Category: Speculation

Avoid Investment Scams and Bad Advice

Avoid Investment Scams and Bad Advice

Posted on by David Merkel

There is one fundamental rule on the idea generation process to get across to new retail investors:

Buy what you have researched.? Don’t buy what your friends are buying, or even worse, what someone is trying to sell you.

(For those with access to RealMoney.com, you could review my Using Investment Advice series.)

The point here is to become capable of doing the basic research necessary to make reasonable decisions.? You don’t have to make great decisions in order to succeed.? You do have to avoid making major errors, which requires a degree of skepticism toward the opinions of your non-expert friends, and modest hostility toward those selling investment products.

What led to this article was a eight-page glossy advertisement from a publication that I do not deign to name (I worry about lawsuits), about a company called GTX Corp [GTXO].? Now, maybe I need to refresh my free subscription to the direct mail preference service, which really cuts down on the amount of junk mail that I receive.

GTX Corp is an example of a company with a high valuation, and uncertain prospects.? There is no provision for adverse deviation.? It trades on the Bulletin Board, and here is its business:

GTX Corporation integrates global positioning system (GPS) technology into consumer electronics devices.? The technology allows for real-time oversight of loved ones.

Now, why don’t I like this company, aside from the advertisement that did not mention valuation, balance sheet strength, or any other risk factors?

  • It trades at a high ratio of book, and trailing earnings don’t exist.
  • It was created out of a merger with a failed mining company.
  • Its recent financing this month offered equity interests far cheaper than the current market price.
  • Their auditor is not a major auditing firm.
  • Give the auditor credit though, they did not give them a “going concern” opinion, but instead expressed doubts.
  • The stock is on the Nasdaq’s Threshold Securities list, so finding shares to short is problematic.
  • Major shareholders are doing a secondary offering.
  • The advertiser was paid $186,000 to do the ad by a third party.

I have no idea how good their GPS technology might be, but there are too many risk factors here to make me even consider a long position.

I am not here to beat on GTX Corp.? I am using them, and the guy who advertised them as an example.

  • The advertisement had all manner of positive things to say about the technology and what it could do.? That’s fine, but what has it done?? Why doesn’t this corporation have significant revenues?
  • Why does the ad use the scam language “as featured on” and “as seen in,” naming prominent publications and channels, when all he likely did was buy some slack advertisements at a late hour, or in regional editions?
  • The ad compares the company to Garmin and other successful companies.
  • The ad uses a bunch of emotive problems that the technology could solve.
  • The ad puts forth a target price of $12 without any justification.

Buyer beware, and don’t listen to strangers giving you advice.? Cultivate networks of knowledgeable friends who are trustworthy, and avoid getting taken for a ride by slick-talking (writing) hucksters who pitch clever ideas to you.? Do your work, and buy cheap, boring ideas like I do.

Facilitating the Dreams of Politicians

Facilitating the Dreams of Politicians

Posted on by David Merkel

I’m a life actuary, not a pension actuary, so take my musings here as the rant of a relatively well-informed amateur.? I have reviewed the book Pension Dumping, and will review Roger Lowenstein’s book, While America Aged, in the near term.

First, a few personal remembrances.?? I remember taking the old exam 7 for actuaries — yes, I’ve been in the profession that long, studying pension funding and laws to the degree that all actuaries had to at that time.? I marveled at the degree of flexibility that pension actuaries had in setting investment assumptions (and future earnings assumptions), and the degree to which funding was back-end loaded to many plan sponsors.?? I felt that there was far less of a provision for adverse deviation in pensions than in life insurance reserving.

I have also met my share (a few, not many) of pension actuaries who seemed to feel their greatest obligation was to reduce the amount the plan sponsor paid each year.

I also remember being in the terminal funding business at AIG, when Congress made it almost impossible for plan sponsors to terminate a plan and take out the excess assets.? Though laudable for trying to protect overfunding, it told plan sponsors that pension plans are roach motels for corporate cash — money can go in, but it can’t come out, so minimize the amount you put in.

The IRS was no help here either, creating rules against companies that overfunded plans (by more than a low threshold), because too much income was getting sheltered from taxation.

Beyond that, I remember one firm I worked for that had a plan that was very overfunded, but that went away when they merged into another firm which was less well funded.

I also remember talking with actuaries working inside the Social Security system, and boy, were they pessimists — almost as bad as the actuaries from the PBGC.

But enough of my musings.? There was an article in the New York Times on the troubles faced by some pension actuaries who serve municipalities.? For some additional color, review my article on how well funded most state pension and retiree healthcare plans are.

