Structured Products and Derivatives – Page 10

The Education of a Mortgage Bond Manager, Part II

Posted on 20 July 2012 by David Merkel

In much of my life, I have been thrust into situations for which I was not ready, and ended up rebuilding the wheel, or came up with an unorthodox approach that worked.? But a lot of the problem came down to the question of time horizon.? How long can you buy and hold, even if temporary market conditions make you squeamish?

I remember the first CMBS bond that I bought in 1998: it was the longest AAA tranche of a Nomura deal, which was out of favor at the time.? I did a lot of work analyzing the deal, and concluded that the bond was a lot safer than many competing bonds and offered more yield.? In early 1999, when I described this purchase to the investment committee of a charitable board the I was on, one said, “Only 7%, and you are locked in for 14 years?”? I said that stock valuations were high, and that 7% was a great return.? It was a great return, and far better than the stock market over the same time period, though I could not have known that at the time.

I became an advocate for CMBS in my firm as I realized that the hot product being offered would have the majority of its cash flows come at the 10-year maturity, but there would still be some level of withdrawals.? After some modeling, I realized that the best strategy was investing 80-85% of the money 10 years out, while leaving 15-20% of the money as pseudo-cash: 2 years out or shorter.? Of all of the mortgage bond categories, only CMBS offered assets with a ten-years or more duration, with minimal credit risk.

I used Charter/Conquest as my software.? It enabled me to set a consistent set of macroeconomic principles to evaluate a large number of properties in different economic areas.? The software would project the cash flows? of each property, given the assumptions that you fed it.

I spent time analyzing geography and property types.? I had a decent idea as to what areas of the country were doing badly, and with what property types.

I created what I called the black bucket.? Property types and geographic areas that I did not like were assigned to the black bucket, and if the? black bucket got big enough, we did not play in the deal.? It was a good method, and one CMBS expert at a bulge-bracket bank said to me that it was the most rigorous means of testing CMBS that he had run into.? Most buyers were far more trusting, and tended to buy quality issuers that were taking advantage of their reputation.

By having an independent standard of value where I worked, I did better than competitors.? I did not follow fads; I followed value to the greatest extent that I knew.

Brokers would be puzzled on why I turned down deals from good dealers, or why I bought deals from originators that were subpar.? My lesson was dig into the details, and ignore names.? Analyze the data, avoid the marketing.

Doing your own analysis is a lot of investing.? Ignore the puzzled expressions of your brokers, and buy what you have determined is valuable.? More in part 3.

Book Review: The Malign Hand of the Markets

Posted on 17 July 2012 by David Merkel

When I first saw the book, and read the introduction, my heart sank and I said to myself, “I doubt I will like this one.”

I was wrong, very wrong, and liked the book more and more as I read it.? The author is a professor of Psychology, Biology and Neurobiology, and is writing about economics.? Those who have read me for some time know that I favor ecological analogies to explain economics, rather than the pseudo-physics that most neoclassical economists employ.? I am beginning to think that non-economists have a better chance of understanding economics than most economists do, because they are free from the indoctrination that comes in the early economics classes where they teach you to assume away all reality, and assume that all men are maximizers of utility or profits, and that the world is radically simple, when it is really very messy.

To the Book

Sorry to be verbose, but I found the author’s approach to be refreshing.? Men are economically rational, but what do we mean by rational?? To some, being rational means imitating what seems good.? “My neighbor is making lots of money speculating in real estate, I will do this also.”? Or rationality can mean something higher, “Real Estate prices are getting far beyond the prices that rentals could justify, I think I will sell my house and rent.”? The difference is the degree of analysis, and the willingness to think about the system as a whole.

The book also highlights why free markets and democracy do not necessarily go together.? There is pressure from the moneyed to affect the democratic process, and there is pressure from the less-well-off to vote money to themselves from the public purse.

The book takes on the concept of economic efficiency, and shows that it leads to instability, as I have argued.? Stable economic systems have slack.? Stable systems do not optimize to the hilt.

He describes the process where more and more loans were provided to the housing market, leading to a bubble.? The bubble involved some sideshows, like CDOs, where Collateralized Debt Obligation buyers provided cheap capital that purchased risky pieces of residential mortgage loans.

Economists like to talk about equilibrium, because that allows them to publish their complex math papers, but economies are big on variation, things are far more volatile than theory can admit.

He takes a dim view of central banking but does not see how we can get rid of it.? The politics are too strong, and the aversion to gold too great.? He lays most of the blame for the bubble and bust at the feet of the Fed, which is right.

He finds Keynes to be a bright guy but with many unrealistic assumptions, and too much aggregation.? The simplification of the economy is too great, and the models don’t work.

