Structured Products and Derivatives – Page 6

Classic: The Correlation Trade Gone Wrong

Posted on 21 December 2013 by David Merkel

The following was published at RealMoney on May 23rd, 2005.? It’s a little obscure, but indicative of what can happen when too much money pursues an obscure arbitrage.? If nothing else, the piece tries to explain a complex concept to those with moderate market knowledge.

Because of the market dislocations last week, I want to give a primer on the class of derivatives that really jolted the markets this week: Indexed Synthetic CDOs.? First, some definitions:

1)????? CDO – Collateralized Debt Obligation.? A trust that owns bonds, loans, or credit default swaps.? The ownership in the trust is hierarchical.? There are several classes of certificates that have different interests in the trust, which get defined by which class receives losses from defaults first, second, third, etc.? The earlier that a class (or tranche) receives losses if they occur, the higher the yield a class of certificates receives.

2)????? Synthetic ? a term used in opposition to ?cash.?? One who transacts in corporate bonds participates in the cash market.? The synthetic market in corporate credit is composed of credit default swaps.? It is called ?synthetic? because it transacts in corporate credit risk without making loans to corporations.

3)????? Credit default swaps ? A market participant who buys default protection on a given corporation through the credit default swap market gains the right to deliver a certain amount of defaulted bonds in exchange for the par value of the bonds, when an event of default occurs for the class of bonds covered by the agreement.? In exchange for this privilege, the buyer of protection pays the seller a fixed fee for the term of the swap, which is usually five years, but can vary.

4)????? Spread ? That fixed fee is called the spread.? When the spread falls, the value of a credit default swap to someone who has previously sold protection becomes more valuable, in the same way that a bond price rises when its yield falls.

5)????? Indexed ? A third party puts together a seemingly diversified (or focused) list of companies so that investors can invest in a liquid pool of similar companies that they want exposure to, whether on a debt, synthetic, or equity basis.

Indexed Synthetic CDOs gather together the risk of debt default for a group of corporations, and parcel the risk of default out in a concentrated form to those who hold the ?first loss? certificates, in exchange for a high yield.? Those who hold other certificates in the loss priority get lesser yields commensurate to the risk of taking losses.

Setting the Stage

The Indexed Synthetic CDO market rallied until March 2005.? In most cases, the more risk an investor took, the better that investor did.? The indexes were rallying.? Those willing to offer protection against the default of a wide number of corporations were willing to do so at smaller and smaller spreads.? As I stated previously on RealMoney, those spreads were too small to compensate for the possibility and severity of losses.

Also, until March of 2005, the decline in spreads was fairly uniform.? There weren?t many credits within each index that were not moving in tune with the rally.? This was significant, because it meant that results were particularly good for the ?first loss? investors.? What hurts ?first loss? investors are credits going into default.? If the spread on the index as a whole improves (goes lower), but a small minority of credits diverge (get wider) and then default, the ?first loss? investor can get hurt, while investors with greater loss protection can still do well.

What Happened Last Week

Last week, not only did spreads rise in general, but some credits related to the auto and auto parts industries widened disproportionately.? This wouldn?t have been such a problem, except that a large number of hedge funds participated in the Indexed Synthetic CDO market doing an esoteric arbitrage trade, where the hedge funds when long the ?first loss? piece, and short 2.0-2.5x the ?second loss? piece.? This trade was sometimes called the ?correlation trade? for reasons I will talk about in a moment.

Why do such a trade?? The lure of free money is inexorable, and the trade had been free money for a while.? So long as movements in the spreads of credits in the index remained closely correlated, the hedge would hold between the ?first loss? and ?second loss? pieces, and the hedged investment would earn a high riskless yield, which to a hedge fund is the holy grail; a lot of hedge fund of funds will throw money at a strategy like that.

All arbitrages boil down to buying and selling two similar securities, and attempting to profit from the price or yield spread over the anticipated time horizon of the transaction.? Arbitrages can be intelligent or foolish depending on whether the anticipated total return is large enough to compensate for the negative results if the convergence anticipated in the arbitrage does not occur.

Last week, conditions for the hedge did not hold as the credit default swap spreads on automotive-related credits rose, leading the ?first loss? pieces to fall in value.? Surprisingly, the ?second loss? pieces actually rose in value, as a number of players moved to close out their hedges, which put downward pressure on the prices of the ?first loss? pieces, and upward pressure on the prices of the ?second loss pieces.? This became self-reinforcing for a while until the close on Tuesday.? On Wednesday, hedge funds and investment banks poured fresh capital into the trade, since the risk reward ratio on the hedged trade was now more attractive, bringing the market back to a more normal state.

Effects on the equity market

This put a damper on the equity market for several reasons: first, some players feared that some of the investment banks were caught on the wrong side of the trade, or had lent to those on the wrong side of the trade.? My guess is that?s not true, but if true, it could raise systemic risk issues, which lowers equity values, as it did in 1998 during the LTCM crisis.? The risk controls at the investment banks are far superior to those at most hedge funds now, and far superior to what they were at the investment banks during LTCM.? That doesn?t mean there can?t be crises, but the preparations for a crisis are better now.? The investment banks have laid off more risks to other market participants.? The other main effect on the equity market was that yields on riskier corporate bonds rose, which usually correlates with lower stock prices.

In closing, just be aware that there are other big markets such as the credit default swap market, both in its single-credit, and indexed forms, that can have a big effect on the equity markets.? There is a lot of leverage around, and ?bets gone wrong? can be big enough to knock some confidence out of the markets.? But I offer this hope: so long as the effects of the ?bets gone wrong? do not affect major institutions such as investment banks, commercial banks or insurance companies, the effects on the markets should be transitory, as they were after LTCM.

On Fat Tails

Posted on 30 October 2013 by David Merkel

I’m reading an investment book that is arguing for market timing.? I’m not impressed with the line of argumentation so far.? I just finished a chapter where the authors pointed out that security price movements are more volatile that the normal distribution would admit.

This is a well known result, or at least it should be well-known.? What I hope to contribute to the discussion is why the tails are fat, and skewed negatively.? There is a famous saying in investments:

Cut your losses, and let your winners run

I regard this saying as vapid, because I have had so many investments where the price action was bad initially, but ended up being incredible investments.? I have also had companies stumble after prior gains, and persevere for greater gains.? Intelligent asset management does not react to the past, but analyzes future prospects, and looks at current margin of safety.

