Category: Pensions

Dave, What Should I Do?

Dave, What Should I Do?

Posted on by David Merkel

I get requests from local friends fairly regularly for aid in understanding their finances.? While coming home from church recently, I mentioned to my wife that many were seeking my opinion in our congregation.? Her response was, “So what else is new?”? Then I began to list it, family by family, and the congregations that were seeking my opinion for their building/endowment funds, and/or borrowing needs.? As I went down the list, my wife’s responses were “Not them!”, and “Them too?!” and “No!”

What can I say? My wife is the best wife I have ever heard of, but even married to me, economics is a distant topic.? Her father was well-off, but humble, and I am well-off, and I try to be humble.? You can be the judge there.

I say to my friends asking advice, “Remember, I am your friend.? I will take no money, but I won’t hold your hand and guide you either.? I will give you very basic advice, and it is up to you to learn and implement it.”? I don’t want to be a financial planner, but I don’t want to leave friends in a lurch.

With that, the scenarios:

1) 90-year old widow, who lives with her daughter and son-in-law.? Another son-in-law, given to incaution, is advising putting everything into gold and silver.? What to do?

She has adequate assets to support her through the rest of her life.? Her husband was responsible.? I asked her if she needed more income, and she said no.? I told her, then relax, ignore the other son-in-law (I know him to a degree), but if you want to, invest 3-5% in precious metals.? She didn’t see the need, and I told her that was fine.? She asked me what I would do in her shoes, and I said that it was a very difficult environment to be investing in, and that we could not tell what the government might do in a crisis, so the best thing to do was to stay diversified, and invested in companies which would have continued demand.? But if you don’t need the money, don’t take the risk now.

2) 80-year old widow, assets in even better shape.? Her husband was a great guy; an inspiration to me in many ways.? He was a mutual fund collector, and left her a basket of 30+ funds, as well as two homes free and clear.? What to do?? I suggested that she harvest funds that had been doing particularly well and reinvest in funds that had lagged.? I suggested purging certain funds that were likely mismanaged.? I also suggested liquidating one property if she could get an acceptable bid.

3) 50-year old bachelor, never married.? Funds are from TIAA-CREF.? We decided on a 50-50 stock-bond mix three years ago.? Recently we rebalanced to add more equities.? He was disappointed that his portfolio had moved backward.? I said “Welcome to the club.”

I will continue with more in part two, but 2008 blew apart many people’s expectations over what their assets could deliver.? My stylized view of it stems from comments that I got at church.? In 1999, my friends were people into equities, as I was holding back.?? In 2002, many said they were exiting equities, and moving to what they understood, residential real estate.? I was adding fresh cash to my positions, and paying off my mortgage. By 2006-2007, they began getting interested in stocks again.? By 2009, both stocks and residential real estate was tarnished, leaving bonds remaining.

Closing then, with three final notes:

a) The low interest rate policy is definitely hurting seniors, and I believe all investors.? We all become worse capital allocators when there is no safe place to put excess funds.? It tempts people to stupid decisions.? If Bernanke wants to do us a favor, let him resign, and put John Taylor or Raghuram Rajan in his place.? Tempting people to dumb investment decisions hurts the economy in the long run, it does not help us.

It may help the banks have a risk-free arb on short government bonds, but that’s not what we should want either.? If they are sound, they should be lending. Raise short rates, and let the banks have a harder time, and give investors a place to put money while they look for better opportunities.

b) Average people, and sadly, many professionals, are hopeless trend-followers.? They have no sense of looking through the windshield, rather they ask what has worked, and do that.? Mimicry can be a help in much of life, e.g., finding where to buy good furniture cheaply, but is harmful with investing where figuratively the devil takes the hindmost.

c) People get caught on eras, and have a hard time letting go of them.? The 70s biased many against inflation, and toward residential real estate. The residential real estate lesson got reinforced in the ’00s.? The equity markets seemed magical from 1975 to 2007, and asset allocators increased their allocations to equities in response.? Now you hear of “bonds only” asset allocations, just as the amount of juice available in most of the bond market is limited.

People got used to refinancing their mortgage every few years, and enjoying the extra cash flow.? The modern era reveals the hidden assumptions on that: that property values would never fall.

The point: markets aren’t magic.? They can only deliver what the real economy does.? Stocks only do well over the long run if profits do well. Valuations come and go.? Bonds make money off the stated interest (coupon) rate less default losses.? Valuations come and go.? Real estate is worth the stream of services that the land and improvements can deliver.? Valuations come and go.

Now, you can play the “come and go” if you are smart, but with the “come and go,” for every winner there is a loser.? But asset allocators need to be more humble in their assumptions for financial planning and not assume that they can earn more than 2% over the 10-year Treasury, or over expected growth in nominal GDP.? The share of income that goes to profits and interest also tends to mean-revert over time, so humility is needed when:

  • Illustrating an investment plan for a family
  • Setting the discount rate for a defined benefit pension plan
  • Setting the spending rate on an endowment
  • or even, setting assumptions for the Social Security trust funds.
Managing Illiquid Assets

Managing Illiquid Assets

Posted on by David Merkel

Illiquidity is an underrated risk.? Most financial company failures are due to illiquidity, which usually takes the form of too many illiquid assets and liquid liabilities.? Adding to the difficulty is that it is generally difficult to price illiquid assets, because they don’t trade often.

So where do we see failures due to illiquidity?

  • Banks — too numerous to mention, though FDIC insurance restrains it now.
  • Life insurers, particularly those that write a lot of deferred annuities.
  • AIG and the GSEs — abominations all.
  • Bear and Lehman — waiving the leverage limit was one of the stupidest regulatory decisions ever.
  • Hedge funds – LTCM was the granddaddy of failures, but many have choked because redemptions forced liquidation of assets at unfavorable prices.
  • No colleges, though those college that were too aggressive on illiquid assets got whupped in 2008.? Some were forced to raise liquidity in costly ways.? Same for many overly aggressive pension plans, many of whom came late to the game with Venture Capital, Hedge Funds, Timber, Commodities, etc.

