Structured Products and Derivatives – Page 24

Fifteen Notes on our Current Economic Situation

Posted on 26 May 2009 by David Merkel

1) I don’t think that residential real estate prices are turning in general.? But even if residential housing recovers, and demand returns, there will be a “housing mismatch.”? There will be too many high end homes relative to buyers.? Financing for high end homes is sparse, and too many expensive homes were built during the boom years.

2) Inflation.? What a debate.? In the short-run, deflationary pressures are favored, but what can you expect when so many dollar claims are being created by the Fed?? The output gap may indicate inflation is impossible, but stagflation is possible when monetary policy exceeds the need for dollar claims amid a collapsing economy, as in the 70s.

3) At the time, I suggested that the banks forced to take TARP funds had been coerced because the regulations could be lightly or tightly enforced.? Looks like that was true.? Why does this matter?? The TARP was supposed to be stigma-free because all major banks were taking it.? Coercion should make the government more lenient on payback terms.

4) I never did all that much with the cramdown that the Obama administration did with Chrysler secured creditors.? All that said:

George Will wrote a good piece on the ethics of the situation.
Subordination of secured claims does happen, but not typically with such loans as brought Chrysler out of Daimler.
One of the main parties fighting the case is not a “bunch of speculators,” but the Indiana State Pension funds.? I think they will win their case.

5) Can global trade patterns be changed to avoid the dollar?? Some are trying.? In the long run, if the US is only a capital importer, the US Dollar will lose its reserve status, and weaken considerably.

6) Union jobs are magic.? They provide these incredible benefits, but with one small problem: they kill the companies that are forced into them.? GM may be sold to the government, but unless the burden of total compensation being above productivity is lifted, there will be no substantive change.

7) Dilution.? I was never a fan of McClatchy, but this seals the story on the newspapers.? Sell equity interests cheaply, so that you can survive.? The same is happening with many banks, and it is forcing the share prices of the industry lower.

8 ) Commercial real esate is the final shoe to drop in our credit bust.? Prices are 20% below the peak.? Refinancing will prove tough.? There are no sectors in commercial real estate that are not overbuilt.

9) The PBGC is taking its share? of losses at present.? This is no surprise here, given all I wrote about the PBGC at RealMoney.? The losses on a market value basis are even greater, because firms with underfunded pensions are more likely to default.

10) Residential real estate has not stabilized yet.? The bottom will come after the resets on Alt-A lending.

11) Are there difficulties with lending in the farm belt?? To a greater degree than I expected, yes.

12) Will California survive?? We can only hope.? Given that there is no bankruptcy code for states, California could prompt a Constitutional crisis if it defaults.

13) Should the Fed regulate systemic risk?? Perhaps when it stops creating it.? My position was, and continues to be that the Fed has been incompetent with monetary policy, bringing us to where we are today.? We need to eliminate the Fed and its bureaucracy, which produces little value for the US.? Monetary policy could be conducted with a far smaller staff; it might even be better.? Remember, bureaucries hit economies of scale rather rapidly.? Small is beautiful with bureaucracies.

14) In the recent slowdown, there has been inventory decumulation.? Those at the end of the supply chain have been hit the hardest.? Welcome to the cyclical world when it has to slow down.? The tail always gets it the worst in a game of “crack-the-whip.”

15) Ending with inflation, John Hussmann makes the case that the current economic policy must result in inflation.? If you are reading this, John, given that we live in the same city, perhaps we could have lunch someday?

What is the Sound of One Hand Clapping? What is the Right Price when there is no Market?

Posted on 24 May 2009 by David Merkel

No, this isn’t another discussion of SFAS 157, though there are some similarities.? There has been a bit of a brouhaha over repayment of TARP options.? Isn’t the government getting shortchanged?

Maybe.? Maybe not.? This one is tough to answer, because at least as yet, there is no active market available for really long-dated call options.? Let me give you an example from my own experience.

