Category: Quantitative Methods

Twenty Answers from the Author of Risk and the Smart Investor

Twenty Answers from the Author of Risk and the Smart Investor

Posted on by David Merkel

A little bit ago, I published Twenty Questions for the Author of Risk and the Smart Investor.? Well, David X. Martin got back to me, and here are his thoughtful answers.? I will have more commentary on this as I write the book review, which I am doing immediately after posting this.

1. Q: Imagine you are talking to a bright 12-year old girl.? How would you explain to her why and how the financial crisis happened?

A: Think of what happens when you blow up a balloon. First it expands, but eventually, if you continue to add more and more air, it bursts. The air going into the balloon in the years leading up to the recent financial crisis was either ?borrowed? air, that is air that was bought on credit, or air that was highly leveraged. In other words, only a small part of the air was paid for, and the rest was borrowed. And when the balloon burst most of those that had borrowed air, or had lent air to others, were left with nothing.

2. Q: I was fascinated with the structure of your book, which I found tedious and hokey at first, but I grew to like it.? The way I see it, you introduce the topic through your experience, then explain the theory, then show neglect of it led to failure, and then you give us the stories of Max and Rob.? How did you hit upon this intriguing and novel way to write your book?

A: I first thought about the decision process, and described the continuous process of risk management in relatively simple steps?i.e., assessment (know where you are and what you do not know); rules of the game (know your risk appetite, transparency, diversification, checks and balances); decision-making (alternatives, responsibilities, reputation and time frame); and finally, reevaluation (monitor and learn from your mistakes ). My goal was not to write a “how to book” but rather to help readers build frameworks?to make good decisions, and it seemed it would be helpful, and entertaining, I hoped, to see the process in action through the fictional risk story.

3. Q: Why do you suppose so few people in risk management, and senior management at major financial firms, were unwilling to consider alternative views of the sustainability of the risks being taken as the risks got larger and larger relative to the equity of individual companies, the industry as a whole, and the economy as a whole?

A: People get lulled into seeing the world from a particular viewpoint, particularly if they have never been through the worse case scenario. I?ve been through many of them.

4. Q: As a risk manager, bosses would sometimes get frustrated with me when they wanted a simple answer to a complex question that had significant riskiness.?They did not like answers like, ?I don?t know, it could have six significant effects on our company.?? How can we convey the limits of our knowledge in a way that management can get the true uncertainty and riskiness of the environment that we work in?? How can we get management to consider scenarios that are reasonable, and could harm the company, but few others in similar situations are testing for?

A: Scenarios are a great way of thinking about the future in terms of the realm of possible outcomes. Thinking now about what you can/should be doing about those possible outcomes, is an excellent way to communicate risk potential to management. and engage their interest.

5. Q: In your experience, how good are the managements of financial companies at establishing their risk tolerances?? Better, how good are they at enforcing those limits, such that they are never exceeded?

A: Not very good. Businesses have strategies, strategies entail risks, and risks require capital. Very few companies take a holistic view of risk, capital, and strategy.

6. Q: How do you create a transparent risk culture in a firm?? How do you get resisters to go along, even if it is management that does not see the full importance of the concept?

A: Cultures do not change rapidly, they migrate. Transparency starts at the top and it will never spread through a company if management doesn?t recognize its importance, and communicate its importance to everyone in the firm.

7. Q: Are most cases where a person or a company fails to diversify intentional or unintentional?? Do we put too many eggs in one basket more out of ignorance or greed?

A: Diversification is a strategy that requires discipline. Take the case where you start with a diversified portfolio, and then one position takes off and acquires a disproportionate weight in your portfolio. Regardless whether the cause is ignorance (you did not monitor your portfolio?s balance) or greed (you rode the stock up ), the root problem is a lack of discipline.

8. Q: Why do you suppose that checks and balances for risk management are not built into the cultures of many financial companies?

