Category: Structured Products and Derivatives

Rationality versus Time Horizons

Rationality versus Time Horizons

Posted on by David Merkel

Would that there were one time horizon — a goal to shoot for, similar to the dispensationalists that plague Christianity with an announced date for the return of Christ.? But a major reason that the Chicago School (as well as the Keynesians) is wrong in their view of economics is that there are multiple time horizons that people consider.

Why one time horizon?? It makes the math simple.? It is similar to the foolish Modern Portfolio Theory which has one version of risk which bears no resemblance to risk in the real world.? Modern Portfolio Theory exists so that bright people who can’t interpret the real world can receive salaries and look smart.? What’s that, you say, Modern Portfolio Theory has a fixed time horizon?? Another reason to cast it over the edge.? It is useless.

There have been a series of interviews at The New Yorker with Chicago School economists to try to test them in their allegiance to the free markets.? There is a problem here in that what makes sense in the short run does not always make sense in the long run.

Bubbles develop from short-run thinking.? What has worked in the immediate past? will work even better in the future.? In hindsight, it sounds dumb, but remember that most people are imitative; they imitate the seeming success of others.? People are rational, but not rational in the way that most economists posit.? Imitating your neighbor is a logical move for many actions.? If he is doing something that looks good, it can make a lot of sense to do the same thing — e.g., asking for the recipe for the delicious meal you had at their house, as well as asking where they got a certain obscure ingredient.

Imitation conserves on thinking.? People avoid thinking, because it hurts.? “If it works for my loser brother-in-law, than it certainly will work better for? me,” is the way some think.? There is the implicit appeal to taking an action out of greed or jealousy.? Smart people avoid those temptations, and think for themselves, looking to the long term consequences of any action.

Momentum investors live on the short-term horizon; value investors invest for the long term — if success comes quickly, very good, if slowly, good.? The ability to wait is a plus, because the ability to wait allows for optionality that may produce more value.

Back to bubbles.? They usually exist because financing is too cheap relative to what financing costs on average over a full market cycle.? Lending or equity investing at such times goes on with little thought for what can go wrong.

“This junk bond won’t default.”

“This equity will grow into its valuation, and then some.”

But near the peaks of bubbles, two things happen.? The prices of the assets being financed are so high, that one borrowing to own the asset faces a negative arb — he has to keep paying to keep the asset afloat — the net yield is negative.? The second thing is that chatter becomes uncertain, and the pace of closing deals slows.

These are signs that the cash flows that the assets throw off are less than the cash flows needed to hold the assets.? Such a condition can only exist for a short time during a mania.? When the pace of deals slackens, and the arb is negative it is time to run, not walk to the exits.

If enough economic actors did this, bubbles would self-deflate.? But it hurts to think.? Valuation questions are tough, and it is much easier to mimic the seemingly successful actions of others.

Better it would be if the Fed, which is the main blower of bubbles through easy monetary policy, would pull back on policy when aggregate levels of debt in the economy get above 200% of GDP, or, would allow us to go through recessions where there is significant pain, and liquidation of bad investments.? But no, during the bubble years, Greenspan was lionized for keeping the economy going smoothly — limiting the impact of recessions.? All that time, debts kept building up until the ratio far exceeded that achieved during the Great Depression.? Now Bernanke is lionized for increasing the Debt/GDP ratio while shifting debts from private to public hands.? He has saved us from the final reckoning of debt service.? Now what will the US Government do as its total obligations pass 4x GDP and head toward 5x GDP?? As I have said before, we are in uncharted waters here.

Debt is not neutral.? It creates inflexibility in the economy, because an economy built on fixed commitments has higher bankruptcy risks than one built on equity commitments.? Real reform would force banks to delever.? It would force the US Government to delever.? Real reform would get the government out of the prosperity business (it has never been good at that), and get it to focus on areas where it can make a difference — justice, defense, public health, and other public goods.

One simple solution: phase out the deduction for interest expenses, and phase in a deduction for dividends (preferred dividends would be at 50%).? Disallow trust preferred and hybrid debt structures.? Make finance more transparent by eliminating complex structures, and limiting all derivative transactions such that only hedgers may initiate transactions.? Transactions between two speculators should be regulated as gambling, because that is what it is.

If the government is not willing to take actions that hurt those being regulated, they are not worthy of being called a government.? The government should look out for the best interests of the nation as a whole, regardless of whom it might seem to favor.

Once again, back to bubbles.? Bubbles don’t get popped by the powers that be because the powers that be like bubbles as they are inflating.? Who would be a humbug and stop the sunbeam of prosperity when it is shining with full power?

But when the deflation of the bubble happens, everyone points the finger outward, few point at themselves.? Let Messrs. Greenspan, Paulson, Geithner, and Bernanke, among others, come before the cameras and apologize for their mismanagement of the US economy, and, let them suggest that the government get out of the economy business, because the government has consistently failed there.

To come back to the beginning of this article, the fetish of rationality exists in economics because the math doesn’t work without it.? Many tests of rationality have failed, yet the profession does not give up, because their skills are useless if man is not economically rational.

It is time to unemploy a lot of economists.? Unemploy them at the Fed; if we don’t eliminate the Fed, at least let’s slim it down.? Unemploy them at universities and colleges.? Let the business departments teach practical economics, and close the economics departments themselves.

The failure of Keynesian, Chicago School, and Neoclassical economics in this present crisis is severe.? We need a new economic paradigm to replace the failures that exist within our universities.

Neoclassical economics will fail; I may not live to see it fail, but it will fail.

Fat Fed Profits Do Not Create a Healthy Economy

Fat Fed Profits Do Not Create a Healthy Economy

Posted on by David Merkel

1) Inflate the size of my balance sheet by 2.5x over last year, all through borrowing at really low rates.

2) Increase my interest spreads by ~50% over last year.

means:

3) I only increased my profits by ~50% over last year??!? :(? I would have thought that profits would have more than tripled.

Such is life for the Fed.? The crisis was a time that led me to write pieces like The Liquidity Monopoly, where the Fed, FDIC, and Treasury played favorites in the economy, and starved the portions of the economy not dominated by large firms, particularly with banks and autos.

My main point is that the Fed should have earned a lot more.? Where did it all go?? It will be interesting to see a detailed rendering of the Fed’s finances when this is done.? Did they realize losses on some of the assets that they bought?