Unlike many other books, he offers solutions, and I think they are reasonable.? He inveighs against insurance where the risk is voluntarily takes on.? We should not backstop voluntary risks, nor should we allow people to speculate on the losses of others, as I have argued elsewhere.

He also argues that the Dodd-Frank bill will largely be ineffective because it does not set rules. You can have rules or scrutiny.? We have used scrutiny in the past for financial regulation and it has not worked, because the regulators were wimps.? Over the last 30 years, they have mostly been wimps.

Rules have value, and insurance regulation has been more rules-based, which helps to account for its success.? Principles-based approaches allow a minority to bend the principles, leading to financial failure.

Particularly the Fed has been lax in financial oversight, as they are the overall regulator, and they have not been tough on the regulators that they oversee.

Naive faith in economic efficiency leads many to neglect the need to regulate banks tightly.? It is far better to set rules that provide negative feedback to banks that are taking too much risk, and negative feedback to those who borrow from or lend to other banks, which increases systemic risk.

At the end, he offers four rules that I will summarize:

Limit the monetary policy discretion of the Fed. (Yes!)
No bailouts.
Insurance products that have the possibility of positive feedback should be banned.
Investment Banks should be partnerships, and commercial banks should be limited from investment banking business.

I am in hearty agreement with all of this.? He adds one further proposal that suggests taxing investment banks on the riskiness of their books; if that can be properly achieved that is a worthy idea.

Quibbles

None.? Great book.

Who would benefit from this book:?? Anyone who wants to understand economics and the crisis better would benefit from this book.? If you want to, you can buy it here: The Malign Hand of the Markets: The Insidious Forces on Wall Street that are Destroying Financial Markets ? and What We Can Do About it.

Full disclosure: The publisher asked if I wanted the book.? I said ?yes? and he sent it to me.

If you enter Amazon through my site, and you buy anything, I get a small commission.? This is my main source of blog revenue.? I prefer this to a ?tip jar? because I want you to get something you want, rather than merely giving me a tip.? Book reviews take time, particularly with the reading, which most book reviewers don?t do in full, and I typically do. (When I don?t, I mention that I scanned the book.? Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website.? Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites.? Whether you buy at Amazon directly or enter via my site, your prices don?t change.

The Education of a Mortgage Bond Manager, Part I

Posted on 14 July 2012 by David Merkel

You might remember my “Education of a Corporate Bond Manager” 12-part series.? That was fun to write, and a labor of love, but before I was a corporate bond manager, I was a Mortgage Bond Manager.? There is one main similarity between the two series — I started out as a novice, with people willing to thrust a promising novice into the big time.? It was scary, fun, and allowed me to innovate, because in each case, I had to rebuild the wheel.? I did not have a mentor training me; I had to figure it out, and fast.? Also, in this era of my career, I had many other projects, because I was the investment risk manager for a rapidly growing life insurer.? (Should I do a series, “The Education of a Financial Risk Manager?”)

One thing my boss did that I imitated was keep notebooks of everything that I did; if this series grows, I will go down to the basement, find the notebooks, and mine them for ideas.? When you are thrust into a situation like this, it is like getting a sip from a firehose.? Anyway, I hope to do justice to my time as a mortgage bond manager; I have been a little more reluctant to write this, because things may have changed more since I was a manager.? With that, here we go!

Liquidity for a Moment

In any vanilla corporate bond deal, when it comes to market for its public offering, there is a period of information dissemination, followed by taking orders, followed by cutoff, followed by allocation, then the grey market, then the bonds are free to trade, then a flurry of trading, after which little trading occurs in the bonds.

Why is it this way?? Let me take each point:

period of information dissemination — depending on how hot the market is, and deal complexity, this can vary from a several weeks to seven minutes.
taking orders — you place your orders, and the syndicate desks scale back your orders on hot deals to reflect what you ordinarily buy and even then reduce it further when deals are massively oversubscribed.? When deals are barely subscribed, odd dynamics take place — you get your full order, and then you wonder, “Why am I the lucky one?”? After that, you panic.
cutoff — it is exceedingly difficult to get an order in after the cutoff.? You have to have a really good reason, and a sterling reputation, and even that is likely not enough.
allocation — I’ve gone through this mostly in point 2.
grey market — you have received your allocation but formal trading has not begun with the manager running the books.? Other brokers may approach you with offers to buy.? Usually good to avoid this, because if they want to buy, it is probably a good deal.
bonds are free to trade — the manager running the books announces his initial yield spreads for buying and selling the bonds.? If you really like the deal at those spreads and buy more, you can become a favorite of the syndicate, because it indicates real demand.? They might allocate more to you in the future.
flurry of trading — many brokers will post bids and offers, and buying and selling will be active that day, and there might be some trades the next day, but…
after which little trading occurs in the bonds — yeh, after that, few trades occur.? Why?

