Structured Products and Derivatives – Page 21

On Life Settlements

Posted on 8 September 2009 by David Merkel

Well, thank you Rolfe Winkler and Reuters.? I go off-line on Sundays because it is the Sabbath, so I don’t review the web or catch e-mail, but when Rolfe e-mailed me and I saw it on Monday morning, I felt I had to give him a response.

Now, my response was a brief one, for me.? There was more to say, some of it of a personal nature, but I was busy this weekend.? We moved six of our children into different rooms, repainted two of them, and simplified our lives — I have more trash sitting outside than I have ever seen in my life.? The house is simpler and prettier than ever before, and our two oldest now both have their own rooms.

So, what I wrote was significant, but limited.? Let me fill in some gaps.

First, the efforts on life settlements have been going on for a long time.? This is not new, but has been happening for a little less than 20 years.? Over the last ten years I have been personally invited to be a part of three (maybe more) of these enterprises, and I have turned them all down early because of the ethical issues involved.? I genuinely believe in the concept of insurable interest.

Second, life insurance is for the most part sold, not bought.? I used to have trouble with that, but there are many people who will not save or seek protection unless someone goads them to do so.? Those who will not actively look out for themselves pay a price relative to those who seek coverage unbidden.

Surrender charges exist on life insurance policies to allow insurers to recover the cost of the commission that they have not amortized.? As GAAP accounting would suggest, all revenues and expenses are spread over the life of the policies.? The significant cost of acquiring a life insurance policygets recovered over the life of the policy.? If a policy owner wants to surrender early, the insurance company has a surrender value or cash value that reflects no loss to the insurer on average.

Pretend for a moment that you are a life insurer.? You want to make a profit, or if a mutual, break even.? You test/underwrite potential insured lives before the policy is issued to assign policies to the proper rating class for them.? The more accurate you are, the more polices you will write, and the fewer surrenders you will have.? But over time, people change.? After issue, insureds tend to get more sloppy in their lives, on average.? Also, things that could never have been caught in underwriting emerge.

Those doing life settlements aim at the policies where there have been negative health events since issue.? Death is considerably more likely, and so the value of the policy is worth more.

Think about it: you as the insurance company did your best job to estimate the risk involved. You did it assuming that policies could not be sold, whether really or synthetically.? You already knew that those who were healthy in the future would surrender and seek another carrier, but thought the those who were less healthy would persist to some degree.? Well, with life settlements, the unhealthy persist at a much higher level, which bites into profits.

This is the box that life insurers are in.? They can’t lock in policyholders, but policyholders can hang on, refinance (so to speak), or sell off their obligations.? That is a tough equation for life insurers to work through, and to the degree that life settlements are allowed, premiums will have to rise to compensate for the loss of profitability.

Waiting for the Death of the Chicago School, and the Keynesian School also, Redux

Posted on 5 September 20096 September 2009 by David Merkel

So Paul Krugman gets a lot of ink, and everyone goes gaga for it.? I don’t buy his arguments for two reasons:

He misdiagnoses the cause of the current crisis.? He thinks it is too much of the “free markets.”? Rather, it was predominantly profligate monetary policy.? Secondarily, it was poor banking regulation.? Monetary policy necessarily involves banking regulation in a fiat money system, because credit is what drives the economy.? A failure to limit the ability of regulated institutions to issue credit is just another form of loose monetary policy, whether it results in measured price inflation or not.
Keynesian economics and Neoclassical economics do not consider the debt structure of the economy to be relevant for policy purposes.? I’ve written about this already in this blog post: Waiting for the Death of the Chicago School, and the Keynesian School also. Debt structure is more relevant than any other factor at present.? Economies with high levels of indebtedness are inherently fragile, because booms and busts are amplified by the financial leverage.

Let me take this a different way.? If monetary policy had been conducted properly through the Greenspan era, what should he have done?? Let’s start with the crash in 1987.? Greenspan should have done nothing — no announcement at all.? Maybe a few small clearing firms would have failed, and maybe some minor investment banks, but so what?? The economy would remain sound.? There would be little danger of an increase in unemployment.

Instead, he announces support for the markets, and debt levels increase as a result.? Bad debts are not liquidated, and new debts are incurred, because policy is favorable toward debtors.

Next came the commercial real estate crisis of the late ’80s to early ’90s.? What did the Fed do?? It cut rates from 9.75% to 3%.? What should it have done?? I have a basic rule that says that the Fed funds rate should never be more than 1% below the yield on the 10-year Treasury.? That means the Fed should have leveled out the Fed funds rate at 6-7%, and waited, and taken political heat for doing so.? If they had done this, there not would have been a residential mortgage convexity crisis in 1994, which ended up sinking Mexico as well.

