Bonds – Page 6 – The Aleph Blog

The Value of Risk-Based Capital in Financial Regulation

Posted on 3 December 20164 December 2016 by David Merkel

Photo Credit: elycefeliz || Duck, it’s a financial crisis! 😉

===============================================================

Should a credit?analyst care about financial?leverage? ?Of course, the amount and types of financial claims against a firm are material to the ability of a firm to avoid defaulting on its debts. ?What about operating leverage? ?Should the credit?analyst care? ?Of course, if a firm has high fixed costs and low variable costs (high operating leverage), its financial position is less stable than that of a company that has low fixed costs and high variable costs. ?Changes in demand don’t affect a firm as much if they have low operating leverage.

That might be fine for industrials and utilities, but what about financials? ?Aren’t financials different? ?Yes, financials are different as far as operating leverage goes because for financial companies, operating leverage is the degree of credit risk that financials take on in their assets. Different types of lending have different propensities for loss, both in terms of likelihood and severity, which are usually correlated.

A simple example would be two groups of corporate bonds — ?one can argue over new classes of bond?ratings, but on average, lower rated corporate bonds default more frequently than higher rated bonds, and when they default, the losses are typically greater on the lower rated bonds.

As such the amount of operating risk, that is, unlevered credit risk, is material to the riskiness of financial companies.

Credit analysis gets done on financial companies by many parties: the rating agencies, private credit analysts, and implicitly by financial regulators. ?They all do the same sorts of analyses using similar underlying theory, though the details vary.

Regulators typically codify their analyses through what they call risk-based capital. ?Given all of the risks a financial institution takes — credit, asset-liability mismatch, and other liability risks, how much capital does a financial institution need in order to stay solvent? ?Along with this usually also comes cash flow testing to make sure that?the financial companies can withstand runs on their capital structure.

When done in a rigorous way, this lowers the probability and severity of financial failures, including the remote possibility that taxpayers could be tagged in a crisis to cover losses. ?In the life insurance industry, actuaries have worked together with regulators to put together a fair system that is hard to game, and as such, few life and P&C insurance companies went under during the financial crisis. ?(Note: AIG went under due to its derivative subsidiary and that they messed with securities lending agreements. ?The only failures in life and P&C insurance were small.)

Banks have risk-based capital standards, but they are less well-designed than those of the US insurance industry, and for the big banks they are more flexible than those for insurers. ?If I were regulating banks, I would get a small army of actuaries to study bank solvency, and craft regulations together with a single banking regulator that covers all depositary financials (or, state regulators like in insurance which would be better) using methods similar to those for the insurance industry. ?Then every five years or so, adjust the regulations because as they get used, problems appear. ?After a while, the methods would work well. ?Oh, I left one thing out — all banks would have a valuation actuary reporting to the board and the regulators who would do the cash flow testing and the risk-based capital calculations. ?Their positions would be funded with a very small portion of money that currently goes to the FDIC.

This would be a very good system for avoiding excessive financial risk. ?Dreaming aside, I write this this evening because there are other dreamers proposing a radically simple system for regulating banks which would allow them to write business with no constraint at all with respect to credit risk. ?All banks would face a simple 10% leverage ratio regardless of how risky their loan books are. ?This would in the short run constrain the big banks because they would need to raise capital levels, though after that happened, they would probably write riskier loans to get their return on equity back to where it was.

My main point here is that you don’t want to incent banks to write a lot of risky loans. ?It would be better for banks to put aside the right amount of capital versus varying classes of risk, and size the amount of capital such that it is not prohibitive to the banking system.

As such, a simple leverage ratio will not cut it. ?Thinking people and their politicians should reject the current proposal being put out by the Republicans and instead embrace a more successful regulatory system manned by intelligent and reasonably risk-averse actuaries.

Stock Returns Versus GDP

Posted on 2 December 2016 by David Merkel

Picture Credit: Third Way Think Tank || Lousy name, but technology moves on and capital gets recycled

===============================================================

Howard Simons said many other intelligent things, but there is one that has stuck with me:

These Aren’t GDP Futures You’re Trading (said with respect to stocks)

Now I’ve written at least one other article on this:?Numerator vs Denominator. ?(If you have time, it is a good summary article.) ?The basic idea is this: in the long-run stocks benefit from growth in the economy. ?In the short-run, growth in the economy can push up the demand for capital because new and existing businesses need investment, and the cost of capital rises as a result. ?Second, as the economy grows, sometimes resources other than capital are proven to be in short supply, e.g., labor and resources. ?GDP may grow, but in certain contexts, profits as a share of GDP can shrink, and the share going to wages, resources, and interest may grow.

I write this for a few?reasons:

It is by no means certain that the economy will grow more rapidly under President-elect Trump.
It is also not certain that profits will grow more rapidly.
Even if profits grow more rapidly, that does not guarantee that stock prices will rise.
There are often surprising second order effects when policies change.

After the election of Trump, the old economy stocks in portfolios that I manage for clients and me?did well, and the emerging market stocks did badly, aside from a Russian small cap ETF (which flew). ?At first I wondered about the emerging market stocks, but with rising interest rates in the US, the Volatility Machine kicked in, amplifying the effects of anticipated growth in demand capital in the US, and raised capital costs in the emerging markets, sending their stock prices down.

The same thing can happen to stocks in the US if there is enough demand for capital from the US Government to rebuild infrastructure. ?Let the US Government try to borrow more than $1 Trillion per year.? Watch interest rates rise, and watch stocks fall, as Government borrowing crowds out private investment.? On a related basis, higher interest rates make dividend-paying common and preferred stocks less attractive.

That doesn’t mean that the stocks supplying the needs of the government will do badly, but remember that the growth in demand for those goods and services might not persist. ?The prices of those stocks have already embedded higher growth rates into them — will the reality outcompete the expectations?

That’s the key question for all investors now and ever: reality versus expectations. ?Good investors make cold calculations of the expectations embedded in their investments versus likely reality, and as the situation changes, they keep adjusting.

