Structured Products and Derivatives – Page 15

Ten Notes on the Current Market Scene

Posted on 24 August 2010 by David Merkel

1) Start with the big one from yesterday.? On of my favorite monetary heretics, Raghuram Rajan, whose excellent book I reviewed, Fault Lines, pointed out how he had gotten it right prior to the crisis, versus many at the Fed who blew it badly.? Rajan suggests that Fed Funds should be at 2-2.25%, which to me would be a neutral level for Fed Funds.? That’s a reasonable level.? The economy needs to work its way out of this crisis, even if it mean failures of enterprises relying on a low short rate.? Entities that can’t survive low positive rates that give savers something to chew on should die.? Mercilessly.? Monetary policy at present is a glorified form of stealing from savers, who deserve more for their sacrifice.

2) Peter Eavis, an old friend, echoes my points on QE, in his piece Government Clouds Value of Investments.? When the government is actively trying to destroy the willingness to hold short-term assets, and engages in QE, it makes all rational calculations on investments a farce.

3) I agree with John Hussman in a limited way.? QE artificially lowers interest rates, which lowers the forward value of the US Dollar.? That doesn’t mean it will generate a collapse; I don’t think it could do that unless the Fed began to do astounding things, like monetize a large fraction of all debt claims.

4) The US Government is so dysfunctional that the baseline budget has increased 4.4 Trillion over the next 10 years.? This is the beginning of the end of the supercycle, and the reduction of America to the influence level of Brazil.? Earnings levels will converge as well, but more slowly.

5) While we are thinking soggy, think of Japan.? Years of fiscal and monetary stimulus have availed little.? Overly low interest rates have fostered an economy satisfied? with low ROEs.? Low interest rates coddle laziness, and encourage stagnation.

6) There are limits to stimulus, whether monetary or fiscal.? There is no magic way to produce prosperity by government fiat.? Stimulus, by its nature, will run into constraints of default or inflation, if taken far enough.? If not, why doesn’t the Fed buy up all debt?? (leaving aside laws) Isn’t QE a free lunch?

7) Deflation is tough; it weighs upon cities, states and other municipalities, who hide their true obligations.

8 ) Hoisington, the best unknown bond manager.? Where do they think long rates are going?? 2% or so on the 30-year.? Makes the current buyers of bond funds look like pikers.? That’s over a 35% gain from here.? If they are right, their fame will be legendary.? Now, that could explain the willingness to fund ultra-long duration debt, because the gains will be bigger still.? What a great confusing time to be a bond investor, until something fails.

9) Or consider the Norfolk Southern 100-year bond deal yesterday.? Quoting the WSJ:

In what bankers hope will be the first in a new round of 100-year bond sales, Norfolk Southern Corp. raised $250 million Monday by selling debt that it won’t have to repay until the next century.

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Investor interest was strong enough that the company increased the size of the new sale from $100 million. Market participants said investors had expressed an interest in buying at least $75 million of the debt before the company decided to announce the $100 million deal.

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The interest rate on Norfolk Southern’s new debt is 6% for a yield of 5.95%, about 0.90 percentage points more than where the company’s outstanding 30 year debt was trading Monday. It was the lowest yield for 100-year debt bankers could recall, breaking through the 6% yield on the company’s 100-year issue in 2005.

—

“There is no question, obviously, that you are giving up a bit of liquidity, but you’re getting a pickup of 90 basis points to move out of the 30-year,” said Jeff Coil, senior portfolio manager at Legal & General Investment Management America. “But you’re getting good income on a stable cash credit in a sector where there are only a handful of rails left.”

Mr. Coil said the firm had a “sizeable” order in the deal. There were approximately 20 investors overall.

Moody’s Investors Service rated the new senior fixed-rate bonds Baa1, and both Standard & Poor’s and Fitch Ratings rated them BBB+.

Is 0.90%/year enough to compensate from going from 30 to 100 years?? I think so. The difference in interest rate sensitivity of a 30 versus a 100 are small at a yield of 5-6%, and if you have a liability structure that can handle it, as a life insurer might, it makes a lot of sense.? After all, a life insurer can’t economically invest in equities because of capital restrictions. You could compare it to investing in long dated preferred stock or junior debt, but then if there is a default, the losses are more severe than with a senior unsecured bond.

10) I’ve never found the yield curve model for recession/recovery compelling.? Limited data set, not covering the Great Depression, etc.

More to come.

Managing Illiquid Assets

Posted on 23 August 201023 August 2010 by David Merkel

Illiquidity is an underrated risk.? Most financial company failures are due to illiquidity, which usually takes the form of too many illiquid assets and liquid liabilities.? Adding to the difficulty is that it is generally difficult to price illiquid assets, because they don’t trade often.

So where do we see failures due to illiquidity?

Banks — too numerous to mention, though FDIC insurance restrains it now.
Life insurers, particularly those that write a lot of deferred annuities.
AIG and the GSEs — abominations all.
Bear and Lehman — waiving the leverage limit was one of the stupidest regulatory decisions ever.
Hedge funds – LTCM was the granddaddy of failures, but many have choked because redemptions forced liquidation of assets at unfavorable prices.
No colleges, though those college that were too aggressive on illiquid assets got whupped in 2008.? Some were forced to raise liquidity in costly ways.? Same for many overly aggressive pension plans, many of whom came late to the game with Venture Capital, Hedge Funds, Timber, Commodities, etc.

Face it.? Most alternative asset classes involve additional illiquidity.? That is an additional risk, and when evaluating those investments, the expected rate of return must be greater than that for liquid investments.

