Personal Finance – Page 24

Save Money on Insurance

Posted on 27 October 2010 by David Merkel

Over the last year, I noticed that my personal insurance carrier had raised my rates, for the third year in a row, with no change in any variable affecting insurability.? Now, having been an insurance equity analyst, knowing what their pricing strategy was made me suspect that this might happen.? Essentially, the insurer quotes a teaser rate, and slowly grades into the real rate over time, while mentioning loyalty bonuses to long-term clients.

I finally got fed up, and decided to bid out my auto, home, and umbrella coverages.? I talked with seven companies, sent them PDF files of my coverages, answered questions about what was not in the PDFs, and now have five bids on my business.? At minimum I will cut $500/year off of my premium, and at maximum, $1500/year.

One surprise in the process is that the insurance companies underwrite very differently.? I was surprised at how many insurers asked questions that no other company did.? What that means to the average consumer, is that it would pay to bid out your personal insurance business every five years or so.? You could save a lot.

Those differences in underwriting mean there are potentially opportunities for better rates.? The differences in underwriting mean that some insurance company won?t catch one of your most prominent risk factors, and you will get a lower rate.

You might be with your best insurance carrier now, but test it ? there might be a better deal for you.? Check local and national firms.? Try some mutual companies as well as stock companies; the economics sometimes varies.? If you tend to go to the name-brand firms with a captive agency force, toss in an independent agent.

And, consider upsizing your deductibles.? Insurance works least well when it is used for fixing small problems; it is meant for true disasters.? Self-insure the small stuff, and don?t cheat by not having a stash of liquid assets to tap.

As an aside, I do the same thing with health insurance. ?I have an HSA with a $5000/year deductible.? I contribute the maximum each year, and pay health costs out of pocket, never tapping the HSA for healthcare.? I get a tax deduction on the money going in, it accrues tax-free, and it comes out tax-free. ?The tax benefits were so great that I turned down the health coverage from my last firm.

But back to the main point, to summarize: it pays to shop your personal lines insurance every five years or so.? The same is true of term life insurance if you are still healthy, every ten years or so.? And consider raising your deductibles to a level where the insurance kicks in only if there is real pain.

Book Review: The Insured Portfolio

Posted on 15 October 201015 October 2010 by David Merkel

Do you have a lotta money?? Lotsa, lotsa money?? And is it liquid?? More than $5 million?? If so, I have a book that could help you, The Insured Portfolio: Your Gateway to Stress-Free Global Investments (Agora Series).

There are risks that the rich want to avoid, or at least minimize:

Losses from lawsuits
Estate taxes
Income taxes
Lack of flight capital, if things go really bad
Inflation, or loss of purchasing power
Fear of US degeneration: Do you want leave the US, renounce your citizenship, and minimize/eliminate your tax liability in the process?? It can be done, at least at present.

The first chapter describes the rise and decline of America.? It is a bit harsh, but for one following demographic trends, it is accurate.? So, why should you keep money in America, if things are so bad?? (Uh, stable politics, relative freedom…)

The second chapter introduces international investing, because diversifying internationally offers greater possibilities for profit and capital preservation, given the greater tendency of the US to inflate the currency.? To the authors, it is a panacea, and I find it somewhat unrealistic.

The third chapter goes into wills and trusts. How do you want to distribute your money after you die?? How much control do you want until then?

The fourth chapter describes insurance policies that minimize taxation, while allowing for limited asset diversification. The strategies are pretty basic, I have seen better.

The fifth chapter goes into tax havens.? Where can you minimize taxes and other costs best? I found this to be pretty boilerplate; if you pay attention, the tax havens are well-known, with their relative liabilities.

The final chapter tries to tie it all together, but it is all generalities, with little additional substance.

This book would be useful to someone who has prospered dramatically and has never considered wealth preservation.? It gives a taste of all of the tools, but does not give enough to execute the tools on their own.? You will have to hire bright? experts to protect your wealth, but at least you will know what they are? doing, and will be able to spot phonies.

Quibbles

I dislike Agora because of the doom-and-gloom outlook that they possess, but this book does not share in that flaw to any large degree.? All of that said, all strategies that use insurance products are very expensive, and there is no proof that you can obtain above average returns on the assets.? The authors talk a good same, but they offer little proof of superior performance.

