Real Estate and Mortgages – Page 8

The Rules, Part XXXIX

Posted on 24 May 2013 by David Merkel

The trouble with VAR and other mathematical models of risk is that if it becomes the dominant paradigm, and everyone begins to use it, it creates distortions in the market, because institutions gravitate to asset classes that the model makes to appear artificially cheap.? Then after a self-reinforcing cycle that boosts that now favored asset class to an unsupportable level, the cashflows underlying the asset can no longer support it, the market goes into reverse, and the VAR models encourage an undershoot.? The same factors that lead to buying to an unfair level also cause selling to an unfair level.

Benchmarking and risk control through VAR only work when few market participants use them.? When most people use them, it becomes like the portfolio insurance debacle of 1987.? VAR becomes pro-cyclical at that point.

Sometimes I think the Society of Actuaries is really dumb.? The recent financial crisis demonstrated the superior power of long-term actuarial stress-testing versus short-term quant models for analyzing risk.? The actuarial profession has not taken advantage of this.? Now, maybe some investment bank could adopt an actuarial approach to risk, and they will be much safer.? But guess what?? They won’t do it because it will limit risk taking more than other investment banks.? Unless the short-term risk model is replaced industry-wide with a long-term risk model, in the short-run, the company with the short-term risk model will do better.

The reason why VAR does not effectively control risk is simple.? VAR is a short-term measure in most of its implementations.? It is a short-term measure of risk for short- and long-term assets.? Just as long-term assets should be financed with long-term liabilities, so should risk analyses be long-term for long-term assets.

This mirrors financing as well, because bubbles tend to occur when long-term assets are financed by short-term liabilities.? Risk gets ignored when long-term assets are evaluated by short-term price movements.

And, as noted above, these effects are exacerbated when a lot parties use them; a monocultural view of short-run risk will lead to booms and busts, much as portfolio insurance caused the crash in 1987.? If a lot of people trade in such a way as to minimize losses at a given level, that sets up a “tipping point” where the market will fall harder than anyone expects, should the market get near that point.

The idea that one can use a short-term measure of risk to measure long-term assets assumes that markets are infinitely deep, and that there are no games being played.? You have the capacity to dump/acquire the whole position at once with no frictional costs.? Ugh.? Today I set up a new client portfolio, and I was amazed at how much jumpiness there was, even on some mid-cap stocks.? Liquidity is always limited for idiosyncratic investments.

The upshot here is simple: with long term assets like stocks, bonds, housing, the risk analysis must be long term in nature or you will not measure risk properly, and you will exacerbate booms and busts.? It would be good to press for regulations on banks to make sure that all risk analyses are done to the greater length of the assets or the liabilities (and with any derivatives, on the underlying, not contract term).

Easy In, Hard Out (Updated)

Posted on 10 May 2013 by David Merkel

My view is that there is no such thing as a free lunch, not even for governments or central banks.? Any action taken may have benefits, but also imposes costs, even if those costs are imposed upon others.? So it is for the Fed.? At the beginning of 2008, they had a small, clean, low duration (less than three years) balance sheet on assets.? Today the asset side of their balance sheet is much larger, long duration (over 6 years), negatively convex, and modestly dirty as a result.? Let me give you a few graphs created from the H.4.1 data, obtained via the poorly designed and touchy Data Download Program at the Fed?s H.4.1 portion of their website.

The first graph gives the liabilities of the Fed over the last 5+ years.? The data is taken from table 1 in the H.4.1 release.? You can see the massive expansion of the liabilities, and the way the crisis unfolded.? Currency, and ?Other Liabilities & Capital? build ?slowly,? i.e. 6.9%/yr and 10.2%/yr, respectively.? The US Treasury steps in with the Supplementary Financing Account at a few points where the Fed could use money deposited there for further expansion of quantitative easing, and leaves when they are no longer needed.

But the real growth comes in the ?Everything else? which grew at 37%/yr, and reserve balances with Federal Reserve Banks, which you can calculate an annualized rate of growth for (112%/yr), but a rate doesn?t do justice to the process, because it grew due to the three events ? QE1, QE2, and QE3.? The Fed bought assets from various parties, who now deposit at banks inside the Federal Reserve System.

The next two graphs come from Table 2 of the H.4.1 report.? These describe the assets that have a maturity, which comprise over 80% of the Fed?s assets over the time of the graph, and over 90% at present.? First, you can see the growth of the assets bought through QE, Treasuries, Agencies, and MBS.? Second, you see the crisis responses: 1) the loan programs in the US, which explode and trail away and 2) the Central Bank Liquidity Swaps, which explode, trail away, and have come back in a muted form in late 2011 to early 2012.

Perhaps the bigger change is that the Fed?s balance sheet has a lot more long-maturity assets than it used to.? This stems from the quantitative easing they have done, as well as their efforts to ~~play God~~ flatten the Treasury yield curve.

Now, almost all of the assets underlying everything 10 years and shorter pay out their principal all at the end, with no right of prepayment.? For 10 years and longer, at present 70% are Mortgage Backed Securities [MBS].? Those have average lives (weighted average time for payment of principal) considerably shorter than a bond that pays all of its principal at the end for three reasons:

Principal gets paid down slowly due to normal amortization.
Prepayments get made when it is advantageous to the borrower, which not only pays off principal today, but shortens the term of the loan, which accelerates the normal repayment of principal.
The final maturity of the longest loan in the pool is the final maturity of the pool.

So, in terms of actual interest rate sensitivity, the over 10 years bucket is probably only a little more sensitive to change in rates than the 5-10 year bucket.

In normal times, central banks buy only government debt, and keeps the assets relatively short, at longest attempting to mimic the existing supply of government debt.? Think of it this way, purchases/sales of longer debt injects/removes liquidity for longer periods of time.? Staying short maintains flexibility.

Yes, the Fed does not mark its securities or gold to market.? Under most scenarios, it is impossible for a central bank which can issue its own currency to go broke.? Rare exceptions ? home soil wars that fail, or political repudiation of the bank, where the government might create a new monetary standard, or closes the bank because of inflation.? (Hey, the central bank has been eliminated twice before.? It could happen again.)

The only real effect is on how much?seigniorage the Fed remits to the Treasury, or, if things go bad, how much the Treasury would have to lend/send to the central bank in order to avoid the bad optics of negative capital, perhaps via the Supplemental Financing Account.? This isn?t trivial; when people hear the central bank is ?broke,? they will do weird things.? To avoid that, the Fed?s gold will be revalued to market at minimum; hey maybe the Fed at that time will be the vanguard of market value accounting, and revalue everything.? Can you imagine what the replacement cost of the NY Fed building is?? The temple in DC?

Or, maybe the bank would be recapitalized by its member banks, if they are capable of doing so, with the reward being the preferred dividend they receive.

Back to the main point.? What effect will this abnormal monetary policy have in the future?