That’s why I don’t think of the post-election period as a re-animation of “animal spirits.”? I do see it as?a rational response to likely changes. ?Does that mean that the likely changes are certain to happen? No. ?But it is likely for the economy and profits to grow faster in an environment where regulation is lower (for an example, consider the first term?of the Reagan Administration. ?It is also possible that interest rates could rise enough to erase the effect of higher profits on stock prices. ?Also, with a political neophyte in the White House, there could be significant volatility in all of the markets as the new President absorbs on-the-job training at our expense. ?Remember, volatility is risk in the short-run, but less so in the long-run. ?That can have a temporary effect on the prices of risky assets like stocks.

Permanent linear changes rarely happen in complex societies, so consider:

All sorts of things will get proposed, but what will get enacted?
Of what is enacted, will it have the expected effect?
Will there be other effects not presently expected, including a quick reversal or slowdown of policy changes because of public opinion changes and future electoral losses?
How will monetary policy react?

The election and its aftermath has not changed my investing plans in any major way. Tastes, demographics, and technology have not been radically altered. ?I am reacting to what the market is doing, but what is likely to get approved, and how regulatory efforts shift is likely to be moderate rather than revolutionary. ? Even if GDP grows faster, it is no guarantee of a rising stock market in the short run.

As such, my responses are?small, and I continue to watch and adjust.

When I was a Boy…

Posted on 29 November 2016 by David Merkel

Photo Credit: Jessica Lucia?|| That kid was like me… always carrying and reading a lot of books.

===========================================

If you knew me when I was young, you might not have liked me much. ?I was the know-it-all who talked a lot in the classroom, but was quieter outside of it. ?I loved learning. ?I mostly liked my teachers. ?I liked and I didn’t like my fellow students. ?If the option of being home schooled had been offered to me, I would have jumped at it in an instant, because then I could learn with no one slowing me down, and no kids picking on me.

I read a lot. A LOT. ?Even when young I spent my time on the adult side of the library. ?The librarians typically liked me, and helped me find stuff.

I became curious about investing for two reasons. 1) my mother did it, and it was difficult not to bump into it. ?She would watch Wall Street Week, and often, I would watch it with her. ?2) Relatives gave me gifts of stock, and my Mom taught me where to look up the price in the newspaper.

Now, if you knew the stocks that they gave me, you would wonder at how I still retained interest. ?The two were the conglomerate Litton Industries, and the home electronics company?Magnavox. ?Magnavox was bought out by Philips in 1974 for a price that was 25% of the original cost basis of my shares. ?We did worse on Litton. ?Bought in the mid-to-late ’60s and sold in the mid-’70s for a 80%+ loss. ?Don’t blame my mother for any of this, though. ?She rarely bought highfliers, and told me that she would have picked different stocks. ?Gifts are gifts, and I didn’t need the money as a kid, so it didn’t bother me much.

At the library, sometimes I would look through some of the research volumes that were there for stocks. ?There are a few things that stuck with me from that era.

1) All bonds traded at discounts. ?It’s not that I understood it well, but I remember looking at bond guides, and noted that none of the bonds traded over $100 — and not surprisingly, they all had low coupons.

In those days, some people owned individual bonds for income. ?I remember my Grandma on my mother’s side talking about how little one of her bonds paid in interest, given that inflation was perking up in the 1970s. ?Though I didn’t hear it in that era, bonds were sometimes called “certificates of confiscation” by professionals ?in the mid-to-late ’70s. ?My Grandpa on my father’s side thought he was clever investing in short-term CDs, but he never changed on that, and forever missed the rally in stocks and long bonds that kicked off in 1982.

When I became a professional bond investor at the ripe old age of 38 in 1998, it was the opposite — almost all bonds traded at premiums, and had relatively high coupons. ?Now, at that time I knew a few firms that were choking because they had a rule that said you can never buy premium bonds, because in a bankruptcy, the premium will be automatically lost. ?Any recoveries will be off the par value of the bond, which is usually $100.

2) Many stocks paid dividends that were higher than their earnings. ?I first noticed that while reading through Value Line, and wondered how that could be maintained. ?The phrase “borrowing the dividend” was bandied about.

Today as a professional I know that we should look at free cash flow as a limit for dividends (and today, buybacks, which were unusual to unheard of when I was a boy), but earnings still aren’t a bad initial proxy for dividend viability. ?Even if you don’t have a cash flow statement nearby, if debt is expanding and earnings don’t cover the dividend, I would be concerned enough to analyze the situation.

3) A lot of people were down on stocks and bonds — there was a kind of malaise, and it did not just emanate from Jimmy Carter’s mind. [Cue the sad Country Music] Some concluded that inflation hedges like homes, short CDs, and gold/silver were the only way to go. ?I remember meeting some goldbugs in 1982 just as the market was starting to take off, and they disdained the idea of stocks, saying that history was their proof.

The “Death of Equities” came and went, but that reminds me of one more thing:

4) There was a decent amount of pessimism about defined benefit plan pension funding levels and life insurer solvency. ?Inflation and high interest rates made life insurers look shaky if you marked the assets alone to market (the idea of marking liabilities to market was at least 10 years off in concept, and still hasn’t really arrived, though cash flow testing accomplishes most of the same things). ?Low stock and bond prices made pension plans look shaky. ?A few insurance companies experimented with buying gold and other commodities, just in time for the grand shift that started in 1982.

Takeaways

The biggest takeaway is to remember that as a fish you don’t notice the water that you swim in. ?We are so absorbed in the zeitgeist (Spirit of the Times)?that we usually miss that other eras are different. ?We miss the possibility of turning points. ?We miss the possibility of things that we would have not thought possible, like negative interest rates.

In the mid-2000s, few thought about the possibility of debt deflation having a serious impact on the US economy. ?Many still feared the return of inflation, though the peacetime inflation of the late ’60s through mid-’80s was historically unusual.

The Soviet Union will bury us.

Japan will bury us. ?(I’m listening to some Japanese rock as I write this.) 😉

China will bury us.

Few people can see past the zeitgeist. ?Many can’t remember the past.

Should we?be concerned about companies not being able pay their dividends and fulfill their buybacks? ?Yes, it’s worth analyzing.

Should we be concerned about defined benefit plan funding levels? Yes, even if interest rates rise, and percentage deficits narrow. ?Stocks will likely fall with bonds if real interest rates rise. ?And, interest rates may not rise much soon. ?Are you ready for both possibilities?

