Real Estate and Mortgages – Page 20

A Baker’s Dozen of Notes on the States

Posted on 14 July 2010 by David Merkel

When I wrote my piece Watch the State of the States, I did not expect the degree that it would be picked up by other blogs and media.? I still think the states are critical to watching the well-0being of the nation, and I want to point out a few more items here:

1) There is some good news.? Tax receipts are increasing.? It would be better if the states were getting ahead of spending, excluding recent subsidies from the Federal Government.? When the states get there, unemployment will stabilize.

2) Though conditions in Real Estate are not good in general, there are some bright spots, like condo activity in Miami.? Though renting now, that can plant the seeds of stabilization, because it means there is some bottom-line demand for the space.? It doesn’t have to be torn down to turn it into orange groves. 😉

3) I agree with Felix, muni bond defaults will not prove to be a source of systemic risk.? They are too broadly held; defaults will hurt individuals more than institutions, and it is quite possible that municipalities may make up lost interest payments and become current on their debts again.? Unless defaults cascade, and there is a change in the ethics of municipalities not subject to Chapter 9, the effect should not be large, except on the taxpayers who get milked to pay, and the government employees that get laid off.

Now there are some banks with outsized holdings of munis, but they are not the majority of banks.? And, though I respect David Goldman, I don’t think the default severities will force the Federal Government to bail out municipalities.? The Federal Government may do so anyway, out of intellectual and moral weakness, until its wings get clipped by the global debt markets.? But they don’t HAVE to do it.

4) One last bright spot: more states are looking at hybrid pension plans.? Hybrid plans combine defined contribution and defined benefit plan attributes.? It is one of the few ways of trying to reduce legacy pension promises, if you can get unions and participants to go along with it.

5) But on the negative side, when DB pension funding gets tough, what do plans do?? Stretch for return through alternative investments.? As I have pointed out on endowments, this is not wise unless you are getting more than compensated for the illiquidity risk.

Illiquidity risk is hard to measure, and only the best risk managers know how to handle it.? It comes down to an analysis of illiquid assets versus liabilities, and the need for cash generation for current use.? In my experience, most investors trade away liquidity for illiquidity far too cheaply.

6) Now, the worries are inclining many to shy away from muni bonds.? I would agree with this, though carefully chosen revenue bonds will do well, as will the states that hold good on their promises.

7) Most states are in trouble, so it should not surprise us that Texas is having problems.? It’s in bad shape, but not as bad as many other states.

8 ) Though this is dated, that six states were delaying tax refund payments in June was notable.

9) Five states are getting aid from the Federal Government because they are the worst hit by the fall in housing values.

10) The deficits of many states on a deficit/GDP ratio are worse than Greece; that said, their debts are not nearly as high even if pension deficits are factored in.

11) But states may default anyway to play for time because they are not insolvent but illiquid.? Many just need to get their political will together, and times have not gotten tough enough to force that.? Oh, who knows, maybe they will sell off some state parks?? Or, threaten to cut police rather than less critical spending, in order to force acceptance of tax increases.

12) States are laboratories for policy ideas.? One stinker came out of Massachusetts on health care, and now the Feds are imitating it.? Read this story to see the problems.? Better in my opinion to move the whole country to HSAs.? Costs will drop like a stone, and insurers will starve.

13) This piece argues that the Feds should subsidize some state on a one time basis.? I think not.? If the Feds do subsidize the states, it will become a habit. It has with every other federal involvement in state politics, so we should not do it. It is a good thing that states are being forced to radically trim their budgets. They grew them at far greater than the rate of GDP growth, which was unsustainable. After we cut state services by 20-30%, we should be back to GDP trend. It will force us to prioritize and focus on the things government does well, e.g. justice, security, etc.

Now, I take no delight in the cuts, but states presumed too much out of their tax increases when they were disproportionate the growth in their state economies.? Along with financial firms they rode the leverage bubble up.? It is only fiar now that they ride it back down.? They presumed wrongly that every rise in their tax base was theirs to keep.? Sorry, but it ain’t so.

Fishing at a Paradox. No Toil, No Thrift, No Fish, No Paradox.

Posted on 6 July 20107 July 2010 by David Merkel

Aggregation of economic variables is required for macroeconomic modeling.? One of the largest problems with macroeconomics is whether that aggregation makes sense, or conceals a more dynamic and diverse economy.

The paradox of thrift as proposed by Keynes assumes that all saving is similar.? People invest excess monies in some simple depositary instrument that earns interest.? As people panic over bad economic activity, they save more, driving interest rates lower.? But wait.? What if they don’t place their money in depositary instruments?? What if they pay down debt, whether secured or unsecured?? In that case, banks will find themselves more willing to lend, as the surplus/assets ratio rises.? The liquidity crunch at the banks will lessen.? Or, people may save in a different way, by:

Buying gold, commodities, or non-perishable consumables
Enhancing their homes, cars, etc., making them cheaper to operate, or giving them longer lifespans
Investing in foreign debt instruments

Saving can take many forms, some of which may look like consumption or investment.? The main idea is to direct your excess assets to the place that will give you the best long term benefit.

Even corporations will want to save during a tough environment.? Building up cash balances gives flexibility for the future, and gives options to buy assets cheaply if competitors crater.? Some firms even borrow long-term to have cash on hand.? It’s a negative arb, but it gives the firm flexibility.? But even firms may have alternative ways to save:

Investing in labor-saving or waste reducing technology.
Stockpiling needed nonperishable commodities, or locking in long-term supply agreements, at attractive prices.
Retiring stock or debt through buybacks at attractive prices.

Saving need not be in money markets or banks.? There are many ways to save, and there are always alternative uses for money.? Each economic actor has to find the most fitting savings method for his needs.

Now, recently I ran across a paper called The Paradox of Toil.? The abstract:

This paper proposes a new paradox: the paradox of toil. Suppose everyone wakes up one day and decides they want to work more. What happens to aggregate employment? This paper shows that, under certain conditions, aggregate employment falls; that is, there is less work in the aggregate because everyone wants to work more. The conditions for the paradox to apply are that the short-term nominal interest rate is zero and there are deflationary pressures and output contraction, much as during the Great Depression in the United States and, perhaps, the 2008 financial crisis in large parts of the world. The paradox of toil is tightly connected to the Keynesian idea of the paradox of thrift. Both are examples of a fallacy of composition.

