Structured Products and Derivatives – Page 14

Who Dares Oppose a Boom?

Posted on 14 March 2011 by David Merkel

I’m in Chicago today giving a talk on Who Dares Oppose a Boom? Here is a copy of my presentation.

The main idea is this: enough people benefit from credit bubbles in the short run that it is impossible to oppose credit bubbles once they get started.? They have political, economic, and societal support.? The nature of man is to seek free money, whether as consumers, businessmen, or politicians.? People are willing to suspend disbelief when times are good.

All for now.? Will write more in the next two days.? Remember, Japan has much bigger problems than the quakes and nuclear incidents, which should make you more bullish on Japan; the current problems will fade.

Book Review: Fatal Risk

Posted on 18 February 2011 by David Merkel

When I came to work at Provident Mutual, I gained a friend who reported to me.? Roy was a real character.? He had his rules for life, and they all made sense to some degree.? When he opined on why we did business the way we did in the pension division, he would say,”We’re the good guys.? We are out to save the world for 0.25% on assets plus postage and handling.”

I like working with the good guys; that is my style, if I can achieve it.? Too many are purely out for personal enrichment, leaving aside the harm/good they do to others.

Roddy Boyd is one of the good guys.? If you haven’t read his stuff before in the papers/magazines in which he has written, you will benefit from his book on AIG.

This book has some real insight to it.? It focuses on the years where AIG stopped being a mere insurer, and started being a player in the capital markets.

That said, it contains new data on M. R. Greenberg, especially regarding his war years.? I found it very insightful, and helped me understand why he was the boss that he was. (I worked at AIG 1989-1992.)? He was one tough man in both war and business.

Boyd interviewed as many as would talk with him, and excluded material that would not be confirmed by two parties.? I felt that was an ethical way to deal with information not yet publicly known.

The driving force behind AIG’s push into financial services was a need for income uncorrelated with the P&C insurance cycle.? That also led to derivatives, commodities trading, airplane leasing, and expansion of the domestic life business, by purchasing SunAmerica and American General (both mistakes via overpayment in my opinion, and I know this business).

This expansion took a toll on AIG and as it could not grow profitably organically anymore at a 15% rate, it began to borrow money, both explicitly and implicitly, so as to lever a falling ROA (return on assets) into a 15% ROE (return on equity).

Greenberg oversaw the expansion into financial services, though not the imprudent risk taking after he was kicked out.? He also managed the increase in debt and implicit debt — most of that occurred under his watch.? But those that followed him were nowhere near his equals.? They could not manage that which was unmanagable by lesser mortals.? Martin Sullivan should have broken up the company on day one; that was his failure.? No one but Greenberg could manage the monstrosity.? If he had remained there, I suspect the company would have blown up in 2010-2015, with him screaming all the way down.? I think it was a mercy to him that he got kicked out.

When everything blew apart, no one could grasp the whole picture.? Greenberg was gone.? AIG was undermanaged.? No one knew the whole story, and all of the correlations hinging on subprime lending: direct lending through the consumer finance arm, investments in the insurance companies, guarantees through the mortgage insurance subsidiaries , securities lending collateralized by subprime in the domestic life companies, and guarantees at AIG Financial Products.

The effort at diversification ended up being an exercise in concentration.? Nothing grows to the sky.? Big firms tend to rot from within and that was the case for AIG, Greenberg or no.? I think Greenberg got sucked into the Wall Street earnings game, and it eventually got too big for him.? It was certainly too big for his successors.

This was a great book.? I loved every minute of reading it.? I could not put it down.? Roddy is one of the “good guys” and fights for what is right.? But he is fair; he does not take someone to task unless he has incontrovertible evidence.? Thus those who are suspected, but have no ironclad case against them walk, which is as it should be.

One more note, this book had a really good balance in how it would leave the main story to explain a concept, and the broader financial world.? It left the main focus on AIG, while explaining how it fit into the broader picture.

Quibbles

The book is not available yet.? I read an advance version, and there were some small errors that I expect will be eradicated when it goes to print.

Who would benefit from this book:

Anyone who wants to know more about AIG wold benefit.? This is the best AIG crisis book yet.? Beyond that, readers wanting to understand the complexity of the financial system, and how it led up to the crisis will benefit, as AIG was a microcosm of the greater panic.

If you want to, you can buy it here: Fatal Risk: A Cautionary Tale of AIG’s Corporate Suicide.

Full disclosure: This book was sent to me by the author, unsolicited.

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.

Creating a Stable Financial System, Part I

Posted on 11 January 2011 by David Merkel

I’ve been thinking a lot about bank reform lately.? Here’s the core of the problem: deposits are sticky in ordinary times, particularly once you have a guarantor of deposits like the FDIC.? But for some banks, they look to other short term funding, whether it is short CDs or repo funding.

Now to me a lot of the issue is asset-liability mismatch.? Banks borrow short and lend long.? That leads to banking panics.? Financing illiquid assets with liquid liabilities is unstable, and begs for bankruptcy at the first significant loss of confidence.

