Speculation – Page 33 – The Aleph Blog

Investing and Demographics, Redux

Posted on 27 August 2008 by David Merkel

My post last night attracted a number of intelligent comments.? I want to expand on what I said.

1) The Baby Boomers are different that other US generations.? They are less provident, willing to sacrifice the future for the present.? Not only do they save less, but they raid existing savings to fund current needs.? They are also more prone to investment scams.? When will Boomers realize that the amount that they can expect from investments with safety is not much higher than what long Treasuries yield?

2) My comment from last night, “The US is bad off demographically, but most of the rest of the world is worse off.? The US has a problem because it has not been saving, but that is largely because much of the rest of the world is neo-mercantilist, and is subsidizing export industries, and the US buys.” needs more explanation.

The US has its birth rate at replacement rate, which is unique among developed nations, and is largely due to the influence of Mormons, Muslims, Orthodox Jews, Evangelicals, recent immigrants (legal or not), and homeschoolers.? (Personal observation: even non-religious homeschoolers tend to have more kids on average.)
The rest of the world is worse off — China’s demographic problem is huge, but at least they save to compensate for it.? Europe is not quite as bad off, but nothing kills fertility quite so well as peace, moderate prosperity (meaning well-off with two working, not one working) and a decline in religious faith.

3) From a reader:

Can you please reconcile these two seemingly conflicting statements:

“[Boomers] will need to labor longer, and they should do so” and “To the extent that this causes labor shortages, the US will see greater employment prospects for its people”

Sorry that I wrote it that way.? There will be a balancing act that occurs in the economy around 2025 — wealthy Boomers retire, poor Boomers continue work.? The relative size of each cohort will determine what the effect is on the economy as a whole.? Beyond that, there is a third factor, immigration.? The US is more friendly than most places to legal and illegal immigration.? That helps solve our demographic problems, but it insures that my children learn Spanish.? If wages rise too much, immigration (and offshoring) will rise as well.? (It is akin to wealthy retired Boomers saying to their children, “You don’t have to care for us, we’ve found people who will do it more cheaply.”

4) Another reader comment:

Jeremy Siegel (Stocks for the Long Run) offers a pretty thorough and generally optimistic take on the Baby Boomer retirement issue in his latest book “The Future for Investors.” At the risk of oversimplifying a complex analysis, Siegel’s bottom line is that while there are not enough younger generation Americans to absorb the Boomers stock and bond assets at current prices, investors in emerging countries, like China and India, will more than make up for that and will end up buying the Baby Boomer’s paper assets as the Boomers sell them off to fund their retirements. The upshot is that foreigners will end up owning a lot of our companies by the year 2050. A potential snag, says Siegel, is whether America will be willing to let this happen, or will pass laws or adopt polices to discourage the transfer of US assets to foreign countries. This remains to be seen, but he is optimistic. On the other hand, the implications for the typical Baby Boomer’s most important asset, his or her house, is rather dire, because homes can’t be sold as readily? to foreigners, for obvious reasons. Siegel doesn’t provide an answer for the housing market, which is outside the scope of a book on stock investing in any event.

There is the political question around how much US corporations we would allow to be owned by foreigners.? I don’t know where the breaking point is there, but the answer will have an impact on the value of the US dollar.? As for homes, if we slow down the growth of the housing stock, and condemn more of the existing housing stock, we will eventually solve the excess housing problem.? As it is now, we have foreigners speculating on the value of residential US real estate.

5) One final note that I omitted last night.? Medicare is the big issue here, and we will begin to feel it over the next five years.? At least one election in the next decade will have Medicare as its top issue.? The Social Security problem is one-quarter the size of the Medicare problem.? No wonder Bush, Jr. did not try to deal with Medicare, but made the problem worse by adding the drug benefit.

6) I don’t see the emerging markets getting rich enough, fast enough, to do the wealth exchange necessary for the developed world on favorable terms for the developed world.

That’s all for now.? More comments, send them on.

Finance When You Can, Not When You Have To

Posted on 23 August 2008 by David Merkel

“Get financing when you can, not when you have to.”? Warren Buffett said something like that, and it is true.? My biggest early investment loss was Caldor, which Michael Price lost a cool billion on.? A retailer that could not hold up to Wal-Mart, Target, and Sears, Caldor expanded in the early 90s by scrimping on working capital.? Eventually a cash shortfall hit, and their Investor Relations guy said something to the effect of, “We have no financing problems at all!”? The vehemence cause the factors that financed their investory to blink, and they pulled their financing, sending Caldor into bankruptcy, and eventually, liquidation.

Caldor had two opportunities to avoid the crisis.? It could have merged with Bradlees and recapitalized, leaving it stronger in the Northeastern US.? It also could have done a junk bond issue, which was pitched to them eight months before the crisis, but they didn’t do it.? In the first case, the deal terms weren’t favorable enough.? In the second case, they thought they could finance expansion on the cheap.

Caldor is forgotten, but the lessons are forgotten today as well.? Today, overleveraged financial companies wish they had raised equity or long-term debt one year ago, when the markets were relatively friendly and P/Es were higher, and credit spreads were lower.