But imagine a situation where many parties have their plans, and they are all similar.? I’ll give a few examples:

Institutional investors decide in 1986 to follow the momentum, but be ready to sell if the momentum breaks.? They want upside, but want to protect the downside.
Japan was a total momentum market up through 1989, and the reverse thereafter.? Loose monetary policy was an aspect of that, as was a loss of fear, warrant speculation, etc.
Those investing in hot emerging markets in the mid-90s did not recognize valuations getting stretched, and the inability of the countries to maintain stimulative policies amid falling currencies.
The guys at LTCM were geniuses until they weren’t.? They had no idea of the risks they were taking.? They did not have an ecological view of investing.? Essentially, they thought liquidity was free, until the jaws of the trap snapped shut, and they died.? Taking a concentrated position is a risk, because the investing typically pushes up the price.? When you are so big in a position that you are affecting the market price, that is a bad place to be for two reasons: 1) if you sell, you drive down the price for future sales, and 2) you no longer know what the fair price would be if you weren’t there.
Aside from that with LTCM, their brokers mimicked their trades, accentuating the boom-bust, but the brokers had risk control desks that forced them to sell out losing trades, which further hurt LTCM.
Think about residential mortgage bonds in 1994.? So many players thought that they had mastered the modeling of prepayment risk only to find amid a Fed tightening cycle that many wanted to limit their interest rate risk as rates skyrocketed, fueling a self-reinforcing panic.
Consider tech stocks 1998-2000.? Momentum ran until the sheer weight of valuations, together with insolvencies, crushed the market as a whole, and tech stocks more.? Think of European financial institutions getting forced by regulators to kick out US stocks in September 2002, putting in the bottom.? Regulators almost always act too late, and exacerbate crises, but they should do that, because worse things would happen if they didn’t.? (Later = bigger crisis, Earlier = Some Type II errors, regulating where it was not needed).
Finally, consider the housing/banking crisis in the US 2005-2009.? People bought homes with a lot of debt financing, and short-dated debt financing.? Banks levered up to provide the financing.? Shallow credit analysis allowed banks to take on far more risk than they imagined.? It all ended in a trail of tears, with many personal, and not enough corporate bankruptcies, with the taxpayers footing the bill.

In each of these cases, you have correlated human behavior.? The greed of investors gives way to fear.

Now if you are thinking about Modern Portfolio Theory, where market players have perfect knowledge, this doesn’t make sense.? These crises should not happen.? But they happen all too regularly, and I will explain why.

Men are not greedy as much as they are envious.? This leads to mimicking behavior when things are going well.? Those not currently playing want a piece of the action, and so they imitate.

Modern Portfolio Theory implicitly assumes that market players don’t react to the actions of other market players, but that is false.? Most market players don’t think; they mimic.

That is what leads to fat tails, because when people move as a herd, you get dramatic price moves.? Because fear is a greater motivator than envy, that is why the big downward moves are almost always greater than the big upward moves.

Add into that the credit cycle, because gains on credit-sensitive bonds are small, but losses are huge when they occur.? The distribution of outcomes has a long left tail.

The main point here is that price movements are non-normal because market players act as a group.? Their behavior is correlated? on the downside, and to a lesser extent on the upside.

Among other things, this means Modern Portfolio Theory is wrong, and needs to be severely modified, or abandoned.? It also means that we need to watch the credit cycle, and speculative activity to get a sense of how committed the hot money is to risk assets.? Hot money follows trends.? Cold money estimates likely returns over a market cycle, and invests in the best ideas when they are out of favor.

I don’t think timing the market is easy.? I do think that fundamental investors have to look at whether they have a lot of opportunities, or few, and vary their safe assets opposite to opportunities.

So beware the fat tails — we haven’t had a lot of volatility recently.? Maybe we are due.

The Rules, Part LVII

Posted on 29 October 20133 November 2013 by David Merkel

The more that markets are united through derivatives, the more systemic risk is created.

Derivatives exist to subvert regulations, at least the regulations that don’t involve derivatives.? Ideally, derivatives allow those that want to take on a given risk, to have the ability to do so.? And the same for laying off risk.

But here’s the difficulty.? You can create all the derivatives you want, but total risk never goes away, it is only shifted.? There are many idiosyncratic risks for which there is no natural counterparty, i.e., one that faces the opposite risk.? What does it take to get someone to speculate on a risk?? Well, you have to offer them good terms, such that on average, they have the expectation of a profit.? The speculator may try to delta-hedge, and/or cross-hedge his risks, or he may not.? But the speculator is usually in a weaker financial position than the hedger.? Let me give an example:

In the insurance world, with a few exceptions, large direct writers have higher ratings than reinsurers.? And for what few reinsurers of reinsurers there are (“retrocessionaires”) they usually have lower ratings than the reinsurers.? There is a tendency for the economic world to arrange itself like a Collateralized Debt Obligation.

Think about it.? In a CDO, the junior tranches insure those that are more senior against loss.? In exchange, they are offered a higher yield.? That’s what goes on with those that speculate with derivatives.? The one being insured typically gives up some economics to the speculator.

Now if this goes on in a small way, there is no trouble.? But if large numbers of parties lay off their risks in this way, a large amount of? risk is in the hands of speculators which don’t have the best balance sheets.? It’s not as bad as people holding stocks in 1929 on 10% margin, but you get the idea.

Anytime risk is concentrated in the hands of those less well capitalized, there is heightened systemic risk.? Think of AIG writing gonzo amounts of subprime AAA RMBS CDS for a pittance.? Everyone on Wall Street took advantage of them, except for one thing — because everyone was insured by AIG, no one was truly insured by AIG.? If the Fed hadn’t stepped in, who knows who could have been insolvent — and that’s what should have happened, with the regulators letting holding companies fail, but protecting regulated subsidiaries, so that ordinary people would not be harmed.

When risks are in the hands of those with weak abilities to bear risk, not only are the weak affected but the strong also.? The strong, thinking their risks are covered, lever up more because they aren’t worried about the risks.? When the weak fail, and the strong find that risk is shifting back to them, they find that they themselves are hard-pressed, because they don’t have so much equity to cushion the losses.

There is no free lunch with risk.? The most we can do is try to analyze who is bearing the risk.? If it is in strong hands, we don’t have to worry.? If it is in weak hands, perhaps it is time to reduce risk, and not synthetically, but by genuine sales of assets.

If we want to solve this problem we should require insurable interest, and only let hedgers initiate transactions.? But who will take on the lobbyists?

Classic: The Fundamentals of Market Tops

Posted on 21 October 2013 by David Merkel

All of my articles from RealMoney have been irreparably lost because of a change in file systems.? Anything written prior to 2008 is gone.? That may not matter for most writers at RealMoney, but I tended to write things of more permanent validity.

So it is with gratitude to Barry Ritholtz that I republish a popular piece of mine that ran on January 13th, 2004.? Barry Ritholtz republished it in 2006, and captured most of it, except for one thing — at the end I said that the rally would go on, which it did.

Anyway, here is Barry’s copy of my piece, without adjustment:

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David Merkel wrote this a year ago; it?s a brilliant set of observations of what market tops look like.

David starts by noting he is “basically a fundamentalist in my investing methods, but I do see value in trying to gauge when markets are likely to make a top or bottom out.”? He adds that his methods “are somewhat vague, but I always have believed that investment is a game that you win by being approximately right. Precision is of secondary importance.”

