Structured Products and Derivatives – Page 26

Unstable Value Funds? (IV)

Posted on 7 March 20098 March 2009 by David Merkel

This should be my last post on this topic for a while.? I thank those that sent me additional data that agreed with my theses in the piece Unstable Value Funds? (III).? I would like to start by quoting from my piece at RealMoney The Biggest Asset Class You Never Heard Of.

The bonds held in stable value funds can’t be valued at book value, because accounting rules require that they be held at market. The stable value pool goes out and purchases derivatives known as wrap agreements in order to allow the bonds to be held at book value. The wrap agreements agree to pay or receive money if any of the bonds have to be liquidated at a loss or gain respectively, thus making the fund whole for any book-value loss.

Typically, wrap agreements are only done on the highest-rated bonds, AAA, so credit risk is not covered by most wrap agreements. With most wrap agreements, once a payment is received or made by the wrapper, the wrapper enters into a countervailing transaction with the pool to pay or receive, respectively, a stream of payments over the life of the bond that was wrapped equal to the present value of the initial payment when the bond was tapped. The wrapper bears almost no risk in the arrangement; the risks are rated back to the stable value pool, and the stable value pool pays for the gains and losses through an adjustment to the pool’s credited rate. Because wrappers bear almost no risk, wrap pricing in 401(k)-type plans is typically 0.05%-0.10% per year of assets wrapped. The only risk a wrapper faces is that the interest-rate-related losses on a bond in a rising interest rate scenario are so severe that the losses can’t be repaid out of the yield of the wrapped bond. In this case, the wrapper would have to pay without reimbursement.

Interest Rate Risks

Stable value funds attempt to maintain a stable share price, but the assets underlying the fund vary as interest rates, prepayment behavior and credit spreads change. There is almost always a difference between the book value of the assets, expressed by the NAV, and the market value. When the stable value fund has a higher market value than book value, typically it pays an above-market yield. There is a risk that in an environment where interest rates have risen sharply, a stable value fund would have a lower market value than book value, with a below-market yield. In a situation like this, particularly when the yield curve inverts, there is a risk that shareholders in the stable value fund will leave in search of higher yields. If that happens to a high degree, it will worsen the gap between the market value and book value of assets. That gap will be covered by the wrappers in the short run but will reduce the fund’s yield as it pays the wrappers back. It is unlikely but possible to get a death spiral here if more and more shareholders leave the pool and the yield sags to zero. It hasn’t happened yet, so this is theoretical for now. In theory, the wrappers would keep paying once the fund’s credited rate dropped to zero, so no one would lose money unless a wrapper defaulted on his obligation. There probably would be some legal wrangling in such an event; the wrappers might try to get the fund manager to take on some of the liability, or negotiate down the amount owed, leaving policyholders with a loss. In 401(k) plans, there are limitations on transferring funds out of a stable value fund to funds that would offer an easy arbitrage, so the risk of a death spiral is further reduced but not eliminated.

Asset Default Risks

For the most part, stable value funds take little credit risk, but it’s little known that this is not universally true. Some of these funds buy corporate bonds or other, more riskily structured product bonds. Some of them take credit risk in hidden ways. For example, there are some exotic, asset- or commercial-mortgage-backed interest-only bonds that are rated AAA by the rating agencies. The agencies rate them AAA because they can’t lose principal; they have no principal to lose. But if the loans underlying the interest-only bonds default or prepay, the interest stream gets shortened. The sensitivity on these securities to default risk is more akin to BB or BBB bonds, but a manager using them can count them as AAA. If an asset in a stable value fund defaults, the fund probably will temporarily suspend withdrawals while the managers pursue one or two courses of action. If the loss is small, its managers might buy a wrap contract for the loss, which will give a haircut to the yield on the stable value fund for the life of the wrap contract. If the loss is big, they will reduce the NAV and attempt to keep the NAV stable from there. Given the history of money market funds breaking the buck, it is possible that the fund manager might pony up the funds to make the stable value fund whole, but I wouldn’t rely on that.

I want to publicly thank Chris Tobe for writing to me.? He brought me back up to speed on some aspects of stable value that I was not in touch with.? (Any errors here are mine, not his.)? After reading what he sent me, there are two major risks.? One I have described in-depth: credit risk.? The other I described in my RealMoney piece: wrapper risk.

When the market value of assets is lower than the book value of assets, the wrapper covers the difference when withdrawals are made.? But the difference typically gets amortized into the credited rate of the stable value fund, lowering the interest rate credited to pay back the wrapper.

But what if the interest rate were forced to zero?? Then the wrapper would take losses.? Investors take losses is if the wrapper is insolvent when book value is more than market value.? The stable value fund could try to replace the wrapper, but it will come out of the hides of investors, unless the management company bears it.

There aren’t many wrappers today.? Here’s a list:

JP Morgan
State Street
RBC
CDC
AEGON
ING
Pacific Life
AIG (few buying from them)
Rabobank (not accepting new business)

As such, with the current financial stress, wrap fees have doubled.? There is more need for wrap capacity than is currently available.? There is the potential for losses as wrappers could go into insolvency.

But how big is this problem for investors?? The stable value marketplace is very big, though the severity of any loss should be small — under 10% of capital on average (some could be worse than 10%).

There are two troubles here.? First, because the stable value industry does not reveal the market value of their assets under management.? The opaqueness adds to the mystery.? Second, because the stable value funds have more accounting flexibility than most investment options, they can wait much longer than a money maket fund, which must declare a credit event if the NAV of the MMF is under 99.5%.? There is not such a threshold for a stable value fund.? The risk is that a stable value fund engages in wishful thinking, assuming that the value of their bonds will rebound, and the rebound does not happen.

Is a loss of 5% horrible, in an investment that is supposed to be safe?? How about 10%?? 20%?? I can’t go over 20%, the fund managers must act by then.

