The last few months have seen a change in expectations of FOMC policy. The next expected move is a tightening, while some incremental loosening was expected 2-3 months ago.
One of the reasons for this is that the Fed has managed to calm the short term lending markets. They have also managed to defuse a possible crisis among derivative books by bailing out Bear Stearns with the aid of JP Morgan. Also, GDP growth hasn’t gone negative yet, at least the way the Government calculates it. As a result, Ben Bernanke feels that the risk of a substantial downturn has receded, and so, the next focus of the FOMC will be inflation.
Now, I don’t think the answer for the Fed is that simple. That said, there are many that would welcome a tighter FOMC policy.
China is importing our lax monetary policy, and they are unsuccessfully trying to fight the implications of the policy, because they won’t raise their exchange rate. They will have to eventually, perhaps after the Olympics, but a tighter US monetary policy relieves some of their stress.
Europe would welcome a tighter US monetary policy, because it would relieve pressure on the rising Euro. As it is, the ECB with its single mandate is moving to fight inflation. Even the Bank of England is not loosening aggressively, and their housing problems may be proportionately greater than those in the US.
The Gulf States would like a stronger US Dollar to help arrest the inflation that they are importing.
Savers in the US might like higher rates.
But the trouble is that there are still weak spots that might cause the Fed, which has a dual/triple mandate to not tighten monetary policy. (Dual — inflation and unemployment. Triple — financial system solvency, inflation and unemployment.)
The Fed is not out of the woods yet on real estate related credit. I commented many times at RealMoney that Home Equity Lending would be a big problem, back in 2006. I also warned on option ARMs. Well, both are looming problems now.
I still expect residential real estate prices to fall further.
The correction in commercial real estate prices has only begun.
Also, investment banks are still delevering and taking writeoffs. Lehman is the most recent poster child there, but other investment banks could still be affected.
Beyond that, we have defaults rising in speculative grade credit, which will do damage directly, and through the CDOs that they are in.
I think the Fed has less freedom to act than is commonly believed. As Yves Smith has commented at his blog, the Fed may have painted itself into a corner. I think the risks from inflation, unemployment, and financial system weakness are fairly well balanced. As it stands, the Fed has adopted the following policy:
Don’t let the monetary base grow. Sterilize all new lending programs.
Allow the banks freedom to expand their lendings; informally relax regulations for now.
Bail out any significant systemic risks.
Work out kinks in the short term lending markets through new programs.
The Fed may make some of those new programs permanent, but then they will need to find a new policy equilibrium involving greater tightness elsewhere in their policy tools. They will also need to decide what to do regarding investment bank leverage, both direct and synthetic. They will also have to figure out what comes first if there is a broader banking solvency crisis, and/or significant shrinkage of real GDP with a rise in unemployment.
It is my guess that Dr. Bernanke is talking a good game today, but that the Fed’s policies will be loose toward inflation, should systemic risk or unemployment prove to be more difficult problems than currently advertised today. They are not out of the woods yet.
Even if Ambac and MBIA (the holding companies) survive, the business that used to be profitable for them will be occupied by others. I’ll throw this out as my next prediction in this space: they both go into conservation, and in runoff, claimants get paid off, senior debtholders get nicked, subordinated debtholders lose a lot, and the equity is a zonk.
One last note: the stocks rally after the downgrade. Probably short covering and other derivative-related activity, but you have to admit it is amazing for the stock to go up when the franchise gets destroyed.
Position: none
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Okay, after yesterday’s piece, there was a fast, opportunistic reaction by S&P. Moody’s action gave them cover to downgrade, and S&P took the ball and ran with it. Now that action gives Moody’s the cover to downgrade freely. There is no longer any reason for them to stay at Aaa. There is no money in it, and their reputation can only take further his from here. Rating agencies are like wolf packs — there is safety in the pack. Don’t be an outsider.