But there is a greater mismatch present, which I want to explore.? Every asset is financed with some liability or equity.? And, every liability is someone else’s asset, but not vice-versa, because assets owned free and clear are equity-financed.

Assets financed by debt are frequently mismatched short.? Long mismatches are rare because of the cost of financing being too high.? Now, if short mismatches are small, that’s not a problem.? There is enough flexibility in financial balance sheets to accept small mismatches.? Real disasters happen when long assets are financed in such a way that there is a risk that the financing will fail prior to the assets being paid off.

The fundamental mismatch in debts that finance assets is that the ultimate assets being financed are longer-dated than the financing.? We fund land, houses, buildings, plant & equipment, and do it off of deposits, savings accounts and CDs.? Some financial companies finance off of short-dated repo funding.? The reason that this mismatch is hard to avoid is that average individuals who save want short-dated assets that can be used for transactions.? That doesn’t fit well against the need to fund long-term assets.

The same problem exists in the municipal bond market.? Much more money wants to invest short, while municipalities want to borrow long.? This leads to a steep muni yield curve.? Commercial insurers writing long tail business, and wealthy people that can tolerate interest rate volatility end up buying the long end, and lower taxes in the process.

If banks were required to approximately match cash flows for assets not financed by equity, yield curves would steepen for other areas of the fixed income markets.? Areas of the financial market where there are long/strong balance sheets, such as Life Insurers, Commerical Insurers, Defined Benefit Pensions and Endowments would get higher yields for longer commitments.? Banks would become a lower ROE business, and that would be good, as there would be many fewer failures, and there would be fewer banks; we are over-banked.? Time to re-educate bankers for more productive activities.

Long dated floating-rate loans could be a solution for banks funding loans? off of short-dated lending, or, using interest rate swaps to achieve the same result.? The risk is that a bank locks in what proves to be a low spread on the asset, while funding costs are volatile.

A few final notes: 1) the standard of broadly matching asset and liability cash flows should be applied to all regulated financial institutions, including investment banks.? Only surplus assets not needed to match liabilities can be used for investments with equity-like risk. 2) There must be an unpacking of complex vehicles with embedded leverage to do the Asset-Liability management.? As examples:

Securitizations
Repo Funding
Private Equity
Hedge Funds
Margin loans
SIVs and the like

would need to be reflected as looking through to the items ultimately financed.? As an example, the AAA portion of a senior-sub securitization is long the loans, and short the certificates sold to the rest of the deal.

Repo funding has its own issues.? In a crisis, haircuts rise as asset values fall.? Institutions relying on that funding often fail at those times, and leaves losses to the repo lender.? There would need to be something reflected for the risk of repo market failure, though the grand majority of the losses go to the borrower, and not the lender.

3) Even short lending to those getting loans that do not fully amortize should be reflected as loans that are longer-dated, because of the risk of rates being higher, and refinancing is not possible.

I have more to say, but I’m going to hit the publish now.? Comments are welcome.

Book Review: All the Devils are Here

Posted on 9 December 2010 by David Merkel

Have you ever seen a complex array of dominoes standing, waiting for the first domino to be knocked over, starting a chain reaction where amazing tricks will happen?? I remember seeing things like that several times on “The Tonight Show with Johnny Carson” back when I was a kid.

When the first domino is knocked over, the entire event doesn’t take long to complete — maybe a few minutes at most.? But what does it take to set up the dominoes?? It takes hours of time, maybe even a whole day or more.? Often those setting up the dominoes leave out a few here and there, so that an accident will spoil only a limited portion of what is being set up.

Those standing dominoes are an unstable equilibrium.? That is particularly true at the end, when the dominoes are added to remove the safety from having an accident.

Most books on the economic crisis focus on the dominoes falling — it is amazing and despairing to watch the disaster unfold, as the leverage in the system is finally revealed to be unsustainable.

This book is different, in that it focuses on how the dominoes were set up.? How did the leverage build up?? How was safety ignored by so many?

The beauty of this book is that it takes you behind the scenes, and describes how the conditions were created that led to a huge creation of bad debts.? I was a small and clumsy kid.? My friends would say to me during sports, “There are mistakes, but your error was so great that it required skill.”

The same was true of the present crisis.? There were a lot of skillful people pursuing their own private advantage, using new financial instruments which were harmless enough on their own, but deadly as a group.? So what were the great financial innovations that enabled the crisis?

Creation of Fannie and Freddie, which led to an over-issuance of mortgages.
Securitization, particularly of mortgages.? This led to a separation between originators and certificateholders. (And servicers, though the book does not go into servicers much.)
Having parties that guarantee debt, whether GSEs, Guaranty Insurers, the Government, or credit default swaps [CDS]
Loosening regulations on commercial banks, investment banks and S&Ls.
Regulatory arbitrage for depository institutions.
Loose monetary policy from the Federal Reserve, together with a disdain for regulating credit.? They saw Mexico and LTCM as successes, and thought that there was no crisis that could not be solved by additional liquidity.
Bad rating agency models, and competition among rating agencies to get business.
Regulators that required the use of rating agencies for capital modeling.
The broad, misinformed assumption that real estate prices only go up.
The creation of Value-at-risk, a risk management concept that has limited usefulness to true crisis management.
The creation of CDOs that did not care for much more than yield.
The development of synthetic CDOs, which allowed securitization to apply to corporate bonds, MBS, and ABS not owned by the trusts.
The creation of subprime loan structures, where are that was cared for was yield.
The creation of piggyback loans, so that people could put no money down for a home.

