Structured Products and Derivatives – Page 40

The Virtue of Lunch with Friends

Posted on 21 December 200721 December 2007 by David Merkel

I really enjoyed being an investment grade corporate bond manager.? I enjoyed interacting with credit analysts and sales coverages, and the hurly-burly of price discovery in markets that were thinner than optimal.? My credit analysts were professionals, and I never went against them; at most, I would explain to them why market technicals favored a delay in the action they proposed.? But I would never permanently disagree.? What they wanted to buy I would buy, and sell I would sell, eventually.? The level of communication evoked greater effort from them.? Machiavelli was wrong.? It is better to be loved than feared, at least in the long run.? I have gotten more out of associates and brokers by being altruistic than through transactional constraint.? People will give far more to someone that cares for them, than someone that threatens them, in the long run.? (The short run is another matter…)

Now, this is not my character.? I tend to be shy, and constant interaction pushes me out of my comfort zone.? But when others are depending on me, I push myself harder, and do what needs to be done for the good of others.? I can’t let down those who rely on me.

Yesterday I had lunch with three friends and a new friend.? Two were sales coverage, and two from the firm that I used to work for.? It was fascinating to hear the tales of woe in the structured securities markets (worse than I expected, and I am cynical).? It was also fascinating to consider why investors for a life insurance company, which has a liability structure that would allow them to buy and hold temporarily distressed assets, does not do so. ? A lot depends on how short-term the investment orientation of the client is, and this client is definitely short-term oriented.

I talked about my new CDO model, and about what I write about for all of you who read this blog.? The summary of our discussions is that it is a tough environment out there, and one that is particularly not kind to complex securities.? After the lunch, which the sales coverages generously paid for (at present, I don’t know what I can do for them), I went back to the office of my old friends, and reacquainted myself with one of the best consumer/retailing credit analysts period, who is a very nice woman.? I also talked with my former secretary, who is sweet, and was always a real help to me and all of the staff.

Friends.? I am richer for them.? I am richer for being one.? Beyond that, it is excellent business to live life in such a way that your business dealings leave people happy for having dealt with you.? I am truly blessed for all the business friends that I have gained.

Options as an Asset Class

Posted on 20 December 200720 December 2007 by David Merkel

Well, my CDO model is complete for a first pass. There is still more work to do. Imagine buying a security that you thought would mature in ten years, but two years into the deal, you find that the security will mature in twenty years from then, though paying off principal in full, most likely. Worse, the market has panicked, and the security you bought with a 6.5% yield is now getting discounted at a mid-teens interest rate. Cut to the chase: that is priced at 40 cents per dollar of par. Such is the mess in some CDOs today.

Onto the topic of the night. There have been a number of articles on volatility as an asset class, but I am going to take a different approach to the topic. Bond managers experience volatility up close and personal. Why?

Corporate bonds are short an option to default, where the equity owners give the company to the bondholders.
Mortgage bonds are short a refinancing option. Volatile mortgage rates generally harm the value of mortgage bonds.
Even nominal government bonds are short an inflation option, should the government devalue the currency. (Or, for inflation-adjusted notes, fuddle with the inflation calculation.)

Why would a bond investor accept being short options? Because he is a glutton for punishment? Rather, because he gets more yield in the short run, at the cost of potential capital losses in the longer-term.

Most of the “volatility as an asset class” discussion avoids bonds. Instead, it focuses on variance swaps and equity options. Well, at least there you might get paid for writing the options. Bond investors might do better to invest in government securities, and make the spread by writing out-of-the-money options on a stock, rather than buying the corporate debt.

I’m not sure how well futures trading on the VIX works. If I were structuring volatility futures contracts, I would create a genuine deliverable, where one could take delivery of a three month at-the-money straddle. Delta-neutral — all that gets priced is volatility.

Here’s my main point. Volatility is not an asset class. Options are an asset class. Or, options expand other asset classes, whether bonds, equities, or commodities. Whether through options or variance swaps, if volatility is sold, the reward is more income in the short run, at the cost of possible capital losses in asset classes one is forced to buy or sell at disadvantageous prices later.