Scenarios

1) Growth strengthens and inflation remains low.? In this unusual combo, it will be easy?for the Fed to collapse its balance sheet, and raise rates.? This is the dream scenario; and I don?t think it is likely.? Look at the global economy; there is a lot of slack capacity.

2) Growth strengthens and inflation rises.? The Fed will likely raise the interest on reserves rate, but not sell bonds.? If they do sell bonds, the market will back up, and their losses will be horrible.? If don?t take the losses,?seigniorage could be considerably reduced, or even vanish, as the Fed funds rate rises, but because of the long duration asset portfolio, asset income rises slowly.? This is where the asset-liability mismatch bites.

If the Fed doesn?t raise the interest on reserves rate, I suspect banks would be willing to lend more, leaving fewer excess reserves at the Fed, which could stimulate more inflation. Now, there are some aspects of inflation that remain a mystery ? because sometimes inflationary conditions affect assets, rather than goods, I think depending on demographics.

3) Growth weakens and inflation remains low.? This would be the main scenario for QE4, QE5, etc.? We don?t care much about the Fed?s balance sheet until the Fed wants to raise rates, which is mainly a problem in Scenario 2.

4) Growth weakens and inflation rises, i.e. stagflation.? There?s no good set of policy options here. The Fed could engage in further financial repression, keeping short rates low, and let inflation reduce the nominal value of debts.? If it doesn?t run wild, it could play a role in reducing the indebtedness of the whole economy, though again, it will favor debtors over savers.? (As I?ve said before, in a situation like this, or like the Eurozone, all creditors want to be paid back at par on the bad loans that they have made, and it can?t be done.? The pains of bad debt have to go somewhere, where it goes is the argument.)

I?ve kept this deliberately simple, partially because with all of the flows going back and forth, and trying to think of the whole system, rather than effects on just one part, I know that I have glossed over a lot.? I accept that, and I could be dead wrong, as I sometimes am.? Comment as you like, with grace and dignity, and let us grow together in our knowledge.? I?ve been spending some time reading documents at the Fed, trying to understand their mechanisms, but I could always learn more.

Summary

During older times, the end of a Fed loosening cycle would end with the Fed funds rate rising.? In this cycle, it will end with interest of reserves rising, and/or, the sale of bonds, which I find less likely (they will probably be held to maturity, absent some crisis that we can?t imagine, or non-inflationary growth).? But when the tightening cycle comes, the Fed will find that its actions will be far harder to take than when they made the ?policy accommodation.?? That has always been true, which is why the Fed during its better times limited the amount of stimulus that it would deliver, and would tighten sooner than it needed to.

Far better to be like McChesney Martin or Volcker, and be tough, letting recessions do their necessary work of eliminating bad debt.? Under Greenspan, and Bernanke to a lesser extent (though he persists in pushing the canard that the Fed was not too loose 2003-2004, ask John Taylor for more), there were many missed opportunities to stop the buildup of bad debts, but the promise of the ?Great Moderation? beguiled so many.

Removing policy accommodation is always tougher than imagined, and carries new risks, particularly when new tools have been used.? Bernanke can go to his carefully chosen venues and speak to his carefully chosen audiences, and try to exonerate the Fed from well-deserved blame for their looseness in the late 80s, 90s, and 2000s.? Please, Mr. Bernanke, take some blame there on behalf of the Fed ? the credit boom could never have happened without the Fed.? Painting the Fed as blameless is wrong; the ?Greenspan put? landed us in an overleveraged bust.

I?m not primarily blaming the Fed for its current conduct; we are still in the aftermath of a lending bust ? too much bad mortgage debt, with a government whose budget is out of balance.? (In the bust, there are no good solutions.)? I am blaming the Fed for loose policies 1984-2007, monetary policy should have been a lot tighter on average.? But now we live with the results of prior bad policy, and may the current Fed not compound it.

Postscript

The main difference between this time and the last time I wrote on this is QE3.? What has been the practical impact since then?? The Fed owns more MBS and long maturity Treasuries, financed by more reserve balances at the Fed.

Banks use this cheap funding to finance other assets.? But if they want to make money, the banks have to take credit risk (something the Fed is trying to stimulate), and/or interest rate rate risk (borrow short, lend long, negative convexity, etc).? The longer low rates go on through interest on reserves, the greater the tendency to build up imbalances in the banking system through credit and interest rate risks. 1992-1993 where Fed funds rates were held at 3%, was followed by the residential mortgage backed security market melting down in 1994, not to mention Mexico.? Sub-2% Fed funds rates from 2002 through mid-2004 led to massive overinvestment in residential housing, leading to the present crisis.

Fed tightening cycles often start with a small explosion where short-dated financing for thinly capitalized speculators evaporates, because of the anticipation of higher financing rates.? Fed tightening cycles often end with a large explosion, where a large levered asset class that was better financed, was not financed well-enough.? Think of commercial property in 1989, the stock market in 2000 (particularly the NASDAQ), or housing/banks in 2008.? And yet, that is part of what Fed policy is supposed to do: reveal parts of the economy that are running too hot, so that capital can flow from misallocated areas to areas that are more sound.? At present, my suspicion is that we still have more trouble to come in banking sector.? Here’s why:

We’ve just been through 4.5 years of Fed funds / Interest on reserves being below 0.5% — this is a far greater period of loose policy than that of 1992-1993 and 2002 to mid-2004 together, and there is no apparent end in sight.? This is why I believe that any removal of policy accommodation will prove very difficult.? The greater the amount of policy accommodation, the greater the difficulties of removal.? Watch the fireworks, if/when they try to remove it.? And while you have the opportunity now, take some risk off the table.

Redacted Version of the May 2013 FOMC Statement

Posted on 1 May 20131 May 2013 by David Merkel

Comments

Notable: they take issue with fiscal policy being too restrictive.? And this is with near-record deficits.? What do they want, larger deficits so they can do more QE?? The relationship between the Fed and the Treasury is already co-dependent enough.
Not so notable, this new sentence: The Committee is prepared to increase or reduce the pace of its purchases to maintain appropriate policy accommodation as the outlook for the labor market or inflation changes.? Not really needed, because it is implied in what follows the sentence.
Aside from that, this FOMC Statement was a nothing-burger.
I really think the FOMC lives in a fantasy world.? The economy is not improving materially. Also note that the CPI is close their 2.5% line in the sand.? TIPS-implied inflation 1X1 (one year ahead for one year) is 2.25%, and 5X5 is around 2.65% annualized.
Current proposed policy is an exercise in wishful thinking.? Monetary policy does not work in reducing unemployment, and I think we should end the charade.
In my opinion, I don?t think holding down longer-term rates on the highest-quality debt will have any impact on lower quality debts, which is where most of the economy finances itself. When this policy doesn?t work, what will they do?
Also, the investment in Agency MBS should have limited impact because so many owners are inverted, or ineligible for financing backed by the GSEs, and implicitly the government, even with the recently announced refinancing changes.
The key variables on Fed Policy are capacity utilization, unemployment, inflation trends, and inflation expectations.? As a result, the FOMC ain?t moving rates up, absent increases in employment, or a US Dollar crisis.? Labor employment is the key metric.
GDP growth is not improving much if at all, and the unemployment rate improvement comes more from discouraged workers.