Who would benefit from this book:

Only the very wealthy could benefit from this book, and many of them have wealth advisers already, who can help them with tax avoidance and estate protection.? But this gives a good introduction to the topic so that a person could be wiser in hiring an adviser.? He would know what the issues are.

If you want to, you can buy it here: The Insured Portfolio: Your Gateway to Stress-Free Global Investments (Agora Series).

Full disclosure: I asked the publisher for a copy, and they sent one to me.

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.

Book Review: MarketPsych

Posted on 13 October 201014 October 2010 by David Merkel

I am no great fan of psychology.? When I was selected for jury duty, 20 years ago, I was the first peremptory challenge because I said that I would not take the word of the psychologist as expert testimony, but rather would consider the opinion of a man on the street as more valuable than that of a psychologist.

There is one place where make an exception, and that is the economics of risk literature.? Daniel Kahneman and Amos Tversky, great.? Richard Thaler, uh-huh.? Behavioral economics?? Yes, I am there.

The easiest way to improve the returns of average investors is to train them to think differently.? Instead of looking at whether the prices have gone up or down, and getting excited or scared, they need to begin to think in terms of what is the future cash flow yield of the investment that I am pursuing?? Past success is not a reason to buy and past failure is not a reason to sell.? Focus on maximizing future cash flow yields, and you will do well.

But that’s hard to do; training the mind to think rationally about investments and take the blood out of it is difficult for average men to do.? As for me it took 5-10 years for me to train myself not to get emotional over investing.? That’s why I don’t look down on people who make mistakes investing over their emotions ? they just need better training and they don’t know where to get it.

The book MarketPsych could help them get it.? The first thing that it encourages people to do is to understand themselves.? You must understand yourself so that you can invest in a way that is consistent with your emotional makeup.? You can’t be investor, if you can’t manage fear.? You can’t be an investor, if you can’t manager greed.

Why do you do the things that you do?? The book MarketPsych has number of exercises that help an investor unravel why he thinks a certain way.

The book does not take a position on questions like value versus growth, or behavioral economics, or any of the anomalies in the market such as momentum.? Rather, it tries to get the investor in touch with himself, so that he can react rational and to invest situations rather than out of fear or greed.? It encourages investors to focus on things that are known, rather than speculation.? It urges them to consider what they need the money for, rather than always seeking for more, more, more.

MarketPsych is good at describing the mental traps and pitfalls that investors suffer.? Though I am past all of those traps and pitfalls, nonetheless, I remember what it was like to get past the, and this book would’ve helped me get past them faster.

Quibbles

I take issue with some of the meditation exercises in the back of book because I believe they are harmful not helpful.? I also don’t go in for visualization exercises; I don’t believe in pretending.? Rather, one should develop competence and understand the markets exceptionally well.

Who would benefit from this book:

Almost any investor who is frustrated with his performance, particularly from bad timing , would benefit from this book.? If you want to, you can buy it here: MarketPsych: How to Manage Fear and Build Your Investor Identity (Wiley Finance).

Full disclosure: I asked the publisher for a copy, and they sent one to me.

Book Review: Risk and the Smart Investor

Posted on 25 September 2010 by David Merkel

Not every book grabs me at first.? “Risk and the Smart Investor” was one such book.? But it grew on me.? Having been through many exercises in risk control inside insurance companies, I can sympathize with the much more complex job that it is to control risk inside investment banks.

I was fascinated with the structure of the book, which I found tedious and hokey at first, but I grew to like the intriguing and novel approach.? The author introduced the topic through his experience, then explained the theory, then showed how neglect of it led to failure, and then gave stories of Max and Rob, two very different men whose lives illustrated risk management, and the lack thereof.

Risk control has to be realistic.? You can’t eliminate all risks.? You shouldn’t even want to eliminate all risks.? Anyone who tries to eliminate all risk will end up killing the profitability the business.? As that great moral philosopher James Tiberius Kirk once said, “Risk is our business.”? (For the jobs were I was explicitly a risk manager, I kept that quote on my wall.)

