Portfolio Management – Page 53

The Education of a Mortgage Bond Manager, Part VII

Posted on 10 February 2013 by David Merkel

1) One place where being an actuary and being a financial analyst melded well was with Affordable Housing and Historic Tax Credits.? In all of these investments, it made a great difference as to what the Statutory, Tax, and GAAP accounting bases.? When I described my methods of working through the free cash flows, AHIC [The Affordable Housing Investors Council] wanted me to speak to the whole regarding my methods.

I never gave the talk because we were full on tax credits, and I was too busy managing the portfolio of Fidelity & Guaranty Life.?? The moral is: watch free cash flow.

2) Probably the ugliest incident in managing money for Fidelity & Guaranty was when the management of F&G decided to try to buy the structured settlement liabilities of Confederation Life.? Big block, five potential buyers.?? St. Paul had a rule: we don’t outsource asset management.? Sadly, the chief actuary, against our admonitions allowed for reinsurance treaties that outsourced asset management.

During the conference call to legitimate the offer that we would make, several things happened:

a) F&G management accused St. Paul management of being bureaucrats, not businessmen.

b) St. Paul management told F&G management that they were ignoring the rules.

c) I informed both sides that we were all gentlemen here, and that the tone of discussion was not worthy of real businessmen.

d) The CEO of F&G eventually broke off the call, calling the St. Paul folks bureaucrats, rather than businessmen, and saying that they killed a good deal.

Personally, I think he said this to save face with his employees.? Also, the deal was marginal at best.? We would have had to take a lot of risk to make the deal work.? But F&G would not listen to us.

3) I liked buying seasoned bonds, because they were more predictable.? Problem: you could not buy them in size.? Buying bonds in the aftermarket is typically picking at scraps.? Face it — most bond buyer want to hold their bonds for a while.? Aside from the few that sell for a quick profit, most bond investors hold on for a long time.? But I would pick up scraps.? Enough scraps, and you have some decent positions.

If you do find a seasoned bond selling at a reasonable price, buy it in, subject to the advice of your credit analyst.

4) Regarding mortgage bonds, remember that default and prepayment are dual.? Debtors divide up into three groups: a) Very solvent, they will easily pay off their debts, and if there is an opportunity to refinance their debt, they will take it.? b) Solvent. They don’t have a lot of margin, but they can pay their debts if nothing serious goes wrong. c) We did not deserve the loan.? We will fail with high probability in the next year.

Ideally, if you want the best yield out of a bunch of consumer lending assets, you want a lot of the middle group.? Not the highest credit quality, but likely to pay off, and not so likely to prepay.? There is a hierarchy:

Best: pay,
Next best: prepay,
worst: don’t pay.

5) So as I learned about CMBS, I wondered about the interest only strip that many of the deals held — from my own testing, it had the credit properties of a BBB tranche at best, and a Single-B tranche at worst.? Sadly, because they had no principal to pay they were nominally rated AAA, and so the firm I worked for (not my area) crammed them into Stable value plans.? Because I had done the credit stress testing, I knew this, and resisted their use in my own portfolios.

But this is another example where accounting rules have led us afoul.? Nominal principal should be implied to “interest only” obligations.? “Principal only” obligations should have implied interest.

That’s all for now.? I will finish up in the last segment, probably on Monday.

Letters from Two Readers

Posted on 9 February 2013 by David Merkel

I wanted to drop you a line to commend you on your blog which I read with interest and almost universal agreement.

Your investment ideology and style is very similar to my own, and I enjoy the snippets of personal insight and glimpses of your life that you share.

I have worked in investment management for a number of life and general insurers in the UK and with a number of actuaries, some of these have been extremely able and had an outlook very similar to that which you hold. The more risk averse, countercyclical heads have tended to perform very strongly when given the time for their ideas to mature.

It is far easier to identify a good idea than to know when the market will come into line with your thinking!

