Speculation – Page 27 – The Aleph Blog

Book Review: Trend Following (3)

Posted on 28 April 2009 by David Merkel

What I find interesting about this subject, whether we call it “trend following” or “price momentum,” there has been a confluence of different parties agreeing that price momentum works.? I have reviewed many books recommending momentum strategies (an example), and have usually recommended them (sometimes with reservations).? I will even recommend Trend Following to those who don’t know that positive price momentum aids investment performance about 80% of the time.

What groups of people have come in to support price momentum?

Most quantitative stock screeners/graders use a mix of momentum and valuation factors.
The academics behind behavioral finance support price momentum and valuation factors, in addition to some others.
Many large (and smaller) hedge funds that trade stocks do so using momentum as a positive factor in stock selection, along with valuation, earnings quality, and a host of other factors.

I know, there are still Efficient Markets Hypothesis zealots in the academic community, but they are being outflanked by the behavioral economists who have hard data to support their theories.? The Adaptive Markets Hypothesis describes the way the markets really work.? Rather than using a physics-based analogy, better to use a biological analogy — I view investment strategies through an ecological frame.? Multiple strategies compete to obtain scarce excess investment returns.? The strategies that are least pursued relative to their validity usually have the greatest punch.

Is everyone a fundamentalist?? Momentum strategies win.? Are there a lot of traders chasing momentum?? Value strategies win.? Is there a dominant view to seek dividends?? Growth strategies win.? Is everyone chasing after growth?? Perhaps we should look for dividends.

I don’t know about everyone, but among quantitative investors the opinion is virtually universal that trend following is the right strategy.? Follow price and earnings momentum.? I even put out a small piece weekly on short-term performance of industry groups, which is largely based off of price momentum.

So, if Mr. Covel thinks that trend following is an underfollowed idea, I can simply say that there are a lot of us following it, to the point where the trade might be crowded.? Trend following is a significant part of the total market ecology, and when it becomes dominant, its short-term returns become curtailed, until enough money leaves the trade.

I’ll discuss this more tomorrow, when I discuss how we test the validity of investment strategies.

Book Review: Trend Following (2)

Posted on 25 April 2009 by David Merkel

I had a long debate inside myself before writing my book review last night.? I could have written the review recommending purchase of Trend Following, because it teaches a truth that often gets ignored in the market — following price momentum pays around 80% of the time.? As a value investor, that was a hard lesson for me to learn, but I accepted it once the evidence was clear enough.

Why I did not recommend the purchase of the book was more over tone and style.? Here are two examples: on pages 294-296, he discusses this paper that shows that Commodity Trading Advisor [CTA] performance is little better than T-bills.? There is one substantive complaint, and I agree with it, that the Sharpe ratio is a lousy measure of performance.? Most of the other arguments focus on the author’s affiliations — AIG Financial Products and Vanguard.? It is not valid to dismiss evidence off of the background of the individual.? Deal with his arguments.? So what if he worked for AIGFP?? That doesn’t make him liable for everything done there.? Same for Vanguard.? Merely because you work for Vanguard does not mean that you shill for mutual fund industry in everything that you do.

Humble Student of the Markets Cam Hui raises these objections in his comments to my piece last night.? I object to the ad hominem arguments of Mr. Covel.? If we must argue, let us argue on the basis of principle, and may the best side win.

Now, when Mr. Covel responded to me, it was also an ad hominem argument, tying me to Jim Cramer.? Now note, the first piece has disappeared from the internet, and I know not why.? Perhaps he gets that I am not a Jim Cramer clone.? To my readers I ask, how many of you think that I am like Jim Cramer in the way I advise?? I wrote a long series of articles on using investment advice to inoculate people against using stock tips from the media, partially because as Jim Cramer became more of a media phenomenon, his recommendations became worse.? He is at his best when he writes/says less, and gives you his considered opinion.? Investing and doing something sensational for the media do not mix.? That’s the conundrum of the value proposition for TSCM.

That said, Cramer does use price momentum as one of the factors in his stock selections.? He is generally a “trend follower.”? Cramer also is not a value investor.? Much as I appreciate him giving me a chance to write, we aren’t very similar.? That’s consistent with TSCM philosophy — they want a large range of views.? I wrote there for four years, and was one of their leading writers.? I rarely interacted directly with Cramer, instead, putting forth my own views, which did better (in my opinion).

I’m not Cramer, and he’s not me.? He just gave me a chance to write, for which many are grateful.? (I would tell you that he taught me how to trade corporate bonds, even though he has never traded corporates, but that would be a long story.)

Pressing on

This is not my last article on this topic.? I intend on continuing this discussion, to flesh out where I agree with Mr. Covel, because at many points I do agree, but there are complexities that need further elucidation.

The main areas I will cover in the future include:

When does trend following fail?
What other factors should we consider?
What constitutes adequate proof that a strategy is superior?

I credit Michael Covel for commenting at my blog, and I will answer his question, but not today.? It is a valid question, but there are other questions that can be posed to him as well.? Let the debate commence on a fair basis.

