Real Estate and Mortgages – Page 23

Fourteen Comments on the Financial Economy

Posted on 7 January 2010 by David Merkel

1) Yield-seeking — it is alive and well.? Check out this article on pay-in-kind bonds.? With PIKs, one can be concerned with the return on the money, and the return of the money at the same time.? The history of returns on PIK bonds are such that you are usually better off putting the money under a mattress.

2) More yield-seeking — spreads on mortgage bonds over Treasuries are at a 17-year low, and as I measure it, and all-time low.? Investors have gone maniac for GSE insured mortgage bonds.

3) I am as close to neutral on PIMCO as anyone I know.? I have written articles explaining how they make money, which is different from the public pronouncements of Gross and McCulley.? The current missive of Gross impresses me as fair, recognizing the limits of the Federal Government and the Fed.? PIMCO is taking less risk, selling US and UK debt, and buying German debt.? This is conservative; they are giving up yield.

4) Bruce Krasting notes that the Social Security system paid out more in 2009 than it took in.? That event was not supposed to happen until 2016 or so.? Aside from that, he notes the negative COLA adjustment.? As for me, I look at this and say, “Whether it comes slower or faster, it will come.? Medicare and Social Security will destroy the Federal budget eventually, or will be scaled back to where those that were taxed complain about it.

5) If you want to consider a technical reason for rates being so low, consider all of the mutual fund buyers.? They have favored bonds.? This is a contrary sign for interest rates — they are headed higher.

6) Bernanke blames bank regulation so that he can absolve monetary policy.? Typical.? Blame what you control less, to absolve what you control directly.? A better and brighter economist (in my opinion), John Taylor disagrees.? He views the mid-decade low rate policies as contributing to the lending frenzy.? Don’t get me wrong.? Bank regulation was lousy, but monetary policy was lousier, helping to create the boom that now gives us the bust that normalizes things.

7) How amazing was the junk bond market?? Better, how amazing was the distressed debt market?? Oh my, though junk bonds paced equities, distressed debt did far better.? Such is the case when a turn happens; this one was forced by the US Government.

8) If you want to understand how finance reform gets blocked, read this article.? Better than most, it explains the intricacies of why the Democrats have a hard time passing the legislation that the radicals would like.

9) I am not a Buffett-lover or hater.? When I read his opposition to Kraft raising its bid, I said to myself, “Of course.? Don’t overpay.? Most deals are best avoided.”? Which is true — M&A is in general a value destroyer.

10) Personal bankruptcies are rising in the US.? It is a messy time.

11) Let the Chicago School of Economics die.? I have already argued for their demise.

12) The CMBS market is experiencing delinquencies that have not been seen before.? This is just another example of the difficulties many commercial mortgage loans are in.

13) Strip malls have high vacancy rates.

14) I appreciate Tyler Cowen’s article, suggesting that things are pretty good.? We should be glad that other places in the world did well, even if we did not do so well.

Yield = Poison (2)

Posted on 2 January 2010 by David Merkel

My first real post at the blog was Yield = Poison.? In late February 2007, prior to the blowup in the Shanghai market, I felt frustrated and wanted to simply say that every fixed income class seemed overvalued.? Short and safe seemed best.

It reminded me of a discussion that I had with a colleague two jobs ago, where in mid-2002, the theme was “yield is poison.”? I did the largest credit upgrade trade that I could in the second quarter of 2002, prior to the blowup of Worldcom.? Moved the whole portfolio up three notches in four months.? Give away yield; preserve capital for another day.

I feel much the same, but not as intensely in the present environment.? Spreads could come in further if the government keeps providing low cost liquidity to those who make money on the spread they earn on financial assets.? But most fixed income assets do not reflect likely default costs.? Perhaps the long end of the Treasury curve is worth a little allocation of assets here, if only as a deflation hedge, but if the Fed is going to start lightening up on their QE, and the Treasury will be having high issuance, I might want to stand back for a while? while supply will be high, and try to buy near the end of the quarterly refunding.

There is another sense in which I say “yield = poison,” though.? When rates for safe assets are low, retail and professional investors are both tempted to stretch for yield.?? Wall Street is more than happy to deliver on your desire for yield.? It is their top illusion, in my opinion.

Two examples from my bond trading days: the first was some local brokers asking to buy a small amount relatively highly-rated junk bonds from us.? They were offering a full dollar over the usual market price.? They called me, since I ran the office, but I handed them over to the high yield manager, who said, “Jamming retail, are we?”? [DM: placing overpriced bonds in customer accounts.]? After a lame reply which amounted to,”Look, don’t ask us about what we are doing, we’re offering you a good deal, do you want to sell your bonds or not?”? the high yield manager sold them a small amount of the bonds, and we didn’t hear from them again.

The second example was when a bulge bracket firm called me and asked me if I owned a certain very long duration bond.? I said yes, and he made me an offer several dollars above what I thought they were worth.? With a bid that desperate, I said I could offer a few there, and more a little back, but for the block he would have to pay more still.? He offered something close to the “more still” price, and I sold the block to him there.

As we were settling the trade, I asked him, “Why the great bid?”? He said, “We need the bonds for retail trusts.? They get an above average yield, but if rates fall, after five years, we buy them out at par, and keep the bonds.? If rates rise, they take the loss.”

Even on Wall Street, if you have a good relationship, you get an honest answer.? That said, it made me sorry that I sold the bonds, even though it was the best thing for my client.

There are many ways to frame the yield question at present, here are two:

You are on a fixed income, and you are having a hard time making ends meet.? Should you lend longer to earn more, go for lower rated credits, or do nothing?
You are earning almost nothing on your money market fund.? You need liquidity, but where else could you invest it?

I would be inclined to buy a mix of foreign-denominated bonds, but most people can’t deal with that.? So, I would advise them to build a “bond ladder” where they have high quality issues maturing every year for the next 10 years.? As each bond matures, I would use the proceeds to buy bonds ten years out, re-establishing the 10-year ladder.

But don’t reach for yield.? Odds are, you will get capital losses great than the excess yield you hoped to receive.? And remember this, don’t buy products someone else wants to sell you.? Specifically, don’t buy high yielding investment products that Wall Street sells to enhance your income.? They prey upon those who want more money, and are weak in their knowledge of how the markets work.

To professionals: don’t reach for yield now; long-run, you are not getting paid for the risks.? You have seen how illiquid structured products can be in the face of credit uncertainty, and impaired balance sheets of holders and likely purchasers.? You have seen how spreads can blow out (bond prices fall), and roar back in (prices rise again) in the absence of safe places to invest money.

I’ll give the Treasury and the Fed this: they have created an environment where savers are punished, and have to take significant risks to get yield.? They have created a situation where the markets are dependent on subsidized credit, and speculation dominates over lending to the real economy.? They are pushing us deeper into a liquidity trap, as low-to-negative return investments in autos, homes, and banks get supported by cheap public credit, rather than getting reconciled in bankruptcy, so that capital can be redeployed to higher returning projects.

Anyway, enough for now — more later.

Happy New Year

Posted on 1 January 2010 by David Merkel

Happy New Year.? I would like to begin by thanking my readers for supporting me in 2009.? Let us hope and pray that 2010 will be even better.

That said, the investment grade corporate bond market, the junk bond market, and the bank loan markets can’t have a better year in 2010.? Rates would have to go below Treasuries, perhaps even to zero.? Also, it will be tough, but not impossible for stocks to manage a gain better than 26.5% gain in 2010.? But it would require stellar corporate earnings amid continued low financing rates, with no significant continuation of corporate defaults at a high level.

I don’t hold this view with a ton of confidence, but today’s selloff was supposedly due to the Fed deciding to consider selling some of the bonds that they have bought over the last six months or so.? I’ve said before a number of times that it is a lot easier to begin an easing program than end one.

