Category: Accounting

Ten Points on the Global Economy: The Diminishing US Dollar

Ten Points on the Global Economy: The Diminishing US Dollar

Posted on by David Merkel

Back after a hiatus of sorts.? I should have a piece on my portfolio reshaping coming on Monday or so.? Tentatively, what I find fascinating, is that I have so many shoe and retail names near the top of my list.? Oh, and a few mortgage REITs, if they make sense… 🙁

But on with this morning’s topic, which deals with global macroeconomic pressures.? A few of the articles are a month dated, most are current, but this is meant to illustrate the pressures that the economy is under.

  1. Let’s start with the good news, ECRI still doesn’t see a recession on the horizon.? They’re pretty accurate, so I give them room, and mute my own views.
  2. That doesn’t mean there aren’t significant pockets of weakness.? Mortgage equity withdrawal is a spent factor, so to speak, and it ripples through current consumption and housing price weakness.? The less equity available, the less to pad consumption, and the less buying power for homes.? Credit card default rates are worsening, which can’t be good for buying power either.? On the low end of the income spectrum, many Hispanic workers are finding it hard, and that affects Wal-Mart, among other retailers on the low end.? That said, I have read that the Hispanic immigrants are much less likely to default on their mortgage loans than non-immigrants with similar credit characteristics.
  3. CLSA predicts a record gold run, and so far, gold is cooperating.? That said, it will take a lot more to get gold to $3400/ounce.? We would need a real dollar collapse, and not this slow grinding selloff.? That said, the grinding selloffs tend to persist; more on that later in this post.
  4. Of course, we could look at the price of wheat, or even just the price of stuff.? If it deals with food or energy, two items that are core to almost everyone’s budget, prices are rising.? John Wasik repeats a number of my arguments for why core CPI does not represent the diminution of the average person’s buying power.? I’m honestly surprised that no one has made a campaign issue out of honesty in inflation statistics so far.? It helped Reagan versus Carter in 1980.
  5. That said, maybe we should be grateful that fuel grade ethanol is in surplus, at least temporarily, because we can’t distribute it to the end consumers efficiently.? Maybe not.? It’s no good for price to go down, if it only indicates lack of effective end-demand.
  6. Oil at $90/barrel?? It’s partly a US dollar phenomenon (new trade-weighted low today), but not just a US dollar phenomenon.? In Euros, as I measure it, it’s a new high there as well, just not by much.?? Now, when a critical commodity becomes scarce, it tends to attract wars, kidnapping, sabotage, etc., because bargaining power goes up as the price of the commodity goes up.? (Think of “blood diamonds” for another example…)? So we see pipeline sabotage, graspy politicians wanting a bigger cut of the royalties (no, not Chavez this time), and tensions between the Turks and the Kurds.? This leaves aside issues in Nigeria, and other aspects of supply disruption.
  7. Now if that’s not enough, Western oil companies, which are often shut out of places where goverment monopoly oil companies tread, are finding less oil, and find that they have to buy back stock because of a limited number of places to invest in new fields.? Now, perhaps OPEC has the same problem, but it manifests differently.? They’re making a lot of money also, and don’t want to plow it into too many new projects, for fear of killing the price.? So what do they do with the free cash flow?? Their governments buy US Treasuries and other US debt claims, closing the money loop and financing the US current account deficit.
  8. Well, maybe not entirely, though.? We had a glitch in capital flows in August, and foreigners sold more US securities than they bought by a significant margin.? Can’t help but think that it led to more pressure on the US dollar.? That said, the books have to balance: foreign capital inflows must balance the current account deficit over the intermediate term.? That doesn’t mean that they have to balance at the same price, though, just that the nominal values must balance at some implied exchange rate.? On the other hand, some nations are adjusting their currency baskets, like Vietnam and Qatar to reflect the lower value of the US dollar.? Quite a statement about their relative faith in their own currencies versus the US dollar.
  9. The US has not had a strong dollar policy for some time, despite protests to the contrary.? We are happier to see export industries prosper, US tourism prosper, and consumer buying power from abroad suffer.? My question is when we will see foreign governments notably uncomfortable.? We’re not there yet, which makes me think that the path for the US dollar is lower still.
  10. One final factor that doesn’t help: the size of the US budget deficit on an accrual basis.? Much larger than the stated deficit because of extra inflows to social security, and debt that doesn’t get counted because other government programs buy it to fund future liabilities.? Add onto that the wars which largely off-budget, and you have a significant present and future cash flow hole to cover.? Here’s to our children and grandchildren, who will have to pay it one way or another.
If Hedge Funds, Then Investment Banks