Face it.? Most alternative asset classes involve additional illiquidity.? That is an additional risk, and when evaluating those investments, the expected rate of return must be greater than that for liquid investments.

As an aside, there is another factor to be considered with alternative investments.? That factor is strategy capacity.? Alternative investments do best when they are new.? Here is my version of the phases that they go through:

  • New — few know about it except some business-minded investors.? Only the best deals get done.
  • Growing — a modest number know about it, and a tiny number of consultants.? Only very good deals get done.
  • Comes of age — many know about it, and most consultants pitch it to their clients as the way to go.? Good deals get done.
  • Maturity — almost everyone knows about it, and it is a standard aspect of asset allocation for consultants, who have their means of differentiating between different providers, based on metrics that will later be revealed to be useless.? All reasonable deals get done.
  • Post-maturity — Late bloomers make it to the party, and beg to get in, thinking that past is prologue, and do not realize that deal quality has eroded severely.
  • Failure, which brings maturity — deals fail, leading the market to scrutinize all investments, leading to true risk-based pricing.? Later adopters abandon the market, and take losses.? Earlier adopters sharpen practices, and prepare for a more normal asset class.

So, when looking at illiquid assets, how do you determine how much to invest?? First determine how much of your funding base will never leave over the next 10 years.? When I was a corporate bond manager, that was 25% of the assets that I was managing, because of structured settlements and immediate annuities.

For a pension plan or endowment, forecast needed withdrawals over the next ten years, and calculate the present value at a conservative discount rate, no higher than 1% above the ten-year Treasury yield.? Invest that much in short to intermediate bond investments.? You can invest the rest in illiquid assets, because most illiquid assets become liquid over ten years.

But after that, there is an additional way of controlling illiquidity risk — time once again for the fusion solution! Money market funds run a ladder of maturities.? Stable value funds run a longer ladder, as should commodity ETFs, rather than floating at spot.? Then there are clever advisers who run municipal and other bond ladders for wealthy and semi-wealthy clients.? Running a ladder of maturities is one of the most robust management techniques as far as interest rate risk is concerned.? There is always money coming out and in every year, which slowly leads the portfolio yield in the direction of average rates.

Now, if these bonds are less liquid muni bonds, but the credit risk is low, you don’t care as much about the illiquidity, because the ladder produces its own liquidity as bonds mature.? The key question is sizing the length of the ladder, which comes down to a question of analyzing the liquidity/income needs of the client, combined with a forecast on the secular direction of rates.? The forecast is the least important item, because it is the toughest to get right.? (An aside: who has been right on bond yields consistently for the last 20+ years?? Hoisington, my favorite deflationists.? Wish I had listened more closely.)

The same principle applies to pension funds, endowments, life insurers with a few twists.? Divide your liabilities in two.? What obligations do you know cannot be changed, except at your discretion?? That group of liabilities can have illiquid assets to fund them.? Try to match the payout streams, but if not, try to match them in broad with a ladder, keeping in mind what mismatches you will likely face over the next 1-2 years in order to properly size your cash position.

The rest of the liabilities need more intensive modeling, analyzing what could make them change.? You can try to buy assets that change along with the liabilities, but in practice that is hard to do.? (That said, there are no end of clever derivative instruments available to solve the problem in theory.? Caveat emptor.)? The assets have to be liquid for this portfolio.? Other aspects of portfolio choice will depend on valuation parameters, credit spreads, yield curve shape, market volatilities, as well as macroeconomic factors.

Three Closing Notes

1) Now, all that said, just because you can take on illiquidity doesn’t mean that you should.? A good manager has a feel from history for what the proper liquidity give up is in valuations for stocks and other risk assets, and credit spreads for fixed income assets of all sorts.

Was it worth moving from the:

  • Relatively liquid AAA tranche to the illiquid AA, A or BBB tranche for 0.10%, 0.20%, 0.40%/year respectively?? As a bond manager at much larger insurance company said back in 2000 — “It’s free money.”? (That is almost always a dangerous phrase.) My view was there was more illiquidity and credit risk than we could consider.
  • Relatively liquid large-issue BBB bank bond to the relatively illiquid small-issue BBB bank bond for 1% more in yield?? Hard to say.? There are a lot of factors involved here, and your credit analyst will have to be at the top of his game.? It also depends on where you are in the speculation cycle.
  • Liquid public equities to private equity or hedge funds with lockups?? Tough question.? Try to figure out what the unlevered returns are for comparative purposes.? Analyze long-term competitive advantage.? Look at current deal quality and valuation metrics.? For hedge funds, look at how credit spreads moved over their performance horizon.? Anyone can make money when spreads are tightening, but who makes money when spreads are blowing out?? Analyze them over a full credit cycle.

2) Institutions that did not previously do more liquidity analysis because we had been in near-boom conditions for decades need to at least do scenario testing to assure that they aren’t overplaying their hands, such that they might be forced to make bad decisions if liquidity gets tight.? Safety first.? (This applies to governments and industrial corporations too, as we will experience over the next three years.)

3) Finally, if you decide to make a large illiquid purchase like Mr. Buffett did last year, make triple-sure of your logic and your liquidity positioning.? Nothing lives forever, but you can prolong the life of the institutions you serve by careful reasoning and planning, particularly regarding liquidity.? Get financing when you can, not when you need it. It takes humility to do so, but it yields the quiet reward of continued existence at a modest price.

A Baker’s Dozen Of Economic Items

A Baker’s Dozen Of Economic Items

Posted on by David Merkel

1) Kind of like my thesis that the States give a better picture of the economy than the Federal Government, I agree with the idea that small banks better represent that health of the US economy.? Most small an medium-sized businesses rely on small banks.? Growth in employment relies on small and medium-sized businesses, because they typically have more room to expand.

2) I’ve been arguing for a weak economy before the double dip concept was derided.? Not that I make the Philly Fed survey a big part of my analysis, but the weak report is consistent with my view that the US economy is weak.

3) All developed markets where there is still confidence are finding long government yields hitting new lows.? No surprise, with so many investors and nations scared, that many would focus on sovereign governments for repayment.

