Category: Accounting

The Humility of Realism — II

The Humility of Realism — II

Posted on by David Merkel

This post is supposed to be a kind of “catch up” post, where I write about a number of small things that I thought were interesting, but weren’t worth a full post.

1) The government can’t fund everybody. The recent backup in the US treasury note market is a great example of that.? As the demands for funds now in exchange for funds later has increased, Treasury interest rates have risen.

I have several biases, but one of them is that the Government can’t unilaterally create prosperity.? It can create conditions that encourage economic activity, through predictable and fair laws, but it can’t make us immediately better off through deficit spending, or tax-and-spending.? The Government does not know what is needed to a better degree than its citizens do individually.

But let the government fund or guarantee everybody.? When they do that, there is just one overleveraged credit that matters, and it will fail, taking us with them.

2) Equity Private is one clever lady.? Fair value accounting primarily exists to deal with investments that are as volatile as equities. How are publicly traded equities valued?? At market.? How about volatile assets where the value is derivable from market prices?? They should be valued at pseudo-market.? If we were back in the old days, and all of our assets were bonds, we wouldn’t need fair value accounting.? Even if we did it, the values wiould not vary much. ? But when you slice and dice the various pieces of bonds, the volatile bits jump around a lot.? To value them at their initial value is ridiculous, the value is too volatile.

3) Felix is right.? There needs to be more of a debate over bank nationalization. I’ve written my pieces there, influenced by the better regulations of the insurance industry, and how they deal with insolvencies.? Mark assets to market.? Do the triage.? Send insolvent institutions to RTC 2, and take stakes in some marginal institutions.? That is where the money will do the most good.

4) “We have to buy up assets that are selling at fire sale prices.? We will even make money for the taxpayers.” So go the arguments of those that want to create a “bad bank”.? Oh, please.? Profits are rare in bailouts.? They happen by happy accidents, a la Chrysler (80s, not now), which possibly could have made it without a bailout.

Assets are at fire sale prices because there is not enough balance sheet capacity to buy and hold them over a period where the realization of value is likely.? I’ve seen structured assets rated AAA where the collateral is okay, and the likely realization of value is in the 90s, if you can hold it for 5 years.? Where does it trade?? Around $60.? Another asset, which would likely be worth $35 if it could be held for 15 years, where does it trade?? It doesn’t trade, but you could get rid of it to a broker for zero.

Strong balance sheets can’t be created out of thin air, though.? Remember how formidable Fannie and Freddie used to be, or many of the FHLBs?? Strong balance sheets only exist through investments where the cash flows will not be needed for decades, like pension and endowment plans.

5) Some commentators complain that the current crisis destroys the concept of efficient markets, because a trust in markets led us to failure. Oh please.? First, all of our markets were by no means free from government mismanagement, and many of the distortions came from poor regulation.? Our dear government had many lending programs pre-crisis, and even more post-crisis.? They further encouraged the increase in debt through the tax code.

Why is debt finance tax deductible, and equity finance not?? What might the system have been like if interest payments could not be deducted on taxable income, but dividends could be?? Leverage would have been a lot lower, and the system would be a lot more stable.

Market efficiency means many things.? In the short run, it means that no one can do better than the current situation. In the intermediate-to-long term, markets are efficient in a different way.? They reveal problems that need to be solved.? Some might call those market failures but they aren’t.? In the present crisis, the invisible hand is saying to us: reduce debt levels; your economic system in too inflexible.? The visible hand, the government, says: “Have some more of the hair of the dog that bit you.? We need lower mortgage rates.? We need more consumer lending.? We’re going to borrow more than ever before in an effort to create prosperity.”? Caroline Baum takes a similar view, and as usual, she expresses it well.

Market efficiency does not mean things are trouble-free, but it gives us sharper incentives to solve our problems.? Some things become revealed as truly public goods that the government needs to regulate.? But that is not the majority of human actions.

6) AIG is one black hole for cash.? Selling or IPO-ing units during the bust phase, when valuations are compressed does not seem to be an optimal strategy here.? If all of the assets were sold, would there be enough for the junior debt or preferred shareholders to get paid?? (Forget the common.)? So, in the face of it, do they IPO partial stakes in enterprises, with an eventual end of IPO-ing or selling the whole thing later?? If so, there is little free cash flow being generated to pay down debt.

What this implies to me is that the huge loans that the government made to AIG will likely hang out there for a long time.? Is this the best use of the government’s credit?? I think not.? If there are still systemic risk issues, wall those off separately, and send the rest of AIG into liquidation.? The insurance units are intact; let others buy and manage them.? Speculating on a future boom in asset prices is not a reaonable government policy.? Hope is not a strategy.