A: When does a problem exist? Even if it has always been there, it comes into existence only when you recognize that it is a problem. Many times checks and balances do not exist because no one recognizes the risk/problem and therefore no one evaluates the checks, and balances, and controls needed to manage it.

9. Q: I have a friend Pat Lewis who developed a risk management system for Bear that could have prevented the failure of the firm, but it was ignored because it got in the way of profit center manager goals.? Was it the same for you at Citigroup when your ?Windows on Risk? got tossed out the window?

A: See pages 124-5 in my book. You never have to ask a portfolio manager what he or she thinks, just look at their portfolio. When I found out Citibank was no longer using Windows on Risk I sold my entire position that day. I recall it was at $51.75.

10. Q: Can culture and personal judgment work in risk management ever?? Take Berkshire Hathaway ? risk control is embedded in the characters of a few people, notably Warren Buffett and Charlie Munger.?If the culture is really, really good, and it comes from the top, can risk management work when it is seemingly informal?? (Remember, you don?t want to disappoint Warren.)

A: Risk management is all about culture and personal judgment. I remember pondering the question, “How high is up” at a Windows on Risk meeting at Citibank. The most senior management were sitting around the table. We came to our answer by asking the following question: What was the amount of loss we would be embarrassed to read about in the WSJ? That number, it turned out, was not very high, at least in the judgment of the people sitting around that table. News of that decision got around and had an impact on the company culture.

11. Q: How can you teach younger people in risk management intuition about risk that helps them have a healthy skepticism for the results of impressive complex modeling?

A: I co-wrote an article with Mike Powers from the London School of Economics titled “The End of Enterprise Risk Management.? Models are just one input; they are not a substitute for good judgment.

12. Q: Is it possible to do effective risk management in a financial firm if management is less than wholeheartedly committed to the goal?

A: I forgot where I first heard the expression, but it explains my feelings. “A fish starts to stink from its head first.?

13. Q: Aside from AIG, and other financial insurers, the insurance industry came through the crisis better than the banks because they focused on longer-term stress tests, and not on short-term measures like VAR.? Should the banking industry imitate the insurance industry, and focus on longer-term measures of risk, or continue to rely on VAR?

A: VaR is one measure. It has deficiencies. For example, the loss amounts predicted in the tails (that is, the extreme cases) are the best case scenarios, not the worse case. Institutionalizing this one measure, or relying on the measurement of “risk based capital,” has not worked.

14. Q: Seemingly the big complex banks did not analyze their liquidity risk, particularly with repo lines.? Why did they miss such an obvious area of risk management?

A: Liquidity is a very difficult concept. If you decide to sell your house in the suburbs at 2AM in the morning and put a “for sale” sign on your lawn at that hour, how quickly do you think it will sell. Liquidity, therefore, has to be thought of in terms of time. If, for instance, you see high average daily volume in a stock what is your real liquidity if the volume is the result of a nano second of high speed trading?.

15. Q: How much can risk management be shaped in financial firms by the compensation incentives that employees and managers receive?

I saw Walter Wriston six months before he died. He asked me how things were going. I said, nothing wrong with risk as long as you manage it. He smiled at me from ear to ear because those were his words, from his book Risk and other Four Letter Words. I think it is all about matching responsibility and authority, having the right culture, learning from errors, and promoting ethics. Incentives are on the list, but not at the top.

16. Q: I have often turned down shady deals in business, saying that you only get one reputation in this world.? How do you encourage an attitude like this in financial firms among staff?

A: If you go to sleep in s–t, you will most likely wake up covered with flies. I would start with an ethics committee, and make sure the most important people in the firm were on it.

17. Q: A lot of portfolio management and risk management is juggling different time frames.? Is there a good structure for balancing the demands of the short-, intermediate-, and long-terms?

A: A poor investment decision is still the same poor investment decision irrespective of the time frame. If you always try to do the right thing, time frames become less important.

I am not saying to forget about the timeframe, just that you shouldn?t let it lead you to a poor decision.