This paper does the same simplifications that Keynes did to produce his paradox of thrift.? There is only one type of labor.? Well, certainly if everyone does the same thing, there are diminishing marginal returns to scale.? Big deal.

But labor is different.? We have the ability to choose different firms to work at.? Not all work is equal, and there are often better and worse opportunities available for labor.? Recessions occur partially because capital and labor are misallocated.? Look for the firms that are showing promise in the recession, and angle to work for them.

But beyond that, workers have one more option: work for yourself; start your own firm.? Find a problem that irritates many, and solve it.? Create a product or service that meets the needs of many.? In a deflationary environment that might mean finding a cheaper way to do things.? But it could be creating a new product that meets needs that people or businesses did not know they wanted.? Go for a Blue Ocean Strategy.

The best businesses are often created in recessions.? Flip the paradox of toil, and work many hours for yourself and your ideals.

Summary

I don’t believe in the paradox of thrift or the paradox of toil.? They are bogus results of oversimplified models that do not reflect reality.? As an investor and an economic historian, I know of many times where massive amounts of money were allocated to a single asset class or a single sector of the market.? If everyone follows a mania strategy, whether due to greed or panic, I can guarantee that there will be a bad result.

The dot-coms of the late ’90s
The one decision stocks of the ’60s.
Gold in the ’70s.
Railroads in the late 1800s.
Buying stocks in the 1920s.
Selling stocks in the 1930s.
Selling bonds in the early ’80s.
The mercantilist era — exporting cheaply to get gold, then getting less in return when liquidating the gold.

I could go on to various manias in earlier eras, less well-known manias, or individual stocks, but that wouldn’t help make my case any more than I have already.? The main point is the same.? Anytime everyone does the same thing, it is foolish.? It would be stupid for everyone to save using T-bills, or sell their excess labor to agricultural day labor.

I trust intelligent people to seek their best advantage in the markets.? That does not mean that foolish people will not get hosed.? That’s the nature of being foolish.? But bright people see recessions as a time to reorient and look ahead, to see what the new economy will want, and ignore what the old economy wanted.

So, I don’t see any value in:

Stimulus programs that don’t produce economic value.? If it only pays a wage, that is destructive.? For stimulus to be effective it must produce infrastructure that lowers the costs of the economy.? Think of all the useless projects built in Japan.
Paying extended unemployment benefits.? Additional consumption today, plus debt tomorrow is a recipe for economic lethargy.
Running large deficits.? If the money is not being spent on something that will produce future growth, it is a loss.
Bailouts of large financial institutions.? We have too many of those.
Housing tax credits.? We have too many houses.
Bailing out auto companies.? Too many autos are made in our world today.
Bailing out the GSEs.? They are deadweight losses.? Let them die, and let the senior bondholders feel the pain.? Let the junior bondholders be wiped out.
Monetary policy that steals from savers, thus depriving the private capital markets of a supply of private capital for productive investments, rather than the government absorbing most of the capital at low rates, and wasting the money on less productive projects.

Don’t listen to the fools that insist that we must run huge deficits and run a loose monetary policy.? A “big bang” would be preferable to the “Chinese water torture” that we are now undergoing.? Far better to take a short dose of sharp pain, where asset prices fall, some more banks fail, and bad debts are purged from the system, than to endure another lost decade, where the ability to employ capital productively is difficult.

As it is, we are pursuing the Japan solution to our overleverage.? They have had two lost decades, and are starting on their third lost decade.? Is that what we want?

11 Notes

Posted on 18 June 2010 by David Merkel

Internet issues are resolved, so here’s a post of things that built up while things were down.

1) You know that I have mixed feelings about the Fed.? They have done a poor job with bank regulation, monetary policy, and managing systemic risk.? The trouble is, if you?re going to have a fiat currency, monetary policy is credit policy, and so your central bank should broadly control credit if you are going to do that at all.? (If not, then set up a currency board, or back your currency with silver/gold.)

So when I hear that the Fed is winning in reconciliation of the finance bill, I think it is good in some ways ? yes, they should oversee small banks, but bad because the Fed should not have bailout authority, or at least they should not be able to hide what they do when monetary policy is unorthodox.? It is one thing to delay oversight of ordinary dealings, but rotten to hide debasement of the currency through special dealings with favored entities.

But I see little value in the size of the Fed.? They have too many people doing too little.? Monetary policy and bank supervision?? Fine if they do it well.? But the institution as a whole could be radically slimmed.? Congress should take closer control of the Fed, slim it down, and focus it on the missions that it should attend to.

2) I am not impressed with Donald Kohn.? He has a farewell interview with the Wall Street Journal, and not once does he mention the buildup of debt in our economy, partially fostered by easy monetary policy from the Fed, as a problem.? Blind guy, and even worse, he still doesn?t get that bubbles are typically able to be seen in advance, or, that the Eurozone isn?t structurally flawed.

Thought experiment time.? What if we tossed out all the Fed governors, and replaced them with a bunch of notable value investors?? Value investors suffer from the problem that we see problems early, and adjust portfolios too soon.? That could be of benefit to monetary policy, because value investors often see when things are becoming overdone, well in advance of it becoming too big to handle.? This would be a big improvement on the current system.

3) I get email from congressional staffs asking for advice on issues, or asking me to write about them.? Recently I was asked what I would ask the nominees for the Federal Reserve Board.? This is what I said:

We find ourselves in this crisis because the Fed ran an asymmetric monetary policy for years: loosen aggressively when the least crisis comes up, and tighten slowly until there are small squeaks of pain.? This led short interest rates progressively lower, until we found ourselves in the liquidity trap that we are now experiencing.? How are you going to get us out of this liquidity trap?

How are you going to provide decent opportunities to savers so that capital formation can begin again?

What have you done in your life that qualifies you for this level of responsibility?

To the economists: neoclassical economics did us no favors with respect to this crisis.? Only a few Austrian economists predicted it, along with a few practical economists in the business world.? We need a new paradigm for monetary policy.? Are you capable of providing it?