I know I am unusual in my dislike for leverage in companies, but on average less levered companies do better than those with more debt.? Caldor went out with a zero for the equity.? A few zeroes can really mess up performance.

Capital flexibility has real value to good management teams.? I don’t mind exess cash hanging out on the balance sheets of good firms.? Hang onto some of it, and maybe during a crisis you can buy a competitor at a bargain price.

But for the financials today, who has the wherewithal to be a consolidator?? Most of the industry played their capital to the limit, and are now paying the price.? Either the door is shut for new capital, or they are paying through the nose.

I don’t see anyone large who fits that bill of being a consolidator.? Maybe some of the large energy companies that have been paying down debt would like to diversify, and buy a bank.? Hey, feeling lucky?!? Lehman Brothers!

Look, I’m being a little whimsical here, but the point remains — run your companies with a provision against adverse deviation.? Be conservative.? For those that invest, avoid companies that play it to the limit, unless you are an investor with enough of a stake that you can control the company.

Ten Notes on Credit Risk

Posted on 15 August 2008 by David Merkel

1) The Modigliani-Miller Theorem asserts that the value of assets at a firm is independent of how they are financed.? The dirty truth is that less levered public firms are more profitable, and generally better investments than highly levered public firms.? Why?? High levels of debt often lead managements to think short-term, and they make more errors.? Yes, some firms will do amazing things when the debt gun is pointed at their head.? More will fail, or muddle.? Perhaps this is a place where private equity does better than heavily indebted public companies, because they are out of the spotlight.? Equity Private, if you are listening, what do you think?

2) Too many foxes, not enough rabbits?? Perhaps true for now.? There is a lot of money in vulture funds relative to the opportunities at present.? That might change as we get near the nadir of the credit crisis, but it does set up an interesting dynamic.? If you were managing a vulture fund, when would you deploy your cash?? It’s a tough decision — too early, and you don’t get the good deals, and the same if you are too late.? Personally, I would do a time-scale, and allocate relatively evenly over the next 18 months.

3) Counterparty risk is still a threat.? Well, sort of.? The investment banks are pretty sharp at limiting their own risks to their clients.? The real risks are the willingness of the investment banks to offer credit to each other.

4) Securitization will come back.? It is too powerful of a technology for it not to come back.? The only question is when.? Deals are still getting done where the GSEs guarantee the risk.? Beyond that, little is getting done.? Better disclosure will help in the long run, but in the short run, it doesn’t mean much.

5) The credit crisis is over!? Well, not according to Caroline Baum and David Goldman.? Both are acquaintances of mine.? Many know Caroline Baum, whose ability to explain the Fed and the credit markets is superior.? David Goldman is less well known, but this is what I wrote at Barry’s site today:

David Goldman is a bright analyst and underrated. I met him back when he was with First Boston, and I was a mortgage bond manager. His commentary at CSFB and BofA helped make me a better investor.

I don’t normally push multimedia, but I thought the interview was a good listen.

6) Default rates are rising on junk grade corporates.? Odds are they will be higher still in 2009.? When junk grade default rates move up, it is typically for three years or so, and in this case, we have more low-rated debt as a percentage of the market than at any time in the past.? Is it possible that we could eclipse the default rate of 2002?? Yes, but I would not put a lot of money on that; I feel the odds are 50/50.? Many corporations are highly levered but prospering from global demand, not US demand.

7) As I suggested regarding ACA Capital Holdings, they ended up owned by their policyholders, who get an equitable interest in the assets of the company, though not enough to settle their claims.? For the bond insurers that are insolvent, this is the paradigm that will be followed as bad guarantees get settled.? And, this will probably be applied to Bluepoint, Wachovia’s subsidiary.? I agree with Calculated Risk, it is an interesting statement that Wachovia would not put fresh capital into it.? Just another sign that the equity is worth zero to Wachovia.

8) The bond insurers aren’t totally dead, though.? They are finding ways to exit debt they have guaranteed, and convert it to more liquid, valuable debts. Hey, every bit of risk shed is a plus, and they can report income in the short run from that.

9) The asset sales go on, as investment banks reconcile their SIVs and CDOs.? The tough part is taking the losses (surprise).? This is normal, because in illiquid markets where there is a lot of credit risks, there are few trades, and when things go bad, prices shift dramatically lower.

10) I have a bias against universal finance.? No company can manage all financial businesses well.? There are different risk control disciplines in different areas of finance, and when you put them together, risk control gets neglected in some businesses.? This was true at UBS, and now they are unwinding the mess.

The Fundamentals of Market Bottoms

Posted on 7 August 200820 June 2017 by David Merkel

A large-ish number of people have asked me to write this piece.? For those with access to RealMoney, I did an article called The Fundamentals of Market Tops.? For those without access, Barry Ritholtz put a large portion of it at his blog.? (I was honored .) When I wrote the piece, some people who were friends complained, because they thought that I was too bullish.? I don?t know, liking the market from 2004-2006 was a pretty good idea in hindsight.

I then wrote another piece applying the framework to residential housing in mid-2005, and I came to a different conclusion? ? yes, residential real estate was near its top.? My friends, being bearish, and grizzly housing bears, heartily approved.