From one of my old RealMoney pieces (12/1/2004): Many of the conflict-of-interest problems still exist today. One more example: Could the ratings agencies downgrade MBIA (MBI:NYSE) or Ambac (ABK:NYSE) even if they wanted to? MBIA and Ambac rely on their Aaa/AAA ratings to the degree that they would have a difficult time operating without the rating. Much of the bond market relies on enhancement from MBIA and Ambac. The loss of a Aaa/AAA rating would be a jolt to the guaranteed bonds.
In addition, MBIA and Ambac structure their risks according to models provided by the ratings agencies. It is the models of the ratings agencies that tell the guarantors how much equity must stand in front of the debt that is being guaranteed. The ratings agencies are an inherent part of the business model of the financial guarantors. MBIA and Ambac can’t get along without them.
The ratings agencies derive so much income from these major financial guarantors that their own financial well-being would be affected by a downgrade. I’m not saying that either should be rated less than Aaa/AAA, but there is a cliff here, and I am wary of investing near cliffs.
Well, we came to the cliff, and S&P shoved MBIA and Ambac to the edge. Now Moody’s can push them over the edge. It should come soon. As with the rating agencies actions on the other financial guarantors, once a guarantor is pushed below AAA, the rating no longer matters as much. There are dedicated “AAA only” investors that care about this, and they will be forced sellers now, or, they will modify their investment guidelines. 🙁
Now, as I have mentioned before, stable value funds will have their difficulties here. Some have positioned themselves as “AAA only” funds, and that led to large holdings of MBIA- and Ambac-guaranteed debt. What they do now is beyond me. I suspect they try to modify their investment guidelines. 🙁
Well, at this point, we have to contemplate life without the old guarantors. They will shrink and disappear, while new guarantors, who are all currently skeptical of doing much more than Municipal bond insurance, will grow, and make it impossible for the old guarantors to return, because they are much better capitalized. Once you lose your AAA as a guarantor, you will rarely get it back.
When the main rating agencies begin downgrading the lesser guarantors, the big guarantors are likely not far behind. Moody’s just downgraded XL Capital Assurance from Aaa to A3, and Security Capital Assurance From Aa3 to Baa3 (barely investment grade).
Psychologically, the major rating agencies, Moody’s and S&P, have been taking baby steps toward downgrading Ambac, MBIA and FGIC. But first they have to do the lesser guarantors that are in trouble. As I have pointed out before, the major rating agencies are co-dependent with the major guarantors, and that will only throw the guarantors over the edge if hurts them more to leave the guarantors at AAA. That will cost them future revenues to cut the ratings of the major guarantors, but it might save their larger franchises. (Fitch, on the other hand, has less to lose and can downgrade with impunity.)
Now, the effects on the broader insured bond market are probably overestimated. There will be new entrants to take the place of the legacy companies that may have to go into runoff. The holding companies for the major guarantors could die, but a rescue of the operating insurance companies in runoff mode is more likely. Those who own equity in the holding companies or debt claims to the holding companies will not be happy with the results, though.
Watch for downgrades of the major guarantors. Unless a lot of new capital gets pumped into their operating insurance companies, the downgrades are coming, maybe within a month.
Please note that due to factors including low market capitalization and/or insufficient public float, we consider Security Capital Assurance to be a small-cap stock. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.
Can we get the equity side of S&P to chat with the debt ratings side? Debt ratings always have a bias toward bigger firms, and Ambac is no longer big enough to rate being in the S&P 500.
Quick, name another corporation that is AAA that is not in the S&P 500. Berkshire Hathaway, but that is because the float is small? but wait, Ambac the holding company is only AA, their regulated subsidiaries are AAA.
Are there any AA- or better US publicly traded corporations not in the S&P 500? One AA ? Genentech. Three AA-: MGE Energy, WGL Holdings, and Northwestern Natural Gas? two utilities and a gas pipeline. Decidedly more stable businesses than Ambac.
So, S&P debt ratings, take the hint from your corporate brother, and downgrade Ambac.
Now, consider this article from the AP, where they say: “Despite raising $1.5 billion in new capital in March, Ambac’s financial flexibility has deteriorated, Moody’s said. A decline in the firm’s market capitalization and high spreads on its debt securities makes it difficult for the company to address potential capital shortfalls.”