There are no heroes in this book, aside from tragic heroes who warned and were kicked aside in the hubris of the era.? Goldman Sachs comes out better than most, because they saw the crisis coming, and protected themselves more than mot investment banks.

I learned a lot reading this book, and I have read a dozen or so crisis books.? I didn’t learn much from the other books.? In this book, the authors interviewed hundreds of people who were integral to the crisis, and read a wide variety of sources that wrote about the crisis previously.

I found the book to be a riveting read, and I read it cover to cover.? I could not change into scan mode; it was that well-written.

This is the best book on the crisis in my opinion, because it takes you behind the scenes.? You will learn more from this book than any other on the crisis.

Quibbles

They don’t get the difficulties of being a rating agency.? There is the pressure to get things right over the cycle, and get it right on a timely basis.? These two goals are contrary to each other, and highlighting that conflict would have enhanced the book.

Who would benefit from this book:

Anyone willing to read a longish book could benefit from this book.? It is the best book on the crisis so far.

If you want to, you can buy it here: All the Devils Are Here: The Hidden History of the Financial Crisis.

Full disclosure: This book was sent to me, because I asked for it.

Book Review: The Last of the Imperious Rich

Posted on 23 November 2010 by David Merkel

This is a great book for those that love economic history, as I do.? It describes the fortunes of the Lehman clan, Jews having emigrated from Germany, to antebellum Montgomery, Alabama, and later New York City, and what they did as a commodity trading firm that morphed into venture capital, and then investment banking.

As a family firm, it lasted for three-four generations.? There was less than one generation as a private company outside of family control.? Stagnation, and a need to allow for liquidity led to a need for a broader capital base, which led to the sale to American Express.

The title stems from the life of Bobbie Lehman, who was the last family member to lead the company, who as a financier, had such a commanding position that he struck fear in the hearts of those he would talk to, though he was a gentleman in many regards, and a patron of the arts to a high degree.

History is Messy

How did three immigrant brothers manage to create a behemoth, particularly with the original leader dying early?? Hard work; they were in the right places at the right times.? Their family structures held together well enough against increasing wealth, at least until the third generation.

They were pragmatic, and sometimes cut against their principles.? There is some evidence that the brother bought at least one slave.

The commodities that they traded in were in hot demand.? They built that into a big business.? That they had a presence both in the agricultural areas for commodities, and in the financial capital, New York City, was an ideal plan to have information from both sides of the market, supply and demand.

But the messiness of history is what makes this an interesting tale, and the author tells it well.

Quibbles

It’s a really good book.? I think it is best paired with A Colossal Failure of Common Sense: The Inside Story of the Collapse of Lehman Brothers, because it tells the end of the story better.? But the beginning of the story is rich, and had a few alternative decisions been made, Lehman might not have failed.

Who would benefit from this book:

I think most investors could benefit from the book, mainly because I believe that economic history is valuable.? History doesn’t repeat but it rhymes, and this gives us more than a few new poems to consider.

If you want to, you can buy it here: The Last of the Imperious Rich: Lehman Brothers, 1844-2008.

Full disclosure: This book was sent to me, and I don’t think I asked for it.? I’m? glad they sent it, though.

Ethics and Investment Writing

Posted on 13 November 201014 November 2010 by David Merkel

There are three things that I am happy with when it comes to writing about investments:

I am glad that Jim Cramer invited me to write for RealMoney seven years ago.? Motown Josh Brown put together a great piece on the influence that TSCM has had on the financial media.? I heartily agree, and I don’t think we know the half of it.? I interacted with a lot of young TSCM staffers, and it amazed me what an education they got in the markets working for TSCM.? TSCM blended respect and skepticism for the markets, and though you couldn’t have done it without Cramer, the effect on the financial media exceeds him, and for that we can all be grateful, because the financial media is a lot sharper than it was 15 years ago.? (Okay, leave out much at CNBC.)? And who knows, maybe I will return to TSCM someday in some capacity; the door is open.
I’m glad I started my blog.? I still think that financial bloggers are the conscience of Wall Street.? There is a need for knowledgeable people to write about economic/investing/finance issues.? It does not replace journalists, but supplements them.? Intelligent commentary complements “neutral” reporting on a topic.? Journalists learn from area experts, playing them off against each other to get a fuller picture of the debate.? (As an aside, the motive to start the blog began on one of the comment boards at TSCM for Cramer.? Readers were fascinated that I would post there, and told me I needed to develop my voice.? A few called me the anti-Cramer, but I never took up that moniker.)
I am grateful that I am a CFA Charterholder.? Harry Markopolos recently spoke to the Baltimore CFA Society, mainly about his uncovering of the Madoff scandal, but he spent a decent amount of time explaining why the CFA Institute and our ethics code can make a huge difference in reforming Wall Street.? I was impressed; his beliefs in honesty and fair dealing drive his actions.? (I talked with him afterward, and we realized we must have met seven years before, at a regional meeting of the Northeastern CFA societies, when I was sent by the Baltimore CFA Board to represent us in a ticklish issue regarding the leadership of AIMR.? He had helped lead the effort to replace the existing leadership.)