The quantitative easing was a way of buying bonds expensively, which would hold down rates in the process.? The bond market ran in front of the Fed, pushing up bond prices, figuring (correctly) that the Fed was a forced buyer.? As the end of the process drew near, bond investors sold as the Fed began buying their remaining bonds.? Now the Fed thinks of selling.? Well, even with the yield curve near record levels of steepness, it could get steeper (though probably not by much, I get the weird feeling that something will break, but I don’t know what).? Once it becomes evident that the Fed has shifted from buy to sell mode, some bond investors will start shorting the market.? Given the record financing schedule that the Treasury will be doing, there will be a lot of supply hitting the market.? The yield curve steepness anticipates much of this, but there will be a very negative tone if the Fed and Treasury are selling bonds at the same time.

This makes the recent actions with Fannie & Freddie more understandable.? Fannie and Freddie can take losses on mortgages, and the losses get passed on to the US Government, eventually.? Losses on bad housing debt gets turned into additional government debt.? (Wonderful, not.) The US Government can use Fannie and Freddie to try to reflate the housing market, at least the lower end of it.

The trouble with all of this is that we are bailing out less productive assets, and taxing more productive assets to do so.? We don’t need more housing, banks, or autos.? We have too much capacity in those areas.? Bailing them out is a recipe for stagnation, a la Japan.? Handing over investment decisions to the government is an utter and total waste of resources.? The role of government in the economy should be to punish theft and fraud, and prevent them where they can.? Assuring prosperity is not possible, so don’t try to promise it, much less attempt it.

I think the Treasury and Fed are trapped.? They will have a really hard time removing the stimulus, because they don’t want to raise interest rates.? Banks have become more reliant on low rates since quantitative easing started.

Then there is China.? Because they own so much of our debt, they are the prisoner of the US.? If the US were to default, their financial system would likely fail.? China is running a bubble policy of its own, and real estate prices are rising, though the ability to service debt is rising more slowly.? As with the Fed, forcing rates down can work for a while.? But only for a while.? Some of that bubble extends to the US, sucking in our debt to keep their currency cheap.? Dumb as a rock, but hey, we get cheap goods, and they get expensive debt.

There is an endgame here, but I do not know the what or the when.? The US Government could default only on external debt.? Hey, if Argentina can do it, so can we, and don’t think that the US Treasury isn’t drawing up contingency plans for that even now.? What could be more a more fitting end to being the world’s reserve currency than to default in the end, but protect their own citizens, and send a large portion of the global banking system into insolvency, aside from that in the US?? Truly perverse, after the way the US has gamed the system so far.? Who knows, after such a crisis, the new US Dollar might seem to be the best possible global reserve currency, but I doubt that would happen when wounds are fresh.

Anyway, here is to a great 2010.? May all of your debtors pay you full value.

Nine Notes and Comments

Posted on 31 December 2009 by David Merkel

As I roll through the day, i often make comments on the blogs and websites of others.? I suppose I could gang them up, and post them here only.? I don’t do that.? Other sites deserve good comments.? Today, though, I reprint them here, with a little more commentary.

1) First, I want to thank a commenter at my own blog, Ryan, who brought this article to my attention.? I’ve written about all of the issues he has, but he has integrated them better.? It is a long read at 74 pages, but in my opinion, if you have 90 minutes to burn, worth it.? I will be commenting on the ideas of this article in the future.

2) My commentary on Dr. Shiller’s idea on Trills drew positive attention, but the best part was being quoted at The Economist’s blog.

3) Tom Petruno at the LA Times Money & Company blog is underappreciated.? He writes well.? But when he wrote Fannie and Freddie shares soar, but for no good reason.? I wrote the following:

From my comments to my report on financials yesterday ?Federal Home Loan Mortgage Corp [FRE] and Federal National Mortgage Assn [FNM] Rise as U.S. Removes Caps on Assistance ? this gives the GSE stocks more time, and hence optionality. I still think they will be zeroes in the end, but there will be a lot of kicking and screaming to get there. The government is engaged in a failing strategy to reflate the housing bubble, and they aren?t dead yet.

I write a daily piece on financials for my company’s clients.? The stock of the GSEs rose because the odds of them digging out of the hole increased.? You can’t dig out of the hole if you are dead, so when you are near that boundary, even small changes in the distance from death can affect sensitive variables lke the stock price.? Plus, the odds rise that the US will do something really dumb, like convert theor preferred shares to common.

4) Kid Dynamite put up a good post on CDOs, I commented:

KD, maybe we should play chess sometime. Spotting a queen and rook is huge. I have beaten Experts, though not Masters on occasion (except in multiple exhibitions), and I can’t imagine losing to anyone who has spotted me a rook and queen.

All that said, I never gamble, and as an actuary, I know the odds of most games that I play.

Now, all of that said, I never cease to be amazed at all of the dross I receive in terms of ideas that look good initially, but are lousy after one digs deep.

Good post. Makes me wonder how I would have done in the same interview. Quants need to have a greater consideration of qualitative data. When I was younger, I didn’t get that.

5) Then again, Yves Smith comments on a similar issue at her blog.? My comment:

I?m sorry, but I think jck is right. The risk factors were clearly disclosed. Buyers should have known that they were taking the opposite side of the trade from Goldman.

As I sometimes say to my kids, ?You can win often if you get to choose your competition,? and, ?Winning in investing comes from avoiding mistakes, not making amazing wins.?

As a bond manager, I was offered all manner of amazing derivative instruments. I turned most of them down. Most people/managers don?t read the prospectus, but only the term sheet. Not reading the prospectus is not doing due diligence.

Since we are on the topic of Goldman Sachs, in 1994, an actuary from Goldman came to meet me at the mutual life insurer where I worked. I wanted to write floating rate GICs which were in hot demand, and all of my methods for doing it were too risky for me and the firm.

Goldman offered a derivative instrument that would allow me to not take too risky of an investment strategy, and credit an acceptable rate on the GIC. So, as I read through the terms at our meeting, a thought occurred to me, and so I asked, ?What happens to this if the yield curve inverts??

He answered forthrightly, ?It blows up. That?s the worst environment for these instruments.? Now, if you read the docs, it was there, and when asked, he told the truth. The information was not up front and volunteered orally.

But that?s true of almost all financial disclosures. You have to read the fine print.

As for the derivative instruments, in early 2005, many large financial institutions took billion dollar writedowns. All of my potential competitors in the floating rate GIC market left the market. I went back to buyers, and offered the idea that I could sell them the GICs at a lower spread, which would give them a decent return, but with adequate safety for my firm. All refused. They basically said that they would wait for the day when the willingness to take risk would return.

And it did, until the next blowup in 1998 around LTCM.

My lesson: the craze for yield drives many derivative trades. What cannot be achieved with normal leverage and credit risk gets attempted, and blows up during hard times.

Structure risks are significant; the give up in liquidity is significant. The big guys who play in these waters traded away liquidity too cheaply, and now they are paying for it.

=-=-=-=-=–=-==-=-Whoops, where I said 2005, I meant 1995. That loss I avoided for the firm was one of my best moves there, but we don?t get rewarded for avoiding losses.

6) Then we have CFO.com.? The editor there said they want to publish my comment in their next magazine.? Nice!? Here is the article.? Here is my comment:

Time Horizon is Critical

Yes, Wheeler did a good job, as did MetLife, including their bright Chief Investment Officer.

What I would like to add is the the insurance industry generally did a good job regarding the financial crisis, excluding AIG, the financial guarantors, and the mortgage insurers.