It is likely that losses will be small in the stable value option, but losses are a real possiblity.? Transferring assets to other fixed income options or other stable options could be smart.

Opportunities in Bank Bonds, Part 1

Posted on 7 March 20098 March 2009 by David Merkel

The following piece was written about two weeks ago for Finacorp clients.? If you are an institutional investor, and would like to be a Finacorp client, please e-mail me.

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Before I get to my main topic, bank bonds, I need to explain my overall theory for this economic crisis. We are presently in a period of debt deflation. This follows a long period where government policy encouraged the buildup of private debt as a ratio of GDP to levels not seen since the Great Depression. Since 1984, the Federal Reserve ran a predominantly easy monetary policy that was quick to bring back the punchbowl the moment the economy showed modest strains.

Under such ?favorable? management of monetary policy, businessmen and consumers bid up the prices of assets, and borrowed money to do it. The additional buying power from leverage set in motion a self-reinforcing cycle that raised asset values, and raised the willingness of lenders to lend progressively more on those assets on favorable terms.

In addition to easy monetary policy, there were other factors that contributed to the increase in leverage. Securitization gave new classes of loans liquidity during the bull phase of the cycle, as leverage built up. Also, bank examiners were increasingly ?hands off? in reviewing the solvency of banks. Derivatives also made the balance sheets of financial institutions more opaque, making regulation more difficult.

Equilibrium is a weak concept in economics. Weak, because most of neoclassical economics relies on the concept that markets tend toward equilibrium. If there is a tendency toward equilibrium, in all my years as a practical economist, that tendency is weak at best. Capitalist economies are dynamic, and equilibria are fleeting. Also, when the government intervenes, it changes the terms of what an equilibrium would be.

But eventually, the unsustainability of the increase in debt would eventually be revealed, and the inability of the assets to service the debt would appear. The value of the assets had been inflated far above equilibrium levels, and a self-reinforcing cycle in falling asset prices began, with a collapse in leverage as defaults grew.

I call this a depression, and it is little different than what happened prior to and during the Great Depression. Monetary policy is tight. Ben Bernanke may not think of it as tight, but his actions are not inflating the nominal value of collateral in order to lessen the debt load. We are facing nationalistic sentiment across the globe, and the international division of labor is breaking down. The only thing different at present is that fiscal policy is as loose as loose can be. Average Americans are blinking at what the government is doing with a sense of moral horror, because those who were imprudent are rewarded by those who were prudent.

How this Affects the Banks

In this environment, bank balance sheets get compromised. The value of loans decline as creditworthiness falls and defaults rise. Also, there are unique securities that were previously thought ?money good.? They trade at low prices because there is a scarcity of buyers who can genuinely buy and hold for the duration of the security. Balance sheets are never big enough or long enough during the bust phase of a cycle, and few risk managers run stress tests severe enough for a bust phase like we are in now.

So, the Government Intervenes

The US Government acts in a wide number of ways in order to fight the crisis. The FDIC takes over failed institutions and sells them off with some degree of subsidy in those banks in deeper trouble. In some situations, where there is a large derivatives counterparty, like AIG, the government acts to protect the stability of the financial system as a whole. Granted, the government should ignore holding companies, and focus on the regulated subsidiaries that are a legitimate interest of the government, but at least in the initial phases of this crisis, the government has allocated funds to holding companies. This is a boon to those that hold holding company unsecured bonds, but expensive to the taxpayers. How long will the largesse continue?

Away from that, we have the distraction of Congress as they try to:

Make the banks lend more
Control remuneration to employees
And control spending on conferences and other normal aspects of business where rewarding talented employees and loyal customers is the norm.

Away from all of this, the Fed tries to heal lending markets at the risk of replacing them. So it goes.

Government Action is not Big Enough, or Effective Enough

The government is a big player in the economy, but not so big that it can dictate terms independently. The economy is larger than the resources of the government; if the government tries to keep the price of a large asset class like residential housing above its equilibrium level, it will fail as borrowers line up for a lot of loans.

But there are other factors that make the response of the government weaker:

They don?t really understand the crisis that they are in. They will try any Keynesian remedy, even though it won?t work.
There is enough disagreement in Congress over what to do, that any approved project is a hash, and not capable of fixing the problems.
The Fed will create a bunch of obscure lending programs, but won?t let inflation take hold which might help those with assets that are underwater.
There is a limit on what the government can borrow, ill-defined as that is. International lenders will balk, and domestic lenders will look for higher rates.

Taxation capacity of the government is limited as well. Who wants to raise taxes during a severe recession?

So what can we expect today?

Let?s start with the recent past. What have the Federal Government?s actions been with respect to the financial sector so far, and how have bondholders been affected? Here is a non-comprehensive list:

Company	Government Action	Effect on Bonds
Bear Stearns	Forced sale to JP Morgan, with some government asset purchases. Equity gets a seemingly low price.	Bonds are still money good.
Fannie Mae, Freddie Mac	Pseudo-nationalization. Equity gets diluted down to near zero, preferred also. Government backstopping the large losses for now, leaving debt capitalization unaffected.	Senior bonds are money good, and may become pari passu with Treasuries eventually.
AIG	Pseudo-nationalization. Equity gets diluted down to near zero, preferred also. Government backstopping the large losses for now, leaving debt capitalization unaffected.	Senior bonds seem to be money good for now, but increasing losses make that less than certain.
Lehman Brothers	No action. Lehman goes into Chapter 11. Common and preferred are wipeouts.	Senior bonds not money good. Recovery values very low and speculative.
Countrywide	Encouraged a merger with Bank of America	As good as Bank of America, with some small amount of extra legal risk
Merrill Lynch	Encouraged a merger with Bank of America	As good as Bank of America, with some small amount of extra legal risk
Washington Mutual	Encouraged a merger with JP Morgan	JPM did not take on all of the bonds. The bonds taken on is JPM quality, and that not taken on is risky.
IndyMac	FDIC took it into conservation, and is selling off the pieces	No bonds
Citigroup	Large investment from the TARP. Guarantee of a large amount of assets. May need even more?	Government actions have helped the position of the bondholders so far. The question is how much more is the government willing to do?
Bank of America	Large investment from the TARP. Guarantee of a large amount of assets. May need even more?	Government actions have helped the position of the bondholders so far. The question is how much more is the government willing to do?
Downey Federal	Filed for liquidation; US Bancorp buys the operating companies.	Bonds trade near zero
Group of large banks receiving unasked-for aid	TARP money was offered to, even forced on some banks. Since the TARP investment is senior preferred. Warrants go along with the TARP money for shares equal to 15% of the preferred investment. Slight chance of dilution.	Government actions have helped the position of the bondholders so far. The question is how much more is the government willing to do?