I used to run a reasonably large options hedging program for a large writer of Equity Indexed Annuities [EIAs].? Much as I did not like the product, still I had to do my job faithfully, and when we were audited by a third party, they commended us having an efficient hedging program.

But here was our problem:? the EIAs lasted for ten years, but paid off in annual installments, based on average returns over each year.? Implied volatility might be low today, and the annual options that we purchased to hedge this year might be cheap, but the product had many years to go.? What if implied volatility rose dramatically, making future annual hedges so expensive that the company would lose a lot of money?

Maybe there could be another way.? What if we purchased the future hedges today?? A few problems with that:

We don’t know how much we need to purchase for the future — the amount needed varies with how much the prior options would finish in the money.
But the bigger problem is once you get outside of three years, the market for options, even on something as liquid as the S&P 500, is decidedly thin.? There’s a reason for that.? The longer-dated the option, the harder it is to hedge.? There are no natural sellers of long dated options, and relatively few Buffetts in the world who are willing to speculate, however intelligently, in selling long-dated options.

There is an odd ending to my story which is tangential to my point, but I may as well share it.? Eventually, the insurance company wanted to make more money, and felt they could do it by hiring an outside manager (a quality firm in my opinion — I liked the outside manager).? But then they told them not to do a total hedge, which was against the insurance regs, given their reserving practices.? Not hedging in full bit them hard, and they lost a lot of money.? Penny wise, pound foolish.

So what about the TARP options?? Did the US Government get taken to the cleaners on Old National Bank?? Is Linus Wilson correct in his allegations and calculations?? Or is jck at Alea correct to be a skeptic?

It all boils down to what the correct long term implied volatility assumption is.? Given that there is is no active market for long-dated implied volatility / long-dated options for something as liquid as the S&P 500, much less a mid-sized bank in southern Indiana, the exercise is problematic.

In quantitative finance, one of the dirty secrets is that common parameters like realized volatility and beta are not the same if calculated? over different intervals.? Also, past is not prologue; just because realized or implied volatility has been high/low does not mean it will remain so.? It tends to revert to mean.? With the S&P 500, implied volatility tends to move 20% of the distance between the current reading and the long term average each month.? That’s pretty strong mean reversion, though admittedly, noise is always stronger in the short run.

Let’s look at a few graphs:

Daily Volatility for ONB:

Or weekly:

or monthly:

or quarterly?

Here’s my quick summary: the longer the time period one chooses, the lower the volatility estimate gets.? Price changes tend to mean revert, so estimates of annualized realized volatility drop as the length of the period rises.? Here’s one more graphic:

I’m not sure I got everything exactly right here, but I did my best to estimate what volatility level would price out the options at the level that the US government bought them.? I had several assumptions more conservative than Mr. Wilson:

In place of a low T-bill rate for the risk-free rate, I used the 10-year Treasury yield.? (Which isn’t conservative enough, I should have used the Feb-19 zero coupon strip, at a yield of 3.79%.)
I set dividends at their current level, and assumed they would increase at 5% per year.
I modeled in the dilution from warrant issuance.

But I was more liberal in one area.? I assumed that ONB would do an equity issuance sufficient to cut the warrants in half.? If the warrants were outstanding, the incentive to raise the capital would be compelling, and it would get done.

The result of my calculation implied that a 21% implied volatility assumption would justify the purchase price of the warrants.? That’s nice, but what’s the right assumption?

There is no right assumption.? Short-frequency estimates are much higher, even assuming mean reversion.? Longer frequency estimates are higher if one takes the present reading, but lower if one looks at the average reading .? After all, Old National is a boring southern Indiana bank.? This is not a growth business.? If it survives, growth will be modest, and the same for price appreciation.

The Solution

It would be a lot better for the US Treasury to get itself out of the warrant pricing business, and into the auction business, where it can be a neutral third party.? Let them auction off their warrants to the highest bidder, allowing banks to bid on their own warrants.? I’ll give the Treasury a tweak that will make them more money: give the warrants to the winning bidder at the second place price.