As an aside, there is another factor to be considered with alternative investments.? That factor is strategy capacity.? Alternative investments do best when they are new.? Here is my version of the phases that they go through:

New — few know about it except some business-minded investors.? Only the best deals get done.
Growing — a modest number know about it, and a tiny number of consultants.? Only very good deals get done.
Comes of age — many know about it, and most consultants pitch it to their clients as the way to go.? Good deals get done.
Maturity — almost everyone knows about it, and it is a standard aspect of asset allocation for consultants, who have their means of differentiating between different providers, based on metrics that will later be revealed to be useless.? All reasonable deals get done.
Post-maturity — Late bloomers make it to the party, and beg to get in, thinking that past is prologue, and do not realize that deal quality has eroded severely.
Failure, which brings maturity — deals fail, leading the market to scrutinize all investments, leading to true risk-based pricing.? Later adopters abandon the market, and take losses.? Earlier adopters sharpen practices, and prepare for a more normal asset class.

So, when looking at illiquid assets, how do you determine how much to invest?? First determine how much of your funding base will never leave over the next 10 years.? When I was a corporate bond manager, that was 25% of the assets that I was managing, because of structured settlements and immediate annuities.

For a pension plan or endowment, forecast needed withdrawals over the next ten years, and calculate the present value at a conservative discount rate, no higher than 1% above the ten-year Treasury yield.? Invest that much in short to intermediate bond investments.? You can invest the rest in illiquid assets, because most illiquid assets become liquid over ten years.

But after that, there is an additional way of controlling illiquidity risk — time once again for the fusion solution! Money market funds run a ladder of maturities.? Stable value funds run a longer ladder, as should commodity ETFs, rather than floating at spot.? Then there are clever advisers who run municipal and other bond ladders for wealthy and semi-wealthy clients.? Running a ladder of maturities is one of the most robust management techniques as far as interest rate risk is concerned.? There is always money coming out and in every year, which slowly leads the portfolio yield in the direction of average rates.

Now, if these bonds are less liquid muni bonds, but the credit risk is low, you don’t care as much about the illiquidity, because the ladder produces its own liquidity as bonds mature.? The key question is sizing the length of the ladder, which comes down to a question of analyzing the liquidity/income needs of the client, combined with a forecast on the secular direction of rates.? The forecast is the least important item, because it is the toughest to get right.? (An aside: who has been right on bond yields consistently for the last 20+ years?? Hoisington, my favorite deflationists.? Wish I had listened more closely.)

The same principle applies to pension funds, endowments, life insurers with a few twists.? Divide your liabilities in two.? What obligations do you know cannot be changed, except at your discretion?? That group of liabilities can have illiquid assets to fund them.? Try to match the payout streams, but if not, try to match them in broad with a ladder, keeping in mind what mismatches you will likely face over the next 1-2 years in order to properly size your cash position.

The rest of the liabilities need more intensive modeling, analyzing what could make them change.? You can try to buy assets that change along with the liabilities, but in practice that is hard to do.? (That said, there are no end of clever derivative instruments available to solve the problem in theory.? Caveat emptor.)? The assets have to be liquid for this portfolio.? Other aspects of portfolio choice will depend on valuation parameters, credit spreads, yield curve shape, market volatilities, as well as macroeconomic factors.

Three Closing Notes

1) Now, all that said, just because you can take on illiquidity doesn’t mean that you should.? A good manager has a feel from history for what the proper liquidity give up is in valuations for stocks and other risk assets, and credit spreads for fixed income assets of all sorts.

Was it worth moving from the:

Relatively liquid AAA tranche to the illiquid AA, A or BBB tranche for 0.10%, 0.20%, 0.40%/year respectively?? As a bond manager at much larger insurance company said back in 2000 — “It’s free money.”? (That is almost always a dangerous phrase.) My view was there was more illiquidity and credit risk than we could consider.
Relatively liquid large-issue BBB bank bond to the relatively illiquid small-issue BBB bank bond for 1% more in yield?? Hard to say.? There are a lot of factors involved here, and your credit analyst will have to be at the top of his game.? It also depends on where you are in the speculation cycle.
Liquid public equities to private equity or hedge funds with lockups?? Tough question.? Try to figure out what the unlevered returns are for comparative purposes.? Analyze long-term competitive advantage.? Look at current deal quality and valuation metrics.? For hedge funds, look at how credit spreads moved over their performance horizon.? Anyone can make money when spreads are tightening, but who makes money when spreads are blowing out?? Analyze them over a full credit cycle.

2) Institutions that did not previously do more liquidity analysis because we had been in near-boom conditions for decades need to at least do scenario testing to assure that they aren’t overplaying their hands, such that they might be forced to make bad decisions if liquidity gets tight.? Safety first.? (This applies to governments and industrial corporations too, as we will experience over the next three years.)

3) Finally, if you decide to make a large illiquid purchase like Mr. Buffett did last year, make triple-sure of your logic and your liquidity positioning.? Nothing lives forever, but you can prolong the life of the institutions you serve by careful reasoning and planning, particularly regarding liquidity.? Get financing when you can, not when you need it. It takes humility to do so, but it yields the quiet reward of continued existence at a modest price.

One Dozen Comments on the Current Market Situation

Posted on 18 August 2010 by David Merkel

Here are my thoughts on the markets, in no particular order:

1) Momentum draws investors.? Long treasuries have run hard, and people like them now.? My view is, if you want to short them, wait until they rise 0.1% more in yield, then short.? There are a lot of weak longs to shake out.

2) That said, long rates are generally falling in the developed world.? Gives a real feel of global debt deflation.

3) Not that the yen sees any problem here for now.? This makes me more bullish on the yen; few nations are willing to allow their currency to appreciate.

4) Arguments over residential mortgages. Geithner sees room for a federal role. Gross want the Feds to make mortgages full-faith-and credit obligations of the US Government.? A shameful statement from a man who built his wealth through free markets, and now looks to protect it through Socialism. John Carney is far better, though he flounders over what to do.? To me it is obvious — take Fannie and Freddie through Chapter 11 after their debt guarantees are gone, and let the market buy up the pieces.? Fannie and Freddie have lost money for the US over their existence; they have served no useful function, any more than some misbegotten tax incentive might have done.? And, as Kid Dynamite has put it, “The problem is that home prices are too high.? We need more deflation, and more debt reduction.

