Category: Real Estate and Mortgages

How to Solve the Housing Crisis

How to Solve the Housing Crisis

Posted on by David Merkel

Now, don’t take me too seriously here, but there is an easy way to solve the housing crisis.? We have too many homes for people with the means to buy them to occupy them.? We also have too much debt to foreigners that they don’t know what to do with.? Well, let’s kill two birds with one stone:? Make a one-time offer of green cards to any foreigner who is willing to buy a house in the US worth $250,000 or more, free and clear.

There are many advantages to this proposal:

  • The foreigners that come will be wealthy, and will contribute even more to the US economy.
  • They will appreciate the stability and freedom of the US, and will send back positive signal to their powerful friends back in the “old country.”
  • Many will want a home in the US for vacations.? Others for a place to flee if politics turns against them in the “old country.”? Either way, we get more of their money.
  • If we want foreigners as citizens, we will be skimming the cream, rather than Emma Lazarus’ comments on the Statue of Liberty.? (Now, if you want to know my heart, I like immigrants, especially poor ones… they work hard to make America great.)
  • It solves problems in mortgage lending and the current account deficit in one fell swoop.

Now, this comes close to selling citizenship.? I don’t want that; they would still have to take the citizenship test, and? have the residency requirement.? Personally, I would like all new citizens to know English as well as? the 25th percentile in the US does now.? (low bar)

This is only partially serious; there are cultural aspects to immigration that are unpopular today.? I would only say to those that don’t like an idea like this, is that your great-grandparents (or so) were openly welcomed here a century ago.? Should we not welcome political, economic, and other migrants looking for a better life, even as our great-grandparents did?? Or are we more stingy than a generation that welcomed our great-grandparents, even if they had stronger negative views against those of different ethnic groups?

Ten Items — Saturday Evening Hodgepodge

Ten Items — Saturday Evening Hodgepodge

Posted on by David Merkel

There are times where I feel the intellectual well is dry, and I come to my keyboard and say, “What do I write tonight?” This is not one of those times. I have too many things to write about, and not enough time. I’ll see how much I can say that is worth reading.

1) Jimmy Rogers (I?ve met him once ? a nice guy) tends toward the sensational. There is a grain of truth in what he says, but the demographic situation in China is worse than that in Japan, which is why they Communist leadership there is considering eliminating the one-child policy:

I gave a talk last October, which included a lot on the effects of demographics on the global economy:

http://alephblog.com/society-of-actuaries-presentation/ (pages 15-23) (non-PDF versions have my lecture notes)

Now, eliminating the one-child policy won?t do that much, because most non-religious women in China don?t want to have kids. In developed societies, once women don?t want children or marriage, no level of economic incentive succeeds in changing their minds.

This isn?t meant to be social commentary. The point is that there is a global demographic shift of massive proportions happening where there will be huge social pressures on retirement/eldercare systems, because the ratio of workers to retirees will fall globally. China will be affected more than most, and the US less than most (if we can straighten out Medicare).

The economic effect will feel a little stagflationary, with wage rates improving in nominal terms, taxes rising to cover transfer payments, and assets being sold (to whom?) to fund retirements and healthcare. There need not be a crisis, like a war over resources, in all of this, but it won?t be an easy next 30 years. One thing for certain, when you look at labor, capital, and resources at present, the scarcest of all is resources. Again, resource price inflation. At present, capital is scarcer than labor, but that will flip in the next 30 years.

2) A few e-mailers asked for more data on how I view monetary aggregates. On monetary aggregates, my view of it is a little different than most, and I take a little heat for it. Ideally, the lower level monetary aggregates indicate a higher degree of liquidity; greater ease and shorter time of achieving transactions. The other way to view it is how sticky the liability structure is for the banks. Demand deposits, not sticky. Savings accounts, stickier. Money market funds, stickier still. CDs, even stickier.

As the Fed changes monetary policy, there are tradeoffs. Willingness of the public to hold cash, versus opportunity at the banks to make money from borrowing short and lending longer, versus banking regulators trying to assure solvency.

That’s why I look at the full spectrum of monetary measures. They tell a greater story as a group.

3) No such thing as a bad asset, only a bad price? No such thing as a bad asset, only a mis-financed asset? Both can be true. What we are experiencing today in many markets is that many assets were financed with too much debt and too little equity. In the process, because of the over-leverage allowed for high returns on equity to be generated from low returns on assets, the buyers of risky assets overpaid for their interests.

This has taken many forms, whether it was Subprime ABS, CDOs, SIVs, Tender Option Bonds, the correlation trade, etc. Also the borrow short, lend long inherent in Auction Rate Securities, TOBs, and other speculations that make wondeful sense occasionally, but players stay too long.

Rationality comes back to these markets when “real money buyers” appear (pension plans, insurance companies, wealthy dudes with nose for value), and these non-traditional buyers soak up the excess supply of investments that are out of favor, and do it with equity, at prices that make the unlevered return look pretty sweet. This is how excess leverage gets purged from the system, and how pricing normalizes, with losses delivered to the overlevered.

4) As I said in my post last night, there is value in the tax-free muni market for non-traditional buyers. Is this the bottom? Probably not, but who can tell? Smart buyers will put a portion of a full position on now, and add if things get worse. Don’t put a full position on yet. I eschew heroism in trading, in favor of a risk-controlled style, where one makes more on average, but protects the downside. It is possible that the drop in prices will bring out more sellers, but I think that there will be more buyers in the next week. That said, the leveraged buyers need to get purged out of the muni markets.

5) In late 2004, I wrote a piece called Default Cycle Will Turn Nasty in 2007. Later I added the following comment:


 David Merkel
A Low Quality Post by David
3/27/2006 3:54 PM EST

Interesting to note on Barry’s blog that he has noted that the “low quality” trade has been so stunning over the past three years. I thought Richard Bernstein at Merrill and I were the only ones who cared about this stuff. But now for the bad news: the trade won’t be over until high yield spreads start blowing out, and presently, they show no sign of doing that. Why? There haven’t been many defaults, for one reason. The few defaults have been for the most part in auto parts and airlines. There’s no systemic panic.

Beyond that, there’s a lot of capital to finance speculative ventures, and to catch bad ones when they fall. That means that marginal ideas are getting forgiveness as they get refinanced.

The demand for yield is huge, which drives the offering of protection in the credit default swap market. Fund of funds encourage hedge funds to seek steady income, which makes them tend to be insurers against default risk, rather than speculators on possible default.

I know that I wrote “Default Cycle Will Turn Nasty in 2007;” I take my calls seriously, because I have money on the line, and many of you do too. I think the low quality trade, absent a market blow-up, won’t outperform by a lot in 2006, but will still outperform. Something needs to happen to make credit spreads not look like a free lunch.

My best guess of what will do that is the seasoning of aggressive corporate bond issuance in 2004 and 2005. Bad credit be revealed for what it is, and even the stocks of low quality companies that eventually survive will get marked down for a time, as strong balance sheets get rewarded once again.

Position: none

Then later, in early 2007, I wrote: I was wrong on underperformance of junk bonds. Tight levels got even tighter, with an absence of significant defaults. Junk bonds led the bond market in 2006. In 2007, I don’t expect a repeat, but I do expect defaults to start rising by the end of 2007, leading to a widening in spreads and some underperformance of junk bonds. The real fun will come in 2008-2009. Corporate credit cycles last four to seven years, and the last bear phase was 2000-2002. We’re due for a correction here.

Well, I got it close to right. Timing is tough.

6) Would you pay a high enough price to buy a short-dated TIPS with a negative real yield? Yes you might, if you were hedging against nominal Treasuries, with the CPI running ahead at 4%, and short-dated (5 years and in) nominal bonds at 2 1/2% and lower. As it is, the market seems to be hesitating at going negative, but in my opinion it will, until the concern of the FOMC changes to price inflation.

7) Wilbur Ross didn’t get rich by being dumb. He didn’t buy stakes in MBIA or Ambac, but in one of the two healthy firms, Assured Guaranty. Better to take a stake in the healthy firm in a tough market; they will survive, and write the business that their impaired competitors can’t. This just puts more pressure on MBIA and Ambac, and provides a lower cost muni insurance competitor to Berky.

