Pensions – Page 12 – The Aleph Blog

Alternative Investments, Illiquidity, and Endowment Management

Posted on 17 September 200920 June 2017 by David Merkel

I am a risk manager first, and a profit maker second.? I tend not to trust solutions that are “magic bullets” unless there is some barrier to entry — why can you do it, and few others can?? Knowledge travels.

So, regarding the “endowment model” of investing, I have been partly a believer, and partly a skeptic.? A believer, because endowments do have the ability to invest for the long-term, and not everyone else does.? A skeptic, because many endowments were taking on too much illiquidity.

Liquidity is an underrated factor for investors who have charge over portfolios that have a long-term stable funding base.? I had that advantage once, as the main investment manager for an insurer the had a large portfolio of structured settlements.? In insurance liabilities, nothing is longer than a portfolio of structured settlements.

Buy long-dated debt?? Illiquid debt?? If the pricing is right, sure; you should have to pay to rent the strength of a strong balance sheet, where the funding is intact.? WHen managing that company’s portfolio I didn’t have to worry about a run on the portfolio, because I kept more than enough liquid assets to satisfy the demands of policyholders should they decide to surrender.

Pushing it Past the Illiquidity Limit

I decided to write about the endowment model after reading this article, of which I will quote the first paragraph:

There has been much written in the popular press lately about the failures and even the “death” of the endowment model. The discourse regarding this matter has been surprisingly simplistic, naive and exceedingly short sighted. As was the case with Mark Twain, reports on the death of the endowment model have been greatly exaggerated. Let’s start with the facts. The “endowment model” practiced by most of the big university endowments and many big foundations (but also by some astute smaller endowments and foundations) has overwhelmingly outperformed virtually all other models over any reasonable time period, and has done so for a very long time now. There is no single model, mode or manner of investing that outperforms in every environment and over every time period, and the endowment model of investing was never predicated on being the exception to this obvious reality. In fact, endowments’ time horizons are as long as any investor’s horizon, and hence are strictly focused on the long term. This is a huge advantage because there is clearly a significant liquidity premium to be captured by investing long term, not to mention the ability to better avoid the chaotic noise and behavioral finance mistakes that arise with a short term environment and outlook – especially in volatile markets.

The idea here is that you will obtain better returns if you can focus out to an almost infinite horizon — after all, endowments will last forever.? There is an edge to having a long investment horizon, but there are still reasons to be cautious, and not aim a majority of investments in such a manner that means that they cannot be touched for a long time.

Here is my example: Harvard.? At the end of fiscal 2008, those that managed Harvard Management Company were heroes.? The largest university endowment, stupendous returns, etc.? Who could ask for more?

The risk manager could ask for more.? With an endowment of nearly $37 billion in June of 2008, only $16 billion was liquid assets.? Of that $16 billion, $11 billion was spoken for because of commitments to fund limited partnerships.? Harvard also had $4 billion in debt, not all of which was directly attributable to the endowment, but still would be a drag on the total Harvard entity.?? If this is representative of the endowment model, let me then say that the endowment model accepts illiquidity risk more than most strategies do.? Even after their great investment successes, Harvard did not have enough liquidity.

Then Came Fiscal 2009 — We’re out of liquid assets!

My guess is that sometime in the fourth quarter of calendar 2008, the powers that be at Harvard concluded that they were in a liquidity bind — negative net liquid assets, and there is a need for liquidity at Harvard, to pay for ordinary operations, as well as expansion.? Thus they moved to sell illiquid investments, and take a haircut on them.? They reduced their forward commitments by $3 billion.? They also raised $1.5 billion in new debt, $500 million worth of 5-, 10-, and 30-year debt each.

This is clear evidence of a panic, and an indication that the portfolio was too illiquid.? What else might indicate that?? Well, Harvard had to scale back capital projects, and had a round of layoffs of ancillary personnel.

The idea of an endowment is that you can run your institution without fear of the future.? But that also implies that those endowed will not make abnormal demands on the endowment.? That applies to the amount disbursed and the liquidity of the underlying investments.

Now at the inception of fiscal 2010, Harvard is much in the same place as it was in 2009.? Net of debt and commitments, Harvard’s endowment does not have liquid assets on net.? (My estimates: $12.5 billion of liquid endowment funds, $8 billion of funding commitments, and $5.5 billion of debt.)? Granted, it was wise to move the endowment’s cash policy target from -5% to -3% to +2% over the past two fiscal years.? Even if cash doesn’t return anything, it is still valuable.? You can’t pay professors with shares of a venture capital partnership.

The Horizon Isn’t Infinite

This brings me to my penultimate point, which is that the investment horizon for endowments is different for other investors in degree, but not in kind.? The horizon for an endowment is infinite only under conditions of permanent prosperity.? Well, anyone can invest forever under conditions of permanent prosperity.? The forever-growing investments can be borrowed against.

The investment horizon must take into account the possibility of a depression, or at least a severe recession or war, if you want to have an endowment that will truly last forever.? There has to be cash and high quality liquid debt adequate to provide a buffer of a few years of expenses.? That will give the institution more than adequate time to adjust to the new economic conditions.

Most college endowments that have not gone overboard on illiquid investments and don’t have a boatload of debt probably don’t have to worry here.? But for those that bought into the alternative investments craze, the idea of invest for forever must at least be tempered into something like 20% of our investments exist to buffer the next 5 years, and the other 80% can be invested to the infinite horizon (maybe).? That’s a more realistic approach to endowment investing, akin to a speculator paying off his mortgage and having a year of savings in the bank before beginning a trading career with capital beyond that.

Alternative Investments are not Alternative Anymore

There is another reason, though, to be cautious about illiquid investments.? With any new alternative investment class, the best deals get done first, and wow, don’t they provide a thundering return!? Trouble is, knowledge travels, and success breeds imitators.? The imitators typically bring deals that will have lower returns or higher risks than the original deals.? But the pressure of additional money into the alternative illiquid investments force progressively more marginal ideas to get done as deals.? Also, mark-to-market returns of earlier investments get marked up, giving them an even more impressive return, which attracts more capital to the investment class.