5) Physics is the wrong analogy for economics.? Ecology is the right analogy.? Like ecologies, economies resist prediction and control.? People adapt, inanimate objects don’t.? So you might enjoy these articles from FT Alphaville and Bookstaber.

6) As I commented today on Twitter: “Get ready for the bookstore massacre http://bit.ly/cywtPT $BKS fiddles with its capital structure, while it gets outcompeted by $AMZN.”? I mean it.? The problems of Barnes & Noble are organic problems of competing against Amazon and losing.? Who controls B&N is less important than what strategy they take from here.? It is a lousy time for B&N to be consumed with a noneconomic issue, when they are getting killed.? And forget BGP… they are dead too.

7) Matthew Lynn hits the nail on the head.? Additional debt does not promote recovery.? If true in Europe, then true here as well.

8 ) The Dallas Fed questions whether we can stimulate our way to prosperity.? My answer: the more we place the decision in the hands of individuals the better the decisions will be.? We know what we need better than the government does.

9) Did we misunderstand the Fed’s recent FOMC non-action?? I don’t think we did , but Federal Reserve Bank of Minneapolis President Narayana Kocherlakota thinks that we did.? I think he has to understand the markets better — we work off of changes in expectations.? We expected the Fed to do nothing again.? Now that you are buying in more Treasuries, we know that the economy is weak, and we buy long fixed income as protection.? At least we are front-running you.

10) Hey, another blogger summit at the Treasury, and this one has three of the originals there (but not me).? Comments from Marginal Revolution as well.? One participant told me it wasn’t worth it to be there and the Treasury was not prepared to answer questions, but who can tell?? I have an idea: let the Treasury webcast the meeting.? I know from the first meeting that neither the Treasury nor the bloggers would have been dominant.? At least it would be transparent; isn’t transparency what the Obama Administration is about? 😉

11) Cramer has ten reasons that the market won’t blow up.? Good.? I am 80% invested.? All I will say is that the rules are different when debts are being deflated.? Things don’t behave the same way as when debts are growing.

12) TIPS are in an awkward spot here.? Negative yields on the short end imply that buyers are looking for more inflation.? I might think that in the long run, but would be reluctant to bet on that over the next five years.

Book Review: Fault Lines

Posted on 31 July 201012 February 2011 by David Merkel

Raghuram Rajan made a name for himself at the Jackson Hole conference in 2005, which was a kind of send-off for the victorious Alan Greenspan.? Alas, but the paper he brought was not appreciated at the time, as it pointed to imbalances in the financial system.

He was ahead of the curve.? Thus his book on the economic crisis deserves our attention. More than most, he sees the problems in a global way, across nations and across asset classes.

His view is that for a variety of reasons, income inequality grew in the US, and in order to paper over that, the government encouraged a credit-oriented society to allow people to stretch for prosperity, hoping that the debts would not catch up with them.

It was a fool’s bargain.? Debt deceives average people.? They overestimate their ability to repay, and end up defaulting at high frequencies.

Like me, he is critical of the Fed’s monetary policy during the ’00s as being too easy.? The “Great Moderation” was a result of over-stimulus, not of sound policy.

Similarly, he faults banking regulation for being too easy, leading to private profits with public risk.

This is a well-written book from a man who was ahead of the curve.? I recommend it.

Quibbles

Where I differ with Dr. Rajan is how easy it would be to fix income inequality in the US.? He suggests a number of policies, many of which sound good, but have the Federal Government intervene in matters that they can’t handle effectively.? Persistent unemployment is a problem, but should that be handled by the Federal Government.? Far better in my opinion that it be handled informally and locally, by family and friends, that there would be more urgency, and more willingness to compromise in finding work.

Retraining is a good thing, but also not something the Federal Government does well.? One of the beauties of the US is that we have community colleges, which can retrain people at modest costs.

He also levels a decent amount of the blame at Fannie and Freddie and the Community Reinvestment Act, for making too many lousy loans.? He is correct in direction, but not likely in degree.? Yes, they were problems, but not the leading problems.

But these are mere quibbles on an otherwise excellent book.? If you want to buy the book, you can buy it here:? Fault Lines: How Hidden Fractures Still Threaten the World Economy

Who would benefit from this book

Anyone who wants a comprehensive view of the crisis would benefit from this book.? It does a fairly complete job, and is not long at ~230 pages.

Full disclosure: The publisher sent me a copy, because I met the author at a conference, and asked to receive a review copy.

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 Market Goes to the Dogs, Which Chase Their Tail Risk

Posted on 26 July 201026 July 2010 by David Merkel

I’ve read a number of articles on hedging tail risk of late.? Most of them were pretty good; I just want to add in my thoughts.

For those who haven’t read the articles, tail risk is when even safe investments get hit hard.? Those market outcomes are rare but severe, so some people look for insurance to clip their risks when everything is getting whacked.

Possibly a reasonable goal, and the best time to aim for it is when things are pretty good, because it is best to buy insurance when it is cheap to do so.

But what form should the insurance take?? I can think of three broad categories:

Assets that come into existence during the disaster.
Ready liquid assets — short-term and high quality.
Liabilities that disappear with the disaster.

The first category is the one most people think about.? What can I buy that will do well when the disaster comes?? There are two branches to that question:

Do I want my downside clipped on this trade (for a price)?
Do I want to make the bet without paying much, and I could win or lose?

In the first category are puts and buying protection via CDS, which will protect for a time, but cost money to put on the trade.? Worse, you could be right on the event, but wrong on the timing, and they end up expiring worthless.