7) It is simple to blame the US for the current global crisis.? Simple and wrong. The US deserves blame, true, but not even the majority of the blame, just a slightly larger than proportionate amount for its size.

But when China blames the US, it goes too far.? In the era of neo-mercantilism, China had political goals to achieve.? Industrialize the country.? Get surplus workers off of the farms and into the cities.? Keep the currency undervalued to support export-led growth.? Force savings through restrictions on imports.? As a result, suck in developed country debts and companies where strategically desirable and possible.? Do these deals in their currencies because of the need to keep the Yuan cheap.

China made its bed, let it sleep in it.? They knew that they were lending to the US in its own currency; it was a necessary part of the bargain to achieve their own goals.? Just as the mercantilists sucked in gold, and then found it to be less valuable than they imagined when they had to draw on it, so it will be when nations want to draw on the US dollar assets that they have hoarded.

=-=–==-=-=-=-=–=

My phrase, “the humility of realism” is meant to get us thinking about the system as a whole, and about the long-term consequences of societal actions, whether by the government or private parties.? Humility says that sometimes we have to say, “No, we can’t.”? It also says that we should think carefully about major policy actions, and not let ourselves get bullied by those who rush, shouting “crisis, crisis,” while quietly angling for their favored pet projects to get swept in while no one is looking.? Realism sometimes means the government has no good solutions, so it should inform the public that they aren’t omnipotent, and humbly say the crisis must be borne with grace.

The problems generated by the short-termism of the past three decades will not get solved by more short-term thinking.? The present rush to assure prosperity will not end well, in my opinion.

Against Bank Nationalization

Against Bank Nationalization

Posted on by David Merkel

With options, we often talk about them being in, out or at the money. When options are in the money, there is a high probability of receiving a payoff.? When options are out of the money, there is a low probability of receiving a payoff.? When options are at the money, it could go either way.

The same is true of banks.? There are some banks that were cautious during the boom era, and their underwriting stayed conservative.? There are others that were so aggressive that once the results of their sloppy underwriting/investing begin to be realized, it will be obvious that they are deeply insolvent.? Then there are those banks that hang in the balance.? Which way will they fall?? Will they survive or not?

I’m not in favor of blanket nationalization of banks.? My best example is the stupid move by Hank Paulson where he forced bailout money on a bunch of big banks, with no attention to whether they needed the money or not.

Who could use the capital?? The banks that have big holes in their balance sheets can’t use the capital, because it will just plug holes, and maybe it will not be enough.? Those that are healthy don’t need the money, and there is a public policy reason why the government should not forcibly buy stakes in solvent companies.? But those that are on the brink could really benefit from a capital injection.? Anything to remove the uncertainty, and the high cost of incremental capital due to uncertainty over survival.

My point is that our dear Government, should it decide to intervene in the banks at all, should aim its capital injections toward banks that are on the cusp of creditworthiness.? (On the cusp assuming that assets and liabilities are fairly valued).? Those that will likely eventually be dead should be declared dead, the assets absorbed by RTC 2 (in concert with the FDIC), and the liabilities absorbed by other local banks.? Those banks that are healthy should continue on.? Giving them more capital in order to lend more is a cute idea, but really, why should the government get involved if there is no crisis?? Many solvent banks are looking for quality borrowers now, and finding few of them.

An aside: Why are we giving money to bank holding companies? If there is trouble in the regulated subsidiaries there might be a reason to help there directly, after cutting off the subsidiaries’ ability to dividend back to the holding company (and watching transfer payments — a good transfer pricing accountant is worth his weight in gold.)? Let the unregulated subsidiaries die, and the holding companies too.? If there are excess assets of these entities let them be distributed through chapters 11 or 7 of the bankruptcy code.? I understand exceptions for systemic risk reasons, but if the operating regulated banks are firewalled, that shouldn’t be as big of a problem.

I’ve been a critic of the industry that I grew up in for a long time, but the state insurance regulators have a better handle on their companies than the banking regulators do from a solvency standpoint.? The insurance risk models work better, even though the companies are more complex.? Imperfect as the insurance risk-based capital models are, they captured much of the action.? The banking regulators did not get as much data, and did not see the damages that could occur in a real credit bust, because many were obscured by securitization and derivatives.

There is no need to nationalize the banking system.? Set up RTC 2.? Let the regulators look at the banks on an asset-by-asset basis, and analyze what the hard-to-value assets are worth.? Compare values across companies to make fair comparisons.? Do triage then.? Send the insolvent to RTC 2.? Pump some money into the operating banks that are marginal, after cutting off dividends to the holding companies.? Let the healthy banks look for opportunities on their own.

