Category: Ethics

Tribune and AIG — Two Debacles

Tribune and AIG — Two Debacles

Posted on by David Merkel

I never thought the deal where Sam Zell bought Tribune was fair, because it relied on the savings of workers in their ESOP [employee stock ownership plan].? Here is what I wrote in the past:

Well, now Mr. Zell is getting sued by Tribune employees, and he deserves it.? Zell could not have bought out Tribune without the support of the ESOP, but his actions harmed the economic interests of the ESOP, and thus the employees.? Many will agree to anything if their job is threatened.? The semi-coercion plus failure will not work out well for Mr. Zell.

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And, speaking of not working out well, we have the NYT Op-ed on AIG.? I say good, let AIG, the Fed and the Treasury disclose what they said during the bailout.? We already know that many areas of AIG would have gone under without the bailout.? Though the Treasury Secretary has changed his tune on why AIG was bailed out, originally it was only and ostensibly for AIGFP, the derivatives subsidiary.

Let AIG and the Government reveal what they said? regarding the bailout.? The American people deserve to know it.

Where the Rubber Meets the Road at Home

Where the Rubber Meets the Road at Home

Posted on by David Merkel

Dear David,

Quick question in case you find yourself with time to spare on your blog (ha!! ) :
You have a large family. What do you teach your children?? How do you prepare them using the economic back drop? What are the hopes, the fears that a parent has for their youngsters ?

It is the real-life application that so often is skipped over in financial blogs.? Maybe that’s as it should be – not every reader might find it of interest.? But isn’t that where the rubber meets the road?

So, I’ll send this off and maybe one of these days, the question ties in with something you were going to write.

Thanks a lot for your insights.

Regards,

A.S.

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As the snow starts to fall, and Baltimore is in the eye of the storm (18-24 inches of snow predicted), I think it is a good time to sit back and think about the bigger things of life.? I’ll be spending all day tomorrow with my family.? Now, that’s normally true.? I work from home, and my wife and I homeschool.? We have two graduates, one drop-out (a sad tale, and what made me start working from home to protect my family until we told him he had to leave), an eleventh grader, ninth grader, two sixth graders, and a second grader.? Five of the eight are adopted, and are African-American to varying degrees.? All of them have very different ability levels, and different levels of being willing to work hard.? The one that left was bright, but lazy, and that was part of his undoing.

I’m not a natural parent, but I have learned to control my temper better as the years have gone by.? I never realized how much I like things quiet until I had a lot of kids. ;)? My wife and I work as a team.? She does most of the teaching, and I do most of the discipline, but each of us does both.? My wife is bright, but I can still do Algebra 2 through Calculus.? I pick up the slack there.

My kids do get some economic training from me in a variety of ways:

1) Informally at dinner, I explain what is going on in the world.? The eleventh grader gets a lot of it, while the college students can’t be bothered.? The ninth grader and sixth graders get a decent amount of it.? But it is precious when one of the kids comes and says “Dad, can you explain to me what happened during the Great Depression?”? That said, it was even more precious when I tried to explain what I did as a corporate bond manager to my kids seven years ago (100 phone call per day), and the then eight-year-old said, “It’s like ordering pizza all day, right?”

2) There is the “Bank of Dad.”? This is not original to me, but I tell the children that they can deposit their money with me, and I will pay them 5% interest (annual equivalent yield).? Oh, and to get started, they must amass $100.? That is psychologically important, because it is a barrier to getting into an exclusive club.? The rate has been 5% for the last 10 years — the rate is subsidized to encourage children to save.

My children are not all natural savers.? Half are and half aren’t.? The ability to earn interest makes them all more inclined to save.? What we try to put forth to those that are not natural savers is to spend less than all that they earn, and save the rest.? If all Americans did that our economy would be much better off.

3) Work hard.? That applies to schoolwork and chores.? Basic chores get no pay but there is an allowance if those normal chores are done.??? Then there are other tasks that are available for pay, and those have varied over the years:

  • Cutting the yard.
  • Yard work.
  • Analyzing documents, and shredding the useless ones.
  • Sorting financial documents.
  • Shredding documents.
  • Checking derivative confirms.
  • Entering ABS cashflows for delivery to Bloomberg.
  • Entering industry rank data into spreadsheets.
  • Washing/waxing the cars.
  • Fixing the cheap Ikea furniture around the home.
  • Killing crickets and other vermin in the home.
  • Teaching math, or other subjects to younger children.
  • And more… if their schooling is done, neighbors often employ them for tasks, because the children are very reliable.