Average people don’t seem that excited about any asset class today. ?The stock market is at new highs, and there isn’t really a mania feel now. ?That said, the ’60s had their highfliers, and the P/Es eventually collapsed amid inflation and higher real interest rates. ?Those that held onto the Nifty Fifty may not have lost money, but few had the courage. ?Will there be a correction for the highfliers of this era, or, is it different this time?

It’s never different.

It’s always different.

Separating the transitory from the permanent is tough. ?I would be lying to you if I said I could do it consistently or easily, but I spend time thinking about it. ?As Buffett has said, (something like)?”We’re paid to think about things that can’t happen.”

Ending Thoughts

Now, lest the above seem airy-fairy, here are my biases at present as I try to separate the transitory from the permanent:

The US is in better shape than most of the rest of the world, but its securities are relatively priced for that reality.
Before the US has problems, Japan, China, OPEC, and the EU will have problems, in about that order. ?Sovereign default used to be a large problem. ?It is a problem that is returning. ?As I have said before — this era reminds me of the 1840s — huge debts and deficits, with continued currency debasement. ?Hopefully we don’t get a lot of wars as they did in that decade.
I am treating long duration bonds as a place to speculate — I’m dubious as to how much Trump can truly change things. ?I’m flat there now. ?I think you almost have to be a trend follower there.
The yield curve will probably flatten quickly if the Fed tightens more than once more.
The internet and global demographics are both forces for deflationary pressure. ?That said, virtually the whole world has overpromised to their older populations. ?How that gets solved without inflation or defaults is a tough problem.
Stocks are somewhat overvalued, but the attitude isn’t frothy.
DIvidend stocks are kind of a cult right now, and will suffer some significant setback, particularly if interest rates rise.
Eventually emerging markets and their stocks will dominate over developed markets.
Value investing will do relatively better than growth investing for a while.

That’s all for now. ?You may conclude very differently than I have, but I would encourage you to try to think about the hard problems of our world today in a systematic way. ?The past teaches us some things, but not enough, which should tell all of us to do risk control first, because you don’t know the future, and neither do I. 🙂

The Sun Will Rise Tomorrow, DV

Posted on 8 November 2016 by David Merkel

Photo Credit: MDV?|| May you live to see many beautiful sunrises!

=============================

Regardless of your political point of view, life will go on after the election. ?Truth, given the two leading candidates, I get why many feel bad — they are both personally flawed to the degree that we shouldn’t want to entrust them with power. ?We all are sinners, myself included. ?That said, those who lead scandalous lives are unfit to lead society.

But under most conditions, cultures, economies, and governments survive bad leaders. ?This is true globally. ?This has been true in the US historically.

And guess what? ?The markets really don’t care that much about current politics. ?Markets in aggregate react to changes in the long-term view of economic activity. ?The only things that interfere with economic activity to that degree are:

Sudden

Wars (think of the World Wars, or the Thirty or Hundred Years Wars)
Plague (think of the Black Death, severe as it was the influenza epidemic of 1918 was just a speed bump in comparison)
Famine (usually associated with severe Socialism… think of the Ukraine in 1932-33, the Great Leap Forward 1958-61, Pol Pot in Cambodia, present-day North Korea or Venezuela…?and there is more)

Gradual

Changes in human fertility
Technological change
Gradual increasing willingness for people to be trusting in economic relationships, leading to investment, lending and trade on a wider scale, leading to lower costs of capital. (That included ending the teaching of Aristotle that money is sterile, which happened among Christians at the Reformation, and among Muslims in the late 20th century in some convoluted workarounds)
Cultural changes such as the willingness to not engage in subsistence agriculture, and trust the division of labor. ?Willingness to educate children (including women) rather than use them for immediate productive purposes.
Desire of the governing powers to wall off resources for their private use or non-use ?(think of governments owning huge amounts of land, and denying use of the land to most. ?Same for technologies?and resources.)

I’m sure there are things I left out, which could make for a lively conversation in the comments. ?But note this: in general, though the sudden events may have severe effects on economies and markets, they tend to be the most transitory. ?It’s the gradual changes that have the most effect in the long-run.

Also note that most of these do not get affected much by normal politics. ?Yes, the “one child policy” affected human fertility, but look at efforts by governments to get husbands and wives to have children and the effects are tiny at best. ?And even the “one child policy” is partially reversed, and I expect that it will be dropped in entire. ?(And then the Christians and Muslims can stop hiding their children…)

Governments can intervene in economies lightly or moderately, and people adjust. ?Overall productivity doesn’t change much. ?At severe levels of intervention, it ?changes a lot. ?Intelligent people look for the exits, even at the cost of being exiles.

Governments can go to war, and if it is small relative to a country that is involved, the effects are light. ?Big wars are different, and can destroy productivity for a generation, or permanently, if the culture doesn’t survive.

The Great Depression, bad it was, and loaded with policy failures of Hoover and FDR, ended in less than a generation. ?The markets recovered as if it had never happened, and then some.

Are our government policies, including those of the central bank, lousy? ?Yes. ?WIll they get worse under Trump or Clinton? ?Sure.

Things won’t likely be bad enough to derail the economy and the markets for more than a generation, so invest for the future. ?The Sun will rise tomorrow, Lord willing.

But,?the Son of God will reign forever.

Afterthought

The collapse of debt fueled bubbles can only affect less than a generation. ?Why? ?They don’t affect productive capital assets, they only affect who owns them, and receives benefits from them. ?That is why depressions have far less effect than major wars on your home soil or major plagues. ?Eventually a new group of people pick up the pieces at reduced prices, and use the capital to new and better ends.

Redacted Version of the November 2016 FOMC Statement

Posted on 3 November 2016 by David Merkel

Information received since the Federal Open Market Committee met in ~~July~~September?indicates that the labor market has continued to strengthen and growth of?economic activity has picked up from the modest pace seen in the first half of?this year. Although the unemployment rate is little changed in recent months,?job gains have been solid~~, on average~~.Household spending has?been ~~growing strongly~~rising moderately but business fixed?investment has remained soft. Inflation has ~~continued to run~~increased?somewhat since earlier this year but is still below the Committee’s?2 percent longer-run objective, partly reflecting earlier declines in energy?prices and in prices of non-energy imports. Market-based measures of inflation?compensation have moved up but remain low; most?survey-based measures of longer-term inflation expectations are little changed,?on balance, in recent months.