Our existing legal framework can deal with operating bank solvency problems.? We did not need something as big as TARP 1 to solve issues at the operating banks… but if we are profligate in handing out money to bank holding companies, then even TARP 2 might not be enough to deal with all of the mess.

-==–=-==–==-=-=–=-=-=

One more note: there have been times in insurance regulation where the regulators looked the other way and said to themselves, “Meh, the company is insolvent if we marked it to market today, but if I just give them a few years, operating profits will bail them out.? We didn’t pay close enough attention to the issues involved in the new assets they bought or new liabilities they issued, so I will be embarrassed in front of the Governor, legislators and media if this company goes down.? I will forbear for now.”

And, about half of the time, that strategy worked.? Half of the time it didn’t, leading to a deeper hole and deeper embarrassment.? In more than a few cases where it worked in the short run, in the long run, the management culture of a firm that survived did not learn the lessons of undue risk taking, and blew it up again.? Part of fixing the system is weeding out bad management teams.

So, when I see arguments that say, “Let the banks in trouble borrow at low rates.? The positive carry will bail out their balance sheets over a period of years,” I say, “Been there.? Done that.? Got the T-shirt, and a Polaroid of them drinking the Kool-aid.”

Why provide a subsidy in such a haphazard way?? Manay banks have spent a great deal of time and effort developing low-cost deposit bases, and rotten managements should now receive a low funding cost?? If banks know that the regulators will forbear, and even subsidize their incompetence, why shouldn’t they take the free option, and continue to speculate?? Let the RTC 2 deal with the problem, and let them borrow at Treasury rates.

Part of the need to collapse bad banks is a need to eliminate bad management teams.? Without that, the system will not reset properly as bad debts get cleared.? They will get cleared eventually, but what will the nation look like when it is done?? Will we still have the same level of property rights and the rule of law?? Will we have a currency that is worth anything?? If the last century changed the value of a dollar from a dollar to a few cents, what will happen with this century?

Book Review: Dear Mr. Buffett

Book Review: Dear Mr. Buffett

Posted on by David Merkel

This is not your ordinary Buffett book.? In one sense, that is because it is not a Buffett book.? When I read other early reviews on the web, I concluded that they hadn’t read the book.? I read almost all of the books that I review at my blog.? If I have not read the book, but have skimmed it, I tell you so in the first few paragraphs.? I also purposely avoid reading the stuff that the PR flacks include with the books.? I find it fascinating how many reviewers rely on the crutches provided.

Why is this not an ordinary Buffett book?? Because it concerns how an expert on derivatives came to know Mr. Buffett, and how the current crises were seen in advance by both of them.? This book’s greatest strength comes from its ability to explain the messes we are currently in.? No solutions, mind you, and Mr. Buffett ain’t handing out any of those either, but understanding how we got to where we are is of value, and Janet Tavakoli is nothing if not a good writer on those points.

There is a second theme — how a derivatives expert came to appreciate value investing.? After all, when short term investing is focused on a variety of arbitrage situations, why not think long, and look for long term capital appreciation?

In the book, much of the current crisis gets examined up through September 2008.? Unlike many, she was right in advance on many of the topics that would eventually bite us:

  • CDOs
  • Subprime mortgages
  • Hedge fund underperformance
  • Failing Financial Guarantors
  • And more…

She also disses the overrated Nassim Taleb, saying that the current events are not a “black swan,” but predictable, given the overage of leverage.? I agree, having written about these thing before the bust hit, while still admiring Taleb’s focus on nonlinearity and feedback cycles.

Janet Tavakoli and Warren Buffett share a similar philosophy on derivatives.? That is what motivates this book.

  • How can they be a systemic hazard?
  • How might one use them properly?

I heartily recommend this book.? One reading this will understand our current crisis very well, and will gain in his understanding of how our markets work.? That said, the virtues of the book do not come from Mr. Buffett, but from one who intelligently admires his views on derivatives and other matters.

You can buy the book here: Dear Mr. Buffett: What An Investor Learns 1,269 Miles From Wall Street

PS — I write book reviews, and I hope you like them, because unlike other reviewers, I read the books.? I use Amazon because their service is good, and they offer a fair commision to those influencing those that buy through them.? My view is that if you need to buy something through Amazon, entering the site through one of my links will not increase your costs, and I will get a small commission.? Thanks to all who buy on Amazon through me.

This is not an Accounting Blog, but…

This is not an Accounting Blog, but…

Posted on by David Merkel

I have argued before that the flawed accounting standards of the FASB are superior to those of the IASB.? I will argue that again, as IASB has compromised its integrity by giving in to the EC.? It is easy to give into pressure as firms with bad balance sheets scream for relief, presuming that markets don’t ignore the accounting, and assume that asset cash flows are inadequate to pay for liabilities.