8 ) MBIA and Ambac are playing for time, and I don’t mean that in a bad way. They are willing to shrink their balance sheets, and write little if any structured business, pay principal and interest in dribs and drabs, and pray that S&P and Moody’s give them the time to do this, and keep the AAA/Aaa intact. It could be three years, and stronger players (FSA, BHAC, AGO) will absorb their non-structured markets. But it could work. If I were Bill Ackman, I would take off half my positions here. Just a rule of thumb for me, when I am managing institutional assets and I become uncertain as to whether I should buy or sell, I do half, and then wait for more data.

Remember, many P&C insurers have been technically insolvent (in hindsight) during the bear phase of the underwriting cycle. They survived by writing better business when their balance sheet was in worse shape than commonly believed. The financial guarantors have a unique ability to wait out losses.

9) There have been all sorts of articles asking whether XXX institution is “too big to fail?” Well, let me “flip it” (sending my pal Cody a nickel for his trademark 😉 ) and ask, “Is the US too big to fail?” There’s a reason for my madness here. “Too big to fail” means that the government will bail out an entity to avoid a systemic crisis. Nice, maybe, but that means the government raises taxes to do so (nah) or issues debt that the Fed monetizes, leading to price inflation. Either way, the loss gets spread over the whole country.

What would a failure of the US look like? The Great Depression springs to mind. Present day Japan does not. They are not growing, but they aren’t in bad shape. Another failure would be an era like the 1970s, but more intense. That’s not impossible, if the Treasury Fed were to rescue a major GSE via monetary policy.

10) I have had an excellent 4Q07 earnings season. As of the end of February, I am still in the plus column for my equity portfolio. But, into every life a little rain must fall… after the close on Friday. 🙁 Deerfield Capital reported lousy GAAP earnings, and I expect the price to fall on Monday. Now, to their credit:

  • They reduced leverage proactively, and sold Alt-A assets before Thornburg blew.
  • They moved to a more conservative balance sheet. It is usually a good sign when a company sells its bad assets in a crisis.

I would expect the dividend to fall to around 30 cents per quarter. I should have more to say after the earnings call. They are becoming a little Annaly with a CDO manager on board (might not be worth much until 2010).

I may be a buyer on Monday. Depends on the market action.

That’s all for this evening. Good night, and here’s to a more profitable week next week.

Full disclosure: long DFR

Berkshire Hathaway — The Anti-Volatility Fortress

Berkshire Hathaway — The Anti-Volatility Fortress

Posted on by David Merkel

I?ve commented on Buffett?s Shareholder letter now for the past five years.? Those who know me well know that I admire Buffett and Berky, but not uncritically.?? Also, I view Berky as primarily an insurance company, secondarily as an industrial conglomerate, and thirdly as an investment company.

Onto the letter:

From page 3:

You may recall a 2003 Silicon Valley bumper sticker that implored, ?Please, God, Just One More Bubble.? Unfortunately, this wish was promptly granted, as just about all Americans came to believe that house prices would forever rise. That conviction made a borrower?s income and cash equity seem unimportant to lenders, who shoveled out money, confident that HPA ? house price appreciation ? would cure all problems. Today, our country is experiencing widespread pain because of that erroneous belief. As house prices fall, a huge amount of financial folly is being exposed. You only learn who has been swimming naked when the tide goes out ? and what we are witnessing at some of our largest financial institutions is an ugly sight.

Buffett starts out with the cause behind most of our current problems in financial companies.?? There are too many houses chasing too few people, and inadequate underwriting of the financing, because of a misplaced trust in the rise of housing prices.

From page 4:

Though these tables may help you gain historical perspective and be useful in valuation, they are completely misleading in predicting future possibilities. Berkshire?s past record can?t be duplicated or even approached. Our base of assets and earnings is now far too large for us to make outsized gains in the future.? (emphasis his)

Buffett has been honest on this point for years.? As the business grows, it is unlikely to find opportunities as good in percentage terms as it did when it was smaller.? That?s normal, even for the best investors.

In our efforts, we will be aided enormously by the managers who have joined Berkshire. This is an unusual group in several ways. First, most of them have no financial need to work. Many sold us their businesses for large sums and run them because they love doing so, not because they need the money. Naturally they wish to be paid fairly, but money alone is not the reason they work hard and productively.

Buffett hits on what I think is one of the great secrets of good capitalism.? The best capitalists are not purely money-motivated, but are idealists, aiming for excellence as they serve others though their businesses.? In the best businesses that I have worked in, we did it because we loved what we did.? That?s a key for all good businesses, from the CEO down to the clerk.

From page 7:

Long-term competitive advantage in a stable industry is what we seek in a business. If that comes with rapid organic growth, great. But even without organic growth, such a business is rewarding. We will simply take the lush earnings of the business and use them to buy similar businesses elsewhere. There?s no rule that you have to invest money where you?ve earned it. Indeed, it?s often a mistake to do so: Truly great businesses, earning huge returns on tangible assets, can?t for any extended period reinvest a large portion of their earnings internally at high rates of return.

This is the core of Buffett the businessman.? He understands the need to redirect free cash flow to the opportunities that offer the best returns.? He knows that certain businesses will never be more than niches, and like a good farmer would, harvests his specialty crop each year, but doesn?t plant much more the next year.

He goes on for two pages on how he distinguishes between businesses, considering their long-term competitive advantage, return on investment, and capital intensiveness.??? It?s a good read, and very basic.? If it weren?t for the fact that many companies operate more for the good of management than shareholders, you might see this in operation more broadly.? (And you would see opportunities diminish for private equity as far as big deals go.? Private equity keeps public management teams on their toes, for the bigger deals.)

From pages 9-11, Buffett discusses his insurance businesses, and spends much less time on them than in prior years.? It is not as if there isn?t a good story to tell.? Are underwriting profits down?? Yes, but only by 10%.? The rest of the P&C insurance industry is struggling with the same problems, and is likely doing worse in aggregate.? I think that some major disasters will have to happen to re-energize earnings here.? Berky is an anti-volatility asset, and always does relatively better when the rest of the insurance industry is hurting.

On page 11, Buffett comments on his utility businesses.? Earnings are up in this line.? These are a natural fit for Berky, with their earnings yield considerably above Berky?s cost of float, and earnings that tend to do well when inflation is higher.? Expect Buffett to buy more here, but only during some significant pullback in utility stock prices.

From that page:

Somewhat incongruously, MidAmerican also owns the second largest real estate brokerage firm in the U.S., HomeServices of America. This company operates through 20 locally-branded firms with 18,800 agents. Last year was a slow year for residential sales, and 2008 will probably be slower. We will continue, however, to acquire quality brokerage operations when they are available at sensible prices.

From page 13:

Last year, Shaw, MiTek and Acme contracted for tuck-in acquisitions that will help future earnings. You can be sure they will be looking for more of these.

and

At Borsheims, sales increased 15.1%, helped by a 27% gain during Shareholder Weekend. Two years ago, Susan Jacques suggested that we remodel and expand the store. I was skeptical, but Susan was right.

?

From page 15:

Clayton, XTRA and CORT are all good businesses, very ably run by Kevin Clayton, Bill Franz and Paul Arnold. Each has made tuck-in acquisitions during Berkshire?s ownership. More will come.

Buffett understands that most good acquisitions are little ones that can be used to increase organic growth of the subsidiary. ?Same thing for intelligent capital spending, as at Borsheim?s.? He may keep a tight hold on free cash flow, but he listens to his subsidiary CEOs, and usually gives them enough to invest to improve the businesses.

Also look at the countercyclical nature of Buffett?s acquisitions.? He is willing to buy real estate sales franchises in this environment, if they come at the right price.? Much as I am a bear on housing, this is the right strategy, if you have a strong enough balance sheet behind it.

On pages 12 and 14, net operating income improved in Manufacturing, Service, and Retailing Operations, and fell in Finance and Finance Products.? He doesn?t discuss it, but there was a loss in life and annuity.? Berky mainly does life settlements there, a business I regard as somewhat malodorous because it undermines the life insurance industry, by weakening the concept of insurable interest.? Also, leasing didn?t do that well, as Buffett points out.