Note: be wary of products Wall Street would like to sell you here.? Most often, they sell something mispriced to you, though it looks attractive.

But even if you are right, your counterparty/exchange? has to remain solvent in order for the trade to work.? Few factor in the cost of insolvency there.? Think of those who though they were clever laying off risk to AIG, a trade which only worked due to government intervention.

In the second category, there are assets like precious metals and long Treasury zero coupon bonds, each of which will do well in a specific crisis, but not just any crisis.? But there is also the shorting of equities and high-yield bonds, which could potentially deliver big gains, or big losses if the rally continues.

I would offer this test to anyone offering a hedge against tail risk: is it any better than puts or buying protection through CDS, or shorting equities or high yield bonds?? I would suspect in most cases the answer is no.

Then there is my preferred solution: hold cash.? Cash is unique; it can be used for anything; it can be used for almost every contingency.? Cash may offer little to nothing; it may even yield negatively, but that is the cost of security and flexibility.

Then there is the third option: offering catastrophe [cat] bonds.? Why should the guys following hurricane, quake, typhoons, and European windstorms have all of the fun?? There are more and bigger disasters than those in the financial markets.

In simple terms, here’s how a cat bond works: after a disaster that meets the terms of the cat bonds occurs, the principal of the bond diminishes by the size of the covered loss, if it is in excess of certain thresholds.? The advantage of an arrangement like this is that an insurer or reinsurer can get reinsurance against a disaster, by issuing a high-yielding cat bond.

The high-yield investors are happy to buy it because typically cat bonds are highly rated, and offer a good return that is uncorrelated with the returns on other high yield bonds.? Physical disasters seem to happen independently from financial market disasters.

The bond issuer gets reinsurance capacity, which is sometimes scarce, at a price that reinsurers would not match.? Cat bonds can never replace reinsurers, though, because the reinsurers offer more tailored coverages, while cat bonds tend to be more broad-brush.? They are usually cross-hedges for the issuer, covering something that is likely to be highly correlated with their loss exposure in a disaster.

What Might be a New Idea

What if we applied the concept of a cat bond to hedging risky security portfolios?? Think of it as an odd sort of margin account.? A hedge fund borrows money via a special purpose vehicle [SPV], which holds high quality collateral.? The hedge fund pays the SPV for insurance coverage; the SPV pays interest to the cat bond investors.? If a loss event happens, say a large decline in the S&P 500 index below a stated level, the principal of the cat bond is written down, and the SPV pays the amount of the writedown to the hedge fund.

Compared to a cat bond based on a physical event, there is one advantage and one disadvantage.? The disadvantage is that the loss trigger on a financial cat bond is highly correlated with bad high yield bond market performance, eliminating a lot of the diversification advantage.? This would mean that a financial cat bond would have to pay a higher premium than a physical cat bond.

There is an advantage, though: it can be hard to set up a large hedge without disrupting the market, and it is difficult to gain protection over long periods of time.? Most hedging instruments are short dated, and limited in the amount of capacity available for laying off risk.

Would this be attractive to a large hedge fund?? I’m not sure.? This sort of protection has the same sort of drip, drip, drip of cash out that most managers hate to see, whether for writing puts or buying protection via CDS.? It would come down to a question of cost versus a locked-in solution that could last for ten years, with little to no counterparty risk.

Conclusion

But personally, my best solution is lower your leverage and hold some cash.? Nothing beats the flexibility and simplicity of cash in a disaster.? Cash is also an index of humility; we are willing to leave something to the side in case we are wrong.? Being wrong is a normal state of affairs in investing, so take time to prepare for the next time you will be wrong.

Book Review: Fortune’s Formula

Posted on 17 July 2010 by David Merkel

When I reviewed the book Priceless, I thought I had reviewed “Fortune’s Formula,” because I had written several pieces on the Kelly Criterion at the blog and at RealMoney (free at TSCM).? But I found that I had not, so I offer you this review of a book I greatly enjoyed:

The book asks a simple question: in making a bet, investment, or business decision, what is the optimal amount of capital to allocate?

But the author, William Poundstone, is not going to give you the answer immediately.? He is going to take you on a journey where you can meet many odd personalities from the ’50s to the early ’00s, and how they came to look at the problem.

Ed Thorp was fascinated with Blackjack, and originated card-counting to improve the probability of winning, to what the card counter had and edge versus the casino.?? He meets John Kelly, Jr. while working together at Bell Labs on Information Theory.? He discovered that an economic actor with an edge could size his bets as a ratio of his edge in? betting divided by the odds received on the bet.

Thorp eventually published a paper, “Fortune’s Formula: A Winning Strategy for Blackjack,” which led to a torrent of interest from gamblers.? With the aid of several backers, Thorp tried out the methods with some success in Reno, with two wealthy gamblers as backers.? That tale was hairy, to say the least, but they more than doubled their money.

Thorp later applied himself to the sleepy market for stock warrants in the 1960s. He developed delta-hedging along with a colleague.? As the book progresses, gambling ceases to be the focus, and advanced strategies for making money on Wall Street with little risk becomes the rule.? And, as in Vegas, as they took steps to lessen the edge in blackjack, on Wall Street competition itself eroded the edge.? But Thorp set up a hedge fund to take advantage of securities mispricing.

One odd sidelight is the number of parties that came up with the option pricing formula known as Black-Scholes, long before B-S wrote their paper.? Life reinsurance actuaries had a version of it in the ’60s, Bachelier had a version of it around 1900. And there were others, but the point was that no one took advantage of the knowledge, except in rough ways, prior to the B-S paper.

Yet option theory could be applied to a wide number of situations, convertible bonds and preferred stocks, even corporate bonds themselves, in addition to warrants and options.? Those that did it early made a lot of money.

A more generalized version of the Kelly Criterion says to focus on the choice that offers the highest geometric mean return.? This led to a conflict with academic economists who insisted the optimal strategy was derived from utility maximization.? What is not disputable is that the Geometric mean will maximize terminal wealth, a result found by Bernoulli and Latane.