So, a number of people came to me and asked if I would write ?The Fundamentals of Market Bottoms.?? Believe me, I have wanted to do so, but some of my pieces at RealMoney were ?labor of love? pieces.? They took time to write, and my editor Gretchen would love them to death.? By the way, if I may say so publicly, the editors at RealMoney (particularly Gretchen) are some of their hidden treasures.? They really made my writing sing.? I like to think that I can write, but I am much better when I am edited.

Okay, before I start this piece, I have to deal with the issue of why equity market tops and bottoms are different.? Tops and bottoms are different primarily because of debt and options investors.? At market tops, typically credit spreads are tight, but they have been tight for several years, while seemingly cheap leverage builds up.? Option investors get greedy on calls near tops, and give up on or short puts.? Implied volatility is low and stays low.? There is a sense of invincibility for the equity market, and the bond and option markets reflect that.

Bottoms are more jagged, the way corporate bond spreads are near equity market bottoms.? They spike multiple times before the bottom arrives.? Investors similarly grab for puts multiple times before the bottom arrives.? Implied volatility is high and jumpy.

As a friend of mine once said, ?To make a stock go to zero, it has to have a significant slug of debt.?? That is what differentiates tops from bottoms.? At tops, no one cares about debt or balance sheets.? The only insolvencies that happen then are due to fraud.? But at bottoms, the only thing that investors care about is debt or balance sheets.? In many cases, the corporate debt behaves like equity, and the equity is as jumpy as an at-the-money warrant.

I equate bond spreads and option volatility because contingent claims theory views corporate bondholders as having sold a put option to the equityholders.? In other words, the bondholders receive a company when in default, but the equityholders hang onto it in good times.? I described this in greater measure in Changes in Corporate Bonds, Part 1, and Changes in Corporate Bonds, Part 2.

Though this piece is about bottoms, not tops, I am going to use an old CC post of mine on tops to illustrate a point.

		David Merkel
		Housing Bubblettes, Redux
		10/27/2005 4:43 PM EDT

From my piece, ?Real Estate?s Top Looms?:

Bubbles are primarily a financing phenomenon. Bubbles pop when financing proves insufficient to finance the assets in question. Or, as I said in another forum: a Ponzi scheme needs an ever-increasing flow of money to survive. The same is true for a market bubble. When the flow?s growth begins to slow, the bubble will wobble. When it stops, it will pop. When it goes negative, it is too late.

As I wrote in the column on market tops: Valuation is rarely a sufficient reason to be long or short a market. Absurdity is like infinity. Twice infinity is still infinity. Twice absurd is still absurd. Absurd valuations, whether high or low, can become even more absurd if the expectations of market participants become momentum-based. Momentum investors do not care about valuation; they buy what is going up, and sell what is going down.

I?m not pounding the table for anyone to short anything here, but I want to point out that the argument for a bubble does not rely on the amount of the price rise, but on the amount and nature of the financing involved. That financing is more extreme today on a balance sheet basis than at any point in modern times. The average maturity of that debt to repricing date is shorter than at any point in modern times.

That?s why I think the hot coastal markets are bubblettes. My position hasn?t changed since I wrote my original piece.

Position: none

I had a shorter way of saying it: Bubbles pop when cash flow is insufficient to finance them.? But what of market bottoms?? What is financing like at market bottoms?

The Investor Base Becomes Fundamentally-Driven

1) Now, by fundamentally-driven, I don?t mean that you are just going to read lots of articles telling how cheap certain companies are. There will be a lot of articles telling you to stay away from all stocks because of the negative macroeconomic environment, and, they will be shrill.

2) Fundamental investors are quiet, and valuation-oriented.? They start quietly buying shares when prices fall beneath their threshold levels, coming up to full positions at prices that they think are bargains for any environment.

3) But at the bottom, even long-term fundamental investors are questioning their sanity.? Investors with short time horizons have long since left the scene, and investor with intermediate time horizons are selling.? In one sense investors with short time horizons tend to predominate at tops, and investors with long time horizons dominate at bottoms.

4) The market pays a lot of attention to shorts, attributing to them powers far beyond the capital that they control.

5) Managers that ignored credit quality have gotten killed, or at least, their asset under management are much reduced.

6) At bottoms, you can take a lot of well financed companies private, and make a lot of money in the process, but no one will offer financing then.? M&A volumes are small.

7) Long-term fundamental investors who have the freedom to go to cash begin deploying cash into equities, at least, those few that haven?t morphed into permabears.

8 ) Value managers tend to outperform growth managers at bottoms, though in today?s context, where financials are doing so badly, I would expect growth managers to do better than value managers.

9) On CNBC, and other media outlets, you tend to hear from the ?adults? more often.? By adults, I mean those who say ?You should have seen this coming.? Our nation has been irresponsible, yada, yada, yada.?? When you get used to seeing the faces of David Tice and James Grant, we are likely near a bottom.? The ?chrome dome count? shows more older investors on the tube is another sign of a bottom.

10) Defined benefit plans are net buyers of stock, as they rebalance to their target weights for equities.