EITF 99-20

Following Jack Ciesielski, I have written the FASB on EITF 99-20.? Here is what I wrote:

Sirs,
Accounting is properly done using discounted cash flows, rather than management judgment.? The value of an asset is the cash flows that it will likely generate, discounted at a rate appropriate for the risks thereof.? I am a life actuary, and I believe that where cash flows can be reasonably projected, that forms an adequate basis for calculating the value of assets.
So, don’t change EITF 99-20.? It provides better guidance than a management’s judgment would.
Sincerely,
David J. Merkel, CFA, FSA
There are no perfect accounting rules, and cheaters will always find a way to abuse the rules.? Management judgment can be a good thing where cash flows can’t be reasonably estimated, but where cash flows are clear, managements should discount them at rates appropriate to their risk.
Fair Value Accounting — It Is What It Is

Fair Value Accounting — It Is What It Is

Posted on by David Merkel

I’ve written on mark-to-market accounting before.? Searching my blog, I was surprised to find how many pieces I have written in 2008 on the topic.

So, it’s interesting to me to see the FASB interested in continuing with Fair Value accounting, despite all of the criticism.? It’s not to say that MTM accounting is perfect — all accounting methods are approximations and are imperfect, but does it convey the best information needed for investors to make? reasonable decisions, at an acceptable cost?

If MTM accounting were proposed in the ’80s it would never have been approved.? The value of common financial instruments did not usually change much; unless an equity had a public market, revaluations occurred only for reasons of impairment.? But derivatives and structured security prices vary considerably, and their prices often vary in a way that approximate valuations can be calculated from the prices of other publicly traded securities.

Now, that many financial companies trade below their net worth is a proof in this environment that investors don’t trust the value of the assets, nor their earning power.?? Many assets have not been marked down to their fair value.

I will defend SFAS 157, and the other mark-to-market accounting standards, but I won’t defend an application of them that is too rigid.? When trades are infrequent, and there are strong reasons why the security deserves a different value than last trade, then let the security be marked to model.? It is the best that can be done.? But merely that a security is at an unrealized loss for several years should not in itself be a reason to mark the security down, if the management concluded that it was “money good.” (they get their principal back.)

The mark-to-market rules as stated have flexibility in them, aiming for a fair statement of the net worth of the firm.? Given the nature of the investments and hedges employed, this is a good thing if done properly and fairly.

Can these rules be used to distort accounting?? Of course, in the short run.? In the intermediate-term, the errors catch up, and destroy the cheater.? In the long run, cash flows determine the value of a business.

So, be wary in the present environment.? Just because a financial institution trades below book value does not mean that it is cheap.? Much of the cheapness stems from the opaqueness in pricing of unique risks.

The challenge is analyzing what an asset is truly worth, and when that value can be realized.? That is the challenge with financials today.

The Credit Crunch at Play

The Credit Crunch at Play

Posted on by David Merkel

(graphic obtained here, by enrevanche)

I’ve subscribed to The Economist for 22 years.? IN my opinion, it is the best English language newsweekly in the world.? Every now and then they toss a game into the magazine.? This time, the Internet aids the game, in that you can download cards, money, pieces, and rules.

This evening, three of my eight children said they wanted to play the game with me.? How it happened: I had printed out the money, cards, pieces and rules, and I had The Economist open to its centerfold, and the one who recently scored well on the National FInancial Literacy challenge saw it and asked what it was.? I told him it was a game from The Economist, and that if he made the effort to cut the pieces of paper and get the pieces together, we would play the game.? Two other children joined in, and we started the game.

Now, ay my house, you learn about the markets atmospherically.? As one of my kids said, who is not markets-oriented, “Yeah, in school neither the teacher nor the students understood what was going on in the economy, but I was able to explain it.”? (That floored me.)? As for the children that played with me this evening, it was filled with “Dad, what does it mean by…?” and laughter over the concept of naked short selling, especially given the graphic on the board.? There were a lot of “teachable moments” from a home schooler’s point of view.

The board and cards are filled with the clever humor of KAL, The Economist’s main cartoonist.? The kids picked up the copious easy humor, while I smiled at the nuances that they missed.? We have not finished the game yet, and two of my other children have said they want to play the next game.? One more aspect of the game: it starts in an intensifying boom cycle, and moves to an intensifying bust cycle.? The business cycle concept is definitely taught.

The length of the game seems to be an hour at minimum, and I’m not sure what the maximum could be.? Already the children are learning aspects of negotiation.? After one child went bankrupt for the second time, she received a buyout offer, a contingent debt offer in exchange for a “Get out of Chapter 11 free” card, and a free offer of money with the condition that if she went bankrupt again, she would sell out for a price fixed now.? She chose the contingent debt offer, and we all said she made the right move.