Why not less than 1% below the 10-year Treasury rate?? Anything more leads to easy profits for the banks, with a large increase in the indebtedness of the economy.? Let the banks remain on a diet, and let savers get their due reward.? We don’t have to flood the economy with liquidity to get it to turn around.? Enough liquidity and willingness to wait will do it.? A policy approach like that will lead to a more stable and yet growing economy.

So what was the next crisis?? LTCM in 1998.? The Fed should have done nothing, and if any or all investment banks failed, it would have had little impact on the economy as a whole, because derivative exposures were small.? But no; they coerced the investment banks into a settlement, and loosened the Fed funds rate 0.75% when it should have kept policy tight, and not loosened at all, staying at 5.5%.

Perhaps the tech bubble would have been less virulent if liquidity had not been so plentiful.? Between the loosenings during LTCM and the extra build-up in liquidity for Y2k, the Fed put in the top of the equity market.? Then the Fed tightened significantly, bursting their new bubble.? After that, they went nuts, loosening Fed funds from 6.5% to 1.75% by the end of 2001.? It probably should have stopped at 3-4% and waited.? But no, not only did they go down to 1.75%, they went all the way down to 1% in June 2003, when it was obvious that a strong recovery was underway, and the FOMC left the rate there for a full year, while asset inflation springing from additional indebtedness coming from cheap financing ruled.

Instead of moving from 1% to 4% rapidly, the Fed chose a slow pace, a robotic pace for the next 17 meetings, increasing 0.25% each meeting.? Language dominated over policy as the market anticipated their actions.? They dared not surprise the market, but they overshot the 4% area that would have been closer to equilibrium.

If the Fed is unwilling to deliver surprises, it is unwilling to govern.? Give us what we need, not what we want.? At present, Fed funds should be in the 3% region, allowing a slightly positively sloped yield curve, which would allow most banks to do well in a normal environment.

What’s that you say?? It’s not a normal environment now, so why should the curve be flatter?? It is not a normal environment now precisely because the Fed was so loose for so long, allowing a huge buildup of debt that we are now fitfully trying to liquidate.? When that debt gets down to 1.5x GDP, we will have robust growth once again.? In the 3.0x+ position that we are now in, there is little hope for significant growth rates.? Our government should be aiding in liquidating zombie institutions, rather than keeping them undead with cheap financing.

Consider the position of David Walker.? He knows how bad the total debt crisis of the US is.? I’ve written about this many times before; this is the latest example.? Keynesianism does not address sovereign indebtedness, which is a huge flaw.? What if a country can’t make good on all of its promises?? Were the US? not the global reserve currency, that would be a big problem for us now.? Deficits are not helping the UK or Japan now.? But what happens when we go into perma-deficit in the next few years, where there is little to no hope to paying off debt, because excess revenues on social programs evaporate, and the elimination of deficits relies on the willingness of the US to raise personal income taxes across the board.? Soaking the rich will never be enough, and they always find ways of sheltering income.? Who will be willing to pick up the knife, and proudly say to constituents, “I did what was right for you and raised your taxes?” or, “I did what was right for you and cut social security payments by 30%, and created a 30% copay on Medicare.” or, “I helped create a new chapter in the bankruptcy code for states, with a modification to ERISA that allows for lowering of pension and healthcare benefits paid to former state employees for states under financial stress.”? No one will say any of that, obviously.

Perhaps there are simple solutions to all of this.? The only one I can think of is a large rise in taxes, which would be bitterly opposed, and might not result in that much additional taxes.? Any other bright ideas out there?

One final comment on the failure of macroeconomics — consider who did peg the crisis in advance.? Most were practical, business-oriented economists who saw the growth in leverage, and said, “This will not end well.”? The trouble is that timing and estimation of severity of the then-future crisis were problematic.? The moment that you say “This end badly,” in the midst of the bull phase, you can get labeled a perma-bear.? I hated that title, so I would tweak my language to avoid sounding too harsh.? Today that’s a pity, because the scenarios we privately talked about at my last employer are what are playing out now.

Why did macroeconomics fail us?? Bad theory in the two main schools of Neoclassical economics — Chicago and Keynesian.? There was an inability to appreciate the effects of overindebtedness on an economy.? Time to send both schools to the junkyard.

PS — I saw this in Barron’s.? If Henry Kaufman’s book is as good as it sounds, perhaps it will provide more insight into this situation.

Book Review: Finding Alpha

Posted on 3 September 2009 by David Merkel

I found this book both easy and hard to review.? Easy, because it adopts two of my biases: Modern portfolio theory doesn’t work, and the equity premium is near zero.? Hard, because the book needed a better editor, and plods in the middle.? I don’t ordinarily do this, but I felt the reviews at Amazon were valuable, particularly the most critical one, which still liked the book.? I liked the book, despite its weaknesses.