If Hedge Funds, Then Investment Banks

Posted on 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

Another Delisting — The Cost of Sarbanes-Oxley

Another Delisting — The Cost of Sarbanes-Oxley

Posted on by David Merkel

I know why Sarbanes-Oxley [SOX] came into existence: to give one of America’s least productive Senators a fitting legacy.? I think the legislation was perhaps well-intended, but on the whole, it has perhaps imposed more costs than produced benefits.? Today I am faced with one of the costs: Lafarge SA has delisted, and now trades on the pink sheets.? Now, big institutional investors will buy and sell shares of this fine firm on the Paris bourse, but I’m not big, so I end up with an illiquid nonsponsored ADR.? This is the third time this has happened to me since the passage of SOX, because my investing travels the world in a cheap way, through ADRs.

It has been said in many ways, but I will summarize it in this way: there is price, quantity, and quality.? You can at most regulate two out of three, and usually, it’s not wise for a government to regulate more than one variable at a time.? Often, it is wisest not to regulate, unless there are material problems in quality that ordinary people cannot verify, and yet ordinary people have a common need for (think of food safety, and our government does well at that, but could do better).

Large companies are complex, and the accounting is more so.? The personal burdens placed on the CEO and CFO are misplaced, in my opinion, and the degree of auditing/testing prior to SOX was adequate to catch most abusive situations.? Are financial statements higher quality now?? Yes, but at a cost: Higher accounting costs, particularly for smaller firms, more firms going private, and fewer foreign firms listed in the US.? (Note to those pushing for unification of GAAP and IFRS.? If you’re trying to get more listings in the US, it would be better to aim for reform of SOX.? If GAAP and IFRS are the same, and I were a medium-sized US firm, maybe I would list in London.)

There is a logical balancing point to regulation, and SOX tipped the balance, imposing more costs than the value of improvements in quality.

Full disclosure: long LFRGY (not LR 🙁 )

More on Fair Value Accounting

More on Fair Value Accounting

Posted on by David Merkel

Earlier today at RealMoney, I responded to a question in the Columnist Conversation. It was a longish post that tried to be complete, so I reprint it here:


 David Merkel
Mark-to-Management Assumptions
9/18/2007 1:50 PM EDT

Bob, Joe is essentially correct, but I’d like to add a little. From the Office of Thrift Supervision Examination Handbook (pages 137 & 138):

Observable Inputs – market participant assumptions developed based on market data obtained from sources independent of the reporting entity

Level 1 Inputs – Unadjusted quoted prices in active markets for the identical assets and liabilities that the reporting entity has the ability to access at the measurement date. Examples: Treasury bonds and exchange traded securities.

Level 2 Inputs – Other than quoted prices included in Level 1 that are observable for the asset or liability, either directly or indirectly. Level 2 inputs include quoted prices for similar assets or liabilities in active markets and quoted prices for identical or similar assets or liabilities in markets that are not active. Examples: loans traded within the secondary market and plain vanilla interest rate swaps.

Unobservable Inputs

Level 3 Inputs – Entity specific inputs to the extent that observable inputs are unavailable. Because there is little to no market activity, these inputs reflect the entity’s supposition about the assumptions of market participants based on the best information available in the circumstances. In those situations, the reporting entity need not undertake all possible efforts to obtain information about market participant assumptions. However, the reporting entity must not ignore information about market participant assumptions that is reasonably available without undue cost and effort. Examples: credit enhancing I/O strips and private equity securities.

Another way to phrase it is this:

  • Level 1 – publicly observable data
  • Level 2 – derived almost entirely from publicly observable data, and a commonly-used model
  • Level 3 – significant use of private firm-specific data, or public data not derived from the markets (think of a life insurance industry standard mortality table)

    • Now, I’m not a fan of SFASs 157 & 159, or any of the current statements dealing with intangibles. Even level 1 is subject to problems when markets are less liquid. I’ve known of situations where a bond manager found himself holding a disproportionate share of the market of a publicly tradable bond, where it almost never trades because he owns so much of the issue. Where do you mark that? That’s just level one!

