Structured Products and Derivatives – Page 20

Problems with Constant Compound Interest (4) (and more)

Posted on 24 November 2009 by David Merkel

At the meeting of the eight bloggers and the US Treasury, one of the differences was whether the recovery was real or not.? The Treasury officials pointed to the financial markets, and the bloggers pointed at the real economy (unemployment and capacity utilization).

With T-bills near/below zero, I feel it is reasonable to trot out an old piece of mine about the last recession.? But I will quote most of it here:

I posted this on RealMoney on 5/6/2005, when everyone was screaming for the FOMC to stop raising rates because the ?auto companies were?dying.?

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On Oct. 2, 2002, one week before the market was going to turn, the gloom was so thick you could cut it with a knife. What would blow up next?

A lot of heavily indebted companies are feeling weak, and the prices for their debt reflected it. I thought we were getting near a turning point; at least, I hoped so. But I knew what I was doing for lunch; I was going to the Baltimore Security Analysts? Society meeting to listen to the head of the Richmond Fed, Al Broaddus, speak.

It was a very optimistic presentation, one that gave the picture that the Fed was in control, and don?t worry, we?ll pull the economy out of the ditch. When the Q&A time came up, I got to ask the second-to-last question. (For those with a Bloomberg terminal, you can hear Broaddus?s full response, but not my question, because I was in the back of the room.) My question (going from memory) went something like this:

I recognize that current Fed policy is stimulating the economy, but it seems to have impact in only the healthy areas of the economy, where credit spreads are tight, and stimulus really isn?t needed. It seems the Fed policy has almost no impact in areas where credit spreads are wide, and these are the places that need the stimulus. Is it possible for the Fed to provide stimulus to the areas of the economy that need it, and not to those that don?t?

It was a dumb question, one that I knew the answer to, but I was trying to make a point. All the liquidity in the world doesn?t matter if the areas that you want to stimulate have impaired balance sheets. He gave a good response, the only surviving portion of it I pulled off of Bloomberg: ?There are very definite limits to what the Federal Reserve can do to affect the detailed spectrum of interest rates,? Broaddus said. People shouldn?t ?expect too much from monetary policy? to steer the economy, he said.

When I got back to the office, I had a surprise. Treasury bonds had rallied fairly strongly, though corporates were weak as ever and stocks had fallen further. Then I checked the bond news to see what was up. Bloomberg had flashed a one-line alert that read something like, ?Broaddus says don?t expect too much from monetary policy.? Taken out of context, Broaddus?s answer to my question had led to a small flight-to-safety move. Wonderful, not. Around the office, the team joked, ?Next time you talk to a Fed Governor, let us know, so we can make some money off it??

PS ? ?Before Broaddus answered, he said something to the effect of: ?I?m glad the media is not here, because they always misunderstand the ability of the Fed to change things.? ?A surprise to the Bloomberg, Baltimore Sun, and at least one other journalist who were there.

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And now to the present application:

Why are commodities rising amid surplus conditions in storage?? Why is it reasonable to take over corporations when it is not reasonable to expand organically?? We are in a position where yields on short? Treasuries are nonexistent, investment grade and junk yields are low for corporates, and equities are rallying, but there is little growth, or some shrinkage in productive capacity.? Why?

The liquidity offered by the Fed is being used by speculators for financial positions, levering up relatively safe positions, rather than speculating on areas that are underwater, like housing and commercial real estate.? This is consistent with prior experience.? When the Fed does not allow a significant recession to occur, one proportionate to the amount of bad loans made, but comes to the rescue to reflate, what gets reflated is the healthy parts of the economy that absorb additional leverage, not the part that is impaired because they can’t benefit from low rates.? They have too much debt already relative to the true value of their assets.

That is why a booming stock market does not portend a good economy.? Banks aren’t lending to fund new growth.? They are lending to collapse capacity through takeovers.? ROE is rising from shrinking the equity base, not by increasing sales and profits.

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There is another current application:

Why do we buy commodities as investments?? Is it that we fear inflation in the short or long run?? Is it that it is a proxy for future prices for consumption in retirement, so we are hedging the future price level in a dirty way?

Think about it.? How do you transfer present resources to the future?? Most consumable goods can’t be stored, or require significant cost for storage.? Services can’t be stored; elderly people can’t store up health care.

Storage occurs through building up productive capacity that will be wanted by other at a later date, such that they will want to trade current goods and services for your productive capacity.? Storage also occurs by purchasing goods that do keep their value, and then trading them for goods and services you need when the time come to consume.