Also quoting from the post at Accrued Interest, quoting from the Moody’s report, “Moody’s stated that the ratings review was prompted, in part, by concerns about the deterioration in ABK’s financial flexibility since the company’s $1.5 billion capital raise in March 2008, as evidenced by the substantial decline in the firm’s market capitalization and high current spreads on its debt securities, making it increasingly difficult to economically address potential shortfalls in the company’s capital position should markets continue to worsen. Additionally, there is meaningful uncertainty surrounding Ambac’s ability to regain market acceptance and underwriting traction within its target markets.”
Now, maybe I’m nuts, but when I think of debt ratings, I don’t want to directly consider the ability to raise new equity capital as a significant factor in my rating decisions.? Why?? Because deterioration can happen slowly, but it doesn’t have to.? Companies the are AAA or AA should be beyond the possibility of having to do a forced equity raise in anything short of a depression.? Aside from that, the decision to raise equity capital is discretionary, and managements rarely do it at the right time — when things are going well.
Naked Capitalism calls it the Monoline Death Watch, and Yves is spot-on.? For financial guarantors, ratings are a slippery slope.? You can go down, but you can’t easily go up.? MBIA and Ambac are close to being in runoff now.? Losing the AAA from either agency will seal that.? Also, once one agency downgrades, the other will quickly follow.? There will be new start-ups, but for now Berky, Dexia, and Assured Guaranty will make hay while the sun shines — they are the new oligopoly, and won’t do structured finance, for now.
PS — If indeed FASB eliminates QSPEs by modifying SFAS 140, and if there are no financial guarantors willing to do structured finance, then what happens to securitization?? It is too useful of an idea to disappear.? I don’t think it will disappear; I just don’t know the form in which it will reappear.? I’ll toss out this idea: Wall Street creates a bunch of small cap companies to own the assets, and the tranches, are simply different levels of subordinated debt.
I decided to review “When Genius Failed,” because reading “While America Aged” reminded me of how much I liked Lowenstein’s writing style, simplifying matters for the average reader.
I was an investment actuary when LTCM was founded, and watched out of the corner of my eye, as I saw articles about their success. Being a risk manager, I was a little skeptical over the leverage employed, but I knew of other firms that had records almost as good, employing esoteric strategies of Residential MBS. That was the era of build a better prepayment model, and the returns will flow. (Perhaps today that would apply to default models…)
When LTCM imploded, I had just joined my first investment department. In the panic that ensued, Treasury yields fell, and my boss asked his new mortgage bond manager, me, why prepayments weren’t accelerating. I suggested that the banks could not borrow at Treasury rates, better to look at single-A bank and financial yields, which were considerably higher. (Surprisingly, I got that one right.) A number of the clever prepayment modelers got their heads handed to them during this era.
The implosion affected all fixed income markets, and it was a lesson to me that markets ordinarily recover from crises starting with short maturities, and moving to longer maturities, and with high quality, and moving to lower quality. We had cash flow, and and provided liquidity at a price.
Um, oh yeah, book review.? LTCM suffered from a number of troubles:
They were systemically short liquidity.
They did not consider the effect of others mimicking their trades.
They were internally disorganized; leadership was weak.
They intensified their leverage at the wrong time.
The liquidity aspect is significant.? Illiquid assets that are similar to a liquid asset usually yield more, because the cost of trading is much higher, and the possibility of being trapped is higher also.? LTCM bought the higher-yielding illiquid assets, and hedged them with more-liquid liabilities.? This set the stage for the run-on-the-fund.? Almost all run-on-the-bank scenarios occur from institutions where the ability of depositors to demand cash is greater than the ability to raise cash in the short run.
In the same way, many on Wall Street mimicked the trades of LTCM, but they had risk control desks that forced them to kick out the trades when they went awry, which further intensified the pressure on LTCM, because it forced the asset prices of LTCM lower.