My friend Peter Eavis of the Wall Street Journal agrees.? Or, read Felix, and then read the exchange between my two friends Alea and Kid Dynamite.? Alea knows more, but I like KD’s spirit.

The Fed has become more like the banks that it regulates.? They are taking on credit risk, duration risk, convexity risk, etc.? And being a government institution, they don’t have good incentives for knowing how to price risk.

So, when I see the Fed’s seniorage profits up only 50%, I am not impressed.? The Fed doesn’t mark to market, so we really don’t know the true performance.? Also, remember that seniorage profits are a hidden tax on savers, would earn a higher yield if the government provided less financing.

Part of why we end up in an economic funk is that we finance dud assets at favorable rates, so capital does not get redeployed to better uses.? Aside from that, cheap leverage creates a yield frenzy over healthy assets, so that they can become over-levered as well.? Examples are numerous:

To me it is no great achievement that the financial markets are doing well while the real economy is in the tank (Unemployment, Production).? That is the nature of what happens when credit is force-fed into an economy, even leaving aside the problems of cronyism.? There should be no optimism over the large profits realized by the Fed; it may defray our taxes, but on net, the policies have not helped create a healthier real economy.

The Trill is Gone

The Trill is Gone

Posted on by David Merkel

This should be my last post on Trills.? Let me begin it by suggesting that we sell all of our national parks (and other land owned by the US Government) to the Saudis in exchange for forgiveness of our debts.? Wait, we could do better.? Disney could create theme parks, even on the national mall, making being American far more fun than the stuffy Smithsonian.

What’s that you say?? We are selling our patrimony?? How dare we sell our precious resources to exploiters/foreigners?? Uh, times are tough, and much as we make paper promises, eventually something hard and enduring has to back them up.

I feel the same way about Trills.? If the US Government ever were to sell trills, it would be the same as selling away a share in the take from the IRS in perpetuity.? Selling shares in the IRS, ridiculous, right?? Well, that is what a trill is — selling a share of the IRS.

Imagine that the US Government taxes at 20% of GDP, and then they sell Trills equal to 1% of GDP.? Initially, the US? Government would get a flood of cash, but would have given up 5% of their income stream.? If we had angels running our government, focusing on long-term projects, I would not object so much, but we spend in the present and neglect the future.

A government that issues Trills reduces its flexibility.? Initially not so, they get a lot of cash in, and don’t have to put a lot out.? The US government at present has explicitly issued debt with a market value around 75% of GDP.?? Implicitly, the funding shortfall when you add in the excess liabilities from the entitlements is 400% of GDP.

To keep things simple, let’s assume that the initial yield of Shiller’s trill is correct (1%), not only for small amounts of issuance, but large amounts.? That is probably a bad assumption in this case, after all, the proportion of Treasury issues out past 20 years is a small minority of Treasury issuance, and even with existing demand, the yield curve is quite steep.? Trills, being perpetual bonds with a growing coupon, are longer than any fixed income instrument that I have ever seen, so if they were issued in large amounts, who knows what the initial yields would be?

(Note to potential investors: if trills ever see the light of day, they could be an interesting buy, but I would let the first few auctions pass until the curve gets satiated and the initial coupon rises to a higher level, i.e., the price falls for all trills. You might even wait for the government to announce the last trills auction to buy.? One thing about trills — every issuance will raise additional doubts about ever being paid back.? They would be more valuable when the government says it won’t create any more of them.)

So, back to the application, imagine the US government auctioning off $11 Trillion (yes, with a “Tr”, not a “B”) of trills to retire the explicit debt.? Assume that the 1% initial coupon holds — we have now walled off 0.75% of GDP as a permanent expense in the Federal budget — keeping the numbers simple, that would be 3.75% of all Federal revenues in perpetuity.? Doesn’t sound like much, but we replace the existing debt with a exponentially growing stream where debt service is initially $110 billion.? That could help balance the budget at present, but at a cost to all future generations, until the US shall be no more.

Now, the 1% initial coupon would not hold for such large issuance.? Say the coupon ends up being 2%.? Now 7.5% of Federal revenues are dedicated to debt service in perpetuity, and 1.5% of GDP.

This would become addictive to the US Government — trills raise a lot of money relative to their initial cashflows, and they have no rollover risk.? Now imagine the US issuing a present value of $70 Trillion in trills (5x current GDP) over the next 30 years to roll over existing debt, take care of all the unfunded liabilities, and cover all of the structural deficit for the next 10 years.? At my assumed coupon of 2%, that would wall off 10% of GDP in perpetuity, or half of Federal revenues to pay for the sins of the past.? The bad human proverb recorded in the Bible might return to common parlance, “The fathers have eaten sour grapes, and the children’s teeth are set on edge.”? (Note: at/near the exile of Judah, some complained they were being punished for the sins their forbears committed, and not their own sins.? God corrects the proverb, saying that people are punished for their own sins.)

Potentially, trills are a heavy burden to place on all future generations for the fiscal profligacy of the last 80 years.? I would rather not see trills see the light of day as a result.? It would postpone the eventual day of reckoning where the US Government would have to slim down dramatically, and live within its budget.? Trills would make the US government more reckless, not more cost conscious.

But, if trills are to be issued, let some more desperate entity issue them first, like Greece or California, and then let the rest of us watch the consequences.? They would provide help in the short run, at a likely cost of a bigger failure later, with more damage to creditors, and the general economy.

This should be my last piece on this, though one final thought tugs at me — the derivatives market that would grow up around trills would be a hoot.? GDP futures and options, stripping coupons to create discount trills and income trusts.? The investment bankers would have a field day, with the cheap cost of burdening all future generations, who I am sure will remember Dr. Shiller warmly.

Fourteen Comments on the Financial Economy

Fourteen Comments on the Financial Economy

Posted on by David Merkel

1) Yield-seeking — it is alive and well.? Check out this article on pay-in-kind bonds.? With PIKs, one can be concerned with the return on the money, and the return of the money at the same time.? The history of returns on PIK bonds are such that you are usually better off putting the money under a mattress.

2) More yield-seeking — spreads on mortgage bonds over Treasuries are at a 17-year low, and as I measure it, and all-time low.? Investors have gone maniac for GSE insured mortgage bonds.

3) I am as close to neutral on PIMCO as anyone I know.? I have written articles explaining how they make money, which is different from the public pronouncements of Gross and McCulley.? The current missive of Gross impresses me as fair, recognizing the limits of the Federal Government and the Fed.? PIMCO is taking less risk, selling US and UK debt, and buying German debt.? This is conservative; they are giving up yield.

