Stocks – Page 121 – The Aleph Blog

Recession or Depression?

Posted on 11 October 200812 October 2008 by David Merkel

Back to the crisis.? I want to be a bull, really.? I read what Barry wrote on 10 bullish signals, and I think, yes that’s what history teaches us.? I have used that for profit in the past.? I even have a few more.

Here’s my knockoff of S&P’s proprietary oscillator:

That’s the lowest reading ever, with statistics going back to 1990.? For more, consider the discounts on closed-end funds — they are lower than ever.? Or, consider that the IPO market is closed.? Or consider that every implied volatility measure under the sun is through the roof in ways that we haven’t seen since 1987.? The yield curve of the US is wide.? Fed policy is accommodative; don’t fight the Fed.? Consider that well-respected value investors like Marty Whitman are finally excited about the market.? Credit spreads are at record highs in the money markets and in the corporate bond markets.? Finally, consider that the lack of insider transactions indicates a potentially bullish situation:

I have a hard time accepting the bullish thesis at this point because of troubles in most of the major banks, and the disappearance of all of the major investment banks.? I have a saying that when you have a major market malfunction, there tend to be many things going screwy at the same time.? I don’t like to say that it is different this time, but rather, we have to be careful whenever there is a significant hint of depressionary conditions.? If that is the case, we should see many abnormalities:

The Treasury has shifted the TARP plan in order to recapitalize banks.? Good move, if late.
Similar things are afoot in the UK and Germany.
Many European banks are in trouble.

This is a global crisis, affecting most governments and firms.?? Our most severe crises, aside from the Great Depression, tended to be local, or limited to just a segment of the world.

Final notes: I warned about this disaster in advance, though I am not as prominent as a George Soros or Jeremy Grantham.?? I can dig up the references at RealMoney if necessary.? Last, as in the Great Depression, some moves by the government exacerbated the crisis, that may be true here as well.

With that, I conclude that we are back to the one key question: are we facing a recession or a depression?? If a recession, we should be buying with both hands, but if a depression, there will be better bargains later. At present, given the condition of the banks and the global scope of the problem, I lean toward the depression side of the argument, but I am not totally sold on the idea. There are bright people on both sides of the question. That said, I am not jumping to buy at present, even with many indicators that are favorable. The state of the financial system matters more.

Blame Game, Redux

Posted on 11 October 2008 by David Merkel

When I write, I don’t always know what will be popular, and what won’t.? Personally, I thought my article
Rethinking Insurable Interest was the more innovative of my two articles last night, but Blame Game made the splash.? Well, perhaps no surprise, the crisis has the attention of all of us.? I just have broader interests; I want to write about a wide number of things.

My readers took me up on my request, and gave me more targets to blame.? Let me expand on them:

21) The Rating Agencies — that was a popular choice.? Yes, the rating agencies messed up.? They always do.? Their job is an impossible one.? Should they be proactive or reactive?? Should they rate over the cycle, or be instantaneous?? Should they care about systemic risk issues?

Where they did err?? They competed for business, leading underwriting standards lower in structured finance.? They overrated the financial guarantors, who were their major clients.? Away from that, they made mistakes, but every firm offereing opinions makes mistakes.? I make mistakes regularly here.

22) Matt give me another party to blame, and I will let him speak for himself: I have one more to add – the Office of the Comptroller of the Currency. Not only did they fail to regulate the national banks, they also stone-walled State and local governments from bringing suit (claiming jurisdiction, but never following up on claims).

Add to that the divided regulatory structures that encouraged regulatory arbitrage.? That encouraged diminished underwriting standards.

23) Investment banks.? They asked the SEC to waive their leverage limts, and now none of the big guys are left as standalone publicly traded institutions.? They made a lot for a while, and then lost more.

24) Then there were the carry traders who have now gotten carried out on their shields. There were too many players trying to clip uncertain interest spreads, from hedge funds to Japanese housewives?

25) House flippers — whenever investors get to be more than 10% of a real estate market, beware.? Sad, but I heard an ad on the radio for buying residential real estate in order to rent it out.? It is not time for that yet.

26) The quants — they enabled models that gave a false sense of security.? They did not take into account decreased lending standards, and assumed that housing prices would continue to go up, albeit slowly.

