Speculation – Page 21 – The Aleph Blog

Dave, What Should I Do?

Posted on 8 September 201011 September 2010 by David Merkel

I get requests from local friends fairly regularly for aid in understanding their finances.? While coming home from church recently, I mentioned to my wife that many were seeking my opinion in our congregation.? Her response was, “So what else is new?”? Then I began to list it, family by family, and the congregations that were seeking my opinion for their building/endowment funds, and/or borrowing needs.? As I went down the list, my wife’s responses were “Not them!”, and “Them too?!” and “No!”

What can I say? My wife is the best wife I have ever heard of, but even married to me, economics is a distant topic.? Her father was well-off, but humble, and I am well-off, and I try to be humble.? You can be the judge there.

I say to my friends asking advice, “Remember, I am your friend.? I will take no money, but I won’t hold your hand and guide you either.? I will give you very basic advice, and it is up to you to learn and implement it.”? I don’t want to be a financial planner, but I don’t want to leave friends in a lurch.

With that, the scenarios:

1) 90-year old widow, who lives with her daughter and son-in-law.? Another son-in-law, given to incaution, is advising putting everything into gold and silver.? What to do?

She has adequate assets to support her through the rest of her life.? Her husband was responsible.? I asked her if she needed more income, and she said no.? I told her, then relax, ignore the other son-in-law (I know him to a degree), but if you want to, invest 3-5% in precious metals.? She didn’t see the need, and I told her that was fine.? She asked me what I would do in her shoes, and I said that it was a very difficult environment to be investing in, and that we could not tell what the government might do in a crisis, so the best thing to do was to stay diversified, and invested in companies which would have continued demand.? But if you don’t need the money, don’t take the risk now.

2) 80-year old widow, assets in even better shape.? Her husband was a great guy; an inspiration to me in many ways.? He was a mutual fund collector, and left her a basket of 30+ funds, as well as two homes free and clear.? What to do?? I suggested that she harvest funds that had been doing particularly well and reinvest in funds that had lagged.? I suggested purging certain funds that were likely mismanaged.? I also suggested liquidating one property if she could get an acceptable bid.

3) 50-year old bachelor, never married.? Funds are from TIAA-CREF.? We decided on a 50-50 stock-bond mix three years ago.? Recently we rebalanced to add more equities.? He was disappointed that his portfolio had moved backward.? I said “Welcome to the club.”

I will continue with more in part two, but 2008 blew apart many people’s expectations over what their assets could deliver.? My stylized view of it stems from comments that I got at church.? In 1999, my friends were people into equities, as I was holding back.?? In 2002, many said they were exiting equities, and moving to what they understood, residential real estate.? I was adding fresh cash to my positions, and paying off my mortgage. By 2006-2007, they began getting interested in stocks again.? By 2009, both stocks and residential real estate was tarnished, leaving bonds remaining.

Closing then, with three final notes:

a) The low interest rate policy is definitely hurting seniors, and I believe all investors.? We all become worse capital allocators when there is no safe place to put excess funds.? It tempts people to stupid decisions.? If Bernanke wants to do us a favor, let him resign, and put John Taylor or Raghuram Rajan in his place.? Tempting people to dumb investment decisions hurts the economy in the long run, it does not help us.

It may help the banks have a risk-free arb on short government bonds, but that’s not what we should want either.? If they are sound, they should be lending. Raise short rates, and let the banks have a harder time, and give investors a place to put money while they look for better opportunities.

b) Average people, and sadly, many professionals, are hopeless trend-followers.? They have no sense of looking through the windshield, rather they ask what has worked, and do that.? Mimicry can be a help in much of life, e.g., finding where to buy good furniture cheaply, but is harmful with investing where figuratively the devil takes the hindmost.

c) People get caught on eras, and have a hard time letting go of them.? The 70s biased many against inflation, and toward residential real estate. The residential real estate lesson got reinforced in the ’00s.? The equity markets seemed magical from 1975 to 2007, and asset allocators increased their allocations to equities in response.? Now you hear of “bonds only” asset allocations, just as the amount of juice available in most of the bond market is limited.

People got used to refinancing their mortgage every few years, and enjoying the extra cash flow.? The modern era reveals the hidden assumptions on that: that property values would never fall.