Item 1: The Investor Base Becomes Momentum-Driven

Valuation is rarely a sufficient reason to be long or short the market. Absurdity is like infinity. Twice infinity is still infinity. Twice absurd is still absurd. Absurd valuations, whether high or low, can become even more absurd if the expectations of market participants become momentum-based. Momentum investors do not care about valuation; they buy what is going up, and sell what is going down.

You?ll know a market top is probably coming when:

a) The shorts already have been killed. You don?t hear about them anymore. There is general embarrassment over investments in short-only funds.

b) Long-only managers are getting butchered for conservatism. In early 2000, we saw many eminent value investors give up around the same time. Julian Robertson, George Vanderheiden, Robert Sanborn, Gary Brinson and Stanley Druckenmiller all stepped down shortly before the market top.

c) Valuation-sensitive investors who aren?t total-return driven because of a need to justify fees to outside investors accumulate cash. Warren Buffett is an example of this. When Buffett said that he “didn?t get tech,” he did not mean that he didn?t understand technology; he just couldn?t understand how technology companies would earn returns on equity justifying the capital employed on a sustainable basis.

d) The recent past performance of growth managers tends to beat that of value managers. In short, the future prospects of firms become the dominant means of setting market prices.

e) Momentum strategies are self-reinforcing due to an abundance of momentum investors. Once momentum strategies become dominant in a market, the market behaves differently. Actual price volatility increases. Trends tend to maintain themselves over longer periods. Selloffs tend to be short and sharp.

f) Markets driven by momentum favor inexperienced investors. My favorite way that this plays out is on CNBC. I gauge the age, experience and reasoning of the pundits. Near market tops, the pundits tend to be younger, newer and less rigorous. Experienced investors tend to have a greater regard for risk control, and believe in mean-reversion to a degree. Inexperienced investors tend to follow trends. They like to buy stocks that look like they are succeeding and sell those that look like they are failing.

g) Defined benefit pension plans tend to be net sellers of stock. This happens as they rebalance their funds to their target weights.

Item 2: Corporate Behavior

Corporations respond to signals that market participants give. Near market tops, capital is inexpensive, so companies take the opportunity to raise capital.

Here are ways that corporate behaviors change near a market top:

a)? The quality of IPOs declines, and the dollar amount increases. By quality, I mean companies that have a sustainable competitive advantage, and that can generate ROE in excess of cost of capital within a reasonable period.

b) Venture capitalists can do no wrong, so lots of money is attracted to venture capital.

c)? Meeting the earnings number becomes paramount. What is ignored is balance sheet quality, cash flow from operations, etc.

d)? There is a high degree of visible and/or hidden leverage. Unusual securitization and financing techniques proliferate. Off balance sheet liabilities become very common.

e) Cash flow proves insufficient to finance some speculative enterprises and some financial speculators. This occurs late in the game. When some speculative enterprises begin to run out of cash and can?t find anyone to finance them, they become insolvent. This leads to greater scrutiny and a sea change in attitudes for financing of speculative companies.

f) Elements of accounting seem compromised. Large amounts of earnings stem from accruals rather than cash flow from operations.

g) Dividends become less common. Fewer companies pay dividends, and dividends make up a smaller fraction of earnings or free cash flow.

In short, cash is the lifeblood of business. During speculative times, watch it like a hawk. No array of accrual entries can ever provide quite the same certainty as cash and other highly liquid assets in a crisis.

These two factors are more macro than the investor base or corporate behavior but are just as important.? Near a top, the following tends to happen:

1. Implied volatility is low and actual volatility is high. When there are many momentum investors in a market, prices get more volatile. At the same time, there can be less demand for hedging via put options, because the market has an aura of inevitability.

2. The Federal Reserve withdraws liquidity from the system. The rate of expansion of the Fed?s balance sheet slows. This causes short interest rates to rise, making financing more expensive. As this slows down the economy, speculative ventures get hit hardest. Remember that monetary policy works with a six- to 18-month lag; also, this indicator works in reverse when the Fed adds liquidity to the system.

The Rules, Part LVI

Posted on 16 October 201320 June 2017 by David Merkel

Leverage and risk eventually transfer to the least regulated

I’m coming near the end of this series. ?It will either end at LX or LXI. ?To refresh, I started a file in 1999 of insights before I started writing at RealMoney or Aleph Blog. ?I ended it in 2003, near the time I started writing for RealMoney. ?I threw a few of the insights away, but not many — there may have been near 70 when I was done. ?These ideas stemmed for all of the new ideas I ran into as I transitioned from being an investment actuary to being a portfolio manager. ?Onto tonight’s idea!

After the recent crisis, tonight’s insight may seem rather banal, but I saw it as an actuary many times as onshore insurers would shed reserves using reinsurance treaties to Bermuda companies and other domiciles with weak reserving, capital or tax rules. ?It was reinforced to me when I blew it badly regarding Scottish Re. ?It was only in the midst of their crisis, that I finally saw a full diagram of their corporate structure. ?It was a hodgepodge of all of the weak insurance domiciles, with many lines going this way and that.

A picture is worth a thousand words, and as I have often said, complexity within financial companies is rarely rewarded. ?That diagram focused my research, and changed my view of what was going on. ?After having bought into the decline, we sold into an incredible one day rally when some positive news was released, while my view had shifted that cash could not make it to the holding company, and the common would go out at zero.

What a mess, and the best thing I can say was that selling into the rally was the right thing to do, as the common did go out at zero.

But in the recent crisis:

How many weakly capitalized investment banks died or were acquired?
How many REITs, particularly mortgage REITs died or were acquired?
How much of the mortgage insurance industry died?
How much of the financial guaranty industry died?
How many significant GSEs died?
And with all of these, how many barely survived?

These all had weak financial models, taking on too much credit risk, with weak, backward-looking models for risk. ?It is no surprise that the bad credit risks found the fools that assumed that housing prices could only go up, and incurred considerable leverage to make their bets.

All of these were weakly regulated. ?There was more than a bit of the “this is free money” attitude to many of these businesses — it was an era that rewarded yield hogs for a time.

Thus, when you see financial firms with weak balance sheets taking on significant credit risks, be wary, it is often a sign that the credit cycle is about to turn.

The Education of an Investment Risk Manager, Part IX (The End)

Posted on 3 October 2013 by David Merkel

I’m bringing this series to a close with some odds and ends — a few links, a few stories, etc.? Here goes:

1) One day, out of the blue, the Chief Investment Officer walked into my office, which was odd, because he rarely left the executive suite, and asked something like: “We own stocks in the General Account, but not as much as we used to.? How much implicit equity exposure do we get from our variable annuities?”? The idea was this: as the equity markets go up, so does our fee stream.? If the equity market goes up or down 1%, how much does the present value of fees change?? I told him I would get back to him, but the answer was an easy one, taking only a few hours to calculate & check — the answer was a nickel, and the next day I walked up to the executive suite and told him: “If we have 20% of our liabilities in variable annuities it is the equivalent to having 1% of assets invested in the stock market.

