Structured Products and Derivatives – Page 7

The Rules, Part XLVIII

Posted on 30 July 201330 July 2013 by David Merkel

If an asset-backed security can produce a book return less than zero for reasons other than default, that asset-backed security should not be permitted as a reserve investment.

Compared to most of my rules, this one is a little more esoteric, so let me explain.? Reserve investments are investments used to back the promises made by a financial institution to its clients.? As such, they should be very certain to pay off.? In my opinion, that means they should have a fixed claim on principal repayment, with risk-based capital factors high enough to take away the incentive invest too much in non-investment grade fixed income claims.

Other assets are called surplus assets.? There is freedom to invest in anything there, but only up to the limits of a company’s surplus.? After all, surplus assets are the company’s share of the assets, right?

If I were rewriting regulation, I would change it to read that only “free surplus” is available to be invested in assets that do not guarantee principal repayment.? Free surplus is the surplus not needed to provide a risk buffer against default on the reserve assets.

But back to the rule.? I think the reason I wrote it out 10+ years ago was my objection to interest only securities that received high ratings, despite the possibility of a negative book yield if prepayments accelerated, and they were rated AAA, and could be used as reserve assets with minimal capital charges.? Buying an asset that can lose money on a book basis for a non-default reason is inadequate to support reserves.? (This leaves aside the ratings’ arbitrage of interest only securities, where defaults hit the yield.? Many have negative yields at levels that would impair related junk rated securities)

This can be applied to other assets as well.? Reverse convertibles that under certain circumstances can be forcibly converted to a weak preferred stock or common stock should only be allowed as surplus assets.? Risk based capital formulas should consider the greater possible risk and adjust required capital up.

Now, maybe this is a rule for another era.? Maybe there aren’t as many games being played with assets today, but games will be played again — having some sort of rule that stress-tests securities to see that they will at least repay principal (leaving aside default), would prevent a certain amount of mischief the next time Wall Street gets creative, putting other financial companies at risk in the process.

Book Review: The Physics of Wall Street

Posted on 6 June 2013 by David Merkel

Let me admit my bias at the start.? Physics is the wrong model for financial markets and economics.? The better models are ecological or biological, because people adapt to conditions that change.? Perhaps we are predictable on average, but there is a wide variation in specific behaviors.

Economics and ecology deal with scarcity and plenty.? Physics does not.? Physics is exact, aside from the quantum and universal scales.? Economics and ecology are never exact, and prediction is fraught with error.

But what of financial instruments where the math of physics might have application?? Perhaps physics has some application there?

Okay, sort of.? Even something as pervasive as option modeling does not truly have a simple model, but implied volatility has to be re-estimated regularly for the Black-Scholes Model.? A true model does not require re-estimation of a parameter, particularly when it varies by time and strike price.

What I liked? about the book

I liked reading about the mathematicians who applied analogies from physics to economics. Even though the models had their flaws, they improved the explanatory power.

I also appreciated how the author kept explanations simple.? He could have gone into a lot more detail, and a lot more math, and he would have lost most of his audience.

He also explained the life circumstances of the men he wrote about.? That adds depth, because science does not occur in a vacuum.? It is a social activity.?? Few men think purely abstractly, and those that do ride the edge of genius/insanity.

There are two motives for understanding? how men approach markets — to explain, and to make money.? The book has both sorts, and it is a strength to see one validate another.

Quibbles

Already given

Who would benefit from this book: If you want to learn about men who shaped the market by their knowledge of math, you will like this book.? If you want a book that explains the markets, this is not it. ?If you want to, you can buy it here: The Physics of Wall Street: A Brief History of Predicting the Unpredictable.

Full disclosure: I received a free copy from the publisher.

If you enter Amazon through my site, and you buy anything, I get a small commission.? This is my main source of blog revenue.? I prefer this to a ?tip jar? because I want you to get something you want, rather than merely giving me a tip.? Book reviews take time, particularly with the reading, which most book reviewers don?t do in full, and I typically do. (When I don?t, I mention that I scanned the book.? Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website.? Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites.? Whether you buy at Amazon directly or enter via my site, your prices don?t change.

On the Designation of Systemically Important Financial Institutions

Posted on 5 June 2013 by David Merkel

What does it take to create a global or national financial crisis?? Not just a few defaults here and there, but a real crisis, where you wonder whether the system is going to hold together or not.

I will tell you what it takes.? It takes a significant minority of financial players that have financed long-dated risky assets (which are typically illiquid), with short-dated financing.

The short-dated financing needs to be rolled over frequently, and during a time of financial stress, that financing disappears, particularly when creditors distrust the value of the assets.? It typically happens to all of the firms with weak liability structures at the same time.

During good times financing short is cheap.? Locking in long funding is costly, but safe.? That is why many financial firms accept the asset-liability mismatch — they want to make more money in the short-run in the bull phase of the market.? But when many parties have financed long risky assets with loans that need to be renewed in the short-term, the effect on the markets is multiplied.? The value of the risky assets falls more because many of the holders have a weak ability to hold the assets.? Where will the new buyers with sound finances come from?

Areas of Short-dated Financing

Short-dated financing is epitomized by bank deposits prior? to the Great Depression.? If doubt grew about the ability of a bank to pay off its depositors, depositors would run to get their cash out of the bank.? Deposits are supposed to be available with little delay.? After creation of the FDIC, deposits under the insurance limit are sticky, because people believe the government stands behind them.

