Category: Speculation

Send AIG to Chapter Eleven

Send AIG to Chapter Eleven

Posted on by David Merkel

There are two reasons to bail out a financial company.? The first is that it’s failure would lead to a run on liquidity at similar companies duewith those of to a lack of confidence.? The second is that it their promises are so interlaced with those of other companies that failure would cause many other companies to fail.

For the first reason, we have the FDIC and similar institutions for deposit-takers, and the insurance guarantee funds for the insurers.? For the second reason, the government should be minimalistic, and only guarantee the entities that threaten systemic risk.

For AIG, what should have happened back in September, and what should happen now, is that the government should have let the holding company fail, and guaranteed the obligations of AIG Financial Products in exchange for a senior loan that would subordinate all existing holding company debt.? [Essentially a DIP loan, because the holding company would be in Chapter 11.]

Aside from Financial Products, most AIG’s subsidiaries are probably fine, and don’t need any help.? Those that might fail don’t pose any systemic risks.

So, when I see AIG coming back to the government for more, I think of several things:

1) When Hartford Steam Boiler was sold for a cheap price, I commented that if that was the price for a good asset like HSB, then AIG common was worthless.

2) Why are we messing around with the holding companies as we do bailouts?? Regulated entities I understand.? There is no compelling interest for the US government to own AIG holding company stock.

3) Let the bondholders suffer a little.? AIG did not trade like a AAA credit, even in its glory days.? It traded more like single-A.? If you didn’t take the warning that the bond market was giving you as the leverage built up, then that is your fault.

4) Back to point 2 in a more general way.? If the government is going to intervene, let them inject money into the regulated subsidiaries, not holding companies, and then limit dividends and transfer payments to the holding company.

5) If large derivative counterparties are so critical to the financial infrastructure, then they need to be regulated as well.? Open the derivative books to the regulator, and let the new regulator set leverage/capital policy.? What?? They can’t do as much business?? Too bad.

6) As I commented regarding the automaker bailouts, the important thing is to get your foot in the door and get some money, so that the legislators/regulators feel they must protect their initial investment with more money later.? With AIG, that is in full force, as this could be the fourth bailout.? When does it dawn on a bureaucrat that you have been bamboozled?

7) The government was hoodwinked on the first few iterations of the bailout.? Shame on them, if they don’t realize that they are throwing good money after bad again.

AIG is a case in point of why I don’t like the way we are doing bailouts now.

  • We bail out the holding company, which is not in the public interest.
  • We accept the creeping costs of bailout rather than use better-understood bankruptcy process.
  • It’s obvious that the government does not understand what it is doing/buying.
  • We do incrementally bad deals, rather than squeezing the stakeholders, as a clever lender of last resort would.

If the US Government wants to prevent systemic risk, fine!? Guarantee the subsidiaries that pose that risk, but let the rest go into bankruptcy.

My, but the Left Tail is Large

My, but the Left Tail is Large

Posted on by David Merkel

Credit bets are asymmetric.? Leveraged bets more so.? A bondholder can lose all of his investment, and can optimistically receive principal and interest.? A leveraged bond investor can lose it all with greater probability and perhaps faster, but at least has the chance of making equity-like returns in the right credit environment.

Thus for Highland Capital Management the recent comeuppance with a recovery of zero is particularly severe.? I don’t care what you did in the past, but if you didn’t pay some income out, then losing it all drives total returns to -100%.? It doesn’t matter if you were once deemed brilliant:

As recently as October 2007, Barron?s magazine ranked Highland CDO Opportunity third among the top 50 hedge funds, with an average annual return of 44.12 percent during the three-year period ended that June. Its fortunes reversed last year, as the securities it invests in, known as collateralized debt obligations, plunged in value amid the credit crunch and downgrades by ratings firms.

When reviewing alternative investments, it is very important to understand the underlying drivers of performance.? With corporate debt instruments, it is the corporate credit cycle.? With corporate credit, it is normal to see 3-5 years of moderate favorable performance, followed by 1-3 years of horrendous performance.? Secondarily, it is choosing the debt of companies offering high yields relative to their likelihood of default.

Understand the cycle, and see if performance isn’t due to the cycle, rather than true skill.? With Highland, it seems that the cycle delivered, and then took it all away with high leverage.