To the non-economist:?You will be working primarily with neoclassical economists, with their theories uncontaminated by?data.? How will you avoid being sucked in by their groupthink?

4) When I went to hear Raghuram Rajan and Carmen Reinhart at the Cato Institute, I was very impressed with what both of them had to say.? Rajan was the skunk at the farewell party for Alan Greenspan back in 2005 at Jackson Hole, when he was the only one to fully suggest that imbalances were building up due to debts being incurred in the financial sector.? Few aside from The Economist noted what he said.? More noted Donald Kohn?s dismissive response, which was not erudite, in my opinion.

Both noted that the current financial reform bill would do little to fix the real underlying problems, with which I agree.? It constrains in many areas that don?t need it, and does not constrain areas that were significant to the crisis ? e.g., the GSEs and the Fed.? Imagine a simple proposal that would immediately force flexibility onto the economy: dividends are deductible, but interest payments (and preferred dividends) are not.? An easy way to lower leverage, and encourage flexible finance.

Also, they noted the possibility that the US Government would engage in financial repression, which would force people to invest in government securities on unfavorable terms.? Ugly stuff.

And as an aside, we met in the F. A. Hayek Auditorium.

5) Can Hayek be cool?? Perhaps, give the recent rap video.? I am not surprised that few neoclassical economists give Hayek any credit; he cuts against most of what they stand for, so why should they commit treason?

As for Glenn Beck, I get tired very quickly of the facile answers that appeal to the anger of the masses.? There are real problems, and we need to deal with them, but oversimplifying the problems will not get us to the solutions; it will only create a new set of problems.? I have no favor toward the Tea Party; they don?t stand for anything coherent.? I am not an Austrian economist, much as I like some of their ideas.? My ideas have been derived from my observation of how financial systems work over the last 25 years.

6) Following Austrian economics would be a huge improvement over what we usually do, though there is a problem.? Once you hit the bust, nothing works.? The Austrian view will be a ?big bang? and clean it up fast, but it will be a lot of sharp pain.? The virtue of Austrian Economics is that it would restrain the boom, and thus make it less likely that one faces the pains of the bust.? But there are no easy solutions in the bust.

Focus on the boom, not the bust.? Solve the boom, and the bust does not come.

7) It is common that many debt classes that have few defaults get an aura about the qualitative factors that forestall default.? Well, what of municipal finance?? Under stress, is it possible that the cultural factors that made default less likely might wither, and defaults cascade in likelihood?? Yes, I think that is possible, and I think that is why Buffett is lightening the boat on munis.

8 ) Solve the revolving door problem for the SEC?? Pay them more.? I get it, but are we really willing to pay market-based salaries for expertise?? I doubt it.? The government tends to be chintzy; penny wise and pound foolish.

But if you hired real experts, would the government be willing to set them free and let them corner real frauds?? That is the question.

9) Fannie and Freddie common stocks are on their way to zero.? Their NYSE delisting is just one more step in the road to total dissolution.? The simplest solution is to fold them into GNMA, and slim down the massive operations that don?t do much for the mortgage market.

10) The unequal signal problem exists with the banks that took TARP money.? We hear a lot about those that repay, but little about those that do not pay.? Well, here is an article about those who did not pay.

11) Evan Newmark is occasionally annoying, but often perceptive.? Should President Obama do what he does not want to do?? It couldn?t hurt; his allies on the far left are already disaffected. The question is whether he can be as dispassionate as Bill Clinton, and pursue a centrist course.? I don?t think he is capable of that, because he is too smart, and smart people, unless they moderate their idealism, don?t compromise well.

That?s all for now.

The Rules, Part XV

Posted on 19 May 201020 June 2017 by David Merkel

What if securitization allows the economy to expand more rapidly than it would at a price of volatility, when intermediaries would prove useful?

Sometimes securitization and tranching creates securities for which there is no native home.

As the life insurance industry shrinks, it will be hard to find buyers for subordinated structured product.

Securitization is an interesting phenomenon.? Take a group of simple securities, like commercial or residential mortgages, and carve the cashflows up in ways that will appeal to groups of investors.? Do investors want ultrasafe investments?? Easy, carve off a portion of the investments representing the largest loss imaginable by most investors.? The remainder should be rated AAA (Aaa if you speak Moody’s).? Then find risk taking parties to buy the portion that could suffer loss, at ever higher yields for those that are willing to take realized losses earlier.

What’s that, you say?? What if you can’t find buyers willing to buy the risky parts of the deal at prices that will make the securitization work?? Easy, he will take the loans and sell them as a block to a bank that will want them on its balance sheet.

That said, securitized assets are typically most liquid near the issuance of the deal, with the short, simple and AAA portions of the deal retaining their liquidity best.? Suppose you hold a security that is not AAA, or complex, or long duration, and you want to sell it.? Well, guess what?? Now you have to engage in an education campaign to get some bond manager to buy it, or, take a significant haircut on the price in order to move the bond.

It helps to have a strong balance sheet.? If the credit is good, even if obscure, a strong balance sheet can buy off the beaten path bonds, and hold them to maturity if need be.? And yet, there is hidden optionality to having a strong balance sheet — you can buy and hold quality obscure bonds, but if thing go really well, you can sell the bonds to anxious bidders scrambling for yield, while you hold more higher quality bonds during a yield mania.

Endowments, defined benefit pension plans, and life insurance companies have those strong balance sheets.? They do not have to worry that money will run away from them.? The promises that these entities make are long duration in nature.? They have the ability to invest for the long-run, and ignore short-term market fluctuations, even more than Buffett does, if they are so inclined.

If there was a decrease in the buying power of institutions with long liability structures, we would see less long term investing in fixed income and equity investments.? Investments requiring a lockup, like private equity and hedge funds, would shrink, and offer higher prospective yields to get deals done.

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But what of my first point?? There are securitization trusts, and there are financial companies.? During a boom phase, the securitization trusts can finance assets cheaply.?? During a bust phase, the securitization trusts have a lot of complicated rules for how to deal with problem assets.? Financial companies, if they have adequate capital, are capable of more flexible and tailored arrangements with troubled creditors.? Having a real balance sheet with slack capital has value during a financial crisis.? Securitization trusts follow rules, and have no slack capital.? Losses are delivered to the juniormost security.