4) I spend time regularly explaining to my children what careers are in demand, and which are not.? I also explain the basic ideas of how companies make money, or not.? Then they follow what is happening in my career, with the media appearances, talks and other things that go on with me.? In any case, I try to explain to them to be practical, which is not generally taught in the schools.? Yes, do what you love, but don’t be dumb… no one will pay for useless bits of knowledge, and there are few teachers needed in such areas.

5) I do drop in on the homeschooling to provide greater background on history, economics, theology, and science.? I see my wife smile as I give greater depth to topics as I motivate them.

6) We have dinner together every night, and the discussion helps the children grasp on to what is going on in the world, as does subscribing to The Economist, and The Wall Street Journal.? I have subscribed to both for the last 20+ years.

7) Hopes and fears?? Ugh.? My third child made my life a mess.? I loved him so, but he gained a bunch of evil friends and turned against us.? But that is just one child.? My goal is not to create clones of me, but to create people who can be productive in the world, and faithful to Jesus Christ.

I have fears that the future won’t be as good for my children as it was for me, but I also know that my children are better prepared than most.? I can’t control the external macroeconomy; even my predictions are only a vague help.? My goal is to turn out children that are better prepared than most, and willing to work.? Beyond that, I pray to Jesus, but that is the best that anyone can do.

In the end I know that my efforts are valuable but not determinative.? I can’t make anything happen.? I can only teach my children, and trust in God for the rest.

Book Review: The Ten Roads to Riches

Book Review: The Ten Roads to Riches

Posted on by David Merkel

Many dream of riches.? Few achieve them.? Why?? It usually involves self-denial and hard work.? It’s not that anyone can’t achieve riches, if they start young enough, but they won’t make the sacrifices to do so.? A strong education helps, but is not absolutely required.? As my old boss Eric Hovde said to his staff repeatedly, the biggest difference in success comes from the degree of effort put forth.? I would only add that working smart amplifies the effort of working hard.

Ken Fisher the billionaire asset manager, identifies the ten ways he has seen to become wealthy.? They are:

1) Build a significant business.

2) Manage a significant business.

3) Be the right hand man of a wealthy person.

4) Be a star athlete, entertainer, or one who significantly facilitates star athletes and entertainers.

5) Marry a wealthy person.

6) Be a lawyer that helps clients sue for major amounts of money on a contingency fee basis.

7) Manage a lot of Other People’s Money.

8 ) Be an inventor of something popular, a popular writer, a prominent politician, or invent an organization that a lot of people want to give money to.

9) Borrow a lot of money and speculate on property appreciation.

10) Work hard, save a lot, and invest wisely.

I think he has nailed it.? My way of summarizing it is that you have to do something that makes a lot of people happy, or at least has the potential to make a lot of people happy.? Or, make one wealthy person very happy or unhappy. Three groups — how do they work out?

A) Those who do something that makes a lot of people happy can earn a lot:

  • Successful business founders, CEOs, right hand men, inventors
  • Stars and their significant enablers
  • Good asset managers
  • Good writers
  • Successful real estate developers

B) But even those that promise to do something to make people happy and fail at it can earn a lot:

  • Any CEO of a big enterprise can earn a lot — at one investment firm, we used to joke that you got paid $50 million to destroy a company — it is what they had to pay to get rid of you.? Their right hand men will still prosper too, just not as much.? In the current financial crisis, that is what gores many about the large surviving firms that were bailed out.? The executives are still prospering after previous dumb decisions.? Easy to complain about it, but it is nice work if you can get it.? (Note: this is why they should not have been bailed out, especially not at the holding company level.? Government officials lie when they say they could not have done it differently.? I for one suggested alternatives ahead of time.)
  • The same applies to CEOs that tweak the company’s earnings while they are there, but leave their successor in the hole.
  • Many still follow stars as their stars fade; they may not make as much, but it is still a lot.? Same for writers that lose their knack.
  • Many asset managers have an early period where they don’t have much in the way of assets, and their track record is great; their ideas for excess return are executable with the current assets under management [AUM].? That leads to growth in assets, until they are too big for the asset class in which they have expertise.? They become index-like, or they venture outside their circle of competence, and their track record suffers.? But AUM is high, and the fees can provide a nice income.? Assets are sticky if you don’t do too badly, and are a good salesman/storyteller.
  • Politicians can make a lot of money off of contacts or giving speeches once out of office, even if they were on net harmful to the nation while in office.
  • Some charities (or nonprofits like mutual insurers or credit unions) can be less than scrupulous about what managers get paid.
  • The real estate speculator, the CEO, and certain investment managers can have a “Heads-I-win, Tails-you-lose” attitude.? America gives people a lot of second chances before you are permanently branded as a fraud.? It only takes one big win to make a lot for yourself, even if you destroy the well-being of others in the process.