But there are other areas where short-dated financing plays a significant role:

Margin accounts, whether for derivatives, securities, securities lending, etc.? If a financial company is required to put up more capital during a time of financial stress, they may find that they can’t do it, and declare bankruptcy.? This can also apply to some securities lending agreements if unusual collateral is used, as happened to AIG’s domestic life subsidiaries.
Putable financing, particularly that which is putable on credit downgrade.? This has happened in the last 25 years with life insurers [GICs used for money market funds], P&C reinsurers, and utilities.? Now this is similar to margin agreements on credit downgrades because more capital must be posted.? Anytime a credit rating affects cash flows, it is a dangerous thing.? The downgrade exacerbates the credit stress.? Then again, why were you dancing near the cliff that you created?
Repo financing was a large part of the crisis.? The weakest large investment banks relied on short-term finance for their assets in inventory.? So did many mortgage REITs.? As repo haircuts rose, undercapitalized players had to sell, lowering asset prices, leading to a new round of selling, and higher repo haircuts.? It was the equivalent of a bank run and only the strongest survived.
Auction-rate preferreds — a stable business for so long, but when creditworthiness became a question, the whole thing fell apart.
Finance companies — GE Finance and other finance companies rely on a certain amount of short-term finance via commercial paper.? It is difficult to be significantly profitable without that.
All other short-term interbank lending.

Crises happen when there is a call for cash, and it cannot be paid because there are not enough liquid assets to make payment, and illiquid assets are under stress, such that one would not want to sell them.? This has to happen to a lot of companies at the same time, such that the creditworthiness of some moderately-well capitalized institutions, that were thought to have adequate liquidity are called into question.

The Value of a Long Liability Structure

Let me give a counterexample to show what would be a hard sort of company to kill.? In the mid-1980s, a number of long-tailed P&C reinsurers found their claims experience in a number of their lines to be ticking up dramatically.? But the claims take a long time to settle, so there was no immediate call for cash.? Later analysis showed that for many of the companies, if the full value of the claims that eventually developed were charged in the year the business was written, many of them would have had negative net worth.? As it was, most of them suffered sub-par profitability, losing money on the insurance, and making a little more than that on their investments.

But they survived.? Other insurers cut some corners in the ’90s & ’00s and wrote policies that were putable if their credit was downgraded.? This would supposedly give more protection to those buying insurance or GICs [Guaranteed Investment Contracts] from them.? Instead, the reverse would happen when the downgrade came — there would be an immediate call on cash that could not be met, and the company would be insolvent.? Even if the majority of the liability structure is long, if a significant part of it was short, or could move from long to short, that’s enough to set the company up for a liquidity crisis of its own design.

Credit cycles come and go.? The financial companies in the greatest danger are the ones that have to renew a significant amount of their financing during a crisis.? It’s not as if firms with long liabilities don’t face credit risk; they face credit risk, and sometimes they go insolvent.? But they have the virtue of time, which can heal many wounds, even financial wounds.? If they die, it will be long and drawn out, and they will hold options to influence the reorganization of the firm.? Creditors may be willing to cut a deal if it would accelerate the workout, or, they might be willing to extend the liability further, in exchange for another concession.

In any case, not having to refinance in a crisis makes a financial company immune from the crisis, leaving aside the regulators who may decide the regulated subsidiaries are insolvent.? But, the regulators may decide they have more pressing issues in a crisis from firms that can’t pay all their bills now.

AIG, Prudential & GE Capital

So the Financial Stability Oversight Council [FSOC] has designated AIG, Prudential & GE Capital as systemically important.? They are certainly big companies in their industries, but are they 1) likely to be insolvent during a credit crisis, and 2) does the failure of any one of them affect the solvency of other financial firms?

That might be true for GE Capital.? They certainly still borrow enough enough in the commercial paper market, though not as much as they used to.? If GE Capital failed, a lot of money market funds would break the buck.

AIG?? The current CEO says he doesn’t mind being being systemically important.? Still, Financial Products is considerably smaller than it was before the crisis, they aren’t doing the same foolish things in securities lending that they were prior to the crisis, and they don’t have much short-term debt at all.? The liabilities of AIG as a whole are relatively long.? And even if AIG were to go down, we shouldn’t care that much, because the regulated subsidiaries would still be solvent.? Financial holding companies are by their nature risky, and regulators should not care if they go bust.

But Prudential?? There’s little short term debt, and future maturities are piddling on long term debt.? If the holding company failed, I can’t imagine that the creditors would lose much on the $27B of debt, nor would it cause a chain reaction among other financial companies.

I feel the same way about Metlife; both companies have long liabilities, and would have little difficulty with financing their way through a crisis.? Just slow down business, and free cash appears in the subsidiaries.

I can make a case that of these four, only GE Capital poses any systemic risk, though I would have to do more work on AIG Financial Products to be sure.? But what the selection of companies says to me was it was mostly a function of size, and maybe complexity.? Crises occur because a large number of financial companies finance long-dated assets with short-dated borrowings.? I think the FSOC would have done better to look at all of the ways short-term finance makes its way into financial companies, and then stress test the ability to withstand a liquidity shock.

My belief is that if you did that, almost no insurers would be on such a list; the levels of stress testing already required by the states exceed what FSOC is doing.

The Rules, Part XLII

Posted on 31 May 201320 June 2017 by David Merkel

During a panic, it is useful to reflect on the degree to which the real economy has been driven by the financial economy.? In the Great Depression, the degree was heavy; in the seventies, it was light.? Today, my guess is that it is in-between, which makes it difficult to figure out the right strategy.