The lack of discipline inside LTCM, was a eye-opener for me, and I would not have appreciated it, were it not for Lowenstein’s book.? Financial businesses that last require tight controls on risk taking.
Another thing captured by Lowenstein was the hubris involved as they cashed out some investors in order to “favor” internal investors and close friends.? They levered up at the wrong time.? The cashed-out investors were offended, but they were the ones who did the best of any; they got the good years, and missed the bad year.
Now, beyond that, Lowenstein delivers the attitudes of LTCM and Wall Street, with all of the fear and greed.? It is entertaining reading, and the book is still timely. Even though there is no dominant investment firm that threatens the financial markets, we have the investment banks as a group taking a great deal of risk in their trading and investment banking.? The assets are illiquid, the liabilities are more liquid.? Their balance sheets are opaque.? Many of them are in the same risk posture.? Many of them are more leveraged than they would like to be.? Bear has already fallen, will Lehman fall next?
Just because investors are smart does not mean that they are infallible.? Any investor playing at a high enough level of leverage can be ruined.? This book inoculates investors against perverse risk-taking, and makes them more skeptical about the claims of hot investors.? Not losing money is a big help in making money, and skepticism in investing is usually a plus.
Full disclosure: If you enter Amazon through a link on my site and buy something, I get a small commission, and your costs don’t increase. This is my version of the ?tip jar.? Thanks to all who support me.
Maybe there is something different about the way that neoclassical economists and historians approach things. I am a bit of a generalist, so I try to look at things from many angles. The two books that I cited in my recent book review on bubbles were written by historians, not economists. Let me cite my summary of Kindleberger’s paradigm:
Loose monetary policy
People chase the performance of the speculative asset
Speculators make fixed commitments buying the speculative asset
The speculative asset?s price gets bid up to the point where it costs money to hold the positions
A shock hits the system, a default occurs, or monetary policy starts contracting
The system unwinds, and the price of the speculative asset falls leading to
Insolvencies of those that borrowed to finance the assets
A lender of last resort appears to end the cycle
That’s not the way a neoclassical economist views the world. Either men are rational, or, their errors tend to cancel each other out in the short run. Certainly there are never destabilizing feedback loops. Errors on the part of one person don’t lead others to make the same errors.
It is said that neoclassical economics cannot explain the existence of marketing and financial markets, without relaxing their rationality assumptions significantly. As an economist trained in the neoclassical school, I think we forget that these are assumptions that are made in order to get the math to work, not the way things actually work in the world. People are influenced by other people, and they do stupid things as a result, even when there is money on the line. (Maybe, especially when there is money on the line, due to the effects of fear and greed.)
Don’t they effectively borrow to finance the oil futures market?
Was the internet a bubble?
Isn’t housing unique, in that the speculators can walk away so easily?
In an attempt to answer these questions, “What’s the definition of a bubble? When does something become a bubble? Was the internet a bubble?” consider this piece from RealMoney’s Columnist Conversation:
In light of Jim Altucher’s and Cody Willard’s pieces on bubbles, I would like to offer up my own definition of a bubble, for what it is worth.A bubble is a large increase in investment in a new industry that eventually produces a negative internal rate of return for the sector as a whole by the time the new industry hits maturity. By investment I mean the creation of new companies, and new capital-raising by established companies in a new industry.This is a hard calculation to run, with the following problems:
1) Lack of data on private transactions.
2) Lack of divisional data in corporations with multiple divisions.
3) Lack of data on the soft investment done by stakeholders who accept equity in lieu of wages, supplies, rents, etc.
4) Lack of data on corporations as they get dissolved or merged into other operations.
5) Survivorship bias.
6) Benefits to complementary industries can get blurred in a conglomerate. I.e., melding “media content” with “media delivery systems.” Assuming there is any synergy, how does it get divided?