The book takes us through financial crisis after crisis, showing how bet sizes were too large relative to the results.? It also takes us to the end where a number of the protagonists end up decidedly wealthy from their attempts to beat the market.

Quibbles

Though Poundstone’s aim is the Kelly Criterion, more of the book is dedicated to finding edges, whether beating the dealer in blackjack, or arbitrage of securities.

If you want to buy the book, you can buy it here:? Fortune’s Formula: The Untold Story of the Scientific Betting System That Beat the Casinos and Wall Street

Who would benefit from this book

Many people would enjoy this book, written in 2005.? Poundstone tells a good story and illustrates how a number of clever men found edges, pursued them, and triumphed.? The reader may not be able to beat the world after reading this, but it may teach him about how bright men found ways to pursue their advantages.

Full disclosure: I bought my copy with my own money.

Book Review: Complicit

Posted on 15 July 201010 December 2010 by David Merkel

I am not sure how many current economic crisis books I have reviewed.? I think I am getting close to a dozen and I am currently reading “Fault Lines.”? I’m not sure I want to do many more crisis book reviews.? Tonight’s review is Complicit, by Mark Gilbert of Bloomberg.

Bloomberg columnists are typically good writers, with detailed knowledge of their subject areas, and a no-nonsense approach to writing.? This book from Mark Gilbert is no different.? As Joe Friday often said, “All we want are the facts, ma’am.”

And for the most part, that’s what you get in Complicit.? It is not a long book at 173 pages, but it comprehensively chronicles the growth in leverage, and how it spread to many areas of the investment markets.

When bubbles grow, everyone is a friend.? Underwriting becomes lax, limits are stretchable, FICO scores are pessimistic approximations, etc.? Risk is transitory; we originate to sell.? Regulators don’t want to stand in the way of seeming prosperity.? Nor do politicians.

Leverage gets higher in explicit and implicit ways.? Credit spreads get tight as a drum.? It is a virtuous cycle… until it become a vicious cycle.

In the bust, credit spreads rise, cutting off the possibility of refinancing.? Then asset defaults come, and GSE and bank insolvencies.

Central banks did not view inflation broadly enough, focusing on goods price inflation, and ignoring the asset inflation that was distorting the economy.? They disclaimed an ability to see, much less deal with bubbles.

The high yield market became a frenzy for yield, with CDO equity bidding for lousy bonds and default protection on lousy corporations.? Debt spreads tightened to levels that indicated perfection had arrived.

Investors chased risk, seeking returns.? There were too many parties willing to make fixed commitments, because they needed to earn a lot.? Balance sheets were ignored, and income statements were everything.? History being bunk, was thrown out the window, because it was different this time, we were in a new era.

The crash in Shanghai was the first warning in February 2007, followed by the equity quant crisis in August 2007, and the breakdown in the money markets.? All of the clever ways parties used to lever up short-term credit blew up, forcing banks to take credit back onto their balance sheets.? At that point, everyone should have dumped the banks, but few did; leverage was too high, and asset prices were falling.

The critical decision was bailing out Bear Stearns.? I agree with Gilbert; either both Lehman and Bear should have been bailed out or neither.? I think not bailing Bear and Lehman out would have led to the best outcome.? After Bear failed, other banks would have moved to straighten themselves out.? We might not have had as much failure had as we eventually did. The inconsistency of regulation, as well as the unwillingness or regulators to be tough added to the crisis.

The book covers the September 2008 climax well, but takes us past that, offering possible solutions.? I particularly liked the ideas of limiting the number of academics in important regulatory posts, and having more regulators with practical experience.? I also liked central bankers being proactive on bubbles, and the asset/liability matching inherent in paying those that make long term decisions with financial instruments that last for the term of the decision, and are contingent on the credit quality of that decision.? An example would be paying securitization originators with pieces of the subordinated tranches.

I liked the book; for those with limited time, the book is particularly suitable, because it is brief.

Quibbles

Gilbert’s style is hard-hitting; though many financial companies took advantage of government largesse, few practically considered the possibility of bailouts while the boom was going on; they were pursuing profit with little thought of systemic risk. There was a lot of greed, but in my opinion, few expected bailouts, but took them when they were offered.

Who would benefit from this book?

Most people would benefit from this book on the crisis.? The book is available here: Complicit: How Greed and Collusion Made the Credit Crisis Unstoppable (Bloomberg)

Full disclosure: The publishers sent me copies of these books, hoping that I would review them.? I review about 80% of the books that get sent to me.

Why Are We The Lucky Ones?

Posted on 2 July 20102 July 2010 by David Merkel

Working as the only analyst in a small broker dealer means you occasionally get some interesting projects.? There are many hucksters out there, and if they drop by your bitty broker-dealer to run their deal, skepticism, not hope, is the proper reaction.? ?Why are we the lucky ones?? should be the skeptical question.

Anyway, here are three responses that I gave to my bosses over a four month period on deals that were brought to them.? Names have been obscured where possible.