Why did the insurance industry do well? 1) They avoided complex investments with embedded credit leverage. They did not trust the concept that a securitized or guaranteed AAA was the same as a native AAA. Even a native AAA like GE Capital many insurers knew to avoid, because the materially higher spread indicated high risk.

2) They focused on the long term. The housing bubble was easy to see with long-term perception — where one does stress tests, and looks at the long term likelihood of loss, rather than risk measures that derive from short-term price changes. Actuarial risk analysis beats financial risk analysis in the long run.

3) The state insurance regulators did a better job than the Federal banking regulators — the state regulators did not get captured by those that they regulated, and were more natively risk averse, which is the way regulators should be.

4) Having long term funding, rather than short term funding is critical to surviving crises. The banks were only prepared to maximize ROE during fair weather.

I know of some banks that prepared for the crisis, but they were an extreme minority, and regarded by their peers as curmudgeonly. I write this to give credit to the insurance industry that I used to for, and still analyze. By and large, you all did a good job maneuvering through the crisis so far. Keep it up.

7) Then we have Evan Newmark, who is a real piece of work, and I mean that mostly positively.? His article😕 My comment:

Good job, Evan. I don?t do predictions, except at extremes, but what you have written seems likely to happen ? at least it fits with the recent past.

But S&P 1300? 15% up? Wow, hope it is not all due to inflation. 😉

8 ) Felix Salmon.? Bright guy.? Prolific.? His article on residential mortgage servicers.? My response:

Hi Felix, here?s my two cents:

I think the servicers are incompetent, not evil, though some of the actions of their employees are evil. Why?

RMBS servicing was designed to fail in an environment like this. They were paid a low percentage on the assets, adequate to service payments, but not payments and defaults above a 0.10% threshold.

Contrast CMBS servicing, in which the servicer kicks dud loans over to the special servicer who gets a much higher charge (over 1%/yr) on the loans that he works out. He can be directed by the junior certificateholder (usually one of the originators) on whether to modify or foreclose, but generally, these parties are expert at workouts, and tend to conserve value. The higher cost of this arrangement comes out of the interest paid to the junior certificateholder. Pretty equitable.

Here?s my easy solution to the RMBS problem, then. Mimic the CMBS structure for special servicing. An RMBS special servicer would have to be paid a higher percentage on assets than a CMBS special servicer, because he would deal with a lot of small loans. The pain of an arrangement like this would get delivered where it deserves to go: to those who took too much risk, and bought the riskiest currently surviving portions of the RMBS deal.

The underfunded RMBS servicers may be doing the best they can. They certainly aren?t making a bundle off this. As a former mortgage bond manager, I always found the RMBS structures to be weaker than the CMBS structures, and wondered what would happen if a crisis ever hit. Now we know.

9) But then Felix again through the back door of Bronte Capital.? My comments:

I don?t short. Short selling is socially productive though. Here is how:

1) Sniffs out bad management teams.

2) Sniffs out bad accounting.

3) Adds liquidity.

4) Defrays the costs of the margin account for retail investors. Institutional longs get a rebate. Securities lending programs provide real money to long term investors, with additional fun because when you want to sell, you can move the securities to the cash account if the borrow is tight, have a short squeeze, and sell even higher.

5) Provides useful data for longs who don?t short. (High short interest ratio is a yellow flag in the long run, leaving aside short squeeze games.)

6) Allows for paired trades.

7) Useful in deal arbitrage for those who want to take and eliminate risk.

8) Other market neutral trading is enabled.

9) Lowers implied volatility on put options. (and call options)

10) And more, see:

http://alephblog.com/2008/09/19/governme nt-policy-created-too-hastily/Short selling is a good thing, and useful to society, as long as a hard locate is enforced.

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That is what my commentary elsewhere is like.? I haven’t published it here in the past, and am not likely to do it in the future, but I write a lot.? Amid the chaos and economic destruction of the present, the actions are certainly amazing, but consistent with the greed that is ordinary to man.

Uncharted Waters

Posted on 22 December 200922 December 2009 by David Merkel

It does not matter how you measure it, the US Treasury yield curve is at its steepest level ever.? Away from that, the value for expected five-year inflation, five years from now is at its highest level ever, excluding the noise that we had as our markets crashed in the fourth quarter of 2008.

This concerns me.? Anytime we hit new extremes on critical financial variables, it makes me think, “What next?”? Treasury yield curve slope and inflation expectations are fundamental.? Reaching unprecedented levels is a big thing.

Could the US Government ever face the possibility that it could not meet its obligations?? I think so, and a record wide yield curve is one of the things that I would see prior to such troubles.

Last week, I had dinner with my friend Cody Willard.? His favorite idea was shorting long bonds.? I indicated that I had some leaning that way but could not go? all the way on that idea, as the Federal Reserve had the option of inflating during the Great Depression, and did not do so.? Cody said something to the effect of “but we have so much less flexibility today.”? Can’t argue with that, though I wonder whether politicians and bureaucrats favor foreign claims over domestic claims.? Would they bankrupt Americans to pay off foreign claimants?? Yes, they might do that.? It has happened before.

Cody might be on the right track, but the steepness of the yield curve may fight him.? It is very, very hard to get a yield super-steep without something breaking — inflation running rampant, etc.

The greater worry from my angle is the US pursuing Japanese solutions that have failed miserably over the past 20 years.? Japan continues to follow failed Keynesian ideas, fostering a low return on asset culture, with all of the failed projects financed by very low interest rates.? Now we do the same.? The Fed runs a low interest rate policy via Fed Funds and buying mortgage bonds.

All that does is reinforce mediocrity by enabling assets with low returns to be financed and survive.? Better that many of those should die, and the capital be released to more profitable uses.

All of this is the price for not allowing recessions to be deep — now we have to clear away bad loans bigtime.? But who has the courage to do that?? Certainly not our government.? They avoid all short-term pain, leading to long-term problems.

That’s where we are now, in uncharted economic waters.

Catching up on Blog Comments

Posted on 18 December 2009 by David Merkel

Before I start, I would like to toss out the idea of an Aleph Blog Lunch to be hosted sometime in January 2010 @ 1PM, somewhere between DC and Baltimore.? Everyone pays for their own lunch, but I would bring along the review copies of many of the books that I have reviewed for attendees to take home, first come, first served.? Maybe Eddy at Crossing Wall Street would like to join in, or Accrued Interest. If you are an active economic/financial blogger in the DC/Baltimore Area, who knows, maybe we could have a panel discussion, or something else.?? Just tossing out the idea, but if you think you would like to come, send me an e-mail.

Onto the comments.? I try to keep up with comments and e-mails, but I am forever falling behind.? Here is a sampling of comments that I wanted to give responses on.? Sorry if I did not pick yours.

=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=–==-=–==-

Blog comments are in italics, my comments are in regular type.

http://alephblog.com/2009/12/16/notes-on-fed-policy-and-financial-regulation/#comments

Spot on David. I often think about the path of the exits strategy the fed may take. In order, how may it look? What comes first what comes last? Clearly this world is addicted to guarantees on everything, zirp, and fed QE policy which is building a very dangerous US dollar carry trade.

Back to the original point, I would think the order of exit may look something like:

1. First they will slowly remove emergency credit facilities, starting with those of least interest, which were aggressively used to curb the debt deflationary crisis on our banking system. The added liquidity kept our system afloat and avoided systemic collapse that would have brought a much more painful shock to the global financial system. Lehman Brothers was a mini-atom bomb test that showed the fed and gov?t would could happen ? seeing that result all but solidified the ?too big to fail? mantra.

2. Second, they will be forced to raise rates ? that?s right folks, 0% ? 0.25% fed funds rates is getting closer and closer to being a hindsight policy. However, I still think rates stay low until early 2010 or unemployment proves to be stabilizing. As rates rise, watch gold for a move up on perceived future inflationary pressures.