I am going to touch on the themes of the book as I understand them.? In order to control risk, one must first be able to control himself.? Without self-control, there is no risk control.? That process requires humility.? Almost every action of risk control involves limiting the behavior of those that have the power to commit money for investment or to sell assets to raise cash.

Part of that comes down to understanding what are reasonable goals, and what aren’t.? Nothing grows without limit.? Almost every business has a maximum growth rate, which if exceeded materially raises the probability of insolvency.? This is true for individuals as well.? Peter Drucker once said something like, “Jobs should be big enough to be challenging, but not so big that they require superhuman effort.”? In the same way, efforts to grow your personal assets too quickly will lead to decisions with a high probability of large losses.

For risk control the context of large firm, the critical question is cultural issues.? That involves instilling the idea of risk control in every person if the firm ? making it a part of the firm DNA.? It must extend to the very pinnacle of management, and not let it be seen as something that is a tradable issue.? It is similar to the idea of a reputation.? You only get one reputation.? Your reputation is your brand.? If your reputation is harmed or destroyed, rebuilding it is desperately tough.? Granted, America is the land of unlimited second chances, but rebuilding is still tough.

We can diversify lines of business.? We can diversify assets.? We can diversify funding sources.? We can’t diversify our reputation.? We only have one reputation.? It is as one of my favorite bosses of the past said, “I’m willing to take lots of moderate risks, but not willing to take an action that has a material probability of destroying the firm.”? This is just another way to say that there are things that can be diversified and things that can’t.

Corporate culture cannot be diversified; it flows from the top and affects all employees.? Good risk control cultures inculcate checks and balances.? They make sure that no one has too much power, such that the work cannot be checked.? They insist on transparency within the firm and transparency outside to the degree that it facilitates business and satisfies regulators.

Such a corporate culture monitors continuously the factors that affect profitability future risks.? It also learns from mistakes, but keeps the risks small early in the process so that learning from mistakes is not an expensive and surprising endeavor.

The structure of the book contrasts financial risks and life risks through the lives of Rob and Max.? They are two very different people, one of whom is careful about risk, and one of whom ignores risk.? Just as we have seen firms that were careful about risk, during the present crisis, and firms that ignored risks, so we have seen the same in ourselves and our friends.? The stories of Rob and Max on the risks that we go through life and the risk that we go through markets.? In my opinion it richens the book a great deal.

Risk is inherent to life.? And, the ultimate risk is death.? You can’t diversify death.? You can’t pay a certain spread over LIBOR in order to engage to death swap on your own life.? The most you can do is build something that may last for some small to moderate amount of time after your death.? Even the great Warren Buffett is trying to do something like this, as I explained in my piece Moat, Float, Growth.

Quibbles

None.? It’s a really good book; very well-thought out.

Who would benefit from this book:

This book would benefit anybody who deals with the question of risk, whether personally or corporately, and that means all of us.? Not only do you get a lucid perspective on the causes of the financial crisis, but you get to see firsthand how corporations deliberately the word sound risk management principles in order to make money in the short term.

The reader also gains perspective on how to deal with risk in his or her own life.? Will you go the way of Rob, or will you go the way of Max?? Or, as most of us, will you do little of both?

I read lots of books on asset allocation, but relatively few books on risk control, because few accessible books get written on that topic.? This in my opinion was a very good book on risk control.? It has my highest recommendation.

If you want to, you can buy it here: Risk and the Smart Investor.

Full disclosure: I was asked if I would review a copy of the book.? It sounded interesting, so I said I would consider it; I was e-mailed an advance copy of the book.

Of Investment Earnings Assumptions and Century Bonds

Posted on 23 September 2010 by David Merkel

Recently I got an e-mail from my friend Kid Dynamite.? He asked me an interesting question about pensions and long-duration bonds:

?back to the concept of century bonds.? I’m not sure if you read my recent pension post (http://fridayinvegas.blogspot.com/2010/09/problem-with-pensions.html) , but I’m having trouble with the concept of pensions investing in 100 year bonds at 6% while using an 8% portfolio return assumption. Does not compute…(and you can even pretend that pensions have 100 year obligations)

I just don’t get the concept of locking in long duration returns below your long term bogey. That just means that you have to do even better on the balance of your portfolio…which is nice to pretend about, but in reality, if you can do better on the balance, why bother with the 6% fixed income???