Pretend that you are a financial planner for families.? You can make a certain number of people happy in the short run if you tell them they can earn a lot of money on their assets with safety — say, 10%/year on average.? Now within 5 years or so, promises like that will blow up your practice, unless you are in the midst of a bull market.

Now think about the poor pension actuary for a municipal plan.? Here are the givens:

  • The municipality does not want to raise taxes.
  • They do want to minimize current labor costs.
  • They want happy workers once labor negotiations are complete.? Increasing pension promises little short term cash outflow, and can allow for a lower current wage increase.
  • A significant number of people on the board overseeing municipal pensions really don’t get what is going on.? It is all a black box to them, and they don’t get what you do.
  • You don’t get paid unless you deliver an opinion that current assets plus likely future funding is enough to fund future obligations.
  • The benefit utilization, investment earnings, and liability discount rates can always be tweaked a little more to achieve costs within budget in the short run, at a cost of greater contributions in the long run, particularly if the markets are foul.
  • There are some players connected to the pension funding process that will pressure you for a certain short-term result.

Even though I think pension plan funding methods for corporate plans are weak, at least they have ERISA for some protection.? With the municipal plans, that’s not there.? As such, more actuaries and firms are getting sued for aggressive assumptions, setting investment rates too high, and benefit utilization rates too low.

The article cites many examples — New Jersey stands out to me because of the pension bonds issued in 1997 to try to erase the deficit they had built up.? They took the money and invested it to try to earn more than the yield on the bonds — the excess earnings would bail out the underfunded plan.? Well, over the last eleven years, returns have been decidedly poor.? The pension bonds were a badly timed strategy at best.

Now, like auditors. who are paid by the companies that they audit, so it is for the pension actuaries — and there lies the conflict of interest.? One of my rules says that the party with the concentrated interest pays for third-party services, so it is no surprise that the plan sponsor pays the actuary.? I’m not sure it can be done any other way, unless the government sets up its own valuation bureau, and tells municipalities what they must pay.? (Now, who will remind them about Medicare? 😉 )

The suits against the pension actuaries and their firms could have the same effect as what happened to Arthur Andersen.? These are not thickly capitalized firms, and many could be put out of business easily.? For others, their liability coverage premiums will rise, perhaps making their services uneconomic.

Finally, the flat markets over the last ten years have exacerbated the problems.? Partially out of a mistaken belief that the equity premium is large (how much do stocks earn on average versus cash), actuaries set earnings rates too high.? The actuarial profession offers some guidance on what rate to set, but the reason they can’t be specific is that there is no good answer.? With all of the talk about the “lost decade,” well, we have had lost decades before, in the 30s and 70s.? Even if the statistics are correct for how big the equity premium is, equity performance comes in lumps, and in the 80s and 90s, when we should have taken the returns of the fat years and squirreled them away for the eventual “lost decade,” instead, politicians increased benefits as if there was no tomorrow.

The states and smaller government entities have dug a hole, and they will have to fill it somehow.? Lacking the ability to print money, they will raise taxes as they can, and borrow where they may.? We are seeing the first pains from this today, but the real crisis is 5-10 years out, as the Baby Boomers start to retire.? You ain’t seen nothin’ yet.

Blowing the Bubble Bigger

Blowing the Bubble Bigger

Posted on by David Merkel

Maybe there is something different about the way that neoclassical economists and historians approach things. I am a bit of a generalist, so I try to look at things from many angles. The two books that I cited in my recent book review on bubbles were written by historians, not economists. Let me cite my summary of Kindleberger’s paradigm:

  • Loose monetary policy
  • People chase the performance of the speculative asset
  • Speculators make fixed commitments buying the speculative asset
  • The speculative asset?s price gets bid up to the point where it costs money to hold the positions
  • A shock hits the system, a default occurs, or monetary policy starts contracting
  • The system unwinds, and the price of the speculative asset falls leading to
  • Insolvencies of those that borrowed to finance the assets
  • A lender of last resort appears to end the cycle

That’s not the way a neoclassical economist views the world. Either men are rational, or, their errors tend to cancel each other out in the short run. Certainly there are never destabilizing feedback loops. Errors on the part of one person don’t lead others to make the same errors.

It is said that neoclassical economics cannot explain the existence of marketing and financial markets, without relaxing their rationality assumptions significantly. As an economist trained in the neoclassical school, I think we forget that these are assumptions that are made in order to get the math to work, not the way things actually work in the world. People are influenced by other people, and they do stupid things as a result, even when there is money on the line. (Maybe, especially when there is money on the line, due to the effects of fear and greed.)

Anyway, when I wrote my last post, I figured that someone would take issue with the concept of bubbles. The commenter raises a few issues, some of which are answered in the article itself.

