When I was a corporate and mortgage bond manager, I would have to look through prospectuses, if the bonds weren’t vanilla in nature. There was a division of labor — credit analysts would opine on the likelihood of whether a company was “money good,” and portfolio managers would try to decide relative value, analyze structure issues, and figure out whether the bond fit client needs.
The structure part didn’t come up often, but when it did, you’d have to read through a prospectus between a quarter of an inch to an inch thick. There were rewards to doing that. Sometimes I learned that protections weren’t what they seemed… I remember looking at an Enron privately placed bond, and after looking at the complex structure, asking what would happen if Enron’s stock price fell so hard that they couldn’t issue preferred or common equity to redeem the notes. I was told that Enron was a very successful corporation, and that wouldn’t happen. We didn’t buy the deal, and we let some of our existing Enron bonds mature. The protections might be valuable in a minor crisis, but not in a major one. In a major crisis, they would be the equivalent of unsecured debt.
After Enron blew up (and we took losses on the smaller amount of bonds still held — that’s another story), all Enron-like deals began to founder in the market. Dominion Utilities had a bond, Dominion Fiber Ventures, that was an Enron-like structure. It was only 3% of their capital structure, though, so unlike Enron, it wouldn’t kill them. We quietly bought as much as we could, after I read the prospectus, saw the protections (must issue preferred stock to redeem bonds if downgraded and stock price is below a certain price for so much time), and saw that Dominion guaranteed the debt. Dominion’s stock price did fall below the threshold, and a downgrade might come, so Dominion negotiated with bondholders to redeem the debt. We had a 10%+ gain plus interest in less than a year.
My point here is that protective measures in bonds must be adequate for the size of the issue involved, and must be capable of handling a big crisis to truly be effective. With Dominion, the protections were adequate, with Enron, they weren’t. Protective systems can work when they only have to take care of 3% of the capital structure — they will be inadequate at 50%.
Let me point you to a few other areas where this can be a problem. General American went under when they had ratings triggers on their floating rate GICs, as did ARM Financial. All it took was a downgrade, and when the money market funds exercised their puts, they couldn’t meet the redemptions, and they were insolvent. For GA, it was 25% of their capital structure. Metlife bought them for less than 75% of their net assets, and paid off the claimants. Mutual Benefit died for similar reasons. (I was a small part of trying to eliminate such triggers in property-catastrophe insurance.)
Or consider the financial guarantors. What if many different types of insured debt got into trouble at once? We may be seeing that now. If it’s not enough to see structured products in trouble, what of municipalities with soft real estate markets, like Vallejo? The rating agency models give some benefit to lack of correlation in the business mix, but in a systemic crisis, there is greater correlation. Insured obligations are AAA (or if you speak Moody’s Aaa) so long as the system is not overwhelmed. In normal times financial guarantors are money-spinners. There are few defaults, and nothing that is concentrated.
Or consider the auction rate securities markets, with all of the failed auctions of late. The dealers bought bonds when it was to their advantage, or, at least, not a big disadvantage. But when a tidal wave came, they protected themselves and not their issuers. Municipalities are working to refinance the high cost debt that they now have. The end result is bad but not horrid, but it will lead to steep yields in the long end of the muni curve for a while. (Also student loans and closed-end muni funds…)
Finally, think of the variable rate demand note (obligation/bond) market (Hi, Liz, another good article!). It is similar to the auction rate securities market, except there are banks that guarantee (for a time, sometimes to maturity, but usually for more like a year or two) to repurchase notes at par, so long as the municipality is still solvent, and the guarantor is still solvent, and not severely downgraded. The escape clauses have not been triggered, so now the banks that guaranteed repurchase at par must buy the bonds. What happens if the bank runs out of liquidity to make the purchases? The bonds will trade decidedly below par in most cases, even at the maximum interest rate payable.
I could go on from here, and talk about other protective structures that fail in disaster scenarios (Florida Hurricane Catastrophe Fund?), but you get the idea. Truth is, almost ant protective structure will fail, given a large enough crisis. Strong as the GSEs are, even they could fail in a large enough crisis, though the US government would likely stand behind senior obligations.
The important thing for fixed income investors is to evaluate the level of crisis that any protective structure/covenant might protect against, and how likely that crisis might be. During a period when many aspects of the credit markets are under threat, it’s too late to begin the analysis. Best to analyze when things are calm, and then ask the question, “What if?…”
1) The blog was out of commission most of Saturday and Sunday, for anyone who was wondering what happened. From my hosting provider:
We experienced a service interruption affecting the Netfirms corporate websites and some of our customer hosted websites and e-mail services.
During scheduled power maintenance at our Data Centre on Saturday Feb. 23 at approximately 10:30 AM ET, the building’s backup generator system unexpectedly failed, impacting network connectivity. This affected several Internet and Hosting Providers, including Netfirms.
Ouch. Reliability is down to two nines at best for 2008. What a freak mishap.
2) Thanks to Bill Rempel for his comments on my PEG ratio piece. I did not have access to backtesting software, but now I do. I didn’t realize how much was available for free out on the web. He comes up with an interesting result, worthy of further investigation. My main result was that PEG ratio hurdles are consistent with a DDM framework within certain moderate values of P/E and discount rates. Thanks also to Josh Stern for his comments.
3) I posted a set of questions on Technical Analysis over at RealMoney, and invited the technicians to comment.
Professionals are Overrated on Fundamental Analysis
2/21/2008 5:19 PM EST
I’m not here to spit at technicians. I have used my own version of technical analysis in bond trading; it can work if done right. But the same thing is true of fundamental investors, including professionals. There are very few professional investors that are capable of delivering above average returns over a long period of time. Part of it is that there are a lot of clever people in the game, and that raises the bar.
But I have known many good amateur investors that do nothing but fundamental analysis, and beat the pros. Why? 1) They can take positions in companies that are too small for the big guys to consider. 2) They can buy and hold. There is no pressure to kick out a position that is temporarily underperforming. With so many quantitative investors managing money to short time horizons, it is a real advantage to be able to invest to longer horizons amid the short-term volatility. 3) They can buy shares in companies that have been trashed, without the “looks that colleagues give you” when you propose a name that is down over 50% in the past year, even though the fundamentals haven’t deteriorated that much. 4) Individual investors avoid the “groupthink” of many professionals. 5) Individual investors can incorporate momentum into their investing without “getting funny looks from colleagues.” (A bow in the direction of technical analysis.)