There are a few common threads here. In general, where the government intervenes, they do so through preferred and common stock investments, and occasionally buying liabilities in situations of severe stress. Also, aside from the takeovers that went through the FDIC, in general, the government has been bailing out holding companies directly, rather than regulated operating entities, which is an odd way of assuring solvency of the financial sector.

So far, all of these actions support the position of bondholders. When the bailouts began to happen, there was some talk of protecting senior unsecured bonds among policymakers, but nothing formal was set as a policy.

Increasingly, there is talk in the media of why bondholders get off the hook so easily, so this operational hypothesis may come under political pressure, particularly since many bonds are issued at the holding company. The holding company can go under with a low level of impact on the regulated operating entities, which if the regulators have been doing their jobs (cough, cough) they should be able to stand on their own, or sold off to better management teams.

Also, this does not apply to smaller institutions. There is some size level where the regulators say, ?Liquidate and sell off the pieces.? Even for the small banks that got small amounts of TARP money, the regulators will let them go under. TARP 1 was a unique exercise where the money flowed freely with very little in the way of restrictions. That won?t happen again.

If this crisis gets larger, and I think it will, with many entities asking for money, and many coming for second, third, fourth, fifth, etc. allotments of aid, the political will to protect the banks and other financials will erode. Along with that will erode support for holding company bondholders.

Opinion:

In bonds, better safe than sorry. So far government actions have supported bondholders, but that may not persist for a number of reasons:

As the crisis gets larger, the resources of the government will get stretched. Already, the government is feeling pinched.
Political pressure is building to make the bondholders of bailed out institutions feel some pain.
The rationale behind bailing out holding companies is dubious. Eventually policymakers will not bailout holding companies because it does not protect the financial system.
So far returns on government actions have been poor, to say the least. The concept that the government would make money on this was laughable at the time, but now it is proven ridiculous.
Eventually the government will take larger insolvencies through the FDIC, and bondholders will accept some amount of equity and warrants for their bonds.

Buying financial holding company bonds is a bet on stability of policy, and that the crisis does not grow. There may be some opportunities in buying unsecured bonds of financial companies here, but institutions relying on government support may prove to be poor investments, because the odds of policy shifting against bondholders is moderate. Don?t assume that ?too big to fail? means that holding company bondholders get a free pass.

The Bane of Broken Balance Sheets

Posted on 6 March 2009 by David Merkel

I?ve talked about the troubles in our economy stemming from asset-liability mismatch.? Too many people/institutions financed risk assets:

With inadequate equity (provision for adverse deviation)
With lending terms that were much shorter than that of the assets financed
Where the borrowing terms can shift against the borrower in an adverse economic environment.? Think of borrowing in a harder currency, or loans that can reset of recast with payments going higher.
Where lending terms could be modified by third parties.? Think of the rating agencies downgrading a company and it has to put up more assets as collateral.

Another way to say it is too many relied on the ability to refinance on favorable terms.? But now that favorable terms are no longer there, we live in a time of broken balance sheets.? What were some of the classic examples of this phenomenon?

Buying houses with little money down.
Buying houses where the terms can reset against you.? Houses are long term assets, and must be funded with a generous amount of equity, and long term financing as far as the debt is concerned.
Hedge funds bought long duration assets, stocks and longer bonds, when their capital bases could be withdrawn at much shorter intervals.
Many mergers were done for cash near the peak of the product pricing cycle for their particular industry.? The debts incurred hang around, but funny, the pricing power doesn?t when demand collapses.
Many companies invested in new productive capacity ? energy, agriculture, mining, just as the global economic cycle was peaking.? Others in developing markets had ramped up industrial capacity beyond the world?s capability to absorb it.
Defined benefit pension liabilities were increased by states and municipalities which relied on the idea that tax revenues would grow indefinitely at a rate of 4-5% or more.? The same for corporations that assumed 7-10% asset returns for the next 50 or so years.
Even 10-year commercial mortgages with 30-year amortization presumed on the ability to refinance 10 years out.? Was there the possibility that ten years out, refinancing terms would be worse than at origination?? Yes, and we are there now.

In any case, there was often a mismatch as the global economy grew during the boom phase.? New long term assets were created, and financed with not enough equity, and debt terms that were shorter than the life of the assets.

Much of this can be laid at the doors of the Central banks of our world, because they pulled out all of the stops in the early 2000s to help establish an unending prosperity.? News flash: the boom/bust cycle is endemic to mankind; efforts to eliminate it merely create a version with long shallow booms and big busts.? Eventually the piper must be paid; there are no free lunches.? The easing of monetary policy 2001-2003 led to one final big bout of risk taking 2003-2007.? We are living with the aftermath now, as the central banks do everything to try to reflate with no success.? When consumers have little capacity to increase indebtedness, monetary policy is useless, leaving aside helicopter tactics.

So what can the government do at a point like this, since they are committed to permanent prosperity?