Classic: Get to Know the Holders? Hands, Part 2

Posted on 24 April 2013 by David Merkel

Note: this was published at RealMoney on 7/2/2004.? This was part four of a? four part series. Part One is lost but was given the lousy title: Managing Liability Affects Stocks, Pt. 1.? If you have a copy, send it to me.

Fortunately, these were the best three of the four articles.

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Investing Strategies

Some groups can reinforce their own behavior in the market, causing booms and busts.

Balance sheet players tend to be strong holders.

Liquidity can change the market landscape.

In Part 1 of this column, I began describing the various classes of investors and their investment behavior. In Part 2, I’ll continue that description, and will follow it up by explaining how some classes of investors can temporarily reinforce their own behavior, causing booms and busts. Finally, I will offer practical ways you can benefit from understanding the behaviors of different investor classes.

8. Leveraged Private Investors

The use of leverage gives the investor the ability to make more out of his bets than his equity capital would otherwise allow, but eliminates some of the advantages that the unleveraged possess. Investors that are leveraged do not entirely control their trade; if their assets decline enough in value, either they or the margin desk will reduce their position.

Leveraged investors are in the same position as the European banks that I discussed in Part 1. Worry sets in as one gets near a margin call, not when the margin call happens. As worry sets in, mental pressures to change the asset positions materialize. The challenge to the investor is to decide whether to liquidate, or take chances. Being forced to make a decision leads to a higher probability, in my opinion, of making the wrong decision.

In addition, leveraged longs have to pay for the privilege of financing additional assets. With overnight rates low today, that might not seem like much of a cost. But when the market is in the tank and interest rates are sky-high, as they were from 1979 to 1982, the cost of leveraged speculation is a deterrent and helps keep a lid on the market.

9. Short-Sellers

Being short is not the opposite of being long. It is closer to the opposite of being a leveraged long. Shorts do not entirely control their trade; if their shorts rise enough in value, either they or the margin desk will reduce their position. This is the opposite of leveraged longs. Remember, unleveraged longs can stay put as long as they like, and almost no one can force them to change. Shorts can be forced to cover through a squeeze, whether through rising prices threatening their solvency or a decrease in borrowable shares from longs moving their shares from margin to cash.

Stocks with a large short interest relative to the float, like Taser (TASR:Nasdaq) , can behave erratically with little regard to anything more than the short-term technicals of trading. (If fundamental investing is akin to a chess game, trading Taser is more akin to a street brawl.)

Short-sellers also have costs that unleveraged longs don’t face. When it is difficult to borrow shares (i.e., the borrow is tight), you might have to pay for the privilege of borrowing. As an example, when I was short Mony Group, I had a 2% annualized rate to pay on the last block of shares that I shorted. The rest came free, but that was before the trade got crowded. (When the borrow is not tight and if you are big enough, it is possible to get a credit, but that’s another story.)

Another cost is paying any dividend that the company might pay. Granted, the stock is likely to drop by the amount of the dividend, but cash going out the door to support a trade makes a trade more difficult to hold on to.

10. Options Traders

Buyers of options fully control their trade and pay a premium for the privilege. Sellers of options give up some control of their trade and receive a premium for their trouble. Being short an option is like being short a stock; theoretically, the risk is unlimited. If the short options of an investor rise enough in value, either they or the margin desk will reduce their position. Long option investors face no such constraints, but they do face the continual decay of the time premium of their options.

When there are company-issued options outstanding, such as warrants, convertible preferreds and convertible bonds, another trading dynamic can develop. Because the company has offered the call options on its stock, unlike other investors, it can issue stock to satisfy calls. The dilution from share issuance can put a ceiling over the price of the stock near the strike price for the call options until enough demand exists for the stock that it overcomes the dilution.

One more example of embedded options shows up in the residential mortgage bond market. Residential mortgages contain an option that allows the mortgage to be prepaid. Mortgage bond managers, who often manage to a constant duration (interest-rate sensitivity), run into the problem that their portfolios lengthen when rates rise, and shorten when rates fall. This can make them buyers of duration (longer mortgages or noncallable Treasuries) when rates fall, and sellers when rates rise.

In either case, with enough mortgage managers (and mortgage originators, who are in the same boat) doing this, it can become self-reinforcing because many market players buy into a rising market and sell into a falling market. This has an indirect effect on the Treasury and swap markets because mortgage hedgers use them to adjust their overall interest-rate sensitivity. In general, mortgage hedgers are weak holders of Treasuries, which they sell off as rates rise.

Balance Sheet Players vs. Total Return Players

I find it useful to divide the players in the investment universe into two camps: balance sheet players and total return players. Balance sheet players can lose it all and then some. Total return players can lose only what they have invested and include mutual funds (including index funds), unleveraged private investors, defined benefit plans, option buyers and endowments. Balance sheet players include banks, insurance companies, leveraged private investors and option sellers.

Total return players tend to resist — or at least are capable of resisting — market trends, which provide stability in the market. At the edges of negative price movements, balance sheet players find that they have to sell risky assets in order to preserve themselves. In severe market conditions, balance sheet players can make market movements more extreme.

I think it helps to view the behavior of balance sheet players through the lens of self-reinforcement. When there are too many of them crowding into a trade, there is the potential for instability. If the price of the asset has been bid up to the point to where a buy-and-hold investor would feel that he could not obtain a free cash flow yield adequate to compensate him for the risk of the purchase, then the asset is unsustainably high, which does not mean that it can’t go higher. When you see long-term investors exiting, it’s usually time to leave.

Fueled by leverage, some players will increase their bets as the price of the asset rises because they have more buying power with a more expensive asset. Finally, a few smart players start to sell and the process works in reverse as leverage levels increase for balance sheet players with a large concentration in the stock and a self-reinforcing cycle of selling begins. The same boom-bust cycle can happen with total return players, but it would be more muted because of the lack of leverage.

At the end of the bust, the buyers typically are unleveraged buy-and-hold investors. For example, I remember picking over tech and telecom stocks in 2001-02 that had been trashed after the bubble burst. This is a sector of the market that I don’t play in often, because I don’t know it so well; that said, it became 30% of my portfolio. Many of those stocks were trading for less than their net cash and a few were even earning money. My thought at the time was that if I tucked a few of these stocks away and held them for five years or so, I’d have something better at the end. With the bull market of 2003, my exit came sooner than I expected; other market players saw the potential of the cheap, conservative tech companies that I held and liked them more than I did.

This brings me back to weak and strong hands. In general, total return players have stronger hands than balance sheet players, at least when market values are out of whack with long-term fundamentals.