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Sometime around 2004, a light went on in the life insurance industry regarding non-AAA securitized investments.? In 2005, with a few exceptions, the life insurance industry stopped buying them.? AIG was a major exception.? The consensus was that the extra interest spread was not worth it.? Fortunately for the investment banks there were a lot of hedge funds willing to take such risks.

There should be some sort of early warning system that clangs when the life insurance industry stops buying, and those that buy in their absence have weaker balance sheets.? When risky assets are held by those with weak balance sheets, it is a recipe for disaster.

-=-=-=-=-=-=-=-=-=-=-=-=-===-=-=-=-=-

During the boom phase, securitization trusts provide capital, cheaper capital than can be funded through banks.? That allows the economy to grow faster for a time, but there is no free lunch.? Eventually economic growth will revert to mean, when securitizations show bad credit results, and the economy has to slow down to absorb losses.

In addition, when losses come, loss severities will tend to be higher than that for corporates.? Usually a tranche offering credit support will tend to lose all of its principal, or none.? (Leaving aside early amortization and the last tranche standing in the deal.)? For years, the rating agencies and investment banks argued that losses on securitized products were a lot lower than that for corporates, because incidence of loss was so low on ABS, CMBS and non-conforming RMBS.? But the low incidence was driven by how easy it was to find financing, as lending standards deteriorated.

Thus, securitization allowed more lending to be done.? First, originators weren’t retaining much of the risk, so they could be more aggressive.? Second, the originators didn’t have to put up as much capital as they would if they had to hold the loans on a balance sheet.? Third, there were a lot of buyers for higher-rated yieldy paper, and ABS, CMBS and non-conforming RMBS typically offered better yields, and seemingly lower losses (looking through the rear-view mirror).? What was not to like?

What was not to like was the increased leverage that it allowed the whole system to run at.? Debt levels increased, and made the system less flexible.?? Investors were fooled into thinking that assets were worth a lot more than they are worth today because of the temporary added buying power from applying additional debt financing to the assets.

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Securitization has been a mixed blessing to investors.? It is brilliant during the boom phase, and exacerbates trouble during the bust phase.? And so it is.? As you evaluate financial companies, have a bias against clipping yield.

Regulators, as you evaluate risk-based capital charges, do it in such a way that securitized products get penalized versus equivalently-rated corporates.? Just add enough RBC such that it takes away any yield advantage versus holding it on balance sheet, or versus the excess yield on equivalently rated average corporates.? It’s not a hard calculation to run.

=-=–==-=-

Off-topic end to this post.? I added Petrobras to my portfolio today.? Bought a little Ensco as well.? I haven’t been posting as much lately since I was busy with two things: studying for my Series 86 exam, which I take tomorrow, and I gave a presentation on AIG to staff members on the Congressional Oversight Panel the oversees the TARP yesterday.? Good people; they seemed to appreciate what I wrote on AIG’s domestic operating subsidiaries last year.

Full disclosure: Long PBR ESV

The Rules, Part XIV & Thoughts on Maiden Lane LLC, Part 1

Posted on 18 May 201020 June 2017 by David Merkel

Prepayment and default are dual to each other.? The less likely is default, the more likely is prepayment, and vice-versa.

In a pool of loans, the critical distinction is the likelihood of loans to prepay or default.? Just because prepayment has been high, does not mean the remainder won?t default under stress.

I don’t have clear answers to Maiden Lane LLC, the bailout of Bear Stearns yet.? The complexity of Maiden Lane LLC, as compared to Maiden Lane 2 or 3, is enormous.? I have a more work to do.? But, at least, I have scrubbed the data, and figured our what the Fed released to us.

In the Bear Stearns bailout, the Fed received a wide variety of securities, including:

Cash

CDOs

Comm RE WLs

CRE Notes

Agency pools

Agency MBS

WL MBS

ABS

Res Re WLs

Treasuries

CDS CDOs

CMBX

CDS Corporate

CDS CRE Securities

CDS Municipal

CDS WL MBS

CDS ABS

Interest Swaps

Maiden Lane 2 & 3 were simple compared to this, and this had over 10x the securities of both combined. Plus, this had CDS transactions which would profit from failure of a wide variety of assets.

Additional difficulties included a lot of coding difficulties on the CDS.? The Fed did not try to make things clear.? I spent many hours trying to clarify the tranches in question.? A few of them are guesses, but 99% are reliable.

The Fed’s principal figures were original principal figures not those for current principal.? That was another area of ambiguity.

After all that, here is my breakdown of?the assets by original principal:

And, here is my breakdown of the assets by current principal:

–

The current value of what is owed to the Fed is over $28 billion.? There is almost $49 billion in current principal, so why worry?

Worry because of all of the interest only securities.? The principal for them is notional; principal payments will never be made.? With CMBS, I know that IO securities are typically worth no more than 5% of the notional principal balance.? Because most CMBS protect against prepayment, the prices of interest only securities reflect? the likelihood of default.? Though they are rated AAA, their creditworthiness is more like BB.

With Residential mortgages, the question is harder.? How big is the interest margin, and when might it cut off due to default or prepayment?? Interest only securities are typically worth a lot less then the? notional principal.? Same for principal only securities.? Their value is the likelihood of payment discounted by the length of time until payment.

Beyond that, there are the residential and commercial loans made, with almost $10 billion of principal, for which we have no idea of the creditworthiness.? Are there any statistics on the currency of the collateral?? The Fed had not deigned to tell us.? I place the creditworthiness at BB, but who knows for sure?

I can tell you now that the securities involved were mostly originated 2005-2007, during the worst of the underwriting cycle.? Is it any surprise?? Few can escape the credit cycle.? Within a given credit cycle, the credit quality of securities originated declines all of the way till slightly past the peak of the credit cycle.

I am going to do more analysis of the RMBS, so that I can get a better feel for the value there.? It is not clear to me whether Maiden Lane LLC is adequately funded or not.? The high degree of junk, whole loans, and interest only securities gives me doubt.

