Real Estate and Mortgages – Page 16

Book Review: The Greatest Trades of All Time

Posted on 5 November 2011 by David Merkel

This book grew on me. Think of it as “How I hit a home run in investing.”? Who are the sluggers that earned outsized returns?

But, there is a problem here, and the book would have been better if it had recognized the problem.? In a few cases, the “greatest” made one (or a few) good decisions.? In more cases, they made many good decisions that compounded over time.

Was the first group lucky? Maybe, but when things work out for the reasons that you specify in advance, I think not.? The problem of the first group is repeatability, which for John Paulson, is proving to be an issue for his asset management shop at present.

The investment markets are cruel.? No matter what you have done in the past, the question comes, “What have you done for me lately?” The pressure is high, so no wonder that one of the investors that the book mentioned has gone into hiding.

There are two more dimensions here.? Imagine an investor that made some amazing gains , but then craters.? There are some brilliant investors for which that has been true: Livermore, Niederhoffer, Keynes, and more… how much credit should we give to the gains, if the price is flameouts?

Second, imagine someone who is the best in class at a low-return area of the asset markets, like Jim Chanos in short-selling, or Bill Gross at Pimco.? They may not earn that much, but the skill level is really high.? But is the skill level so high when they chose areas of the market to work in that are low -return?

Maybe the book should have featured private equity players, or real estate investors, or those that have managed university endowments well… there are other investors that would be comparable or better to the returns of some in this book.

Or ask, where is Buffett?? He would deserve a spot here, not for any one trade, but for the multitude of clever trades and mergers he has done over the years.

Quibbles

The book needed a better editor.? Information on Templeton is repeated.? Beyond that, most of the ideas on how an average investor could try to replicate the strategies of the great investors are akin to drinking near-beer.? They are too weak, but on the other hand, without the brilliance of the investors, an average person would not know when to but and sell.

With those caveats, I recommend the book highly.? It is well-written, and it will fill out knowledge gaps in amateur investors.

Who would benefit from this book: Most investors would benefit from this book.? If you want to, you can buy it here: The Greatest Trades of All Time: Top Traders Making Big Profits from the Crash of 1929 to Today (Wiley Trading).

Full disclosure: The publisher asked if I wanted the book.? I said ?yes? and he sent it 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.

Redacted Version of the November 2011 FOMC Statement

Posted on 2 November 20112 November 2011 by David Merkel

Comments

This release of the FOMC statement was really kind of a nothing-burger, aside from the hawks going with the majority, and Evans arguing for looser policy.
The main shift in the FOMC?s economic reasoning is that GDP growth is improving.? One quarter on the GDP data should not get us that definite.
In my opinion, I don?t think holding down longer-term rates on the highest-quality debt will have any impact on lower quality debts, which is where most of the economy is located.
Also, the reinvestment in Agency MBS should have limited impact because so many owners are inverted, or ineligible for financing backed by the GSEs, and implicitly the government, even with the recently announced refinancing changes.
The key variables on Fed Policy are capacity utilization, unemployment, inflation trends, and inflation expectations.? As a result, the FOMC ain?t moving rates up, absent increases in employment, or a US Dollar crisis.? Labor employment is the key metric.
The Fed is out of good policy tools, so it will use bad policy tools instead.

Questions for Dr. Bernanke:

Why do you think that holding down longer-term rates on the highest-quality debt will have any impact on lower quality debts, which is where most of the economy is located?
Why will reinvestment in Agency MBS help the economy significantly?? Doesn?t that only help solvent borrowers on the low end of housing, who don?t really need the help?
Couldn?t increased unemployment be structural, after all, there is a lot more competition from labor in emerging markets?
Isn?t stagflation a possibility here?? I mean, no one expected it in the ?70s either.
Could we end up with another debt bubble from keeping short rates so low?
If the Fed ever does shrink its balance sheet, what effect will it have on the banks?
Is it possible that you don?t really know what would have worked to solve the Great Depression, and you are just committing an entirely new error that will result in a larger problem for us later?

Dominoes

Posted on 11 October 201111 October 2011 by David Merkel

When I was a kid, I liked to set up large arrays of dominoes so that I could watch them fall.? Early on, I realized the errors in setup were frequent enough that I left gaps such that if I accidentally knocked down a domino, it wouldn’t destroy all of the work.? I usually put in a number of gaps close to the square root of the dominoes.? Once complete, I would fill in the gaps, and after that would come the show.