When I first came to RM 4.4 years ago, I asked a question of the technicians, and, I received no response. I do have two questions for the technicians on the site, not meant to provoke a fundy/technician argument, but just to get opinions on how they view technical analysis. If one of the technicians wants to take me up on this, I’ll post the questions — hey, maybe RM would want to do a 360 on them if we get enough participation. Let me know.
I received some e-mails from readers asking me to post the questions that I mentioned in the CC after the close of business yesterday. Again, I’m not trying to start an argument between fundies and techies. I just want to hear the opinions of the technicians. Anyway, here goes: 1) Is there one overarching theory of technical analysis that all of the popular methods are applications of, or are there many differing forms of technical analysis that compete against each other for validity (and hopefully, profits)? If there is one overarching method, who has expressed it best? (What book do I buy to learn the theory?)
2) In quantitative investing circles, it is well known (and Eddy has written about it recently for us) that momentum works in the short run, and is often one of the most powerful return anomalies in the market. Is being a good technician just another way of trying to decide when to jump onto assets with positive price momentum for short periods of time? Can I equate technical analysis with buying momentum?
To any of you that answer, I thank you. If we get enough answers, maybe the editors will want to do a 360.
Position: none
I kinda thought this might happen, but I received zero public responses. I did receive one thoughtful private response, but I was asked to keep it private. Suffice it to say that some in TA think there is a difference between TA and chart-reading.
As for me, though I have sometimes been critical of TA, and sometimes less than cautious in my words, my guesses at the two questions are: 1) There is no common underlying theory to all TA, there are a variety of competing theories. 2) Most chart-readers are momentum players, as are most growth investors. Some TA practitioners do try to profit from turning points, but they seem to be a minority.
I’m not saying TA doesn’t work, because I have my own variations on it that I have applied mainly to bond investing. But I’m not sure how one would test if TA in general does or doesn’t work, because there may not be a commonly accepted definition of what TA would say on any specific situation.
Um, after reading this article at the Financial Times, I thought it would be a good idea for me to point readers to my article that explained the 2005 Correlation Crisis. Odds are getting higher that we get a repeat. What would trigger the crisis? A rapid decline in creditworthiness for a minority of companies whose debts are referenced in the relevant credit indexes, while the rest of the companies have little decline in creditworthiness. One or two surprise defaults would really be gruesome.
Just something to watch out for, as if we don’t have enough going wrong in our debt markets now. I bumped into some my old RM articles and CC comments from 2005, and the problems that I described then are happening now.
Position: none, and there are times when I would prefer not being right. This is one of them. Few win in a bust.
There are situations that are micro-stable and macro-unstable, and await some force to come along and give it a push, knocking it out of its zone of micro-stability, and into a new regime of instability. When you write about situations like that before the fact, it is quite possible that you can end up wrong for a long time. I wrote for several years as RM about overleveraging credit, mis-hedging, yield-seeking, over-investment in residential real estate (May 2005), subprime lending (November 2006), quantitative strategies gone awry, etc. The important thing is not to put a time on the prediction because it gives a false message to readers. One can see the bubble forming, but figuring out when cash flow will be insufficient to keep the bubble financed is desperately hard.
5) This brings up another point. It’s not enough to know that an investment will eventually yield a certain outcome, for example, that a distressed tranche of an ABS deal will eventually pay off at par. One also has to understand whether an investor can handle the financing risks before receiving the eventual payoff. Will your prime broker continue to finance you on favorable terms? Will your regulator force you to put up more capital against the position? Will your investors hang around for the eventual payoff, or will they desert you, and turn you into a forced seller? Can your performance survive an asset that might be a dud for some time?
This is why the price path to the eventual payoff matters. It shakes out the weak holders, and moves assets that should be financed by equity onto strong balance sheets. It’s also a reason to be careful with your own balance sheet during boom times, and in the beginning and middle of financial crises — don’t overextend your positions, because you can’t tell how long or deep the crisis might be.
6) I agree with Caroline Baum; I don’t think that the FOMC is pushing on a string. The monetary aggregates are moving up, and nominal GDP will as well… it just takes time. The yield curve has enough slope to benefit banks that don’t face a lot of credit problems… and the yield curve will steepen further from here, particularly if the expected nadir of Fed funds drops below 2%. Now, will real GDP begin to pick up steam? Not sure, the real question is how much inflation the Fed is willing to accept in the short run as they try to reflate.
7) Now, inflation seems to be rising globally. At this point in the cycle, the FOMC is ahead of almost all major central banks in loosening policy. I think that is baked into the US dollar at present, so unless the FOMC gets even more ahead, the US Dollar should tread water here. Eventually inflation elsewhere will get imported into the US. It’s just a matter of time. That’s why I like TIPS here; eventually the level of inflation passing through the CPI will be reflected in implied inflation rates.
8 ) Okay, MBIA will split in 5 years? That is probably enough time to strike deals with most everyone that they wrote coverage for structured products, assuming the losses are not so severe that the entire holding company is imperiled. If it’s five years away, splitting is a possibility, but then are the rating agencies willing to wait that long? S&P showed that they are willing to wait today. Moody’s will probably go along, but for how long?
9) I found it interesting that AQR Capital has not been doing well in 2008. When quant funds did badly in the latter half of 2007, I suffered along with them. At present, I am certainly not suffering, but it seems that the quants are. I wonder what is different now? I suspect that there is too much money chasing the anomalies that the quant funds target, and we reached the end of the positive self-reinforcing cycle around mid-year 2007; since then, we have been in a negative self-reinforcing cycle, with clients pulling money, and the ability to carry positions shrinking.
10) Now some graphs tell a story. Sometimes the story is distorted. This graph of the spread on Fannie Mae MBS is an example. Not all of the spread is due to the creditworthiness of Fannie Mae. Those spreads have widened 30 basis points or so over the past six months for Fannie’s on-the-run 5-year corporate bond, versus 50 basis points on the graph that I referenced. So what’s the difference? Increased market volatility makes residential MBS buyers more skittish, and they demand a higher yield for bearing the negative optionality inherent in RMBS. Fannie and Freddie are facing harder times from the guarantees that they have written, and the credit difficulties at the mortgage insurers, but it would be difficult to imagine the US Government allowing Fannie or Freddie to default on senior obligations.