2) This post, Why are we the Lucky Ones? could have been a post in this series.? At a small broker-dealer, all sorts of charlatans bring their ideas for financing.? The correct answer is usually no, but that conflicts with hope.? Sadly, Finacorp did not consult me on the last deal, which is part of the reason why they don’t exist now.

3) The first half of the post, The Education of a Mortgage Bond Manager, Part IX, would also fit into this series — the amount of math that went into the analysis was considerable, but the regulatory change that drove it led us to stop investing in most RMBS.

4) While working for a hedge fund, I had the opportunity to sit in on asset-liability management meetings for a bank affiliated with our firm.? I was floored by the low level of rigor in the analyses — it made me think that every bank should have at least one actuary to do analyses with the level of rigor in the insurance industry.

Now, this doesn’t apply to the big banks and investment banks because of their complexity, but even they could do well to borrow ideas from the insurance industry, and do stress testing.? Go variable by variable, on a long term basis, and ask:

At what level does this bring line profits to zero?
At what level does this bring company profits to zero?
At what level does this imperil the solvency of the company?

5) This story is a little weird.? One day my boss called me in and said, “There’s a meeting of corporate actuaries at the ACLI in DC.? You are our representative.? They will be discussing setting up an industry fund to cover losses from failures of Guaranteed Investment Contracts.? Your job is to make sure the fund is not created.”

His concern in 1996 was that it would become a black hole, and would encourage overly aggressive writing of GICs.? He didn’t want to get stuck with losses.? I told him the persuasion was not my forte, but I would do my best.? I said that my position was weak, because we were the smallest company at the table, but he said to me, “You have a voice at the table.? Use it.”

A few days later, I was on the Metroliner down to DC.? I tried to understand both sides of the argument.?? I even prayed about it.? Finally it struck me: what might be the unintended consequences from the regulators from setting up a private guaranty fund?? What might be the moral hazard implications?

At the meeting, I found one friend in the room from AIG.? We had worked together, and AIG didn’t like the idea either.? In the the early parts of the meeting it seemed like there were 10 for the industry fund, and 3 against, AIG, Principal, and us.? Not promising.? We talked through various aspects of the proposal, the three representatives taking the opposite side — it seemed like no one was changing their minds, but some opinions were weaker on the other side.

By 3PM the moderator asked for any final comments before the vote.? I raised my hand and said something like, “You have to think of the law of unintended consequences here.? What will be the impact on competition here?? What if one us, a large company decides to be more aggressive as a result of this?? What if regulators look at this as a template, and use it to ask for similar funds more broadly in life insurance??? The state guaranty funds would certainly like the industry to put even more skin into the game.”

The room went silent for a few seconds, and the vote was taken.

4-9 against creating the guaranty fund.

The moderator looked shocked.

The meeting adjourned and I went home.? The next day I told my boss we had won against hard odds.? He was in a grumpy mood so he said, “Yeah, great,” barely acknowledging me.? This is the thanks I get for trying something very hard?

6) In early 2000, I had an e-mail dialogue with Ken Fisher.? I wanted to discuss value investing with him, but he challenged me to develop my own proprietary sources of value.? Throw away the CFA syllabus, and all of the classics — look for what is not known.

So I sat down with my past trading and looked for what I did best.? What I found was that I did best buying strong companies in damaged industries.? That was the key idea that led to my eight portfolio rules. Value investing with industry rotation may be a little unusual, but it fit my new view of the world. I couldn’t always analyze changes in pricing power directly, but I could look at industries where prices had crashed, and pick through the rubble.

In Closing

My career has been odd and varied, which has led to some of the differential insights that I write about here.? In some ways, we are still beginning to understand investment risks — for example, how many saw the financial crisis coming — where a self-reinforcing boom would give way to a self-reinforcing bust?? Not many, and even I did not anticipate the intensity of the bust.? At least I didn’t own any banks, and only owned sound insurers.

Investment risk is elusive because it depends partly on the collective reactions of investors, and not on external shocks like wars, hurricanes, bad policy, etc.? We can create our own crises by moving together in packs, going from bust to boom and back again.

It is my hope after all these words that some will approach investing realizing that avoiding risks is as important as seeking returns, and sometimes, more important.? It is not what you earn, but what you keep that matters.

The Education of an Investment Risk Manager, Part VII

Posted on 1 October 2013 by David Merkel

In late 2007, I was unemployed, but had a line on a job with a minority broker-dealer who would allow me to work from home, something that I needed for family reasons at that point.? The fellow who would eventually be my boss called me and said he had a client? that needed valuation help with some trust preferred CDOs that they owned.

Wait, let’s unpack that:

CDO — Collateralized Debt Obligation.? Take a bunch of debts, throw them into a trust, and then sell participations which vary with respect to credit risk.? Risky classes get high returns if there are few losses, and lose it all if there are many losses.
Trust preferred securities are a type of junior debt.? For more information look here.

I got to work, and within four days, I had a working model, which I mentioned here.? It was:

A knockoff of the KMV model, using equity market-oriented variables to price credit.

Uncorrelated reduced discrepancy point sets for the random number generator.

A regime-switching boom-bust cycle for credit

Differing default intensities for trust preferred securities vs. CMBS vs. senior unsecured notes.

It was a total scrounge job, begging, borrowing, and grabbing resources to create a significant model.? I was really proud of it.

But will the client like the answer?? My job was to tell the truth.? The client had bought tranches originally rated single-A from three deals originated by one originator.? There had been losses in the collateral, and the rating agencies had downgraded the formerly BBB tranches, but had not touched the single-A tranches yet.? The junk classes were wiped out.

Thus they were shocked when I told them their securities were worth $20 per $100 of par.? They had them marked in the $80s.

Bank: “$20?! how can they be worth $20.? Moody’s tells us they are worth $85!”

Me: “Then sell them to Moody’s.? By the way, you do know what the last trade on these bonds was?”

B: “$5, but that was a tax-related sale.”

Me: “Yes, but it shows the desperation, and from what I have heard, Bear Stearns is having a hard time unloading it above $5.? Look, you have to get the idea that you are holding the equity in these deals now, and equity has to offer at least a 20% yield in order attract capital now.”

B: “20%?! Can’t you give us a schedule for bond is worth at varying discount rates, and let us decide what the right rate should be?”

Me: “I can do that, so long as you don’t say that I backed a return rate under 20% to the regulators.”

B: “Fine.? Produce the report.”

I wrote the report, and they chose an 11% discount rate, which corresponded to a $60 price.? As an aside, the report from Moody’s was garbage, taking prices from single-A securitizations generally, and not focusing on the long-duration junky collateral relevant to these deals.