It may not be Monopoly, but it’s a fun game, and it is free.? Give The Economist and KAL credit for a clever game that sheds some light on the current crisis in a fun way.

Twenty Comments on the Current Economic Scene

Twenty Comments on the Current Economic Scene

Posted on by David Merkel

1) There are firsts for everything.? Americans paid down debt for the first time, according to a Federal Reserve Study that started in 1952.? America has always been a pro-debt and pro-debtor nation.? It goes all the way back to the Pilgrims, who paid back the merchant adventurers who funded them at a rate of nearly 40%/yr over a 15-20 year period.? But, the Pilgrims did extinguish the debt.? Us, well, I’m amazed at the decrease, but we need more of that to restore normalcy to financial institutions.

2) Dropping to 45%, though, is the amount of aggregate home value funded by equity.? With the decline in housing values, the fall in the ratio was inevitable.? The low ratio puts downward pressure on home prices, because it means that more homes are underwater.? Perverse, huh?

3) It’s a long interview, but Eric Hovde (my former boss) has a lot of important things to say regarding the financial sector.? Few hedge funds focused on financials remained bearish on the sector, but Hovde’s funds survived to 2007-2008 where his bets paid off.

4) Is there a Treasury bubble?? Yes, but it may persist for a while because of panic, central bank buying, buying from pension funds and endowments, mortgage hedging, and more.

5) Now these same low yields whack Treasury money funds. How many will close?? How many will cut fees?? How many will break the buck, and credit negative interest?? An unintended consequence of monetary policy.? Another unintended consequence reduces liquidity in the repo markets.? Yet another unintended consequence is the reduction in investment from Japan and other nations that don’t want to hold dollars at low rates.

6) Brave Ben Bernanke is fighting the Depression.? If his theories are right (and mine wrong), if he succeeds, he will face a difficult challenge in collapsing the Fed’s balance sheet as inflation re-emerges, without taking the wind out of the economy.? But if I’m right (or London Banker, or Tim Duy, or Stephanie Pomboy) things could be considerably ugly as the situation proves too big for the Fed and the US Government to handle.

7) Inflation is the lesser evil at this point.? It would raise the value of collateral over the value of the loans, dealing purchasing power losses to those that made the bad loans, but not nominal losses.

8 ) I have said before that the Fed and Treasury are making it up as they go, and Elizabeth Warren now confirms it for the Treasury.? My Dad (turned 79 yesterday) used to say, “The hurrier I go, the behinder I get.”? So it is for the TARP bailout.? Policy made hastily rarely works.? Spend more time, get it right.? The market won’t die as you work it out.

9) But will AIG die, or the automakers?

10) Even VCs are looking at the survivability of their portfolio holdings.? Who can survive and become cash-flow positive in a tough environment.? Who needs little additional funds?

11) Leveraged loans are attractive, but it is a situation of too many loans with too few native buyers.? Watch the loan covenants, so that you can get good recoveries in a default.? If you are an institutional investor, this is a place to play now that will deliver reliable returns net of defaults.? For retail investors, the closed end funds typically employ too much leverage — it is possible that one could collapse before this crisis is over.

12) Residential mortgages continue to weaken along with property prices.? Two examples: Alt-A loans and second mortgages.

13) I have a lot of respect for Dan Fuss.? This is a tough time for anyone taking credit risk.? That said, it could be a good time to take on credit risk now, if you have fresh money to deploy.

14) Two views of the crisis: one that focuses on structured finance, particularly CDOs, and one that focuses on macroeconomics.? I favor the latter, but both have good things to say.

15) Michael Pettis is one of my favorite bloggers.? He notes the weakness in China, and notes that the current economic situation is ripe for trade disputes.

16) You can give the banks funds, but you can’t make them lend.? Would you lend if you didn’t have a lot of creditworthy borrowers?

17) The export boom is dead, for now.? Fortunately, imports are falling faster, so the current account deficit is falling.

18) I blinked when I saw this Wall Street Journal Op-Ed.? Sorry, but the secret to changing the residential real estate market is not lowering interest rates, but writing-off? portions of loan balances.? Most delinquents can’t make even reduced payments, half re-default, and can’t refinance because the property is underwater.? Yes, I know that the government is pressing to have Fannie and Freddie suck down more losses by letting underwater loans refinance, but if you’re going to do that, why not be more explicit and let the losses be realized today by resetting the loan’s principal balance to 80% of the property value, and giving the GSE a property appreciation right on any growth in the home value on sale, of say 150% of the amount written down?