11) Value investors find no lack of promising ideas, only a lack of capital.

12) Well-capitalized investors that rarely borrow, do so to take advantage of bargains.? They also buy sectors that rarely attractive to them, but figure that if they buy and hold for ten years, they will end up with something better.

13) Neophyte investors leave the game, alleging the the stock market is rigged, and put their money in something that they understand that is presently hot ? e.g. money market funds, collectibles, gold, real estate ? they chase the next trend in search of easy money.

14) Short interest reaches high levels; interest in hedged strategies reaches manic levels.

Changes in Corporate Behavior

1) Primary IPOs don?t get done, and what few that get done are only the highest quality. Secondary IPOs get done to reflate damaged balance sheets, but the degree of dilution is poisonous to the stock prices.

2) Private equity holds onto their deals longer, because the IPO exit door is shut.? Raising new money is hard; returns are low.

3) There are more earnings disappointments, and guidance goes lower for the future.? The bottom is close when disappointments hit, and the stock barely reacts, as if the market were saying ?So what else is new??

4) Leverage reduces, and companies begin talking about how strong their balance sheets are.? Weaker companies talk about how they will make it, and that their banks are on board, committing credit, waiving covenants, etc.? The weakest die.? Default rates spike during a market bottom, and only when prescient investors note that the amount of companies with questionable credit has declined to an amount that no longer poses systemic risk, does the market as a whole start to rally.

5) Accounting tends to get cleaned up, and operating earnings become closer to net earnings.? As business ramps down, free cash flow begins to rise, and becomes a larger proportion of earnings.

6) Cash flow at stronger firms enables them to begin buying bargain assets of weaker and bankrupt firms.

7) Dividends stop getting cut on net, and begin to rise, and the same for buybacks.

8 ) High quality companies keep buying back stock, not aggresssively, but persistently.

Other Indicators

1) Implied volatility is high, as is actual volatility. Investors are pulling their hair, biting their tongues, and retreating from the market. The market gets scared easily, and it is not hard to make the market go up or down a lot.

2)The Fed adds liquidity to the system, and the response is sluggish at best.? By the time the bottom comes, the yield curve has a strong positive slope.

No Bottom Yet

There are some reasons for optimism in the present environment.? Shorts are feared.? Value investors are seeing more and more ideas that are intriguing.? Credit-sensitive names have been hurt.? The yield curve has a positive slope.? Short interest is pretty high.? But a bottom is not with us yet, for the following reasons:

Implied volatility is low.
Corporate defaults are not at crisis levels yet.
Housing prices still have further to fall.
Bear markets have duration, and this one has been pretty short so far.
Leverage hasn?t decreased much.? In particular, the investment banks need to de-lever, including the synthetic leverage in their swap books.
The Fed is not adding liquidity to the system.
I don?t sense true panic among investors yet.? Not enough neophytes have left the game.

Not all of the indicators that I put forth have to appear for there to be a market bottom. A preponderance of them appearing would make me consider the possibility, and that is not the case now.

Some of my indicators are vague and require subjective judgment. But they?re better than nothing, and kept me in the game in 2001-2002. I hope that I ? and you ? can achieve the same with them as we near the next bottom.

For the shorts, you have more time to play, but time is running out till we get back to more ordinary markets, where the shorts have it tough.? Exacerbating that will be all of the neophyte shorts that have piled on in this bear market.? This includes retail, but also institutional (130/30 strategies, market neutral hedge and mutual funds, credit hedge funds, and more).? There is a limit to how much shorting can go on before it becomes crowded, and technicals start dominating market fundamentals.? In most cases, (i.e. companies with moderately strong balance sheets) shorting has no impact on the ultimate outcome for the company ? it is just a side bet that will eventually wash out, following the fundamental prospects of the firm.

As for asset allocators, time to begin edging back into equities, but I would still be below target weight.

The current market environment is not as overvalued as it was a year ago, and there are some reasonably valued companies with seemingly clean accounting to buy at present.? That said, long investors must be willing to endure pain for a while longer, and take defensive measures in terms of the quality of companies that they buy, as well as the industries in question.? Long only investors must play defense here, and there will be a reward when the bottom comes.

The Fundamentals of Market Bottoms, Part 3 (Final)

Posted on 7 August 20087 August 2008 by David Merkel

12) Value investors find no lack of promising ideas, only a lack of capital.

13) Well-capitalized investors that rarely borrow, do so to take advantage of bargains.? They also buy sectors that rarely attractive to them, but figure that if they buy and hold for ten years, they will end up with something better.

14) Neophyte investors leave the game, alleging the the stock market is rigged, and put their money in something that they understand that is presently hot — e.g. money market funds, collectibles, gold, real estate — they chase the next trend in search of easy money.

15) Short interest reaches high levels; interest in hedged strategies reaches manic levels.

Changes in Corporate Behavior

1) Primary IPOs don’t get done, and what few that get done are only the highest quality. Secondary IPOs get done to reflate damaged balance sheets, but the degree of dilution is poisonous to the stock prices.

2) Private equity holds onto their deals longer, because the IPO exit door is shut.? Raising new money is hard; returns are low.