Inflate, raising the nominal value of collateral.? This is the simplest solution, and the Fed resists it.? It would also force the other governments of the world to go along.
Provide long-term financing to troubled corporations, whether through long debt, equity, or hybrid instruments.
Bail out states and municipalities with burdensome pension liabilities.

(NB: I am not saying the government should do any of these things.? I am simply saying that these are better than what the government is currently doing.)

Government funding is short duration by nature because of the annual appropriations process, and lack of any restraint ? little in the way of rainy day funds ? a presumption of prosperity in budgeting.? Few governmental entities in the US assume that receipts will be lower in future years.? Budgets are often made assuming that spending will increase, and that taxes will rise to fill the gap.? Well, no more of that, at least for a while.

Any scheme that relies on increasing prosperity is inherently mismatched.? No tree grows to the sky, and that includes nations and their governments.? There is a natural process where nations are born, grow, mature, decay, and die, unless some event intervenes to revivify the nation, giving it new purpose and energy.? With the US over the last 75 years, there has been slow decay amid prosperity.? Payment for obligations is pushed out into the future, because growth will solve our funding crises.? Government debt covers a multitude of sins, in the intermediate-term.

Financing the Economy at Treasury Interest Rates

When I hear talk that the government should borrow to fund mortgages, or dodgy companies, I cringe.? I hear things like: ?These assets are at depressed levels because of a lack of confidence.? The government can borrow and buy them, and make a profit on the spread, particularly after confidence resumes.?? ?Let the government absorb Fannie and Freddie and make loans at affordable rates to people.? They can provide mortgages much cheaper than the private sector.?? ?The value of the assets of AIG is artificially depressed.? The government can finance those assets and sell them for a profit when confidence reappears.?

The borrowing capacity of the US Government is limited.? I don?t know what the limit is ? which straw will finally break the back of the camel, but there is a limit.? The borrowing capacity of our government should be used to its best effect, and playing as a bank or a hedge fund is likely not the right answer.

An overage of private and public leverage pushed asset prices above their equilibrium levels.? Residential housing is a good example here.? Prices still need to come down to restore the affordability levels that existed through the second half of the 20th century.? The Fed could inflate some of the problems away, but that does not seem to be on their menu of choices at present.

I have seen private residential mortgage bonds trading at levels where I said, ?The odds of these not being money good are remote.?? Yet, the bonds trade (if they trade) below 70.? (100 is being paid in full.)

This is because there are fewer entities capable of holding the bonds to anything near maturity.? When someone complains to me about the price of a mortgage bond, after analysis, I often say to find an entity that is willing to hold the bond to maturity, or slightly less, and they can garner full value.? But anyone holding that bond that can?t hold it to maturity, or doesn?t want to, is merely a speculator.

We developed too many speculators in the 2000s, and not enough parties that would hold assets to maturity.? We now suffer for that, including our dear government.? Our dear government is like Brer Rabbit punching the Tar Baby, but without the advantage of being born and bred in the briar patch.? They don?t know what they are doing.? They have some vague idea about what Keynes said, but don?t understand the limitations of his theory.? Bernanke is the expert on the Great Depression, so whatever he suggests in this context must be right? Right?!

Sadly, no.? To the extent that private sector debts are not reduced, the crisis does not end.? Even the swapping of private for government debt is merely a ?delay of game? strategy, because there will be a greater crisis when the US Government cannot service its debts.? We live in a period of waning prosperity, with the US Government having decreasing ability to influence events.

At present, absent inflation for the Fed, the broken balance sheets of our world imply a slow recovery, where any earnings go to fill in balance sheet holes, and buy up broken competitors.? It?s not a fun environment, but it is an environment where good managements can pursue relative advantage if they are careful.? Guard your liquidity carefully, and persevere through this tough time.

Give Buffett Credit

Posted on 28 February 20091 March 2009 by David Merkel

The chatty, folksy annual report of Berkshire Hathaway is out.? I have occasionally been a critic of Buffett, but this year, I see little to criticize.? In a bad year, he told it straight.? He lost more book value in 2008 than any other year in percentage and dollar terms.? Worse yet, the market capitalization fell much more.

But guess what?? Berky is the biggest financial company in the US, bar none, by a wide margin.? Financials have done horribly, Berky less so.? Comparing the book value performance of Berky versus the market value of the S&P 500, this was one of Berky’s best years.

Looking at his divisions, insurance, utilities, and other businesses did well, and his investing did horribly, like most of the rest of us.? Sure, his timing was bad with some of his preferred stock purchases, and his willingness to write index put options.? But if those that Berky invested in survive the crisis, Buffett will come back smiling broadly.

Here’s another pillar of strength.? A lot of capital has been destroyed in the insurance industry in the capital markets, reducing surplus.? Those that have surplus will benefit.? Who is the most ready to write more business?? Berky.? After that, maybe PartnerRe.? Insurance should do well for Berky in the intermediate term.

Though I don’t own it, I find Berky to be intriguing.? Who knows, I might finally join the Buffett cult and buy some under $75,000.

PS — Give Buffett credit?? I would argue that Berky is cheap relative to other insurance credits.? Complexity creates the discount, but the firm is well-managed.

Full disclosure: long PRE

Send AIG to Chapter Eleven

Posted on 24 February 2009 by David Merkel

There are two reasons to bail out a financial company.? The first is that it’s failure would lead to a run on liquidity at similar companies duewith those of to a lack of confidence.? The second is that it their promises are so interlaced with those of other companies that failure would cause many other companies to fail.

For the first reason, we have the FDIC and similar institutions for deposit-takers, and the insurance guarantee funds for the insurers.? For the second reason, the government should be minimalistic, and only guarantee the entities that threaten systemic risk.

For AIG, what should have happened back in September, and what should happen now, is that the government should have let the holding company fail, and guaranteed the obligations of AIG Financial Products in exchange for a senior loan that would subordinate all existing holding company debt.? [Essentially a DIP loan, because the holding company would be in Chapter 11.]