The point: markets aren’t magic.? They can only deliver what the real economy does.? Stocks only do well over the long run if profits do well. Valuations come and go.? Bonds make money off the stated interest (coupon) rate less default losses.? Valuations come and go.? Real estate is worth the stream of services that the land and improvements can deliver.? Valuations come and go.

Now, you can play the “come and go” if you are smart, but with the “come and go,” for every winner there is a loser.? But asset allocators need to be more humble in their assumptions for financial planning and not assume that they can earn more than 2% over the 10-year Treasury, or over expected growth in nominal GDP.? The share of income that goes to profits and interest also tends to mean-revert over time, so humility is needed when:

Illustrating an investment plan for a family
Setting the discount rate for a defined benefit pension plan
Setting the spending rate on an endowment
or even, setting assumptions for the Social Security trust funds.

One Dozen Comments on the Current Market Situation

Posted on 18 August 2010 by David Merkel

Here are my thoughts on the markets, in no particular order:

1) Momentum draws investors.? Long treasuries have run hard, and people like them now.? My view is, if you want to short them, wait until they rise 0.1% more in yield, then short.? There are a lot of weak longs to shake out.

2) That said, long rates are generally falling in the developed world.? Gives a real feel of global debt deflation.

3) Not that the yen sees any problem here for now.? This makes me more bullish on the yen; few nations are willing to allow their currency to appreciate.

4) Arguments over residential mortgages. Geithner sees room for a federal role. Gross want the Feds to make mortgages full-faith-and credit obligations of the US Government.? A shameful statement from a man who built his wealth through free markets, and now looks to protect it through Socialism. John Carney is far better, though he flounders over what to do.? To me it is obvious — take Fannie and Freddie through Chapter 11 after their debt guarantees are gone, and let the market buy up the pieces.? Fannie and Freddie have lost money for the US over their existence; they have served no useful function, any more than some misbegotten tax incentive might have done.? And, as Kid Dynamite has put it, “The problem is that home prices are too high.? We need more deflation, and more debt reduction.

5) Physics is the wrong analogy for economics.? Ecology is the right analogy.? Like ecologies, economies resist prediction and control.? People adapt, inanimate objects don’t.? So you might enjoy these articles from FT Alphaville and Bookstaber.

6) As I commented today on Twitter: “Get ready for the bookstore massacre http://bit.ly/cywtPT $BKS fiddles with its capital structure, while it gets outcompeted by $AMZN.”? I mean it.? The problems of Barnes & Noble are organic problems of competing against Amazon and losing.? Who controls B&N is less important than what strategy they take from here.? It is a lousy time for B&N to be consumed with a noneconomic issue, when they are getting killed.? And forget BGP… they are dead too.

7) Matthew Lynn hits the nail on the head.? Additional debt does not promote recovery.? If true in Europe, then true here as well.

8 ) The Dallas Fed questions whether we can stimulate our way to prosperity.? My answer: the more we place the decision in the hands of individuals the better the decisions will be.? We know what we need better than the government does.

9) Did we misunderstand the Fed’s recent FOMC non-action?? I don’t think we did , but Federal Reserve Bank of Minneapolis President Narayana Kocherlakota thinks that we did.? I think he has to understand the markets better — we work off of changes in expectations.? We expected the Fed to do nothing again.? Now that you are buying in more Treasuries, we know that the economy is weak, and we buy long fixed income as protection.? At least we are front-running you.

10) Hey, another blogger summit at the Treasury, and this one has three of the originals there (but not me).? Comments from Marginal Revolution as well.? One participant told me it wasn’t worth it to be there and the Treasury was not prepared to answer questions, but who can tell?? I have an idea: let the Treasury webcast the meeting.? I know from the first meeting that neither the Treasury nor the bloggers would have been dominant.? At least it would be transparent; isn’t transparency what the Obama Administration is about? 😉

11) Cramer has ten reasons that the market won’t blow up.? Good.? I am 80% invested.? All I will say is that the rules are different when debts are being deflated.? Things don’t behave the same way as when debts are growing.

12) TIPS are in an awkward spot here.? Negative yields on the short end imply that buyers are looking for more inflation.? I might think that in the long run, but would be reluctant to bet on that over the next five years.

Two Quick Notes on Investing

Posted on 14 August 201015 August 2010 by David Merkel

Insect bites, bruises, sore feet, tiredness, happy sons… I am back from backpacking.

