David Merkel – Page 266 – The Aleph Blog

The Sea Change in Bonds

Posted on 26 April 2008 by David Merkel

The bond market has had quite a shift since the last Fed meeting. What are the common themes?

Outperformance of credit, especially high yield.
Return of the carry trade.
Tax-free Munis have run.
Underperformance of Treasuries (longer= worse), and foreign bonds, particularly carry trade currencies like the Yen and Swiss Franc.

The willingness to take risks in fixed income has returned, particularly in the last two weeks. I don’t want to tell you that this is a trend that won’t reverse… it might reverse. Remember that bear market rallies tend to be short and sharp, and that the credit bear market in 2000-2002 had several legs. Leg one may be over for this credit bear market, but that doesn’t mean the credit bear market is over; there are still too many unresolved credit issues in housing, builders and investment banks.

Now, to flesh out the changes, I looked at the total returns on 15 major ETFs in different sectors of the bond market. Here are the returns since 3/19:

HYG — High yield Corporates + 4.47%
DBV — Carry trade fund +2.83%
MUB — National Municipals +1.10%
LQD — Investment Grade Corporates +0.99%
FXE — Euro currency Trust +0.29%
BIL — Treasury Bills -.06% (Negative on T-bills?!)
AGG — Lehman Aggregate -1.03%
SHY — Short Treasuries -1.18%
TIP — TIPS ETF -2.85%
IEI — 3-7 yr Treasuries -3.41%
FXF — Swiss Franc Currency Trust -3.44%
BWX — Intl. Gov’t Bond Fund -3.49%
IEF — 7-10 yr Treasuries -3.74%
TLT — 20+ Treasuries – 4.87%
FXY — Yen Currency Trust -5.30%

What a whipping for safe assets. Perhaps the Fed will be happy that they helped engineer the whacking. Then again, the TED spread is still high, and the change might just be a normal shift in sentiment after the panic leading up to the last FOMC meeting. Interesting to see both the return of the carry trade and credit spreads outperforming the move in Treasuries.

For those that follow my sector recommendations, I would be lightening, but not exiting credit positions in the near term. I’m in the midst of considering my other sector recommendations, and will report on this soon. For more on this topic, refer to:

Its against my programming to call bottoms (and anything by Accrued Interest)
RIP Bond Rally 2005-2008
Signs of Improvement in the Credit Markets
Debt Investors Show Signs Of Relief

Before I close, one large negative area where there is excess supply: preferred stock of financial companies.? There is a lot floating around from balance sheet repair efforts where they didn’t want to dilute the common.? (That’s the next act.)? I would stay away for now, but keep my eyes on selected floating rate trust preferreds, to leg into on the next leg down.

Book Review: Beating the Market, 3 Months at a Time

Posted on 26 April 200826 April 2008 by David Merkel

A word before I start: I’m averaging two book review requests a month at present. I tell the PR people that I don’t guarantee a review (though I have reviewed them all so far), or even a favorable review. They send the books anyway.

Included in every book is a 2-6 page summary of what a reviewer would want to know, so he can easily write a review. Catchy bits, crunchy quotes, outlines…

I don’t read those. I read or skim the book. If I skim the book, I note that in my review. Typically, I only skim a book when it is a topic that I know cold. Otherwise I read, and give you my unvarnished opinion. I’m not in the book selling business… I’m here to help investors. If you buy a few books (or anything else) through my Amazon links, that’s nice. Thanks for the tip. I hope you gain insight from me worth far more.

If I can keep you from buying a bad book, then I’ve done something useful for you. I have more than enough good books for readers to buy. Plus, I review older books that no one will push. I hope eventually to get all of my favorites written up for readers.

Enough about my review process; on with the review:

When the PR guy sent me the title of the book, I thought, “Oh, no. Another investing formula book. I probably won’t like it.” Well, I liked it, but with some reservations.

The authors are a father and son — Gerard Appel and Marvin Appel, Ph. D. They manage over $300 million of assets together. The father has written a bunch of books on technical analysis, and the son has written a book on ETFs.

