising inflation.

At present, the fall in housing prices may be self-reinforcing, as lower prices make more homeowners marginal, and with a negative life event (unemployment, divorce, disease, disaster, disability), they can no longer afford their property.? Prime mortgages are no exception here, particularly if bought near the peak of the recent real estate craze.

Just be aware that the fall in housing prices will take a while to work out.? It may cause larger financial institutions to fail.? But eventually, there will be a bottom that can be bought, perhaps in 2009-2010.? Until then real estate related financials will remain under pressure, and some with concentrated interests, like the mortgage insurers, will die.

Now, That Was Fast!

Posted on 6 June 2008 by David Merkel

From the RealMoney Columnist conversation yesterday:

		David Merkel
		Stealing a March; Next Comes the Pile-On
		6/5/2008 3:37 PM EDT

So yesterday Moody’s places MBIA and Ambac on Negative Watch. S&P grabs the ball and downgrades them, leaving them on negative outlook. I pointed out a while ago that the dike had been breached, and it was only a matter of time until the downgrades came.

And, as I pointed out yesterday, there will be new entrants to the market. Not only will Berky be there, with Assured Guaranty and Dexia, but Macquarie Group joins the party as well.

Even if Ambac and MBIA (the holding companies) survive, the business that used to be profitable for them will be occupied by others. I’ll throw this out as my next prediction in this space: they both go into conservation, and in runoff, claimants get paid off, senior debtholders get nicked, subordinated debtholders lose a lot, and the equity is a zonk.

Position: none

		David Merkel
		This Is a Great Country
		6/5/2008 3:41 PM EDT

One last note: the stocks rally after the downgrade. Probably short covering and other derivative-related activity, but you have to admit it is amazing for the stock to go up when the franchise gets destroyed.

Position: none

-=-=-=-=-=-=–==–==-=–=-=-==–=

Okay, after yesterday’s piece, there was a fast, opportunistic reaction by S&P. Moody’s action gave them cover to downgrade, and S&P took the ball and ran with it. Now that action gives Moody’s the cover to downgrade freely. There is no longer any reason for them to stay at Aaa. There is no money in it, and their reputation can only take further his from here. Rating agencies are like wolf packs — there is safety in the pack. Don’t be an outsider.

From one of my old RealMoney pieces (12/1/2004): Many of the conflict-of-interest problems still exist today. One more example: Could the ratings agencies downgrade MBIA (MBI:NYSE) or Ambac (ABK:NYSE) even if they wanted to? MBIA and Ambac rely on their Aaa/AAA ratings to the degree that they would have a difficult time operating without the rating. Much of the bond market relies on enhancement from MBIA and Ambac. The loss of a Aaa/AAA rating would be a jolt to the guaranteed bonds.

In addition, MBIA and Ambac structure their risks according to models provided by the ratings agencies. It is the models of the ratings agencies that tell the guarantors how much equity must stand in front of the debt that is being guaranteed. The ratings agencies are an inherent part of the business model of the financial guarantors. MBIA and Ambac can’t get along without them.

The ratings agencies derive so much income from these major financial guarantors that their own financial well-being would be affected by a downgrade. I’m not saying that either should be rated less than Aaa/AAA, but there is a cliff here, and I am wary of investing near cliffs.

Well, we came to the cliff, and S&P shoved MBIA and Ambac to the edge. Now Moody’s can push them over the edge. It should come soon. As with the rating agencies actions on the other financial guarantors, once a guarantor is pushed below AAA, the rating no longer matters as much. There are dedicated “AAA only” investors that care about this, and they will be forced sellers now, or, they will modify their investment guidelines. 🙁

Now, as I have mentioned before, stable value funds will have their difficulties here. Some have positioned themselves as “AAA only” funds, and that led to large holdings of MBIA- and Ambac-guaranteed debt. What they do now is beyond me. I suspect they try to modify their investment guidelines. 🙁

Well, at this point, we have to contemplate life without the old guarantors. They will shrink and disappear, while new guarantors, who are all currently skeptical of doing much more than Municipal bond insurance, will grow, and make it impossible for the old guarantors to return, because they are much better capitalized. Once you lose your AAA as a guarantor, you will rarely get it back.

Don’t Do It!

Posted on 5 June 2008 by David Merkel

Fifteen years ago, when I was still pretty much a novice investor, I went to an AAII meeting to hear Jeremy Siegel speak about his new book, “Stocks for the Long Run.”? I brought my copy to have him sign it.? I hung around after the talk to? listen to some of the more informal things he might say, and in a dead moment, I asked him (something to the effect of),? “You suggest that young people should lever up to buy stock; do you really mean that?”? His answer was and unreserved “Yes.”