By now you are telling me that I am nuts — giving it to the winner at the second place price will reduce proceeds, not increase them.? Wrong!? We tell the bidders that we want aggressive bids, and that they will get some of it back if they win.? I’ve done it many times before — it makes them overbid.

So, with no market for these warrants, I am suggesting that the Treasury creates their own market for the warrants in order to realize fair value.? Is it more work?? Yeah, you bet it is more work, but it will realize better value, and indeed, it will be more fair.

Book Review: Financial Shock

Posted on 22 May 2009 by David Merkel

Note to readers: for this review, I read the first chapter, and skimmed the rest of the book. (full disclosure)? I usually read the entirety of every book I review, but I did not this time.? Why?? Chapter 1 is the backbone of the book, and tells the whole story in a nutshell.? The remaining chapters flesh out Chapter 1.? Most of my writings over the past five years shadow what Mr. Zandi has written, and he has created an integrated description that covers every major area of the crisis, with particular attention to mortgages, and the huge effect that the speculative mania in real estate had on the financial economy.

This is a serious book, one that explains the roots of our crisis.? If you haven’t understood it in a systematic way from reading my blog, or those that I recommend, this book will give you a coherent explanation of how we got here.

I do have some quibbles with the book.? When he describes residential mortgage securitization on page 117, the mezzanine and subordinated tranches are too large, even for subprime.? Also, his recommendations in the last chapter — I can agree with most of them, but not with mark-to-market, and the uptick rule.

This edition of the book takes us up to the first quarter of 2009, allowing Zandi to comment on the initial actions of the Obama administration.

All in all a very good book.? If you have a relative that doesn’t understand the crisis, this will explain it to him in a simple way.? If you want to buy it, you can buy it here:

Financial Shock (Updated Edition), (Paperback): Global Panic and Government Bailouts–How We Got Here and What Must Be Done to Fix It

As with all of my reviews, if you buy something through Amazon after entering through my site, I get a small commission, and you don’t pay anything more.? Don’t buy anything that you don’t want to buy on my account, though.

One Dozen More Notes on the Economic Scene

Posted on 20 May 200920 May 2009 by David Merkel

1) I may as well start out the evening with some predictions. I’m not an expert on this, but Chapter 9 of the bankruptcy code applies to municipalities, but not states. Given the problems with state & municipal pensions, we will probably see chapter 9 modified over the next two decades to allows states to default. There will also be some modification to retirement funding laws as applied to municipalities, states, and maybe the US Government, to allow for retroactive negotiation of pensions and healthcare benefits for an insolvent government.

2) California will lead the parade of states in trouble.? They want the US to guarantee their municipal debt.? Schwartzenegger did all he could to try to pass the referenda that might partially close the budget gap, but from what I see now, it looks like most of the important ones have failed.? Having been a California resident for seven years, I went though my share of referenda; the referendum process makes the politicians of California lazy… they pass the tough stuff off to the electorate, who then get to decide off of voters’ guides and soundbites.

3) California is an exaggerated version of the troubles that other states are having.? Social program spending rises, while taxes on wages, corporate profits, real estate, real estate transfers, etc., all fall.? If you can’t print your own money, and must balance your budget, life is tough, kind of like it is for most Americans.

4) Another municipal issue — can financial guarantors split in two?? I have argued “no,” but who cares what I think?? We do care about those that use the courts, and banks are suing to prevent the MBIA split.? It is a simple issue of fraudulent conveyance.

5) One last municipal issue: pension placement agents.? This is very similar to what I experienced in Pennsylvania regarding municipal pensions there.? Pension consultants would gain business through campaign contributions, and the Democratic and Republican consultants would collaborate and share to control the profits jointly.? Insurance companies providing pension services would pay? compensation to the consultants in exchange for business.? It’s a dirty business, and when I raised ethical objections to it, I was told that I was naive.? Perhaps I have more company now.

Anytime you have opaqueness of compensation, politics, and uncertainty of results (investing), there is always room for corruption.