That’s another reason why I like agency-backed RMBS here. You’re getting paid a decent spread to bear the risks involved.
11) I would be cautious about using prics from CMBX, ABX, etc., to make judgments about the cash bonds that they reference. It is relatively difficult to borrow and short small ABS and CMBS tranches. It is comparatively easy to buy protection on the indexes, the only question is what level does it take to induce another market participant to sell protection to you. When there is a lot of pressure to short, prices overshoot on the downside, and stay well below where the cash bonds would trade.
12) One last point, this one coming via one of our dedicated readers passing on this blurb from David Rosenberg at Merrill Lynch:
A client sent this to us last week
It was a New York Times article by Louis Uchitelle in December 1990 on the housing and credit crunch. In the article, there is a quote that goes like this ? ?This is different from the experience of the Great Depression, but something related to the 1930?s is beginning to happen?. Guess who it was that said that (answer is at the bottom of the Tidbits).
Answer to question above
?Ben Bernanke, a PrincetonUniversity Economist? (and future Fed chairman, but who knew that then?).
My take: it is a very unusual time to have a man as Fed Chairman who is a wonk about the Great Depression. That makes him far more likely to ease. The real question is what the FOMC will do if economic weakness persists, and inflation continues to creep up. I know that they want to save the day, and then remove all policy accomodation, but that’s a pretty difficult trick to achieve. In this scenario, I don’t think the gambit will work; we will likely end up with a higher rate of price inflation.
As I have said before, most companies in financial trouble would just love to split themselves in two.? Create company A with the good business, and company B with the bad business, and the holding company owns them both.? Send company B into insolvency, and the holding company hasn’t lost much… most of the value was in company A.? Who lost, though?? The creditors of the company before the split, who now rely on company B.? In the real world, it gets called fraudulent conveyance.
Ackman’s proposal avoids that.? It makes the CDO guarantor the owner of the municipal guarantor, and the holding company only directly owns the CDO guarantor.? From my example above, it would mean that the holding company would own company B, which in turn owns company A.? If B goes bust, creditors of B still have the advantage of being to draw on the value of company A in insolvency.? In this split-up, in the short run, no one’s rights are compromised.
But for Ackman, it is still talking his book, because he is trying to protect against a split-up where the holding company owns both A and B independently, because the holding company (which he is short) is worth more if the regulators allow such a split-up, and the court cases fail that challenge such a split-up.
This is one of those cases where the proposer of the idea gets ignored because of his self-interest.
It seems that a number of Constant Proportion Debt Obligations are being downgraded or forced to delever.? This was something I thought would happen; it was only a question of when.? It’s a pity that S&P did not totally abandon its model framework for CPDOs; it is less liberal now, but not consistent with the way they rate other investments.? Here’s a trip through my thoughts on CPDOs over the last 16 months:
Periodically, I gain a sense of wonder from the derivative markets. This stems from the optimism of the markets vs. my knowledge of economic history. There are risks being taken that have not worked out in the past. My current wonder-generator is the CPDO [Constant Proportion Debt Obligation] market. With a CPDO, you leverage up a basket of investment grade credits, in an effort to earn a certain amount over the life of the CPDO. {Note: the CPDO is rated AAA, but the average of the underlying credits is rated weak single-A at best.
If the deal goes well, i.e. no defaults, it delivers early, and risk decreases. If defaults occur, the structure levers up more in an effort to make back what has been lost, up to a 15x leverage limit. After that, the CPDO rapidly takes on losses.
This structure is notable, because it attempts to achieve risk reduction for free, the same way the stock managers tried to do so in the mid-80s with dynamic portfolio management. It has no external guarantors, nor subordination.
The rumor at present is that these new CPDOs are leading to a tightening in the credit default swap market. Spreads are tight as a drum, so I can see the effect, if true.
Position: None, but I always get concerned when market players try to get risk control for free. Off-loading risk is never free on average.
Be sure and look at Tony’s blog post, “Default Insurance Costs at New Low.” I checked the other Dow Jones CDX North America Investment Grade Indexes, and yes, they also are at all time tight levels. Tony cites the spread from the newest one. Should we be worried? A little. As I noted in my post from this morning, some of this tightness is due to the CPDO market. They have to suck in a lot of long credit exposure to issue these, which puts downward pressure on spreads.
But bottoms in the stock market are an event. Tops are a process. Credit spreads are tight for long periods during the bull phase, and very fat for short periods during the bear phase. (Can I have BBB spreads in the 400s again, please?) Same for implied volatility… the VIX spikes during equity and credit market panics, but lolls around at low levels during the bull phase. This is complacency.
Trouble is, complacency can last a looong time, and many fixed income and equity managers don’t have the luxury of saying, “I think I’ll just stay in T-bills for now.” The greed of those they invest for (or their actuarial funding targets) force them into risk, often at bad times. The good times end when cash flow is insufficient to refinance marginal assets. Typically that’s three years after the issuance of debt deals that should never have been done, but in this environment, there is so much private equity amd vulture capital around that I don’t see many troubled assets not getting financing.
The party will continue a while longer. Oh look, there are the hedge fund-of-funds at the head of the Conga line, followed by the CDO equity managers, the investment banks, the credit hedge funds, and the cash bond market at the tail. What a party!
PS — I think it is irresponsible of the rating agencies to assign AAA ratings to securities like these CPDOs that are composed of BBB and single-A paper, and do not have any guarantor or subordination to protect the creditworthiness. This is akin to thinking that a martingale method, like doubling down, will protect you from loss in Vegas. It might most of the time, but you lose big when it doesn’t work.
I’ve gotten numerous pings since my initial posts on CPDOs [Constant Proportion Debt Obligations]. This post is designed to correct a few errors, and explain how we as equity investors might profit from a potential disaster here. My first posts were based off what I read in a few blogs. They got a few things wrong, so I am correcting what I wrote. The structure levers up investment grade credit fifteen times, allowing the purchaser to buy a bond with a coupon two percent (or so) higher than Treasuries, with a AAA rating. What a deal; it is difficult to find AAA bonds yielding 0.5% more than Treasuries. (Ignoring odd beasts like CMBS IOs, etc.) I have seen reports that $1.0-1.5 billion of these have been created in the recent past, which means around $20 billion of credit exposure has been absorbed, depressing credit spreads over the last month.