4) So there are failures to deliver in the MBS market.? Part of it is due to the Fed sucking up a large part of the market.? Part due to the low cost of short term funds.? My question to anyone reading, are there any significant costs?

5) A crisis like this is divisive.? In the US, it separates the strong versus the weak states.? In the EU, it separates the strong versus the weak countries.? That is the nature of financial crises — they divide the healthy from the sick,with some slight tweaking from government action.? As it is now, there is a divergence where countries with some flexibility fight to maintain their independence.

6) Jake makes the argument that one would pay a lot for certainty of return of principal in this environment. SO, don’t sniff at low short term rates.

7) Ordinarily I agree w/Jesse.? For example, I agree that there could be a lot more extracted from the rich in taxes.? But I don’t think it would succeed.? There are too many holes in the tax code, and the wealthy would hire bright people to make the tax obligation go away.? I speak as one that has seen this in action.? Rich people are much smarter than poor people when it comes to money. It would take radical tax reform to change matters.

8 ) The ultimate stories on GM and AIG, as well as FNMA and FHCC, is that the government loses money on the deals, but spins them positively, in saying, “look, they are operational again.” Truth, better that they all failed, but the government aims at fixing things, even when it can’t.

9) This piece gets it right on Social Security in minor, blows it in major.? Yes, the bonds built up over the last 20 years will be paid out of current tax revenues, but will the US Government be able to bear the total burden as Medicare expenses go through the roof?

10) What a fight on stocks vs. bonds.? I favor bonds in the short run, stocks in the long run.? Where I disagree with both is that government action is needed to preserve value.

11) Are we turning into Japan? I have argued yes for some time because we are following the same government actions that Japan did.

12) How bad is the economy?? Bad enough that average people are liquidating 401(k)s.

13) China might finally be getting smart on population policy.? But getting women to have more kids once you have convinced them of the short-term value of not doing it — you will have a better career, and the long-term benefit of not doing it — we have too many people for the planet already; it’s pretty tough.? They take the easy road of not having kids, and it doesn’t matter how many economic incentives get kicked up — once women decide they don’t want to have children, there is no amount of economic policy that will change their minds.

But, there are other ways to do it: show reruns of happy families with many kids.? Waltons, Brady Bunch, Eight is Enough, etc.? We had eight kids, (we adopted five) and there is a lot of value in the many relationships that exist in a large family.

Okay, enough for now.? Time for sleep.? Just don’t go shorting bonds thinking I told you to do it.

The Point of No Return

The Point of No Return

Posted on by David Merkel

I first became interested in Social Security back in the 80s.? In order to become a Fellow in the Society of Actuaries you had to study all manner of insurance programs, both private and social, to understand the framework in which insurance and pension products existed.

The Greenspan Commission back in 1981-1983 proposed another large increase to Social Security taxes.? The system only needed a small lift to get it past some demographic difficulties, but the Commission proposed, and Congress passed a large change, which would mean that the Social Security would develop a large base of Treasury Notes, because income to the system would outstrip benefit payments for a long time, and the proceeds would be invested in Treasuries, because they are a neutral asset.? Investing in other assets would invite socialism and cronyism.

But really, what was needed was to move to a pay-as-you-go system, as Pat Moynihan suggested in the early 1990s.

But the fix could never be permanent, because even as taxes were increased, the benefits increased along with them, and there would come a day of reckoning.? But when?? There are three dates that many would point to:

  1. When the excess of taxes over benefits would peak.
  2. When benefits and taxes would be equal.
  3. When the trust fund would be broke.

I always looked at the first of these, whereas most commentators looked at the last of them.? My reasoning worked like this: the Federal Government has cynically integrated its budget with Social Security to make its deficits look smaller.? This is like a drug to the government; the real pain will come to it when the subsidy begins to fall.? By the time it goes negative, the US Government will account for it separately, so as to minimize the deficit again.

Given my view of how the US Government could no longer balance its books, the real change would come when they would have to increase their borrowing because there was not as much excess from the Social Security system.

When I first started looking at the Social Security system, the three dates in question were in the 2010s, the 2020s, and in the 2040s.? I thought that those dates were optimistic, but what I did not expect was that the current economic crisis would accelerate the first two dates dramatically.? As it is, date one has passed in 2008 (+/- a year), and I think the second date is happening in 2010.? Bruce Krasting’s post highlights the details, but I would concur, this recession will not end rapidly in the place where is counts for Social Security — employment.? We are not likely to see Social Security deliver surpluses to the US Government anymore.? Thus I expect deconsolidation of Social Security’s finances with that of the Federal Government.

What I never expected was that dates one and two would come so rapidly — almost together.? Let the morons who talk about trust fund exhaustion pontificate.? “We have all of these assets with which to pay future benefits….”? Nonsense.? As they sell bonds issued to the Social Security System, they must issue even more debt to the public.? How much can they bear, and at what yield?

Going back to my trip to the US Treasury, I want to remember one particular incident:

After the meeting, I said to one Treasury staffer, ?One of the quiet casualties of this crisis is that you lost your last bit of slack from the entitlement systems.?

?What do you mean??

?Just this, prior to the crisis, Social Security and Medicare would produce cash flow surpluses for the Government until 2018.? Now the estimates are 2016, and my guess is more like 2014.? The existing higher deficit takes us out to the point where the entitlement systems go into permanent negative cash flow.? This means that the US budget is in a structural deficit for as far as the eye can see, fifty years or more, absent changes to entitlements.?

He looked at me and commented that it would be the job of a later administration.? No way to handle that now.? To me, the answer reminded me of what I say to myself when I go on a scary ride at Six Flags with my kids.? There is nothing we can do to change matters.? The only thing to adjust is attitude.? So, ignore the fact that you are afraid of heights, and enjoy the torture, okay?

The crisis has accelerated that date to 2010.? That’s a lot of change in just eight months.? The long-term problem is upon us now.? We are at the point of no return, absent large changes that those influenced by Keynesians will resist.

There are no good solutions now.? Budgetary cuts and tax increases reduce the possibility of government default.? They also will tend to slow the economy, unless the tax increases stem from cutting cheating, and the budget cuts affect only things that are a fraudulent waste.