    Aside from AAA securities, most asset backed bonds never trade. Level 2 comes into play here, because the dealers estimate a pricing grid from what few transactions take place. with “fair value” accounting, there is no way to avoid mark-to-model, but there are significant possibilities for error.

    The classic case of level 3 is how one estimates the changing value of private equity investments over time. Discounted cash flow anyone?

    As a result of the changes, we have to be a lot more careful in how we interpret the financial statements of financial companies. The game just got a lot more complex given the new fair value accounting rules.

    Position: none

    After I wrote that, a friend of mine e-mailed me saying that Private Equity accounting was for the most part conservative at present, but that there was some pressure to use fair value accounting to smooth results. He also thought the use of these methods wouldn’t make private equity correlate more closely with public equities. I think he is onto something there, and that could affect that amount allocated by pensions and endowments to private equity. On the flip side, if the returns are smoothed through these accounting methods, the standard deviation of returns would drop, which is a bigger effect than the correlation effect. So allocations might go up, and some Private Equity managers, believing the smoother returns, might be tempted to lever up more.

    One other note: I expect that companies with high percentages of level 3 assets will trade at discounts to relative to their peers. Accounting complexity and opaqueness always have valuation discounts. I see it in insurance for financial insurers, reinsurers, and long-tailed commercial lines. Uncertain assets and liabilities should always get lower valuations. Thus, aggressive users of fair value will wonder why their P/Es and P/Bs are so low. It’s because of the lack of ability of investors to verify the asset and liability figures used.

    The Longer View, Part 4

    The Longer View, Part 4

    Posted on by David Merkel

    In my continuing series where I try to look beyond the current furor of the markets, here are a number of interesting items I have run into on the web:

     

    1) Asset Allocation

     

    • Many people who want to stress the importance of their asset allocation services will tell you that asset allocation is responsible for 90% of all returns, so ignore other issues.? An article on the web reminded me of this debate.? The correct answer to the question, as pointed out by this paper, is that asset allocation explains 90% of the variability of the returns of a given fund across time, but only explains only 40% of the variability of a fund versus other funds.? Security selection matters.
    • Two interesting papers on asset class correlation.? Main upshots: historical correlations are not fully reliable, because risky assets tend to trade similarly in a crisis.? Value tends to march to its own drummer more than other equity styles in a crisis.? The effects on correlation in crises vary by crisis; no two are alike.? Natural resources and globa bonds tend to be good diversifiers.
    • In bull markets, risky asset classes all tend to do well.? Vice-versa in the bear markets.? My reason for this correlation is that you have institutional asset buyers all focusing on asset classes that were previously under-recognized, and are now investing in them, which raises the correlation level, not because the economics have changed, but becuase the buyers have very similar objectives.
    • There are a few good states, but by and large, public pensions are a morass.? Most are underfunded, and rely on future taxation increases to support them.? When a public system realizes that it is behind, the temptation is to take more investment risk by purchasing alternative asset classes that might give higher returns.? This will end badly, as I have commented before… I suspect that some state pension plans are the dumping grounds for a lot of overpriced risk that Wall Street could not offload elsewhere.

     

    2) Insurance

     

     

    3) Investment Abuse of the Elderly

     

    It’s all too common, I’m afraid.? Senior citizens get convinced to buy inappropriate investments.? Even the SEC is looking into it.? This applies to annuities as well, mainly deferred annuities, which I generally do not recommend, particularly for seniors.? The comment that a CEO doesn’t fully understand his own annuity products is telling.

     

    Now fixed immediate annuities are another thing, and I recommend them highly as a bond substitute for those in retirement, particularly for seniors who are healthy.

     

    The only real cure for these deceptive practices is to watch out for the seniors that you care for, and tell them to be skeptics, and to run all major investment decisions by you, or another trusted soul for a second opinion.