Consistent?with its statutory mandate, the Committee seeks to foster maximum employment?and price stability. The Committee expects that, with gradual adjustments in?the stance of monetary policy, economic activity will expand at a moderate pace?and labor market conditions will strengthen somewhat further. Inflation is?expected?~~to remain low in the near term, in part because of earlier declines in energy?prices, but~~ to rise to 2 percent over the medium term as the?transitory effects of past declines in energy and import prices dissipate and?the labor market strengthens further. Near-term risks to the economic outlook?appear roughly balanced. The Committee continues to closely monitor inflation?indicators and global economic and financial developments.

Against?this backdrop, the Committee decided to maintain the target range for the?federal funds rate at 1/4 to 1/2 percent. The Committee judges that the case?for an increase in the federal funds rate has ~~strengthened~~continued to?strengthen but decided, for the time being, to wait for some?further evidence of continued progress toward its objectives. The stance of
monetary policy remains accommodative, thereby supporting further improvement?in labor market conditions and a return to 2 percent inflation.

In?determining the timing and size of future adjustments to the target range for?the federal funds rate, the Committee will assess realized and expected?economic conditions relative to 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 and?international developments. In light of the current shortfall of inflation from?2 percent, the Committee will carefully monitor actual and expected progress?toward its inflation goal. The Committee expects that economic conditions will?evolve in a manner that will warrant only gradual increases in the federal?funds rate; the federal funds rate is likely to remain, for some time, below?levels that are expected to prevail in the longer run. However, the actual path?of the federal funds rate will depend on the economic outlook as informed by?incoming data.

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, and it anticipates doing so until normalization of the level?of the federal funds rate is well under way. This policy, by keeping the?Committee’s holdings of longer-term securities at sizable levels, should help?maintain accommodative financial conditions.

Voting?for the FOMC monetary policy action were: Janet L.?Yellen, Chair; William C. Dudley, Vice Chairman; Lael?Brainard; James Bullard; Stanley Fischer; Jerome H.?Powell; Eric?Rosengren; and Daniel K. Tarullo. Voting against the action were: Esther L. George, and?Loretta J. Mester~~, and Eric Rosengren~~,?each of whom preferred at this meeting to raise the target range for the?federal funds rate to 1/2 to 3/4 percent.

Thoughts

If the FOMC wanted to throw a curve ball at the markets (not that they have had the courage to do that in some time), there’s a simple thing that they could do, and it is not that big: ?Stop reinvesting the maturing proceeds from the Treasury debt, agency debt, and agency MBS. ?It would be an interesting test of the markets, and if things go nuts, they could always reverse direction.

As it is, with a flattish yield curve and financial companies hungry for safe yield, it would be a low cost way to estimate what normalization of policy might do. ?After all, the maturing proceeds are short duration assets; the investments of the Fed in longer duration securities would be mostly untouched. ?As the Fed receives “cash” and reduces bank deposits at the Fed, banks would look for replacement assets.

Just a thought. ?As for today’s announcement, it was a nothing-burger — not much change aside from Rosengren switching sides. ?After all, you can’t make that much out of seeming economic changes over a 6-8 week period. ?They are typically just noise that the FOMC over-interprets in their statement.

Personally, I think that the FOMC will do nothing in December. ?Remember, they always talk a good game, but bow to loose policy in the end. ?There will come a time when they surprise and tighten, but that time may come sometime in 2017, if not later.

Me Too!

Posted on 22 October 201623 October 2016 by David Merkel

==================================

I have sometimes said that it is common for many people to imitate the behavior of others, rather than think for themselves. ?There are several reasons for that:

It”s simple.
It’s fast.
And so long as you don’t run into a resource constraint it works well.

People generally have a decent idea who their smartest friends are, and who seems to give good advice on simple issues. ?If your neighbor says that the new Chinese food place is excellent, and you know he knows his food, there is a very good chance that when you go there that you will get excellent Chinese food as well.

You might even tell your friends about it; after all, you want to look bright as well, and its neighborly to share good information. ?That works quite well until the day that Yogi Berra’s dictum kicks in:

Nobody goes there anymore. It?s too crowded.

The information indeed was free, but space inside the restaurant was not, even if patrons weren’t paying to get in. ?And even if they have carryout, the line could go around the block… a hardship for many even if?you are getting the famous Ocean Broccoli Beef. ?(Warning: Hot in every way.)

Readers of my blog know that the same thing happens in markets. ?Imitation was a large part of the dot-com bubble and the housing bubble. ?When a less knowledgeable friend is making what is seemingly free money, it is very difficult for many people to resist the temptation to imitate, because if it works for him, it ought to work better for the more knowledgeable.

As such, prices can get overbid, and the overshoot above the intrinsic value of the assets can be considerable. ?It all ends when the cost of capital to finance?the asset is considerably higher than the cash flow that the asset throws off. ?And as with all bubbles, the end is pretty ugly and rapid.

But what if you had a really big and liquid strategy, one that threw off decent cash flow. ?Could that ever be a bubble? ?The odds are low but the answer is yes. ?It is possible for any strategy to distort?relative prices such that the assets inside a strategy get significantly above intrinsic value — to the point where they discount negative future returns over a 5-10 year horizon. ?(As an aside, negative interest rates are by definition a bubble, and the instruments traded there are in big liquid markets. ?The severity of that bubble collapsing is likely to be limited, though, unless there is some sort of payments crisis. ?The relative amount of overvaluation is small, and has to be small.)

Indexing as Imitation

Today, indexing is a form of imitation in two ways. ?The first way is not new — it is a way of saying “I want the average result, and very low fees.” ?It’s a powerful idea and generally a good idea. ?If used for long-term investment, and not short-term speculation, it allows capital to compound over long periods of time, and keeps people from making subpar investment decisions through panic and greed.

Then there is the second way of imitation: indexing because it is now the received wisdom — all your friends are doing it. ?This is a momentum effect, and at some point even indexing through a large index like the S&P 500 or Wilshire 5000 could become overdone. ?The effects could vary, though.