19) On commercial property, when do you extend on a loan vs foreclosing?? In CMBS, if the special servicer has no bias, or if a healthy insurer/bank holds the loan on balance sheet, you extend when you are optimistic that this is just a short-term difficulty with the property, and you think that the property owner just needs a little more time in order to refinance the loan.? More cynically, extensions can occur in CMBS because the juniormost surviving class directs the special servicer to extend because it maximizes the value that they will get out of their investment, because a foreclosure will wipe out a portion of their interests, since they are in the first loss position.? With a less than healthy bank or insurer, the same procedure can happen if they feel they can’t take the loss now.? (I know that in a extension/modification there should be some sort of writedown, but some financial entities find ways to avoid that.)

20) Time to go bungee jumping with the US Dollar?? As Bespoke pointed out, the Dollar Index has just come off its biggest 6-day loss ever.? Should we expect more as the US heads into a ZIRP [zero interest rate policy], with aggressive expansion of the Fed’s balance sheet, much of which might be eventually monetized?? The best thing that can be said for the US Dollar is that it is already in ZIRP-land, and much of the rest of the rest of the world is being dragged there kicking and screaming.? As the interest rate differentials narrow in real terms, the US Dollar should improve.

But, there are complicating factors.? Future growth or shrinkage of the demand for capital will have an impact, as will future inflation rates.? Even if the whole world is in a global ZIRP, there will still be differences in the degree of easing, and how much easing the central bank allows to leak into the money supply.

This is a mess, and over the next few years, expect to see a whole new set of metrics develop in order to evaluate monetary policies and currencies.? For now, put your macroeconomics books on the shelf, because they won’t be useful for some time.

The Occasional Seemingly Free Lunch

The Occasional Seemingly Free Lunch

Posted on by David Merkel

hmf asks, “David – if possible, whenever you have a chance, could you please explain why there is any spread whatsoever between govt-guaranteed bank-issued debt (e.g., the GS TLGP bonds) and comparable treasuries.? It would seem they’re one and the same – thus no default risk.? Thank you very much!”

I left a comment on this on John Hempton’s blog, who also addressed this question.? The comment is still in moderation, so I will attempt to recreate my argument.

There are many US Government securities, some of which are “Full Faith and Credit” [FFC] that trade with a spread over on-the-run Treasury securities:

  • Off-the-run Treasuries trade at a discounted price (higher yield) due to illiquidity.? Note: On-the-run securities are the ones that have recently been issued.? They are often used by Wall Street for hedging purposes in other bond issuance, which adds to the liquidity (most of the time).
  • Title XI shipping bonds (full faith and credit) trade at a spread to a ladder of similar maturity Treasuries.? They are less liquid, but there is usually good demand for this paper.
  • Aid to Israel and TVA bonds are full faith and credit [FFC] and usually trade at a spread over Treasuries.
  • Overseas Private Investment Corp bonds (FFC) often trade at a spread over Treasuries.? I once bought some OPIC put bonds where the option adjusted spread was 2% over Treasuries.? I had to buy the whole issue, so, again, it was illiquid, because anyone you would try to sell it to you would have to educate them on the bond.? Not easy, why should the seller trust your explanation, particularly as you no longer want the bond?? (That’s what brokers are for…)
  • I used to manage a portfolio of Credit Tenant Leases.? Most of my leases were on buildings leased by agencies of the US Government, and the lease payments were not subject to appropriation, so I did not have to worry about the budgeting process of Congress.? These were not FFC, I had a cut-through claim to the lease payments; I had priority over the building owner in getting paid.? If the US were to fail to pay, I had recourse to the building owner (can’t squeeze blood from a stone, though), and failing that, I could take possession of the building.? So with a hard asset behind the loan, I was doing secured lending to the US Government, and getting 1.5-2.0% over Treasuries to boot.? Though the CTLs were fungible, they were definitely illiquid.? But when you think about the extra spread versus the possibility of loss — the property was high quality, the return was disproportionate to the risk.
  • Another [not FFC] piece of paper was a first mortgage note on a building that served a critical government purpose, where the government could not move because of old computers which they could not move due to fragility and security reasons.? We got roughly 3% over Treasuries in a small deal where I ended up buying 20% of the issue.
  • Are Fannie and Freddie guaranteed by the government?? They seem to be, but you can pick up an additional 100-140 bps if you lend to them.

So, it’s not unusual for FFC securities to trade at spreads over Treasuries.? And, it is normal for pseudo-government securities to so trade.? But it is weird for the 3+ year Goldman Sachs securities to be issued at 2.2% over the relevant Treasury security.? It’s not an illiquid issue — $5 billion is a big deal.? There is a little structural complexity, but it is in the nature of a financial guarantee from the government.