Again, this was written in 2002 or so.? As I posted last night, the banks were in relatively good shape then.? I made a lot of money for my clients buying bank floating rate trust preferred securities at ~$80.? There was no security that we did not clear at least $10 on, and most cleared $20 within a year.? One even went from $68 to $100, plus a healthy coupon.? In bond terms those were a series of home runs.? As an aside, as a bond investor, I focused more on net capital gains than most, and that helped us in a rocky era.? I often gave up current income to gain the potential for capital gains, which was the opposite of most of my competitors.

So in 2002 it was reasonable to buy banks as the willingness to supply of credit grew.? But there are limits to how much credit you can have in an economy without things getting screwy.? An economy with too many promises to pay becomes inflexible; far better to finance more of the economy with equity, but that requires a Fed that works properly, like it was under Eccles, Martin and Volcker.? Under men of less courage, like Bernanke, Greenspan, Burns, Miller, Crissinger, and Young, it simply paves the way for asset bubbles and price inflation.

In 1929 and 2008, though, it was relatively easy to know that the financial economy had grown too large for the real economy.? Total debt to GDP levels were at records.

Or think of it from this angle: in 2004, I was recruited by another financial hedge fund to be their insurance analyst.? I talked with them, but ultimately I refused, because I felt the boss was probably less competent than my current boss.? A major part of his presentation was how amazing the outperformance of financial stocks had been over the prior 10 years, implying that it would be the same over the next 10.? That outperformance was not repeatable because the capital of the banking and shadow banking industries had gotten so large that there was no longer any way that they could extract a high return out of the rest of the economy.? As it was, the effort to do so made them take on asset risks that killed many companies, and should have killed many, many more, had economic policy been handled properly.

This is one reason why my long only portfolio was so light on financials, excluding insurers, going into 2008.? I sold the last of my banks in 2007, realizing Europe would be no safe haven.? I retained one mortgage REIT that cratered as repo fell apart, teaching me a valuable lesson that I had bought something cheap, but not safe.? That was my only significant loss during the crisis starting in 2007-2008.? Repo funding is not a safe funding source during crises, and this is something that is not fixed from the last crisis, along with portfolio margining, and a few other weak liability structures.

With respect to the eras starting in 1929 and 2008, the key concept is debt deflation?? When there are too many debts, there will be too many bad debts.? That is the time to only only companies with strong balance sheets that will not need to refinance under any conditions.? That eliminates all banks and shadow banks.

I can’t guarantee that we are past the crisis, because we haven’t seen what will happen to the economy when the Fed starts to lessen policy accommodation, much less tighten.? As it is, for the most part, I not only own companies that are cheap, but primarily companies that are safe.? Value investing is “safe and cheap,” not just cheap.? This applies to financials as well, but many value investors lost a lot of money on financials because they ignored credit quality near the end of a credit boom.? Many credit-sensitive companies looked cheap near the end of the 2007, but they were cheap for a reason — they were about to get pelted by a ton of losses.

As an aside, do you know how hard it is to get a value manager to short something trading at 50% of book value?

I know how tough that is.? I’ve been through it.? He would not bite.

The company had asset risks as well as liability risks.? I extrapolated the liability cash flows to realize the long-term care? policies the company had written would likely bankrupt them.? But when the boss came to me pitching it as a long because one his buddies thought it was dirt-cheap, I uttered, “Gun to the head boss, I would tell you to short it.”? Reply: “But it’s trading at half of book value.” Me: “Book value is misstates true economic value.? Can’t say for certain, but I think this one goes out at zero.”

As it was, we did nothing, and the stock, Penn Treaty, did go out at zero. (There was one small positive out of this, I did convince the private equity arm not to fund a competitor in long-term care.)

Back to the main point.? Have a sense as to the financial economy.? This will probably only happen once in your life, but that time is crucial.? If there is a financial mania going on, move to safety, and reduce exposure to credit-sensitive financials.? It’s that simple, but to most value investors who invest in seemingly cheap financials that is a hard move.? Remember, safe comes before cheap in value investing, and that means questioning asset accrual items.? Financial companies have that in spades.

The Rules, Part XXXIX

Posted on 24 May 2013 by David Merkel

The trouble with VAR and other mathematical models of risk is that if it becomes the dominant paradigm, and everyone begins to use it, it creates distortions in the market, because institutions gravitate to asset classes that the model makes to appear artificially cheap.? Then after a self-reinforcing cycle that boosts that now favored asset class to an unsupportable level, the cashflows underlying the asset can no longer support it, the market goes into reverse, and the VAR models encourage an undershoot.? The same factors that lead to buying to an unfair level also cause selling to an unfair level.

Benchmarking and risk control through VAR only work when few market participants use them.? When most people use them, it becomes like the portfolio insurance debacle of 1987.? VAR becomes pro-cyclical at that point.

Sometimes I think the Society of Actuaries is really dumb.? The recent financial crisis demonstrated the superior power of long-term actuarial stress-testing versus short-term quant models for analyzing risk.? The actuarial profession has not taken advantage of this.? Now, maybe some investment bank could adopt an actuarial approach to risk, and they will be much safer.? But guess what?? They won’t do it because it will limit risk taking more than other investment banks.? Unless the short-term risk model is replaced industry-wide with a long-term risk model, in the short-run, the company with the short-term risk model will do better.

The reason why VAR does not effectively control risk is simple.? VAR is a short-term measure in most of its implementations.? It is a short-term measure of risk for short- and long-term assets.? Just as long-term assets should be financed with long-term liabilities, so should risk analyses be long-term for long-term assets.

This mirrors financing as well, because bubbles tend to occur when long-term assets are financed by short-term liabilities.? Risk gets ignored when long-term assets are evaluated by short-term price movements.