Corporate bonds are not like stocks; they tend to get salted away by institutions wanting income in order to pay off liabilities; they mature or default, but they are not often traded.

By this point, you are wondering, if the title is about mortgage bonds, why is he writing about corporate bonds?? The answer is: for contrast.

period of information dissemination — depending on how hot the market is, and deal complexity, this can vary from a several weeks to a few days.? Sometimes the rating agencies provide “pre-sale” reports.? Collateral inside ABS, MBS & CMBS vary considerably, so aside from very vanilla deals, there is time for analysis.
taking orders — you place your orders, and the syndicate desks scale back your orders on hot deals to reflect what you ordinarily buy and even then reduce it further when deals are massively oversubscribed.? When deals are barely subscribed, odd dynamics take place — you get your full order, and then you wonder, “Why am I the lucky one?”? After that, you panic.
cutoff — it is exceedingly difficult to get an order in after the cutoff.? You have to have a really good reason, and a sterling reputation, and even that is likely not enough.
allocation — I’ve gone through this mostly in point 2.
grey market — there is almost no grey market.? There is a lot of work that goes into issuing a mortgage bond, so there will not be competing dealers looking to trade.
bonds are free to trade — the manager running the books announces his initial yield spreads for buying and selling the bonds.? If you really like the deal at those spreads and buy more, you can become a favorite of the syndicate, because it indicates real demand.? They might allocate more to you in the future.
no flurry of trading — aside from the large AAA/Aaa tranches very little will trade.? Those buying mezzanine and subordinated bonds are buy-and-hold investors.? Same for the junk tranches, should they be sold.? These are thin slices of the deal, and few will do the research necessary to try to pry bonds out of their hands at a later date.
after which little trading occurs in the AAA bonds — yeh, after that, few trades occur.? Same reason as above as for why.? Institutions buy them to fund promises they have made.

Like corporate bonds, but more so, mortgage bonds do not trade much after their initial offering.? The deal is done, and there is liquidity for a moment, and little liquidity thereafter.

Again, if you’ve known me for a while, you know that I believe that liquidity can’t be created through securitization and derivatives.? Imagine yourself as an insurance company holding a bunch of commercial mortgage loans.? You could sell them into a trust and securitize them.? Well, guess what?? Only the AAA/Aaa tranches will trade rarely, and the rest will trade even more rarely.? The mortgages are illiquid because they are unique, with a lot of data.? You would have a hard time selling them individually.

Selling them as a group, you have a better chance.? But as you do so, investors ramp up their efforts, because the whole thing will be sold, and it justifies the analysts spending the time to do so.? But after it is sold, and months go by, few institutions have a concentrated interest to re-analyze deals on their own.

And so, with mortgage bond deals, even more than corporate bond deals, liquidity is but for a moment, and that affects everything that a mortgage bond manager does.? More in part 2.

On Floating Rates

Posted on 12 July 2012 by David Merkel

I have to admit I don’t have much sympathy for those who lent or borrowed at floating rates like LIBOR.? Personally, I have always preferred fixed-rate deals where everything is locked in from the beginning.? It means the terms are fixed, and either you can meet them or you can’t.

There are two problems with floating rate deals.? The first is that you can’t control your funding costs.? This stems from two things: short rates are volatile, and the index is typically not controlled, though it often acts like it is.? Here is an example: there were mortgages that floated off of the one-year Treasury Note rate.? Then the Treasury cancelled the one-year Treasury Note auction, and investment banks scrambled to come up with a substitute.? As I recall, they used the interpolated rate on six month bills, and two year notes.

When I was a corporate bond manager, aside from rare occasions, I never bought floating rate debt.? Why?? I needed more certainty for the client.? Fixed rate bonds and loans are more certain.? When you float, you are subject to the vicissitudes of the index, whether a borrower or a lender.

Whatever else is true, you do not control a floating rate index.? If a related party has some influence on it, that is a negative surprise, but there may be nothing illegal about their influence, particularly if it is moderate as is likely with LIBOR.

As I say to so many others in related situations: don’t give others options against you; don’t play in their casino by their rules.? Average people should not let financial institutions have variability of terms; terms should be fixed to the greatest extent possible.