In late 2008, amid the crisis, they came back to me and asked what I thought the bonds were worth.? Looking at the additional defaults, and that the bonds no longer paid interest to the single-A tranches, I told them $5.? There was a chance if the credit markets rallied that the bonds might be worth something, but the odds were remote — it would mean no more defaults, and in late 2008 with a lot of junior debt financial exposure, that wasn’t likely.

They never talked to me again.? The bonds never paid a dime again.? I didn’t get paid for running my models a second time.

The bank wrote down the losses one more time, and another time, etc.? How do you eat an elephant?? One bite at a time.? It did not comply well with GAAP, and eventually the bank sold itself to another bank in its area, for a considerably lower price than when they first talked to me.

So what are the lessons here?

Ethics matter.? Don’t sign off on an analysis to make a buck if the assumptions are wrong.
Run your bank in such a way that you can take the hit, rather than spreading the losses over time.? (Like P&C reinsurers did during the 1980s.)? But that’s not how GAAP works, and the CEO & CFO had to sign off on Sarbox.
A model is only as good as the client’s willingness to use it.? There are lots of charlatans willing to provide bogus analyses — but if you use them, you know that you are committing fraud.
Beware of firms that won’t accept bad news.

I don’t know.? Wait, yes, I do know — I just don’t like it.? This is a reason to be skeptical of companies that are flexible in their accounting, and that means most financials.? So be wary, particularly when financials are near or in the “bust” phase — when the credit markets sour.

Sorted Weekly Tweets

Posted on 28 September 2013 by David Merkel

China

Chinese Cities Hooked on Land Revenue Fuel Housing Costs http://t.co/8SXwubzUjk Ppl invest in what they think they ctrl; no alternatives $$ Sep 28, 2013
Amway Bankrolls Harvard Course?For Chinese Cadres http://t.co/XVk5MXV2eh May not b pyramid, but successful sellers mostly recruit sellers $$ Sep 26, 2013
Chanos Undeterred by China Growth as O?Neill Bullish http://t.co/xwvC9mOFHa China will become the biggest windshield bugsplat ever seen $$ Sep 25, 2013
Party Will Pay the Price for China?s Rebalancing http://t.co/inQ5BHYMdn The Day has arrived: Michael Pettis is on Bloomberg. Go Michael! $$ Sep 25, 2013
China?s Generation Winnebago Avoids Traffic in RVs http://t.co/Q8z41qGv1j New Chinese status symbol: RVs. Rest while your driver works $$ Sep 24, 2013
China + Gold = 9 Million iPhones Sold http://t.co/DfIAopLDLV Gold may do nothing, but it is beautiful, & beauty drives much marketing $$ Sep 24, 2013
Michael Pettis, in his current newsletter, reminds us that loan growth outstrips ability to repay in China, recent “growth” is a fake-out $$ Sep 24, 2013

Companies & Industries

Meet Hummingbird: Google Just Revamped Search To Answer Your Long Questions Better http://t.co/mtAf5pxGIA Improved Search Engine $$ $GOOG Sep 28, 2013
JC Penney Is on the Brink http://t.co/UtMX5sa3ZT Now $JCP has liquidity, @ a cost, but can they transform their business model? $$ #unlikely Sep 28, 2013
Penney’s Share Offering Prices at a Discount http://t.co/CWVp8dOKln $JCP Danger Will Robinson! Stock price does not hold secondary level $$ Sep 27, 2013
Kat Cole, Former Hooters Waitress, Runs Cinnabon’s $1B Empire http://t.co/sOe9WKUB1v Ppl go gaga 4 Classic Roll. 60% more cals vs Big Mac $$ Sep 27, 2013
Oaktree group to sell US foreclosed homes http://t.co/dUuGn768TI Too many investors chasing residential RE vs owner occupiers $$ #badsign Sep 24, 2013
Meet Prem Watsa: The Man Riding to BlackBerry?s Rescue http://t.co/flg4xn1MkX A case of regret, throwing good $$ after bad $BBRY Sep 24, 2013
Banks Prove Safer Than Industrials in Bond Rally http://t.co/B2t3pbaNGd I would b willing 2 overweight industrials now; they r safer $$ Sep 24, 2013
Do Amazon’s Lockers Help Retailers? Depends on What They Sell http://t.co/Pbd2cPK6zl Works if $AMZN doesn’t sell what u sell, &vice-versa $$ Sep 23, 2013
FireEye Takes Off as Shares Rise 80% in IPO Debut http://t.co/fnY1YkvvD1 Score processes on weirdness, share info globally 2 stop malware $$ Sep 23, 2013

Rest of the World

Irish Billionaire Has ?Boatload? of Customers for Spanish http://t.co/GhyDzrhkhk Get your own Spanish Villa while supplies last! $$ Sep 27, 2013
Debt Disaster Seen Unless VAT Rises to 20% by 2020 http://t.co/fXyeptRNJZ Japan is a bug in search of a windshield; 20% would kill econ $$ Sep 26, 2013
Merkel?s Cold Embrace Leaves SPD Wary of Coalition Talks http://t.co/6pCmU9KgCf If SPD doesn’t compromise, cud a minority government form $$ Sep 24, 2013
Believing Data Not Required W/GDP Warrants http://t.co/36SKEKLcha Do u think Argentina is fudging GDP #s up? Buy Argentine GDP Warrants $$ Sep 23, 2013
For Migrants, New Land of Opportunity Is Mexico http://t.co/jy3XaZeRCA Immigrants r moving to Mexico as the economy deregulates a little $$ Sep 23, 2013
Czechs Yearning for Growth Set to Abandon Merkel Path http://t.co/sU8mxocTL7 No natural political coalition 4 austerity, even when right $$ Sep 23, 2013
Greece Plans Foreclosures to Meet Bailout Demands http://t.co/W7Ryxvv6J6 Inability 2 foreclose gums up Greece’s financial system $$ Sep 23, 2013

Central Banking

Richard Koo says ‘vicious cycle’ taking hold as Fed faces ‘QE trap’ http://t.co/se3uPY5eP1 Similar to my arguments in Easy in, Hard out $$ Sep 27, 2013
Constitutional Money by Richard Timberlake http://t.co/iipZBfnFqm “Treaties may become inapplicable because of changes in circumstances” $$ Sep 25, 2013
US Fed Shouldn’t Give Forward Guidance, Former Bank of Israel Head Fischer Says http://t.co/ZzbTLqTEU9 Correct. Fischer 4 Fed Chair $$ Sep 24, 2013
Why we listen to former FOMC members who r partisans of the Fed, rather than skeptics of central banking, like James Grant, amazes me $$ Sep 24, 2013
Yellen Would Bring Tougher Tone to Fed http://t.co/xoNY2kKWqa Academic economists, like Yellen, do not understand how the economy works $$ Sep 24, 2013