C) Then there are those that only have to serve a few:

  • The spouse of a wealthy person.
  • The right hand man of a wealthy person, and
  • The Trial Lawyer going after a big tort
  • Serve yourself, as an ordinary person working at a job.

No one begrudges the wealth of those in group A — they have served society well.? Many begrudge the wealth of those in group B — they have not served society well.? Group C?? It depends on motives.? More later on this.

One thing is certain, though.? There aren’t many seats in each of the “roads to riches,” except for the last ordinary one, #10.? Few are founders of massive enterprises, or CEOs, or stars, or investors of must-have products or processes.? Few can serve in high office, or write best-sellers, or be able to source a lot of assets to manage.? Few can get the capital markets or banks to loan them millions, even billions.? Few get to try a lawsuit where a huge award is won.? Few get to marry rich.? Also, most succeeding have to hit their right path while young, to allow enough time for compounding their success.

It takes a lot of effort and good breaks in order to be at the top of any economic situation where there is a lot of wealth.? Even road #10, doing well at your job, saving a lot and investing wisely is tough.? Few get to become “The Millionaire Next Door,” but more achieve reasonable wealth that way than all of the rest combined.

Ken Fisher writes about all of these areas in an entertaining way, and gives practical advice on how to follow each road, including additional books to read, and techniques for getting started.? It is an ambitious and compact book weighing in at around 230 pages of text including the preface.? It is an easy, breezy read. As a bonus, in road 10, Ken Fisher shares basic investment advice for the retail investor.

More than Quibbles:

I owe a lot to Ken Fisher for advice that he gave me in Winter 2000, and though I enjoyed the book, I can’t endorse it wholeheartedly.? He is out to tell you how to do it, even in cases where there might be significant moral compromise.? He acknowledges that, but says it is a part of the game.

To me, the key question is what your motives are.? It’s one thing to enter into a risky business, offer full disclosure to all stakeholders in advance, make a best effort, and fail.? It is quite another to trick/cajole people into backing you without full knowledge, and fail.

It is one thing to try a legal case where the damages are proportionate to the harm caused, and another thing to help create disproportionate judgments. It is one thing to serve a wealthy person who asks you to do things that are ethical, and another thing to serve in things that are unethical.? Once you have fans, a privileged job, or “sticky assets,” do you start giving less than your best?? I write this as one that is himself prone to laziness when things go well.? It is a common sin that one has to fight.

Are you looking out for the best interests of those you serve, and society more broadly?? A tough question for any of us, but society itself does not do well when a dominant proportion of it does not serve for good motives.? If it gets bad enough, the society will lose legitimacy and vitality.

Finally, it is one thing to marry because you love the person, and want to give your all to your future spouse.? It is quite another thing to enter in with crossed fingers, and say, “Maybe this will work, maybe it won’t.? I will be careful to protect myself, because the odds of failure are significant.? But economically, it will work out for me either way.? I’m wealthy if we marry, whether it works or not, because the prenup will leave me well off.”

Here’s the common vow: I, (Bride/Groom), take you (Groom/Bride), to be my (wife/husband), to have and to hold from this day forward, for better or for worse, for richer, for poorer, in sickness and in health, to love and to cherish; from this day forward until death do us part. Maybe promises don’t mean much any more, but I can’t see how one marrying for money can say that with a clear conscience.

Before my wife and I married, but after we were engaged, we were at a bookstore together, and we were looking over some marriage books to find one our pastor recommended.? She found a book entitled, “Marry Rich.”? She said to me, “This is a joke book, right?”? I said, “Uh, you would be surprised at the motives some have in marriage.”? She began leafing through it, amazed at the level of greed involved.? She married her poor graduate student boyfriend anyway.? 23 years later things are still working out well for her (and me).

One final note, not from the book: greed wears people out.? It is one thing to do what you love so long as money is not the sole purpose.? But those that are greedy for gain at all costs destroy themselves, and those around them.? It is not a good trade.

With those caveats, if you want to buy the book, you can buy it here: The Ten Roads to Riches: The Ways the Wealthy Got There (And How You Can Too!) (Fisher Investments Press).