But that’s not my major reason for writing tonight.? I want to comment on two pieces in the Wall Street Journal that comment on shady practices.

The first one is entitled Shining a Light On Murky 401(k) Fees.? The Department of Labor has the dubious distinction of being less effective than the SEC on investment regulation.? A lady I sat next to at the Denver conference regaled us with how her daughter’s 401(k) plan had expenses equal to 12%/year of assets.? I hope she made a math error, but she is a Ph. D; it’s not likely.

From my own experience at Provident Mutual in the nineties, it was easy to see how expenses could get layered.? We tried to be among the more ethical in that business, but the temptation to pay a lot in order get more business was dangled in front of us regularly, and we refused.? We had a rule that if comp was not disclosed, agents had to disclose that comp was not disclosed. And if they took nondisclosed comp, they could not have additional disclosed comp, because it would give the illusion of “That’s all I am paid.”

Do we need limits on 12b-1 fees?? I would prefer a full disclosure of fees — who and how much, poking through relationships to explain who ultimately is giving services to the 401(k) plan, and who is collecting rents as “gatekeepers” for the plan.

There is a lot to be done here.? Would that the DOL would invest a little money in buying skeptical experts, and really grasp the complexity of what is going on there.

The second one is entitled Structured Notes: Not as Safe as They Seem.? When I (along with others) was taking a demo of a custodian recently, the rep of the custodian went out of his way to show the area of the website that offered structured notes.? I commented, “Those are evil. They offer yield, but they make people short expensive options.”? After an embarrassed pause, the rep said, “Let me demonstrate an area of bonds that is not evil,” and he moved onto Agencies.? I didn’t have the heart to tweak him twice.

I wrote a piece a while ago called “Yield, the Oldest Scam in the Books.”? Structured notes offer above market yield, while that yield, or some of the capital, could be negatively affected if events perceived to be unlikely would occur.? The investment banks can hedge those risks more effectively than the Structured Noteholders can, and they pocket large profits.

The concept of “contingent protection” annoys me.? The odds of triggering such protection are much higher than the average person expects.

Do not buy structured notes.? The investment banks know far more than you.? Do not buy what others want to sell you.?? Use your good mind, and buy what you like.

There is no one on Wall Street looking to do you a favor, so view your broker with skepticism.

Comment on: Was It All Just A Bad Dream? Or, Ten Lessons Not Learnt

Posted on 6 November 20109 November 2010 by David Merkel

I have the fun of speaking at the Burridge Center Conference at the University of Colorado at Boulder this week on Friday.? The CFA Society of Colorado is co-sponsoring it.? As a guide, they have asked my panel to comment on this piece? by James Montier of GMO: Was It All Just A Bad Dream? Or, Ten Lessons Not Learnt.? I’m going to comment on each of the ten questions, and show where I agree and disagree.

Lesson 1: Markets aren?t efficient.

“As I have observed previously, the Efficient Market Hypothesis (EMH) is the financial equivalent of Monty Python?s Dead Parrot. No matter how many times you point out that it is dead, believers insist it is just resting.”

I partially disagree.? The EMH is valid as a limiting concept. The markets tend toward efficiency, but there are many disturbances in the market, and some of them are quite big.

The EMH properly understood only means that it is intensely difficult to beat the market, nothing more.? Market prices reveal the current expectations of the market as a knife edge — sharp but thin.? They might be the best estimate of values for the moment, but offer no infallible guide to the future. The crisis tells us nothing about the EMH.

Lesson 2: Relative performance is a dangerous game.

Definitely true.? Those chasing relative performance tend to destabilize markets to the degree that their time horizons are short.? Focusing on short term relative performance leads to an over-emphasis on momentum, and when too many focus on momentum, the markets tend to go nuts — overshooting and falling dramatically, until enough momentum players exit.

Lesson 3: The time is never different.

It’s never different, or it’s always different — which one you choose is a matter of semantics.? The main thing to remember is that human nature never changes.? In aggregate, we don’t learn from market behavior.? We follow trends — we arrive late to the party, and leave the hangover near the nadir.

Most professionals and nonprofessionals tend to chase performance — see lesson 2.? That is a large part of the boom-bust cycle, which no amount of government intervention can repeal.

Here’s some advice: read books on economic history, and avoid current books on how to beat the market.? Learning economic history will help inoculate an investor against greed and panic, and will help the investor understand the guts of the speculation cycle.

Lesson 4: Valuation matters.

You bet it matters.? Excellent long term results stem from buying cheap, among other factors, like margin of safety, earnings quality, and having a sense of the credit cycle, and industry pricing cycles.