You could see more larger private corporations go public because the advantage of cheap capital overwhelms the informational and other advantages of remaining private.
You could see corporations reverse financial engineering, and issue more cheap stock to retire expensive debt. ?On the other hand, it would be more likely that credit spreads would tighten significantly, leaving debt and equity balanced.
You would see pressure on corporations with odd capital structures like?multiple share classes to simplify, so that all of the equity would trade at high multiples.
Corporations could dilute their stock to pay for resources — labor, land, intellectual capital and physical capital. ?Or, buy up competitors. ?If you think that is farfetched, I remember the late ’90s where it was cool for executives to say, “Let the stock market pay your employees.”
People could borrow against their homes to buy more stock, or just margin up.

If you see what I am doing — I’m trying to show what a distorted price for publicly traded stocks in an big index could do — and I haven’t even suggested the obvious — that an unsustainable price will correct eventually, and maybe, in a dramatic way.

I’m not saying that indexing is a bubble presently. ?I’m only saying it could be one day. ?Like the imitation illustrations given above, when a lot of people want to do the same thing without bringing additional information to the process, shortages develop, and in some cases prices rise as a result.

One final note: active management would get more punch at some point, because informationless index investing would lead to some degree of mispricing that active managers would take advantage of. ?At the rate money is currently exiting active management and going into indexing, that could be five years from now (just a guess).

As with all things in investing, the proof will be seen only in hindsight, so take this with a saltshaker of salt. ?As for me, I will continue to pick stocks. ?It has worked well for me.

Of Milk Cows and Moats

Posted on 21 October 2016 by David Merkel

============================================

Before I write my piece, I want to say a word about the virtue of voting for third party candidates for President. ?Personally, I would like to see an option where we can vote for None of the Above, on all races. ?That would allow us to break the duopolistic power of the Democrats and Republicans without having to have a viable third party. ?The ability to reject all of the candidates so that a new election would have to be held with new candidates would be powerful, and would make both parties more sensitive to all of the voters, not just minorities on the left and right.

Still, I’m voting for a third party candidate mostly as a protest. ?I consider the protest to be an investment, because it has no value for the current election, but may have value for future elections if it teaches the two main parties that they no longer have a stranglehold on the electorate. ?The cost of doing so in this election for President is minuscule, because both candidates are dishonest egotists.

Character matters; if a person is not honest you will not get what you thought you were voting for. ?In this election, more than most, people are projecting onto Hillary and Donald what they want to see. ?Trump is not a man of the people, and neither is Clinton. ?They are both elitist snobs; they are members of rival cliques that dominate their respective parts of the main country club that the privileged enjoy.

There is no loss in not voting for them. ?If you want to send a message, vote for someone other than Clinton or Trump.

==============================

Of Milk Cows and Moats

It’s become fashionable to talk about moats in investing as an analogy for sustainable competitive advantages. ?Buffett popularized it, and many use it in investment analysis today. ?Morningstar has made a lot out of it.

I’d like to talk about the concept from a broader societal angle. ?This may look like a divergence from talk on investing, but it does have a significant influence on some investing.

I live in the great state of Maryland. ?A while ago, I wrote an award-winning piece on publicly traded companies in Maryland. ?My main conclusion was that many corporations are?in Maryland because the founder lived here. ?Other corporations were in Maryland because of the talent available to manage healthcare firms, defense firms, hotels, and REITs. ?Only the last one, REITs, had any significant advantage imparted by the state itself — Maryland was the first state with a statute allowing for REITs.

Why do corporations leave Maryland? ?Well, when a merger takes place, the acquirer usually figures out that the company would likely be better off reducing its presence in Maryland, and increasing its presence elsewhere. ?Costs, taxes and regulation will be lower. ?The countervailing advantage of an educated workforce is usually not enough to keep jobs here, unless that is the main input to what the firm does, such as biotechnology — hard to beat the advantage of having Johns Hopkins, NIH, and the University of Maryland nearby.

All of this suggests a model of businesses and people entering and leaving an area that is akin to the moats we describe in business. ?Most businesses know that it will be expensive to move.

They will lose people, or, it will be costly to move them
There will be an interruption to operations in some ways.
The educational quality of people might not be as great in the new area.
Some taxes and regulations could be higher.

Thus to induce a move, another municipality might offer incentives of tax abatement, a low interest loan, etc. ?The attracting municipality is making a business decision — what do they give up in taxes (and have to spend on services) versus what they gain in other taxes, etc. ?The attracting municipality also assumes that there will be some stickiness when the incentives run out. ?If you need an analogy, it is not that much different than what it takes to attract and retain a major league sports franchise.

What municipalities lose businesses and people? ?Those that treat them like milk cows. ?Take a look at the states, counties and cities that have lost vitality, and will find that is one of the two factors in play, the other being a concentrated industry mix in where the dominant industry is in decline.

The more a municipality tries to milk its businesses and people, the more the businesses begin to hit their flinch point, and look for greener pastures. ?With the loss of businesses and people, they may try to raise taxes to compensate, leading to a self-reinforcing cycle that eventually leads to insolvency.

A municipality can fight back by offering its own incentives to retain companies and people. ?This can lead to a version of the prisoners’ dilemma, or a “race to the bottom” as corporations play off municipalities against each other in order to get the best deal possible. ?There is an analogy to war here, because the mobile enemy has significant advantages. ?There is an analogy to antitrust as well, because municipal governments are allowed to collude against corporations, and it would be to their advantage to do so, if they could agree.

In a game like this, the healthiest municipalities have the strongest bargaining position — they can offer the best deals. ?There is a tendency for the strong to get stronger and the weak weaker. ?Past prudence has its rewards. ?Present prudence is costly, both economically and politically, is difficult to achieve, and?future people will benefit who will not remember you politically.

One more note: Maryland has another problem, which affects some of my friends in the industry who have Maryland-centric.investment management practices. ?(My firm is national. ?More of my clients are outside of Maryland than inside.) ?When wealthy people in Maryland retire, their probability of leaving Maryland goes up, as the “moat” of their Maryland job disappears. ?Again states can adjust their tax policies to try to retain people in their states. ?On the other hand, some attempt to tax former residents who earned their pensions in their states, and things like that.

This is just another example of how municipalities have limits to the amount they can tax before the tax base erodes.

(Dare we mention how the internet is still costing states some of their sales taxes? ?Nah, too well known.)

Upshot

When considering businesses that rely on a given locality, ask how the health of the locality affects the business. ?It’s worth considering. ?For those who invest in municipal bonds, it is a critical factor. ?Particularly as the Baby Boomers age, weak municipalities will come under pressure. ?Stick with strong municipalities, and services that would be impossible to do without.