On page 15, I don?t have a strong opinion on his stock positions? they are a little more expensive than I like to buy, but he has to deploy a lot more money than I do, and has a longer time horizon.? His focus on long term competitive advantage is exactly right for his position in the market.

On page 16, Buffett discusses his derivative book:

Last year I told you that Berkshire had 62 derivative contracts that I manage. (We also have a few left in the General Re runoff book.) Today, we have 94 of these, and they fall into two categories. First, we have written 54 contracts that require us to make payments if certain bonds that are included in various high-yield indices default. These contracts expire at various times from 2009 to 2013. At yearend we had received $3.2 billion in premiums on these contracts; had paid $472 million in losses; and in the worst case (though it is extremely unlikely to occur) could be required to pay an additional $4.7 billion.

?

We are certain to make many more payments. But I believe that on premium revenues alone, these contracts will prove profitable, leaving aside what we can earn on the large sums we hold. Our yearend liability for this exposure was recorded at $1.8 billion and is included in ?Derivative Contract Liabilities? on our balance sheet.

?

The second category of contracts involves various put options we have sold on four stock indices (the S&P 500 plus three foreign indices). These puts had original terms of either 15 or 20 years and were struck at the market. We have received premiums of $4.5 billion, and we recorded a liability at yearend of $4.6 billion. The puts in these contracts are exercisable only at their expiration dates, which occur between 2019 and 2027, and Berkshire will then need to make a payment only if the index in question is quoted at a level below that existing on the day that the put was written. Again, I believe these contracts, in aggregate, will be profitable and that we will, in addition, receive substantial income from our investment of the premiums we hold during the 15- or 20-year period.

?

Two aspects of our derivative contracts are particularly important. First, in all cases we hold the money, which means that we have no counterparty risk.

?

Second, accounting rules for our derivative contracts differ from those applying to our investment portfolio. In that portfolio, changes in value are applied to the net worth shown on Berkshire?s balance sheet, but do not affect earnings unless we sell (or write down) a holding. Changes in the value of a derivative contract, however, must be applied each quarter to earnings.

?

Thus, our derivative positions will sometimes cause large swings in reported earnings, even though Charlie and I might believe the intrinsic value of these positions has changed little. He and I will not be bothered by these swings ? even though they could easily amount to $1 billion or more in a quarter ? and we hope you won?t be either. You will recall that in our catastrophe insurance business, we are always ready to trade increased volatility in reported earnings in the short run for greater gains in net worth in the long run. That is our philosophy in derivatives as well.

?

Okay, so Buffett is long high yield credit, and seemingly receiving a pretty reward for it (the numbers seem too good, what is he doing?), and is long the US and other equity markets by writing long-dated European puts.? Sounds pretty good to me on both, though I?d love to see the details on the high yield, and on the equity index puts, Berky will be vulnerable in a depression scenario (it would be interesting to know the details there also).

?

Buffett is behaving like a long-tail P&C insurer, and he is willing to take on volatility if it offers better returns.? Berky is almost always willing to take on catastrophe risks, if they are more than adequately compensated.? If you are uncertain about this, ask the financial guarantors, they will tell you.

?

On page 17:

?

There?s been much talk recently of sovereign wealth funds and how they are buying large pieces of American businesses. This is our doing, not some nefarious plot by foreign governments. Our trade equation guarantees massive foreign investment in the U.S. When we force-feed $2 billion daily to the rest of the world, they must invest in something here. Why should we complain when they choose stocks over bonds?

?

Indeed, what?s sauce for the goose is sauce for the gander.? Why should the rest of the world buy our depreciating bonds, when they can buy our companies, which in my opinion, often offer much better prospects?? As Buffett puts it later, we are force-feeding dollars to the rest of the world? the decline in value is to be expected.

?

Also on page 17:

?

At Berkshire we held only one direct currency position during 2007. That was in ? hold your breath ? the Brazilian real. Not long ago, swapping dollars for reals would have been unthinkable. After all, during the past century five versions of Brazilian currency have, in effect, turned into confetti. As has been true in many countries whose currencies have periodically withered and died, wealthy Brazilians sometimes stashed large sums in the U.S. to preserve their wealth.

?

Clever move, and emblematic of the shift happening in our world where resource- and cheap labor-driven nations grow rapidly, and build up trade surpluses against the developed world.? Their currencies have appreciated.

?

Also on page 17:

?

Our direct currency positions have yielded $2.3 billion of pre-tax profits over the past five years, and in addition we have profited by holding bonds of U.S. companies that are denominated in other currencies. For example, in 2001 and 2002 we purchased ?310 million Amazon.com, Inc. 6 7/8 of 2010 at 57% of par. At the time, Amazon bonds were priced as ?junk? credits, though they were anything but. (Yes, Virginia, you can occasionally find markets that are ridiculously inefficient ? or at least you can find them anywhere except at the finance departments of some leading business schools.)

?

The Euro denomination of the Amazon bonds was a further, and important, attraction for us. The Euro was at 95? when we bought in 2002. Therefore, our cost in dollars came to only $169 million. Now the bonds sell at 102% of par and the Euro is worth $1.47. In 2005 and 2006 some of our bonds were called and we received $253 million for them. Our remaining bonds were valued at $162 million at yearend. Of our $246 million of realized and unrealized gain, about $118 million is attributable to the fall in the dollar. Currencies do matter.

?

Though Buffett got scared out of many of his foreign currency positions over the last few years, intellectually he was right about the direction of the US dollar, and made decent money off it.? The Amazon position was a home run in bond terms.? Bill Miller benefited from that one as well.? (I also endorse the comment on occasional inefficient markets.)

?

On page 18:

?

At Berkshire, we will attempt to further increase our stream of direct and indirect foreign earnings. Even if we are successful, however, our assets and earnings will always be concentrated in the U.S. Despite our country?s many imperfections and unrelenting problems of one sort or another, America?s rule of law, market-responsive economic system, and belief in meritocracy are almost certain to produce ever-growing prosperity for its citizens.

?

This is one of America?s greatest sustainable competitive advantages.? We allow more flexibility and failure than anywhere else in the world.? We have a relatively open and free system of markets and government.? Woe betide us if we change this.

?

On pages 18-20, Buffett takes on employee stock option accounting and pension accounting.? He believes options should be expensed, and that companies should bring down their assumptions for investment earnings, because they are unrealistically high.? I agree on the latter, and on the former, I think full disclosure is good enough.? Accounting rules are important, but investors (like Buffett) look for long-term free cash flows, which are largely unaffected by accounting rules.

?

I don?t think the market is fooled in either case.? Companies with large stock option grants and high assumed earning on pension plans both tend to trade cheap.? Their earnings quality is light.

?

Finally, on page 20:

Whatever pension-cost surprises are in store for shareholders down the road, these jolts will be surpassed many times over by those experienced by taxpayers. Public pension promises are huge and, in many cases, funding is woefully inadequate. Because the fuse on this time bomb is long, politicians flinch from inflicting tax pain, given that problems will only become apparent long after these officials have departed. Promises involving very early retirement ? sometimes to those in their low 40s ? and generous cost-of-living adjustments are easy for these officials to make. In a world where people are living longer and inflation is certain, those promises will be anything but easy to keep.

?

Ummm? say it again, Warren.? I?ve been saying this for years.? Hey, throw in multiple employer trusts as well.

?

With that, I would offer two observations about this letter from Warren.? First, it is shorter, and contains less data on the businesses, particularly the insurance businesses, but then, it was a quiet year.? Second, he had less in the way of ?soap box? issues this year.

?

In closing, Berky had a good year, and I have little to quibble with in this letter.? Another good job, Warren.

One Dozen Thoughts on Bonds, Financials and Financial Markets

One Dozen Thoughts on Bonds, Financials and Financial Markets

Posted on by David Merkel

1) The blog was out of commission most of Saturday and Sunday, for anyone who was wondering what happened. From my hosting provider:

We experienced a service interruption affecting the Netfirms corporate websites and some of our customer hosted websites and e-mail services.

During scheduled power maintenance at our Data Centre on Saturday Feb. 23 at approximately 10:30 AM ET, the building’s backup generator system unexpectedly failed, impacting network connectivity. This affected several Internet and Hosting Providers, including Netfirms.