Not All Bubbles Lead to Depressions

Posted on 7 April 2009 by David Merkel

I enjoyed the opinion piece in yesterday’s WSJ, From Bubble to Depression? I want to clear up a few of their misconceptions.? Key quote:

Earlier, during the downturn in the equities market between December 1999 and September 2002, approximately $10 trillion of equity was erased. But a measure of financial system performance, the Keefe, Bruyette, & Woods BKX index of financial firms, fell less than 6% during that period. In the current downturn, the value of residential real estate has fallen by approximately $3 trillion, but the BKX index has now fallen 75% from its peak of January 2007. The financial sector has been devastated in this crisis, whereas it was almost completely unaffected by the downturn in the equities market early in this decade.

How can one crash that wipes out $10 trillion in assets cause no damage to the financial system and another that causes $3 trillion in losses devastate the financial system?

They almost get it in their later paragraphs, but the answer is simple.? In the first “crash,” the losses were mainly equity-based, so there were no knock-on effects on other entities.? No additional dominoes fell.? With housing in the late 2000s, a loss of $3 billion happened on assets that were usually levered with debt at 5x to 30x, probably averaging 10x.? And, these mortgages were held by leveraged banks that had borrowed in many other places in the overall financial system, and sometimes by even more leveraged speculators using CDOs.

Let me say it again — Bubbles are financing phenomena; depressions are financing phenomena.? They are opposite sides of the same coin.? The severity of bubbles differs with the amount of debt employed and the pervasiveness of the sectors of the economy affected.? The tech bubble did not have much debt, and it was contained.? The real estate bubble was the opposite.

The thing is, the amount of debt we have racked up as a fraction of GDP exceeds that of the Great Depression.? My view is that many debts will have to be liquidated before the US economy grows robustly again, whether through payoff, compromise or inflation.

Now, we had Michael Mayo today offering his opinions on the banks, (two, three) which are not all that much different than mine.? In an era of debt deflation, coming off record debt-to-GDP ratios, it is next to impossible for the US Government to make any significant difference against the deflation.? Better not to try at all.? An action big enough for the US Government to absorb the necessary amount of bad debt will kill the Dollar.

This last bubble has led to a depression, because of the debts incurred.? We must liquidate debts, but in the process, the economy will suffer.? I’m sorry, I like prosperity too, but there is no way out of this period of debt liquidation.? Just as the period of debt growth pushed asset prices up, so the period of debt deflation will push asset prices down.

My advice?? Avoid almost all banks, and other financial companies sensitive to the stock market or real estate, in terms of both equity and bond investments.

Corporate Anorexia

Posted on 3 April 2009 by David Merkel

As I looked at replacement candidates for my portfolio, I ran across many companies with negative tangible net worth.? Knowing that intangibles often have value, I looked for the gap that should exist between free cash flow (earnings, less depreciation, amortization, and capital expenditure) and earnings, and more often than not, it was not there.

Ugh, as a buyside insurance analyst, I often encouraged management teams to not buy back stock, but build up capital against contingencies.? It was a contrarian point of view, and not listened to for the most part.

I understand the troubles that come from managements that keep too much of a reserve on hand.? That’s not the problem now.? In the bust phase of the credit cycle, companies with more reserves do better.? The disciplines that minimize net working capital are worthless now in the bust phase.

As I have said before, the boom-bust cycle cannot be repealed.

Of Course not at Par; That’s Par for the Course

Posted on 31 March 2009 by David Merkel

There are several truths well-known to educated investors that have been glossed over in all of the discussions of mark-to-market accounting, or SFAS 157.? (Really SFAS 133, but SFAS 157 clarified it.)

Accounting rules have little impact on stock prices.? Almost every academic study on accounting rules supports that idea.? Why?? Investors attempt to estimate the stream of free cash flows that an asset will throw off.? Accounting rules can help or hinder that.? Because SFAS 157 attempts to calculate a present value of cash flows for level 2 and 3 assets, it aids in that estimation.
Parties involved confuse regulatory with financial accounting.? Mainly due to the laziness of financial corporations in the boom phase of our markets, they looked to minimize effort, and make the accounting the same for regulatory and financial purposes.? This was foolish, because there is no one accounting method that is ultimate.? Every financial statement answers one main question.? For GAAP, the balance sheet asks “What is the net worth?”? Regulatory accounting would ask “Is net worth positive under conditions of moderate stress, including the possibility that markets go illiquid, and we have to rely on cash flows to pay off the liabilities?”
There are always two ways to do accounting.? You can do mark-to-market, or you can do book value accounting with impairment.? Darkness encourages skepticism.? In a period where there are few credit risks, book value? accounting will be well-received.? In an era where credit risks are significant, book value accounting will be no help, investors will distrust book value, and the effect might be less than where fair value estimates are provided. ? Regardless, the cash flows will still flow.
Equity-like investments deserve equity-like accounting.? They should be market to market, as equities are.? With derivatives, this is the reason that we mark them to market, their values are so variable.? So we should mark speculative mortgage investments: estimate the future cash flows, and discount them at a high, but not equity-like interest rate.
But what of assets that are seemingly money good, but the few trades that have happened indicate a value at 60% of par, possibly because of The Bane of Broken Balance Sheets, or Time Horizon Compression.? Here’s the problem: we have a lot of people alleging that those values can’t be right.? Let them stand up and start buying to prove it all wrong.? Part with precious liquidity to gain uncertain yield.? It is quite possible that we are in a depression, and as such, there are too many assets relative to the ability to fund them — asset values must fall.? Don’t immediately assume that the few trades in the market are ridiculous because they are lower than your current marks.
Some argue that there is an inconsistency between loans and bonds.? Bonds get marked to market, while loans are marked at book.? There is no inconsistency.? The loans are held to maturity, unless sold.? The bonds could be held to maturity as well, in which case they are at book value, and only changed if there is a need for a writedown, the same as the loans.? Most companies have not chosen that option, largely because they want the right to sell assets if they want to.? But that locks in their accounting; if they want the ability to sell, they must accept balance sheet volatility.
We have to differentiate SFAS 157 from misapplications of SFAS 157, which might be driven by the auditors.? SFAS 157 does not mean last trade.? In thin markets, companies are free to use discounted cash flow and other analyses to estimate fair value.
Now all of this said, practically, SFAS 157 leads to overestimating the value of assets.? In the consulting work I have done, companies are not willing to mark their volatile assets down to levels near their fair value, much less last trade, which is worse.? They are hoping for some huge return of risk-taking to appear, and revalue their assets. What if present conditions persist for five to ten years, where there are too many debts relative to the wilingness to fund them, as in the Great Depression?? In that situation, SFAS 157 would prove to be too flexible, with banks marking assets higher than warranted.