Project 1

This was a deal that attempted to securitize life settlements, i.e. life insurance policies where the owner has sold off his interests to a third party.? The biggest problem was all of the money sucked out of the deal that would not be invested to earn a return.? Here is what I wrote:

Dear Boss,

Notes on the deal

I have read the Overview and the Private Placement Memorandum [PPM], and have scanned everything else.? Here are the main points:

1. The key page of the entire document is page 18 of the PPM.? In it we learn: the zeros get a 4.07% return, but the collateral has to earn 11.72% net of fees in order to make this deal pay off.? Also, 65.52% of the proceeds go to other than investment purposes.? Why so large?? (As an aside, this yield is at a discount to Treasuries.? An equivalent length treasury zero yields 4.55%, AAA Aid to Israel – ~5%.)
2. The continuing fees are hefty – Servicing 1%/year of Face?? Origination – 1%/month of the Matured Policy Increase Amount [MPIA – essentially a measure of cash flow profitability]?? Administrative expenses as well to third parties.? I can’t tell how big those are, or how much the collateral would have to earn to make the bond pay off.
3. The residual value guarantor, AAACO, is not in good shape.? The central bank of CN has taken over the assets and liabilities for now, but it does not seem that they have guaranteed the liabilities permanently. They are rated “B” by AM Best – not a sound rating.? On taking over the group that owned AAACO, S&P said that it was a big enough rescue that they might have to downgrade CN from its A rating.? They have since reaffirmed the rating as stable, but Moody’s now rates CN as Baa1.
4. The residual value policy doesn’t do much if there is a modest deviation from perfect performance by the originator or servicer, the policy won’t pay.
5. We don’t have all of the documents, such as the Blocked Account Control Agreement.? But beyond documents, we don’t have any sort of cash flow analysis.? How are they going to earn so much on so little invested capital?
6. We don’t have any data on the life policies, insurers, etc.? Some insurers fight life settlements.
7. The Overview dramatically oversells the virtues of the deal.? Many of the things it lists as protections are weak.? Points 3 and 5 are the same points, but it makes them sound different.? Further, CN do not own AAACO, they have it in a form of semi-receivership.? If they did own it, AM Best would give it a better rating.
8. BBB is the actuary, but she owns the originator and the servicer. [Origco & Servco]? She is not bound to continue with the deal till maturity if it gets originated (she will be 75 herself then).
9. Servco and Origco have defaulted on prior deals, and they weren’t able to get enough interest on the first deal to make it work.
10. Origco is basically broke.? They have assets of $500K, and liabilities of $2 million.? The assets are receivables from Servco.? Servco owes $16 million that it can’t pay off either.
11. Origco and Servco do not use accrual accounting.? They could not pass a GAAP audit.? Even with accrual accounting, they would not be a going concern.
12. Origco and Servco have existing default judgments against them, and no way to pay them.
13. If Servco or Origco default, the residual value policy does not pay.
14. Servco and Origco have no significant staff.? If this gets originated, there will be a significant risk as they staff up.?? They also don’t have licenses.? This is not a bond, it is seed stage venture capital.
15. They have had run-ins with the SEC, Texas Securities Commission, and Securities Division of North Carolina.
16. The notes are deemed equity for tax purposes, which seems aggressive to me.

If you want, read page 18, and scan the risk factors section of the PPM (pages 19-57).? It is my belief that this is something that we don’t want to get mixed up with, at any price.? I can understand why no underwriter wants to take this on, and why they are looking to smaller broker-dealers.? But if you want to look into this further, have them forward to me their cash flow analyses.? I can’t imagine how they get this to work.

I have this phrase that I use sometimes, “Holding my nose as I hit the delete key.”? That is when something smells so bad, the odor can even travel over the Internet.? This feels like the attempt of some desperate people who are deeply in debt, and need one “grand slam” to bail themselves out of debt
and have a happy retirement.

Postscript: this deal not only did not get done, but the boss apologized for bringing it to me.

Project 2

This was a case where someone was willing to offer us $5 million in capital if we gave them $1 million.? What an altruist!? Not.? Yes, the value of shares if you could sell them all at the ?last trade? was worth $5 million, but the company was basically a warrant on the success of a technology, and the balance sheet was horrendous.? This is what I wrote:

Dear Boss,

This doesn’t smell good.? Here’s my commentary, together with excerpts from their recent 10-K and 10-Q:

$6250 Stock Trading Volume per day

Negative earnings, cash flow, and net worth.? Little to no liquidity ? huge negative net working capital.

1-100 reverse split

Auditors comment for 2008 10K: The accompanying consolidated financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 11 to the consolidated financial statements, the Company has a significant working capital deficit, has recognized significant operating losses in each of the years in the three year period ended December 31, 2008, and will need significant amounts of investment funds to fully develop its oil and gas leases. Management’s plans in regard to these matters are described in Note 11. The financial statements do not include any adjustments that might result from the outcome of this uncertainty.

The Company currently has three full-time employees.

Risk factor: The Company has incurred net operating losses since 1997. However, the Company currently has operations that provide working capital. The Company is also seeking further project based financing to develop its existing projects. There is no assurance that the Company will be able to secure adequate financing to fund those operations.

High compensation to management for not much of a company.? $5 million in 2008.

The Company failed to timely file a current report on Form 8-K upon the occurrence of the Default Notice and Acceleration Notice under the Credit Agreement with CCC, and the July 22, 2008 Limited Forbearance Agreement pursuant to which Gas Rock agreed to refrain from pursuing remedies for a limited time.

NOTE 7 – Note Payable – CCC CAPITAL LLC

The Company entered into an advancing term credit agreement for $30,000,000 on April 13, 2006 through its subsidiary DDDa, LLC with CCC Capital, LLC to fund the purchase of the EEE Field in GGG Oklahoma. This agreement was increased to $50,000,000 on April 2, 2007. The balance at December 31, 2008 was $13,423,221, net of debt discount of $41,077, and the Company paid interest of $1,957,294 for the year ended December 31, 2008. The note is secured by all of DDDa’s assets and certain personal assets owned by EEE, CEO of the Company. DDDa’s assets are cross-collateralized on a $3,469,000 loan made by CCC Capital, LLC to FFF, a related party. This loan is currently in default, with interest only payments being made.