Once you reach the point of no return, it doesn’t matter what prescriptions one follows — failure is coming.? One can shape the type of failure, but not that there will be failure.

All that said, there are still options, though none of them are good.? Will the currency be inflated?? Will the government default?? Will taxes be raised dramatically? I don’t know.? Be alert; be ready.? The endgame is here; we will see what moves the government makes.

PS — I have a signed copy of A. Haeworth Robertson’s book, Social Security: What Every Taxpayer Should Know.? He was the Chief Actuary of the Social Security System for a time, and a noted skeptic of the program.? He sent me the copy after I shared some of my misgivings with him in the 1990s.

Alas, but the average actuary has been skeptical of the Social Security system, and I have met many actuaries that work there, and they agree.? But leaders of the Society of Actuaries, when asked to give a clear warning on the troubles to come have refused.? I have my theories as to why — they curried favor with politicians for their own personal reasons.? Sad.

Full disclosure: 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.

13 Notes

13 Notes

Posted on by David Merkel

Pardon the infrequency of posting.? I have been having internet issues.

1) A response to those commenting on my piece A Stylized View of the Global Economy: when I say stylized, is does not mean that every nation fits the paradigm, only that most do.? My view is that the debt overages will have to be liquidated, and there is no possible policy that can avoid it except large scale inflation.? Those looking for clever ways out of this bind will be disappointed by what I write.? When nations are heavily indebted their options decline, particularly when they don’t control their own currency.? For the US I say that we should have liquidated insolvent firms rather than bailing them out.

Also, read Falkenstein as he takes on the idea that stimulus spending works.? I have little confidence that the linear reasoning behind stimulus spending yields long-term economic benefits.

2) One blogger that I have some respect for, but have not mentioned often is Bruce Krasting.? He writes some good things on US social insurance programs. His recent post Social Security at Mid-Year highlighted what should shock many: we have hit the tipping point on Social Security.? From here on out it will be a drag on the federal budget.? Expect Congress to remove it from the federal budget.? It no longer aids the illusion of smaller deficits.? (What a cleverly hidden illusion.)

As he commented at the end of his article:

-SS is $2.5T of the $4.5T Intergovernmental account. I believe that this entire group is going cash flow negative. The IG account cost us ~$160 billion in interest last year, but some out there are pretending the IG account does not exist. An example of this is in the following link.

Sorry, U.S. Federal Debt Is NOT Approaching 100% Of GDP Anytime Soon

This kind of thinking is not only lunacy; it is dangerous.

And I agree.? There only two ways to look at the balance sheet of the US.? Look at explicit debt vs GDP, regardless of who is owed the debt.? Or, look at total liabilities vs GDP.? But never look at explicit debt not used to fund social insurance funds.? It is meaningless.? The total liabilities number tells the whole story.

3) Spain is in trouble.? Their banks are borrowing a lot from the ECB, with no end in sight.?? Perhaps that leads them to push for stress testing across all European banks.? Or, maybe things are so bad that the banks are identified with the sovereign credit, and both are tarnished.

4) Or consider the Eurozone as a whole: the system begs for debt relief, but the Euro and ECB are tough taskmasters.? The Euro has been an excellent successor to the Deutschmark in terms of preserving purchasing power, but perhaps purchasing power needs to be sacrificed in order to relieve debtors.? The ECB is steps away from monetizing the debts of its governments.? Perhaps they could preserve the Eurozone by destroying the value of the Euro.? Germany might not stand for it, but it has significant unfunded liability issues as well.

As with the US, unless there is a large inflation, debts will eventually have to be liquidated, whether through austerity or default.? There is no other way.? Austerity will have its costs, but unless debts are inflated away or defaulted, those are costs that must be paid.

5) Can pensions be cut?? The typical answer is no, but what if a state pays less than what was promised in inflation-indexed terms?? That is what is being tested.? I think that eventually states and municipalities will be forced into bankruptcy because they can?t make employee benefit payments, and still maintain minimal services to the populace.

6) Debtors prison.? I have mixed feelings here, because I think that those that can?t pay should not be put there for long, if at all.? Those that can pay but won?t, should go there.? Regardless, this is a trend, and those that think they can walk away from debts should think twice before doing so.? You may be setting yourself up for prison.

This is just another front in the war against those who can pay but won?t.? More lenders are suing those who won?t pay, and going after their assets.? My only surprise is that it has taken so long for this to happen.

7) Fannie and Freddie are a giant black hole.? It astounds me that there is any respect given to two companies that have lost massive amounts of money since their inception.? The US would have been better off without them, and will be better off with them in bankruptcy.? The US should not promote single family housing as a goal, because it cannot create the conditions where marginal people can be capable of financing housing on their own.

So, when some suggest one last bailout, I say, let them fail.? Cancel the common and preferred stocks, and fold the remainder into Ginnie Mae.

8 ) Occasionally, there are really dumb articles, like this one.? The time for debt was November 2008 through March 2009, when I recommended investing in junk bonds.? There is little reason to borrow now; valuations are relatively high, don?t take your life into your hands.

9) And, occasionally, smart articles, like this one.? If you are in a volatile profession, reduce your risks by investing in high quality bonds.? If you are in a safe profession, invest in stocks.? When I went to work for a hedge fund, the first thing I did was pay off my mortgage, so that I could take more risk, without worrying about getting kicked out of my house.

10) Felix Zulauf has generally been a bearish guy, and so has done well over the past decade.? But is he right now?? Will stocks revisit their March 2009 lows?? It is possible, but I lean against it.? We would need a situation where most of the developed nations decided to aim for recession and stay there a while.? I do not see that yet.

11) Is it is liquidity problem or an insolvency problem?? If you have to ask, it is usually insolvency.? Consider Richard Koo, and his thoughts on the matter.

12) Using the rubric of the ?Tragedy of the Commons? Kid Dynamite points out how it sets up the wrong incentives if we bail out profligate states and municipalities.? As a part of my ?new mormal,? it is no surprise to me that this is happening.? It should be happening, and will happen for at least the next five years.