Housing/Mortgages

Mortgage Bonds Without Government Backing Face Tough Time http://t.co/MrtGxmynes Tough 2 mkt private label RMBS, not enough excess spread $$ Sep 28, 2013
Subprime bond bounces back, leaving behind a subprime borrower http://t.co/x7KRB8Rp9n Long article about a deadbeat & his subprime loan $$ Sep 27, 2013
There have been a scad of articles like this, but the guy did not do “due diligence” on the loan, and did not have to buy the house $$ Sep 27, 2013
Home gold rush is over http://t.co/AASXbe14zc Too many investors vs owner occupiers creates an imbalance as smarter players start 2 sell $$ Sep 26, 2013
FHA, Facing Losses, Likely to Tap Treasury http://t.co/Hdpqqdplri Shortfall for Fiscal Year Could b at Least $1B, Early Projection Shows $$ Sep 26, 2013

Financial Sector

BATS Prepares to Take On Big Bell Ringers http://t.co/x8PjU05xE9 NYSE + Arca > BATS + Direct Edge > NASDAQ $$ Graph: http://t.co/rDV3hY7uzf Sep 28, 2013
Shine a Light on Repo http://t.co/KrF4MtaA7Y Did u know that repos r 96 years old? Learn about obscure corner of the fixed income market $$ Sep 27, 2013
The bank that rejects the most mortgages http://t.co/JxD3xhvlY4 $JPM highest rejection rate, $STI lowest, $WFC biggest lender, avg 20.6% $$ Sep 27, 2013
Covenant-Lite Loans Need Uniform Definition http://t.co/RbEywreAEC It would help, but there is always nonstandard data in securitizations $$ Sep 26, 2013
Wells Fargo: New CLO Regulations May Lead to Issuance Slump http://t.co/FcK5NLQvba Forcing securitizers 2 take first losses ruins profits $$ Sep 24, 2013
The VC Secret: 3 Out of 4 Start-Ups Fail http://t.co/jjFrQc9JNP Ratio sounds high, but when VC-backed firm wins, it pays 4a lot of losers $$ Sep 24, 2013
That’s the way 2 manage pension assets if u r big enough. In-source, build up expertise, & keep adding smart people 2 addl asset classes $$ Sep 23, 2013
In-Sourced, Fully Funded, Public, and American http://t.co/ISUDgDvGhC! South Dakota Retirement System manages 65%-70% of assets in-house $$ Sep 23, 2013
America’s latest financial crisis? It’s incredibly personal. http://t.co/yHLcIm7xuR People do NOT understand how to save or handle cash $$ Sep 23, 2013
Value Investor Charles de Vaulx On China, Gold, Apple And Berkshire Hathaway http://t.co/4LgwGyzI7g Longish good interview. $$ $STUDY $BRK.B Sep 23, 2013
Fidelity sued by employees over its own 401(k) plan http://t.co/yo5h32QQD6 Biting hand that feeds them, they object 2 high fees 4 funds $$ Sep 23, 2013
Inside Nasdaq’s succession planning process http://t.co/6uOUsgrpuQ $NDAQ trades at a discount 2 peers; it needs a merger or better mgmt $$ Sep 22, 2013

Other

Billionaires Battle as Bezos-Musk Companies Vie for Launch Pad http://t.co/jEOhw4xXac Fight over a launchpad @ Kennedy Space Center $$ Sep 28, 2013
Supersonic Drones Can Outmaneuver Humans. So Why Do We Still Need Pilots? http://t.co/J5N9FhDVbH Pilots fly better in complex situations $$ Sep 28, 2013
Postal rate hike proposal faces Senate scrutiny http://t.co/aq7gKcDnm1 First Class would go to 49 cents, as internet slowly eats USPS $$ Sep 26, 2013
This Year’s SAT Scores Are Out, and They’re Grim http://t.co/04jtzUJMtL <50% of 2013 graduating seniors got “college-ready” SAT scores $$ Sep 26, 2013
Little GAAP Could Drive Accounting Simplification http://t.co/Ti24zRMFY2 If the acctg is 2 complex, biz is probably 2 complex as well $$ Sep 26, 2013
Work is not waiting for a job. If you don’t have a job, start your own business. http://t.co/pkUXupCOJg Sep 25, 2013
Investors Are Buying High, Yet Again http://t.co/PaTcowZvk8 Opportunities are fewer now, listen to Buffett & Klarman & trim back risk $$ Sep 25, 2013
Tweet tips: Most effective calls to action on Twitter http://t.co/PrcHMiNDMc! U could also ask them to favorite your tweet $$ $TWTR Sep 24, 2013
Death Dinners at Baby Boomers? Tables Take on Dying Taboo http://t.co/68nxd534eB Good 2 talk about death, but r u ready 4 the afterlife? $$ Sep 24, 2013
Here Are The Best Fundamental Investors To Follow On StockTwits http://t.co/a72aV98KUo A good list of resources & teachers; I’m listed #5 $$ Sep 23, 2013
A Backdoor Roth IRA for a High-Income Couple http://t.co/79fYNIF5d6 Invest in regular IRA, convert 2 Roth, repeat process annually $$ Sep 23, 2013

PPACA / Obamacare

Will Obamacare hurt job creation and marriage? http://t.co/n7h7BEkrXK Belief in Obamacare is akin 2 belief in magic; resources r free $$ Sep 27, 2013
Prices Set for New Health-Care Exchanges http://t.co/J4VFjvF5HR Younger Buyers May Face Higher Insurance Premiums $$ Obamacare #FTL Sep 26, 2013
Best of the Web Today: The Young and the Clueless http://t.co/3GbWYOqipM ObamaCare may work, provided no one responds to its incentives. $$ Sep 26, 2013
Young Invincibles Caught in Crossfire Over Obamacare Cost http://t.co/hgyCGtZMaj Note how Obama packs the gallery w/young people $$ Sep 24, 2013

Municipal Debt / Detroit

Stockton to Unveil Plan Including Cuts for Creditors http://t.co/zBj3ngCXMz Trying to preserve pensions may draw lawsuit from bondholders $$ Sep 28, 2013
Detroit spent billions extra from pensions http://t.co/UBdb3GaqtI That’s what u get 4 having 1-party rule, w/no 1 to look over shoulder $$ Sep 27, 2013
Orr proposes freeze for Detroit pension funds http://t.co/sSFtqADV23 Unions don’t get that they destroyed the finances of Detroit $$ Sep 27, 2013
Judge Rules Retiree Health Protected Like Pension http://t.co/xg7bcR28oM! Loopy ruling sets Los Angeles on a course 2 bankruptcy $$ Sep 25, 2013
Hands off DIA, pensions, Detroiters say in poll http://t.co/dHmp2qjc5n! Detroit is an example of a complex system self-destructing $$ #dying Sep 23, 2013