     

    4) Accounting

     

    • I am against the elimination of the IFRS to GAAP reconciliation for foreign firms.? What is FASB’s main goal in life — to destroy comparability of financial statements?? We may lose more foreign firms listed in the US, which I won’t like, but a consistent accounting basis is critical for smaller investors.
    • Congress moves from one ditch to the other.? This time it’s sale of subprime loans.? Too many modifications, and sale treatment is at risk, so Congress tries to soften the blow for the housing market.? Let auditors be auditors, and if you want the accounting rules changed, then let Congress do the job of the FASB, so that they can be blamed for their incompetence at a complex task.
    • As I’ve said before, I don’t like SFAS 159.? It will lead to more distortions in financial statements, because managements will tend to err in favor of higher asset and lower liability values, where they have the freedom to set assumptions.

     

    5) Volatility

     

    • Earn 40%/year from naked put selling?? Possible, but with a lot of tail risk.? I remember how a lot of naked put sellers got smashed back in October 1987.? That said, it looks like you can make up the loss with persistence, that is, until too many people do it.
    • Here’s an interesting graph of the various VIX phases over the past 20 years.? Interesting how the phases are multiyear in nature.? Makes me think higher implied volatility is coming.
    • I don’t think a VIX replicating ETF would be a good idea; I’m not sure it would work.? If we want to have a volatility ETF, maybe it would be better to use variance swaps or a fund that buys long delta-neutral straddles, and rebalances when the absolute value of delta gets too high.

     

    That’s all for now.? More coming in the next part of this series.

    Fifteen Notes on the State of the Markets

    Fifteen Notes on the State of the Markets

    Posted on by David Merkel

    1)? Start with the pessimists:


    2)? Move to the optimists:

    3) Hedge funds are getting outflows at present (and here), and August performance was pretty bad (and here — look at? “Splutter”).? I began toting up a list of notable losers, but it got too big.? One positive note, many of the large quant funds bounced back from their mid-August stress.

    4)? When muni bonds get interesting, you know it’s a weird environment.? It starts with the fundamental mismatch of muni bonds.? Muni issuers want to lock in long term financing, but most investors want to invest shorter.? Along come some trusts that buy long bonds and sell short-dated participations against them, and hedge the curve risk with Treasuries.? When credit stress got high, long munis were sold because they could be, and long Treasuries rallied, which was the opposite of what was needed for a hedge.? (Note: hedging with Treasuries can work in normal markets, but fails utterly in panics, as happened in 1998.)? When the selling was done, in many cases high quality muni yields were high than Treasuries even before adjusting for taxes.? That didn’t last long, but munis are still a good deal here.

    5) Large caps are outperforming small caps.? Foreign exposure that large caps have here is a plus.

    6) Not all emerging markets are created equal.? Some are more likely to have trouble because they are reliant on foreign financing. (Latvia, Iceland, Bulgaria, Turkey, Romania)? Others are more likely to have trouble if the US economy slows down, because they export to us. (Mexico, Israel, Jordan, Thailand, Taiwan, Peru)? I would be more concerned about the first group.

    7) Are global banks cheap?? Yes on an earnings basis, probably not on a book basis.? We need to see some writedowns here before the group gets interesting.

    8) I’ve talked about SFAS 159 before, and you know I think it is a bad accounting rule.? This article from my friend Peter Eavis helps to point out some of the ways that it allows too much freedom to managements to revalue assets up.? What I would watch in financial companies is any significant increase in their need for financing, which could point out real illiquidity, even though the balance sheet might look strong; this one is tough because financials are opaque, and the cash flow statement is not so useful.? Poring over the SFAS 159 disclosures will be required as well.

    9) As I have suggested, pension plans will probably end up with a decent amount of the hit from subprime lending, through their hedge fund-of-funds.

    10) Hedge funds do better if the managers went to schools that had high average SAT scores?? I would not have guessed that.? Many of the best investors I have known were clever people who went to average schools.

    11) My but bond trading has changed.? When I was a corporates manager, hedge funds weren’t a factor in trading.? Now they are 30% of the market.? Wow.? Surprises me that volatility isn’t higher.

    12) Rich Bernstein of Merrill (bright guy) is getting his day in the sun.? His call for outperformance of quality assets seems to be happening.? Now the question is whether the cost of capital is going up globally or not.? If so, he says to avoid: “1) China, 2) emerging market infrastructure, 3) small stocks, 4) indebted U.S. consumers, 5) financial companies, 6) commodities and energy companies.“? Personally, I think the cost of capital is rising for companies rated BBB and below, which brings it back to the quality trade.

