Structured Products and Derivatives – Page 16

Morning Financials Update

Posted on 3 June 2010 by David Merkel

Big Movers

Top 20 Financial Stock Movers
Company [ticker]	News	Price Move
Washington Mutual Inc [WAMUQ]	Valuation-insensitive buyers on high volume and no news.	13%
Pacific Capital Bancorp NA [PCBC]	Strong buying at the open leads the stock up on no news.	6%
Ashford Hospitality Trust Inc [AHT]	No news materially driving the stock price	6%
First BanCorp/Puerto Rico [FBP]	No news materially driving the stock price	4%
Radian Group Inc [RDN]	No news materially driving the stock price	4%
EastGroup Properties Inc [EGP]	Jim Cramer likes it for the yield.? Mentioned on Mad Money.	3%
Advance America Cash Advance C [AEA]	No news materially driving the stock price	3%
LoopNet Inc [LOOP]	No news materially driving the stock price	3%
Heartland Financial USA Inc [HTLF]	No news materially driving the stock price	3%
China Real Estate Information? [CRIC]	No news materially driving the stock price	3%
Move Inc [MOVE]	Banxquote.com sues them for antitrust reasons.	2%
First Bancorp/Troy NC [FBNC]	No news materially driving the stock price	2%
United America Indemnity Ltd [INDM]	No news materially driving the stock price	2%
Enstar Group Ltd [ESGR]	No news materially driving the stock price	-3%
New York Community Bancorp Inc [NYB]	No news materially driving the stock price	-3%
Stewart Information Services C [STC]	No news materially driving the stock price	-3%
Waddell & Reed Financial Inc [WDR]	No news materially driving the stock price	-3%
Artio Global Investors Inc [ART]	Dilution.? Issuing shares to buy back units from principals.	-4%
First American Financial Corp [FAF]	Index investors sell off FAF as CLGX remains in the S&P 400.	-4%
Assured Guaranty Ltd [AGO]	Determined sellers on light volume and no news.	-4%

Thoughts:

Real Estate servicers and finance companies lead.? GSEs and guarantors trail.? Light corporate news day.
AIG Bankers Said to Value Asia Unit at Up to $36 Billion in Stock Offering ? dream, baby.? You can?t get as much as Pru plc was willing to overpay.
Citi U.S. Consumer Unit to Show Profit by Shifting Loans, Closing Branches ? Wisdom.? Shrink operations and focus on what makes money.? Universal banking does not work, because managements lack focus.
Covered Bond Sales Surge, Transocean Falls, GE Buys CMBS ? the panic in Europe takes a breather, but RIG has some worried about its survival.? For a primer on covered bonds look here: Covering Covered Bonds.
Buffett Forced to Testify Backs Moody’s in Hearing Without `Candid’ Voice — well, what do expect when he is compelled to testify by a subpoena?? I would be careful about what I said as well.
Buffett Expects ?Terrible Problem? for Municipal Debt ? Buffett sounds the same themes as my ?New Normal,? where municipalities will have a hard time for a long while.
AIG?s Benmosche May Survive AIA Deal Failure ? Who else has the chutzpah to take on the job?
The short-term performance model for financial stocks recommends Real Estate Services, Real Estate Development, Residential REITs, Consumer Finance, Hotels, Office REITs, Diversified REITs, Multiline Insurance, Regional Banks, and Retail REITs.
Whether insurers or banks, avoid equity-sensitive names here ? aim at companies that don?t have a high degree of sensitivity to stock market performance.

Group Price Movements for this Morning

Real Estate Mgmnt/Servic	1.2%	Reinsurance	0.0%	REITS-Health Care	-0.3%
Commercial Serv-Finance	1.1%	Diversified Banking Inst	0.0%	REITS-Storage	-0.3%
Finance-Consumer Loans	1.0%	Multi-line Insurance	0.0%	Commer Banks-Western US	-0.3%
Insurance Brokers	0.7%	Exchanges	0.0%	S&L/Thrifts-Central US	-0.4%
Life/Health Insurance	0.7%	Property/Casualty Ins	0.0%	Commer Banks-Central US	-0.5%
Other	0.5%	Fiduciary Banks	-0.1%	Invest Mgmnt/Advis Serv	-0.5%
Retail-Pawn Shops	0.4%	REITS-Hotels	-0.1%	REITS-Diversified	-0.5%
Real Estate Oper/Develop	0.4%	Commer Banks-Eastern US	-0.1%	REITS-Single Tenant	-0.5%
Finance-Invest Bnkr/Brkr	0.4%	Grand Total	-0.1%	Finance-Credit Card	-0.5%
REITS-Mortgage	0.4%	REITS-Office Property	-0.1%	S&L/Thrifts-Eastern US	-0.7%
REITS-Regional Malls	0.1%	REITS-Forestry	-0.1%	Finance-Auto Loans	-0.7%
Commer Banks Non-US	0.1%	REITS-Warehouse/Industr	-0.1%	Super-Regional Banks-US	-1.0%
REITS-Apartments	0.1%	REITS-Shopping Centers	-0.2%	Financial Guarantee Ins	-1.1%
S&L/Thrifts-Western US	0.1%	Commer Banks-Southern US	-0.2%	GSEs	-2.3%

I look at these companies for big news events that have occurred since the last close.? Often there isn?t any, but big changes here can be an indication that someone knows something, or there is trading noise.? After that, it is up to the analyst to dig.? Often, the dog that does not bark is the clue, as stocks move up or down on no news, as well as unexplained large spikes in volume, CDS spreads, and implied volatility of options.

Note: If I use the phrase ?better seller,? it does not mean ?sell.?? If I use the phrase ?better buyer,? it does not mean ?buy.?? ?Better seller? and ?better buyer? are bond portfolio manager terms that simply mean that if I were forced to take action on a security, what would I do as a trader in the short run, given the current news.

Disclosure: long ALL NWLI SAFT RGA AIZ PRE CB

Yield, the Oldest Scam in the Books

Posted on 3 June 2010 by David Merkel

There are two ways to fleece (cheat) someone: appeal to their greed, or appeal to their fear.? But the most effective approach that I know of is to appeal to elderly investors who did not save enough, and are finding it difficult to make ends meet.? They don’t want to take big chances, but they do need the yield.