5) Accounting tends to get cleaned up, and operating earnings become closer to net earnings.? As business ramps down, free cash flow begins to rise, and becomes a larger proportion of earnings.

6) Cash flow at stronger firms enables them to begin buying bargain assets of weaker and bankrupt firms.

7) Dividends stop getting cut on net, and begin to rise, and the same for buybacks.

Other Indicators

2)The Fed adds liquidity to the system, and the response is sluggish at best.? By the time the bottom comes, the yield curve has a strong positive slope.

No Bottom Yet

Implied volatility is low.
Corporate defaults are not at crisis levels yet.
Housing prices still have further to fall.
Bear markets have duration, and this one has been pretty short so far.
Leverage hasn’t decreased much.? In particular, the investment banks need to de-lever, including the synthetic leverage in their swap books.
The Fed is not adding liquidity to the system.
I don’t sense true panic among investors yet.? Not enough neophytes have left the game.

Not all of the indicators that I put forth have to appear for there to be a market bottom. A preponderance of them appearing would make me consider the possibility, and that is not the case now.

Some of my indicators are vague and require subjective judgment. But they’re better than nothing, and kept me in the game in 2001-2002. I hope that I — and you — can achieve the same with them as we near the next bottom.

For the shorts, you have more time to play, but time is running out till we get back to more ordinary markets, where the shorts have it tough.? Exacerbating that will be all of the neophyte shorts that have piled on in this bear market.? This includes retail, but also institutional (130/30 strategies, market neutral hedge and mutual funds, credit hedge funds, and more).? There is a limit to how much shorting can go on before it becomes crowded, and technicals start dominating market fundamentals.? In most cases, (i.e. companies with moderately strong balance sheets) shorting has no impact on the ultimate outcome for the company — it is just a side bet that will eventually wash out, following the fundamental prospects of the firm.

As for asset allocators, time to begin edging back into equities, but I would still be below target weight.

=-=-=-=-=-=-=-==-=-=-=-=-=

That’s all for this post.? After comments are in, I will reformat the piece as one post and republish it.

Downgrades Come Easy, Upgrades Come Hard, Upgrades to AAA? — Forget It.

Posted on 20 June 200820 June 2008 by David Merkel

We’re not quite to the endgame yet, but the jig is up for MBIA and Ambac, after the downgrades from Moody’s at the holding companies to Baa2 and A3 respectively.? Wait, why I am I mentioning the holding companies?? Isn’t it the operating subsidiaries that matter?

Well, yes, for sales and regulatory purposes, but the ratings at the holding companies matter for a different reason — notching.? But let me tell a story first.

Failure improves markets by introducing risk-based pricing.? In the late 80s and very early 90s, virtually all of the life insurance industry was rated AAA/Aaa, or A+ from A.M. Best.? Taking advantage of the good opinion that the raters had of the industry, many life insurance companies issued Guaranteed Investment Contracts [GICs] to institutions for their Defined Benefit and Defined Contribution pension plans.? The insurance companies levered up issued AAA liabilities, and invested the proceeds in lower rated bonds, commercial mortgages, limited partnerships, and other things yet more risky.? (These were the days prior to risk-based capital.)

After a few failures hit — Pacific Standard (who?), Executive Life, Mutual Benefit, Fidelity Mutual, Confederation, and the near miss on the Equitable (what a story — I was on AIG’s failed takeover attempt team), the rating agencies went into full scale defense mode, downgrading every company in sight.? It was everything a company could do to retain its ratings — and there were almost no ratings upgrades until 1996 or so.

The rating agencies are ratchets. (or, do I mean rackets? 😉 )? Downgrades come easily, upgrades come hard, and almost no corporate credit ever gets upgraded to AAA.? But, in this case, the downgrades have come for this industry in the way that I predicted earlier this year:

		David Merkel
		Moody’s Downgrades XL Capital Assurance
		2/7/2008 3:34 PM EST

When the main rating agencies begin downgrading the lesser guarantors, the big guarantors are likely not far behind. Moody’s just downgraded XL Capital Assurance from Aaa to A3, and Security Capital Assurance From Aa3 to Baa3 (barely investment grade).

Psychologically, the major rating agencies, Moody’s and S&P, have been taking baby steps toward downgrading Ambac, MBIA and FGIC. But first they have to do the lesser guarantors that are in trouble. As I have pointed out before, the major rating agencies are co-dependent with the major guarantors, and that will only throw the guarantors over the edge if hurts them more to leave the guarantors at AAA. That will cost them future revenues to cut the ratings of the major guarantors, but it might save their larger franchises. (Fitch, on the other hand, has less to lose and can downgrade with impunity.)

Now, the effects on the broader insured bond market are probably overestimated. There will be new entrants to take the place of the legacy companies that may have to go into runoff. The holding companies for the major guarantors could die, but a rescue of the operating insurance companies in runoff mode is more likely. Those who own equity in the holding companies or debt claims to the holding companies will not be happy with the results, though.

Watch for downgrades of the major guarantors. Unless a lot of new capital gets pumped into their operating insurance companies, the downgrades are coming, maybe within a month.