Well, it is an investing formula book… it has a simple method for raising returns and reducing risks that has worked in the past. The ideas are simple enough that an investor could apply them in one hour or so every three months. I won’t give you the whole formula, because it wouldn’t be fair to the authors. The ideas, if spun down to their core, would fill up one long blog post of mine. But you would lose a lot of the explanations and graphs which are helpful to less experienced readers. The book is well-written, and I found it a breezy read at ~200 pages.

I will summarize the approach, though. They use a positive momentum strategy on three asset classes — domestic equities, international equities, and high yield bonds, and a buy-and-hold strategy on investment grade bonds. They apply these strategies to open- and closed-end mutual funds and ETFs. They then give you a weighting for the four asset classes to create a balanced portfolio that is close to what I would consider a reasonable allocation for a middle aged person.

Their backtests show that their balanced portfolio earned more than the S&P 500 from 1979-2007, with less risk, measured by maximum drawdown. Okay, so the formula works in reverse. What do we have to commend/discredit the formula from what I know tend to happen when formulas get applied to real markets?

Commend

Momentum effects do tend to persist across equity styles.
Momentum effects do tend to persist across international regional equity returns.
Momentum effects do tend to persist on high yield returns in the short run.
The investment grade buy-and-hold bond strategy is a reasonable one, if a bit quirky.
Keeps investment expenses low.
Gives you some more advanced strategies as well as simple ones.
The last two chapters are there to motivate you to save, because they suggest the US Government won’t have the money they promised to pay you when you are old. (At least not in terms of current purchasing power…)

Discredit

The time period of the backtest was unique 3/31/1979-3/31/2007. There are unique factors to that era: The beginning of that period had high interest rates, and low equity valuations. Interest rates fell over the period, and equity valuations rose. International investing was particularly profitable over the same period… no telling whether that will persist into the future.
I could not tie back the numbers from their domestic equity and international equity strategies in the asset allocation portfolio to their individual component strategies.
I suspect that might be because though the indexes existed over their test period, tradeable index funds may not have existed, so in the individual strategy components they might be done over shorter time horizons, and then used indexes for the backtest. This is just a hypothesis of mine, and it doesn’t destroy their overall thesis — just the degree that it outperforms in the past.
They occasionally recommend fund managers, most of whom I think are good, but funds change over time, so I would be careful about being married to a fund just because it did well in the past.
If style factors or international regional return factors get choppy, this would underperform. I don’t think that is likely, investors chase past performance, so momentum works in the short run.
Though you only act four times a year, that’s enough to generate a lot of taxable events if you are not doing this in a tax-sheltered account.
It looks like they reorganized the book at the end, because the one footnote for Chapter 9 references Chapter 10, when it really means chapter 8.

The Verdict

I think their strategy works, given what I know about momentum strategies. I don’t think it will work as relatively well in the future as in the past for 3 reasons:

There is more momentum money in the market now than in the past… momentum strategies should still work but not to the same degree.
International investing is more common than in the past… the payoff from it should be less. There aren’t that many more areas of the world to go capitalist remaining, and who knows? We could hit a new era of socialism abroad, or even in the US.
Interest rates are low today, and equity valuations are not low.

Who might this book be good for? Someone who only invests in mutual funds, and wants to try to get a little more juice out of them. The rules on managing the portfolio are simple enough that they could be done in an hour or two once every three months. Just do it in a tax-sheltered account, and be aware that if too many people adopt momentum strategies (not likely), this could underperform.

Full disclosure: If you buy anything from Amazon after entering through one of my links, I get a small commission.

Eight Fed Notes

Posted on 25 April 2008 by David Merkel

1)? Let’s start out with my forecast.? I’ve given it before, but it has become the conventional wisdom — at the next FOMC meeting at the end of April, the Fed will cut by 25 basis points.? They will make the usual noises about both inflation and economic weakness, as well as difficulties in the financial system, and comment that they have done a lot already — it is time to wait to see the power flow.? The only difficulty is whether we get another blowup in the lending markets that affects the banks.? We could see Fed funds below 2% in that case, but absent another crisis, 2% looks like the low point for this cycle.? Now all that said, I think the odds of another crisis popping up is 50/50.? We aren’t through with the decline in housing prices, and there are a lot of mortgages and home equity loans that will receive their due pain.

2) One interesting sideshow will be how loud the hawks will be opposing a 25 basis point cut.? We have comments from voting members Plosser and Fisher already. Price inflation is a real threat to them, and one that is closer to the Fed’s core mission than protecting the financial system.