When the dominoes are set up, there is an unstable equilibrium.? Any jolt to the system will topple most or all of them.? Now, some would say the jolt causes the toppling of the dominoes, but the dominoes were arranged in order to make them all fall at once.? Whether the designer topples the first domino, or a marble from a kid brother rolls into the room, or there is a small earthquake, the array of dominoes was designed to fall.

So it was for the financial crisis.? These thoughts are my own, though others have uttered them as well.?? In order for there to be a panic that destroys a large portion of the financial system, there has to be:

High levels of leverage.
Leverage that is layered, where many parties are lending, and carry trades are common.? Parties borrow to lend more aggressively.
Collateralized lending — financial entities lend far more when lending is collateralized.? Most of the time, the existence of collateral prevents defaults.? But when things get really bad there is no protection with most collateral.
Problems with highly rated debt.? When debts are highly rated, in order to get high returns out of them, there must be a high degree of leverage applied.
There must also be general confidence that it is highly unlikely that there would be significant losses associated with the asset class.
Regulators must be similarly blind, and assume that risks are low in that set of assets.

So when the crisis struck it started in real estate lending, moving from Subprime, to Alt-A, to Prime, each one in turn more leveraged, and less likely to be prone to a crisis.? That’s why the crisis was so large.

The system had been optimized across many asset subclasses where many borrowers were trying to achieve equity-like returns through borrowing.? Thus when the overlevered previously safe asset classes began to fail, the failure was large, and had second-order effects that extended to lenders.

No one should say the current financial crisis was an accident; yes, no one aimed for it, but no, it was preventable.? It occurred from human activity that was left unchecked, building up leverage in safe asset classes, and pushing up the trading value of those assets to unsustainable levels.? Regulators had the power to bring it all to a halt, but they were complicit with the bankers.

That’s what you need to have a real crisis, and that ‘s why we still suffer from it.? The crisis will continue until enough of the safe debts have been rationalized, and the total level of debt gets paid down enough for the average borrower to borrow once again on a basis that has significant provision against adverse deviations.? Maybe we’ll get there in another 2-3 years.

Redacted Version of the September 2011 FOMC Statement

Posted on 21 September 2011 by David Merkel

Comments

Announces an operation to twist the yield curve, sending the long bond up almost 3% in price.? Also announces the reinvestment of proceeds from Agency Bonds and MBS into more Agency MBS.
In my opinion, I don?t think holding down longer-term rates on the highest-quality debt will have any impact on lower quality debts, which is where most of the economy is located.
Also, the reinvestment in Agency MBS should have limited impact because so many owners are inverted, or ineligible for financing backed by the GSEs, and implicitly the government.
Still engages in wishful thinking regarding inflation, thinking that it is declining.? Points at energy and commodities, but that?s not the largest part of what drives inflation.
The key variables on Fed Policy are capacity utilization, unemployment, inflation trends, and inflation expectations.? As a result, the FOMC ain?t moving rates up, absent increases in employment, or a US Dollar crisis.? Labor employment is the key metric.
Difficult to tell how much the hawks disagreed with the new ?easing tools.?
The Fed is out of good policy tools, so it will use bad policy tools instead.

Questions for Dr. Bernanke:

Why do you think that holding down longer-term rates on the highest-quality debt will have any impact on lower quality debts, which is where most of the economy is located?
Why will reinvestment in Agency MBS help the economy significantly?? Doesn?t that only help solvent borrowers on the low end of housing, who don?t really need the help?
Couldn?t increased unemployment be structural, after all, there is a lot more competition from labor in emerging markets?
Isn?t stagflation a possibility here?? I mean, no one expected it in the ?70s either.
Could we end up with another debt bubble from keeping short rates so low?
If the Fed ever does shrink its balance sheet, what effect will it have on the banks?
Is it possible that you don?t really know what would have worked to solve the Great Depression, and you are just committing an entirely new error that will result in a larger problem for us later?
How big is the effect on employment from higher food and energy prices on consumer purchasing power and spending as well as supply chain disruptions associated with the tragic events in Japan?