And, as noted above, these effects are exacerbated when a lot parties use them; a monocultural view of short-run risk will lead to booms and busts, much as portfolio insurance caused the crash in 1987.? If a lot of people trade in such a way as to minimize losses at a given level, that sets up a “tipping point” where the market will fall harder than anyone expects, should the market get near that point.

The idea that one can use a short-term measure of risk to measure long-term assets assumes that markets are infinitely deep, and that there are no games being played.? You have the capacity to dump/acquire the whole position at once with no frictional costs.? Ugh.? Today I set up a new client portfolio, and I was amazed at how much jumpiness there was, even on some mid-cap stocks.? Liquidity is always limited for idiosyncratic investments.

The upshot here is simple: with long term assets like stocks, bonds, housing, the risk analysis must be long term in nature or you will not measure risk properly, and you will exacerbate booms and busts.? It would be good to press for regulations on banks to make sure that all risk analyses are done to the greater length of the assets or the liabilities (and with any derivatives, on the underlying, not contract term).

The Rules, Part XXXVII

Posted on 21 May 2013 by David Merkel

The foolish do the best in a strong market

“The trend is your friend, until the bend at the end.”? So the saying goes for those that blindly follow momentum.? The same is true for some amateur investors that run concentrated portfolios, and happen to get it right for a while, until the cycle plays out and they didn’t have a second idea to jump to.

In a strong bull market, if you knew it was a strong bull market, you would want to take as much risk as you can, assuming you can escape the next bear market which is usually faster and more vicious.? (That post deserves updating.)

Here are four examples, two each from stocks and bonds:

In 1998-2000, tech and internet stocks were the only place to be.? Even my cousins invested in them and lost their shirts.? People looked at me as an idiot as I criticized the mania.? Buffett looked like a dope as well because he could not see how the enterprises could generate free cash reliably at any intermediate time span.
In 2003-2007, there were 3 places to be — owning homebuilders, owning depositary financials or shadow banks, and buying residential real estate directly.? This was not, “Buy what you know,” but “Buy what you assume.”
In 1994 many took Mexican credit risk through Cetes, Mexican short-term government debt.? A number of other clever investors thought they had “cracked the code” regarding residential mortgage prepayment, and using their models, invested in some of the most volatile mortgage securities, thinking that they had eliminated all risk, but gained a high yield.? Both trades went badly.? Mexico devalued the peso, and mortgage prepayments did not behave as expected, slowing down far more than anticipated, leading the most levered players to? blow up, and the least levered to suffer considerable losses.
2008 was not the only year that CDOs [Collateralized Debt Obligations] blew up.? There were earlier shocks around 2002, and the late ’90s.? Those buying them in 2008 and crying foul neglected the lessons of history.? The underlying collateral possessed no significant diversification.? Put a bunch of junk debt in a trust, and guess what?? When the credit cycle turns, most of those bonds will be under stress, and an above average amount will default, because the originators tend to pick the worst bonds with a rating class to maximize the yield, which allows the originator to make more.? Yes, they had a nice yield in a bull market, when every yield hog was scrambling, but in the bear market, alas, no downside protection.

I could go on about:

The go-go years of the ’60s or the ’20s
The various times the REIT market has crashed
The various times that technology stocks have wiped out
And more, like railroads in the late 1800s, or the money lost on aviation stocks, if you leave out Southwest, but you get the point, I hope.

People get beguiled by hot sectors in the stock market, and seemingly safe high yields that aren’t truly safe.? But recently, there has been some discussion of a possible “safety bubble.”? The typical idea is that investors are paying up too much for:

Dividend-paying stocks
Low-volatility stocks
Stable sectors as opposed to cyclical sectors.

A “safety bubble” sound like an oxymoron.? It is possible to have one?? Yes.? Is it likely?? No.? Are we in one now?? Gotta do more research; this would be a lot easier if I were back to being an institutional bond manager, and had a better sense of the bond market pulse.? But I’ll try to explain:

After 9/11/2001, institutional bond investors did a purge of many risky sectors of the bond market; there was a sense that the world had changed dramatically.? At my shop, we didn’t think there would be much change, and we had a monster of a life insurer sending us money, so we started the biggest down-in-credit trade that we ever did.? Within six months, yield starved investors were begging for bonds that we had picked up during the crisis.? They had overpaid for safety — they sold when yield spreads were wide, and bought when they were narrow.

But does this sort of thing translate to stocks?? Tenuously, but yes.? Almost any equity strategy can be overplayed, even the largest and most robust strategies like momentum, value, quality, and low volatility.? In August of 2007, we saw the wipeout of hedge funds playing with quantitative momentum and value strategies, particularly those that were levered.

Those with some knowledge of market? history may remember in the ’60s and ’70s, there was an affinity for dividends, with many companies borrowing to pay the dividend, and others neglecting necessary capital expenditure to pay the dividend.? When some of those companies ran out of tricks, they would cut or eliminate the dividend, and the stock would fall.? Now, earnings coverage of dividends and buybacks seems pretty good today, but watch out if one of the companies you own has a particularly high dividend.? You might even want to look at some of their revenue recognition and other accounting policies to see if the earnings are perhaps somewhat liberal.? You also compare the dividend to what the cash flow from operations is, less cash needed for maintenance capital expenditure.