3)? Okay, give the Fed some credit regarding the TSLF, which is now almost not needed.? The TAF is another matter — there is continuing demand for credit there.? It will be interesting to see when the Fed will stop the the TSLF, and what happens when they try to unwind the TAF.? As it seems, some banks still need significant liquidity from the TAF.

4) Indeed, if the Fed is lending to investment banks, it should regulate them.? I would prefer they didn’t lend to investment banks, though.? Better they should lend to commercial banks that are negatively affected by investment bank failures, and let the investment banks fail.? After all, there is public interest in the safety of depositary institutions, but I’m not sure that if the investment banks disappeared, and the commercial banks were fine, that the public would care much.? It certainly would teach the investment banks and the investing public a real lesson on overdoing leverage.

5)? Okay, so LIBOR rises after it seems that some bankers have been lowballing the rate in an effort to show that they are not desperate for funds.? Significant?? Yes, the TED spread has widened 12 basis points since then. ? I’m sure that borrowers with mortgages that float off LIBOR will be grateful for the scrutiny.

Having been in similar situations in the insurance industry regarding GIC contracts, I’m a little surprised that the BBA doesn’t have some requirement regarding honoring the rate quote up to some number of dollars.? On the other hand, can’t they track actual eurodollar trading the way Fed funds gets done, and then just publish an average rate?

6) Onto the last three points, which are the most controversial.? You know that I think the core rate of inflation is a bogus concept.? If you are trying to smooth the result, better to use a median or a trimmed mean, rather than throwing out classes of data, particularly ones that have had the highest rates of inflation.? Given the inflation that is happening in the rest of the world, I find it difficult to believe that we are the only ones with low inflation, unless it is an artifact of being the global reserve currency.

7) I was quoted at TheStreet.com’s main site regarding the Fed. I think that the Fed is caught between a rock and a hard place, but I am not as pessimistic as this piece.

8 ) Finally, how do the actions of the Fed get viewed abroad?? Given the fall in the US Dollar, not nearly as favorably as the press coverage goes in the US.? Do I blame them? No.? They sense that they are losing economic value to the US, and that they are implicitly subsidizing us.? No wonder they complain.

Book Reviews: Manias, Panics, and Crashes, and Devil Take the Hindmost

Posted on 24 April 200824 April 2008 by David Merkel

Sometimes we forget how bad it can be, and then we howl over minor bad times in the markets. We may be past a mania in residential housing, but we have not really experienced a panic or crash yet. People squeal over how bad the equity market is, but recently we haven’t had anything like the 2000-2002 experience, much less the 1973-1974 or 1929-1932 experience.

Two books come to mind when I think about disaster in a non-fear-mongering way: Manias, Panics, and Crashes, by Charles Kindleberger, and Devil Take the Hindmost, by Edward Chancellor. They take two different approaches to the topic, and those approaches complement each othe, giving a fuller picture. Chancellor takes a historical approach, while Kindleberger deals with the structures of financial crises.

From Chancellor, you will see that manias and their subsequent fallout are endemic to Western culture. Someone living a full life over the last 300+ years would see one or two big ones, and numerous small ones. Relatively free societies give people freedom to make mistakes. Given the way that people chase performance, we can all make mistakes as a group, with large booms and busts. Much as the regulators might want to tame it, they can pretty much only affect what kind of crisis we get, and not whether we get one. He is somewhat prescient in suggesting that the leverage inherent in derivatives post-LTCM could be the next crisis. This book is a better one if you like the stories, and don’t want to dig into the theories.

But if you like trying to place the manias, panics, and crashes on a common grid, to see their similarities, Kindleberger has written the book for you. In it he draws on a number of common factors:

Loose monetary policy
People chase the performance of the speculative asset
Speculators make fixed commitments buying the speculative asset
The speculative asset’s price gets bid up to the point where it costs money to hold the positions
A shock hits the system, a default occurs, or monetary policy starts contracting
The system unwinds, and the price of the speculative asset falls leading to
Insolvencies with those that borrowed to finance the assets
A lender of last resort appears to end the cycle

I liked them both, but I am an economic history buff, and a bit of a wonk. The benefit of both books is that they will make you more aware of how financial crises come to be, and what the qualitative signs tend to manifest during the boom and bust phases of the overall speculation cycle.