Finally, think about your own life. ?Is it possible:

that your firm could move and leave you behind?
that your taxes could rise significantly because businesses and people are leaving?
that your taxes could rise significantly because state employee benefit plans are deeply underfunded?
that your municipal job could be put in danger because of prior weak economic decisions on the part of the municipality?
that real estate prices could fall if the exodus of people from your area accelerates?
Etc.

Then consider what your own “plan B” might be, and remember, earlier actions to leave are better actions if you are correct. ?The options are always lousy once an economic bust arrives.

Thinking About Monetary Policy: A Counterfactual

Posted on 8 October 20169 October 2016 by David Merkel

Photo Credit: Daniel Mennerich || A bridge described in fiction to bridge me to the counterfactual argument of this post

==============================

I received an email from a longtime reader:

David, here is a (possibly useless) thought experiment.

In 2005, PIMCO’s Paul McCulley was begging Ben Bernanke to halt the on- going quarter-point raises in the Fed Funds rate at 3.5 percent. I forget his exact reasoning, but he clearly thought that the financial markets couldnot accommodate short-term rates above 3.5 percent without substantial disruptions.

Suppose that Bernanke had listened to McCulley and capped the Fed Funds rate at 3.5 percent until it was clear how the markets would fare at that level. Would that alone have been sufficient to postpone or even avert the housing crisis? Or would it have made the crash even worse?

According to FRED, the Funds rate reached 3.5 percent in August 2005, and as we know housing prices nationally peaked about one year later, just as the Funds rate was topping out at 5.25 percent. Question is, did the additional 1.75 percent of increases serve to tip the housing market into decline, or was the collapse inevitable with or without the last seven quarter-point raises?

Any thoughts?

Here was my response:

I proposed the same thing at RealMoney, except I think I said 4%.? My idea was to stop at a yield curve with a modestly positive slope.? It might have postponed the crisis, and maaaaybe allowed banks and GSEs to slowly eat up all of the bad loan underwriting.

I had Googlebots tracking housing activity daily, and August 2015 was when sales activity peaked.? I announced it tentatively at RealMoney, and confirmed it two months later.? From data I was tracking, housing prices flatlined and started heading down in 2006.? The damage was probably done by 2005 — maybe the right level for Fed funds would have been 3%.

The trouble is, hedge funds and other entities were taking risk every which way, and a mindset had overwhelmed the markets such that we had the correlation crisis in May 2005, and other bits of bizarre behavior.? Things would have blown up eventually.? Speculative frenzy rarely cools down without the bear phase of the credit cycle showing up.

So, much as it would have been worth a try, it probably wouldn’t have worked.? The housing stock was already overvalued and overleveraged.? But it might have taken longer to pop, and it might not have been as severe.

But now for the fun question.? Is the Fed trying to do something like that now?? Are they so afraid of popping any sort of asset bubble that they have to be extra ginger in raising rates?? It seems any market “burp” takes rate rises off the table for a few months.

I don’t know.? I do know that the FOMC has only 1% of tightening to play with before the yield curve gets flat.? Also, obvious speculation is limited right now.? There is a lot that is overvalued, but there is no frenzy… unless you want to call nonfinancial corporation and government borrowing a frenzy.

Thanks for writing.

=============================================

The FOMC is Afraid of its own Shadow

If I were the Fed, I would end the useless jabbering that they do. ?I would also end the quarterly forecasts and press conference. I would also end publishing the statement and the minutes, and let people read the transcripts five years later. We would go back to the pre-Greenspan years, when monetary policy was managed better. ? Before I did that I would say:

The Fed has three responsibilities: controlling inflation, promoting full employment, and regulating the solvency of the banking system. ?We are not responsible for the health and well-being of financial markets. ?The ‘Greenspan Put’ is ended.

We will act to limit speculation within the banks, such that market volatility will have minimal impact on them. ?We want our pursuit of limited inflation and full employment to not be hindered by looking over our shoulder at the boogeyman that could affect the banking system. ?To that end, please realize that we will not care if significant entities lose money, including countries that may get whipped around by our pursuit of monetary policy in a way that benefits the American people.

We are not here as guarantors of prosperity for speculators. ?Really, we’re not here to guarantee anything except pursue a stable-ish price level, and to the weak extent that monetary policy can do so, aid full employment.

We hope you understand this. ?We do not intend to use our “lender of last resort” authority again, and will manage bank solvency in a way to avoid this. ?We may get called ‘spoilsports’ by the banks that we regulate, but in the end we are best served as a nation if solvency concerns dominate over the profitability of the banking industry.

As it is, the present FOMC fears acting because it might derail the recovery or spark a bear market in risky assets. ?Going beyond the mandate of the Fed has led to bad results in the past. ?It will continue to do so in the future.

The best way for the Fed to maintain its independence is to act independently and responsibly. ?Don’t listen to outside influences, particularly when hard things need to be done. ?Be the adult in the room, and tell the children that the medicine that you give them is for their good. ?Recessions are good, because they clear away bad uses of capital from the ecosystem, and make room for new more productive ideas to use the capital instead.

As it is, the Fed is afraid of its own shadow, and will not take any hard actions. ?That will either end with inflation, or an asset bubble that eventually affects the banks. ?A central bank like that does not follow its mandate does not deserve its independence. ?So Fed, if you won’t act for our long-term good, will you act to preserve your existence in your?present form?

The Cash Will Prove Itself

Posted on 1 September 2016 by David Merkel

Photo Credit: Renegade98 || What was it that Buffett said 'bout swimmin' naked? — Photo Credit: Renegade98 || What was it that Buffett said ’bout swimmin’ naked?

=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=

It?s only when the tide goes out that you learn who has been swimming naked.

— Warren Buffett, credit Old School Value

When I was 29, nearly half a life ago, Donald Trump was a struggling real estate developer. ?In 1990, I was still trying to develop my own views of the economy and finance. ?But one day heading home from work at AIG, I was listening to the business report on the radio, and I heard the announcer say that Donald Trump had said that he would be “the king of cash.” ?My tart comment was, “Yeah, right.”