I suggested in my earlier writings that the structures could only allow for 15x leverage, but they can go higher if the deals go badly at first. They only unwind and take losses if the market value of the underlying assets would drop down to a threshold level, say, around 90%-94% of par. That’s not to say that losses are limited to 6%-10%. The losses could be worse if the market is moving against them as they liquidate.
Now, how to profit? There will be some sort of crisis from CPDOs; after all, the buying in order to establish these securities has been characterized by some as a panic. At some point, there will be a situation where there is a default on one or more of the companies in one of the CPDOs. If it is severe enough, at that time, the CPDOs will have to deliver, and that will push credit spreads wider, and stock prices lower.
Since the companies involved are all big capitalization companies, we can watch the price and volume patterns on the S&P 500 Spyder, and look for where volume is cresting, while price is trough-ing, and take a long position after the crisis. Watch the VIX. When it spikes in a situation like this, there will be profits from going long equity exposure.
If it means anything, I used strategies like this in 2001-2002 to generate profits when things were going crazy. These strategies will work again when the CPDOs fail. I can’t say they will fail soon; I just know they will fail, as Dynamic Portfolio Management did in 1987.
I’m not alone on not liking what Moody’s and S&P have done on constant proportion debt obligations [CPDOs]. Now a rival rating agency, Dominion, better known for rating Canadian debt, has weighed in on the issue with skepticism. I’m annoyed at the irresponsibility of Moody’s and S&P for two main reasons. A weak single-A, strong-BBB portfolio should have credit losses of 10-15 basis points per year on average. Unfortunately, losses tend to come in heaps for investment grade corporate debt. No losses for five years, and large losses for two years. Now these structures are levered up 9-15 times on average, so during the two loss years, we are talking about 9-10% losses of equity over a two year period. If that is not bad enough, spreads will widen during the loss period even on healthy debt, further adding to the problems.
In the old days, say, two years ago, Moody’s and S&P would have called a CPDO structure AAA once it had de-levered, not on the prospect that it is very likely to de-lever. Remember a AAA means it can survive the Great Depression, and pay principal and interest on a timely basis. I can say with certainty that a levered portfolio of weak single-A bonds can’t do what an unlevered AAA bond can do in a period of severe economic stress.
Can rating agencies be sued for malpractice? Perhaps the boards of Moody’s and S&P should spruce up their D&O coverage…
Position: none
Beyond these pieces, I had three posts here that followed the decline:
Now we may have an opportunity as some CPDOs are forced to delever, credit spreads are being forced higher.? I commented before (all too recently) that it was time to dip our toes into the waters of credit, and buy 25% of a full position, with carefully selected credits.? I think it is now time to raise that allocation to 50%.? It is time to begin taking some credit risks; spreads are discounting a lot of unfavorable future news, and it is time to take advantage of it.? Is the current news gloomy?? You bet, and I can tell you that at the end of many days in mid-2002, I would hold my head in my hands in disbelief at the carnage.? But good credit investors must invest when the spreads are wide, and give up income when spreads are tight.
As for the 2002 carnage, I sent Cramer e-mails on the bond market back then, and this CC post recounts one of them, where Cramer used one of my e-mails for a post (he did that twice in 2002):
If you haven’t read it yet, please read Cody’s piece, “The Nature of Feedback Loops.” I do a lot with this for two reasons. First my investment methods lead me to rotate sectors, and all mature businesses are cyclical; they just aren’t all on the same cycle. Second, the insurance industry is very cyclical. I spend most of my time analyzing trends in pricing power.At cycle peaks and troughs, I tend to stop looking at quantitative data, and look for anomalous behavior that might hint that the cycle is changing. No one rings a bell at the top or bottom, and you can never get tops and bottoms exactly, but sometimes people behave funny near turning points. Greed and fear get excessive, and then people do foolish things. As an aside, before I wrote for RealMoney, I would drop Jim Cramer notes on the corporate bond market. This article resulted from one of my missives. There was still five months of craziness remaining, but I kept my trading discipline in 2002, though I sometimes wondered if I was sane. At the turns in July and October, some of my best brokers called me in a panic, saying that there were no bids in the market and many sellers. Implied equity volatility had gone through the roof.
What to do? I got out the liquidity that I reserved for such occasions and put out lowball bids for medium-quality bonds. By the time I used up all my liquidity in the early afternoon, the market had turned. Nerve-wracking, but it really made for good performance in a horrible year.
There are a variety of interested parties with an interest in keeping the guarantors in one piece, as is pointed out in this article from Bloomberg. Downgrading half a trillion of asset-backed bonds if a split happens? Yes, that is the price, and that is why there will be many lawsuits to contest any split, as pointed out by naked capitalism. The discussion of that post is worth reading, because it got me thinking about the differences between swaps and insurance. There are two ways to go here:
A swap that mimics the nature of an insurance contract is an insurance contract. After all, that is the way their regulators have been behaving, at least up until now.
A swap is a side agreement between the operating company (the actual insurer, not the parent holding company MBIA or Ambac), and the counterparty. In liquidation, they would be treated at general creditors, behind the policyholders in liquidation preference.
I looked at a few of the relevant state legal codes yesterday, and if the state regulators want to play hardball, they would go with the second interpretation, and pull the rug out from under the feet of those who were relying on the first interpretation. They could argue that swaps are a different class of business than insurance, and try to make the case that if an insolvency occured, those with with swap contracts would face a much lower recovery than those with insurance contracts, so let’s make it formal and do a split.
Now, most of the business done was by insurance contracts, and the laws on rehabilitation, conservation and liquidation indicate that similar parties are to be treated equitably within each class of claimants. Policyholders are all in the same class. Splitting the companies into municipal insurance and everything else would not treat all policyholders equally. Thus the lawsuits.
As I’ve said before, I would not be bullish on the equities of the compromised financial guarantors. They may survive, but only after much dilution. Now we have Ambac trying to raise $2 billion. What will they use? A rights offering? A PIPE? Mandatorily convertible debt? Surplus notes at their operating insurance companies? In order to get cash today, they have to give up a lot of the potential profits of the business. And what, will they take the $2 billion to try to buy off the structured securities claimants? Not enough, I think, if that half-trillion figure is correct, with $35 billion of mark-to-market losses for the market as a whole (Ambac’s portion would be big).