Over the long term, in equities, unlike bonds, being short options has been a winning strategy, if consistently applied. (And one might need an iron gut to do it.) But when many apply this strategy, the excess returns will dry up, at least until discouragement sets in, and the trade is abandoned. For an example, this has happened in risk arbitrage, where investors are short an option for the acquirer to walk away. For a long time, it was a winning strategy, until too much money pursued it. At the peak you could make more money investing in Single-A bonds. Eventually, breakups occurred, and arbs lost money. Money left risk arbitrage, and now returns are more reasonable for the arbs that remain.

Most simple arbitrages are short an option somewhere. That’s the risk of the arbitrage. With equities, being perpetually short options is a difficult emotional place to be. You can comfort yourself with the statistics of how well it has worked in the past, but there will always be the nagging doubt that this time it will be different. And, if enough players take that side of the trade, it will be different.

Like any other strategy, options as an asset class has merit, but there is a limit to the size of the trade that can be done in aggregate. Once enough players pursue the idea, the excess returns will vanish, leaving behind a market with more actual volatility for the rest of us to navigate.

Reinsurance: The Ultimate Derivative

Posted on 15 December 2007 by David Merkel

Some housekeeping before I begin this evening. Here’s my progress on the blog:

RSS as far as I can test has no problems.? If you have problems with my feed, please e-mail me any details.? Before you do, try dropping my feed, and re-adding it through Feedburner.
My logo was anti-aliased for me by BriG.? Looks a lot cleaner.? Thanks ever so much, BriG!
The comment error problem is gone, and I suspect also the same one that I have when I post.? It was a bug in one of my WP plugins that was not 2.3.1 compliant.
My descriptive permalinks are still lost, though.

I still need to fix my left margins as well, and make my top banner clickable.? Still, that’s progress.

On to tonight’s first topic: my view on derivatives differs from that of other commentators because I am an actuary (as well as an economist and financial analyst).? In the late 1980s, the life insurance industry went through a problem called mirror reserving.? Mirror reserving said that the company reducing risk through reinsurance could not take a greater reserve credit than the reinsurer posted.

That’s not true with derivatives today.? There is no requirement that both parties on the opposite sides of an agreement hold the same value on the contract.? From my own financial reporting experience (15 years worth), I have seen that managements tend to take favorable views of squishy accounting figures.? The one that is short is very likely to have a lower value for the price of the derivative than the one who is long.

But can you dig this?? The life insurance industry is in this area more advanced than Wall Street, and we beat them there by 20 years minimum.? :D? Given the way that life insurers are viewed as rubes, as compared to the investment banks, this is rich indeed.

Now, as for one comment submitted yesterday: yes, counterparty risk is big, and I have written about it before, I just can’t remember where.? I would argue that the investment banks? have sold default on the counterparties with which they can do so.? That said, it is difficult to monitor true exposures with counterparties; one investment bank may not have the whole relationship.

Also, many exposures are hard to hedge because there are no natural counterparties that want the exposure.? When no party naturally wants? an exposure, either a speculator must be paid to bear the risk, or the investment bank bears it internally.

The speculators are rarely well-capitalized, and the risks that the investment banks retain are in my estimation correlated to confidence.? When there is panic, those risks will suffer.? Were that not so, there would be counterparties willing to take those risks on today to hedge their own exposures.

So, is counterparty risk a problem?? Yes, but so is deadweight loss from differential pricing.

If Hedge Funds, Then Investment Banks, Redux

Posted on 14 December 200722 June 2017 by David Merkel

Every now and then, you get a reader response that deserves to be published.? Such was this response to my piece, “If Hedge Funds, Then Investment Banks.”? I have redacted it to hide his identity.

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I read your latest blog entry with interest because I have worked in the derivatives business and as a part of that helped to set up General Re’s financial subsidiary in 19XX – General Re Financial Products (GRFP). I was one of XX people that started that business from the ground up. I left shortly XXX Buffett arrived on the scene but I still knew a large number of people that remained and I have very good information about what happened there. I may be a bit biased so you should consider where I am coming from as you continue to read.