Bubble language such as “This time is different,” often appears near the end of booms.? The truth is: it’s never different, or, it’s always different.? Human nature in individual and aggregate, does not change.? Watching valuation is a major way of avoiding getting whipped at extremes, and encourages willingness to invest in the depths of panic.

Lesson 5: Wait for the fat pitch

Also agreed.? One thing that I have focused on in my money management ideas, is to avoid thinking short-term.? There are too many hedge funds, day traders, swing traders, and high-frequency traders out there for me to compete against.? Even mutual funds turn over their positions too rapidly.

I aim to hold investments for three years, but I am not wedded to a time period.? If an investment still looks attractive after five years, compared to the other investments that I hold, I will keep it.? If I find a more? attractive investment than my median idea, I will buy it, and fund it with the proceeds from one of my investments scoring worse than my median idea.

Lesson 6: Sentiment Matters

Yes, sentiment matters, at least until too many people follow it.? I do this in an informal way by following the credit cycle — when risky yields are tight, only own safe stocks.? Volatile stocks rely on sentiment — it is almost a tautology.

Lesson 7: Leverage can’t make a bad investment good, but it can make a good investment bad!

Any investment can be overlevered, and die.? Think of Fannie and Freddie.? They ran on thin capital bases for years, thinking that they could never lose.? So long as housing prices continued to rise, they were right.? And for many, the idea of housing prices falling in aggregate was ridiculous.? Those who suggested that it would happen, like me, were roundly derided.

Yes, leverage can make a good investment bad.

Lesson 8: Over-quantification hides a real risk.

Just because you can quantify it does not mean you understand it.? The Society of Actuaries has a vapid motto quoting John Ruskin: The work of science is to substitute facts for appearances and demonstrations for impressions. Easy to say; hard to do.? Scientists are biased? like everyone else.

Mathematics applied to economics or finance serves to show where assumptions are inaccurate.? Mathematical risk controls are less important than changing the culture of a firm, and setting in place checks and balances.? Toss out VAR, and reduce incentives that would motivate people to take inordinate risks — instead, hire idealists that love the work because they would do it even if they weren’t paid.? That’s how I feel about investing; I just love the game, and wouldn’t want to do anything else.

Lesson 9: Macro matters.

Much as I admire Marty Whitman (and Peter Lynch), I am with Montier and Graham regarding the value of Macro.? Whitman, Pzena, Miller and some others rightfully got their heads handed to them when they neglected the key doctrine of value investing , which is “margin of safety.”? Most of my great mistakes have come from similar neglect.

Particularly when times are unusual, macro factors drive stocks.? But, how well can we predict that?? I’ve done okay over the years, but I am skeptical on being able to do that all of the time.

Lesson 10: Look for sources of cheap insurance.

Again, easy to say, hard to do.? I would like an infinite stream of patsies to soften the blow if I make bad decisions.? In the middle of the 2000s, I felt that shorting credit was nearly a free option, but will there always be bulls making stupid decisions during the bull phase of the market?

On second thought, yes, that should always be true, so where you find cheap insurance, like CDS 2003-2007, buy it.

-==–==-=-=-=-=–=-==-=–==-=-=-

So, after all that, aside from point one, I agree with Montier almost entirely.? What a great article he wrote, and what a great article to stimulate the panel that I am on.

The Rules, Part XX

Posted on 26 October 2010 by David Merkel

In the end, economic systems work, and judicial systems modify to accommodate that.? The only exception to that is when a culture is dying.

I have been scratching my head over all the problems in the residential mortgage market.? How can foreclosure take place, when there is no note, properly endorsed, to display?? How can certificate holders of securitizations be comfortable when the transfer of ownership interests in mortgages was never completed.

But, I’m not all that worried.? In one sense, the bigger the problem, the easier it is to solve.? Why?? Because the political systems that surround the economic systems tend to focus better on big problems than little problems.

As in Cordwainer Smith’s “The Instrumentality of Man,” the first priority of any government is to survive.? This is one reason why it is easier for them to survive large crises than small problems.? That’s why I give Rudy Giuliani relatively little credit for what he did on 9/11, but give him more credit for what he dealt with on budget issues.

In large crises, the range of options becomes limited.? Also, it becomes easier to see which option is the best one.

So, given the systematic and severe errors that occurred in residential mortgage securitization, shouldn’t there be an obvious answer to what must be done now?? Yes, but a solution here will take time.? Banks will have to make the effort to secure the notes that allow them to foreclose.? And then, they will foreclose.? Will that mean a lot of upset for the residential property market in the short run?? Yes.? Will the residential property market survive this?? Yes.

Foreclosures will take place.? But the legal niceties that protect our property rights in other areas must be observed by the banks.? Courts should not give in to pressure that they must do something to preserve the proper functioning of the market.? Yo, courts.? The markets will survive even if you delay.? Take your time and do it right. Yo, lenders; delay is the price for not having done it right in the first place.

As for the securitization certificateholders, let me remind you of the investment banks and AIG.? AIG absorbed subprime mortgage risk from all of the investment banks.? The investment banks thought they were pretty clever, until they realized that they all had taken advantage of AIG, and thus, AIG might not be able to make good on all the risks that they had absorbed.

