David Merkel – Page 291 – The Aleph Blog

Society of Actuaries Presentation

Posted on 13 October 200720 June 2017 by David Merkel

Finishing off the presentation proved to be harder than I estimated, together with all of my other duties.? Well, it’s done now, and available for your review here.? For those looking at one of the non-PDF versions, you might be able to see the notes for my talk as well.

I’m writing this before I give the talk.? If I had it to do all over again, I would have made the talk less ambitious.? Then again, of the four topics that I offered them, they picked the most ambitious one.? When you look at the talk, you’ll see that it is a summary of the macroeconomic views that frame my investment decisions.? The presentation will run 40 minutes or so, plus Q&A.? Reading it is faster. 🙂

Enjoy it, give me feedback, and I’ll be back to normal blogging Monday evening.

Learning Little Letters for Little Ones

Posted on 13 October 2007 by David Merkel

Years ago, I created a spreadsheet to help young children learn their lowercase letters once they had learned their uppercase letters.? I created it for my two oldest, and now my youngest is using it.? My wife says that it has made that teaching task simple.

The spreadsheet generates seven unique random letters in uppercase on the left, and scrambles them in lowercase on the right.? Print a sheet, and the child draws lines to match the letters.? Hit the recalc [F9] button, and you have a new sheet.? With a little bit of coaching, the child gets the concept in a week or so.? The sheets are easy to use, and the limited matching doesn’t overload their ability to remember, particularly because a few letters on each page will be easy.

If it works well for you, let me know.

Almost Done With The Presentation

Posted on 11 October 2007 by David Merkel

The Society of Actuaries presentation is a “labor of love” piece.? When I say that, I mean that it took a lot of effort to think through and put together.? If you have a subscription to RealMoney, you can look through the articles on my Major Articles List.? Most of them are still relevant today.? I wrote long-dated pieces for RealMoney that would stand the test of time.? For what they paid me, they really got their money’s worth. 🙂

I don’t have a lot to say tonight.? I’ll be back to regular blogging tomorrow evening, because my presentation will be done.

If Hedge Funds, Then Investment Banks

Posted on 10 October 2007 by David Merkel

I’m still flooded by my workload, so just one comment this evening.? The Wall Street Journal posts an article on overly favorable (and smoothed) returns at hedge funds through securities that are mismarked favorably.? It was no surprise to naked capitalism, and no surprise to me either (point 26).? I’ve been writing about this issue off and on for three years now, because economic processes are messy, and tend to generate messy returns, not smooth returns, particularly once the easy arbitrages are glutted with yield-seeking investors.? Also, I know what the temptation is to mismark illiquid bond positions when incentive payments may be riding on the result (which is why we took the marking out of our hands at a prior firm).

Having been an actuary in financial reporting for twelve years, I know what the pressure is when someone above you in the hierarchy asks if your reserve is wrong.? It is rarely asked when the reserves are too low.? Few managements are so farsighted.? It is always asked when income is too low, and adjusting reserves downward is so convenient.? And who will notice?? Few, I’m afraid, but most actuaries I know are highly ethical, and resist these pressures.

My target here not insurance companies, though, but the investment banks.? Actuaries have detailed rules for setting reserves.? We have societies and ethics codes.? Those who work at the investment banks are not typically CFAs, which is more of a buy-side thing, so there is no industrywide ethics code there.? Also, the value setting rules for many investment banking assets and liabilities are far more squishy than for insurance liabilities.? Finally, investment banks frequently hold the same instruments as the hedge funds, and get their pricing marks from the same sets of sources.? I suspect that the positions are similarly mismarked, and they are big enough to hide it, because derivative books are never unwound.

Well, almost never.? Buffett phrased it well in his 2005 Annual Report: (pp. 9-10)

Long ago, Mark Twain said: ?A man who tries to carry a cat home by its tail will learn a lesson that can be learned in no other way.? If Twain were around now, he might try winding up a derivatives business. After a few days, he would opt for cats.

We lost $104 million pre-tax last year in our continuing attempt to exit Gen Re?s derivative operation. Our aggregate losses since we began this endeavor total $404 million.

Originally we had 23,218 contracts outstanding. By the start of 2005 we were down to 2,890. You might expect that our losses would have been stemmed by this point, but the blood has kept flowing. Reducing our inventory to 741 contracts last year cost us the $104 million mentioned above.