Ouch. Reliability is down to two nines at best for 2008. What a freak mishap.

2) Thanks to Bill Rempel for his comments on my PEG ratio piece. I did not have access to backtesting software, but now I do. I didn’t realize how much was available for free out on the web. He comes up with an interesting result, worthy of further investigation. My main result was that PEG ratio hurdles are consistent with a DDM framework within certain moderate values of P/E and discount rates. Thanks also to Josh Stern for his comments.

3) I posted a set of questions on Technical Analysis over at RealMoney, and invited the technicians to comment.


 David Merkel
Professionals are Overrated on Fundamental Analysis
2/21/2008 5:19 PM EST

I’m not here to spit at technicians. I have used my own version of technical analysis in bond trading; it can work if done right. But the same thing is true of fundamental investors, including professionals. There are very few professional investors that are capable of delivering above average returns over a long period of time. Part of it is that there are a lot of clever people in the game, and that raises the bar.

But I have known many good amateur investors that do nothing but fundamental analysis, and beat the pros. Why? 1) They can take positions in companies that are too small for the big guys to consider. 2) They can buy and hold. There is no pressure to kick out a position that is temporarily underperforming. With so many quantitative investors managing money to short time horizons, it is a real advantage to be able to invest to longer horizons amid the short-term volatility. 3) They can buy shares in companies that have been trashed, without the “looks that colleagues give you” when you propose a name that is down over 50% in the past year, even though the fundamentals haven’t deteriorated that much. 4) Individual investors avoid the “groupthink” of many professionals. 5) Individual investors can incorporate momentum into their investing without “getting funny looks from colleagues.” (A bow in the direction of technical analysis.)

When I first came to RM 4.4 years ago, I asked a question of the technicians, and, I received no response. I do have two questions for the technicians on the site, not meant to provoke a fundy/technician argument, but just to get opinions on how they view technical analysis. If one of the technicians wants to take me up on this, I’ll post the questions — hey, maybe RM would want to do a 360 on them if we get enough participation. Let me know.

Position: none


 David Merkel
The Two Questions on Technical Analysis
2/22/2008 12:15 AM EST

I received some e-mails from readers asking me to post the questions that I mentioned in the CC after the close of business yesterday. Again, I’m not trying to start an argument between fundies and techies. I just want to hear the opinions of the technicians. Anyway, here goes: 1) Is there one overarching theory of technical analysis that all of the popular methods are applications of, or are there many differing forms of technical analysis that compete against each other for validity (and hopefully, profits)? If there is one overarching method, who has expressed it best? (What book do I buy to learn the theory?)

2) In quantitative investing circles, it is well known (and Eddy has written about it recently for us) that momentum works in the short run, and is often one of the most powerful return anomalies in the market. Is being a good technician just another way of trying to decide when to jump onto assets with positive price momentum for short periods of time? Can I equate technical analysis with buying momentum?

To any of you that answer, I thank you. If we get enough answers, maybe the editors will want to do a 360.

Position: none

I kinda thought this might happen, but I received zero public responses. I did receive one thoughtful private response, but I was asked to keep it private. Suffice it to say that some in TA think there is a difference between TA and chart-reading.

As for me, though I have sometimes been critical of TA, and sometimes less than cautious in my words, my guesses at the two questions are: 1) There is no common underlying theory to all TA, there are a variety of competing theories. 2) Most chart-readers are momentum players, as are most growth investors. Some TA practitioners do try to profit from turning points, but they seem to be a minority.

I’m not saying TA doesn’t work, because I have my own variations on it that I have applied mainly to bond investing. But I’m not sure how one would test if TA in general does or doesn’t work, because there may not be a commonly accepted definition of what TA would say on any specific situation.

4) One more note from RM today:


 David Merkel
Just in Case
2/25/2008 4:20 PM EST

Um, after reading this article at the Financial Times, I thought it would be a good idea for me to point readers to my article that explained the 2005 Correlation Crisis. Odds are getting higher that we get a repeat. What would trigger the crisis? A rapid decline in creditworthiness for a minority of companies whose debts are referenced in the relevant credit indexes, while the rest of the companies have little decline in creditworthiness. One or two surprise defaults would really be gruesome.

Just something to watch out for, as if we don’t have enough going wrong in our debt markets now. I bumped into some my old RM articles and CC comments from 2005, and the problems that I described then are happening now.

Position: none, and there are times when I would prefer not being right. This is one of them. Few win in a bust.

There are situations that are micro-stable and macro-unstable, and await some force to come along and give it a push, knocking it out of its zone of micro-stability, and into a new regime of instability. When you write about situations like that before the fact, it is quite possible that you can end up wrong for a long time. I wrote for several years as RM about overleveraging credit, mis-hedging, yield-seeking, over-investment in residential real estate (May 2005), subprime lending (November 2006), quantitative strategies gone awry, etc. The important thing is not to put a time on the prediction because it gives a false message to readers. One can see the bubble forming, but figuring out when cash flow will be insufficient to keep the bubble financed is desperately hard.

5) This brings up another point. It’s not enough to know that an investment will eventually yield a certain outcome, for example, that a distressed tranche of an ABS deal will eventually pay off at par. One also has to understand whether an investor can handle the financing risks before receiving the eventual payoff. Will your prime broker continue to finance you on favorable terms? Will your regulator force you to put up more capital against the position? Will your investors hang around for the eventual payoff, or will they desert you, and turn you into a forced seller? Can your performance survive an asset that might be a dud for some time?

This is why the price path to the eventual payoff matters. It shakes out the weak holders, and moves assets that should be financed by equity onto strong balance sheets. It’s also a reason to be careful with your own balance sheet during boom times, and in the beginning and middle of financial crises — don’t overextend your positions, because you can’t tell how long or deep the crisis might be.

6) I agree with Caroline Baum; I don’t think that the FOMC is pushing on a string. The monetary aggregates are moving up, and nominal GDP will as well… it just takes time. The yield curve has enough slope to benefit banks that don’t face a lot of credit problems… and the yield curve will steepen further from here, particularly if the expected nadir of Fed funds drops below 2%. Now, will real GDP begin to pick up steam? Not sure, the real question is how much inflation the Fed is willing to accept in the short run as they try to reflate.

7) Now, inflation seems to be rising globally. At this point in the cycle, the FOMC is ahead of almost all major central banks in loosening policy. I think that is baked into the US dollar at present, so unless the FOMC gets even more ahead, the US Dollar should tread water here. Eventually inflation elsewhere will get imported into the US. It’s just a matter of time. That’s why I like TIPS here; eventually the level of inflation passing through the CPI will be reflected in implied inflation rates.

8 ) Okay, MBIA will split in 5 years? That is probably enough time to strike deals with most everyone that they wrote coverage for structured products, assuming the losses are not so severe that the entire holding company is imperiled. If it’s five years away, splitting is a possibility, but then are the rating agencies willing to wait that long? S&P showed that they are willing to wait today. Moody’s will probably go along, but for how long?

9) I found it interesting that AQR Capital has not been doing well in 2008. When quant funds did badly in the latter half of 2007, I suffered along with them. At present, I am certainly not suffering, but it seems that the quants are. I wonder what is different now? I suspect that there is too much money chasing the anomalies that the quant funds target, and we reached the end of the positive self-reinforcing cycle around mid-year 2007; since then, we have been in a negative self-reinforcing cycle, with clients pulling money, and the ability to carry positions shrinking.

10) Now some graphs tell a story. Sometimes the story is distorted. This graph of the spread on Fannie Mae MBS is an example. Not all of the spread is due to the creditworthiness of Fannie Mae. Those spreads have widened 30 basis points or so over the past six months for Fannie’s on-the-run 5-year corporate bond, versus 50 basis points on the graph that I referenced. So what’s the difference? Increased market volatility makes residential MBS buyers more skittish, and they demand a higher yield for bearing the negative optionality inherent in RMBS. Fannie and Freddie are facing harder times from the guarantees that they have written, and the credit difficulties at the mortgage insurers, but it would be difficult to imagine the US Government allowing Fannie or Freddie to default on senior obligations.