They also assumed that various classes of risky business would be less correlated, but when hedge funds and fund-of-funds take many risks, returns become correlated because of investoors enter ing and exiting sectors.

27) The tax havens and hedge funds.? Hedge funds are weak holding structures for assets.? In a crisis they can be sellers, because they want to lower leverage.

28) Mainstream financial media — CNBC, etc.? They were relentless cheerleaders for the bull markets in stock and housing.? This isn’t a compliment, but financial radio makes CNBC sound cautious.? FInancial radio seems to be a home for hucksters.

And, that’s all for now.? If you have more parties to blame, feel free to respond.? One final note on my point 16, diversification, from the prior post: many quants did us wrong by focusing on correlations stemming from only boom periods.? There are many problems with correlation statistics in finance, but the big problem is that correlations are not stable even during boom times, much less between booms and busts.? In a bust, all risky assets become highly correlated with each other, invalidating ideas of risk control through diversification.

My view of diversification is holding safe assets and risky assets.? High quality short-term debt does wonders to reduce the volatility of results.? Other hedges are less certain.? Nothing beats cash, even when money market funds are open to question.

Blame Game

Posted on 10 October 200810 October 2008 by David Merkel

Some people don’t like the concept of blame.? They view it as useless because it wastes time in looking for a solution.? I will tell you differently.? Blame is useful because it identifies offenders, which is the first step in eliminating the problem.? The trouble is that few have the stomach to get rid of the offenders.

So, as I traveled home from prayer meeting with my children last night, we listened to a radio show discussing the current credit crisis.? This was a good discussion, unlike many that I hear.? But the discussion (on NPR) eventually focused on “who should we blame?”? Okay, here is my incomplete version of who we should blame:

1) The Federal Reserve, especially Alan Greenspan.? For the past 20 years, we couldn’t let the economy have a severe, much less a moderate recession.? Rates were reduced before significant pain was felt by those who had borrowed too much.? The 1% Fed funds rate in 2003 was the pinnacle of that effort.? It created the ultimate bubble; there is nothing left to reflate in 2008 from easy monetary policy.

2) Congress and the Presidency — they encouraged undue leverage in a variety of ways:

a) Fannie, Freddie, the FHLB, and more: Everyone has gotta live in a single family home.? Gotta do that.? Thomas Jefferson’s ideal was that we should encumber future generations so that marginal buyers could live in houses beyond their means.? They compromised lending standards more and more, along with private lenders as the boom went on.

b) The SEC: in a fiat currency world, controlling the currency means controlling leverage of financial institutions.? The SEC waived leverage restrictions on the investment banks in 2004, leading to a boom, and a bust. Big bust.? Ginormous bust — how many large standalone investment banks are left?

c) Particularly the Democrats in Congress defended the GSEs as their own pet project.? I am not bashing the CRA here; I am bashing the goal of having everyone live in a house beyond their means.

d) We offered a tax deduction on mortgage interest, and a limited exemption on capital gains from selling a home.? There is no good reason for these measures.

e) And, the Republicans in Congress who favored deregulation in areas for which it was foolish to deregulate.? Much as I favor deregulation, you can’t do it if you have fiat money (unbacked paper money).? In that case you must restrain the growth of credit.

f) The Bush Jr. Administration — they did not enforce regulations over financial institutions the way that the law would demand on a fair reading.? Again, I’m not crazy about regulation, but unless you have a gold standard, or something like it, you have to regulate the issuance of credit.

g) Their unfunded programs with promises to the future; the states and Federal Government always promise today, and don’t fund it.? Hucksters.

3) Lenders steered borrowers to bad loans.? There was often implicit fraud, and in some cases, fraud.? The lenders paid their staff to do it.

4) Borrowers were lazy and greedy.? What? You’re going to enter into a transaction many times your income or net worth, and you haven’t engaged helpers or friends to advise you?? Regardless of the housing price mania, you should have gone slower, and done more homework.? Caveat emptor — you neglected that.

5) Appraisers were slaves of the lenders who wanted to originate and sell.

6) Those that originated MBS did not check the creditworthiness adequately.? They just sold it away.? Investment banks did not care where a profit was coming from in the short run.

7) Servicers did not demand a high price for their services, making it hard for them to service anything but solvent borrowers.