I don’t know whether we are in a “safety bubble” now for stocks.? I do think there is a “yield craze” in bonds, and I think it will end badly when the credit cycle turns.? But with stocks, I would simply say look forward.? Analyze:

Margin of safety
Valuation, absolute & relative
Return on equity
Likely and worst case earnings growth

And then balance margin of safety versus where you have the best opportunities for compounding capital.? If relative valuations have tipped favorably to less common areas for stock investing that considers safety, then you might have to consider investing in industries that are not typically on the “safe list.”? Just don’t? compromise margin of safety in the process.

Classic: Get to Know the Holders? Hands, Part 2

Posted on 24 April 2013 by David Merkel

Note: this was published at RealMoney on 7/2/2004.? This was part four of a? four part series. Part One is lost but was given the lousy title: Managing Liability Affects Stocks, Pt. 1.? If you have a copy, send it to me.

Fortunately, these were the best three of the four articles.

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Investing Strategies

Some groups can reinforce their own behavior in the market, causing booms and busts.

Balance sheet players tend to be strong holders.

Liquidity can change the market landscape.

In Part 1 of this column, I began describing the various classes of investors and their investment behavior. In Part 2, I’ll continue that description, and will follow it up by explaining how some classes of investors can temporarily reinforce their own behavior, causing booms and busts. Finally, I will offer practical ways you can benefit from understanding the behaviors of different investor classes.

8. Leveraged Private Investors

The use of leverage gives the investor the ability to make more out of his bets than his equity capital would otherwise allow, but eliminates some of the advantages that the unleveraged possess. Investors that are leveraged do not entirely control their trade; if their assets decline enough in value, either they or the margin desk will reduce their position.

Leveraged investors are in the same position as the European banks that I discussed in Part 1. Worry sets in as one gets near a margin call, not when the margin call happens. As worry sets in, mental pressures to change the asset positions materialize. The challenge to the investor is to decide whether to liquidate, or take chances. Being forced to make a decision leads to a higher probability, in my opinion, of making the wrong decision.

In addition, leveraged longs have to pay for the privilege of financing additional assets. With overnight rates low today, that might not seem like much of a cost. But when the market is in the tank and interest rates are sky-high, as they were from 1979 to 1982, the cost of leveraged speculation is a deterrent and helps keep a lid on the market.

9. Short-Sellers

Being short is not the opposite of being long. It is closer to the opposite of being a leveraged long. Shorts do not entirely control their trade; if their shorts rise enough in value, either they or the margin desk will reduce their position. This is the opposite of leveraged longs. Remember, unleveraged longs can stay put as long as they like, and almost no one can force them to change. Shorts can be forced to cover through a squeeze, whether through rising prices threatening their solvency or a decrease in borrowable shares from longs moving their shares from margin to cash.

Stocks with a large short interest relative to the float, like Taser (TASR:Nasdaq) , can behave erratically with little regard to anything more than the short-term technicals of trading. (If fundamental investing is akin to a chess game, trading Taser is more akin to a street brawl.)

Short-sellers also have costs that unleveraged longs don’t face. When it is difficult to borrow shares (i.e., the borrow is tight), you might have to pay for the privilege of borrowing. As an example, when I was short Mony Group, I had a 2% annualized rate to pay on the last block of shares that I shorted. The rest came free, but that was before the trade got crowded. (When the borrow is not tight and if you are big enough, it is possible to get a credit, but that’s another story.)

Another cost is paying any dividend that the company might pay. Granted, the stock is likely to drop by the amount of the dividend, but cash going out the door to support a trade makes a trade more difficult to hold on to.

10. Options Traders

Buyers of options fully control their trade and pay a premium for the privilege. Sellers of options give up some control of their trade and receive a premium for their trouble. Being short an option is like being short a stock; theoretically, the risk is unlimited. If the short options of an investor rise enough in value, either they or the margin desk will reduce their position. Long option investors face no such constraints, but they do face the continual decay of the time premium of their options.

When there are company-issued options outstanding, such as warrants, convertible preferreds and convertible bonds, another trading dynamic can develop. Because the company has offered the call options on its stock, unlike other investors, it can issue stock to satisfy calls. The dilution from share issuance can put a ceiling over the price of the stock near the strike price for the call options until enough demand exists for the stock that it overcomes the dilution.

One more example of embedded options shows up in the residential mortgage bond market. Residential mortgages contain an option that allows the mortgage to be prepaid. Mortgage bond managers, who often manage to a constant duration (interest-rate sensitivity), run into the problem that their portfolios lengthen when rates rise, and shorten when rates fall. This can make them buyers of duration (longer mortgages or noncallable Treasuries) when rates fall, and sellers when rates rise.

In either case, with enough mortgage managers (and mortgage originators, who are in the same boat) doing this, it can become self-reinforcing because many market players buy into a rising market and sell into a falling market. This has an indirect effect on the Treasury and swap markets because mortgage hedgers use them to adjust their overall interest-rate sensitivity. In general, mortgage hedgers are weak holders of Treasuries, which they sell off as rates rise.

Balance Sheet Players vs. Total Return Players

I find it useful to divide the players in the investment universe into two camps: balance sheet players and total return players. Balance sheet players can lose it all and then some. Total return players can lose only what they have invested and include mutual funds (including index funds), unleveraged private investors, defined benefit plans, option buyers and endowments. Balance sheet players include banks, insurance companies, leveraged private investors and option sellers.

Total return players tend to resist — or at least are capable of resisting — market trends, which provide stability in the market. At the edges of negative price movements, balance sheet players find that they have to sell risky assets in order to preserve themselves. In severe market conditions, balance sheet players can make market movements more extreme.