Reasons for Optimism, Or Not

Reasons for Optimism, Or Not

Posted on by David Merkel

Natively, I tend to be an optimist.? The present environment has given thin gruel for optimism, so I haven’t been as perky as I might otherwise be.? Here are a few reasons for optimism:

  • Credit spreads have been declining, and more corporate bond deals are getting done in the credit markets.
  • Commodity prices have fallen and stabilized.
  • The balance sheet of the Federal Reserve is shrinking.
  • Money market and other short duration funds seem to be safe.
  • Equities might be cheap relative to cash, but are still expensive relative to junk and low investment grade bond yields.

On that last point I want to quote Doug Kass, who I respect as an investor:

On multiple fronts, equities appear to have incorporated the bad news and are undervalued both absolutely and relative to fixed income:

  1. The risk premium, the market’s earnings yield less the risk-free rate of return, is substantially above the long-term average reading.
  2. Using reasonably conservative assumptions (most importantly, a near 50% peak-to-trough earnings decline, which is over 3x the drop in an average recession), the market has discounted 2009 S&P 500 earnings of about $47.
  3. Valuations are low vis-?-vis a decelerating (and near zero) rate of inflation. Indeed, the current market multiple is consistent with a 6% rate of inflation.
  4. Stock prices as a percentage of replacement book value stand at 1x, well below the 1.4x long-term average.
  5. The market capitalization of U.S. stocks vs. stated GDP has dropped dramatically, to about 80%, now at the long-term average. Warren Buffett was recently interviewed in Fortune Magazine and observed that this ratio was evidence that stocks have become attractive.
  6. The 10-year rolling annualized return of the S&P is at its lowest level in nearly 75 years, having recently broken below the levels achieved in the late 1930s and mid 1970s.
  7. A record percentage of companies have dividend yields that are greater than the yield on the 10-year U.S. note. At 46% of the companies, that is over 4x higher than in 2002 and compares against only 5% on average over the last 30 years.

On point 1, I will say that equities are cheap to cash and Treasuries, but not Corporate bonds and bank debt.

For point 2, we have gone through a massive levering up; it would be no surprise to see a leveraging down.

Point 3 — I don’t get it.? Inflation has a small effect on valuations.

Point 4 — This is true but it could go lower because there is no one that wants to buy and hold at present.

Point 5 — In this environment, where there is a lack of buy and hold capacity, why are we satisfied with normal valuations?

Point 6 — True for Treasuries, wrong for corporates.

Point 7 — The 10-year Treasury is artificially low.?? It is not a good metric for dividend yields.

Mr. Kass is a bright man, and probably a better investor than me, but there are reasons to be concerned in this economic environment.? Be careful, and don’t make rash moves in this volatile environment.

Ten Aspects of Our Current Market Troubles

Ten Aspects of Our Current Market Troubles

Posted on by David Merkel

1) One of the unwritten rules of the corporate bond market is avoid the sector that has been the biggest issuer lately.? Underwriting and credit quality get sloppy in any sector that issues a lot of debt.? It would be a salutary warning for telecom bonds in 2000 and financials in the mid-2000s.? Even though they are not? corporates, the same would apply to mortgage bonds near the end of the real estate boom.? The little bit of extra spread would not be worth it.

Well, what if a sector is expanding rapidly, and there is no incremental spread?? Again, not a corporate sector, but that describes our dear Government today.? We talked about “crowding out” in early 80s, but it never truly materialized.? It is probably not happening now either.? Most corporations that want to borrow can’t, and those that can don’t want to.

All the same, outside of TIPS, I don’t see a lot of value in Treasuries at present.

2) Note to the Fed: if you want to keep mortgage rates low, buy mortgage bonds, not Treasuries.? The cost of that is that the Fed would bear some risk if Fannie of Freddie went down.? But Fannie, Freddie, and the Fed have one unified balance sheet given that the Federal Government is behind all of them.

3) But, is it desirable that banks lend at this point?? It might be better for them to restore their balance sheets, battered from the sloppy underwriting of the boom years.? Then they could once again lend soundly.