4) Bruce Krasting notes that the Social Security system paid out more in 2009 than it took in.? That event was not supposed to happen until 2016 or so.? Aside from that, he notes the negative COLA adjustment.? As for me, I look at this and say, “Whether it comes slower or faster, it will come.? Medicare and Social Security will destroy the Federal budget eventually, or will be scaled back to where those that were taxed complain about it.

5) If you want to consider a technical reason for rates being so low, consider all of the mutual fund buyers.? They have favored bonds.? This is a contrary sign for interest rates — they are headed higher.

6) Bernanke blames bank regulation so that he can absolve monetary policy.? Typical.? Blame what you control less, to absolve what you control directly.? A better and brighter economist (in my opinion), John Taylor disagrees.? He views the mid-decade low rate policies as contributing to the lending frenzy.? Don’t get me wrong.? Bank regulation was lousy, but monetary policy was lousier, helping to create the boom that now gives us the bust that normalizes things.

7) How amazing was the junk bond market?? Better, how amazing was the distressed debt market?? Oh my, though junk bonds paced equities, distressed debt did far better.? Such is the case when a turn happens; this one was forced by the US Government.

8) If you want to understand how finance reform gets blocked, read this article.? Better than most, it explains the intricacies of why the Democrats have a hard time passing the legislation that the radicals would like.

9) I am not a Buffett-lover or hater.? When I read his opposition to Kraft raising its bid, I said to myself, “Of course.? Don’t overpay.? Most deals are best avoided.”? Which is true — M&A is in general a value destroyer.

10) Personal bankruptcies are rising in the US.? It is a messy time.

11) Let the Chicago School of Economics die.? I have already argued for their demise.

12) The CMBS market is experiencing delinquencies that have not been seen before.? This is just another example of the difficulties many commercial mortgage loans are in.

13) Strip malls have high vacancy rates.

14) I appreciate Tyler Cowen’s article, suggesting that things are pretty good.? We should be glad that other places in the world did well, even if we did not do so well.

Trillusions

Trillusions

Posted on by David Merkel

My article on Dr. Shiller’s idea of Trills was warmly received in some quarters, and not in others.? Though I think Trills are a very bad idea for financing the US Government (though I think the US Government is not creative enough in its financing plans), there is one thing that I do agree with Dr. Shiller on — the price of Trills.? He says they would trade near $1400 — a 1% initial yield.? My view of a 1.06% initial yield largely agrees — the bond math is the bond math; we can argue about assumptions, but given the assumptions, there is only one answer.? Comments about risk premium miss the point.? Yes, we don’t know the future growth of the economy, but pricing assumes a growth path.? Also, these are US Treasury securities — default risk is nonexistent in dollar terms, right? 😉

Why are Trills a bad idea?? First, they seem cheap because of the low initial yield, but they aren’t cheap because the interest rate grows exponentially.? Assuming 3.4% average nominal GDP growth, the coupon doubles every 21 years, forever.? Suppose we issue a Trill in 2010, and we get a 1% coupon like Schiller suggests.? What will future coupons be?

  • 2031 — 2%
  • 2052 — 4%
  • 2073 — 8%
  • 2094 — 16%
  • 2115 — 32%
  • 2136 — 64%
  • 2157 — 128%

And so on.? Unlike ordinary bonds, the price for calling the issue grows along with the coupon, so there is no escape.? The best that can be said is that Trills would guarantee the default of the US Government if issued widely enough.

But now for the illusion of Trills.? Because they pay one one-trillionth of GDP each year, some deem them to be the equivalent of owning one one-trillionth of the US economy.? Oh no, they are far more valuable than that.

The US economy is subject to all manner of risks, risks that are higher than that of the US Government paying on its debts.? Whether thinking of all the producers in aggregate, or all of the consumers in aggregate, the average cost of capital is a lot higher than what the US Government could borrow at in perpetuity.? Rather than evaluate the Trills at the rate of the US Government at 4.4%, I think the proper rate is more like 7%, give or take a percent.? You might think 7% is too high, but there are significant risks to growth in any economy from government intervention, plague, war, famine, etc.? At 7%, the value of a trill drops from $1400 to $400.? The difference is the guarantee of payment by the US government, rather than the economy as a whole, so long as the US Government is solvent.

And, that is another significant difference.? If the US government is ever credit impaired, Trills will cease to be a share of one one-trillionth of the US economy.

I have suggested before that Dr. Shiller is more creative than the markets will allow.? Derivative instruments are facile creatures — we can dream up anything, but what derivatives the cash markets will support is another matter.? Shiller’s housing ETFs have gone away.

Trills are government bonds, should they ever be created.? They are not shares in the US economy.? That distinction is significant to the value of the securities, and the effect on the republic of the United States.

Yield = Poison (2)

Yield = Poison (2)

Posted on by David Merkel

My first real post at the blog was Yield = Poison.? In late February 2007, prior to the blowup in the Shanghai market, I felt frustrated and wanted to simply say that every fixed income class seemed overvalued.? Short and safe seemed best.

It reminded me of a discussion that I had with a colleague two jobs ago, where in mid-2002, the theme was “yield is poison.”? I did the largest credit upgrade trade that I could in the second quarter of 2002, prior to the blowup of Worldcom.? Moved the whole portfolio up three notches in four months.? Give away yield; preserve capital for another day.

I feel much the same, but not as intensely in the present environment.? Spreads could come in further if the government keeps providing low cost liquidity to those who make money on the spread they earn on financial assets.? But most fixed income assets do not reflect likely default costs.? Perhaps the long end of the Treasury curve is worth a little allocation of assets here, if only as a deflation hedge, but if the Fed is going to start lightening up on their QE, and the Treasury will be having high issuance, I might want to stand back for a while? while supply will be high, and try to buy near the end of the quarterly refunding.

There is another sense in which I say “yield = poison,” though.? When rates for safe assets are low, retail and professional investors are both tempted to stretch for yield.?? Wall Street is more than happy to deliver on your desire for yield.? It is their top illusion, in my opinion.

Two examples from my bond trading days: the first was some local brokers asking to buy a small amount relatively highly-rated junk bonds from us.? They were offering a full dollar over the usual market price.? They called me, since I ran the office, but I handed them over to the high yield manager, who said, “Jamming retail, are we?”? [DM: placing overpriced bonds in customer accounts.]? After a lame reply which amounted to,”Look, don’t ask us about what we are doing, we’re offering you a good deal, do you want to sell your bonds or not?”? the high yield manager sold them a small amount of the bonds, and we didn’t hear from them again.