Eventually deals get done that make no sense, but the momentum of demand carries the asset class until returns of newer deals prove to be negative.? That? gets the mark-to-market process moving in reverse, and demand for the “no longer new” investment class declines.? In some cases, investors will try to get out of funding commitments, and even try to sell their interests to a third party, usually at a significant concession to the hard-to-define fair market value.

Eventually enough capital exits the class, inferior deals get written down, and the once new investment class might still be labeled “alternative,” but has entered the mainstream, because it has been around long enough to go through a failure cycle.? The now mainstream but still illiquid investment class is near a normal size versus the investment universe, and should possess forward-looking returns that embed a risk premium to reflect the disadvantages of illiquidity.? Also, the now mainstream investment becomes more correlated with risk assets generally, because the actions of institutional investors chasing past returns is common to much of what qualifies for asset allocation.

Summary

Liquidity is valuable, and should not be surrendered without proper compensation.
Alternative investment classes eventually go through a mania phase, and then go through a failure cycle.
After failure, they tend to be more correlated with other risk assets.
Endowments can indeed invest for a long horizon, but should keep sufficient liquid assets on hand to deal with significant market corrections.
Harvard’s endowment would be vulnerable if we had a repeat in the near term of what happened in fiscal 2009 because of its low net liquidity.

Investing is a business where the smarter you are, the more it pays to be humble and recognize risk limits.? Major universities and colleges (and defined benefit plans) should review their asset allocations and stress-test them on scenarios where liquidity is in short supply.? Better safe than sorry.

Articles on the Harvard Endowment

6:46 PM Update — So I write this, and Morningstar comes out with a good piece like this one.? So it goes.

Ten Unsolved Problems in the Global Economy

Posted on 15 August 2009 by David Merkel

There are many celebrating the recovery as if it were already here.? This is a brief post to outline my main remaining concerns for recovery of the global economy.

1)? China is overstimulating its economy, and forcing its banks to make bad loans.? This pushes up commodity prices, and makes it look like China is growing, but little of the investments made are truly needed by the rest of the global economy.

2)? Western European banks have lent too much to Eastern European nations in Euros.? The Eastern Europeans can’t afford it, and widespread defaults are a possibility.

3)? The average maturity of bonds held by foreign investors in US Treasuries is falling.? Runs on currencies happen when countries can no longer roll over their debts easily, which is facilitated by having a lot of debt to refinance at once.

4)? On a mark-to-market basis, market values for commercial real estate have fallen dramatically.? Neither REIT stocks nor carrying values for loans on the books of banks reflect this yet.? Many banks are insolvent at market-clearing prices for commercial real estate.

5)? We still have yet to feel the effects from pay-option ARMs resetting and recasting.? Most of the pain in residential housing is done, but on the high end, there is still more pain to come, and the pay-option ARMs will reinforce that.

6)? The rally in corporate debt and loans was too early and fast.? Conditions are not back to normal for creditworthiness.? There should be a pullback in corporate credit.

7)? We had global overbuilding is cyclical sectors 2002-2007.? We overshot the demand for large boats as an example.? We overdeveloped energy supplies (that will be short-lived), metals, and other commodities.? It will take a while to grow into the extra capacity.

8 )? The US consumer is still over-levered.? It will be a while before he can resume his profligate ways, assuming a new frugality does not overcome the US.? (Not likely by historical standards.)

9)? The Federal Reserve will have a hard time removing their nonstandard policy accommodation.

10)? We still have the pensions/retiree healthcare crisis in front of us globally.

That’s all.? To my readers, if you can think of large unsolved problems in the global economy, forward them on to me here in the comments.? If I agree, I will incorporate them in future articles.

Book Review: Mr. Market Miscalculates

Posted on 29 July 200920 June 2017 by David Merkel

Since the first time I read him, I have been a fan of James Grant.? He helped to sharpen my focus on how money and credit work in the long run, and how they affect the economy as a whole.? Reading one of his early books, Minding Mr. Market: Ten Years on Wall Street With Grant’s Interest Rate Observer, I gained perspective on the increasingly complex financial world that we were moving into.

But not all have shared the opinion of Mr. Grant’s wisdom.? When I worked for Provident Mutual, the Chief Portfolio Manager (at that time new to me, but eventually a dear colleague) said to me, “feel free to borrow any of the publications we receive.”? For a guy who likes to read, and learn about investments, I was jazzed. But, when I came back and asked whether we subscribed to Grant’s Interest Rate Observer, I got the look that said, “You poor fool; what next, conspiracy theories?” while she said, “Uh, noooo. We don’t have any interest in that.”

Now the next two firms I worked for did subscribe, and I enjoyed reading it from 1998 to 2007. But now the question: why buy a book that repeats articles written over the last fifteen years?

I once reviewed the book Just What I Said: Bloomberg Economics Columnist Takes on Bonds, Banks, Budgets, and Bubbles, by another acquaintance of mine, the equally bright (compared to James Grant) Caroline Baum.? This book followed the same format, reprinting the best of old columns, with modest commentary.? In my review, I cited Grant’s earlier book as a comparison, Minding Mr. Market.

As an investor, why read books that will not give an immediate idea of where to invest now?? Isn’t that a waste of time? That depends.? Are we looking to become discoverers of investment/economic ideas, or recipients of those ideas?? Books like those of Grant and Baum will help you learn to think, which is more valuable than a hot tip.

Here are topics that the book will help one to understand:

How does monetary policy affect the financial economy?
Why throwing liquidity at every financial crisis eventually creates a bigger crisis.
Why do value (and other) investors need to be extra careful when investing in leveraged firms?
What is risk?? Variation of total return or likelihood of loss and its severity?
Why financial systems eventually fail at compounding returns at rates of growth significantly above the growth rate of GDP.
Why great technologies may make lousy investments.
Why does neoclassical economics fail us when trying to understand the financial economy?
How does one recognize a speculative mania?
And more…

The largest criticism that can be leveled at James Grant was that he saw that he would happen in this crisis far sooner than most others.? Being too early means you eventually get disregarded.? The error that the “earlies” made, and I knew quite a few of them, was not recognizing how much debt could be crammed into the financial economy in order to juice returns on fixed income assets with yields lower than likely default losses.? That’s a mouthful, but the financial economy had not enough good loans to make relative to the amount of loans needed to maintain the earnings growth expectations of the shareholders of financial companies. Thus, the credit bubble, facilitated by the Fed and the banking regulators.? You can read all about it in its many facets in James Grant’s book.