Performance can be poor whilst you wait for the market to adjust, so you need have established your investment credentials beforehand. I have also seen a company destroyed by the unwillingness of a board to wait for investment performance switching managers and strategy at the peak of the TMT bubble, which ended up putting one of the strongest life funds into run-off.

Thanks for the words of encouragement.? It?s always challenging to strike the balance between earning returns and avoiding undue risk, much less having any sense of timing the risk cycle.? With bonds, it is a little easier, because you can tell when debt covenants, etc., and other terms of lending weaken.? We can see when incremental yield is most likely not going to be compensate for the risks involved.

The same applies to insurance ? stylistically, first pricing declines to technical levels, then terms and conditions deteriorate, then pricing declines further, until there is a disaster, capital reduces and pricing strengthens.

Thanks for writing.

I really appreciate the way you do twitter and blog. ?You always include your thoughts to some degree in your tweets, which I appreciate; and your blogging is great! ?I often read to hear about what your thinking and you do a good job of translating a lot of technical or specific information into applicable or at least thoughtful steps I can take.

I’m probably most amazed by your ability to find “truth” through mathematics due to your skills as an actuary. ?As a younger man in this business I’ve been from awed to disillusioned from the market and I still struggle to have a grasp. ?We use mutual funds predominantly so I don’t have to worry about knowing so much about the market and the individual goings-on but I still do a lot of asset allocation. ?Frankly, I think there is more risk in a poor asset allocation than a poor asset selection within that allocation.

Right now I’m thinking that high yield spreads are too tight and credit too frothy, but I read Third Avenue on high yield and they argue that we have a few years before that’s a problem. ?I guess what I’m asking for is advice on how to find the truth of where we are in the market cycle and how to take smart risks with my clients’ money. ?Should I be reducing or eliminating HY debt because of the “seemingly clear” overheated risk? ?If so, where do I find a decent return in fixed income or do I bite the bullet and stay short with little/no yield.

Especially for the more conservative investors who really need every penny to work out – it’s a hard balance to find right now. ?I don’t think I’m alone. ?Nevertheless, sorry for the long email. I hope to see something on your blog or a response if you find a minute of what must be a very busy life.

Yes, high yield is frothy, but it could get frothier.? Cramer had a saying, ?Absurd is like infinity.? Twice absurd is still absurd; twice infinity is still infinity.?? I read through the Third Avenue report? I generally like the way they do things though Marty Whitman got whacked in the financial crisis for owning too many low quality financials.

I learned early on from a junk bond manager who currently has five stars from Morningstar, that spreads are less critical to junk bond than dollar prices.? His view is that there is some irreducible risk in high yield, such that you need yield, not just spread, to guide your decisions.? Particularly when junk bond prices get so high that they are likely? to be called.? With such a steep yield curve for Treasuries, it is possible for option-adjusted spreads to rise as the bond price rises.

I can?t tell you what to do.? I can tell you what I am doing.? For my bond clients, I have assets? allocated half to emerging markets, both local currency and dollar denominated.? The governments of most emerging markets are run in a more orthodox manner than most of the developed markets, so I am comfortable with the risks.?? The rest is invested in short and longer investment grade corporate, and a small wager on the Swiss Franc appreciating.

I am happier getting yield from emerging markets than getting it from weak corporate credits. ?There are risks in the world today, and we could see high yield strategies fail.? After all, no one thinks about a moderate-sized war changing risk preferences.

That?s what I am doing.

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To all my readers, risk is sometimes not obvious.? In this time of abnormal monetary policy and large budget deficits, it pays to be careful.

The Education of a Mortgage Bond Manager, Part V

Posted on 8 February 2013 by David Merkel

Sometimes you have to do odd stuff for your client.? My boss and I were asked to come to a client meeting where there would be games (and a dopey speaker, I will leave that out).? As it was I found myself in a game where the one who moves his feet amid pushing loses.? I came in 4th (amid 60), I eventually lost to the tax guy… a very clever guy who should never be underestimated.? I ended up beating him in a game where we were all blindfolded, and those that were touched were out (we were the last two).