One core idea of the book is that risk is not rewarded on net.? It doesn’t matter if you measure risk by standard deviation of returns, beta, or credit rating (with junk bonds).? Junk underperforms investment grade bonds on average.? Lower beta and standard deviation stocks overperform on average.

A second core idea is that some people are so risk averse that they only accept the safest investments, which leaves investment opportunities for those that are willing to compromise a little with credit quality or maturity.? Moving from money markets to one year out is an almost riskless move for most, and usually adds a lot of excess return.? Bond ladders do the same thing, though Falkenstein does not discuss those.

Also, the move from high investment grade to low investment grade does not involve a lot more investment risk, but it does offer more yield on a risk adjusted basis.

A third core idea is that equities, though more risky than high quality bonds, have not returned that much more than bonds when the returns are measured properly.? See this post for more details.

A fourth core idea is that people are more willing to take risks to be wealthy than theory would admit.? Most of those risks lose money on average , but people still pursue them.

A fifth core idea is that alpha is hard to define.? Helpfully, Falkenstein defines alpha as comparative advantage.? Focus on what you can do better than anyone else.

A sixth core idea is that leverage, however obtained, does not add alpha of itself.? This should be obvious, but people like to try to hit home runs.

A seventh core idea is that when an alpha generation technique becomes well-known, it loses its potency.

An eighth core idea is that people are more envious than greedy; they care more about their relative position in this world than their absolute well-being.

One idea he could have developed more fully is that retail investors are easily deluded by yield.? They underestimate the amount of yield needed to compensate for illiquidity, optionality, and default.? Wall Street makes money out of jamming retail with yieldy investments that deliver capital losses.

Another idea he he could have developed is that strategies that lose their potency lose investors, and tend to become less efficiently priced, leading to new opportunities.? Investment ideas go in and out of fashion, leading to overshooting and washouts.

How one achieves alpha is not defined — Falkenstein leaves that blank, because there is no simple formula, and I respect him for that.? He encourages readers to devise their own methods in areas where there is not a lot of competition.? Alpha? comes from being better than your competition.

Summary

What this all says to me is that investors are too hopeful.? They look for the big wins and ignore smaller ways to make extra money.? They swing for the fences and get an “out,” rather than blooping singles with some regularity.? I like blooping singles with regularity.

I recommend this book for quantitative investors who can find a way to buy it for less than $40.? The sticker price is $95, though it can be obtained for less than $60.? Try to find a way to borrow the book, through interlibrary loan if necessary — that was how I read Margin of Safety by Seth Klarman.? Klarman’s book is not worth $1000.? Falkenstein’s book is not worth $95.? Falkenstein’s very good blog will give you much of what you need to know for free, and even more than he has covered in his book.

This book would also be valuable for academics and asset allocators wedded to Modern Portfolio Theory and a large value for the equity premium, though some would snipe at aspects of the presentation.? Parts of the book are more rigorous than others.

If you still want to buy the book at the non-discounted price, you can buy it here: Finding Alpha: The Search for Alpha When Risk and Return Break Down (Wiley Finance)

PS: Unless I state otherwise, I read the books cover-to-cover, unlike most book reviewers.? The books are often different from what the PR flacks encourage reviewers to think.? If you enter Amazon through my site and buy anything, I get a small commission.

Ten Points on Commercial Real Estate Lending

Posted on 2 September 2009 by David Merkel

Before I begin this evening, I would like to give a big praise to Calculated Risk.? CR and his readers do a great job of highlighting stories in economics and real estate; I get a lot of data from that blog.? Some articles cited this evening have sprung from links on a CR post; my non-citing of CR is not a lack of respect for what CR does.

1)? We are at the beginning of seeing large commercial properties slide into default where equity sponsors have concluded that there is no use throwing good money after bad.? Recourse typically does not exist on commercial loans, aside from the smallest loans.

The last article is interesting to me, in that the ability of the US Postal Service to walk away from leases is greater than I previously thought.? It is also interesting to contemplate the economics of a collapsing postal service.? Will the postal service charge a differential rate to serve rural areas?? It would align revenues with costs, but politically I can’t imagine it is feasible given the US Senate.

2)? Of course, those defaults have large negative implications for large and small banks, as well as CMBS and Commercial REITs.

The difficulty for banks is different because they do not hold their Commercial Real Estate [CRE] loans at fair value.? So long as the loan is performing, it can be held at par.? The accounting does not require anticipating failure, no matter how likely on average that failure would be.

The banks have writeoffs to take which the CMBS market is already anticipating.? Absent a larger rally in CMBS, there will be significant writeoffs at the banks eventually.

For a broader look at the troubles the banks face, look at this article: Q2 2009 Bank Stress Test Results: The Zombie Dance Party Rocks On.