Illiquidity and LTCM

An asset is illiquid when the bid-ask spread is wide, or even worse, when there is no bid or ask for a given asset in the short run. This can happen with large orders in small-cap stocks and in “off the run” corporate bonds. Often an illiquid asset offers a higher potential return than a more liquid asset; given the disadvantage of illiquidity, in a normal market it would have to. Even a liquid asset can act illiquid if you hold a large amount of it relative to the total float. Trying to sell rapidly would drive down its price.

To hold illiquid assets, you either have to hold them with equity or a low degree of leverage with a funding structure for the leverage that can’t run away. One example is the type of portfolio I ran in the mid-1990s: unleveraged micro-cap value stocks. Another example is Warren Buffett’s portfolio. He buys whole companies and large positions in other companies, and funds those purchases with a modest amount of leverage from his insurance reserves.

My counterexample is more interesting (failure always is). Long Term Capital Management for the most part bought illiquid bonds and shorted liquid bonds that were otherwise similar to the illiquid bonds. When LTCM was small relative to the markets that it played in, it could move in and out of positions reasonably well, and given the nature of bonds, absent a default, there was a natural tendency for the bonds to converge in value as they got close to maturity.

As LTCM became better known, it received more capital to invest. Assets grew from profits as well. Wall Street trading desks began to figure out some of the trades that LTCM was making and started to mimic the firm. This made LTCM’s position more illiquid. It was fundamentally short liquidity, leveraged up using financing that could disappear in a crisis and had LTCM wannabes swarming around its positions.

At the beginning of 1998, it had earned huge returns and its managers were considered geniuses. The only problem was that they were running out of places to put money. The yield spreads between their favored illiquid and liquid bonds had narrowed considerably. “The juice had been squeezed out of the trade,” but they still had a lot of money to manage.

By mid-1998, with the Asian crisis brewing and Russia defaulting, there came a huge premium for liquidity. Everyone wanted to get liquid all at once. Liquid bonds rose in price, while illiquid bonds fell. The LTCM imitators on Wall Street got calls from their risk control desks telling them that they had to liquidate the trades that mimicked LTCM; the trades were losing too much money. In at least one case, it imperiled the solvency of one investment bank. But at least the investment banks had risk-control desks to force them to take action. LTCM did not, and the unwinding of all the trades by the investment banks worsened its position.

When the severity of the situation finally dawned on the investment banks, with the aid of the Federal Reserve, the investment banks realized that there was no way to easily solve the situation. LTCM couldn’t be liquidated; its positions were so large that a “fire sale” meant that the investment banks that lent it money would have to take a haircut. LTCM needed time and a bigger balance sheet, if the investment banks were to be repaid. The investment banks eventually agreed to recapitalize LTCM funds and unwind the trades at a measured pace. Even the equity investors got something back when the liquidation of LTCM was complete. LTCM’s ideas weren’t all bad, but it was definitely misfinanced.

Final Advice

Keep these basic rules in mind as you consider how to apply these concepts to your own trading. They aren’t commandments, but paying attention to them will help you make more informed investment decisions.

All good investment relies at least implicitly on sound asset-liability management. Assets should be matched to the type of investor and funding structure that can best support them.
Understand the advantages that you have as an investor, particularly how your own cash flow and funding structure affect your investing.
Try to understand who else is in a trade with you, what their motivations are, their ability to carry the trade, etc.
Don’t overleverage your positions. Always leave enough room to be able to recover from a bad scenario.
Be aware of the effects that changing demographics may have on pension plans and individual investors.
Always play defense. Consider what can go wrong before you act on what can go right.
Be contrarian. Maximize your flexibility when the market pays you to do so. Be willing to sell into manias and buy after crashes.

Redacted Version of the March 2013 FOMC Statement

Posted on 20 March 2013 by David Merkel

Comments

Notable: they mention that fiscal policy is less accommodative.? Also, some new language leaves room for policy gradualism.
Not so notable: they shade up their views on GDP and employment, and shade down their views on global financial market stability.
I really think the FOMC lives in a fantasy world.? The economy is not improving materially, and inflation is rising. Note that the CPI is close their 2.5% line in the sand.? TIPS-implied inflation 1X1 (one year ahead for one year) is 2.32%, and 5X5 is around 2.86% annualized.
Current proposed policy is an exercise in wishful thinking.? Monetary policy does not work in reducing unemployment, and I think we should end the charade.
In my opinion, I don?t think holding down longer-term rates on the highest-quality debt will have any impact on lower quality debts, which is where most of the economy finances itself. When this policy doesn?t work, what will they do?
Also, the investment in Agency MBS should have limited impact because so many owners are inverted, or ineligible for financing backed by the GSEs, and implicitly the government, even with the recently announced refinancing changes.
The key variables on Fed Policy are capacity utilization, unemployment, inflation trends, and inflation expectations.? As a result, the FOMC ain?t moving rates up, absent increases in employment, or a US Dollar crisis.? Labor employment is the key metric.
GDP growth is not improving much if at all, and the unemployment rate improvement comes more from discouraged workers.

Question for Dr. Bernanke

Ever liability is someone else’s asset.? Aren’t you doing nothing by trying to hold long term interest rates lower?

The Education of a Mortgage Bond Manager, Part IX

Posted on 13 February 2013 by David Merkel

The Negative Convexity Project

Me: We can’t buy the majority of Residential Mortgage Backed Securities [RMBS] anymore.

Boss: What! That is a staple asset class of ours.? There’s nothing illegal about life companies owning RMBS.

Me: nothing illegal, yes, but because of new cash flow testing rules which our client is subject to, the negative convexity of RMBS will force our client to put up more risk-based capital than they would otherwise have to.? Most RMBS will require so much additional capital that the additional yield is uneconomic, and that assumes we get the yield when we want it, ignoring prepayment and extension risks.

Boss: I can’t believe that we can’t buy any RMBS… are there any exceptions?

Me: There are a few.? You know about the odd RMBS classes that have positive convexity, but little yield?

Boss: Yes, Yes… but why would we want to buy that?? Our client needs yield!

Me: I know that.? Would that they could do something other than need yield to sell yield.? There is one type of RMBS that still fits, and it is the NAS bond [Non-accelerating security], last cash flow structure.? Also, some of the credit-sensitive RMBS bonds rated less than AAA don’t affect the convexity issue, but we might not want to buy them, because the additional yield per unit risk is not compelling.

Boss: So what do we do?

Me: Buy NAS bonds when they are attractive, and buy CMBS that is attractive, after that look to corporates that our analysts like.

Boss: You are right, but I hate to lose a staple asset class.

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What I wrote there took longer than a single conversation, and involved contact with the client as well.? The client was very conservative with capital, because they levered up more than most life insurers.? The results of detailed cash flow testing would affect large annuity writers like my client, and negative convexity would make them put up more capital, constraining the amount of business they could write.

Wait: negative convexity simply means your bond portfolio hates interest rate volatility — it does better when things are calm.? That is certainly true with residential mortgages, where people refinance easily when rates fall, and in that era, no one faced falling property prices.

It took some effort, but I made my case to the client and my boss, and we stopped buying most RMBS.? As an aside, it made asset-liability management tighter.