It makes little sense to try to force debt onto the US consumer who is largely overleveraged.? So why try to prompt banks to lend?? This applies to my mutual bank idea as well.? Do we really need more aggregate lending when the economy as a whole remains overlevered?

4) ?We hate you guys. Once you start issuing $1 trillion-$2 trillion [$1,000bn-$2,000bn] . . .we know the dollar is going to depreciate, so we hate you guys but there is nothing much we can do.?

So said Mr. Luo, a director-general at the China Banking Regulatory Commission.? I’ve been saying for a long time that China is stuck, and that we are their problem, and not vice-versa.? There may come a point where they stop buying US Dollar-denominated debt, and let existing debt mature, but that will come after a shift in their own economy where they are no longer driven bythe promotion of their exports.? There aren’t many large good alternatives to US debt for parking the proceeds from exporting aggressively.

5) In a downdraft, pockets of hidden leverage get revealed.? Consider the states of the US.? With the declining economy, revenues from real estate taxes decline, as do capital gains and wage taxes.? Budgets of 46 of the states are facing significant deficits.? Governments got to used to capital gains taxes, rising wages, rising property assessments, and high turnover of property.? Now those are gone. ? Rainy day funds were not established at necessary levels and were drained too early.

6) In a downdraft, pockets of hidden leverage get revealed.? Consider the Ponzi schemes that have come to light: Madoff, Stanford (it seems), and a small number of smaller Ponzis.? Why revealed now?? During a boom period liquidity is superadequate; most investors don’t face a need to call for cash.? Investors are happy to receive highish stable rates of return that come with seeming safety.? During the bust period many need cash, and the frauds are revealed for what they are.? Ponzi schemes are mini-bubbles; they pop when the call on cash is too great, if aren’t discovered as frauds during their growth phase.

7) In a downdraft, pockets of hidden leverage get revealed. Prime brokerage is very profitable to investment banks, but even they have to do risk control in a tough environment.? Hedge funds with better risk control get more leverage, those with worse risk control get less.? As I have said before, hedge funds aren’t the most stable vehicles in a downdraft.? They are reliant on the good graces of their prime brokers and the patience of their limited partners.

8 ) In a downdraft, pockets of hidden leverage get revealed. While housing prices kept rising, aided by increasing buying power facilitated by poorly underwritten loans, the mortgage insurers happily clipped profits; their greatest worry was the banks eating their business through second lien loans.? Most of the banks that did a lot of that financing have gotten whacked.? The mortagage insurers had somewhat more flexibility in their balance sheets, but if present loss rates continue for the next two years, many of their operating insurance subsidiaries will need to file a plan to remedy their impaired balance sheets.

9) In a downdraft, pockets of hidden leverage get revealed. (Sorry, last one.)? Just as Iceland was a harbinger of global weakness, and especially to the UK, might Eastern Europe prove to be that for Western Europe, and particularly Austria?? (Also here and here.)? Many Western European banks are exposed to Eastern European creditworthiness.? Some individual borrowers in Eastern Europe have mortgages denominated in Swiss Francs or Euros.

I’ve seen situations like that before, and sometimes I call it a currency vise.? It works well for a time during the boom phase, but then weaker currencies get trashed during the bust phase.? It simultaneously makes it more difficult to service the debt in the newly expensive hard currency, and the lender isn’t better off either — he now faces credit problems.

10) I’ve done many pieces on hidden credit problems inside ETFs and ETNs.? After my last piece, a reader asked if I would do a survey article on the problems.? Sorry, no survey article, but I can summarize them all for you here.

  • Exchange Traded Notes [ETNs] carry the risk that their sponsor will default.? They are unsecured obligations of a bank, but they have done some sort of hedge to provide the ETN buyer with a certain return so long as their bank is solvent.? For the bank, it is a sweet deal, because to them it is cheap funding.
  • Leveraged funds carry two risks.? The first is that any swap counterparties that the fund deals with goes bust.? The second is the money market instruments / cash equivalents behind the derivatives in these funds don’t prove good.? Granted, it is hard to lose in the money markets, but choose your credits with care.? Lehman went down pretty quickly.
  • Then there is the risk that a counterparty could go bust in a currency fund, as in the last article that I wrote.