The anti-SFAS 157 arguments rely on an assumption that things aren’t so bad — that mean-reversion is right around the corner.? We are in a situation where marginal cash flows to purchase dud assets aren’t there.? Mean reversion is a long way off, and the valuations of financial assets reflect that consistently.? Try selling a bunch of whole loans held at par.? See what the offers are.? Why aren’t banks doing that to raise liquidity?? Because the prices don’t justify it.

You can’t fight cash flows.? Accounting exists to partition cash flows into periods, so that analysis of businesses can be done, and debt financing can be secured.? In the end, cash flows win out, regardless of the accounting methods.

Thus my opinion: SFAS 157 is a good standard, and I am no fan of the FASB generally.? There are misapplications of SFAS 157, forced by auditors, I believe.? SFAS 157 already offers decent flexibility to management teams — let them use that flexibility, but no more.? After that, let the regulators set their own solvency rules.

-==-=-=–==–=-=-=-==–=-==-=-=-

PS — What foes of SFAS 157 are unwilling to admit, is that lenders lent money near the peak of an amazing bull market, and now the collateral values lent against are far less than imagined at the time of lending.

It’s like the FRAM oil filter ad — “you can pay me now or pay me later.”? There is a great deal of hubris involved in arguing that the market as a whole is out-of-whack.? (Much as I had hubris toward the end of the bull phase… let me stab myself.)? In ordinary bear markets, there is some strength somewhere to support asset values.? That is not true now.? We are dealing with something not normal over the last 70 years, and overall market values are reflecting that.? Eventually accounting values will get there, as they did in the thirties.

The Great Omission

Posted on 27 March 200927 March 2009 by David Merkel

This seems to be the era for dusting off old articles of mine.? This one is one year old, I wrote it on April Fools’ Day — Federal Office for Oversight of Leverage [FOOL].? (Today I would simplify it to: Federal Office Overseeing Leverage.) I would recommend a re-read of that article, and encourage those at the Treasury to realize the enormity of what it is trying to do.

Well, now the Treasury ain’t foolin’ around.? They think they can harness systemic risk.? Check out the speech of Mr. Geithner, and his proposed policy outline.? What are the main points of the policy outline?

1) A Single Independent Regulator With Responsibility Over Systemically Important Firms and Critical Payment and Settlement Systems

Defining a Systemically Important Firm
Focusing On What Companies Do, Not the Form They Take
Clarifying Regulatory Authority Over Payment and Settlement Activities

2) Higher Standards on Capital and Risk Management for Systemically Important Firms

Setting More Robust Capital Requirements
Imposing Stricter Liquidity, Counterparty and Credit Risk Management Requirements
Creating Prompt-Corrective Action Regime

3) Registration of All Hedge Fund Advisers With Assets Under Management Above a Moderate Threshold

Requiring Registration of All Hedge Funds
Mandating Investor and Counterparty Disclosure
Providing Information Necessary to Assess Threats to Financial Stability
Sharing Reports With Systemic Risk Regulator

4) A Comprehensive Framework of Oversight, Protections and Disclosure for the OTC Derivatives Market

Regulating Credit Default Swaps and Over-the-Counter Derivatives for the First Time
Instituting a Strong Regulatory and Supervisory Regime
Clearing All Contracts Through Designated Central Counterparties
Requiring Non-Standardized Derivatives to Be Subject to Robust Standards
Making Aggregate Data on Trading Volumes and Positions Available
Applying Robust Eligibility Requirements to All Market Participants

5) New Requirements for Money Market Funds to Reduce the Risk of Rapid Withdrawals

6) A Stronger Resolution Authority to Protect Against the Failure of Complex Institutions

Covering Financial Institutions That May Pose Systemic Risks

i. A Triggering Determination

ii. Choice Between Financial Assistance or Conservatorship/Receivership

Options for Financial Assistance

Options for Conservatorship/Receivership

iii. Taking Advantage of FDIC/FHFA Models:

Requiring Covered Institutions to Fund the Resolution Authority

(As an aside, did anyone else notice that point 6 didn’t make it into the introductory outline?)