8) Realtors steered people into buying more than they could rationally afford; I’m not saying they did that on purpose, but their nature was to sell to get the highest commissions.

9) Mortgage insurers and financial guarantee insurers — because of the laxness of accounting rules, they were able to offer guarantees significantly in excess of what they could pay in the deepest crisis.

10) Hedge funds, investment banks and their investors — they demanded returns that were higher than what was sustainable.? They entered into businesses that would not survive difficult times.

11) Regulators let themselves be compromised by those following the profit motive.? Many hoped to make money after joining private industry later.

12) America.? We let ourselves become short-term as a culture, encouraging short-term prosperity, regardless of the cost.

13) Neomercantilists — they lent us money, because they wanted they export sectors to grow for political reasons.? This made our interest rates too low, encouraging overinvestment and overconsumption.

14) Average people who voted in Congress, and demanded perpetual prosperity — face it, we elect those that govern us, and there is the tendency in America to love the representative that brings home the pork, while hating Congress as a whole.? Also, we need to bear with recessions, and let them do their work, and not force our government to deal with them.

15) Auditors that did a cursory job auditing financial entities.? As the boom went on, standards got lower.

16) Academics who encouraged a naive view of diversification, and their followers who believe in uncorrelated returns.? In a bad economy, everything is correlated, and your statistics from a good economy don’t matter.

17) Pension and other funds that believed the academics.? It is amazing what institutional investors will fund, given the mistaken idea that correlation coefficients are stable.? Capitalistic economies are unstable by nature!? Why should we expect certain strategies to workallo the time?

18) Governmental entities that happily expanded government programs as the boom went on.? Now they are talking about increased taxes, rather than eliminating programs that are of marginal value to society.? Governments should not rely on increased taxes from capital gains, or real estate tax assessments.

19) Those that twitted “doom-and-gloomers,” and investors who only cared if markets went up.? It is hard to write about what could go wrong in the markets.? Many call you a wet blanket, spoiling their fun, and alleging that you are a short, or some sort of misanthrope.? The system is biased in favor of happy talk.? Just watch CNBC.

20) Me, and others who warned about the current crisis. Perhaps we weren’t clear enough.? Maybe our financial interests made us look like we were talking our books.? I know that I spent a lot of time on these issues, but in the short run, I was still an investor, trying to make money in the markets, hoping that what I feared would not occur.? Now I am getting my just desserts.

This is an incomplete list.? I invite you to add others to the list in your comments.

Industry Ranks for the Reshaping

Posted on 9 October 2008 by David Merkel

There has been only one other time in my life where I felt so skittish about my methods: June-September 2002.? I got whacked hard by the market then, harder than at present, but I bounced back October 2002 – January 2004, making it up and then some.

I don’t count on that now, but I will give you may industry ranks as of this week:

Running my usual screens, I get a bunch of new tickers to consider:

ABD ??? ABG ??? ACE??? ACGL??? ADCT??? AEG??? AEL??? AFG??? AFSI??? AGII??? AHL AIG??? ?AIZ??? ALL??? ALU??? AMPH??? AMSF??? AN??? ANEN??? ARRS??? ASI??? AWH??? AXA??? AXS??? AZ??? CB??? CBG??? CHEUY??? CIEN??? CINF??? CMVT??? CNA??? ?CNO CPHL??? CPII??? CRMT??? CRNT??? CTV??? DFG??? DSITY??? EBF??? EIHI??? EJ??? ENH??? ENTG??? FFG??? FMR??? FNSR??? FSR??? GBE??? GCOM??? GILT??? GLRE??? GLW??? GNW??? GPI??? GSIG??? HALL??? HCC??? HIG??? HMC??? HMN??? HYSNY IHC INDM ING IPCR IRS JDSU JLL KGFHY L LGGNY LNC LTXC MET MHLD MIG MIGP MRH MRVC MXGL NDVLY NSANY NVTL OB OPLK OPXT PAG PEUGY PFG PL PMACA PNX PRE PRU PTP PUK PWAV RE RFMD RGA/A RNR RTEC RUSHA RUSHB SAFT SAH SAIA SEAB SUR SWCEY SYMM TER THG TLAB TM TMK TRH TRV TTM UAM UFCS UNM UTR VOD VR VTIV WRB XL YRCW ZFSVY

Some of these are on the last list, and some of them I own.? Personally, my “green zone” methods are making me queasy at present because in a credit crisis, trends tend to persist a lot longer, so I will be more likely to look at names that are stalwarts in this crisis.? My investment methods are not purely quantitative.? I use quantitative methods to assist my qualitative reasoning.