But the best part of the contest? was the square game.? We were blindfolded, and rope was around us, and they told us we had five minutes to form a square.? When the official said, “Go!” a marketing guy shouted out, “I know there has to be an actuary in our group.? What do we do?”

I shouted out, “I’m an actuary!”? “To the right of me, counterclockwise, count off, I am number one!” And so I heard, “two, three, four… fifteen.”

Fifteen? Uh-oh, that does not divide by four, so I shouted, “Okay, listen to me!? Five, Nine, and Thirteen, put your arms at right angles, and pull out.? You are the corners of the square.? Everyone else, put no pressure on the ropes.? Fourteen and Fifteen, make sure that you are not touching.”

After that, I shouted, “Has everyone complied with what I said!”? After agreement, I shouted to the judges, “Okay, we’re done!”

When we took off our blindfolds, behold, a square!? Way ahead of the other teams, who looked like blobs.

All actuaries are bright, but many lack courage.? I have courage, and a desire to learn more in areas where I am not an expert.

I needed all of my skills and my courage working for that difficult client. Here’s an example: I did not invest in a hedge fund structured note, with a guarantee from the AA insurer who was pushing it.? I said to them, “most hedge funds are short liquidity.? Why should I invest there?”? He disputed that hedge funds were short liquidity, but he dropped the case and we did not buy.

Here’s another example: A guy called me, asking me to let him pay at par a premium mortgage that we needed to fulfill our liabilities.? I said to him, “I can’t do that, we need the payment over time so that our shareholders are not badly affected.”? Then I said, “Why not get a second mortgage if you need to take money out?”? He said, “A second mortgage? Those guys wear ‘panky rangs.'”

I had the same experience on the most prominent building in Baltimore — the TransAmerica Building, which was the Legg Mason building when I was dealing with it.? Toward he end of my tenure at Dwight, they called me, asking to buy out the second mortgage, which was now the first mortgage.? They offered a slight premium to par, and I said no.? I told them that we needed 125% of par to make us whole, and we would be done.? They offered 110%, and I told them to go away; I would not counteroffer.

I had a strong position, and so I did not have to move.? Sadly, when I left, the company made a bad deal with the borrower, and lost a lot of money.

What can I say? I did my best, and they lost due to their stupidity.? They got more interest due to my intransigence at minimum.

Is High Yield Expensive?

Posted on 8 February 2013 by David Merkel

Event	Date	AAA	AA	A	BBB	BB	B	CCC
CDO Trough	6/5/2007	5.62	5.68	5.90	6.21	6.74	7.34	9.12
Recent Trough	1/25/2013	2.09	2.09	2.47	3.34	4.51	5.64	9.57
Now	2/6/2013	2.10	2.12	2.50	3.42	4.73	6.10	9.80

Yes, I think high yield is expensive, and stocks as well.? We have replaced a set of maniacs who were creating CDOs, with a single maniac, the Federal Reserve.? The Federal Reserve has less effect on junk bonds because they directly affect Treasuries and Agency MBS.? Those are far more similar to AAAs than junk bonds.

When CDOs were bidding for every yieldy bond, they compressed relative yield spreads to unbelievable levels.? Today, those unbelievable yields come from the Fed.? They bid for MBS and Treasuries, leaving others to seek yield in riskier notes.

There is real risk here, and the Fed will get whacked when normal yield relationships, and real yields re-emerge.

On Operating Company Defaults

Posted on 8 February 2013 by David Merkel

From an e-mail from a reader:

Hi, David. I hope this e-mail finds you well. I am a long-time reader of your blog and have learned an immense amount about markets from your writings.

I am a stock analyst and am just starting to learn the nuances in the operating vs. holding co. relationship.

I saw your brief explanation here:

http://alephblog.com/2009/03/25/holding-and-operating-companies/

Could you point me to any websites, books, or articles that really delves into this? Specifically, there are lots of bonds issued on both the opco and holdco levels ( EIX, CZR, and many others).