At that point in time, I knew that a lot of different entities were in need of financing. ?Though the stock market had come back from the panic of 1987, many entities had overborrowed to buy commercial real estate. ?The major insurance companies of that period were deeply at fault in this as well, largely driven by the need to issue 5-year Guaranteed Investment Contracts [GICs] to rapidly growing stable value funds of defined contribution plans. ?Outside of some curmudgeons in commercial mortgage lending departments, few recognized that writing 5-year mortgages with low principal amortization rates against long-lived commercial properties was a recipe for disaster. ?This was especially true as lending yield spreads grew tighter and tighter.

(Aside: the real estate area of Provident Mutual avoided most of the troubles, as they sold their building that they built seven years earlier for twice what they paid to a larger competitor. ?They also focused their mortgage lending on small, ugly, economically necessary properties, and not large trophy properties. ?They were unsung heroes of the company, and their reward was elimination eight years later as a “cost saving move.” ?At a later point in time, I talked with the lending group at Stancorp, which had a similar philosophy, and expressed admiration for the commercial mortgage group at Provident Mutual… Stancorp saw the strength in the idea, and still follows it today as the subsidiary of a Japanese firm. ?But I digress…)

Many of the insurance companies making the marginal commercial mortgage loans had come to AIG seeking emergency financing. ?My boss at AIG got wind of the fact that I was looking elsewhere for work, and subtly regaled me of the tales of woe at many of the insurance companies with these lending issues, including one at which I had recently interviewed. ? ?(That was too coincidental for me not to note, particularly as a colleague in another division asked me how the search was going. ?All this from one stray comment to an actuary I met coming back from the interview…)

Back to the main topic: good investing and business rely on the concept of a margin of safety. ?There will be problems in any business plan. ?Who has enough wherewithal to overcome those challenges? ?Plans where everything has to go right in order to succeed will most likely fail.

With Trump back in 1990, the goal was admirable — become liquid in order to purchase properties that were now at bargain prices. ?As was said in the Wall Street Journal back in April of 1990, the article started:

In a two-hour interview, Mr. Trump explained that he is raising cash today so he can scoop up bargains in a year or two, after the real estate market shakes out. Such an approach worked for him a decade ago when he bet big that New York City’s economy would rebound, and developed the Trump Tower, Grand Hyatt and other projects.

“What I want to do is go and bargain hunt,” he said. “I want to be king of cash.”

That’s where?Trump said it first. ?After that he received many questions from reporters and creditors, because his businesses were heavily indebted, and?property values were deflated, including the properties that he owned. ?Who wouldn’t want to be the “king of cash” then? ?But to be in that position would mean having sold something when times were good, then sitting on the cash. ?Not only is that not in Trump’s nature, it is not in the nature of most to do that. ?During good times, the extra cash that Buffett keeps on hand looks stupid.

Trump did not get out of the mess by raising cash, but by working out a deal with his creditors in bankruptcy. ?Give Trump credit, he had convinced most of his creditors that they were better off continuing to finance him rather than foreclose, because the Trump name made the properties more valuable. ?Had the creditors called his bluff, Trump?would have lost a lot, possibly to the point where we wouldn’t be hearing much about him today.

Trump escaped, but most other debtors don’t get the same treatment Trump did. ?The only way to survive in a credit crunch is plan ahead by getting adequate long-term financing (equity and long-term debt), and keep a “war kitty” of cash on the side.

During 2002, I had the chance to test this as a bond manager. ?With the accounting disasters at mid-year, on July 27th, two of my best brokers called me and said, ?The market is offered without bid.? We?ve never seen it this bad.? What do you want to do??? I kept a supply of liquidity on hand for situations like this, so with the S&P falling, and the VIX over 50, I put out a series of lowball bids for BBB assets that our analysts liked.? By noon, I had used up all of my liquidity, but the market was turning.? On October 9th, the same thing happened, but this time I had a larger war chest, and made more bids, with largely the same result.

That’s tough to do, and my client pushed me on the “extra cash sitting around.” ?After all, times are good, there is business to be done, and we could use the additional interest to make the estimates next quarter.

To give another example, we have the visionary businessman Elon Musk facing a?cash crunch?at Tesla?and?SolarCity. ?Leave aside for a moment his efforts to merge the two firms when stockholders tend to prefer “pure play” firms to conglomerates — it’s interesting to look at how two “growth companies” are facing a challenge raising funds at a time when the stock market is near all time highs.

Both Tesla and Solar City are needy companies when it comes to financing. ?They need a lot of capital to grow their operations before the day comes when they are both profitable and cash flow from operations is positive. ?But, so did a lot of dot-com companies in 1998-2000, of which a small number exist to this day. ?Elon Musk is in a better position in that presently he can ~~dilute~~?issue shares of Tesla to finance matters, as well as buy 80% of the Solar City bond issue. ?But it feels weird to have to finance something in less than a public way.

There are other calls on cash in the markets today — many companies are increasing dividends and buying back stock. ?Some are using debt to facilitate this. ?I look at the major oil companies and they all seem to be levering up, which is unusual given the recent trajectory of crude oil prices.

We are in the fourth phase of the credit cycle now — borrowing is growing, and profits aren’t. ?There’s no rule that says we have to go through a bear market in credit before that happens, but that is the ordinary?way that excesses get purged.

That is why I am telling you to pull back on risk, and review your portfolio for companies that need financing in the next three years or they will croak. ?If they don’t self finance, be wary. ?When things are bad only cash flow can validate an asset, not hopes of future growth.

With that, I close this article with a poem that I saw as a graduate student outside the door of the professor for whom I was a teaching assistant when I first came to UC-Davis. ?I did not know that is was out on the web until today. ?It deserves to be a classic:

Quoth The Banker, ?Watch Cash Flow?

Once upon a midnight dreary as I pondered weak and weary
Over many a quaint and curious volume of accounting lore,
Seeking gimmicks (without scruple) to squeeze through
Some new tax loophole,
Suddenly I heard a knock upon my door,
Only this, and nothing more.

Then I felt a queasy tingling and I heard the cash a-jingling
As a fearsome banker entered whom I?d often seen before.
His face was money-green and in his eyes there could be seen
Dollar-signs that seemed to glitter as he reckoned up the score.
?Cash flow,? the banker said, and nothing more.

I had always thought it fine to show a jet black bottom line.
But the banker sounded a resounding, ?No.
Your receivables are high, mounting upward toward the sky;
Write-offs loom.? What matters is cash flow.?
He repeated, ?Watch cash flow.?