Before I go on, what is yield?? This sounds like a dumb question — the simple answer is the percentage of money remitted to investors relative to the market value of the security.? And that is true as far as it goes, but there is more wood to chop here.

Yield is four things:

The risk free return on capital over a specified horizon.
The return required in order to induce someone to give up liquidity if the bond is not marketable.
The return required to take on any optionality, whether call or put risk, conversion, prepayment or extension risk.
The return needed to compensate for the possibility of default.

I have written before against buying structured notes from Wall Street.? Retail investors, take note.? Wall Street knows more than you do, and you are the patsy at their poker table.? The deck is stacked against you.? Avoid buying their products where they try to sell you an enhanced yield in exchange for a less certain return of principal, whether due to default, prepayment, call, or extension.

Though there are instruments that are undervalued, yielding more then they ought to, most of the time high relative yields indicate high risk.? Stretching for yield is usually a mistake.? With bonds and preferred stocks, it usually means more credit risk.? With equities and LPs, it usually means paying out more than the underlying cashflows from operations can handle, which is another form of credit risk.? Dividends can be reduced quickly if the cashflows can’t support them.

Now I turn to the article that drove this piece: Nonlisted REIT Sales Get Heightened Scrutiny by Finra.? Anytime you buy a security without a secondary market, you leave yourself at the mercy of the company.? Liquidity is poor, but the poor fool who buys these investments does not consider how much extra yield he needs to compensate for illiquidity.? Instead, he looks at his income needs, and buys.? Do you really want to play in someone else’s casino?? The casino analogy is apt, because the company controls the dividend payout and the buyback price.? Worse still, they have a better idea of what the asset are worth than the investors do.? Those with short-term cash flow needs are in a bad spot investing with them; they will not get the true economic value of their holdings.? (But, they should have planned for it — anytime one takes on illiquidity, one should make sure that there is enough liquidity elsewhere to compensate.)

With listed REITs, an investor has real estate equity or debt levered up through borrowings.? A nonlisted REIT is the same, except that there is no third party market to buy and sell shares.? You owe your soul to the company store, though you the the creditor, not the debtor.? My view is simple here: don’t buy into roach motels for cash, where the cash goes in easy, and comes out hard, unless you can negotiate your own terms.

Don’t give up liquidity without fair compensation.? I am happy to say that in my personal and professional investing career, I have never taken a loss off of illiquid investments.? Why?? Because they have to be bulletproof to me before I invest.? They must have table stability, not just bicycle stability.? Can they pay me back when liquidity is scarce?

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I have been through three exercises at the firm I work for where a life settlements securitization has been proffered to us as a great way to start up a securitization business.? Every one of them was bogus, and I protected the firm by telling them not to do the deals.

The life settlements seemingly carry a lot of yield, so it takes some backbone to suggest that there is not enough yield, or that capital losses will eat up yield, so the deal should not be done.? For a time, I ended up saving the firm.? The lesson is this: in investing, ignore yield to the greatest extent possible.? Focus instead on earning a good return, with safety, and ignoring the payout.? It is a little known secret that REITs with the lowest payouts tend to be the best performers over the intermediate-to-long term.? It is easier to earn money off of taking equity risk than credit risk.

So, aim for best advantage in investing.? Don’t trust yields, but rather look at the underlying economics of the business that you are investing in or lending to.? Yes, it is a lot more work, but it is work that you should be doing.

Was AIG Chronically Underreserved in its P&C Lines? (Part II)

Posted on 30 May 201025 December 2010 by David Merkel

I read every email sent to me, and every comment? written at my blog.? But much as I would like to, I can’t answer them all.? One comment to my last piece on this topic questioned the validity of accrual entries in insurance accounting.? I would like to say that the standards for GAAP reserve accounting are pretty good.? They need some tweaks here and there, but they do the job fairly well.

One of the things you learn as a fundamental investor is that the quality of accounting derived from accrual entries is always lower than that for cash entries.? There is an implicit assumption behind every accrual entry that someone will make good in the future to pay cash, whether the amount is fixed or estimated.

Accruals vary in quality.? Accounts Receivable are more reliable than inventories.? Who knows what fixed assets, property, plant and equipment are worth?? Pension obligations are squishy, the assumptions can be manipulated within reason.? Deferred tax assets rely on the ability to earn more money, but most companies with the deferred tax assets have lost significant money in the past.? Will the company bounce back?

And there are intangibles.? Goodwill is only worth something if a company earns cash from operations in excess of net income over the long run.? Capitalized R&D, software costs, must produce cash flows that justify capitalizing the expenses, otherwise capitalizing is merely deferring losses.

So there are tests such as normalized operating accruals that for industrial companies and utilities can flag many companies that look cheap, but may not be, because too much of their income comes from accrual entries.

With financial companies, the problem is worse, because financial companies are a bag of accruals.? What are the loans worth?? What are those weird structured securities worth?? And with insurance it gets tougher.? What level of claims do you expect to pay out and when?? Will you recover the amounts that you invested in acquiring the policies that have been written?

Tough questions, but they are what accounting rules have been designed to try to answer.? Because there is complexity, unscrupulous management teams can take advantage of the flexibility.? That does not mean the rules are wrong, though.? No human system can be both consistent and comprehensive.? There are tradeoffs between modeling the details of a company’s financials accurately, and doing the accounting consistently across corporations.? To what degree do you make accounting “cookie cutter” versus tailored?? That is the tough question that vexes those that set the accounting standards.

I would add that insurance accrual quality is subject to three factors:

Length of the accrual — longer is worse.
Uncertainty of the contingency in question — uncertainty of amount and timing?
Does the law of large numbers apply?? What is uncertain in specific, may be more predictable in aggregate.

I received another comment, and initially I said, “I can’t get that done.? Yes that would be good but….”? Here is the comment:

Doug Says:

May 24th, 20109:10 am at Edit

It would be interesting to normalize the reserve charges two ways:

1) Adverse reserve development as a % of beginning reserves.
2) The ratio in #1 above compared with the industry.