Dr. Siegel is brighter than me.? The guys who write the CXO Advisory Blog are brighter than me as well.? Felix Salmon is clever, and he puts up this supporting piece.

I am here to disagree.? Why?? It is all very well and good for academics to assume that returns occur randomly, but returns occur in streaks.? Think of all of the “lost decade” articles you have seen in the recent past.? Here’s my main reason for not levering up while young: It won’t work well about? one-third of the time, because young people will take humongous losses during a “lost decade,” and in the panic, they will sell at the wrong time.? My secondary reason, is that in really bad markets, such as 1929-32, 1973-4, and 2000-2002, you could be wiped out.

Don’t trust the results that rely on the veracity of Modern Portfolio Theory, when those ideas would have failed off of historical returns.? As I often say, “The markets always have a new way to make a fool out of you.”? This is another example.

One final note, perhaps more scholarly: the idea of levering up requires buying and holding, and that bad markets happen randomly, with no streaks.? Unfortunately, the equity market returns less than a buy-and-hold investor receives, because people buy and sell at the wrong times.? Buy-and-hold investors are daring people; they confront the natural tendencies toward greed and panic, and they do better than average in the long run.? One buying and holding on leverage would have to have a steel gut, which is not characteristic of younger investors.

So, don’t lever up.? I say this to investors young and old, experienced and inexperienced.? Getting an equity-like return is difficult enough in the long run.? Don’t make your life more difficult by levering up.

The rating agencies have been dragged. When will the kicking and screaming stop?

Posted on 5 June 2008 by David Merkel

First, an old RealMoney Columnist Conversation post:

		David Merkel
		Moody’s Downgrades XL Capital Assurance
		2/7/2008 3:34 PM EST

When the main rating agencies begin downgrading the lesser guarantors, the big guarantors are likely not far behind. Moody’s just downgraded XL Capital Assurance from Aaa to A3, and Security Capital Assurance From Aa3 to Baa3 (barely investment grade).

Psychologically, the major rating agencies, Moody’s and S&P, have been taking baby steps toward downgrading Ambac, MBIA and FGIC. But first they have to do the lesser guarantors that are in trouble. As I have pointed out before, the major rating agencies are co-dependent with the major guarantors, and that will only throw the guarantors over the edge if hurts them more to leave the guarantors at AAA. That will cost them future revenues to cut the ratings of the major guarantors, but it might save their larger franchises. (Fitch, on the other hand, has less to lose and can downgrade with impunity.)

Now, the effects on the broader insured bond market are probably overestimated. There will be new entrants to take the place of the legacy companies that may have to go into runoff. The holding companies for the major guarantors could die, but a rescue of the operating insurance companies in runoff mode is more likely. Those who own equity in the holding companies or debt claims to the holding companies will not be happy with the results, though.

Watch for downgrades of the major guarantors. Unless a lot of new capital gets pumped into their operating insurance companies, the downgrades are coming, maybe within a month.

Please note that due to factors including low market capitalization and/or insufficient public float, we consider Security Capital Assurance to be a small-cap stock. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.

Position: none

And this comment that I left at WSJ MarketBeat on their article Ambac Falls on S&P 500 Deletion.

Can we get the equity side of S&P to chat with the debt ratings side? Debt ratings always have a bias toward bigger firms, and Ambac is no longer big enough to rate being in the S&P 500.

Quick, name another corporation that is AAA that is not in the S&P 500. Berkshire Hathaway, but that is because the float is small? but wait, Ambac the holding company is only AA, their regulated subsidiaries are AAA.

Are there any AA- or better US publicly traded corporations not in the S&P 500? One AA ? Genentech. Three AA-: MGE Energy, WGL Holdings, and Northwestern Natural Gas? two utilities and a gas pipeline. Decidedly more stable businesses than Ambac.

So, S&P debt ratings, take the hint from your corporate brother, and downgrade Ambac.

Comment by David Merkel – June 4, 2008 at 11:07 am

Now, consider this article from the AP, where they say: “Despite raising $1.5 billion in new capital in March, Ambac’s financial flexibility has deteriorated, Moody’s said. A decline in the firm’s market capitalization and high spreads on its debt securities makes it difficult for the company to address potential capital shortfalls.”

