Category: Bonds

The Reason for Failure Matters

The Reason for Failure Matters

Posted on by David Merkel

When I was a young actuary, say in the early 90s, my boss came to me, and gave me an unrequested lesson. ?He said something to the effect of:

Most pricing actuaries make assumptions. ?Well, I test assumptions. ?That involves checking how actual results are coming in?expected, but in the early phases of a new product, you are living under the law of small numbers — you don’t have enough data to be statistically credible. ?You should still do the statistical analysis, but I take it one step further.

I pull the first 10-20?claim files and look at the cause for the claim. ?If the qualitative causes are not chance events, but are indications that the business is being sold improperly to those who know they are close to death (or disability) and evade the limited underwriting of the group coverage, that means the group is low quality, and the program should be discontinued, or severely modified.

He then told me about some credit life insurance that the company was offering through two well known, prestigious banks, and how the deaths were coming in from non-random causes: AIDS, Cancer, Drowned in the Hudson River, Murder, etc.

He fought to get that insurance line shut down, and it took him five years, as the line manager argued there was not enough experience. ?The line manager tried to get my boss fired, and finally, the line manager was fired. ?But if the company had listened early they would have lost $10M. ?As it was, they lost several hundreds of millions of dollars.

Now, most of my readers don’t care much about insurance, but this tale is meant to illustrate that reason for losses matters as much, and sometimes more than the absolute amount lost. ?Now to illustrate this for a different and perhaps more timely reason:

Wups, wups,?wups,?wups, pop, Pop, POP, Yaaaaaauuughhhh!

Maybe I am growing up a little, but I am trying to have better titles for my articles. ?The subheading above would have been my title. ?But let me explain what it means:

The credit cycle tends to be like this: in the bull phase, a long period (4-7 years) with few defaults and low loss severity followed by a bear phase, a shorter period (1-3 years) with high defaults and high loss severity. ?This is a phenomenon where history may not repeat exactly, but it will rhyme very well.

In the bull phase of the credit cycle there are a few defaults, but when you analyze the defaults, they occur for reasons unrelated to the economy as a whole. ?What do the failures look like? ?Fraud (think Enron), bad business plans from a megalomanic (think Reliance Insurance, ACH, Southmark, etc.) , a sudden shift in relative prices (think Energy Future Holdings), etc. ?Bad banking — think Continental Illinois in 1984.

In the bull phase, companies that fail would fail in any environment. ?But now let’s talk about the transition between the bull and bear phase — that is the “pop, Pop, POP.”

As the credit cycle shifts, a few companies fail that are closely related to the crisis that will come. ?They are your early warning. ?Think of the subprime lenders under stress in 2007, or the failure of Bear Stearns in early 2008. ?Think of LTCM in 1998, or the life insurers that came under stress for writing too many GICs [Guaranteed Investment Contracts] in the late 80s and invested the money in commercial mortgages.

As the cycle moves on defaults become more closely related to the financial economy as a whole. ?Fed policy is tight, and a bunch of things blow up that borrowed too much money short term. ?This is when the correlated failures happen:

  • Banks, mortgage insurers, and overly leveraged homeowners default 2008-2011.
  • Dot-coms fail because they can’t pay their vendor finance.
  • Mexico and the mortgage markets blow up in 1994.
  • Commercial mortgages blow up in the early 90s.
  • LDC loans blow up in the early 80s.

To the Present

The present is always confusing. ?I get it right more often than most, but not by a large margin. ?We have companies threatening to fail in China?and?Portugal, but I don’t see much systemic lending risk in the US yet, aside from what is leftover from the last crisis.

It is worth noting that deleveraging has occurred more in word than in deed over the last five years. ?Yes, debt has traveled from public to private hands, but that only defers the problems, as governments will either have to inflate, tax more, or default to deal with the additional debts.

I am not trying to sound the alarm here. ?I am trying to tell you to be ready. ?During the intermediate phase between bull and bear, the weakest companies fail from unrecognized systemic risk. ?Personally, I think I have heard the first ‘pop.” ?It is coming from nations that did not delever, and that may suffer further if the bad debts overwhelm the banking systems.

Are you ready for the bear phase of the credit cycle? ?Screen your portfolios, and look for weak names that will not survive a general panic where only the best names can get credit.

Book Review: Taking Down the Lion

Book Review: Taking Down the Lion

Posted on by David Merkel

taking down the lion This is a tough book for me to review. ?The credit distress of Tyco caused me considerable stress, and let me explain to you how that was.

I was the leading corporate bond manager at the fastest growing life insurance company 2001-2003. ?We had a significant position in Tyco bonds, and as thy fell, we were concerned. ?As a new corporate bond manager, I drew upon all of my analysts and portfolio managers, and asked them, “Who can give me the bear case here?” ?I did my own analysis as well. ?No one could come up with a way that Tyco could go broke.

So I asked the next question: Is there anyone on Wall who thinks Tyco could go broke? ?We found one. ?We read the analysis. ?We thought the argument was ridiculous, and so we wanted to buy more. ?We had a problem: our client was under pressure from the rating agencies to decrease our exposure to Tyco.