You can buy the book here: Mr. Market Miscalculates: The Bubble Years and Beyond.

Who would benefit from the book?

Those that have assumed that neoclassical economics adequately explains the way our economy works.
Those that want to understand how monetary policy really works, or doesn’t.
Those that want to learn about equity or fixed income value investing from a quirky but accurate viewpoint.
Those that want to be entertained by intelligent commentary that proved right in the past.

As with other James Grant books, this does not so much deal with current problems, as much as educate us on how to view the problems that face us, through the prism of how past problems developed.

Full disclosure: If you buy anything through the links to Amazon at my blog, I get a small commission,? but your costs don’t go up.?? Also, thanks to Axios Press for the free review copy.? I read the whole thing, and enjoyed it all.

The Equity Premium is No Longer a Puzzle

Posted on 15 July 2009 by David Merkel

For a number of years, I have mused over the equity premium puzzle, and have generally written that the premium return that equities earn over stocks is less than most asset allocators assume. In January 2006, wrote an article on this topic at RealMoney: Kiss the Equity Premium Goodbye.? A few quotes:

This article won’t win me a lot of friends in the money management industry. Here’s the skinny: Stocks are unlikely to return much more than bonds over the next 10 to 20 years.Most investment consultants tell people to invest in equities because, in the long run, stocks beat bonds and cash. I agree, but how big is this advantage? Many studies suggest that the equity premium is somewhere in the vicinity of 6%; i.e., stocks beat cash by 6 percentage points a year. Against bonds, the advantage is said to be 4% or so.

However, there are persuasive arguments that the value of the equity premium will be much lower going forward. In the book Triumph of the Optimists, Elroy Dimson, Paul Marsh and Mike Staunton argue that the future equity premium in the U.S. is likely to be closer to 4% over cash for two main reasons:

Corporate cash flows have grown faster in the last 50 years than in the prior 50, and investors have bid up stocks as a result. However, the authors believe that such high rates of growth will not continue. If corporate cash flow growth reverts to the rate of the first half of the 20th century, future returns based on current equity values will be poor indeed.

Perceived risk in stock investing has diminished. Investors have bid prices up in anticipation that the equity premium is higher than it should be, and on the belief that it is not risky to try to capture it.

The researchers Peter Bernstein and Robert Arnott draw similar conclusions, but they get there in different ways. They point out that over the years, the size of the future equity premium has varied with the level of belief in its existence. When market players deny its existence, equity valuations are low, past equity performance has probably been poor, and the future equity premium is large — think of 1931, 1937, 1974, 1982, November 1987 and 2002. When everyone believes in the inevitability of stocks, ? la “Dow 36,000” (we’ll get there by 2025 or so), equity valuations are high, past equity performance has probably been great, and the future equity premium is small — think 1929, 1972, August 1987 and February 2000.

I believe stocks have been bid up because of the benefit needs for the retirement of the baby boomers. Though the savings rate is low, investment vehicles such as pension plans have made large commitments to equities, partially because plan sponsors can justify lower contributions to benefit plans by assuming a high rate of return, which stems from assuming that the equity premium will persist.

and this:

This doesn’t directly generalize to the market as a whole, because all stocks are owned by someone at the end of each day. Isn’t there always a buyer for every seller, and vice versa? Yes, but they aren’t always public-market buyers and sellers. Cash comes into the market via IPOs (both primary and secondary), rights offerings and any other way that new shares get created for the payment of cash. Cash comes out of the market through dividends, buybacks and any other way that companies disburse cash to shareholders, whether directly or in exchange for shares.

Companies tend to sell stock when it is advantageous; IPOs happen more frequently when valuations are high, and buybacks happen more frequently when valuations are low. This suggests a project for future study: Calculate the dollar-weighted return for the public equity market as a whole, and compare it with the time-weighted return figures.

It’s a difficult but not impossible project, but I don’t have the time or resources to do it. If it hasn’t been done already, it might make a rare practical Ph.D. thesis for someone. Returns for the market as a whole would equal the change in market value, plus the cash cost of shares taken out of the market (buybacks, LBOs, etc.) and dividends, less the cash added to the market through IPOs and other forms of share issuance for cash (i.e., employee stock option exercise, rights offerings, etc.). I don’t have firm numbers, but my guess is that dollar-weighted returns are less than the time-weighted returns by 1 percentage point, give or take 50 basis points.

Though the composition of an index fund changes by period to reflect additional equity issuance/buyback by companies in the index, it misses the effect on returns from having to allocate more capital when valuations are high, and having to receive capital back when valuations are low. In a whipsaw period like that which we have had from 1998 to the present, it makes a lot of difference, because many investments during the bubble era put fresh capital into the market at a time of high valuations, with buybacks predominating as valuations troughed.

In short, though the academic studies rely on time-weighted rates of return for their conclusions regarding the equity premium, which represents buy-and-hold investors, dollar-weighted returns, which is what most investors actually receive on their investments, are lower. The difference occurs because corporations issue stock when valuations are high, and retire it when valuations are low.

Okay, here’s the punchline — with not just a hat tip, but a full bow to Eric Falkenstein at Falkenblog, Ilia D. Dichev has done the research that I wanted to see done.? The difference between time-weighted and dollar-weighted returns is around 1.3% for NYSE stocks (1926-2002), around 5.3% for NASDAQ stocks (1973-2002), and 1.5% for developed market stocks generally? (1973-2004).

Doing a very rough average, and considering that the NASDAQ was in a boom period for most of the study period, I am comfortable with a reduction in the US equity risk premium over bonds down to 1-2% on average, and over cash to 3-4% on average.

At that level, being in stocks works for long term investing, but it would almost never pay to be 100% in stocks.? The old 60/40 stocks/bonds allocation begins to look really intelligent over the long haul, but maybe not today because high quality bond yields are so low.

So, where does this leave me on the equity premium puzzle?? It is no longer a puzzle.? One can gain moderately over the very long haul in stocks versus bonds, but with significant volatility.? Don’t risk what you can’t afford to lose in the stock market, and other risky investment vehicles.

PS — this makes the old dictum on the cost of equity valid again — the cost of equity capital for a firm should be 2-3% above their longest bond yield.? Bye, bye, CAPM.