As such, I have a few more tickers to toss into the hopper, many of which are safe names, or, names in the red zone that seem cheap:

AA??? ABX??? ALL??? ALOG??? BGP??? BHI??? BKS??? BRNC??? CAG??? CNI??? CP??? DD??? DLX??? DOW??? DPS??? EOG??? FCX??? HAR??? HCC??? HOLX??? HPQ??? IBM??? ITW??? ITW??? MCF??? MET??? MMM??? MSFT??? NBR??? NYX??? ORCL??? PBR??? PFG??? POT??? PRU??? RDC??? REXI??? RTI??? SII??? TAP??? TEL??? TIE??? TM??? VEIC??? WMT??? XTO

Together with my last post, these are the tickers that I will compare against my existing portfolio to choose new names for my portfolio.? As for where I got the batch of tickers for my last post on this topic, my method is to take every idea that I hear over a quarter that I think is interesting, and I note it down, or print it out.? It is eclectic in that sense, but when I analyze the ideas at the end of the quarter, I try to forget where I got the ideas, so that I can analyze them fresh.? I am the main analyst here, and I try to avoid believing the arguments of others when I do my final analysis.

Entering the Endgame for Monetary Policy, Part II

Posted on 8 October 2008 by David Merkel

Here’s my updated graph of the composition of the Fed’s balance sheet, with modifications as suggested by some of my readers:

As you can see, the percentage of the Fed’s balance sheet containing Treasuries, whether held for itself, or together with the government is declining.? Let’s look at it another way that contains some editorializing by me:

By lower quality assets, I simply mean assets less creditworthy than the US Government or its agencies.? That’s an estimate on my part.? Why does balance sheet quality at the Fed matter?? If the Fed wants to extend credit, it can more easily do so by having higher quality assets, like Treasuries.? Now, the Fed can lose money, and it means that seniorage profits that go to the US Treasury get reduced, or go negative, which implies increased borrowing or taxation.

I can’t remember which Greek philosopher said something like, “Democracy is doomed when people learn that they can vote to get money for themselves from the public treasury.”? I know Tyler and de Tocqueville said something like that as well.? At a time like this there are a lot of demands on the public treasury, and they are growing:

There is a trouble here.? In the absence of a functioning market, how can the bureaucrats at the Fed figure out the right prices/yields to charge?? This is the same problem as valuing level 3 assets, but without a profit motive to aid in focusing the efforts of the businessman.

Now, the little graph above (from The Economist) describes the real cause of the problems.? As in the Great Depression, there was too much debt financing of assets.? The debt was more liquid than the assets, as well.? Borrow short, lend long.? Oh, and remember, the graph above does not contain the hidden debts of the Federal Government (Medicare, Social Security, and old unfunded DB plans), the states (low funded DB plans and unfunded retiree medical plans), and corporations (poorly funded DB plans).? Nor does it take account of the synthetic leverage from derivatives.

What we are seeing at present is not a reduction of the debt structure of the economy, but a shift from public to private hands.? That can lead to four results, when the debt of the US Treasury is so large that it cannot be serviced:

Inflation when the Fed monetizes the debt,
Depression from vastly increased taxes,
Debt repudiation (whether internal, external, or both), or
Japan-style malaise for a long time.

Japan-style malaise is sounding pretty good. ;)? No growth for several decades while the government debt bloats, and financial balance sheets slowly normalize.? Trouble is, we don’t internally fund our debts.? At some point, our creditors will tire of throwing good money after bad, and then the next cycle can begin in earnest, when the neomercantilistic nations give up, and accept that their investments in the US are worth a lot less than they had thought, and allow their currencies to come to a fairer level against the US dollar.

Financial intermediation has limits.? Financial and economic systems function better at lower levels of leverage if you want it to be sustainable.? Granted, you can have big boom phases if you pile on the leverage, but they will be followed by big bust phases, where the deleveraging is painful.