  • What’s the definition of a bubble? When does something become a bubble?
  • When did housing become a bubble? Who identified it?

Another commenter, more polite, poses these questions:

  • Don’t they effectively borrow to finance the oil futures market?
  • Was the internet a bubble?
  • Isn’t housing unique, in that the speculators can walk away so easily?

In an attempt to answer these questions, “What’s the definition of a bubble? When does something become a bubble? Was the internet a bubble?” consider this piece from RealMoney’s Columnist Conversation:


 David Merkel
Bubbling Over
1/21/05 4:38 PM ET
In light of Jim Altucher’s and Cody Willard’s pieces on bubbles, I would like to offer up my own definition of a bubble, for what it is worth.A bubble is a large increase in investment in a new industry that eventually produces a negative internal rate of return for the sector as a whole by the time the new industry hits maturity. By investment I mean the creation of new companies, and new capital-raising by established companies in a new industry.This is a hard calculation to run, with the following problems:

1) Lack of data on private transactions.
2) Lack of divisional data in corporations with multiple divisions.
3) Lack of data on the soft investment done by stakeholders who accept equity in lieu of wages, supplies, rents, etc.
4) Lack of data on corporations as they get dissolved or merged into other operations.
5) Survivorship bias.
6) Benefits to complementary industries can get blurred in a conglomerate. I.e., melding “media content” with “media delivery systems.” Assuming there is any synergy, how does it get divided?

This makes it difficult to come to an answer on “bubbles,” unless the boundaries are well-defined. With the South Sea Bubble, The Great Crash, and the Nikkei in the 90s, we can get a reasonably sharp answer — bubbles. But with industries like railroads, canals, electronics, the Internet it’s harder to come to an answer because it isn’t easy to get the data together. It is also difficult to separate out the benefits between related industries. Even if there has been a bubble, there is still likely to be profitable industries left over after the bubble has popped, but they will be smaller than what the aggregate investment in the industry would have justified.

To give a small example of this, Priceline is a profitable business. But it is worth considerably less today than all the capital that was pumped into it from the public equity markets, not even counting the private capital they employed. This would fit my bubble description well.

Personally, I lean toward the ideas embedded in Manias, Panics, and Crashes by Charles Kindleberger, and Devil take the Hindmost by Edward Chancellor. From that, I would argue that if you see a lot of capital chasing an industry at a price that makes it compelling to start businesses, there is a good probability of it being a bubble. Also, the behavior of people during speculative periods can be another clue.

It leaves me for now on the side that though the Internet boom created some valuable businesses, but in aggregate, the Internet era was a bubble. Most of the benefits seem to have gone to users of the internet, rather than the creators of the internet, which is similar to what happened with the railroads and canals. Users benefited, but builders/operators did not always benefit.

In the internet bubble, there wasn’t that much debt, aside from vendor financing. Some faced the obligations of paying taxes on employee stock options, without having the cash to do so. Others speculated on margin, favoring the long side, of course. The real bubble was the low cost of equity capital, which led to the creation of dubious businesses, and weird stock price movements at IPOs. Say what you want about the present era, the IPO market is relatively calm, and the few deals getting done seem to have some quality.

Regarding the oil futures markets, yes, many participants are levered, but the commodity funds which are huge typically are not. Most of the selling to them comes from the oil companies, which find it profitable to lock in prices at $60, $70, $80…. $130, you get it. In that sense, I don’t think the majority of the activity is coming from levered players that are active investors — the commodity funds are passive hoarders, and the oil companies have a commercial interest.

For another example, consider the silver bubble in the late 70s / early 80s. The Hunt brothers tried to corner the silver market. In the process, the price of silver touched $54/ounce. What stopped them?

  • COMEX limited their ability to hold silver futures.
  • The Fed tightened monetary policy.
  • Silver came from everywhere to meet demand. People sold the family silver, mines that were closed reopened, mines that were marginal began producing like the was no tomorrow.

That last point is why I think it is very hard to corner any commodity, and why bubbles don’t last. Supply overwhelms speculative demand. The speculative demand in this environment is coming from a bunch of nerds who advise pension funds. This isn’t hot money.

This brings me to the last point, regarding housing: “When did housing become a bubble? Who identified it? Isn’t housing unique, in that the speculators can walk away so easily?”

Housing became a bubble when lenders loosened underwriting standards and offered lending terms that were atrocious — what lender in his right mind would ignore equity, recourse, and amortization? Yet in a mania to earn current profits, many lenders did. The bubble started in 2003, and crested in 2005. I posted on this for four years 2003-2007. I posted at RealMoney as it was cresting, with my main article in May 2005, and several more through the remainder of the year.