3)? When the price of properties are down 36% from the peak, it implies that most recent lending, 2006 and beyond, is under water, and 2005 is iffy.

4) $165 Billion in Commercial Loans are Due in ?09.? Banks will extend the loans, whereas CMBS special servicers will foreclose on some and extend others — the balance sheet of a CMB Securitization is not as flexible as that of a bank.

5) “What evil lurks in the heart of Commercial Real Estate loans?? The Shadow Supply knows.”? Whether it is condos in Manhattan, or apartments in the same, the problem of underemployed real estate weighs on the market, waiting for a moment to sell, and making the recovery that much longer.

6)? Goldman Sachs is the key component of the oligarchy that controls the US Government and sucks the blood of the American taxpayer for profit. ;)? Now they are planning to repeat their clever pillage of residential housing in the commercial sector.

Look, GS is clever, and they will make money they can.? I never supported any of the bailouts, but if the government sets the rules inadequately, and GS finds holes to profit off of, where does the blame go, but to the government who set loose rules.

7)? Goldman also sees hard times ahead for Commercial REITs, as I do.? Prices are too high relative to NAVs.? There will be significant loan defaults.? Shall I mention that Deutsche Bank agrees?

8) At such a time, as is normal, underwriting standards rise, and loan volumes decline.? It adds insult to injury, but banks have to protect their balance sheets.

9) This is also affecting pension plans, which are large investors in commercial real estate, both equity and mortgages.

10)? And looking at the architectural billings index, any turn in commercial real estate will not be soon.

I will be considerably more bullish when these problems are half solved.? Until then, I am still a bear on financials.

Fusion Solution: The Stable Value Fund Guide to Commodity ETF Management

Posted on 21 August 200920 June 2017 by David Merkel

This piece is one of my experiments where I try to straddle two different investment worlds in an effort to bring more understanding.? The two world are stable value funds and commodity ETFs.

Commodity ETFs have a hard job, in that they are supposed to replicate the returns on spot commodities.? Given the difficulty of storage, only a few commodities — gold and silver, can be physically stored — they don’t deteriorate.? Unlike government promises, they are uniquely suitable for being money.? (Sorry, had to say that.)

Other commodities require futures markets or off-exchange markets where swaps get traded.? The swaps introduce counterparty risk, which is a common risk in many currency and commodity-linked funds.? I’ve written about that before, along with criticisms of exchange-traded notes.

One of the problems that some commodity open-end funds and ETFs run into is that their investment strategy is too simple.? “Buy the front month futures contract, and roll to the second month contract before the front month expires.”? Nice, it should replicate holding the commodity itself, until a large amount of money starts to do it, and other investors recognize what a slave the funds are to their strategy.

So, what do the other investors do?? They take the opposite side of the trade early, in order to make it more expensive to do the roll.? Buy the second month contract, and short the first.? As the first gets close to maturity, cover the first, sell and then short the second, and go long the third month contract.? What a recipe to extract value out of the poor shlubs who buy into a commodity fund in order to get performance equivalent to the spot market.

Compounding Money Slowly

If you want to keep your money safe, and earn a little bit, what should you do?? Invest in a money market fund.? “Wait a minute,” some intrepid investor would say, “I can do better than that.? I don’t need all of my money for immediate liquidity.? I can ladder my funds out over a longer period.? I can invest surplus funds out to the end of my period, and earn a better yield, and over time, my funds will mature bit by bit.? I will have liquidity in a regular basis, and I will get a higher yield because yield curves slope up on average.”

Leaving aside the wrap agreements that a stable value fund buys, stable value funds build a bond ladder with and average maturity of 1.0 to 4.5 years.? Commonly, it averages around 2.0 years.

The funds could invest everything short and give up yield.? That would give them certainty, but lose yield.? That is what the commodity funds are doing.

What could go wrong?? There could be a large demand to withdraw funds when longer-dated contracts are priced below amortized cost, and the fund might not be able to meet all withdrawal requests.? So far that has not happened with stable value funds.

The Fusion Solution

Whether in war or in business, it is not wise to be too predictable; opponents will take advantage of you.? In this particular example, I would urge commodity funds to look at their liquidity needs over the next month, and leave an amount maturing in the next three months equal to 4-6x that amount.? Then spread the remainder of funds according to advantage, looking at the tradeoff of time into the future versus yield of the futures contracts versus spot.? Longer dated futures do not move as tightly with the spot markets, but they often offer more yield.

Ideally, a commodity fund ends up looking like a bond ladder, and as excess funds mature, they don’t get invested in the new front month contract, instead, they get invested in the longer dated contracts, near the end of the ladder, as a stable value fund would do.