All of the government’s/Fed’s choices are bad here.? Dr. Bernanke is on a hopeless task, and his theories, borne out his academic studies of the Great Depression, means that we will get a new sort of Great Depression.? There is no easy solution; it is merely a situation where we choose which poison we want to take while the deleveraging goes on.? My guess is that we see some combination of malaise plus inflation.

As Martina McBride said in her song “Love’s the Only House,” “Yeah, the pain’s gotta go someplace.”? The pain is going somewhere; our policymakers are merely determining where.

PS — I am by nature a moderate optimist.? I invest in equities, and many of my sub-theories of the world, i.e., how well will the life insurance business fare, and how well will global demand fare versus that of the US, are being tested now, and I am finding myself the loser on both counts.? Yeah, the pain’s gotta go someplace

Begin the Fourth Quarter Reshaping

Posted on 4 October 2008 by David Merkel

Here we go again.? Once a quarter, I gether together the ideas that I have gathered from the last three months, so that I can consider them as replacements for companies in my current portfolio.? Here are the initial candidates:

AAUK??? ABC??? AE??? AGNC??? AHS??? AIB??? AIMC??? AIQ??? AKLE??? AKO.B??? ALJ??? ALV??? AMAT??? AMN??? AMOT??? AMX??? APA??? APD??? ARG??? ATPG??? AUO??? AXP??? AZZ??? BBSI??? BHE??? BRNC??? BTM??? BWS??? CIG??? CNH??? CNMD??? COMS??? COP??? CPOG??? CPX??? CRESY??? CTGX??? CVI??? DAC??? DAI??? DAN??? DCM??? DDS??? DE??? DIT??? DPS??? DVR??? EROC??? ETH??? EXH??? FCS??? FLR??? FRZ??? FWLT??? GD??? GIB??? GIGM??? GIII??? GLT??? GNW??? GRMN??? GSK??? GT??? GVA??? HANS??? HAWK??? HD??? HDNG??? HES??? HOC??? HRZ??? HURC??? IAR??? IP??? IPAS??? ISYS??? JAH??? JMHLY??? JOS\B??? JOYG??? KHD??? KLAYN??? LCRY??? LII??? LINC??? LINE??? LOGI??? LONG??? LOW??? LSR??? LWSN??? LYTS??? MC??? MDR??? MF??? MIDD??? MLM??? MOV??? MRO??? MRX??? MWA??? N??? NCS??? NFX??? NGLS??? NLC??? NOK??? NOV??? NSRGY??? NTGR??? NTL??? NTT??? NUE??? NYX??? OME??? OMI??? ORBK??? OTEX??? PARL??? PBR??? PCP??? PCR??? PDLI??? PHG??? PII??? PKX??? PLCM??? PLUS??? PNX??? PQ??? PRDT??? PRE??? PRU??? PTP??? PWR??? PX??? RAME??? RDS.A??? RE??? RHD??? RIG??? RIO??? SB??? SCHN??? SCL??? SCX??? SDXC??? SGY??? SHLO??? SHS??? SM??? SMCI??? SNX??? SNY??? STX??? SU??? SUN??? SYNL??? TAR??? TEL??? TEO??? TEVA??? TEX??? TFCO??? THRX??? TKTM??? TMB??? TNE??? TOT??? TRID??? TRMA??? TRS??? TRV??? TSO??? TTM??? UFCS??? UFS??? UPL??? USAK??? VMC??? VMW??? VQ??? VRS??? WERN??? WES??? WEYS??? WINN??? WMW??? WNI??? WRB??? WST??? WTS??? ZNT??? ZZ

Now, what have I done in the recent past, aside from losing more money than the S&P 500?? The following transactions:

Rebalancing Buys: ESV DVN IBA KPPC MGA VLO HIG (twice) LNC XEC SFD AVT NTE YRCW CHIC GMK HMC (twice) SBS OMX TNP

Rebalancing Sales: RGA/A YRCW GPI NTE CHIC

Complete Sales: GPI SFD MET RGA/A IRF

New Buy: RGA/B

I sold International Rectifier because of the bid from Vishay.? I would buy more Vishay, except that I fear their bid could succeed, and financing a cash deal in this environment, so large for them, would be a disaster.? I sold Group One and Smithfield for balance sheet reasons.? Metlife I sold because I needed to lighten up in asset sensitive life insurance; I sold the one that I felt could get hurt the worst in a prolonged slump.? FInally, I swapped RGA/A for RGA/B, getting the lesser voting shares at a decent discount.?? It is possible that the two classes will be unified at some point, or, that RGA could be bought out, and the B shares would do better than the A shares in such a situation.