Energy

Pipeline Billionaire Ready for Next Round of Deal Making http://t.co/KhTwsdBDRs $ETP CEO thinks there is room to consolidate pipelines $$ Sep 28, 2013
Six Myths About Renewable Energy http://t.co/G0dB1SJ2aU Balanced article. 3 myths pro, 3 myths con. It will b a minority of total energy $$ Sep 23, 2013

The Economic views of Ray Dalio

One more note, this slideshow put together from BI moves a lot faster than Dalio’s video or the… http://t.co/ytGIHQEaxP Sep 24, 2013
And for those that want to read Ray Dalio’s economic template book, it is free here: http://bwater… http://t.co/f1AVlDufxo Sep 24, 2013

US Politics & Policy

Texas Counties Lead in Job Growth, Lag in Wage Gains http://t.co/XdyNF4ZEJt No surprise, but biz leaves CA & there is high unemployment 2 $$ Sep 27, 2013
CHRISTIE KEEPS PENSION PROBE RECORDS FROM PUBLIC VIEW AS GOVERNOR EYES 2ND TERM http://t.co/NmnbLRxRwd! Running mate has pension scandal $$ Sep 24, 2013
Open-Government Laws Fuel Hedge-Fund Profits http://t.co/P5vZBpkiDq Hedge funds file FOIA requests 2get FDA reports on drugs, etc. $$ Sep 23, 2013
At 77 He Prepares Burgers Earning in Week His Former Hourly Wage http://t.co/jQJaWTiQd3 Example of “failed 2 save” Don’t let it happen 2u $$ Sep 23, 2013
Self-Driving Vehicles Progress Faster Than Rules of Road http://t.co/1lFAmdlJKz Regulations, laws, insurance all need 2b revised 4 this $$ Sep 23, 2013
The Hidden Classified Briefing Most of Congress Missed http://t.co/eSBnz0uPxd How intelligence gets disseminated w/o getting disseminated $$ Sep 23, 2013
How the NFL Fleeces Taxpayers http://t.co/OeG5kRTM2O Longish article on how they get free stadiums, pay no federal or state taxes, etc. $$ Sep 23, 2013
Facebook ?Likes? Are Now Legally Protected Speech http://t.co/Oi7XQkYVlB Political speech is protected by the 1st Amendment even “like” $$ Sep 22, 2013

Wrong

Over the Top: Jordan R. VanOort Earns Prestigious CFA Designation http://t.co/jRMcdyRq1R CFA designation is good, but prestigious? $$ Sep 28, 2013
& really, when there are over 100,000 of us, does receiving your CFA Charter really rate a press release? Tougher to become an Actuary $$ Sep 28, 2013
Wrong:Pimco shook hands with Fed – & made a killing http://t.co/gBlELQ6U7p 2 notes: agency MBS r easy 2 understand, & TBA mkt not obscure $$ Sep 27, 2013
Point: Fed could have easily done this internally. What! They can’t find any among their 1000s of Ph.D. economists to get simple mkts? $$ Sep 27, 2013
It is probable that enough data on what the Fed would do escaped over the transom 2 give PIMCO & the other firms insider info. $$ Sep 27, 2013
Wrong: New idiots, same as the? actually these idiots might be worse http://t.co/Xa5jGmbQII US economy grew faster under balanced budgets $$ Sep 27, 2013
Wrong: Reduce working week to 30 hours, say economists http://t.co/HiI7Zmhimo More work means more production means more GDP, Consumption $$ Sep 27, 2013
Loony: Detroit Union Seeks 2 Revive `13th’ Pension Check Policy http://t.co/Lf5YMVBKxW Practice that continues 4 28Y is a tacit agreement $$ Sep 27, 2013
Wishful thinking: Let ObamaCare Collapse http://t.co/n3yNizNAfP Until the US itself fails, no entitlement has ever been eliminated $$ Sep 26, 2013
Wrong:Shinzo Abe: Unleashing the Power of ‘Womenomics’ http://t.co/R00AN5pUEH This comes from nation w/a shrinking population. Ridiculous $$ Sep 26, 2013
Wrong: How Sensitive Is Public Pension Funding to Investment Returns? http://t.co/hSeoOLsvrc! Should use mkt-based assmptns not historic $$ Sep 25, 2013
Wrong: US city, county public pension levels sank in 2012 http://t.co/o2JUwsi5JF! 2 optimistic, b/c risk assets bottomed in late 2002 $$ Sep 25, 2013
Wrong: Don?t Be Alarmed by Obamacare?s Failures http://t.co/fS63xQpaaP PPACA doesn’t make actuarial sense, young people won’t participate $$ Sep 24, 2013
Wrong: Yellen Isn?t a ?Knee-Jerk Dove,? Kroszner Says http://t.co/0aeTM6BIiB Favoring negative interest rates == ?Knee-Jerk Dove? $$ Sep 24, 2013

Replies, Retweets & Comments

Thanks @TightTalk @BabyFreshNuggz @X9T_Trading for being top new followers in my community this week (insight via http://t.co/sern3wLA13) Sep 27, 2013
“Here is part of my solution: accounting for repos should be bifurcated, so that is not treated ?” ? David_Merkel http://t.co/caWGlbe3eL $$ Sep 27, 2013
Loonies, Detroit is dead MT @ToddSullivan: RT @AmyResnick: just wow. Detroit Union Seeks to Revive `13th’ #Pension http://t.co/u3XJAER0bi $$ Sep 27, 2013
Believe MT @ReformedBroker: You’re not gonna believe this – but Detroit’s pension doled billions left and right http://t.co/9i5MinpGAX $$ Sep 27, 2013
RT @ezraklein: Perhaps if President Obama makes the House GOP 300 sandwiches, they’ll agree to lift the debt ceiling. Sep 27, 2013
#FollowFriday Thanks @ReformedBroker @pelias01 @researchpuzzler for being top influencers in my community this week 🙂 Sep 27, 2013
‘ @allstarcharts @jfahmy The 1st discipline of investing/trading is humility; even if you know more, the timing/environment can be tough $$ Sep 27, 2013
Commented on StockTwits: I think Watsa can be trusted. Aside from financials in the old days that were dodgy, I th… http://t.co/dJ8g2rVKmK Sep 27, 2013
Thanks @abnormalreturns @dpinsen for being top engaged members in my community this week (insight via http://t.co/sern3wLA13) Sep 26, 2013
“I never directly pay for research… most of it is freely available on the web. What is not, I?” ? David_Merkel http://t.co/EAk37XXNdJ $$ Sep 26, 2013
“This is already known by those that study the statistics. Look at year over year figures, you ?” ? David_Merkel http://t.co/5J46Rm19vo $$ Sep 26, 2013
I just left a comment in “We’ve got bubbles, we’ve got troubles – MarketWatch” http://t.co/P11awJw1KQ Sep 26, 2013
‘ @Reddy Cummings is my gerrymandered rep. He is by far one of the most intellectually underpowered members of the House, & that says a lot Sep 25, 2013
@moorehn @ReformedBroker @SimoneFoxman @SallyPancakes @kensweet @jennablan They r favorites of mine. $$ Sep 25, 2013
Entitlements will have to be reduced; it is only a question of how and when. Druckenmiller’s presentation:… http://t.co/BsA9S78RTI Sep 24, 2013
Thanks @MarshaCollier @EdmundSLee @rwohlner for being top new followers in my community this week (insight via http://t.co/sern3wLA13) Sep 24, 2013
Thanks @researchpuzzler @pelias01 for being top engaged members in my community this week (insight via http://t.co/sern3wLA13) Sep 23, 2013

On Alternative Investments

Posted on 6 September 2013 by David Merkel

What makes an investment alternative?? Typically, it is because not many institutional investors own it.? But why don?t they own alternatives?? What attributes can characterize them?

