Ethics – Page 11 – The Aleph Blog

Book Review: The Club No One Wanted To Join

Posted on 15 September 201012 February 2011 by David Merkel

When life gives you lemons, make lemonade.? Over two dozen people that survived losing a lot of their money in the Madoff Ponzi scheme wrote down their stories.? For one thing, I’m sure it was cathartic to do so.? Something that many regarded as being one of the most dependable parts of their lives ended up proving utterly undependable.

Out of loss, many of the writers rediscovered the simpler joys of life — family and friends.? Even new friends, as many of them banded together to figure out which end was up.

The tales that the authors tell are not identical, but they certainly rhymed.? Here would be my stylized example of the outline of one of their stories:

Growing up in a lower-to-middle class family
Being taught to work hard and be frugal
Achieved some degree of success
Was not sure what to do as the excess assets grew
A family member or friend introduced me to Madoff
Looked like a smart deal; Madoff always seemed to do well, so the person put most to all of his investable assets there.
Sometimes even borrowed money rather than tap the Madoff funds.
Life was good; he was charitable, enjoyed life, was generous with friends.
The shock came that Madoff was a fraud, a Ponzi scheme.
Adding insult to injury, learned that the SIPC would not pay off much at all of the losses, seemingly contrary to their prior actions in other cases.
The best option for many was to file as a total loss, and recover back taxes.
Retirement dreams turned back to work, and who would hire an old person?
Friends and family often proved helpful, but it is hard to go from being a giver to being dependent.

Personally I would like to meet most of these people, give them a hug, and affirm to them that true wealth isn’t money, but relationships.? Poor people are poor because they lack the connections the they can trust, and have the power to help them.

Now, I don’t want to say they should not have seen this coming.? This blog is about risk control in investing.? Remember, you are your own best defender when it comes to investing, and saying “no” is almost always safer than saying “yes.”? Let me quote from a piece written near the time that Madoff was sent off to the pokey:

The sad aspect of plumbing for the financial markets today is that we are drawn to the front end of investing processes.? This man looks successful.? He has a great story; a way to make money that others do not know about.? There are documents showing his track record ? impressive, though he doesn?t solicit publicly; investing with him is a family affair.? Do you want to be part of the family and gain the benefits thereof?

There are questions to be asked, particularly of nonstandard ventures:

How are the returns earned?

Who checks the results?? (Auditing ? should not be a small firm.)

Who has custody of the assets?

Is the trustee a reputable third party?

Is liquidity proportionate to the asset class invested in?

Is this under US law?

Do the returns look too good to be true, either in absolute amount, or always positive with low volatility?

Is this marketed to everyone, or just a select few suckers?

Is the profit motive of the sponsor obvious and standard?

How are asset values calculated each accounting period?

Whether we are talking about Madoff, Stanford, or any of the other recent frauds, an attention to the details of how the financial plumbing works can pay off in terms of avoiding situations that are too good to be true.

You are ultimately responsible for losses that you receive.? Yes, no one can know everything, but if you don’t have any idea of how someone investing for you is making money, you probably should not invest with that person, because you are incapable of evaluating what they do in broad.

No one with a serious risk control discipline invested with Madoff or Stanford.? These are cases where paying a little for expert help would have paid off big.

Does that mean I look down on those that lost?? Not at all.? Most ordinary investors don’t have the vaguest idea what they are doing.? They are blessed because no one they knew would introduce them to Madoff.? For those that lost, I only have sorrow and pity.? I wish that you had friends and family that would have steered you better.? We all rely on friends, but there is still a danger in that reliance.

Quibbles

As I read more of the book, it felt like some of the authors had rehearsed story lines with each other.? Now, that is natural, because they talked with each other and planned strategy together regarding the SIPC and other hurdles.? So, I don’t begrudge that much.

What I do begrudge is the 8-page investment “analysis” at the end of the book that says that no one should have been suspicious of an 11%/year return, because equity funds from many major mutual fund companies earned 11%/year over the same period.? Total hooey.? Few would have invested with Madoff given the lack of disclosure had not the returns been so regular on a monthly basis.? The mutual funds had large runs up, and large drawdowns.? Investors, not savers, would buy such mutual funds.? The attraction of Madoff’s scam was that it was designed for savers, not investors.? No volatility, high returns, no worries.? Thus someone with the personality of a saver could put money there, and not worry, because Uncle Bernie was a genius who was taking care of them.

And indeed, Madoff took care of them, with malice.? The underfunded SIPC could do little to help, given the enormity of the fraud.

Who would benefit from this book

Anyone who wants to sympathize with and support those who lost to Madoff would benefit from this book.? It does a fairly complete job, and is not long at ~230 pages.? As I write this it is, out of stock at Amazon, but when available, you can buy it here: The Club No One Wanted To Join-Madoff Victims In Their Own Words Barnes & Noble does have copies.

Full disclosure: An author sent me a copy, after asking if I would like to receive a review copy.

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.

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Twenty Questions for the Author of Risk and the Smart Investor

Posted on 11 September 2010 by David Merkel

This is the first time I have done something like this, but I am interviewing an author of a book on Risk Management, which delves into the nature of the current crisis.? My interview occurs before the book is published, and lends to its publicity, which I don’t mind because I think it is an excellent book. The book is entitled, “Risk and the Smart Investor,” and is written by David X. Martin.? Anyway, here are the questions that I will ask him:

Imagine you are talking to a bright 12-year old girl.? How would you explain to her why and how the financial crisis happened?
I was fascinated with the structure of your book, which I found tedious and hokey at first, but I grew to like it.? The way I see it, you introduce the topic through your experience, then explain the theory, then show neglect of it led to failure, and then you give us the stories of Max and Rob.? How did you hit upon this intriguing and novel way to write your book?
Why do you suppose so few people in risk management, and senior management at major financial firms, were unwilling to consider alternative views of the sustainability of the risks being taken as the risks got larger and larger relative to the equity of individual companies, the industry as a whole, and the economy as a whole?
As a risk manager, bosses would sometimes get frustrated with me when they wanted a simple answer to a complex question that had significant riskiness.? They did not like answers like, ?I don?t know, it could have six significant effects on our company.?? How can we convey the limits of our knowledge in a way that management can get the true uncertainty and riskiness of the environment that we work in?? How can we get management to consider scenarios that are reasonable, and could harm the company, but few others in similar situations are testing for?
In your experience, how good are the managements of financial companies at establishing their risk tolerances?? Better, how good are they at enforcing those limits, such that they are never exceeded?
How do you create a transparent risk culture in a firm?? How do you get resisters to go along, even if it is management that does not see the full importance of the concept?
Are most cases where a person or a company fails to diversify intentional or unintentional?? Do we put too many eggs in one basket more out of ignorance or greed?
Why do you suppose that checks and balances for risk management are not built into the cultures of many financial companies?
I have a friend Pat Lewis who developed a risk management system for Bear that could have prevented the failure of the firm, but it was ignored because it got in the way of profit center manager goals.? Was it the same for you at Citigroup when your ?Windows on Risk? got tossed out the window?
Can culture and personal judgment work in risk management ever?? Take Berkshire Hathaway ? risk control is embedded in the characters of a few people, notably Warren Buffett and Charlie Munger.? If the culture is really, really good, and it comes from the top, can risk management work when it is seemingly informal?? (Remember, you don?t want to disappoint Warren.)
How can you teach younger people in risk management intuition about risk that helps them have a healthy skepticism for the results of impressive complex modeling?
Is it possible to do effective risk management in a financial firm if management is less than wholeheartedly committed to the goal?
Aside from AIG, and other financial insurers, the insurance industry came through the crisis better than the banks because they focused on longer-term stress tests, and not on short-term measures like VAR.? Should the banking industry imitate the insurance industry, and focus on longer-term measures of risk, or continue to rely on VAR?
Seemingly the big complex banks did not analyze their liquidity risk, particularly with repo lines.? Why did they miss such an obvious area of risk management?
How much can risk management be shaped in financial firms by the compensation incentives that employees and managers receive?
I have often turned down shady deals in business, saying that you only get one reputation in this world.? How do you encourage an attitude like this in financial firms among staff?
A lot of portfolio management and risk management is juggling different time frames.? Is there a good structure for balancing the demands of the short-, intermediate-, and long-terms?
Most developed country economic players assume that wars will have no impact on their portfolios.? Same for famine, plague, or environmental degradation.? What can you do to get investors to think about the broader risks that could materially harm their well-being?
Are Rob?s more common in the world than Max?s??? That?s my experience; what do you think?
At the end of your book, one of your friends dies.? Did you mean to teach us that even if we manage our risks right, we still can?t overcome problems beyond our scope, or were you trying to say something else, like creating a system or family that can perform well after you die?