Full Disclosure: I review books because I love reading books, and want to introduce others to the good books that I read, and steer them away from bad or marginal books.? Those that want to support me can enter Amazon through my site and buy stuff there.? Don?t buy what you don?t need for my sake.? I am doing fine.? But if you have a need, and Amazon meets that need, your costs are not increased if you enter Amazon through my site, and I get a commission.? Win-win.

Book Review: Warren Buffett on Business

Book Review: Warren Buffett on Business

Posted on by David Merkel

In the Fall of 2005, I was at the Annual Meeting of the Casualty Actuarial Society in exotic Baltimore, Maryland.? The Keynote address was by Roger Lowenstein who did a talk on two topics.? Warren Buffett the great investor, and the looming problems from the demographic crisis.

At the end of what was arguably a good talk, he asked for questions.? No one raised their hands.? After a pause, he asked for questions again, and I raised my hand.? I commented that he should have given his talk to the Life actuaries — they are the ones concerned about longevity and health costs, and if he really wanted to do a favor for casualty actuaries, don’t talk about Buffett the investor — talk about Buffett the P&C insurance CEO.

He commented that he was asked to speak about the topic by the CAS.? I like Lowenstein, so if you are reading this Roger, my apologies for making the comment.

Warren Buffett on Business is one step closer to the book I would like to see — I would like to see a book on Buffett as an insurance CEO.? Buffett is a great insurance CEO, and deserves a lot of credit in that capacity.? (Warren, I doubt you are reading this, but if you would like me to write that book, please e-mail me.)

But Berkshire Hathaway is an insurance/industrial hybrid, unique among companies.? Warren Buffett on Business ignores Buffett the investor to take up issues that are just as significant: Buffett the business owner and manager.

The words in the book are Buffett’s.? The man who organized the book took Buffett’s words over the last 25-30 years, and organized them into categories regarding management issues.? The topics include:

  • Berky acts like a partnership even though it is a corporation.
  • Corporate Culture and Governance
  • Competent Managers and Honest Communication
  • GEICO and Gen Re acquisitions (personally I think Buffett got hosed moving to terminate financial contracts? at Gen Re rapidly.? There is a rule of thumb that says negotiations on illiquid contracts should be undertaken slowly, unless the other side is panicking.)
  • Assessing and Managing Risk
  • Compensating Management
  • Time Management
  • Crisis Management
  • Acquisitions — Buffett gets to own a wide number of unique corporations, because the one selling out wants the culture preserved, and if the price is right Buffett will do that.
  • Ethics in Business
  • And more…

Both in the chapters and in the appendices, the words of Buffett shine forth as a way to manage corporations for the best long term results, even if things don’t work so well in the short run.

Quibbles

Much as I like the words of Buffett, I prefer a second voice adding analysis.? Let the words of Buffett star, but let someone else add color and history, because Buffett’s own words are not complete enough.

Also, an analysis of how Buffett managed the insurance lines of his enterprise would be welcome.? Even for those looking exclusively at investment issues, the insurance enterprises offered Buffett the balance sheet he needed to buy assets that could take a while to work out.

Who would benefit from this book: Any manager of any company would benefit from this book.? Buffett lovers, if you have read the last 25-30 years of annual reports from Buffett, and notable things he has said outside of that, you likely do not need this, unless you have specific questions on management that you want answered by Buffett, and you can’t remember what he said in the past.

For most of the rest of us, this will still be a valuable book.? If you want to buy this book, you can buy it here: Warren Buffett on Business: Principles from the Sage of Omaha

Full Disclosure:? I review books because I love reading books, and want to introduce others to the good books that I read, and steer them away from bad or marginal books.? Those that want to support me can enter Amazon through my site and buy stuff there.? Don?t buy what you don?t need for my sake.? I am doing fine.? But if you have a need, and Amazon meets that need, your costs are not increased if you enter Amazon through my site, and I get a commission.? Win-win.

On Sovereign and Quasi-Sovereign Risks

On Sovereign and Quasi-Sovereign Risks

Posted on by David Merkel

I like investing internationally, because of the diversification it offers, both in stocks and bonds.? Or, think of it as a hedge.? Will the American Experiment continue to prosper?? We have come a long way from the Founding Fathers, and more than half of it is not good.

But there are some place in our world that I will not invest in.? I have two requirements.

  • Contract law must be close to that in the US, or better.
  • Accounting practices must be close to the quality of the US, or better.

Sounds simple, but foreign tales are beguiling.? There is an exclusiveness about them, and a sense of greater knowledge for the one who has bothered to learn a trifle.? My acid test is watching over a long period and seeing how they treat foreign shareholders.? That is a good measure of the morality of management.? If they cheat foreign shareholders, they will eventually cheat domestic shareholders as well.