Lower Liquidity ? this can take the form of long lockups for private equity, liquidity limitations on hedge funds, Real Estate LPs, etc.
Limited market for trying to sell out of limited partnership interests early
Can go both long and short financial instruments, use derivatives
Can hold commodities and collectibles (Art, wine, who knows?)

Typically, the form of the investment is a limited partnership.? The limited partnership can own all manner of assets, and short some of them also.

As with most valid investment ideas, those that get there first do the best.? You don’t want to be the last one to the party — you buy into a saturated market at an overvalued price.? Far better to avoid the market than to be the last one in.

You have to understand, there is nothing truly different about alternative investments.? They may invest in private businesses, and lever them up, but the returns aren’t greater than if we levered up public companies to the same degree.

They may go long and short, but there are so many trying to do it that the limits of arbitrage are tested, which is a major reason for why hedge funds are doing so badly.? When you have a lot of parties trying to make differential bets, the reward to the exercise declines.

Briefly, while working for Finacorp before it liquidated, I had the opportunity to give advice to some large pension plans that were charging into alternative investments in 2009.? I counseled them to stick to more liquid investments, because alternative investments had become common.? Alternatives are not magic — you have to evaluate them like any business, and ask whether the entry price discounts a high return or a low return.? Are the commodities/collectibles in over- or under-supply?? What possibility might you face of needing to raise liquidity at an inopportune time?

There are two matters affecting any investment:

Underlying behavior of the asset in term of its relative value, and
Behavior of those who hold the investment, their perception of relative value, and their need for liquidity.

To give an absurd example, think of Bernie Madoff.? The actual value of the assets never did anything.? But parties owning interests in Madoff’s “fund” needed to raise liquidity when the public equity markets plunged in 2008, which led to the insolvency.

Investor behavior affects asset prices.? Big surprise, not.? This is Ben Graham’s voting machine.? The weighing machine eventually catches up when there are liquidity events where investment vehicles get dissolved for cash or other securities.

This is not to say that there is no superior management talent with respect to alternative investments, but that it is subject to the same limits as public investments.? As more capital is allocated to a manager, he moves down his list and says, “Okay, what’s the next best thing to which I can allocate capital?”? Too much money kills even the best of managers.

Perhaps the best way to go is to focus on the Seth Klarmans and Howard Marks of our world, and be opportunistic.? Hold cash when it makes sense, or send it back to the limited partners, but invite them back and invest heavily when conditions warrant.

My view is this: given the wide level of investing in alternative investments, there is no reason why they should outperform, and no reason why they should be uncorrelated with other risk assets, because the same owners own both.

The Fed Needs Valuation Actuaries (and More Steel in the Spine)

Posted on 20 August 2013 by David Merkel

I reviewed the following report from the Federal Reserve to Congress today, and found it disappointing.? From my prior experience as an actuary, and the time that I spent on the asset-liability committee of a small bank, I know that? the banking industry is far behind the life insurance industry on risk control.? The Fed would have done far better to have studied the works of the Society of Actuaries and the National Association of Insurance Commissioners, and learned from their efforts.

Now, I know that the contingencies of banks are far less predictable then those of life insurers.? Further, life insurers have long liabilities, whereas the liabilities of banks are short, and thus, they are more subject to runs.? But liquidity risk management does not play a large role in their document — and this is a severe defect in what they write.? Almost all failures of financial firms are due to loss of liquidity.? The word liquidity only appears once in the document, on page 15.? This shows the amateurish work of the writers.

The Fed focuses on a lot of process issues that don’t matter as much as the substantive issues of discovering forward-looking measures of risk, and changing business processes to reflect those risks.

Here are some examples:

1) Internal controls matter, but it is a rare internal control auditor that can truly analyze a complex mathematical process.? They don’t have the capacity to review those processes, or they would be doing it and earning far more.

2) Risk identification is important, but the Fed document would have not helped in 2007-2009.? How do you detect risks that have (seemingly) never happened before?? Further, if you do detect a major problem that has happened before, and it would impair some very profitable businesses, why do you think management will kill profits to appease your lunacy?

3) Governance is important, but the board gets data so late that it is useless.? This is not worth bothering with.? Management has to do the job here.

4) The language on capital targets is weak, and allows the banks way too much latitude in performing their own calculations.? The Fed needs to be far more specific, and prescribe the scenarios that need to be tested.? It need to prescribe the loss severities, asset class by asset class.? It needs to prescribe the correlations, if any, that can be used in the models.

5) The document does not speak of ethics.? Valuation Actuaries do the same work on a higher level, and they have an ethics code.? That may occasionally make them oppose the management team that pays them, but it is a necessary check against managements trying to manipulate results.

6)? The piece spends too much time on the dividend policies of bank holding companies, and no significant time on the abilities of the subsidiaries ability to dividend to the bank holding companies.? The proper focus of a bank regulator is on the health of the operating subsidiaries.? Who care if the holding company goes broke?? Big deal, at least we protected depositors.

Banking regulators should adopt the same policy as insurance regulators.? Outside of ordinary limits, they can deny any special dividends from subsidiaries to the holding company.

7) The piece does not get forward-looking estimates of risk.? On new classes of assets, you don’t have historical data to aid in estimates of risk.? At such a point, one must look at similar businesses that have gone through a failure cycle, or do something even more difficult: do a cash flow model to estimate where losses will fall if asset values decline for an unspecified reason (okay, no more ability to buy…)

8 ) Macroeconomic factors rarely correlate well with the factors that lead to losses on assets.? Most of that effort is a waste.

9) As Buffett said (something like): “We’re paid to think about things that can’t happen.”? This is why the Fed has to specify scenarios, and be definite.? The mealy-mouthed language of the document can be gainsayed.? Life Actuaries have better guidance.

10) So all of the banks did not pass the mark.? With the vagueness of the guidelines, no surprise.? Let the Fed put forth real guidelines for bank stress tests, and let the banks scream when they get them.? Better to have slow growth in the banking sector than another crisis.