There were many others who also pointed at the bubble, but as with all bubbles, the naysayers are at the fringe. It can’t be otherwise.

Regarding the ability of the housing speculators to walk away, I like Tanta’s line at Calculated Risk that there aren’t many true walk aways. Most people abandoning their former homes have tried to keep them, and have lost a lot in the process. Away from that, the lenders do screen delinquencies for likely ability to pay. If there are significant assets in a state that allows for recourse, you can bet the lawyers are active.

In closing, I think the concept of a bubble is meaningful. It is a series of two self-reinforcing cycles, one positive, and one negative. These cycles occur because market players chase past performance, suffering from greed as prices rise, and fear as they fall. Any lending to finance the speculation intensifies the size and the speed of the event.

PS — if it helps at all, my equity investing methods borrow from these ideas. I am always trying to analyze industry cycles, to make money and avoid losses. So far it has worked well.

Toiling Over Bubble Troubles

Toiling Over Bubble Troubles

Posted on by David Merkel

There is a religious war aspect to what I will discuss this evening. It surprises me, but there are many people who believe that bubbles cannot exist, because economic players are rational in aggregate. I question the latter assumption — anyone who follows the equity markets understands the fads that sweep through the markets, leading to a lot of disappointment later.

From one of my comments in the RealMoney Columnist Conversation:


 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

(If you have a subscription to RealMoney, you should look at the Real Estate piece. It was prescient. I occasionally get things right.)

At present, we are hearing murmurs about a crude oil bubble. Here’s my initial question: Who is borrowing money to buy oil? When we had the housing bubble, we had many investors that had to feed their properties to keep them afloat. They were relying on capital gains to keep themselves solvent. That is always a sign of an overheated market. With the tech bubble, we had vendor financing, and stock options on which people had a hard time affording the taxes. In the commercial real estate bubble 1989-92, rents were not sufficient to cover financing costs.

Think of it this way: at the end of a bubble, someone looks at buying an asset, and concludes that it is not worth buying because of the likely stream of payments he will have to make after the initial purchase.

But what of crude oil? There are a number of noises over short covering in the press. The futures curve looks like a bowl, with the far distant futures higher than spot. Crude oil has had a vicious move upward over the last three months. That doesn’t bother me because vicious moves are common in markets where supply and demand are inelastic in the short run.

But there are speculators. Not your common run-of-the-mill speculators, but ones that dress in fancy suits, and have fancy asset allocation equations. Pension funds, and other long term investors are buying commodities and hoarding them, because they think the commodities will be more valuable in the future. But, they are not borrowing to do it, are they? Er, no, not exactly, but yes, in practice. Every pension plan is borrowing implicitly at the discount rate specified by their actuary. If you don’t earn that rate, you fall behind. For now, ignore the correlation arguments that are meaningless because correlations aren’t stable, and think in absolute terms. Every investment that my pension plan invests in should aim to beat the actuarial funding rate.

Will crude oil appreciate at an 8% rate for the next 10 years? Maybe. Can the pension fund emotionally survive a 40% drawdown? Probably not; most pension trustees are scaredy-cats. They will sell oil during the panic. The consultants, with new statistics, will help them do it.

Now, in the present environment, I think that oil has some bubble in it, but it is not the majority of the recent move. As in the late 70s and early 80s, conservation moves slowly, but it does grind prices down. What is different here is that there are many countries willing to take up the slack near current prices, thank you.

So, I don’t buy the bubble rhetoric for crude oil here. Supply and demand are tight, and over time, high prices will create new technologies that use less fuel. But it will take time. For the next few months, will be volatile, but the one scenario I don’t think will happen is a large fall in the price in the short run.

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Before I leave for the evening, one last comment from the past on bubbles from me:

Rapid money supply growth with no consumer price inflation can only really occur within the confines of an asset price bubble, or else, where does the money go? Interest rates are low at such a time because of the incredible liquidity, and complacency of lenders that they will get an equal amount of purchasing power back. Perhaps another possibility is when a country?s currency is being used more and more as a shadow currency, like the US in the Third World. But even that will come home someday.

Losing Money is Part of the Game (Part I)

Losing Money is Part of the Game (Part I)

Posted on by David Merkel

I’ve been debating in my mind how I would write this piece. In the end, I just decided that I would tell it plain. Part of investing is losing money. There is a connection between willingness to lose money in the short run, and ability to make money in the long run. My experience has been that if you don’t take the risk of losing significant money, you don’t make significant money. Another way of saying it is that if you don’t blow one up every now and then, you’re not taking enough risk.