    13) Econocator asks if markets have priced in a recession, and he says no. My problem with the analysis is that we would need 10-year Treasury yields in the 2.5% area to fully price it in by his measure, and that makes no sense, outside of a depression, and then, nothing is priced in.

    14) Morningstar moves into options research.? Could be interesting, though Value line has had a similar publication, and I’m not sure that the market for publications like this is big enough.? They make a good point that most people use options wrong, and get the short end of the stick.

    15) Oil is amazing, but wheat is through the roof.? I’ve seen articles about bread prices rising.? Fortunately, the cost of grain is a small part of the cost of foods that rely on grain.

    With that, I bid you good night.

    Eight Notes on Residential Real Estate

    Eight Notes on Residential Real Estate

    Posted on by David Merkel

    For those wanting a road map of where I am likely to post over the next few days, tonight is mortgages and real estate, tomorrow is speculation, and Friday should involve longer dated topics. For those that commented on the blog redesign, I want to say that I appreciated your comments, particularly the critical ones. In the next two months, I’ll be doing a minor redesign to fix some of the flaws that I introduced in the process. I’m not perfectly happy with the result, and it can be improved. Trivia: I co-edited the best high school yearbook in the nation back in 1979, so I do have some eye for design. It’s more of a question of the computer implementation.

    Onto real estate:

    1) After a bubble bursts, it’s amazing the details that come out on the ethical lapses that transpired. With Countrywide, people were steered into loans that were worse than what they might have qualified for there or elsewhere. Now, they should have shopped around; I always do that on mortgage loans. That Countrywide is still facing problems after the Bank of America infusion might not be too surprising; companies that cut corners with their customers are more likely to be aggressive in their accounting practices. After the post-bailout bounce, the convertible preferred that Countrywide got is now under the $18 strike price.

    CFC price chart

    2) Can the mortgage crisis swallow a town?? Yes.? I know this personally, as some friends of mine on the Eastern Shore of Maryland are finding out right now.? They are not in one of the best areas, and demand has dropped off a cliff.? Entire neighborhoods near them are in bad shape, making everything else less salable.? They need to sell their home for medical reasons, and they can’t do it without taking a loss, which would impoverish them.

    3) The internals of the housing market are now such that no one is arguing over the troubles faced.? Consider:

    4) But won’t the President and Congress bail out strapped homeowners?? Tough task.? Current proposals are just dust on the scales, and doing anything big would be a budget-buster.? I agree with Accrued Interest; a bailout is bad policy.? I suspect one will happen anyway.? Washington, DC specializes in bad policy, if it wins votes.

    5)? After a bubble bursts the second order effects can be quite significant.? Consider:

    6) Now, I wonder if Merrill Lynch will have any significant hits from subprime.? I would expect it, but who can tell for sure?

    7)? Was it such a good idea for the US government to promote home ownership so vigorously?? I have generally said no, and Caroline Baum questions the wisdom of the policy as well.

    8) Finally, we keep them in a bubble to make sure that their theories on how the economy works do not get contaminated by data.? I’m partly kidding here, but the Fed is very optimistic that any spillover from residential real estate to the general economy will be light.? I think the effect will be moderate; it will definitely hurt, but not destroy the US economy.

    Tickers mentioned: BAC CFC GS MER

    The Longer View, Part 2

    The Longer View, Part 2

    Posted on by David Merkel

    When the market gets wonky, I write more about current events.? I prefer to write about longer-dated topics, because the posts will have validity for a longer time, and I think there is more money to be made off of the longer trends.? Before I go there tonight, I would like to say that at present the Fed says that it is ready to act, but it hasn’t done much yet.? As for the Bush Administration, and Congress, they have done nothing so far, and the few credible promises are small in nature.? My counsel: don’t be surprised if the markets stay rough for a while.