Aside from Financial Products, most AIG’s subsidiaries are probably fine, and don’t need any help.? Those that might fail don’t pose any systemic risks.

So, when I see AIG coming back to the government for more, I think of several things:

1) When Hartford Steam Boiler was sold for a cheap price, I commented that if that was the price for a good asset like HSB, then AIG common was worthless.

2) Why are we messing around with the holding companies as we do bailouts?? Regulated entities I understand.? There is no compelling interest for the US government to own AIG holding company stock.

3) Let the bondholders suffer a little.? AIG did not trade like a AAA credit, even in its glory days.? It traded more like single-A.? If you didn’t take the warning that the bond market was giving you as the leverage built up, then that is your fault.

4) Back to point 2 in a more general way.? If the government is going to intervene, let them inject money into the regulated subsidiaries, not holding companies, and then limit dividends and transfer payments to the holding company.

5) If large derivative counterparties are so critical to the financial infrastructure, then they need to be regulated as well.? Open the derivative books to the regulator, and let the new regulator set leverage/capital policy.? What?? They can’t do as much business?? Too bad.

6) As I commented regarding the automaker bailouts, the important thing is to get your foot in the door and get some money, so that the legislators/regulators feel they must protect their initial investment with more money later.? With AIG, that is in full force, as this could be the fourth bailout.? When does it dawn on a bureaucrat that you have been bamboozled?

7) The government was hoodwinked on the first few iterations of the bailout.? Shame on them, if they don’t realize that they are throwing good money after bad again.

AIG is a case in point of why I don’t like the way we are doing bailouts now.

We bail out the holding company, which is not in the public interest.
We accept the creeping costs of bailout rather than use better-understood bankruptcy process.
It’s obvious that the government does not understand what it is doing/buying.
We do incrementally bad deals, rather than squeezing the stakeholders, as a clever lender of last resort would.

If the US Government wants to prevent systemic risk, fine!? Guarantee the subsidiaries that pose that risk, but let the rest go into bankruptcy.

Fifteen Notes on Our Troubled Global Economy

Posted on 20 February 2009 by David Merkel

1) It’s nice to see someone else recommend my proposal for partially solving housing woes.? Immigration made America great.? Kudos to my Great-great-grandparents.

2) Is there Any Such Thing as Systemic Risk? Surely you jest.? Systemic risk exists apart from klutzy governmental intervention, as noted in my article, Book Reviews: Manias, Panics, and Crashes, and Devil Take the Hindmost.

3) The Economist has another good post on the effect of past buybacks affecting companies today.? As for me, I criticized dividends in the past:

		David Merkel
		Buybacks Depend on the Management Team
		1/5/2006 12:11 PM EST

I neither like nor dislike buybacks, special dividends, and other bits of financial engineering that extract limited value at a cost of increasing leverage. In one sense, these measures are a type of LBO-lite at best, merely covering the tracks of the dilution from options issuance mainly, or preparing to send the company to bankruptcy at worst.

A lot depends on what spot in an industry’s pricing cycle a given company is. It’s fine to increase leverage when the bad part of the cycle has played out and pricing power is finally returning. Unfortunately, unless they are careful, companies tend to have more excess cash toward the end of the good part of the cycle, at which point increasing leverage is ill-advised, but often happens because of pressure from activist investors and sell-side analysts.

My first article on RealMoney dealt with the concept of financial slack, and why it is particularly valuable for cyclical companies not to take on as much leverage as possible. One of the dirty secrets of investing is that highly-levered companies typically do not do well in the long run; they sometimes do exceptionally well in the short run, though, so if it is your cup of tea to speculate on highly-levered companies, just remember, don’t overstay your welcome at the party.

One final note: If a management team is talented, they should retain a “war chest” for the opportunities presented by volatility. Lightly-levered companies benefit from volatility, because they can buy distressed assets on the cheap. Highly-levered companies need volatility to stay low, because adverse conditions could lead to insolvency.

Leverage policy is just another tool in the bag of corporate management; it is neither good nor bad, but in the wrong hands, it can be poisonous to the health of a company. For most investors, sticking with strong balance sheets pays off in the longer-term.

Position: None

4) Financial accounting rules can work one of two ways: best estimate (fair value), or book value with adjustments for impairment.? Either system can work but they have to be applied fairly, estimating the value/amount of future cash flows.? Management discretion should play a small role.

5) Regarding Barry’s post on Bank Nationalization: I don’t like the term “nationalization.”? It’s too broad, as others have pointed out.? I am in favor of triage, which is what insurance departments (and banking regulators are supposed to) do every year.? Separate the living from the wounded from the dead.

The dead are seized and sold off, with the guaranty fund taking a hit, as well as any investors in the operating company getting wiped out.? The wounded file plans for recovery, and the domiciliary states monitor them.? The living buy up the pieces of the dead that are attractive, and kick money into the guaranty fund.? No money from the public is used.

We have made so many errors in our “nationalization” (bailout) that it isn’t funny.? We give money to them, rather than taking them through insolvency.? Worse, we give money to the holding companies, which does nothing for the solvency of operating banks.? We don’t require plans for recovery to be filed.? Further, we let non-experts interfere in the process (the politicians).? Better that the regulators get fired for not having done their jobs, and a new set put in by the politicians, than that the politicians add to the confusion through their pushing of unrelated goals like increasing lending, and management compensation.

The concept of the “stress test” is crucial here.? It could be set really low (almost all banks pass) or really high (almost all banks fail — akin to forcible nationalization).? Clearly, something in-between is warranted, but the rumors are that the test will be set low, ensuring that few banks get reconciled, and the crisis continues for a while more.

I’m in favor of the bank regulators doing their jobs, and the FDIC guiding the rationalization of bad banks, with an RTC 2 to aid them.? Beyond that, there isn’t that much to do, and there shouldn’t be that much money thrown at the situation.? We have wasted enough money already with too little in results.