The Great Omission

There’s a bias among Americans for action.? That is one of our greatest strengths, and one of our greatest weaknesses, and I share in that weakness.? Whenever a crisis strikes, or an egregious crime is committed, or a manifestly unfair scandal develops, the klaxon sounds, and “Something must be done!? This must never, never, NEVER happen again!”

So, instead of merely having a broad-based law against theft/fraud, and allowing the judges discretion for aggravating/extenuating circumstances, we create lots of little theft/fraud laws to fit each situation, fighting the last war.? Oddly, because of specificity of many statutory laws, it weakens the effect of the more general theft/fraud laws.

The Treasury will fight the last war, as they always do, but there is a great omission in their fight, even to fight the last war.

Why did they ignore the Fed?? Why did they ignore that many of the existing laws and regulations were simply not enforced?? For much but not all of this crisis, it was not a failure of laws but a failure of men to do their jobs faithfully.

Consider this opinion piece from the Wall Street Journal today.? There is some disagreement, which helps to flesh out opinions.? I think a majority of them concur with the idea that the greatest creator of systemic risk, particularly since 2001, was easy credit from the Federal Reserve.? It’s been my opinion for a long time.? For example, consider this old (somewhat prescient) CC post from RealMoney:


		David Merkel
		The Fed Vs. GSEs: Which Is Most Threatening to the Economy?
		2/24/04 1:35 PM?ET
I found Dr. Greenspan’s comments about Fannie and Freddie this morning a little funny. I agree with him that the government-sponsored entities, or GSEs, have to be reined in; they are creating too much implied leverage on the Treasury’s balance sheet. They may prove to be a threat to capital market stability if they get into trouble; they are huge. Well, look to your own house, Dr. Greenspan. As it stands presently, the incremental liquidity that the Fed is producing is going into housing and financial assets. The increase in liquidity has led to low yields, high P/E ratios and subsidized issuance of debt. All of this has led to stimulus for the economy and the equity and bond markets, but at what eventual cost? The Fed has far more systemic risk to the economy than the GSEs. No stocks mentioned

Since then, the GSEs have failed, and the Federal Reserve is trying to clean up the mess they created in creating the conditions that allowed for too much leverage to build up.? Now they are fighting deleveraging by bringing certain preferred types of private leverage onto the balance sheet of the Fed/Treasury/FDIC.

The first commenter in the WSJ piece makes some comments about monetary aggregates, suggesting that the Fed had nothing to do with the housing bubble.? Consider this graph, then:

Outpacing M2 (yellow) for two decades, MZM (green), the monetary base (orange) and my M3 proxy, the total liabilities of banks in the Federal Reserve really began to take off in the mid-90s, and accelerated further as monetary policy eased starting in 2001.

This brings up the other part of the omission: bank and S&L exams were once tougher, but became perfunctory.? The standards did not shift, enforcement of the standards did.? Together with increased use of securitization, and to some extent derivatives, this allowed the banks to lever up a lot more, creating the systemic risk that we face today.

There are other problems (and praises) that I have with (for) the Treasury’s proposals, and I will list them in the addendum below.? But the most serious thing is what was not said.? The government can create as many rules and regulations as it likes, but rules and regulations are only as good as how they are executed.? The Government and the Fed did not use its existing powers well.? Why should we expect things to be better this time?

Addendum

Praises

A single regulator for large complex firms is probably a good idea.? Perhaps it would be better to limit the total assets of any single financial firm, such that any firm requiring more than a certain level risk based capital would be required to break up.
Higher risk-based capital is a good idea, but be careful phasing it in, lest more problems be caused.
With derivatives, most of the proposal is good, but the devil is in the details of dealing with nonstandard contracts.

Problems

Risk based capital should higher for securitized assets versus unsecuritized assets in a given ratings class, because of potentially higher loss severities.
You can’t tame the boom/bust cycle.? You can’t eliminate or tame systemic risk.? It is foolish to even try it, because it makes people complacent, leading to bigger bubbles and busts.
Hedge funds are a sideshow to all of this.? Regulating them is just wasted effort.
With Money Market funds, my proposal is much simpler and more effective.
Do you really know what it would take to create a macro-FDIC, big enough to deal with a systemic risk crisis like this?? (The FDIC, much as it is pointed out be an example, is woefully small compared to the losses it faces, and it is not even taking on the large banks.)? It would cost a ton to implement, and I think that large financial services firms would dig in their heels to fight that.? Also, there would be moral hazard implications — insured behavior is almost always more risky than uninsured behavior.
Very vague proposal with a lot of high-sounding themes.? (late addition after the initial publishing, but that was my first thought when I read it.)

Liquidity and the Current Proposal by the US Treasury

Posted on 24 March 2009 by David Merkel

One of the earliest pieces at this blog was What is Liquidity?, followed by What is Liquidity? (Part II).? I’ve written a bunch of pieces on liquidity (after doing a Google search and being surprised at the result), largely because people, even sophisticated investors and unsophisticated politicians and regulators misunderstand it.? Let’s start with one very simple premise:

Many markets are not supposed to be liquid.

Why?