    Onto longer-dated topics:

    1. Perhaps this should go into my “too many vultures” file, but conservative players like Annaly can take advantage of bargains produced by the crisis.? My suspicion is that they will succeed in their usual modest conservative way.
    2. Falling rates?? Falling equity prices?? Pension funding declines.? This issue has not gone away in the UK, and here in the US, the PBGC is still struggling.? As it is, FASB is facing the issue head on (finally), and the result will likely be a diminution of shareholders’ equity for most companies with defined benefit plans.
    3. China is a capitalist country?? Eminent domain can be quite aggressive there.? At least now they are promising compensation, but who knows whether the government really follows through.
    4. Any strategy, like quant funds, can become overcrowded.? As a strategy goes from little known to crowded, total returns rise and then flatten.? Prospective returns only fall as more and more compete for scarce excess returns.? As the blowout occurs, total returns go negative, and more so for the most leveraged.? Prospective returns rise as capital exits the trade.? Smart quants measure prospective return, and begin liquidating as prospective returns get too low.? Not many do that for institutional imperative reasons (investor: what do you mean cash is building up?? What am I paying you for?), but it is the right strategy regardless.
    5. This is a useful graph of sector weights in the S&P 500.? If nothing else, it is worth knowing what one is underweighting and overweighting.? I am overweight Energy, Basic Materials, Staples, Utilities, and (urk) Financials, and underweight the rest.? My portfolio, right or wrong, never looks like the market.
    6. I’ve written about SFAS 159 before.? Well, we may have a new poster child for why I don’t like it, Wells Fargo.? Mark-to-model is impossible to escape in fixed income, but I would treat gains resulting from changes in model assumptions as very low quality.? Watch SFAS 159 disclosures closely with complex financial companies.? If we wanted to repeat the late 90s headache from gain on sale accounting, we may have created the conditions to repeat the experience in a related way.
    7. How dishonest is the P&C insurance industry?? It varies, as in most industries.? Insurance is a bag of complex promises, which leaves it more open to abuse.? This article goes into some of that abuse, and teaches us to evaluate a company’s claims paying record.? You may have to pay more to get Chubb or Stancorp, but they almost always pay.
    8. China’s financial system is maturing slowly; one example of that is reduced reliance on bank finance, and issuing bonds directly.
    9. I don’t care what regulations get put into place, capitalist economies are unstable, and that’s a good thing.? There are always information asymmetries, and always crowd behavior, such that risk preferences change precipitously.? That’s the nature of the system.? The only true protection is to be aware of this reality, and adjust your behavior before things get crazy.
    10. A firm I was with had an early opportunity to invest in LSV and we didn’t do it.? The two members of our committee that read academic research thought we ought to (I was one), but the practical men of the committee objected to investing with unproven academics.? Oh, well, win some, lose some.
    11. Speaking of academic research, here’s a non-mathematical piece on cognitive biases.? Economists believe that man is economically rational not because of evidence, but because it simplifies the models enough to allow calculations to be made.? They would rather be precisely wrong than approximately right.
    12. Bit by bit, the efficient markets hypothesis get chipped away.? Here we have a piece indicating persistence of excess returns of the best individual investors.? For those of us that have done well, and continue to plug away in the markets, this is an encouragement.? It’s not luck.

    I have enough for two more pieces on longer dated data.? It will have to come later.

    Tickers Mentioned: NLY WFC CB SFG

    The Longer View, Part 1

    The Longer View, Part 1

    Posted on by David Merkel

    Here are some posts that have caught my attention over the last month, but I never commented on because of the increase in volatility placed more of a premium on covering current events.