To be short about it, what happened at GRFP after Buffett took over was a complete mess. I can give you more information on that if you like but I will simply say that what Buffett writes about GRFP, has spin on it. Let me give you a somewhat quick example. Of that $104 million loss he refers to, how much of that could be attributed to salaries and operating expenses? How much of it was due to the forced unwinding of trades on the wrong side of the market? We know that there are high operational costs (these people are paid very well with nice offices, technology, etc.) and that one would expect to pay to get out of these transactions even if they are being marked perfectly correctly. It SHOULD cost money to unwind these trades. So why doesn’t Buffett, who normally gives us so much information, tell us how much of the loss was due to mismarking and how much was due to expected costs? I’ll let you guess at that answer. There’s a lot more to this story but let’s move on…

I am sure you felt safe quoting someone like Buffett – meaning he is likely to get things right almost every time, but even Buffett is not perfect and he has his blind spots. I believe that derivatives may be such a blind spot. I could go into detail about where I see holes in Buffett’s arguments however the bottom line is that I believe the vast majority of transactions done in the derivatives market are plain vanilla transactions that are extremely easy to mark. Did you know that the US Treasury market is now quoted as a spread off of swaps? That is how liquid the plain vanilla instrument is these days. These transactions will certainly not have two traders both booking a profit even though they are on opposite sides of a transaction. Bid/ask spreads in the plain vanilla market are less than 1 basis point per year in yield. I am certain there are exotic transactions that are mismarked for all the reasons that Buffett mentions but how many of these are really out there? My suspicion is that the total number is small enough to not be of any huge concern from a systematic standpoint.

Here is something interesting to consider. Why would the leader of a AAA-rated institution (a financial Fort Knox) that competes in many ways with other large financial institutions wish to lead people to believe that those other institutions may be engaged in a business that is particularly risky?

Just thought I would add my two cents (looks more like 25 cents now).
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For the record, both he and I are admirers of Buffett, but not uncritical admirers.? The initiator of a trade usually has to offer a concession to the party facilitating the trade.? Forced sellers or impatient buyers typically don’t get the best execution.? What my correspondent suggests here is at least part of the total picture in the liquidation of GRFP.? All that said, I still think there are deadweight losses hiding inside that swap books of the major investment banks.

Personal Finance, Part 5.1 ? Inflation and Deflation 2

Posted on 7 December 2007 by David Merkel

I wish that I had more time to respond to readers both in the comments and e-mail.? Unfortunately, I am having to spend more time working as I am in transition as far as my work goes.? I’ll try to catch up over the next week or so, but I am behind by about 50 messages, and I hate to compromise message quality just to clear things out.

That said, my inflation/deflation piece yesterday attracted two comments worthy of response.? The first was from James Dailey, who I would recommend that you read whenever he comments here.? We may not always agree, but what he writes is well thought out.? He thinks I attribute too much power to the Fed.? He has a point.? From past writings, I have suggested that the Fed is not all-powerful.? What I would point out here is that the Fed controls more than just the monetary base.? They control (in principle) the terms of lending that the banks employ.? With a little coordination with the other regulators, the Fed could restrict non-bank lenders by raising the capital requirements that banks (and other regulated institutions) must maintain in lending to non-bank lenders.? So, if credit is outpacing the growth in the monetary base, it is at least partially because the Fed chooses to allow it.? Volcker reined in the credit card companies in the early 80s, which was not a normal policy for the Fed; it had a drastic impact on the economy, but inflation slowed considerably.? (Causation?? I’m not sure.? Fed funds were really high then also.)

The other comment came from Bill Rempel.? He objected more to my terminology than my content, though he disliked my comment that “Inflation is predominantly a monetary phenomenon.”? I think we are largely on the same page, though.? I know the more common phraseology here, “Inflation is purely a monetary phenomenon,” and I agree with it, but with the following provisos:

If we are talking about goods, services, and assets as a group, or,
If the period of time is sufficiently long, like a century or so, or,
If we are talking about monetary inflation.? (Who disagrees with tautologies? 🙂 Not me.)