On Multiparty Transactions

Posted on 7 September 20118 September 2011 by David Merkel

I’m not an expert on game theory, but the rule of thumb I have run across is to win in games with more than two parties, you must assemble a coalition that has more than 51% of the aggregate power within the game.

Practical rule number two is that the one on the winning side that arranges/controls the communications/relationships tends to walk off with a larger proportion of the stakes won in the game.

I learned this early as a young actuary working on my pricing models, and noted that those that really made out well in insurance were the successful agents.? They brought two parties, insured and insurer together, who most of the time would not have found each other.? Then, they did policyholder service for the company and the customer controlling the flow of information in the process.? There were times when I thought it would be useful for the company to talk more directly to the insured, but marketing sometimes objected, and so we didn’t.? The agents owned all the loyalty in the transactions.

As an older actuary, I saw this writ large when I was running an annuity division.? Using regression, I did what I think was one of the industry’s most advanced studies of deferred annuity withdrawal.? The Society of Actuaries produced a similar (but broader) study roughly one year behind me.? One of the main results of the study was that withdrawal rates spike when the surrender charge ends.? The reason is because most agents try to roll the business to a new product so that they can earn another commission.? (Trivia note: I learned that those policyholders that did not roll along with the agent were very sticky business.)

Multiparty transactions exist because there is something complex going on, and the multiple parties each serve a need, providing a service, or eliminating a risk.? Let’s move to the concept of buying a house.? Here is my informal list of all of the parties:

Buyer
Seller
Realtor for the Seller — helps convince the buyer to buy.
Realtor for the Buyer, or, sub-agent for the seller — helps the buyer find a good property to buy.
Title insurer — assures that there are no mistakes in the transfer of title.
Mortgage insurer — insures mortgage lender against default when there is little equity for the buyer.
Property & Casualty insurer — protects the lender and buyer against losses from property damage, or injury to people on the property.
Mortgage lender (first lien) — provides most of the money for the purchase
Mortgage lender (second lien and beyond) — provides some money for the purchase, but in foreclosure gets paid after the first lien lender.
Appraiser — gives an estimate of the value of the property so that the first lien lender does not lend too much.
Home Inspector — finds defects in the property so that the buyer can adjust his price down.
Taxation authorities — collect taxes, so that services that make the community livable are provided.
Community Association — enforces neighborhood standards, so that property values are enhanced.
There are more, but I can’t think of them…

Note: I did the “smiley-face” version of the roles parties play in the process.? I could have done the cynical version, but didn’t.? Also note that not all of the parties are needed on a given transaction.? The complexity erupts because the buyer needs to borrow to complete the transaction, and the lender wants protection.

Now, going back to my earlier thoughts, in this case, the first-lien mortgage lender has things set up to his advantage.? Many of the parties to the sale of a house exist to protect his interests.? It is the dominant party in this sort of transaction.? This leads to two current problems:

Mortgage reinsurance captives owned by banks originating the loans.
P&C Insurance that is forcibly placed by the lender when the buyer does not make P&C insurance payments.

On the first point there was an article today that I found surprising because it is so late to the game.? Don’t get me wrong, it is a good article, but for an insurance analyst that spent time analyzing the mortgage insurers, it is old news.? As I wrote back in 2003 (and published in 2010):

In addition, lenders that originate low down payment mortgages often force the mortgage insurers to cede low-risk parts of the business to reinsurance captives controlled by the lenders. This is a continuing problem, with many of the mortgage insurers refusing to go along with the most uneconomic reinsurance deals.

It got worse from there, with more mortgage insurers giving in, and lenders demanding a larger proportion of the profits.? Nominally they were reinsurance premiums, but for the most part they were closer to being commissions.? Why did the mortgage insurers go along with this?? Because the first-lien lenders were the dominant party in the transactions, controlling most of the other parties.? As a result, borrowers putting small amounts of money down ended up paying more for their mortgage insurance because of the pseudo-commission paid to the mortgage lender because of the captive reinsurer.? As I have sometimes said, “Reinsurance is the ultimate derivative; it can obscure almost any transaction.”

On force-placed insurance I have written as well, and it sounds a lot like this post.? The similarity is that the insurance is primarily designed to protect the mortgage lender, and the mortgage lender again collects a commission in the process because it is at the hub of communications.? The mortgage agreements give them discretionary power.