Queasing over Quantitative Easing, Part IV

Posted on 31 August 2010 by David Merkel

In my last post on this topic, I went over the orthodox and unorthodox monetary policy responses to the crisis in the US.? Here were the orthodox options:

Lower the Fed funds rate into lower positive territory.
Offer language that says that the Fed Funds rate will be low for a long time.
Buy more long-dated Treasury bonds.

And the unorthodox options:

Lend directly to classes of private borrowers.
Create negative interest rates for Fed funds.
Debase the currency by expiration dates, lotteries, etc.

On orthodox policy: I’m not sure there is that much difference between Fed funds at 0.25% and 0.10%, except that money market funds will find themselves in further trouble, as yields are too low to credit anything. That the Fed will be on hold for a long time seems to be the default view of the market already, so an explicit declaration would likely prove superfluous.? On buying long-dated Treasury bonds, that will benefit the US Government by pseudo-monetizing the debt, but won’t help the real economy much.

Yes, some high-quality corporate and mortgage bond rates will be pulled down with it, but so will discount rates for liabilities.? The same applies to spending rules for endowments, and how much retirees can get if they go to buy an annuity.? The effects of QE are mixed at best, and on balance, might be depressing, not stimulating.? But what practical proof, if any, do we have that QE has ever worked?

We need policymakers to understand the bankruptcy of the theories they are working with.? So many macroeconomic models work with one interest rate.? But in the real world there are many rates, and duration and quality of lending make a huge difference in what rate is charged.? I would urge that every person who would be on the FOMC work at a buyside firm managing bonds and money market instruments.? Let them see how the markets really work, and it might disabuse them of their false neoclassical views of how the lending markets work.? Better still, if their P&L is less than the cost of capital, revoke their appointment.? It’s time to kick out the academics, with their failed ideologies, and let those who have worked in the markets successfully manage the economy.

Direct Lending

But then there are the unorthodox methods.? When Social Security came into existence, they argued over where the money would be invested.? It was decided that the only fair investment was in government bonds, because it was neutral.? Investing in other assets, like the S&P 500 would be unfair, because they would be favoring a sector of the economy.

The same argument applies to direct lending by the Fed, because it would smack of favoritism.?? Going back to my last article, favoritism undermines confidence in the system, and makes people less willing to invest unless the government gives them an edge — cash for clunkers, $8,000 tax credit, etc.? We are Americans, after all.? Why buy from the retailer now, when you know that there will be another sale coming soon?? Economic policymakers should not rely on people to behave “as usual” when policy becomes unpredictable and unfair to the average person.

So I don’t see direct lending by the Fed, or buying high yield bonds, or offering protection on baskets of bonds as wise moves.? It may temporarily goose an area for a time, and make an area of the economy QE-dependent, or stimulus-dependent, but at best it is helping a few, while discouraging the rest.

Negative Fed Funds

I’ve been thinking about negative rates for Fed funds, and I think that they will have the following effects:

Banks will drop their excess reserves at the Fed to zero, and vault cash (or its short-term debt equivalents) will increase.
Banks will try to borrow from the Fed at negative interest rates, if they allow it, and just sit on the cash, park it in T-bills, Top-top CP — it’s free money, after all.? Of course, some point free money may be construed as valueless money, but that is another thing.

Required reserves are not a large percentage of liabilities.? Unless Fed funds goes deeply negative, it’s not going to affect bank profitability that much.? Banks may just view it as a cost of doing business, and pass it on to customers.

Destructive Creative Currency Debasement

With apologies to Schumpeter, who popularized the concept of creative destruction, I’ll try to define a new concept that is the opposite — destructive creativity.? Destructive creativity is when bureaucrats or regulators get too clever, and in an attempt to solve a lesser problem, end up creating a bigger problem.

I’ve heard proposals for further debasement of the currency via placing expiration dates on currency, or randomly canceling currency through lotteries based on the serial numbers on the bills.? The idea is that people will change their behavior: save less and spend more.

I can’t say that I can see every unintended consequence with these proposals, but according to Keynes, Lenin said, “The best way to destroy the capitalist system is to debauch the currency.”? These creative means of debasing the currency might do it.

Who gets to be the one holding the Old Maid card as expiry draws near.? How much time would be wasted scanning currency at registers as money is handed over and change is handed out?? Is the money cancelled or expired?? Close to expiration?? Quick, put it into the pile to give as change to the next customer.? There may be legal tender laws, but I can tell you that there would be fights over things like this.? Would all of the dollar bills used as a shadow currency overseas come trotting home?

If the Fed wanted to write its own death warrant, it should implement schemes like these.? The Fed is already viewed with enough skepticism by average people, that it wouldn’t take much to tip the scale from “Audit the Fed,” to “End the Fed,” where it gets replaced with the currency board tied to a commodity standard.

This leaves aside ideas like expiring/canceling a certain amount of monies in savings or checking accounts.? After all, why stop with the paper money?? Move onto the blips that we transfer day after day, silently, quietly choking the economic well-being of people, making them feel less safe, less secure, more paranoid.? Would we set up checking/savings accounts in other currencies to avoid this trouble?? Would that even work, such that we would have to set them up in foreign countries, and access funds that way?? What’s that you say?? Exchange controls?? Destructive creation indeed.? To “solve” a smaller problem, a dud economy, create a much larger problem…

Want to kill the economy/country?? Taxation is one thing, confiscation is another.? There are more than enough people who have question marks in their heads over what the government is doing with monetary policy and stimulus.? Aggressive actions to debase the currency can turn those question marks in to exclamation points.

This has gone longer than I thought.? Time to hit publish, and I will finish this tonight.

The Education of a Corporate Bond Manager, Part XI

Posted on 7 August 2010 by David Merkel

I appreciate my readers.? That doesn’t mean that I am the fastest to respond to e-mails, but I appreciate what they write, even when I don’t agree.? But here is an e-mail very relevant to tonight’s piece:

Great series, David.

If you have more posts planned, it would be interesting to know what the biggest mistake you’ve made that you learned from the most.