Remember that the rationale for establishing this unit in 1990 was Gen Re?s wish to meet the needs of insurance clients. Yet one of the contracts we liquidated in 2005 had a term of 100 years! It?s difficult to imagine what ?need? such a contract could fulfill except, perhaps, the need of a compensation conscious trader to have a long-dated contract on his books. Long contracts, or alternatively those with multiple variables, are the most difficult to mark to market (the standard procedure used in accounting for derivatives) and provide the most opportunity for ?imagination? when traders are estimating their value. Small wonder that traders promote them.

A business in which huge amounts of compensation flow from assumed numbers is obviously fraught with danger. When two traders execute a transaction that has several, sometimes esoteric, variables and a far-off settlement date, their respective firms must subsequently value these contracts whenever they calculate their earnings. A given contract may be valued at one price by Firm A and at another by Firm B.

You can bet that the valuation differences ? and I?m personally familiar with several that were huge ? tend to be tilted in a direction favoring higher earnings at each firm. It?s a strange world in which two parties can carry out a paper transaction that each can promptly report as profitable.

I dwell on our experience in derivatives each year for two reasons. One is personal and unpleasant. The hard fact is that I have cost you a lot of money by not moving immediately to close down Gen Re?s trading operation. Both Charlie and I knew at the time of the Gen Re purchase that it was a problem and told its management that we wanted to exit the business. It was my responsibility to make sure that happened. Rather than address the situation head on, however, I wasted several years while we attempted to sell the operation. That was a doomed endeavor because no realistic solution could have extricated us from the maze of liabilities that was going to exist for decades. Our obligations were
particularly worrisome because their potential to explode could not be measured. Moreover, if severe trouble occurred, we knew it was likely to correlate with problems elsewhere in financial markets.

So I failed in my attempt to exit painlessly, and in the meantime more trades were put on the books. Fault me for dithering. (Charlie calls it thumb-sucking.) When a problem exists, whether in personnel or in business operations, the time to act is now.

The second reason I regularly describe our problems in this area lies in the hope that our experiences may prove instructive for managers, auditors and regulators. In a sense, we are a canary in this business coal mine and should sing a song of warning as we expire. The number and value of derivative contracts outstanding in the world continues to mushroom and is now a multiple of what existed in 1998, the last time that financial chaos erupted.

Our experience should be particularly sobering because we were a better-than-average candidate to exit gracefully. Gen Re was a relatively minor operator in the derivatives field. It has had the good fortune to unwind its supposedly liquid positions in a benign market, all the while free of financial or other pressures that might have forced it to conduct the liquidation in a less-than-efficient manner. Our accounting in the past was conventional and actually thought to be conservative. Additionally, we know of no bad behavior by anyone involved.

It could be a different story for others in the future. Imagine, if you will, one or more firms (troubles often spread) with positions that are many multiples of ours attempting to liquidate in chaotic markets and under extreme, and well-publicized, pressures. This is a scenario to which much attention should be given now rather than after the fact. The time to have considered ? and improved ? the reliability of New Orleans? levees was before Katrina.

When we finally wind up Gen Re Securities, my feelings about its departure will be akin to those expressed in a country song, ?My wife ran away with my best friend, and I sure miss him a lot.?

I could go on about this, but it’s late.? There are other weaknesses in the system as well.? A good rule of thumb is that whenever there is a lack of natural counterparties, there will be pricing difficulties.

Closing comment: When I was at a Stable Value conference in 1994, I ran into some investment bankers and talked to them about this topic.? I asked them how they hedged their synthetic wrap exposures.? They said they didn’t hedge because it was riskless “free money.” I pointed out the scenario under which they could lose money, and asked how their auditor could sign off on the lack of the hedge.? Their comment went like this: “When we find an auditor capable of auditing our derivative books, we hire him and pay him ten times the salary.”

In a world like that, who knows what problems may lurk in the derivative books, because the auditors stand a better chance of figuring out the truth than the ratings agencies and regulators.

Tickers mentioned: BRK/A, BRK/B

Swamped With Work, but Here’s a Dozen Observations

Posted on 9 October 2007 by David Merkel

I’m swamped with putting the finishing touches on my talk for the Society of Actuaries, so this post will be brief.? When it’s done, I’ll be posting it here for all of my readers.? When the transcript gets published, I’ll post that as well, but that takes a while.