We had a large block of two-year Tyco bonds that were trading near par, and I sold them, and reinvested into a smaller market value of 30-year Tyco bonds. ?Problem solved, but we were now taking more risk in Tyco debt, a bet that we would win.

The Book

Taking Down the Lion takes the view that Kozlowski had a subpar legal team which made many blunders in representing him. ?It also notes how the informal management culture played against Kozlowski as things that were formal at many other corporations, and thus could not be argued, were not so at Tyco.

If the book is correct, this was a perfect storm for Kozlowski, leading to an unjust conviction and sentence. ?Having worked at firms that were informal, I can believe that Kozlowski was framed during a witch-hunt era that produced the dreadful Sarbox law. ?Few legislators think of what the side-effects will be from their legislation.

My Thoughts

Tyco as a corporation was not a fraud. ?Yes, Kozlowski was tone-deaf regarding some conspicuous consumption that he did, or was done on his behalf. ?There is no crime for being a vulgar consumer. ?Supposedly Kozlowski paid for it all, but still he got judged for it in court.

Truth, ?don’t know whether Kozlowski was guilty or not, but the company was well-run, and what company could you not find a few things that have some taint?

Summary

I think it is a good book, and I lean toward the idea that Kozlowski should not have been convicted, ?If you want to, you can buy it here:Taking Down the Lion: The Triumphant Rise and Tragic Fall of Tyco’s Dennis Kozlowski.

Full disclosure:?The PR flack asked me if I would like a copy, and I said yes.

If you enter Amazon through my site, and you buy anything, I get a small commission.? This is my main source of blog revenue.? I prefer this to a ?tip jar? because I want you to get something you want, rather than merely giving me a tip.? Book reviews take time, particularly with the reading, which most book reviewers don?t do in full, and I typically do. (When I don?t, I mention that I scanned the book.? Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website.? Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites.? Whether you buy at Amazon directly or enter via my site, your prices don?t change.

On Fixed Payment Annuities

On Fixed Payment Annuities

Posted on by David Merkel

Before I start, thanks to all those who e-mailed me over my “sorted weekly tweets.” ?I am likely to continue doing them. ?That will start next week, because I have had a flood of new clients, and other obligations.

On Fixed Payment Annuities

How often do you run into articles in quality publications talking about annuities that will pay a fixed sum over your life, or over your life if you live past a certain age? ?Not often, right? ?Right. ?Well, today I got two articles on the same day:

Longevity insurance is an important topic, and everyone should consider getting an income that they can’t outlive. ?That said, there are two problems with this:

  • Inflation, and
  • Credit risk (will the insurer survive to make the payments?)

It is possible to buy inflation-protected annuities, but at a cost of a lower initial payment. ?With credit risk, consider what the state guaranty funds will cover in insolvency, and realize that any payments over that amount could be lost due to insurer insolvency. ?If you have a large payment, only buy from strong insurers.

Then there are the deferred fixed payment annuities. ? You are 50 years old, and you want a payment stream that kicks in when you are 80, should you live so long. ?You can buy a lot of income that far out, which will help you if you survive, subject to the same two main risks: inflation and credit risk. ?I am not aware of any deferred inflation-adjusted payment annuities.

Now, you can think of your annuity as a replacement for long-dated fixed interest bonds. ?A portfolio of fixed payment annuities, cash, maybe some commodities/gold, and stocks could be very stable, balancing the risks of inflation and deflation, and of high and low real rates.

There is the added benefit of the regular income which is useful to average people, who are okay with budgeting, but really don’t understand investments. ?Just beware inflation and credit risk.

One more note: most insurance agents will never suggest immediate annuities to you because when you buy one, that’s the last commission the agent ever gets. ?They would rather you buy a deferred annuity, where they can gain another commission when the surrender charge period is up, and roll you to a new product.

Summary

Longevity insurance is good, but be sure you avoid credit risk, and have other assets to compensate for potential inflation risk.

What is Liquidity? (Part VII)

What is Liquidity? (Part VII)

Posted on by David Merkel

For those that want the quick hit and don’t care about the underlying ideas, here is the main idea:

A vehicle holding assets may appear more liquid than the assets themselves, but that is only true in bull markets. ?When bad times come, the liquidity proves elusive, particularly for large trades.

ETPs are wonderful things, but there is one thing that ETPs can’t do. ?They can’t change the underlying assets that they own. ?Merely because you have the ability to buy or sell at will does not change the performance of the assets held. ?Like most investment products, the amount of assets invested expands in a bull market and contracts in a bear market.

People follow trends. ?As they follow trends, they tend to lose money, because they buy and sell too late. ?As such, average investors in ETPs tend to lose money relative to buy and hold investors.

In this sense, liquidity is not your friend. ?Just because you can trade, does not mean that you should. ?Speculators tend to lose to the longer-term investors, who hold for longer periods of time. ?Trading itself is a zero-sum game, but bearing risk is a positive sum game, if done with a margin of safety.