3. Third, they can sell securities to primary dealers via POMO at the NY Fed, thereby draining liquidity from excess reserves. I think this will be a solid part of their exit strategy down the road ? perhaps later in 2010 or early 2011. As of now, some $760Bln is being hoarded in excess reserves by depository institutions. That number will likely come way down once this process starts. The question is, will banks rush to lend money that was hoarded rather then be drained of freshly minted dollars from the debt monetization experiment. For now, this money is being hoarded to absorb future loan losses, cushion capital ratios and take advantage of the fed?s paid interest on excess reserves ? the banks choose to hoard rather then aggressively lend to a deteriorating quality of consumer/business amid a rising unemployment environment. This is a good move by the banks as the political cries for more lending grow louder. The last thing we need is for banks to willy-nilly lend to struggling borrowers that will only prolong the pain by later on.

4. And finally, as a final and more aggressive measure, we could see capital or reserve requirements tightened on banks to hold back aggressive lending that may cause inflationary pressures and money velocity to surge. Right now, banks must retain 10% of deposits as reserves and maintain capital ratios set by regulators. Either can be tweaked to curb lending and prevent $700bln+ from entering the economy and being multiplied by our fractional reserve system.

I think we are starting to see #1 now, in some form, and will start to see the rest around the middle of 2010 and into 2011. The last item might not come until end of 2011 or even 2012 when economy is proven to be on right track and unemployment is clearly declining as companies rehire.

Thoughts????

UD, I think you have the Fed’s Order of Battle right.? The questions will come from:

1) how much of the quantitative easing can be withdrawn without negatively affecting banks, or mortgage yields.

2) How much they can raise Fed Funds without something blowing up.? Bank profits have become very reliant on low short term funding.? I wonder who else relies on short-term finance to hold speculative positions today?

3) Finance reform to me would include bank capital reform, including changes to reflect securitization and derivatives, both of which should require capital at least as great as doing the equivalent transaction through non-derivative instruments.

http://alephblog.com/2009/12/15/book-reviews-of-two-very-different-books/#comments

David,
A few years back you mentioned to me in an e-mail that Fabozzi was a good source for understanding bonds (thank you for that advice by the way, he is a very accessible author for what can be very complex material.)? In the review of Domash’s book you mention that he does not do a good job with financials. I was wondering, is there an author who is as accessible and clear as Fabozzi, when it comes to financials, who you would recommend.

Regards,
TDL

TDL, no, I have not run across a good book for analyzing financial stocks.? Most of the specialist shops like KBW, Sandler O?Neill and Hovde have their own proprietary ways of analyzing financials.? I have summarized the main ideas in this article here.

http://alephblog.com/2007/04/28/why-financial-stocks-are-harder-to-analyze/

http://alephblog.com/2009/12/05/the-return-of-my-money-not-the-return-on-my-money/#comments

Sorry to be a bit late to this post, but I really like this thread (bond investing with particular regard to sovereign risk). One thing I’m trying to figure out is the set of tools an individual investor needs to invest in bonds globally. In comparison to the US equities market, for which there are countless platforms, data feeds, blogs, etc., I am having trouble finding good sources of analysis, pricing, and access to product for international bonds, so here is my vote for a primer on selecting, pricing, and purchasing international bonds.

K1, there aren?t many choices to the average investor, which I why I have a post in the works on foreign and global bond funds.? There aren?t a lot of good choices that are cheap.? It is expensive to diversify out of the US dollar and maintain significant liquidity.

A couple of suggested topics that I think you could do a job with:? 1) Quantitative view of how to evaluate closed end funds trading at a discount to NAV with a given NAV and discount history, fee/cost structure, and dividend history;?? 2) How to evaluate the fundamentals of the return of capital distributions from MLPs – e.g. what fraction of them is true dividend and what fraction is true return of capital and how should one arrive at a reasonable profile of the future to put a DCF value on it?

Josh, I think I can do #1, but I don?t understand enough about #2.? I?m adding #1 to my list.

http://alephblog.com/2009/12/05/book-review-the-ten-roads-to-riches/#comments

I see that Fisher’s list reveals his blind spot–how about being born the child of wealthy parents. . .

BWDIK, Fisher is talking about ?roads? to riches.? None of us can get on that ?road? unless a wealthy person decided to adopt one of us.? And, that is his road #3, attach yourself to a wealthy person and do his bidding.

I am not a Ken Fisher fan, but I am a David merkel fan—so what was the advice he gave you in 2000?

Jay, what he told me was to throw away all of my models, including the CFA Syllabus, and strike out on my own, analyzing companies in ways that other people do not.? Find my competitive advantage and pursue it.

That led me to analyzing industries first, buying quality companies in industries in a cyclical slump, and the rest of my eight rules.

http://alephblog.com/2009/11/28/the-right-reform-for-the-fed/#comments

“The Fed has been anything but independent.? An independent Fed would have said that they have to preserve the value of the dollar, and refused to do any bailouts.”

This seems completely wrong to me.? First, the Fed’s mandate is not to preserve the value of the dollar, but to “”to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.”? I don’t see that bailouts are antithetical to those goals. Second, I don’t see how the Fed’s actions in 2008-2009 have particularly hurt the value of the dollar, at least not in terms of purchasing power.? Perhaps they will in the future, but it is a bit early to assert that, I think.

Matt, even in their mandates for full employment and stable prices, the Fed should have no mandate to do bailouts, and sacrifice the credit of the nation for special interests.? No one should have special privileges, whether the seeming effect of purchasing power has diminished or not.? It is monetary and credit inflation, even if it does not result in price inflation.

?Make the Fed tighten policy when Debt/GDP goes above 200%.? We?re over 350% on that ratio now.? We need to save to bring down debt.?

David, I fully agree (as with your other points).
However, I do not see it happening.

Why would we save when others electronically ?print? money to buy our debt?

See todays Bloomberg News:
?Indirect bidders, a group of investors that includes foreign central banks, purchased 45 percent of the $1.917 trillion in U.S. notes and bonds sold this year through Nov. 25, compared with 29 percent a year ago, according to Fed auction data compiled by Bloomberg News.?

Please note that last year the amount auctioned was much lower (so foreign central banks bought a much lower percentage of a much lower total).

Please also note that all of a sudden, earlier this year, the definition of ?indirect bidders? was changed, making it more complicated to follow this stuff. What is clear however, is that almost half of the incredible amount of $ 2 trillion, i.e. $ 1000 billion (!!), is being ?purchased? by the printing presses of foreign central banks.

This could explain both the record amount of debt issued and the record low yields.

As the CBO has projected huge deficits PLUS huge debt roll-overs (average maturity down from 7 years to 4 years) up to at least 2019, do you think we could extend the ?printing? by foreign central banks? — CB?s ?buying? each others debt — for at least 10 more years?
That would free us from saving, enabling us to ?consume? our way to reflation of the economy (as is FEDs/Treasuries attempt imo).

I?d appreciate your, and other readers?, take on this.

Carol, you are right.? I don?t see a limitation on Debt to GDP happening.

As to nations rolling over each other?s debts for 10 more years, I find that unlikely.? There will be a reason at some point to game the system on the part of those that are worst off on a cash flow basis to default.

The rollover problem for the US Treasury will get pretty severe by the mid-2010s.

http://alephblog.com/2009/11/13/the-forever-fund/#comments

Any chance of you doing portfolio updates going forward? I?d be curious to see if you still like investment grade fixed incomes, given the rally.

Matt, I would be underweighting investment grade and high yield credit at present.

As for railroads, I own Canadian National ? unlike US railroads, it goes coast to coast, and slowly they are picking up more business in the US as well.