It’s a great question and one that deserves more thought.? To do that, we have to separate the accounting from the economics.

When I was a young actuary, I was preparing to take the old Society of Actuaries test eight, which was the Investments exam.? An older British actuary made a comment in one of the study notes that I had to think about several times before I understood it: “Risk premiums must be taken as earned, and never capitalized.”

Sadly, the pension profession never got the memo on that idea.? The setting of investment assumptions accepts as a rule that risk margins will be earned without fail.? Therefore, when looking at a portfolio of common stocks in a pension trust, the actuary will assume that the equity premium will be earned over the long haul and build that into his discount rate assumptions and earned rate assumptions.? The same is true of bonds in the pension trust.? They may haircut the yield for potential default losses, but they will assume that much of the spread over Treasuries will be earned without fail and thus they capitalize the excess returns.

Let’s pretend that the 6% century bond that Kid Dynamite told me about is risk free.? Also, let’s pretend that the pension actually needs bonds as long as a century bond.? Defined benefit pension plans, if trying to match cash flows, need bonds longer than 30 years, but probably don’t need bonds longer than 75 years.? That said, given the lack of bonds that are longer than 30 years, a century bond will still prove useful in trying to immunize the tail cash flows of the defined benefit pension plan.

What that 6% century bond tells us is that the investment return assumption on an economic basis is too high.? And, given that the yields on safe debt shorter than a century is much less than 6%, it probably means that the investment earnings assumption rate is way too high at 8%, and should definitely be lower than 6%.

I know that’s not what GAAP accounting requires.? GAAP accounting allows you to choose whatever investment earnings rate you can justify using statistics.? That’s not the way GAAP accounting should work though.? GAAP accounting should work with discount rates derived from low risk fixed income securities, and use those to develop the investment earnings assumption.

If you earn more than the risk free investment earnings assumption, good.? Those excess earnings will reduce the pension plan deficit or increase its surplus.

Okay, then suppose we reset the investment earnings assumption at 4%, because that’s closer to where it should be economically.? My, what large pension deficits we see.? But now, all of a sudden, that 6% century bond looks pretty good, because it brings the cash flows of the plan into better balance, and earns a decent return in excess of the earnings assumption.

So, the problem isn’t with the century bond, it’s with the earnings assumption.? Now why does that earnings assumption exist?

The US government wanted to encourage the creation of defined benefit pension plans, and so informally encouraged loose standards with respect to the earnings assumption.
For years, it worked well, while we had bull markets going on, and interest rates were high, which decreased the value of the pension liabilities.
The IRS took actions to prevent defined benefit plans from building up large surpluses, because it decreased their tax take.? Had companies been allowed to build up large surpluses, we wouldn’t be in the mess that we?re in today.
There is the lazy acceptance of long-term historical figures in setting earnings assumptions, instead of building them from the ground up using a low risk yield curve, and conservative assumptions on how much risky assets can earn over the low risk yield curve.

So in an environment like this, where interest rates are low, and surpluses could not be built up in the past, pension funds are hurting.? The truth is, they are worse off than their stated deficits imply.? For economic and political reasons, the likely outcome resembles the riddle of how one eats an elephant: one bite at a time.

So we will see investment earnings assumptions and discount rates fall slowly, far too slowly to be the economic truth, but slowly recognizing funding gaps as corporations eat the loss one bite at a time, as they can afford to.

The investing implication is this: for any stock you own that sponsors the defined benefit pension plan, take a look at the earnings assumption and raise the value of the liabilities.? Also recognize that earnings will be lower than expected if the deficit is large and they need to make cash contributions in order to fund the pension plan.? That said, they could terminate the plan, and I suspect many current defined benefit plan sponsors will do so.

And given that, there is one more implication: if you are employed by, or are a beneficiary of a defined benefit pension plan, take a look at the form 5500, or at the company’s financial statements and look at the size of the deficit.? Take a look at what the PBGC will guarantee for you, and adjust your plans so that you are not relying on the continued well-being of the defined benefit pension plan.