Whenever a financial product is plentiful, it is usually time to avoid it.? Tonight’s poster child for such nuttiness is junk bonds.? If you are a speculator, you can own junk bonds, and the stocks of the companies that are issuing them, because the market is hot for now, but be ready to sell; have your stop orders ready.? Fundamental investors would need to be more careful.? Though default rates may be declining, there is no guarantee that that will continue to be so; given troubles at the banks, cautious stance is warranted.

If looking at individual issues, those aiming for organic growth are better candidates than those that are doing mergers, paying special dividends, or just levering up.? So be wary, and realize that conditions could change rapidly.? Stick to sounder credits, including investment grade issues.? There is more juice to be squeezed in the long end of investment grade, then in shorter junk issues.

My second point for the evening is avoid the equities of scale acquirers.? In general, acquirers of large entities overpay, and execution after the acquisition is tough because it is tough to integrate:

Management teams — different views are often incompatible, and the victor looks down on the company acquired.
Cultures — same thing.? Cultures encompass the ways that a broad body of people implement the views of management.? Incompatible cultures are tough to merge; usually that of the acquirer must die, much like ancient war that destroyed losing cultures.
Systems — rarely compatible.? It takes a lot of effort to make all of the critical computer systems speak the same language.
Marketing — different philosophies lead to a need for the best to remain, and the worst to die.
Finances — easy, except that differing practices must be integrated.? Accounting is often more liberal coming out of an acquisition, because of the need to make the acquisition look good.

The best acquisitions are small, incremental, and facilitate the organic growth of the acquirer.? They add new products that can be sold through existing infrastructure.? They add new markets to sell existing products to.

In an environment like this, focus on organic growth, and perhaps those companies likely to be acquired.? Organic growth because it shows where there is real and perhaps repeatable growth in the economy; targets because if capital is cheap, there may be future companies bought out by fools who serve themselves and not their shareholders.

All for now.? Back on Monday.

The Rules, Part XVII

Posted on 31 July 20101 August 2010 by David Merkel

In a panic, only two attributes of a financial instrument get priced — liquidity and quality/survivability.

In a panic, all risky assets become highly positively correlated with each other.

Given that correlations tend to rise in a panic, a reasonable measure of sentiment is to measure the average absolute value of 10-day correlations.

Markets cannot survive for long periods of time at high levels of actual or implied volatility.? They eventually revert to normal.

Panics and booms are different — they may be opposites, but they behave differently.? Panics are events, often multiple events, and booms are processes.? The nature of this is best explained through the credit cycle.? The boom phase of the credit cycle involves rising profits of corporations.? Stocks and bonds behave differently here.

Say the expectation of income moves from negative to a low positive figure.? Stocks will rally; bond may rally more, because the threat of bankruptcy is lifted.

Now suppose that the expectation of income moves from a low positive to a normal positive figure.? Stocks will rally a lot, but bonds will rally a little.? The odds of the bonds being paid rise a minuscule amount.? The stocks estimate of future distributable profits rise a great deal.

Now suppose that the expectation of income moves from a normal positive to a high positive figure.? Stocks will rally some, but bonds will not rally much.? The odds of the bonds being paid don’t change.? The stocks estimate of future distributable profits rise, but with a sense of possible mean reversion.

So in a boom, credit spreads [the difference between the yields of corporate bonds and Treasury bonds] tighten quickly, tighten slowly, and then stop tightening, even though things seem to be going great.? The end of the boom, as far as the credit market is concerned, can last a long time.

The end of the boom comes when a significant amount of companies the overextended their balance sheets during the boom find themselves in a compromised condition, and have a hard time gaining financing.? The suspicion of credit troubles travels fast, and all of the companies where investors waved their hands at problems now get a fresh look with a different set of eyes.

The moment incremental financing seems less likely or more expensive, companies that will need financing get re-evaluated by the market — stock prices move down, bond yields go up.? This is when analysis of the balance sheet and the cash flow statement are worth the most, and the income statement is worth the least.? The bull phase of the cycle is all about income statements, and estimating what future income will be.? The bear phase of the cycle is about estimating? cash flows, and the strength of balance sheets, to identify who might not survive the bear phase well.

During the boom phase of the cycle, the degree of correlation of asset returns is low.? There is noise, and not everything does equally well.? There are multiple risk factors and strategies that are working.? But in the bust phase, the acid test of survival dominates.? One factor gets priced, whether an asset is money good or not. [For bonds, “money good” means the par value of the bond will be repaid at maturity.]