Problems with Constant Compound Interest (3)

Posted on 16 June 2009 by David Merkel

This post should end the series, at least for now.? Tonight I want to talk about the limits to compounding growth.? Drawing from an old article of mine freely available at TSCM, I quote? the following regarding talking to management teams:

What single constraint on the profitable growth of your enterprise would you eliminate if you could?

Companies tend to grow very rapidly until they run into something that constrains their growth. Common constraints are:

insufficient demand at current prices
insufficient talent for some critical labor resource at current prices
insufficient supply from some critical resource supplier at current prices (the “commodity” in question could be iron ore, unionized labor contracts, etc.)
insufficient fixed capital (e.g., “We would refine more oil if we could, but our refineries are already running at 102% of rated capacity. We would build another refinery if we could, but we’re just not sure we could get the permits. Even if we could get the permits, we wonder if long-term pricing would make it profitable.”)
insufficient financial capital (e.g., “We’re opening new stores as fast as we can, but we don’t feel that it is prudent to borrow more at present, and raising equity would dilute current shareholders.”)

There are more, but you get the idea.

Again, the intelligent analyst has a reasonable idea of the answer before he asks the question. Part of the exercise is testing how businesslike management is, with the opportunity to learn something new in terms of the difficulties that a management team faces in raising profits.

As with biological processes, when there are unlimited resources, and no predators, growth of populations is exponential.? But there are limits to business and investment profits because of competition for customers or suppliers, and good untried ideas are scarce.? Once a company has saturated its markets, it needs a new highly successful product to keep the growth up. Perhaps international expansion will work, or maybe not?? Are there new marketing channels, alternative uses, etc?

Trying to maintain a consistently high return on equity [ROE] over a long period of time is a fools bargain and I’ll use an anecdote from a company I know well, AIG.? I was pricing a new annuity product for AIG, and I noticed the pattern for the ROE of the product was not linear — it fell through the surrender charge period, and then jumped to a high level after the surrender charge period was over.

I scratched my head, and said “How can I make a decision off of that?”? I decided to create a new measure called constant return on equity [CROE], where I adjusted for capital employed, and calculated the internal rate of return of the free cash flows.? I.e., what were we earning on capital, on average over the life of the product.

I took it to my higher-ups, hoping they would be pleased, and one said, “You don’t get it!? You don’t argue with Moses!? The commandment around here is a 15% return on average equity after-tax!? I don’t care about your new measure!? Does it give us a 15% return on average equity or not?!”

This person did not care for nuances, but I tried to explain the ROE pattern, and how this measure averaged it out.? It did not fly.? As many have commented, AIG was not a place that prized actuaries, particularly ones with principles.

As it was AIG found ways to keep its ROE high:

Exotic markets.
Be in every country.
Be in every market in the US.
Play sharp with reinsurers.
Increase leverage
Press the accounting hard, including finite reinsurance and other distortions of accounting.
Treat credit default swap premiums as “found money.”
Take on additional credit risk, like subprime lending inside the life companies through securities lending.

In the end, it was a mess, and destroyed what could have been a really good company.? Now, it won’t pay back the government in full, much less provide anything to its shareholders, common and preferred.

Even a company that is clever about acquisitions, like Assurant, where they do little tuck-in acquisitions and grow them organically, will eventually fall prey to the limits of their own growth.? That won’t happen for a while there, but for any company, it is something to watch.? Consistently high growth requires consistently increasing innovation, and that is really hard to do as the assets grow.

If True of Companies, More True of Governments

This is not only true of companies, but even nations.? After a long boom period, state and federal governments stopped treating growth in asset values as a birthright, granting them a seemingly unlimited stream of taxes from capital gains, property, and transfer taxes.? They took it a step further, borrowing in the present because they knew they would have more taxes later.? The states, most of which had to run a balanced budget, cheated in a different way — they didn’t lay aside enough cash for their pension and retiree healthcare promises.? The Federal government did both — borrowing and underfunding, because tomorrow will always be better than today.

Over a long enough period of time, things will be better in the future, absent plague, famine, rampant socialism, or war on your home soil.? But when a government makes long-dated promises, the future has to be better by a certain amount, and if not, there will be trouble. That’s why an economic downturn is so costly now, the dogs are behind the rabbit already, running backwards while the rabbit moves forwards makes it that much harder to catch up.

I’ve often said that observed economic relationships stop working when people start relying on them, or, start borrowing against them.? The system shifts in order to eliminate the “free lunch” that many thought was available.

A Final Note

Hedge funds and other aggressive investment vehicles should take note.? Just as it is impossible for corporations to compound their high profits for many decades, it is impossible to do the same as an investor.? Size catches up with you.? It’s a lot easier to manage a smaller amount — there are only so many opportunities and inefficiencies, and even fewer when you have to do so in size, like Mr. Buffett has to do.

“No tree grows to the sky.”? Wise words worth taking to heart.? Investment, Corporate, and Economic systems have limits in the intermediate-term.? Wise investors respect those limits, and look for growth in medium-sized and smaller institutions, not the growth heroes of the past, which are behemoths now.

As for governments, be skeptical of the ability of governments to “do it all,” being a savior for every problem.? Their resources are more limited than most would think. Also, look at the retreat in housing prices, because the retreat there is a display of what is happening? to tax revenues… the dearth will last as long.

Full disclosure: long AIZ

Problems with Constant Compound Interest

Posted on 4 June 20094 June 2009 by David Merkel

This piece is an experiment.? I’m not exactly sure how this will turn out by the time I am done, so if at the end you think I blew it, please break it to me gently.

People in general don’t get compound interest, or exponential processes generally.? It is not as if they are pessimistic, they are not numerate? enough to apply the rule of 72.? (Rule of 72: For interest rates between 3 and 24%, the time it takes to double the money is approximately 72 divided by the interest rate, expressed as a whole number.)

But there is a greater problem, and it applies to the bright as well as the dull.? People don’t understand the limitations of compound interest.

Let me begin with a story: I started my career at Pacific Standard Life, a little life insurer based in Davis, California.? The universal life policieswere crediting 11-12% interest, and annuities were in the 9-10% region.? It was fueled by junk bonds.? One of my first projects was to set the factors that would give us GAAP reserves for the universal life products.? To do this, I was told to project UL account values ahead at 11-12% interest for the life of the policies.