Also, if you are trying to do an institutional-size trade in an ETP, you will find that the market impact costs are significant. ?Just because there is an exit door in the theater does not mean that everyone can get out instantly.

Repo Transactions

But here is my favorite bugbear in liquidity: repo transactions. ?Repurchase?transactions turn a long-term asset financed short into a short term asset. ?Now the Fed thinks that it can control the repo market.

Honestly, the easy solution is to disallow the accounting treatment of repos, and force those who do them to display them as a long asset and a short liability. ?Why?

Because in crises, the long assets are illiquid, and as such the value shrinks when liquidity is prized. ?The liquid liabilities still demand to be paid at par.

The accounting change would be better than what the Fed thinks that it might do. ?You can’t make long-dated assets liquid. ?The cash flows are distant. ?Yes, there may be some interest payments that are near, but ultimate repayment of principal is distant.

Let me suggest a better concept of liquidity: assets are liquid to the degree that you can turn the?underlying?into cash. ?When I say that, I do not mean trading big blocks of stock, but selling companies for cash. ?That is liquidity, and as such most risky assets do not have significant liquidity, though many trade every day during bull markets.

Liquidity is a scaredy cat, it disappears when it is most needed. ?That happens because people think they can sell at par when they can’t.

All for now, but remember this — liquidity is a bull market phenomenon. ?People are far more likely to trade when they have unrealized?gains rather than losses.

 

A Few Notes on Bonds

A Few Notes on Bonds

Posted on by David Merkel

My comments this evening stem from a Bloomberg.com article entitled?Bond Market Has $900 Billion Mom-and-Pop Problem When Rates Rise. ?A few excerpts with my comments:

It?s never been easier for individuals to enter some of the most esoteric debt markets. Wall Street?s biggest firms are worried that it?ll be just as simple for them to leave.

Investors have piled more than $900 billion into taxable?bond?funds since the 2008 financial crisis, buying stock-like shares of mutual and exchange-traded funds to gain access to infrequently-traded markets. This flood of cash has helped cause prices to surge and yields to plunge.

Once bonds are issued, they are issued. ?What changes is the perception of market players as they evaluate where they will get the best returns relative expected future yields, defaults, etc.

Regarding ETFs, yes, ETFs grow in bull markets because it pays to create new units. ?They will shrink in bear markets, because it will pay to dissolve units. ?That said when ETF units are dissolved, the bonds formerly in the ETF don’t disappear — someone else holds them.

But in a crisis, there is no desire to exchange existing cash for new bonds that have not been issued yet. ?Issuance plummets as yields rise and prices fall for risky debt. ?The opposite often happens with the safest debt. ?New money seeks safety amid the panic.

Last week, Fed Chair Janet Yellen said she didn?t see more than a moderate level of risk to financial stability from leverage or the ballooning volumes of debt. Even though it may be concerning that?Bank of America?Merrill Lynch index data shows yields on?junk bonds?have plunged to 5.6 percent, the lowest ever and 3.4 percentage points below the decade-long average, the outlook for defaults does look pretty good.

Moody?s Investors Service predicts the global speculative-grade default rate will decline to 2.1 percent at year-end from 2.3 percent in May. Both are less than half the rate?s historical average of 4.7 percent.

Janet Yellen would not know financial risk even if Satan himself showed up on her doorstep offering to sell private subprime asset-backed securities for a yield of Treasuries plus 2%. ?I exaggerate, but yields on high-yield bonds are at an all-time low:

Could spreads grind tighter???Maybe, we are at 3.35% now. ?The record on the BofA ML HY Master II is 2.41% back in mid-2007, when interest rates were much higher, and the credit frenzy was astounding.

But when overall rates are higher, investors are willing to take spread lower. ?There is an intrinsic unwillingness for both rates and spreads to be at their lowest at the same time. ?That has not happened historically, though admittedly, the data is sparse. ?Spread data began in the ’90s, and yield data in a detailed way in the ’80s. ?The Moody’s investment grade series go further back, but those are very special series of long bonds, and may not represent reality for modern markets.

Also, with default rates, it is not wise to think of them in terms of averages. ?Defaults are either cascading or absent, the rating agencies, most economists and analysts do not call the turning points well. ?The transition from “no risk at all” in mid-2007 to mega-risk 15 months later was very quick. ?A few bears called it, but few bears called it shifting their view in 2007?– most?had been calling it for a few years.

The tough thing is knowing when too much debt has built up versus ability to service it, and have all short-term ways to issue yet a little more debt been exhausted? ?Consider the warning signs ignored from mid-2007 to the failure of Lehman Brothers:

  • Shanghai market takes a whack (okay, early 2007)
  • [Structured Investment Vehicles] SIVs fall apart.
  • Quant hedge funds have a mini meltdown
  • Subprime MBS begins its meltdown
  • Bear Stearns is bought out by JP Morgan under stress
  • Auction-rate preferred securities market fails.
  • And there was more, but it eludes me now…

Do we have the same amount of tomfoolery in the credit markets today? ?That’s a hard question to answer. ?Outstanding derivatives usage is high, but I haven’t seen egregious behavior. ?The Fed is the leader in tomfoolery, engaging in QE, and creating lots of bank reserves, no telling what they will do if the economy finally heats up and banks want to lend to private parties with abandon.