On April 9, 2008, CCC delivered to the Company a Notice of Events of Default and Unmatured Events of Default (“Default Notice”) under the Credit Agreement. Due to these claimed Events of Default, interest under the Credit Agreement began accruing at the Default Rate of 15% and 100% of DDD’s Net Revenues were applied to Debt Service and other Obligations as of April 9, 2008. On April 16, 2008, CCC delivered to the Company a Notice of Acceleration (“Acceleration Notice”) under the Notes due to the continuing claimed Events of Default under the Credit Agreement. The Acceleration Notice declared the amounts due under the Note to be accelerated and due and owing in full as of April 16, 2008.

On July 22, 2008, CCC, DDDa and FFF (“FFF”, and together with DDDa, the “Borrowers”), entered into that certain Limited Forbearance Agreement, pursuant to which CCC agreed, subject to the terms thereof, to forbear from pursuing remedies under the Credit Agreement and Notes in respect of the Events of Default claimed as of that same date until the earlier of (i) November 15, 2008 and (ii) the date that CCC gives DDDa notice of any additional payment default under the Credit Agreement. FFF is controlled by the Company’s CEO and is a guarantor of the DDDa Obligations under the Credit Agreement. CCC is also a lender to FFF under an Advancing Term Credit Agreement (the “FFF Credit Agreement”, and together with the Credit Agreement, the “Credit Agreements”.

The Forbearance is subject to the following conditions to be fulfilled:

1) On or before November 15, 2008, (i) the Borrowers must repay all Obligations (as defined in the Credit Agreements) or (ii) DDD must have entered an agreement for the full or partial sale of the EEE Field, the proceeds of which would fully repay the Obligations owing under the Credit Agreements, and such sale shall close and repayment of the Obligations shall be made by December 31, 2008;

2) If the Obligations are not repaid by November 15, 2008, DDD must assign a 5.0% net profits interest in the EEE Field to CCC, effective as of November 1, 2008. The form of this assignment and the potential assignments discussed in paragraph 3, below, will be substantially in the form of the Conveyance of Net Profits Overriding Royalty Interests, attached as Exhibit A to the Forbearance Agreement;

3) If the Obligations are not repaid by December 15, 2008, DDD must assign an additional 1.0% net profits interest in the EEE Field to CCC, effective as of December 1, 2008, and will assign to CCC an additional 1.0% net profits interest each subsequent month if the Obligations are not repaid by the 15th of such month;

4) DDD shall escrow one 5% net profits interest conveyance and five 1% net profits interest conveyances to ensure it’s delivery of any potential obligations under paragraphs 2 and 3, above;

5) Any and all Net Proceeds (as defined in the Forbearance Agreement) from any equity issuance, refinancing, or asset sale will be applied first to outstanding fees and expenses of CCC, second to the accrued and unpaid interest on the Notes, and third to the outstanding principal balances on the Notes; and

6) The Borrowers must ensure that its hydrocarbon purchasers make payments relating to any of CCC’s overriding royalty interests in the EEE Field directly to CCC.

NOTE 11 – Going Concern

The Company has reported operating losses aggregating $9,877,016 for the two (2) year period ended December 31, 2008. At December 31, 2008, the consolidated balance sheet reported a working capital deficit of $23,887,172. The Company must raise significant amounts of cash to pay its current liabilities and to provide investment funds to continue development of its oil and gas leases. There can be no assurance the Company’s management will be able to secure funding.

David here: There is little assurance that an immature development stage company like this will ever be worth anything.? I am no expert on hydrocarbons but this company is overindebted, and it is likely that debtholders will own the assets within a year or two, and equityholders get nothing.

DDD shares would not, not, not be an asset to our firm.

Postscript: 6 months later, the stock worth $5 million is worth $300,000.? And will be worth zero soon.

Project 3

Another life settlements securitization.? The originator seems to be honest, but is using the securitization to get a cheap commercial mortgage loan.? What I wrote:

Dear Boss,

I’ve read through the whole document.? Here are my thoughts:

Summary Notes

The officers of the company have no experience at all with life settlements.? They do have some experience with multifamily housing.? They are using a life settlements securitization to facilitate loans for their multifaqmily housing expansion plans.? To me, that is pretty convoluted.? Why not simply go out and borrow the money?

I realize the offering memorandum is preliminary, but there are several things that need to be clarified:

Need to see the financials of the GGG enterprises
Correct address for their website.
Who is HHH Capital Management?? Can’t find them –?the portfolio managers.
Need fees, policy data, and expected cash flows
What are they doing to source portfolio 2?
Need actuarial projections
Exactly what are the trusts receiving as collateral for the loans?? I need pro-forma financials on the property(ies) to be developed?
Where are the related party transactions?
If this deal is 3x overcollateralized, where does the excess money come from?? Who is the equity, and what are their motives?

That’s all for now.? Looking forward to more data.

After the response, I wrote:

Dear Boss,

I realize the offering memorandum is preliminary, but there are several things that need to be clarified:

I have three tentative conclusions (with questions):

1.????? The largest asset is a 9 year fully amortizing 2.7% loan on the $40,000,000 to the sponsoring company.? It is a hidden source of profit to them, but the full amortization makes the loan more secure, it they can make the first few payments.? That said, they would need 12% cash flow on the loan to make the payment, and where will they get that?

2.????? The deal would need a 6.1% return on the Life policies to get a Treasury yield on the certificates.? 8.0% return to get T+100.? 15.75% to get T+500.? What would it take to sell these notes?

3.????? There is a low probability of full payment of principal.? A margin of $25 million on a $250 million principal payment is skimpy, and in my opinion, decidedly not investment grade.? I assume these aren?t going to be rated, right?

And I have additional data needs:

4.????? Who is HHH Capital Management?? It looks like a new firm ? do they have the ability to do their part?

5.????? I need fees, policy data, and more detailed expected cash flows. Where is Appendix B?

6.????? How were the life expectancies calculated?? That?s hard to do right.? Second opinions?

7.????? I need actuarial projections, with considerable detail. That would mean a copy of the JJJ review.