That rate of interest doubles policy account values every six or so years.? What economic environment would it imply to sustain such a rate of interest?

High inflation, or
High opportunities, because there is little competition.

The former was a possibility, the latter not.? As it was, inflation was receding, and 1986 was the nadir for the 80s.

People buying policies would see these tremendous returns illustrated, and would buy, because they saw an easy retirement in sight.? Alas, constant compound growth rarely happens in economics.? Policyholders ended up very disappointed; Pacific Standard went insolvent in 1989, and the rump was sold off to The Hartford.

Where do we often see constant compound growth modeled in finance?

Asset allocation models, including simple illustrations done by financial planners
Life insurance sales and accounting
Defined benefit pension accounting
Long-dated debt obligations
Simple stock price models, like the Gordon Model, and all of its dividend discount model cousins.
Social finance systems, like public pensions and healthcare.

There are likely many more.? Whenever we talk about long-dated financial obligations, whether assets or liabilities, we need something simple to aid us in decision-making, because the more variables that we toss in, the harder it is for us to make reasonable comparisons.? We need to reduce calculations to single variables of yield, present values, or future retirement incomes.? Our frail minds need simple answers to aid us.

I’m not being a pure critic here, because I need simple answers also.? Knowing the yield of a long debt obligation has some value, though if that yield is high, one should ask what the is likelihood of realizing the value of? the debt.? Similarly, it would be useful to know how likely it is that one would receive a certain income in retirement.

I’m going to hit the publish button now, and pick this up in a day or so.? Until then.

Fifteen Thoughts on Advantage in the Markets

Posted on 29 May 2009 by David Merkel

1) I made the point last week when I talked about my experiences in the pension division of Provident Mutual.? The investment choices of 90% of individuals follows recent performance.? This is another factor in why markets overshoot, and why mean-reversion is a weak tendency.? Thus when I see many leaving the stock market for absolute return, bonds, cash, commodities, it makes me incrementally more bullish, though I am slightly bearish at present.

2) Has this been a “suckers rally?”? That’s too severe, but there is some truth to it. Many of the large financials may be safe, but at a cost of higher taxes and inflation.? Also, the losses on commercial real estate have not been felt yet on the balance sheets of banks.? I think we will break the recent lows on the S&P 500 before this is all done.? Debt deflation and dilution continues on.? We have an overhang in residential housing that will require prices to go below equilibrium in order to clear.? Global growth is anemic, even if some of the emerging markets are doing well.

3) When writing for RealMoney, I was usually diffident about buybacks, because I liked to see strong balance sheets.? Now in this era, those that bought back a lot in the past are paying the price.? Buy high, dilute low is a recipe for big underperformance, and we are seeing it in financials now.? (The comments about pension design in the article are spot-on as well.)

4) Behavioral economics does justice to what man is really like, both individually and collectively.? We are prone to laziness, greed and fear.? There is a weak tendency for a minority of individuals to break free from the fads and fashions of men, and pursue profit exclusively.? Remember, thinking hurts, so people conserve on it, unless the reward for thinking exceeds the pain.

5) Quantitative managers have gotten whacked, and few more than Cliff Asness of AQR.? It doesn’t help that you are outspoken, or that you took time away to aid the CFA Institute.? When the business goes south, thereare no excuses that work.? In times like this, be quiet, analyze? failure, and stick to your knitting.

6)? Ken Fisher made an argument like this in his book The Wall Street Waltz.? Eddy’s argument is ordinarily right; buy during bad times.? The only time that is not true is when you are in a depression, and there is much more debt to be liquidated, and more jobs to be lost.

7)? From Quantifiable Edges, there is some evidence that the ratio of the Nasdaq Composite to the S&P 500 can be used as a timing indicator.? Nasdaq Composite outperformance presages more positive returns in the S&P.

8 )? I read the article on the “purified VIX” and other “purified” indicators, and I get it.? Adam is still correct that periods where the VIX and SPX move in the same direction tall you something about future SPX performance.? If both are up, then the trend for the SPX tends to be up.?? Vice-versa if both are down.

9) Regarding this article on David Rosenberg, I think the earnings? are too optimistic, but the P/E multiple is too pessimistic.? Things may be ugly for a while, but I can see an S&P 500 above 1000 in 2011.? (That may be inflation.)

This phrase is problematic “As for the multiple, Rosie believes the P/E should approximate a Baa bond yield, leading to an “appropriate” multiple of 12x.”? E/P on average should be equal to a Baa bond average less 4%, making a fair P/E at 20+.

10) Beta stinks.? You knew that.? Here’s more ammo for the gun.? I have doubted the CAPM for almost 30 years.? It’s only value is to confuse other wise intelligent comptetitors.

11) Is small cap value still relevant?? Is winning relevant?? Please ignore the studies that use betas that adjust for small cap, value, and momentum — using each of those is a management choice, and those of us that choose to be smart take credit for following research, not that research should discount our actions.

12) Yes, the Q-ratio works.? Don’t tell anyone about it, though.? Shh…

13) Dow 36,000.? Yes, in 2030.? Glassman and Hassett were sensationalists that pushed an idea of rationality too hard, suggesting that people could accept a near-zero risk premium to invest in stocks, versus treasury bonds.? Bad idea.? The E/P of stocks averages near the Baa bond yield less 4%.? Stocks need 4% earnings growth to compete with bonds on average.

14) Homes are for living in; they are only secondarily investments, if you know what you are doing.? Compared to TIPS, gains in homeowning, less expenses, are comparable.

15)? As this post points out, and I have said it before, “The vast majority of currency ETFs represent stakes in an interest-bearing?bank account denominated in a foreign currency. They derive all their?return from two sources: the cash yield of the foreign currency over the expense ratio of the fund and changes in the exchange rate against the dollar.”? Be careful with foreign currency funds; they often embed financial credit risk.

So What’s a Year Worth?

Posted on 14 May 2009 by David Merkel

When I heard the announcement on Tuesday about Social Security and Medicare, I emoted something between a grin and a grimace, and said, “A pity that I have been right on this.”? I’ve always felt that Social Security and Medicare? have had optimistic economic assumptions.? It does not surprise me that the year that Social Security revenues are exceeded by expenses has moved in by one year, from 2017 to 2016.? Medicare, we are already exceeding revenues in 2008 and now.