Small markets are illiquid because they are small.? Big sophisticated players can’t play there without overwhelming the market, making volatility high.
Securitization takes illiquid small loans and transforms them into a bigger security(if it were left as a passthrough), which then gets tranched into smaller illiquid securities which are more difficult to analyze.? Any analysis begins with analyzing the underlying loan collateral, and then the risks of cashflow timing and default.? There is an investment of time and effort that must go into each analysis of each unique security, and is it worth it when the available amount to invest in is small?
Buy-and-hold investors dominate some markets, so the amount available for sale is a small portion of the total outstanding.
Some assets are opaque, where the entity is private, and does not publish regular financial statements.? An? example would be lending to a subsidiary of a corporation without a guarantee from the parent company.? They would never let and important subsidiary go under, right?? 😉
The value of other assets can be contingent on lawsuits or other exogenous events such as natural disasters and credit defaults.? As the degree of uncertainty about the present value of free cash flows rises, the liquidity of the security falls.

When is a securitization most liquid?? On day one.? Big firms do their due diligence, and put in orders for the various tranches, and then they receive their security allocations.? For most of the small tranches, that’s the last time they trade.? They are buy-and-hold securities by design, meant to be held by institutions that have the balance sheet capacity to buy-and-hold.

When are most securitizations issued?? During the boom phase of the market.? During that time, liquidity is ample, and many financial firms believe that the ability to buy-and-hold is large.? Thus thin slices of a securitization get gobbled down during boom times.

As an aside, I remember talking to a lady at a CMBS conference in 2000 who was the CMBS manager for Principal Financial.? She commented that they always bought as much of the AA, single-A and BBB tranches that they could when they liked the deals, because the yield over the AAA tranches was “free yield.”? Losses would never be that great.? Privately, I asked her how the securitizations would fare if we had another era like 1989-92 in the commercial property markets.? She said that the market was too rational to have that happen again.? I kept buying AAA securities; I could not see the reason for giving up liquidity and safety for 10, 20, or 40 basis points, respectively.

Typically, only the big AAA tranches have any liquidity.? Small slices of securitizations (whether credit-sensitive or not) trade by appointment even in the boom times.? In the bust times, they are not only not liquid, they are permafrost.? In boom times, who wants to waste analytical time on an old deal when there are a lot of new deals coming to market with a lot more information and transparency?

So, how do managers keep track of these securities as they age?? Typically, they don’t track them individually.? There are pricing grids or formulas constructed by the investment banks, and other third-party pricing services.? During the boom phase, tight spread relationships show good prices, and an illusion of liquidity.? Liquidity follows quality in the long run, but in the short run, the willingness of investors to take additional credit risk supports the prices calculated by the formulas.? The formulas price the market as a whole.

But what of the bust phase, where time horizons are trimmed, balance sheets are mismatched, and there is considerable uncertainty over the timing and likelihood of cash flows?? All of a sudden those pricing grids and formulas seem wrong.? They have to be based on transactional data.? There are few new deals, and few trades in the secondary market.? Those trades dominate pricing, and are they too high, too low, or just right?? Most people think the trades are too low, because they are driven by parties needing liquidity or tax losses.

Then the assets get marked too low?? Well, not necessarily.? SFAS 157 is more flexible than most give it credit for, if the auditors don’t become “last trade” Nazis, or if managements don’t give into them.? More often than not, financial firms with a bunch of illiquid level 3 assets act as if they eating elephants.? How do you eat an elephant?? One bite at a time.? They write it down to 80, because that’s what they can afford to do.? The model provides the backing and filling.? Next year they plan on writing it down to 60, and hopefully it doesn’t become an obvious default before then.? Of course, this is all subject to limits on income, and needed writedowns on other assets.? I have seen this firsthand with a number of banks.

So, relative to where the banks or other financials have them marked, the market clearing price may be significantly below where they are currently marked, even though that market clearing price might be above what the pricing formulas suggest.

The US Treasury Proposal

The basics of the recent US Treasury proposal is this:

Banks and other financial institutions gather up loans and bonds that they want to sell.
Qualified bidders receive information on and bid for these assets.
High bid wins, subject to the price being high enough for the seller.
The government lends anywhere from 50-84% of the purchase price, depending on the quality and class of assets purchased.? (I am assuming that 1:1 leverage is the minimum.? 6:1 leverage is definitely the maximum.)? The assets collateralize the debt.
The FDIC backs the debt issued to acquire the assets, there is a maximum 10 year term, extendable at the option of the Treasury.
The US Treasury and the winning private investor put in equal amounts, 7-25% each, to complete the funding through equity.
The assets are managed by the buyers, who can sell as they wish.
If the deal goes well, the winning private investors receive cash flows in excess of their financing costs, and/or sell the asset for a higher price.? The government wins along with the private investor, and maybe a bit more, if the warrants (ill-defined at present) kick in.
If the deal goes badly, the winning private investors receive cash flows in lower than their financing costs, and/or sell the asset for a lower price.? The government may lose more than the private investor if the assets are not adequate to pay off the debt.