I think it helps to view the behavior of balance sheet players through the lens of self-reinforcement. When there are too many of them crowding into a trade, there is the potential for instability. If the price of the asset has been bid up to the point to where a buy-and-hold investor would feel that he could not obtain a free cash flow yield adequate to compensate him for the risk of the purchase, then the asset is unsustainably high, which does not mean that it can’t go higher. When you see long-term investors exiting, it’s usually time to leave.

Fueled by leverage, some players will increase their bets as the price of the asset rises because they have more buying power with a more expensive asset. Finally, a few smart players start to sell and the process works in reverse as leverage levels increase for balance sheet players with a large concentration in the stock and a self-reinforcing cycle of selling begins. The same boom-bust cycle can happen with total return players, but it would be more muted because of the lack of leverage.

At the end of the bust, the buyers typically are unleveraged buy-and-hold investors. For example, I remember picking over tech and telecom stocks in 2001-02 that had been trashed after the bubble burst. This is a sector of the market that I don’t play in often, because I don’t know it so well; that said, it became 30% of my portfolio. Many of those stocks were trading for less than their net cash and a few were even earning money. My thought at the time was that if I tucked a few of these stocks away and held them for five years or so, I’d have something better at the end. With the bull market of 2003, my exit came sooner than I expected; other market players saw the potential of the cheap, conservative tech companies that I held and liked them more than I did.

This brings me back to weak and strong hands. In general, total return players have stronger hands than balance sheet players, at least when market values are out of whack with long-term fundamentals.

Illiquidity and LTCM

An asset is illiquid when the bid-ask spread is wide, or even worse, when there is no bid or ask for a given asset in the short run. This can happen with large orders in small-cap stocks and in “off the run” corporate bonds. Often an illiquid asset offers a higher potential return than a more liquid asset; given the disadvantage of illiquidity, in a normal market it would have to. Even a liquid asset can act illiquid if you hold a large amount of it relative to the total float. Trying to sell rapidly would drive down its price.

To hold illiquid assets, you either have to hold them with equity or a low degree of leverage with a funding structure for the leverage that can’t run away. One example is the type of portfolio I ran in the mid-1990s: unleveraged micro-cap value stocks. Another example is Warren Buffett’s portfolio. He buys whole companies and large positions in other companies, and funds those purchases with a modest amount of leverage from his insurance reserves.

My counterexample is more interesting (failure always is). Long Term Capital Management for the most part bought illiquid bonds and shorted liquid bonds that were otherwise similar to the illiquid bonds. When LTCM was small relative to the markets that it played in, it could move in and out of positions reasonably well, and given the nature of bonds, absent a default, there was a natural tendency for the bonds to converge in value as they got close to maturity.

As LTCM became better known, it received more capital to invest. Assets grew from profits as well. Wall Street trading desks began to figure out some of the trades that LTCM was making and started to mimic the firm. This made LTCM’s position more illiquid. It was fundamentally short liquidity, leveraged up using financing that could disappear in a crisis and had LTCM wannabes swarming around its positions.

At the beginning of 1998, it had earned huge returns and its managers were considered geniuses. The only problem was that they were running out of places to put money. The yield spreads between their favored illiquid and liquid bonds had narrowed considerably. “The juice had been squeezed out of the trade,” but they still had a lot of money to manage.

By mid-1998, with the Asian crisis brewing and Russia defaulting, there came a huge premium for liquidity. Everyone wanted to get liquid all at once. Liquid bonds rose in price, while illiquid bonds fell. The LTCM imitators on Wall Street got calls from their risk control desks telling them that they had to liquidate the trades that mimicked LTCM; the trades were losing too much money. In at least one case, it imperiled the solvency of one investment bank. But at least the investment banks had risk-control desks to force them to take action. LTCM did not, and the unwinding of all the trades by the investment banks worsened its position.

When the severity of the situation finally dawned on the investment banks, with the aid of the Federal Reserve, the investment banks realized that there was no way to easily solve the situation. LTCM couldn’t be liquidated; its positions were so large that a “fire sale” meant that the investment banks that lent it money would have to take a haircut. LTCM needed time and a bigger balance sheet, if the investment banks were to be repaid. The investment banks eventually agreed to recapitalize LTCM funds and unwind the trades at a measured pace. Even the equity investors got something back when the liquidation of LTCM was complete. LTCM’s ideas weren’t all bad, but it was definitely misfinanced.

Final Advice

Keep these basic rules in mind as you consider how to apply these concepts to your own trading. They aren’t commandments, but paying attention to them will help you make more informed investment decisions.

All good investment relies at least implicitly on sound asset-liability management. Assets should be matched to the type of investor and funding structure that can best support them.
Understand the advantages that you have as an investor, particularly how your own cash flow and funding structure affect your investing.
Try to understand who else is in a trade with you, what their motivations are, their ability to carry the trade, etc.
Don’t overleverage your positions. Always leave enough room to be able to recover from a bad scenario.
Be aware of the effects that changing demographics may have on pension plans and individual investors.
Always play defense. Consider what can go wrong before you act on what can go right.
Be contrarian. Maximize your flexibility when the market pays you to do so. Be willing to sell into manias and buy after crashes.

Classic: Avoid the Dangers of Data-Mining, Part 2

Posted on 15 April 2013 by David Merkel

The following was published on 6/1/2004 at RealMoney.com

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Investing Strategies

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Models that work well on data about the past may not work in the future.

Check methods for weak points, like overfitting or ignoring illiquidity or business relationships.

Keep in mind some practical considerations when testing a theory.

Other Areas of Data-Mining

In 1992-1993, there were a number of bright investors who had “picked the lock” of the residential?mortgage-backed securities market. Many of them had estimated complex multifactor relationships that allowed them to estimate the likely amount of mortgage prepayment within mortgage pools.