8.????? Exactly what are the trusts receiving as collateral for the $40 million loan?? Pro-forma financials on the property(ies) to be developed? And, I would need to see the financials of the GGG enterprises.

I think this deal will prove hard to complete.

Postscript: we went further with this group than the other two, but when faced with my data requests, the originator gave up.

After this happened to me, I talked with an investment banker who is local, and has many contacts like mine.? He commented on how small broker dealers get hit up with slick pitches, any one of which if accepted, could destroy the broker-dealer.? The trafficking of blocks of life settlements is endemic, and is a search for what lemming has the lowest discount rate — has mis-estimated the risks.

He also mentioned how these groups toss around big names as those that will buy the senior certificates.? I experienced that myself.? Kuwaiti Investment Authority, indeed.

So, in four months time, I kept my firm from making dumb decisions three times, any one of which might have severely damaged or destroyed the firm.? What did I get get for my efforts?? The best thing of all: gratitude from my bosses, and knowing that I did my best for those that hired me, protecting the interests of all stakeholders of the firm.

Skepticism is a necessary aspect of investing, particularly as the complexity level rises.? Aim for simplicity, and put safety first in your investing.? It is easier to protect value than to try to earn back losses from mistakes.

To phrase it another way — in order to work through these deals, I had to read through over 1000 pages of data.? Don’t let the multiplicity of words dull you to the risks that exist.? Even for small investors I would say avoid complexity.?? Where there is complexity, there is a much higher risk of loss, almost always.? Stick to simple investments, and let the complex stuff be bought by experts, who will turn away most of the charlatans.

An Opportunity in Comerica Warrants

Posted on 19 June 201019 June 2010 by David Merkel

This will be a bit of an unusual post for me.? How often do I suggest option trades?? Almost never.? But because of auctioning of TARP warrants, there are a decent number of very long dated options trading on some bank stocks, and many of them are cheap.? I’m here to talk about the cheapest one this evening, Comerica.

Comerica warrants [CMA/WS] closed at $14.50 today, a price that makes the computer say, “does not compute.”

The Comerica warrants are trading so cheaply that they discount negative volatility.? At zero volatility, the warrants would trade 5% higher:

And at a fair-ish volatility level, 17% higher.

Now there are two ways to extract value here.? Buy the warrant and sell short 2/3rds of a share of the common stock, which is empirically delta-neutral.

As the delta of the positions change, adjust your hedge in the common stock to reflect it.? The other way is not to short the common stock, but to short long dated options.? The most liquid long dated options are the 40s expiring in 2012.? The hedge would be to sell options on 170 shares of stock against every 100 warrants owned.

Over ten months the transaction makes a profit with CMA stock between 30 and 53.? That is one wide band, and there is still room for adjusting hedges in ways that could improve matters.

Now, I am open to feedback from readers/bloggers who trade options.? What’s wrong with this idea?? Free money is rare in the markets, but this warrant really seems like a mispriced security.

Full disclosure: no positions

PS — note that you may not get favorable margining being long the warrant and short the option.

Book Review: Confidence Game

Posted on 12 June 201012 February 2011 by David Merkel

This book review is special to me.? I don’t often get quoted in books, but in this book I get quoted on page 98.? Here is the quotation:

When I asked an insurance analyst whether he thought the credit rating companies would ever rethink MBIA’s top rating, he was skeptical.? “For Moody’s [or Standard and Poor’s] to put a bond insurer on negative watch (indicating a rating cut was being considered) could have extremely negative ramifications” for the entire bond insurance business, said David Merkel with Hovde Capital Advisors in Washington, DC.? “It’s a bit of a confidence game.”

Confidence Game indeed.? I did not see the phrase elsewhere in the book, but I may have missed it. If I inadvertently titled the book, I am honored.

I do not remember talking to the author, Christine Richard, but what she quoted was broadly representative of half of my view on the financial guarantee insurers.? I believed that it would be very difficult for the rating agencies to downgrade the financial guarantors, because they were such a large part of their AAA ratings, and because they would lose money in the short run from doing so.? Though it was written a year later, this article at RealMoney reflected my views.

In the short run, I viewed the rating agencies and financial guarantors as co-dependent.? The rating agencies? would protect the guarantors for as long as they could, and after that, the bottom would fall out, and it would become a “free fire” zone.

All in all, over the next five years I wrote over 30 times about the financial guarantors.? Here is a sample of that (in rough chronological order):

Again, my view was that the financial guarantors would eventually be downgraded, but that the rating agencies would delay it for as long as they possibly could.? That is what happened.

Now, as for Bill Ackman, he was prescient; he saw the problems early — way too early.? As I said about Markopolous and Madoff, it is usually a mistake to obsess over something that is manifestly wrong, but that you can’t affect.? Ackman spun his wheels for years over MBIA, and he was right eventually.? Many other men would have given up, but not Ackman.? And part of that is the nature of shorting; it is normally supposed to be a tactical discipline rather than a strategic one.? There are few companies that one can short into the ground, and Ackman almost went that way with MBIA.

But when you are right, you are right, so long as your funding base sticks with you.? Ackman had loyal investors, because the gains took years to manifest.

As for the author, she has carefully balanced the words of Ackman versus the words of others in the situation.? She has done an admirable job of being neutral while still portraying the victor fairly; would that the heads of MBIA talked to her more.? Sadly, they come off as a bunch of hacks who don’t understand that their models relied on a highly liquid economy, with rising housing prices.

I recommend this book highly.? If you want to buy the book, you can buy it here:? Confidence Game: How a Hedge Fund Manager Called Wall Street’s Bluff.

Who would benefit from this book

Most average investors could benefit from the book.? It would tell them that economic systems that rely on third-party appraisals are inherently fragile.? They can be gamed by those with a concentrated interest for a time, until reality catches up with them.

Full disclosure: Janet Tavakoli told me I was quoted in the book, so I asked the publisher for a copy to review.