That is how one preserves value over time, and it is not easy.? It will be even harder if there are such disruptions to the economy that markets that are virtual do not survive.? (I.e. paper promises are exchanged, but their is significant failure to deliver at maturity.)

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In an environment where the government is playing such a large role in the economy, it is difficult to see how one can invest for the long term — when we are twisted between deflation and inflation, rational calculations are circumscribed, and simple judgments, such as buying out a competitor and shrinking the overall balance sheet are made.? In one sense, that is the rational thing.? Less capacity is needed.? But unemployment will rise.

That’s sad, but wage rates may be too high for some to be employed, given the lack of demand.? I view this as true in aggregate, but people that are aggressive in seeking employment are able to do much better.? I have seen it.? Even in a bad market, those that strive intelligently get hired.

My Visit to the US Treasury, Part 5

Posted on 7 November 20097 November 2009 by David Merkel

One other blogger took his nameplate with him — I’m not sure who; the rest left theirs.? But this is what was in front of each one of us as we sat down to discuss matters at the US Treasury.? Treasury officials had similar nameplates.? It dictated where we would sit as well.? From the front of the room on the left, for bloggers it was Financial Armageddon, (Megan McArdle — not there), Accrued Interest, and Across the Curve.? On the right, Naked Capitalism, Kid Dynamite, Interfluidity, Me, and Marginal Revolution.? Aside from putting the two bloggers with the most traffic at the front, there did not seem to be any rhyme or reason to the seating.

The Treasury officials presenting generally sat in front, a few sat to the side and behind us.? It made for an interesting dynamic during the portion of the meeting where some bloggers disagreed over whether derivatives should be exchange traded or not.? The folks from the Treasury grinned.? See?? These aren’t easy questions to answer!? For me, with a middle view (bring interest rate swaps to exchanges first and see how they work, then try other instruments that are less liquid), I found the exchange to be a waste of precious time, but it was revealing of the attitudes of those in the Treasury.? I knew what the bloggers thought already.

The Biggest Financial Problem

I’ve written a number of pieces on why debt matters. (Or, where is the breaking point?)? I am in the process of reviewing This Time is Different: Eight Centuries of Financial Folly — a book that deals with the reality of sovereign defaults over the last 800 years.

Surprise! Over-indebted countries do default on their debt more often than less-indebted countries.? During the current crisis, we have two mechanisms running to blunt the troubles.? The government is running a large deficit, and the central bank is sucking in longer-dated bonds to lower interest rates.? I talked about why lower interest rates are not necessarily a blessing yesterday.? Today’s thoughts are on deficits.

After the meeting, I said to one Treasury staffer, “One of the quiet casualties of this crisis is that you lost your last bit of slack from the entitlement systems.”

“What do you mean?”

“Just this, prior to the crisis, Social Security and Medicare would produce cash flow surpluses for the Government until 2018.? Now the estimates are 2016, and my guess is more like 2014.? The existing higher deficit takes us out to the point where the entitlement systems go into permanent negative cash flow.? This means that the US budget is in a structural deficit for as far as the eye can see, fifty years or more, absent changes to entitlements.”

He looked at me and commented that it would be the job of a later administration.? No way to handle that now.? To me, the answer reminded me of what I say to myself when I go on a scary ride at Six Flags with my kids.? There is nothing we can do to change matters.? The only thing to adjust is attitude.? So, ignore the fact that you are afraid of heights, and enjoy the torture, okay?

Would that I could do that with the present situation.? The long term problems are too numerous, and the present crisis saps attention from what is arguably a larger problem.? Medicare, Social Security, unfunded Federal pensions and retiree healthcare, underfunded state pensions and unfunded retiree healthcare, and underfunded corporate pensions (flowing to the PBGC) are the crisis of the future.? We are talking underfunding and debts equivalent to 4x GDP in total.

The deficits may be helping out areas of our economy for which there is already too much capacity — autos, banks, housing, but isn’t aiding the parts of the economy that don’t have excess capacity.? The one advantage to Americans is that a decent amount of the debt is absorbed by the neomercantilists, who will get paid? back in cheaper dollars (if at all) than the goods that they provided originally.

This all feels like the Japan scenario.? Low interest rates, low growth if any in non-protected sectors, soggy debt-laden protected sectors, excess capacity in areas not salable to the rest of the world, high government debt, and a demographic crisis.? Also speculation using cheap leverage for carry trades.

I’ll try to tie this up in another post or two.? Sorry if this is verbose.

My Visit to the US Treasury, Part 1

Posted on 3 November 2009 by David Merkel

This will have to be brief, because I am tired.? I have had to deal with family and work issues today, and only now have time to blog.