Long CNI

http://alephblog.com/2009/11/10/my-visit-to-the-us-treasury-part-7-final/#comments

Did none of the bloggers raise the question of the GSEs? I can understand Treasury not wishing to tip their hands as to their future, but I would have expected their status to be a hot topic among the bloggers.

I also don?t buy the idea that the sufferings of the middle class were inevitable. Over the past 15 or so years the financial sector has grown due to the vast amount of money that it has been able to extract. Where would we be if all of those bright hard working people and capital spending had gone to the real economy? I?m not suggesting a command economy, but senior policymakers decided to let leverage and risk run to dangerous levels. Your comment seem to indicate that this was simply the landscape of the world, but it seems more to be the product of a deliberate policy from the Federal government.

Chris, no, nothing on the GSEs.? There was a lot to talk about, and little time.

I believe there have been policy errors made by our government ? one the biggest being favoring debt finance over equity finance, but most bad policies of our government stem from a short-sighted culture that elects those that govern us.? That same short-sightedness has helped make us less competitive as a nation versus the rest of the world.? We rob the future to fund the present.

http://alephblog.com/2009/11/07/my-visit-to-the-us-treasury-part-6/#comments

it?s not clear from your writing whether the treasury officials talked to you about the GSEs or whether your comments (in the paragraph beginning with ?When I look at the bailouts,?) are your own. could you clarify?

q, That is my view of how the Treasury seems to be using the GSEs, based on what they are doing, not what they have said.

http://alephblog.com/2009/10/31/book-review-nerds-on-wall-street/

?There are a lot of losses to be taken by those who think they have discovered a statistical regularity in the financial markets.?
David, take a look at equilcurrency.com.

Jesse, I looked at it, it seems rather fanciful.

http://alephblog.com/2009/10/27/book-review-the-predictioneers-game/#comments

David,
Just wondering if there?s an omission in this line:

?The last will pay for the book on its own. I have used the technique twice before, and it works. That said, that I have used it twice before means it is not unique to the author.?

Did you mean to write ?that I have used it doesn?t mean it is not unique?.?

In the event it is, I?ll look it up in the book, which I intend to buy anyway.
Otherwise, may I request a post that details, a la your used car post,your approach to buying new cars?

Saloner, no omission.? I said what I meant.? I?ll try to put together a post on new car purchases.

http://alephblog.com/2009/10/22/book-review-the-bogleheads-guide-to-retirement-planning/

thanks for the book review. it sounds like something that i could use to get the conversation started with my wife as she is generally smart but has little tolerance for this sort of thing.

> unhedged foreign bonds are a core part of asset allocation

i agree in principle ? it would be really helpful though to have a roadmap for this. how can i know what is what?

I second that request for help in accessing unhedged foreign bonds ? Maybe a post topic?

JK, q, I?ll try to get a post out on this.

http://alephblog.com/2009/10/20/toward-a-new-theory-of-the-cost-of-equity-capital-part-2/#comments

to the point above, basically just an IRR right?

JRH, I don?t think it is the IRR.? The IRR is a measure of the return off of the assets, not a rate for the discount of the asset cash flows.

When I was an undergraduate (after already having been in business for a long time), I realized that M-M was erroneous, because of all the things they CP?d (ceteris paribus) away. For my own consumption, I went a long way to demonstrating that quantitatively, but children, work and family intervened, and who was I to argue with Nobel winners.

But time, experience and events convince me that I was right then and you are right now. As you?ve noted the market does not price risk well. In large part this is due to a fundamental misunderstanding of value. The professional appraisal community has a far better handle on this, exemplified by drawing the formal distinction between ?fair market value as a going concern?, ?investment value?, ?fair market value in a orderly liquidation?, ?fair market value in a forced liquidation? and so on. One corollary to the foregoing is one of those lessons that stick from sit-down education, that ?Book Value? is not a standard of value but rather a mathematical identity.

Without going into a long involved academic tome, the cost of capital (and from which results the mathematical determination of value per the income approach) has a shape more approaching that of a an asymmetric parabola (if one graphs return on the y axis and equity debt weight on the x.).

If I was coming up with a new theorem, risk would be an independent variable. So for example:

WAAC = wgt avg cost of equity + wgt avg cost of debt + risk premium

You?ll note the difference that in standard WAAC formulation risk is a component of the both the equity and debt variable ? and practically impossible to consistently and logically quantify. Yes, one can look to Ibbottson for historical risk premia, or leave one to the individual decision making of lenders, butt it complicates and obscures the analysis.

In the formulation above, cost of equity and cost of debt are very straightforward and can be drawn from readily available market metrics. But what does risk look like? Again if you plot risk as a % cost of capital on the y axis and on the x axis the increasing debt weight, on a absolute basis risk is lowest @ 100% equity. From there is upwards slopes. However, risk however is not linear, but rather follows a power law.

The reason risk follows a power law is that while equity is prepared to lose 100%, debt is not. Also, debt weight increases IRR to equity (in the real world) contrary to MM. Again, debt is never priced well, because issuers don?t understand orderly and forced liquidation, whereby in ?orderly?, e.g. say Chapter 11,recoveries may be 80 cents on the dollar, and forced, e.g., Chapter 7, 10 cents on the dollar. One really doesn?t begin to understand the foregoing until you?ve been through it more than a few times.

So in the real world, as debt increases, equity is far more easily ?playing with house money.? A recent poster child for this phenomena is the Simmons Mattress story. In the most recent go round equity was pulling cash out (playing with house money) and the bankers were either (depending on one?s POV) incredibly stupid for letting equity do so, or incredibly smart, because they got their fees and left someone else holding the bag. I?m seen some commentators say that ?Oh it was OK because rates were so low, the debt service (the I component only) was manageable.? Poppycock; sometime it?s the dollar value and sometimes it?s the percentage weight and sometimes it is both.

But you?ve already said that: ?company specific risk is significant and varies a great deal.? I would also add that ? or amplify ? that in any appraisal assignment the first thing that must be set is the appraisal date. Everything drives off that and what is ?known or knowable? at the time.

Gaffer, thanks for your comments.? I appreciate the time and efforts you put into them.? This is an area where finance theory needs to change.

http://alephblog.com/2009/10/10/pension-apprehension/

I have a DB plan with Safeway Stores-UFCW, which I?ve been collecting for a few years. I?m cooked?

Craig, not necessarily.? Ask for the form 5500, and see how underfunded the firm is.? Safeway is a solid firm, in my opinion.

Long SWY

http://alephblog.com/2009/09/29/recent-portfolio-actions/#comments

David, I am curious about your rebalancing threshold. Do you calculate this 20% threshold using a formula like this:

= Target Size / Current Size ? 1

I have a small portfolio of twenty securities. A full position size in the portfolio is 8% (position size would be 1 for an 8% holding). The position size targets are based generally on .25 increments (so a position target of .25 is 2% of the portfolio and there are 12.5 slots ?available?). I used that formula above for a while, but I found that it was biased towards smaller positions.

Instead I began using this formula:

= (Target ? Current Size) / .25

So a .50 sized holding and a full sized holding may have both been 2% below the target (using the first formula), but using the second formula, they would be 8% and 16% below the target respectively. I found this showed me the true deviation from the portfolio target size and put my holdings on an equal footing for rebalancing.

I was curious how you calculated your threshold, or if it was less of an issue because you tended to have full sized positions. For me, I tend to start small and build positions over time. There are certain positions I hold that I know will stay in the .25-.50 range because they either carry more risk, they are funds/ETFs, or they are paired with a similar holding that together give me the weight I want in a particular sector.