I know distressed guys do this all day and I’ve already read Stephen Moyer’s Distressed Debt Analysis. ?I understand structural vs. contractual subordination, cross guarantees, and other basics, but, I’d like to know how it would impact the publicly traded shares at the holdco level.

?For example, if holdco A has publicly traded shares and has opcos B and C. B is a profitable company while C is loss-making company. B and C both have publicly traded debt.

What would happen if C defaults? ?Nothing is clear cut but I’m trying to find a good way think about these things.

I have been here already.? If company C defaults, company A has no obligation to make you whole.? In my case with Teleglobe, the bondholders got zero.? The parent, BCE, is still doing well.

This is a major aspect of being a bondholder.? You must analyze the relationships, so that you do not rely on those that do not legally need to pay you.? Implicit support is always suspect.? In a crisis, it goes away.

The Education of a Mortgage Bond Manager, Part IV

Posted on 7 February 2013 by David Merkel

I sat down this evening with my trading notebooks.? It was a reminiscence of 11-14 years in the past.? I may produce another chapter of “education of a corporate bond manager” from the books.? But it gave me a flavor of what I learned (rapidly) as a mortgage bond manager 1998-2001.? So let me share a few more bits of what I learned.

1) Avoid esoteric asset classes.? I am truly amazed at how many people believed that securitization created a lot of value, when it was more incremental.? There were many who proclaimed “Buy every new ABS structure,” because it had worked well in the past.

Sadly, that is a bull market argument, and many would lose a lot of money following that advice.? In 2008, it all came crashing down for unique structures.

2) Avoid volatile asset classes.? Collateralized Debt Obligations are volatile, and not worthy of being investment grade.? That said, when I was younger, I erred with CDOs and we lost money.? Never invest with those whose incentives are different from yours.

3) There was also a period where CDO managers would buy each others BBB tranches — it was a way of lowering capital costs, at least on a GAAP basis.? We did that with NY Life, but never got the benefit, because we never did our CDO.

4) The are many asset sub-classes that have ?only been through a bull market cycle.?? That is the nature of new ideas that are introduced to applause.? But those are bull market babies.? Avoid sub-asset classes that have never seen failure.

5) There was the desire that we could originate our own commercial mortgages, with me doing the work of a full mortgage department.? I conveyed to my boss that this was impossible even if I dedicated 100% of my time to the process, and then he would not have me for the reasons he hired me.? This came up many times, and took a long time to die.

6) But at a later date, something better came up, doing credit tenant leases.? They are illiquid, but they have good protection.? The credit tenant guarantees the mortgage.? If there is non-payment, the property is yours.? I can get into securitized lending.? This was a great deal, but my colleagues in the firm overruled me, and foolishly.? Why give up protection, when you can’t get a safe yield at an equivalent spread.

7) I also learned that in the merger in 2001 that little things mattered.? So when they came to meet us in Baltimore in mid-2001, we took them to an Italian Deli that we liked.? They loved it, saying that there was nothing like it in Burlington.

I will continue this in the next part/episode.

The Education of a Mortgage Bond Manager, Part III

Posted on 6 February 2013 by David Merkel

In this irregular series, you can see that I wrestled with the concept of credit quality.? I built my own models.? I did not trust the rating agencies.

Why did I not trust the rating agencies in 1998-2001?? What great errors had they committed?? They had not created many errors at all… but I knew my job was to uncover value, and take risks where they were warranted.? Ratings will not help you there.

That said, many of the rating agency writeups and presale reports were quite erudite.? As our saying goes,”Ignore the rating, but read the writeup.”? After all, the rating agencies are “inside the wall,” unlike most, and often disclose bits of insider information that are no longer totally insider.? The rating agencies offer valuable information; the problem is that their ratings are less than golden.

In 2000, I remember going to a CMBS Conference where there was a young woman from Principal Financial, who ran their CMBS portfolio.? She said something to the effect of, “Because we know that defaults in CMBS are unlikely, we buy all of the mezzanine and subordinated tranches of most deals.? It’s free money.”? We had a different opinion.? We knew that liquidity had value, so we rarely bought non-AAA bonds.? You could not easily trade bonds that were not AAA.