You might have seen my fanciful post, Fallowhaven, Part 1.? I wrote that because I thought I could reveal almost nothing of my visit to the US Treasury today.? As it is, I can talk about it, but not quote any officials there, nor say who was there from the Treasury.

My surprise was that only bloggers were there.? I expected reporters from major papers, but that was not the target audience.? The closest to mainstream media would have been Megan McArdle, who presumably said she would be there (there was a placard for her), but did not show.? The rest of us were independents:

As I write now, only John Jansen has commented on the meeting, and only briefly.? I have a lot to say about the meeting, but I can’t get it into one post.? I will spread it out over several posts, and try to explain the? views of the Treasury, are where they make sense, or not.

I appreciated being able to meet my fellow bloggers.? Putting faces to the names is special.? Would that I could bring all of the major investment/finance/economics bloggers together for a gathering.? There would be many disagreements, but it would sharpen us all.

More tomorrow –? I want to talk about the successes and failures of the current rescue, and how the Treasury views them.

On Bond Investing, ETFs, Indexes, and the Current Market Environment

Posted on 29 October 2009 by David Merkel

Bond indexes are what they are.? They represent the average dollar invested in the bond markets.? Those that say that the indexes are flawed miss the point.? Indexes represent the average return of an asset class, with all of its warts and wrinkles.? That is the nature of an index; it earns what the asset class as a whole earns.

So what if big issuers dominate the index?? The average dollar in bonds reflects that.? Do you want to take a bet against the average?? You probably do, and I do as well.? But it is not the purpose of an index to make that bet, so much as to facilitate that bet for active managers.

I appreciated the book The Fundamental Index ? Arnott did us a favor by writing it.? The book shows how to do enhanced indexing off of fundamental factors.? (A pity that the book went public at the point where most of those factors were overpriced.)

The trouble with enhanced indexing is scalability.? Suppose Arnott?s fund and those like it grew large relative to the market as a whole.? The components of his strategy that are smallest relative to their total market size will get bid up disproportionately.? Eventually they will not be a favored investment of the strategy, and as they move to sell, they will find that they are large holders of something the market is not so ready to buy.? As the price goes down, perhaps it becomes attractive again. Perhaps an equilibrium will be reached.

One thing is certain, though.? The non-enhanced index can be held be everyone.? The enhanced index will run into size limits.

What then for bond ETFs?? Are they chained to inferior indexes? ?No.? By their nature, bond indexes are almost impossible to replicate perfectly because of liquidity constraints. Many institutional bond investors buy and hold, particularly for unique issues.? That?s why indexes are constructed out of liquid issues which will have adequate tradability.? Who issues those bonds?? The big issuers.? It is not possible to create a scalable bond index in any other way, and even then, there will always be some bonds in the index that are impossible to find, and/or, because they are index bonds, they trade artificially rich to similar bonds that are not in the index.

Almost all bond indexers are enhanced indexers, because they don?t have enough liquidity to exactly replicate the index.? Instead, bond indexers try to replicate the factors that drive the index, with better performance if they can manage it.? That?s where choosing non-index bonds that are similar in characteristics, but have better yields comes in.? That is the value of active bond management; it does not mean that the indexes are flawed, but that there are ways for clever investors to systematically do better, that is, until there are too many clever investors.

Pricing Issues

Morningstar prepared this piece on pricing difficulties with bond ETFs and open-ended bond funds.? Yes, it is true that many bonds don?t trade regularly, and that matrix pricing gives estimates for prices on bonds that have not traded near the close, where an asset value must be calculated.

Remember the scandal over mutual fund front-running?? In that case, stale pricing off of last trades enabled clever connected ?investors? to place late trades where the calculated NAV was far away from the theoretically correct NAV (if assets traded continuously).? In order to calculate the theoretically correct NAV (which the late traders did in order to make money), the mutual funds had to engage in a form of matrix pricing, adjusting the last trades to reflect changes in the market since each last trade until the close.? Far from being inaccurate, matrix pricing is far superior to using the last trade.

I will take the opposite side of the trade from the Morningstar piece.? Markets are not rational, especially bond ETF investors.? I trust the NAV more than the current price; matrix pricing is complex, but it is pretty accurate.? Yes, for some really illiquid, unique issues, it will get prices wrong, but that is a tiny fraction of the bond universe.? We can ignore that.

Rationality comes to bond ETFs when sophisticated investors do the arbitrage, and create new ETF units when there is a premium to the NAV, or melt ETF units into their constituent parts when there is a discount to NAV.? That pressure places bounds on how large premiums and discounts can become.