In the same way, if all residential mortgage-backed securitizations are unwound at the same time, the sponsors of the mortgage-backed securitizations will not be able to make good on their obligations.

As I see it, residential mortgage-backed certificate holders have an incentive to work with the sponsors to see how this crisis can be worked through.? And as I see it, perhaps the solution is to pay a consent fee to the certificate holders in exchange for waiving their rights to sue over the malfeasance of not transferring the notes from the originator all the way to the trust.

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

As with other crises, the probability of total failure is remote.? Total failure only occurs when those at the top of the power structure are so self consumed that they do not see the threat to their lives.

That’s why I see a slow but reasonable solution coming through the court system to solve the malfeasance engendered through the sloppy execution of securitizations.? Yes, things are bad.? Yes, our current politicians are clueless.? But there is enough interest in coming to a solution for society as a whole that an equitable solution will be arrived at in the courts ? not through Congress, not through the President.

That doesn’t mean that things won’t be choppy and messy.? Indeed, there will be many ugly times en route to a solution.? But things are not so bad in our judicial systems, as a whole, that we will not come to the correct solution, after exhausting all imaginable alternatives.

Twenty Answers from the Author of Risk and the Smart Investor

Posted on 25 September 2010 by David Merkel

A little bit ago, I published Twenty Questions for the Author of Risk and the Smart Investor.? Well, David X. Martin got back to me, and here are his thoughtful answers.? I will have more commentary on this as I write the book review, which I am doing immediately after posting this.

1. Q: Imagine you are talking to a bright 12-year old girl.? How would you explain to her why and how the financial crisis happened?

A: Think of what happens when you blow up a balloon. First it expands, but eventually, if you continue to add more and more air, it bursts. The air going into the balloon in the years leading up to the recent financial crisis was either ?borrowed? air, that is air that was bought on credit, or air that was highly leveraged. In other words, only a small part of the air was paid for, and the rest was borrowed. And when the balloon burst most of those that had borrowed air, or had lent air to others, were left with nothing.

2. Q: I was fascinated with the structure of your book, which I found tedious and hokey at first, but I grew to like it.? The way I see it, you introduce the topic through your experience, then explain the theory, then show neglect of it led to failure, and then you give us the stories of Max and Rob.? How did you hit upon this intriguing and novel way to write your book?

A: I first thought about the decision process, and described the continuous process of risk management in relatively simple steps?i.e., assessment (know where you are and what you do not know); rules of the game (know your risk appetite, transparency, diversification, checks and balances); decision-making (alternatives, responsibilities, reputation and time frame); and finally, reevaluation (monitor and learn from your mistakes ). My goal was not to write a “how to book” but rather to help readers build frameworks?to make good decisions, and it seemed it would be helpful, and entertaining, I hoped, to see the process in action through the fictional risk story.

3. Q: Why do you suppose so few people in risk management, and senior management at major financial firms, were unwilling to consider alternative views of the sustainability of the risks being taken as the risks got larger and larger relative to the equity of individual companies, the industry as a whole, and the economy as a whole?

A: People get lulled into seeing the world from a particular viewpoint, particularly if they have never been through the worse case scenario. I?ve been through many of them.

4. Q: As a risk manager, bosses would sometimes get frustrated with me when they wanted a simple answer to a complex question that had significant riskiness.?They did not like answers like, ?I don?t know, it could have six significant effects on our company.?? How can we convey the limits of our knowledge in a way that management can get the true uncertainty and riskiness of the environment that we work in?? How can we get management to consider scenarios that are reasonable, and could harm the company, but few others in similar situations are testing for?

A: Scenarios are a great way of thinking about the future in terms of the realm of possible outcomes. Thinking now about what you can/should be doing about those possible outcomes, is an excellent way to communicate risk potential to management. and engage their interest.

5. Q: In your experience, how good are the managements of financial companies at establishing their risk tolerances?? Better, how good are they at enforcing those limits, such that they are never exceeded?

A: Not very good. Businesses have strategies, strategies entail risks, and risks require capital. Very few companies take a holistic view of risk, capital, and strategy.

6. Q: How do you create a transparent risk culture in a firm?? How do you get resisters to go along, even if it is management that does not see the full importance of the concept?

A: Cultures do not change rapidly, they migrate. Transparency starts at the top and it will never spread through a company if management doesn?t recognize its importance, and communicate its importance to everyone in the firm.

7. Q: Are most cases where a person or a company fails to diversify intentional or unintentional?? Do we put too many eggs in one basket more out of ignorance or greed?

A: Diversification is a strategy that requires discipline. Take the case where you start with a diversified portfolio, and then one position takes off and acquires a disproportionate weight in your portfolio. Regardless whether the cause is ignorance (you did not monitor your portfolio?s balance) or greed (you rode the stock up ), the root problem is a lack of discipline.

8. Q: Why do you suppose that checks and balances for risk management are not built into the cultures of many financial companies?

A: When does a problem exist? Even if it has always been there, it comes into existence only when you recognize that it is a problem. Many times checks and balances do not exist because no one recognizes the risk/problem and therefore no one evaluates the checks, and balances, and controls needed to manage it.