13) Because of my employment agreement, I can?t tell you exactly what I know about the demise of Finacorp.? But I can tell you that the article cited is wrong.? Finacorp never carried an inventory of assets.? It only crossed bonds between buyers and sellers.? The failure of Finacorp occurred for far simpler reasons.

Morning Financials Update

Morning Financials Update

Posted on by David Merkel

Big Movers

Top 20 Financial Stock Movers
Company [ticker] News Price Move
Washington Mutual Inc [WAMUQ] Valuation-insensitive buyers on high volume and no news.

13%
Pacific Capital Bancorp NA [PCBC] Strong buying at the open leads the stock up on no news.

6%
Ashford Hospitality Trust Inc [AHT] No news materially driving the stock price

6%
First BanCorp/Puerto Rico [FBP] No news materially driving the stock price

4%
Radian Group Inc [RDN] No news materially driving the stock price

4%
EastGroup Properties Inc [EGP] Jim Cramer likes it for the yield.? Mentioned on Mad Money.

3%
Advance America Cash Advance C [AEA] No news materially driving the stock price

3%
LoopNet Inc [LOOP] No news materially driving the stock price

3%
Heartland Financial USA Inc [HTLF] No news materially driving the stock price

3%
China Real Estate Information? [CRIC] No news materially driving the stock price

3%
Move Inc [MOVE] Banxquote.com sues them for antitrust reasons.

2%
First Bancorp/Troy NC [FBNC] No news materially driving the stock price

2%
United America Indemnity Ltd [INDM] No news materially driving the stock price

2%
Enstar Group Ltd [ESGR] No news materially driving the stock price

-3%
New York Community Bancorp Inc [NYB] No news materially driving the stock price

-3%
Stewart Information Services C [STC] No news materially driving the stock price

-3%
Waddell & Reed Financial Inc [WDR] No news materially driving the stock price

-3%
Artio Global Investors Inc [ART] Dilution.? Issuing shares to buy back units from principals.

-4%
First American Financial Corp [FAF] Index investors sell off FAF as CLGX remains in the S&P 400.

-4%
Assured Guaranty Ltd [AGO] Determined sellers on light volume and no news.

-4%

Thoughts:

Group Price Movements for this Morning

Real Estate Mgmnt/Servic

1.2%

 Reinsurance

0.0%

 REITS-Health Care

-0.3%
Commercial Serv-Finance

1.1%

 Diversified Banking Inst

0.0%

 REITS-Storage

-0.3%
Finance-Consumer Loans

1.0%

 Multi-line Insurance

0.0%

 Commer Banks-Western US

-0.3%
Insurance Brokers

0.7%

 Exchanges

0.0%

 S&L/Thrifts-Central US

-0.4%
Life/Health Insurance

0.7%

 Property/Casualty Ins

0.0%

 Commer Banks-Central US

-0.5%
Other

0.5%

 Fiduciary Banks

-0.1%

 Invest Mgmnt/Advis Serv

-0.5%
Retail-Pawn Shops

0.4%

 REITS-Hotels

-0.1%

 REITS-Diversified

-0.5%
Real Estate Oper/Develop

0.4%

 Commer Banks-Eastern US

-0.1%

 REITS-Single Tenant

-0.5%
Finance-Invest Bnkr/Brkr

0.4%

 Grand Total

-0.1%

 Finance-Credit Card

-0.5%
REITS-Mortgage

0.4%

 REITS-Office Property

-0.1%

 S&L/Thrifts-Eastern US

-0.7%
REITS-Regional Malls

0.1%

 REITS-Forestry

-0.1%

 Finance-Auto Loans

-0.7%
Commer Banks Non-US

0.1%

 REITS-Warehouse/Industr

-0.1%

 Super-Regional Banks-US

-1.0%
REITS-Apartments

0.1%

 REITS-Shopping Centers

-0.2%

 Financial Guarantee Ins

-1.1%
S&L/Thrifts-Western US

0.1%

 Commer Banks-Southern US

-0.2%

 GSEs

-2.3%

I look at these companies for big news events that have occurred since the last close.? Often there isn?t any, but big changes here can be an indication that someone knows something, or there is trading noise.? After that, it is up to the analyst to dig.? Often, the dog that does not bark is the clue, as stocks move up or down on no news, as well as unexplained large spikes in volume, CDS spreads, and implied volatility of options.

Note: If I use the phrase ?better seller,? it does not mean ?sell.?? If I use the phrase ?better buyer,? it does not mean ?buy.?? ?Better seller? and ?better buyer? are bond portfolio manager terms that simply mean that if I were forced to take action on a security, what would I do as a trader in the short run, given the current news.

Disclosure: long ALL NWLI SAFT RGA AIZ PRE CB

The Rules, Part XIII, subpart C

The Rules, Part XIII, subpart C

Posted on 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.

More with Less.? Almost all of us want to do more with less.? Save and invest less today, and make up for it by investing more aggressively.? We have been lured by the wrongheaded siren song that those who take more risk earn more on average.? Rather, it is true 1/3rd of the time, and in spectacular ways.? Manias are quite profitable for investors until they pop.

As I have said many times before, the lure of free money brings out the worst in people.? Few people are disposed to say, “On a current earnings yield basis, these investments yield little.? I should invest elsewhere,”? when the price momentum of the investment is high.

I will put it this way: in the intermediate-term, investing is about buying assets that will have good earnings three or so years out relative to the current price.? Whether one is looking at trend following, or buying industries that are currently depressed, that is still the goal.? What good investments will persist?? What seemingly bad investments will snap back?

That might sound odd and nonlinear, but that is how I think about investments.? Look for momentum, and analyze low momentum sectors for evidence of a possible turnaround.? Ignore the middle.

Less with More.? Doesn’t sound so appealing.? I agree.? As a bond manager, I avoided complexity where it was not rewarded.? I was more than willing to read complex prospectuses, but only when conditions offered value.? Away from that, I aimed at simple situations that my team could adequately analyze with little time spent.

That is one reason why I am not sympathetic to those who lost money on CDOs.? We had two prior cycles of losses in CDOs — a small one in the late ’90s, and a moderate one around 2001-2003.? CDOs are inherently weak structures.? That is why they offer considerably more yield relative to similarly rated structured assets.