Full disclosure: if you buy anything through Amazon after entering their site by clicking on one of the links here, I get a small commission. That’s my version of the tip jar.

I Don’t Get It

Posted on 23 April 2008 by David Merkel

1) Liberty Mutual buys Safeco?? Pays 1.75x book, and 11x estimated earnings?? Mutual companies have limited access to the credit markets, and have no equity to pay with, so it is mainly a cash deal.? They must have had a lot of cash lying around — might we wonder why they might not have enhanced policyholder dividends instead?? This is not an economic use of capital in my opinion. Kudos to those who owned Safeco — it was cheap, though in the negative part of the underwriting cycle.

I know this diversifies Liberty Mutual geographically and from a line of business standpoint, but I don’t expect there are a lot of costs to take out here. Intellectually, it is harder to grow organically, but at this point in the underwriting cycle, it is definitely preferred to acquisitions.? There are no equity investors in Liberty Mutual, but I would not lend them money on a trust preferred or a surplus note at present.? There are better places to put money at interest — remember, acquirers usually underperform.

But for those with a RM subscription, check out Cramer.? Off of Safeco, he likes Chubb.? Okay, I like Chubb too.? Great company, and cheap.?? I prefer Allstate, HCC, or Safety, and if I wanted to speculate, maybe Affirmative.? Lots of cheap P&C names out there, but it is the wrong side of the underwriting cycle — premiums falling, losses coming in unabated.

2) I don’t get fundamental weighting on bonds.? With bonds, the best one can do is get paid interest and principal, if one is buy-and-hold.? With stocks, a buy-and hold investor can do better in the long run by buying better earnings streams (value), rather than accepting market value weightings.? With bonds, there is no such upside, so I don’t get the fundamental weighting, except perhaps in foreign currency denominated bonds, and using purchasing power parity, which is still a weak tool.? I wouldn’t go there.

3) I don’t get Bill Miller.? I’m a value investor.? I like companies that trade at modest multiples of book and earnings.? I agree in principle with the concept of deferred performance that he mentioned in his quarterly letter:

My friend Jeremy Hosking, who has delivered around 400 basis points per year of excess return over two decades at Marathon (in London), corrected me recently when I spoke about our underperformance. “You mean, your deferred outperformance,” he said. I thought it a clever line, but it contains an important point. For investors who are trend followers, or theme driven, or who primarily build portfolios around forecasts, or who employ momentum strategies, price is dispositive. When they do badly, it is because prices moved in a direction different from what they thought. For value investors, price is one thing, and value is another. When prices move against us, it usually means that the gap between price and value is growing, and our future expected rates of return are higher.

With stable, cheap businesses, this definitely applies, but as you step out onto the growth spectrum, it no longer applies.? Check out the beginning of the letter, he is only 41 basis points ahead of the S&P 500 on a ten-year basis.? At this rate next year, he might be behind the S&P over ten years.? Quite a flameout for one who was so lionized.? Could he be fired?? Yes, but not by Chip Mason.? They are too close.? If one succeeds unconventionally, there is less tolerance for failure, because they weren’t sure why it worked in the first place.

4) I’ll take the opposite side of this trade.? Financial literacy is a good thing, and most people would be better off knowing more about finances, so long as they can mix it with humility.? I’m a professional, and I think humility is a key virtue in handling money.? As I say in my disclaimer:

David Merkel is an investment professional, and like every investment professional, he makes mistakes. David encourages you to do your own independent “due diligence” on any idea that he talks about, because he could be wrong. Nothing written here, or in my writings at RealMoney is an invitation to buy or sell any particular security; at most, David is handing out educated guesses as to what the markets may do. David is fond of saying, “The markets always find a new way to make a fool out of you,” and so he encourages caution in investing. Risk control wins the game in the long run, not bold moves.