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My simple rule to average people when involved in complex transactions is this: be cynical.? No one is interested in your well-being, and most of the transactional terms are skewed against you.? To the extent that you can borrow less, and eliminate some of the parties that would be a part of the transaction, it is to your good that you do so.? The best situation is that you buy for cash, if you have it.

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Now, this same sort of analysis can be applied to securitizations, and other multiparty transactions.? Watch for who has control; it is a valuable option to have.? But that is an essay for another day.

The Yield Curve Can?t Invert With Fed Manipulation

Posted on 3 September 2011 by David Merkel

This piece should be short.? I have heard otherwise intelligent people say that the economy can?t go into a recession because the slope of the Treasury yield curve is too positive.

With the Fed trying to manipulate the yield curve for its own policy purposes, starving savers of income, the yield curve is not a useful measure.? To invert the Treasury yield curve when the Fed is holding short rates at zero, we would have to see the Fed engage in Quantitative Easing to the degree that Treasury Notes and Bonds can be issued at significant negative interest rates.

To argue that we can?t have a recession at present because of the Treasury yield curve essentially says that if the Fed holds short rates at zero, we can?t have a recession.

I?m sorry, but with an overindebted economy, we can have a structural, not cyclical recession, where the shape of the yield curve doesn?t matter much because of all the debt.? When large portions of the economy have no inclination to borrow, monetary policy, even unorthodox and evil monetary policy has little effect on the real economy, where ordinary people borrow money (excluding from the GSEs).

This is another reason why I think the Fed actions to twist the yield curve will fail. ?They can twist the curve, yeah, but it will do little to stimulate an overindebted economy where many mortgage loans are inverted.

The Fed may control the Treasury yield curve, but it does not control the free market yield curve where (aside from Fannie and Freddie and the FHA), ordinary people and firms borrow.

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PS — I’m still without power.? Yeah, day 7, and I’m in the lucky 2%.? Still, we’re not doing badly, and this is a lesson from God, teaching us patience.

.? I thought I would have more to say on yesterday’s piece, but I don’t.? If anyone reading this has a copy of what a collateral swap agreement looks like, I would enjoy looking through it.