9. Q: I have a friend Pat Lewis who developed a risk management system for Bear that could have prevented the failure of the firm, but it was ignored because it got in the way of profit center manager goals.? Was it the same for you at Citigroup when your ?Windows on Risk? got tossed out the window?

A: See pages 124-5 in my book. You never have to ask a portfolio manager what he or she thinks, just look at their portfolio. When I found out Citibank was no longer using Windows on Risk I sold my entire position that day. I recall it was at $51.75.

10. Q: Can culture and personal judgment work in risk management ever?? Take Berkshire Hathaway ? risk control is embedded in the characters of a few people, notably Warren Buffett and Charlie Munger.?If the culture is really, really good, and it comes from the top, can risk management work when it is seemingly informal?? (Remember, you don?t want to disappoint Warren.)

A: Risk management is all about culture and personal judgment. I remember pondering the question, “How high is up” at a Windows on Risk meeting at Citibank. The most senior management were sitting around the table. We came to our answer by asking the following question: What was the amount of loss we would be embarrassed to read about in the WSJ? That number, it turned out, was not very high, at least in the judgment of the people sitting around that table. News of that decision got around and had an impact on the company culture.

11. Q: How can you teach younger people in risk management intuition about risk that helps them have a healthy skepticism for the results of impressive complex modeling?

A: I co-wrote an article with Mike Powers from the London School of Economics titled “The End of Enterprise Risk Management.? Models are just one input; they are not a substitute for good judgment.

12. Q: Is it possible to do effective risk management in a financial firm if management is less than wholeheartedly committed to the goal?

A: I forgot where I first heard the expression, but it explains my feelings. “A fish starts to stink from its head first.?

13. Q: Aside from AIG, and other financial insurers, the insurance industry came through the crisis better than the banks because they focused on longer-term stress tests, and not on short-term measures like VAR.? Should the banking industry imitate the insurance industry, and focus on longer-term measures of risk, or continue to rely on VAR?

A: VaR is one measure. It has deficiencies. For example, the loss amounts predicted in the tails (that is, the extreme cases) are the best case scenarios, not the worse case. Institutionalizing this one measure, or relying on the measurement of “risk based capital,” has not worked.

14. Q: Seemingly the big complex banks did not analyze their liquidity risk, particularly with repo lines.? Why did they miss such an obvious area of risk management?

A: Liquidity is a very difficult concept. If you decide to sell your house in the suburbs at 2AM in the morning and put a “for sale” sign on your lawn at that hour, how quickly do you think it will sell. Liquidity, therefore, has to be thought of in terms of time. If, for instance, you see high average daily volume in a stock what is your real liquidity if the volume is the result of a nano second of high speed trading?.

15. Q: How much can risk management be shaped in financial firms by the compensation incentives that employees and managers receive?

I saw Walter Wriston six months before he died. He asked me how things were going. I said, nothing wrong with risk as long as you manage it. He smiled at me from ear to ear because those were his words, from his book Risk and other Four Letter Words. I think it is all about matching responsibility and authority, having the right culture, learning from errors, and promoting ethics. Incentives are on the list, but not at the top.

16. Q: I have often turned down shady deals in business, saying that you only get one reputation in this world.? How do you encourage an attitude like this in financial firms among staff?

A: If you go to sleep in s–t, you will most likely wake up covered with flies. I would start with an ethics committee, and make sure the most important people in the firm were on it.

17. Q: A lot of portfolio management and risk management is juggling different time frames.? Is there a good structure for balancing the demands of the short-, intermediate-, and long-terms?

A: A poor investment decision is still the same poor investment decision irrespective of the time frame. If you always try to do the right thing, time frames become less important.

I am not saying to forget about the timeframe, just that you shouldn?t let it lead you to a poor decision.

18. Q: Most developed country economic players assume that wars will have no impact on their portfolios.? Same for famine, plague, or environmental degradation.? What can you do to get investors to think about the broader risks that could materially harm their well-being?

A: Great question, but this one is outside my realm of expertise.

19. Q: Are Rob?s more common in the world than Max?s? That?s my experience; what do you think?

A: I purposely made Rob and Max pretty different in order to illustrate the principles in the book. I think we are all human and have a little bit of each.

20. Q: At the end of your book, one of your friends dies.? Did you mean to teach us that even if we manage our risks right, we still can?t overcome problems beyond our scope, or were you trying to say something else, like creating a system or family that can perform well after you die?

A: My first draft of the book began with what is now the concluding chapter?the one in which I discuss the courage necessary to face death. The developmental editor at McGraw-Hill, of course, didn?t like it up front, so I moved it to the end, where I wrote: ?It is at that moment, when death is imminent, and there is no possibility of escape, that courage comes into the picture.?

My view is that this mindset can be useful long before we consider our mortality, by helping us understand that there are realities that must be faced and not avoided. In investing as in life, long term success results from thoughtful, timely preparation. Or in other words, the best decisions are made before we are forced to make them. The best decisions are made before certain inevitabilities, so long on the horizon, appear unexpectedly in front of us, and we no longer have the time to consider the alternatives; when we can still calmly and intelligently assess our circumstances, consider alternatives, and make informed decisions, monitoring the results as we go.