A few observations, some of them obvious, because we’re at an interesting juncture in the markets now:

The equity markets are near new highs.? Who’da thunk it?
Equity implied volatilities have returned to a semi-normal state, and corporate credit spreads have tightened, but lagged.
Fixed income implied volatilities look high.
Fed policy, if LIBOR, narrow money, or the monetary base is the measure, hasn’t worked that well.
Fed policy, if the stock market or total bank liabilities is the measure (credit expansion), has worked pretty well.
The dollar has bounced, but I would expect it to retrace the losses.
We’re experiencing a small period of macroeconomic quiet amid the start of earnings season.? Earnings season should be good overall, with weakness in housing-related areas, and strength in export-related areas.
Banks should be able to end the logjam in the LBO debt markets.? The cost is feasible.
Residential real estate prices are still weakening, and provide most of the drag on the US banking system and economy.
Inflation is rising with many of our trading partners; the US may begin absorbing some of it.
Our trading partners are going to have to choose between controlling their interest rates, and following US policy, or letting their exchange rates rise further.
In this environment, I am trimming my equity portfolio slowly as positions hit the upper end of their trading bands.? 20% of the portfolio is within 5% of the upper rebalance point.? Almost nothing is within 10% of my lower rebalance point, so I’m not likely to add anytime soon.

The Next Portfolio Reshaping Starts

Posted on 6 October 2007 by David Merkel

Every 3-4 months, I do a comprehensive review of my portfolio, comparing all of my current companies to a set of potential buy candidates.? The buy candidates come from all sorts of sources, and I do my best to forget who gave them to me, so that I can approach them fresh.? Here are the candidates:

ACH ADP AHN AIB AIG AKR AMGN APA ARP ATI BBD BBV BJS BK BLL BMA BMO BP BTU BWA CAH CCK CCRT CENX CHT CMI CNQ CNX CODI COF COG CPA CPL CR CRI CRK CS CTL CVH CVX CW CXW DDS DEI DFS DRC DSX DVN ECA EIX EMC EOG EPD EQ EXP FCX FLR FLS FRX FWLT GFI GLYT GNI GOL GOLD GR GSB GSF HCC HD HDL HGRD HLX HSR IBCP IM IMOS INFY IR IRE ITU IVN JCI JCP JEC JNJ JOYG JRT JWA KBW KEG KFT KMP LM LMT LNT LOW LSI MBT MBWM MDR MEOH MER MI MMC MOS MPG MRO MU MVO NBR NC NCI NEM NOV NTRS OXY PBR PBT PCH PCL PCZ PG PMD PNC POPEZ POT PPC PTI PXP QTM R RAIL RDY REXI RHI RIO RRD RS RTP RWT RYN SAN SBR SDA SE SGR SGY SII SKX STD STT STX STZ SVVS SYNT T TBSI TD TEN TEVA TEX TLM TRS TSO TTM TWIN UBS UFS UG UHT USB USG USTR VCP VIP VIV VSL VZ WDC WFC WHG WLL XTO XTXI

Alphabet soup, I’ll tell ya.? Here’s where we go from here:

Update my industry models.
Run a screen off of the results of the industry models to pick up a few more ideas.
Scrub the quantitative data for errors.
Run my ranking system.
Fundamentally analyze the top buy candidates to find a few good buys.
Look at the bottom of my current companies in the rankings to decide what I sell to fund the buys.

And, if you have a company you’d like to toss into the mix, let me know.? I’ll toss it in.? This process should complete sometime in the week that begins on 21st, because I need to finish up preparations for a speech that I am giving on the 15th.

Many tickers mentioned, but I own none of them.

Deerfield Triarc Revisited

Posted on 6 October 2007 by David Merkel

I am basically at breakeven, and above my tough rebalancing buy in August.?? I bought lower as well.? My view is that Deerfield returns to book value ($13) or above, because the market for prime and AAA whole-loan mortgage backed securities is improving.

It would not surprise me to hear that repo margins return to prior levels, which would benefit Deerfield Triarc.? The market for low risk mortgage collateral has returned.