This makes it difficult to come to an answer on “bubbles,” unless the boundaries are well-defined. With the South Sea Bubble, The Great Crash, and the Nikkei in the 90s, we can get a reasonably sharp answer — bubbles. But with industries like railroads, canals, electronics, the Internet it’s harder to come to an answer because it isn’t easy to get the data together. It is also difficult to separate out the benefits between related industries. Even if there has been a bubble, there is still likely to be profitable industries left over after the bubble has popped, but they will be smaller than what the aggregate investment in the industry would have justified.
To give a small example of this, Priceline is a profitable business. But it is worth considerably less today than all the capital that was pumped into it from the public equity markets, not even counting the private capital they employed. This would fit my bubble description well.
Personally, I lean toward the ideas embedded in Manias, Panics, and Crashes by Charles Kindleberger, and Devil take the Hindmost by Edward Chancellor. From that, I would argue that if you see a lot of capital chasing an industry at a price that makes it compelling to start businesses, there is a good probability of it being a bubble. Also, the behavior of people during speculative periods can be another clue.
It leaves me for now on the side that though the Internet boom created some valuable businesses, but in aggregate, the Internet era was a bubble. Most of the benefits seem to have gone to users of the internet, rather than the creators of the internet, which is similar to what happened with the railroads and canals. Users benefited, but builders/operators did not always benefit.
In the internet bubble, there wasn’t that much debt, aside from vendor financing. Some faced the obligations of paying taxes on employee stock options, without having the cash to do so. Others speculated on margin, favoring the long side, of course. The real bubble was the low cost of equity capital, which led to the creation of dubious businesses, and weird stock price movements at IPOs. Say what you want about the present era, the IPO market is relatively calm, and the few deals getting done seem to have some quality.
Regarding the oil futures markets, yes, many participants are levered, but the commodity funds which are huge typically are not. Most of the selling to them comes from the oil companies, which find it profitable to lock in prices at $60, $70, $80…. $130, you get it. In that sense, I don’t think the majority of the activity is coming from levered players that are active investors — the commodity funds are passive hoarders, and the oil companies have a commercial interest.
For another example, consider the silver bubble in the late 70s / early 80s. The Hunt brothers tried to corner the silver market. In the process, the price of silver touched $54/ounce. What stopped them?
COMEX limited their ability to hold silver futures.
The Fed tightened monetary policy.
Silver came from everywhere to meet demand. People sold the family silver, mines that were closed reopened, mines that were marginal began producing like the was no tomorrow.
That last point is why I think it is very hard to corner any commodity, and why bubbles don’t last. Supply overwhelms speculative demand. The speculative demand in this environment is coming from a bunch of nerds who advise pension funds. This isn’t hot money.
This brings me to the last point, regarding housing: “When did housing become a bubble? Who identified it? Isn’t housing unique, in that the speculators can walk away so easily?”
Housing became a bubble when lenders loosened underwriting standards and offered lending terms that were atrocious — what lender in his right mind would ignore equity, recourse, and amortization? Yet in a mania to earn current profits, many lenders did. The bubble started in 2003, and crested in 2005. I posted on this for four years 2003-2007. I posted at RealMoney as it was cresting, with my main article in May 2005, and several more through the remainder of the year.
There were many others who also pointed at the bubble, but as with all bubbles, the naysayers are at the fringe. It can’t be otherwise.
Regarding the ability of the housing speculators to walk away, I like Tanta’s line at Calculated Risk that there aren’t many true walk aways. Most people abandoning their former homes have tried to keep them, and have lost a lot in the process. Away from that, the lenders do screen delinquencies for likely ability to pay. If there are significant assets in a state that allows for recourse, you can bet the lawyers are active.
In closing, I think the concept of a bubble is meaningful. It is a series of two self-reinforcing cycles, one positive, and one negative. These cycles occur because market players chase past performance, suffering from greed as prices rise, and fear as they fall. Any lending to finance the speculation intensifies the size and the speed of the event.
PS — if it helps at all, my equity investing methods borrow from these ideas. I am always trying to analyze industry cycles, to make money and avoid losses. So far it has worked well.