And, why do borrowers go for floating rates, if they can be harmed by them?? Because they are cheaper on average.? Yield lust works on the downside as well, and many borrow shorter than is prudent for them, in order to save a little.? Works most of the time, but not all of the time, and when it doesn’t work, it can be ugly.

Thus I encourage fixed rate finance, as always, and encourage lenders and borrowers to fix their financing in advance.

On Internal Indexes, like LIBOR

Posted on 5 July 2012 by David Merkel

When I was a life actuary, following the deferred annuity market, the concept of market-value-adjusted annuities arose.? Annuity values could react like bonds to:

An external index rate, or,
An internal index, driven off of the new money rate for annuities

Now, the internal index sounds soft, but it is not so.? Yes, you can lower your new money rate but reserves grow on indexed products.? You can raise your rates, but reserves will shrink.? It’s not perfect here, but the internal index will work over the long haul.

So when I look at LIBOR and potential manipulation, I don’t see a lot of reason for concern.

When bond deals are priced, the relative yield is what is priced; it does not matter what the benchmark is, roughly the same overall yield would have been obtained.? Spreads are a way of expressing the excess yield over equivalent maturity government or AA bank (swap/LIBOR) yields.? They are a result of the process, not a driver of the process.

If 3-month LIBOR were replaced by the on-the-run 3-month Treasury yield, new deals would be priced, and the spreads would be higher by the TED (EuroDollar – Treasury) yield spread.

When I was a bond manager, dealer desks would often try to sell or buy bonds off of unusual benchmarks.? I would always make the necessary adjustments to calculate the option adjusted spread over interpolated swap rates, with further adjustments for the degree of premium or discount to par.? (Note: A premium bond carries extra credit risk because if it defaults, the most you can recover is par.? Opposite for discount bonds.? There is a mathematical method for calculating the amount of yield tradeoff between premium/par/discount bonds, even in the absence of a credit default swap [CDS] market.? You assume that the spread over swap is the CDS premium, and calculate the annual cost of insuring the premium to par.? Deduct that from the current spread, and you have the hypothetical true par spread.? Once you have that, you can make rational swap trades.)

What I am trying to say is that benchmarks/indexes aren’t all powerful.? Bright bond investors look past them, and analyze the economics of the situation.? Same for intelligent borrowers; they know that LIBOR rises during times of financial stress.? If you are a floating rate investor/borrower, you ought to analyze the rate that your investment/loan is tied to.

Many commentators with knowledge of the situation think that lawsuits regarding LIBOR will amount to little (one, two).? Yes, there may have been some manipulation in a micro-sense for some banks, but in terms of having a big effect on many, I don’t think that is possible.? There might be some degree to which borrowers benefited and savers/lenders lost.? That’s a tough case to press on any side.? Courts favor borrowers, and they benefited from any manipulation.

In closing, I don’t think much will come from the “LIBOR scandal” the same way that nothing will come from the “rating agencies scandal.” Both are examples of summarizing information/opinions that investors can use at their own risk.? They are not fiduciaries; those who use the information do so at their own risk.

The Rules, Part XXXIII

Posted on 3 July 201220 June 2017 by David Merkel

When politicians don?t have answers, they blame speculators, financiers (Wall Street), or foreigners.? They do anything to take the spotlight off their culpability or ineptitude.

The above saying is similar to the idea that when a company blames short sellers, it is usually a sign that the short sellers are right, and the company is mismanaged.? Think about it: when a short seller builds a short position, someone else is building a long position.? The borrowed shares that are sold have to be sold to someone.? Also note that the shorting does not change the cash flows of the company.? Even the dividends don?t change because the shorts pay dividends to the extra shares.

The shorting is a side bet on a greater question: will the company be able to produce free cash flow adequate to justify the current stock price?

What applies to companies also applies to nations.? During a debt crisis or a currency crisis, there will be an appeal against speculators that are shorting the debt.? Well, guess what, for every unit of debt shorted, there is another party buying the debt.? This applies to credit default swaps as well ? on the other side of the trade there is a guy saying, ?What a nice yield.?

The politicians complain, but they could fight back: they could buy in their debts and squeeze the shorts.? What?s that, you say?? If they did that, they would either have to raise taxes or cut programs?? And that is anathema?? Well, then the shorts aren?t to blame.? The government is to blame; it has made its own bed, let them sleep in it.

After all, shorts target companies that are mismanaged; they have no free cash flow, and can?t fight back.? The same for nations that are mismanaged; they have structural budget deficits, and a political culture that won?t change it.? No surprise that the shorts show up.

The shorts don?t change anything; they recognize a fundamentally weak situation, and locate a stock lender and a dumb buyer.? Same thing for a bond lender, and a dumb buyer as far as countries or deeply distressed companies are concerned.? And all of this can occur via derivatives if this is the best manner of doing the trade.