There is disagreement over whether the merger with the asset manager is a good thing or not.? I favor the merger, because I think CDOs have a future.? That said, if it happens or not, I won’t be harmed much.

My view is this: at 73% of book, there is significant value to obtain here.? The company is not going broke.? I will only sell my full stake when the company trades over book.

Full disclosure: long DFR

Cut-throat Anagrams

Posted on 5 October 20075 October 2007 by David Merkel

A dear friend of mine introduced me to this game, which I play with my kids every now and then. All you need is a set of Scrabble tiles. You place all of the tiles face down, and swirl them around. The dealer (ordinarily the best player, so it distracts him), flips one tile at a time. When enough tiles are flipped to create a word of at least three letters, the first player to name the word claims it, and takes it for himself.

Play continues, with more tiles flipped, but there are two choices now for the tiles that are face up. You can use the tiles to create new words, or combine them with existing words of yours, or words of your opponents. Suppose your opponent has the word “ham,” and there are an “s” and an “e” on the board. The player that calls out “shame” claims the tiles from “ham” and creates the word “shame” in his field. Stealing the words of opponents is often more effective than creating new words, though there is a balance to be maintained. It is also wise to boost the letters in your own words, which makes them harder to steal. Additional note: the letter orders can be rearranged. If “gun” and “one” have been claimed by players, and there is a “d” on the board, a player could take the two words for the word “dungeon.”

Play ends two minutes after the last tile is flipped. Additional rules:

No proper nouns
No foreign words, unless they are in common use in English discourse.
Appeal to an unabridged dictionary is permitted for words in dispute.
Blanks are wild cards, but the first time a blank is played, it stays that letter for the remainder of the game.

Scoring: each word gets points equal to the number of letters minus two.

Benefits of the game: children learn to think along multiple lines of strategy and structure words in ways that they don’t commonly consider. It is a real mind-stretcher. An aside: this is a game where speed of thought helps but is not determinative. Having a large vocabulary helps, which benefits the grownups.

Nine Points on the International Scene

Posted on 5 October 2007 by David Merkel

1) In an open economy, you can control your exchange rate or your interest rates, but not both.? The first time I learned that was late 1986, when the Dollar crashed, then the bond market crashed (May 1987), then the stock market crashed(October 1987).? This article from Morgan Stanley goes over the same idea.? Pay attention to the investment? implications at the end, though Hong Kong may have already rallied enough.

For a more bearish view, many Asian economies are facing the choice of slowing their economies, or importing inflation from the US. My sense is that we are in an uptrend for inflation globally.? Few central banks are truly pursuing sound currencies.

2)? Europe is no monolith here.? Managing the ECB is some trick, because money is political, and there is monetary union without political union.? The Swiss Central Bank continues to tighten, while the Bank of England effectively loosens, because of the recent panic there, involving Northern Rock.

3) One of my favorite observations about technical analysis is that slow moves tend to persist, while fast moves tend to mean-revert.? Well, the US dollar is having a grinding, slow adjustment downward. ? To me, that is just another indicator that the decline will persist.

4) Will the Saudis drop the dollar peg?? Maybe.? Given the current inflation rate there, I would suspect that they, and other Persian Gulf nations, will move to a currency basket approach that has a high US Dollar weighting.? That will allow themselves the flexibility to make further adjustments that allows them to arrest inflation.? That will lead to further declines in the dollar against other currencies.

5) What makes a currency attractive?? GDP growth and high real (inflation-adjusted) interest rates.? The US has neither of those now.

6) An old dear friend of mine, Roy Hallowell, had two merciful rules: a) We all make mistakes.? We ALL make mistakes. b) Most of them are like the rest of them.? Such is Goldman Sachs Global Alpha.? They played too much on the carry trade and got burned, among other bad trades.

7) I am not a bear on emerging markets as a group.? There are some running bad monetary and fiscal policies that I would avoid (Latvia, Iceland, Bulgaria, Turkey, and Romania are examples).? But in general, many of the emerging markets are not dependent on US conditions to the same degree that they were before.? Many are in better shape to face volatility than the US.

8)? Given the fall in the implied volatility of the yen, the yen carry trade is coming back.? The carry trade works best when implied volatilities are low, because the cost of protection against adverse moves is modest.? But, if low interest currencies persist in tightening, the carry trade could be a bad bet.? My thought : Japan is not tightening anytime soon, and? the carry trade continues there.? Switzerland goes the other way.