Many focus on when the trust funds will run out — now 2017 for Medicare, and 2037 for Social Security.? Consider this, the trust funds are invested in nonmarketable US Treasury Notes.? That’s safe, right?? Safe, yes, as safe as the US government.? They will pay with the dollars that they print via their stepchild, the Fed.

This is my advice to all who read me.? Given that these social insurance programs invest only in US government debt, on an accounting basis, it makes sense to unify their balance sheets with that of the US government.? Once we unify the balance sheets, it is easy to realize that the negative consequences will come when expenses exceed revenues, not when the funds go to zero. When expenses exceed revenues, the US government will either need to tax or borrow more in order to make ends meet.? The US Government bonds held are a convenient accounting fiction to show that the taxes paid have been spent for other purposes.? There are no “Trust Funds,” only nonmarketable bit of US debt, that will get repaid through higher taxes, or further borrowings.? China and OPEC, ready to fund US retirements in style? 😉

As for the economic assumptions that Social Security uses, I think they are still optimistic.? One thing I have learned about cash flow modeling is that though the averages matter, the early years matter the most.? There is more time for their results to compound with interest.

We could have two more bad years (flat/down GDP on average), and then face the total system revenue breakeven in 2013.? Even if their assumptions prove correct, total system breakeven will come in 2014-2015.

And the markets will react ahead of that, because it will be so well known.? The need for tax revenues will be significant, and more so as we proceed into the 2020s.? This will lead to the need for solutions — with Medicare, much sooner than Social Security.

Medicare

Possible solutions (and their liabilities):

Nationalize the healthcare system and Medicare goes away.? (Medicare is solved, at the expense of creating a bigger problem.? Other cultures may fit nationalized healthcare, but American will chafe at it.)
Create a second parallel healthcare reimursement system that only serves Medicare clients with limited services to those that are terminally ill.? Ease the pain, but nothing radical and expensive.? (I like this one, so it can’t be a good idea.)
Raise taxes.? (lower the reasons to employ labor)
Raise eligibility ages, and quickly. (Listen to the screams.)
Lower reimbursement rates. (Also won’t work because fewer doctors will do Medicare medicine… and quality drops as well.)
Mandate that doctors must take Medicare clients at Medicare rates.? (Nasty.? But once rights of contract get violated in one place, they get violated in others.)
Eliminate plan D, the drug prescription benefit.? It’s young and too complicated, so just kill it.
Means-test eligibility for reimbursement.? (It would lose political legitimacy.)
Terminate the system, such that children born after 1/1/2010 don’t pay in, and would not receive benefits. (Doesn’t really solve the funding problem, unless mixed with some of the above.)

Social Security

Possible solutions (and their liabilities):

Means-test eligibility for reimbursement.? (It would lose political legitimacy.)
Raise taxes.? (lower the reasons to employ labor)
Raise eligibility ages, and quickly. (Listen to the screams.)
Lower benefit payments. (More screams.)
Remove the cost of living adjustments, and inflate the currency.? (At least this rates the problem back to the Baby Boomers, who would get hurt the worst over this… a generation that failed to save and produce enough kids.)
Terminate the system, such that children born after 1/1/2010 don’t pay in, and would not receive benefits. (Doesn’t really solve the funding problem, unless mixed with someof the above.)

“I’ll Gladly Pay You Tuesday for a Hamburger Today.”

The nature of the US government, the lower Federal governments, many of its corporations, and some of its people has been to promise/borrow today, and pay it off later, because tomorrow will be, much, much, better than today.? With the the debt overhang and the looming pension crises, we are beginning to see that much American prosperity was a debt-fueled illusion.? We are presently in stage 1 of dealing with the grief of this shattered illusion — denial.

If the Federal Social Insurance schemes (Social Security, Medicare, Veterans Pensions, Old Federal Employee Pensions) and most State Pensions and Elderly Medical Care are going to pay off, taxes will have to be raised significantly.? That will be one nasty political fight, which might result in the death of certain sacrosanct laws governing the inviolability of pension promises to state employees, and perhaps Federal employees.? Also note, you can raise tax rates, but if it harms the economy, you will get less taxes.

The Federal Government will try to borrow its way out of the problem, until foreign creditors finally rebel, realizing they are throwing good money after bad.? After that, taxes will have to be raised, or promises abandoned/reduced.

For underfunded private defined benefit and retiree healthcare plans, they will likely be terminated, and lesser benefits paid.? All three of the legs of the modern retirement tripod (social insurance, savings, and pensions) are under threat as the era of debt deflation progresses.

Now, realize that though I talk about the US, most of the rest of the developed world is in worse shape as the demographic crisis affects pensions and elderly healthcare globally — they had even fewer kids than in the US, which is close to replacement rate, and so the ratio of workers to those supported will fall even more than in the US, setting up many nasty political fights — all the more nasty, because the governments are much more heavily involved already.? Don’t even think about China, which will come to regret the one child policy that led to so many abortions, and so many beautiful Chinese girls coming to the US to be adopted.

So What’s a Year Worth?

A year can teach us a lot.? 2008 showed us the limitations of our economy.? Future years will show us the limitations of the power of our governments.? Conditions for prosperity can be created, but prosperity can never created by governments.? That is up to the culture of those governed.

This has gotten a bit long, so I will do a follow-up piece within a few days.? Here are a few good articles to consider:

The Bane of Broken Balance Sheets

Posted on 6 March 2009 by David Merkel

I?ve talked about the troubles in our economy stemming from asset-liability mismatch.? Too many people/institutions financed risk assets:

With inadequate equity (provision for adverse deviation)
With lending terms that were much shorter than that of the assets financed
Where the borrowing terms can shift against the borrower in an adverse economic environment.? Think of borrowing in a harder currency, or loans that can reset of recast with payments going higher.
Where lending terms could be modified by third parties.? Think of the rating agencies downgrading a company and it has to put up more assets as collateral.

Another way to say it is too many relied on the ability to refinance on favorable terms.? But now that favorable terms are no longer there, we live in a time of broken balance sheets.? What were some of the classic examples of this phenomenon?