The more specific the bonds must be to create a new unit, the harder it is to do the arbitrage, and the higher the level of premium can become before an arbitrage can occur.? If a less specific group of bonds can be delivered to create a new unit, i.e., the bonds must satisfy certain constraints on issuer percentages, issue sizes, duration [interest rate sensitivity], convexity [sensitivity to interest rate sensitivity], sector percentages, option-adjusted spread/yield, etc., then arbitrage can proceed more rapidly, and premiums over NAV should be smaller.

So, when there are large premiums to NAV, it is better to sell.? Large discounts, better to buy.? Of course, take into account that short bond funds should never get large premiums or discounts.? If they do, something weird is going on.? Long bond funds can get larger premiums and discounts because their prices vary more.? It takes a wider price gap versus NAV before arbitrage can occur.

As for cash creations, those that run the ETF could publish a shadow ETF price, which would represent the price that they could create new units themselves, taking into account how they would like to change the ETF?s positions in order to better outperform while matching the underlying characteristics of the index.? That shadow ETF price could not be a fixed percentage of the existing NAV.? It would have to vary based on the cost of sourcing the needed bonds.? This would run in reverse for cash-based redemptions, which would only likely be asked for when the ETF was at a discount.? Better for the fund to do some modified ?in-kind? distribution, agreed to in advance by the sophisticated unit liquidator.

Derivative Issues

Well, if there?s not enough liquidity in the bond market to accommodate our desired investment, why not create it synthetically through credit default swaps?? That might work, but if the bonds are illiquid, often the derivatives are as well, or, the derivatives trade rich to where an identical bond would trade in the cash market.? There is also credit risk from the party buying protection on the default swap; if he goes broke, your extra yield goes away, at least in part.

I don?t see derivatives as being a solution here, though they might be helpful in the short-run while waiting to source a bond that can?t be found.? Derivatives aren?t magic; liquidity comes at a cost, and some of those costs aren?t obvious until a market event hits.

Also, I would argue that the rating agencies are better judges of creditworthiness on average than the prices of credit default swaps.? Though rating agencies should be examined for their conduct in structured securities, their record with corporates is pretty good.? The rating agencies do fundamental research; yields do reflect riskiness, but markets sometimes wander away from their fundamental moorings.? Derivatives can trade rich or cheap to the cash market for their own unique reasons.? Same for bond spreads ? just because one bond has a higher spread than another similar bond, it does not mean that that bond is necessarily more risky.

When I was a corporate bond manager, I would occasionally find bonds that yielded considerably more than others of a given class.? My job, and the job of my analyst was to find out why. ?Often the bond was not well known, or was a better quality name in a bad industry.? On average, spreads reflect riskiness, but in individual situations, I would rather trust the judgments of fundamental analysts, including the rating agencies, though private analysts are better still.

So what should I do in the Current Environment?

I don?t think we are being paid to take credit risk at present, so stay conservative in bonds for now.? Specifically:

Underweight credit risk.
With equities, stress high-quality balance sheets, and stable industries.
Underweight financials, particularly banks and names that are related to commercial real estate.
GSE-related residential mortgages look okay.
TIPS don?t look good on the short end, but look okay on the long end.
Be wary of paying premiums on bond ETFs? and maybe look at some closed-end funds that trade at discounts.
The yield curve is steep, but that is ahead of a lot of long supply coming from the US Treasury.? Stick to short-to-intermediate debt, and wait for supply to be digested.? After that, maybe some long maturity positions can be taken as rentals, so long as inflation does not take off.
Diversify into foreign bonds, but don?t go crazy here. ?The Dollar has run down hard, and opportunities are fewer.? (I will have a deeper piece on this in time, I hope.)

This is a time to preserve capital, not reach for gains.? Don?t grasp for yields that cannot be maintained.

PS — Thanks to the guys at Index Universe and Morningstar for the articles; they stimulated my thinking.? I like both sites a lot, and recommend them to my readers.? The articles that I cited had many good things in them, I just wanted to take issue with some of their points.

Toward a New Theory of the Cost of Equity Capital

Posted on 17 October 200918 October 2009 by David Merkel

I have never liked using MPT [Modern Portfolio Theory] for calculating the cost of equity capital for two reasons:

Beta is not a stable parameter; also, it does not measure risk well.
Company-specific risk is significant, and varies a great deal.? The effects on a company with a large amount of debt financing is significant.

What did they do in the old days?? They added a few percent on to where the company’s long debt traded, less for financially stable companies, more for those that took significant risks.? If less scientific, it was probably more accurate than MPT.? Science is often ill-applied to what may be an art.? Neoclassical economics is a beautiful shining edifice of mathematical complexity and practical uselessness.