With that introduction, let me present my 10 worst losses since starting this strategy 7.7 years ago, beginning with the worst, and moving to progressively lesser losses. These ten losses comprise 55% of the total dollar value of losses since I started this strategy.

Deerfield Capital

What can I say?? My original thesis was that Deerfield was a mortgage REIT that did it right.? In spite of my negative real estate views, I did not think that the risk would extend all of the way to prime mortgage and Alt-A (no stated income) collateral.? Alas, my training as an actuary should have told me to avoid companies dependent on market confidence to maintain financing.? As the repo haircuts rose, free assets diminished, aand they had to collapse their balance sheet.? My main mistake was thinking that repo haircuts couldn’t get that high.? I was wrong. I finally sold when I thought the likelihood of insolvency was significant.

YRC Worldwide

I got in this one too early.? My industry models sometimes flash “cheap” when things will get cheaper.? Sometimes I have the sense to remember that.? This time I didn’t.? YRC has more debt than I would like, but it has a huge amount of upside when the economy turns.? Waiting for that turn could be fatal, but I continue to do so.? One other note: for the remainder of this piece — where my graphs say exit, it does not mean sale. For companies that I still owned at 4/30/2008, I market them down as “exited” because that is where my calculations end.

The jury is out on this one.? As with all of my investments, I try to analyze a company versus its likely future prospects.? I don’t care a lot about the past, I just try to analyze current price versus future prospects.? My estimate of future value warrants continued inclusion in the portfolio.

Dynegy

Catch a falling knife?? When there is fraud, I give other investors a pass.? As for me, I should have known better.? Cash flow was light relative to earnings — not a good sign.? Another warning sign ignored: avoid managements that are self-absorbed.? Dynegy and their investment banks had to kick in to fund a settlement.? (Note: it is only worth going through the settlement process when a deep third pocket gets tagged.? Most fraud cases are broke, and only the lawyers do well.)

I’m afraid that friends influenced me here; a number of people in my investment department owned Dynegy, and when I bought, e comment was “Welcome to the Dark Side.”? Dark? — better to say red ink. I can’t prevent being taken in by fraud, but I can minimize it if I focus on companies with strong cash generation.? It’s hard to fake free cash flow.

Jones Apparel Group

Again, my industry models flashed “Cheap” too soon.? Everything depends on whether Jones can turn their operating businesses around.? I think they have a chance, and given the recent sale of one of their subsidiaries, there is enough cash.? That said, I tend to worry when debt levels verge on high, and the debt maturities are near.? There is a new CEO, who was the old CFO.? At present, I still think there is value here, but I will take my loss before the end of 2008 if earnings results don’t turn.

Cable & Wireless plc

One of my ways of trying to make money is to buy strongly capitalized companies in an industry that is having troubles.? Well, the strength of C&W’s balance sheet was overstated; there was a bit of a fraud issue there.? And, I should have listened to Cody Willard, who e-mailed me before we really knew me, and said something to the effect of, “Yeah, they have a balance sheet, but no good businesses.? Can’t make money with that.”

Part I Summary

Every loss is stupid in hindsight.? We all get tempted to say “woulda, coulda, shoulda.”? But the same principles that led to my losses also led to my greatest gains.? Two articles from now in this series, I’ll go over those.? But it is best to lead with failure… we learn far more from our failures than our successes.? What are my lessons here?

  • Don’t play with companies that have moderate credit quality during times of economic stress.
  • Measure credit quality not only by the balance sheet, but by the ability to generate free cash.
  • Spend more time trying to see whether management teams are competent or not.

I’ll see if I can’t do better on these concepts in the future.

Full disclosure: long YRCW and JNY

The Market is Catching Up with ETNs

The Market is Catching Up with ETNs

Posted on by David Merkel

Two years ago I wrote at RealMoney:


 David Merkel
In Bondage to Barclays plc
6/21/2006 2:41 PM EDT

Roger, there is a reason to be aware the the ETNs issued by Barclays plc are notes. (or, bonds) If Barclays went bankrupt, the value of the notes would be impaired. From my limited glance through the prospectus:

The Securities are medium-term notes that are uncollateralized debt securities and are linked to the performance of the GSCI? Total Return Index (the “Index”).

and later…

The Securities are unsecured promises of Barclays Bank PLC and are not secured debt. The Securities are riskier than ordinary unsecured debt securities. The return on the Securities is linked to the performance of the Index. Investing in the Securities is not equivalent to investing directly in Index Components or the Index itself.

and much later…

USE OF PROCEEDS

Unless otherwise indicated in the applicable pricing supplement, the net proceeds from the offering of the notes will be applied for our hedging and general corporate purposes.