THe next article n this series will be on my industry model and ideas for there, but if you have ideas that I should consider, add a comment, and I will throw the idea into the hopper.

Illiquid Assets Financed by Liquid Liabilities (Or, why were you playing near the cliff?)

Posted on 3 October 2008 by David Merkel

I have been overloaded the past few days.? I took the FINRA series seven exam today and passed (88%, no section below 75%).? I may have my first client.? A dear friend of mine died.? The market has been lousy, and I have done worse than that.? Reporters have been regularly calling to talk about the markets.

When I thought I needed to reposition my portfolio a week ago, it was after the last H.4.1 report.? Well, the next one has come out and it is worse.? The Fed is stretching itself thin, with the aid of the Treasury.? I’ll post on that tomorrow.

I was a little surprised about some of the responses to my article on accounting rules not affecting cash flows.? Uh, that should be obvious.? But those that disagree point to arrangements where perceived reductions in credit quality lead to a need for more capital.

Let me first say that that is not a problem with the accounting rules.? It is a problem with liability stability.? What is the possibility of a run on the bank/company/fund?? Even if it is remote, have you guarded against it?

Runs occur in unusual ways.? Derivative agreements that require more collateral on a downgrade?? Enron-like structures that issue preferred to redeem senior debt, after some triggers are hit?? Uncertainty about ability to roll over short-term financing lines?? Ratings triggers on floating rate GICs?? Ratings triggers on regular GICs (a separate event)?? Ratings triggers on property-catastrophe reinsurance?? Over-reliance on factors to finance inventory?? Dare we mention the S&Ls in the late 80s/early 90s) Visiting the local loan shark each evening? 😉

Most insolvencies occur because assets are considerably less liquid than liabilities, and the margin of assets over liabilities on? a “fair value” basis is thin to negative.? The company is playing near the cliff, and is relying on the kindness of strangers not to push them over.

What I have been arguing for the last five years, whether here or at RealMoney, is that companies of all sorts need to play at a lower level of leverage.? FInancial slack is valuable, especially in a bear market.? Just ask Warren Buffett.

Almost any company that goes bankrupt, does so because the need to cash out liabilities runs ahead of their ability to cash out assets, without having fire sales where the total value of assets drops below that of liabilities.? I.e., they run out of cash!

That is why I don’t buy arguments that mark-to-market accounting is doing firms in.? First for financial firms, SFASs 133 and 157 don’t affect solvency, only the views of shareholders.? The regulatory/statutory accounting matters.? Also, private agreements, whether margin or derivative agreements, matter even more, because they can result in a call on cash during a crisis.? To eliminate MTM accounting is to eliminate doing business.? (Can you get a brokerage to look at your margin account only once a year, or less often?)

The problems for financial firms arise from too much debt that is too short term in order to finance longer dated assets.? They run the risk that they will hit a cash crunch.? Sorry, but that’s the way that it goes, and it doesn’t matter what the accounting rule is if you don’t leave sufficient margin to survive the worst case scenario.

The crises today boil down to an asset-liability mismatch in both time and liquidity, which are correlated.? It points toward a cash flow crunch, over which accounting rules have no control.? This is endemic to the market during crises.

Aside from all of the scholarly articles indicating that accounting rule changes have little impact on valuations, this line of argumentation explains why accounting changes have little effect on the prices of stocks.? If it doesn’t happen broadly, it is unlikely to happen narrowly.

Under the wrong circumstances, and we are living in wrong times now, almost any security can be equity-like, having an uncertain outcome.? Even T-bills face that uncertainty in purchasing power terms.? (Should we bring back the debates of adjusting accounting for inflation?? Dead issue for 20 years, could it live again?)? Equity-like instruments should be marked to the best current estimate of value, which does not mean last trade if the markets are thin.? Instead, if reliable markets don’t exist, and the calculation of market inputs is uncertain, then go back to a cash flow model with a “reasonable” discount rate.