This maximizes returns for the bond/stable value funds, and I believe it would work for commodity funds as well.? Please pass this on to those who might benefit from it.

A Closing Aside:

Back in the late 90s, I ran one of my interest rate models to try to determine what the best investment strategy would be.? I found that the humble bond ladder was almost always the second best strategy, regardless of the scenario, because it was always throwing off cash that could be reinvested out to the end of the ladder.

Again, please pass this along, and commodity fund managers that don’t get this, please e-mail me.? I will help you.

Return of the “Carry Trade”

Posted on 20 August 2009 by David Merkel

The idea of a carry trade is simple.? Borrow inexpensively, and invest at a higher yield.? Make money.

Too easy you say?? Right.? Usually something has to be compromised for a carry trade to work, usually betting on lower rated credits performing, or currencies not moving against those borrowing in a low interest rate currency, and investing in a high interest rate currency.? Or, borrow short and lend long when the yield curve is steep, hoping the situation will correct with the long yield coming down, rather than a 1994 scenario, where short rates outrace long rates higher.

Carry trades blow up during times of high volatility, which typically have high yield bonds or countries seeming to be more risky than usual. Carry trades return when times are quiet, allowing placidity to clip yield.? As the WSJ has commented, that time is now, and the carry trade has returned.

I’m going to use the Japanese Yen as my example here.? Because of the chronically low interest rates there, it is a favorite currency for borrowing, and using the money to invest in higher yielding currencies.

That’s the yen over the last five years.? Wish I could have gotten option implied volatility over the same period, but I got nearly the last two years here, by using the CurrencyShares Yen ETF:

You can see how option implied volatility peaked in late October of 2008.? At that time, with the strength of the yen, which would not crest until mid-December, there was a rush to buy protection against the rising yen, because those with carry trades on were losing money, and wanted to get out.? Momentum carried the yen for another six weeks.

After significant fury, the implied volatility settled out at a baseline level, and the carry trade returns because conditions are more placid.? Implied volatility and the currency have stabilized for now.

As another example. consider this:

The Powershares DB G10 Currency Harvest Fund [DBV] borrows in the three lowest yielding currencies of the ten countries that it tracks, and invests in the three highest yielding.? This is the perpetual carry trade fund.

Note the plunge into October/November 2008.? High yield currencies were getting killed, and low yield currencies were rallying.? Since then, the performance of DBV has improved.? Why?? The currencies are more placid, so clipping excess yield makes sense to some in the short-run.

And so it will be until the next big implied volatility explosion occurs.? Carry trades don’t offer significant profits across a full cycle, but can profit those who time it right, few as those people are, and matched by those who lose.

-=-==–==-=–=-=-=-=-==-

PS — Sorry for not writing about commercial mortgages, as I said I would.? I will get to it soon, but I have been hindered by personal issues.

Nine Notes on Residential Real Estate

Posted on 15 August 200916 August 2009 by David Merkel

I don’t really have one unified article type when I write here.? Sometimes I have a really strong conviction about something, and then it flows.? At other times, I gather data, do an analysis, and come up with a way of motivating it.? Then there are the Seven, Eight, Ten, Twelve, Fifteen, Twenty Points/Notes/Comments articles.? Tonight’s piece is one of those.

(An aside — the numbers stem from a comment from an editor of a Canadian business publication — he told me that certain numbers grab people’s attention more.? True?? Not sure.? I do know that one of my editors at RealMoney felt that some of my quirky titles lost readership.? Even today, my editor at SA freely revises my titles, sometimes making something an emphasis that I had not intended.? Whatever; she titles better than me.? What intrigues me is that other sites sometimes pick up her title, not mine, even when they link directly to my blog.)

I don’t do linkfests.? I don’t do them not because they are not valuable, but because others do them better then me, like Abnormal Returns.? So, I do something different.? As I troll the web each day, I tag articles for future comment.? I then wait until I have a critical mass of articles on a given topic, and then I publish one of the “XX Points” articles.? This enables a greater range of facets on a given issue.? I also allows me to give more of an integrated explanation of how I think it all fits together.? Now, the price is that some of the articles are dated.? I think they are fresh enough to highlight trends.

Enough explaining.? On to tonight’s topic, real estate and its effect on the real and financial economies.

1)? Principal forgiveness — it is what underwater homeowners want, and what they are unlikely to get.? Principal forgiveness means that a loss has to be taken by someone now.? Adjust the rate, adjust the term, adjust the amortization — it is all tinkering, even if it lowers the payment slightly, because the owner is still inverted on his mortgage.

Ideas like lowering the principal, but giving the bank a large chunk of the price appreciation at sale, or say 30 years out, would be cute, but still, the bank (or juniormost MBS certificate holder, who usually directs the servicer) would take a loss now.