18. Q: Most developed country economic players assume that wars will have no impact on their portfolios.? Same for famine, plague, or environmental degradation.? What can you do to get investors to think about the broader risks that could materially harm their well-being?

A: Great question, but this one is outside my realm of expertise.

19. Q: Are Rob?s more common in the world than Max?s? That?s my experience; what do you think?

A: I purposely made Rob and Max pretty different in order to illustrate the principles in the book. I think we are all human and have a little bit of each.

20. Q: At the end of your book, one of your friends dies.? Did you mean to teach us that even if we manage our risks right, we still can?t overcome problems beyond our scope, or were you trying to say something else, like creating a system or family that can perform well after you die?

A: My first draft of the book began with what is now the concluding chapter?the one in which I discuss the courage necessary to face death. The developmental editor at McGraw-Hill, of course, didn?t like it up front, so I moved it to the end, where I wrote: ?It is at that moment, when death is imminent, and there is no possibility of escape, that courage comes into the picture.?

My view is that this mindset can be useful long before we consider our mortality, by helping us understand that there are realities that must be faced and not avoided. In investing as in life, long term success results from thoughtful, timely preparation. Or in other words, the best decisions are made before we are forced to make them. The best decisions are made before certain inevitabilities, so long on the horizon, appear unexpectedly in front of us, and we no longer have the time to consider the alternatives; when we can still calmly and intelligently assess our circumstances, consider alternatives, and make informed decisions, monitoring the results as we go.

This is what I refer to as ?de-risking,? and although the principles set out here are drawn from my experience as a risk manager at a number of leading investment firms, they apply not only to financial matters, but to almost every decision you?ll make over the course of your life.

So to my way of thinking, ?when lightning strikes–the processes that you have put in place make courage less necessary. Put another way, if you embrace risk by following an orderly process you will have constructed a framework that will help you make the right decisions

Of Investment Earnings Assumptions and Century Bonds

Of Investment Earnings Assumptions and Century Bonds

Posted on 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.

Twenty Questions for the Author of <I src=

Twenty Questions for the Author of Risk and the Smart Investor

Posted on by David Merkel

This is the first time I have done something like this, but I am interviewing an author of a book on Risk Management, which delves into the nature of the current crisis.? My interview occurs before the book is published, and lends to its publicity, which I don’t mind because I think it is an excellent book. The book is entitled, “Risk and the Smart Investor,” and is written by David X. Martin.? Anyway, here are the questions that I will ask him:

  1. Imagine you are talking to a bright 12-year old girl.? How would you explain to her why and how the financial crisis happened?
  2. I was fascinated with the structure of your book, which I found tedious and hokey at first, but I grew to like it.? The way I see it, you introduce the topic through your experience, then explain the theory, then show neglect of it led to failure, and then you give us the stories of Max and Rob.? How did you hit upon this intriguing and novel way to write your book?
  3. Why do you suppose so few people in risk management, and senior management at major financial firms, were unwilling to consider alternative views of the sustainability of the risks being taken as the risks got larger and larger relative to the equity of individual companies, the industry as a whole, and the economy as a whole?
  4. As a risk manager, bosses would sometimes get frustrated with me when they wanted a simple answer to a complex question that had significant riskiness.? They did not like answers like, ?I don?t know, it could have six significant effects on our company.?? How can we convey the limits of our knowledge in a way that management can get the true uncertainty and riskiness of the environment that we work in?? How can we get management to consider scenarios that are reasonable, and could harm the company, but few others in similar situations are testing for?
  5. In your experience, how good are the managements of financial companies at establishing their risk tolerances?? Better, how good are they at enforcing those limits, such that they are never exceeded?
  6. How do you create a transparent risk culture in a firm?? How do you get resisters to go along, even if it is management that does not see the full importance of the concept?
  7. Are most cases where a person or a company fails to diversify intentional or unintentional?? Do we put too many eggs in one basket more out of ignorance or greed?
  8. Why do you suppose that checks and balances for risk management are not built into the cultures of many financial companies?
  9. I have a friend Pat Lewis who developed a risk management system for Bear that could have prevented the failure of the firm, but it was ignored because it got in the way of profit center manager goals.? Was it the same for you at Citigroup when your ?Windows on Risk? got tossed out the window?
  10. Can culture and personal judgment work in risk management ever?? Take Berkshire Hathaway ? risk control is embedded in the characters of a few people, notably Warren Buffett and Charlie Munger.? If the culture is really, really good, and it comes from the top, can risk management work when it is seemingly informal?? (Remember, you don?t want to disappoint Warren.)
  11. How can you teach younger people in risk management intuition about risk that helps them have a healthy skepticism for the results of impressive complex modeling?
  12. Is it possible to do effective risk management in a financial firm if management is less than wholeheartedly committed to the goal?
  13. Aside from AIG, and other financial insurers, the insurance industry came through the crisis better than the banks because they focused on longer-term stress tests, and not on short-term measures like VAR.? Should the banking industry imitate the insurance industry, and focus on longer-term measures of risk, or continue to rely on VAR?
  14. Seemingly the big complex banks did not analyze their liquidity risk, particularly with repo lines.? Why did they miss such an obvious area of risk management?
  15. How much can risk management be shaped in financial firms by the compensation incentives that employees and managers receive?
  16. I have often turned down shady deals in business, saying that you only get one reputation in this world.? How do you encourage an attitude like this in financial firms among staff?
  17. A lot of portfolio management and risk management is juggling different time frames.? Is there a good structure for balancing the demands of the short-, intermediate-, and long-terms?
  18. Most developed country economic players assume that wars will have no impact on their portfolios.? Same for famine, plague, or environmental degradation.? What can you do to get investors to think about the broader risks that could materially harm their well-being?
  19. Are Rob?s more common in the world than Max?s??? That?s my experience; what do you think?
  20. At the end of your book, one of your friends dies.? Did you mean to teach us that even if we manage our risks right, we still can?t overcome problems beyond our scope, or were you trying to say something else, like creating a system or family that can perform well after you die?
Dave, What Should I Do?

Dave, What Should I Do?

Posted on by David Merkel

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

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

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

With that, the scenarios:

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

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

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

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

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

Closing then, with three final notes:

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

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

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

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

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

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

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

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

Tickers for the Current Portfolio Reshaping

Posted on by David Merkel

I haven’t written about my portfolio management methods in a while.? I’ll be writing on this a few more times over the next week or so.? The eighth rule of my investing is:

Make changes to the portfolio 3-4 times per year. Evaluate the replacement candidates as a group against the current portfolio. New additions must be better than the median idea currently in the portfolio. Companies leaving the portfolio must be below the median idea currently in the portfolio.

First I have to get new ideas.? I have two sources for that:

  • My industry rank study.? Within those industries chosen, I run a screen that uses financial strength, valuation, and growth potential to highlight promising names.? Of the 34 current names in the portfolio, the screen chose 10 of them, out of 79 suggested names.
  • Trolling around on the web and talking to friends.? When I hear a promising idea, I print it out or write it down, and put it in a pile to wait for the next reshaping.? This helps me to forget who suggested it and why, so that I am forced evaluate it independently.? If I don’t fully understand it, I will not know when to buy more or sell it.? That generated 40 additional names.

Anyway, here are the tickers for the?replacement candidates:

ABFS ACM AEP AFL AMGN APA APC APOL ATPG AXS BCE BDX BHI BRY BT CAG CALM CAM CDI CL CLX CNQ CPO CVS DFG DLM DO EGN ENR ESLT FDP FISV FLIR FRX FST FTO GD GLRE GMXR HAL HOGS HRL HSII IP JBL KELYA KEX KFT KHDHF LLL LNC LPX MDT MDU MET MMM MOG/A MOT MRO MUR MWV NBR NEMNLC NOV NVDA OCR OII OSG PCCC PG PRU PXD PXP RAH RDS/A RE REP RIG RNR RTN SJM SPR SU SUN SXT TDW TDY TEG THS TK TLM TMK TMO TRH TRP TSO TTI UNM V VZ WAG WAT WMT WPP WY YUM

I will run my quantitative model on these companies versus the current companies in the portfolio, and kick out companies I now own that score poorly and buy some the score well.? This procedure is not absolute; there are often bits of data? that the quantitative factors ignore.? But when all is said and done, I buy companies that I think are better than those that I am selling.