9) China is different.? So what’s happening?

They continue to raise rates to slow down their economy.
Shades of Nixon: they are attempting price controls.? (Well, only Nixon could go to China. 🙂 )
They raise the minimum mortgage downpayment to cool the economy.
The Chinese banking system still can’t stand on its own.? It’s not as bad as it was, but it still needs more of a capital cushion to be more certain of survival.
They have punished over 3000 government officials for illegal land transfers.? And we complain about eminent domain.? On the bright side, perhaps the Chinese government finally realizes that property rights are necessary to a healthy economy.

That’s all on this topic for now.

Ten Notes on Our Funky Federal Reserve

Posted on 4 October 200722 June 2017 by David Merkel

1) Fed chatter has gotten a little quieter, so maybe it is time for an update.? Let me begin by saying in an era of detailed press releases from the Fed, many analysts spend more time parsing phrases than looking at the quantitative guts of monetary policy.? This article from Mish, which cites this article from Gary North is close to my views, in that they are looking at what is happening to the critical variables of the money supply.

2) For another example, Look at the discount window.? That has faded as a factor over the past two weeks.? You have to dig into Dow Jones Newswires just to hear about this.? The discount window is back to being a non-entity.

3) Review his book.? Cite his article.? Though I think the FOMC will loosen more, I agree that it should not be loosening.? The Fed will overstimulate healthy areas of the economy, while sick areas get little additional credit; that’s how fiat monetary policy works.? (Maybe I should review James Grant’s The Trouble With Prosperity?)

4)? I may not vote for him, but I like Ron Paul.? He is one of the few economically literate members of Congress. Thus I enjoyed his question to Ben Bernanke.? I favor a sound dollar, and risk in our system.? It keeps us honest.? Without that, risk taking gets out of control.

5) Now, onto the chattering Fed Governors.? Consider Donald Kohn, a genuinely bright guy trying to spin the idea that the Fed is not to blame for residential real estate speculation.? He argues that much of the speculation occurred while the FOMC was tightening.? Sorry, but the speculation only cut of when the FOMC got rates above a threshold that deterred speculation because positive carry from borrowing to buy real estate disappeared, which finally happened in September of 2005, when the FOMC was still tightening.

Or, consider Fed Governor Frederic Mishkin, who thinks that troubles in the economy from housing can be ameliorated by proactive FOMC policy.? If his view is dominating the Fed, then my prediction of 3% fed funds sometime in 2008 is reasonable.

But no review of Fed Governor chatter would be complete without the obligatory, “Don’t expect more rate cuts.”? They don’t want their policy moves to be impotent, so they verbally lean against what they are planning on doing.? This maximizes surprise, which adds punch to policy moves.

6)? Consider foreign central banks for a moment.? I’ll probably write more about this tomorrow, but a loosening Fed presents them with a problem.? Do they let their currencies appreciate, slowing economic growth, or do they import inflation from the US by cutting rates in tandem?? Tough decision, but I would take the growth slowdown.

7) What central bank has had a rougher time than the Fed?? The Bank of England.? When push came to shove, they indicated that they would bail out a large portion of the UK banking system.? Northern Rock financed a large part of their assets via the Bank of England during their crisis.? This just sets up the system for greater moral hazard in the future.

8) Now the CP market is returning to health; almost all of the questionable CP has been refinanced by other means.? Now, money market funds are better off than they were one month ago, but all of the issues are not through yet.? Some money market funds contain commercial paper financing subprime CDOs.? Now, the odds are that the big fund sponsors would never let the ir funds break the buck.? They would eat the loss.? That’s not a certainty though so be aware.

9) This article is the one place where the Fed lists most of the Large Complex Banking Organizations [LCBOs — pages 32-33].? Some suggest that this is the “too big to fail list,” though by now, it is quite dated.? On the bright side, it correlates highly with asset size, so maybe a list of the 20 largest bank holding companies in the US would serve as well.

10) We end with Goodhart’s Law, which states that “any observed statistical regularity will tend to collapse once pressure is placed upon it for control purposes.”? My way of saying it is that trying to control a system changes the system.? The application here is that when the Fed tries to affect the shape of the yield curve by FOMC policy, it eventually stops working.