Part of my difficulty here, is that when we talk about money, we are talking about something that lies on the spectrum? between currency and credit.? By currency I am talking about whatever physical medium can be commonly deployed to effectuate transactions.? By credit, anything where the eventual exchange of currency is significantly delayed, and perhaps with some doubt of collection.? Because of the existence of credit, over shorter periods, the link between monetary inflation and good price inflation is more tenuous, which leads people to doubt the concept that “Inflation is purely a monetary phenomenon.”? My post, rather than weakening that concept, strengthens it, because it broadens the concept of inflation, so that the pernicious effects of monetary inflation can be more clearly seen.? I wrote what I wrote to distinguish between monetary, goods and asset inflation.? I think it is useful to make these distinctions, because most people when they hear the word “inflation” think only of goods price inflation, and not of monetary or asset inflation.

Now, onto today’s topic: how to protect ourselves from inflation and deflation.? With goods price deflation (should we ever see that under the Fed), the answers are simple: avoid debt, lend to stable debtors, and make sure you are economically necessary to the part of the economy that you serve.? You want to make sure that you have enough net cash flow when net cash flow is scarce.? You can use that cash flow to buy distressed assets on the cheap.? Economically necessary and low debt applies to the stocks you own as well.

On goods price inflation, take a step back and ask what is truly in short supply, and buy/supply some of that.? It could be commodities, agricultural products, or gold. ? As a last resort you could buy some TIPS, or just stay in a money market fund.? You won’t get rich that way, but you might preserve purchasing power.? In stocks, look for those that can pass through price inflation to their customers.? In bonds, stay short, unless they are inflation-protected.

This is not obscure advice, but there is an art to applying it.? There comes a point in every theme where prices of the most desirable assets discount or even over-discount the scenario.? Safe assets get overbought in a deflation toward the end of that phase of the cycle.? Same thing for inflation-sensitive assets during an inflation.? As for me at present, you can see my portfolio over at Stockpickr; at present, I split the difference, though my results over the last five months have been less than stellar.? I have companies with relatively strong balance sheets, and companies with a decent amount of economic sensitivity, whether to price inflation or price inflation-adjusted economic activity.

I don’t see the global economy heading into recession; I do see price inflation ticking up globally, and also asset inflation in some countries (China being a leading example). ? But we have a debt overhang in much of the developed world, so we have to be careful about balance sheets.

I may have it wrong at this point.? My equity performance over the last seven-plus years has been good, but the last five months have given me reason for pause.? Well, things were far worse for me 6/2002-9/2002; I saw that one through.? I should survive this one too, DV.

Ten Notes on Our Crazy Credit Markets

Posted on 5 December 2007 by David Merkel

This post may be a little more disjointed than some of my posts.? Recently I have been working on calculating the fair value for mezzanine tranches of a series of real estate oriented CDOs.? Not pretty.? Anyway, here are few articles that got me thinking yesterday:

Let’s? start with CD rates.? Bloomberg had a nifty table on its system which I can’t reproduce here, except to point you to the data source at the Fed.? Note how one-, three-, and six-month CD rates have been rising, somewhat in sync with LIBOR, but widening the gap with Treasury yields. (Hit your “end” button to see the most recent rates…)
As a result, I have been debating whether the FOMC might not do a 50 basis point loosen next Tuesday.? CDs aren’t the bulk of how most banks fund themselves, but they can be a way to get a lot of cash fast.? Remember that after labor unemployment and inflation, the Fed’s hidden third mandate is protecting the depositary financial system, particularly the portion that belongs to the Federal Reserve System.
Now, I’m not the only one wondering about what the FOMC will do.? There’s Greg Ip at The WSJ, who speculates on the size of the cut, and whether the discount rate might not be cut even more, with a loosening of terms and conditions as well.? Bloomberg echoes the same themes.? Even the normally placid Tony Crescenzi sounds worried if the FOMC doesn’t act aggressively here.
The US isn’t the only place where this is a worry.? The Bank of Canada cut rates yesterday, as noted by Trader’s Narrative, partly because of credit pressures in Canada and the US.? The Financial Times notes that Euro-LIBOR [Euribor] is also rising vs. Government short-term yields, which may prompt the ECB to cut as well.? Or, they also could cut their version of the discount rate, or liberalize terms.
It doesn’t make sense to me, but the Yen is weakening at present.? With forward interest rate differentials narrowing as more central banks tip toward easing, I would expect the carry trade to weaken; instead, it is growing.? For now.
As noted by Marc Chandler, the Gulf States have largely decided to keep their US Dollar peg.? I found the article to be interesting and somewhat counterintuitive at points, but hey, I learned something.? Inflation is rising in Kuwait after they switched from the US Dollar to a basket of currencies, because residential real estate prices are rising.
Credit problems continue to emerge on the short end of the yield curve.? Accrued Interest has a good summary of the problems in money market funds.? It almost seems like Florida is a “trouble magnet.”? If it’s not hurricanes, it’s bad money management.? Then there’s Orange County, which has a 20% slug of SIV-debt in its Extended Fund.? It’s all highly rated, so they say, but ratings don’t always equate to credit quality, particularly in unseasoned investment classes.? Then there’s the credit stress from borrowers drawing down on standby lines of credit, which further taxes the capital of the banks.
As a final note, both here (point 6) and at RealMoney, I was very critical of S&P and Moody’s when they decided to rate CPDO [Constant Proportion Debt Obligation] paper AAA.? I’ll let the excellent blog Alea take the victory lap though.? We finally have CPDOs that are taking on serious losses (and here).
In summary, we are increasingly in a situation where the major central banks of our world are reflating their currencies as a group in an effort to inflate away embedded credit problems.? Most of the credit problems are too deep for a lowering of the financing rate to solve, though it will help financial institutions with modest-to-moderate-sized credit problems (say, less than 25% of tangible net worth — does the rule of thumb for P&C reinsurers apply to banks?).? This can continue for some time, and credit spreads and yield curves should continue to widen, and inflation (when fairly measured) should increase.? Some of the inflation will move to assets that aren’t presently troubled, perhaps commodities, and higher quality equities, which are doing relatively well of late.
Quite an environment.? The big question is when the “free lunch” period for the rate cuts end, and the hard policy choices need to be made.? My guess is that would be in mid-to-late 2008, just in time for the elections.? Now, wouldn’t that spice things up? 🙂

In Defense of the Ratings Agencies

Posted on 4 December 2007 by David Merkel

The ratings agencies have come under a lot of flak recently for rating instruments that are new, where their models might not be do good, and for the conflicts of interest that they face.? Both criticisms sound good initially, and I have written about the second of them at RealMoney, but in truth both don’t hold much water, because there is no other way to do it.? Let those who criticize put forth real alternatives that show systematic thinking.? So far, I haven’t seen one.

Here are the realities:

There is no way to get investors to pay full freight for the sum total of what the ratings agencies do.
Regulators need the ratings agencies, or they would need to create an internal ratings agency themselves.? The NAIC SVO is an example of the latter, and proves why the regulators need the ratings agencies.? The NAIC SVO was never very good, and almost anyone that worked with them learned that very quickly.
New securities are always being created, and someone has to try to put them on a level playing field for creditworthiness purposes.
Somewhere in the financial system there has to be room for parties that offer opinions who don’t have to worry about being sued if their opinions are wrong.
Ratings can be short-term, or long-term, but not both.? The worst of all worlds is when the ratings agencies shift time horizons.

For my first point, the fixed-income community has learned that the ratings agencies offer an opinion, and they might pay for some additional analysis through subscriptions, but if they were forced to pay the fees that issuers pay, they would balk; they have in-house analysts already.? The ratings agencies aren’t perfect, and good buy-side shops use them, but don’t rely on them.

Second, the regulators need simple ways in a complex environment to account for credit risk, so that capital positions can be properly sized.? They either need rating agencies, or have to be one.? No way around it.

Third, financial institutions will buy new securities, and someone has to rate them so that proper capital levels can be held (hopefully).

Fourth, financial institutions and regulators have to be “big boys.” If you were stupid enough to rely on the rating without further analysis, well, that was your fault.? If the ratings agencies can be sued for their opinions (out of a misguided notion of fiduciary interest), then they need to be paid a lot more so that they can fund the jury awards.? Their opinions are just that, opinions.? Smart institutional investors often ignore the rating, and read the commentary.? The nuances of opinion come out there, and often tell smart investors to stay away, in spite of the rating.