That concern is also revealed in BlackRock Inc.?s pitch in a paper published last month that regulators should consider redemption restrictions for some bond mutual funds, including extra fees for large redeemers.

A year ago, bond funds suffered record withdrawals amid hysteria about a sudden increase in benchmark yields. A 0.8 percentage point rise in the 10-year Treasury yield in May and June last year spurred a sell-off that caused $248 billion of market value losses on the Bank of America Merrill Lynch U.S. Corporate and High Yield Index.

Of course, yields on 10-year?Treasuries (USGG10YR)?have since fallen to 2.6 percent from 3 percent at the end of December and company bonds have resumed their rally. Analysts are worrying about what happens when the gift of easy money goes away for good.

With demand for credit still weak, it is more likely that rates go lower for now. ?That makes a statement for the next few months, not the next year. ?The ending of QE and future rising fed funds rate is already reflected in current yields. ?Bloomberg.com must be breaking in new writers, because the end of Fed easing is already expected by the market as a whole. ?Deviations from that will affect the market. ?But if the economy remains weak, and lending to businesses stays punk, then rates can go lower for some time, until private lending starts in earnest.

Summary

  • Is too much credit risk being taken? ?Probably. ?Spreads are low, and yields are record low.
  • Is a credit crisis near? ?Wait a year, then ask again.
  • Typically, most people are surprised when credit turns negative, so if you have questions, be cautious.
  • Does the end of QE mean higher long rates?? Not necessarily,?but watch bank lending and inflation. ?More of either of those could drive rates higher.
Redacted Version of the June 2014 FOMC Statement

Redacted Version of the June 2014 FOMC Statement

Posted on by David Merkel
April 2014 June 2014 Comments
Information received since the Federal Open Market Committee met in March indicates that growth in economic activity has picked up recently, after having slowed sharply during the winter in part because of adverse weather conditions. Information received since the Federal Open Market Committee met in April indicates that growth in economic activity has rebounded in recent months. The FOMC has constantly overestimated GDP growth, They forecast badly because they serve their political masters, who demand optimism to delude the public.
Labor market indicators were mixed but on balance showed further improvement. The unemployment rate, however, remains elevated. Labor market indicators generally showed further improvement. The unemployment rate, though lower, remains elevated. No significant change.? What improvement?
Household spending appears to be rising more quickly. Business fixed investment edged down, while the recovery in the housing sector remained slow. Household spending appears to be rising moderately and business fixed investment resumed its advance, while the recovery in the housing sector remained slow. Shades household spending down, raises their view on business fixed investment.

The FOMC needs to stop interpreting every short-term wiggle in the data.? They whipsawed on business fixed investment over the last three periods.
Fiscal policy is restraining economic growth, although the extent of restraint is diminishing. Fiscal policy is restraining economic growth, although the extent of restraint is diminishing. No change.? Funny that they don?t call their tapering a ?restraint.?
Inflation has been running below the Committee’s longer-run objective, but longer-term inflation expectations have remained stable. Inflation has been running below the Committee’s longer-run objective, but longer-term inflation expectations have remained stable. No change.? TIPS are showing slightly higher inflation expectations since the last meeting. 5y forward 5y inflation implied from TIPS is near 2.46%, up 0.05% from April.
Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. No change. Any time they mention the ?statutory mandate,? it is to excuse bad policy.
The Committee expects that, with appropriate policy accommodation, economic activity will expand at a moderate pace and labor market conditions will continue to improve gradually, moving toward those the Committee judges consistent with its dual mandate. The Committee expects that, with appropriate policy accommodation, economic activity will expand at a moderate pace and labor market conditions will continue to improve gradually, moving toward those the Committee judges consistent with its dual mandate. No change.
The Committee sees the risks to the outlook for the economy and the labor market as nearly balanced. The Committee sees the risks to the outlook for the economy and the labor market as nearly balanced. No change.
The Committee recognizes that inflation persistently below its 2 percent objective could pose risks to economic performance, and it is monitoring inflation developments carefully for evidence that inflation will move back toward its objective over the medium term. The Committee recognizes that inflation persistently below its 2 percent objective could pose risks to economic performance, and it is monitoring inflation developments carefully for evidence that inflation will move back toward its objective over the medium term. No change.? CPI is at 2.1% now, yoy.? Hey, above the threshold, and no comment from the FOMC?
The Committee currently judges that there is sufficient underlying strength in the broader economy to support ongoing improvement in labor market conditions. The Committee currently judges that there is sufficient underlying strength in the broader economy to support ongoing improvement in labor market conditions. No change.
In light of the cumulative progress toward maximum employment and the improvement in the outlook for labor market conditions since the inception of the current asset purchase program, the Committee decided to make a further measured reduction in the pace of its asset purchases. Beginning in May, the Committee will add to its holdings of agency mortgage-backed securities at a pace of $20 billion per month rather than $25 billion per month, and will add to its holdings of longer-term Treasury securities at a pace of $25 billion per month rather than $30 billion per month. In light of the cumulative progress toward maximum employment and the improvement in the outlook for labor market conditions since the inception of the current asset purchase program, the Committee decided to make a further measured reduction in the pace of its asset purchases. Beginning in July, the Committee will add to its holdings of agency mortgage-backed securities at a pace of $15 billion per month rather than $20 billion per month, and will add to its holdings of longer-term Treasury securities at a pace of $20 billion per month rather than $25 billion per month. Reduces the purchase rate by $5 billion each on Treasuries and MBS.? No big deal.