ETFs and ETNs are great new? products that increase the scope that an investor can pursue.? Just be aware that in some funds there can be credit risk — with currencies, commodities, leveraged funds, and ETNs.

Buy and Hold Will Return

Buy and Hold Will Return

Posted on by David Merkel

I’ve been seeing a bunch of “buy and hold is dead” pieces.? Here’s an example.? Look, my view is that investment methods travel in eras.? I remember the 80s-90s, where buy-and-hold was the rage.? I also remember the 70s where tactical asset allocation returned, as well as gold bugs and other tangential market participants.

The popularity of investment styles is a trailing indicator of investment performance.? Buy and hold will once again be popoular after three years of a rising market, and that should arrive in the next 20 years sometime.

It may take too long, but “buy and hold” will return.

On Animal Spirits

On Animal Spirits

Posted on by David Merkel

Animal Spirits: A notion of Keynes that implied that the willingness of businessmen to take risk was unpredictable and somewhat irrational, leading to booms and busts.? I don’t agree, at least not entirely, but first a word about rationality and economics.

Thinking hurts, at least for most people.? It takes effort, which is why people conserve on doing it.? Instead, they substitute “shortcuts” for thinking that may have some plausibility.

  • This has worked in the recent past, so it should work in the near future.
  • My friend Fred has done this, and it has worked for him, so it should work for me.
  • James Cramer (or Warren Buffett, or fill in your favorite expert, even me) thinks this will work wonderfully, so I will do it as well.
  • Everyone is doing this and doing well.? I have missed out on it in the past, so I better get going now.
  • The academics say you can’t succeed at beating the market, so I won’t try to do so.
  • I’ve read some books on investing, and there is a really simple formula for beating the market.? I’ll follow that method.
  • No one hedges that risk, so I won’t either.? The risk can’t be that large.
  • The government has always been capable of dealing with economic troubles; they should be capable of dealing with this one as well.

Though my examples come from investing, they apply to other areas of business, finance, and life generally.? Few people like to go back to first principles to think through a problem.? Many follow the crowd, or so-called experts.

As an aside, because people don’t like to think hard, they don’t optimize, as the neoclassical economists posit.? Instead, they choose solutions that they deem to be “pretty good,” and stop their searching.? Searching is a cost.? But neoclassical economists insist? that consumers maximize utility and producers maximize profit anyway.? Why?? If they don’t assume that the math doesn’t work, and they can’t publish something that looks semi-scientific.

Crowd-following is common to humanity.? It takes a lot to stand apart from highly correlated behavior.? I’ve told this story before, but in late 1999, I was talking with my mother (a very good self-taught investor), she told me about many of my cousins who were speculating in tech stocks.? I said to her, “They don’t know anything about investing!”? My mom replied, “Oh, David.? You’re such a fuddy-duddy.? I just bought some Inktomi!”

Now, to set the record straight, that was just 1% (or less) of my mom’s assets, so an occasional flyer is acceptable.? Call it “Mad Money.”? ;)? For my cousins, it was most of their investable assets.? My mom is fine, and the fuddy-duddy did all right also, but the cousins swore off stock investing.

I saw the same thing with people in their 401(k)s and other DC plans in 2002 — no more investing in equities.? Real estate was the place to be. Buy what you know, and residential real estate always goes up.

Before I continue with the residential real estate example, here are two questions I ask in order to decide whether a course of action makes sense:

  • What if everyone did this?
  • What is the current risk-adjusted free cash flow yield?

The first point should make you remember that any smart strategy can be overdone.? Any business can be overlevered, etc.? We can ask questions about market size, profit capacity and other things to try to determine what a speculative stock or industry could potentially be worth in the long run.? The same thing is true on the bear side — almost everything has some value even in bear market phases.

The second point has value as well.? I use an equation like this:

Free Cash Flow Yield + Necessary Capital Gains Yield = Funding Yield

or:

Necessary Capital Gains Yield = Funding Yield – Free Cash Flow Yield

By necessary capital gains yield [NCGY], I mean what is needed to keep an asset whole.? During “normal times” the NCGY is negative by some amount that reflects the normal risk margin for the asset class.? Near the peaks of bull markets, NCGY goes positive.? Think of real estate investors having to feed their properties.? Rents less expenses are less than the mortgage payments.