In the end, only free cash flows matter, and companies with large free cash flow never have to worry about the shorts.? Same for nations that have their budgets in accrual balance.

Book Review: The Little Book of Hedge Funds

Posted on 30 June 2012 by David Merkel

I have worked for a hedge fund, and I have many friends that work for hedge funds.? I understand hedge funds well.

The “Little Book” people at Wiley should indeed have done this book, but with a different author.? Why?? When there are significant areas of controversy around a topic, and you write a book as if there is no controversy, it means you haven’t done your homework.

There are many like Simon Lack, who wrote “The Hedge Fund Mirage,” and Dichev and Yu, who wrote “Higher risk, lower returns: What hedge fund investors really earn.” (Note to readers at Amazon.com, if you read this at my blog, AlephBlog.com, you get links to aid your learning.

Quoting from my review of Simon Lack’s book:

But, some of the problems with hedge funds, as a opposed to open-end mutual funds, is that:

1) Many hedge funds go out of business, and as they do, their bad performance is not recorded, and sometimes lost.

2) Hedge funds with good performance give the databases their early performance.? Bad early performance does not get reported.

3) The activity of investors chasing trends is more pronounced in hedge funds than in mutual funds, with a loss of returns of 5% in hedge funds, versus 3% in mutual funds.? This is all due to greater volatility.

4) Double alpha is generally not achievable, because most managers good at longs are not good at shorts, and vice-versa.? Going long and short are different skill sets.

These are issues that the author of the “Little Book” does not address in any significant way.? He mentions Simon Lack’s book once in passing, but doesn’t do anything substantive with it.? He also does not deal with the difference between dollar-weighted and time-weighted returns.? Because hedge funds are often quite volatile, investors buy at the wrong time (after a strong performance), and sell at the wrong time (after a weak performance).? What that implies is that the average investor in a hedge fund typically does worse than a buy-and-hold investor.

Other Problems

Page 121 contains a math error in the first example on shorting.? Yo! This is only arithmetic.? Didn’t anyone proofread the work?
Page 136 attempts to describe deal arbitrage, and makes what should be an easy concept rather turgid.? It is so unclear, that I would have to assume the author does not understand what is a simple concept.
The book does not spend any significant time on how we live in a different world now than in the glory days of hedge fund outperformance.? Even some slight commentary on the limits to arbitrage would have been useful.

Some Strengths

Much of the advice that the author gives in selecting hedge fund managers is sound, especially the list of red flags.
The “due diligence questionnaire” was also interesting.
Most of the descriptive material in the book was accurate, but there are other books and blog posts that provide that information, minus the hype.
This book is not mathematical, sometimes to a fault, where a chart or graph could have proven useful.

Summary

To be truly educated about hedge funds, you would need a lot more than this book.? This book reads like you are being pitched on how great hedge funds are; it does not provide enough on the limitations of hedge funds, nor does it interact with the critiques of hedge funds.

Who would benefit from this book: Most investors would not benefit from this book.? Particularly those that advise institutional clients and high net worth individuals would not benefit. It is too optimistic about the performance of hedge funds.? If you want to, you can buy it here: The Little Book of Hedge Funds (Little Books. Big Profits).

Full disclosure: The publisher asked if I wanted the book.? I said ?yes? and he sent it to me.

Redacted Version of the June 2012 FOMC Statement

Posted on 20 June 2012 by David Merkel

Comments

Operation Twist is extended for six months, but there is no amount set for it.? Looks like an oversight, then again, they may not have a lot of bonds three years and shorter to sell.
The changes are significant, because in the space of one meeting, they went from things are good to things are bad.? They shaded down their views on GDP growth, employment, inflation, and household spending.
In my opinion, I don?t think holding down longer-term rates on the highest-quality debt will have any impact on lower quality debts, which is where most of the economy finances itself.
Also, the reinvestment in Agency MBS should have limited impact because so many owners are inverted, or ineligible for financing backed by the GSEs, and implicitly the government, even with the recently announced refinancing changes.
The key variables on Fed Policy are capacity utilization, unemployment, inflation trends, and inflation expectations.? As a result, the FOMC ain?t moving rates up, absent increases in employment, or a US Dollar crisis.? Labor employment is the key metric.
Do they want the yield on 30 year TIPS to go negative?? Looks that way.
GDP growth is not improving much if at all, and the unemployment rate improvement comes more from discouraged workers.? Inflation has moderated, but whether it will stay that way is another question.