Brian, you have my calculations right.? I originally backed into the figure because concentrated funds run with between 16-40 names.? Since I concentrate in industries, I have to run with more names for diversification.? I don?t scale, typically, though occasionally I have double weights, and rarely, triple weights.? The 20% band was borrowed from three asset managers that I admire.? After some thought, I did some work calculating the threshold in my Kelly criterion piece.

A fuller explanation of the rebalancing process is here in my smarter seller pieces.

http://alephblog.com/2009/09/04/tickers-for-the-latest-portfolio-reshaping/

Have you seen DEG instead of SWY?
Extremely able operator. Some currency diversification as well. I?d like to know your thougts.

MLS, I don?t have a strong idea about DEG ? I know that back earlier in the decade, they had their share of execution issues.? It does look cheaper than SWY, though.

Long SWY

http://alephblog.com/2009/06/11/problems-with-constant-compound-interest-2/

I like your post and want to comment on a couple of items.? You point to the peak of the 1980’s inflation rates and the associated interest rates.

Robert Samuelson wrote a book called The Great Inflation and it’s Aftermath.?? http://tiny.cc/z9H9V

Basically you can explain a great deal the US stock market history of the 40 years by the spike in interest/inflation until the mid 80’s and the subsequent decline.? Since you need an interest rate to value any cash flow, the decline in interest rates made all cash flows more valuable.

The thing that is odd and sort of ties this together is the last year.? After interest rates crossed the 4% level things started blowing up.? The amount of debt that can be financed at 3% to 4% is enormous.? That is, as everyone knows, on of the root causes of the housing bubble.? Anyway, starting last year, treasury interest rates continued to decline and all other rates went through the roof.

I was looking at this chart yesterday.? _ http://tiny.cc/eCZzF The interesting thing to me was that when the system blew up, treasury rates continued to decline and all non guaranteed debt rates went through the roof.

Most of this is obvious and everyone knows the reasons.? The one thing that seems novel is thinking of this as the continuation of a very long secular trend — or secular cycle.? I don’t want to get overly political, but the decrease in inflation/interest in the 90’s to the present was a function of productivity/technology and Foreign/Chinese imports.? Anyway, one effect of these policies was a huge rise in asset values, especially in the FIRE (finance, insurance, real estate) sector of the economy at the expense of our industrial and manufacturing sectors.? This was also a redistribution of wealth from the rust belt to the coasts.

It is much more complicated then the hand full of influences I mentioned, but the one thing i haven’t seen discussed a lot is the connection of the current catastrophe to the long term decline in inflation/interest rates since the mid/late 1980’s.? If you think about it, declining interest rates increase the value of financial assets and are an enormous tailwind for finance.? I suppose if you had just looked at the curve, it would have been obvious that the trend couldn’t continue.? Prior to the blowup, there were lots of people financing long term assets with short term, low interest rate liabilities. That was a big part of the basic playbook for structured finance, hedge funds, etc.

The reason that the yield spread exploded is well known.? Here is a snippet from Irving Fisher.? http://capitalvandalism.blogspot.com/2009/01/deflationary-spirals.html

CapVandal ? Great comment.? A lot to learn from here.? I hope you come back to blogging; you have some good things to say.? Fear and greed drive correlated human behavior.

Redacted Version of the December FOMC Statement

Posted on 17 December 200917 December 2009 by David Merkel

November 2009	December 2009	Comments
Information received since the Federal Open Market Committee met in September suggests that economic activity has continued to pick up.	Information received since the Federal Open Market Committee met in November suggests that economic activity has continued to pick up and that the deterioration in the labor market is abating.	They think that the labor market is getting worse but at a very slow rate.
Activity in the housing sector has increased over recent months.	The housing sector has shown some signs of improvement over recent months.	No real change.
Household spending appears to be expanding but remains constrained by ongoing job losses, sluggish income growth, lower housing wealth, and tight credit.	Household spending appears to be expanding at a moderate rate, though it remains constrained by a weak labor market, modest income growth, lower housing wealth, and tight credit.	Shading up income growth, shading down unemployment.
Businesses are still cutting back on fixed investment and staffing, though at a slower pace; they continue to make progress in bringing inventory stocks into better alignment with sales.	Businesses are still cutting back on fixed investment, though at a slower pace, and remain reluctant to add to payrolls; they continue to make progress in bringing inventory stocks into better alignment with sales.	More shading unemployment downward.

———————————————————————————————————

Conditions in financial markets were roughly unchanged, on balance, over the intermeeting period.	Financial market conditions have become more supportive of economic growth.	Sentence moved from higher up in the statement. More optimistic.
Although economic activity is likely to remain weak for a time, the Committee anticipates that policy actions to stabilize financial markets and institutions, fiscal and monetary stimulus, and market forces will support a strengthening of economic growth and a gradual return to higher levels of resource utilization in a context of price stability.	Although economic activity is likely to remain weak for a time, the Committee anticipates that policy actions to stabilize financial markets and institutions, fiscal and monetary stimulus, and market forces will contribute to a strengthening of economic growth and a gradual return to higher levels of resource utilization in a context of price stability.	No real change.
With substantial resource slack likely to continue to dampen cost pressures and with longer-term inflation expectations stable, the Committee expects that inflation will remain subdued for some time.	With substantial resource slack likely to continue to dampen cost pressures and with longer-term inflation expectations stable, the Committee expects that inflation will remain subdued for some time.	No change.
In these circumstances, the Federal Reserve will continue to employ a wide range of tools to promote economic recovery and to preserve price stability.		A useless sentence eliminated.
The Committee will maintain the target range for the federal funds rate at 0 to ? percent and continues to anticipate that economic conditions 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 ? 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.	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 will purchase a total of$1.25?trillion of agency mortgage-backed securities and up to $200 billion of agency debt.	To provide support to mortgage lending and housing markets and to improve overall conditions in private credit markets, the Federal Reserve is in the process of purchasing $1.25 trillion of agency mortgage-backed securities and about $175 billion of agency debt.	No real change. We knew this from prior announcements.
The Committee will gradually slow the pace of these purchases in order to promote a smooth transition in markets and anticipates that they will be executed by the end of the first quarter of 2010.		Sentence no longer needed.

—————————————————————————————————

	In light of ongoing improvements in the functioning of financial markets, the Committee and the Board of Governors anticipate that most of the Federal Reserve?s special liquidity facilities will expire on February 1, 2010, consistent with the Federal Reserve?s announcement of June 25, 2009. These facilities include the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility, the Commercial Paper Funding Facility, the Primary Dealer Credit Facility, and the Term Securities Lending Facility. The Federal Reserve will also be working with its central bank counterparties to close its temporary liquidity swap arrangements by February 1. The Federal Reserve expects that amounts provided under the Term Auction Facility will continue to be scaled back in early 2010. The anticipated expiration dates for the Term Asset-Backed Securities Loan Facility remain set at June 30, 2010, for loans backed by new-issue commercial mortgage-backed securities and March 31, 2010, for loans backed by all other types of collateral.	New sentence. This was well-disclosed in advance. That part of the Fed balance sheet has been shrinking for some time. The real elephant is what the Fed does with the MBS.
As previously announced, the Federal Reserve?s purchases of $300?billion of Treasury securities will be completed by the end of October 2009.		Treasury program is done.
The Committee will continue to evaluate the timing and overall amounts of its purchases of securities in light of the evolving economic outlook and conditions in financial markets.		A useless sentence eliminated.
The Federal Reserve is monitoring the size and composition of its balance sheet and will make adjustments to its credit and liquidity programs as warranted.	The Federal Reserve is prepared to modify these plans if necessary to support financial stability and economic growth.	No real change. Another useless sentence.
Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; Elizabeth A. Duke; Charles L. Evans; Donald L. Kohn; Jeffrey M. Lacker; Dennis P. Lockhart; Daniel K. Tarullo; Kevin M. Warsh; 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; Donald L. Kohn; Jeffrey M. Lacker; Dennis P. Lockhart; Daniel K. Tarullo; Kevin M. Warsh; and Janet L. Yellen.	No change.