One final comment — for years, many claimed that the banks were better regulated than the insurers.? Who will claim that now?

6) Equity Private rides again at Finem Respice (“look to the end”).? A good first post on how this all will not end well.

7) Whatever one thinks about mortgage cramdowns (I can see both sides), they will have a negative effect on bank solvency, and the solvency of those who hold non-Fannie and Freddie mortgage backed-securities.

8 ) What has happened to Saab is what should happen to insolvent automakers here in the US.? The companies will survive in a smaller form, with the old owners wiped out, and new owners recapitalizing them.

9)? Will the new housing plan work?? I’m not sure, but I would imagine that it would cost a great deal to support a large asset class above its theoretical equilibrium value.? There are also the issues of favoritism, and rewarding those less prudent.? We will see whether it doesn’t work (like Bush’s proposals), or works too well (my, but we burned through that money fast).? (Other thoughts: Mean Street, Barry, simple explanation from the NYT.)? As it is, many people will not be eligible for the help.

10) How do you eat an elephant?? One bite at a time. How well did Japan do in working through its leverage problem in the 90s and 2000s?? Reasonably well, though it took a while.? Deleveraging takes time when many balance sheets are constrained, and asset values are falling back to psuedo-equilibrium levels.? One person’s liability is another person’s asset; when a large fraction of parties are significantly levered, the reconciliation of bad debts can cascade, like a child playing with dominoes.

So, Japan took its time with a messy process rather than have a “big bang,” with less certain results in their eyes.? In America, we want to get this over with quickly, but not do a “big bang” either.? That’s where a lot of the cost comes in, because in order to reconcile private debts rapidly, the government must subsidize the process.? All that said, in the end we will have a lot of debt issued by the US Government, just in time to deal with the pensions/entitlement crisis from a position of weakness. And, that’s where Japan is today, facing a shrinking population with a lot of government debt, and rising demands for entitlement spending.? Japan may be a laboratory for the US, Canada, and Europe as we look at the same problems 5-20 years out.

11) If you want to search for prices and other data on bonds, look here.

12) Marc Faber makes many of the point that I have made about the crisis in this editorial.

13) Swiss bankruptcy?? I would never have thought of that possibility, but considering that it is a smaller country with a relatively large banking system, and those banks have made a decent amount of loans to weaker creditors in Eastern Europe.? Add Switzerland to the list with Austria on Eastern European lending troubles.

14) What is Buffett thinking in his recent sale of stocks?? Some criticize him for being inconsistent with his philosophy of long holding periods, but Buffett is a very rational guy.? He is getting some good opportunities in this market, and is selling opportunities that seem less good to him.? Could he be wrong?? Yes, but over the year, he has been pretty good at estimating the relative values of assets.? He’s made his share of mistakes recently, but 95% of investors have been in that same boat.? At least he has the insurance franchise to carry things along, and given the reduction in surplus across the industry from the fall in equitiues and other risky assets, pricing power should begin improving soon.? Berky is interesting here.

15) Mirroring the bubble, Anglo-Irish Bank rode the global liquidity wave up, then down.? Ireland was the hot place in the EU, and now the bigger boom, fueled by easy credit, has given way to a bigger bust.

Ten Aspects of Our Current Market Troubles

Posted on 18 February 2009 by David Merkel

1) One of the unwritten rules of the corporate bond market is avoid the sector that has been the biggest issuer lately.? Underwriting and credit quality get sloppy in any sector that issues a lot of debt.? It would be a salutary warning for telecom bonds in 2000 and financials in the mid-2000s.? Even though they are not? corporates, the same would apply to mortgage bonds near the end of the real estate boom.? The little bit of extra spread would not be worth it.

Well, what if a sector is expanding rapidly, and there is no incremental spread?? Again, not a corporate sector, but that describes our dear Government today.? We talked about “crowding out” in early 80s, but it never truly materialized.? It is probably not happening now either.? Most corporations that want to borrow can’t, and those that can don’t want to.

All the same, outside of TIPS, I don’t see a lot of value in Treasuries at present.

2) Note to the Fed: if you want to keep mortgage rates low, buy mortgage bonds, not Treasuries.? The cost of that is that the Fed would bear some risk if Fannie of Freddie went down.? But Fannie, Freddie, and the Fed have one unified balance sheet given that the Federal Government is behind all of them.

3) But, is it desirable that banks lend at this point?? It might be better for them to restore their balance sheets, battered from the sloppy underwriting of the boom years.? Then they could once again lend soundly.

It makes little sense to try to force debt onto the US consumer who is largely overleveraged.? So why try to prompt banks to lend?? This applies to my mutual bank idea as well.? Do we really need more aggregate lending when the economy as a whole remains overlevered?

4) ?We hate you guys. Once you start issuing $1 trillion-$2 trillion [$1,000bn-$2,000bn] . . .we know the dollar is going to depreciate, so we hate you guys but there is nothing much we can do.?

So said Mr. Luo, a director-general at the China Banking Regulatory Commission.? I’ve been saying for a long time that China is stuck, and that we are their problem, and not vice-versa.? There may come a point where they stop buying US Dollar-denominated debt, and let existing debt mature, but that will come after a shift in their own economy where they are no longer driven bythe promotion of their exports.? There aren’t many large good alternatives to US debt for parking the proceeds from exporting aggressively.

5) In a downdraft, pockets of hidden leverage get revealed.? Consider the states of the US.? With the declining economy, revenues from real estate taxes decline, as do capital gains and wage taxes.? Budgets of 46 of the states are facing significant deficits.? Governments got to used to capital gains taxes, rising wages, rising property assessments, and high turnover of property.? Now those are gone. ? Rainy day funds were not established at necessary levels and were drained too early.