I suspect that once we get a TLGP [Treasury Liquidity Guaranty Program] yield curve extending past 3 years, that spreads on the TLGP debt will exceed 1% over Treasuries on the long end.? Why?? The spreads are in the 50-150 basis point region now for TLGP borrowers at 3 years, and if it were regarded to be as solid as the US Treasury, the spread would just be a small one for illiquidity.? (Note: the guarantee is “full faith and credit” of the US Government, but it is not widely trusted.? Personally, I would hold TLGP debt in lieu of short Treasuries and Agencies — if one doesn’t trust the TLGP guarantee, one shouldn’t trust a Treasury note — the guarantees are the same.)

One thing I am unclear on with respect to the financing on asset disposition: does the TLGP bondholder get his money back then and there when an asset is sold?? If so, the cashflow uncertainty will push the TLGP spread over Treasuries higher.

Thinking About it as an Asset Manager

There are a number of things to consider:

Sweet financing rates — 1-2% over Treasuries. Maybe a little higher with the TLGP fees to pay.? Not bad.
Auction?? Does the winner suffer the winner’s curse?? Some might not play if there are too many bidders — the odds of being wrong go up with the number of bidders.
What sorts of assets will be auctioned?? [Originally rated AAA Residential and Commercial MBS] How good are the models there versus competitors?? Where have the models failed in the past?
There will certainly be positive carry (interest margins) on these transactions initially, but what will eventual losses be?

The asset managers would have to consider that they are a new buyer in what is a thin market.? The leverage that the FDIC will provide will have a tendency to make some of the bidders overpay, because they will factor some of the positive carry into the bid price.

I personally have seen this in other thin market situations.? Thin markets take patience and delicate handling; I stick to my levels and wait for the market to see it my way.? I give one broker the trade, and let him beat the bushes.? If nothing comes, nothing comes.

But when a new buyer comes into a thin market waving money, pricing terms change dramatically after a few trades get done.? He can only pick off a few ignorant owners initially, and then the rest raise their prices, because the new buyer is there.? He then becomes a part of the market ecosystem, with a position that is hard to liquidate in any short order.

Thinking About it as a Bank

More to consider:

What to sell?
What is marked lower than what the bank thinks the market is, or at least not much higher?
Where does the bank know more about a given set of assets than any bidder, but looks innocuous enough to be presumed to be? a generic risk?
Loss tolerances — where to set reservation prices?
Does participating in the program amount to an admission of weakness?? What happens to the stock price?

Management might conclude that they are better off holding on, and just keep eating tasty elephant.? Price discovery from the auctions might force them to write up or down securities, subject to the defense that prices from the auctions are one-off, and not realistic relative to the long term value.? Also, there is option value in holding on to the assets; the bank management might as well play for time, realizing that the worst they can be is insolvent.? Better to delay and keep the paychecks coming in.

Thinking about it as the Government and as Taxpayers

Still more to consider:

Will the action process lead to overpriced assets, and we take losses?? Still, the banks will be better off.
Will any significant amount of assets be offered, or will this be another dud program?? Quite possibly a dud.
Will the program expand to take down rasty crud like CDOs, or lower rated RMBSand CMBS?? Possibly, and the banks might look more kindly on that idea.
Will the taxpayers be happy if some asset managers make a lot of money?? Probably, because then the government and taxpayers win.

Summary

This program is not a magic bullet.? There is no guarantee that assets will be offered, or that bids for illiquid assets will be good guides to price discovery.? There is no guarantee that investors and the government might? not get hosed.? Personally, I don’t think the banks will offer many assets, so the program could be a dud.? But this has some chance of success in my opinion, and so is worth a try.? If they follow my advice from my article Conducting Reverse Auctions for the US Treasury, I think the odds of success would go up, but this is one murky situation where anything could happen.? Just don’t the markets to magically reliquefy because a new well-heeled buyer shows up.

Ten Comments on the Current Market Melange

Posted on 17 March 2009 by David Merkel

1) I like PartnerRe — they invest in their people; they limit their risks; they keep their balance sheet strong.? So it was with pleasure when I saw they had bought back the majority of some of their their junior debt at 50+ cents on the dollar.? Good move.

2) The short-term performance model for financial stocks recommends insurance brokers and reinsurers here. No surprise, because both of them face little risk on the asset side of the balance sheet.? For insurance brokers, short?term performance favors BRO, AOC, and EHTH.? For reinsurers, short-term performance favors VR, RNR, GLRE, and AWH.? Personally, I would consider BRO and AWH. Very soundly run firms.

3) There are troubles with life insurers as noted in this WSJ piece.? Personal notes: I applied to be chief investment officer of Shenandoah Life in 2003.? They told me they needed to get more out of their asset portfolio.? I gave them some free consulting — I told them that their portfolio was fine, but that they had too many lines of business, and their expenses were too high.

Penn Treaty (spit, spit) — I know some of the management there; they were dealt a bad hand.? I fault the state insurance department of Pennsylvania for not taking them over four years ago, and allowing a reserve credit for a reinsurance treaty that did not pass risk.

As for Conseco and Genworth, it is just another demonstration of how long term care insurance is not an underwritable liability.? There is too much freedom for policyholders to influence benefits paid.

Then there are the equity-sensitive insurers, like Hartford, Lincoln National, and Phoenix.? They will have a very high beta versus the market, because they are on the cusp.? Sad place to be.