The second example was when a bulge bracket firm called me and asked me if I owned a certain very long duration bond.? I said yes, and he made me an offer several dollars above what I thought they were worth.? With a bid that desperate, I said I could offer a few there, and more a little back, but for the block he would have to pay more still.? He offered something close to the “more still” price, and I sold the block to him there.

As we were settling the trade, I asked him, “Why the great bid?”? He said, “We need the bonds for retail trusts.? They get an above average yield, but if rates fall, after five years, we buy them out at par, and keep the bonds.? If rates rise, they take the loss.”

Even on Wall Street, if you have a good relationship, you get an honest answer.? That said, it made me sorry that I sold the bonds, even though it was the best thing for my client.

There are many ways to frame the yield question at present, here are two:

  • You are on a fixed income, and you are having a hard time making ends meet.? Should you lend longer to earn more, go for lower rated credits, or do nothing?
  • You are earning almost nothing on your money market fund.? You need liquidity, but where else could you invest it?

I would be inclined to buy a mix of foreign-denominated bonds, but most people can’t deal with that.? So, I would advise them to build a “bond ladder” where they have high quality issues maturing every year for the next 10 years.? As each bond matures, I would use the proceeds to buy bonds ten years out, re-establishing the 10-year ladder.

But don’t reach for yield.? Odds are, you will get capital losses great than the excess yield you hoped to receive.? And remember this, don’t buy products someone else wants to sell you.? Specifically, don’t buy high yielding investment products that Wall Street sells to enhance your income.? They prey upon those who want more money, and are weak in their knowledge of how the markets work.

To professionals: don’t reach for yield now; long-run, you are not getting paid for the risks.? You have seen how illiquid structured products can be in the face of credit uncertainty, and impaired balance sheets of holders and likely purchasers.? You have seen how spreads can blow out (bond prices fall), and roar back in (prices rise again) in the absence of safe places to invest money.

I’ll give the Treasury and the Fed this: they have created an environment where savers are punished, and have to take significant risks to get yield.? They have created a situation where the markets are dependent on subsidized credit, and speculation dominates over lending to the real economy.? They are pushing us deeper into a liquidity trap, as low-to-negative return investments in autos, homes, and banks get supported by cheap public credit, rather than getting reconciled in bankruptcy, so that capital can be redeployed to higher returning projects.

Anyway, enough for now — more later.

Catching up on Blog Comments

Catching up on Blog Comments

Posted on by David Merkel

Before I start, I would like to toss out the idea of an Aleph Blog Lunch to be hosted sometime in January 2010 @ 1PM, somewhere between DC and Baltimore.? Everyone pays for their own lunch, but I would bring along the review copies of many of the books that I have reviewed for attendees to take home, first come, first served.? Maybe Eddy at Crossing Wall Street would like to join in, or Accrued Interest. If you are an active economic/financial blogger in the DC/Baltimore Area, who knows, maybe we could have a panel discussion, or something else.?? Just tossing out the idea, but if you think you would like to come, send me an e-mail.

Onto the comments.? I try to keep up with comments and e-mails, but I am forever falling behind.? Here is a sampling of comments that I wanted to give responses on.? Sorry if I did not pick yours.

=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=–==-=–==-

Blog comments are in italics, my comments are in regular type.

http://alephblog.com/2009/12/16/notes-on-fed-policy-and-financial-regulation/#comments

Spot on David. I often think about the path of the exits strategy the fed may take. In order, how may it look? What comes first what comes last? Clearly this world is addicted to guarantees on everything, zirp, and fed QE policy which is building a very dangerous US dollar carry trade.

Back to the original point, I would think the order of exit may look something like:

1. First they will slowly remove emergency credit facilities, starting with those of least interest, which were aggressively used to curb the debt deflationary crisis on our banking system. The added liquidity kept our system afloat and avoided systemic collapse that would have brought a much more painful shock to the global financial system. Lehman Brothers was a mini-atom bomb test that showed the fed and gov?t would could happen ? seeing that result all but solidified the ?too big to fail? mantra.

2. Second, they will be forced to raise rates ? that?s right folks, 0% ? 0.25% fed funds rates is getting closer and closer to being a hindsight policy. However, I still think rates stay low until early 2010 or unemployment proves to be stabilizing. As rates rise, watch gold for a move up on perceived future inflationary pressures.

3. Third, they can sell securities to primary dealers via POMO at the NY Fed, thereby draining liquidity from excess reserves. I think this will be a solid part of their exit strategy down the road ? perhaps later in 2010 or early 2011. As of now, some $760Bln is being hoarded in excess reserves by depository institutions. That number will likely come way down once this process starts. The question is, will banks rush to lend money that was hoarded rather then be drained of freshly minted dollars from the debt monetization experiment. For now, this money is being hoarded to absorb future loan losses, cushion capital ratios and take advantage of the fed?s paid interest on excess reserves ? the banks choose to hoard rather then aggressively lend to a deteriorating quality of consumer/business amid a rising unemployment environment. This is a good move by the banks as the political cries for more lending grow louder. The last thing we need is for banks to willy-nilly lend to struggling borrowers that will only prolong the pain by later on.

4. And finally, as a final and more aggressive measure, we could see capital or reserve requirements tightened on banks to hold back aggressive lending that may cause inflationary pressures and money velocity to surge. Right now, banks must retain 10% of deposits as reserves and maintain capital ratios set by regulators. Either can be tweaked to curb lending and prevent $700bln+ from entering the economy and being multiplied by our fractional reserve system.

I think we are starting to see #1 now, in some form, and will start to see the rest around the middle of 2010 and into 2011. The last item might not come until end of 2011 or even 2012 when economy is proven to be on right track and unemployment is clearly declining as companies rehire.

Thoughts????

UD, I think you have the Fed’s Order of Battle right.? The questions will come from:

1) how much of the quantitative easing can be withdrawn without negatively affecting banks, or mortgage yields.

2) How much they can raise Fed Funds without something blowing up.? Bank profits have become very reliant on low short term funding.? I wonder who else relies on short-term finance to hold speculative positions today?