In my short tenure as a corporate bond manager, I had a very good run in the midst of a bad environment.? Sometimes I think my lack of formal training was a plus for analyzing a situation where little was going well.

But I did make my mistakes. One was Enron — don’t get me wrong, I urged the sale of Enron bonds, but was countermanded.? Could I have argued the cause better?

Fast-growing company in a slow-growing industry.
Management that could not take criticism.
Growing profits, shrinking cash flow.
We had a peek inside the veil, because we had financed some of their private deals.? The complexity was astounding.
Opaque balance sheet.

I made all of those points and still lost; my new bosses were not deep when it came to corporate credit; they were skilled in other areas of the bond market.? I eventually ended up selling the Enron bonds at an unfavorable price.? Would that I had sold on the date of the default, rather than a month later.

Then there was the Teleglobe situation, where I erred in many ways.? BCE, Incorporated had a unregulated subsidiary called Teleglobe.? Think of Global Crossing, and other marginal telecom ideas.? BCE was a sound company, and they offered verbal support for their subsidiary, but would not put it into writing, and formally guarantee their debt.

I did not know the company well, and I had no stock price to give me aid.? Stock prices are more sensitive than bond prices, and can give warnings before bond prices move dramatically.? My analyst went off to a telecom/technology conference, where the S&P analyst disclosed over dinner that she was likely to downgrade Teleglobe because of the lack of explicit support from the parent company.

Now given the broader picture, this should have been obvious.? There were too many situations where implicit support did not translate into real support, and Teleglobe, most than most, needed support.

My analyst called me after the comment from the S&P analyst, and I asked, “Should I sell?”? He said I should wait; he wanted to gather a little more data.? We had our opportunity to sell at $90, and waiting missed that.? By the time he returned, the S&P analyst indicated that a downgrade was likely, and the pseudo-price fell to $70.? But, we were now determined to sell.

So I called my favorite broker, who was at the only firm making a market in Teleglobe bonds.

DM: “What’s the market in Teleglobe bonds?”

FB: “$68/$72.”

DM: “Very good.? I sell you $XX Milllion of Teleglobe bonds at $68.”

FB: “I’m sorry, that’s not a real market, that is an indicative market.”

DM: “So where is the real market?”

FB: “We’ll take an order from you.”

DM: “You mean there is no real market?? You brought this deal to market, you have to maintain a market.”

FB: “We’ll take an order from you.”

DM: (Pause) You have an order for $XX million Teleglobe bonds at $65.

FB: “We will do our best for you.”

To this day, I have no doubt that she was serious with me.? Teleglobe bonds after that point traded in the $50s, but never at the main broker.? As I learned later, they had 10+ times more Teleglobe bonds than I did, and were trying to minimize their own exposure.? They lost a lot more than I did.

When BCE sent Teleglobe into bankruptcy several weeks later, we sold the bonds at $20.? The eventually went out as a zonk.? No value.

Lesson learned: bonds are asymmetric.? You are paid to be cautious regarding failure.? When in doubt, sell.? Also, don’t take your broker at face value always.

The fallout from the Teleglobe failure was twofold.? 1) the client accused us of incompetence, because we had missed on Enron, KMart, and Teleglobe. 2) My boss asked me how I could have missed it, and I said, “I was following it and did the best I could.? But I am following over 500 credits.”

Sadly, he made the wrong decision, and hired another corporate bond manager, and we split the portfolio.? It led to poorer portfolio management.

Another error: I am not politics-sensitive.? I am more interested in doing what is right for clients, than what looks best.? So when the client proposed value destroying ideas that would benefit them directly, I argued against them.? The asset manager took me out of direct client contact, aside from actuarial risk management, but asked me to tell them what was up, because the client asked for weird things.? The same applied inside the asset manager, where my willingness to take or avoid risk was in sync with opportunity, but out of sync with the firm.

I had learned to avoid undue pessimism from the high yield manager who sat next to me, and that often made me more optimistic amid gloom than others in the firm.? I was not a pea in the pod, and perhaps that made those that had acquired my firm wonder about me.? I never did anything more than make my opinions known, but that is enough for some to take umbrage.

Maybe the point is this: you can be right in the long run, but wrong in the short run.? What eventually happened to the client?? Well, I mentioned all of the dismissals before, but as God would have it, the client was sold yesterday to hedge-fund manager Phil Falcone.? The new CEO of Old Mutual said:

But just to remind you of the background of the transaction, we bought US Life in 2001 with the aim of building a Life business in the United States. This has proved to be a poor acquisition for the Group, and we acknowledge it, largely due to taking excessive credit risk, the impacts of which came to a head in the 2008 global financial crisis. So we said in March we intended to explore the sale of the business.

Old Mutual pumped in hundreds of millions in capital, in addition to what they paid for it.? They lost badly.? But they did not list the real reason why they lost, which gives me little confidence that they will do better in the future.? They lost because their US life division sold policies at levels that did not cover the cost of capital.? In order to avoid the inevitable losses from selling policies too cheaply, they pushed those who invested for them to try to make it up by taking much more risk.? The risk didn’t come first; what came first was a bad management culture that pushed sales growth at the expense of everything else.

Hopefully, Mr. Falcone will see that and realize that sales aren’t everything, and dial back investment risk.? But who can tell?

My main errors came from mis-estimating people.? I was not strong enough to change the culture, and I should have realized that, and tried to be more incremental.? As it was, I was right, but frozen out from being able to effect change.

Final episode tomorrow, most likely…

The Education of a Corporate Bond Manager, Part X

Posted on 6 August 20106 August 2010 by David Merkel

“We’re doing a CDO.”? So said the head of investments.? A few days later, the staff of an investment bank crashed the branch office where I worked, and told us what they would like us to do.? We would buy a lot of their distressed inventory of utility bonds and financial bonds, add in some bonds of our own design, and sell a CDO.

I thought the idea stunk.? I also thought we should do it.? Why?? Get your foot in the door.? You can only do deal #2 if you have done deal #1.? Investment banks were not banging on our door to help us create a CDO, and the collateral wasn’t horrible.? It wasn’t what I would have chosen if I had discretion, but it wasn’t horrible.? Besides, we would own the equity, so who would take the first losses?

Unfortunately, the deal meant a trip to Wall Street, or at least midtown Manhattan. Now, some find that a lot of fun, and I do as well, because I like meeting bright people, and exploring new ideas.? Often my brokers wanted to introduce me to some of their “thought leaders.”? I found that to be a lot of fun.

But much as I like wine and good food, I sometimes found the schmoozing to be a burden.? I try to be an ethical guy.? I’m out to serve my client within the scope of the law, and within extra-legal ethical codes (I am an actuary and I hold the Financial Analysts’ Charter.)? I’m also a “cheap date.”? I don’t have to have an expensive steak… a good burger will do.

We had a practice in my office, that we would take visiting brokers from Wall Street to Victor’s Cafe, which was a 3 minute walk from our office.? Not very expensive, and good food.? We could get back to work quickly.? The brokers would look at the bill and say, “How am I going to explain this cheap tab to my boss?”? I told them that it was our way; we enjoy people, not spending.