4)? Why are we trying to reassure China regarding their purchases of US Government debt?? As a government, they made efforts to push their exports on the US, and had to take back US debt, because it seemed to be the best store of value, or at least, the most liquid.? Personally, I do not see any reason to kowtow.? They are not our problem; we are their problem.? Let China figure out that they have been playing ina rigged casino.? They still don’t have many places to park spare funds.

5) I have a little more sympathy for Ben Bernanke after he appeared on 60 Minutes.? That doesn’t mean that I think he is right, but to see an honest man trapped in a situation where his gifted intellect is stunted because he has bought into a flawed paradigm is painful.? Worse is that he will drag us along with him.? That said, I find it laughable that the recession will end in 2009.? That’s just political talk to make us comfortable.

6) When the dollar and gold move together, it is a sign that the rest of the world is in worse shape than the US.? Frightening, huh?

7) As I have commented long before this, state and municipal pensions are in deep trouble, or worse the states and municipalities are in trouble.? It may add up to a lot of funds.? Also, they may have made a number of bad investments.

There were many years where some of the states rested on their laurels and did not put a cent into the pension coffers.? The surging market took care of their funding, wrong as that was to assume.? Now they are paying the price for their political indolence.

8 ) The flub.? Whoops, the FHLB. What, they invested in dodgy mortgage securities?? They are supposed to support the mortgage markets regardless.? Big surprise that they get whacked in this environment.

9) I am no big fan of fair value, but I detest those that want to modify FAS 157. The problems are due to bad investment decisions, not bad accounting rules.? Even with held-to-maturity accounting, there is loss recognition.? Investors are not dumb.? To the extent that losses are not recognized in the accounting, suspicion grows.

Accounting does not affect cash flows, and as such does not affect the valuation of firms.? Most major accounting studies reflect this truth.

10) Can you pass the CEO test?? Personally, I found this article to be edifying.? It describes what an effective/good CEO is.

Full Disclosure: Long PRE HIG

The Bane of Broken Balance Sheets

Posted on 6 March 2009 by David Merkel

I?ve talked about the troubles in our economy stemming from asset-liability mismatch.? Too many people/institutions financed risk assets:

With inadequate equity (provision for adverse deviation)
With lending terms that were much shorter than that of the assets financed
Where the borrowing terms can shift against the borrower in an adverse economic environment.? Think of borrowing in a harder currency, or loans that can reset of recast with payments going higher.
Where lending terms could be modified by third parties.? Think of the rating agencies downgrading a company and it has to put up more assets as collateral.

Another way to say it is too many relied on the ability to refinance on favorable terms.? But now that favorable terms are no longer there, we live in a time of broken balance sheets.? What were some of the classic examples of this phenomenon?

Buying houses with little money down.
Buying houses where the terms can reset against you.? Houses are long term assets, and must be funded with a generous amount of equity, and long term financing as far as the debt is concerned.
Hedge funds bought long duration assets, stocks and longer bonds, when their capital bases could be withdrawn at much shorter intervals.
Many mergers were done for cash near the peak of the product pricing cycle for their particular industry.? The debts incurred hang around, but funny, the pricing power doesn?t when demand collapses.
Many companies invested in new productive capacity ? energy, agriculture, mining, just as the global economic cycle was peaking.? Others in developing markets had ramped up industrial capacity beyond the world?s capability to absorb it.
Defined benefit pension liabilities were increased by states and municipalities which relied on the idea that tax revenues would grow indefinitely at a rate of 4-5% or more.? The same for corporations that assumed 7-10% asset returns for the next 50 or so years.
Even 10-year commercial mortgages with 30-year amortization presumed on the ability to refinance 10 years out.? Was there the possibility that ten years out, refinancing terms would be worse than at origination?? Yes, and we are there now.

In any case, there was often a mismatch as the global economy grew during the boom phase.? New long term assets were created, and financed with not enough equity, and debt terms that were shorter than the life of the assets.

Much of this can be laid at the doors of the Central banks of our world, because they pulled out all of the stops in the early 2000s to help establish an unending prosperity.? News flash: the boom/bust cycle is endemic to mankind; efforts to eliminate it merely create a version with long shallow booms and big busts.? Eventually the piper must be paid; there are no free lunches.? The easing of monetary policy 2001-2003 led to one final big bout of risk taking 2003-2007.? We are living with the aftermath now, as the central banks do everything to try to reflate with no success.? When consumers have little capacity to increase indebtedness, monetary policy is useless, leaving aside helicopter tactics.

So what can the government do at a point like this, since they are committed to permanent prosperity?

Inflate, raising the nominal value of collateral.? This is the simplest solution, and the Fed resists it.? It would also force the other governments of the world to go along.
Provide long-term financing to troubled corporations, whether through long debt, equity, or hybrid instruments.
Bail out states and municipalities with burdensome pension liabilities.

(NB: I am not saying the government should do any of these things.? I am simply saying that these are better than what the government is currently doing.)

Government funding is short duration by nature because of the annual appropriations process, and lack of any restraint ? little in the way of rainy day funds ? a presumption of prosperity in budgeting.? Few governmental entities in the US assume that receipts will be lower in future years.? Budgets are often made assuming that spending will increase, and that taxes will rise to fill the gap.? Well, no more of that, at least for a while.