So, I’m not surprised when I read articles like these:

Governments have power, but it is very difficult to fight the economics of the situation.? One further note, as is mentioned by a few of the above articles, is that the most profitable situation for the lenders/servicers, is that the property teeters on the edge of solvency, not only paying the mortgage slowly, but pays additional fees in the process.

2)? Will there be a second foreclosure wave?? Maybe.? First American CoreLogic argues that it will be the existing wave continuing.? I tend to agree with CoreLogic for the following reason: when you have enough of the mortgaged homes of the country underwater, it is difficult to slow the rate of foreclosure, because foreclosures happen to properties that underwater where one of the following occurs:

Death
Divorce
Unemployment
Disability
Disaster
Strategic default (buy a nicer home cheaper, and stop paying off this overpriced garbage)
Debt reset/recast

3)? The GSEs, despite the rally, are still in lousy shape.?? Fannie lost $14.8 Billion, and tapped the Treasury for liquidity.? Freddie earned less than $1 billion, but only because they revalued assets $5 billion higher.? Their regulator believes that they won’t be able to repay all aid that the US has granted them.? My verdict: the common of each company is an eventual zero.? Stay away.? Thrillseekers that like zero shorts, don’t do it; the odds are good for a zero, but the payoff is asymmetric.

4)? What percentage of homeowners are or will be upside-down or underwater?

24 or 32% (now and soon)
30% (Zillow — soon)
32% (First American CoreLogic — now)
48% (Deutsche Bank — in two years, challenged by Lawler)

I favor the estimates of First American CoreLogic.? First, they have great data.? Second, my view is that properties with greater than 90% LTVs are likely upside-down in a sale due to closing costs.? The inflection point in mortgagee behavior occurs between 90-100% LTVs, not at 100%+.

That’s why we are in such deep trouble.? With 32% of all mortgages inverted, there will be many more foreclosures, and prices should still head downward, even on the low end.

5)? But maybe things aren’t so bad, at least on the low end.

Home inventories fell in July.
In some markets, on the low end, foreclosures are selling fast.
New home sales increased in June.
Bottoms are longer than we would like to expect.

6)? All that said, the high end isn’t seeing much action, and prices continue to sag.? There aren’t many move-up buyers.

7)? What characterizes the underwater borrower?? Cash-out refinancing, and home equity loans.? The home as an ATM always relied on the “greater fool” theory implicitly — that there would always be a greater fool willing to buy out the home at a greater price than the new amount of leverage.? On the home equity loans — banks are doing all that they can to avoid recognizing losses.? With home equity loans, losses are usually total.? The only thing that surprises me here is that it has taken this long to get to realizing the losses.

8 ) So you want appraisers to be honest, but not yet?? Appraisers, auditors, etc. — third party evaluators are conflicted — he who pays the piper calls the tune, and no one is willing to have the buyer pay for the appraisal.? So now the appraisers try to be honest and business can’t get done?!? Those who hire appraisers, make up your minds; do you want a few short term deals, or do you want reliable long term business?

9)? On the dark side, many option ARMs will default before the payments recast.? That means the recast wave will be more gradual, but it won’t be any less troublesom in aggregate.

That’s all for this evening.? Absent something else pressing, I will write about commercial real estate on Monday night.

Ten Unsolved Problems in the Global Economy

Posted on 15 August 2009 by David Merkel

There are many celebrating the recovery as if it were already here.? This is a brief post to outline my main remaining concerns for recovery of the global economy.

1)? China is overstimulating its economy, and forcing its banks to make bad loans.? This pushes up commodity prices, and makes it look like China is growing, but little of the investments made are truly needed by the rest of the global economy.

2)? Western European banks have lent too much to Eastern European nations in Euros.? The Eastern Europeans can’t afford it, and widespread defaults are a possibility.

3)? The average maturity of bonds held by foreign investors in US Treasuries is falling.? Runs on currencies happen when countries can no longer roll over their debts easily, which is facilitated by having a lot of debt to refinance at once.

4)? On a mark-to-market basis, market values for commercial real estate have fallen dramatically.? Neither REIT stocks nor carrying values for loans on the books of banks reflect this yet.? Many banks are insolvent at market-clearing prices for commercial real estate.

5)? We still have yet to feel the effects from pay-option ARMs resetting and recasting.? Most of the pain in residential housing is done, but on the high end, there is still more pain to come, and the pay-option ARMs will reinforce that.

6)? The rally in corporate debt and loans was too early and fast.? Conditions are not back to normal for creditworthiness.? There should be a pullback in corporate credit.

7)? We had global overbuilding is cyclical sectors 2002-2007.? We overshot the demand for large boats as an example.? We overdeveloped energy supplies (that will be short-lived), metals, and other commodities.? It will take a while to grow into the extra capacity.