That’s another reason why I like agency-backed RMBS here. You’re getting paid a decent spread to bear the risks involved.

11) I would be cautious about using prics from CMBX, ABX, etc., to make judgments about the cash bonds that they reference. It is relatively difficult to borrow and short small ABS and CMBS tranches. It is comparatively easy to buy protection on the indexes, the only question is what level does it take to induce another market participant to sell protection to you. When there is a lot of pressure to short, prices overshoot on the downside, and stay well below where the cash bonds would trade.

12) One last point, this one coming via one of our dedicated readers passing on this blurb from David Rosenberg at Merrill Lynch:

A client sent this to us last week

It was a New York Times article by Louis Uchitelle in December 1990 on the housing and credit crunch. In the article, there is a quote that goes like this ? ?This is different from the experience of the Great Depression, but something related to the 1930?s is beginning to happen?. Guess who it was that said that (answer is at the bottom of the Tidbits).

Answer to question above

?Ben Bernanke, a Princeton University Economist? (and future Fed chairman, but who knew that then?).

My take: it is a very unusual time to have a man as Fed Chairman who is a wonk about the Great Depression. That makes him far more likely to ease. The real question is what the FOMC will do if economic weakness persists, and inflation continues to creep up. I know that they want to save the day, and then remove all policy accomodation, but that’s a pretty difficult trick to achieve. In this scenario, I don’t think the gambit will work; we will likely end up with a higher rate of price inflation.

One Year At The Aleph Blog!

One Year At The Aleph Blog!

Posted on by David Merkel

It has been one year since I started The Aleph Blog. During that time, we have seen a lot of changes:

  • The panic in China in late February 2007.
  • The troubles in subprime, home equity, and residential real estate generally. (Commercial real estate is a work in progress.)
  • Increased realized volatility in the markets.
  • Increased price inflation.
  • The accelerated decline in the US Dollar.
  • Blowout of private equity lending.
  • Trouble as the rating agencies and the financial guarantors.
  • Trouble in the money markets from SIVs and ABCP.
  • Troubles in the municipal bond markets, mainly from overspeculation, but also from troubles at the guarantors.
  • The FOMC shifts from being an inflation fighter to a weak economy and lending fighter.
  • I left my previous employer (good guys generally), and have become employed elsewhere (a much better match for my abilities and desires).
  • My broad market portfolio has adjusted to changing market conditions, and continues to outperform the S&P 500, as it has for the last 7.5 years.

Pretty amazing, I think. My blog is an expression of my character in the economics/finance/investment world. I have a lot of interests, so my blog is diversified in what I write about. There is almost always someone more experienced than me writing about a given issue. I think of myself as a good number 2 (3? 5? 10?) on many issues. Because of that, my job is to look for the interactions — the second-order effects in other markets that may give us a clue as to future happenings.

If you want to see a sampling of what I felt my best articles have been, you can look here. If you have other nominations for this category, I am all ears.

Why did I start the blog? Rejection from those that I wrote for and worked with. I was frustrated, and needed an outlet for self-expression. Learning from what I wrote at RealMoney, from the first day, I followed the same ethics code, to protect those that I worked for.

What of the future? I plan on some meaty articles on inflation, the PEG ratio, some book reviews, and perhaps a series on long-term investing for children. (In addition to what I mentioned in Post 500.)

Now, I did not expect the level of acceptance that I received in my first year, and so I thank my readers. I have been quoted in a wide number of places that I would not have expected when I started this. I only ask that if you like what I write, please refer my blog to your friends, as it seems best to you.

To all of my readers, here’s to a profitable year number two. Thanks for being with me over the past year. For those that have commented here, a special thank you. To my family and church, thank you. Finally, thanks be to Jesus Christ. Woo-hoo! What a great year! 😀

Ten Fed Notes, Plus One

Ten Fed Notes, Plus One

Posted on by David Merkel

I like variety at my blog.? I like to think about a lot of issues, and the interconnections within the markets.? Sometimes that makes me feel like a lightweight compared to others on critical issues.? But what I am is a stock and bond investor who analyzes the economy to make better investment decisions, primarily at the sector level, and secondarily at the asset class level.

At present, analyzing the FOMC is a little confusing.? Why?

  • We have Fed Governors speaking their minds, because Bernanke doesn’t maintain the control that Greenspan did.? Thus we hear a variety of views.
  • The economy is neither strong nor weak, but is muddling along.
  • The Dollar is weak, but doesn’t seem to be getting weaker; it seems that a pretty accommodative forecast of FOMC policy has been baked in.
  • MZM and my M3 proxy are running ahead at double-digit rates, while M2 trots at around 6%, and the monetary base lags at a 2% rate.? We are now more than nine months since our last permanent injection of liquidity.? I asked the Federal Reserve in an e-mail to tell me what the longest time was previously between permanent open market operations one month ago, but they did not respond to me.? (They did respond to me when I suggested my M3 proxy, total bank liabilities.)
  • The Treasury yield curve still has a 2% Fed funds rate in 2008, but the recent curve widening should begin to inject some doubt into the degree of easing that the Fed can do.? Once yield curves get near maximum steep levels, something bad happens, and the loosening stops.? At a 2% Fed funds rate, we will be near maximum steep.
  • The steepening of the curve has raised mortgage rates.? So much for helping housing.
  • The TAF auctions have reduced the TED spread to almost reasonable levels, but it almost seems that the Fed can’t discontinue the auctions, because the banks have found a cheap source of financing for collateral that can’t be accepted under Fed funds.
  • At present, I see a 50 basis point cut coming at the 3/18 meeting.? That’s what fits the yield curve, Fed funds futures, and the total chatter.? For the loosening trend to change, we will need something severe to happen, such as a inflation scare or a dollar panic.
  • Now the equity markets are not near their peak, but the debt markets are showing more fear, and that is what is motivating the Fed.? Capital levels at banks?? Credit spreads on bonds?? Ability to get financing?? The Fed cares about these things.
  • In some ways, Bernanke cares the most.? Of all the people to have in the Fed Chairman seat at this time, we get a man who is a scholar on the Great Depression, and determined to not let it happen again, supposing that it was insufficient liquidity from the Federal Reserve that led to the Depression.? That might not have been the true cause, but it does indicate a Fed biased toward easing, until price inflation smacks them hard.

One last note.? Though I haven’t read through the 2001 transcripts of the FOMC, I have scanned the 1999 and 2000 transcripts.? The FOMC is flexible in the way that they view policy, and willing to consider things that aren’t perfectly orthodox, such as the stock market, even if it is hidden in the rubric of the wealth effect.

Eight Thought on Our Fragile Debt Markets

Eight Thought on Our Fragile Debt Markets

Posted on by David Merkel

It’s early morning now, after two days on the road.? It is good to be home, and it will be good to get back to “regular work” once the workday begins.? A few thoughts:

1) Here are two Fortune articles where Colin Barr quotes me regarding Buffett’s offer to reinsure the muni liabilities of the financial guarantors.? He correctly quotes my ambivalent view.? I am not willing to take Ackman’s side here, nor that of the guarantors and rating agencies.? This is one of those situations where I don’t think anyone truly knows the whole picture.? My thoughts are limited to Buffett’s offer.? He’ a bright guy, and he is hoping that one of the guarantors is desperate enough to take him up on his offer.

2) Personally, I found this note from the WSJ economics blog worrisome.? Ben Bernanke is probably a lot smarter than me, but I can’t see amelioration in the residential real estate markets in 2008.? We still have increases in delinquency and defaults at present.? Vacancy is increasing. Inventory is increasing.? The market is not close to clearing yet.

3) I like the “quants.”? Are they a big force in the stock market?? Yes.? But they are an aspect of Ben Graham’s dictum that in the short run the stock market is a voting machine, but in the long run it is a weighing machine.? “Dark pools” sound worrisome, but to long-term investors they are a modest worry at best.? Traders should be concerned, but that is part of the perpetual war between traders and market makers/specialists.

4) There are two aspects to the concept of the rise in housing prices.? One is the scarcity of desirable land near where people want to live.? The second is that financing terms got too loose.? Marginal Revolution says there is/was no housing bubble.? They are focusing on the first issue, and downplaying the second issue.? My view is that there are legitimate reasons for housing prices to rise, but we built more homes than were needed, and offered financing terms to buyers that were way too generous.? To me, that is a bubble, and we are still working through it.