    1. Will we ditch GAAP accounting for IFRS?? Personally, I don’t want to learn a new set of rules, but if it improves our ability to invest in a more global era, then maybe it will be a good thing.
    2. Do we care if we have auditors or not?? BDO Seidman recently got hit for damages of $521 million.? If this damage amount stands, it will bankrupt them, and possibly eliminate the #5 auditor in the US.? My argument here is not over guilt, but merely the size of the award.? That said, if the damage amount stands my solution would be to award 30% of the ownership of BDO Seidman to the plaintiffs.? Let them earn it through shared profits.
    3. Peter Bernstein takes my side in the understating inflation debate.? As I have said before, if you want to smooth inflation, use the median or the trimmed mean, which is more statistically robust than excluding food and energy.
    4. Jeff Matthews comments on how many companies that paid large special dividends, or bought back too much stock are regretting it in this environment.? What should they say to shareholders, but won’t?? I’ve said that for years at RealMoney, but during a boom phase, who listens?
    5. I found it fascinating that private issuances of equity via 144A are exceeding IPOs at present.? Only the big institutions get to invest, and they can only trade it to each other.? I experienced that as a bond manager, but for equities, this is new, and a growing thing.? Question: most trading will then be negotiated block trades as in the bond market.? If a mutual or hedge fund buys one of these 144A issues, how do they price it?? With bonds, it doesn’t usually matter as much, because things usually move slowly, but with equities?
    6. Can we time the value premium?? (I.e., when do we invest in growth versus value?)? The answer seems to be no.? Value strategies work about two-thirds of the time, which makes them dominant, but not so much so as to overcome the more sexy growth investing.? This allows the anomaly to continue.? The end of the article concludes: The bottom line for investors is that the prudent strategy is to ignore the calls to action you hear from Wall Street and the media and adhere to your investment plan. The only actions you should be taking are to rebalance your portfolio and to harvest losses when that can be done in a tax-efficient manner.? I like it.
    7. I’ll say it again.? Be careful with ETNs.? They may have tax advantages versus ETFs, but the hidden risk is that the sponsor of the ETN goes bankrupt, in which case you are a general creditor.? With an ETF, bankruptcy of the sponsor should pose little risk.
    8. Hit me again, please.? If financials didn’t hurt me recently, then it was cyclicals.? Ouch.? Both are at risk, but for different reasons.? Financials, because of a fear of systemic risk.? Cyclicals, because of a fear of a slowdown stemming from an impaired financial system being unwilling/unable to lend.

    I’ll try to post on the other half of this on Monday.? Have a great Sunday.

    All’s Wells at Assurant

    All’s Wells at Assurant

    Posted on by David Merkel

    Assurant, which is still my favorite insurance company and stock, is down 10% as I write. The CEO, CFO, and EVP, Chief Actuary, and VP-Risk Management for Solutions/Specialty Property, have all received Wells notices, and are now on administrative leave.So what are the issues? Prior to its IPO, when it was a part of Fortis, Assurant entered into a treaty that provided a limited amount of reinsurance to Assurant’s property lines. From the 8/16/2005 NT 10-Q:

    As disclosed in the Risk Factors section of Assurant, Inc.’s (the “Company”) Annual Report on Form 10-K for the year ended December 31, 2004, one of the Company’s reinsurers thinks the Company should have been accounting for premiums ceded to them as a loan instead of as an expense. Based on the Company’s investigation to date into this matter, the Company has concluded that there was a verbal side agreement with respect to one of the Company’s reinsurers under its catastrophic reinsurance program, which has accounting implications that may impact previously reported financial statements. While management believes that the difference resulting from any alternative accounting treatment would be immaterial to the Company’s financial position or results of operations, regulators may reach a different conclusion. In 2004, 2003 and 2002, premiums ceded to this reinsurer were $2.6 million, $1.5 million and $0.5 million, respectively, and losses ceded were $10 million, $0, and $0, respectively. This contract expired in December of 2004 and was not renewed.

    From my reading, when the original reinsurance deal was done, the current CEO was CFO, and the current CFO was head of Solutions. So, all five were involved with the unit in question, so the Wells notices to the CEO and CFO do not necessarily mean that Assurant as a whole is implicated, just the Solutions unit, and not the Solutions unit’s current operations either. If earnings have to be restated, the net result should be near zero, and it would be only for 2002-2004.

    It is possible that the finite reinsurance treaty in question may have smoothed earnings during the IPO and the first year, but from my angle, it seems to be going the wrong way. That said, in 2005, the audit committee found the side letter, which is the incriminating bit of data, which turned a reinsurance treaty into an accounting ploy that should have been treated as a loan.

    There are only two risks here. Assurant loses five great employees, who get replaced from their exceptionally deep bench. No other insurer in the industry invests as much in their people as Assurant does. They have the people to fill the shoes, if need be. The second possibility is some sort of legal settlement, and in this day and age, who can tell how large that will be? For Ren Re on a more serious lapse on finite Re, the size of the fine was $15 million.

    So, I have been buying Assurant today. Hasn’t been this cheap on earnings since 2004. You get a top quartile ROE insurer at a below market multiple.

    Full disclosure: long AIZ

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