Redacted Version of the August 2011 FOMC Statement

Posted on 9 August 2011 by David Merkel

June 2011	August 2011	Comments
Information received since the Federal Open Market Committee met in April indicates that the economic recovery is continuing at a moderate pace, though somewhat more slowly than the Committee had expected.	Information received since the Federal Open Market Committee met in June indicates that economic growth so far this year has been considerably slower than the Committee had expected.	Shades down their view of GDP again.? I think they need to hire better modelers.
Also, recent labor market indicators have been weaker than anticipated.? The slower pace of the recovery reflects in part factors that are likely to be temporary, including the damping effect of higher food and energy prices on consumer purchasing power and spending as well as supply chain disruptions associated with the tragic events in Japan.	Indicators suggest a deterioration in overall labor market conditions in recent months, and the unemployment rate has moved up.	Shades down their view of employment further.? Wishful thinking regarding transitory factors disappears? Japan does not have that big of an impact on US employment, nor do food and energy prices, which have been going up for some time. (See 2 boxes below.)
Household spending and business investment in equipment and software continue to expand.? However, investment in nonresidential structures is still weak, and the housing sector continues to be depressed.	Household spending has flattened out, investment in nonresidential structures is still weak, and the housing sector remains depressed. ?However, business investment in equipment and software continues to expand.	Shades down their view of household spending, otherwise similar.
	Temporary factors, including the damping effect of higher food and energy prices on consumer purchasing power and spending as well as supply chain disruptions associated with the tragic events in Japan, appear to account for only some of the recent weakness in economic activity.	New sentence that takes back part of their wishful argument from last month.? They were grasping at straws.
Inflation has picked up in recent months, mainly reflecting higher prices for some commodities and imported goods, as well as the recent supply chain disruptions.	Inflation picked up earlier in the year, mainly reflecting higher prices for some commodities and imported goods, as well as the supply chain disruptions.	Basically the same.
	More recently, inflation has moderated as prices of energy and some commodities have declined from their earlier peaks.	What evidence do they have that overall inflation is declining?? I don?t see it; this is more grasping at straws.
However, longer-term inflation expectations have remained stable.	Longer-term inflation expectations have remained stable.	Basically the same.
Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability.? The unemployment rate remains elevated; however, the Committee expects the pace of recovery to pick up over coming quarters and the unemployment rate to resume its gradual decline toward levels that the Committee judges to be consistent with its dual mandate.	Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. ?The Committee now expects a somewhat slower pace of recovery over coming quarters than it did at the time of the previous meeting and anticipates that the unemployment rate will decline only gradually toward levels that the Committee judges to be consistent with its dual mandate.	Shades down their view of the recovery overall.? The misplaced optimism is declining.
Inflation has moved up recently, but the Committee anticipates that inflation will subside to levels at or below those consistent with the Committee’s dual mandate as the effects of past energy and other commodity price increases dissipate. ?However, the Committee will continue to pay close attention to the evolution of inflation and inflation expectations.	Moreover, downside risks to the economic outlook have increased. The Committee also anticipates that inflation will settle, over coming quarters, at levels at or below those consistent with the Committee’s dual mandate as the effects of past energy and other commodity price increases dissipate further.? However, the Committee will continue to pay close attention to the evolution of inflation and inflation expectations.	Shades down their views on inflation, but for little good reason.
To promote the ongoing economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate, the Committee decided today to keep the target range for the federal funds rate at 0 to 1/4 percent.	To promote the ongoing economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate, the Committee decided today to keep the target range for the federal funds rate at 0 to 1/4 percent.	No change.
The Committee continues to anticipate that economic conditions–including low rates of resource utilization and a subdued outlook for inflation over the medium run–are likely to warrant exceptionally low levels for the federal funds rate for an extended period.	The Committee currently anticipates that economic conditions–including low rates of resource utilization and a subdued outlook for inflation over the medium run–are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013.	Defines the ?extended period to be 2 years.
The Committee will complete its purchases of $600 billion of longer-term Treasury securities by the end of this month and will maintain its existing policy of reinvesting principal payments from its securities holdings.	The Committee also will maintain its existing policy of reinvesting principal payments from its securities holdings.	No real change.
The Committee will regularly review the size and composition of its securities holdings and is prepared to adjust those holdings as appropriate.	The Committee will regularly review the size and composition of its securities holdings and is prepared to adjust those holdings as appropriate.	No change
The Committee will monitor the economic outlook and financial developments and will act as needed to best foster maximum employment and price stability.	The Committee discussed the range of policy tools available to promote a stronger economic recovery in a context of price stability. It will continue to assess the economic outlook in light of incoming information and is prepared to employ these tools as appropriate.	The Fed doesn?t have any good tools left.? All they can work with are the bad tools, and work they will.
Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; Elizabeth A. Duke; Charles L. Evans; Richard W. Fisher; Narayana Kocherlakota; Charles I. Plosser; Sarah Bloom Raskin; Daniel K. Tarullo; and Janet L. Yellen.	Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; Elizabeth A. Duke; Charles L. Evans; Sarah Bloom Raskin; Daniel K. Tarullo; and Janet L. Yellen.	Note dissenters below.
	Voting against the action were: Richard W. Fisher, Narayana Kocherlakota, and Charles I. Plosser, who would have preferred to continue to describe economic conditions as likely to warrant exceptionally low levels for the federal funds rate for an extended period.	They would have preferred the old language not specifying how long the extended period would be at minimum.? This is a pretty weak dissent; there is a lot more to be objected to in our monetary policy.

Comments

The FOMC defines the ?extended period to be 2 years.? Short-intermediate part of the Treasury curve flattens.? Long end goes on a speculative tear.? Hope the FOMC likes that, but it will only allow high quality borrowers to borrow more cheaply, not average people and small businesses. The Fed?s policy can?t bring down credit spreads, not that it should.
Still engages in wishful thinking regarding inflation, thinking that it is declining.? Points at energy and commodities, but that?s not the largest part of what drives inflation.
Finally shades down its views on GDP and employment growth.
The Fed ends much of its wishful thinking regarding transitory employment factors? Japan does not have that big of an impact on US employment, nor do food and energy prices, which have been going up for some time.
The key variables on Fed Policy are capacity utilization, unemployment, inflation trends, and inflation expectations.? As a result, the FOMC ain?t moving rates up, absent increases in employment, or a US Dollar crisis.? Labor employment is the key metric.
The hawks finally flew with a weak dissent, objecting to specifying how long the extended period would be at minimum.
The Fed is not shrinking its balance sheet anytime soon.
The Fed is out of good policy tools, so it will use bad policy tools instead.