3) Finance reform to me would include bank capital reform, including changes to reflect securitization and derivatives, both of which should require capital at least as great as doing the equivalent transaction through non-derivative instruments.

http://alephblog.com/2009/12/15/book-reviews-of-two-very-different-books/#comments

David,
A few years back you mentioned to me in an e-mail that Fabozzi was a good source for understanding bonds (thank you for that advice by the way, he is a very accessible author for what can be very complex material.)? In the review of Domash’s book you mention that he does not do a good job with financials. I was wondering, is there an author who is as accessible and clear as Fabozzi, when it comes to financials, who you would recommend.

Regards,
TDL

TDL, no, I have not run across a good book for analyzing financial stocks.? Most of the specialist shops like KBW, Sandler O?Neill and Hovde have their own proprietary ways of analyzing financials.? I have summarized the main ideas in this article here.

http://alephblog.com/2007/04/28/why-financial-stocks-are-harder-to-analyze/

http://alephblog.com/2009/12/05/the-return-of-my-money-not-the-return-on-my-money/#comments

Sorry to be a bit late to this post, but I really like this thread (bond investing with particular regard to sovereign risk). One thing I’m trying to figure out is the set of tools an individual investor needs to invest in bonds globally. In comparison to the US equities market, for which there are countless platforms, data feeds, blogs, etc., I am having trouble finding good sources of analysis, pricing, and access to product for international bonds, so here is my vote for a primer on selecting, pricing, and purchasing international bonds.

K1, there aren?t many choices to the average investor, which I why I have a post in the works on foreign and global bond funds.? There aren?t a lot of good choices that are cheap.? It is expensive to diversify out of the US dollar and maintain significant liquidity.

A couple of suggested topics that I think you could do a job with:? 1) Quantitative view of how to evaluate closed end funds trading at a discount to NAV with a given NAV and discount history, fee/cost structure, and dividend history;?? 2) How to evaluate the fundamentals of the return of capital distributions from MLPs – e.g. what fraction of them is true dividend and what fraction is true return of capital and how should one arrive at a reasonable profile of the future to put a DCF value on it?

Josh, I think I can do #1, but I don?t understand enough about #2.? I?m adding #1 to my list.

http://alephblog.com/2009/12/05/book-review-the-ten-roads-to-riches/#comments

I see that Fisher’s list reveals his blind spot–how about being born the child of wealthy parents. . .

BWDIK, Fisher is talking about ?roads? to riches.? None of us can get on that ?road? unless a wealthy person decided to adopt one of us.? And, that is his road #3, attach yourself to a wealthy person and do his bidding.

I am not a Ken Fisher fan, but I am a David merkel fan—so what was the advice he gave you in 2000?

Jay, what he told me was to throw away all of my models, including the CFA Syllabus, and strike out on my own, analyzing companies in ways that other people do not.? Find my competitive advantage and pursue it.

That led me to analyzing industries first, buying quality companies in industries in a cyclical slump, and the rest of my eight rules.

http://alephblog.com/2009/11/28/the-right-reform-for-the-fed/#comments

“The Fed has been anything but independent.? An independent Fed would have said that they have to preserve the value of the dollar, and refused to do any bailouts.”

This seems completely wrong to me.? First, the Fed’s mandate is not to preserve the value of the dollar, but to “”to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.”? I don’t see that bailouts are antithetical to those goals. Second, I don’t see how the Fed’s actions in 2008-2009 have particularly hurt the value of the dollar, at least not in terms of purchasing power.? Perhaps they will in the future, but it is a bit early to assert that, I think.

Matt, even in their mandates for full employment and stable prices, the Fed should have no mandate to do bailouts, and sacrifice the credit of the nation for special interests.? No one should have special privileges, whether the seeming effect of purchasing power has diminished or not.? It is monetary and credit inflation, even if it does not result in price inflation.

?Make the Fed tighten policy when Debt/GDP goes above 200%.? We?re over 350% on that ratio now.? We need to save to bring down debt.?

David, I fully agree (as with your other points).
However, I do not see it happening.

Why would we save when others electronically ?print? money to buy our debt?

See todays Bloomberg News:
?Indirect bidders, a group of investors that includes foreign central banks, purchased 45 percent of the $1.917 trillion in U.S. notes and bonds sold this year through Nov. 25, compared with 29 percent a year ago, according to Fed auction data compiled by Bloomberg News.?

Please note that last year the amount auctioned was much lower (so foreign central banks bought a much lower percentage of a much lower total).

Please also note that all of a sudden, earlier this year, the definition of ?indirect bidders? was changed, making it more complicated to follow this stuff. What is clear however, is that almost half of the incredible amount of $ 2 trillion, i.e. $ 1000 billion (!!), is being ?purchased? by the printing presses of foreign central banks.

This could explain both the record amount of debt issued and the record low yields.

As the CBO has projected huge deficits PLUS huge debt roll-overs (average maturity down from 7 years to 4 years) up to at least 2019, do you think we could extend the ?printing? by foreign central banks? — CB?s ?buying? each others debt — for at least 10 more years?
That would free us from saving, enabling us to ?consume? our way to reflation of the economy (as is FEDs/Treasuries attempt imo).

I?d appreciate your, and other readers?, take on this.

Carol, you are right.? I don?t see a limitation on Debt to GDP happening.

As to nations rolling over each other?s debts for 10 more years, I find that unlikely.? There will be a reason at some point to game the system on the part of those that are worst off on a cash flow basis to default.

The rollover problem for the US Treasury will get pretty severe by the mid-2010s.

http://alephblog.com/2009/11/13/the-forever-fund/#comments

Any chance of you doing portfolio updates going forward? I?d be curious to see if you still like investment grade fixed incomes, given the rally.

Matt, I would be underweighting investment grade and high yield credit at present.

As for railroads, I own Canadian National ? unlike US railroads, it goes coast to coast, and slowly they are picking up more business in the US as well.

Long CNI

http://alephblog.com/2009/11/10/my-visit-to-the-us-treasury-part-7-final/#comments

Did none of the bloggers raise the question of the GSEs? I can understand Treasury not wishing to tip their hands as to their future, but I would have expected their status to be a hot topic among the bloggers.

I also don?t buy the idea that the sufferings of the middle class were inevitable. Over the past 15 or so years the financial sector has grown due to the vast amount of money that it has been able to extract. Where would we be if all of those bright hard working people and capital spending had gone to the real economy? I?m not suggesting a command economy, but senior policymakers decided to let leverage and risk run to dangerous levels. Your comment seem to indicate that this was simply the landscape of the world, but it seems more to be the product of a deliberate policy from the Federal government.