This is what I refer to as ?de-risking,? and although the principles set out here are drawn from my experience as a risk manager at a number of leading investment firms, they apply not only to financial matters, but to almost every decision you?ll make over the course of your life.

So to my way of thinking, ?when lightning strikes–the processes that you have put in place make courage less necessary. Put another way, if you embrace risk by following an orderly process you will have constructed a framework that will help you make the right decisions

Ten More Notes on the Current Market Scene

Posted on 24 August 2010 by David Merkel

11) I was surprised to read that there is not a perfect market in interest rate swaps.? They are so vanilla, but counterparty risk interferes.

12) There is always a skunk at the party, and who better than Baruch to dis bonds?? I half agree with him.? Half, because the momentum can’t be ignored entirely.? Half, because profit margins are wide.? But rates are low, and unless we are heading into the second great depression, stocks look cheap.? That’s the risk though.? Is this the second Great Depression? (Or the Not-so-great Depression that I have called it earlier.)

13) Housing is a mess.? The US government has been engaged in a delaying action on defaults, while calling it a rescue effort.? The sag in housing prices may lead to a recession.? The FHA is raising the costs of mortgages because their past loans have had too many losses.

14) Commercial Real Estate continues to do badly while some CMBS performs — no surprise that what is more secured does well.

15) The Fed gets whacked on its lack of transparency.? This could be a trend for the future.

16) In the current difficulties in the Eurozone, the ECB is beginning to suck in more bonds, presumably from peripheral Eurozone countries that are seeing their financing rates rise.? As central banks get creative, a simple question for currency holders becomes what backs the money?? It would seem to be governments, which will absorb losses if central banks generate them, and cover it with additional taxes or borrowing (some of which could eventually be monetized).? What a mess.

17) Bruce Krasting is almost always worth a read, and he digs up something that I had forgotten about how interest is credited on the Social Security Trust Funds.? It’s calculated this way:

The average market yield on marketable interest-bearing securities of the Federal government that are not due or callable until after 4 years from the last business day of the prior month (the day when the rate is determined). The average yield must then be rounded to the nearest eighth of 1 percent.

Krasting thinks that’s too high.? I think that is too low, given the true tradeoff that is going on here.? Think about it: when the government borrows from the SSTFs in a given year, a slice of the benefits incurred over that year don’t get “funded.”? The debt claim to back that should match the maturity profile of those future claims.? Medicare would have some short claims, Disability and Supplemental Security slightly longer, but Old Age Security develops most of the assets, and is a long claim.? Say the average person paying in is 40, and they will retire on average at 65.? That is a 25-year deferred claim that will last for maybe 20 years on average, with inflation adjustment.? The US offers no debt that is that long to back such a liability, so I would argue that the proper rate to use would be that of the longest noncallable debt offered by the Treasury.

But here would have been my second twist on this: they should have absorbed the longest marketable securities from the debt markets, and bought and held them.? That would have looked really ugly as the rates looked piddling against current interest costs.? But today, it would reflect the true costs of the borrowing from the SSTFs, and that cost would likely be greater than what was paid to the trust funds.? My guess is that the interest rate paid on the trust funds today would be higher than 5%, maybe higher than 6%, if a fair method had been used.

If there is enough interest, I could try to run the numbers, but the point is academic.? It would not change the total claims against the government plus SSTFs as a whole, but it might have changed the behavior of the government if it had tried to borrow on a long duration basis, competing for funds with private industry.? It would have revealed the true tradeoff earlier, and shown what a trouble we were heading for.

18) On retained asset accounts, this Bloomberg piece makes me say, “Yes, this is a big enough issue to deal with.”? For MetLife particularly, which has its own bank, it would be simple enough to set up a genuine bank account with all of the statutory protections involved.? If there are risks from forgery, that is big.? Even the risks of not being covered by the state guaranty funds is big enough.

My view is this: full cash payment should be the default, and a genuine bank account an option.? If you have one of these checkbooks now, and you want to minimize your risks, do this: write one check for the balance so that it is deposited in your bank account.? Simple enough.? You can protect yourself with ease here, even without legal change.

19) The yen will continue to rally until the Japanese economy screams.? Currency moves tend to last longer than we anticipate, and secular moves force needed economic changes on countries.

20) Consider what I wrote last week on long Treasuries:

I am not a Treasury bond bull, per se, but I am reluctant to short until I see real price weakness.? And some think that I am only a fundamentalist value investor.? With bonds, it is tough to catch the turning points, and tough to grasp the motivations of competitors.? Better to miss the first 10% of a move, than miss it altogether.

Now, I never expect to be right so fast, but with rates gapping lower on economic weakness — the 10-year below 2.5%, and the 30-year below 3.6%, I would simply say this: don’t fight it.? Let the momentum run.? Wait until you see a significant pullback in prices, and then short.? Don’t be a macho fool fighting forces much larger than yourself.? The markets can remain crazy for longer than you remain solvent.