The Rules, Part XIII, subpart C

Posted on 4 May 201020 June 2017 by David Merkel

The need for income naturally biases a portfolio long.? It is difficult to earn income without beneficial ownership of an asset ? positive carry trades will almost always be net long, absent major distress or dislocation in the markets.? Those who need income to survive must then hope for a bull market.? They cannot live well without one, absent an interest rate spike like the late 70s/early 80s.? But in order to benefit in that scenario, they had to stay short.

More with Less.? Almost all of us want to do more with less.? Save and invest less today, and make up for it by investing more aggressively.? We have been lured by the wrongheaded siren song that those who take more risk earn more on average.? Rather, it is true 1/3rd of the time, and in spectacular ways.? Manias are quite profitable for investors until they pop.

As I have said many times before, the lure of free money brings out the worst in people.? Few people are disposed to say, “On a current earnings yield basis, these investments yield little.? I should invest elsewhere,”? when the price momentum of the investment is high.

I will put it this way: in the intermediate-term, investing is about buying assets that will have good earnings three or so years out relative to the current price.? Whether one is looking at trend following, or buying industries that are currently depressed, that is still the goal.? What good investments will persist?? What seemingly bad investments will snap back?

That might sound odd and nonlinear, but that is how I think about investments.? Look for momentum, and analyze low momentum sectors for evidence of a possible turnaround.? Ignore the middle.

Less with More.? Doesn’t sound so appealing.? I agree.? As a bond manager, I avoided complexity where it was not rewarded.? I was more than willing to read complex prospectuses, but only when conditions offered value.? Away from that, I aimed at simple situations that my team could adequately analyze with little time spent.

That is one reason why I am not sympathetic to those who lost money on CDOs.? We had two prior cycles of losses in CDOs — a small one in the late ’90s, and a moderate one around 2001-2003.? CDOs are inherently weak structures.? That is why they offer considerably more yield relative to similarly rated structured assets.

So, for those buying CDOs backed by real estate assets mid-decade in the 2000s, I say they deserved to lose money.? Not only were they relying on continued growth in real estate prices, but they were reaching for yield in a low yield environment.? Goldman and other investment banks may have facilitated that greed, but the institutional investors happily took down the extra yield.? No one held guns to their heads.? The only question that I would raise is whether they disclosed all material risk factors in their prospectuses.? (Not that most institutional investors read those — they call it “boilerplate.”)

Reaching for yield always has risks, but the penalties are most intense at the top of the cycle, when credit spreads are tight, and the Fed’s loosening cycle is nearing its end.? It is at that point that a good bond manager tosses as much risk as he can overboard without bringing yield so low that his client screams.

Perhaps the client can be educated to accept less yield for a time.? I suspect that is a losing battle most of the time, because budgets are fixed in the short-run, and many clients have long term goals that they are trying to achieve — actuarial funding targets, mortgage payments, college tuition, cost of living in retirement, endowment spending rule goals, implied cost of funds, etc.

That’s why capital preservation is hard to achieve, particularly for those that have fixed commitments that they have to meet.? It is impossible to serve two masters, even if the goals are preserving capital and meeting fixed commitments.? Toss in the idea of beating inflation, and you are pretty much tied in knots — it goes back to my “Forever Fund” problem.

This third subpart ends my comments on this rule.? You’ve no doubt heard the Wall Street maxim, “Bulls make money; Bears make money; Hogs get slaughtered.”? Yield greed is one of the clearest examples of hogs getting slaughtered.? So, when yield spreads are tight (they are tight relative to risk now, but could get tighter), and the Fed nears the end of its loosening cycle (absent a crisis, they are probably not moving until unemployment budges, more’s the pity), be wary for risk.? Preserve capital.

The peak of the cycle may not be for one to three years, or an unimaginable crisis could come next month.? Plan now for what you will do so that you don’t mindlessly react when the next bear market in credit starts.? It will be ugly, with sovereigns likely offering risk as well.? At this point, I wish I could give simple answers for here is what to do.? What I will do is focus on things that are very hard for people to do without, and things that offer inflation protection.? What I will avoid is credit risk.

The Rules, Part XII

Posted on 30 April 201020 June 2017 by David Merkel

Growth in total factor outputs must equal the growth in payment to inputs.? The equity market cannot forever outgrow the real economy.

This is the “real economy rule,” and was listed first in my document, but i have not gotten to it until now.? It is very important to remember, because men are tempted to forget that financial markets depend on the real economy.? If the global economy grows at a 3% rate, well guess what?? In the long run, payments to the factors — wages, interest, rents, and profits will also grow at a 3% rate.? Maybe some of the factor payments will grow faster, slower, or even shrink, but you can’t get more out of the system than the system produces year by year.

The value of equity is the capitalized value of the profit stream.
The value of debt is the capitalized value of the interest stream.
The value of property, plant and equipment is the capitalized value of the rent stream.
The value of a slave/employee is the capitalized value of the wage stream.

Hmm, that last one doesn’t sound right.? We no longer capitalize people, as if one could legally own a person today.? Contracts for labor are short-term, and employees typically can leave at will.

But, there can be bubbles in property, debt and equity markets.? We just happen to be the beneficiaries of a situation where we have simultaneously had bubbles in all three.? Think of late 2006 — high values for residential and commercial real estate, low credit spreads, and high P/Es (relative to future profits).? Market participants expected far more growth than the overindebted economy could deliver.

Important here are the discount rates.? By asset class, relatively low discount rates relative to swap or Treasury yields indicate complacency.? It is one thing if stocks move up because profits are rising rapidly, and another if the discount rate is declining.? Similarly, it is one thing if stocks are rising because GDP is growing rapidly, and thus revenues are rising, and another thing if it is due to profit margins rising, and profit margins are near record levels, as they are today.

Extreme profit margins invite competition.? Extreme profit margins tend not to last.

In many asset classes, investors were fooled.? Home buyers bought thinking the prices could only go up.? They ignored the high ratio of property value relative to what they would currently pay.? Commercial real estate investors bought at lower and lower debt service coverage ratios.? Collateralized debt investors accepted lower and lower interest spreads at higher and higher degrees of leverage.? With equity, investor assumed that growth in asset values in excess of growth in GDP would continue.? The stock market does grow faster than GDP, but the advantage is less than double GDP growth.