If a thinly traded security is genuinely “money good” SFAS 157 offers enough flexibility to not mark it down heavily.? Granted, you might have an argument with your auditors and consultants, but SFAS 157 is not the ogre that everyone makes it out to be.? (The rating agencies, regulators and margin clerks may disagree though… and that means companies need a greater than normal provision against bad times.)

Nor is it freedom for a management to ignore the trading values of illiquid assets, because rating agencies and counterparties will still watch those factors, and a run on the company is as likely in a fog as on a sunny day.

The only way to avoid runs on the company is to hold enough slack assets that you know you will be alright in the worst of times, meaning a depression scenario, or, scenarios where nothing trades.? Does your company/strategy possess bicycle stability or table stability?? Is there a chair to sit on if the music stops?

What’s that you say?? Holding that much capital would kill our ROE?? That’s the thinking that got us into this mess, and is what makes risk management so tough, because the short run need for profits always leads to a diminution of risk control.? Now we are not only paying the price for it with individual companies, but across our corporate sector as a whole.

Deleveraging is painful.? There are almost always defaults and reductions of future profitability involved.? And, bailouts of the sort that our government that out government is pursuing have a low probability of success.? So, analyze your own investments for survivability this weekend.? Who can survive for two years without financing at any reasonable rate?? That’s an acid test.? I just wish that when I reviewed the recent actions of the Fed, I had acted more quickly.? Alas, perhaps my next post should be what do you do when you find yourself behind the curve…

Oppose the Current Bailout Plan, Redux

Posted on 1 October 2008 by David Merkel

Perhaps the tide is turning.? Congress is now receiving more calls in favor of the bailout? Ugh.? People are so attuned to short term market moves defining what is right or wrong.? They would surrender their liberties just to make the markets rise.? Well, the Senate votes on Wednesday evening, and the House probably on Thursday, so I urge my readers, and the rest of the blogosphere to call Congress to oppose the Bailout.

Now, the current plan is better than the original one, having more oversight, and requiring equity stakes.? I still don’t like the proposal, because it won’t work on the areas of our economy that need help now, mainly the short term lending markets between banks.

As it is, the pressure in those markets is high, and the Fed is stretching its balance sheet to cope.? Other nations and central banks are acting to stem the panic, and are moving to support the short-term lending markets.

This is a global crisis, with rates rising in Asia, with failing banks in Europe, and the rescue of AIG protecting the interests of European banks, as well as domestic institutions.? The other nations of the world should step up to their responsibilities; we are all in this together.? If not, we will probably experience a global recession lasting two or more years.

Not that anything is certain in economics; the global economy has been straining over the last few years to goose growth in ways that seem foolish to me.? We know the lessons of mercantilism.? Why force exports when the returns may prove to be far less than advertised?? China may laugh over a growing economy where they sell an increasing amount to the US, but what are they receiving in return but devaluing US T-notes?

Look, there is a better bailout available.? Aim at the short term lending markets; use the $700 billion to recapitalize the Fed, and let them provide liquidity until the short-term lending markets calm down.

Or, use the money to take super-senior convertible stakes in financial institutions that are in trouble.? If the government is bailing institutions out, let them do it in a way that minimizes loss, that they would have a senior creditor position if there is loss, and significant ownership if there is a recovery.

With that, I close by saying don’t listen to foolish people who say that we can make money off of the bailout.? The objective of a bailout is to lose less money than you expected.? There are rare cases where money is made, but as we would expect with government intervention in tough times, the incentives are perverse.

What A Fine Mess You Have Gotten Us Into

Posted on 27 September 200828 September 2008 by David Merkel

One week ago, I posted Oppose The Treasury?s Bailout Plan.? Since then, most criticisms of Henry Paulson’s original proposal supposedly have been incorporated into the new compromise bill, including my criticisms.

But my concern at present is whether the bailout will work at all. I think the complexities of the reverse auctions on small illiquid distressed securitized assets will prove difficult.? Further, the talk that the baioout won’t cost anything is highly unlikely.? Of all of the US Government’s bailouts, only the Chrysler bailout made money.? So long as you are in a fiat money system, in a bailout, the job of the government is to prevent contagion and minimize loss, in that order.? Bailouts don’t make money, and that should not be expected.