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

Position: none

Once your insurance operating subsidiary is downgraded below AAA/Aaa, there are many classes of business that cannot be written anymore.? Revenue dries up.? What’s worse, is that the rating agencies no longer have any practical reason to not downgrade further; the revenue model is broken for the rating agencies, and if there are highly rated new entrants, there is no reason to care about the company; the industry will survive, and the rating agencies will get fees.

Now, supposedly, New York doesn’t want to take the operating subsidiaries into conservation because it would trigger acceleration clauses in the CDS.? If those contracts were written at the operating companies, the insurance commissioner has the power to nullify any seniority those contracts possess — you can’t favor one insurance claimant over another.

But Dinallo wants to favor municipal claimants, which is probably illegal.? They could force the capital into the operating company, but they would rather see the municipal business reinsured.

Oh, notching — once a holding company is rated lower than Aa3/AA-, there is no way to get a subsidiary to have a Aaa/AAA rating.? The rating agencies will not allow it to happen.

So, I don’t see good things ahead for the guarantors.? Two final notes: Ambac tells Fitch to take a hike.? Fitch won’t do it.? Expect a downgrade soon.? Triad goes into runoff; my old colleague John must be smiling… he always thought they wrote the worst business.

Ten Notes on Residential Housing

Posted on 18 June 200818 June 2008 by David Merkel

I’m waiting for the day when I can write upbeat stuff about housing…? when I can buy homebuilder and mortgage stocks and crow about my gains.? I hope I live two more years. ;)? (Many thanks to Calculated Risk for their excellent coverage of residential housing.)

1) The first thing to note is that residential real estate values are still falling nationwide.? That affects Mortgage Equity Withdrawal [MEW] and derivatively, consumption.

2) Now, housing prices are likely to fall another 10-15%, which is what I have been saying for a while.? That will lead to more situations where there is negative equity, and more defaults, as they happen with negative equity and negative life events.

3) Foreclosures are making up a larger percentage of all sales, which is not a positive in the short run for prices.? In Sacramento, and some other places in California, foreclosures are the majority of sales.? As a result, it is no surprise that housing sales are at a low.? Foreclosures have risen rapidly across the country, not boding well for future sale prices.? Even in Florida, foreclosures are gumming up the market, and are getting reconciled slowly.

4) The GSEs are in a tough spot.? The government pushes them to make suboptimal loans that their shareholders don’t like.? I guess that’s a part of their deal.? As it is, the GSEs are playing a large role in many loans today.? Private capital doesn’t step up in an environment like this.

5) Labor mobility is limited when housing prices fall.? Pretty normal, if infrequent, in my opinion.? I faced this back in 1989; employers offered limited housing perks to new hires.? In three years, this will be gone.

6) Now, it should be no surprise for lending standards to tighten now.? We always shut the barn doors after the cows are in the fields.

7) Mortgage rates are rising, largely due to the reaction of the bond market to Fed chatter.

8 ) Prime ARMs will fuel the next wave of delinquencies.? If home values fall enough, any class of lending is vulnerable.

9) It should not surprise us that housing starts are low in an environment like this.? The bigger the boom, the bigger the bust.

10) I am not generally a Tom Brown fan.? He is too perma-bullish for my tastes.? He may have a correct technical point on subprime losses, but it may misrepresent losses for the financial sector as a whole.? Subprime is small.? Alt-A and Prime are much bigger, and losses are growing there.

Ten Notes on Crude Oil: The Fixation

Posted on 14 June 200815 June 2008 by David Merkel

In different economic eras, different things attract the attention of the media, investors, politicians, etc.? Today a leading attention grabber would be crude oil, and the energy complex.? It is a honeypot for conspiracy theorists and unscrupulous politicians (not quite an oxymoron).

1)? Fuel is subsidized across much of the world, particularly in countries where there is a large state owned oil company.? Current high prices are making it difficult to maintain those subsidies, so countries like Egypt and Indonesia are reducing subsidies.? Yet subsidies are not being eliminated everywhere yet.

2) Speculators — perhaps they need a new name, and a branding campaign.? Risk bearers, maybe.? I don’t know.? But discouraging speculation by raising margin requirements will not necessarily decrease the cost of crude — those who are short crude also face margin requirements.

Now, many commodities have no futures contracts.? On average their prices have increased more than those that have futures contracts recently. ? That indicates to me that those that have futures contracts are not in a bubble.

Some look at the dollar change in prices and think that speculation must be high.? Bespoke does a good job in breaking it down into percentage terms, which indicates that the oil market has been more volatile more than half a dozen times in the past.

Do speculators include the ordinary shmoes like you and me who use ETFs?? I’ve used currency and stock and bond index ETFs, but not commodities so far.? Amazing how the trading interest on commodities has grown through ETFs — here’s another good chart from Bespoke.

As I have commented before, I think the run-up in the price of oil is fundamental, not manipulation.? Ignore the futures, and just look at spot prices — it is hard to affect where the real buyers and sellers trade in a global commodity.? If prices get too high, like the last move of OPEC in the 1979, where they overshot, and supply eventually overwhelmed their too high price.