6) Asset allocation.? The belief in a large equity premium led many to overweight stocks.? I have argued against that.? Now there are many who are finding the they have to start over, after bad equity returns.? There is no magic in any asset class.? Yes, equities do better than bonds in the long run, but only by 1-2%/yr, not 5-7%.

As for the arguments of Ayres and Nalebuff, only the most emotionally dead investors can live with levering up 1.9 times perpetually.? Most people panic.? They can barely deal with the volatility of the S&P 500, much less double that.

7) Mmmm… is it time to take on Bill Miller again?? Yeh.? Overweighting financial stocks?? That is quite a bet, and probably irresponsible again.? Here is my free advice — analyze your estimates of intrinsic value with commercial real estate prices 30% lower than today.? Aside from short-tail insurers, I don’t think you want to be overweight financials.

8 ) On the same note, many small and intermediate-sized banks face troubles under stress, particularly from commercial real estate lending.

9) I think we are in the second inning for declines in prices for commercial real estate, but perhaps the seventh inning for residential real estate.? So long as residential properties sell for less than their mortgages there is downward pressure on prices, because negative events lead to foreclosures, not sales.

10) How will derivatives be regulated?? That is the question.? Will it be as transparent as TRACE?? I doubt it.? The market is not that liquid.

11) Will the US Government likely get full value back on TARP buyouts? No, because they lack expertise at analyzing these situations.? They don’t know what a warrant is worth.

12) Will low-rate mortgages rescue the economy?? No, but many middle class people with equity will breathe easier after they refinance.? Also, some will buy homes, but who will have the downpayment necessary to qualify now that underwriting has tightened?? Not many.

Book Review: Street Fighters

Posted on 16 May 200916 May 2009 by David Merkel

This week, amid everything else I was doing, I read the entirety of the newly released book, “Street Fighters: The Last 72 Hours of Bear Stearns, the Toughest Firm on Wall Street,”? written by Kate Kelly, Wall Street Journal reporter who covered Securities firms like Bear Stearns, and wrote three major articles as it declined.

Here is how the book works: it takes you from Thursday evening to Sunday evening during the crisis.? When a new topic or person is brought in in an important way, Kate Kelly does a flashback to give readers the needed background.? It detracts from the urgency of the rest of the story, but does flesh out how Bear Stearns came to this ugly situation.

Culture matters in an organization.? A well-run organization, such as existed under Ace Greenberg developed pride in the organization, because it worked so well.? But pride, once engendered, is a fickle mistress.? Under James Cayne, once he stopped checking the details, and even major issues like exposure to the mortgage markets, pride was destructive.? Alan Schwartz believed that Bear Stearns was a great institution, and it blinded him regarding raising capital.? They couldn’t need additional liquidity, until it was too late to raise it.

Kate Kelly interviewed many people extensively for her book, and includes footnotes where parties don’t agree with her renderings.? She does make? the? last 72 hours live, with all of the uncertainty and fear of the situation.? I liked the book, and would recommend it.? That said, there are other books out on Bear Stearns, and I have not read them.

It’s a Small World After All

Now, what are the odds that a kid I used to stand with at the bus stop to go to kindergarten would end up in this book that I am reviewing?? To an actuary, it boggles the mind.? There is a “bit player” who appears twice in the book, my old friend Pat Lewis.? He lived three doors down from me, and was the popular, tall athlete, while I was a short nerd who tried my best in athletics.? We were both long distance runners, but he was my better by far.

After many years, I came back into contact with him in 2000 or so, when he had gotten a job in risk control at Bear Stearns.? I met him for lunch during an actuarial conference in midtown Manhattan — what a place to meet for two guys from the Milwaukee suburbs.? We caught up on each other lives and careers.? Me, married with seven children (then — eventually eight) — he, unmarried, but still more handsome than me.? Both of us are risk managers — he at Bear, me at F&G Life.? As the book records, Pat and those working with him try to create mathematical models that will highlight the risks of Bear.? James Cayne, not understanding the value of them, kills the project.