So, for those buying CDOs backed by real estate assets mid-decade in the 2000s, I say they deserved to lose money.? Not only were they relying on continued growth in real estate prices, but they were reaching for yield in a low yield environment.? Goldman and other investment banks may have facilitated that greed, but the institutional investors happily took down the extra yield.? No one held guns to their heads.? The only question that I would raise is whether they disclosed all material risk factors in their prospectuses.? (Not that most institutional investors read those — they call it “boilerplate.”)

Reaching for yield always has risks, but the penalties are most intense at the top of the cycle, when credit spreads are tight, and the Fed’s loosening cycle is nearing its end.? It is at that point that a good bond manager tosses as much risk as he can overboard without bringing yield so low that his client screams.

Perhaps the client can be educated to accept less yield for a time.? I suspect that is a losing battle most of the time, because budgets are fixed in the short-run, and many clients have long term goals that they are trying to achieve — actuarial funding targets, mortgage payments, college tuition, cost of living in retirement, endowment spending rule goals, implied cost of funds, etc.

That’s why capital preservation is hard to achieve, particularly for those that have fixed commitments that they have to meet.? It is impossible to serve two masters, even if the goals are preserving capital and meeting fixed commitments.? Toss in the idea of beating inflation, and you are pretty much tied in knots — it goes back to my “Forever Fund” problem.

This third subpart ends my comments on this rule.? You’ve no doubt heard the Wall Street maxim, “Bulls make money; Bears make money; Hogs get slaughtered.”? Yield greed is one of the clearest examples of hogs getting slaughtered.? So, when yield spreads are tight (they are tight relative to risk now, but could get tighter), and the Fed nears the end of its loosening cycle (absent a crisis, they are probably not moving until unemployment budges, more’s the pity), be wary for risk.? Preserve capital.

The peak of the cycle may not be for one to three years, or an unimaginable crisis could come next month.? Plan now for what you will do so that you don’t mindlessly react when the next bear market in credit starts.? It will be ugly, with sovereigns likely offering risk as well.? At this point, I wish I could give simple answers for here is what to do.? What I will do is focus on things that are very hard for people to do without, and things that offer inflation protection.? What I will avoid is credit risk.

The Whole Earth is Owned; Debts Net Out to Zero

The Whole Earth is Owned; Debts Net Out to Zero

Posted on by David Merkel

Tonight’s post could be one in the “rules” series, but since I did not get this idea prior to 2003, when I started investment writing at RealMoney.com, it does not qualify for me.? But here it is:

At the end of the day, the world as a whole is owned 100%.? There are people with short positions, calls, puts, etc., and even things more exotic.? Those are noise around the real economy that produces the goods and services of our world.

Beyond that there are debt transactions in order to own assets, or purchase products and services.? But every debt is an asset to another party, and cancels out across the globe.? There are no debts on net in the world.

Does that mean that debts are irrelevant?? No.? Debts are relevant for two reasons: 1) Highly indebted economic systems are inflexible, because there are too many fixed claims.? They are far more prone to crises.? 2) The debt of financial companies is very important because they often borrow short-term to finance longer-term assets.? In the current crisis, repo funding is the great example of this.

A financial firm thinking long run would not do repo financing because it can be easily pulled.? It would float long debt equal to the term of the assets that they want to finance.? But that might make their margins inadequate.? Don’t you know that short rates are volatile, and that they tend to be lower then long term rates most of the time?

Well, maybe.? But when debts increase, parties step forward to finance long credit via short borrowing.? That is an essential element of the credit system when it is in bubble mode.? (Side note: the exception to this is lending against sticky checking and savings account liabilities.? Those liabilities are sticky only because of deposit insurance.? The policy question there is whether the insurance premium is set too low. In hindsight, the answer is yes, though at my prior employer, we talked about the inadequacy of the FDIC, and bank reserving regularly.)

Though all debts net out to zero across the global economy as a whole, a lot depends on who owns the debts.? If the debts are owned by those who are borrowing money, risks of a debt crisis rise.? The layering of debt upon debt, and borrowing short to lend long decrease financial system resilience.

Finally, the willingness to make loans to marginal borrowers is really a statement that lenders are willing to make an equity investment in someone they are lending to, or some property that they are lending against.? Formally, it is all a loan, but economically the lender is betting on prosperity, much as a stock investor might.

When I wrote my piece on the residential housing bubble at RealMoney back in May of 2005, I did not focus on the high prices much; instead, I focused on the financing issues:

  • Amount of debt vs assets
  • Borrowing short term to buy a long-lived asset, a house.
  • Quality of the debt underwriting

And, much the same when I wrote my piece on subprime mortgages in November 2006, too much leverage, the teaser rates are short term borrowing, and the loan underwriting was horrible.? As with residential mortgages generally, subprime mortgages were even more set up for failure.

If you want to find a bubble, focus on the financing.? The rise in asset prices is not sufficient, assets must be misfinanced for there to be a bubble.

When I was writing at RealMoney, I did a series of four articles to illustrate market dynamics:

Managing Liability Affects Stocks, Pt. 1
Separating Weak Holders From the Strong
Get to Know the Holders? Hands, Part 1
Get to Know the Holders? Hands, Part 2

I wanted them to have similar titles, but it was not to be.? Even for managing equities, understanding the balance sheets of companies, and those that own companies can make a difference.? When stocks are owned by those that can truly buy and hold, downside is limited.? When stocks are owned by those who are under pressure to earn money in the short run, upside is limited.

But what of liabilities for which there are no assets?? What of underfunded municipal and corporate pension plans?? With the corporate plans there is bankruptcy and the PBGC.? With municipalities, and the Federal Government it is more questionable.? There are few assets to lay claim to, even if there were a right to do so.? They rely on increased taxation, and the willingness of the courts to enforce pension promises.? This will prove politically difficult, and perhaps prove to be a greater challenge to the constitution than anything previous, because the economic demands are far greater than what the US taxpayer has been willing to bear.