 
The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction. The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction. No change
The Committee’s sizable and still-increasing holdings of longer-term securities should maintain downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative, which in turn should promote a stronger economic recovery and help to ensure that inflation, over time, is at the rate most consistent with the Committee’s dual mandate. The Committee’s sizable and still-increasing holdings of longer-term securities should maintain downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative, which in turn should promote a stronger economic recovery and help to ensure that inflation, over time, is at the rate most consistent with the Committee’s dual mandate. No change.? But it has almost no impact on interest rates on the long end, which are rallying into a weakening global economy.
The Committee will closely monitor incoming information on economic and financial developments in coming months and will continue its purchases of Treasury and agency mortgage-backed securities, and employ its other policy tools as appropriate, until the outlook for the labor market has improved substantially in a context of price stability. The Committee will closely monitor incoming information on economic and financial developments in coming months and will continue its purchases of Treasury and agency mortgage-backed securities, and employ its other policy tools as appropriate, until the outlook for the labor market has improved substantially in a context of price stability. No change. Useless paragraph.
If incoming information broadly supports the Committee’s expectation of ongoing improvement in labor market conditions and inflation moving back toward its longer-run objective, the Committee will likely reduce the pace of asset purchases in further measured steps at future meetings. If incoming information broadly supports the Committee’s expectation of ongoing improvement in labor market conditions and inflation moving back toward its longer-run objective, the Committee will likely reduce the pace of asset purchases in further measured steps at future meetings. No change.? Says that purchases will likely continue to decline if the economy continues to improve.
However, asset purchases are not on a preset course, and the Committee’s decisions about their pace will remain contingent on the Committee’s outlook for the labor market and inflation as well as its assessment of the likely efficacy and costs of such purchases. However, asset purchases are not on a preset course, and the Committee’s decisions about their pace will remain contingent on the Committee’s outlook for the labor market and inflation as well as its assessment of the likely efficacy and costs of such purchases. No change.
To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that a highly accommodative stance of monetary policy remains appropriate. To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that a highly accommodative stance of monetary policy remains appropriate. No change.
In determining how long to maintain the current 0 to 1/4 percent target range for the federal funds rate, the Committee will assess progress–both realized and expected–toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments. In determining how long to maintain the current 0 to 1/4 percent target range for the federal funds rate, the Committee will assess progress–both realized and expected–toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments. No change.? Monetary policy is like jazz; we make it up as we go.? Also note that progress can be expected progress ? presumably that means looking at the change in forward expectations for inflation, etc.
The Committee continues to anticipate, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate for a considerable time after the asset purchase program ends, especially if projected inflation continues to run below the Committee’s 2 percent longer-run goal, and provided that longer-term inflation expectations remain well anchored. The Committee continues to anticipate, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate for a considerable time after the asset purchase program ends, especially if projected inflation continues to run below the Committee’s 2 percent longer-run goal, and provided that longer-term inflation expectations remain well anchored. No change.? Its standards for raising Fed funds are arbitrary.
When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent. When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent. No change.
The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run. The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run. No change.
Voting for the FOMC monetary policy action were: Janet L. Yellen, Chair; William C. Dudley, Vice Chairman; Richard W. Fisher; Narayana Kocherlakota; Sandra Pianalto; Charles I. Plosser; Jerome H. Powell; Jeremy C. Stein; and Daniel K. Tarullo. Voting for the FOMC monetary policy action were: Janet L. Yellen, Chair; William C. Dudley, Vice Chairman; Lael Brainard; Stanley Fischer; Richard W. Fisher; Narayana Kocherlakota; Loretta J. Mester; Charles I. Plosser; Jerome H. Powell; and Daniel K. Tarullo. Stanley Fischer is an interesting addition to the FOMC, because he would be capable of an independent opinion, not that he will ever do that.? Brainard and Mester are sock puppets.? If we see a dissent out of them, I will be shocked, and revise my opinion.

?