Once I became the CIO in 2001, I decided that we would look at older deals where? wanted to sell BBB bonds.? I would subject them to my usual standards, and analyze the properties in depth.? I didn’t buy much, but what I did buy was quality.? Though markets were tough, all of them paid off.

An example was when JP Morgan did what they called a “kick-out” deal.? All of the properties that the B-piece cartel had refused to finance were in that deal.? The spreads were very wide, and I bought all of the AA & A-rated tranches.? I did a lot of due diligence, and I knew that the taint of the collateral was more than compensated for from the amount of subordination.

That was one of my lessons — be willing to buy things that are tainted in the eyes of many, so long as you have adequate protections, and a decent yield.

At the Life Insurance Conference

Though I was not a bond manager at the time that I went to a Life Insurance Conference in 2006, there were several themes in play.? Here are two of them.

1) Odd Types of Collateral: there was the sense that new and odd types of asset backed securities [ABS] should be bought with abandon because the past experience has been so great.

I did not buy that idea.? Most ABS requires a steady cash flow stream, and many industries don’t have that.

2) One guy said AAA bonds never default.? I stood up and told him? that AAA bonds that I had bought in franchise loans did default, so it was not true.? That said, losses were not large.

At the conference, I managed to speak to the CEO of Principal Financial, and tell him that he faced considerable credit difficulties in his CMBS book.? He was a big guy, tall and muscular, so he looked at me, average guy that I am, and told me he would consider it.? The look on his face disdained me, but I am used to that.? My appearance has never been my leading attribute.

Manufactured Housing ABS

In 2001, I came up with the idea that the Manufactured Housing ABS market was bifurcated.? Current deals were lousy in their credit metrics, so we stopped buying any current deals.? But older deals from GreenTree were seasoned and would likely deliver value.? Lehman Brothers shared with me their default database, and I built my model, and it told me that deals from 1998 would allow tranches A and above to get their money back.? It also told me that deals from 1997 and prior would allow tranches BBB and above to get their money back.

This proved to be true, but it meant that those that held the securities to maturity had to endure a time when the offered prices for the securities were far less than par, though all paid their principal and interest to maturity.? I don’t feel bad about my purchases, because I looked long-run, and knew I had a strong balance sheet behind me.

Now in late 2001, the new CIO came to me and said, “I’m taking over the CMBS, MBS, and ABS portfolios.”? I told him, “They are yours now, do what you like, do not care for my own preferences, do what you think is right.”? As it was, he panicked, and sold many things that would later be money good, and he blamed me, according to friends.

So what? I have my own share of blame here, because you never want to buy near par something that will test your willingness to hold it. Though what I bought went through the valley of the shadow of death and came out whole, there is a cost to making everyone worry; and many in the same situation would sell and take losses that they should not have.

All of the Big Boys know you should never trust a rating

When I was a mortgage bond manager, I did my own work.? I did not trust ratings, but did my own due diligence. I would analyze loss statistics where I had them, and some up with my own risk assessments.

This is why I don’t favor the prosecution of the rating agencies.? The rating doesn’t matter, and if people are willing to trust a ratings scale, rather than a description of the business of those that are rated, they deserve the bad result.

It is utterly puzzling to me why the government is going after the rating agencies, because they just did their jobs.? Yes, their models were flawed, but many ignored them in the insurance industry and elsewhere.? Ratings are not guarantees, they are opinions, and so the Supreme Court will rule eventually.

Wall Street Hates You

Posted on 3 February 2013 by David Merkel

I have a saying, “Don’t buy what someone wants to sell you. Buy what you have researched.”

And so I would tell everyone: don’t give brokers discretion over you accounts, and don’t let them convince you to buy unusual bonds, or obscure securities of any sort.? By unusual bonds, I mean structured notes, and eminent men like Joshua Brown and Larry Swedroe encourage the same thing: Don’t buy them.