There are other references to him in the book, but this is a tale where those more powerful would not listen to reason.? Pat Lewis is a standup guy, and stated what he believed, even when things were chaotic.

Lessons

Though the book gives its own set of lessons, I want to give a few of my own.

Love beats fear… we need friends

Bear might have felt like a big swinging dick after LTCM, where they stiffed the rest of the securities industry by refusing to pony up capital, but that cemented the view of the rest of the industry: Bear was not a team player.? That cost them when their disaster hit.? My conclusion: love beats arrogance in the long run.? Better to have friends than to suffer alone.

Don’t take your eye off the ball

Cayne clearly took his eye off the ball thinking that the business would do fine without close attention — he could go off and play bridge and smoke pot.? Inattention destroys businesses.

Risk control wins in the long run.

Cayne ignored risk control.? He was happy with a high ROE, and did not look closely to see how it was generated.

Liquidity is lifeblood — consider the BONY box.

Goldman is the only securities firm to come through this crisis almost unscathed.? Rather than pressing it to the limit, they would add assets during good times to the BONY box.? That is, they would save safe assets to protect themselves in the long run.? What a wise strategy.? No wonder that they run our government.

Summary

This is a good book that deserves to be read by those that want a clear view of how Bear Stearns went down.? It is engaging and informative.

As For Me

Here are some posts that I wrote during the crises:

If you want to buy the book you can buy it through the link in my leftbar. ?? Or, you can buy it here:

Street Fighters: The Last 72 Hours of Bear Stearns, the Toughest Firm on Wall Street

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The Zero Short

Posted on 13 May 2009 by David Merkel

Wrong

Something for nothing.

Intellectual and financial achievement.

We showed those losers.

Hey, it’s free money!

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

Possibly Right

Don’t play for the last nickel.? It may cost you a buck or more.

Shorting is not the opposite of being long, it is the opposite of being leveraged long.? You don’t control your trade in entire, and the margin desk, or fear of the margin desk can make you leave a trade prematurely.

Pride goeth before a fall.

Would you rather be right, make money, neither, or both?

Free money in the market exists until too many people start searching for it.

Whom God would destroy, He makes overconfident.

=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-

Though I do risk control different than many people, risk control is behind much of what I do in managing money.? Avoid risks that I am not being paid to take, and take risk where I am getting fair compensation or better.

Now, I can think of several companies where I think the common is an eventual zero.? Fannie, Freddie, AIG, GM, and Ford (I am less certain about the last one).? My calls on GM and Ford were ones made long ago.? The same for Fannie and Freddie.? AIG is more recent.

Now, I rarely short, because my risk control methods are not designed to work with shorting.? But one thing I would almost never do is try to “zero short” — short a stock to zero.? As I have said before, seemingly free money brings out the worst in people, and makes them play more aggressively than they should.

Don’t underestimate the power of control.? There is an optionality there that is underappreciated.? With the right offer management can sell assets, change the capital structure, get a bailout, etc.

Don’t overestimate the uniqueness of the reasoning involved.? Zero shorts attract parties wanting to short to the bitter end; they think that zero is inevitable.? No risk here.? One decision.

I would look at the borrow.? Can I borrow a lot more stock easily, without paying a premium either directly, or indirectly through the cost of some derivative instrument? (options, swaps, etc…)? If I can, perhaps I don’t have to worry so much about losing control of the trade.? If not, it may be time to close out the trade (for a little while, then re-evaluate), or at least evaluate how high the price could go in a short squeeze.? As we have seen recently, some lousy companies in a short squeeze can double or triple.? Would I have enough capital to carry the trade under such adverse conditions?

At least I should estimate short-term upside versus downside for that position versus others in the portfolio.? After a successful short, it may not employ a lot of capital; perhaps I should close it out.

What’s that you say?? The borrow is plentiful, and I should short more?? After all, it is going to zero.? I would not do it because the upside/downside ratio is worse than when the? trade began.? Figuratively, playing for that last nickel could cost me several bucks.