I?ve also never been a fan of the Modigliani-Miller irrelevance theorems.? They are true in fair weather, but not in foul weather.? The costs of getting in financial stress are high, much less when a firm is teetering on the edge of insolvency.? The cost of financing assets goes up dramatically when a company needs financing in bad times.

But the fair weather use of the M-M theorems is still useful, in my opinion.? The cost of the combination of debt, equity and other instruments used to finance depends on the assets involved, and not the composition of the financing.? If one finances with equity only, the equityholders will demand less of a return, because the stock is less risky.? If there is a significant, but not prohibitively large slug of debt, the equity will be more risky, and will sell at a higher prospective return, or, a lower P/E or P/Free Cash Flow.

Securitization is another example of this.? I will use a securitization of commercial mortgages [CMBS], to serve as my example here.? There are often tranches rated AAA, AA+, AA, AA-, A+, A, A-, BBB+, BBB, BBB-, and junk-rated tranches, before ending with the residual tranche, which has the equity interest.

That is what the equity interest is ? the party that gets the leftovers after all of the more senior capital interests get paid.? In many securitizations, that equity tranche is small, because the underlying assets are high quality.? The smaller the equity tranche, the greater percentage reward for success, and the greater possibility of a total wipeout if things go wrong.? That is the same calculus that lies behind highly levered corporations, and private equity.

All of this follows the contingent claims model that Merton posited regarding how debt should be priced, since the equityholders have the put option of giving the debtholders the firm if things go bad, but the equityholders have all of the upside if things go well.

So, using the M-M model, Merton?s model, and securitization, which are really all the same model, I can potentially develop estimates for where equities and debts should trade.? But for average investors, what does that mean?? How does that instruct us in how to value stock and bonds of the same company against each other?

There is a hierarchy of yields across the instruments that finance a corporation.? The driving rule should be that riskier instruments deserve higher yields.? Senior bonds trade with low yields, junior bonds at higher yields, and preferred stock at higher yields yet.? As for common stocks, they should trade at an earnings or FCF yield greater than that of the highest after-tax yield on debts and other instruments.

Thus, and application of contingent claims theory to the firm, much as Merton did it, should serve as a replacement for MPT in order to estimate the cost of capital for a firm, and for the equity itself.? Now, there are quantitative debt raters like Egan-Jones and the quantitative side of Moody?s ? the part that bought KMV).? If they are not doing this already, this is another use for the model, to be able to consult with corporations over the cost of capital for a firm, and for the equity itself.? This can replace the use of beta in calculations of the cost of equity, and lead to a more sane measure of the weighted average cost of capital.

Values could then be used by private equity for a more accurate measurement of the cost of capital, and estimates of where a portfolio company could do and IPO.? The answer varies with the assets financed, and the degree of leverage already employed.? Beyond that, CFOs could use the data to see whether Wall Street was giving them fair financing options, and take advantage of finance when it is favorable.

I?ve wanted to write this for a while.? Though this is an outline of how to replace MPT in estimating the cost of capital, it has broader ramifications, and could become a much larger business, much like the rating agencies started with a simple business, and branched out from there.

Maybe someone is doing this already.? If you are aware of that, let me know in the comments.

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PS — Sorry that I have been gone for the last few days.? Church business took me away. I’m back now, and will be posting on Monday.

Miscellaneous Notes

Posted on 1 October 2009 by David Merkel

When I wrote for RealMoney, I would sometimes do Columnist Conversation [CC] posts that would be entitled “Miscellaneous Notes,” or “Odds and Ends,” etc.? Occasionally my editor would chide me saying that I should be able to come up with better titles.? I don’t know; I have a wide vista of interests in investing.? It is hard to make me focus on a single issue for a long period of time.

So here are some miscellaneous notes.? It is my website, after all.

1) A recent comment on the piece On Vanilla Products😕 David, doesn’t Vanguard and Fidelity offer a low fee VA product using in house funds?? At some point I another low fee insurace offering was out there (under 50bps+fund fees) for no fee planners, but cannot remember the name for the life of me.? I think they worked with Rydex to grab traders assets.

I agree it’s a great way to retain sticky assets.

A dear friend of mine told me that Jackson National was offering such a product.? No jealousy from me; any product that I think should exist makes me grateful when it comes into existence.

2) A reader commented on the the piece, Recent Portfolio Actions: It sounds as if you’re more bearish now than in 2003.? Why?? It is doubtful that the Fed will remove liquidity any time soon.? While there may be headwinds in terms of value, the consumer, and real estate, the appetite for junk bonds keeps growing.? As long as that’s the case, the likely-to-become-insolvent crowd will be able to meet short-term payments, and asset bubbles could continue to grow.