At the depths of bear markets, both free cash flow yields and funding yields rise considerably, but the FCF yields more so.? Few are investing, because they are looking through the rear view mirror at the past losses.

Eventually, some enterprising sorts that don’t care about convention see the large negative NCGY, and start putting money to work.? The cycle starts to turn, and things begin to normalize, or at least, begin the next cycle.

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By believing in limited rationality for men, and recognizing the boom-bust cycle, do I come to the conclusion that Keynes did about animal spirits?? No, I don’t.? Businessmen may follow trends, but enough of them pay attention to the NCGY of their businesses that they know when future opportunities are good or bad.

In that same sense, if our government is trying to get economic behvavior to “normalize,” perhaps it should look at the constraints that businesses/consumers live under, and ask what could be done to change things.? It is not so much a question of animal spirits, as where people find that they have an advantage.

At this point, where so many find themselves hemmed in by debt, demand falls, and the economy suffers.? Perhaps an approach similar to what Barry Ritholtz has proposed would be useful.? Give each household a voucher that can only be applied against debts.? The indebtedness of the private sector will decline.? Their willingness to spend will rise.? Overleveraged households delever; underleveraged households spend more; the US is that much more indebted.

Though it may seem unduly populist, giving money to each household solves two problems: it reduces household debt problems, and it also reduces credit stress at the banks.? What could be better in this environment?

Thinking About Debt Deflation

Thinking About Debt Deflation

Posted on by David Merkel

Amid my recent difficulties (sickness, loss of my main computer, difficulties updating my blog software), I have been musing about the health of our economy going forward.? Before I give my opinion, I want to share a range of views that I think are worth reading:

I admire the efforts that many are making in moving back to first principles.? We see analyses from Classical, Austrian, Post-Keynesian, Minsky (nonlinear dynamics), and other perspectives.

My view remains that depressions result? from a buildup of too much debt, including debt complexity.? With the recent analysis from Credit Suisse, they dissed adding together financial and nonfinancial debts, as there would be double counting.? Let me first say that there is no good measure here, but the double counting in a complex debt economy is useful to see.? When there is a chain of parties relying on debt repayment, like a set of dominoes, the system is fragile; one little jolt could change things for many.

Aside from that, our economy behaves like an? economy in a depression.? The banks lend considerably less.? Corporations as a whole cut back as aggregate demand drops.? People save more.? Prices of asset ratchet down to reflect current buying power, which seems to be shrinking every day.? The government replaces markets in the process of trying to save them.? Protectionist pressures are global, as is the economic weakness.

I don’t find the actions of the Fed or the current stimulus bill to be very relevant to our crisis, because they do little to reduce our indebtedness as a percentage of GDP.? In a credit based economy, once the banks and consumers are stuffed full of badly underwritten debt, it is difficult for the system to clear until those debts are reduced/liquidated.

Who Do You Work For?

Who Do You Work For?

Posted on by David Merkel

When I was an actuary running a GIC desk inside a medium-sized insurer in the 1990s, I quickly learned about creditworthiness.? My company, for the sake of accounting convenience, placed all GICs in a separate account.? Now the state of domicile did not have a law that said that guaranteed products in separate accounts have protection from the assets in the separate account, and the company if the assets in the separate account fail.

So, when no one would buy the GICs, because an A1/A+ insurer was no longer good enough, in 1997, I shut the line down.? I looked into credit enhancement — the cost was too high.? I asked the CEO for a guarantee — he refused (he did not understand much generally, except how to line his venal pockets).? I did what was best for the company, given the limitations of the management team, and closed the line of business.

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My goal as an actuarial businessman was to make profits with modest risk for my ultimate owners, who were the mutual policyholders.? Once I faced a situation where there might be easy profits — writing floating rate GICs.? So, I went to my models and tried to figure out how we could make money safely while our interest rates would shift every three months.? I came to the conclusion that there was no safe way to do so, and so I walked into the office of my boss and told him so.? He surprised me by supporting my thesis, and in his usual back-of-the-envelope way, explained to me in a few minutes why it had to be so.