There is the matter as to whether the Government would ever selectively default on FFC guaranteed issues, but the courts would have something to say on that, unless Congress deleted their authority on the matter.? You can’t fight city hall; you certainly can’t fight the US Government, and it has been behaving erratically of late.

So, if I were managing insurance/bank assets, would I buy these issues with a FFC guarantee from the FDIC.? Yes, all day long unil I was full of them.? The reasons cited for not buying them don’t add up, and they seem really cheap.? I would use them as a substitute for Treasury and Agency securities.

PS — A note to the new administration: want to save money?? Easy.? Create a capital account for the budget, and borrow using Treasuries to buy the buildings that you use.? Don’t do CTLs anymore.

Here’s a bonus idea off of yesterday’s post.? Offer longer-dated floating-rate debt indexed to 3-month T-bills.? It would be a TIPS substitute, and cheaper.

Update: 10/27 10AM: Bond Newbie is correct. TVA securities are not FFC — I slipped on that one because of a project that I worked on long ago, and my knowledge was garbled. Here is an incomplete list of all FFC securities:

  • Farmers Home Administration Certificates of beneficial ownership
  • General Services Administration Participation certificates
  • U.S. Maritime Administration Guaranteed Title XI financing
  • Small Business Administration Guaranteed participation certificates and Guaranteed pool certificates
  • Government National Mortgage Association (GNMA) –? GNMA-guaranteed mortgage-backed securities, and GNMA-guaranteed participation certificates
  • U.S. Department of Housing & Urban Development Local authority bonds
  • Washington Metropolitan Area Transit Authority Guaranteed transit bonds

If anyone knows where there is a full list, I would be happy to post it.

Fifteen Notes on the Markets

Fifteen Notes on the Markets

Posted on by David Merkel

1) Where are we?? Is the equity market cheap or dear?? Personally, I think it is cheap, and though it might rally in the short run, it could get cheaper.? When the financials are compromised, all bets are off.? Here are some article indicating that things are cheap:

And, not cheap, consider the arguments of this humble student of the markets.? He considers survivorship bias and war as factors that investors should consider.? I agree, and I would urge all to consider that wars often occur as a result of economic crises.

2) The trouble is, quantitative finance is tough.? We don’t have enough data.? Our models are poor, and until recently, often reflected two major bull cycles, and only one bear cycle.? My view is that the equity premium is more like 3% over the long run, and not the 6% bandied about by careless consultants.

3) During the “great moderation,” I argued over at RealMoney that volatility and credit spreads were too low, and would eventually snap back.? Okay, we are there now.? Volatility is high, and so are credit spreads.? The brain-dead VAR models used by Wall Street have been falsified again.? Quantitative investors have gotten savaged again; it only works when implied volatility is flat/declining — it is an implicit credit bet.

4) This is a global crisis.? Where is it appearing?

5) As I have mentioned before , the IMF, previously seeming irrelevant, has a new lease on life.? But how much firepower do they have, and will countries in crisis send them money to aid foreigners?

Consider their new plans for a short term lending facility, and the exogenous shocks facility.? They will have a lot to fund in this environment.

6) Might government programs to guarantee bank deposits have caused a shift from stocks to bank deposits?? Possible, though for every seller, there is a buyer.

7) How do we pay back what we borrow?? Who will borrow more from us?? Those are? the great unanswered questions as we attempt to bail out many troubled entities.? I’m a pessimist here, and think that we will have higher long rates as a result, and that “Bernanke” will become a cuss word.? (Among the cognoscenti, only “Greenspan” will do as a proper insult.)? On the despondent side, will the US default in 2009?? Doom-and-gloomers are always early, and ignore the flexibility in the financial system prior to failure.? I see default as more of a 2017-2020 issue.

8 ) Uh, let Lawrence Meyer pontificate.? There is nothing good about a zero Fed funds rate.? Let him wax grandiloquent about Japan over the past two decades.? Consider how low interest rates destroy money markets funds.? Consider as well how much low rates destroy saving, sometyhing that we have had too little of.

9) In an environment like this, every M&A deal is open to question.? M&A is credit sensitive, and higher volatility impairs the flow of credit.

10) I don’t think that GAAP mark-to-market accounting has had a material impact on this crisis.? True, many accounting firms have interpreted mark-to-market as mark-to-last-trade, but that is not what SFAS 157 specifies, and firms can ignore their auditors (with some risk).? The truth is that the firms that have failed choked on bad balance sheets and inadequate cash flow.? It doesn’t matter what the accounting rules are when a company is running out of cash.? Cash is impervious to accounting rules.