That’s a very good question, and it is one that makes me wonder in the present environment.? The comparison should not be 2003, but 2001-2003.? It is rare for the fixed income market to have a V-shaped recovery.? More often than not, the recovery is a W, or a pair of Ws.

Also, in 2003, when I looked at the credit troubles remaining, there were few of them.? in 2009, there are a lot of them, in residential housing, in commercial real estate, in junk bonds, etc.? I don’t care about the current speculative wave; bear market rallies are sharp and severe.? Big as it is, I believe that we have experienced a humongous bear market rally.

3) Because I am a fan of James Grant, that does not mean that I have praise for him on his recent WSJ op-ed.? If you had said this 6-10 months ago, when I recommended buying junk bonds, I would be impressed.? But most of the rally has already happened, and bear markets often have multiple bottoms.? This bear market has only had one bottom, and there are many more defaults to come in this recession.

4) One reader said to me regarding this piece: David, I know what you mean.?? But I’m curious in this context about the role of absolute valuation strategies in what you recommend.?? Is it a) no role (relative valuation rules!), b) plays a role, but only within the 10% stretch band, c) matters, but one can always find a portfolio’s worth of low absolute valuation stuff (if one doesn’t worry about the implied adverse selection bias that when everything else is pricey, the cheap stuff is much more likely to be cheap for a good reason), or d) something else?

I don’t have a good answer here.? I use a blend of absolute and relative valuation criteria.? I would like to use absolute valuation all of the time, but that does not give enough opportunities.? I live in an era where the competition is much higher than it was for Ben Graham, or Warren Buffett, when he was starting his partnership.

I will say this, though: absolute valuation can be an excuse for investors that are not willing to do the digging necessary to unearth more complex values.

That said, I like to buy companies below 2x book, and below 14x earnings.? Multiplying them, as Graham did, most of my companies trade below 22.5x book times earnings.? That helps protect against companies that manipulate earnings or the balance sheet, if one relies on a joint criterion.? Behind that, I review the cash flow statement.? Clever companies can fuddle two of the three main statements; no one can fuddle all three.? Accounting fraud usually can be seen from the cash flow statement being less positive than the income statement.

Name Your Poison

Posted on 25 September 2009 by David Merkel

Last night I wrote a longish post, and the system ate it.? Probably I had not established a firm connection with the server, and when I hit the publish button, it disappeared.? My main point was to ask where the limits were for all of the borrowing and spending? going on from the Treasury, and all of the lending going on with the Fed.

I have talked about this before in articles like It is Good to be the World?s Reserve Currency.? Both China and?OPEC have their political reasons for lending to the US, and those keep the dollar afloat for now.

I began last night’s doomed post by declaring to readers that they were part owners in the largest hedge fund (or CDO) in the world — the US Government.? Very distant from the founders’ designs, the government lends to private enterprises in a big way, clipping a spread, while still being exposed to default.

The US government has absorbed many private debts into the government’s debt in exchange for many private debt and equity claims.? Given that the government is clipping a spread, and borrowers are obtaining better terms than the market could give, could there be any problem?

Yes, there are several problems:

The federal credit is not infinite — dare we risk the survival of our government to rescue special interests?
The ability of the Fed to stretch the currency is not infinite — price inflation has not come yet, but when it does come, it will likely accelerate from all of the promises made.
There is some degree of favoritism in who gets funds.? The larger banking firms have been bailed out at their holding companies, which is a travesty, because only regulated subsidiaries are to be protected, not the interests of holding company stock and bondholders.? Small banks have been left to fail.
Private lenders who would lend at higher rates are getting cheated by the government, who has no business being a lender.? (Yes, I know, they have been doing it for decades, but that does not make it right.)
There is little ability for the government to know whether they are offering fair terms or not as far as the taxpayer is concerned.? What is the right tradeoff between offering more loans, and taxing the populace more?
The FDIC trades on the creditworthiness of the US.? They offer guarantees using the Federal credit, rather than surcharge the banks to make up for losses.? Letting banks lend to them at Treasury rates is clever to replenish the reserve funds, but what happens when there are more large defaults?? The hole will be deeper, and the climb out more challenging.
So long as the productive capacity of the US is not expanding, arguing about how it is financed is not a fruitful endeavor.

Leaving aside the mutual suicide pact of those that own a disproportionate amount of US Treasuries, the risks that exist stem from an over-indebted economy, and the inability of consumers to resume their role of excess consumption, with accumulation of debt.

Aside from that, should we have a resumption in the decline of housing prices, an acceleration in corporate defaults, or commercial mortgage defaults that affect the big banks, it doesn’t matter that the government is clipping an interest spread, because the losses will be worse.