Chris, no, nothing on the GSEs.? There was a lot to talk about, and little time.

I believe there have been policy errors made by our government ? one the biggest being favoring debt finance over equity finance, but most bad policies of our government stem from a short-sighted culture that elects those that govern us.? That same short-sightedness has helped make us less competitive as a nation versus the rest of the world.? We rob the future to fund the present.

http://alephblog.com/2009/11/07/my-visit-to-the-us-treasury-part-6/#comments

it?s not clear from your writing whether the treasury officials talked to you about the GSEs or whether your comments (in the paragraph beginning with ?When I look at the bailouts,?) are your own. could you clarify?

q, That is my view of how the Treasury seems to be using the GSEs, based on what they are doing, not what they have said.

http://alephblog.com/2009/10/31/book-review-nerds-on-wall-street/

?There are a lot of losses to be taken by those who think they have discovered a statistical regularity in the financial markets.?
David, take a look at equilcurrency.com.

Jesse, I looked at it, it seems rather fanciful.

http://alephblog.com/2009/10/27/book-review-the-predictioneers-game/#comments

David,
Just wondering if there?s an omission in this line:

?The last will pay for the book on its own. I have used the technique twice before, and it works. That said, that I have used it twice before means it is not unique to the author.?

Did you mean to write ?that I have used it doesn?t mean it is not unique?.?

In the event it is, I?ll look it up in the book, which I intend to buy anyway.
Otherwise, may I request a post that details, a la your used car post,your approach to buying new cars?

Saloner, no omission.? I said what I meant.? I?ll try to put together a post on new car purchases.

http://alephblog.com/2009/10/22/book-review-the-bogleheads-guide-to-retirement-planning/

thanks for the book review. it sounds like something that i could use to get the conversation started with my wife as she is generally smart but has little tolerance for this sort of thing.

> unhedged foreign bonds are a core part of asset allocation

i agree in principle ? it would be really helpful though to have a roadmap for this. how can i know what is what?

I second that request for help in accessing unhedged foreign bonds ? Maybe a post topic?

JK, q, I?ll try to get a post out on this.

http://alephblog.com/2009/10/20/toward-a-new-theory-of-the-cost-of-equity-capital-part-2/#comments

to the point above, basically just an IRR right?

JRH, I don?t think it is the IRR.? The IRR is a measure of the return off of the assets, not a rate for the discount of the asset cash flows.

When I was an undergraduate (after already having been in business for a long time), I realized that M-M was erroneous, because of all the things they CP?d (ceteris paribus) away. For my own consumption, I went a long way to demonstrating that quantitatively, but children, work and family intervened, and who was I to argue with Nobel winners.

But time, experience and events convince me that I was right then and you are right now. As you?ve noted the market does not price risk well. In large part this is due to a fundamental misunderstanding of value. The professional appraisal community has a far better handle on this, exemplified by drawing the formal distinction between ?fair market value as a going concern?, ?investment value?, ?fair market value in a orderly liquidation?, ?fair market value in a forced liquidation? and so on. One corollary to the foregoing is one of those lessons that stick from sit-down education, that ?Book Value? is not a standard of value but rather a mathematical identity.

Without going into a long involved academic tome, the cost of capital (and from which results the mathematical determination of value per the income approach) has a shape more approaching that of a an asymmetric parabola (if one graphs return on the y axis and equity debt weight on the x.).

If I was coming up with a new theorem, risk would be an independent variable. So for example:

WAAC = wgt avg cost of equity + wgt avg cost of debt + risk premium

You?ll note the difference that in standard WAAC formulation risk is a component of the both the equity and debt variable ? and practically impossible to consistently and logically quantify. Yes, one can look to Ibbottson for historical risk premia, or leave one to the individual decision making of lenders, butt it complicates and obscures the analysis.

In the formulation above, cost of equity and cost of debt are very straightforward and can be drawn from readily available market metrics. But what does risk look like? Again if you plot risk as a % cost of capital on the y axis and on the x axis the increasing debt weight, on a absolute basis risk is lowest @ 100% equity. From there is upwards slopes. However, risk however is not linear, but rather follows a power law.

The reason risk follows a power law is that while equity is prepared to lose 100%, debt is not. Also, debt weight increases IRR to equity (in the real world) contrary to MM. Again, debt is never priced well, because issuers don?t understand orderly and forced liquidation, whereby in ?orderly?, e.g. say Chapter 11,recoveries may be 80 cents on the dollar, and forced, e.g., Chapter 7, 10 cents on the dollar. One really doesn?t begin to understand the foregoing until you?ve been through it more than a few times.

So in the real world, as debt increases, equity is far more easily ?playing with house money.? A recent poster child for this phenomena is the Simmons Mattress story. In the most recent go round equity was pulling cash out (playing with house money) and the bankers were either (depending on one?s POV) incredibly stupid for letting equity do so, or incredibly smart, because they got their fees and left someone else holding the bag. I?m seen some commentators say that ?Oh it was OK because rates were so low, the debt service (the I component only) was manageable.? Poppycock; sometime it?s the dollar value and sometimes it?s the percentage weight and sometimes it is both.

But you?ve already said that: ?company specific risk is significant and varies a great deal.? I would also add that ? or amplify ? that in any appraisal assignment the first thing that must be set is the appraisal date. Everything drives off that and what is ?known or knowable? at the time.

Gaffer, thanks for your comments.? I appreciate the time and efforts you put into them.? This is an area where finance theory needs to change.

http://alephblog.com/2009/10/10/pension-apprehension/

I have a DB plan with Safeway Stores-UFCW, which I?ve been collecting for a few years. I?m cooked?

Craig, not necessarily.? Ask for the form 5500, and see how underfunded the firm is.? Safeway is a solid firm, in my opinion.

Long SWY

http://alephblog.com/2009/09/29/recent-portfolio-actions/#comments

David, I am curious about your rebalancing threshold. Do you calculate this 20% threshold using a formula like this:

= Target Size / Current Size ? 1

I have a small portfolio of twenty securities. A full position size in the portfolio is 8% (position size would be 1 for an 8% holding). The position size targets are based generally on .25 increments (so a position target of .25 is 2% of the portfolio and there are 12.5 slots ?available?). I used that formula above for a while, but I found that it was biased towards smaller positions.