What if the position moves against me and the borrow is plentiful?? Should I short more?? After all, it is going to zero.? Sigh.? Review the thesis.? I might look for someone who doesn’t always agree with me, and ask him what he thinks.? If the thesis does not change, I would short a little more once the momentum against the position has stopped.

One more note: I review pricing across the capital structure.? Where does the bank debt trade?? Where are Credit Default Swaps [CDS] trading?? Yields of senior unsecured notes across the maturities?? Junior debt, trust preferreds, hybrids, preferred stock, etc…? These are all relevant bits of data to tell whether the common stock will indeed zero out.? If the next most senior class of capital to the common is trading above 50% of par, I would do more research on my thesis.? If it is over 80% of par, the zero short is not a good idea.

Risk control wins in the long run.? To me shorting all the way to zero is a risky way to do business, and so I am very unlikely to do it.? There is a pride element involved, and all good investing relies on having control over your attitude.? If you decide to zero short, be very careful.? It is not as easy as it looks, even if in the end, it does go to zero.

Stressing Bank Tests

Posted on 11 May 200911 May 2009 by David Merkel

Perhaps we have it easy in the life insurance industry. Solvency is defined on two criteria: risk-based capital, and a variety of cash flow testing schemes, both contingent and noncontingent. Truth is, it’s not that easy, but the life insurance industry has been more proactive on risk management than the banks.

I have not talked much, if at all about the “bank stress tests” for one major reason: in life insurance, there are detailed rules for performing cash flow analyses. With the bank stress tests, the adverse scenario posited higher unemployment, lower residential housing prices, and lower real GDP than “baseline” estimates.

Okay, that’s nice, but as is often said, the devil is in the details. Did the banks get relief from the scenarios? It seems so. Why? When I first saw the adverse scenario, I said to myself, “Not adverse enough. Aside from that, how do you translate the adverseness into actual credit losses?”

The latter question is a critical assumption, particularly for complex financial institutions. There is no immediate good answer, so how did the US government simplify matters? We do not know, but we do know that the financial institutions pushed back.

What concerns me the most is that the stress scenarios did not explicitly consider weakness in commercial mortgage pricing. This is a process that is in its early phases. Much as REIT stock prices have fallen, and CMBS prices have fallen, the impact has yet to be realized on commercial whole loans on bank balance sheets.

It is very difficult to transform the macroeconomic assumptios of the stress test into usable credit loss data. Reasons:

Differences in bank lending practices makes uniformity tough.
Attempts at getting accurate on a company-specific basis introduces the ability of the company to tilt the analysis their way. Also, company specific loss estimates lack credibility.
Loss estimates on new lending classes also lack credibility.
Estimates of how sensitive loss estimates are to unemployment, GDP and residential housing prices lack credibility for most lending classes. We don’t have enough data.

Now I have done stress tests at life insurance companies. You estimate how much you can take in credit losses without having to dip into surplus assets over a 1, 3, 5, 10, etc-year periods. You compare those statistics to worst few credit losses over 1, 3, 5, 10, etc-year horizons to get an idea of the likelihood of such large losses. That has its troubles, but it is better than nothing. The life insurance industry keeps pretty extensive statistics on its asset losses.

I didn’t get too encouraged by the results of the stress tests. They were easy tests to pass for many because:

The stress scenario isn’t that severe. I give it better than 50% odds of occurring. A real stress test has perhaps a 5% chance of occurring.
The stress scenario isn’t very prolonged, like the Great Depression.
Creating the models that connect the economic assumptions to the loss costs is problematic. Errors are unlikely to be on the conservative side — both the banks and the regulators are incented to be aggressive, because they don’t want to cause specific panic over their company, or general panic over the banks. Remember, their is a large number of people who think this panic is merely confidence/liquidity, and not solvency. (Then why are we raising capital or selling assets?)
There are many new lending classes that have not gone through a full asset default cycle, so their default loss properties in an era of debt deflation won’t be calculable. We don’t have the data.