As a final note, let’s watch the end of the Quantitative Easing from the Fed.? Together with the Treasury they already own over 30% of all 30-year GSE-conforming mortgages, if not more.? What?? Do we want the government to absorb every bad debt?? Where is the responsibility to those that contracted the loans, expecting profit or pleasure?

This will not end well. The only question is whether it ends in inflation or greater taxation.? Name your poison.

Ten Notes on Current Market Risks

Posted on 19 September 200920 September 2009 by David Merkel

1)? You hear me talk about this more than most, but liquidity risk needs more emphasis.? This is true whether you are a retail or institutional investor.? As the old saying goes, “Only invest what you can afford to lose.”? The basic operations of life require liquidity.

That even applies to the abstract mathematicians who developed much of modern finance.? The moment they assume a simple arbitrage argument, it implies that liquidity is free, or nearly so, in the markets.? I remember asking questions of my professors over Black-Scholes 25 years ago, because equity markets did not trade continuously, except for large companies.

My view is that introducing liquidity risk will be difficult for academic finance, because it will blow apart the simple models that they need in order to write their research.? Once markets do not trade continuously, the math gets tough.

2)? Insiders are selling, should you worry?? Perhaps a little, but I would wait until the price momentum starts to fail.? Like value investors, insiders tend to be early.

3)? What works in a time of rising leverage will not work well when leverage is decreasing.? Or, a strategy that requires liquid markets does not so well in a time of deleveraging.? Consider Citadel, then.? The period from 1991-2007 was pretty care-free.? What crises occurred were not systemic, and were quickly snuffed out by the Fed, as it edged us closer to a liquidity trap.? In 2008, the trap was sprung and Citadel had a lousy year.? Amid the carnage, they were forced to sell into? falling market.? Now they are running at reduced leverage, and planning products that would have been smart eight months ago.

4)? Average retail investors don’t understand regulated investments well enough to invest in them.? It would be stupid to allow them to invest in hedge funds, then.? If we would do such a thing, then deregulate the simpler investments first, telling people that they are on their own, the ineffective SEC is being disbanded, and that “caveat emptor” is the only risk control remaining.

I can’t see that happening in my lifetime.? The nature of American culture abhors implicit fraud, and thus we regulate most of those that take money and offer uncertain promises, when those offering the money don’t have much.? (The culture abhors little investors being fleeced by bigger institutions.)

5)? Auction rate preferred securities — when I was younger, I wondered how they worked.? By the time I figured that out, the market failed.? Now the lawsuits fly.? Yes, they were marketed as money market equivalents, but none of them made it into money market funds.? Now, having read many of the prospectuses, the risks that eventually emerged were disclosed in advance.? Few believed them because it had worked so well for so long.? My view is this — investors needed to read the “risk factors,” and did not.? ARPS were designed to be investment vehicles that could survive a storm, but not a tornado.? Tornadoes do happen, and those that assumed that such volatility would never happen lost.

6)? My, but the high yield market and lower investment-grade corporate markets have moved higher.? What observers miss is that yields for sensitive financials are a lot higher than they were in early 2007, about the time I started this blog.? Systemic risk is still high.

7)? Spreads have fallen for high yield; I have previous suggested to lose the overweight in credit.? I now suggest that credit be underweighted.? This is not a time to stretch for yield.

8 )? After many other crises, junior debt gets grabbed when seniors have rallied a great deal.? The need for yield is significant, much as I think it is premature to buy those junior debts.

9) The same is true for high yield.? When does the rally end? Now?? Typically near a market peak, there is confusion, and a diminution in volume.? I think we are close to the end, but as I usually say, honor the momentum.? If it is still going up, hold it.

10)? This article is a little unusual for me, but it points out something that I often talk about in different terms.? Trees don’t grow to the sky.? In almost any process, the results are not linear as one increases effort, but there comes diminishing returns because improvement is not costless.? Exponential growth meets the constraint that resources are not infinite, and so growth follows more of an S-curve.? So it is with business, and much of finance.

Ten Notes on Risk in the Markets

Posted on 12 September 200913 September 2009 by David Merkel

1) Credit cycles tend to persist for more than just one year.? That is one reason why I am skeptical of the run in the high yield corporate bond market at present.? Sharp short moves are very unusual.? To use 2001-2003 as an example, we got faked out twice before the final rally commenced.? So, as I look at record high defaults after a significant rally, I am left uneasy.? Yes, defaults have been less than predicted, but defaults tend to persist for at least two years, and current yields for junk don’t reflect a second year of losses in my opinion.? S&P is still bearish on default rates.? I don’t know if I am that bearish, but I would expect at least one back-up in junk yields before this cycle ends.