To the extent that it can, Wall street tries to sell retail investors the exposures that they don’t want.? They offer a higher yield, but take it away and then some if the things that they want to hedge go wrong.? They sell you their problems, and if things go well you are unharmed, but woe betide your capital if things go wrong.

Trust is not owed to financial advisers or brokers.? You need to treat them skeptically; if possible, you need to understand? how they are compensated.? They tend to earn more from securities that are less in the interest of buyers.? (It is not much different from insurance salesmen.)

Wall Street exists to sell promises.? That can take several forms, two of which are:

1) Buy an ownership interest in this promising company.? It’s the wave of the future.

2) Buy a promise to pay from this company under these conditions, and we will pay you an above average yield.

Wall Street knows more than you.? They may make occasional mistakes, some of them big, but compared to retail investors, they know far more.? They profit off of retail investors.? You are the natural resources that they mine.

So why play with them?? If you are using a broker, it is time to end your relationship there, and work with someone who has to put your interests first.? Look for someone who is required to put your interests first.

It’s not as if investment advisors like me always succeed; we don’t.? But the best of us do avoid greed and fear, and so protect investors from their worst instincts — selling low, and buying high.

Take control of your investing, and if you can’t do it yourself, find a talented person with self control who can.

Four Sources of Buy Ideas

Posted on 3 February 2013 by David Merkel

Presently, I have four ways of sourcing buy ideas in the stock market.? Here they are:

1) I read widely, and when I see something interesting, I either jot it down, or hit the “print” button.? I put it in the pile for the quarterly portfolio reshaping.

2) Preston Athey gave me this idea.? I set up a bunch of Googlebots to let me know when a CEO leaves a firm.? For companies with a lot of underused assets, that can be an incredible catalyst to unlock value.? Print, add to pile.

3) My industry studies produce a list of out of favor companies with better prospects than most — the challenge is to separate out the “buggy whip” industries, from those that are genuinely cheap.

4) Finally, I study 13Fs, and try to understand what bright investors are holding and buying.

After I assemble all of the companies that might be worthy investments, I try to forget where I got the idea from.? That forces me to analyze the company my own way, and not merely trust someone or some method that I think is bright.

After that, I engage Portfolio Rule Eight, and make my current portfolio holdings compete against the new ideas.? This is a much better way, a more businesslike way to choose companies to buy.? It forces managers to make explicit decisions that improve the characteristics of the portfolio, improving the probability of winning.

Do you have better ways of sourcing ideas?? If so, leave them in the comments.

On Investing Games & Contests

Posted on 2 February 2013 by David Merkel

I am not a fan of investing games and contests.? Here are my reasons:

They are too fast.? Investing is a slow process; games make money far more quickly than markets do.
They are biased toward winning.? Many games have a positive bias built into them, returns are far higher than are commonly attainable.
Contests encourage undiversified portfolios.? The only contest I have seen that did not do that was the Value Line Contest in 1984, where everyone had to pick ten stocks from ten buckets going form low to high price volatility.? Great contest — I was in the top 1%, but did not win.
Good investing is boring.? It is work.? Most of it is not a game, though I will admit there is some game in buying and selling — gotta beat the algorithms at their game.
Games are not as robust as the markets.? The markets serve up all manner of surprises, while games typically mimic the past.

Here’s what I can endorse, if done fairly: paper-trading.? As with any sort of self study, if you want it to be valuable, you have to be a strict cop on yourself.? I papertraded a number of times in the 80s, and I always did well vs the market.? My porfolios typically had 40-60 companies, but they always did well.? As a TA in Corporate Financial Management, I would share my ideas with students, who liked my enthusiasm.? The professor was a EMH devotee, who when he heard that my paper portfolio was up 40% while the broad market was up 20%, said, “Oh, you pick stocks that have a beta of two.”? I tried to show him that was not the case, but “you can’t teach a Sneech.”

Paper-trading moves at the speed of the market.? It is close to real.? It shows you how difficult it is to make money.? I recommend it to all of my readers.