Armed with that knowledge, they bought some of the riskiest securities backed by portions of the cash flows from the pools. They probably estimated the past relationships properly, but the models failed when no-cost prepayment became common, and failed again when the Federal Reserve raised rates aggressively in 1994. The failures were astounding: David Askin’s hedge funds, Orange County, the funds at Piper Jaffray that Worth Bruntjen managed, some small life insurers, etc. If that wasn’t enough, there were many major financial institutions that dropped billions on this trade without failing.

What’s the lesson? Models that worked well in the past might not work so well in the future, particularly at high degrees of leverage. Small deviations from what made the relationship work in the past can be amplified by leverage into huge disasters.

I recommend Victor Niederhoffer and Laurel Kenner’s book, Practical Speculation, because the first half of the book is very good at debunking data-mining. But it also mines data on occasion. In Chapter 9, for example, the authors test methods to improve on buying and holding the index over long periods by adjusting position sizes based off of the results of prior years. Enough results were tested that it was likely that one of them might show something that would have worked in the past. My guess is that the significant results there are a statistical fluke and may not work in the future. The results did not work in the recent 2000-2002 downturn.

As an aside, one of the reasons Niederhoffer’s hedge fund blew up is that he placed too much trust in the idea that the data could tell him what events could not happen. The market has a funny way of doing what everyone “knows” it can’t, particularly when a majority of market participants rely on an event not happening. In this case, Niederhoffer knew that when U.S. banks fall by 90% in price and survive, typically they are a good value. Applying that same insight to banks in Thailand demanded too much of the data, and was fatal to his funds.

What to Watch Out for

Investors who are aware of data-mining and its dangers can spot trouble when they review quantitative analyses by looking for these seven signals:

1. Small changes in method lead to big changes in results. In these cases, the method has likely been too highly optimized. It may have achieved good results in the past through overfitting the model, which would interpret some of the noise of the past as a signal to return to the earlier analogy.

2. Good modeling takes into account the illiquidity of certain sectors of the market. Any method that comes out with a result that indicates you should invest a large percentage of money in a small asset class or small stock should be questioned. Illiquid or esoteric assets should be modeled with a liquidity penalty for investment. They can’t be traded, except at a high cost.

3. Be careful of models that force frequent trading, particularly if they ignore commission costs, bid/ask spreads, and, if you are large enough relative to the market, market impact costs. These factors make up a large portion of what is called implementation shortfall. In general, implementation shortfall often eats up half of the excess returns predicted by back-testing, even when back-testing is done with an eye to avoiding data-mining.

For a full description on the pitfalls of implementation shortfall, read Investing by the Numbers, by Jarrod X. Wilcox.? Chapter 10 discusses this issue in detail. This is the best single book I know of on quantitative methods in investing.

4. Be careful when a method uses a huge number of screens in order to come down to a tiny number of stocks and then, with little or no further analysis, says these are the ones to buy or sell. Though the method may have worked very well in the past, accounting data are, by their very nature, approximate and manipulable; they require further processing in order to be useful. Screening only winnows down the universe of stocks to a number small enough for security analysis to begin. It can never be a substitute for security analysis.

5. Avoid using quantitative methods that lack a rational business explanation. Effective quantitative methods usually come from processes that mimic the actions of intelligent businessmen. Never confuse correlation with causation. Sometimes two economic variables with little obvious financial relationship to each other will show a statistically significant relationship in the past. Two financials merely being correlated in the past does not mean that they will be so in the future. This is particularly true when there is no business reason that relates them.

6. Look for the use of a control. A control is a portion of the data series not used to estimate the relationship. It’s left to the side to test the relationship after the “best” model is chosen. Often, the control will indicate that the “best” method isn’t all that good. And beware of methods that use the control data multiple times in order to test the best methods. That defeats the purpose of a control by data-mining the control sample.

7. One of the trends in accounting is to make increasingly detailed rules in an attempt (wrongheaded) to fit each individual company more precisely. The problem with that is it makes many ratios difficult to compare across companies and industries without extra massaging to make the data comparable. This makes thinning out a stock universe via screening to be less useful as a tool. For quantitative analysis to succeed, the data need to represent the same thing across different firms.

Practical Recommendations

There are many pitfalls in quantitative analysis. But three simple considerations will help protect investors from the dangers of data-mining.

1. Paper trade any new quantitative method that you consider using. Be sure to charge yourself reasonable commissions, and take into account the bid/ask spread. Take into account market impact costs if you are trading in a particularly illiquid market. Even after all this, remember that your real-world results often will underperform the model.

2. Think in terms of sustainable competitive advantage. What are you bringing to the process that is not easily replicable? How does the method allow you to use your business judgment? Is the method so commonly used that even if it is a good model, returns still might be meager? Even good methods can be overused.

3. If doing quantitative analysis, do it honestly and competently. Form your theory before looking at the data and then test your theory. Then, if the method is a good one, apply the results to your control. If you perform quantitative analysis this way, you will have fewer methods that seem to work, but the ones that pass this regimen should be more reliable.

The Education of an Investment Risk Manager, Part III

Posted on 30 March 201331 March 2013 by David Merkel

There’s kind of a rule of thumb in Asset-Liability management, that you match liquidity over the next 12 months, and match interest rate sensitivity overall.? I would do more than that, creating my own randomized interest rate models, as well as a new way of creating structured randomness in simulation models.? For a brief period of time, I had one of the best multivariate randomness programs out there, eliminating the problem of correlations in higher dimensions common with Hammersly points.? (My work was not theoretical, but intuitive… once I saw how the randomness was created, I figured out how to de-correlate the higher dimensions (since it was based on prime numbers, create more number than you need, and use a higher prime number to select observations.)