This also forces me to review the whole portfolio, and be dispassionate about what gets sold.? It also forces me to take things slow, and not make hasty decisions.

What factors exist in my scoring model:

  • Valuation – Earnings, Book, Sales
  • Momentum
  • Earnings Quality
  • Sentiment indicators — neglect, volatility, etc.

I change the weights over time.? I ask myself, “What is working now?” and, “What has or hasn’t been working for too long?”? What working now should get extra weight, while leaning away from ideas that are too popular, and leaning toward those that are unfairly tarred as dead.

But this is only an aid and a guide.? If I put something into the portfolio, it has to pass my qualitative reasoning tests, which admittedly are subjective, but encompass my reasoning as a businessman.

In short, that is what I do.? I hope to give you an update in a few days to explain how this practically worked out in this reshaping.? If you have other tickers that you think I should consider please let me know in the comments, and I will toss them into the mix.? Thanks.

Managing Illiquid Assets

Managing Illiquid Assets

Posted on by David Merkel

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

So where do we see failures due to illiquidity?

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

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

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

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

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

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

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

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

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

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

Three Closing Notes

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

Was it worth moving from the:

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

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

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

A Baker’s Dozen Of Economic Items

A Baker’s Dozen Of Economic Items

Posted on by David Merkel

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The Rules, Part XVII

The Rules, Part XVII

Posted on by David Merkel

In a panic, only two attributes of a financial instrument get priced — liquidity and quality/survivability.

In a panic, all risky assets become highly positively correlated with each other.

Given that correlations tend to rise in a panic, a reasonable measure of sentiment is to measure the average absolute value of 10-day correlations.

Markets cannot survive for long periods of time at high levels of actual or implied volatility.? They eventually revert to normal.

Panics and booms are different — they may be opposites, but they behave differently.? Panics are events, often multiple events, and booms are processes.? The nature of this is best explained through the credit cycle.? The boom phase of the credit cycle involves rising profits of corporations.? Stocks and bonds behave differently here.

Say the expectation of income moves from negative to a low positive figure.? Stocks will rally; bond may rally more, because the threat of bankruptcy is lifted.

Now suppose that the expectation of income moves from a low positive to a normal positive figure.? Stocks will rally a lot, but bonds will rally a little.? The odds of the bonds being paid rise a minuscule amount.? The stocks estimate of future distributable profits rise a great deal.

Now suppose that the expectation of income moves from a normal positive to a high positive figure.? Stocks will rally some, but bonds will not rally much.? The odds of the bonds being paid don’t change.? The stocks estimate of future distributable profits rise, but with a sense of possible mean reversion.

So in a boom, credit spreads [the difference between the yields of corporate bonds and Treasury bonds] tighten quickly, tighten slowly, and then stop tightening, even though things seem to be going great.? The end of the boom, as far as the credit market is concerned, can last a long time.

The end of the boom comes when a significant amount of companies the overextended their balance sheets during the boom find themselves in a compromised condition, and have a hard time gaining financing.? The suspicion of credit troubles travels fast, and all of the companies where investors waved their hands at problems now get a fresh look with a different set of eyes.

The moment incremental financing seems less likely or more expensive, companies that will need financing get re-evaluated by the market — stock prices move down, bond yields go up.? This is when analysis of the balance sheet and the cash flow statement are worth the most, and the income statement is worth the least.? The bull phase of the cycle is all about income statements, and estimating what future income will be.? The bear phase of the cycle is about estimating? cash flows, and the strength of balance sheets, to identify who might not survive the bear phase well.