6) In a downdraft, pockets of hidden leverage get revealed.? Consider the Ponzi schemes that have come to light: Madoff, Stanford (it seems), and a small number of smaller Ponzis.? Why revealed now?? During a boom period liquidity is superadequate; most investors don’t face a need to call for cash.? Investors are happy to receive highish stable rates of return that come with seeming safety.? During the bust period many need cash, and the frauds are revealed for what they are.? Ponzi schemes are mini-bubbles; they pop when the call on cash is too great, if aren’t discovered as frauds during their growth phase.

7) In a downdraft, pockets of hidden leverage get revealed. Prime brokerage is very profitable to investment banks, but even they have to do risk control in a tough environment.? Hedge funds with better risk control get more leverage, those with worse risk control get less.? As I have said before, hedge funds aren’t the most stable vehicles in a downdraft.? They are reliant on the good graces of their prime brokers and the patience of their limited partners.

8 ) In a downdraft, pockets of hidden leverage get revealed. While housing prices kept rising, aided by increasing buying power facilitated by poorly underwritten loans, the mortgage insurers happily clipped profits; their greatest worry was the banks eating their business through second lien loans.? Most of the banks that did a lot of that financing have gotten whacked.? The mortagage insurers had somewhat more flexibility in their balance sheets, but if present loss rates continue for the next two years, many of their operating insurance subsidiaries will need to file a plan to remedy their impaired balance sheets.

9) In a downdraft, pockets of hidden leverage get revealed. (Sorry, last one.)? Just as Iceland was a harbinger of global weakness, and especially to the UK, might Eastern Europe prove to be that for Western Europe, and particularly Austria?? (Also here and here.)? Many Western European banks are exposed to Eastern European creditworthiness.? Some individual borrowers in Eastern Europe have mortgages denominated in Swiss Francs or Euros.

I’ve seen situations like that before, and sometimes I call it a currency vise.? It works well for a time during the boom phase, but then weaker currencies get trashed during the bust phase.? It simultaneously makes it more difficult to service the debt in the newly expensive hard currency, and the lender isn’t better off either — he now faces credit problems.

10) I’ve done many pieces on hidden credit problems inside ETFs and ETNs.? After my last piece, a reader asked if I would do a survey article on the problems.? Sorry, no survey article, but I can summarize them all for you here.

Exchange Traded Notes [ETNs] carry the risk that their sponsor will default.? They are unsecured obligations of a bank, but they have done some sort of hedge to provide the ETN buyer with a certain return so long as their bank is solvent.? For the bank, it is a sweet deal, because to them it is cheap funding.
Leveraged funds carry two risks.? The first is that any swap counterparties that the fund deals with goes bust.? The second is the money market instruments / cash equivalents behind the derivatives in these funds don’t prove good.? Granted, it is hard to lose in the money markets, but choose your credits with care.? Lehman went down pretty quickly.
Then there is the risk that a counterparty could go bust in a currency fund, as in the last article that I wrote.

ETFs and ETNs are great new? products that increase the scope that an investor can pursue.? Just be aware that in some funds there can be credit risk — with currencies, commodities, leveraged funds, and ETNs.

Thinking About Debt Deflation

Posted on 12 February 2009 by David Merkel

Amid my recent difficulties (sickness, loss of my main computer, difficulties updating my blog software), I have been musing about the health of our economy going forward.? Before I give my opinion, I want to share a range of views that I think are worth reading:

I admire the efforts that many are making in moving back to first principles.? We see analyses from Classical, Austrian, Post-Keynesian, Minsky (nonlinear dynamics), and other perspectives.

My view remains that depressions result? from a buildup of too much debt, including debt complexity.? With the recent analysis from Credit Suisse, they dissed adding together financial and nonfinancial debts, as there would be double counting.? Let me first say that there is no good measure here, but the double counting in a complex debt economy is useful to see.? When there is a chain of parties relying on debt repayment, like a set of dominoes, the system is fragile; one little jolt could change things for many.

Aside from that, our economy behaves like an? economy in a depression.? The banks lend considerably less.? Corporations as a whole cut back as aggregate demand drops.? People save more.? Prices of asset ratchet down to reflect current buying power, which seems to be shrinking every day.? The government replaces markets in the process of trying to save them.? Protectionist pressures are global, as is the economic weakness.

I don’t find the actions of the Fed or the current stimulus bill to be very relevant to our crisis, because they do little to reduce our indebtedness as a percentage of GDP.? In a credit based economy, once the banks and consumers are stuffed full of badly underwritten debt, it is difficult for the system to clear until those debts are reduced/liquidated.

Who Do You Work For?

Posted on 11 February 2009 by David Merkel

When I was an actuary running a GIC desk inside a medium-sized insurer in the 1990s, I quickly learned about creditworthiness.? My company, for the sake of accounting convenience, placed all GICs in a separate account.? Now the state of domicile did not have a law that said that guaranteed products in separate accounts have protection from the assets in the separate account, and the company if the assets in the separate account fail.

So, when no one would buy the GICs, because an A1/A+ insurer was no longer good enough, in 1997, I shut the line down.? I looked into credit enhancement — the cost was too high.? I asked the CEO for a guarantee — he refused (he did not understand much generally, except how to line his venal pockets).? I did what was best for the company, given the limitations of the management team, and closed the line of business.

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My goal as an actuarial businessman was to make profits with modest risk for my ultimate owners, who were the mutual policyholders.? Once I faced a situation where there might be easy profits — writing floating rate GICs.? So, I went to my models and tried to figure out how we could make money safely while our interest rates would shift every three months.? I came to the conclusion that there was no safe way to do so, and so I walked into the office of my boss and told him so.? He surprised me by supporting my thesis, and in his usual back-of-the-envelope way, explained to me in a few minutes why it had to be so.