On that two-day trip to Wall Street to talk with brokers and cement the CDO deal, the meal on the second night would be at a certain five-star restaurant.? One problem: no reservations were made.? So, at the beginning of the second day, a competitor broker (the piece of work featured in part nine) asked what we were doing that evening, and we mentioned the other broker, the restaurant, and that we did not have a reservation.? He said, “I am close friends, with the manager of [that restaurant].? If you want I can get you reservations this evening.? The only thing I ask is that your coverage at [the competitor] send me a thank-you note.”? We said sure.? He called them up, and BAM! Reservations for twelve on the spot.

The guy was a piece of work, but he could get things done.? The evening was great; I made the bright move of ordering a Russian beer, which was so bitter that I drank little.? The food was rich, for the nth time on this trip, and as I went home on Amtrak, I said to myself, “You can’t do this to your body — too much rich food over two days.”? I felt horrible.

And, as God would have it, the CDO deal blew up within a week.? Management did not want to do a deal that they did not shape.? As for me, I could go either way.? Deal one for shops that don’t have a big name is typically a compromise.

But, I learned from my times visiting in Manhattan, enjoy it, but not too much.? The best parts were learning how the brokers worked.? In the times that I visited the trading floors, Wall Street completed moving the cash guys next to the derivative guys, to share information effectively.

I also learned that we were up against organizations that were so much more clever than those that they served (us!), that we were better off cooperating with them than competing against them.? It was fascinating to watch the flow of information ripple across the trading floor.

-==–=-=-==-=–=-=-==-=-=-=-=-=-=-=-=-

Making Money

Merger arbitrage was an area I was surprised to find had value as a manager of bonds.? I trust my analysts; if they said a deal will go through, it will go through.? I would analyze the downside, and see if it was not acceptable.? In that era, the incremental yield on swapping acquirer bonds for target bonds was 40% annualized.? Woo-hoo!? Given all of the credit losses in 2002, I was able to make up for it all and more with some of these trades.

There was one big deal where my analyst said that the deal was a lock, and so I traded all of my shorter bonds, and bonds in the acquirer, for 30-year non-deal-protected bonds, and went up to my credit risk limit.? To my surprise, I got a call from the chief investment officer.

“Hey.”

DM: “What’s up?”

“What are you doing?”

DM: “Making money, and you?”

“Not funny.? You are messing with all of our credit risk limits here.? What if the deal doesn’t go through?”

DM: “It will go through.? The target will not survive well without it, though the bonds are money good, and the acquirer has its reputation on the line.”

“No more trading in this name, got it?”

DM: “Got it.” (I was done anyway.)

That ended up being our largest single capital gain for the year.? A close competitor was when I began buying the junior debts of banks in late 2002, particularly of the floating rate variety, which offered more upside.? After putting 2% of the client’s assets into the floating-rate trust preferreds, I got the call.

“Hey.”

DM: “What’s up?”

“What are you doing?”

DM: “Making money, and you?”

“Not funny.? You are messing with all of our credit risk limits here.? What if the banks don’t do so well?”

DM: “These are major, solid banks, where there is little risk of insolvency.? You’ve bought some outright preferred stock of some of these banks for portfolios, and this is safer.”

“Forget that. This trade is done, no more, got it?”

DM: “Got it.”? Again, the trade was done, and spreads had begun to collapse in, rapidly.? One broker who dominated the sub-market, but who I had done few trades through, told me that there was a buyer in the market, and so spreads were falling fast.? I wonder who that buyer was? 😉

Anyway, the smallest capital gain they cleared on that trade was 10%, and in bond terms, those were home runs.

I had other notable trades, such as credits tainted with Brazil exposure, where the company would be fine even if the Brazil exposure defaulted in entire — we loaded the boat, and sold after Lula was elected.? (Remember how worried people worried about Lula?? Another reason to remember that stability usually triumphs over discontinuity.)

If you give your bond managers enough rope, they may work wonders for you, or they might hang themselves.? We had our share of losses and gains in what was a horrible period 2001-2003.? On the whole, it was well above average, but our client was tough, and we got little appreciation for what we did.

If you work for money, you will be disappointed.? If you work for praise, the same.? If you work for excellence, you can only disappoint yourself.? I was happy with what I achieved for the client, even though the client didn’t like me much. More in the next piece.

PS — the broker did not send the thank-you note, and “the piece of work” got after him until he did.? What an episode!

The Education of a Corporate Bond Manager, Part IX

Posted on 5 August 2010 by David Merkel

You aren’t supposed to act like a market-maker as a bond manager.? That is the role of a broker-dealer, and should they know that you aspire to making the risk-free profits that they do, they may use their power to harm you, notably:

Give you lower allocations on new deals.
Be tougher with you on haggling.

There are exceptions, though, and both tales are instructive.? One time, I received an offer that had a lot of spread on a bank bond that I had never heard of (given my memory, that was rare).? It was from a third-tier dealer that I rarely traded with.? I called over my new banking analyst (NOTE: She is a stupendous corporate bond analyst for banks, and is looking for a job now… if you need such an analyst e-mail me.? You won’t be sorry.) and asked her about the company.? She commented, “Solid franchise, boring.? Credit metrics are fine.? Go ahead.”? So I bought the bonds.? Remember, I trust my analysts, but if the trade works out badly, it is my fault.? The buck stops here.

On that day, the new corporate bond manager, with whom I would divide the portfolio (because it had gotten so big) was there for the first time.? We met and chatted for a while, but while we met, I got a phone call from a different third-tier dealer who wanted the exact same bonds that I had just bought.? He asked be where I would sell them, and I named a spread level 50 basis points tighter than where I had bought them minutes ago.? To my surprise, he bought the bonds at the level.? The new portfolio manager asked where I had bought them, and when he heard that I had cleared $3 per $100 on a 15 minute trade, he gave me a big “high five” and told me that I was the best.

Now, for those that know me well, in person, I get embarrassed with too much attention.? Writing, that’s another thing because it is somewhat anonymous to sit in front of a screen and write to people that you don’t know personally, like now.? I was surprised at his reaction, and it proved to be an indicator of what he was like as a trader.? He liked to take advantage of the Street where he could, and he had a bit of a greedy reputation, as some of my brokers told me later.

Most corporate bonds I traded had three basis points between the bid and the ask.? I would try to shrink that to two, or even one where I could, without being rude.? This was common after the new guy was hired:

DM: “Could I get the bonds one basis point wider?”

Broker: “Let me talk to the trader.”? (Fainter: “could he have them a basis point wider?”)? Pause, indecipherable.

Broker: “Let me try again.” (Fainter: “It’s XXX.” naming my firm)? Pause, indecipherable.

Broker: “Let me try again.” (Fainter: “It’s Merkel.”)? Pause, indecipherable.

Broker: “You are done at your level.”

DM: “Thanks! You’re the best!”

Reputation matters.? There was another example where I crossed bonds where it was legitimate — if it was done to help a broker in distress.? One day, someone offered me a rare type of Capital One bonds at a normal level, and I asked whether the bonds in question were the ones that were in a major bond index, without saying that per se.? After figuring that out, I bought them at the level, and called a broker that was likely to be short the bonds to see if he wanted them.? He certainly did, and offered them at a three basis point concession to where I bought them, as opposed to ripping the eyeballs out (as the technical term went).

The whole set of two transactions took 15 minutes, and made $15,000 for my client.? What was funnier, was that my whole family came to visit me that day, my wife and at that time, seven kids.? They heard the two transactions, though I had to explain it to them later. To the second broker, I had each of the kids say “Hi,” ending with the then three-year old girl who squeaked “Hi.”? He said something to the effect of, “I knew you had a large family, but it only really struck me now.”