Two last notes: legally, I don’t see how splitting the guarantors gets done. It flies in the face of decades of contract law regarding insurers. Second, wouldn’t it be a troubling unintended consequence if the regulators managed to protect the municipalities, and in the process, ended up destroying the investment banks, leading to a bigger catastrophe? 🙁
What do municipalities want from their bond market? Low long-term financing rates. In and of itself, that’s not a bad goal to pursue. The question is how you do it.
What prompted this post was an article from The Bond Buyer (via Google cache). The need for short-dated tax-free muni bonds drives hedge funds (typically) to buy long munis and sell short term debt to finance the bonds, which tax-free money market funds buy. For more on Variable Rate Demand Structures, look here. (Thanks, Accrued Interest. The article was prescient to the current troubles.) The Wall Street Journal also anticipated the current troubles in this article. The hedge funds could only take the pain for so long. As perceived risks rose with the sagging prospects of the financial guarantors, fewer market players wanted to buy the short term debt, because the collateral underlying the short term debt no long had high enough ratings. That led to the hedge funds having to collapse their balance sheets, selling the long munis, and repaying the short term debts, taking losses in the process.
Part of the difficulty here is that auction rate structures are unstable. They can handle 30 mph winds, but not 60 mph winds. Auction rate structures deliver low rates when things are calm, but can be toxic when short term liquidity dries up. A sophisticated borrower like the NY Port Authority should have known that going in. Small borrowers are another matter, their investment banks should have explained the risks.
Yes, the explanations are all there in the documents, but a good advisor explains things in layman?s terms. That said, it is usually the shortsightedness of local governments wanting low rates and long term funding at the same time that really causes this. You can have one or the other, but not both with certainty.
Most of the municipalities with the failed auctions are creditworthy entities that don’t need bond insurance. Bond insurance is “thought insurance.” The bond manager doesn’t have to think about the credit if he knows the guarantor is good. If the guarantor is not good, then the bond manager has to get an analyst to look at the underlying creditor. That takes work and thought, and both of those hurt. Daniel Dicker is on the right track when he says the municipalities are racing refinance. Well, good. Auction rate structures are stable under most conditions, but under moderate stress, like the lack of confidence in the guarantor, they break. I would like to add, though that auction rate structures are kind of a cheat. Why?
1) The municipality gets to finance short, which usually reduces interest costs, but loses the guarantee of fixed-rate finance. 2) This is driven by investors who want tax-free money market funds. Most municipalities don’t want to issue the equivalent of commercial paper. They want long term financing. 3) The auction rate structure seems to give the best of both worlds: long term financing at short rates, without having to formally issue a floater. 4) For minor hiccups, an interested investment bank might take down bonds, but in a crisis, they run faster than the other parties from a failed auction.
The municipalities could have issued fixed or floating-rate debt over the same term, but they didn’t because it was more expensive. Well, now they will have to bear that expense, and yes, as Daniel points out, that will make the muni yield curve steepen.
Pain to municipalities, which will mean higher taxes for debt service. Fewer auction rate securities to tax free money market funds. It’s a crisis, but not a big crisis.
Position: none
Let me put it another way. No one complained when hedge funds levered up the long end of the muni market, allowing municipalities to finance more cheaply than they should have been able to. But now that the leverage is collapsing, and municipalities that did not prudently lock in their rates, but speculated on short rates are getting hurt, should it be a major crisis? I think not. Personally, I think the wave of auction failures will give way to refinancing long, and a new group of speculators buying auction rate securities at higher yields than the prior short-term equilibrium yield.
This will be a brief note because it is late, but the state insurance commissioners lack authority to favor one class of claimants over another to the degree of setting up a “good bank/bad bank” remedy, where municipalities get preferential treatment ovr other potential claimants.? The regulators allowed the nonstandard business to be written for years, with no objection.? The insureds that would be forced into the “bad bank” would likely not have agreed to the contract had they known that the claims-paying ability of the guarantor would be impaired.
There is nothing in contract law that should favor municipalities over other claimants.? Now, if they want to modify the law prospectively, that’s another thing.? Create a separate class of muni insurers, distinct from financial guarantors that can guarantee anything for a fee.? Different reserving and capital rules for each class.
Now this doesn’t mean that New York won’t try to split the guarantors in two; I think they will lose on Ambac because it is Wisconsin-domiciled.? With MBIA, they will lose after a longer fight, because they don’t have the authority to affect the creditworthiness of contracts retroactively.
It’s early morning now, after two days on the road.? It is good to be home, and it will be good to get back to “regular work” once the workday begins.? A few thoughts:
1) Here are two Fortune articles where Colin Barr quotes me regarding Buffett’s offer to reinsure the muni liabilities of the financial guarantors.? He correctly quotes my ambivalent view.? I am not willing to take Ackman’s side here, nor that of the guarantors and rating agencies.? This is one of those situations where I don’t think anyone truly knows the whole picture.? My thoughts are limited to Buffett’s offer.? He’ a bright guy, and he is hoping that one of the guarantors is desperate enough to take him up on his offer.
2) Personally, I found this note from the WSJ economics blog worrisome.? Ben Bernanke is probably a lot smarter than me, but I can’t see amelioration in the residential real estate markets in 2008.? We still have increases in delinquency and defaults at present.? Vacancy is increasing. Inventory is increasing.? The market is not close to clearing yet.
3) I like the “quants.”? Are they a big force in the stock market?? Yes.? But they are an aspect of Ben Graham’s dictum that in the short run the stock market is a voting machine, but in the long run it is a weighing machine.? “Dark pools” sound worrisome, but to long-term investors they are a modest worry at best.? Traders should be concerned, but that is part of the perpetual war between traders and market makers/specialists.
4) There are two aspects to the concept of the rise in housing prices.? One is the scarcity of desirable land near where people want to live.? The second is that financing terms got too loose.? Marginal Revolution says there is/was no housing bubble.? They are focusing on the first issue, and downplaying the second issue.? My view is that there are legitimate reasons for housing prices to rise, but we built more homes than were needed, and offered financing terms to buyers that were way too generous.? To me, that is a bubble, and we are still working through it.