Questions for Dr. Bernanke:

How big is the effect on employment from higher food and energy prices on consumer purchasing power and spending as well as supply chain disruptions associated with the tragic events in Japan?
Couldn?t increased unemployment be structural, after all, there is a lot more competition from labor in emerging markets?
Isn?t stagflation a possibility here?? I mean, no one expected it in the ?70s either.
Could we end up with another debt bubble from keeping short rates so low?
If the Fed ever does shrink its balance sheet, what effect will it have on the banks?
Is it possible that you don?t really know what would have worked to solve the Great Depression, and you are just committing an entirely new error that will result in a larger problem for us later?

The Rules, Part XXIII

Posted on 2 August 20112 August 2011 by David Merkel

A Ponzi scheme needs an ever-increasing flow of money to survive.? Same for a market bubble.? When the flow?s growth begins to slow, the bubble will wobble.? When it stops, it will pop.? When it goes negative, it is too late.

Here’s how a Ponzi scheme works for the promoter:

Prior Net Assets + Receipts + True Investment Earnings (if any)? – Withdrawals – Expenses = Net Assets

But this is what it looks like to the investor:

Investor Prior Net Assets + Receipts + Reported Earnings – Withdrawals = Investor Net Assets

The investor’s view of the assets is higher than the actual assets by the cumulative difference between reported and true investment earnings, and cumulative expenses. The promoter wants to keep the good times rolling, and keep the ratio of actual to investor net assets as high as possible.? But to do that requires additional receipts, and a lack of withdrawals, which in turn requires an attractive reported rate of earnings, higher than what could be ordinarily achieved. But the higher the reported rate of earnings goes, the further behind the promoter gets.? Also, at very high levels, the authorities take interest.? At very low levels, the Ponzi dies.? Part of the evil genius of Madoff was striking the balance.? He also did four other things:

Soft-peddled the marketing so that it was like joining an exclusive club.
Discouraged withdrawals by saying you would not get back in (for some).
Deluding regulators into thinking that it was a front-running scam.
He did not rake off much.

Most Ponzi schemes die rapidly because of the greed and impatience of the promoters.? All Ponzi schemes eventually fail. So how does this relate to market bubbles?? With a market bubble, the increase in market values significantly exceeds the increase in intrinsic values.? This could be due to a number of factors:

Players see that borrowing to chase a rising asset is a winner.
Promoters make it easy to do for inexperienced investors.
An easy monetary policy lowers financing costs, aiding bubble financing.
Players seek stock gains, and disdain debt claims.
At the end, investors have to feed the asset to keep it afloat, giving up current income to support the “asset.”

Positive cash flow into the bubble asset class supports valuations for a time, the cash flows driven by momentum, but eventually positive cash flows are overwhelmed by negative cash flow from an overvalued asset class. My advice: avoid speculating on momentum, particularly after it has gone on for a few years.? Put a margin of safety first in your investing, such that you will always be around to invest in the future, no matter how bad the? investment environment is.

The Costs of Illiquidity — II

Posted on 28 July 2011 by David Merkel

I thought it was bad enough to try to dissuade people from buying life contingent cash flows.? Now I get to talk about Non-Traded REITs.

This is the first time I heard about them.? Doing a little digging, there is controversy around them.? But let’s talk about the benefits first:

You receive a high and steady income.
The stated value of your holdings remains stable, thus insulating investors from the chaos of the market.
Professional management of commercial real estate is now available to small investors, with high returns.

But then there are the limits:

Liquidation through the sponsor is limited.? (Dated, but gives you some idea…)
You likely can’t cash out in full except through illiquid secondary markets where you take quite a haircut.
If the underlying real estate does not do well, your income will shrink or disappear.
You have little data on how the underlying real estate is doing.? Is the dividend they are paying coming from income or return of capital?

Long-dated, illiquid assets exist for two reasons:

To illustrate high yields to non-knowledgeable investors.
To pay large commissions to those that sell them.

It’s hard to tell which of those are more important, but this is another reason why I continue to talk about illiquid investments, and why most people should avoid them.? It is much easier to cheat people when there is no liquid market available to validate what is happening with the investment.? It is not that Non-Traded REITs protect investors from volatility, as much as they hide volatility from investors.