Any scheme that relies on increasing prosperity is inherently mismatched.? No tree grows to the sky, and that includes nations and their governments.? There is a natural process where nations are born, grow, mature, decay, and die, unless some event intervenes to revivify the nation, giving it new purpose and energy.? With the US over the last 75 years, there has been slow decay amid prosperity.? Payment for obligations is pushed out into the future, because growth will solve our funding crises.? Government debt covers a multitude of sins, in the intermediate-term.

Financing the Economy at Treasury Interest Rates

When I hear talk that the government should borrow to fund mortgages, or dodgy companies, I cringe.? I hear things like: ?These assets are at depressed levels because of a lack of confidence.? The government can borrow and buy them, and make a profit on the spread, particularly after confidence resumes.?? ?Let the government absorb Fannie and Freddie and make loans at affordable rates to people.? They can provide mortgages much cheaper than the private sector.?? ?The value of the assets of AIG is artificially depressed.? The government can finance those assets and sell them for a profit when confidence reappears.?

The borrowing capacity of the US Government is limited.? I don?t know what the limit is ? which straw will finally break the back of the camel, but there is a limit.? The borrowing capacity of our government should be used to its best effect, and playing as a bank or a hedge fund is likely not the right answer.

An overage of private and public leverage pushed asset prices above their equilibrium levels.? Residential housing is a good example here.? Prices still need to come down to restore the affordability levels that existed through the second half of the 20th century.? The Fed could inflate some of the problems away, but that does not seem to be on their menu of choices at present.

I have seen private residential mortgage bonds trading at levels where I said, ?The odds of these not being money good are remote.?? Yet, the bonds trade (if they trade) below 70.? (100 is being paid in full.)

This is because there are fewer entities capable of holding the bonds to anything near maturity.? When someone complains to me about the price of a mortgage bond, after analysis, I often say to find an entity that is willing to hold the bond to maturity, or slightly less, and they can garner full value.? But anyone holding that bond that can?t hold it to maturity, or doesn?t want to, is merely a speculator.

We developed too many speculators in the 2000s, and not enough parties that would hold assets to maturity.? We now suffer for that, including our dear government.? Our dear government is like Brer Rabbit punching the Tar Baby, but without the advantage of being born and bred in the briar patch.? They don?t know what they are doing.? They have some vague idea about what Keynes said, but don?t understand the limitations of his theory.? Bernanke is the expert on the Great Depression, so whatever he suggests in this context must be right? Right?!

Sadly, no.? To the extent that private sector debts are not reduced, the crisis does not end.? Even the swapping of private for government debt is merely a ?delay of game? strategy, because there will be a greater crisis when the US Government cannot service its debts.? We live in a period of waning prosperity, with the US Government having decreasing ability to influence events.

At present, absent inflation for the Fed, the broken balance sheets of our world imply a slow recovery, where any earnings go to fill in balance sheet holes, and buy up broken competitors.? It?s not a fun environment, but it is an environment where good managements can pursue relative advantage if they are careful.? Guard your liquidity carefully, and persevere through this tough time.

A New Appreciation for the Plumbing

Posted on 27 February 2009 by David Merkel

I am the son of a plumber, who was the son of a plumber.? My wife gives me a bemused look when I go off to fix a plumbing problem, usually minor, when she asks, “Can you do it?” and I say, “Son of a son of a plumber.”? Truly, my statement means nothing, though I worked with my Dad for two summers that I enjoyed a great deal.? He installed sewers all over southeastern Wisconsin, and was known for doing quality work.? He never got sued once in his 35-year career.

So, I can appreciate plumbing.? Most of us never think about it.? Open the spigot — water!? Flush the toilet — waste gone!? Simple.? Beautiful.? As my Dad, a happy man, would say, “I have brought civilization to southeastern Wisconsin.”? A good man, my Dad.

Figuratively, plumbing exists in many areas of life.? People don’t want to think about the mechanics of how something works; they just want it to work when they need it.? More people drive cars than are mechanics.? More people listen to music than can sing well.? (I love to sing.)

The sad aspect of plumbing for the financial markets today is that we are drawn to the front end of investing processes.? This man looks successful.? He has a great story; a way to make money that others do not know about.? There are documents showing his track record — impressive, though he doesn’t solicit publicly; investing with him is a family affair.? Do you want to be part of the family and gain the benefits thereof?

There are questions to be asked, particularly of nonstandard ventures:

How are the returns earned?
Who checks the results?? (Auditing — should not be a small firm.)
Who has custody of the assets?
Is the trustee a reputable third party?
Is liquidity proportionate to the asset class invested in?
Is this under US law?
Do the returns look too good to be true, either in absolute amount, or always positive with low volatility?
Is this marketed to everyone, or just a select few suckers?
Is the profit motive of the sponsor obvious and standard?
How are asset values calculated each accounting period?

Whether we are talking about Madoff, Stanford, or any of the other recent frauds, an attention to the details of how the financial plumbing works can pay off in terms of avoiding situations that are too good to be true.

When the next bull phase comes, be aware, and avoid slick talkers who have a good private game going, unless it can be verified by many competent independent third parties.? The bear phase is here now, revealing the slick talkers, and those that were taken in by them.? Be aware; you are your first and best line of defense.