Alternative Investments

I was not totally hidebound with respect to derivatives.? I bought our first asset-swapped convertibles, and synthetic corporates.? If the risks associated with getting additional yield were small, I would take those risks.? In both cases, they converted other asset into straight corporate debt (plus counterparty risk).

But I wouldn’t do anything.? I grew to hate CDOs, as I saw how perverse the structure was. I remember one weird CMBS deal structure that added a note that combined the AAA, BBB & BB CMBS of the deal.? What a nice yield, but the riskiness was greater than my models would allow for the incremental yield.

Finally, for this piece, the “piece of work” broker that I have previously described pitched me a private placement debt deal for a power producer affiliated with his firm.? After hearing the initial spiel, I said, “Okay, soft-circle me for $25 million, subject to due diligence; send me all of the hard data via email and paper.”

My request should not have obligated me to buy the deal.? Indeed, when I got the hard data, and began estimating the counterparty risks, I thought the deal was a loser, so I contacted the “piece of work,” and said, “Sorry, but we are dropping out of the deal — it just doesn’t offer enough value for the yield.”? After some arguing, he eventually said, “Look, stay in the deal, and I promise you that I will get you out at par at minimum on deal day.? Okay?”

Sigh, even though he was number eight with us, he served an important firm that could potentially do a lot for us, so I agreed.? The day of the deal came, and indeed, he got us out at a teensy premium (I would have accepted par, maybe even a slight scrape).? The deal did horribly, at least initially, though I have no idea of what the eventual credit result was.

As my boss who taught me bonds would say, “On Wall Street, if you want a friend, get a dog.”? There are some honorable people on Wall Street, but the economics of Wall Street often leads to suboptimal results for clients, and indeed, the salesmen may be sweet enough, but they live to distribute paper; they don’t live to be your friend in any true sense.? Professional duty to company trumps friendship.

The Education of a Mortgage Bond Manager, Part VI

Posted on 9 February 2013 by David Merkel

1) One thing that impressed me about working in a life insurance investment department is how many ideas we kicked around and abandoned.? I did not experience that to the same degree working at a hedge fund.? I think that is true for two reasons: 1) we have a significant balance sheet, and can take on illiquidity. 2) we are conservative, and aren’t going to take on marginal risks.

2) Another thing that impressed me was how well the money was managed, and how poorly the liability writers thought it was managed.? I did a big study to analyze what we had earned for F&G Life over the prior seven years.? We beat single-A bond yields by more than 0.7%/year.? That’s huge.? That said, they kept asking for more.? I shake my head and wish that we were running a mutual fund; we would have gotten a lot of respect.

3) When I came, the client held no CMBS, after three years 25% of the assets were CMBS.? It made so much sense given the 10-year duration of the EIAs that were growing so rapidly.? Given my models, and the lack of yield from corporates, this was a big improvement.

CMBS, because it is noncallable, makes a lot more sense for longer-dated liabilities.? Hey, I was not only the mortgage bond manager, I was the interest rate risk manager.? I would not knowingly take bad risks.

4) When the merger happened, the boss decided to jump to another firm.? Unintentionally, I may have encouraged that, because when he asked me, ‘What would I do in this new organization?”? I said, “Let me draw it out for you,” showing that he would be CIO of insurance asset management.? He was crestfallen, and sought other avenues of employment.? When he announced his new job, there was a big change.

First, the St. Paul talked with me and the High Yield manager, and gave me authority to manage things, so long as the high yield manager agreed.? Basically, they trusted me, but knew I was inexperienced, so they wanted the high yield manager, who was far more experienced than me, to guide me.? There was an economic incentive here: the better we did, the less cash the St. Paul had to transfer to Old Mutual at the closing.

But after that, the analysts came to me and said “you be our leader.”? The high yield manager agreed.? When I asked why, they said, “We trust you. You have always had a better call on credit than the prior boss, and you understand our client better than anyone else!”

That led to something hard.? I called a meeting of the analysts and managers, but told the old boss, who was still with us, that he was not invited.? I almost cried.? He was our leader for so long, and a good one, but I had to take control.

Once I did so, I asked the analysts for reports on all companies where the stock price had fallen by more than 50% since bond purchase.? We began selling those bonds where it made sense.? Those sells were almost always good sells, and I wish I had not been countermanded by my new bosses on Enron (the greatest company in the world.)

I have more to say but that will have to wait for the next part.

Sorted Weekly Tweets

Posted on 8 February 2013 by David Merkel

Currency Wars

Battling the unknowns of currency devaluation | Reuters http://t.co/3kiN75eT A tough game to play, particularly w/changed policy in Japan $$ Feb 09, 2013
This is what a currency war looks like http://t.co/ibWgIZTg Japan is leading the #currencywar by no longer sterilizing monetary policy $$ Feb 08, 2013
The Dark Side of Japan’s Creating Inflation http://t.co/3O384dKU Risk is interest rates rise and Japan can’t finance itself. #tippingpoint Feb 07, 2013
Japan Inc.?s appreciation of the yen?s depreciation http://t.co/zdYFkcYR Japanese stocks rally as their exports get relatively cheaper $$ Feb 07, 2013
Falling yen set to spark renewed currency wars http://t.co/1QXtUFoA Japan has finally “thrown the hammer down.” No more sterilization $$ Feb 05, 2013

LBOs

Dell?s largest outside shareholder thinks it?s worth $10 more a share – Quartz http://t.co/1gr8dTZb Let Southeastern et al bid 4 control $$ Feb 09, 2013
The Three Scariest Letters for Bondholders: L-B-O | Fox Business http://t.co/wEEHVJUR Note: junk bonds r protected from this, not invt grade Feb 09, 2013
New Worry for Bondholders: LBOs http://t.co/KumxFjws Company is cheap & has good Bal Sheet, it could LBO, harming current bondholders $$ Feb 04, 2013

Pensions

Danger Seen in Pension Fund Cuts on Abe Inflation http://t.co/wDu6fWjE Guess what? Inflation can harm pensioners. Sad 4 them. $$ Feb 07, 2013
Pension Funds Cut Back On Commodity Indexes http://t.co/ZSvFgIoG Hoarding not a panacea, also, can get clipped on the roll $$ Feb 07, 2013
The Asset Mix (Stocks-Bonds) will make the Difference – 2 many Bonds Mr Abe? http://t.co/AOHm6p5X On pension asset allocation globally $$ Feb 07, 2013
Baby Boomers Sicker Than Parents? Generation, Study Finds http://t.co/Xy7VIs0n Will live longer too; big reason to reshape Medicare $$ Feb 05, 2013
Americans Rip Up Retirement Plans http://t.co/s5UARuld Nearly 2/3rds of Those Between 45 & 60 Plan Delays, Steep Rise From 2 Yrs Ago $$ Feb 05, 2013
Low Rates Force Companies to Pour Cash Into Pensions http://t.co/32JNXekQ Low long rates push pension liabilities higher, req $$ payment Feb 04, 2013