When I look at the modest cost of $75 billion of capital to raise, I think of all the capital raised prior to this — and now a measly $75 billion will assure the future solvency of the system. This is only an opinion, but I think that number is too low, particularly with the troubles in commercial real estate being so early in its cycle. Remember 1989-92? The degree of overbuilding now is greater than then. The losses should at least be proportionate.

My simple bit of investment advice is to underweight the securities (bonds, preferred and common stocks), of the companies that failed an easy test. That means underweighting:

Bank of America
Citi
Fifth Third
GMAC (debt, there is no public common)
Keycorp
Morgan Stanley
PNC
Regions Financial
SunTrust
Wells Fargo

At least, this will be worth watching as a basket from 5/8 on. It may give us clues to the economy as a whole. I expect that it will underperform, but I am more certain that it will covary very highly with the market as a whole. Let’s see what happens.

One Dozen Notes on our Current Situation in the Markets

Posted on 8 May 20098 May 2009 by David Merkel

I’m leaving for two days.? I might be able to post while I’m gone, but connectivity is never guaranteed, particularly in southwestern Pennsylvania.? (Sometimes I call it “the land that time forgot.”) Apologies to those that live there — Pittsburgh is the capital city of Appalachia.

Here are a few thoughts of mine:

1) Many have been critical of Buffett after a poor showing in 2008.? Much as I have criticized Buffett in the past, I do not do so here. The mistake that many make in analyzing Berky is forgetting that it is first an insurance company, second an industrial conglomerate, and last an investment vehicle for Warren Buffett for stocks, bonds, derivatives, etc. With most of his investments, he owns the whole company, so you can’t tell how Buffett’s investing is doing through looking at the prices of the public holdings, but by reading Berky’s financial statements. By that standard, 2008 was not a banner year for Berky — book value went down — but it was hardly a disaster. Buffett remains an intelligent businessman who deserves the praise that he receives.

From The Investor’s Consigliere, he agrees with me.? Berky is more like a special private equity shop than like a mutual fund.

2) I’m past my limit for cash for my broad market portfolio.? I have sold bit-by-bit as the market has risen.? I’m planning on buying more of my losers, or finding a few new names to throw in.? Will the current “bull market” evaporate?? There are some sentiment measures that say so.? Also, when cyclicals lead, I get skeptical.

3) As correlations rise, so does equity market risk.? Are we facing crash-like risks now?? I don’t think so, but I can’t rule it out.? My opinion would change if I knew that major foreign investors were willing to “bite the bullet” and recognize the losses that they will experience from investing in Treasuries.

4) My initial opinion of Ben Bernanke, which I repudiated, may be correct.? My initial opinion was that he would be a disaster.? Now that the transcripts of the 2003 Fed meetings are out, he was among the most aggressive in loosening policy, which was the key blunder leading into our current crisis.? It also explains the novel policies adopted by the Fed over the last 18 months.

5) Investors are geting too excited about a recovery in residential housing.? Such a recovery is not possible while 20%+ of all residential properties are under water.? Foreclosures happen because of properties under water where a random glitch hits (death, disaster, disability, divorce, debt spike (recast or reset), and disemployment).

6) I have long had GM and Ford as “zero shorts.”? Sell them short, and you won’t have to pay anything back.? Though Ford is prospering for now, GM is declining rapidly.? In bankruptcy the common is a zonk.? With dilution, the common will almost be a zonk.

7) I worry over our government’s involvement in the markets.? First, I am concerned over contract law.? The bankruptcy code in the US strikes a very good balance between the needs of creditors and debtors.? I worry when the government tampers with that.? I fear that the Obama administration does not grasp that if they attempt to change certain regulations, it will have a disproportionate effect on the economy.

8) I have almost always liked TIPS.? Do I like them now?? Of course, particularly if they are long-dated.

9) Much as I do not trust it, we have had a significant rally in leveraged loans and junk bonds.

10) Did major banks support subprime lenders?? Of course many did.? No surprise here.