But panics don’t last long — usually two years or so.? As the panic drags on three processes take place:

Companies in horrible shape default.
Investors examine companies in okay shape, and find weaknesses.? Some will default, and some will clean their acts up.
Companies clean up their acts, and it becomes obvious that they will survive.

Toward the end of the bust phase, like a fire running out of fuel, there is a moment of clarity where some realize that things aren’t getting worse.? Most companies have cleaned up, and there will be fewer future defaults.? That sets the scene for the next rally.

Through the bust, equity volatility and credit spreads remain high; they are correlated phenomena, but there is a point of exhaustion.? High yields attract needed financing to companies that are mis-financed, rather than insolvent.? Credit spreads can only get so high before money comes in willing to buy no matter what the future may hold.? Equity volatility can only get so high before players begin writing short straddles, knowing that the odds of winning are tipped in their favor.

It pays to watch both the equities and bonds, and other related securities — it gives a richer picture of what is going on.? In particular, when the bull phase has gone on for two full years, watch for equity volatility and credit spreads to stop falling.? That is a sign that the bull market is getting close to the end, and most of the easy gains have been made.? Watch for telltale signs of cashflow shortfalls where banks are less than willing to plug the gap at a price.

Learn this well, and your ability to play the market will improve considerably.

The Education of a Corporate Bond Manager, Part III

Posted on 22 July 2010 by David Merkel

A reader MorallyBankrupt, asked,

What I am wondering here is the following, how fast was the decision process? For those of us that have never worked in the new-issue market for corps, the timeline is not obvious. How did it all flow, from getting notice of the deal, to getting a feel for the demand for it, to knowing what the offering price was going to be? How long did you have before requesting allocation in the deal?

Good question.? I answered part of this in the last piece.? It would vary based on three things:

The complexity of the deal — more complexity, more time
The creditworthiness of the issuer — lower creditworthiness, more time
The speculative nature of the market — less speculative, more time

Most new issue corporates do not require explanation; they are just straight bond deals.? Senior unsecured, do the credit work, do you want into the deal or not?? But some deals require thought.? When Prudential (US) went public, they securitized the business associated with their oldest policies, and issued debt against it.? Thick prospectus.? Many scared away in the midst of the credit troubles in 2002.? I looked at it and said, “They are offering more yield than on their surplus notes, but with better protection.? Time to buy.”

So I called my broker at Goldman and expressed interest in the deal.? He sounded a little surprised, and said that few had offered orders yet.? I said that I was interested, and he said that the syndicate would be interested in pricing guidance.? I gave him a schedule where I would be willing to buy more as the pricing went higher in spread.

But after that, I asked for protection on my order.? Early orders deserve protection.? Protection means you will get everything that you asked for, while others get pro-rated if the deal is successful.? They protected my order, which was large for us, while the marketing of the deal continued.

As it was, in the midst of the chaos of 2002. there were few takers for the low risks in a complex deal like that of Prudential’s old business.? So as the deal came to pricing, the yield rose.? The eventual yield for the non-guaranteed bonds was 8.695%, yielding a price in the $98s.? The first trade was $104, and went up from there.? What could be better? for us?? I bought some more when my credit limit expanded at $108.? What a great misunderstood bond.

But that is the way things work when credit markets are slow.? When they are fast, deals close rapidly, and syndicates allocate bonds proportionately to where their estimate of buying power is.? There is no protection there, aside from any big investors who move very early.

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But now onto the times when markets go nuts.? Deals are closing in less than 10 minutes.? You have to get your order in rapidly, or you will get nothing.? My one minute drill helps, but is not perfect.? On a deal on Disney bonds, they had a great yield in a hot market.? I bid for $30 million in bonds, and found myself trapped with 30 million of Disney long bonds, after an allocation that went bad.? I flipped 10 million for a small gain, and another 10 million at par, leaving me with 10 million that I did not want to hold.? I waited, and took my losses later.

But more often, I would avoid the deals when they got hot, and let others buy them.? I had strong opinions on what would work and what would not.? I remember several large deals where the syndicates begged me to buy (GE Capital, and AT&TWireless) and I refused.? The speculative cycle was high, and it was fun to refuse Wall Street when it was trying to stuff accounts full of promises that were underpriced.? I did not play in those deals, and it was fun to see the deals fail, and prices fall considerably versus the original offer.