Underwriting Your Brokers

Just as I said in an earlier part about underwriting your credit analysts, the same was true of brokers.? It paid to analyze what they would say, and what they would do, and compare them.? Over time, I gravitated secondary trading business to those the “walked the walk.”? So, one day, one of the brokers of a big firm who did not “walk the walk” called me and asked, “Of all of your brokers, where am I in your ranking of getting trades done?”? I told him that I didn’t know, but asked him to call back tomorrow.? With my computer expertise, I ran a few analyses, and got the answer.? When he called back the next day, I told him that he was number eight.

“EIGHT! I am number three at worst with the rest of my clients, and you are my smallest client! Who is ahead of me with you?”

DM: “Salomon, B of A, Chase, Wachovia…”

“What!”

DM: “Hey, he covers me like a glove; you don’t often call. Lehman, Goldman Sachs…”

“No one does corporate business with Goldman!”

DM: “I do corporate business with Goldman, and I get a lot done because my coverage is earnest and looks out for me.? Merrill, Legg Mason…”

“LEGG MASON!!!? You’re &*^*&^ kidding me, they are nobodies!”

DM: “but they talk to me daily, and the broker I deal with there is honest, and we get trades done.? They may be nobodies, but I deal with those who will deal with me, and we care about the fixed income community of the city we are in.? You are next, do you want to hear who is after you?”

“NO! You are a TOTAL EMBARRASSMENT to me.? I don’t need to have you as a client.? You are my smallest client, and I have other clients who treat me with the respect the I deserve.”

DM: “Do what you want.? Other brokers send me ideas every day, but you don’t.? If you want to be a big broker with me; I am open to that, but you have to spend time on me.”

The conversation ended soon after that, but there were two results: I began to get more trade ideas from him, and he handed me off to a junior broker who worked for him who spent more time on me.? Business went up.

I have described some people I have worked with to my kids, but he was the first that I described as “a piece of work.”

There was a time that I had lunch with him in Midtown, with my old boss there as well, where he described the travails of his wife with two nannies, for his two kids.? My boss got angry on my behalf: my wife dealt with seven, home schooling, with no help, and he talked of the troubles of his wife.? Me?? I give people room.? What is hard for one is tough for others.

But what this touches on is the schmoozing that goes on with clients, and how that affects business decisions.? More on that in the next part.

The Rules, Part XVI

Posted on 13 July 2010 by David Merkel

Governments are smaller than markets; markets are smaller than cultures.

This rule has always had a special place in my heart.? It is an attempt to explain what drives human action in our world.? Though I think economic reasons for action are important, they are not the dominant reason for human action.? Human actions are dominated by the religious and philosophical views of each culture.? That is what men will sacrifice for.? Economics is how they fund those ideals.

Homo Oeconomicus does not exist.? Few live to merely maximize their personal enjoyment of life, narrowly described.? Yes, if one broadens the paradigm to say that enjoyment of life means achieving the unique goals that one might have for influencing society, that might make the two similar, but there is no way for that to be true for all men at the same time, because views differ there.

Cultures are not Neutral with Respect to Economics

Let’s take a step back.? The embedded beliefs of cultures affect what can be done by its inhabitants economically.? Does the culture permit/encourage:

Borrowing and lending with interest? (In non-stilted ways)
Taking risks?? Having a bankruptcy code that is not too punitive?
Avoiding big risks, that might harm parties two or three links removed?
Education of children, such that they are motivated to learn.? (Note: only parents can do this effectively.? Teachers will try, but school cultures depend on parenting cultures.? Lazy parents –> lazy kids.? This applies to children in public, private and home schools.)
Education, so long as we don’t get too many people in any area where there is not enough demand.? (I am thinking of the science and math deficit here.)
Labor flexibility; will a significant subset of people retrain when their area of the economy is no longer in so much demand?
Basic honesty in business dealings?? Business is based on trust.
A strong view of the value of time?? Time is money, and cultures that say “tomorrow” will not prosper as much.
Allowing freedom to business within the basic boundaries of ethics?
Government officials don’t commonly take bribes, or political action committee contributions?
People to have an interest in building something through their lives, and free to pass on the benefits as they wish?
Charity, not welfare, to those who have had a rough go of it.
Fair courts that will adjudicate rights and claims impartially.
Legislatures that will be restrained?
Executive officers and bureaucrats that will balance the varying needs of society in accordance with the laws, and not become pseudo-dictators?
Honest money, where a stable unit of account is maintained, rather than trying to trick people into doing more or less through monetary policy.
And more, I hope you get the idea.

Cultures set the backdrop for what men will value and do.? More than laws and regulations, cultures have the soft power such that it is difficult for a man to imagine other ways to do things rather than the accepted norms of the culture.

Cultures are not contiguous with nations; it is more of a tribal thing.? Some cultures exist inside a single nation, some exist across nations.? I think it boils down to a similar view of life that gets propagated through families sharing a similar world view.

Each nation has a meta-culture that is a weighted average of the influences of the cultures inside it.? The weightings depend on size, and willingness to exert effort.

Over the long haul, I think that culture has a bigger impact on the growth of GDP/person than natural resources of an area.? Hong Kong and Singapore are small examples of successful meta-cultures.? Russia and Venzuela would be examples of a resource-rich places that did not capitalize on its opportunities because of the lack of honesty in government.

Governments Have Limits Relative to their Economies

The present time helps show the limits of governments.? Yes, governments have taken bold actions to prevent a banking crisis.? And, it may have worked, but who can tell two years out?? But the governments took on a lot of debt to do so.? Debt-based systems are inherently less flexible than equity-based systems.? As such, the governments of our world are less capable of meeting a significant crisis than they were ten years ago.

Governments that try to do too much run the risk of growing beyond their meta-culture’s willingness to fund them.? It makes sense for governments to focus on the few things that they should do well: internal security, defense, public health, justice, etc.? Beyond that, the effectiveness of governments breaks down.? Governments that try to favor/disfavor a wide variety of actions through tax and stimulus policies don’t typically achieve what they wish for.? Instead, they get populaces that get a minority of clever people who milk the legal code to their advantage, and pay lobbyists to continue the practice, while the average person is frozen out through barriers to entry.

There is something similar to the Laffer Curve that applies to governments, though the shape is unknown to me.? At some point, increasing tax rates stops leading to an increase in revenues, and at some point beyond that increasing tax rates leads to a decrease in revenues.? Those break points will vary, but the clever rich forever reduce their taxes through loopholes.? For the second break point to be hit, taxes have to rise such that the middle class starts to seek shelter from taxes.

Conclusion

Governments can’t dominate economies or meta-cultures.? If they do, they will enforce relative poverty on their countries.? They have to reflect the basic ethics of their meta-cultures, or they won’t survive for long.? Economies will only grow to the degree that their meta-cultures allow them to do so.? Willingness to take and fund risk are culture-driven.

When you consider international investing, examine the culture that you are investing in and ask whether it will be fair to foreign shareholders.? Ask whether they will have standards of governance as good or better than in your home country.? Ask whether they will be motivated to do their best for themselves and their owners.

Don’t underestimate cultural effects in economies.? Men are not the same everywhere; their cultures lead them to think differently.

Why Are We The Lucky Ones?