I wish I could be the bearer of better news than this, but it is better to be aware of problems, then to learn that what you don’t know can hurt you.

Dave, What Should I Do? (2)

Posted on 9 September 20109 September 2010 by David Merkel

For what it is worth, I don’t encourage calling me “Dave.”? My wife, my pastor, and some close friends call me that.? I learned to love my given name when I became an adult — David is a wonderful name, and I am glad my parents gave me that name.? It is an informal age, with the benefits and problems thereof.

On with the scenarios:

4) I have had short jobs: helping a young man to decide whether to buy a house or not.? My counsel: not.? So far so good.? Helping an older lady figure a complex tax basis of stock her father left her inside a DRIP.? A pain but a finite process.

5) A friend my age (50s) who runs a successful business asked me for advice ten years ago.? My advice was don’t run with negative working capital; leave some margin for error.? It took him nine years to figure out that I was right, and the business suffered 3-4 near death experiences en route.? Now he is more profitable than ever, and was grateful for my advice.? As a shareholder, I am glad that he listened.

6) A younger friend (30s) who runs a successful small business who asks what he should do with his excess money.? I told him to put it in Vanguard’s Balanced Fund, or the STAR fund, if he really did not need it for his business.? But he is the sort that always wants to do the best, and feels mediocre results are laziness.? I have told him, focus on your business; it is what you are best at.? What you earn on spare cash balances, particularly in this low-return era, will not avail as much as you could by selling more, and providing good service.

7) A friend (50s) a few years older than me has been put to the test.? His employer has offered him a severance package if he leaves of a little more than one year’s income.? His pension, if taken today, will barely cover expenses, but is roughly equal to his salary.? He has no savings, and has helped put 3 of his 5 kids through college, with 2 to go.? I advise that he continues to work, and that he turn down the package, because it is unlikely that he could get work nearly as remunerative.? Risk: his company folds, and he loses the package.

8 ) A friend (50s) who has planned asks whether his plan is wise.? I told him that the asset allocator using DFA is pretty smart, and and the cost is reasonable.? Beating the S&P 500 over 9 years by 4%/year is hot stuff.? My only critique is that it is a 100% equities program, which is fine if you can live with that level of volatility.

9) My pastor came to me in 2007, asking whether he should still be in the money market fund for his defined contribution plan.? I had been waiting for this moment, because he was too cowardly in investing, but it was the wrong moment.? I told him to take the moderate allocation, because moderate and aggressive allocations do the same over time, but the moderate will let you sleep.? He came through 2008 like a trooper, with the losses, and bounced back in 2009.? The mix will do him well over the long run.

His case made me look over the denominational plan.? I concluded that the asset allocations were set one notch too high at each level… technically, the percentages allocated between risky and safe assets might be correct when thinking about lifespan, certainty of future earnings, but does not take into account the fear factor so well, i.e., people changing their strategy in the midst of panic, at the wrong moment.

So I let the pastors know that, and told them to shade their asset allocations to the conservative side last June.? It does not help that we are in a period of debt deflation, which will retard asset appreciation for some time.? It is harder for asset prices to rise, when the buying power from debt is diminishing.

And yet there are more who want my advice but haven’t sent me the documents yet… It reinforces to me that most don’t know what to do with excess money.

Perhaps that is a lesson — most people are technical specialists, and do their jobs well, but many are ill-adapted to managing their excess funds wisely.? Another reason to end Participant-directed defined contribution pension plans, and create trustee-directed plans, or even defined benefit plans.

Yes, this is a paternalistic view, and is at odds with my normal libertarian ways of thinking.? As policy goes, let people be free to have whatever savings/investment plan they like.? But if you care for those that you have some charge over, create a plan that takes the investing out of their hands.? Then make sure that it is prudently invested.

And in the end, remember, though it is almost always better to have more than less, invest in such a way that you, and those that rely on you will make it to your goal comfortably.? Just as valuable is the ability to sleep at night, and know that your plan has enough slack to enable you to take some hits, and come through fine.

Dave, What Should I Do?

Posted on 8 September 201011 September 2010 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

Posted on 23 August 201023 August 2010 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.