So, what don’t I invest in?

  • Russia
  • China
  • Most of the Middle East.
  • Venezuela
  • And other places that do not protect foreign shareholders on a level that is at least close to that of citizens.

The idea is to avoid situations where your rights as a shareholder might be ignored.? It does not matter how cheap an asset is; if the ability of the asset to be liquidated is low, so should the valuation of the asset be low.? Don’t buy pigs in pokes.

This has application today with Dubai.? The Dubai government is telling creditors that it will not stand behind Dubai World, and nor will the UAE, but Abu Dhabi will stand behind UAE banks.? This is tough on foreign creditors because foreign creditor rights in Dubai have not been tested until now.? Even domestic rights are unclear.

A Note on Debt Risks

Much Islamic debt, because of the prohibition on interest, acts like an extremely volatile hybrid bond during times of stress.? This incident will prove instructive on how these bonds keep or lose value in a reorganization.? What happens here will probably have an impact on how much money will be willing to flow into these vehicles in the future.? Personally, I never found them compelling, and probably won’t in the future.? There is something compelling about straight senior unsecured debt that pays interest.? I think the guarantees involved, together with straightforward reorganization processes, create a fair game where it is easier to decide whether lending or borrowing makes sense.

Complexity in bonds is usually a loser for the lender — whether complexity of the borrower’s finances, complexity of holding company structures, complexity of the governing laws, or even enforcing a complex contract where the lender duped the less-knowledgeable borrower.

What applies to corporate debt — long term buy and hold investors do okay with investment grade debt, but less well with junk debt, and worse the junkier it gets.? Layer on top of that the difficulty of being able to psychologically buy and hold during a crisis.? Even if you personally have the fortitude to do so, there may be others that influence you that don’t.? (E.g., the rating agencies come along near the trough of the crisis, and tell the CEO that they will downgrade you if you don’t sell bonds with the risk du jour.? Or, your clients look at their statements, and see the unrealized losses and beg you to sell — it doesn’t matter, the screaming is always the loudest at the bottom (in hindsight).

A Final Note on Sovereign Risks

Sovereign and quasi-sovereign risks like Dubai World may play a larger role in overall credit risk as the broader crisis plays out.? When I was younger, I thought the great risk of the Euro was that it would be too weak.? Bite my tongue.? The risk is that it could be too strong, and marginal European countries (Greece, Iceland, Ireland, Spain, Portugal, and many Eastern European countries) that have too much Euro-denominated debt relative to their ability to tax and pay will find themselves pinched — and they can’t inflate their way out.

When I first came to bond investing (early 90s), sovereign risks were viewed? skeptically, excluding the large Western nations — bond managers had been taught by the greyheads who had seen sovereign defaults, and the difficult of recovering money in default, still had a bias against sovereign and quasi-sovereign risks.? That bias is largely gone today, after a period of few sovereign losses.? Yes, Mexico, Russia and Argentina have given their share of heartburn, but the significant growth in the emerging markets has made bondholders forgiving.? Add in the long term structural deficits of the US and Japan, and it makes for a really interesting investment picture.

Be aware.? If you hold sovereign debts, look at the ability of the government to tax and pay over the long haul.? On quasi-sovereigns, analyze the explicit guarantees, if any, and the governing law — as you can see with Dubai World, in a crisis, only the guarantees matter, and only to the degree that they are enforceable under law.? With Dubai World, it will be judged in Dubai courts by a judge appointed by the ruling family of the emirate, which owns the equity of Dubai World.? Not a strong bargaining position in my opinion.? The only thing worse than relying on the kindness of strangers, is relying on the kindness of adversaries.

A Final Aside

I knew about how dodgy the investments were that Dubai and its corporations were undertaking, so I was always a skeptic, though I never wrote about Dubai, because it is so far afield for me.? What I did not know was the near slavery of foreign workers tricked to go to Dubai, and then forced to work with little to no rights.? Read the story, it is not pretty, but reinforces a belief of mine that governments and corporations willing to cheat one group of people, will cheat other groups of people as well.? Character is important in any credit decision, and the government of Dubai does not have good character in my book.