Questions for Dr. Bernanke:

Is it possible that you don?t really know what would have worked to solve the Great Depression, and you are just committing an entirely new error that will result in a larger problem for us later?
Why do think extending the period of accommodation by a little more than two years will have any significant effect on the economy, aside from stock and bond prices?
Discouraged workers are a large factor in the falling unemployment rate. Why do you think the economy is doing well?
Couldn?t increased unemployment be structural, after all, there is a lot more competition from labor in emerging markets?
Why do you think that holding down longer-term rates on the highest-quality debt will have any impact on lower quality debts, which is where most of the economy finances itself?
Why will reinvestment in Agency MBS help the economy significantly?? Doesn?t that only help solvent borrowers on the low end of housing, who don?t really need the help?
Isn?t stagflation a possibility here?? I mean, no one expected it in the ?70s either.
Could we end up with another debt bubble from keeping short rates so low?
If the Fed ever does shrink its balance sheet, what effect will it have on the banks?

Modified Glass-Steagall

Posted on 16 June 201217 June 2012 by David Merkel

If you’ve read me for more than two months, you probably know that I am an actuary, though not a practicing actuary at present.? I grew up in the life insurance industry.? It’s an unusual place for an investor to start, but there are some advantages:

You learn some of the most complex accounting rules in business.
You learn the value of having a strong balance sheet, because when it slips, it is hard to get back.
You learn the value of simplicity, because many companies that wander from that die.
You get to know a lot of people with different bits of specialized knowledge, which you the actuary have to tie together.? And, respecting the older people in dead-end jobs which they do well goes a long way toward getting significant cooperation.
If you are a corporate actuary, as I sometimes was, potentially you become a good risk manager.
If are an investment actuary, you learn that risk control is far more difficult than it seems, and so you learn not to take obscure risks, and test a variety of modeling assumptions, because models can go wrong.
You build in margins for error if you are a pricing actuary, as I often was, and review actual results when setting assumptions.
You get to see regulation up close and personal, because you have to interact with 51 different regulators if you do valuation, cash flow testing, pricing, etc., with your home state regulators leading the way.

There’s more, but my topic this evening is financial regulation generally.? I’ve been thinking about it, and I have had a moderate shift in my views: I think it would be wise to reinstitute a modified version of Glass-Steagall, but modeled after the way that insurance regulation is done today.? For solvency regulation, insurers are much better regulated than banks.? The banking industry should imitate the insurance industry in a number of ways.

Here’s the main idea: Allow financial holding companies to own all manner of financial subsidiaries, but disallow:

Stacking of subsidiaries.? No A owns B, B owns C.? This allows capital to be stretched thin.
Cross-ownership and cross-lending: subsidiaries may not interlace their capital.
There may be no reinsurance or derivative agreements across subsidiaries.

This would bar complex ownership charts.? There would be a big box at the top, with lines to little boxes below, but only one level of depth, and no lines between subsidiaries.

Also:

Each subsidiary must be subject to its own regulator.? There must not be an overall regulator for “financial supermarkets.”? Keep it simple and focused.? Remember, the Fed has never been a good regulator.
Since financial holding companies die if they don’t get dividends, make the payment of dividends from any subsidiary to the parent company subject to the discretion of the regulators.? Regulators should not care about the holding companies, but only about the solvency of subsidiaries.
If a company is presently in two businesses with different regulators, the company must divide the business into two subsidiaries which each regulator can separately regulate.
Subsidiaries do not get to choose their regulators.? If there are potentially duplicate regulators, merge them and create one regulator if that makes sense.? Otherwise, make rules so that there is no ambiguity on who regulates what.

The view of the government toward financial holding companies should be this: we don’t care if you fail.? We do care if your subsidiaries fail, so if the solvency of any of them is getting marginal, dividends to the holding company will be cut off.

Now, I would prefer the rest of the financial industry mimic the insurance industry, in that State regulation is better than Federal regulation.? If you want to end too big to fail, split up banks into state subsidiaries.? Each state regulator would separately determine solvency issues, and would limit dividends back to the holding company.

Remember, we don’t care if holding companies go broke.? If a holding company goes broke, and all of the subsidiaries are solvent, the subsidiaries will easily be sold to other holding companies.? The creditors of the bankrupt financial holding company will divide the spoils after a year or so.? Cost to the taxpayers: zero.

And maybe, mimic the guarantee funds of the insurance industry, and let the financial subsidiaries self-fund the losses of their fallen competitors.? Cost to the taxpayers: zero.