People who are educated will still make mistakes with their money, but they will make fewer mistakes on net.? Hey, I’ve paid market tuition, and it is painful.? But boy, I learned a lot, and I don’t repeat mistakes often.? (Repeating mistakes sometimes is bad enough… 😉 )

Full disclosure: long SAFT (not SAF)

Book Review: Pension Dumping

Posted on 23 April 200812 February 2011 by David Merkel

I?m an actuary, but not a Pension Actuary. I don?t understand the minutiae of pension law; I only know the basics. Where I have more punch than most pension actuaries is that I understand the investing side of pensions, whereas for most of them, they depend on others to give them assumptions for investment earnings. I?ve written on pension issues off and on for 15 years or so. I remember my first article in 1992, where I suggested that the graying of the Baby Boomers would lead to the termination of most DB plans.

I am here to recommend to you the book Pension Dumping. It is a very good summary of how we got into the mess we in today with respect to Defined Benefit [DB] pension plans. Now, much of the rest of this review will quibble with some aspects of the book, but that does not change my view that for those interested in the topic, and aren?t experts now, they will learn a lot from the book. The author, Fran Hawthorne, has crammed a lot of useful information into 210 pages.

The Balancing Act

One of the things that the book gets right is the difficulty in setting pension regulations and laws. In hindsight, it might have been a good idea to give pensioners a higher priority claim in the bankruptcy pecking order. But if that had been done, many companies might have terminated their plans then and there, because of the higher yields demanded from lenders who would have been subordinated.

She also covers the debate on the ?equity premium? versus immunization well. Yes, it is less risky to immunize ? i.e., buy bonds to match the payout stream. Trouble is, it costs a lot more in the short run. With equities, you can assume that you will earn a lot more.

She also notes how many companies were deliberately too generous with pension benefits, because they did not have to pay for them all at once. Instead, they could put up a little today, and try to catch up tomorrow.

Things Missed

? Individuals aren?t good at managing their own money. Even if a participant-directed 401(k) plan is cheaper than a DB plan in terms of plan sponsor outlay, the average person tends to panic at market bottoms and get greedy at market tops. DB plans and trustee-directed DC plans are a much better option for most people. That said, most people prize the illusion of control, and will not choose what is best for them.
? Technological progress was probably a bigger factor in doing in the steel industry, and other unionized industries, than foreign competition. Nucor and its imitators did more damage to the traditional steel industry than did foreign competition. With commodity products, low price wins, and Nucor lowered the costs of creating steel significantly.
? In the analysis of what industries could face pension problems next, she did not consider banks and other financial institutions. Most of those DB plans are very well-funded. Why? They understand the compound interest math, and the variability of the markets. But what if the current market stress led to financial firms cutting back on their plan contributions?
? She gets to municipal pensions at the end, and spends a little time there, but those face bigger funding gaps than most private plans. Also, she could have spent more time on Multiple Employer Trusts, where funding issues are also tough, and plan sponsor failures leave the surviving plan sponsors worse off.
? She also thinks that if you stretch out the period of time that companies can contribute in order to fund deficits, it will make things better. In the short run, that might be true, but in the intermediate term, companies that are given more flexibility tend to get further behind in funding DB pensions.
The book could have spent more time on changes in investing within DB pension plans, which are drifting away from equities slowly but surely, in favor of less liquid investments in private equity and hedge funds. How that bet will end is anyone’s guess, but pension investors at least have a long time horizon, and can afford the illiquidity. My question would be whether they can fairly evaluate the skill of the managers.

Summary

This book describes the motives of all of the parties in DB pension issues very well, and why they tend to lead to DB plan terminations. There are possible solutions recommended at the end, but in my judgment they might save some plans that are marginal, but not those that are sick. If you are interested in the topic of pensions, buy the book, and if you buy it through the links above, I get a small commission. (If you buy anything through Amazon after entering from a link on my site, I get a small commission. That?s my tip jar, and it doesn?t raise your costs at all.)

Blog Outage

Posted on 23 April 2008 by David Merkel

Apologies for no post last night.? It is rather disconcerting to find the database of my website corrupt, and wonder whether I will have anything of it left.? If anyone has any recommendations on good hosting providers, I am all ears.

In the “what is coming up” file, I have the following ideas that I am working on:

Several book reviews.
A piece on ETFs
Monetary policy 101
Fundamentals of Market Bottoms
Intraday trading — does not seem to follow a random walk
What of strategies that need continuous liquidity?
Fixing the title of my blog, so that clicking it takes one to the home page

That’s all for now.? Thanks for reading my posts, and interacting with me, even though I find it difficult to keep up with the flow of e-mails.