In Defense of the Rating Agencies — IV

In Defense of the Rating Agencies — IV

Posted on by David Merkel

I guess I am a glutton for punishment, but I am going to take the opposite side of the argument from what most have been saying of late regarding the rating agencies.? Those who want historical context can read my earlier three pieces:

And let me repeat my five realities:

  • There is no way to get investors to pay full freight for the sum total of what the ratings agencies do.
  • Regulators need the ratings agencies, or they would need to create an internal ratings agency themselves.? The NAIC SVO is an example of the latter, and proves why the regulators need the ratings agencies.? The NAIC SVO was never very good, and almost anyone that worked with them learned that very quickly.
  • New securities are always being created, and someone has to try to put them on a level playing field for creditworthiness purposes.
  • Somewhere in the financial system there has to be room for parties that offer opinions who don?t have to worry about being sued if their opinions are wrong.
  • Ratings can be short-term, or long-term, but not both.? The worst of all worlds is when the ratings agencies shift time horizons.

First, please understand that institutions own most of the bonds out there.? Second, the big institutions do their own independent due diligence on the bonds that they buy.? We had a saying in a firm that I managed bonds in, “Read the writeup, but ignore the rating.”? The credit analysts at the rating agencies often knew their stuff, giving considerable insight into the bonds, but may have been hemmed in by rules inside the rating agency regarding the rating. It’s like analysts at Value Line.? They can have a strong opinion on a company, but their view can only budge the largely quantitative analysis a little.

So there are systematic differences and weaknesses in bond ratings, but the investors who own most of the bonds understand those foibles.? They know that ratings are just opinions, except to the extent that they affect investment policies (“We can’t invest in junk bonds.”) or capital levels for regulated clients.

On investment policies, whether prescribed by regulators or consultants, ratings were a shorthand that allow for simplicity in monitoring (see Surowiecki’s argument).? Now, sophisticated investors knew that AAA did not always mean AAA.? How did they know this?? Because the various AAA bonds traded at decidedly different interest rates.? The more dodgy the collateral, the higher the yield, even if it had a AAA rating.? My mistake: I, for one, bought some AAA securitized franchise loan paper that went into default long before the current crisis hit.? Many who bought post-2000 AAA securitized manufactured housing loan paper are experiencing the same.? Early in the 2000s, sophisticated investors got burned, and learned.? That is why few insurers have gotten burned badly in the current crisis.? Few insurers bought any subprime residential securitizations after 2004.? But, unsophisticated investors and regulators trust the ratings and buy.

Recently, the rating agencies have lost some preliminary arguments in a court case where a defense they made is that ratings are free speech has been shot down.? I must admit, I never would have made such an argument, because it is dumb (See Falkenstein’s logic on the matter).? People and corporations cannot say what they want, and say that they are immune from prosecution because of free speech.? Fraud, and implied fraud from speech is prosecutable.

But what are rating agencies to do when presented with novel financial instruments that have no significant historical loss statistics?? Many of the likely buyers are regulated, and others have investment restrictions that depend on ratings, so aside from their own profits, there is a lot of pressure to rate the novel financial instrument.? A smart rating agency would punt, saying there is no way to estimate the risk, and that their reputation is more important than profits.? Instead, they do some qualitative comparisons to similar? but established financial instruments, and give a rating.

Due to competitive pressures, that rating is likely to be liberal, but during the bull phase of the credit markets, that will be hidden.? Because the error does not show up (often) so long as leverage is expanding, rating agencies are emboldened to continue the technique.? As it is, when liquidity declines and leverage follows, all manner of errors gets revealed.? Gaussian copula?? Using default rates for loans on balance sheet for those that are sold to third parties?? Ugh.

But think of something even more pervasive.? For almost 20 years there were almost no losses on non-GSE mortgage debt.? How would you rate the situation?? Before the losses became obvious the ratings were high.? Historical statistics vetted that out.? No wonder the levels of subordination were so small, and why AAA tranches from late vintages took losses.

When prosperity has been so great for so long, it should be no surprise that if there is a shift, many parties will be embarrassed.? In this case both raters and investors have had their heads handed to them. And so it is no surprise that the rating agencies have no lack of detractors:

I may attend a meeting this Thursday on the rating agencies and the insurance industry, if my schedule permits.? If I get a chance to speak, I hope I can make my opinion clear in a short amount of time.

As for solutions, I would say the following are useful:

  • Competition (yes, more rating agencies)
  • Compensate with residuals and bonuses (give the raters some skin in the game)
  • Deregulation (we can live without rating agencies, but regulators will have to do a lot more work)
  • Greater disclosure (sure, let them disclose their data and formulas (perhaps with a delay).