5) Auction-rate securities have always seemed to me to be micro-stable, but subject to macro-instability.? What do I mean?? Small fluctuations get absorbed by the investment banks, but large ones don’t.? As an old boss of mine used to say, “liquidity is a ‘fraidy cat.”? It’s around for minor jolts, but disappears in a crisis.

6) Muni bond insurance is thought insurance.? Most municipal bonds are small.? What credit analyst wants waste time analyzing a small municipality?? With a AAA guaranty, the bonds get bought in a flash, and they are liquid (so long as the guarantor continues to be viewed positively).? So, I still view municipal guarantees as having value.? Not everyone else does.

7)? Intuitively, I can feel the dispute regarding the recycling of the current account deficit.? The two sides boil down to:

  • When are they going to stop buying depreciating assets?
  • What choice do they have?? They have to do something with all the dollars that they hold.

It’s a struggle.? In the short run, supporting the US Dollar makes a lot of sense, but the build-up of continual imbalances is tough.? Why should we buy into a depreciating currency in order to support our exporters?

8 ) Privatize your gains, socialize your losses.? It’s a dishonest way to live, but many press their advantage in such an area. Personally, I think that losses need to be realized by aggressive institutions.? They took the risk, let them realize the (negative) reward.

That’s all for the morning.? Trade well, and be wary of things that work in the short run, but are long run unstable.

Still More Odds & Ends (Twelve this Time)

Still More Odds & Ends (Twelve this Time)

Posted on by David Merkel

1) I might not be able to post much for the next two days. I have business trips to go on. One is to New York City tomorrow. If everything goes right, I will be on Happy Hour with my friend Cody Willard on Tuesday.

2) As I wrote at RealMoney this morning:


 David Merkel
Buy Other Insurers off of the Bad AIG News
2/12/2008 2:54 AM EST

Sometimes I think there are too many investors trading baskets of stocks, and too few doing real investing work. I have rarely been bullish on AIG? I think the last time I owned it was slightly before they added it to the DJIA, and I sold it on the day it was added.Why bearish on AIG? Isn?t it cheap? It might be; who can tell? There?s a lot buried on AIG?s balance sheet. Who can truly tell whether AIG Financial Products has its values set right? International Lease Finance? American General Finance? The long-tail casualty reserves? The value of its mortgage insurer? I?m not saying anything is wrong here, but it is a complex company, and complexity always deserves a discount.

You can read my articles from 2-3 years ago where I went through this exercise when the accounting went bad the last time, and Greenberg was shown the door. (And, judging from the scuttlebutt I hear, it has been a good thing for him. But not for AIG.)

AIG deserves to be broken up into simpler component parts that can be more easily understood and valued. Perhaps Greenberg could manage the behemoth (though I have my doubts), no one man can. There are too many disparate moving parts.

So, what would I do off of the news? Buy other insurers that have gotten hit due to senseless collateral damage (no pun intended). As I recently wrote at my blog:

If Prudential drops much further, I am buying some. With an estimated 2009 PE below 8, it would be hard to go wrong on such a high quality company. I am also hoping that Assurant drops below $53, where I will buy more. The industry fundamentals are generally favorable. Honestly, I could get juiced about Stancorp below $50, Principal, Protective, Lincoln National, Delphi Financial, Metlife? There are quality companies going on sale, and my only limit is how much I am willing to overweight the industry. Going into the energy wave in 2002, I was quadruple-weight energy. Insurance stocks are 16% of my portfolio now, which is quadruple-weight or so. This is a defensive group, with reasonable upside. I?ll keep you apprised as I make moves here.

What can I say? I like the industry?s fundamentals. These companies do not have the balance sheet issues that AIG does. I will be a buyer of some of these names on weakness.

Position: long LNC HIG AIZ

3) More on AIG. As Cramer said yesterday: One last thought on the AIG issue: if President and CEO Martin Sullivan were to step down, the company might be more of a buy than a sale!

Maybe. Sullivan is a competent insurance executive with the biggest insurance job in the world. Breaking up the company, and letting the parts regain focus makes more sense. As an aside, M. R. Greenberg was known to be adamant about his ROE goal (15% after-tax on average equity), but he also liked the company to have bulk (high assets ? he liked asset-sensitive lines), which is why the ROA slid in the latter part of his tenure.

4) Some praise for Cramer on the same topic. As he said yesterday: AIG let me have it after I said last year that I couldn?t value the stock. They told me that there was a 92-page disclosure document and they wanted to know if I even looked at it. I shot back that not only did I look at it, but I had people comb it, including the forensic accountant I have on staff. The issue was always that despite the disclosure that they had CDO exposure, we couldn?t figure out what the real exposure was and we questioned whether THEY could.

Nothing gets a management more angry than being told that they don?t know what they are doing, but I was marveling at the certainty that they expressed. I told them they had tons of disclosure, but their estimation of possible losses seemed chimerical. I couldn?t figure out how THEY could value the stuff when no one else could with any certainty until it was off their books or written down. OF course, insurance companies aren?t held to the same standards of mark-to-market that banks are. They used mark-to-model, and the model, we learned today ? the Binomial Expansion Technique ? was totally wrong and dramatically understated the losses. All of this cuts to the incredible level of arrogance and stupidity on the Street, making judgments that were anti-empirical on data that could not be modeled but had to be experienced and examined nationally. In short, they were scientific and certain about something that couldn?t be quantified by science and certainly couldn?t be certain about.

Aside from the quibble that insurers for GAAP purposes are subject to the same rules as banks, Cramer got it right here. It is a major reason why I have been skeptical about AIG. Complexity in financial companies, especially financial companies that grow fast, is warranted. It is an unforgiving business where moderate conservatism works best.

5) Brief NAHC note: the CEO purchased more shares in the last few days. At least, it looks like it. Could he be acquiring shares to combat Hovde Capital? Honestly, I?m not sure, but this is looking more interesting by the day.

6) A new favorite blog of mine is Going Private. This post on insurance issues in Florida was unusual for that blog, but I thought it was perceptive. I wrote similar things at RealMoney:


 David Merkel
Move to Florida, Become a Reinsurer
3/27/2007 3:30 PM EDT

Interesting note in the National Underwriter on a Towers Perrin Study (also try here) describing how much Floridians will have to pay if a 1-in-250 hurricane hits Florida. Cost per household: $14,000, or $467 per year for 30 years. On a 1-in-50 storm, the figures would be $5,640, or $188 per year. There would also be a higher initial assessment as well. Note that the odds are actually higher than stated odds would admit. The stated odds of the large losses from the 2004 and 2005 storms happening in consecutive years would have been considered astronomical, but it happened anyway.

The Florida legislature can determine how the pain is shared, but they can?t legislate that the pain go away. No free lunch.

P.S. As an aside, the state of Florida is subsidizing reinsurance rates through its catastrophe fund. Ostensibly, Florida homeowners get a cut in rates, but the insurers give that cut only because their reinsurance costs are lower. Who?s the loser? The citizens of Florida will have to reach into their pockets to recapitalize the Hurricane Catastrophe Fund if big losses hit, and at the very time that they won?t want to do it. (Note to S&P: why do you give this state a AAA GO bond rating?)

Position: none mentioned


 David Merkel
The Worst Insurance State In The USA
2/2/2007 3:52 PM EST

I don?t want to go on a rant here, but I do feel strongly about this. It ill-befits a state government to behave like a bunch of thugs, even if it pleases the electorate. For over two decades, the worst state to do business in as an insurer was Massachusetts. New Jersey was competitive for a while, and California was pretty bad on Worker?s Comp, but now we have a new state on the top of the heap: Florida.

The failure of the Florida property insurance market was due to the lack of willingness to allow rates to rise sufficiently to attract capital into the market. The partial socialization of risk drove away that capital. So what does the governor and legislature of Florida do to meet the crisis? Increase the level of socialization of risk, and constrain companies to a binary decision: accept profits that don?t fairly reflect the risks underwritten, or leave the state. (And, they might try to forbid insurers from leaving.)