During the boom phase of the cycle, the degree of correlation of asset returns is low.? There is noise, and not everything does equally well.? There are multiple risk factors and strategies that are working.? But in the bust phase, the acid test of survival dominates.? One factor gets priced, whether an asset is money good or not. [For bonds, “money good” means the par value of the bond will be repaid at maturity.]

But panics don’t last long — usually two years or so.? As the panic drags on three processes take place:

  • Companies in horrible shape default.
  • Investors examine companies in okay shape, and find weaknesses.? Some will default, and some will clean their acts up.
  • Companies clean up their acts, and it becomes obvious that they will survive.

Toward the end of the bust phase, like a fire running out of fuel, there is a moment of clarity where some realize that things aren’t getting worse.? Most companies have cleaned up, and there will be fewer future defaults.? That sets the scene for the next rally.

Through the bust, equity volatility and credit spreads remain high; they are correlated phenomena, but there is a point of exhaustion.? High yields attract needed financing to companies that are mis-financed, rather than insolvent.? Credit spreads can only get so high before money comes in willing to buy no matter what the future may hold.? Equity volatility can only get so high before players begin writing short straddles, knowing that the odds of winning are tipped in their favor.

It pays to watch both the equities and bonds, and other related securities — it gives a richer picture of what is going on.? In particular, when the bull phase has gone on for two full years, watch for equity volatility and credit spreads to stop falling.? That is a sign that the bull market is getting close to the end, and most of the easy gains have been made.? Watch for telltale signs of cashflow shortfalls where banks are less than willing to plug the gap at a price.

Learn this well, and your ability to play the market will improve considerably.

The Market Goes to the Dogs, Which Chase Their Tail Risk

The Market Goes to the Dogs, Which Chase Their Tail Risk

Posted on by David Merkel

I’ve read a number of articles on hedging tail risk of late.? Most of them were pretty good; I just want to add in my thoughts.

For those who haven’t read the articles, tail risk is when even safe investments get hit hard.? Those market outcomes are rare but severe, so some people look for insurance to clip their risks when everything is getting whacked.

Possibly a reasonable goal, and the best time to aim for it is when things are pretty good, because it is best to buy insurance when it is cheap to do so.

But what form should the insurance take?? I can think of three broad categories:

  • Assets that come into existence during the disaster.
  • Ready liquid assets — short-term and high quality.
  • Liabilities that disappear with the disaster.

The first category is the one most people think about.? What can I buy that will do well when the disaster comes?? There are two branches to that question:

  • Do I want my downside clipped on this trade (for a price)?
  • Do I want to make the bet without paying much, and I could win or lose?

In the first category are puts and buying protection via CDS, which will protect for a time, but cost money to put on the trade.? Worse, you could be right on the event, but wrong on the timing, and they end up expiring worthless.

Note: be wary of products Wall Street would like to sell you here.? Most often, they sell something mispriced to you, though it looks attractive.

But even if you are right, your counterparty/exchange? has to remain solvent in order for the trade to work.? Few factor in the cost of insolvency there.? Think of those who though they were clever laying off risk to AIG, a trade which only worked due to government intervention.

In the second category, there are assets like precious metals and long Treasury zero coupon bonds, each of which will do well in a specific crisis, but not just any crisis.? But there is also the shorting of equities and high-yield bonds, which could potentially deliver big gains, or big losses if the rally continues.

I would offer this test to anyone offering a hedge against tail risk: is it any better than puts or buying protection through CDS, or shorting equities or high yield bonds?? I would suspect in most cases the answer is no.

Then there is my preferred solution: hold cash.? Cash is unique; it can be used for anything; it can be used for almost every contingency.? Cash may offer little to nothing; it may even yield negatively, but that is the cost of security and flexibility.

Then there is the third option: offering catastrophe [cat] bonds.? Why should the guys following hurricane, quake, typhoons, and European windstorms have all of the fun?? There are more and bigger disasters than those in the financial markets.