But hey, if they are going to play for profit, let them play big.? I was joking around when I wrote my article 2300 Smackers, and I am joking a little here as well.? Why not use the $700 billion to capitalize 10 new banks with $70 billion of capital each?? Let them lever up 10:1 — you have $7 trillion of buying power.? Let the public participate along side the government and the power expands further.? With a profit motive, they will buy and finance what makes sense, and five years from now, the government would sell its stakes, and pay down debt.

The rough part is that they have a non-profit-oriented main shareholder, looking to bail out dodgy institutions.? Also, if the risk is smaller than $7 trillion, these institutions won’t do well.? Also, what of the financials who don’t have government sponsorship?? Couldn’t the government just take super-senior convertible bond stakes in institutions that are under duress?? (Oh, that sounds like one-off bailouts?? Could be a lot cheaper than the current plan…)

And what of the borrowing?? Can this be funded at reasonable yields, and with the dollar at current purchasing power levels?? I have my doubts, though the markets have been benign over the last few days.

Consider the actions of the Federal Reserve in concert with the Treasury.? As I pointed out in Entering the Endgame for Monetary Policy,there is a panic quality to the Fed’s actions.? This concept is endorsed by Brad Setser, Randall Forsyth, and Michael Panzner, among others.? With the short term money markets in disarray, we have Asian Central Banks cutting rates, which aids the West, but increases inflationary risk.

Three notes to close:

I don’t know what Monday will bring in entire, but a failure of Fortis seems likely.?? Note that the ECB is not on the hook here but the Belgian central bank (which probably feeds into their Treasury).
What the FDIC did with WaMu affects other banks like Wachovia.? Bidders will let the holding company fail, and bid for the operating bank subsidiary assets.? Holders of holding company securities get hit, as their likelihood of getting reasonable recoveries disappears.
We are putting a lot of faith in the health of Citigroup, Bank of America, and JP Morgan.? If one of them fails, the game is over.? Given their complexity, and the recent takeovers, the odds of there being a significant mistake are high.? Consider further that they are counterparties for more than 50% of all derivative transactions, so the synthetic leverage is high as well.

All “solutions” to the crisis at this point in time are bad solutions.? The time to act was 10-15 years ago, where we could have implemented contra-cyclical policies in bank regulation, as well as enforcing a strict separation between regulated and nonregulated financial intermediaries.? (No ownership, no lending, no derivative agreements.)

I don’t know what next week will bring us.? Last week was bad for me on a relative performance basis.? My inclination is to look at companies that have good global demand, and not much debt.? As for bonds, keep them short, unless you are buying long TIPS.

Two Updates

Posted on 21 September 2008 by David Merkel

I want to update my two Thursday evening pieces.? First with respect to Liquidity for the Government and no Liquidity for Anyone Else, the degree of financial stress in the short-term part of the market is worse.? Here’s the graph:

Much as the government wants to eliminate stress in the lending markets, I don’t think they are succeeding.? The little bounce still leaves the indicator below Thursday’s close.

One reader brought up the timing mismatch in this indicator, because I have a 2-year Treasury versus a 90-day commercial paper series.? I use the 2-year Treasury, because it is very sensitive to changes in expectations for short-term interest rates.? I suppose I could use 3-month T-bills to match, but this indicator arose out of comparing two different series that change in opposite directions when the economy strengthens or weakens.

Part 2

Now for my article Now We?re Talking Volatility.? Okay, so we had three 4% moves in a five business day period, well, now you have four of them.? Now how do the statistics look?

Oddly, after four 4% events in five days the average return is lower than that for three 4% days.? Most of the history here comes from the Great Depression, and we are dealing with the “Law of Small Numbers” here, so I am not inclined to offer definitive analysis here.? I will give you my guess, though.? Extreme volatility often begets an opportunity for profit, but also sometimes begets significant future losses.? I lean toward the profit side here in the short run, but I also realize that the actions of the US Government might not be the best for the markets, even if the markets have interpreted it positively in the short run.

I would be neutral-to-positive on the US equity market here.? The presidential cycle is a positive, as is the current market volatility.? Given the difficulties with financials, I can’t get very positive, though.? Play defense, wherever you are.