Take some low single-A or high-BBB rated debt, lever it up 15 times.? If spreads back up, lever up more, and buy more at the higher spreads, and hope spreads don’t continue to rapidly widen, such that you have to break the deal and realize the losses.? If spreads tighten enough, de-lever, and declare victory.? That is a great bull market strategy to make money in investment grade credit, but it is not a high quality strategy.
If I created a Collateralized Debt Obligation [CDO] out of similar instruments, with what would be light leverage of 15 times, and it had just two tranches — 94% senior, 6% junior, the senior obligations would get a AAA (probably), but the junior obligations would be rated BB or so — just my back-of-the-envelope guess, but consistent with my experience.
But for Constant proportion debt obligations [CPDOs], they were not rated BB but AAA, because the dynamic portfolio management would allow the structure to survive modest bear markets in credit.? Unfortunately, when a lot of parties lever up credit, the historical statistics on how the credit markets behave at lower leverage levels don’t apply.? The odds of a sharp self-reinforcing bear market in credit rise.
So, it is not a surprise that I was an early bear on CPDO structures.? Here’s a summary piece on what I wrote, and when I wrote it.
Now today it gets revealed in the Financial Times that Moody’s had a mistake in their ratings model for CPDOs that allowed them to offer ratings equivalent to those of S&P.? Needless to say, this is getting a lot of coverage today, from:
There are conflicts of interest in the way that ratings agencies get paid by the issuers, and the CPDO debacle highlights them.? I don’t think you can create a system where the users of ratings carry the full weight of the ratings process.? The issuers have the concentrated interest in a way buyers do not.
But maybe there is a way to re-align matters.? What if the ratings agencies received half of their fee by receiving interests in the juniormost class?? (For non-structured deals, make that a subordinated interest strip.)? My, but I think that subordination levels would rise.? Also, I think the ratings agencies would become more generally cautious.
From my angle, though, the CPDO debacle is more egregious than other rating failures, because the agencies deviated from their normal way of rating debt, seemingly just to make more money.? Well, they made the money, but how much is a reputation for quality ratings worth?? In the long run, the CPDO deals will be net losers for Moody’s and S&P, and a net win for skeptics like Fitch and Dominion.
We haven’t quite made it back to the highs made in July or October. But the VIX has normalized:
And the spread between A2/P2 commercial paper and the two-year Treasury has narrowed as well. Normalcy has returned to the lending markets?
Well, sort of. The question remains as to what happens when the Fed ends their new lending programs, that is, if they can end them. As with many government programs, they take on a life of their own, and they are difficult to end. If the Fed can’t end the new facilities, can they really say that they have ended the crises?
As for market sentiment, consider this graph:
This is a knockoff of the oscillator that Cramer cites. How accurate is it? Over +/- 500, Cramer comments that there are extreme readings. But as for now we are near zero — this indicator tells us nothing here.
So, what am I saying? We have rallied a great deal, and a lot of fear has come out of the markets, but we still have not eclipsed the highs of July or October. My sense is that we will muddle from here and not do much on net for the next three months. Fear has ended too quickly.
It’s that time again. As WordPress counts, this is post 700 on my blog, though the actual number is more like 80% of that. I take this time to write a post about the blog itself, rather than the things I ordinarily write about.
My blog is a tough one in some ways. I admire many narrowly focused blogs, because they do such a good job at their narrow tasks. Many of them are in my blogroll. I read my blogroll daily; that’s what is in my RSS reader.
But I care about a wide range of topics in economics, finance and investments. Anytime I focus on one narrow area for a time, I get negative e-mail saying that I’m not writing about what he wants to read. Well, I’m sorry. My interests are broad, and you will get a melange when you read me. I felt the same way at RealMoney, because I was one of the few writers that you could not predict what area I would write about next.
The markets have calmed down, and my equity portfolio has done well, but I do not think we are past the troubles yet:
We still have an oversupply of houses.
Investment banks are still overlevered in their swap books.
Commercial property prices are beginning to fall, and that will have negative effects on the equityholders, and those who finance them.
As for my business life, I am busy preparing to pitch my equity management methods to institutional investors. I have been on the other side of the table in my life. Hopefully that will help me meet their needs.