In simple terms, here’s how a cat bond works: after a disaster that meets the terms of the cat bonds occurs, the principal of the bond diminishes by the size of the covered loss, if it is in excess of certain thresholds.? The advantage of an arrangement like this is that an insurer or reinsurer can get reinsurance against a disaster, by issuing a high-yielding cat bond.

The high-yield investors are happy to buy it because typically cat bonds are highly rated, and offer a good return that is uncorrelated with the returns on other high yield bonds.? Physical disasters seem to happen independently from financial market disasters.

The bond issuer gets reinsurance capacity, which is sometimes scarce, at a price that reinsurers would not match.? Cat bonds can never replace reinsurers, though, because the reinsurers offer more tailored coverages, while cat bonds tend to be more broad-brush.? They are usually cross-hedges for the issuer, covering something that is likely to be highly correlated with their loss exposure in a disaster.

What Might be a New Idea

What if we applied the concept of a cat bond to hedging risky security portfolios?? Think of it as an odd sort of margin account.? A hedge fund borrows money via a special purpose vehicle [SPV], which holds high quality collateral.? The hedge fund pays the SPV for insurance coverage; the SPV pays interest to the cat bond investors.? If a loss event happens, say a large decline in the S&P 500 index below a stated level, the principal of the cat bond is written down, and the SPV pays the amount of the writedown to the hedge fund.

Compared to a cat bond based on a physical event, there is one advantage and one disadvantage.? The disadvantage is that the loss trigger on a financial cat bond is highly correlated with bad high yield bond market performance, eliminating a lot of the diversification advantage.? This would mean that a financial cat bond would have to pay a higher premium than a physical cat bond.

There is an advantage, though: it can be hard to set up a large hedge without disrupting the market, and it is difficult to gain protection over long periods of time.? Most hedging instruments are short dated, and limited in the amount of capacity available for laying off risk.

Would this be attractive to a large hedge fund?? I’m not sure.? This sort of protection has the same sort of drip, drip, drip of cash out that most managers hate to see, whether for writing puts or buying protection via CDS.? It would come down to a question of cost versus a locked-in solution that could last for ten years, with little to no counterparty risk.

Conclusion

But personally, my best solution is lower your leverage and hold some cash.? Nothing beats the flexibility and simplicity of cash in a disaster.? Cash is also an index of humility; we are willing to leave something to the side in case we are wrong.? Being wrong is a normal state of affairs in investing, so take time to prepare for the next time you will be wrong.

The Education of a Corporate Bond Manager, Part III

The Education of a Corporate Bond Manager, Part III

Posted on by David Merkel

A reader MorallyBankrupt, asked,

What I am wondering here is the following, how fast was the decision process? For those of us that have never worked in the new-issue market for corps, the timeline is not obvious. How did it all flow, from getting notice of the deal, to getting a feel for the demand for it, to knowing what the offering price was going to be? How long did you have before requesting allocation in the deal?

Good question.? I answered part of this in the last piece.? It would vary based on three things:

  • The complexity of the deal — more complexity, more time
  • The creditworthiness of the issuer — lower creditworthiness, more time
  • The speculative nature of the market — less speculative, more time

Most new issue corporates do not require explanation; they are just straight bond deals.? Senior unsecured, do the credit work, do you want into the deal or not?? But some deals require thought.? When Prudential (US) went public, they securitized the business associated with their oldest policies, and issued debt against it.? Thick prospectus.? Many scared away in the midst of the credit troubles in 2002.? I looked at it and said, “They are offering more yield than on their surplus notes, but with better protection.? Time to buy.”

So I called my broker at Goldman and expressed interest in the deal.? He sounded a little surprised, and said that few had offered orders yet.? I said that I was interested, and he said that the syndicate would be interested in pricing guidance.? I gave him a schedule where I would be willing to buy more as the pricing went higher in spread.