5) Auction-rate securities have always seemed to me to be micro-stable, but subject to macro-instability.? What do I mean?? Small fluctuations get absorbed by the investment banks, but large ones don’t.? As an old boss of mine used to say, “liquidity is a ‘fraidy cat.”? It’s around for minor jolts, but disappears in a crisis.
6) Muni bond insurance is thought insurance.? Most municipal bonds are small.? What credit analyst wants waste time analyzing a small municipality?? With a AAA guaranty, the bonds get bought in a flash, and they are liquid (so long as the guarantor continues to be viewed positively).? So, I still view municipal guarantees as having value.? Not everyone else does.
7)? Intuitively, I can feel the dispute regarding the recycling of the current account deficit.? The two sides boil down to:
When are they going to stop buying depreciating assets?
What choice do they have?? They have to do something with all the dollars that they hold.
It’s a struggle.? In the short run, supporting the US Dollar makes a lot of sense, but the build-up of continual imbalances is tough.? Why should we buy into a depreciating currency in order to support our exporters?
8 ) Privatize your gains, socialize your losses.? It’s a dishonest way to live, but many press their advantage in such an area. Personally, I think that losses need to be realized by aggressive institutions.? They took the risk, let them realize the (negative) reward.
That’s all for the morning.? Trade well, and be wary of things that work in the short run, but are long run unstable.
I have never been on live television before; the only other times that I have been on any sort of television was when I taped two segments for TheStreet.com last October. We only did one take of each segment, so I guess that’s as good as live, though there was the possibility of re-taping.
What was I going to talk about? Well, that was uncertain until 2PM today. Cody wanted to talk stocks, but he also wanted to talk macroeconomics as well. I offered him seven stocks, four foreign, and three US insurers. He took the insurers. I offered him four macro topics, and he took the most topical one, Buffett’s offer to reinsure the muni business of the major financial guarantors.
As of 3PM, I had a problem, though. I hadn’t been able to connect to the internet all day long, and though I had talked with many people about Buffett’s proposal, I really did not have any in-depth knowledge of the proposal. The Waldorf Astoria’s free Wi-fi was not working for me, so I retreated to the business center for 20 minutes of catching up. That’s all it took to get the details hammered down, so I headed down to the Bull and Bear for the show.
I got there about four, and a perceptive staff member said, “Are you one of the guests? You have that look about you.” He then seated me at a nearby table and I pulled out my laptop, and wrote out my notes for what I would say. They read like this:
Guarantors:
Company that?s in trouble: sell your good business or bad business?
Buffett wants to buy the good business at what is a bargain price to him, leaving the bad business behind and less wherewithal to pay the claims, because the profit stream from the good muni business will be gone.NPV of the muni business is more than Buffett is offering.A company would only take up Buffett?s offer if they were desperate, or forced to by the regulators.
Now effect on Munis is limited, just because you might lose your guarantee doesn?t mean that the municipality can?t make payments.
Insurers:
?Dragged down by financials
?Dragged down by AIG
?Assets are relatively clean (got religion 2001-2003)
?Favorable demographics.
?Growth in the markets will raise AUM.
?Inexpensive on earnings and book.
?High quality balance sheets.
HIG
?Very diversified– P&C, Life, Group Benefits ? domestic and international
?1.2x book, 6.8x 2009 earnings
?Quality company
?Variable products sensitive to market movements
LNC
?Still room for cost savings from the JP merger
?Well positioned in life, annuity, and group benefits
?1.2x book, 8x 2009 earnings
?Variable products sensitive to market movements
AIZ
?The next AFLAC
?Focused on specialty businesses that can obtain an above average ROE.
?Warranties, Force-placed Homeowners, Individual Health, Small Group Benefits, Funeral (pre-need)
?Deep management team ? they invest in their people
?Good capital allocators
?1.8x book, 8.8x 2009 earnings
By the time I had written that, David Newbert, of ThePanelist.com showed up, and we began to talk. Nice guy with some heavy duty Wall Street experience. Then the Fanelli twins showed up; bright ladies.
By this point it was close to 5PM. A little powder for my face and balding pate, I am going second at about 5:13. I ask the staff for advice, and they simply tell me to be opinionated and energetic. I try to be self-effacing, but I steel myself up for the task.
The first guy completes and they go to break. I’m up! They tell me to look at Cody and Rebecca, and sooner than I can expect it, we’re off. I had committed my notes to memory, but as in war, as Cody and Rebecca interact with me, I have to deviate from what I jotted out. We talk about Buffett and the Financial Guarantors, then move to stocks. I talk about Hartford, and a little about Assurant, and then, we’re out of time! That was fast! I get to name Lincoln National at the end as an afterthought. (At one point, Cody lavishes praise on me, and I get a little embarrassed. So it goes.)
The rest of the show goes on in the crowded space of the Bull and Bear, and before you know it, it’s over. The staff efficiently shuts down, and in 10 minutes, there’s no trace of what went on before. Cody and I meet for dinner later. It’s good to re-sync in our friendship.
I hope to get a copy of the video clip to post at my blog. If so, you will see it here. I had a lot of fun, and they invited me back. Should I get back to NYC, I will be back on Happy Hour.
1) I might not be able to post much for the next two days. I have business trips to go on. One is to New York City tomorrow. If everything goes right, I will be on Happy Hour with my friend Cody Willard on Tuesday.
Sometimes I think there are too many investors trading baskets of stocks, and too few doing real investing work. I have rarely been bullish on AIG? I think the last time I owned it was slightly before they added it to the DJIA, and I sold it on the day it was added.Why bearish on AIG? Isn?t it cheap? It might be; who can tell? There?s a lot buried on AIG?s balance sheet. Who can truly tell whether AIG Financial Products has its values set right? International Lease Finance? American General Finance? The long-tail casualty reserves? The value of its mortgage insurer? I?m not saying anything is wrong here, but it is a complex company, and complexity always deserves a discount.
You can read my articles from 2-3 years ago where I went through this exercise when the accounting went bad the last time, and Greenberg was shown the door. (And, judging from the scuttlebutt I hear, it has been a good thing for him. But not for AIG.)
AIG deserves to be broken up into simpler component parts that can be more easily understood and valued. Perhaps Greenberg could manage the behemoth (though I have my doubts), no one man can. There are too many disparate moving parts.