In my opinion, if they bar the door to insurers leaving, or not being allowed to non-renew policies, it is an unconstitutional ?taking? by the state of Florida. No one should be forced to do business that they don?t want to do. Fine to set up the regulatory rules (maybe), but it?s another thing to compel parties to transact.

Okay, here?s a possible future for Florida:

1) By the end of 2007, many insurers leave Florida; the state chartered insurer now has 33% of all of the primary property risk.
2) Large windstorm damages in 2008-2009, $100 billion in total, after a surprisingly light 2006-2007.
3) Florida finds that the capital markets don?t want to absorb more bonds in late 2009, after the ratings agencies downgrade them from their present AAA to something south of single-A.
4) The lack of ability to raise money to pay storm damages leads to higher taxes, plus the high surcharges on all insurance classes to pay off the new debt, makes Florida a bad place to live and do business. The state goes into a recession rivaling that of oil patch in the mid-1980s. Smart people and businesses leave, making the crisis worse.

Farfetched? No, it?s possible, even if I give a scenario of that severity only 10% odds. What is more likely is a watered-down version of this scenario. And, yes, it?s possible that storm damages will remain light, and Florida prospers as a result of the foolishness of their politicians. But I wouldn?t bet that way.

Position: long one microcap insurer that will remain nameless


 Marc Lichtenfeld
Florida Insurance
2/2/2007 4:17 PM EST

David,

While I don?t pretend to be the insurance maven that you are, I don?t believe it?s quite as black and white as you portray.

First, let me preface my comments by saying that I believe in free markets and don?t agree with the Governor?s plan, although I stand to benefit. Secondly, my insurance rates, while higher than I?d like are not too bad compared to others in the state.

That being said, I think something had to be done. In one scenario that you lay out, you describe smart people leaving due to higher taxes. That was already happening due to high insurance rates. Some people with affordable mortgages suddenly found their insurance rates skyrocketing from $2,000 to over $6,000. Lots of seniors on fixed incomes also saw their rates jump.

One factor in the housing slump is that buyers are having a hard time finding insurance on a house they are ready to close on. I know that three years ago, we were scrambling at the last minute to find an insurer who would write a policy ? and that was before all of the storms.

I?m not sure what the answer is. I fear that in an entirely free market, there will be very few insurers willing to do business here if there?s another bad storm.

Maybe that?s an argument that we shouldn?t be building major population centers right on the coast, but that?s another story.

Position: None



 David Merkel
My Sympathies to the People of Florida
2/2/2007 4:45 PM EST

Marc,

I understand the pain that many people in Florida are in. I know how much rates have risen. What I am saying is that the new law won?t work and will leave the people of Florida on the whole worse off. Florida is a risky place to write property coverage, and the increase in rates reflects a lack of interest of insurers and reinsurers to underwrite the risk at present rates and terms.

We don?t have a right to demand that others subsidize our lifestyle. But Florida is slowly setting up its own political crisis as they subsidize those in windstorm-prone areas, at the expense of those not so exposed. Commercial risks must subsidize coastal homeowners. Further, there is the idea lurking that the Feds would bail out Florida after a real emergency. That?s why many Florida legislators are calling for a national catastrophe fund.

They might get that fund too, given the present Congress and President, but Florida would have to pay in proportionately to their risks, not their population. Other proposed bills would subsidize Florida and other high risk areas. Why people in New York, Pennsylvania, Ohio should pay to subsidize Florida and California is beyond me.

The new law also affects commercial coverages; the new bill basically precludes an insurer from writing any business in Florida, if they write homeowners elsewhere, but not in Florida. If you want to chase out as many private insurers as possible, I?m not sure a better bill could have been designed. The law will get challenged in the courts; much of it will get thrown out as unconstitutional. But it will still drive away private insurance capacity.

I?m not writing this out of any possible gain for myself. I just think the state of Florida would be better served, and at lower rates, with a free market solution. Speaking as an insurance investor, I know of half a dozen or so new companies that were contemplating entering Florida prior to the new law. All of those ideas are now dead.

I hope that no hurricanes hit Florida, and that this bet works out. If there is political furor now in Florida, imagine what it would be like if my worst-case scenario plays out.

Position: long a small amount of one microcap insurer with significant business in Florida

Florida had now dodged the bullet for two straight years. Hey, what might happen if we have a bad hurricane year during an election year? Hot and cold running promises; I can see it now!

7) One of the best common-sense writers out there is Jonathan Clements of the WSJ. He had a good piece recently on why houses are not primarily investments. Would that more understood this. There are eras where speculation works, but those eras end badly. You can be a landlord, with all of the challenges, if you like that business. You can own a large home, but you are speculating that demand for the land it is on will keep growing. That is not a given.

8 ) My favorite data-miner Eddy, at Crossing Wall Street comes up with an interesting way to demonstrate momentum effects. Large moves up and down tend to continue on the next day, and the entire increase in the market can be attributed to the days after the market moves up 64 basis points.

9) This is not an anti-Cramer day. I like the guy a lot. I just want to take issue with this article: ?Trading in CDOs Slows to a Trickle.?? The basic premise is that CDOs are going away because trading in CDOs is declining.? Well, the same is true of houses, or any debt-financed instrument.? Volumes always slow as prices begin to fall, because momentum buyers stop buying.

Short of outlawing CDOs, which I don’t think can be done, though the regulators should consider what financial institutions should be allowed to own them.? That would shrink the market, but not destroy it.? Securitization when used in a moderate way is a good thing, and will not completely disappear.? Buyers will also become smarter (read risk-averse) at least for a little while.? This isn’t our first CDO blowup.? The cash CDO vintages 1997-1999 had horrible performance.? Now we have horrible performance.? Can we schedule the next crisis for the mid-teens?

10) On Chavez, he is a dictator and not an oil executive.? Maybe someone could send him to school for a little while so that he could learn a little bit about the industry that he is de facto running?? As MarketBeat points out, take him with with a grain of salt.? Venezuelan crude oil needs special processing, much of which is done in the US.? If he diverts the crude elsewhere, who will refine it for sale?

11) I am really ambivalent about Bill Gross.? He’s a bright guy, and has built a great firm.? Some of the things he writes for the media make my head spin.? Take this comment in the FT:

That the monolines could shoulder this modern-day burden like a classical Greek Atlas was dubious from the start. How could Ambac, through the magic of its triple-A rating, with equity capital of less than $5bn, insure the debt of the state of California, the world?s sixth-largest economy? How could an investor in California?s municipal bonds be comforted by a company that during a potential liquidity crisis might find the capital markets closed to it, versus the nation?s largest state with its obvious ongoing taxing authority? Apply the same logic to the gargantuan size of the asset-backed market it has insured in recent years ? subprimes and CDOs in the trillions of dollars ? and you must come to the same logical conclusion: this is absurd. It is as if Barney Fife, television?s Sheriff of Mayberry in The Andy Griffith Show, promised to bring law and order to the entire country.

Most municipal defaults are short term in nature, even those of states, of which there have been precious few.? Ambac, or any other guarantor, typically only has to make interest payments for a short while on any default.? It is a logical business for them to be in… they provide short term liquidity in a crisis, while the situation gets cleaned up.? In exchange for guarantee fees the municipalities get lower yields to pay.

The muni business isn’t the issue here… the guarantors should not have gotten into the CDO business.? That’s the issue.

12) I try to be open-minded, though I often fail.? (The problem of a permanently open mind is that it doesn’t draw conclusions when needed.? Good judgment triumphs over openness.)? I have an article coming soon on the concept of the PEG ratio.? This is one where my analytical work overturned my presuppositions, and then came to a greater conclusion than I would have anticipated.? The math is done, but the article remains to be written.? I am really jazzed by the results, because it answers the question of whether the PEG ratio is a valid concept or not.? (At least, it will be a good first stab.)

Full disclosure: long AIZ HIG LNC NAHC

The Boom-Bust Cycle, Applied to Many Markets

The Boom-Bust Cycle, Applied to Many Markets

Posted on by David Merkel

Every now and then, valuation metrics in a market will get changed by the entrance of an aggressive new buyer or seller with a different agenda than existing buyers or sellers in the marketplace.? Or conversely, the exit of an aggressive buyer or seller.