Book Review: Fortune’s Formula

Posted on 17 July 2010 by David Merkel

When I reviewed the book Priceless, I thought I had reviewed “Fortune’s Formula,” because I had written several pieces on the Kelly Criterion at the blog and at RealMoney (free at TSCM).? But I found that I had not, so I offer you this review of a book I greatly enjoyed:

The book asks a simple question: in making a bet, investment, or business decision, what is the optimal amount of capital to allocate?

But the author, William Poundstone, is not going to give you the answer immediately.? He is going to take you on a journey where you can meet many odd personalities from the ’50s to the early ’00s, and how they came to look at the problem.

Ed Thorp was fascinated with Blackjack, and originated card-counting to improve the probability of winning, to what the card counter had and edge versus the casino.?? He meets John Kelly, Jr. while working together at Bell Labs on Information Theory.? He discovered that an economic actor with an edge could size his bets as a ratio of his edge in? betting divided by the odds received on the bet.

Thorp eventually published a paper, “Fortune’s Formula: A Winning Strategy for Blackjack,” which led to a torrent of interest from gamblers.? With the aid of several backers, Thorp tried out the methods with some success in Reno, with two wealthy gamblers as backers.? That tale was hairy, to say the least, but they more than doubled their money.

Thorp later applied himself to the sleepy market for stock warrants in the 1960s. He developed delta-hedging along with a colleague.? As the book progresses, gambling ceases to be the focus, and advanced strategies for making money on Wall Street with little risk becomes the rule.? And, as in Vegas, as they took steps to lessen the edge in blackjack, on Wall Street competition itself eroded the edge.? But Thorp set up a hedge fund to take advantage of securities mispricing.

One odd sidelight is the number of parties that came up with the option pricing formula known as Black-Scholes, long before B-S wrote their paper.? Life reinsurance actuaries had a version of it in the ’60s, Bachelier had a version of it around 1900. And there were others, but the point was that no one took advantage of the knowledge, except in rough ways, prior to the B-S paper.

Yet option theory could be applied to a wide number of situations, convertible bonds and preferred stocks, even corporate bonds themselves, in addition to warrants and options.? Those that did it early made a lot of money.

A more generalized version of the Kelly Criterion says to focus on the choice that offers the highest geometric mean return.? This led to a conflict with academic economists who insisted the optimal strategy was derived from utility maximization.? What is not disputable is that the Geometric mean will maximize terminal wealth, a result found by Bernoulli and Latane.

The book takes us through financial crisis after crisis, showing how bet sizes were too large relative to the results.? It also takes us to the end where a number of the protagonists end up decidedly wealthy from their attempts to beat the market.

Quibbles

Though Poundstone’s aim is the Kelly Criterion, more of the book is dedicated to finding edges, whether beating the dealer in blackjack, or arbitrage of securities.

If you want to buy the book, you can buy it here:? Fortune’s Formula: The Untold Story of the Scientific Betting System That Beat the Casinos and Wall Street

Who would benefit from this book

Many people would enjoy this book, written in 2005.? Poundstone tells a good story and illustrates how a number of clever men found edges, pursued them, and triumphed.? The reader may not be able to beat the world after reading this, but it may teach him about how bright men found ways to pursue their advantages.

Full disclosure: I bought my copy with my own money.

Why Are We The Lucky Ones?

Posted on 2 July 20102 July 2010 by David Merkel

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

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

Project 1

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

Dear Boss,

Notes on the deal

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

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

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

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

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

Project 2

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

Dear Boss,

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

$6250 Stock Trading Volume per day

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

1-100 reverse split

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

The Company currently has three full-time employees.

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

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

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

NOTE 7 – Note Payable – CCC CAPITAL LLC

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

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

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

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

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

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

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

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

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

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

NOTE 11 – Going Concern

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

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

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

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

Project 3

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

Dear Boss,

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

Summary Notes

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

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

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

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

After the response, I wrote:

Dear Boss,

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

I have three tentative conclusions (with questions):

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

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

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

And I have additional data needs:

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

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

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

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

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

I think this deal will prove hard to complete.

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

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

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

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

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

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