Under this sort of arrangement, you can have “financial supermarkets,” but they would be very different, because the solvency of each part would be separately regulated.? You don’t want macro-regulators, they are far easier to fool; specialization in financial regulation is a plus; don’t give any credit to those who use a diversification argument.? We are focusing on risks, not risk.? Failure does not happen from risk in abstract, but from particular risks that were underrated.

Finally you need risk managers inside all regulated financial institutions that are either FSAs [Fellows in the Society of Actuaries] or CFAs [Chartered Financial Analysts].? I am both, though my FSA status is inactive, because I don’t pay the dues.? Why is this valuable?

You need organizations with ethics codes to teach and monitor the behavior of those within.? There are failures amid FSAs and CFAs, but society and legal punishment tends to decrease the occurrence.

If we did this, financial companies would be much more stable, and we would reduce the need for the FDIC.? There would be personal ethics standards among risk managers inside financial companies, and less reason for regulators to compromise from political pressure.

This is my modified version of Glass-Steagall, which gives financial industries most of what they want, but offers solvency protections far beyond what we have today.? Is this a good compromise, or what?

Book Review: The Alpha Masters

Posted on 21 May 201221 May 2012 by David Merkel

This book has just been released.? I got an early copy.? The book is interesting enough that I would like to do a Q&A with the author, and I have contacted the PR flack to do so.

To the review:

Would you like to understand the mindsets of a variety of successful hedge fund managers?? This book will give that to you, but there is a catch: you will also learn how these managers developed, and this is a big plus.

Most of the managers went through rigorous experiences that made them far more effective at evaluating risk and return potentials.?? Have you been through anything similar to that?? If not, you might read this very interesting set of accounts, but then realize that you don’t have the personality/skills necessary to replicate what they have done.? Don’t feel bad, most people don’t have that.

A large part of what makes hedge fund managers successful is their willingness to limit their activity to areas where they have genuine expertise.? They gain insight beyond most into areas where they are experts in discerning value.

This book does not give you a formula for how to make money; instead, it gives you lessons in the characters of those that have made a lot of money for themselves and their clients.? What are they like?

Among their many attributes, they are:

Driven/competitive — though I have known my share of failures in investing that have that attribute.
Lifelong learners, like Buffett and Munger — though I have known some really bright people who know a lot about investing/finance who add little to an investment process.
Opportunistic — they recognize what their best opportunities are, and pursue them to the exclusion of others.
Focused — they develop an edge, and try to be “best in class,” whether in mathematics of the markets, understanding the legal rights of different types of securities, understanding industry dynamics, accounting nuances, etc.
Patient — if opportunities are not promising, don’t do much.? It’s like being an intelligent underwriter — when your competitors are giving away the store, don’t write business, spend time sharpening your skills.? Study what could go wrong, and see if there is a way to take advantage of the situation.
Team-builders — They develop talented teams/cultures and motivate them to excellence.
Sensible — They know when to be doggedly persistent, and know when to admit defeat.

Now, no hedge fund manager has all of these, but the best have most of them.

Contents

The book covers nine managers/firms:

Ray Dalio — Bridgewater
Pierre LaGrange & Tim Wong — MAN Group / AHL
John Paulson — Paulson & Co.
Marc Lasry and Sonia Gardner — Avenue Capital Group
David Tepper — Appaloosa Management
William A. Ackman — Pershing Square Capital Management
Daniel Loeb — Third Point
James Chanos — Kynikos Associates LP
Boaz Weinstein, Saba Capital Management

About the Author

Her name is Maneet Ahuja, and is a producer for CNBC, specializing in covering hedge funds.? That’s how she gained the contacts in order to write the book.? Business Insider did a profile on her, and you can find it here.

Quibbles

The book needs something to tie it together and give it depth, otherwise the book is only “Meet these nine nifty hedge fund managers that I have gotten to know.”? That’s a serious deficiency; even a single chapter at the front or back would have enriched the book, making it more general and cohesive.

I also think there would have been better choices for those that wrote the foreword (Mohamed El-Erian) and the afterword (Myron Scholes).? The former is an accomplished investor, but is not an expert on hedge funds.? Myron Scholes is an accomplished academic, has worked for hedge funds, but is still not an expert on them.

Who would benefit from this book: If you want to learn about what type of people these nine hedge fund managers are, and read anecdotes about some of their best and worst trades, this would be a book you would enjoy.? If you want to, you can buy the book here: The Alpha Masters: Unlocking the Genius of the World’s Top Hedge Funds.

Full disclosure: The book was sent to me out of the blue; did not ask for it.