National Atlantic Notes, Part II

Posted on 22 April 200822 April 2008 by David Merkel

National Atlantic has filed its Preliminary Proxy Statement. I’m only going to tackle one part of it here tonight — the section starting on page 24, “Opinion of the Financial Advisor.” Those who have read me for a long time know that I am neither biased for or against any “fairness opinion.” For those who want to go back to my early days on RealMoney, you can view what I wrote on the MONY acquisition by AXA. The fairness opinion was correct, and the contesting value investors were dead wrong. Part of the problem was not understanding the insurance accounting.

With National Atlantic, I think the fairness opinion does not truly represent the value of the company. Let me go through a few critical bits of the fairness opinion:

(Page 26)

     Selected Publicly Traded Companies Analysis. Banc of America Securities
reviewed publicly available financial and stock market information for National
Atlantic and the following seven publicly traded personal lines property and
casualty insurance companies with a market capitalization below $2.5 billion:

        o   Mercury General Corporation
        o   State Auto Financial Corporation
        o   Horace Mann Educators Corporation
        o   Infinity Property & Casualty Corporation
        o   Safety Insurance Group, Inc.
        o   Donegal Group, Inc.
        o   Affirmative Insurance Holdings, Inc.

Banc of America Securities reviewed, among other things, per share equity
values, based on closing stock prices on March 7, 2008, of the selected publicly
traded companies as a multiple of calendar years 2008 and 2009 estimated
earnings per share, commonly referred to as EPS, and as a multiple of book value
per share as of December 31, 2007 (in the case of Safety Insurance Group and
Affirmative Insurance Holdings, as of September 30, 2007).

Affirmative and Infinity do not belong in this group, because they are both nonstandard auto writers, which get lower valuations than standard writers. Donegal is mainly a commercial writer when last I looked… the rest are fine. I might have included Gainsco, Commerce Group, or Universal Insurance Holdings. In any case, it biases the calculation of the estimated price low.

     Implied Per Share Equity Value Reference Ranges for National Atlantic         Consideration
     ---------------------------------------------------------------------         -------------

          2008E EPS                                    2007 Book Value
       ---------------                               -------------------

        $3.27 - $4.20                                   $5.24 - $7.85                   $6.25

It also would have been better to do a scatterplot of Price-to-book versus expected ROE on compared companies. I will have to perform that analysis eventually.

(Page 27)

Selected Precedent Transactions Analysis. Banc of America Securities
reviewed, to the extent publicly available, financial information relating to
the following twenty selected transactions involving property and casualty
insurance companies with a transaction value below $500 million:

Announcement
Date Acquiror Target
- --------------- -------------------------------------------------- -----------------------------------------

2/20/08 o Meadowbrook Insurance Group, Inc. o ProCentury Corp.
1/3/08 o QBE Insurance Group Ltd. o North Pointe Holdings Corp.
4/4/07 o Fortress Investment Group LLC o Alea Group Holdings Ltd.
3/14/07 o Argonaut Group, Inc. o PXRE Group Ltd.
12/4/06 o Elara Holdings Inc. o Direct General Corp.
11/22/06 o Clal Insurance Enterprises Holdings Ltd. o GUARD Financial Group Inc.
11/13/06 o Tower Group Inc. o Preserver Group Inc.
10/31/06 o American European Group, Inc. o Merchant's Group Inc.
10/6/06 o Affordable Residential Communities Inc. o NLASCO, Inc.
10/3/06 o Affirmative Insurance Holdings, Inc. o USAgencies, L.L.C.
9/28/06 o Arrowpoint Capital Corp. o Royal & Sun Alliance Insurance
8/16/06 o QBE Insurance Group Ltd. o One Beacon Insurance Group, Ltd.
8/4/06 o Delek Group, Ltd. o Republic Companies Group, Inc.
7/19/06 o Inverness Management L.L.C. o Omni Insurance Group Inc.
11/4/05 o General Motors Acceptance Corp. o MEEMIC Insurance Company
5/22/03 o Liberty Mutual Holding Company Inc. o Prudential Financial Inc.
5/22/03 o The Palisades Group o Prudential Financial Inc.
3/26/03 o Nationwide Mutual Insurance Co. o Prudential Financial Inc.
11/1/00 o American National Insurance Company o Farm Family Holdings, Inc.
10/25/00 o State Automobile Mutual Insurance Company o Meridian Insurance Group, Inc.