Comments

The FOMC sees unemployment and GDP growth improving in the near term.? I would not be so sure.
Ignore the long new sentence about the liquidity programs going away.? We knew that was coming.? The critical issue at present is what the Fed will do with all of the MBS it owns.? There is no easy way to shrink that without affecting the long end of the yield curve negatively.
The Fed is more optimistic about the financial markets, but I am not sure why.
As I said last month, the trigger for when the Fed will raise the Fed Funds rate is this:
- watch capacity utilization
- unemployment
- inflation trends
- inflation expectations.

Notes on Fed Policy and Financial Regulation

Posted on 16 December 2009 by David Merkel

I’m not likely to be able to comment when the FOMC announces its lack of action today.? The Fed will continue to keep policy loose, while slowly closing down ancillary lending programs, and bloating their balance sheet with mortgage backed securities [MBS] guaranteed by Fannie and Freddie, and ultimately by the Federal Government, which gets the profit or loss from the Fed’s financing (of the mortgages at 0% interest for now).

Going back to last night’s post, strip away the complexity, and what you have is the Federal Government intervening in the MBS market, and forcing down yields, at a cost of indebting future generations (should they decide to make good on those).? This will eventually fail as a strategy.? Unless the Fed wants to keep its balance sheet permanently larger, yields on MBS will rise when they stop buying.? And, the moment that they hint that they will start unloading, rates will back up significantly.? They are too large relative to the MBS market.

They can engage in fancy strategies where they try to remove policy accommodation either through rates or the size of the balance sheet, but one thing Fed history teaches us is that the Fed doesn’t know what will happen when a tightening cycle starts, but usually it ends with a bang — some market blowing up.

Two more notes: it doesn’t matter who the Fed Chairman is.? The structure of the Fed matters more than the man.? That said, Bernanke has promised transparency but has not given it at the most crucial times — those dealing with the bailouts.? All of the talk to audit/limit/shrink/end the Fed comes from abuse of those powers, which should be done by the Treasury and Congress, so that voters can hold them accountable.

Finally, one quick note on regulation of financials.? Laws don’t mean squat if regulators won’t enforce them.? There was enough power in prior laws for regulators to have curbed all of the abuses.? The regulators did not use their powers then; what makes us think that they will use expanded powers?? Regulatory capture has happened in the banking industry; regulators will have to get ugly with those that they regulate if they genuinely want to regulate.

This includes changing risk-based capital formulas to remove the advantage of securitizing debt.? I’m not saying penalize securitization, but put it on a level playing field so that the inherent leverage involved in securitization gets a higher capital charge relative to straight debt of a similar risk class.

That also includes not letting banks fudge asset values to give the appearance of solvency, but more on that tonight.? I gotta fly now on business.

Book Review: The Ten Roads to Riches

Posted on 5 December 20096 December 2009 by David Merkel

Many dream of riches.? Few achieve them.? Why?? It usually involves self-denial and hard work.? It’s not that anyone can’t achieve riches, if they start young enough, but they won’t make the sacrifices to do so.? A strong education helps, but is not absolutely required.? As my old boss Eric Hovde said to his staff repeatedly, the biggest difference in success comes from the degree of effort put forth.? I would only add that working smart amplifies the effort of working hard.

Ken Fisher the billionaire asset manager, identifies the ten ways he has seen to become wealthy.? They are:

1) Build a significant business.

2) Manage a significant business.

3) Be the right hand man of a wealthy person.

4) Be a star athlete, entertainer, or one who significantly facilitates star athletes and entertainers.

5) Marry a wealthy person.

6) Be a lawyer that helps clients sue for major amounts of money on a contingency fee basis.

7) Manage a lot of Other People’s Money.

8 ) Be an inventor of something popular, a popular writer, a prominent politician, or invent an organization that a lot of people want to give money to.

9) Borrow a lot of money and speculate on property appreciation.

10) Work hard, save a lot, and invest wisely.

I think he has nailed it.? My way of summarizing it is that you have to do something that makes a lot of people happy, or at least has the potential to make a lot of people happy.? Or, make one wealthy person very happy or unhappy. Three groups — how do they work out?

A) Those who do something that makes a lot of people happy can earn a lot:

Successful business founders, CEOs, right hand men, inventors
Stars and their significant enablers
Good asset managers
Good writers
Successful real estate developers

B) But even those that promise to do something to make people happy and fail at it can earn a lot:

Any CEO of a big enterprise can earn a lot — at one investment firm, we used to joke that you got paid $50 million to destroy a company — it is what they had to pay to get rid of you.? Their right hand men will still prosper too, just not as much.? In the current financial crisis, that is what gores many about the large surviving firms that were bailed out.? The executives are still prospering after previous dumb decisions.? Easy to complain about it, but it is nice work if you can get it.? (Note: this is why they should not have been bailed out, especially not at the holding company level.? Government officials lie when they say they could not have done it differently.? I for one suggested alternatives ahead of time.)
The same applies to CEOs that tweak the company’s earnings while they are there, but leave their successor in the hole.
Many still follow stars as their stars fade; they may not make as much, but it is still a lot.? Same for writers that lose their knack.
Many asset managers have an early period where they don’t have much in the way of assets, and their track record is great; their ideas for excess return are executable with the current assets under management [AUM].? That leads to growth in assets, until they are too big for the asset class in which they have expertise.? They become index-like, or they venture outside their circle of competence, and their track record suffers.? But AUM is high, and the fees can provide a nice income.? Assets are sticky if you don’t do too badly, and are a good salesman/storyteller.
Politicians can make a lot of money off of contacts or giving speeches once out of office, even if they were on net harmful to the nation while in office.
Some charities (or nonprofits like mutual insurers or credit unions) can be less than scrupulous about what managers get paid.
The real estate speculator, the CEO, and certain investment managers can have a “Heads-I-win, Tails-you-lose” attitude.? America gives people a lot of second chances before you are permanently branded as a fraud.? It only takes one big win to make a lot for yourself, even if you destroy the well-being of others in the process.

C) Then there are those that only have to serve a few:

The spouse of a wealthy person.
The right hand man of a wealthy person, and
The Trial Lawyer going after a big tort
Serve yourself, as an ordinary person working at a job.

No one begrudges the wealth of those in group A — they have served society well.? Many begrudge the wealth of those in group B — they have not served society well.? Group C?? It depends on motives.? More later on this.

One thing is certain, though.? There aren’t many seats in each of the “roads to riches,” except for the last ordinary one, #10.? Few are founders of massive enterprises, or CEOs, or stars, or investors of must-have products or processes.? Few can serve in high office, or write best-sellers, or be able to source a lot of assets to manage.? Few can get the capital markets or banks to loan them millions, even billions.? Few get to try a lawsuit where a huge award is won.? Few get to marry rich.? Also, most succeeding have to hit their right path while young, to allow enough time for compounding their success.

It takes a lot of effort and good breaks in order to be at the top of any economic situation where there is a lot of wealth.? Even road #10, doing well at your job, saving a lot and investing wisely is tough.? Few get to become “The Millionaire Next Door,” but more achieve reasonable wealth that way than all of the rest combined.

Ken Fisher writes about all of these areas in an entertaining way, and gives practical advice on how to follow each road, including additional books to read, and techniques for getting started.? It is an ambitious and compact book weighing in at around 230 pages of text including the preface.? It is an easy, breezy read. As a bonus, in road 10, Ken Fisher shares basic investment advice for the retail investor.