High Yield

US High Yield Bonds: HYG On the support http://t.co/Gcj35TAJ In order 4 HY 2 rally from here, need dumb buyers 2 apply leverage $$ Feb 08, 2013
Fed?s Stein: Signs of Overheating in Credit Markets http://t.co/TAT7QcwB Junk yields less than in June 2007. Replace CDO bid w/Fed $$ Feb 07, 2013
Two Things about High-Yield Bonds Investors Must Understand Today http://t.co/w3n4IODi Low yields & spread relatives & high $$ prices Feb 07, 2013
A Mad Rush Could Be Coming In The Corporate Credit Markets http://t.co/KFGkM3gQ Possible, but it depends on how levered investors are $$ Feb 05, 2013
No, there probably isn?t a bond bubble http://t.co/92p5SJBz Misses key question: how much debt is being issued to acquire other debts? $$ Feb 05, 2013
US Higher Yield Bonds: A Corrective Update http://t.co/RITd5UGl Corrections may be happening w/ both credit & high-quality long-duration $$ Feb 04, 2013

S&P Lawsuit

State Lawsuits Could Add to S&P Exposure http://t.co/oQSwfYFR Attorneys General for states become profit centers; opportunistic thieves Feb 07, 2013
Wrong: Levitt Says McGraw-Hill ?Foolish? to Not Settle S&P Lawsuit http://t.co/dEL4g1ja There’s a good chance that S&P will win, y give up Feb 07, 2013
S&P Lawsuit Undermined by SEC Rules That Impede Competition http://t.co/GCUE01zz Will not be simple for the govt to win its case $$ #FTL Feb 07, 2013
S&P Lawsuit Portrays CDO Sellers as Duped Victims http://t.co/rAI69G1G Stretching truth; CDO sellers knew credit better than agencies $$ Feb 07, 2013
S&P feels Justice’s lash, but can law ever conquer greed? http://t.co/SVDZVZtG Diffcult 2 single out people/firms 2 prosecute in big crisis Feb 05, 2013

Companies

Top NY court throws Travelers asbestos award into question http://t.co/GAujEmCH Case started in 1948, when USF&G insured Western Asbestos Feb 08, 2013
Buffett?s Son Says He?s Prepared Whole Life for Berkshire Role http://t.co/xYWVlMu8 As Chairman, Howard will be “cultural guardian.” $$ Feb 08, 2013
San Francisco Gasoline Rises as Tesoro Seen Cutting Rates http://t.co/4Rmvbcz1 It’s tough when state governments discourage refineries $$ Feb 07, 2013
Bond insurers aren’t the only winners in Rakoff’s Flagstar ruling http://t.co/6A2IICLD All can rely on reps & warranties of mtge origin8rs Feb 07, 2013
Berkshire-Insured Muni Sees Good Demand http://t.co/yKX1lGPy Nothing amazing; some $BRK.B businesses r part of the development borrowing Feb 07, 2013
Life Insurer CFOs Say Their Financial Models Fall Short: Survey http://t.co/zJ3f2DJc Surprising, another reason 2b bearish on life ins Feb 07, 2013
BlackRock Cautious as Sales End Dollar Bond Rally: China Credit http://t.co/4LZDSoMf Questions over credit quality, maybe 2 much supply $$ Feb 04, 2013
Herbalife Drops After Report of Law-Enforcement Probe http://t.co/zC0a9GGv $HLF rises today. $$ Worries over being named “pyramid scheme” Feb 04, 2013
Was the AIG Rescue Legal? http://t.co/LUTVHQa9 Of course not. Gov’t should not play favorites; emergencies b a DIP lender of last resort Feb 02, 2013

US Politics & Policy

House Speaker: Washington Has to Address Spending http://t.co/lZcQcinD Yes it does, but will the Senate and President ratify that? $$ Feb 07, 2013
Party Eyes ‘Red-State Model’ to Drive Republican Revival http://t.co/qrlp6Zn5 First balance budget on an accrual basis; no state does $$ Feb 05, 2013
House Leaders Weigh US Spending Bill Below $1T http://t.co/0nBcoURd Good luck w/Senate & President on that, you will need it $$ Feb 05, 2013
Study Says States Lose Billions in Offshore Tax Avoidance http://t.co/qTnlUpTX Just an effect of federal tax policy, which needs change $$ Feb 05, 2013
The Fed?s Worst Fear http://t.co/nanNt52c Losing control of long interest rates; the bond market will eventually trump the Fed $$ Feb 04, 2013

Market Impact

Americans Are Tapping Into Home Equity Again http://t.co/gLLrlDEx Does this mean a return to the reckless equity withdrawals? Likely not $$ Feb 08, 2013
Banks Should Defer Bonuses for Up to 10 Years, Jenkins Says http://t.co/udabGhNT Better that banks become partnerships; creates caution Feb 08, 2013
Insiders now aggressively bearish http://t.co/vWogX2LF Last Fri: sell-to-buy ratio for NYSE-listed shares listed stood at 9.20-to-1 $$ Feb 08, 2013
SP500 Complacent Divergence – Risk Factors http://t.co/CPqaNYY4 Decelerating earnings growth threatens valuations. Econ surprises falling 2 Feb 08, 2013
Interdealer Brokers Emerge as Key Enablers in Libor Scandal http://t.co/bTgMtUOa & http://t.co/yBo7oxKJ Them & Rain Man Tom Hayes $$ Feb 08, 2013
Schwab Unveils Game-Changing Commission-Free ETF Platform http://t.co/yqCaunnJ Part of the ETF’s fees go to $SCHW . No free lunch here $$ Feb 07, 2013
H-P Aside, Corporate Splits Are Wholly Worth Investors? While http://t.co/e9dptR0E Managements gain new focus; Behemoths lack true mgmt $$ Feb 07, 2013
U.S. to Offer Floating-Rate Notes Within a Year http://t.co/eXCUd3Ni Money-market funds take heart; yield (w/spread duration risk!) $$ Feb 07, 2013
Small lenders ride US mortgage wave as big banks cut back http://t.co/KbACkvJk Interesting 2c little independent mortgage brokers return $$ Feb 04, 2013
America’s Baby Bust http://t.co/CaWPjZVU Heard on Radio C-SPAN yd http://t.co/Ow86Jsfs ?Economies don’t work well when popul shrinks $$ Feb 02, 2013