8 )? The US consumer is still over-levered.? It will be a while before he can resume his profligate ways, assuming a new frugality does not overcome the US.? (Not likely by historical standards.)

9)? The Federal Reserve will have a hard time removing their nonstandard policy accommodation.

10)? We still have the pensions/retiree healthcare crisis in front of us globally.

That’s all.? To my readers, if you can think of large unsolved problems in the global economy, forward them on to me here in the comments.? If I agree, I will incorporate them in future articles.

Twenty Notes on Current Risks in the Markets

Posted on 14 August 2009 by David Merkel

1)? A modest proposal: The government announces that they will refinance all debtors.? Not only that, but they will buy out existing debt at par, and allow people and firms to finance all obligations at the same rate that the government does for whatever term is necessary to assure profitability or the ability to make all payments.? The US Treasury/Fed will become “The Bank.”? No need for the lesser institutions, The Bank will eat them up and dissolve their losses, taking over and refinancing their obligations.? Hey, if we want a single-payer plan in healthcare, why not in finance?? Being healthy is no good if you can’t make your payments. 😉

This scenario extends the US Government’s behavior to its logical absurd.? The US Government would never be large enough to achieve this, but what they can’t do on the whole, they do in part for political favorites.? They should never have bailed out anyone, because of the favoritism/unfairness of it.? Better to have a crash and rebuild on firmer ground, than to muddle through in a Japan-style malaise.? That is where we are heading at present.? (That’s the optimistic scenario.)

2)? I have exited junk bonds, and even low investment-grade corporates.? Consider what Loomis Sayles is doing with junk.? Yield = Poison, to me right now, which echoes a very early post in this blog.? There are times when every avenue in bonds is overpriced — that is not quite now, because of senior CMBS, carefully chosen.? All the same, it makes me bearish on the US Dollar, and bullish on foreign bonds.? This is a time for capital preservation.

3) High real yields are driving the sales of US Government debt.? Is that a positive or a negative?? I can’t tell, but there is always a tradeoff for indebted governments, because they can usually reduce interest expense by financing short.? When their average debt maturity gets too short, they have a crisis rolling over the debt.? We are not there yet, but we are proceeding on that road.

4)? I have a bias in favor of buyside analysts, after all I was one.? But this research makes me question my bias.? Perhaps sellside analysts are less constrained than buyside analysts?

5) Debtor-in-possession lending is diminishing, reflecting the likelihood of loss.? In some cases that may mean more insolvencies go into liquidation.? Interesting to be seeing this in the midst of a junk bond rally.

6)? Short-selling isn’t dead yet.? Would that they would take my view that a “hard locate” is needed; one can’t short unless there is a hard commitment of shares to borrow.

7) Should we let managers compete free of the constraints imposed by manager consultants?? You bet, it would demonstrate the ability to add value clearly.? I face that? problem myself, in that I limit myself to anything traded on US equity exchanges.? As such, I have beaten most US equity managers (and the indexes) over the last nine years, but no one wants to consider me because I don’t fit the paradigms of most manager consultants.

8 )? Is there a fallacy in the “fallacy of composition?”? I think so.? Yes, if everyone does the same thing same time, the system will be unstable.? But if society adopts a new baseline for saving/spending, the system will adjust after a number of years, and there will be a new normal to work from.? That new normal might be higher savings and investment, in this case, leading to a better place eventually than the old normal.

9)? Anyway, as I have said before, stability of a capitalist system is not normal.? Instability is normal, and is one of the beauties of a capitalist system, because it adjusts to conditions better than anything else.

10)? Corporate treasurers are increasingly engaged in a negative arbitrage where they borrow long and hold cash so that the company will be secure.? How will this work out?? Will this turn into buybacks when things are safe?? Or will it just be a drag on earnings, waiting for an eventual debt buyback?

11)? Does debt doom the recovery?? Maybe.? I depends on where the debt is held, and how is affects consumption spending.? Personally, I think that consumers and small businesses are under a lot of stress now, and it won’t lift easily.

12)? So things are looking better with junk bond defaults.? Perhaps it was an overestimate, or that it would not all come in 2009.? We will see.

13)? Junk bonds do well; junk stocks do better.? In a junk rally, everything flies.? All the more to hope that this isn’t a bear market rally; if so, the correction will be vicious.

14)? Eddy, pal.? Guys who criticize data-mining are near and dear to me.? Now the paper in question has a funny definition of exact.? I don’t know how to describe it, except that it seems to mean progressively more accurate.? I didn’t think the paper was serious at first, but given the relaxed meaning of “exact,” it data-mines for demographic influences on the stock market.? Hint: if you have lots of friends when you are nine, ask for stock as a birthday present.