Posted on 2 July 20102 July 2010 by David Merkel

Working as the only analyst in a small broker dealer means you occasionally get some interesting projects.? There are many hucksters out there, and if they drop by your bitty broker-dealer to run their deal, skepticism, not hope, is the proper reaction.? ?Why are we the lucky ones?? should be the skeptical question.

Anyway, here are three responses that I gave to my bosses over a four month period on deals that were brought to them.? Names have been obscured where possible.

Project 1

This was a deal that attempted to securitize life settlements, i.e. life insurance policies where the owner has sold off his interests to a third party.? The biggest problem was all of the money sucked out of the deal that would not be invested to earn a return.? Here is what I wrote:

Dear Boss,

Notes on the deal

I have read the Overview and the Private Placement Memorandum [PPM], and have scanned everything else.? Here are the main points:

1. The key page of the entire document is page 18 of the PPM.? In it we learn: the zeros get a 4.07% return, but the collateral has to earn 11.72% net of fees in order to make this deal pay off.? Also, 65.52% of the proceeds go to other than investment purposes.? Why so large?? (As an aside, this yield is at a discount to Treasuries.? An equivalent length treasury zero yields 4.55%, AAA Aid to Israel – ~5%.)
2. The continuing fees are hefty – Servicing 1%/year of Face?? Origination – 1%/month of the Matured Policy Increase Amount [MPIA – essentially a measure of cash flow profitability]?? Administrative expenses as well to third parties.? I can’t tell how big those are, or how much the collateral would have to earn to make the bond pay off.
3. The residual value guarantor, AAACO, is not in good shape.? The central bank of CN has taken over the assets and liabilities for now, but it does not seem that they have guaranteed the liabilities permanently. They are rated “B” by AM Best – not a sound rating.? On taking over the group that owned AAACO, S&P said that it was a big enough rescue that they might have to downgrade CN from its A rating.? They have since reaffirmed the rating as stable, but Moody’s now rates CN as Baa1.
4. The residual value policy doesn’t do much if there is a modest deviation from perfect performance by the originator or servicer, the policy won’t pay.
5. We don’t have all of the documents, such as the Blocked Account Control Agreement.? But beyond documents, we don’t have any sort of cash flow analysis.? How are they going to earn so much on so little invested capital?
6. We don’t have any data on the life policies, insurers, etc.? Some insurers fight life settlements.
7. The Overview dramatically oversells the virtues of the deal.? Many of the things it lists as protections are weak.? Points 3 and 5 are the same points, but it makes them sound different.? Further, CN do not own AAACO, they have it in a form of semi-receivership.? If they did own it, AM Best would give it a better rating.
8. BBB is the actuary, but she owns the originator and the servicer. [Origco & Servco]? She is not bound to continue with the deal till maturity if it gets originated (she will be 75 herself then).
9. Servco and Origco have defaulted on prior deals, and they weren’t able to get enough interest on the first deal to make it work.
10. Origco is basically broke.? They have assets of $500K, and liabilities of $2 million.? The assets are receivables from Servco.? Servco owes $16 million that it can’t pay off either.
11. Origco and Servco do not use accrual accounting.? They could not pass a GAAP audit.? Even with accrual accounting, they would not be a going concern.
12. Origco and Servco have existing default judgments against them, and no way to pay them.
13. If Servco or Origco default, the residual value policy does not pay.
14. Servco and Origco have no significant staff.? If this gets originated, there will be a significant risk as they staff up.?? They also don’t have licenses.? This is not a bond, it is seed stage venture capital.
15. They have had run-ins with the SEC, Texas Securities Commission, and Securities Division of North Carolina.
16. The notes are deemed equity for tax purposes, which seems aggressive to me.

If you want, read page 18, and scan the risk factors section of the PPM (pages 19-57).? It is my belief that this is something that we don’t want to get mixed up with, at any price.? I can understand why no underwriter wants to take this on, and why they are looking to smaller broker-dealers.? But if you want to look into this further, have them forward to me their cash flow analyses.? I can’t imagine how they get this to work.

I have this phrase that I use sometimes, “Holding my nose as I hit the delete key.”? That is when something smells so bad, the odor can even travel over the Internet.? This feels like the attempt of some desperate people who are deeply in debt, and need one “grand slam” to bail themselves out of debt
and have a happy retirement.

Postscript: this deal not only did not get done, but the boss apologized for bringing it to me.

Project 2

This was a case where someone was willing to offer us $5 million in capital if we gave them $1 million.? What an altruist!? Not.? Yes, the value of shares if you could sell them all at the ?last trade? was worth $5 million, but the company was basically a warrant on the success of a technology, and the balance sheet was horrendous.? This is what I wrote:

Dear Boss,

This doesn’t smell good.? Here’s my commentary, together with excerpts from their recent 10-K and 10-Q:

$6250 Stock Trading Volume per day

Negative earnings, cash flow, and net worth.? Little to no liquidity ? huge negative net working capital.

1-100 reverse split

Auditors comment for 2008 10K: The accompanying consolidated financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 11 to the consolidated financial statements, the Company has a significant working capital deficit, has recognized significant operating losses in each of the years in the three year period ended December 31, 2008, and will need significant amounts of investment funds to fully develop its oil and gas leases. Management’s plans in regard to these matters are described in Note 11. The financial statements do not include any adjustments that might result from the outcome of this uncertainty.

The Company currently has three full-time employees.

Risk factor: The Company has incurred net operating losses since 1997. However, the Company currently has operations that provide working capital. The Company is also seeking further project based financing to develop its existing projects. There is no assurance that the Company will be able to secure adequate financing to fund those operations.

High compensation to management for not much of a company.? $5 million in 2008.

The Company failed to timely file a current report on Form 8-K upon the occurrence of the Default Notice and Acceleration Notice under the Credit Agreement with CCC, and the July 22, 2008 Limited Forbearance Agreement pursuant to which Gas Rock agreed to refrain from pursuing remedies for a limited time.

NOTE 7 – Note Payable – CCC CAPITAL LLC

The Company entered into an advancing term credit agreement for $30,000,000 on April 13, 2006 through its subsidiary DDDa, LLC with CCC Capital, LLC to fund the purchase of the EEE Field in GGG Oklahoma. This agreement was increased to $50,000,000 on April 2, 2007. The balance at December 31, 2008 was $13,423,221, net of debt discount of $41,077, and the Company paid interest of $1,957,294 for the year ended December 31, 2008. The note is secured by all of DDDa’s assets and certain personal assets owned by EEE, CEO of the Company. DDDa’s assets are cross-collateralized on a $3,469,000 loan made by CCC Capital, LLC to FFF, a related party. This loan is currently in default, with interest only payments being made.

On April 9, 2008, CCC delivered to the Company a Notice of Events of Default and Unmatured Events of Default (“Default Notice”) under the Credit Agreement. Due to these claimed Events of Default, interest under the Credit Agreement began accruing at the Default Rate of 15% and 100% of DDD’s Net Revenues were applied to Debt Service and other Obligations as of April 9, 2008. On April 16, 2008, CCC delivered to the Company a Notice of Acceleration (“Acceleration Notice”) under the Notes due to the continuing claimed Events of Default under the Credit Agreement. The Acceleration Notice declared the amounts due under the Note to be accelerated and due and owing in full as of April 16, 2008.