Comments

  • Small $10 B/month taper.? Equities and long bonds both rise.? Commodity prices rise.? The FOMC says that any future change to policy is contingent on almost everything.
  • They shaded household spending down, and raised their view on business fixed investment.? Don?t know they keep an optimistic view of GDP growth, especially amid falling monetary velocity.
  • The FOMC is ignoring rising inflation data.
  • The FOMC needs to chop the ?dead wood? out of its statement.? Brief communication is clear communication.? If a sentence doesn?t change often, remove it.
  • In the past I have said, ?When [holding down longer-term rates on the highest-quality debt] doesn?t work, what will they do?? I have to imagine that they are wondering whether QE works at all, given the recent rise and fall in long rates.? The Fed is playing with forces bigger than themselves, and it isn?t dawning on them yet.
  • The key variables on Fed Policy are capacity utilization, unemployment, inflation trends, and inflation expectations.? As a result, the FOMC ain?t moving rates up, absent increases in employment, or a US Dollar crisis.? Labor employment is the key metric.
  • GDP growth is not improving much if at all, and much of the unemployment rate improvement comes more from discouraged workers, and part-time workers.
Avoid Illiquidity

Avoid Illiquidity

Posted on by David Merkel

There are several reasons to avoid illiquidity in investing, and some reasons to embrace it. ? Let me go through both:

Embrace Illiquidity

  • You are offered a lot of extra yield for taking on a bond that you can’t easily sell, and where you are convinced that the creditor is impeccable, and there are no sneaky options that you have implicitly sold embedded in the bond to take value away from you.
  • An unusual opportunity arises to invest in a private company that looks a lot better than equivalent public companies and is trading at a bargain valuation with a sound management team.
  • You want income that will last for your lifetime, and so you take some of the money you would otherwise allocate to bonds, and buy a life annuity, giving you some protection against longevity. ?(Warning: inflation and credit risks.)
  • In the past, you bought a Variable Annuity with some good-looking?guarantees. ?The company approaches you to buy out your annuity at a 10-20% premium, or a 20-30% premium if you roll the money into a new variable annuity with guarantees that don’t seem to offer much. ?Either way, turn the insurance company down, and hold onto the existing variable annuity.
  • In all of these situations, you have to treat the money as money lost to present uses. ?If there is any significant probability that you might need the money over the term of the asset, don’t buy the illiquid asset.

Avoid Illiquidity

  • Often the premium yield on an illiquid bond is too low, or the provisions take value away with some level of probability that is easy to underestimate. ?Wall Street does this with structured notes.
  • Why am I the lucky one? ?If you are invited to invest in a private company, be skeptical. ?Do extra due diligence, because unless you bring something more than money to the table (skills, contacts), the odds increase that they are after you for your money.
  • Often the illiquid asset is more risky?than one would suppose. ? I am reminded of the times I was?approached to buy illiquid assets as the lead researcher for a broker-dealer that I served.
  • Then again, those that owned that broker-dealer put all their assets on the line, and ended up losing it all. ?They weren’t young guys with a lot of time to bounce back from the loss. ?They saw the opportunity of a lifetime, and rolled the bones. ?They lost.
  • We tend to underestimate how much we might need liquidity in the future. ?In the mid-2000s people encumbered?their future liquidity by buying houses at inflated prices, and using a lot of debt. ?When everything has to go right, the odds rise that everything will not go right.
  • And yet, there are?two more?more reason to avoid illiquidity — commissions, and inability to know what is going on.

Commissions

Illiquid assets offer the purveyor of the assets the ability to pay a significant commission to their salesmen in order to move the product. ? And by “illiquid” here, I include all financial instruments that carry a surrender charge. ?Do you want to know how much the agent made selling you an insurance product? ?On single-premium products, it is usually very close to the difference between the premium you paid, and the cash surrender value the next day.

Financial companies build their margins into their products, and shave off a portion of them to pay salesmen. ?This not only applies to insurance products, but also mutual funds with loads, private REITs, etc. ?There are many?brokers masquerading as financial advisers, who do not have to?act strictly in the best interests of the client. ?The ability to receive a commission makes them less than neutral in advising, because they can make a lot of money selling commissioned products. ?In general, it is good to avoid buying from commissioned salesmen. ?Rather, do the research, and if you need such a product, try to buy it directly.

Not Knowing What Is Going On

There are some that try to turn a bug into a feature — in this case, some argue that the illiquid asset has no volatility, while its liquid equivalents are more volatile. ?Private REITs are an example here: the asset gets reported at the same price period after period, giving an illusion of stability. ?Public REITs bounce around, but they can be tapped for liquidity easily… brokerage commissions are low. ?Some private REITs take losses and they come as a negative surprise as you find ?large part of your capital missing, and your income reduced.

What I Prefer

In general, I favor liquid investments unless there is a compelling reason to go illiquid. ?I have two private equity investments, both of which are doing very well, but most of my net worth is tied up in my equity investing, which has done well. ?I like the ability to make changes as time goes along; there is value to being able to look forward, and adjust.

No one knows the future, but having some slack capital available to invest, like Buffett with his “elephant gun,” allows for intelligent investing when liquidity is scarce, and yet you have some. ?Many wealthy people run a liquidity “barbell.” ?They have a concentrated interest in one company, and balance that out by holding very safe cash equivalents.

So, in closing, avoid illiquidity, unless you don’t need the money, and the reward is very, very high for making that fixed commitment.

A Brief Note on Dividend-Paying Common Stocks

A Brief Note on Dividend-Paying Common Stocks

Posted on by David Merkel

The equity strategy that I have run for the last 13+years always has a slightly higher yield than the S&P 500. ?But I never look for dividends. ?It’s not a factor in my process. ?That said, looking for businesses that produce free cash flow, and voila, the dividends appear.