In order to keep the system honest, some deals had to fail, and not provide profits to those who would flip.? Otherwise, many managers would beg for more bonds than they could hold onto, just so they could flip them.? When the market runs hot, the odds rise that the syndicates will overprice a deal, to deliver losses to those that foolishly ask for overly large allocations.

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Once you had notice of a bond deal, you could act. You could put in for bonds if you wanted.? But when conditions were speculative you had to move rapidly, and ask for an allocation quickly, or risk getting nothing at all.? Once the books closed, that was it.? Also, if multiple dealers controlled the books, it paid to put in through all of them.? One might have influence that the others did not on very rare occasions.? You wanted all of the bookrunners fighting for you.

All of that said, on some deals you would end up with a lousy allocation, and get less than 10% of what you asked for.? At times like that, one would typically flip the bonds to the highest bidder, because it was not worth the bother to hang onto a small position.? On massively oversubscribed deals, the percentage profits on the flip were high, but they weren’t big in dollar terms.

As an aside, occasionally, shortlyafter the deal closed, if you had a sterling reputation, and could say to your brokers that you had been hindered from putting in for bonds but had wanted to, you could still squeeze in.? Reputation and size matters.

Some deals were highly subscribed by large sponsoring buyers before deals went public.? Those deals would open and close in a minute shutting everyone else out but the large buyers, and what few got some crumbs.? I remember getting crumbs on a few occasions.

One way you could get the syndicates to notice you, was that if you really liked a deal, you would buy on the break.? The break is where bonds become free to trade.? Now, truth, there is what is called the “grey market” where after bonds are allocated but before they are “free to trade,” you could deal them away, or, buy some more.? Dealing in the grey market has some taint, and you don’t want to be seen doing it, lest your allocations be reduced.? The opposite is true for those who buy through a syndicate dealer on the break.? It shows the syndicate that you are a real money buyer, as opposed to? a flipper.? Syndicates want to place bonds entirely with long term holders if they can; that is their goal, because it means they priced it right, leaving little money for mere speculators.

As for me, I employed one second tier broker who would buy lousy allocations from me on oversubscribed deals.? No reason to make the analyst write it up.? It wasn’t worth holding onto, and the yield after the break was not attractive enough to buy more.

More to come in part 4.

Book Review: Fortune’s Formula

Posted on 17 July 2010 by David Merkel

When I reviewed the book Priceless, I thought I had reviewed “Fortune’s Formula,” because I had written several pieces on the Kelly Criterion at the blog and at RealMoney (free at TSCM).? But I found that I had not, so I offer you this review of a book I greatly enjoyed:

The book asks a simple question: in making a bet, investment, or business decision, what is the optimal amount of capital to allocate?

But the author, William Poundstone, is not going to give you the answer immediately.? He is going to take you on a journey where you can meet many odd personalities from the ’50s to the early ’00s, and how they came to look at the problem.

Ed Thorp was fascinated with Blackjack, and originated card-counting to improve the probability of winning, to what the card counter had and edge versus the casino.?? He meets John Kelly, Jr. while working together at Bell Labs on Information Theory.? He discovered that an economic actor with an edge could size his bets as a ratio of his edge in? betting divided by the odds received on the bet.

Thorp eventually published a paper, “Fortune’s Formula: A Winning Strategy for Blackjack,” which led to a torrent of interest from gamblers.? With the aid of several backers, Thorp tried out the methods with some success in Reno, with two wealthy gamblers as backers.? That tale was hairy, to say the least, but they more than doubled their money.

Thorp later applied himself to the sleepy market for stock warrants in the 1960s. He developed delta-hedging along with a colleague.? As the book progresses, gambling ceases to be the focus, and advanced strategies for making money on Wall Street with little risk becomes the rule.? And, as in Vegas, as they took steps to lessen the edge in blackjack, on Wall Street competition itself eroded the edge.? But Thorp set up a hedge fund to take advantage of securities mispricing.

One odd sidelight is the number of parties that came up with the option pricing formula known as Black-Scholes, long before B-S wrote their paper.? Life reinsurance actuaries had a version of it in the ’60s, Bachelier had a version of it around 1900. And there were others, but the point was that no one took advantage of the knowledge, except in rough ways, prior to the B-S paper.