Rest of the World

Mind the Liquidity Gap – Credit Gap http://t.co/m2xTMEIs 3 factors: global monetary policy, global credit supply & global credit demand $$ Feb 08, 2013
German Hope French Despair and EU Rescue: PMIs http://t.co/qioLvblN Eurozone PMIs r rising, but economies r still contracting $$ #France Feb 07, 2013
Basel Seen Rotten in Denmark as Banks Bypassed http://t.co/HX9a6vOI Denmark has many covered mtge bonds; Basel doesn’t care much 4them $$ Feb 07, 2013
Shades of ’80s for Japan’s Stocks http://t.co/68rhfLmX What, Japanese stocks can go up after the demographic dividend has faded? Feb 07, 2013
Desperate Greeks scuffle at free food handout http://t.co/XpQUEBMM Total desperation. Democracy started there, and it may end there too $$ Feb 07, 2013
Canadians back2borrowing: avg consumer debt hits new hi http://t.co/wtSpy1pB overall debt low | cred: evergreen http://t.co/ndpBH0Ch Feb 07, 2013
Last tweet derives from this article http://t.co/wjSwNztf I believe in freedom, and small biz capitalism, with equality 4 all. $$ Feb 06, 2013
We need Obama/Hollande 2create economic barriers average people can’t surmount, so the clever rich can get richer. Cynical, but true $$ Feb 06, 2013
ECB Executive Board Member Asmussen: ‘German Interest Rates Will Rise Again’ http://t.co/oIJZtFtK Thinks *real* interest rates will rise $$ Feb 05, 2013
Top Iranians Trade Barbs in Rare Public Feud http://t.co/W1uR6M1p Corruption is endemic to Iran; rare 4 the mafiosi 2 fink on each other Feb 05, 2013

Other

An Insider’s Guide to Counterfeiting Wine – Businessweek http://t.co/SoVp0OrF 3 ways to counterfeit expensive wines & how to avoid them $$ Feb 09, 2013
Most Australian Wine Exports Ship in Giant Plastic Bladders http://t.co/jL1S9KLF ?We don?t ship glass around the world, we ship wine.? $$ Feb 09, 2013
Super Bowl Blackout Caused by Faulty Relay, Entergy Says http://t.co/GKd5619I That was what I guessed; weak spot in many power grids $$ Feb 08, 2013
Asteroid to Traverse Earth?s Satellite Zone, NASA Says http://t.co/ZnpmCxXD Interesting we only get one week’s notice on the near miss $$ Feb 08, 2013
What Abraham Lincoln Liked About Richard III http://t.co/oAp8PQjg Lincoln was Shakespeare buff; 1 controversial man’s thoughts on another Feb 08, 2013
Lease Surprise in Stuyvesant Town http://t.co/O7DQsILq “clause that allows landlord to increase the rent in the middle of the lease” $$ Feb 07, 2013
Nine Questions for Peter Levine, Andreessen Horowitz?s Enterprise Dude http://t.co/yiubWsqj How SDN commoditizes much special hardware $$ Feb 07, 2013
On Pins and Needles: Stylist Turns Ancient Hairdo Debate on Its Head http://t.co/RgrZqc80 Kinda of a quirky story, but interesting $$ Feb 07, 2013
‘They Owe It to Me’: FBI Identifies Top Email Phrases Used by Fraudsters – Compliance Week http://t.co/9FtlTkEH Set up filters, compliance Feb 06, 2013
Legacy of Benjamin Graham: http://t.co/GztBNt53 via @youtube In last minute, BG anticipates the Efficient Markets Hypothesis years ahead $$ Feb 05, 2013
Legacy of Benjamin Graham: http://t.co/GztBNt53 via @youtube Fascinating video w/Buffett, Kahn (2), Schloss, & other students of his $$ Feb 05, 2013
US Construction Jobs – A very Constructive Story http://t.co/Gqy8YIU0 Construction jobs coming back, looks like a dead cat bounce $$ Feb 04, 2013
Sending electronic money to friends catching on http://t.co/zRBh8tkT Creating next great avenue 4 money laundering; cheap & convenient $$ Feb 04, 2013
Hitler Awakes in 2011 Berlin, Becomes YouTube Hero http://t.co/ore3XtWB Hard 4 me 2 believe. Does humor have any limits anymore? Funny $$ Feb 04, 2013

Replies & Retweets

@dpinsen 16x deteriorating free cash flow @ $24/sh. There’s some bluster there. Wouldn’t want to be a bondholder here $DELL $$ Feb 08, 2013
Commented on StockTwits: Wait, I’m wrong. Didn’t look far enough — they have 8.5% of shares, but 7.5% of votes. Onl… http://t.co/18jIZ94S Feb 08, 2013
Commented on StockTwits: Here: http://t.co/a3SdyNFq http://t.co/4OBGCIp0 Feb 08, 2013
‘ @ampressman Thanks, Aaron. Reading it now. http://t.co/aGpdRr8R Good stuff. SE recently bought more http://t.co/UGh12nkp $$ $DELL Feb 08, 2013 ?(This tweet was wrong, SE has been a seller of $DELL shares, and even recently?)
Owns 7.5%, what could they b thinking? $$ RT @BloombergNews: BREAKING: Dell holder Southeastern Asset plans ‘All Options’ to stop deal Feb 08, 2013
Worth the read RT @cate_long: Is the U.S. growing, or just issuing debt? – #MuniLand http://t.co/KLB1838k Feb 08, 2013
Seems reasonable to me $$ RT @TFMkts: @AlephBlog the high yield market is on cusp of some stop losses getting triggered Feb 08, 2013
@GaelicTorus Did not know that, thanks Feb 08, 2013
Small caps +7% http://t.co/ewRvffTb $$ RT @credittrader: Gentle Reminder Japan Nikkei 225 +0.75% YTD in USD http://t.co/cxxhjMoG Feb 07, 2013
@anatadmati Twitter is too small for this. Read: http://t.co/JDnLfhJ5 & http://t.co/yo7C05d0 Biggest problem isn’t capital, but liquidity $$ Feb 07, 2013
@Nonrelatedsense @credittrader Thanks, missed that Feb 07, 2013
@BlandDexter In a word, yes. Feb 07, 2013
@The_Analyst What floors me are professional investors that don’t read the prospectus the first time they analyze a new type of investment. Feb 07, 2013
@SapienQuis A lot of investment banks got pinned w/crud they could not sell whether due to secondary trading or origination Feb 07, 2013
@The_Analyst Yes, they did have staff. If u r a professional firm, you must independent vet out credit quality; ignore rating read writeup Feb 07, 2013
Well done! RT @jasonzweigwsj: 2 things about high-yield bonds investors should understand today, from @DavidSchawel http://t.co/EYo8KSEQ $$ Feb 07, 2013
@anatadmati A better idea would be double liability, where mgmt & directors lose their capital before shareholders do. Change incentives Feb 07, 2013
@anatadmati At current margins, banks could not earn their cost of capital w/30% E/A. Banks & credit would shrink a lot -> crisis Feb 07, 2013
@DavidSchawel Where will it be? Feb 06, 2013
Bondholders will get badly hurt $$ http://t.co/i7Fxa10p RT @DougKass: HPQ mulling a break up. $HPQ Feb 05, 2013
It’s starting $$ RT @LisaCNBC: The Japanese are going to overdo it and create an inflation problem. #Yen will spike in 2013. @PeterSchiff Feb 05, 2013
@TFMkts People made absurd predictions about capital mkts off of the experience 1982-2000, culmination ing tech bubble / lost decade $$ Feb 05, 2013
Mersenne Primes RT @motokorich: Largest Prime Number Discovered, and it’s 17,425,170 digits long. http://t.co/U8GzYFj1 via @sciam Feb 05, 2013
@TFMkts Would be interesting 2c a firm try that. The wind seems to still b blowing the wrong way there, w/discount rates so low. Feb 05, 2013
He was/is a bright guy $$ RT @munilass: Picking on S&P just isn’t as much fun without @EconOfContempt around. Feb 05, 2013
RT @LaurenLaCapra: “big exchanges therefore stand to gain tremendously from even a relatively small shift twd futures & away from sw … Feb 05, 2013
“I only want to add one thing: its not what pundits say that matters, it is what people rely on economically… http://t.co/zAPlxIHU $$ Feb 04, 2013
RT @moorehn: Pffft. MT @nycjim: Washington Post says it, too, was victim of hacking attack that appeared to originate in China. http://t … Feb 03, 2013
Good marketing kills bad ideas, people & products $$ RT @MattVATech: Marketing is never a substitute for substance. Feb 03, 2013
“Only if you think that by waiting a little while you might have higher yields to invest at. Can’t?” ? David_Merkel http://t.co/Vt16DKeU $$ Feb 02, 2013
“Hi, KD… my bond mandate is unconstrained, so I just aim for total returns. Right now I am pretty?” $$ David_Merkel http://t.co/4x41D4D2 Feb 02, 2013