So, what would I do off of the news? Buy other insurers that have gotten hit due to senseless collateral damage (no pun intended). As I recently wrote at my blog:
If Prudential drops much further, I am buying some. With an estimated 2009 PE below 8, it would be hard to go wrong on such a high quality company. I am also hoping that Assurant drops below $53, where I will buy more. The industry fundamentals are generally favorable. Honestly, I could get juiced about Stancorp below $50, Principal, Protective, Lincoln National, Delphi Financial, Metlife? There are quality companies going on sale, and my only limit is how much I am willing to overweight the industry. Going into the energy wave in 2002, I was quadruple-weight energy. Insurance stocks are 16% of my portfolio now, which is quadruple-weight or so. This is a defensive group, with reasonable upside. I?ll keep you apprised as I make moves here.
What can I say? I like the industry?s fundamentals. These companies do not have the balance sheet issues that AIG does. I will be a buyer of some of these names on weakness.
Position: long LNC HIG AIZ
3) More on AIG. As Cramer said yesterday: One last thought on the AIG issue: if President and CEO Martin Sullivan were to step down, the company might be more of a buy than a sale!
Maybe. Sullivan is a competent insurance executive with the biggest insurance job in the world. Breaking up the company, and letting the parts regain focus makes more sense. As an aside, M. R. Greenberg was known to be adamant about his ROE goal (15% after-tax on average equity), but he also liked the company to have bulk (high assets ? he liked asset-sensitive lines), which is why the ROA slid in the latter part of his tenure.
4) Some praise for Cramer on the same topic. As he said yesterday: AIG let me have it after I said last year that I couldn?t value the stock. They told me that there was a 92-page disclosure document and they wanted to know if I even looked at it. I shot back that not only did I look at it, but I had people comb it, including the forensic accountant I have on staff. The issue was always that despite the disclosure that they had CDO exposure, we couldn?t figure out what the real exposure was and we questioned whether THEY could.
Nothing gets a management more angry than being told that they don?t know what they are doing, but I was marveling at the certainty that they expressed. I told them they had tons of disclosure, but their estimation of possible losses seemed chimerical. I couldn?t figure out how THEY could value the stuff when no one else could with any certainty until it was off their books or written down. OF course, insurance companies aren?t held to the same standards of mark-to-market that banks are. They used mark-to-model, and the model, we learned today ? the Binomial Expansion Technique ? was totally wrong and dramatically understated the losses. All of this cuts to the incredible level of arrogance and stupidity on the Street, making judgments that were anti-empirical on data that could not be modeled but had to be experienced and examined nationally. In short, they were scientific and certain about something that couldn?t be quantified by science and certainly couldn?t be certain about.
Aside from the quibble that insurers for GAAP purposes are subject to the same rules as banks, Cramer got it right here. It is a major reason why I have been skeptical about AIG. Complexity in financial companies, especially financial companies that grow fast, is warranted. It is an unforgiving business where moderate conservatism works best.
5) Brief NAHC note: the CEO purchased more shares in the last few days. At least, it looks like it. Could he be acquiring shares to combat Hovde Capital? Honestly, I?m not sure, but this is looking more interesting by the day.
6) A new favorite blog of mine is Going Private. This post on insurance issues in Florida was unusual for that blog, but I thought it was perceptive. I wrote similar things at RealMoney:
Interesting note in the National Underwriter on a Towers Perrin Study (also try here) describing how much Floridians will have to pay if a 1-in-250 hurricane hits Florida. Cost per household: $14,000, or $467 per year for 30 years. On a 1-in-50 storm, the figures would be $5,640, or $188 per year. There would also be a higher initial assessment as well. Note that the odds are actually higher than stated odds would admit. The stated odds of the large losses from the 2004 and 2005 storms happening in consecutive years would have been considered astronomical, but it happened anyway.
The Florida legislature can determine how the pain is shared, but they can?t legislate that the pain go away. No free lunch.
P.S. As an aside, the state of Florida is subsidizing reinsurance rates through its catastrophe fund. Ostensibly, Florida homeowners get a cut in rates, but the insurers give that cut only because their reinsurance costs are lower. Who?s the loser? The citizens of Florida will have to reach into their pockets to recapitalize the Hurricane Catastrophe Fund if big losses hit, and at the very time that they won?t want to do it. (Note to S&P: why do you give this state a AAA GO bond rating?)
I don?t want to go on a rant here, but I do feel strongly about this. It ill-befits a state government to behave like a bunch of thugs, even if it pleases the electorate. For over two decades, the worst state to do business in as an insurer was Massachusetts. New Jersey was competitive for a while, and California was pretty bad on Worker?s Comp, but now we have a new state on the top of the heap: Florida.
The failure of the Florida property insurance market was due to the lack of willingness to allow rates to rise sufficiently to attract capital into the market. The partial socialization of risk drove away that capital. So what does the governor and legislature of Florida do to meet the crisis? Increase the level of socialization of risk, and constrain companies to a binary decision: accept profits that don?t fairly reflect the risks underwritten, or leave the state. (And, they might try to forbid insurers from leaving.)
In my opinion, if they bar the door to insurers leaving, or not being allowed to non-renew policies, it is an unconstitutional ?taking? by the state of Florida. No one should be forced to do business that they don?t want to do. Fine to set up the regulatory rules (maybe), but it?s another thing to compel parties to transact.
Okay, here?s a possible future for Florida:
1) By the end of 2007, many insurers leave Florida; the state chartered insurer now has 33% of all of the primary property risk.
2) Large windstorm damages in 2008-2009, $100 billion in total, after a surprisingly light 2006-2007.
3) Florida finds that the capital markets don?t want to absorb more bonds in late 2009, after the ratings agencies downgrade them from their present AAA to something south of single-A.
4) The lack of ability to raise money to pay storm damages leads to higher taxes, plus the high surcharges on all insurance classes to pay off the new debt, makes Florida a bad place to live and do business. The state goes into a recession rivaling that of oil patch in the mid-1980s. Smart people and businesses leave, making the crisis worse.
Farfetched? No, it?s possible, even if I give a scenario of that severity only 10% odds. What is more likely is a watered-down version of this scenario. And, yes, it?s possible that storm damages will remain light, and Florida prospers as a result of the foolishness of their politicians. But I wouldn?t bet that way.
Position: long one microcap insurer that will remain nameless
While I don?t pretend to be the insurance maven that you are, I don?t believe it?s quite as black and white as you portray.