Buying houses with little money down.
Buying houses where the terms can reset against you.? Houses are long term assets, and must be funded with a generous amount of equity, and long term financing as far as the debt is concerned.
Hedge funds bought long duration assets, stocks and longer bonds, when their capital bases could be withdrawn at much shorter intervals.
Many mergers were done for cash near the peak of the product pricing cycle for their particular industry.? The debts incurred hang around, but funny, the pricing power doesn?t when demand collapses.
Many companies invested in new productive capacity ? energy, agriculture, mining, just as the global economic cycle was peaking.? Others in developing markets had ramped up industrial capacity beyond the world?s capability to absorb it.
Defined benefit pension liabilities were increased by states and municipalities which relied on the idea that tax revenues would grow indefinitely at a rate of 4-5% or more.? The same for corporations that assumed 7-10% asset returns for the next 50 or so years.
Even 10-year commercial mortgages with 30-year amortization presumed on the ability to refinance 10 years out.? Was there the possibility that ten years out, refinancing terms would be worse than at origination?? Yes, and we are there now.

In any case, there was often a mismatch as the global economy grew during the boom phase.? New long term assets were created, and financed with not enough equity, and debt terms that were shorter than the life of the assets.

Much of this can be laid at the doors of the Central banks of our world, because they pulled out all of the stops in the early 2000s to help establish an unending prosperity.? News flash: the boom/bust cycle is endemic to mankind; efforts to eliminate it merely create a version with long shallow booms and big busts.? Eventually the piper must be paid; there are no free lunches.? The easing of monetary policy 2001-2003 led to one final big bout of risk taking 2003-2007.? We are living with the aftermath now, as the central banks do everything to try to reflate with no success.? When consumers have little capacity to increase indebtedness, monetary policy is useless, leaving aside helicopter tactics.

So what can the government do at a point like this, since they are committed to permanent prosperity?

Inflate, raising the nominal value of collateral.? This is the simplest solution, and the Fed resists it.? It would also force the other governments of the world to go along.
Provide long-term financing to troubled corporations, whether through long debt, equity, or hybrid instruments.
Bail out states and municipalities with burdensome pension liabilities.

(NB: I am not saying the government should do any of these things.? I am simply saying that these are better than what the government is currently doing.)

Government funding is short duration by nature because of the annual appropriations process, and lack of any restraint ? little in the way of rainy day funds ? a presumption of prosperity in budgeting.? Few governmental entities in the US assume that receipts will be lower in future years.? Budgets are often made assuming that spending will increase, and that taxes will rise to fill the gap.? Well, no more of that, at least for a while.

Any scheme that relies on increasing prosperity is inherently mismatched.? No tree grows to the sky, and that includes nations and their governments.? There is a natural process where nations are born, grow, mature, decay, and die, unless some event intervenes to revivify the nation, giving it new purpose and energy.? With the US over the last 75 years, there has been slow decay amid prosperity.? Payment for obligations is pushed out into the future, because growth will solve our funding crises.? Government debt covers a multitude of sins, in the intermediate-term.

Financing the Economy at Treasury Interest Rates

When I hear talk that the government should borrow to fund mortgages, or dodgy companies, I cringe.? I hear things like: ?These assets are at depressed levels because of a lack of confidence.? The government can borrow and buy them, and make a profit on the spread, particularly after confidence resumes.?? ?Let the government absorb Fannie and Freddie and make loans at affordable rates to people.? They can provide mortgages much cheaper than the private sector.?? ?The value of the assets of AIG is artificially depressed.? The government can finance those assets and sell them for a profit when confidence reappears.?

The borrowing capacity of the US Government is limited.? I don?t know what the limit is ? which straw will finally break the back of the camel, but there is a limit.? The borrowing capacity of our government should be used to its best effect, and playing as a bank or a hedge fund is likely not the right answer.

An overage of private and public leverage pushed asset prices above their equilibrium levels.? Residential housing is a good example here.? Prices still need to come down to restore the affordability levels that existed through the second half of the 20th century.? The Fed could inflate some of the problems away, but that does not seem to be on their menu of choices at present.

I have seen private residential mortgage bonds trading at levels where I said, ?The odds of these not being money good are remote.?? Yet, the bonds trade (if they trade) below 70.? (100 is being paid in full.)

This is because there are fewer entities capable of holding the bonds to anything near maturity.? When someone complains to me about the price of a mortgage bond, after analysis, I often say to find an entity that is willing to hold the bond to maturity, or slightly less, and they can garner full value.? But anyone holding that bond that can?t hold it to maturity, or doesn?t want to, is merely a speculator.

We developed too many speculators in the 2000s, and not enough parties that would hold assets to maturity.? We now suffer for that, including our dear government.? Our dear government is like Brer Rabbit punching the Tar Baby, but without the advantage of being born and bred in the briar patch.? They don?t know what they are doing.? They have some vague idea about what Keynes said, but don?t understand the limitations of his theory.? Bernanke is the expert on the Great Depression, so whatever he suggests in this context must be right? Right?!

Sadly, no.? To the extent that private sector debts are not reduced, the crisis does not end.? Even the swapping of private for government debt is merely a ?delay of game? strategy, because there will be a greater crisis when the US Government cannot service its debts.? We live in a period of waning prosperity, with the US Government having decreasing ability to influence events.

At present, absent inflation for the Fed, the broken balance sheets of our world imply a slow recovery, where any earnings go to fill in balance sheet holes, and buy up broken competitors.? It?s not a fun environment, but it is an environment where good managements can pursue relative advantage if they are careful.? Guard your liquidity carefully, and persevere through this tough time.

Fifteen Notes on Our Troubled Global Economy

Posted on 20 February 2009 by David Merkel

1) It’s nice to see someone else recommend my proposal for partially solving housing woes.? Immigration made America great.? Kudos to my Great-great-grandparents.

2) Is there Any Such Thing as Systemic Risk? Surely you jest.? Systemic risk exists apart from klutzy governmental intervention, as noted in my article, Book Reviews: Manias, Panics, and Crashes, and Devil Take the Hindmost.

3) The Economist has another good post on the effect of past buybacks affecting companies today.? As for me, I criticized dividends in the past:

		David Merkel
		Buybacks Depend on the Management Team
		1/5/2006 12:11 PM EST

I neither like nor dislike buybacks, special dividends, and other bits of financial engineering that extract limited value at a cost of increasing leverage. In one sense, these measures are a type of LBO-lite at best, merely covering the tracks of the dilution from options issuance mainly, or preparing to send the company to bankruptcy at worst.