FWIW

My week on twitter: 77 retweets received, 4 new listings, 86 new followers, 81 mentions. Via: http://t.co/SPrAWil0 Feb 07, 2013

The Education of a Mortgage Bond Manager, Part IV

Posted on 7 February 2013 by David Merkel

I sat down this evening with my trading notebooks.? It was a reminiscence of 11-14 years in the past.? I may produce another chapter of “education of a corporate bond manager” from the books.? But it gave me a flavor of what I learned (rapidly) as a mortgage bond manager 1998-2001.? So let me share a few more bits of what I learned.

1) Avoid esoteric asset classes.? I am truly amazed at how many people believed that securitization created a lot of value, when it was more incremental.? There were many who proclaimed “Buy every new ABS structure,” because it had worked well in the past.

Sadly, that is a bull market argument, and many would lose a lot of money following that advice.? In 2008, it all came crashing down for unique structures.

2) Avoid volatile asset classes.? Collateralized Debt Obligations are volatile, and not worthy of being investment grade.? That said, when I was younger, I erred with CDOs and we lost money.? Never invest with those whose incentives are different from yours.

3) There was also a period where CDO managers would buy each others BBB tranches — it was a way of lowering capital costs, at least on a GAAP basis.? We did that with NY Life, but never got the benefit, because we never did our CDO.

4) The are many asset sub-classes that have ?only been through a bull market cycle.?? That is the nature of new ideas that are introduced to applause.? But those are bull market babies.? Avoid sub-asset classes that have never seen failure.

5) There was the desire that we could originate our own commercial mortgages, with me doing the work of a full mortgage department.? I conveyed to my boss that this was impossible even if I dedicated 100% of my time to the process, and then he would not have me for the reasons he hired me.? This came up many times, and took a long time to die.

6) But at a later date, something better came up, doing credit tenant leases.? They are illiquid, but they have good protection.? The credit tenant guarantees the mortgage.? If there is non-payment, the property is yours.? I can get into securitized lending.? This was a great deal, but my colleagues in the firm overruled me, and foolishly.? Why give up protection, when you can’t get a safe yield at an equivalent spread.

7) I also learned that in the merger in 2001 that little things mattered.? So when they came to meet us in Baltimore in mid-2001, we took them to an Italian Deli that we liked.? They loved it, saying that there was nothing like it in Burlington.

I will continue this in the next part/episode.

Seven Notes on Blogging and the Markets

Posted on 5 February 2013 by David Merkel

I need to catch up on a few things, so bear with me.? This might ramble.

1) Should I live and continue to write until mid-October of 2013, I will reach 10 years of investment writing.? I started writing for RealMoney in October 2003, and that changed my life.? Thanks to Cramer, because he created an organization that revolutionized financial media.? Former TST news writers occupy a wide number of top spots in many places in the financial press — it is astounding how much better financial news is today.? I am grateful to know many of them, some of whom would call me for help on occasion.

2) In a few more weeks, Aleph Blog will hit its sixth blogoversary.? Seems like minutes to me, but I have a lot more grey to prove that the time has passed.? I do want to note that much as I wrote at RealMoney, I have written far more here.? I have a problem though.? It seems that RealMoney has lost its ability to recover old posts pre-2008.? I would love to get copies of my old posts that are listed here.? If any of you know how to do that, please let me know.

3) Saturday night’s second article was hate me or love me in terms of responses.? There are no other writers at this site; the same flawed man writes them all.? My main point is that you need someone who acts like a fiduciary (whether they are a fiduciary or not) to tend to your assets.? Investment banks do use retail to lay off exposures that they do not want.

In any significant transaction, you want to know who is with you and who is not.? (This was true in the housing bubble, where many parties teamed up against buyers.)? For my clients, they know that over 50% of my net worth is on the line in the same portfolio that they have. (At present, over 70%.)? I have a lot of confidence in my ideas.? I eat my own cooking.

You want to invest in situations where there is alignment of incentives.? Are there brokers who are noble?? Yes.? But to use one, he needs to jump through extra hoops, because he is not under obligation to be a fiduciary.

4) 4+ years ago I wrote a piece called: Inflation for Goods Prices, Attempted Inflation for Housing-Related Assets, but Sorry, No Inflation for Wages.? Probably one of my longest titles… but that still seems to be the case today.? Fed policy inflates housing-related assets, gives some price inflation, but because labor is not scarce globally, wages are flattish.

5) I wrote this piece summarizing my views on the rating agencies.? I stand by it.? The rating agencies are not the problem.? Regulators are the problem.? They create the conditions where ratings are needed.? Ratings by their nature are opinions, they are not guarantees.? They can’t be otherwise, or else the rating agencies will have to become financial guaranty insurers, and charge far higher fees that will destroy financing for so many.

That’s why I think the lawsuits against the rating agencies will fail, again.? This is not to say the rating agencies were blameless, but it is very difficult to estimate future losses on any class of securities that has not ever gone though a failure cycle.

6) I believe in the conservation of liquidity: it can’t be created or destroyed, but it can be shifted.? My first example is stock price increments.? I think that the tick size is arbitrary, and a small tick size will favor small investors who are looking to buy small positions.? A large tick size will favor larger institutions that wait patiently to buy and sell.

7)? I believe in the conservation of liquidity in bigger ways also.? The Fed does not create liquidity, at least not in the sterilized? way that they do it presently.? But they can shift liquidity; who do the QE programs help?? The US Government and the GSE-backed mortgage market.? Liquidity has been shifted there, and away from everyone else.

That’s all for now.