More than Quibbles:

I owe a lot to Ken Fisher for advice that he gave me in Winter 2000, and though I enjoyed the book, I can’t endorse it wholeheartedly.? He is out to tell you how to do it, even in cases where there might be significant moral compromise.? He acknowledges that, but says it is a part of the game.

To me, the key question is what your motives are.? It’s one thing to enter into a risky business, offer full disclosure to all stakeholders in advance, make a best effort, and fail.? It is quite another to trick/cajole people into backing you without full knowledge, and fail.

It is one thing to try a legal case where the damages are proportionate to the harm caused, and another thing to help create disproportionate judgments. It is one thing to serve a wealthy person who asks you to do things that are ethical, and another thing to serve in things that are unethical.? Once you have fans, a privileged job, or “sticky assets,” do you start giving less than your best?? I write this as one that is himself prone to laziness when things go well.? It is a common sin that one has to fight.

Are you looking out for the best interests of those you serve, and society more broadly?? A tough question for any of us, but society itself does not do well when a dominant proportion of it does not serve for good motives.? If it gets bad enough, the society will lose legitimacy and vitality.

Finally, it is one thing to marry because you love the person, and want to give your all to your future spouse.? It is quite another thing to enter in with crossed fingers, and say, “Maybe this will work, maybe it won’t.? I will be careful to protect myself, because the odds of failure are significant.? But economically, it will work out for me either way.? I’m wealthy if we marry, whether it works or not, because the prenup will leave me well off.”

Here’s the common vow: I, (Bride/Groom), take you (Groom/Bride), to be my (wife/husband), to have and to hold from this day forward, for better or for worse, for richer, for poorer, in sickness and in health, to love and to cherish; from this day forward until death do us part. Maybe promises don’t mean much any more, but I can’t see how one marrying for money can say that with a clear conscience.

Before my wife and I married, but after we were engaged, we were at a bookstore together, and we were looking over some marriage books to find one our pastor recommended.? She found a book entitled, “Marry Rich.”? She said to me, “This is a joke book, right?”? I said, “Uh, you would be surprised at the motives some have in marriage.”? She began leafing through it, amazed at the level of greed involved.? She married her poor graduate student boyfriend anyway.? 23 years later things are still working out well for her (and me).

One final note, not from the book: greed wears people out.? It is one thing to do what you love so long as money is not the sole purpose.? But those that are greedy for gain at all costs destroy themselves, and those around them.? It is not a good trade.

With those caveats, if you want to buy the book, you can buy it here: The Ten Roads to Riches: The Ways the Wealthy Got There (And How You Can Too!) (Fisher Investments Press).

Full Disclosure: I review books because I love reading books, and want to introduce others to the good books that I read, and steer them away from bad or marginal books.? Those that want to support me can enter Amazon through my site and buy stuff there.? Don?t buy what you don?t need for my sake.? I am doing fine.? But if you have a need, and Amazon meets that need, your costs are not increased if you enter Amazon through my site, and I get a commission.? Win-win.

On Sovereign and Quasi-Sovereign Risks

Posted on 1 December 2009 by David Merkel

I like investing internationally, because of the diversification it offers, both in stocks and bonds.? Or, think of it as a hedge.? Will the American Experiment continue to prosper?? We have come a long way from the Founding Fathers, and more than half of it is not good.

But there are some place in our world that I will not invest in.? I have two requirements.

Contract law must be close to that in the US, or better.
Accounting practices must be close to the quality of the US, or better.

Sounds simple, but foreign tales are beguiling.? There is an exclusiveness about them, and a sense of greater knowledge for the one who has bothered to learn a trifle.? My acid test is watching over a long period and seeing how they treat foreign shareholders.? That is a good measure of the morality of management.? If they cheat foreign shareholders, they will eventually cheat domestic shareholders as well.

So, what don’t I invest in?

Russia
China
Most of the Middle East.
Venezuela
And other places that do not protect foreign shareholders on a level that is at least close to that of citizens.

The idea is to avoid situations where your rights as a shareholder might be ignored.? It does not matter how cheap an asset is; if the ability of the asset to be liquidated is low, so should the valuation of the asset be low.? Don’t buy pigs in pokes.

This has application today with Dubai.? The Dubai government is telling creditors that it will not stand behind Dubai World, and nor will the UAE, but Abu Dhabi will stand behind UAE banks.? This is tough on foreign creditors because foreign creditor rights in Dubai have not been tested until now.? Even domestic rights are unclear.

A Note on Debt Risks

Much Islamic debt, because of the prohibition on interest, acts like an extremely volatile hybrid bond during times of stress.? This incident will prove instructive on how these bonds keep or lose value in a reorganization.? What happens here will probably have an impact on how much money will be willing to flow into these vehicles in the future.? Personally, I never found them compelling, and probably won’t in the future.? There is something compelling about straight senior unsecured debt that pays interest.? I think the guarantees involved, together with straightforward reorganization processes, create a fair game where it is easier to decide whether lending or borrowing makes sense.

Complexity in bonds is usually a loser for the lender — whether complexity of the borrower’s finances, complexity of holding company structures, complexity of the governing laws, or even enforcing a complex contract where the lender duped the less-knowledgeable borrower.

What applies to corporate debt — long term buy and hold investors do okay with investment grade debt, but less well with junk debt, and worse the junkier it gets.? Layer on top of that the difficulty of being able to psychologically buy and hold during a crisis.? Even if you personally have the fortitude to do so, there may be others that influence you that don’t.? (E.g., the rating agencies come along near the trough of the crisis, and tell the CEO that they will downgrade you if you don’t sell bonds with the risk du jour.? Or, your clients look at their statements, and see the unrealized losses and beg you to sell — it doesn’t matter, the screaming is always the loudest at the bottom (in hindsight).

A Final Note on Sovereign Risks

Sovereign and quasi-sovereign risks like Dubai World may play a larger role in overall credit risk as the broader crisis plays out.? When I was younger, I thought the great risk of the Euro was that it would be too weak.? Bite my tongue.? The risk is that it could be too strong, and marginal European countries (Greece, Iceland, Ireland, Spain, Portugal, and many Eastern European countries) that have too much Euro-denominated debt relative to their ability to tax and pay will find themselves pinched — and they can’t inflate their way out.

When I first came to bond investing (early 90s), sovereign risks were viewed? skeptically, excluding the large Western nations — bond managers had been taught by the greyheads who had seen sovereign defaults, and the difficult of recovering money in default, still had a bias against sovereign and quasi-sovereign risks.? That bias is largely gone today, after a period of few sovereign losses.? Yes, Mexico, Russia and Argentina have given their share of heartburn, but the significant growth in the emerging markets has made bondholders forgiving.? Add in the long term structural deficits of the US and Japan, and it makes for a really interesting investment picture.

Be aware.? If you hold sovereign debts, look at the ability of the government to tax and pay over the long haul.? On quasi-sovereigns, analyze the explicit guarantees, if any, and the governing law — as you can see with Dubai World, in a crisis, only the guarantees matter, and only to the degree that they are enforceable under law.? With Dubai World, it will be judged in Dubai courts by a judge appointed by the ruling family of the emirate, which owns the equity of Dubai World.? Not a strong bargaining position in my opinion.? The only thing worse than relying on the kindness of strangers, is relying on the kindness of adversaries.

A Final Aside

I knew about how dodgy the investments were that Dubai and its corporations were undertaking, so I was always a skeptic, though I never wrote about Dubai, because it is so far afield for me.? What I did not know was the near slavery of foreign workers tricked to go to Dubai, and then forced to work with little to no rights.? Read the story, it is not pretty, but reinforces a belief of mine that governments and corporations willing to cheat one group of people, will cheat other groups of people as well.? Character is important in any credit decision, and the government of Dubai does not have good character in my book.