11) The EMH exists in a dynamic tension with its opposite.?? Because many, like me, are willing to hunt out inefficiencies, the inefficiencies often get quite small.? So it is that those that come into investing with no hint that the EMH exists think it is ridiculous.? Coming from a household where the EMH had been stomped on for many years (thanks, Mom) made me ill-disposed to believe it, and not just because we subscribed to Value Line.

12) He who pays the piper calls the tune.? To the degree that the government gets involved in business, it will intrude into lesser details that should only be the province of shareholders.? What this says to management teams is “don’t let the government in in the first place,” which should be pretty obvious.? Major shareholders with secondary interests are often painful.? With the government, that secondary interest is regulation, which makes them a painful shareholder.

With that, I bid all of you adieu for a time.? May the Lord watch over you.

Choose Two: Principal Protection, Liquidity, and Above-Market Returns

Posted on 5 May 2009 by David Merkel

Two pieces worth reading today from Eleanor Laise at the Wall Street Journal, which go along with what I have been writing in my Unstable Value Funds series:

I just want to make the short, simple point that an investor can only get two of the following three items (at best):

Principal Protection
Liquidity
Above-Market Returns

Perhaps I am a bit of a pessimist, but as a wide number of products came into existence attempting to offer all three back in the 90s, I would ask questions like, “But what happens if you have losses on assets and redemption requests at book at the same time?”? An answer would come back on the order of, “You worry too much.? We’re making money.”

True, as parties are willing to take more and more risk, you can get all three for a time.? But over a full market cycle, it can’t be done.? And, by a full market cycle, I mean a period of time long enough to include a major debt deflation, like the 30s and now.

So, be aware of withdrawal provisions on your investments, both the formal ones listed in the prospectus or its equivalent, and the informal ones where ability to withdraw is suspended as a matter of fairness to all clients, and/or protecting a business at a financial firm (though risking lawsuits in the process).

Also, try to understand what underlies the shares in any pooled investment vehicle that you own.? If the underlying does not have a liquid secondary market, the shares of the pool won’t be liquid under all conditions.? If the value of the assets vary considerably over time, stability of principal won’t be possible under all conditions.

So, be aware.? Though there are laws and courts, you are your own first and best defender when it comes to any investments.

AIG errata et addenda

Posted on 1 May 2009 by David Merkel

This is a clean-up post to finish my work on AIG.? I caught an error in my work which overstated the degree to which Alico was funded by AIG common stock back at the beginning of 2008.? I said it was almost entire, but rechecking, half of Alico’s net worth was backed by AIG common stock.? Still ridiculous, but not as much so.

I also corrected the word “centimillion” to be “hectomillion.”? Thanks to reader IF, who pointed this out.

There were a few small grammar errors corrected as well.? the complete document can be found here.? That doesn’t mean the document is perfect.? I miss my editor Gretchen from my RealMoney days.

Now, I have started to pass this around to a few other financial bloggers, and my mainstream media contacts.? We’ll see if it goes anywhere.? One blogger said to me, “You are aware that many of the legit AIG INS subsidiaries were festooned with AIG FP junk?”

I looked at that and my heart sank… what could I have missed?? I grabbed the 45 or so statutory statements, and rummaged through the derivative counterparty disclosures, and found that indeed AIGFP was the leading derivative counterparty to the subsidiaries.? But after collateral posted, and netting, none of the (almost entirely life) subsidiaries had exposure more than 1-2% of surplus.

So, unless AIG buried AIGFP exposure through structured bonds on Schedule D, or schedule BA partnerships, and didn’t disclose it in the related parties disclosures, the exposure of the OISs to AIGFP was small.? Whew.

Now, should I send the article to those that will grill Ed Liddy on May 13th?? I like Ed Liddy, so I don’t want to make his life tougher.

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Unrelated note: kudos to Dr. Jeff Miller on his piece on economic strength today.? ECRI makes me stand up and take notice, their methods are so good.? My only short-term misgivings are the continued stress in residential and commercial real estate lending markets.? I don’t know how ECRI deals with those.