3) We could be in overshoot mode now; it’s hard to tell.? As I have said before, sustained high prices are necessary to create the investment in alternative technologies that save energy and produce energy
more cheaply.? I don’t think that it will happen quickly though… in the early 80s, oil prices edged down, and then came down rapidly in the mid-80s.? It took a while for the new supply to be developed, and for conserving technologies to be created and deployed.

If you want a current example, think of the new big oil field found off the coast of Brazil.? It will be three years or so until we see new production there.? Another example is that it is hard to ramp up additional production from existing fields.? If you try to force more oil out more rapidly than is prudent, you can destroy the long-term viability of the oil fields.

4) But, there are dissenting voices, whether wishful ones like this one from a Japanese Vice Minister, or this article from Fortune which is more nuanced.? His arguments sound like mine, but on a faster timetable, with less consideration for future depletion.? This article from the Dallas Fed is similar; though it says that it will be difficult for oil to stay over $100/barrel in 2008 dollars, they have a ten-year horizon on that forecast.? Hey, even I think that oil will drop below $100/barrel within 10 years.

5) Now, there is demand destruction.? We are already seeing it in the UK.? We are not seeing it in China, yet.? Part of the difference has to do with China subsidizing gasoline, which blunts the market effect.

From this article, within a year gasoline demand is pretty inflexible with respect to price.? Beyond one year, people adjust their behavior.

And, it is worth noting that OPEC thinks demand in the US and globally is shrinking.? They are probably right, though the effect on price is problematic, because many oil producers can’t produce what the used to — Mexico, Venezuela, Indonesia…

6) Now, this article indicates that changes in demand for oil have been more significant than changes in supply.? Whether that will be true in the future remains to be seen, but as the rest of the world gets better off, they will demand more energy.? A wealthy life is energy-intensive.

7) Inventories are light compared to average, but I’m not sure that is as big of a factor as many indicate.? At the edges when inventory is close to capacity, or when it is close to running out, that has a big impact, but in the middle zone, the impact should be modest.

8) When I read this summary of a speech by Donald Kohn, I concluded a few things:

The Fed is stuck.
Because the Fed is stuck, it will let things drift for a while.
A certain amount of idealism is waning inside the Fed, with a creeping suspicion that they aren’t wizards, but only sorcerer’s apprentices.

9) It has been a long term theme of mine that the oil that is easiest to refine would get relatively more scarce.? This article from Naked Capitalism is another demonstration of that.? And, for those who want a stock pick, that favors Valero, which can refine the heavy and sour crudes.

10) A large part of the US current account deficit is the increase in the price of crude oil.? Eventually, the decline in the US Dollar will stimulate exports, but for a while, the J-curve effect remains in place, and the Dollar takes a beating.? That beating isn’t happening at this instant, but it has gotten hit over the past several years.? I’m not sure that this recent rise is the reversal, but there will come a time when the current account normalizes.? Hopefully other nations will liberalize trade; that would do it in its own.

Full disclosure: long VLO

PS — I am market weight in energy stocks.

Book Review: When Genius Failed

Posted on 4 June 200822 June 2017 by David Merkel

One review of a good Roger Lowenstein book deserves another? Perhaps good things come in pairs. 😉

I decided to review “When Genius Failed,” because reading “While America Aged” reminded me of how much I liked Lowenstein’s writing style, simplifying matters for the average reader.

I was an investment actuary when LTCM was founded, and watched out of the corner of my eye, as I saw articles about their success. Being a risk manager, I was a little skeptical over the leverage employed, but I knew of other firms that had records almost as good, employing esoteric strategies of Residential MBS. That was the era of build a better prepayment model, and the returns will flow. (Perhaps today that would apply to default models…)

When LTCM imploded, I had just joined my first investment department. In the panic that ensued, Treasury yields fell, and my boss asked his new mortgage bond manager, me, why prepayments weren’t accelerating. I suggested that the banks could not borrow at Treasury rates, better to look at single-A bank and financial yields, which were considerably higher. (Surprisingly, I got that one right.) A number of the clever prepayment modelers got their heads handed to them during this era.

The implosion affected all fixed income markets, and it was a lesson to me that markets ordinarily recover from crises starting with short maturities, and moving to longer maturities, and with high quality, and moving to lower quality. We had cash flow, and and provided liquidity at a price.

Um, oh yeah, book review.? LTCM suffered from a number of troubles:

They were systemically short liquidity.
They did not consider the effect of others mimicking their trades.
They were internally disorganized; leadership was weak.
They intensified their leverage at the wrong time.

The liquidity aspect is significant.? Illiquid assets that are similar to a liquid asset usually yield more, because the cost of trading is much higher, and the possibility of being trapped is higher also.? LTCM bought the higher-yielding illiquid assets, and hedged them with more-liquid liabilities.? This set the stage for the run-on-the-fund.? Almost all run-on-the-bank scenarios occur from institutions where the ability of depositors to demand cash is greater than the ability to raise cash in the short run.

In the same way, many on Wall Street mimicked the trades of LTCM, but they had risk control desks that forced them to kick out the trades when they went awry, which further intensified the pressure on LTCM, because it forced the asset prices of LTCM lower.