In economics, where there are more than two players, easy solutions are tough.? I only ask that solutions to the rating agency difficulties be reasonably certain that they do not create larger problems.? Ratings have their benefits as well as problems.

No economic interest

Living with Excluded Views

Living with Excluded Views

Posted on by David Merkel

1)? As I’ve said before, I don’t care whether Bernanke is reappointed or not, because who will be appointed that has a materially different theory of central banking than Bernanke?? I don’t see Ron Paul getting appointed.

But to reappoint Bernanke because a bunch of economists think it is a good idea is dumb.? The neoclassical economists were blind going into this crisis, and only a few outside the mainstream saw the debt building up, and said this would not work out well.

And, if I were in Bernanke’s shoes, I would not want endorsements from economists.? Oh wait, he is one.? Alas, I am one too, though rogue. Outside of economists, are politicians the only ones who trust economists?? Yet, the politicians use the economists as a useful shield.? “We only did what the economists suggested would bring prosperity.? We cannot be blamed if the experts are dunces.”

I think Bernanke will be reappointed.? I only hope he is there long enough to see him either struggle with stagflation, or with a Japan-style malaise, or both.? As I have said since 2004 at RealMoney, “This will not work out well.”

2)? Barack Obama is a bright guy.? He may be the brightest president since… um, I’m not sure, he might be the brightest of them all.? That does not mean that I agree with his ideas, because a bright man starting from bad postulates ends up in a bad place quicker.? That said, there seems to be some restraint on his part, as noted in this WSJ article:

In early July, the president ordered a briefing on derivatives — financial contracts that track the return on stocks, bonds, currencies or other benchmarks. Critics had been raising questions about administration proposals to regulate certain derivatives, such as credit-default swaps, which many blame in part for the financial crisis. With advisers gathered round on the Oval Office’s twin sofas, Mr. Obama said he was concerned that the administration hadn’t struck the right balance.

Its proposal called for standard derivatives to be traded on an exchange, bringing them into the open. Critics were calling the proposal too timid because it also would allow “customized” derivatives to continue trading privately. “What is to assure that this won’t drive all derivatives off the exchange?” the president asked, according to Mr. Emanuel.

He says Mr. Obama was frustrated his team wasn’t offering up a full range of views on how to approach derivatives regulation. “Get me some other people’s opinions on this,” Mr. Emanuel recalls the president as saying. “I want more than what’s in this room.”

In the end, the administration tweaked its position on derivatives. In legislative language drafted this week, it is seeking to require financial firms that offer customized derivatives to maintain higher capital cushions.

And so goes the proposed legislation.? It only tweaks at the edges the existing derivative setup, and does not question the troubles that the financial markets wreak on the cash markets when they are allowed to become gambling markets, where speculators trade with speculators, and the tail begins to wag the dog.? Synthetic markets must be smaller than the real markets, if we want to have longer-term stability.? Hedgers must lead the markets, not speculators.

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That’s all for now.? I don’t have much hope in the legislation on derivatives, or who leads the Fed.? Given where the terms of debate are, the debate excludes my views.

“Throw it into the Crack!”

“Throw it into the Crack!”

Posted on by David Merkel

Twice in my career, I have worked in financial reporting in an insurance company where an accounting change would happen because of an acquisition, or some other type of corporate event, such that there would be a change in the accounting periods.? It did not have to be like Goldman Sachs, where they moved their yearend from November to December.

At such a time, there would be an inclination to clean up the balance sheet, because no one would see the income statement effect from adjusting values closer to economic reality.

American investors focus on the income statement, but they would be better to focus on the balance sheet, particularly on the change period-to-period.? Why?

Twice I have seen the ethic of “throw it into the crack,” where no income statement damage occurs, but losses are quietly recognized.? The income statement shows little effect, though the balance sheet takes a whack.

There are always weaknesses in accounting, and the temptation is to make adjustments while out of the spotlight.? Thus the temptation tothrow accounting adjustments into the “crack,” when the opportunity is there.

Recommendation to readers: look at the change in the balance sheets, and ignore earnings.

Add a New Chapter to the Bankruptcy Code, Redux

Add a New Chapter to the Bankruptcy Code, Redux

Posted on by David Merkel

Given the news of the morning, I thought I would dust off my four-month old proposal Add a New Chapter to the Bankruptcy Code.? Until we limit our dear government’s power to encourage the private sector to borrow money until it chokes, we need something that enables timely reduction of debt in TBTF (too big to fail) institutions, delevering them? with minimal impact to taxpayer and the rest of the economy.