Thus after the long rally, with no appreciable growth in the economy, I would be careful about equities, and corporate debt as well.? Some yields are high relative to long run averages, but the risk is higher as well.

The main point is to remember that the real businesses behind the financial markets drive performance in the long haul, even if adjustments to the discount rate do it in the short run.? To be an excellent manager, focus on both factors — likely payments, and rate at which to discount.? But who can be so wise?

FOMC Comparison April 2010

Posted on 29 April 2010 by David Merkel

Sorry that I did not do this in real time.? When the FOMC released its report, I was with my sons touring college campuses.? Anyway, here is the comparison:

David J. Merkel, CFA, FSA

28 April 2010

April 2010 Redacted FOMC Statement

March 2010	April 2010	Comments
Information received since the Federal Open Market Committee met in January suggests that economic activity has continued to strengthen and that the labor market is stabilizing.	Information received since the Federal Open Market Committee met in March suggests that economic activity has continued to strengthen and that the labor market is beginning to improve.	They shade their views up a bit on the labor market.? I think that is premature.? They are missing the weakness in employment.
Household spending is expanding at a moderate rate but remains constrained by high unemployment, modest income growth, lower housing wealth, and tight credit.	Growth in household spending has picked up recently but remains constrained by high unemployment, modest income growth, lower housing wealth, and tight credit.	No real change, though they shade their views up a bit on the labor market.? There is little growth in household spending.
Business spending on equipment and software has risen significantly. However, investment in nonresidential structures is declining, housing starts have been flat at a depressed level, and employers remain reluctant to add to payrolls.	Business spending on equipment and software has risen significantly; however, investment in nonresidential structures is declining and employers remain reluctant to add to payrolls. Housing starts have edged up but remain at a depressed level.	Shades up housing.
While bank lending continues to contract, financial market conditions remain supportive of economic growth.	While bank lending continues to contract, financial market conditions remain supportive of economic growth.	No change.
Although the pace of economic recovery is likely to be moderate for a time, the Committee anticipates a gradual return to higher levels of resource utilization in a context of price stability.	Although the pace of economic recovery is likely to be moderate for a time, the Committee anticipates a gradual return to higher levels of resource utilization in a context of price stability.	No change.
With substantial resource slack continuing to restrain cost pressures and longer-term inflation expectations stable, inflation is likely to be subdued for some time.	With substantial resource slack continuing to restrain cost pressures and longer-term inflation expectations stable, inflation is likely to be subdued for some time.	No real change.
The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period.	The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period.	No change.? This gives you the trigger for when they will raise the Fed Funds rate.? As I said last month, watch capacity utilization, unemployment, inflation trends, and inflation expectations.
To provide support to mortgage lending and housing markets and to improve overall conditions in private credit markets, the Federal Reserve has been purchasing $1.25 trillion of agency mortgage-backed securities and about $175 billion of agency debt;		Paragraph dropped.? MBS purchases are done.
those purchases are nearing completion, and the remaining transactions will be executed by the end of this month.		Paragraph dropped.? MBS purchases are done.
The Committee will continue to monitor the economic outlook and financial developments and will employ its policy tools as necessary to promote economic recovery and price stability.	The Committee will continue to monitor the economic outlook and financial developments and will employ its policy tools as necessary to promote economic recovery and price stability.	No change.
In light of improved functioning of financial markets, the Federal Reserve has been closing the special liquidity facilities that it created to support markets during the crisis. The only remaining such program, the Term Asset-Backed Securities Loan Facility, is scheduled to close on June 30 for loans backed by new-issue commercial mortgage-backed securities and on March 31 for loans backed by all other types of collateral.	In light of improved functioning of financial markets, the Federal Reserve has closed all but one of the special liquidity facilities that it created to support markets during the crisis. The only remaining such program, the Term Asset-Backed Securities Loan Facility, is scheduled to close on June 30 for loans backed by new-issue commercial mortgage-backed securities; it closed on March 31 for loans backed by all other types of collateral.	No real change.
Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; James Bullard; Elizabeth A. Duke; Donald L. Kohn; Sandra Pianalto; Eric S. Rosengren; Daniel K. Tarullo; and Kevin M. Warsh. Voting against the policy action was Thomas M. Hoenig, who believed that continuing to express the expectation of exceptionally low levels of the federal funds rate for an extended period was no longer warranted because it could lead to the buildup of financial imbalances and increase risks to longer-run macroeconomic and financial stability.	Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; James Bullard; Elizabeth A. Duke; Donald L. Kohn; Sandra Pianalto; Eric S. Rosengren; Daniel K. Tarullo; and Kevin M. Warsh. Voting against the policy action was Thomas M. Hoenig, who believed that continuing to express the expectation of exceptionally low levels of the federal funds rate for an extended period was no longer warranted because it could lead to a build-up of future imbalances and increase risks to longer run macroeconomic and financial stability, while limiting the Committee?s flexibility to begin raising rates modestly.	Hoenig dissents, as last month.? Thinks that we might be starting a new financial bubble, and that it might affect future FOMC policy, making a shift more severe.

Comments

The FOMC is overly optimistic on employment and housing issues.
Hoenig still dissents; hasn?t gotten bored with it yet.
Watch capacity utilization, unemployment, inflation trends, and inflation expectations.
As a result, the FOMC ain?t moving, absent increases in employment, or a US Dollar crisis.? Labor employment is the key metric.

Industry Update April 2010

Posted on 25 April 2010 by David Merkel

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With regard to equity market performance, I am torn.? My head says, “Go with the momentum. Broad rally here.”? My heart says, “Profit margins will be at records with the 2011 earnings estimates; aim for industries that are out of favor.”

If I try to unify the two, I remain convinced that high quality companies are the better place to be — better valuations and far less risk.

In any case, I am looking at modifying my portfolio, and the industries that interest me fall into energy, utilities, healthcare, and stable sectors.

Note for my first model, the green zone is the anti-momentum or value zone.? The red zone is the momentum zone.