April 2012	June 2012	Comments
Information received since the Federal Open Market Committee met in March suggests that the economy has been expanding moderately.	Information received since the Federal Open Market Committee met in April suggests that the economy has been expanding moderately this year.	?This year? makes it more of a historical statement, and shades the GDP view down.
Labor market conditions have improved in recent months; the unemployment rate has declined but remains elevated.	However, growth in employment has slowed in recent months, and the unemployment rate remains elevated.	Shades labor employment down.? Still thinks there is growth in employment rate.
Household spending and business fixed investment have continued to advance. Despite some signs of improvement, the housing sector remains depressed.	Business fixed investment has continued to advance. Household spending appears to be rising at a somewhat slower pace than earlier in the year. Despite some signs of improvement, the housing sector remains depressed.	Shades down household spending.
Inflation has picked up somewhat, mainly reflecting higher prices of crude oil and gasoline. However, longer-term inflation expectations have remained stable.	Inflation has declined, mainly reflecting lower prices of crude oil and gasoline, and longer-term inflation expectations have remained stable.	Shades down ?their view of inflation. TIPS are showing virtually unchanged inflation expectations since the last meeting. (5y forward 5y inflation implied from TIPS.)
Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability.	Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability.	No change.
The Committee expects economic growth to remain moderate over coming quarters and then to pick up gradually. Consequently, the Committee anticipates that the unemployment rate will decline gradually toward levels that it judges to be consistent with its dual mandate.	The Committee expects economic growth to remain moderate over coming quarters and then to pick up very gradually. Consequently, the Committee anticipates that the unemployment rate will decline only slowly toward levels that it judges to be consistent with its dual mandate.	Shades down its views of future GDP growth.
Strains in global financial markets continue to pose significant downside risks to the economic outlook.	Furthermore, strains in global financial markets continue to pose significant downside risks to the economic outlook.	No real change.
The increase in oil and gasoline prices earlier this year is expected to affect inflation only temporarily, and the Committee anticipates that subsequently inflation will run at or below the rate that it judges most consistent with its dual mandate.	The Committee anticipates that inflation over the medium term will run at or below the rate that it judges most consistent with its dual mandate.	Declares victory in their view on energy prices.
To support a stronger economic recovery and to help ensure that inflation, over time, is at the rate most consistent with its dual mandate, the Committee expects to maintain a highly accommodative stance for monetary policy.	To support a stronger economic recovery and to help ensure that inflation, over time, is at the rate most consistent with its dual mandate, the Committee expects to maintain a highly accommodative stance for monetary policy.	No change.
In particular, the Committee decided today to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that economic conditions–including low rates of resource utilization and a subdued outlook for inflation over the medium run–are likely to warrant exceptionally low levels for the federal funds rate at least through late 2014.	In particular, the Committee decided today to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that economic conditions–including low rates of resource utilization and a subdued outlook for inflation over the medium run–are likely to warrant exceptionally low levels for the federal funds rate at least through late 2014.	No change.
The Committee also decided to continue its program to extend the average maturity of its holdings of securities as announced in September.	The Committee also decided to continue through the end of the year its program to extend the average maturity of its holdings of securities. Specifically, the Committee intends to purchase Treasury securities with remaining maturities of 6 years to 30 years at the current pace and to sell or redeem an equal amount of Treasury securities with remaining maturities of approximately 3 years or less. This continuation of the maturity extension program should put downward pressure on longer-term interest rates and help to make broader financial conditions more accommodative.	Extends Operation Twist for six months.? Doesn?t say how much.
The Committee is maintaining its existing policies of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction.	The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities.	I guess the renewal of Operation Twist changes the language here.
The Committee will regularly review the size and composition of its securities holdings and is prepared to adjust those holdings as appropriate to promote a stronger economic recovery in a context of price stability.	The Committee is prepared to take further action as appropriate to promote a stronger economic recovery and sustained improvement in labor market conditions in a context of price stability.
Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; Elizabeth A. Duke; Dennis P. Lockhart; Sandra Pianalto; Sarah Bloom Raskin; Daniel K. Tarullo; John C. Williams; and Janet L. Yellen.	Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; Elizabeth A. Duke; Dennis P. Lockhart; Sandra Pianalto; Jerome H. Powell; Sarah Bloom Raskin; Jeremy C. Stein; Daniel K. Tarullo; John C. Williams; and Janet L. Yellen.	Adds in the two new doves; can?t have enough groupthink.
Voting against the action was Jeffrey M. Lacker, who does not anticipate that economic conditions are likely to warrant exceptionally low levels of the federal funds rate through late 2014.	Voting against the action was Jeffrey M. Lacker, who opposed continuation of the maturity extension program.	Does this mean Lacker is on board with policy accommodation through 2014?? Don?t think so, but maybe a reporter should ask.