This morning we have the following articles:

In my proposal, the Treasury Secretary would initiate the process, but then would get handed off to a special bankruptcy court for adjudication of claims.? The Treasury becomes the DIP lender, but otherwise is a minor player in the process.

Why not let the Treasury do it all?? Wouldn’t it be faster?? Yes, it would be faster, but at a price.? The current Bush/Obama administration policies have relied heavily on intelligent discretion from regulators.? We haven’t gotten that yet.? Even really intelligent regulators are men with limited time.? Even big organizations staffed with Ph.D. economists and other bright people like the Federal Reserve are less than the sum of the parts, as the bureaucracy enforces groupthink (and the Treasury is even worse).

When the Treasury Secretary or the Fed Chairman acts with discretion, there is always the charge of unfairness that can be laid at their doors.? Why is the credit of the US going to support special interests?? You say that it is for the good of the nation, but then why aren’t equity and preferred shareholders wiped out, management thrown out, and bondholders forced to compromise, and accept back equity in the new firm in exchange for their debt claims?

Our bankruptcy processes are transparent, fair, and even speedy (for what is being done) in the US; we just need to augment them for firms that pose risk to a large portion of the financial and economic systems.? But regulatory discretion in bailing out firms in this crisis has been a disaster.? Speed kills; a handoff to the bankruptcy court with the US Treasury backstopping the firm in the short run would be the best minimalist solution, stopping contagion, and allowing for an orderly resolution of competing claims under conditions transparent to the US taxpayer.

Leave AIG to its own Devices, and let it Fail if Need be

Leave AIG to its own Devices, and let it Fail if Need be

Posted on by David Merkel

When I was a young actuary, I worked for the now defunct Pacific Standard Life.? In 1984, PSL discovered Universal Life Insurance, and sold so much of it that it went insolvent, and was bought out of bankruptcy by Southmark.? I came to the company in 1986, but by 1988 I had my concerns.? Aside from the aggressive investment policy (junk bonds), Southmark had interlaced the capital of their subsidiaries, with one subsidiary owning the preferred stock of another, and vice-versa.? They even did a deal with ICH, exchanging preferred stock.? So long as neither defaulted, both looked more solvent, like two drunks holding each other upright.

My point for the evening is that there are clever ways to make an insurance company look more solvent than it should appear to be.? I mentioned the preferred stock manuever.? There are also deals regarding reinsurance.? A common traansaction is to sell of future profits in exchange for capital today.

Why do I write about this?? AIG again.? While I worked for the domestic life companies 1989-1992, I served as the actuary for the annuity line of business.? That involved the reinsurance treaties on annuities, which were designed to reduce the capital needs of the business, and thus increase leverage.? As I have sometimes said, “reinsurance is the ultimate derivative.”? If derivatives are opaque, reinsurance doubly so.? Tearing apart a reinsurance treaty is tough, and it takes significant skills that most auditors and regulators don’t have.

During my tenure at AIG, the reinsurance treaties were designed to decrease the capital needed to support the business.? Given the need for a 15% after-tax return on average equity (which was sometimes described as the “religion” of AIG), the easiest way to do it was to compromise the capital needed to support the business through reinsurance.? Equity goes down, ROE goes up.? That was the nature of AIG, and I could never be a lifer there because of the ethical problems I faced.

Now one of the assumptions that I have made about AIG is that the subsidiaries of AIG are well-regulated and solvent.? But why should I assume that things have gotten better since when I served in AIG?

If I had the Statutory data (regulatory accounting), I would look at all of the statutory statements of domestic insurers that AIG owns, and look for reinsurance and cross-shareholdings.? I would discount external reinsurance credits, and internal reinsurance I would check to make sure that reserves reinsured equal reserves insured.

If things are today like tkey were in the early 90s, I would expect to find the amount of capital needed to support the business compromised through reinsurance treaties.? Within a year, we will know if that is true.? There are some alleging large fraud here.

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Now, ther are other problems with the bailout of AIG, notably that it harms their competitors.? Government support may lead AIG to discount premiums because they don’t have to turn a profit in their current state.? This harms the rest of the industry.? Why should insurers with no government support have to battle an insurer with govenment support?

Also, as I have said before, there is no reason to bail out AIG the holding company, which is what our dear government has done.? We only care about the operating insurers, not the company that owns them.? For the nonregulated entities inside AIG, the only one that has a material impact on the rest of the world if AIGFP.? Guarantee this if the US government must, but stay out of the rest of AIG.? Let that go into insolvency, there is no compelling reason tfor the US to protect it with tax monies.

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