Still, the greater challenge for countries is the ability to continue to manage debt issuance.? As we see with Greece today, that is not a simple thing.? Countries can be misfinanced, as much or more so than corporations.

Risk management is primarily management of liquidity, and planning to avoid? liquidity risks over the long haul.? Easy to state, hard to do.? The siren song of the short-run is so compelling, but the long–run eventually arrives, and when it does, it comes to stay.? Plan your life, or your corporation’s life such that you control your destiny, and are never in a spot where you are forced to do anything.? That takes discipline, but the man who controls his own soul is ready to rule things far greater.

Promises, Promises

Promises, Promises

Posted on by David Merkel

My piece on bank reform will have to delay until Monday evening.? I am still working on it.? Tonight’s piece is on entitlements and pensions globally and locally.

I asked recently if anyone had data on other countries of the world to analyze where other countries were in terms of debt plus unfunded liabilities as a percentage of GDP.? I got a few good suggestions, but then I stumbled across this article in the New York Times that provided the graph to the left.

The article is about Greece, but the graph covers all of Europe and the US.? I am not sure where the author got the 5x GDP estimate for the US, but I have e-mailed him.? My own estimate was 4x GDP.

Either way the US and the EU are more comparable than different by this measure.? They are both in the 4-5x GDP zone.? But the EU contains some real basket cases such as Poland, Greece, Slovakia, Slovenia, and Latvia.? Oddly, Spain looks good on this measure, and Ireland and Italy are better than the EU average.

Now, recognize that these figures are from 2004, so they could be worse by now — they are unlikely to be better.? Here is the original article from Jagadeesh Gokhale, the fellow who calculated the European figures at the Cato Institute.? Quoting from his paper:

No EU government has made the necessary investment. As an alternative, the next-best option is for these countries immediately to gradually but significantly increase saving and investment. In particular, the average EU country could fund its projected budget shortfall through the middle of this century if it put aside 8.3 percent of its GDP each and every year. Despite this adjustment, a budget shortfall is likely to emerge after 2050, requiring additional fiscal reforms.

What will happen if EU countries do not set aside these funds? Unless they reform their health and social welfare programs, they will have tomeet these unfunded obligations by increasing tax burdens as the larger benefit obligations come due. Although spending averages 40 percent of GDP today:

  • By 2020, the average EU country will need to raise the tax rate to 55 percent of national income to pay promised benefits.
  • By 2035, a tax rate of 57 percent will be required.
  • By 2050, the average EU country will need more than 60 percent of its GDP to fulfill its obligations.

Later, he continues:

In comparison, the United States? shortfall for Social Security and Medicare alone has been somewhat smaller than the EU average, at 6.5 percent of future GDP. But as a result of the expansion of the Medicare program to cover prescription drugs, the U.S. fiscal imbalance is now 8.2 percent of future GDP. Putting this in perspective, to close its fiscal imbalance:

  • The United States would need to save and invest an amount equal to 8.2 percent of its GDP beginning now and continuing every year forever to pay expected future benefits without future tax increases.
  • This could be accomplished by more than doubling the current 15.3 percent payroll tax on employers and employees, immediately and forever.
  • Alternatively, the federal government could immediately stop spending nearly four out of every five dollars on programs other than Social Security and Medicare ? eliminating most discretionary spending on such programs as education, national defense, environmental protection and welfare ? forever.

Each year that the United States does not take action to reduce the projected shortfall, it grows by more than $1.5 trillion, after adjusting for inflation.

If you are a wonk on these matters, I recommend that you read the paper.? But the article from the New York Times motivated the issue in other ways.? A hairdresser in Greece retires at age 50?? In the US, aside from the military, the only people I know of that retire with a full pension at age 50 are oil wildcatters, and those that similarly punishing hard work.? Also, it is backward for women to retire earlier than men; they live a lot longer.

There is no way that we are going to get governments to run 8% of GDP surpluses per year to deal with these crises.? I hate to say this, but if some of the profligate European governments want to deal with this situation, they will need to change their constitutions or laws that guarantee pension payments at a certain level and age, and extend the age and drop the benefits.? Political suicide, I know.? But do you care if the Eurozone fails?? Do you care if your nation fails?? I’m not saying that one group has to bear pain while another does not, but aside from those that work at physically demanding jobs, there is no reason why everyone can’t work until age 75.? Yes, 75, leaving aside disability.? Retirement should be the last 10 years of life on average, not the last 20, much less 35.

When someone stops working, the rest must pick up the slack.? Is there any way for a culture to work where those who work must support 2+ people excluding themselves?? Many Western governments are staring at cultural failure, and can’t see the forest for the trees.? They see the short run funding difficulty, but do not see the long-term problem that is lurking to begin to bite in the next decade.? The sad thing is — it’s too late.? Aside from cutting benefits, or raising benefit ages, there is no way out.

The Divided States

The Barron’s cover article dealt with high state and municipal pensions.? Though I wrote a piece on this recently, talking about the Pew report study, among other things, this article makes the valid point that the state and municipal discount rates on pension liabilities are likely too high, averaging 8% or so.? The nominal GDP growth rate of the economy of the whole is probably the best estimate of where discount rates should be — what shall we say? 4-5%/year?? In this low rate environment, earning 8% forever is ludicrous.? But at 4-5%/year we are talking about a deficit of ~$3 trillion, not $1 trillion.

As the article points out, workers in the public sector earn more on average than those in the private sector.? The need to have high pensions to attract workers is no longer valid.

Also, the states and municipalities are taking above average risks to try to earn their target rate, even though doing so is highly unlikely.? As it says in the article:

Finance professors Robert Novy-Marx at the University of Chicago and Joshua Rauh of Northwestern University asserted in a recent paper that the funding gap for state pension plans alone might exceed $3 trillion, in part because state funds are using an unrealistic long-term annual investment return of 8% to compute the present value of future payments to retirees, as is permitted in government standards for pension-fund accounting.