A few weeks later, he informed me that an actuary from Goldman Sachs (yes), would be dropping by to tell about one of their new derivative contracts that would enable us to write floating rate GICs profitably.? The meeting day came, and I validated the expectations of my boss.? The year was 1993.? I asked the actuary from Goldman what happens if the yield curve inverts.? He answered honestly, “This strategy blows up when the yield curve inverts.”? Score a small victory for me.? I gave myself points for avoiding trendy bad ideas.? Over the next twelve months, two major insurers and one investment bank would announce billion-dollar blowups from following that strategy.

After the blowups, I went back to the buyers of floating-rate GICs, and asked them if they would accept a lower spread over LIBOR.? The response was a firm “no.”? So much for that market.

=-=–=-=-=-==–=-=-=-=-=

Shortly after the visit from the Goldman Sachs actuary, interest rates began to rise.? I had benefited from falling rates for some time, and I had gotten a bit lazy, because the investment department could buy investments, and I could wait to sell my GICs.? After all, with rates going down, time was on my side.

Now, there was one odd thing about the company that I worked for.? They left the hedging decision in the hands of the line actuary and not at the investment department (no joke).? I had control of interest rate policy for my line of business.

1994 started out bad for me.? The rest of the industry went wildly competitive selling GICs, and I was way behind my quota.? What was worse, I had a lump of maturing GICs that left my line of business short of cash.? Our Treasurer gave me a curt phone call that my line of business had forced the company to draw down on its line of credit.? (The Treasurer was the only person in the firm that could have blended in easily at AIG.)

I considered my options.? I could sit on my hands, and the wrath of Senior Management would grow.? Or, I could write business with subpar profitability.? With the yield curve so steep, I wrote a bevy of barbell GICs that the buyers mispriced.? They would compare a GIC with half maturing in one year and half in five to a three year GIC.? With a steep yield curve, that was the wrong decision.

I sold a bunch of those barbells to get out of my cash hole, and then began cutting bargains, and selling like mad, as I concluded that the residential mortgage-backed market was pushing up interest rates.? I sold my quota early that year, and the investment department dawdled (at my request), waiting to put cash to work at higher rates, and improving credit quality as well.? It was the best year we ever had, amid the worst year for the bond market in 60+ years.

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I don’t recommend handing over interest rate policy to those that manage the line of business.? That is too dangerous a thing to do.? I didn’t undersatand that at the time, so I did the best that I could, which was pretty good.? Sadly, the same was not true for the actuaries at the other two lines of business — they assumed rates would stay low.

I tell these three stories to illustrate the ethical choices one faces when working in a financial business.? Will you act in the best interests of your ultimate owners, or will you serve the management, or worse, yourself?

We can lay the blame for mismanagement at the doors of the company managers of financial companies.? But lower level managers have their share of blame as well.? Did they follow the short term economic incentives given by their companies, or did they do what was right for their owners.

When working for investment firms at later dates, I would tell the junior analysts these stories, and I would ask them, “What do you think they gave me as a bonus?” (for my work that protected the company and made very good money?)? They would always guess high.? I never received more than a couple of thousand dollars, and I was happy with it.? I did my job to do what was right in my field, not to make excess money.

And so I would say to my peers in financial services… have you done what is right?? Have you served the best interests of shareholders?? Not you, your boss, your CEO…? You have a choice, as I do.? Life is too short to work for unethical firms.? Find a place where you can ply your trade ethically and competently.? I am grateful to my current firm for having such a place today.

Financial Versus Actuarial Models of Risk

Financial Versus Actuarial Models of Risk

Posted on by David Merkel

There are two basic investment risk models, one based on projected cash flows over a long period of time, discounted at a variety of future interest rate scenarios, and one based on short term correlations of expected market values.? I call the first model the actuarial model, and the second the financial model (pejoratively, the Wall Street model).

Under ordinary conditions, the financial model looks better.? It asks, “Can we make money in the short run versus our capital costs?” The? actuarial model asks, “Can we assure that we will be solvent under a wide number of economic scenarios over the long run, some of which might be quite severe?”

During boom conditions, the financial model wins, while those following an actuarial model are branded fuddy-duddies.? During bust conditions, those following an actuarial model survive, while many following the financial model don’t.