In essence, a holder of the ETN has bought a senior unsecured zero coupon bond from Barclays, with an ultimate payoff based off of the return on the commodities index less 0.75%/year. But unlike a bond, there is no floor on the implied interest at zero. If commodity indexes fall, the ETN would give a negative return.

I like Barclays. I own the stock. But there is more than one risk to the ETNs: commodity price risk (of course), and Barclays plc credit risk (surprise!).

Position: long BCS, and pondering the days when I used to read structured bond prospectuses regularly…

-=-=-=-

Now, today, I find it funny to see other retail investment commentators catching up with the credit risk angle of ETNs.? Perhaps it is my background in the Equity Indexed Annuity [EIA], Variable Annuity [VA], DC pension and GIC businesses — we had all sorts of guarantees and non-guarantees floating around, so we were used to analyzing the risks.

Now, what if the sponsors packaged the ETN with a default swap (written by third parties) to protect the investors if the company failed?? At that level, the ETN provider should buy Treasuries or Agencies, and layer on the futures or options as the case may be, creating an ETF, because all of the advantage from doing the ETN goes away.

Be wary of ETNs, at least to the level of asking how likely it will be for the sponsor to be in good shape when the ETNs mature.

What is Liquidity? (Part II)

What is Liquidity? (Part II)

Posted on by David Merkel

Liquidity is like water. Is water a solid, a liquid, or a gas? Depending on the situation, water can be any or all of the three. When I started my blog, my first serious post was “What is Liquidity?” Given what was about to happen in Shanghai seven days later, and what that would do to liquidity, the post was ahead of its time.

Yesterday I saw two posts on liquidity:

Both had a number of good points, though I like my piece better.? Let me borrow from Peter Bernstein, where he said something to the effect of “Liquidity is the ability to have a do-over.”? In other words, if you make an investment mistake, how much does it cost you to reverse it?

The three aspects of liquidity:

  • What sort of premium does it take to get someone to lock into a long-term commitment?
  • Slack assets available for deployment into new investments, and
  • Bid-ask spreads

are correlated.? When there are few slack assets relative to investment needs, large premiums have to be offered to get investors to lock into a long-term investment, and bid-ask spreads tend to be wide as well.

But let’s consider the flip side of liquidity.? Liquidity is akin to holding a long option.? Rising volatility is the friend of one who has liquidity or a long option.? But, being long an option means someone else is short an option.? Having liquidity means that someone else has to provide cash should you choose to buy something.? If you liquidate shares in a money market fund, cash must come either from new investors in the fund who take your spot, or the fund has to raise liquidity internally, handing you some of the proceeds from not entering into an overnight loan.

Or, consider the bid-ask spread in stocks, or other securities.? When the bid-ask spread is tight, it means that the market maker (or specialist), is comfortable that short-term volatility is low enough, that he will be able to profit from the tight spread on average.? When there is severe uncertainty, as there often is in esoteric fixed income instruments during a panic period, the bid-ask spread disappears, and one is reduced to “price discovery, using a broker who is discreet about your intentions regarding buying or selling.? (My, but I got good at that during 2001-2003. ? Ouch.)

I like my definition of liquidity, which is the willingness (price) to enter into or exit fixed commitments.? It covers all three aspects of liquidity, and helps explain why they are usually different manifestations of the same phenomenon.

As for now, versus mid-February 2007, the willingness to enter into fixed commitments has declined markedly, even though it has improved over the last seven weeks.? That is no guarantee that it will continue to improve linearly.? Bear markets have their rallies, and this current rally has been a good one.? It would be rare to have such a short bear market, or one that ended without clearing away most of the prior excess lending problems.? We still have a lot of wood to chop there.

One Dozen Notes on Markets Around the World

One Dozen Notes on Markets Around the World

Posted on by David Merkel

1) Desperation and the Dollar. In mid-March, pessimism over the US economy and monetary policy were so thick that people were considering the old Greenspanian rate of 1% Fed funds as possible. Well, times change, at least for now. The orange line above is the 2-year Treasury yield which gives a fair read on expectations of monetary policy, which bottomed in mid-March. It took the Dollar a little longer to move along, but the present course of dollar is up in the short-term (consider the Euro). That doesn’t address the possibilities of a wider lending problem, or the overly aggressive fiscal policies that will be employed by the next President. (Deficits don’t matter, until they are big enough to matter.)

2) I’ve talked about the US Dollar and the five stages of grieving. I think the G7 got to the second stage, anger, in threatening action recently. I think they get a respite from fear because of the bounce in US monetary expectations. My guess is that they would intervene when the Dollar gets to $1.70/Euro. Neither the threats nor the intervention will have much impact in the long run, though. This will only change when foreigners stop buying our bonds, and start buying our goods and services.