15)? I’m increaisngly skeptical about China, and this doesn’t help.? I sense that the global recession is intesifying, amid the current positive signs in the US.

16)? Do firms with female board members do worse than companies with only male board members?? No, but they get lower valuations, according to this study.? I started a study on female CEOs in the US, and I got the same result, but it is imcomplete at present — perhaps new data will invalidate my earlier findings.? Why does this happen, if true?? Men seem to be better at managing single investments, while women are better at managing portfolios.

17)? Do we have more pain coming from the banks?? I think so.? Residential real estate problems have not reconciled, and Commercial real estate problems are just beginning.? If we mark loans to market, many large banks are insolvent, and this is not an issue that will easily be healed with time.

18)? As a nation, I like Japan, and would like to visit it someday.? What I don’t want is for the US to imitate its economic stagnation, but maybe that could be the best of all possible worlds for the US.

19)? I am de-risking my equity and bond portfolios at present.? I do not think that the present market levels fairly reflect the risks involved.? I am reducing risk in bonds, and looking for strong sustainable equity yields in equities.

20)? Echoing point 17, we face real problems on bank balance sheets from commercial real estate lending.? There is more pain to come.? The time to de-risk is now.

Book Review: Mr. Market Miscalculates

Posted on 29 July 200920 June 2017 by David Merkel

Since the first time I read him, I have been a fan of James Grant.? He helped to sharpen my focus on how money and credit work in the long run, and how they affect the economy as a whole.? Reading one of his early books, Minding Mr. Market: Ten Years on Wall Street With Grant’s Interest Rate Observer, I gained perspective on the increasingly complex financial world that we were moving into.

But not all have shared the opinion of Mr. Grant’s wisdom.? When I worked for Provident Mutual, the Chief Portfolio Manager (at that time new to me, but eventually a dear colleague) said to me, “feel free to borrow any of the publications we receive.”? For a guy who likes to read, and learn about investments, I was jazzed. But, when I came back and asked whether we subscribed to Grant’s Interest Rate Observer, I got the look that said, “You poor fool; what next, conspiracy theories?” while she said, “Uh, noooo. We don’t have any interest in that.”

Now the next two firms I worked for did subscribe, and I enjoyed reading it from 1998 to 2007. But now the question: why buy a book that repeats articles written over the last fifteen years?

I once reviewed the book Just What I Said: Bloomberg Economics Columnist Takes on Bonds, Banks, Budgets, and Bubbles, by another acquaintance of mine, the equally bright (compared to James Grant) Caroline Baum.? This book followed the same format, reprinting the best of old columns, with modest commentary.? In my review, I cited Grant’s earlier book as a comparison, Minding Mr. Market.

As an investor, why read books that will not give an immediate idea of where to invest now?? Isn’t that a waste of time? That depends.? Are we looking to become discoverers of investment/economic ideas, or recipients of those ideas?? Books like those of Grant and Baum will help you learn to think, which is more valuable than a hot tip.

Here are topics that the book will help one to understand:

How does monetary policy affect the financial economy?
Why throwing liquidity at every financial crisis eventually creates a bigger crisis.
Why do value (and other) investors need to be extra careful when investing in leveraged firms?
What is risk?? Variation of total return or likelihood of loss and its severity?
Why financial systems eventually fail at compounding returns at rates of growth significantly above the growth rate of GDP.
Why great technologies may make lousy investments.
Why does neoclassical economics fail us when trying to understand the financial economy?
How does one recognize a speculative mania?
And more…

The largest criticism that can be leveled at James Grant was that he saw that he would happen in this crisis far sooner than most others.? Being too early means you eventually get disregarded.? The error that the “earlies” made, and I knew quite a few of them, was not recognizing how much debt could be crammed into the financial economy in order to juice returns on fixed income assets with yields lower than likely default losses.? That’s a mouthful, but the financial economy had not enough good loans to make relative to the amount of loans needed to maintain the earnings growth expectations of the shareholders of financial companies. Thus, the credit bubble, facilitated by the Fed and the banking regulators.? You can read all about it in its many facets in James Grant’s book.

You can buy the book here: Mr. Market Miscalculates: The Bubble Years and Beyond.

Who would benefit from the book?

Those that have assumed that neoclassical economics adequately explains the way our economy works.
Those that want to understand how monetary policy really works, or doesn’t.
Those that want to learn about equity or fixed income value investing from a quirky but accurate viewpoint.
Those that want to be entertained by intelligent commentary that proved right in the past.

As with other James Grant books, this does not so much deal with current problems, as much as educate us on how to view the problems that face us, through the prism of how past problems developed.

Full disclosure: If you buy anything through the links to Amazon at my blog, I get a small commission,? but your costs don’t go up.?? Also, thanks to Axios Press for the free review copy.? I read the whole thing, and enjoyed it all.