On July 22, 2008, CCC, DDDa and FFF (“FFF”, and together with DDDa, the “Borrowers”), entered into that certain Limited Forbearance Agreement, pursuant to which CCC agreed, subject to the terms thereof, to forbear from pursuing remedies under the Credit Agreement and Notes in respect of the Events of Default claimed as of that same date until the earlier of (i) November 15, 2008 and (ii) the date that CCC gives DDDa notice of any additional payment default under the Credit Agreement. FFF is controlled by the Company’s CEO and is a guarantor of the DDDa Obligations under the Credit Agreement. CCC is also a lender to FFF under an Advancing Term Credit Agreement (the “FFF Credit Agreement”, and together with the Credit Agreement, the “Credit Agreements”.

The Forbearance is subject to the following conditions to be fulfilled:

1) On or before November 15, 2008, (i) the Borrowers must repay all Obligations (as defined in the Credit Agreements) or (ii) DDD must have entered an agreement for the full or partial sale of the EEE Field, the proceeds of which would fully repay the Obligations owing under the Credit Agreements, and such sale shall close and repayment of the Obligations shall be made by December 31, 2008;

2) If the Obligations are not repaid by November 15, 2008, DDD must assign a 5.0% net profits interest in the EEE Field to CCC, effective as of November 1, 2008. The form of this assignment and the potential assignments discussed in paragraph 3, below, will be substantially in the form of the Conveyance of Net Profits Overriding Royalty Interests, attached as Exhibit A to the Forbearance Agreement;

3) If the Obligations are not repaid by December 15, 2008, DDD must assign an additional 1.0% net profits interest in the EEE Field to CCC, effective as of December 1, 2008, and will assign to CCC an additional 1.0% net profits interest each subsequent month if the Obligations are not repaid by the 15th of such month;

4) DDD shall escrow one 5% net profits interest conveyance and five 1% net profits interest conveyances to ensure it’s delivery of any potential obligations under paragraphs 2 and 3, above;

5) Any and all Net Proceeds (as defined in the Forbearance Agreement) from any equity issuance, refinancing, or asset sale will be applied first to outstanding fees and expenses of CCC, second to the accrued and unpaid interest on the Notes, and third to the outstanding principal balances on the Notes; and

6) The Borrowers must ensure that its hydrocarbon purchasers make payments relating to any of CCC’s overriding royalty interests in the EEE Field directly to CCC.

NOTE 11 – Going Concern

The Company has reported operating losses aggregating $9,877,016 for the two (2) year period ended December 31, 2008. At December 31, 2008, the consolidated balance sheet reported a working capital deficit of $23,887,172. The Company must raise significant amounts of cash to pay its current liabilities and to provide investment funds to continue development of its oil and gas leases. There can be no assurance the Company’s management will be able to secure funding.

David here: There is little assurance that an immature development stage company like this will ever be worth anything.? I am no expert on hydrocarbons but this company is overindebted, and it is likely that debtholders will own the assets within a year or two, and equityholders get nothing.

DDD shares would not, not, not be an asset to our firm.

Postscript: 6 months later, the stock worth $5 million is worth $300,000.? And will be worth zero soon.

Project 3

Another life settlements securitization.? The originator seems to be honest, but is using the securitization to get a cheap commercial mortgage loan.? What I wrote:

Dear Boss,

I’ve read through the whole document.? Here are my thoughts:

Summary Notes

The officers of the company have no experience at all with life settlements.? They do have some experience with multifamily housing.? They are using a life settlements securitization to facilitate loans for their multifaqmily housing expansion plans.? To me, that is pretty convoluted.? Why not simply go out and borrow the money?

I realize the offering memorandum is preliminary, but there are several things that need to be clarified:

Need to see the financials of the GGG enterprises
Correct address for their website.
Who is HHH Capital Management?? Can’t find them –?the portfolio managers.
Need fees, policy data, and expected cash flows
What are they doing to source portfolio 2?
Need actuarial projections
Exactly what are the trusts receiving as collateral for the loans?? I need pro-forma financials on the property(ies) to be developed?
Where are the related party transactions?
If this deal is 3x overcollateralized, where does the excess money come from?? Who is the equity, and what are their motives?

That’s all for now.? Looking forward to more data.

After the response, I wrote:

Dear Boss,

I realize the offering memorandum is preliminary, but there are several things that need to be clarified:

I have three tentative conclusions (with questions):

1.????? The largest asset is a 9 year fully amortizing 2.7% loan on the $40,000,000 to the sponsoring company.? It is a hidden source of profit to them, but the full amortization makes the loan more secure, it they can make the first few payments.? That said, they would need 12% cash flow on the loan to make the payment, and where will they get that?

2.????? The deal would need a 6.1% return on the Life policies to get a Treasury yield on the certificates.? 8.0% return to get T+100.? 15.75% to get T+500.? What would it take to sell these notes?

3.????? There is a low probability of full payment of principal.? A margin of $25 million on a $250 million principal payment is skimpy, and in my opinion, decidedly not investment grade.? I assume these aren?t going to be rated, right?

And I have additional data needs:

4.????? Who is HHH Capital Management?? It looks like a new firm ? do they have the ability to do their part?

5.????? I need fees, policy data, and more detailed expected cash flows. Where is Appendix B?

6.????? How were the life expectancies calculated?? That?s hard to do right.? Second opinions?

7.????? I need actuarial projections, with considerable detail. That would mean a copy of the JJJ review.

8.????? Exactly what are the trusts receiving as collateral for the $40 million loan?? Pro-forma financials on the property(ies) to be developed? And, I would need to see the financials of the GGG enterprises.

I think this deal will prove hard to complete.

Postscript: we went further with this group than the other two, but when faced with my data requests, the originator gave up.

After this happened to me, I talked with an investment banker who is local, and has many contacts like mine.? He commented on how small broker dealers get hit up with slick pitches, any one of which if accepted, could destroy the broker-dealer.? The trafficking of blocks of life settlements is endemic, and is a search for what lemming has the lowest discount rate — has mis-estimated the risks.

He also mentioned how these groups toss around big names as those that will buy the senior certificates.? I experienced that myself.? Kuwaiti Investment Authority, indeed.

So, in four months time, I kept my firm from making dumb decisions three times, any one of which might have severely damaged or destroyed the firm.? What did I get get for my efforts?? The best thing of all: gratitude from my bosses, and knowing that I did my best for those that hired me, protecting the interests of all stakeholders of the firm.

Skepticism is a necessary aspect of investing, particularly as the complexity level rises.? Aim for simplicity, and put safety first in your investing.? It is easier to protect value than to try to earn back losses from mistakes.

To phrase it another way — in order to work through these deals, I had to read through over 1000 pages of data.? Don’t let the multiplicity of words dull you to the risks that exist.? Even for small investors I would say avoid complexity.?? Where there is complexity, there is a much higher risk of loss, almost always.? Stick to simple investments, and let the complex stuff be bought by experts, who will turn away most of the charlatans.

The Rules, Part XIII, subpart A

Posted on 1 May 201020 June 2017 by David Merkel

The need for income naturally biases a portfolio long.? It is difficult to earn income without beneficial ownership of an asset ? positive carry trades will almost always be net long, absent major distress or dislocation in the markets.? Those who need income to survive must then hope for a bull market.? They cannot live well without one, absent an interest rate spike like the late 70s/early 80s.? But in order to benefit in that scenario, they had to stay short.