3) Another thing that correlates with the shift in expectations of US monetary policy are yields in long government bonds around the world. Surprise, as the anticipated future financing rates rise, the willingness to try to clip a spread off of long bonds declines.

4) So what could replace the Dollar as the global reserve currency? The Euro, maybe? The Yen and Pound are too small, and everything else is smaller still. The Yuan might be ready in 15 years when their financial markets are developed. It takes a long time for the reserve currency to shift.

5) So, why not the Euro? I’m still a skeptic that the EU will hang together without political union. Also, a strong Euro is testing the monetary union in places where credit markets are weak, and export markets are weakening because the US is getting more competitive with the weak Dollar. That said a persistently weak dollar raises the incentives for other countries to look for a new reserve currency. Leaving aside the potential instability of the EU (unlikely in the short run) the Euro is probably the best alternative.

6) This piece by Felix Salmon helps point out why why Iceland is the canary in the coal mine. They are the smallest economy with a floating currency. It seems like they are successfully defending their currency at present, at the cost of 15% interest rates.

7) Is the UK economy just a miniature version of the US economy?

8 ) Why is Chinese inflation rising? Loose monetary policy, and an undervalued Yuan, at least versus the Dollar. Now, maybe the Chinese will start buying Euro-denominated bonds, and sell more to the EU than they buy. (Note that I am not the only skeptic on the Euro’s survival.)

9) What of the Gulf States? What will they do with all of the dollars that they have? Along with China, their huge depreciating Dollar reserves are fueling inflation. Personally, if I were in their shoes, I would buy US corporations quietly, perhaps through the purchase of ETFs. But the huge accumulation of dollars threatens to create the same “white elephant” development schemes that they experienced in the early 80s, when the socialist Gulf governments had too many Dollars, and too few places to use them.

10) Inflation is rising in the OECD. This is a “sea change” in terms of economics. Policymakers have enjoyed falling inflation rates for so long that perhaps they aren’t ready for the degree of monetary tightening necessary to squeeze out inflation.

11) Development isn’t easy after a point. It reveals shortages, as India is experiencing in semi-skilled and skilled labor. This will eventually work out, but in the short run, it makes infrastructure and construction projects difficult. Bodies aren’t enough; skills are needed, and many better skilled Indians work abroad, where they can make more.

12) A rice cartel? Everything old is new again. I remember in the 1970s when the US talked about a wheat/corn cartel, in response to the new strength of OPEC. Personally, I don’t think it would be effective. Agriculture is too flexible for cartel-like schemes to work in the intermediate-term. But, let them try. It will be interesting to see what happens.

One Dozen Observations on Residential Housing

One Dozen Observations on Residential Housing

Posted on by David Merkel

1) The rating agencies have been running like crazy. They do that when they are behind the curve. Whether it is Moody’s on subprime, or S&P on Alt-A lending, the downgrades are coming in packs. Then there are difficulties with the debts of real estate partnerships, like LandSource Communities Development, which is likely to file for insolvency, together with some residential developers.

2) Now, there have been a few summary pieces on how the rating agencies changed as the housing boom moved on. Here is one from the New York Times, and one from the Wall Street Journal. As I had commented long before in my writings at RealMoney, the rating agencies were co-dependent with those that paid them. That said, it would be hard to construct a system that would not be that way. Buyers don’t have a concentrated interest in ratings. Issuers so.

3) If I were Ambac, I would be doing all that I could to allege fraud on contracts where representations and warranties were not upheld. Ambac is fighting to survive.

4) Mortgage insurers — it is the best of times, if you survive, because you are the almost the only game in town for those wanting to do low down payments, and rates for mortgage insurance are way up. But, it is the worst of times, housing prices are falling, rating agencies are downgrading, and defaults on insured mortgages are rising.

5) Foreclosures:

6) Gotta love OFHEO, which is trying to rein in the GSEs during a lending crisis. Even though they may have traction, I don’t see how they tighten the regulations during a crisis.

7) For that matter, consider the lenders. Countrywide seemed to purposely ignore the creditworthiness of borrowers as they jammed it out the door lent on mortgages. Even with all this, mortgage lenders are complaining that new regulations will make mortgages less affordable. What they mean is that they will issue fewer mortgages, and they will make less profit. Please, let’s stop making it easy for those that can’t afford a home to take the risk of buying one. Higher mortgage rates are bad in the short run, but good in the long run.