Last, ratings agency opinions are long-term by nature, rating over a full credit cycle.? During panics people complain that they should be more short-term.?? Hindsight is 20/20.? Given the multiple uses of credit ratings, having one time horizon is best, whether short- or long-term.? Given the whipsaw that I experienced in 2002 when the ratings agencies went from long- to short-term, I can tell you it did not add value, and that most bond manager that I knew wanted stability.

Now there are alternatives.? The regulators can ban asset classes until they are seasoned.? Could be smart, but there will be complaints.? I experienced in one state the unwillingness of the regulators to update their permitted asset list, which had not been touched since 1955.? In 2000, I wrote the bill that modernized the investment code for life companies; perhaps my grandson (not born yet), will write the next one.? Regulators are slow, and they genuinely don’t understand investments.

Another alternative would be to allow for more rating agencies.? I’m in favor of a free-ish market here, allowing the regulators to choose those raters that are adequate for setting capital levels, and those that are not.? For other purposes, though, the more raters, the better.

Let those who criticize the ratings agencies bring forth a new paradigm that the market can embrace, and live with in the long term.? Until then, the current system will persist, because there is no other realistic way to get business done.? There are conflicts of interest, but those are unavoidable in multiparty arrangements.? The intelligent investor has to be aware of them, and compensate for the inherent bias.

Seven Observations From Barron’s

Posted on 17 November 200718 November 2007 by David Merkel

Kinda weird, and it makes you wonder, but on the WSJ main page, I could not find a link to Barron’s. I know I’ve seen a link to Barron’s in the past there; I have used it, which is why I noticed its absence today.
I found it amusing that the mutual fund that Barron’s would mention on their Blackrock interview, underperformed the Lehman Aggregate over 1, 3 and 5 years. Don’t get me wrong, Blackrock is a great shop, and I would work there if they offered me employment that didn’t change my location. Why did Barron’s pick that fund?
I’m not worried about the effect of a financial guarantor downgrade on the creditworthiness of the muni market. Munis rarely fail. Most of those that do fail lacked a real economic purpose. What would be lost in a guarantor downgrade is liquidity. Muni bond insurance is a substitute for analysis. “AAA insured, I’ll buy that.” Truth, an index fund of uninsured munis would beat an index of insured munis, because default rates are so low. But the presence of insurance makes the bonds a lot more liquid, which makes portfolio management easier.
I’ve been a US dollar bear for the last five years, and most of the last fifteen years. Though we have had a little bounce recently, the dollar has of late been at record lows against currencies that trade freely against the dollar. I expect the current bounce to persist in the short term and fail in the intermediate term. The path of the dollar is lower, unless the Fed decides to not loosen more. Balance needs to be restored in the global economy, such that the rest of the world purchases more goods and services, and fewer assets from the US.
I don’t talk about it often, but when it comes up, I have to mention that municipal pensions in the US are generally in horrid shape. The Barron’s article focuses on teachers, but other municipal worker groups are equally bad off. The article comments on perverse incentives in teacher retirement, which leads older teachers to retire when it is feasible to do so. For older teachers, I would not begrudge them; they weren’t paid that well at the start, and the pension is their reward. Younger teachers have been paid pretty well. I would not expect them to get the same pension promises.
I like Japan. I own shares in the Japan Smaller Capitalization Fund [JOF]; it’s my second-largest position.

Japan is cheap, and small cap Japan is even cheaper. I would expect a modest bounce on Monday.
We still need a 15-20% decline in housing prices to bring the system back to normal. There might be an undershoot in price from the sales that forced sellers must do. Hopefully it doesn’t turn into a self-reinforcing decline, but who can be sure about that? At that level of housing prices, man recent conforming loans will be in trouble, much less non-conforming loans.