A few weeks later, he informed me that an actuary from Goldman Sachs (yes), would be dropping by to tell about one of their new derivative contracts that would enable us to write floating rate GICs profitably.? The meeting day came, and I validated the expectations of my boss.? The year was 1993.? I asked the actuary from Goldman what happens if the yield curve inverts.? He answered honestly, “This strategy blows up when the yield curve inverts.”? Score a small victory for me.? I gave myself points for avoiding trendy bad ideas.? Over the next twelve months, two major insurers and one investment bank would announce billion-dollar blowups from following that strategy.

After the blowups, I went back to the buyers of floating-rate GICs, and asked them if they would accept a lower spread over LIBOR.? The response was a firm “no.”? So much for that market.

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Shortly after the visit from the Goldman Sachs actuary, interest rates began to rise.? I had benefited from falling rates for some time, and I had gotten a bit lazy, because the investment department could buy investments, and I could wait to sell my GICs.? After all, with rates going down, time was on my side.

Now, there was one odd thing about the company that I worked for.? They left the hedging decision in the hands of the line actuary and not at the investment department (no joke).? I had control of interest rate policy for my line of business.

1994 started out bad for me.? The rest of the industry went wildly competitive selling GICs, and I was way behind my quota.? What was worse, I had a lump of maturing GICs that left my line of business short of cash.? Our Treasurer gave me a curt phone call that my line of business had forced the company to draw down on its line of credit.? (The Treasurer was the only person in the firm that could have blended in easily at AIG.)

I considered my options.? I could sit on my hands, and the wrath of Senior Management would grow.? Or, I could write business with subpar profitability.? With the yield curve so steep, I wrote a bevy of barbell GICs that the buyers mispriced.? They would compare a GIC with half maturing in one year and half in five to a three year GIC.? With a steep yield curve, that was the wrong decision.

I sold a bunch of those barbells to get out of my cash hole, and then began cutting bargains, and selling like mad, as I concluded that the residential mortgage-backed market was pushing up interest rates.? I sold my quota early that year, and the investment department dawdled (at my request), waiting to put cash to work at higher rates, and improving credit quality as well.? It was the best year we ever had, amid the worst year for the bond market in 60+ years.

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I don’t recommend handing over interest rate policy to those that manage the line of business.? That is too dangerous a thing to do.? I didn’t undersatand that at the time, so I did the best that I could, which was pretty good.? Sadly, the same was not true for the actuaries at the other two lines of business — they assumed rates would stay low.

I tell these three stories to illustrate the ethical choices one faces when working in a financial business.? Will you act in the best interests of your ultimate owners, or will you serve the management, or worse, yourself?

We can lay the blame for mismanagement at the doors of the company managers of financial companies.? But lower level managers have their share of blame as well.? Did they follow the short term economic incentives given by their companies, or did they do what was right for their owners.

When working for investment firms at later dates, I would tell the junior analysts these stories, and I would ask them, “What do you think they gave me as a bonus?” (for my work that protected the company and made very good money?)? They would always guess high.? I never received more than a couple of thousand dollars, and I was happy with it.? I did my job to do what was right in my field, not to make excess money.

And so I would say to my peers in financial services… have you done what is right?? Have you served the best interests of shareholders?? Not you, your boss, your CEO…? You have a choice, as I do.? Life is too short to work for unethical firms.? Find a place where you can ply your trade ethically and competently.? I am grateful to my current firm for having such a place today.

Return to Aggbank

Posted on 6 February 2009 by David Merkel

When someone proposes a strategy for dealing with the economic crisis, he undertakes a hard issue.? There are many conflicting priorities:

Don’t harm the taxpayer much.
Arrest the decline in asset values.
Protect the solvent banks.
Increase the flow of credit to the rest of the economy.
Prevent the contagion in credit uncertainty from spreading.
Facilitate price discovery on illiquid assets.
And more, depending upon the most recent disaster.

The recent talk in Washington is over guarantees, Bad Banks, and more.? I’m a skeptic on all of these, because you can’t get something for nothing.? Now, it is not as if I haven’t made my own series of proposals:

Aggbank
Against Bank Nationalization
What I Would Do
A New Goal For TARP Money: Create Mutual Banks
And more, if you are willing to dig further back into my archives.

But others have proposals as well:

I’m going to modify my Aggbank piece, because it represents my best thoughts on what could be done to minimize the uncertainty to all parties involved, leading to a simpler, more transparent bailout.

Aggbank should solicit offers of assets, with prices.? It should then publish that it will buy so much of assets that have been offered, so if anyone is willing to sell it cheaper, submit their offers.

The winning offers hand over the assets and receive cash in return.? They also issue equity to Aggbank the difference between par and the price paid, in exchange for an equivalent equity stake in Aggbank. The Aggbank equity stake is reducible/increasible if the eventual value of the asset sold proves less or more than the price it was sold for. [Changes in Bold]

The main idea here is that the auctions should produce reasonably fair results, leading to price discovery.? (Banks learn what their assets are worth.)? The secondary idea is that any subsidy to banks should be limited.? If an asset purchase price is high, they lend more money to the government, and give less stock, in exchange shares in Aggbank.? Vice-versa if the purchase price is low.

Now, Aggbank shares are a high quality asset, given that it is a “full faith and credit” institution of the US Government.? Capital charges on it would be low, as they are for FHLB common stock.? The difference here is that the amount of Aggbank stock eventually received depends on the value of the assets purchased, when they are sold.? Positive variances add to the number of shares, and negative variance decrease the number of shares, pro-rata.

The beauty of this idea is that the government does not have to be worried about whether the auctions are working perfectly right or not.? The second step after the auctions trues things up, as Aggbank stakes are increased or reduced.? Third, this allows banks taking losses to issue equity to the government, which will help them recover.

A proposal like this would give the banks time to heal, and would limit losses to the taxpayers.? The eventual payout form the liquidation of Aggbank would approximately give each bank back its pro-rata portion of value contributed.? It would give banks time, while facilitating price discovery in obscure structured lending markets.