While these reserve charges were bad, long-tailed P&C insurers were taking similar reserve charges ? even the more ?responsible? ones.

Look at the results of one of AIG?s smaller competitors ? W.R. Berkley. Similar business mix and a charismatic CEO to boot. Same string of reserve charges, but the CEO is still there, and investors got a nice 20% annual rate of return from 2000. The difference? AIG was trading at 4x book value in 1999, while Berkley was trading below book.

So I went and did it, choosing eleven peer companies that were large, having long tailed liabilities.? This was the peer group:

ACE — ACE Limited
BRK — Berkshire Hathaway
CB — Chubb
CINF — Cincinnati Financial
CNA — CNA Financial
MKL — Markel
PRE — PartnerRe
TRV — Travelers
WRB — W. R. Berkley
WTM — White Mountains Insurance
XL — XL Capital Limited

I could have chosen more, but I thought these were representative of stockholder-owned insurers and reinsurers that write long-tailed P&C business.

So what did I find?? I found that AIG was among the worst of major P&C insurance companies in terms of having to strengthen reserves from 1993 to the present.? AIG had to strengthen its reserves 2.1%/yr versus my peer group average of 0.6%/year.? CNA did worse, and White Mountains (a company that talks a lot about conservative accounting) was slightly behind.

Note that the four companies that did not stretch all the way back to 1993 in terms of reported numbers likely would have looked better, because they missed some favorable underwriting years.

Here is the graph of the twelve companies, and the average:

And here is the graph of the companies that were not as good as the average:

The clear conclusion is that AIG was among a group of P&C insurers that were less conservative in reserving than most of their large competitors. CNA and White Mountains were much smaller companies — AIG was dropping a boulder into the pond.

Among all the other difficulties that AIG had, from a yield-seeking derivatives subsidiary, to life and mortgage insurance subsidiaries in trouble, this was just another facet of a company that played it fast and loose.? They under-reserved their P&C divisions, and there can be no reasonable defense on that topic.

PS — I like investing in P&C insurers and reinsurers that regularly release reserves for the business of prior years.? Conservative companies have high earnings quality, and are reasonable investments, despite all of the uncertainty.

Full disclosure: long PRE, CB

What are Credit Ratings For?

Posted on 25 May 2010 by David Merkel

Why do we have credit ratings?? What are the main reasons they exist?

To provide profits to those that rate credit.
To provide credit standards for regulators and creditors (shame on you, do your homework) that can’t judge credit risk.
To allow debtors to easily issue debt; simplifying the pricing decisions of creditors.
Providing quantitative and qualitative analyses of? new and existing debt issues, particularly small ones where it could not be economic for an asset manager to do his own analysis.

But credit ratings don’t exist for perfection.? Rating agencies are encouraged to rate new structures and new collateral types, whether they have good data or not.? Regulators need a rating for any asset they allow, and new asset classes should be viewed skeptically by analysts.

Applied to the Present

The standards proposed in the current finance reform bill don’t go far enough.? The existing bill allows for ratings shopping.? A better way to do it would be to allow the Credit Rating Agency Board to veto ratings of those that are too aggressive.? The CRAB could set real standards for structured lending, and perhaps, push back against the continued downgrade in ratings standards.? There would be competition to meet the standards of the CRAB, and of the originator at the same time.

Now this could eliminate securitization, and that is not all bad.? Accounting rules should not affect economic actions.? If accounting rules do affect economic? actions, it means there was something wrong with either or both of the starting and ending accounting rules.? And better that lenders keep the results of their lending decisions.? In a levered economy, it is best for lenders to eat heir own cooking; it keeps things sane.

Securitization should only exist to the degree that parties that are more willing to take on illiquidity and credit risk do so, with fair compensation for the risk that they bear.? There is no free lunch; just because there is a rating, it means you should believe it?

Caveat Emptor! should be on the wall of every house and business.? Let the Buyer Beware! Regardless of how many government agencies or politicians pretend to protect you, you are your own best and most reliable defender.

Do your homework, and don’t buy complex instruments that you don’t understand.? Don’t buy simple instruments of simple comanies that you don’t understand.

When rates are low, we struggle to find income.? Be conservative if you can be.? You are your own best defender.

The Rules, Part XV

Posted on 19 May 201020 June 2017 by David Merkel

What if securitization allows the economy to expand more rapidly than it would at a price of volatility, when intermediaries would prove useful?

Sometimes securitization and tranching creates securities for which there is no native home.

As the life insurance industry shrinks, it will be hard to find buyers for subordinated structured product.

Securitization is an interesting phenomenon.? Take a group of simple securities, like commercial or residential mortgages, and carve the cashflows up in ways that will appeal to groups of investors.? Do investors want ultrasafe investments?? Easy, carve off a portion of the investments representing the largest loss imaginable by most investors.? The remainder should be rated AAA (Aaa if you speak Moody’s).? Then find risk taking parties to buy the portion that could suffer loss, at ever higher yields for those that are willing to take realized losses earlier.

What’s that, you say?? What if you can’t find buyers willing to buy the risky parts of the deal at prices that will make the securitization work?? Easy, he will take the loans and sell them as a block to a bank that will want them on its balance sheet.

That said, securitized assets are typically most liquid near the issuance of the deal, with the short, simple and AAA portions of the deal retaining their liquidity best.? Suppose you hold a security that is not AAA, or complex, or long duration, and you want to sell it.? Well, guess what?? Now you have to engage in an education campaign to get some bond manager to buy it, or, take a significant haircut on the price in order to move the bond.

It helps to have a strong balance sheet.? If the credit is good, even if obscure, a strong balance sheet can buy off the beaten path bonds, and hold them to maturity if need be.? And yet, there is hidden optionality to having a strong balance sheet — you can buy and hold quality obscure bonds, but if thing go really well, you can sell the bonds to anxious bidders scrambling for yield, while you hold more higher quality bonds during a yield mania.

Endowments, defined benefit pension plans, and life insurance companies have those strong balance sheets.? They do not have to worry that money will run away from them.? The promises that these entities make are long duration in nature.? They have the ability to invest for the long-run, and ignore short-term market fluctuations, even more than Buffett does, if they are so inclined.