Instead I began using this formula:

= (Target ? Current Size) / .25

So a .50 sized holding and a full sized holding may have both been 2% below the target (using the first formula), but using the second formula, they would be 8% and 16% below the target respectively. I found this showed me the true deviation from the portfolio target size and put my holdings on an equal footing for rebalancing.

I was curious how you calculated your threshold, or if it was less of an issue because you tended to have full sized positions. For me, I tend to start small and build positions over time. There are certain positions I hold that I know will stay in the .25-.50 range because they either carry more risk, they are funds/ETFs, or they are paired with a similar holding that together give me the weight I want in a particular sector.

Brian, you have my calculations right.? I originally backed into the figure because concentrated funds run with between 16-40 names.? Since I concentrate in industries, I have to run with more names for diversification.? I don?t scale, typically, though occasionally I have double weights, and rarely, triple weights.? The 20% band was borrowed from three asset managers that I admire.? After some thought, I did some work calculating the threshold in my Kelly criterion piece.

A fuller explanation of the rebalancing process is here in my smarter seller pieces.

http://alephblog.com/2009/09/04/tickers-for-the-latest-portfolio-reshaping/

Have you seen DEG instead of SWY?
Extremely able operator. Some currency diversification as well. I?d like to know your thougts.

MLS, I don?t have a strong idea about DEG ? I know that back earlier in the decade, they had their share of execution issues.? It does look cheaper than SWY, though.

Long SWY

http://alephblog.com/2009/06/11/problems-with-constant-compound-interest-2/

I like your post and want to comment on a couple of items.? You point to the peak of the 1980’s inflation rates and the associated interest rates.

Robert Samuelson wrote a book called The Great Inflation and it’s Aftermath.?? http://tiny.cc/z9H9V

Basically you can explain a great deal the US stock market history of the 40 years by the spike in interest/inflation until the mid 80’s and the subsequent decline.? Since you need an interest rate to value any cash flow, the decline in interest rates made all cash flows more valuable.

The thing that is odd and sort of ties this together is the last year.? After interest rates crossed the 4% level things started blowing up.? The amount of debt that can be financed at 3% to 4% is enormous.? That is, as everyone knows, on of the root causes of the housing bubble.? Anyway, starting last year, treasury interest rates continued to decline and all other rates went through the roof.

I was looking at this chart yesterday.? _ http://tiny.cc/eCZzF The interesting thing to me was that when the system blew up, treasury rates continued to decline and all non guaranteed debt rates went through the roof.

Most of this is obvious and everyone knows the reasons.? The one thing that seems novel is thinking of this as the continuation of a very long secular trend — or secular cycle.? I don’t want to get overly political, but the decrease in inflation/interest in the 90’s to the present was a function of productivity/technology and Foreign/Chinese imports.? Anyway, one effect of these policies was a huge rise in asset values, especially in the FIRE (finance, insurance, real estate) sector of the economy at the expense of our industrial and manufacturing sectors.? This was also a redistribution of wealth from the rust belt to the coasts.

It is much more complicated then the hand full of influences I mentioned, but the one thing i haven’t seen discussed a lot is the connection of the current catastrophe to the long term decline in inflation/interest rates since the mid/late 1980’s.? If you think about it, declining interest rates increase the value of financial assets and are an enormous tailwind for finance.? I suppose if you had just looked at the curve, it would have been obvious that the trend couldn’t continue.? Prior to the blowup, there were lots of people financing long term assets with short term, low interest rate liabilities. That was a big part of the basic playbook for structured finance, hedge funds, etc.

The reason that the yield spread exploded is well known.? Here is a snippet from Irving Fisher.? http://capitalvandalism.blogspot.com/2009/01/deflationary-spirals.html

CapVandal ? Great comment.? A lot to learn from here.? I hope you come back to blogging; you have some good things to say.? Fear and greed drive correlated human behavior.

Notes on Fed Policy and Financial Regulation

Notes on Fed Policy and Financial Regulation

Posted on by David Merkel

I’m not likely to be able to comment when the FOMC announces its lack of action today.? The Fed will continue to keep policy loose, while slowly closing down ancillary lending programs, and bloating their balance sheet with mortgage backed securities [MBS] guaranteed by Fannie and Freddie, and ultimately by the Federal Government, which gets the profit or loss from the Fed’s financing (of the mortgages at 0% interest for now).

Going back to last night’s post, strip away the complexity, and what you have is the Federal Government intervening in the MBS market, and forcing down yields, at a cost of indebting future generations (should they decide to make good on those).? This will eventually fail as a strategy.? Unless the Fed wants to keep its balance sheet permanently larger, yields on MBS will rise when they stop buying.? And, the moment that they hint that they will start unloading, rates will back up significantly.? They are too large relative to the MBS market.

They can engage in fancy strategies where they try to remove policy accommodation either through rates or the size of the balance sheet, but one thing Fed history teaches us is that the Fed doesn’t know what will happen when a tightening cycle starts, but usually it ends with a bang — some market blowing up.

Two more notes: it doesn’t matter who the Fed Chairman is.? The structure of the Fed matters more than the man.? That said, Bernanke has promised transparency but has not given it at the most crucial times — those dealing with the bailouts.? All of the talk to audit/limit/shrink/end the Fed comes from abuse of those powers, which should be done by the Treasury and Congress, so that voters can hold them accountable.

Finally, one quick note on regulation of financials.? Laws don’t mean squat if regulators won’t enforce them.? There was enough power in prior laws for regulators to have curbed all of the abuses.? The regulators did not use their powers then; what makes us think that they will use expanded powers?? Regulatory capture has happened in the banking industry; regulators will have to get ugly with those that they regulate if they genuinely want to regulate.

This includes changing risk-based capital formulas to remove the advantage of securitizing debt.? I’m not saying penalize securitization, but put it on a level playing field so that the inherent leverage involved in securitization gets a higher capital charge relative to straight debt of a similar risk class.

That also includes not letting banks fudge asset values to give the appearance of solvency, but more on that tonight.? I gotta fly now on business.

Book Review: Market Indicators

Book Review: Market Indicators

Posted on by David Merkel

Every one one us has limited bandwidth for analysis of data.? We pick and choose a few ideas that seem to work for us, and then stick with them.? That is often best, because good investors settle into investment methods that are consistent with their character.? But every now and then it is good to open things up and try to see whether the investment methods can be improved.