Think of the residential mortgage marketplace over the last several years.? With an “originate and securitize” model where no one enforced credit standards at all, credit spreads got really aggressive, and volumes ballooned. Many marginal mortgage lenders entered the market, because it was strictly a volume business.? Now with falling housing prices, there are high levels of delinquency and default, and mortgage volumes have shrunk, leading to the failures/closures of many of those marginal lenders.? Underwriting standards rise, as capacity drops out.? Even prime borrowers face tougher standards.? In two short years, fire has given way to ice.

If you’ll indulge another story of mine, I worked for an insurer who had a well-run commercial mortgage arm.? Very conservative.? They did small-ish loans on what I would call “economically necessary real estate.”? See that ugly strip mall with the grocery anchor?? Everyone in the area shops there; that’s a good property.

Well, in 1992, the head of the Commercial Mortgage area had a problem.? The company had only three lines of business, and two lines representing 60% and 20% of the assets of the firm were full up on mortgages.? What was worse, was they didn’t want to even replace maturing loans, because the ratings agencies had told the company that commercial mortgage loans were a negative rating factor.? Never mind the fact that the default loss rate was 40% of the industry average.

He stared down the possibility that he would have to close down his division.? He had one last chance.? He called the actuary that ran the division that I was in (my boss), and pitched him on doing some commercial mortgages.? The conversation went something like this:

Mortgage Guy: I know you haven’t liked commercial mortgages in the past, but my back is against the wall, and if you don’t take my originations, I’ll have to shut down.? You’ve heard that the other two divisions won’t take any more mortgages at all.?

Boss: Yeah, I heard.? But the reason we never took commercial mortgages was that we didn’t like the credit spread compared to the risks involved.? 150 basis points over Treasuries just doesn’t make it for us.

M: Well, because many companies have reduced originations, the spreads are 300 basis points now.

B: 300?! But what about the quality of the loans?

M: Only the best quality loans are getting done now.? I can insist on additional equity, in some cases recourse, and faster amortization.? My loan-to-values are the lowest I’ve seen in years.? Coverage ratios are similarly good.

B: Well, well.? Perhaps I’ve been right in the past, but I’m not pigheaded.? Look, we could take our percentage of assets in mortgages from 0% to 20%, but no more.? At your current origination rate, that would allow you to survive for two years.? We will take them all, subject to you keeping high credit quality standards.? Okay?

M: Thank you.? We’ll do our best for you.

And they did.? For the next two years, our line of business and the mortgage division had a symbiotic relationship, after which, spreads tightened significantly as confidence came back to the market.? We had 20% of our assets in mortgages, and the other two lines of business now felt comfortable enough with commercial mortgages to begin taking them again — at much lower spreads (and quality) than we received.

It’s important to try to look through the windshield, and not the rear-view mirror in investing.? Analyze the motives of current participants, new entrants, and their likely staying power to understand the competitive dynamics.? I’ll give one more example: the life insurance industry was a lousy place to invest for years.? Why?? A bunch of fat, dumb, and happy mutual companies were willing to write life insurance business earning a minimal return on capital.? As another boss of mine once said, “It doesn’t take mere incompetence to kill a mutual life insurer; it takes malice.”? Well, malice, or at least its cousin, killed a number of insurers, and crippled others in the late 80s to mid 90s.? Investment policies that relied on a rising commercial real estate market failed.

But that was the point to begin investing in life insurers.? They began pricing capital economically, and the industry began insisting on higher returns as a group.? Many mutuals demutualized, and the remaining large mutuals behaved indistinguishably from their stock company cousins.? The default cycle of 2001-2003 reinforced that; it is one of the reasons that the life insurance industry has had only modest exposure to the current difficulties afflicting most financials.? After years of being outperformed by the banks, the life insurers look pretty good in comparison today.

I could go on, and talk about the CDO and CLO markets, and how they changed the high yield bond and loan markets, or how credit default swaps have changed fixed income.? Instead, I want to close with an observation about a very different market.? Who likes Treasury bonds at these low yields?

Well, I don’t.? At these yield levels the odds are pretty good that you will lose purchasing power over a 2-3 year period.? Then again, I’m a bit of a fuddy-duddy.? So who does like Treasury yields at these levels?

  • Players who are scared.
  • Players who have no choice.

There is a “fear factor” in Treasury yields now.? Beyond that, there is the recycling of the current account deficit, which is still large relative to the issuance of Treasuries.? The current account deficit is large, but shrinking, since the US dollar at these low levels is boosting net exports.? As the current account deficit shrinks, Treasury yields should rise, because foreign demand has been a large part of the buyers of Treasuries.? The Fed can hold the short end of the curve where it wants to, but the long end will rise as the current account deficit shrinks.

I think the current account deficit does shrink from here, because the cost of buying US debts, and not buying US goods is getting prohibitive.? Also, fewer retail buyers will take negative real yields.

That’s my thought for the evening.? Analyze the motives of other players in your markets, and don’t assume that the current state of the market is an equilibrium.? Equilibria in economics are phantoms.? They exist in theory, but not reality.? Better to ask where new entrants or exits will come from.

Five Thoughts on the Financial Guarantors

Five Thoughts on the Financial Guarantors

Posted on by David Merkel

The Financial Guarantors are receiving a lot of attention these days, and for good reason.? I want to offer a few observations to give my own take on the problem:

1) With structured finance, the initial choice is “Do we ask a financial guarantor to bring the credit up to AAA, or do we do it through a senior-subordinate structure?”? A senior-subordinate structure has classes of lenders with differing rights to payment.? The AAA, or, senior lenders only take losses after the subordinate lenders (who are receiving higher yields) have lost all of their money.? In the present environment, S&P and Moody’s have been downgrading subordinates, and even some senior bonds in senior-sub structures.

This should lead to downgrades of MBIA and Ambac, eventually.? The rating agencies can’t keep downgrading bonds that are similar to those guaranteed by MBIA and Ambac, without downgrading them as well.? Remember, MBIA and Ambac were late to the party; their bonds are disproportionately weak because later lending standards were weaker.

2) The main difficulty with a bailout of the guarantors is that most interested parties have different interests.? That said, the beauty of a bailout is that the guarantor can sit back and pay timely principal and interest, while waiting for better times to come.

3) Did the rating agencies force the guarantors into the CDO business?? I’ve heard rumors to this effect, but it would be pretty easy to prove or disprove.? Look at when MBIA and Ambac entered the business, and look at the commentary from the rating agencies around it; if they are trumpeting diversification, then it is likely that they pitched it to the guarantors.? If not, then the guarantors did it on their own.

4) Even in a bailout of financial guarantors, current shareholders may find themselves diluted beyond measure.? Given current political pressures, those risks are elevated; remember that management teams want to keep their jobs, and that regulators have some say in that.

5) As I noted today at RealMoney:


 David Merkel
Considering the “Margin of Safety”
2/5/2008 11:07 AM EST

Tim, I like your stuff, since I am a value investor. Be careful with XL Capital. The challenge is estimating what sort of guarantees they face from Security Capital Assurance. When I looked at them last, the potential payments could be huge — potentially larger than XL’s net worth, but hey, that’s the financial guarantee business. I looked at XL during my last portfolio reshaping — Finish Line also, and could not get past the potential risks. I had easier plays to go for, with less uncertainty, if also lower upside. I don’t try to hit home runs, so it makes it easier for me to not buy the stocks that are optically stupid cheap, but might have balance sheet issues. Cheap means that a company will have the capability to carry their positions through a downturn; it’s part of the “margin of safety” that we require.

Anyway, keep it up, and let’s see if we can’t make some money on our value investing.

Please note that due to factors including low market capitalization and/or insufficient public float, we consider Security Capital Assurance and Finish Line to be small-cap stocks. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.

Position: none

?XL was downgraded recently as a result of those guarantees.? I would be cautious here.

-=-=-=-=-=-

Summary: there is still downside risk here.? Avoid the financial guarantors, and economic areas affected by the overleveraging of our credit markets. ? Stick with companies that have strong balance sheets.

Theme: Overlay by Kaira.