Yet option theory could be applied to a wide number of situations, convertible bonds and preferred stocks, even corporate bonds themselves, in addition to warrants and options.? Those that did it early made a lot of money.

A more generalized version of the Kelly Criterion says to focus on the choice that offers the highest geometric mean return.? This led to a conflict with academic economists who insisted the optimal strategy was derived from utility maximization.? What is not disputable is that the Geometric mean will maximize terminal wealth, a result found by Bernoulli and Latane.

The book takes us through financial crisis after crisis, showing how bet sizes were too large relative to the results.? It also takes us to the end where a number of the protagonists end up decidedly wealthy from their attempts to beat the market.

Quibbles

Though Poundstone’s aim is the Kelly Criterion, more of the book is dedicated to finding edges, whether beating the dealer in blackjack, or arbitrage of securities.

If you want to buy the book, you can buy it here:? Fortune’s Formula: The Untold Story of the Scientific Betting System That Beat the Casinos and Wall Street

Who would benefit from this book

Many people would enjoy this book, written in 2005.? Poundstone tells a good story and illustrates how a number of clever men found edges, pursued them, and triumphed.? The reader may not be able to beat the world after reading this, but it may teach him about how bright men found ways to pursue their advantages.

Full disclosure: I bought my copy with my own money.

If you enter Amazon through my site, and you buy anything, I get a small commission.? This is my main source of blog revenue.? I prefer this to a ?tip jar? because I want you to get something you want, rather than merely giving me a tip.? Book reviews take time, particularly with the reading, which most book reviewers don?t do in full, and I typically do. (When I don?t, I mention that I scanned the book.? Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website.? Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites.? Whether you buy at Amazon directly or enter via my site, your prices don?t change.

13 Notes

Posted on 17 June 2010 by David Merkel

Pardon the infrequency of posting.? I have been having internet issues.

1) A response to those commenting on my piece A Stylized View of the Global Economy: when I say stylized, is does not mean that every nation fits the paradigm, only that most do.? My view is that the debt overages will have to be liquidated, and there is no possible policy that can avoid it except large scale inflation.? Those looking for clever ways out of this bind will be disappointed by what I write.? When nations are heavily indebted their options decline, particularly when they don’t control their own currency.? For the US I say that we should have liquidated insolvent firms rather than bailing them out.

Also, read Falkenstein as he takes on the idea that stimulus spending works.? I have little confidence that the linear reasoning behind stimulus spending yields long-term economic benefits.

2) One blogger that I have some respect for, but have not mentioned often is Bruce Krasting.? He writes some good things on US social insurance programs. His recent post Social Security at Mid-Year highlighted what should shock many: we have hit the tipping point on Social Security.? From here on out it will be a drag on the federal budget.? Expect Congress to remove it from the federal budget.? It no longer aids the illusion of smaller deficits.? (What a cleverly hidden illusion.)

As he commented at the end of his article:

-SS is $2.5T of the $4.5T Intergovernmental account. I believe that this entire group is going cash flow negative. The IG account cost us ~$160 billion in interest last year, but some out there are pretending the IG account does not exist. An example of this is in the following link.

Sorry, U.S. Federal Debt Is NOT Approaching 100% Of GDP Anytime Soon

This kind of thinking is not only lunacy; it is dangerous.

And I agree.? There only two ways to look at the balance sheet of the US.? Look at explicit debt vs GDP, regardless of who is owed the debt.? Or, look at total liabilities vs GDP.? But never look at explicit debt not used to fund social insurance funds.? It is meaningless.? The total liabilities number tells the whole story.

3) Spain is in trouble.? Their banks are borrowing a lot from the ECB, with no end in sight.?? Perhaps that leads them to push for stress testing across all European banks.? Or, maybe things are so bad that the banks are identified with the sovereign credit, and both are tarnished.

4) Or consider the Eurozone as a whole: the system begs for debt relief, but the Euro and ECB are tough taskmasters.? The Euro has been an excellent successor to the Deutschmark in terms of preserving purchasing power, but perhaps purchasing power needs to be sacrificed in order to relieve debtors.? The ECB is steps away from monetizing the debts of its governments.? Perhaps they could preserve the Eurozone by destroying the value of the Euro.? Germany might not stand for it, but it has significant unfunded liability issues as well.