If there was a decrease in the buying power of institutions with long liability structures, we would see less long term investing in fixed income and equity investments.? Investments requiring a lockup, like private equity and hedge funds, would shrink, and offer higher prospective yields to get deals done.

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But what of my first point?? There are securitization trusts, and there are financial companies.? During a boom phase, the securitization trusts can finance assets cheaply.?? During a bust phase, the securitization trusts have a lot of complicated rules for how to deal with problem assets.? Financial companies, if they have adequate capital, are capable of more flexible and tailored arrangements with troubled creditors.? Having a real balance sheet with slack capital has value during a financial crisis.? Securitization trusts follow rules, and have no slack capital.? Losses are delivered to the juniormost security.

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Sometime around 2004, a light went on in the life insurance industry regarding non-AAA securitized investments.? In 2005, with a few exceptions, the life insurance industry stopped buying them.? AIG was a major exception.? The consensus was that the extra interest spread was not worth it.? Fortunately for the investment banks there were a lot of hedge funds willing to take such risks.

There should be some sort of early warning system that clangs when the life insurance industry stops buying, and those that buy in their absence have weaker balance sheets.? When risky assets are held by those with weak balance sheets, it is a recipe for disaster.

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During the boom phase, securitization trusts provide capital, cheaper capital than can be funded through banks.? That allows the economy to grow faster for a time, but there is no free lunch.? Eventually economic growth will revert to mean, when securitizations show bad credit results, and the economy has to slow down to absorb losses.

In addition, when losses come, loss severities will tend to be higher than that for corporates.? Usually a tranche offering credit support will tend to lose all of its principal, or none.? (Leaving aside early amortization and the last tranche standing in the deal.)? For years, the rating agencies and investment banks argued that losses on securitized products were a lot lower than that for corporates, because incidence of loss was so low on ABS, CMBS and non-conforming RMBS.? But the low incidence was driven by how easy it was to find financing, as lending standards deteriorated.

Thus, securitization allowed more lending to be done.? First, originators weren’t retaining much of the risk, so they could be more aggressive.? Second, the originators didn’t have to put up as much capital as they would if they had to hold the loans on a balance sheet.? Third, there were a lot of buyers for higher-rated yieldy paper, and ABS, CMBS and non-conforming RMBS typically offered better yields, and seemingly lower losses (looking through the rear-view mirror).? What was not to like?

What was not to like was the increased leverage that it allowed the whole system to run at.? Debt levels increased, and made the system less flexible.?? Investors were fooled into thinking that assets were worth a lot more than they are worth today because of the temporary added buying power from applying additional debt financing to the assets.

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Securitization has been a mixed blessing to investors.? It is brilliant during the boom phase, and exacerbates trouble during the bust phase.? And so it is.? As you evaluate financial companies, have a bias against clipping yield.

Regulators, as you evaluate risk-based capital charges, do it in such a way that securitized products get penalized versus equivalently-rated corporates.? Just add enough RBC such that it takes away any yield advantage versus holding it on balance sheet, or versus the excess yield on equivalently rated average corporates.? It’s not a hard calculation to run.

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Off-topic end to this post.? I added Petrobras to my portfolio today.? Bought a little Ensco as well.? I haven’t been posting as much lately since I was busy with two things: studying for my Series 86 exam, which I take tomorrow, and I gave a presentation on AIG to staff members on the Congressional Oversight Panel the oversees the TARP yesterday.? Good people; they seemed to appreciate what I wrote on AIG’s domestic operating subsidiaries last year.

Full disclosure: Long PBR ESV

The Rules, Part XIV & Thoughts on Maiden Lane LLC, Part 1

Posted on 18 May 201020 June 2017 by David Merkel

Prepayment and default are dual to each other.? The less likely is default, the more likely is prepayment, and vice-versa.

In a pool of loans, the critical distinction is the likelihood of loans to prepay or default.? Just because prepayment has been high, does not mean the remainder won?t default under stress.

I don’t have clear answers to Maiden Lane LLC, the bailout of Bear Stearns yet.? The complexity of Maiden Lane LLC, as compared to Maiden Lane 2 or 3, is enormous.? I have a more work to do.? But, at least, I have scrubbed the data, and figured our what the Fed released to us.

In the Bear Stearns bailout, the Fed received a wide variety of securities, including:

Cash

CDOs

Comm RE WLs

CRE Notes

Agency pools

Agency MBS

WL MBS

ABS

Res Re WLs

Treasuries

CDS CDOs

CMBX

CDS Corporate

CDS CRE Securities

CDS Municipal

CDS WL MBS

CDS ABS

Interest Swaps

Maiden Lane 2 & 3 were simple compared to this, and this had over 10x the securities of both combined. Plus, this had CDS transactions which would profit from failure of a wide variety of assets.

Additional difficulties included a lot of coding difficulties on the CDS.? The Fed did not try to make things clear.? I spent many hours trying to clarify the tranches in question.? A few of them are guesses, but 99% are reliable.

The Fed’s principal figures were original principal figures not those for current principal.? That was another area of ambiguity.

After all that, here is my breakdown of?the assets by original principal:

And, here is my breakdown of the assets by current principal:

–

The current value of what is owed to the Fed is over $28 billion.? There is almost $49 billion in current principal, so why worry?

Worry because of all of the interest only securities.? The principal for them is notional; principal payments will never be made.? With CMBS, I know that IO securities are typically worth no more than 5% of the notional principal balance.? Because most CMBS protect against prepayment, the prices of interest only securities reflect? the likelihood of default.? Though they are rated AAA, their creditworthiness is more like BB.

With Residential mortgages, the question is harder.? How big is the interest margin, and when might it cut off due to default or prepayment?? Interest only securities are typically worth a lot less then the? notional principal.? Same for principal only securities.? Their value is the likelihood of payment discounted by the length of time until payment.

Beyond that, there are the residential and commercial loans made, with almost $10 billion of principal, for which we have no idea of the creditworthiness.? Are there any statistics on the currency of the collateral?? The Fed had not deigned to tell us.? I place the creditworthiness at BB, but who knows for sure?