8 ) Dr. Jeff reluctantly asks what inning we are in on housing. I understand that it is an overused metric, but it is overused for a reason. Nine is an intuitive number — are we halfway through? Fifth inning. One-quarter? Third. Almost done? Eight or ninth. He also makes a simple request to those of us who opine on the housing slump, to be more definite in what we say, provide more data, and what will be signs that the troubles are turning.

I need to set up some housing recovery googlebots to scan for me, but my guess is that we are in the fifth inning of the troubles. When I get more definitive guesses/answers to the questions, I will post.

9) Delinquencies:

10) Home prices continue to fall, and estimates to the nadir (cycle low) range between 0-50%, with 10-20% being the most common.

11) Falling home prices will lead to many more foreclosures in prime loans, and of course Alt-A and subprime. Foreclosures happen when a sale would result in a loss, and a negative life event hits ? death, divorce, disaster, disability, and unemployment.

12) Second-order effects:

Still Too Early For Banks

Still Too Early For Banks

Posted on by David Merkel

One thing about Jim Cramer, he is quotable.? Take this short bit from his piece, Graybeards Get It Wrong on Financials.

One of the loudest and most pervasive themes by a lot of the graybeards is that there is still much more pain ahead in the financials.Let me explain why that is wrong. First, the group is down from a year ago. It’s been hammered mercilessly.

More important, every time the stock market rallies is another chance for these companies to refinance.

Remember, as they go up, the companies are in shape to tap the equity market again because those who bought lower are being rewarded, psyching others to take a chance. In fact, other than the monoline insurance faux bailouts, people who pony up are doing pretty well.

Now, he might be right, and me wrong on this point (with my gray beard, though I am younger than he is).? But let me point out what has to go right for his forecast to be correct.

1) The inventory of vacant homes has to start declining.? Still rising for now, another new record.? Beyond that, you have a lot of what I call lurking sellers around, waiting to put more inventory out onto the market, if prices rise a little.? They will have to wait a while, and many will lose patience and sell anyway.? There is still to much debt financing our housing stock, and though most of the subprime shock is gone, much of the shock from other non-subprime ARMs that will reset remains.? Will prices drop from here by 20%?? I think it will be more like 12%, but if it is 20% there will be many more foreclosures, absent some change in foreclosure laws.? Foreclosures happen when a sale would result in a loss, and a negative life event hits — death, divorce, disaster, disability, and unemployment.

2) We still have to reconcile a lot of junk corporate debt issued from 2004-2007, much of which is quite weak.? Credit bear markets don’t end before you take a lot of junk defaults, and we have barely been nicked.? Yes, we have had a sharp rally in credit spreads over the last five weeks, but bear market rallies in credit are typically short, sharp, and common, keeping the shorts/underweighters on their toes.? You typically get several of them before the real turn comes.

3) We have not rationalized a significant amount of the excess synthetic leverage in the derivatives market.? With derivatives for every loser, there is a winner, but the question is how good the confidence in creditworthiness between the major investment banks remains.? Away from that, Wall Street will be less profitable for some time as securitization, and other leveraged businesses will recover slowly.

4) Credit statistics for the US consumer continue to deteriorate — if not the first lien mortgages, look at the stats on home equity loans, auto loans, and credit cards.? All are doing worse.

5) Weakness in the real economy is increasing as a result of consumer stress.? Will real GDP growth remain positive?? I have tended to be more bullish than most here, but the economy is looking weaker.? Let’s watch the next few months of data, and see what wanders in… I don’t see a sharp move down, but measured move into very low growth in 2008.

6) What does the Fed do?? Perhaps they can take a page from Cramer, and look at the progress from private repair of the financial system through equity and debt issuance.? It’s a start, at least.? But the Fed has increasingly encumbered is balance sheet with lower quality paper.? Two issues: a) if there are more lending market crises, the Fed can’t do a lot more — maybe an amount equal to what they have currently done.? b) What happens when they begin to collapse the added leverage?? Okay, so they won’t do it, unless demand goes slack… that still leaves the first issue.? There are limits to the balance sheet of the Fed.

Beyond that, the Fed faces a weak economy, and rising inflation.? Again, what does the Fed do?

7) Much of the inflation pressures are global in nature, and there is increasing unwillingness to buy dollar denominated fixed income assets.? The books have to balance — our current account deficit must be balanced by a capital account surplus; the question is at what level of the dollar do they start buying US goods and services, rather than bonds?

8 ) Oh, almost forgot — more weakness is coming in commercial real estate, and little of that effect has been felt by the investment banks yet.

As a result, I see a need for more capital raising at the investment banks, and more true equity in the capital raised.? Debt can help in the short run, but can leave the bank more vulnerable when losses come.? The investment banks need to delever more, and prepare for more losses arising from junk corporates and loans, housing related securities, and the weak consumer.

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