In closing, I want to thank Abnormal Returns, The Big Picture (thanks, Barry), Alea (thanks, jck), FT Alphaville, The Kirk Report, Seeking Alpha, and Newsflashr for their support. I also want to thank the many small blogs that like me and have me on their blogroll. That means something to me; I thank you for your support. I also thank the TSCM/RealMoney fraternity for their support. TSCM has done the world a service by training young financial journalists, and bringing talented investors into writing for the public.
I have a list of thing to write about next, and it is long. If you have opinions about what you want me to cover e-mail me here. I am horrendously behind on my mail, but I read everything that gets written to me.
Again, many thanks for reading me. I appreciate all who take their valuable time to read my blog.
In some ways, this one was pure slop on my part.? In September 2005, I thought the setback in Dana’s auto parts business was temporary, and bought a little more.? After the second dose of bad news, I looked at the statements afresh and kicked myself.? How could I have missed the growing negative divergence between earnings and cash flow?? I waited a few days for a rally, and sold.? As it was, Dana filed for Chapter 11 in March 2006.? This could have been a lot worse for me.
How much can you lose on a $7 stock? Seven dollars. Dana (DCN:NYSE) just filed for bankruptcy, and trading is temporarily suspended. I think the common will get wiped out, so any long trades here are purely speculative. Unsecured debt is trading in the high $60s, so they look like they are the new owners of the company (but that’s just a guess).
Don’t be afraid to take losses, if you know the situation is worse than the current price would indicate.
The common was wiped out when Dana recently emerged from bankruptcy in February of this year.? PXRE made out better, merging with Argonaut.
National Atlantic Holdings
I’ve written more than my share on NAHC, and for the good of my readers, probably too much.? Perhaps this one might be a good example of taking time to accumulate a position.? My average cost is $6.67, which means that if the deal goes through at $6.25, this isn’t one of my ten largest losses.? Tentatively, though, I plan on filing for appraisal rights if the deal goes through.
Consider the 1Q08 earnings conference call on Monday:
Operator:
And we have a follow up from David Merkel with Finacorp Securities.
<Q – David Merkel>: Hi.? Sorry to trouble you, one follow up. It’s basically the questions I asked on the last call.? Your loss reserves, there’s nothing there in terms of future development that should have been reflected in the first quarter that isn’t there in the statements, and your bonds are stated at their fair market value to the best of your knowledge.? You’ve got a high-quality portfolio there.
<A – Frank Prudente>: Yes we do, David.? This is Frank Prudente. I’ll take the second part of your question first if you don’t mind.? Our portfolio remains to be very conservative and very high quality.? With the implementation of the new accounting standard we’re at Level 2 two for all of our available for sale securities.? So we continue to feel very comfortable about our investment portfolio.? And as Bruce alluded to earlier, we do a comprehensive actuarial analysis every quarter which is further validated by the review performed by our external auditors each and every quarter.? And what I can tell you is we base our estimates of loss and loss adjustment expense reserves based on all of the most relevant data we have available to us for each and every financial statement close process.
<Q – David Merkel>: Thanks, Frank. I appreciate that. Take care.
What that may mean to the court is that twice after the announcement of the merger, they publicly stated that their most variable assets and liabilities were correctly and conservatively stated on their balance sheet.? That means anyone receiving much less than book is not getting fair compensation.? This one is not over yet; I may get out of this one with a gain.? :(? (Dreamer…)
My failure here was not carefully evaluating the management team, and rely on my usual benchmark that a short-tail P&C company earning money, and trading below book is a good deal.
Vishay Intertechnology
I am still invested in Vishay.? It earns money, generates free cash flow, debt is being reduced, and the balance sheet looks decent.? The sorts of electronic components that they make will be difficult to make obsolete.? I still like the name; I don’t think this one will be a loss for me in the end.
Tellabs
Tellabs looked cheap and got cheaper.? Almost every small tech company was getting thrown out; valuations reached record low levels by the end of third quarter 2002.? Tellabs had disappointment after disappointment, and I concluded that if it couldn’t earn money, the book value was overstated.? I sold, and bought stocks that I thought have more promise.