At present, with interest rates so low, many people look at dividend paying common stocks as a means of obtaining income. ?They also add REITs, MLPs, BDCs, and an assortment of other things that trade like stocks and have yield. ?I don’t think this is a safe way to get yield, at least not now. ?Here’s why:

1) Think of the 1970s, when I was a teenager. ?Not only were interest rates higher, and?inflation eating away at purchasing power, but when companies got into trouble, they would cut their dividends, and often severely. ?During that era, you had to make sure that the company was actually earning the dividend, or were they borrowing to pay it.

2) There have been many flameouts in REITs, especially mortgage REITs. ?I remember buying broken mortgage REITs in the mid-90s at less than half of their net worth after they had bought exotic CMO pieces, trying to create funds where the value rose as interest rates moved higher. ?They got crushed in the early-90s by Greenspan’s hyper-easy monetary policy. ?In 1994, as rates were rising, they rallied significantly.

Mortgage REITs also got crushed in 2008-9. ?But Equity REITs have their times of trouble as well — they tend to be bull market babies. ?When commercial real estate is doing well, they do extra well. ?When it goes badly, extra badly for the REITs because of all the leverage.

3) I mentioned 1994. ?In 1994, as rates rose, dividend paying stocks underperformed. ?The value manager that Provident Mutual used at that time was an absolute yield manager. ?In other words, that manager only bought stocks that had a yield higher than a fixed threshold. ?At that point, the threshold was 4% or so. ?From 1982 to 1993, as interest rates fell, this manager was golden, but it was an artifact of the era. ?In 1994, the?performance was abysmal. ?The manager?was replaced the next year.

High yielding stocks paying out a large portion of their earnings as dividends tend to have their dividends grow slowly, because there is little left over to reinvest into new business. ?It is akin to owning a bond disguised as a stock. ?Lower-yielding stocks often grow their dividends more rapidly, as they reinvest more free cash into new business. ?With Equity REITs, the latter strategy has generally been more successful. ?Better to buy the lower yielding REITs that grow their dividends faster.

4) The REITs, MLPs, and BDCs that pay out a a high proportion of their taxable income are weak vehicles because they are forced to pay out so much. ?During crises, that really bites them.

(This wasn’t as short as I thought it would be. ?Oh well.)

Conclusion

If interest rates rise, and I do mean if, because the economy is weak, be ready to see these modern income vehicles take a hit. ?If we have a severe recession, be aware that dividends do get cut. ?Do not rely on stocks for income. ?Bonds are designed for income and return of principal. ?Stocks are designed for gains or losses depending upon the underlying business performance. ?They aren’t income vehicles, but performance vehicles.

Self-Regulation in the Financial Markets: My Thoughts

Self-Regulation in the Financial Markets: My Thoughts

Posted on by David Merkel

Self-regulation: let’s think about a person. ?Can he regulate his own life on his own? ?Of course he can. ?But will he?

The same is true of markets. SROs can be?effective if the culture is good, and people are willing to take actions against friends. ?But an SRO can also develop a culture that has a blind eye toward offenses, until the media embarrasses them. ?The same can be true of regulators, though. ?They can be “in bed” with the industry if the wrong culture exists in the regulatory body.

2) The trouble with financial companies and products is that they make promises, whether sharp or?vague, about the future. ?That leads some people to commit money today to those products, which may be bad or good. ?When done across a whole economy, that can lead to booms and busts. ?That is a great reason to regulate the promises made by financial firms.

3) But how do you regulate? ?Do you have a sharp separation between the regulators and the regulated, which can make regulation adversarial, or do you introduce a third party, the SRO? ?The SRO is a kind of middleman, who executes the will of the regulator, but takes into account the special conditions in each market, and talks with the regulator about where they might be wrong in what they would ordinarily do.

4) SROs have specialized knowledge, drawing from the firms they regulate. ?Well, regulators could have the also, if they hired the best, and paid them what they could earn in the private sector. ?My but the regulated would be baffled if they faced the “stone wall” of their equals in dealing with regulators.

But our government is chintzy where it should be bold. ?Aside from idealistic investors like me, (and I have applied to various government positions without the decency of a reply) it is difficult to attract top talent without paying top dollar. ?And as such, they have not gotten top talent. ?Academics are not top talent. ?They don’t really know how the markets work. ?They know how their models of the markets work.

Ideally, you need investors who understand the academic research, like me. ?If you have regulators with that strength of knowledge, you could regulate well.

5) Many of the speakers today talked about mining big data to get results. ?I will tell you that the only way to get those results is to hire talented programmers, then train them in the markets. ?Waste time teaching them; they’re bright, they will learn. ?Then after the initial training, propose the first project. ?You will create a cadre of clever programmers that can sniff out problems. ?Pamper them, and you will have a fantastic corps for sniffing out financial irregularities.