I can tell you now that the securities involved were mostly originated 2005-2007, during the worst of the underwriting cycle.? Is it any surprise?? Few can escape the credit cycle.? Within a given credit cycle, the credit quality of securities originated declines all of the way till slightly past the peak of the credit cycle.

I am going to do more analysis of the RMBS, so that I can get a better feel for the value there.? It is not clear to me whether Maiden Lane LLC is adequately funded or not.? The high degree of junk, whole loans, and interest only securities gives me doubt.

The Rules, Part XIII, subpart B

Posted on 1 May 201020 June 2017 by David Merkel

The need for income naturally biases a portfolio long.? It is difficult to earn income without beneficial ownership of an asset ? positive carry trades will almost always be net long, absent major distress or dislocation in the markets.? Those who need income to survive must then hope for a bull market.? They cannot live well without one, absent an interest rate spike like the late 70s/early 80s.? But in order to benefit in that scenario, they had to stay short.

To short bonds with success, you have to identify a tipping point.? The one shorting a bond borrows it and then sells it.? After that, he has to pay the interest on the bond, and maybe a little more, if the bond is hard to borrow, while he waits for the bond’s price to collapse.? If the capital losses to a holder of the bond are not greater than the interest paid, the short loses money.? (Yes, he makes some money off of interest on the proceeds from the sale, but let’s ignore that for now.) Bonds mostly have finite maturities; time can work against the short seller as the bond gets closer to maturity, because the bond will mature at par, and he will have to pay the par value.

The same applies to credit default swaps [CDS].? The party buying protection must pay for the protection. He looks for a disaster to happen, but as time elapses, and gets closer to the swap termination date, the odds of making money off of a failure declines.

Thus being short any sort of fixed income, whether through shorting or CDS involves paying money out regularly to support the position, with the possibility of incredible payoffs if default happens within the lifetime of the bond or CDS.

This mindset is the opposite of the way bond managers think.? A common way they view things is to maximize expected yield over the expected lifetime of their liabilities.? That is a simple way for bond managers at banks, insurance companies, pension funds and endowments to manage their bond assets.? It is not so easy for total return mutual fund managers, because they can’t tell with accuracy how patient/jumpy their mutual fundholders will be.? Typically, they pick an index of bonds, and mirror the most critical aspects of it — duration, convexity, credit quality, etc.? Retail investors don’t care about that but they look at the return series, and analyze whether the volatility is too great or too small for them, and if they have beaten many of their peers.

To a good bond manager, he aims to add risk when he is well compensated for it, and reduce risk when it is not well compensated.? That said, many bond managers have dumb clients.? They want more yield, because they think that yield is free.

I remember the Chief Actuary of a client insurance firm saying to me, “Why can’t you earn the returns of ARM Financial, General American, Jefferson Pilot, and Conseco?? (This was around early 1999.)? My response was: “You want to take absurd risks?? Not only do these firms take asset risks, they are taking more risks than any large firm that I can find.? They take asset risks everywhere.? Worse, their liability structures are weak, and their leverage is high.? A lot of their liabilities can run at will.”

It was not long before General American and ARM Financial failed.? Conseco took a few more years; the acquisition of Green Tree helped kill them.? Jefferson Pilot wasn’t as bad as the others, but they sold out to Lincoln National while they could.

It is foolish to be a yield hog.? Yet, many institutional investors were yield hogs prior to the crisis.? Someone had to buy the CCC junk bonds.? Someone had to sell protection in order to receive yield.? The investment banks could not manufacture gains for those shorting the mortgage market on their own.? There had to be yield hogs that wanted to receive yield in exchange for guaranteeing debts.? Given the low interest rate environment that they faced, many parties felt they needed to earn more.? AIG in particular offered protection on many bonds in order to suck in extra income so that earnings estimates might be achieved.? They were the ultimate yield hog, and like most hogs, they got slaughtered.

As for the one offering protection, he must be sure that there is no tipping point over the life of the swap.? Then the extra yield would be safe.

I have more to say on this, but let me summarize for now.? The need to earn income biases many bond investors to take too much risk.? Repeat after me: “Yield is not free.” It exists because of perceived risks; the great question is whether the perceived risks are underplayed, overplayed, or accurate.? The good bond manager looks at the risks versus the incremental yields, and spreads his investments among? a mix of good risks.

The Rules, Part XIII, subpart A

Posted on 1 May 201020 June 2017 by David Merkel

My paternal Grandfather invested in CDs through the interest rate? spike of the late 70s and early 80s.? He looked pretty smart for a time, but he never shifted to take risk when there was a reward to do so.? Contrast my Mom, who had her 50/50 mix of utility stocks and growth stocks (a clever strategy, which as far as I know, she thought up herself).? As she once said to me, “My utilities are my bonds.”? Though my Mom’s strategy underperformed my Grandfather’s in the short run, in the intermediate term it soundly beat his strategy.? Long term?? No contest.

There is something about yield.? Almost everyone wants to have it, and have more than what would be average.? My own equity portfolio throws off more yield than the S&P 500, even with 19% earning nothing in cash.? There is something tangible about yield: cash in hand, vs. uncertain capital gains, even if the dividend leads the stock price to drop.

There is a sense that yield is free, like harvesting eggs from your chicken coop in the morning.? Mentally, that is the way that many view it.? They may adjust the yield for risk of nonpayment, but there is a tendency to assume that the yield will come in.

Here’s an example: in 1999-2000, Morgan Stanley did a piece on some corporate bonds that they called, “The Dirty Thirty.”? They were the worst of BBB-rated bonds, but they argued off of a limited period of past returns, that the widening in yield spreads over Treasuries was not justified, so but them because they survive and outperform.? Very bad timing, I must say.? Many of the companies defaulted 2000-2002, and enough came under severe stress, that those with weak balance sheets kicked them out at the wrong time, for fear of their possible insolvency.

This was a prime example of a brokerage providing advice that was technically correct off of history, but deadly wrong with respect to the situation at hand.? Now, was Morgan Stanley trying to lighten its inventory of Dirty Thirty bonds?? I don’t know, but I suspect not.? Most corporate bonds of large corporations are liquid enough that they can be bought and sold easily.