But after that, I asked for protection on my order.? Early orders deserve protection.? Protection means you will get everything that you asked for, while others get pro-rated if the deal is successful.? They protected my order, which was large for us, while the marketing of the deal continued.

As it was, in the midst of the chaos of 2002. there were few takers for the low risks in a complex deal like that of Prudential’s old business.? So as the deal came to pricing, the yield rose.? The eventual yield for the non-guaranteed bonds was 8.695%, yielding a price in the $98s.? The first trade was $104, and went up from there.? What could be better? for us?? I bought some more when my credit limit expanded at $108.? What a great misunderstood bond.

But that is the way things work when credit markets are slow.? When they are fast, deals close rapidly, and syndicates allocate bonds proportionately to where their estimate of buying power is.? There is no protection there, aside from any big investors who move very early.

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But now onto the times when markets go nuts.? Deals are closing in less than 10 minutes.? You have to get your order in rapidly, or you will get nothing.? My one minute drill helps, but is not perfect.? On a deal on Disney bonds, they had a great yield in a hot market.? I bid for $30 million in bonds, and found myself trapped with 30 million of Disney long bonds, after an allocation that went bad.? I flipped 10 million for a small gain, and another 10 million at par, leaving me with 10 million that I did not want to hold.? I waited, and took my losses later.

But more often, I would avoid the deals when they got hot, and let others buy them.? I had strong opinions on what would work and what would not.? I remember several large deals where the syndicates begged me to buy (GE Capital, and AT&TWireless) and I refused.? The speculative cycle was high, and it was fun to refuse Wall Street when it was trying to stuff accounts full of promises that were underpriced.? I did not play in those deals, and it was fun to see the deals fail, and prices fall considerably versus the original offer.

In order to keep the system honest, some deals had to fail, and not provide profits to those who would flip.? Otherwise, many managers would beg for more bonds than they could hold onto, just so they could flip them.? When the market runs hot, the odds rise that the syndicates will overprice a deal, to deliver losses to those that foolishly ask for overly large allocations.

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Once you had notice of a bond deal, you could act. You could put in for bonds if you wanted.? But when conditions were speculative you had to move rapidly, and ask for an allocation quickly, or risk getting nothing at all.? Once the books closed, that was it.? Also, if multiple dealers controlled the books, it paid to put in through all of them.? One might have influence that the others did not on very rare occasions.? You wanted all of the bookrunners fighting for you.

All of that said, on some deals you would end up with a lousy allocation, and get less than 10% of what you asked for.? At times like that, one would typically flip the bonds to the highest bidder, because it was not worth the bother to hang onto a small position.? On massively oversubscribed deals, the percentage profits on the flip were high, but they weren’t big in dollar terms.

As an aside, occasionally, shortlyafter the deal closed, if you had a sterling reputation, and could say to your brokers that you had been hindered from putting in for bonds but had wanted to, you could still squeeze in.? Reputation and size matters.

Some deals were highly subscribed by large sponsoring buyers before deals went public.? Those deals would open and close in a minute shutting everyone else out but the large buyers, and what few got some crumbs.? I remember getting crumbs on a few occasions.

One way you could get the syndicates to notice you, was that if you really liked a deal, you would buy on the break.? The break is where bonds become free to trade.? Now, truth, there is what is called the “grey market” where after bonds are allocated but before they are “free to trade,” you could deal them away, or, buy some more.? Dealing in the grey market has some taint, and you don’t want to be seen doing it, lest your allocations be reduced.? The opposite is true for those who buy through a syndicate dealer on the break.? It shows the syndicate that you are a real money buyer, as opposed to? a flipper.? Syndicates want to place bonds entirely with long term holders if they can; that is their goal, because it means they priced it right, leaving little money for mere speculators.

As for me, I employed one second tier broker who would buy lousy allocations from me on oversubscribed deals.? No reason to make the analyst write it up.? It wasn’t worth holding onto, and the yield after the break was not attractive enough to buy more.

More to come in part 4.

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