Use the model consistent with your personality.? If you like buying mean-reversion buy in the green zone.? Momentum, buy the red zone.

My selections in “Dig Through” reflect higher quality areas of the market that I think will be rewarded over time.? Remember that I am for outperformance over a three-year period, though I have often done that over shorter periods.

The second industry table comes from the S&P 1500 supercomposite, while the first comes from Value Line.? The results are broadly similar.? Still, at this point in the markets, I am more inclined to caution than risk-taking.? I feel that it is 10% upside and 30% downside here.

These are only educated guesses, but as I readjust my portfolio, I sense that I will toss out cyclicality, and buy utilities and other stable? companies.

In Defense of the Rating Agencies ? V (summary, and hopefully final)

Posted on 23 April 2010 by David Merkel

I write this because I was invited to be on CNBC on the topic, but I suggested that my opinion would not make for good television.? That said, I have taken my four prior posts on the topic, and assembled them into one comprehensive post.? I do not intend on posting on this again.? With that, here is my post:

The ratings agencies have come under a lot of flak recently for rating instruments that are new, where their models might not be do good, and for the conflicts of interest that they face.? Both criticisms sound good initially, and I have written about the second of them at RealMoney, but in truth both don?t hold much water, because there is no other way to do it.? Let those who criticize put forth real alternatives that show systematic thinking.? So far, I haven?t seen one.

Most of the current problems exist in exotic parts of the bond market; average retail investors don?t have much exposure to the problems there, but only less-experienced institutional investors.

Here are my five realities:

Somewhere in the financial system there has to be room for parties that offer opinions who don?t have to worry about being sued if their opinions are wrong.
Regulators need the ratings agencies, or they would need to create an internal ratings agency themselves, or something similar.? The NAIC SVO is an example of the latter, and proves why the regulators need the ratings agencies.? The NAIC SVO was never very good, and almost anyone that worked with them learned that very quickly.
New securities are always being created, and someone has to try to put them on a level playing field for creditworthiness purposes.
There is no way to get investors to pay full freight for the sum total of what the ratings agencies do.
Ratings can be short-term, or long-term, but not both.? The worst of all worlds is when the ratings agencies shift time horizons.

Ratings are Opinions

The fixed-income community has learned that the ratings agencies offer an opinion, and they might pay for some additional analysis through subscriptions, but if they were forced to pay the fees that issuers pay, they would balk; they have in-house analysts already.? The ratings agencies aren?t perfect, and good buy-side shops use them, but don?t rely on them.? Only rubes rely on ratings, and sophisticated investors did not trust the rating agencies on subprime.? My proof?? Look how little exposure the Life and P&C insurance industries had to subprime mortgages outside of AIG.? Teensy at best.

Please understand that institutions own most of the bonds out there.? We had a saying in a firm that I managed bonds in, ?Read the write-up, but ignore the rating.?? The credit analysts at the rating agencies often knew their stuff, giving considerable insight into the bonds, but may have been hemmed in by rules inside the rating agency regarding the rating. It?s like analysts at Value Line.? They can have a strong opinion on a company, but their view can only budge the largely quantitative analysis a little.

Let?s get one thing straight here.? The rating agencies will make mistakes.? They will likely make mistakes on a correlated basis, because they compete against one another, and buyers won?t pay enough to support the ratings.

So there are systematic differences and weaknesses in bond ratings, but the investors who own most of the bonds understand those foibles.? They know that ratings are just opinions, except to the extent that they affect investment policies (?We can?t invest in junk bonds.?) or capital levels for regulated clients.

On investment policies, whether prescribed by regulators or consultants, ratings were a shorthand that allow for simplicity in monitoring (see Surowiecki?s argument).? Now, sophisticated investors knew that AAA did not always mean AAA.? How did they know this?? Because the various AAA bonds traded at decidedly different interest rates.? The more dodgy the collateral, the higher the yield, even if it had a AAA rating.? My mistake: I, for one, bought some AAA securitized franchise loan paper that went into default long before the current crisis hit.? Many who bought post-2000 AAA securitized manufactured housing loan paper are experiencing the same.? Early in the 2000s, sophisticated investors got burned, and learned.? That is why few insurers have gotten burned badly in the current crisis.? Few insurers bought any subprime residential securitizations after 2004.? But, unsophisticated investors and regulators trust the ratings and buy.

Financial institutions and regulators have to be ?big boys.? If you were stupid enough to rely on the rating without further analysis, well, that was your fault.? If the ratings agencies can be sued for their opinions (out of a misguided notion of fiduciary interest), then they need to be paid a lot more so that they can fund the jury awards.? Their opinions are just that, opinions.? As I said before, smart institutional investors ignore the rating, and read the commentary.? The nuances of opinion come out there, and often tell smart investors to stay away, in spite of the rating.

How Can Regulators Model Credit Risk?

It started with this piece from FT Alphaville, which made the point that I have made, markets may not need the ratings, but regulators do.? (That said, small investors are often, but not always, better off with the summary advice that bond ratings give.)? The piece suggests that CDS spreads are better and more rapid indicators of change in credit quality than bond ratings.? Another opinion piece at the FT suggests that regulators should not use ratings from rating agencies, but does not suggest a replacement idea, aside from some weak market-based concepts.

Market based measures of creditworthiness are more rapid, no doubt.? Markets are faster than any qualitative analysis process.? But regulators need methods to control the amount of risk that regulated financial entities take.? They can do it in four ways:

Let the companies tell you how much risk they think they are taking.
Let market movements tell you how much risk they are taking.
Let the rating agencies tell you how much risk they are taking.
Create your own internal rating agency to determine how much risk they are taking.

The first option is ridiculous.? There is too much self-interest on the part of financial companies to under-report the amount of risk they are taking.? The fourth option underestimates what it costs to rate credit risk.? The NAIC SVO tried to be a rating agency, and failed because the job was too big for how it was funded.

Option two sounds plausible, but it is unstable, and subject to gaming.? Any risk-based capital system that uses short-term price, yield, or yield spread movements, will make the management of portfolios less stable.? As prices rise, capital requirements will fall, and perhaps companies will then buy more, exacerbating the rise.? As prices fall, capital requirements will rise, and perhaps companies will then sell more, exacerbating the fall.