The only deal here that would truly be a “comparable” might be Republic Companies. It was a company that was mainly a personal lines company, unlike many of the rest of these deals which are for commercial insurers and reinsurers (I am not familiar with all of them). Republic was sold significantly over its book value. And, where is Commerce Group? I know it is too big to meet the cutoff, but there is a sale of a single state insurer. I would think that valuation would be relevant.

                 Implied Per Share Equity Value
              Reference Ranges for National Atlantic            Consideration
            ------------------------------------------        ------------------
               2008E EPS             2007 Book Value
            ----------------       -------------------

             $5.36 - $6.30             $8.51 - $9.82                $6.25

So, I think these values are low as well. There is far more certainty to the valuation of the reserves of a short-tailed insurer, which usually deserves a higher valuation.

(Page 28)

     Discounted Cash Flow Analysis. Banc of America Securities performed a
discounted cash flow analysis of National Atlantic to calculate the estimated
present value of the standalone unlevered, after-tax free cash flows that
National Atlantic could generate during National Atlantic's fiscal years 2008
through 2012 based on the National Atlantic management forecasts. Banc of
America Securities calculated terminal values for National Atlantic by applying
terminal forward multiples of 7.0x to 9.0x to National Atlantic's fiscal year
2013 estimated GAAP earnings and of 0.40x to 0.70x to National Atlantic's
estimated 2012 year-end book value. The cash flows and terminal values were then
discounted to present value as of March 7, 2008 using discount rates ranging
from 15% to 17%. This analysis indicated the following implied per share equity
value reference ranges for National Atlantic as compared to the Consideration:

             Implied Per Share Equity Value
          Reference Range for National Atlantic             Consideration
     -----------------------------------------------  --------------------------
                       $5.42 - $7.42                            $6.25

I’d like to see them spill the guts of the calculation, and the other calculations above as well. Using “0.40x to 0.70x to National Atlantic’s estimated 2012 year-end book value” and “discount rates ranging from 15% to 17%” is too severe. This is a company with no debt. It’s marginal cost of capital, using the “pecking order” theory is low. Also, short-tail P&C companies under competent management teams don’t retain valuations below 0.8x book.

     Run-off Analysis. Banc of America Securities also performed a run-off
analysis of National Atlantic to calculate the net present value of dividends
that would be paid to shareholders over the remaining life of the company
assuming that it serviced its existing policies without writing any additional
policies or renewing any existing policies. Based on the assessment of National
Atlantic management that the company would not be permitted to pay annual
dividends by the New Jersey regulators, this analysis calculated the net present
value of the final dividend available for distribution to shareholders after all
payouts on loss reserves and losses on unearned premium reserves, estimated to
be approximately $88.0 million payable in 2016. Banc of America Securities
applied a sensitivity analysis to assess a range of values if the loss reserves
were inadequate by up to 10% or were overstated, showing a redundancy of up to
10%. The range of final dividend distributions were then discounted to present
value as of March 7, 2008 using discount rates ranging from 13% to 17%. This
analysis indicated the following implied per share equity value reference ranges
for National Atlantic as compared to the Consideration:

             Implied Per Share Equity Value
          Reference Range for National Atlantic             Consideration
     -----------------------------------------------  --------------------------
                      $1.36 - $3.60                             $6.25

Again, the discount rate is too high. Beyond that, they make the fatal assumption that the company can’t close its books until 2016. If National Atlantic stopped writing policies today, then, one year from today, it would receive its last premium. The company would operate with a skeleton staff for one more year, after which, the remaining book could easily be sold to a company specializing in run-offs. You wouldn’t get your money in 2016. It would be more like 2010. Six years of interest discount at 13-17% makes a huge difference in the price.

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I have more work to do here, but my fundamental view is not changed. I will be voting against the deal, and encouraging others to do the same. Should the deal succeed, I will likely file for appraisal rights. As I have noted before, I believe that I have meritorious arguments for a better price.