There were many on Wall Street that claimed to be following a WOW “Worst Of the Worst” model.? I remember interviewing the chief risk officer of one of those firms in 2005 — Bear Stearns.? Talked a really good game.? To be fair, so did the risk manager of Goldman Sachs that year.? I assume most of the risk managers of Wall Street had their WOW models — after the crisis with LTCM, they had to look at the correlations on risk assets going to one in a crisis.

My guess is the WOW models were largely ignored, and the more common VAR models followed.? Perhaps Goldman And Morgan Stanley gave more weight to the worst outcomes, but hindsight is 20/20.? They might have survived in spite of themselves.

My point: you’ve got to survive in order to win.? Models that emphasize current profits at the expense of survivability get whacked during large busts.? Even if they survive, the hole that they must crawl out of is deep.

The economy is highly variable, and the financial economy as a derivative of it is even more so.? Companies that think long-term with respect to risk management tend to survive crises; they have limited their risks, and left returns on the table during the boom times.

Survival is a major part of the game.? Look at previously successful financial companies.? It doesn’t matter how well you did in the past if you are down 90, 95, 99% over the last two years.

As such, for those that invest in financial companies, evaluate their survivability.? How likely is it that they will get hit badly?? Are they overleveraged?? Do they need additional financing?

Actuarial models focus on the long run, and analyze survivability.? Why aren’t they used more frequently?? The actuarial models indicate a greater need for capital than VAR models.? More capital left in reserve means a lower return on equity, and a lower stock price in the short run.

High quality management teams for financials place more value on their long-run (actuarial) risk models.? They want to make money over the long term, if they can.? Those that focus on VAR will do better in the short run, until the next big bear market hits.? For value investors, stick with the quality players relying on long-term risk models.? Momentum players are free to play with the VAR users, but keep your stop orders ready.

Return to Aggbank

Return to Aggbank

Posted on by David Merkel

When someone proposes a strategy for dealing with the economic crisis, he undertakes a hard issue.? There are many conflicting priorities:

  • Don’t harm the taxpayer much.
  • Arrest the decline in asset values.
  • Protect the solvent banks.
  • Increase the flow of credit to the rest of the economy.
  • Prevent the contagion in credit uncertainty from spreading.
  • Facilitate price discovery on illiquid assets.
  • And more, depending upon the most recent disaster.

The recent talk in Washington is over guarantees, Bad Banks, and more.? I’m a skeptic on all of these, because you can’t get something for nothing.? Now, it is not as if I haven’t made my own series of proposals:

But others have proposals as well:

I’m going to modify my Aggbank piece, because it represents my best thoughts on what could be done to minimize the uncertainty to all parties involved, leading to a simpler, more transparent bailout.

Aggbank should solicit offers of assets, with prices.? It should then publish that it will buy so much of assets that have been offered, so if anyone is willing to sell it cheaper, submit their offers.

The winning offers hand over the assets and receive cash in return.? They also issue equity to Aggbank the difference between par and the price paid, in exchange for an equivalent equity stake in Aggbank. The Aggbank equity stake is reducible/increasible if the eventual value of the asset sold proves less or more than the price it was sold for. [Changes in Bold]

The main idea here is that the auctions should produce reasonably fair results, leading to price discovery.? (Banks learn what their assets are worth.)? The secondary idea is that any subsidy to banks should be limited.? If an asset purchase price is high, they lend more money to the government, and give less stock, in exchange shares in Aggbank.? Vice-versa if the purchase price is low.

Now, Aggbank shares are a high quality asset, given that it is a “full faith and credit” institution of the US Government.? Capital charges on it would be low, as they are for FHLB common stock.? The difference here is that the amount of Aggbank stock eventually received depends on the value of the assets purchased, when they are sold.? Positive variances add to the number of shares, and negative variance decrease the number of shares, pro-rata.

The beauty of this idea is that the government does not have to be worried about whether the auctions are working perfectly right or not.? The second step after the auctions trues things up, as Aggbank stakes are increased or reduced.? Third, this allows banks taking losses to issue equity to the government, which will help them recover.

A proposal like this would give the banks time to heal, and would limit losses to the taxpayers.? The eventual payout form the liquidation of Aggbank would approximately give each bank back its pro-rata portion of value contributed.? It would give banks time, while facilitating price discovery in obscure structured lending markets.

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