Large commissions on investments are only possible when there is a lock-in where surrender charges pay off the commission.? Where there are large commissions, misguided investing is more likely.

Look, I could set up 10-year stock trusts.? I will tell you what I will invest in, but since you have no withdrawal rights, you’ll have to wait 10 years for liquidity.? That does not sound like a better investment than going to Vanguard.? But many don’t go to Vanguard because they will not do their homework.? Should we begrudge those who sell to the fools that will not do their own homework?

I wish that we could.? Hey, the SEC is going after them.? Why not?? It is a reply of the limited partnership era of the ’80s.? Illustrate high returns — deliver capital losses.? I could not get why my first boss bought his limited partnerships, because of the losses taken in the era.

It follows the paradigm for illiquid investments — Offer high yields, suck in money, pay high yields, and if things go bad, deliver large capital losses.

With publicly traded REITs low yields have returned better then high yields.? The attempt to generate high yields requires a strategy where everything must go right.? That doesn’t work.? The low yield strategy does work, because there is more flexibility to manage, and raise payouts only after strategies have succeeded.

It is the same for Non-Traded REITs.? They offer high yields after paying high commissions.? Those high yields rely on capital gains on the properties.?? Relying on capital gains is poison.

I will say it plainly: unless you are an expert who knows more than the seller, avoid buying illiquid investments.

Closing notes

There are many well-dressed people in this business.? But none discuss the scandal surrounding it.

This an example of those that prey upon small investors to get them to invest in non-traded REITs.

This is a growing area of investment, as people seek yield.

Pricing of Non-Traded REITs is controversial.

Here’s an example of a Non-Traded REIT that failed.

Look, my view is that that value of liquidity is usually underrated.? Liquid investments allow you to shift when opportunity favors such a move.? Whether you are ready for such a move is another matter, but whether you are ready to give up liquidity should require a similar degree of thinking.

I would not invest in Non-Traded REITs, the protections are lower than comparable investments.? Avoid illiquidity.

Book Review: Reckless Endangerment

Posted on 16 June 2011 by David Merkel

This book on the crisis is different for two reasons:

1) It focuses on the causes of the financial failure, and the history behind them.? It spends relatively little time on the failure in 2008.

2) It spends almost all of its time on the GSEs, Fannie Mae and Freddie Mac.? They were big contributors to the crisis, but they weren’t the majority of the crisis.

This book chronicles the growth of the housing bubble, which was a financing bubble, as most bubbles are.? How did financing for housing get so cheap?

Low interest rates from the Fed.
Lower underwriting standards from Fannie, Freddie, and independent lenders.
Trickery from lenders offering a low initial rate.
Pressure from Congress to make more loans to low-income borrowers who should have been renters.
A mistaken idea that more housing owned by residents was good social policy.

It also describes many of the people who disproportionate benefited from the bubble, and what their motives were for helping to expand the bubble.? It also mentions many who tried to fight the bubble unsuccessfully.? It does *not* mention the “Fannie Fraud Patrol,” who helped to uncover Fannie Mae’s errors in 2003-2004.? It was a loose group of analysts who found inconsistencies in Fannie’s financial statements… we fed OFHEO.? I was one of them, and I have the T-shirt to prove it, even though my contributions were the least of the group.

One? more note: consider Walker Todd, reprimanded by the Fed in 1993 for suggesting that the Fed should not be allowed to bail out non-banks.? Prescient guy, punished of course.? He was one of many who took the chance and fought the Fed or the GSEs.? Almost no one comes out the better for that effort.

Quibbles

The authors blame the rating agencies rather than the regulators that demanded that ratings be used, even if the agencies were less than certain about their models.? Real bond investors never look at the ratings, except as investment policy constraints.

Who would benefit from this book:

It’s an easy read.? This book benefits from having a good writer, and someone who actually knows that markets.? Great combination.? Most people would benefit from this book, because it would disabuse them of the notion that the actions of the government are for the good of the nation.? Special interests won, and many average people lost.

If you want to, you can buy it here: Reckless Endangerment: How Outsized Ambition, Greed, and Corruption Led to Economic Armageddon.

Full disclosure: The publisher asked me if I wanted the book and I said “yes.”