As with the US, unless there is a large inflation, debts will eventually have to be liquidated, whether through austerity or default.? There is no other way.? Austerity will have its costs, but unless debts are inflated away or defaulted, those are costs that must be paid.

5) Can pensions be cut?? The typical answer is no, but what if a state pays less than what was promised in inflation-indexed terms?? That is what is being tested.? I think that eventually states and municipalities will be forced into bankruptcy because they can?t make employee benefit payments, and still maintain minimal services to the populace.

6) Debtors prison.? I have mixed feelings here, because I think that those that can?t pay should not be put there for long, if at all.? Those that can pay but won?t, should go there.? Regardless, this is a trend, and those that think they can walk away from debts should think twice before doing so.? You may be setting yourself up for prison.

This is just another front in the war against those who can pay but won?t.? More lenders are suing those who won?t pay, and going after their assets.? My only surprise is that it has taken so long for this to happen.

7) Fannie and Freddie are a giant black hole.? It astounds me that there is any respect given to two companies that have lost massive amounts of money since their inception.? The US would have been better off without them, and will be better off with them in bankruptcy.? The US should not promote single family housing as a goal, because it cannot create the conditions where marginal people can be capable of financing housing on their own.

So, when some suggest one last bailout, I say, let them fail.? Cancel the common and preferred stocks, and fold the remainder into Ginnie Mae.

8 ) Occasionally, there are really dumb articles, like this one.? The time for debt was November 2008 through March 2009, when I recommended investing in junk bonds.? There is little reason to borrow now; valuations are relatively high, don?t take your life into your hands.

9) And, occasionally, smart articles, like this one.? If you are in a volatile profession, reduce your risks by investing in high quality bonds.? If you are in a safe profession, invest in stocks.? When I went to work for a hedge fund, the first thing I did was pay off my mortgage, so that I could take more risk, without worrying about getting kicked out of my house.

10) Felix Zulauf has generally been a bearish guy, and so has done well over the past decade.? But is he right now?? Will stocks revisit their March 2009 lows?? It is possible, but I lean against it.? We would need a situation where most of the developed nations decided to aim for recession and stay there a while.? I do not see that yet.

11) Is it is liquidity problem or an insolvency problem?? If you have to ask, it is usually insolvency.? Consider Richard Koo, and his thoughts on the matter.

12) Using the rubric of the ?Tragedy of the Commons? Kid Dynamite points out how it sets up the wrong incentives if we bail out profligate states and municipalities.? As a part of my ?new mormal,? it is no surprise to me that this is happening.? It should be happening, and will happen for at least the next five years.

13) Because of my employment agreement, I can?t tell you exactly what I know about the demise of Finacorp.? But I can tell you that the article cited is wrong.? Finacorp never carried an inventory of assets.? It only crossed bonds between buyers and sellers.? The failure of Finacorp occurred for far simpler reasons.

The Rules, Part XV

Posted on 19 May 201020 June 2017 by David Merkel

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Full disclosure: Long PBR ESV

Book Review: No One Would Listen

Posted on 13 May 201012 February 2011 by David Merkel

This is a book about Harry Markopolos, who is the author of this book.? He talks about how he attempted? for years to expose the fraud that was Bernie Madoff.

The book takes the following form (from my view of how the author sees it):

How he came to a quick conclusion that Bernie Madoff was a fraud.
How he tried to convince others of that view, especially those that were feeding more money to Madoff.
Two journalists took his side and wrote about Madoff in 2001 or so, but to no avail.
Trying to come up with a similar strategy that would work, though it would return much less than Madoff’s supposed returns, and finding few would invest in it.
Fruitless wranglings with the clueless SEC.
Finally, in 2009, Madoff blows up.
Vindicated, he talks to the media, Congress, and anyone who will listen.
He excoriates the toothless SEC, and proposes better ways to root out financial fraud.

That’s the book in a nutshell.? But stylistically, the book harps on how no one would listen.? Well, duh.? No one did listen, or the book would have been over sooner.

People are not Vulcans.? They aren’t logical.? Most don’t think; instead, they mimic.? “If it works for him, it will work for me also.”

That was the case with Madoff.? He maneuvered many sheep into position to be fleeced, and worse, they begged for the privilege to be his clients.