2) Of course, there are bank loans in the same predicament.? Most bank loans are not listed as trading assets, so they get marked at par (full value) unless a default occurs.? Along with Commercial Real Estate loans, this remains an area of weakness for commercial banks.

3) Where should your asset allocation be?? Value Line is more bearish than at any time I can remember — though the last time they were more bearish was October 2000.? Good timing, that.

David Rosenberg favors high quality bonds over stocks in this environment, which is notable given the low yields.? For that bet to work out, deflation must persist.

One reason this still feels like a bear market is that there are still articles encouraging a lesser allocation to stocks.? Though one person disses the traditional 60/40 stocks/bonds mix, in an environment where complex asset allocations are getting punished, I find it to be quite reasonable.

4) Maybe demographics are another way to consider the market.? When there are more savers/investors vs. spenders, equity markets do better.? I’ve seen this analysis done in other forms.? So we buy Japan?? I’m not ready for that yet.

5) Illiquid assets require a premium return.? After the infallibility of the Harvard/Yale model, that rule is on display.? As their universities began to rely on their returns, even though there was little cash flowing from the investments, they did not realize that there would be bear markets.? Harvard and Yale may indeed have gotten a premium return versus equities.? It’s hard to say, the track record is so short.? One thing for certain, they did not understand the need for liquidity; a severe present scenario has revealed that need.? As such, investors in alternative investments are looking for more liquidity and transparency.

6)? There are limits to arbitrage.? As an example, consider long swap rates.? 30-year swap yields should not be less than Treasury yields — they are more risky, but do do the arbitrage, one would need a very strong balance sheet, with an ability to hold the trade for a few decades.

7) One thing that makes me skeptical about the present market is the lack of deployment of free cash flow in dividends or buybacks.? When managements are confident, we see that; managements are not yet confident.

8 ) I would be wary of buying into a distressed debt fund.? Yields have come down considerable on distressed debt, and I think there will bew better opportunities later.

9) It seems that the US Dollar, with its cheap source of funds for high quality borrowers, is attracting some degree of interest for borrowing in US Dollars in order to invest in other higher yielding currencies.? I’m not sure how long that will last, but many see the combination of a low interest rate and a potentially deteriorating currency as attractive to borrow in.

10) The difference between an investor and a gambler is that an investor bears risk existing in the economic system in order to earn a return, whereas the gambler adds risk to the economic system that would not have existed, aside from his behavior.

Risk Management at Banks

Posted on 12 September 2009 by David Merkel

I have never been a fan of VAR (Value at Risk), but I recognize that mathematical techniques are only as good as those that use them.? Questions arise with any quantitative risk technology:

What’s my time horizon?? (What’s your longest asset or liability?)
Do I have to be good over this entire time horizon, or just the end?? (The whole thing, sorry.)
How do I work with options in assets or liabilities?? (Assume optimal exercise by the option holder.)
What are the worst losses can I take from this business activity?? (Much worse than you can assume, and this present crisis is an example of that.)
How do I model liquidity of liabilities?? (Assume they exit when it is in their interest.)

With one employer, he invited me to consult for the Asset-Liability committee of his bank.? Having been a risk manager inside two life insurance companies, when I reviewed the documents, I was surprised, because they were so much less sophisticated than what life companies of a similar size did.

With banks, the grand weakness is in the assets, and the analysis should focus on two things:

Liquidity of the assets versus liquidity of the liabilities.
Potential credit losses of the assets versus the surplus of the bank.

I write this because of the commentary of Taleb and Bookstaber.? They are bright men, but they have never managed the risks of a financial institution.? Leverage ratios are not enough.? One must dig into the loss experience and analyze whether emerging losses might overwhelm the capital of the institution.? One must also look at risk-based liquidity — what is the likelihood? of running out of cash?

There is always a tension between rules versus principles.? What must first be admitted is that both can be fuddled by sinful men.? Rules can be observed, and cheaters bring items that meet the letter of rules, but violate the spirit of the rules.? Principles can be bent by those that implement the principles.? Neither is a perfect solution — better to settle on one way of regulating, though, and understanding the soft spots, than to vacillate.

Perhaps the banks need to employ actuaries.? I don’t say that so that friends might find work, but because many banks do not get how to preserve their existence.? Actuaries think longer-term; they think about scenarios where loss experience might prove to be unsustainable.? They are more skeptical on risk compared to most bankers.

With that, I commend all who read this to be careful, and to analyze financial situations carefully.? Don’t follow the crowd.