My paternal Grandfather invested in CDs through the interest rate? spike of the late 70s and early 80s.? He looked pretty smart for a time, but he never shifted to take risk when there was a reward to do so.? Contrast my Mom, who had her 50/50 mix of utility stocks and growth stocks (a clever strategy, which as far as I know, she thought up herself).? As she once said to me, “My utilities are my bonds.”? Though my Mom’s strategy underperformed my Grandfather’s in the short run, in the intermediate term it soundly beat his strategy.? Long term?? No contest.

There is something about yield.? Almost everyone wants to have it, and have more than what would be average.? My own equity portfolio throws off more yield than the S&P 500, even with 19% earning nothing in cash.? There is something tangible about yield: cash in hand, vs. uncertain capital gains, even if the dividend leads the stock price to drop.

There is a sense that yield is free, like harvesting eggs from your chicken coop in the morning.? Mentally, that is the way that many view it.? They may adjust the yield for risk of nonpayment, but there is a tendency to assume that the yield will come in.

Here’s an example: in 1999-2000, Morgan Stanley did a piece on some corporate bonds that they called, “The Dirty Thirty.”? They were the worst of BBB-rated bonds, but they argued off of a limited period of past returns, that the widening in yield spreads over Treasuries was not justified, so but them because they survive and outperform.? Very bad timing, I must say.? Many of the companies defaulted 2000-2002, and enough came under severe stress, that those with weak balance sheets kicked them out at the wrong time, for fear of their possible insolvency.

This was a prime example of a brokerage providing advice that was technically correct off of history, but deadly wrong with respect to the situation at hand.? Now, was Morgan Stanley trying to lighten its inventory of Dirty Thirty bonds?? I don’t know, but I suspect not.? Most corporate bonds of large corporations are liquid enough that they can be bought and sold easily.

Truth is, if you are a bond manager, you get lots of sell side research telling you how to get a higher yield.? To clients who report on a book value basis, like banks or insurers, that is manna, or pennies from Heaven.? Yield goes straight to the bottom line.? Capital gains or losses can be deferred, at least until default or maturity, and even if they are realized, analysts exclude them from operating earnings.

Thus the tendency for many regulated financial institutions to be yield hogs, unless the management team has religion regarding risk control.? As for me, I held the unique position of being risk manager and leading corporate bond manager at one job.? There was a conflict of interest there, but for me, it enabled me to be more cautious, and more risk-taking at appropriate times.? Gaining real market experience is something most risk managers never get, but it imparts knowledge of likely ways in which asset management can go astray.

It can easily go astray.? As Warren Buffett says, “If you’ve been playing poker for half an hour and you still don’t know who the patsy is, you’re the patsy.”? Goes double for trading with the main desks on Wall Street.? They look for weaknesses, and the leading weakness is being a yield hog.? They will more than happily dig up yieldy securities that are more risky than normal for such a client, because the client wants it, and it is easy to find those securities.

The investment banker may think the client is dumb, but he is under no obligation to tell him so.? And besides, in investments, who knows?? The client may know things that the investment bank does not.

To illustrate, I got cheated on my first corporate bond trade with CSFB.? It looked like a good trade to me.? It would gain incremental yield on a seemingly similar security.? My boss was gone, so I, the new assistant, made the trade.? On a $5M trade, I lost $20K instantly.? My boss was leaving for another job in a week, but he chewed me out anyway, and told me at some firms I would have been fired for what I had done.

I took it to heart, and hyperanalyzed the trade to understand all of my errors.? I did not make those errors again, and I was very diligent to be a skeptic regarding the trades that I did with the big firms.? That did not mean that I did not trade, but that I drove the trades that I did, rather than accepting the trades that the Street suggested.

Instead, I relied on our in-house analysts to do our digging, and I became persistent at pursuing what we wanted, and enlisted second-tier brokers that could help us.

I would often do swap trades that gave up yield, if I saw a greater improvement in the risk profile.? That is rare among bond traders.? Even among professionals, there is a bias toward more yield.? I ended up preserving capital for our main client, allowing me to reinvest at favorable yields as the crisis was cresting.

The bias for yield among individual investors is worse, and Wall Street readily takes advantage of individual investors in order to hedge expensive options by offering seemingly high yields through structured products.? The credit and interest rate risks take away what the yield offers, and more.? That’s the business, and smart investors stay away.? Don’t be the patsy at the investment poker game.

At the Fordham Conference: Time for a New Antitrust? False Assumptions

Posted on 12 March 2010 by David Merkel

Carl Felsenfeld: Do we know what the problem is?? What are we trying to solve?? Antitrust does not deal with Citigroup/Travelers, it should deal with Bank of America/Fleet, Wells Fargo/Norwest.? But it didn’t deal with those bank acquisitions.? The regulators were out to lunch.

Jesse Markham: Antitrust can only do so much. It also does not do so well where size is due to organic growth.? (DM: like Google or Microsoft.)

Zephyr Teachout: Antitrust should be based on size.? The DOJ is less subject to regulatory capture, and more inclined to prosecute.

Paul Kaplan: These ideas are against current trends in antitrust.? Perhaps a more rigorous application of the Sherman Act would be more effective.? Organic growth to a large size is still a problem, but how do you avoid punishing success?

(DM: just met Colin Barr of Fortune.? Nice to put a face to the name after all these years.)

Discussant: Canada disallowed securitization for the most part, and stopped more mergers with their banks.

False Assumptions

William Black — Control Fraud & Systematically Dangerous Institutions -Accounting values can be fudged.? RBC as well.? Difficult to detect Control Fraud.? Originating bad loans allows a bank to grow rapidly.? Need forensic accountants.

(DM: look for fast growth — quality, quantity, price. Look for new products.)

Lawrence Baxter — When Big Becomes a Problem.? – Worked ten years at a major bank that went through? a ton of mergers.? The self-regulations with each bank having its own risk model doesn’t work.? The regulators don’t understand them, and spend time learning what is going on.

(DM: fascinating that no one has talked about why the US bailed out holding companies, rather than letting them fail, and merely backing up the operating subsidiaries.? Also, few have fingered the Fed’s monetary policy.)

Shawn Bayern — False Assumptions in Law and Economics — Innovation in the banking is not always a positive.? Bonuses to executives skew incentives.? (DM: it is a form of asset/liability management.)

Russell Pearce — discussant — Business is self-interested, and short-term greedy.? Profit-making is maximized, not even long-term greedy (DM: maximizing the net present value of profits).? (DM: incent using long dated restricted common stock — trouble is, it doesn’t incent as well as cash.)

Mark Gimein — discussant — 3 questions a) What of a big rogue banker?? The market is good at absorbing single failures.? (DM: but not multiple failures.)? b) who should do the regulation?? Tough to get bright men who are tough who won’t go to work for the banks, or buy into the banks logic. c) Control Fraud is hard to prevent; human nature is that way.? No systematic approach to dealing with fraud.

Detecting Fraud — check for adverse selection, honest businessmen won’t do business that way.? Also, it never make sense for a secured lender to accept inflated appraisals.

(DM: Look for gain-on-sale accounting.? Analyze management culture for short-termism.? Remember you can never get pricing, volume and quality at the same time.? Financial companies are in a mature industry, so beware sompanies that grow fast.? Be aware of long dated accruals.)

Discussant — are we worse off today than in the robber baron era? Not necessarily.

Holmes bad man theory — the law exists to constrain bad men.

I gave a 3-minute rant on how insurers are better regulated than banks.? I’ll write more about that tonight in a piece that articulates my views on banking reform.