Also quoting from the post at Accrued Interest, quoting from the Moody’s report, “Moody’s stated that the ratings review was prompted, in part, by concerns about the deterioration in ABK’s financial flexibility since the company’s $1.5 billion capital raise in March 2008, as evidenced by the substantial decline in the firm’s market capitalization and high current spreads on its debt securities, making it increasingly difficult to economically address potential shortfalls in the company’s capital position should markets continue to worsen. Additionally, there is meaningful uncertainty surrounding Ambac’s ability to regain market acceptance and underwriting traction within its target markets.”

Now, maybe I’m nuts, but when I think of debt ratings, I don’t want to directly consider the ability to raise new equity capital as a significant factor in my rating decisions.? Why?? Because deterioration can happen slowly, but it doesn’t have to.? Companies the are AAA or AA should be beyond the possibility of having to do a forced equity raise in anything short of a depression.? Aside from that, the decision to raise equity capital is discretionary, and managements rarely do it at the right time — when things are going well.

Naked Capitalism calls it the Monoline Death Watch, and Yves is spot-on.? For financial guarantors, ratings are a slippery slope.? You can go down, but you can’t easily go up.? MBIA and Ambac are close to being in runoff now.? Losing the AAA from either agency will seal that.? Also, once one agency downgrades, the other will quickly follow.? There will be new start-ups, but for now Berky, Dexia, and Assured Guaranty will make hay while the sun shines — they are the new oligopoly, and won’t do structured finance, for now.

PS — If indeed FASB eliminates QSPEs by modifying SFAS 140, and if there are no financial guarantors willing to do structured finance, then what happens to securitization?? It is too useful of an idea to disappear.? I don’t think it will disappear; I just don’t know the form in which it will reappear.? I’ll toss out this idea: Wall Street creates a bunch of small cap companies to own the assets, and the tranches, are simply different levels of subordinated debt.

The Odd Man Out

Posted on 4 June 200822 June 2017 by David Merkel

At present I own a position in the Japan Smaller Capitalization Fund.? One of the things that I talk less about in my investing, is my willingness to allow some professionals closer to the situation manage a small amount of the assets, if they have a good track record, and the area of the global markets is deeply out of favor.? When I do this, it is typically for just one investment, and not more than 5% of the total portfolio.

Japanese small caps?? Definitely out of favor.? When I look at the top ten holdings of the Japan Smaller Capitalization Fund, I can justify holding them on a book value basis, and on an earnings basis, relative to the low interest rates in Japan, they make sense as well.

Now, the fund is trading at a premium to its NAV, so I don’t recommend purchases, at present.? perhaps the ETF SPDR Russell/Nomura Small Cap Japan would be better [JSC].? At a premium of 8% on JOF, I would swap for JSC.? That level would discount the good investing of JOF versus the index of JSC.? Either way, I like Japanese small caps, and I am happy to hold them for a while.

Full disclosure: long JOF

Book Review: When Genius Failed

Posted on 4 June 200822 June 2017 by David Merkel

One review of a good Roger Lowenstein book deserves another? Perhaps good things come in pairs. 😉

I decided to review “When Genius Failed,” because reading “While America Aged” reminded me of how much I liked Lowenstein’s writing style, simplifying matters for the average reader.

I was an investment actuary when LTCM was founded, and watched out of the corner of my eye, as I saw articles about their success. Being a risk manager, I was a little skeptical over the leverage employed, but I knew of other firms that had records almost as good, employing esoteric strategies of Residential MBS. That was the era of build a better prepayment model, and the returns will flow. (Perhaps today that would apply to default models…)

When LTCM imploded, I had just joined my first investment department. In the panic that ensued, Treasury yields fell, and my boss asked his new mortgage bond manager, me, why prepayments weren’t accelerating. I suggested that the banks could not borrow at Treasury rates, better to look at single-A bank and financial yields, which were considerably higher. (Surprisingly, I got that one right.) A number of the clever prepayment modelers got their heads handed to them during this era.

The implosion affected all fixed income markets, and it was a lesson to me that markets ordinarily recover from crises starting with short maturities, and moving to longer maturities, and with high quality, and moving to lower quality. We had cash flow, and and provided liquidity at a price.

Um, oh yeah, book review.? LTCM suffered from a number of troubles:

They were systemically short liquidity.
They did not consider the effect of others mimicking their trades.
They were internally disorganized; leadership was weak.
They intensified their leverage at the wrong time.

The liquidity aspect is significant.? Illiquid assets that are similar to a liquid asset usually yield more, because the cost of trading is much higher, and the possibility of being trapped is higher also.? LTCM bought the higher-yielding illiquid assets, and hedged them with more-liquid liabilities.? This set the stage for the run-on-the-fund.? Almost all run-on-the-bank scenarios occur from institutions where the ability of depositors to demand cash is greater than the ability to raise cash in the short run.