Market-based systems are not fit for use by regulators, because ratings are supposed to be like fundamental investors, and think through the intermediate-term.? Ratings should not be like stock prices ? up-down-down-up.? A market based approach to ratings is akin to having momentum investors dictating regulatory policy.

Also, their models that I am most familiar with only apply to publicly-traded corporate credit.? Could they have prevented the difficulties in structured credit that are the main problem now?

What to do with New Classes of Securities?

Financial institutions will want to buy new securities, and someone has to rate them so that proper capital levels can be held (hopefully).? But what are rating agencies to do when presented with novel financial instruments that have no significant historical loss statistics?? Many of the likely buyers are regulated, and others have investment restrictions that depend on ratings, so aside from their own profits, there is a lot of pressure to rate the novel financial instrument.? A smart rating agency would punt, saying there is no way to estimate the risk, and that their reputation is more important than profits.? Instead, they do some qualitative comparisons to similar?but established financial instruments, and give a rating.

Due to competitive pressures, that rating is likely to be liberal, but during the bull phase of the credit markets, that will be hidden.? Because the error does not show up (often) so long as leverage is expanding, rating agencies are emboldened to continue the technique.? As it is, when liquidity declines and leverage follows, all manner of errors gets revealed.? Gaussian copula?? Using default rates for loans on balance sheet for those that are sold to third parties?? Ugh.

Some will say that rating agencies must say ?no? to Wall Street when asked to rate exotic types of debt instruments that lack historically relevant performance data.? That?s a noble thought, but were GICs [Guaranteed Investment Contracts] exotic back in 1989-1992?? No.? Did the rating agencies get it wrong?? Yes.? History would have said that GICs almost never default.? As I have stated before, a market must fail before it matures.? After failure, a market takes account of differences previously unnoticed, and begins to prospectively price for risk.

But think of something even more pervasive.? For almost 20 years there were almost no losses on non-GSE mortgage debt.? How would you rate the situation?? Before the losses became obvious the ratings were high.? Historical statistics vetted that out.? No wonder the levels of subordination were so small, and why AAA tranches from late vintages took losses.

When prosperity has been so great for so long, it should be no surprise that if there is a shift, many parties will be embarrassed.? In this case both raters and investors have had their heads handed to them.

Now there are alternatives.? The regulators can ban asset classes until they are seasoned.? That would be smart, but there will be complaints.? I experienced in one state the unwillingness of the regulators to update their permitted asset list, which had not been touched since 1955.? In 2000, I wrote the bill that modernized the investment code for life companies; perhaps my grandson (not born yet), will write the next one.

Regulators are slow, and they genuinely don?t understand investments.? The ratings agencies aren?t regulators, and they should not be put into that role, because they are profit-seeking companies. Don?t blame the rating agencies for the failure of the regulators, because they ceded their statutory role to the rating agencies.? But if the regulators ban asset classes, expect those regulated to complain, because they can?t earn the money that they want to, while other institutions take advantage of the market inefficiencies.

Compensation and Conflicts

Some say that rating agencies must be encouraged to make their money from investor subscriptions rather than fees from issuers, to ensure more impartial ratings.? If this were realistic, it would have happened already.? The rating agencies would like nothing more than to receive fees from only buyers, but that would not provide enough to take care of the rating agencies, and provide for a profit.? They don?t want the conflicts of interest either, but if it is conflicts of interest versus death, you know what they will choose.

Short vs. Long-Term Opinions

Ratings agency opinions are long-term by nature, rating over a full credit cycle.? During panics people complain that they should be more short-term.?? Hindsight is 20/20.? Given the multiple uses of credit ratings, having one time horizon is best, whether short- or long-term.? Given the whipsaw that I experienced in 2002 when the ratings agencies went from long- to short-term, I can tell you it did not add value, and that most bond manager that I knew wanted stability.

Non-solutions

Some say rating agencies no longer should have exclusive access to nonpublic information, to even out the playing field.? That sounds good, but the regulators want the rating agencies to have the nonpublic information.? They don?t want a level playing field.? As regulators, if they are ceding their territory to the rating agencies, then they want the rating agencies to be able to demand what they could demand.? Regulators by nature have access to nonpublic information.

Some ask for greater disclosure of default rates, but that is a non-issue.? They also look to punish rating agencies that make mistakes, by pulling their registration. ?Disclosing default rates is already done, and sophisticated investors know this.? Yanking the registration is killing a fly with a sledgehammer.? It would hurt the regulators more than anyone else.?The rating agencies are like the market.? The market as a whole gets it wrong every now and then.? Think of tech stocks in early 2000, or housing stocks in early 2006.? To insist on perfection of rating agencies is to say that there will be no rating agencies.? It takes two to make a market, and agencies will often be wrong.

Solutions

As for solutions, I would say the following are useful:

Competition. ?I?m in favor of a free-ish market here, allowing the regulators to choose those raters that are adequate for setting capital levels, and those that are not.? For other purposes, though, the more raters, the better.? I don?t think rating fees would drop, though.? Remember, ratings are needed for regulatory purposes.? Will Basel II, NAIC, and other regulators sign off on new credit raters?? I think that process will be slow.? Diversity of opinion is tough, unless a ratings agency is willing to be paid only by buyers, and that model is untested at best.
Compensate with residuals and bonuses (give the raters some skin in the game)

Deregulation (we can live without rating agencies, but regulators will have to do a lot more work)
Greater disclosure (sure, let them disclose their data and formulas (perhaps with a delay).
Have regulators bar unseasoned asset classes.

Summary

Let those who criticize the ratings agencies bring forth a new paradigm that the market can embrace, and live with in the long term.? Until then, the current system will persist, because there is no other realistic way to get business done.? There are conflicts of interest, but those are unavoidable in multiparty arrangements.? The intelligent investor has to be aware of them, and compensate for the inherent bias.

Unless buyers would be willing to pay for a new system, it is all wishful thinking.? Watch the behavior of the users of credit ratings.? If they are unwilling to pay up, the current system will persist, regardless of what naysayers might argue.