Full disclosure: long JOF

Contemplating Life Without the Guarantors

Posted on 8 November 2007 by David Merkel

Here’s another recent post from RealMoney:

		David Merkel
		Contemplating Life Without the Guarantors
		11/1/2007 1:30 PM EDT

Hopefully this post marks a turning point for the Mortgage Insurers and the Financial Guarantee Insurers, but when I see Ambac trading within spitting distance of 50% of book, I cringe. I’ve never been a bull on these companies, but I had heard the bear case for so long that my opinion had become, “If it hasn’t happened already, why should it happen now?” Too many lost too much waiting for the event to come, and now, perhaps it has come. But, what are all of the fallout effects if we have a failure of a mortgage insurer? Fannie, Freddie, and a number of mortgage REITs would find their credit exposure to be considerably higher. The Feds would likely stand behind the agencies, because Fannie and Freddie aren’t that highly capitalized either. That said, I would be uncomfortable owning Fannie or Freddie here; just because the government might stand behind senior obligations doesn’t mean they would take care of the common and preferred stockholders, or even the subordinated debt.

Fortunately, the mortgage insurers don’t reinsure each other; there won’t be a cascade from one failure, though the same common factor, falling housing prices will affect all of them.

Other affected parties will include the homebuilders and the mortgage lenders, because buyers without significant down payments will be shut out of the market. Piggyback loans aren’t totally dead, but pricing and higher underwriting standards restrict availability. Third-order effects move onto suppliers, investment banks and the rating agencies. More on them in a moment… this will have to be a two-parter, if not three.

Position: none

And since then, the mortgage insurers have fallen a bit further.? On to part two, the financial guarantors:

Unfortunately, the financial guarantors have had a tendency to reinsure each other.? MBIA reinsures Ambac, and vice-versa. ? RAM Holdings reinsures all of them.? The guarantors provide a type of “branding” to obscure borrowers in the bond market.? Rather than put forth a costly effort to be known, it is cheaper to get the bonds wrapped by a well-known guarantor; not only does it increase perceived creditworthiness, it increases liquidity, because portfolio managers can skip a step in thinking.

Now, in simpler times, when munis were all that they insured, the risk profiles were low for the guarantors, because munis rarely defaulted, particularly those with economic necessity behind them.? In an era where they insure the AAA portions of CDOs and other asset-backed securities, the risk is higher.

Now, guarantors only have to pay principal and interest on a timely basis.? Mark to market losses don’t affect them, they can just pay along with cash flow.? The only trouble comes if they get downgraded, and new deals become more scarce.? Remember CAPMAC?? MBIA bought them out when their AAA rating was under threat.? Who will step up to buy MBIA or Ambac?? (Mr. Buffett! Here’s your chance to be a modern J. P. Morgan.? Buy out the guarantors! — Never mind, he’s much smarter than that.)

Well, at present the rating agencies are re-thinking the ratings of the guarantors.? This isn’t easy for them, because they make so much money off of the guarantors, and without the AAA, business suffers.? If the guarantors get downgraded, so do the business prospects of the ratings agencies (Moody’s and S&P).

Away from that, municipalities would suffer from lesser ability to issue debt inexpensively.? Also, stable value funds are big AAA paper buyers.? They would suffer from any guarantor getting downgraded, and particularly if Fannie or Freddie were under threat as well.?? All in all, this is not a fun time for AAA bond investors.? A lot of uncertainties are surfacing in areas that were previously regarded as safe.? (I haven’t even touched AAA RMBS whole loans…)

This is a time of significant uncertainty for areas that were previously regarded as certain.? Keep your eyes open, and evaluate guaranteed investments both ways.? I.e., ABC corp guaranteed by GUAR corp, or GUAR debt secured by an interest in ABC corp. This is a situation where simplicity is rewarded.

Society of Actuaries Presentation

Posted on 13 October 200720 June 2017 by David Merkel

Finishing off the presentation proved to be harder than I estimated, together with all of my other duties.? Well, it’s done now, and available for your review here.? For those looking at one of the non-PDF versions, you might be able to see the notes for my talk as well.

I’m writing this before I give the talk.? If I had it to do all over again, I would have made the talk less ambitious.? Then again, of the four topics that I offered them, they picked the most ambitious one.? When you look at the talk, you’ll see that it is a summary of the macroeconomic views that frame my investment decisions.? The presentation will run 40 minutes or so, plus Q&A.? Reading it is faster. 🙂

Enjoy it, give me feedback, and I’ll be back to normal blogging Monday evening.