Truth is, if you are a bond manager, you get lots of sell side research telling you how to get a higher yield.? To clients who report on a book value basis, like banks or insurers, that is manna, or pennies from Heaven.? Yield goes straight to the bottom line.? Capital gains or losses can be deferred, at least until default or maturity, and even if they are realized, analysts exclude them from operating earnings.

Thus the tendency for many regulated financial institutions to be yield hogs, unless the management team has religion regarding risk control.? As for me, I held the unique position of being risk manager and leading corporate bond manager at one job.? There was a conflict of interest there, but for me, it enabled me to be more cautious, and more risk-taking at appropriate times.? Gaining real market experience is something most risk managers never get, but it imparts knowledge of likely ways in which asset management can go astray.

It can easily go astray.? As Warren Buffett says, “If you’ve been playing poker for half an hour and you still don’t know who the patsy is, you’re the patsy.”? Goes double for trading with the main desks on Wall Street.? They look for weaknesses, and the leading weakness is being a yield hog.? They will more than happily dig up yieldy securities that are more risky than normal for such a client, because the client wants it, and it is easy to find those securities.

The investment banker may think the client is dumb, but he is under no obligation to tell him so.? And besides, in investments, who knows?? The client may know things that the investment bank does not.

To illustrate, I got cheated on my first corporate bond trade with CSFB.? It looked like a good trade to me.? It would gain incremental yield on a seemingly similar security.? My boss was gone, so I, the new assistant, made the trade.? On a $5M trade, I lost $20K instantly.? My boss was leaving for another job in a week, but he chewed me out anyway, and told me at some firms I would have been fired for what I had done.

I took it to heart, and hyperanalyzed the trade to understand all of my errors.? I did not make those errors again, and I was very diligent to be a skeptic regarding the trades that I did with the big firms.? That did not mean that I did not trade, but that I drove the trades that I did, rather than accepting the trades that the Street suggested.

Instead, I relied on our in-house analysts to do our digging, and I became persistent at pursuing what we wanted, and enlisted second-tier brokers that could help us.

I would often do swap trades that gave up yield, if I saw a greater improvement in the risk profile.? That is rare among bond traders.? Even among professionals, there is a bias toward more yield.? I ended up preserving capital for our main client, allowing me to reinvest at favorable yields as the crisis was cresting.

The bias for yield among individual investors is worse, and Wall Street readily takes advantage of individual investors in order to hedge expensive options by offering seemingly high yields through structured products.? The credit and interest rate risks take away what the yield offers, and more.? That’s the business, and smart investors stay away.? Don’t be the patsy at the investment poker game.

The Lack of Cultural Agreement Roars, the Eurozone Mews

Posted on 28 April 2010 by David Merkel

Economic systems are the result of cultures.? Where there is little cultural agreement, the economic system will be unstable, as will be governmental action.

No, this is not another “Rules” post.? But this is a post about the Eurozone and Japan today.? Japan faces trouble, but there is cultural agreement on what should be done, so there is no great crisis today, though the demographics may force issues eventually.

The Eurozone does not publicly recognize that there are large disagreements over what economic policy should be.? In the countries that are in economic trouble, there are many that push their governments to spend more on them, forcing the governments to borrow more.? This is particularly true of the unions.

My view of unions is that they slowly kill whomever they serve.? Industries with high unionization die eventually.? Countries that support unions die slowly as well.

Unions introduce inflexibility into the economic process which has a huge cost, eventually.? Greece is controlled by its unions.? They are willing to seek their own prosperity even if it leads to the destruction of the nation.? They don’t think the nation will be destroyed, but think that there are parties in power that hold back value from them, and they must be opposed, deluded fools that the unions are.

But there is a bigger problem for the Eurozone.? What do they do about Portugal, Ireland, Spain, and maybe Italy?? Yeah, the Eurozone could rescue Greece, but could it rescue Spain?? The answer is simple, NO.? But rescuing Greece discourages Spain from taking hard actions.

There is a lot of moral hazard involved in rescuing countries in the Eurozone.? Far better for nations to rescue banks that have lent to Greece, Portugal, Ireland, Spain, Italy, etc.? From what I have read, Europeans don’t exist.? Nations exist around a common culture and language.? Nations in Europe exist, and many act against the concept of a Eurozone.

Both positively and negatively, one can say that the Eurozone can’t make everyone into Germans.? The Germans exercised discipline that other nations would not.? Because of the size of Germany, and those allied with them in the Eurozone, the Euro is a hard currency, harder than many cultures/nations with lower labor productivity would like.

Why is the Euro weak?? Because the present crisis has relegated it to the status of an experiment.? Wondering over how Eurozone obligations will be repaid is an issue outside the Eurozone.? There are solutions, but they are painful — 1) let Greece become a state of Germany.? Not happening. 2) Let the Eurozone pour money into Greece; I’m sure they will reward you by adopting austerity measures, not. 3) Let Greece default, and then, let the Eurozone attempt to ameliorate it.? It will be difficult, and I doubt that debts to Greece will be settled at over 40% per Euro.

The major trouble is that banks in countries with relatively orthodox finances have lent to countries with liberal finances.? Well, who else could have done it, but the banks making the loans are in a fix because their health is subject to the creditworthiness of those that they lent to, which should be no surprise, but we forget.

Thus the big crisis in Europe is really over the soundness of the banking sector.? Rather than bailing out nations in trouble, far better to bailout your own banks that made bad loans, and let the profligate nations fail.? Remember, the Eurozone was not a promise to support profligate nations, but an effort for responsible nations to share a common currency.? If nations are not responsible, it is not the responsibility of the other Eurozone nations to subsidize them.

Do you want to save the Eurozone?? Save it by protecting your own banks, and letting profligate nations fail.? You will end up with a “hard” Eurozone of nations that are not profligate, and can live up to the demands of a strong currency.? The Eurozone exists without the UK.? It can exist without Greece, Portugal, Spain, Italy, and Ireland.

Subsidies don’t work, and that is what the loans to Greece are.? The Greeks will just suck them in, and continue their unruly fracas over who gets what.? Far better to let Greece fail, and scare marginal nations to clean up their acts.