That said, my rebalancing discipline allowed me to reduce the overall losses from this volatile stock.? I didn’t lose nearly as much as a buy-and-hold investor would have.
Deutsche Bank
This was a failure to integrate my overall markets view, and allowing short-term valuation issues to dominate my decision.? I thought the investment banks wouldn’t do well, but I thought Deutsche Bank might escape the troubles.? Well, I was wrong.? European institutions mimicked Wall Street to a higher degree than most would have expected.
My last buy was a rebalancing buy, but as results came in from other European banks, I ended up selling Deutsche Bank, and RBS as well.? Time will tell how smart that was… the investment banks of our world are tied together through counterparty exposure — to a degree, they succeed and fail as a group… that’s why the Fed bailed out Bear Stearns.
Summary of Part II
I’ll repeat what I said in part one, and add a little.
Don?t play with companies that have moderate credit quality during times of economic stress.
Measure credit quality not only by the balance sheet, but by the ability to generate free cash.
Spend more time trying to see whether management teams are competent or not.
Cut losses when your estimate of future profitability drops to levels that no longer justify holding the asset.
The next two articles in this series will be about investments that went right.? They should come soon.
Roger, there is a reason to be aware the the ETNs issued by Barclays plc are notes. (or, bonds) If Barclays went bankrupt, the value of the notes would be impaired. From my limited glance through the prospectus:
The Securities are medium-term notes that are uncollateralized debt securities and are linked to the performance of the GSCI? Total Return Index (the “Index”).
and later…
The Securities are unsecured promises of Barclays Bank PLC and are not secured debt. The Securities are riskier than ordinary unsecured debt securities. The return on the Securities is linked to the performance of the Index. Investing in the Securities is not equivalent to investing directly in Index Components or the Index itself.
and much later…
USE OF PROCEEDS
Unless otherwise indicated in the applicable pricing supplement, the net proceeds from the offering of the notes will be applied for our hedging and general corporate purposes.
In essence, a holder of the ETN has bought a senior unsecured zero coupon bond from Barclays, with an ultimate payoff based off of the return on the commodities index less 0.75%/year. But unlike a bond, there is no floor on the implied interest at zero. If commodity indexes fall, the ETN would give a negative return.
I like Barclays. I own the stock. But there is more than one risk to the ETNs: commodity price risk (of course), and Barclays plc credit risk (surprise!).
Position: long BCS, and pondering the days when I used to read structured bond prospectuses regularly…
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Now, today, I find it funny to see other retail investment commentators catching up with the credit risk angle of ETNs.? Perhaps it is my background in the Equity Indexed Annuity [EIA], Variable Annuity [VA], DC pension and GIC businesses — we had all sorts of guarantees and non-guarantees floating around, so we were used to analyzing the risks.
Now, what if the sponsors packaged the ETN with a default swap (written by third parties) to protect the investors if the company failed?? At that level, the ETN provider should buy Treasuries or Agencies, and layer on the futures or options as the case may be, creating an ETF, because all of the advantage from doing the ETN goes away.
Be wary of ETNs, at least to the level of asking how likely it will be for the sponsor to be in good shape when the ETNs mature.
One 
Can we get the equity side of S&P to chat with the debt ratings side? Debt ratings always have a bias toward bigger firms, and Ambac is no longer big enough to rate being in the S&P 500.
Quick, name another corporation that is AAA that is not in the S&P 500. Berkshire Hathaway, but that is because the float is small? but wait, Ambac the holding company is only AA, their regulated subsidiaries are AAA.
Are there any AA- or better US publicly traded corporations not in the S&P 500? One AA ? Genentech. Three AA-: MGE Energy, WGL Holdings, and Northwestern Natural Gas? two utilities and a gas pipeline. Decidedly more stable businesses than Ambac.
So, S&P debt ratings, take the hint from your corporate brother, and downgrade Ambac.