For those that use market indicators, this is the sort of book that will make one say, “What if?? What if I combine this market indicator with what I am doing now in my investing?”? In most cases, the answer will be “Um, that doesn’t seem to fit.”? But one good idea can pay for a book and then some.? All investment strategies have weaknesses, but often the weaknesses of one method can be complemented by another.? My favorite example is that as a value investor, I am almost always early.? I buy and sell too soon, and leave profits on the table.? Adding a momentum overlay can aid the value investor by delaying purchases of seemingly cheap stocks when the price is falling rapidly, and delaying sales of seemingly cheap stocks when the price is rising rapidly.

Looking outside your current circle of competence may yield some useful ideas, then.? But how do you know where you might look if you’re not aware that there might be indicators that you have never heard of?? Market Indicators delivers a bevy of indicators in the following areas:

  • Options-derived (VIX, put/call)
  • Volume and Price driven (Money flow, rate of change, 90% up/down days, and more)
  • Where the fast money invests (money in bull vs bear funds, sector fund sizes, and more)
  • Analyzing the likely motives of other classes of investors (margin balances, short interest, etc.)
  • Price Momentum and Mean-Reversion
  • Measuring asset classes and sectors using fundamental metrics? (Fed model, sector weightings, Q-ratio, etc.)
  • Investor sentiment surveys
  • How to use analyst opinions, if at all?
  • News reporting and reactions of stocks to news
  • Odd bits of news (CEO behavior, little things that indicate a qualitative change in the life of a company)
  • Insider buying and selling
  • Commodity market data (COT, etc.)
  • Bond market behavior (credit cycle, Fed moves, Credit Default Swaps, and more)
  • Changes in the capital structure (M&A, equity/debt issuance, etc.)
  • Monitoring the greats (13F filings)

No one can use all of these indicators.? You can probably only use a fraction of these indicators.? But being aware of how others view the market can widen your perspective, and help to reduce negative surprises on your part.

Quibbles

By its nature, since the book cuts across a wide number of areas in 216 short pages, you only get a taste of everything.? I liked this book, but there is room for a second book in this area — one of additional indicators passed over (I have a bunch!), or going into greater depth on the indicators covered.

Who will benefit from this book?

You have to have a quantitative bent, at least to the level of being willing to go out and collect simple data in order to benefit here.? Now, most serious investors do that, so I would say that serious investors can benefit from the “cook’s tour” of market indicators that this book gives, unless they are so serious that they know all of these indicators.? (Like me.)

If you would like to buy the book, you can buy it here: Market Indicators: The Best-Kept Secret to More Effective Trading and Investing.

Full disclosure: This book is unusual for me in two ways.? First, the author (not the PR flack) sent me a copy, with a nice handwritten letter thanking me for my blog and my assistance.? That is why there is the second reason.? Pages 80-81 summarize the longer argument made in my blog post, The Fed Model, where I take the so-called Fed model, and rederive it using the simple version of the Dividend Discount Model, giving a more robust model with reasonable theoretical underpinnings.

I earn a small commission from Amazon for anyone entering Amazon through my site, and buying anything there.? Your price does not rise from my commission.? Don’t buy anything you don’t want to buy if you want to reward me for my writing.? Only buy what you need if Amazon offers you the best deal.

Dubai? Do Sell?

Dubai? Do Sell?

Posted on by David Merkel

There are always areas of excess in every market boom phase.? Dubai is an example of that.? Why can they build the tallest building, and construct islands in the Persian Gulf?? Cheap capital, riding on the oil boom, sent Dubai to incredible heights.? In an economic game of crack-the whip, Dubai is at the end of the line — they don’t have much energy production, but they have grandiose ideas that benefit if those with oil wealth decide to spend money nearby for fun, rather than abroad.

Now the Dubai government’s champion development corporation, Dubai World, faces bankruptcy.? Given the debt guarantees of the Dubai government, what happens?? Dubai is not big, and as part of the United Arab Emirates, is reliant on help from the other Emirates, particularly Abu Dhabi.? The worries are that there could be “contagion”-type effects that could affect the creditworthiness of related entities, particularly those that have lent to Dubai World.? Most of those are either UAE-related or European banks.? This isn’t a US issue, unless it becomes a big European issue — unlikely, but remember that European banks are more levered than US banks.? The US Dollar has been gaining on this news.

Secondary aftershocks would be entities similar to Dubai — other places in the world that have borrowed a lot in an attempt to grow rapidly.? Thus many emerging markets are getting hit in this mini-crisis.? What investors should remember is that in ordinary circumstances (peace, absence of famine, plague, or rampant socialism), the economy tends to grow at about 2%/year.? One can try to increase that by borrowing, and at the right opportunity that can be a winner.? But most of the time, huge increases in debt levels are eventually associated with default.? In a highly leveraged financial system where lenders are themselves indebted, defaults can cascade.? Also, as mentioned above suspicions get raised with similar entities for a different type of cascade.? A third aspect can involve a reduction in general willingness to take risk on the part of most investors.

Often at such a time, various government ministers/bureaucrats come forth and say, “There is nothing fundamentally wrong here.? All we need is to restore confidence.? This is not a solvency issue, it is a liquidity issue!”? Uh, maybe, but keep your hand on your wallet.? One has to examine how separable the various economic issues are.? Where contagion exists, it is like a massive arrangement of dominoes.? The more leverage on any entity, the taller that domino is.? The more leverage in the system, the more tightly the dominoes are spaced.? That arrangement can be stable for a time.? Stable, that is, until someone knocks over a key domino.

Now, most analysts are saying that this situation is contained, and after falling hard for the two prior days, European markets are rallying today, including financials.? Values for debts closely related to Dubai World have fallen hard, and S&P and Moody’s have downgraded them, and may declare the payment delay to be a default. (Also, with credit to Moody’s — they did downgrade many Dubai-related entities earlier this month.? Remember, with rating agencies, smart investors ignore the ratings, and look at what the analyst says.? The Moody’s analyst highlighted the lack of any explicit guarantees from Dubai.)

I would simply say be careful.? The total debts of Dubai-related entities are not clearly known, and the degree of willingness of friends and lenders to support them is unknown.? In the credit business, relying on the kindness of strangers is not a wise strategy.? The challenge is to see that in advance and avoid debt situations where informal reliance on third parties is a large part of the case for creditworthiness.? I would add that investors in junior debt issues, including Islamic pseudo-debt issues have to be cognizant of the lack of guarantees involved.? Study the prospectuses with care in such situations, and avoid risks that are less clear, particularly during bull markets, where the rewards for being correct are small.

Other selected articles on the mini-crisis:

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