11) Want a closer view of the Fed and politics.? Read this piece at The Institutional Risk Analyst.? While at RealMoney I espoused a view that the Fed was more political than economic.? This article confirms it.

12) How do I view Greenspan’s apology?

13) At a prior employer, we often commented that credit risk in credit cards appears late in the credit cycle.? Well, we are there now.? It is seemingly the last form of credit to default on.? In this environment, one can lose their home, but losing financial flexibility can be bigger.

14) The FDIC can modify many mortgages, at a cost to taxpayers.? It could cost a lot, and many people who made dumb decsions could be bailed out by the prudent.

15) If John Henry were alive, he would be smiling.? Let humans make markets, and not machines.

Recent Portfolio Moves

Recent Portfolio Moves

Posted on by David Merkel

Since I wrote my last portfolio update two months ago, it is time for a new report.

New Buys

  • PartnerRe
  • Allstate
  • Assurant
  • Nucor
  • Genuine Parts
  • Pepsico
  • CRH
  • Alliant Energy

New Sells

  • Avnet
  • Lincoln National
  • YRC Worldwide
  • CRH
  • Jones Apparel
  • Assurant
  • Group 1 Automotive
  • Smithfield Foods
  • MetLife
  • International Rectifier
  • Cemex
  • Officemax
  • Universal American

Rebalancing Buys

  • Shoe Carnival
  • Charlotte Russe
  • Devon Energy (2)
  • RGA
  • SABESP
  • Ensco International (2)
  • Industrias Bachoco
  • Magna International
  • Valero
  • Kapstone Paper
  • Hartford International (3)
  • Cimarex Energy
  • Lincoln National
  • Smithfield Foods
  • Allstate
  • ConocoPhillips (2)
  • Tsakos Energy Navigation

Rebalancing Sells

  • PartnerRe
  • Safety Insurance
  • Devon Energy
  • Ensco International
  • Hartford Financial (3)
  • Kapstone Paper
  • Cimarex Energy
  • Nam Tai Electronics (2)
  • Honda Motors (2)
  • Lincoln National (2)
  • ConocoPhillips
  • Charlotte Russe
  • Shoe Carnival

I’ve had a lot of trades over the past two months, which is normal for me when volatility rises.

I have been asked by a number of parties why I don’t write about the insurance industry in this environment, given my past experience.? My main reason is that I have left it behind.? When I became a buyside insurance analyst, I had strong opinions about what made a good or bad insurance company.? For the most part, those opinions were correct, but there is a fundamental opaqueness to insurance.? One truly can’t analyze it from outside.? No boss would hear that, even if true.

I benefitted from the cleaning up of insurance assets 2002-3, and thought that the cleanup had persisted.? Largely, it has, but many life companies rely too heavily on variable products for profitability, and as the market has fallen, profits from variable products have fallen harder.? Thus my mistakes with Hartford, MetLife and Lincoln National.

That brings up two other possibilities where things can continue to go wrong in life insurance.? If fees are permanently reduced the companies might have to write down the deferred acquisition costs [DAC] that they capitalized when originally writing the business, if the expected cumulative fees are less than the DAC.? The second issue is hedging the guaranteed living benefits.? I will never forget the look that the CEO of Principal Financial gave me when I asked him how well the futures/options hedges during a month where the S&P 500 is down 20-30%.? It was not a pleasant look.? Not that that scenario could ever happen. 😉

My picks in pure P&C insurance have fared better.? Safety Insurance is a solid company; so is PartnerRe.? Would that I had done more there, and less in life companies, especially the equity sensitive ones.

So what do I hold today among insurers?

  • Allstate
  • Assurant (bought after the marginally bad earnings announcement)
  • Hartford (yes 🙁 )
  • PartnerRe
  • Reinsurance Group of America
  • Safety Insurance

Yes, I am overweight insurance, and I have paid the price, particularly with Hartford.? There is an uncertainty connected with life insurance holding companies about the ability to upstream dividends to service debt.? That uncertainty only appears in bear markets, and all the hubbub over optimizing the capital structure is so much hooey.? Assurant is in better shape because it ceased buying back stock because of the (somewhat bogus) investigation of a few of their executives.

Two final notes to close.? I had a bad October, worse than the S&P 500 by a significant margin.? My exposures in life insurance and emerging markets drove that.? Second, I may have my first equity client, and so I may be curtailing some of my discussion of individual names in my portfolio, and deleting my portfolio at Stockpickr.com.? My clients come first.

Full disclosure: long ALL AIZ HIG PRE RGA SAFT SCVL CHIC COP HMC NTE XEC KPPC ESV DVN TNP VLO MGA SBS CRH LNT PEP GPC NUE (what have I left out?!)

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