First, let me preface my comments by saying that I believe in free markets and don?t agree with the Governor?s plan, although I stand to benefit. Secondly, my insurance rates, while higher than I?d like are not too bad compared to others in the state.
That being said, I think something had to be done. In one scenario that you lay out, you describe smart people leaving due to higher taxes. That was already happening due to high insurance rates. Some people with affordable mortgages suddenly found their insurance rates skyrocketing from $2,000 to over $6,000. Lots of seniors on fixed incomes also saw their rates jump.
One factor in the housing slump is that buyers are having a hard time finding insurance on a house they are ready to close on. I know that three years ago, we were scrambling at the last minute to find an insurer who would write a policy ? and that was before all of the storms.
I?m not sure what the answer is. I fear that in an entirely free market, there will be very few insurers willing to do business here if there?s another bad storm.
Maybe that?s an argument that we shouldn?t be building major population centers right on the coast, but that?s another story.
I understand the pain that many people in Florida are in. I know how much rates have risen. What I am saying is that the new law won?t work and will leave the people of Florida on the whole worse off. Florida is a risky place to write property coverage, and the increase in rates reflects a lack of interest of insurers and reinsurers to underwrite the risk at present rates and terms.
We don?t have a right to demand that others subsidize our lifestyle. But Florida is slowly setting up its own political crisis as they subsidize those in windstorm-prone areas, at the expense of those not so exposed. Commercial risks must subsidize coastal homeowners. Further, there is the idea lurking that the Feds would bail out Florida after a real emergency. That?s why many Florida legislators are calling for a national catastrophe fund.
They might get that fund too, given the present Congress and President, but Florida would have to pay in proportionately to their risks, not their population. Other proposed bills would subsidize Florida and other high risk areas. Why people in New York, Pennsylvania, Ohio should pay to subsidize Florida and California is beyond me.
The new law also affects commercial coverages; the new bill basically precludes an insurer from writing any business in Florida, if they write homeowners elsewhere, but not in Florida. If you want to chase out as many private insurers as possible, I?m not sure a better bill could have been designed. The law will get challenged in the courts; much of it will get thrown out as unconstitutional. But it will still drive away private insurance capacity.
I?m not writing this out of any possible gain for myself. I just think the state of Florida would be better served, and at lower rates, with a free market solution. Speaking as an insurance investor, I know of half a dozen or so new companies that were contemplating entering Florida prior to the new law. All of those ideas are now dead.
I hope that no hurricanes hit Florida, and that this bet works out. If there is political furor now in Florida, imagine what it would be like if my worst-case scenario plays out.
Position: long a small amount of one microcap insurer with significant business in Florida
Florida had now dodged the bullet for two straight years. Hey, what might happen if we have a bad hurricane year during an election year? Hot and cold running promises; I can see it now!
7) One of the best common-sense writers out there is Jonathan Clements of the WSJ. He had a good piece recently on why houses are not primarily investments. Would that more understood this. There are eras where speculation works, but those eras end badly. You can be a landlord, with all of the challenges, if you like that business. You can own a large home, but you are speculating that demand for the land it is on will keep growing. That is not a given.
8 ) My favorite data-miner Eddy, at Crossing Wall Street comes up with an interesting way to demonstrate momentum effects. Large moves up and down tend to continue on the next day, and the entire increase in the market can be attributed to the days after the market moves up 64 basis points.
9) This is not an anti-Cramer day. I like the guy a lot. I just want to take issue with this article: ?Trading in CDOs Slows to a Trickle.?? The basic premise is that CDOs are going away because trading in CDOs is declining.? Well, the same is true of houses, or any debt-financed instrument.? Volumes always slow as prices begin to fall, because momentum buyers stop buying.
Short of outlawing CDOs, which I don’t think can be done, though the regulators should consider what financial institutions should be allowed to own them.? That would shrink the market, but not destroy it.? Securitization when used in a moderate way is a good thing, and will not completely disappear.? Buyers will also become smarter (read risk-averse) at least for a little while.? This isn’t our first CDO blowup.? The cash CDO vintages 1997-1999 had horrible performance.? Now we have horrible performance.? Can we schedule the next crisis for the mid-teens?
10) On Chavez, he is a dictator and not an oil executive.? Maybe someone could send him to school for a little while so that he could learn a little bit about the industry that he is de facto running?? As MarketBeat points out, take him with with a grain of salt.? Venezuelan crude oil needs special processing, much of which is done in the US.? If he diverts the crude elsewhere, who will refine it for sale?
11) I am really ambivalent about Bill Gross.? He’s a bright guy, and has built a great firm.? Some of the things he writes for the media make my head spin.? Take this comment in the FT:
That the monolines could shoulder this modern-day burden like a classical Greek Atlas was dubious from the start. How could Ambac, through the magic of its triple-A rating, with equity capital of less than $5bn, insure the debt of the state of California, the world?s sixth-largest economy? How could an investor in California?s municipal bonds be comforted by a company that during a potential liquidity crisis might find the capital markets closed to it, versus the nation?s largest state with its obvious ongoing taxing authority? Apply the same logic to the gargantuan size of the asset-backed market it has insured in recent years ? subprimes and CDOs in the trillions of dollars ? and you must come to the same logical conclusion: this is absurd. It is as if Barney Fife, television?s Sheriff of Mayberry in The Andy Griffith Show, promised to bring law and order to the entire country.
Most municipal defaults are short term in nature, even those of states, of which there have been precious few.? Ambac, or any other guarantor, typically only has to make interest payments for a short while on any default.? It is a logical business for them to be in… they provide short term liquidity in a crisis, while the situation gets cleaned up.? In exchange for guarantee fees the municipalities get lower yields to pay.
The muni business isn’t the issue here… the guarantors should not have gotten into the CDO business.? That’s the issue.
12) I try to be open-minded, though I often fail.? (The problem of a permanently open mind is that it doesn’t draw conclusions when needed.? Good judgment triumphs over openness.)? I have an article coming soon on the concept of the PEG ratio.? This is one where my analytical work overturned my presuppositions, and then came to a greater conclusion than I would have anticipated.? The math is done, but the article remains to be written.? I am really jazzed by the results, because it answers the question of whether the PEG ratio is a valid concept or not.? (At least, it will be a good first stab.)