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I don’t write this because I want the US Dollar to prosper because of a failure of the Euro.? Hey, I want credible alternatives to the Dollar, because it is at best the best of a bunch of sorry currencies, and I am not ready to sign on to the cult of Gold.? I like gold as a currency, but am not crazy about it as an investment.

My view is that the Euro can exist even after the failure of nations that leave the Euro, and that Euro obligations could still be enforced on defaulting nations because of the large amount of commerce inside Europe.

My advice to European statesmen, including those that share my surname, is to focus on your national interests.? The Eurozone is too vague to matter to those who elect you.? Focus on protecting your banks, rather than those the banks have lent to, which would waste money.

In Defense of the Rating Agencies ? V (summary, and hopefully final)

Posted on 23 April 2010 by David Merkel

I write this because I was invited to be on CNBC on the topic, but I suggested that my opinion would not make for good television.? That said, I have taken my four prior posts on the topic, and assembled them into one comprehensive post.? I do not intend on posting on this again.? With that, here is my post:

The ratings agencies have come under a lot of flak recently for rating instruments that are new, where their models might not be do good, and for the conflicts of interest that they face.? Both criticisms sound good initially, and I have written about the second of them at RealMoney, but in truth both don?t hold much water, because there is no other way to do it.? Let those who criticize put forth real alternatives that show systematic thinking.? So far, I haven?t seen one.

Most of the current problems exist in exotic parts of the bond market; average retail investors don?t have much exposure to the problems there, but only less-experienced institutional investors.

Here are my five realities:

Somewhere in the financial system there has to be room for parties that offer opinions who don?t have to worry about being sued if their opinions are wrong.
Regulators need the ratings agencies, or they would need to create an internal ratings agency themselves, or something similar.? The NAIC SVO is an example of the latter, and proves why the regulators need the ratings agencies.? The NAIC SVO was never very good, and almost anyone that worked with them learned that very quickly.
New securities are always being created, and someone has to try to put them on a level playing field for creditworthiness purposes.
There is no way to get investors to pay full freight for the sum total of what the ratings agencies do.
Ratings can be short-term, or long-term, but not both.? The worst of all worlds is when the ratings agencies shift time horizons.

Ratings are Opinions

The fixed-income community has learned that the ratings agencies offer an opinion, and they might pay for some additional analysis through subscriptions, but if they were forced to pay the fees that issuers pay, they would balk; they have in-house analysts already.? The ratings agencies aren?t perfect, and good buy-side shops use them, but don?t rely on them.? Only rubes rely on ratings, and sophisticated investors did not trust the rating agencies on subprime.? My proof?? Look how little exposure the Life and P&C insurance industries had to subprime mortgages outside of AIG.? Teensy at best.

Please understand that institutions own most of the bonds out there.? We had a saying in a firm that I managed bonds in, ?Read the write-up, but ignore the rating.?? The credit analysts at the rating agencies often knew their stuff, giving considerable insight into the bonds, but may have been hemmed in by rules inside the rating agency regarding the rating. It?s like analysts at Value Line.? They can have a strong opinion on a company, but their view can only budge the largely quantitative analysis a little.

Let?s get one thing straight here.? The rating agencies will make mistakes.? They will likely make mistakes on a correlated basis, because they compete against one another, and buyers won?t pay enough to support the ratings.

So there are systematic differences and weaknesses in bond ratings, but the investors who own most of the bonds understand those foibles.? They know that ratings are just opinions, except to the extent that they affect investment policies (?We can?t invest in junk bonds.?) or capital levels for regulated clients.

On investment policies, whether prescribed by regulators or consultants, ratings were a shorthand that allow for simplicity in monitoring (see Surowiecki?s argument).? Now, sophisticated investors knew that AAA did not always mean AAA.? How did they know this?? Because the various AAA bonds traded at decidedly different interest rates.? The more dodgy the collateral, the higher the yield, even if it had a AAA rating.? My mistake: I, for one, bought some AAA securitized franchise loan paper that went into default long before the current crisis hit.? Many who bought post-2000 AAA securitized manufactured housing loan paper are experiencing the same.? Early in the 2000s, sophisticated investors got burned, and learned.? That is why few insurers have gotten burned badly in the current crisis.? Few insurers bought any subprime residential securitizations after 2004.? But, unsophisticated investors and regulators trust the ratings and buy.

Financial institutions and regulators have to be ?big boys.? If you were stupid enough to rely on the rating without further analysis, well, that was your fault.? If the ratings agencies can be sued for their opinions (out of a misguided notion of fiduciary interest), then they need to be paid a lot more so that they can fund the jury awards.? Their opinions are just that, opinions.? As I said before, smart institutional investors ignore the rating, and read the commentary.? The nuances of opinion come out there, and often tell smart investors to stay away, in spite of the rating.

How Can Regulators Model Credit Risk?

It started with this piece from FT Alphaville, which made the point that I have made, markets may not need the ratings, but regulators do.? (That said, small investors are often, but not always, better off with the summary advice that bond ratings give.)? The piece suggests that CDS spreads are better and more rapid indicators of change in credit quality than bond ratings.? Another opinion piece at the FT suggests that regulators should not use ratings from rating agencies, but does not suggest a replacement idea, aside from some weak market-based concepts.

Market based measures of creditworthiness are more rapid, no doubt.? Markets are faster than any qualitative analysis process.? But regulators need methods to control the amount of risk that regulated financial entities take.? They can do it in four ways:

Let the companies tell you how much risk they think they are taking.
Let market movements tell you how much risk they are taking.
Let the rating agencies tell you how much risk they are taking.
Create your own internal rating agency to determine how much risk they are taking.

The first option is ridiculous.? There is too much self-interest on the part of financial companies to under-report the amount of risk they are taking.? The fourth option underestimates what it costs to rate credit risk.? The NAIC SVO tried to be a rating agency, and failed because the job was too big for how it was funded.

Option two sounds plausible, but it is unstable, and subject to gaming.? Any risk-based capital system that uses short-term price, yield, or yield spread movements, will make the management of portfolios less stable.? As prices rise, capital requirements will fall, and perhaps companies will then buy more, exacerbating the rise.? As prices fall, capital requirements will rise, and perhaps companies will then sell more, exacerbating the fall.