There were many red flags flying:

No independent custodian
No independent Trustee
Small Auditor, incapable of auditing such an enterprise.
Returns were too smooth for being so high.
The asset size was to large for the markets supposedly employed.
Even front-running profits would not be enough, were Madoff to do that.
No profit motive.? Other managers with lesser track records charged more.
Marketing was by invitation.
Investors were sworn to secrecy.
And more, read the book.

Markopolos saw all of this, and ten years before it all blew.? All that said, I came away less than fully impressed with Harry Markopolos.? When I counsel people in trouble, I often tell them, “Don’t let the one who troubles you define your life.? You should be living for more than to see the one who troubles you punished.”? Markopolos triumphed here; good for him.? But many people in similar situations become fixated on seeing the enemy punished, and ruin their lives, focusing on punishing another, rather than doing good themselves.? There is a proper humility that should come to many of us when we can’t prove something beyond a shadow of a doubt, where we must give up.

My view is that Markopolos should have given up earlier, even though he succeeded in the end.? I have known too many people who have destroyed their lives on similar quests.? Good for Harry that he succeeded, but it was more likely that he would have ended up destroying his life.

And do I need more proof than that he had a plan to kill Madoff if Madoff threatened to kill him?? Throughout the book, there is no indication that Madoff would try to kill his enemies.

This was a book that needed a strong editor.? Much as I liked it because I appreciated the tale of the rise and fall of Madoff, someone needed to grab control of the narrative, and make it less personal for Mr. Markopolos.

Then again, if that had happened, the book would have been better written, but less colorful.? Hearing the off-color remarks of Mr. Markopolos is entertaining, if off-key.

With all that I have said here, I strongly recommend the book.? The best part of the book, though the least graphic, is the last chapter, where he recommends solutions, all of which I think make eminent sense.

If you want to buy the book, you can buy it here:? No One Would Listen: A True Financial Thriller

Who would benefit from this book

Most average investors could benefit from the book.? What it would point out to them is that if something seems to good to be true, it usually is, and that they should do their own due diligence.

Full disclosure: The publisher e-mailed me, and I requested a copy, if they had an extra one.

The Financial Equivalent of Bungee Jumping

Posted on 7 May 2010 by David Merkel

One quick note on my book reviews.? I have two books read, and ready to review.? I am reading Harry Markopolos’ book on Madoff, and am almost done.? That book really needed a stronger editor.? Next in the queue after that is Tony Boeckh’s new book, The Great Reflation.

I had other things planned to write this evening, but the brief plunge in the equity markets this afternoon caught my attention.? What caused the mini-panic?? Was it:

Dynamic hedging, a la 1987?
A “fat finger” placing a sell trade that was too large?
Panic of a single trader? Or, maybe a few?
Or, program trading gone awry?
Or, some combination thereof?

The “fat finger” hypothesis seems to be ruled out.? The NYSE says that there were no erroneous trades on their exchange, though they blame NASDAQ, and the NASDAQ is canceling trades where the rise or fall was over 60%.

My guess is that electronic trading got out of control, because human beings would not offer to sell the stock of valuable companies for exceptionally low prices, in some case less than a buck or less than a penny.

Yes, there might have been some dynamic hedging.? And some traders likely panicked and sold when they should not have.? But, buyers came in and prevented the market from tripping circuit breakers that would have shut down the markets for half an hour.? We came with a few points on the Dow of doing that.? No telling what might have happened if that had occurred.? There might have been a greater panic, or, a greater resurgence in the last half hour.? Curious that we got so close to that uncertain trigger, but did not cross the line.? More grist for the mills of conspiracy theorists.? All I can say is that I snagged some shares of Noble Corp @ $35.40, near the low of the day.

I said to one of my sons — there are four ways to act on a day like today:

The brave man: “Buy, buy, BUY!!!”
The wise man: “I will buy a little more of this undervalued stock.”
The indexer, or buy-and-holder: “Huh?”
The wimp: “Get me out of these stocks, they are killing me!”

We do not know what tomorrow will bring.? I had a very good relative value day, while losing quite a bit in absolute terms.

But my sense of the day is that some algorithmic trading programs went wild, and made trades that no sane human would.? John Henry may yet prevail in the markets.

But one note before I close: NASDAQ should not have canceled the trades.? It ruins the incentives of market actors during a panic.? Set your programs so that they don’t so stupid things.? Don’t give them the idea that if they do something really stupid, there will be a do-over.? In the absence of fraud, trades should not be canceled.

Full disclosure: long NE