Then I tried to tell the story of our lovely inventory
Which, though large, is full of most delightful stuff.
But the banker saw its growth, and with a might oath
He waved his arms and shouted, ?Stop!? Enough!
Pay the interest, and don?t give me any guff!?

Next I looked for noncash items which could add ad infinitum
To replace the ever-outward flow of cash,
But to keep my statement black I?d held depreciation back,
And my banker said that I?d done something rash.
He quivered, and his teeth began to gnash.

When I asked him for a loan, he responded, with a groan,
That the interest rate would be just prime plus eight,
And to guarantee my purity he?d insist on some security?
All my assets plus the scalp upon my pate.
Only this, a standard rate.

Though my bottom line is black, I am flat upon my back,
My cash flows out and customers pay slow.
The growth of my receivables is almost unbelievable:
The result is certain?unremitting woe!
And I hear the banker utter an ominous low mutter,
?Watch cash flow.?

Herbert S. Bailey, Jr.

On Pricing Grids, Part 1

Posted on 27 August 201628 August 2016 by David Merkel

=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-

This post may be a little more complex than most. It will also be more theoretical. For those disinclined to wade through the whole thing, skip to the bottom where the conclusions are (assuming that I have any). 😉

Asset Prices are (Mostly) Validated by a Thin Stream of Transactions

One thing that I have been musing about recently is how few transactions exist to validate the pricing of various markets. ?I’ll start with two obvious ones, and then I will broaden out to some more markets that are less obvious. ?(Hint: markets that have a high level of transactions relative to the underlying asset value have a lot of speculative “noise traders.”)

Let me start with the market that I know best as far as this topic goes: bonds. ?Aside from some government and quasi-governmental bonds, very few bonds trade each day — less than a few percent. ?It’s very difficult to use the small volume of trades to price the whole market, but it can be done.

When I was a bond manager for a semi-major insurance company, I was the only one of the top managers that was a mathematician, and?familiar with all of the structures underlying the bonds. ?I could create my own models of bonds if needed, and I often did for interest rate risk analyses (which was still a responsibility amid bond management). ?Combined with my knowledge of insurance accounting, it made me ideal to do a certain monthly task: making sure all of the bonds got priced.

The first part of that isn’t hard. ?The pricing service typically covers 90-98% the bonds ?in the portfolio. ?What I would receive on the first day of the month was a list of all the bonds the pricing service could not calculate a price for. ?I would take that list and compare it to last month’s?list of the same bonds and add to it any new bonds we had bought that month, and who the lead dealer was. ?I would then ask the dealers for their prices on the bonds (which were typically illiquid). ?I would compare those prices to the prices of the prior month, and maybe ask a question or two about the prices that were out of line. ?That would usually elicit a comment from my coverage akin to, “The analyst thinks spreads have widened out for that credit because spreads in that industry have widened out, and a less liquid bond would widen out more. ?The why the price fell more (or rose less).

After that was done, that left me with a small number of utterly illiquid bonds that we had sourced totally privately, or where the dealers who had originated the bonds had ceased to exist. ?All of those deals lacked options to accelerate or decelerate payment, so it was a question of modeling the cash flows and applying an appropriate yield spread over the Treasury or Swap yield curve. ?[Note: the swap curve gives the yield rates at which AA-rated banks are willing to trade fixed rate exposures in their own credit for floating rate exposures in their own credit, and vice-versa.]

But what is appropriate and how did the three methods of getting prices differ? ?The second question is easier. ?They didn’t differ much at all. ?The dealers and I were likely doing the same things — just with different sets of bonds. ?The pricing service, on the other hand, was much more complex, and the other two methods relied on its results.

It was was called “grid” or “matrix” pricing, though it was much more complex than a grid or a matrix. ?The pricing service models would look at all of the most recent trades that had happened in the bond market, and use all of the prices to estimate yields that were adjusted for the options inherent in the bonds that could accelerate or decelerate payments. ?From that, they would piece together yield curves that varied by industry and collateral type, credit rating (agency or implied by a model that involved stock prices and equity option prices), individual creditors, etc. ?Trades on different days were adjusted for market conditions to make the?pricing?as similar as possible to the end of the month. ?After that the yield and yield spread curves generated would be applied to the structures of individual bonds with a adjustments for whether the bonds were:

premium or discount
large deals that were widely traded or small illiquid deals
callable or putable
senior or subordinate or structurally subordinate (a bond of a subsidiary not guaranteed by the parent company)
secured or unsecured
bullet or laddered maturities (sinking funds, etc.)
different currencies
and more

And there you would have a set of self-consistent prices that would price most of the bond universe. ?That’s not where transactions would necessarily take place… particularly with illiquid securities, what would matter most is who was more incented to make the trade happen — the buyer or the seller.

Implicitly, I learned a lot of this not just from modeling for risk purposes, but from trading a lot of bonds day by day. ?How do you make the right adjustments when you compare two bonds to make a swap, and, how much of a margin do you put in as a provision to make sure you are getting a good deal without the other side of the trade walking away? ?It’s tough, but if you?know how all of the tradeoffs work, you can come to a reasonable answer.

One more note before the summary. ?The less common it is for a bond or group of related bonds to trade, the more effect a trade has on the overall process. ?It becomes a critical datapoint that can redefine where bonds like it trade. ?Illiquidity begets volatile prices changes in the grid/matrix as a result. ?On the bright side, illiquidity is usually associated with small sizes, so it doesn’t affect most of the market. ?There is an exception to this rule: trades done during a panic or the recovery from a panic tend to be sparse as well. ?The trades that happen then can temporarily change a wider area of pricing. ?I remember that vividly from the whipsaw markets 2001-3, especially when the bond market was restarting after 9/11. ?If that crisis had happened later in the month, the quarterly closing prices might not have been as accurate.

Summary for Part 1 (Bonds)

The bond market is complex, far more complex than the stock market. ?Pricing the market as a whole is a complex affair, but one for which prices are reasonably calculable. ?For the average retail investor investing in ETFs, the bonds are liquidi enough that pricing of NAVs is fairly clean. ?But even for a large ugly insurance company bond portfolio, pricing can be significantly accurate. ?Next time, I’ll talk about a related market that has its own pricing grid(s) — mortgages and real estate. ?Till then.