In the same way, many on Wall Street mimicked the trades of LTCM, but they had risk control desks that forced them to kick out the trades when they went awry, which further intensified the pressure on LTCM, because it forced the asset prices of LTCM lower.

The lack of discipline inside LTCM, was a eye-opener for me, and I would not have appreciated it, were it not for Lowenstein’s book.? Financial businesses that last require tight controls on risk taking.

Another thing captured by Lowenstein was the hubris involved as they cashed out some investors in order to “favor” internal investors and close friends.? They levered up at the wrong time.? The cashed-out investors were offended, but they were the ones who did the best of any; they got the good years, and missed the bad year.

Now, beyond that, Lowenstein delivers the attitudes of LTCM and Wall Street, with all of the fear and greed.? It is entertaining reading, and the book is still timely. Even though there is no dominant investment firm that threatens the financial markets, we have the investment banks as a group taking a great deal of risk in their trading and investment banking.? The assets are illiquid, the liabilities are more liquid.? Their balance sheets are opaque.? Many of them are in the same risk posture.? Many of them are more leveraged than they would like to be.? Bear has already fallen, will Lehman fall next?

Just because investors are smart does not mean that they are infallible.? Any investor playing at a high enough level of leverage can be ruined.? This book inoculates investors against perverse risk-taking, and makes them more skeptical about the claims of hot investors.? Not losing money is a big help in making money, and skepticism in investing is usually a plus.

Full disclosure: If you enter Amazon through a link on my site and buy something, I get a small commission, and your costs don’t increase. This is my version of the ?tip jar.? Thanks to all who support me.

Abandon the Playbook; Adopt the Global Playbook; Adjust the Playbooks for Valuations

Posted on 3 June 200822 June 2017 by David Merkel

It was 7 3/4 years ago that I modified my value investing method to incorporate industry rotation.? That was probably the most significant change to my methods that I made in the last 16 years.? I did it reluctantly, after an analysis of where I had done best over the prior eight years.? I had many significant wins when I had gotten the industry cycle correct.

I commented recently on industry selection.? I want to make two additional points on that here.

1)? Analyze where an industry gets its demand.? Is it domestic or foreign?? If foreign, then use the global playbook.? Instead of looking at GDP growth, look at the growth from foreign demand.? Decouple your reasoning from the traditional view, because in a global economy, things get messy.

2) Even if an industry is driven primarily by domestic demand, often portfolio managers using the playbook may trash the valuation to levels that should be below trough valuations.? These are long-term opportunities, and should be bought.? VIce-versa for companies that have favorable future growth prospects, but the valuation discounts those prospects, and then some.? Those should be sold, even if they are in industries with good prospects.

That’s all for the evening.? I wrote this piece because active managers haven’t been doing well lately.? Uh, in order to do well, one must be willing to brave the possibility of failing (you can’t hug the benchmark), by taking opportunities that others find distasteful.? I benefit because I don’t care about tracking error; I just buy cheap stocks, in industries where the long run value is not appreciated by most investors.

A Comment on SFAS 159

Posted on 3 June 2008 by David Merkel

I am ambivalent about fair value accounting standards because they ruin comparability of financial statements across companies.? Recently, SFAS 159 has come into the news because some securities firms used it to book gains because the market value of debt that they issued had fallen.? Four notes:

1) They had no choice, they had to do it.? Their debt has liquid markets — those are level 1 and at worst level 2? liabilities.

2) Many of the assets that they carry have credit risk also.? The pressures that are leading the prices of their debt to fall, are also causing the carrying value of some of their assets to fall as well.

3) If credit markets for their debt improve, they will have to write those liabilities up to higher values.? Even if creditworthiness stays the same, the passage of time will make the liabilities rises in value as they get closer to the ultimate payoff.

4) In bankruptcy, their obligation to pay par does not change.? It is not as if they can pay the reduced market? value to pay off their debt, except through a deal agreed to by the court and plaintiffs.

Look, I don’t like the confusion SFAS 159 creates at this point any more than the next guy, but the gains here will likely reverse over time, absent bankruptcy.? As an analyst, I strip those gains out of income, and I should strip out losses on the asset side that I think will reverse as well.

We can change the way that gains and losses are reported — book, market, model, hybrid… but we can’t change the ultimate cash flows from the business, which is what will ultimately drive the value of the firm.? Be careful and conservative here, as accrual entries get more subjective, they become less trustworthy, and managements on average release more into income from accrual entries than they ought to.