Market-based systems are not fit for use by regulators, because ratings are supposed to be like fundamental investors, and think through the intermediate-term.? Ratings should not be like stock prices ? up-down-down-up.? A market based approach to ratings is akin to having momentum investors dictating regulatory policy.

Also, their models that I am most familiar with only apply to publicly-traded corporate credit.? Could they have prevented the difficulties in structured credit that are the main problem now?

What to do with New Classes of Securities?

Financial institutions will want to buy new securities, and someone has to rate them so that proper capital levels can be held (hopefully).? But what are rating agencies to do when presented with novel financial instruments that have no significant historical loss statistics?? Many of the likely buyers are regulated, and others have investment restrictions that depend on ratings, so aside from their own profits, there is a lot of pressure to rate the novel financial instrument.? A smart rating agency would punt, saying there is no way to estimate the risk, and that their reputation is more important than profits.? Instead, they do some qualitative comparisons to similar?but established financial instruments, and give a rating.

Due to competitive pressures, that rating is likely to be liberal, but during the bull phase of the credit markets, that will be hidden.? Because the error does not show up (often) so long as leverage is expanding, rating agencies are emboldened to continue the technique.? As it is, when liquidity declines and leverage follows, all manner of errors gets revealed.? Gaussian copula?? Using default rates for loans on balance sheet for those that are sold to third parties?? Ugh.

Some will say that rating agencies must say ?no? to Wall Street when asked to rate exotic types of debt instruments that lack historically relevant performance data.? That?s a noble thought, but were GICs [Guaranteed Investment Contracts] exotic back in 1989-1992?? No.? Did the rating agencies get it wrong?? Yes.? History would have said that GICs almost never default.? As I have stated before, a market must fail before it matures.? After failure, a market takes account of differences previously unnoticed, and begins to prospectively price for risk.

But think of something even more pervasive.? For almost 20 years there were almost no losses on non-GSE mortgage debt.? How would you rate the situation?? Before the losses became obvious the ratings were high.? Historical statistics vetted that out.? No wonder the levels of subordination were so small, and why AAA tranches from late vintages took losses.

When prosperity has been so great for so long, it should be no surprise that if there is a shift, many parties will be embarrassed.? In this case both raters and investors have had their heads handed to them.

Now there are alternatives.? The regulators can ban asset classes until they are seasoned.? That would be smart, but there will be complaints.? I experienced in one state the unwillingness of the regulators to update their permitted asset list, which had not been touched since 1955.? In 2000, I wrote the bill that modernized the investment code for life companies; perhaps my grandson (not born yet), will write the next one.

Regulators are slow, and they genuinely don?t understand investments.? The ratings agencies aren?t regulators, and they should not be put into that role, because they are profit-seeking companies. Don?t blame the rating agencies for the failure of the regulators, because they ceded their statutory role to the rating agencies.? But if the regulators ban asset classes, expect those regulated to complain, because they can?t earn the money that they want to, while other institutions take advantage of the market inefficiencies.

Compensation and Conflicts

Some say that rating agencies must be encouraged to make their money from investor subscriptions rather than fees from issuers, to ensure more impartial ratings.? If this were realistic, it would have happened already.? The rating agencies would like nothing more than to receive fees from only buyers, but that would not provide enough to take care of the rating agencies, and provide for a profit.? They don?t want the conflicts of interest either, but if it is conflicts of interest versus death, you know what they will choose.

Short vs. Long-Term Opinions

Ratings agency opinions are long-term by nature, rating over a full credit cycle.? During panics people complain that they should be more short-term.?? Hindsight is 20/20.? Given the multiple uses of credit ratings, having one time horizon is best, whether short- or long-term.? Given the whipsaw that I experienced in 2002 when the ratings agencies went from long- to short-term, I can tell you it did not add value, and that most bond manager that I knew wanted stability.

Non-solutions

Some say rating agencies no longer should have exclusive access to nonpublic information, to even out the playing field.? That sounds good, but the regulators want the rating agencies to have the nonpublic information.? They don?t want a level playing field.? As regulators, if they are ceding their territory to the rating agencies, then they want the rating agencies to be able to demand what they could demand.? Regulators by nature have access to nonpublic information.

Some ask for greater disclosure of default rates, but that is a non-issue.? They also look to punish rating agencies that make mistakes, by pulling their registration. ?Disclosing default rates is already done, and sophisticated investors know this.? Yanking the registration is killing a fly with a sledgehammer.? It would hurt the regulators more than anyone else.?The rating agencies are like the market.? The market as a whole gets it wrong every now and then.? Think of tech stocks in early 2000, or housing stocks in early 2006.? To insist on perfection of rating agencies is to say that there will be no rating agencies.? It takes two to make a market, and agencies will often be wrong.

Solutions

As for solutions, I would say the following are useful:

Competition. ?I?m in favor of a free-ish market here, allowing the regulators to choose those raters that are adequate for setting capital levels, and those that are not.? For other purposes, though, the more raters, the better.? I don?t think rating fees would drop, though.? Remember, ratings are needed for regulatory purposes.? Will Basel II, NAIC, and other regulators sign off on new credit raters?? I think that process will be slow.? Diversity of opinion is tough, unless a ratings agency is willing to be paid only by buyers, and that model is untested at best.
Compensate with residuals and bonuses (give the raters some skin in the game)

Deregulation (we can live without rating agencies, but regulators will have to do a lot more work)
Greater disclosure (sure, let them disclose their data and formulas (perhaps with a delay).
Have regulators bar unseasoned asset classes.

Summary

Let those who criticize the ratings agencies bring forth a new paradigm that the market can embrace, and live with in the long term.? Until then, the current system will persist, because there is no other realistic way to get business done.? There are conflicts of interest, but those are unavoidable in multiparty arrangements.? The intelligent investor has to be aware of them, and compensate for the inherent bias.

Unless buyers would be willing to pay for a new system, it is all wishful thinking.? Watch the behavior of the users of credit ratings.? If they are unwilling to pay up, the current system will persist, regardless of what naysayers might argue.