Full disclosure: long NAHC SAFT

The Financings of Last Resort, Part II

Posted on 22 April 2008 by David Merkel

When I wrote my last piece, “The Financings of Last Resort,” I did meant to add that this will be a common phenomenon for a year or so. Pretend you are part of a senior management team of a credit-sensitive financial institution, and your worst nightmare is slowly unfolding in front of you. You’re looking looking at delinquency and loss statistics stratified by year of issuance (“vintage”) and time since issuance. Every vintage since 2003 looks worse than the prior year, and the loss seasoning curves are all pointed upward — in the early vintages, mildly, and in the 2006-2007 vintages, wildly.

You are seeing current losses come through, and they are erasing much of current profits, or, creating crushing losses if you try to get ahead of the loss curve and put in sufficient reserves to handle likely future losses. Any loan loss estimate toward the beginning of a “bust” phase is a wild guess, and management teams are often behind the curve as they hope that the most recent data point was a statistical fluke.

But management teams often think along two tracks. The first is the “best current estimate,” which they give to the market through GAAP accounting. The second is “What if things get bad, and we run short of capital? Better to get financing now, while our stock price is relatively high, and bond and preferred spreads low.”

That reasoning drives two types of capital raising — financings of last resort, and protective financing. That second class of financing was what I commented on at Felix Salmon’s blog regarding JP Morgan.? Borrow when you can, not when you have to.? Get in front of the loss curve, not behind it.

But, for those that are behind the curve, the financings of last resort are protective, at least for a little while, of management teams and bondholders.? Consider the actions at:

But who loses? Current stockholders get diluted.? I can imagine the management consoling their consciences with the thought, “Yes, the stockholders lose, but what would they get in bankruptcy if things got worse, and we didn’t raise capital?”

So, even if credit-sensitive financial companies avoid going broke, they may not be good equity investments because of the dilution.? I said that early on with the financial guarantors.? The big guys are still alive, but their stock prices are down significantly.? (Oh, and note that the regulators like this approach.? No public funds get used.? No embarrassing front page insolvency news.? “What was the regulator doing?”)

How long will this continue?? Financings of last resort can go on until the stockholders rebel and throw out management (hard to do), or the estimated net present value of the profit stream of the company is negative; no one will finance that.? (Think of ACA Capital Holdings, maybe.)? The nature of a financing of last resort is that the financier hands over cash in exchange for cheap equity that can be recycled into the market.? It’s a coercive way of doing an equity or debt offering, and requires a significant discount to current financing valuations.

So, how long will the bailouts go on?? I think for quite some time, which I why I am avoiding that area of the market.? Avoid the equity “fire sales” if you can.? Remember, management teams usually know more than the average analyst when it comes to knowing the true value of cash that can be generated from illiquid assets.? So when you see financial firms pursuing liquidity during a time of debt deflation, don’t be a hero — avoid those companies.

Angry Freeholders?

Posted on 19 April 200820 April 2008 by David Merkel

After seeing the website Angry Renter, I considered my own position in the matter, because I’m not in favor of bailouts either.? I own my home free and clear, and I paid off my mortgage well in advance of when I had to.? I own a house smaller than I could afford, and with eight kids, sometimes I wish I had chosen otherwise.

But I love our little hovel, and wouldn’t have it any other way.? That said, there would be reason for people like me to be annoyed at any bailout.? I stayed within my means; I sacrificed other goals to own my home free and clear of any encumbrances.

Here is my version of the Angry Renter graph, with one major modification.? Using data from First American (LoanPerformance), I estimated what percentage of homeowners will be vulnerable if home prices fall another 10% or so.? They fall into my “under stress” bucket.? My view of the situation is this — over the next two years, with a fall in housing prices of 10%, roughly 12% of the housing stock of the US will be in a negative equity position, and more so, if one considers closing costs.

Remember, default in housing means negative equity in a sale, plus a negative life event: unemployment, death, disability, disaster, or divorce.

The problem is bigger than Anger Renter represents, which is why the politicians will do something (though it will likely be ineffective).? Politicians care about the banks, also… bank failures are not conducive to a happy economy.? Renters tend to not have much political clout, because they aren’t usually well-off.? My view is that Angry Renter as a movement goes nowhere.? Now, if you could get the relatively well-off freeholders involved, that could be another thing, but, I still think opposing a bailout would fail politically — politicians care about the banks.