The lack of discipline inside LTCM, was a eye-opener for me, and I would not have appreciated it, were it not for Lowenstein’s book.? Financial businesses that last require tight controls on risk taking.

Another thing captured by Lowenstein was the hubris involved as they cashed out some investors in order to “favor” internal investors and close friends.? They levered up at the wrong time.? The cashed-out investors were offended, but they were the ones who did the best of any; they got the good years, and missed the bad year.

Now, beyond that, Lowenstein delivers the attitudes of LTCM and Wall Street, with all of the fear and greed.? It is entertaining reading, and the book is still timely. Even though there is no dominant investment firm that threatens the financial markets, we have the investment banks as a group taking a great deal of risk in their trading and investment banking.? The assets are illiquid, the liabilities are more liquid.? Their balance sheets are opaque.? Many of them are in the same risk posture.? Many of them are more leveraged than they would like to be.? Bear has already fallen, will Lehman fall next?

Just because investors are smart does not mean that they are infallible.? Any investor playing at a high enough level of leverage can be ruined.? This book inoculates investors against perverse risk-taking, and makes them more skeptical about the claims of hot investors.? Not losing money is a big help in making money, and skepticism in investing is usually a plus.

Full disclosure: If you enter Amazon through a link on my site and buy something, I get a small commission, and your costs don’t increase. This is my version of the ?tip jar.? Thanks to all who support me.

Again, Not Worried About Reinsurance Group of America

Posted on 3 June 20083 June 2008 by David Merkel

From the 6/2 RealMoney Columnist Conversation:

		David Merkel
		Rebalancing Sales, and a Buy
		6/2/2008 4:08 PM EDT

Late last week, I had two rebalancing sells, Charlotte Russe and Smithfield. Today, two more, Honda Motor and Nam Tai Electronics. As the market has risen (or, some of my stocks at least), cash has been building up, and I have added some of my own free cash to the Broad Market portfolio. I’m at about 14% cash.

So, it’s time to buy something, though I am waiting on the market to show a little more weakness before I act. But, though dinner may wait, perhaps an appetizer is in order: today I added to my position in Reinsurance Group of America. MetLife finally decides to shed this noncore asset in a tax-free stock swap, allowing current MetLife shareholders to swap their MetLife shares for shares in RGA.

RGA should get a higher multiple as a “pure play” life reinsurer; that will come later. Today was the selling pressure in advance of the new supply. I like the management team at RGA, and think this will allow them the freedom to add value on their own. One other odd kicker… it might allow them to do more reinsurance business with MetLife, because they will be independent and thus truly be a third party.

Position: long CHIC SFD HMC NTE RGA

A few additional notes, for me long only means running with 0-20% cash. I don’t go above 20%; I don’t borrow. Under normal conditions, I like running around 5-7% cash. If the NAHC stake is counted in, (arbitrage gets a pseudo-cash return) then we are at that 20% upper limit.

That leads me to take a few actions — I have bumped up my central band for my holdings by 16%. Translated, the points at which I do buy and sell rebalancing trades has risen 16%, as has my normal position size. Looking back through the years, back to 1992 when I started value investing, my position sizes were 5% of what they are today, and back then I had 10 positions, not 35. There’s been growth. 🙂

My second action was a temporary purchase of some RGA. I doubled my position temporarily, because I think most analysts will smile on the deal, and RGA has always been a good buy at book value.

No telling whether buying at 1.0x book will continue to be a good idea in the future. RGA is a well-run company in an oligopolistic industry. The management is smart and conservative. They have international growth opportunities, and now, possible new business from MetLIfe. The moat is wide here. You can’t reverse engineer the #2 life reinsurer in the US and the World.

So, I’m happy with my position here. That said, I may trade away the speculative part of my holdings in the short run, and I may buy some MetLife as well. MetLife is cheap, though not as cheap as RGA, but I suspect when MetLife offers RGA shares in exchange for MetLife shares, they will have to make the tradeoff sweet in order to get some flexible institutional investors to do the swap. Why? MetLife is a large cap stock that is very diversified. RGA is a midcap that is not as diversified. MetLife is a well-respected brand name. RGA? Who?

Insurance is opaque; reinsurance is doubly so. There are no comparables for RGA. MetLife has Pru, Principal, Lincoln National, and a few more. So, I may speculate on MetLife in order to get some cheap RGA. Most likely, I’ll need to see the terms, but if RGA is up a lot tomorrow, and MetLife is not, I may just do the swap.

Note to my readers: one odd thing about my blog is that I write about a wide number of issues. I know I have been doing more on my stock investing lately, but that is partially due to the lack of news on the macro front. That’s the nature of what I do. I am an investor that pays attention to the global economy. I’m trying to make money off my insights, and not merely report on what is happening. I hope some of it rubs off on my readers also, and that you personally benefit from it. For those who find my blog to be a confusing melange — well, that’s who I am, a generalist whose interests are broad.

But, if you like the individual stock coverage, let me know. If you hate it, let me know also.

Full disclosure: long CHIC SFD HMC NTE RGA NAHC LNC