A lot depends on what spot in an industry’s pricing cycle a given company is. It’s fine to increase leverage when the bad part of the cycle has played out and pricing power is finally returning. Unfortunately, unless they are careful, companies tend to have more excess cash toward the end of the good part of the cycle, at which point increasing leverage is ill-advised, but often happens because of pressure from activist investors and sell-side analysts.

My first article on RealMoney dealt with the concept of financial slack, and why it is particularly valuable for cyclical companies not to take on as much leverage as possible. One of the dirty secrets of investing is that highly-levered companies typically do not do well in the long run; they sometimes do exceptionally well in the short run, though, so if it is your cup of tea to speculate on highly-levered companies, just remember, don’t overstay your welcome at the party.

One final note: If a management team is talented, they should retain a “war chest” for the opportunities presented by volatility. Lightly-levered companies benefit from volatility, because they can buy distressed assets on the cheap. Highly-levered companies need volatility to stay low, because adverse conditions could lead to insolvency.

Leverage policy is just another tool in the bag of corporate management; it is neither good nor bad, but in the wrong hands, it can be poisonous to the health of a company. For most investors, sticking with strong balance sheets pays off in the longer-term.

Position: None

4) Financial accounting rules can work one of two ways: best estimate (fair value), or book value with adjustments for impairment.? Either system can work but they have to be applied fairly, estimating the value/amount of future cash flows.? Management discretion should play a small role.

5) Regarding Barry’s post on Bank Nationalization: I don’t like the term “nationalization.”? It’s too broad, as others have pointed out.? I am in favor of triage, which is what insurance departments (and banking regulators are supposed to) do every year.? Separate the living from the wounded from the dead.

The dead are seized and sold off, with the guaranty fund taking a hit, as well as any investors in the operating company getting wiped out.? The wounded file plans for recovery, and the domiciliary states monitor them.? The living buy up the pieces of the dead that are attractive, and kick money into the guaranty fund.? No money from the public is used.

We have made so many errors in our “nationalization” (bailout) that it isn’t funny.? We give money to them, rather than taking them through insolvency.? Worse, we give money to the holding companies, which does nothing for the solvency of operating banks.? We don’t require plans for recovery to be filed.? Further, we let non-experts interfere in the process (the politicians).? Better that the regulators get fired for not having done their jobs, and a new set put in by the politicians, than that the politicians add to the confusion through their pushing of unrelated goals like increasing lending, and management compensation.

The concept of the “stress test” is crucial here.? It could be set really low (almost all banks pass) or really high (almost all banks fail — akin to forcible nationalization).? Clearly, something in-between is warranted, but the rumors are that the test will be set low, ensuring that few banks get reconciled, and the crisis continues for a while more.

I’m in favor of the bank regulators doing their jobs, and the FDIC guiding the rationalization of bad banks, with an RTC 2 to aid them.? Beyond that, there isn’t that much to do, and there shouldn’t be that much money thrown at the situation.? We have wasted enough money already with too little in results.

One final comment — for years, many claimed that the banks were better regulated than the insurers.? Who will claim that now?

6) Equity Private rides again at Finem Respice (“look to the end”).? A good first post on how this all will not end well.

7) Whatever one thinks about mortgage cramdowns (I can see both sides), they will have a negative effect on bank solvency, and the solvency of those who hold non-Fannie and Freddie mortgage backed-securities.

8 ) What has happened to Saab is what should happen to insolvent automakers here in the US.? The companies will survive in a smaller form, with the old owners wiped out, and new owners recapitalizing them.

9)? Will the new housing plan work?? I’m not sure, but I would imagine that it would cost a great deal to support a large asset class above its theoretical equilibrium value.? There are also the issues of favoritism, and rewarding those less prudent.? We will see whether it doesn’t work (like Bush’s proposals), or works too well (my, but we burned through that money fast).? (Other thoughts: Mean Street, Barry, simple explanation from the NYT.)? As it is, many people will not be eligible for the help.

10) How do you eat an elephant?? One bite at a time. How well did Japan do in working through its leverage problem in the 90s and 2000s?? Reasonably well, though it took a while.? Deleveraging takes time when many balance sheets are constrained, and asset values are falling back to psuedo-equilibrium levels.? One person’s liability is another person’s asset; when a large fraction of parties are significantly levered, the reconciliation of bad debts can cascade, like a child playing with dominoes.

So, Japan took its time with a messy process rather than have a “big bang,” with less certain results in their eyes.? In America, we want to get this over with quickly, but not do a “big bang” either.? That’s where a lot of the cost comes in, because in order to reconcile private debts rapidly, the government must subsidize the process.? All that said, in the end we will have a lot of debt issued by the US Government, just in time to deal with the pensions/entitlement crisis from a position of weakness. And, that’s where Japan is today, facing a shrinking population with a lot of government debt, and rising demands for entitlement spending.? Japan may be a laboratory for the US, Canada, and Europe as we look at the same problems 5-20 years out.

11) If you want to search for prices and other data on bonds, look here.

12) Marc Faber makes many of the point that I have made about the crisis in this editorial.

13) Swiss bankruptcy?? I would never have thought of that possibility, but considering that it is a smaller country with a relatively large banking system, and those banks have made a decent amount of loans to weaker creditors in Eastern Europe.? Add Switzerland to the list with Austria on Eastern European lending troubles.

14) What is Buffett thinking in his recent sale of stocks?? Some criticize him for being inconsistent with his philosophy of long holding periods, but Buffett is a very rational guy.? He is getting some good opportunities in this market, and is selling opportunities that seem less good to him.? Could he be wrong?? Yes, but over the year, he has been pretty good at estimating the relative values of assets.? He’s made his share of mistakes recently, but 95% of investors have been in that same boat.? At least he has the insurance franchise to carry things along, and given the reduction in surplus across the industry from the fall in equitiues and other risky assets, pricing power should begin improving soon.? Berky is interesting here.

15) Mirroring the bubble, Anglo-Irish Bank rode the global liquidity wave up, then down.? Ireland was the hot place in the EU, and now the bigger boom, fueled by easy credit, has given way to a bigger bust.