The guy from the National Futures Association emphasized the idea that mandatory membership in the association as a requirement to do business was paramount for an SRO and I can see that. ?The SRO then has the “death penalty” hanging over the heads of those they regulate. ?That said, consider this: the CFA Institute may dream of the day when all involved in investing *must* hold a?CFA Charter.

I have no doubt that this would be a good thing. ?Ethics codes are good for the industry, and to kick out bad apples would be a good thing.

6) When there are more than two?parties in any economic arrangement, regulation gets tough. ?It becomes difficult to separate the various interests, and come up with the right division of duties toward the ultimate consumer.

7) On Rules-based vs Principles-based regulation, in the American context, I lean toward rules-based. ?Rules-based has the advantage of comparability. ?Let the analysts make their adjustments, and let the companies provide the data to do so. ?But provide a consistent set of rules that all need to comply with first.

8 ) Finally, on derivatives. ?Regulate them as insurance, and let the states deal with it. ?Require insurable interest such that only bona fide hedgers can initiate trades. ?Speculators should not be allowed to trade with each other; that is gambling. ?If we did this, the derivatives market would shrink dramatically, and no one would be hurt.

That is what I would do, and Wall Street would fight it, tooth and nail.

Self-Regulation in the Financial Markets: Exchange Issues, Market Structure, and Investor Protections (Part 3)

Self-Regulation in the Financial Markets: Exchange Issues, Market Structure, and Investor Protections (Part 3)

Posted on by David Merkel

US System of Self-Regulation through SROs: Strengths and Areas for Reform?

Questions

 

  • What are the most substantial/significant contributions of the current SRO system in the United States?
  • What areas present the greatest need for reform?
  • How can the private versus ?state actor? functions of non-exchange SROs be reconciled?

 


David Blass
Chief Counsel, Division of Trading and Markets
US Securities and Exchange Commission

Trading markets division oversees oversees rules, rule changes, etc. ?Promulgate rules, exposes to the public. ?Dodd-Frank gives strict deadlines now, which if exceeded leads to proceedings, which now means further time to evaluate, decide, and additional public exposure.

Lynnette Kelly
Executive Director
Municipal Securities Rulemaking Board (MSRB)

Created in 1975 to deal with egregious conduct. ?Regulates the muni market. ?Writes rules and others enforce. ?SEC regulates on anti-fraud. ?Protect muni issuers since Dodd-Frank. ?Provides data to other regulators.

 

Daniel J. Roth
President and CEO
National Futures Association

SRO deals with Futures & Swaps — interacts with the CFTC. ?NFA is to CFTC as FINRA is to the SEC regarding crafting of regulations.


Moderated by: Cheryl L. Evans, CFA Institute

DM Note: attendance down to about 50 at this point.
Q to LK: ?How does MSRB “protect issuers?”
LK: Qualified professionals are held to a higher standard. ?[DM: note Poway School District…]
Q: What do you look for in an SRO?
DJR: Mandatory membership is needed, which makes expulsion end the business of the one thrown out.
LK: Collection of data is important. ?Led the way on “pay to play” issues. ?Argues that the muni market is the most transparent bond market after Treasuries. ?[DM: I doubt that.]
DB: Authority, Deep Knowledge, Sanctions help make for a good SRO.
Q: How can SROs aid regulators with data issues?
DB: we are data hungry in order to classify market participants. ?MIDAS — more timely analysis of market trading data.
LK: Aids in collecting analyzing data. ?Analyzes trade data daily. ?Responds to requests from law enforcement and regulators. ?They have allocated a lot more time and money getting analyses together.
DJR:?Drawing together all of the data is tough, but when you do it, you uncover anomalies. ?Constantly developing new systems. ?Have to have human intervention, computers aren’t enough.
Q to DB: How are you increasing your analyses of data at the SEC?
DB: lots of ways, one example is churning.
Q: Conflict challenges, how do you deal with them?
DJR: Create a system of checks and balances. ?34 people on his board, public director are the largest bloc. ?Diverse interest also sometimes checks matters.
LK: We are audited. ?Staff is independent of the board. ?Directors must be competent & ethical.
Q to LK: How do you provide interpretative guidance?
LK: they try to interact quietly with the regulators to resolve differences of opinion.
DB: FINRA is in the same place regarding the SEC. ?FINRA has to enforce SEC securities rules.
Q: What the data sharing rules regarding agencies and SROs?
DJR: CFTC has full access to our data. ?We notify other affiliated regulators/SROs.
LK: Formal rules w/FINRA, IRS, banking regulators, etc., law enforcement via subpoenas.
Q to LK: Additional financial information on new issues?
LK: No authority over financial issuers, more frequent disclosure would be better. ?We make our systems easy for?issuers to upload data. ?FOIA requests can be made as well on issuers. ?Munis are not high quality liquid securities.
Q: Thoughts on principles-based rules and regulations?
DB: perennial issue, we will never be fully one way or another. ?Market participants request rules to guide them when principles are issued.
LK concurs.
DJR says that principles-based rules allow them to be tougher. ?Market participants have a rule: they complain. ?(laughter from audience)
Theme: Overlay by Kaira.