This establishes a “false equivalence” between pension liabilities and the likely investment outcomes of state investment portfolios, which are increasingly taking on more risk by beefing up their exposure to stocks, private-equity deals, hedge funds and real estate. Using a much lower expected return — say, one at least partially based on the riskless rate of return on government securities — would both properly and dramatically boost the present value of the pensions’ liabilities while decreasing their likely ability to meet them. The academic pair, using modern portfolio theory, claim that state funds, as currently configured, have only a one-in-20 chance of meeting their obligations 15 years out.

As I said above with countries, so it might be with states.? Some states will have to repeal statutory or constitutional guarantees on pensions in order to survive.? I don’t like saying this, but I don’t think there is any choice eventually.? Do you want your state or municipality to survive or not?? Even Chapter 9 and/or ERISA should be amended to allow for adjustment of pension obligations in municipal bankruptcy.? States also should be able to use Chapter 9, or, a new Chapter of the Bankruptcy code for States.

That is why bond investors are getting skittish over General Obligation bonds, and moving to Revenue bonds, if the revenues are stable enough, and protected for bondholders.? They don’t trust the states and municipalities.

Now, this comes after years of underfunding the pension funds.? Few truly were farsighted, and set aside the assets, rather than having more current spending, or deceasing taxes.

Where does this leave us?? In no good place.? Is there a solution?? Yes, but only that of shared pain.? We have to decide whether we take structured pain now, through benefit cuts and higher taxes, or, take unstructured pain when the riots arrive, time to be determined.? Cultural failure is a real possibility; civilization is more veneer than solid when everyone argues for their self interest, and few argue for the good of the whole.

The Pain Has To Go Somewhere, But Where?

The Pain Has To Go Somewhere, But Where?

Posted on by David Merkel

Roughly three months later than originally scheduled, the fiscal year 2009 Financial Report of the United States Government came out.? I had predicted a few times (latest here) that the final total of debts and unfunded liabilities would be about 4x GDP.? Well, I was close:

Category Amount
OASDI (Social Security)

(7,677)
Medicare Part A

(13,770)
Medicare Part B

(17,165)
Medicare Part D

(7,172)
Unfunded Liabilities

(45,784)
Net Explicit Debt

(11,456)
Total Debt and Unfunded Liabilities

(57,240)
GDP 9/2009

14,242
Ratio

402%

As I commented in my piece The Biggest, Baddest Bubble of Them All:

This doesn?t take into account the value of land and certain less tangible assets that the U.S. Government has. It also does not take into account the considerable operating and capital lease liabilities, deferred maintenance, or liabilities for the GSEs, and other lending guarantee programs of the federal government.

That comment was originally written in October 2003.? As I commented at RealMoney a number of times, I felt that it was possible that the GSEs would fail — they held so little in reserve against mortgage losses.? Back then, the figure wasn’t $57 billion, it was $25 billion for fiscal year 2002, which would be 2.4x GDP.

The US Government has made a lot of promises to pay.? I have no idea how big the annual obligations for capital and operating leases are, but it would be cheaper for the Government? to borrow and buy their buildings, rather than hiding the debts through Credit Tenant Leases.? I also can’t quantify the full range of guarantees they have made, including implicit ones to bail out GSEs, big financials, allies, etc.

A reader wrote me asking: Would you please write a post on what will happen if the US goes bankrupt? This government spending continues to get worse and I am wondering what if anything I, a retired person, can do to get in front of this.

Okay, here goes.? Remember that the US Government has choices.? It can raise taxes, inflate, or default.? I don’t think default, even if it is only an external default, is the most likely option.? Also, the promises for Social Security and Medicare are not guaranteed — they can be reduced or canceled by Congress and the President.? Changing Social Security and Medicare would be political suicide, but suicide is an option.

An aside, why have I not mentioned cutting discretionary spending (or defense or entitlements)?? Because they aren’t that large a portion of the budget.? Defense and entitlements are large, but who could get a consensus on cutting those?? Our culture has a “more is better” mentality, even though spending money on “defense” has probably not made us more secure.

In order of highest likelihood, here is how I see the options:

    1. Borrow more
    2. Raise taxes
    3. Inflation
    4. Cut discretionary spending
    5. Cut defense spending
    6. External default
    7. Total default
    8. Cut entitlement spending
    9. Internal default

      Much as I would like to see the US Government reduced in size to only core functions, my views are not the consensus.? They will try to raise taxes, and failing that, inflate the currency.

      To the one who asked the question, I am not a tax expert, so consult one to limit your taxes.? On inflation, you probably know the drill: Money market funds, TIPS, commodities, and equities with hard assets or pricing power.

      The US government talks about cutting discretionary spending, but rarely does so.? Defense is worse; it always expands.? For the US to cut defense spending would be a mindshift requiring closing overseas bases, and a quiet surrender of the idea that the world is ours to guard/rule.? We think we are neutral, when we are genuinely self-interested.

      External default would not be enough to solve the problems the US faces, and, it would enrage the rest of the world.? We would find our assets abroad seized by foreign governments.? Say goodbye to goodwill and globalization.

      I don’t know what to say about total default, aside from depression everywhere, with many financial institutions failing in the US and abroad.? If the global reserve currency fails, well, those that rely on it will fail.

      I don’t view cutting entitlement spending or an internal default only as likely.? They are political suicide for whoever does it.

      My sense is when the ability to raise taxes fails, inflation will be the solution.? If/when the political outcry becomes too great against inflation, then the lesser remedies will be considered.

      The pain has to go somewhere — we’ve been really good at ignoring the problem, delaying the payment, etc., but it has only had the effect of building up the eventual pain that will have to be taken.? Our leaders are seemingly opting for a Japan-style solution — stagnation for two-plus decades with debt shifted from private to public entities.? We have better much better demographics, but Japan has had better saving in the past — more of their explicit debts are internally funded compared to the US.

      The trouble with offering advice in a situation like this is that the right answer depends on what our officials do.? The best or worst investment could be long Treasury zero coupon bonds.? Or it could be gold.? Remember, many thought the Great Depression would end with inflation, but it didn’t, at least not to the degree that many feared.? Me?? I am invested in a mix of well financed businesses that generate a lot of cash and would be difficult to do without, and some money market funds, where I suffer the punishment of a saver, while retaining flexibility.

      There are no easy answers here.

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