Anyway, when I brought my full-interest rate curve scenarios to the investment department in 1994, they said to me, “These are the first realistic interest rate scenarios we have ever seen.? Did you constrain them?”? I told them “No, just weak mean reversion.? Noise dominates in the short run, mean reversion dominates in the long run.”

As a result, for the lines of business over which I had oversight, we measured our interest rate mismatch in terms of days, weeks, and months, but never years.? Please ignore this incident where things drifted, but worked out exceptionally well (really, that should be a part of this series).? We published a document to show everyone how well we managed interest rate risk in Provident Mutual’s pension division.? We used scenarios far beyond what was required to show how well we did our work.? The regulators never complained.

At that point in time, the ability to integrate residential mortgage-backed securities into cash flow analyses was rudimentary at best.? But I found ways to make it work, most of the time.? That said, I remember joking with the MBS manager in late 1993, and saying there was a new term for a well-protected PAC bond.? He asked, “What is it?”? I replied, “Cash.”? He sarcastically said, “Oh, you are so funny.”?? That said, I pointed out to the investment department that some of their bonds that they thought would last another four years would disappear in 2-3 months.

Then there was the floating rate guaranteed investment contract project that I eventually killed because it was impossible.? You can’t argue with expectations that are unrealistic.? Even better, I beat the Goldman Sachs representative.

In running the GIC desk at Provident Mutual, I had to review a lot of strategies because making money on short-term bonds/loans was difficult, and difficult the degree that I doubted as to whether we were in a good business.? On the bright side, I protected the firm until the day that we? could not write any more? GICs, because our credit quality was too low.? That was the fault of the less entrepreneurial part of the company, so I couldn’t so much about it, except close my operations down.? I asked the senior management team to provide a guarantee to my GICs, but they refused.

As such, I shut the line of business down.? With clients that were unreasonable over credit quality, and management unwilling to extend credit protection to GICs, the battle over GICs was ended, and I sent the line into runoff.

Five years later, as we were now part of the same firm I stood at the estate of John Dwight, with a young woman that I had sold the last GIC of Provident Mutual to, I said, “The end of the GIC business of Provident Mutual.”? We talked, she smiled, but it was part of the end of an era, because GICs were a minority of the assets in Stable Value funds.

If nothing else, this helps to highlight the impermanence of all that is done in financial firms.? I know this in my own life, but I am sure that it is true for most people in finance.

Buffett’s Career in Less Than 1000 Words

Posted on 27 March 201327 March 2013 by David Merkel

This post is at the behest of my friend Tom Brakke of The Research Puzzle.? It is meant to briefly describe how Warren Buffett’s investing changed over the years.

Compounding Capital

The basic idea of Warren Buffett’s investing is simple.? Try to compound your capital at the fastest rate consistent with a margin of safety.? That margin of safety might be a strong balance sheet, or it might be a product with high gross margins that faces little competition.? But compound capital over the long haul.? Do it, whether it is public or private investing.? Do it, regardless of the form of the asset.? Do it, if you have to change in midstream from being an asset manager, to being the manager of an investment-oriented conglomerate.

Those are themes I will explore in this essay, but who can explain Buffett well in less than 1000 words?

Buying Cigar Butts

Ben Graham had a huge influence on Buffett, but Buffett was his own man.? He had made money in many ways prior to working for Graham/Newman — he was a very driven, determined man.? But buying dud companies where the price was far lower than what the net assets were worth was a simple strategy that few followed.? It had great returns from the mid-30s to mid-60s or so.

Why? The Great Depression left the stock market in disarray, and convinced a generation not to touch stocks; they were not able to be analyzed.? So a few enterprising men analyzed and made a lot of money.

After Graham-Newman folded in 1956, Buffett started his own investing partnerships, which he eventually consolidated into one partnership in

But there were limits to this exercise.? Companies were sold for a profit, and the number of companies selling at bargain basement prices shrank dramatically.? Ben Graham folded; Warren Buffett adapted.

End of Buffett Partnership

Buffett ended his investment partnership as opportunities declined, and distributed out the shares to holders around 1969.? After a little delay, he consolidated his holdings under Berkshire Hathaway.? This was a significant move because now Buffett was running a business as an investor.? He had permanent capital, and could use it were he thought best.? Berkshire Hathaway itself was a failing textile producer.? In hindsight Buffett was too kind, and gave it too many chances, it would have been better to shut down the textile company earlier.

Textile Company to Insurance/Conglomerate Holding Company

Buffett discovered insurance early, through GEICO in 1952, and then through Berkshire Hathaway bought insurance companies which became the bedrock of the company, including buying 50% GEICO in 1974 to rescue it.? This would provide the capacity to finance/leverage investment insights.

Influence of Charlie Munger (Growth/Moat)

His friendship with Charlie Munger began in 1959, and he affected the way Buffett thought about investing.? Companies that had protected boundaries, or, sustainable competitive advantages deserved a premium valuation.? That insight began to free Buffett from the Cigar Butts, i. e., dud companies that have no growth potential, only sellout potential.? Such businesses could be bought in whole or in part, but they had to possess a durable advantage.? This would play a role as Buffett wold buy Coke, Capital Cities, American Express, Wells Fargo, and many other high quality businesses.

Willing to work Public or Private, and increasingly Private

Though Buffett was known in the 70s and 80s as a public equity manager inside a public company, he increasingly bought private companies like:

See’s Candies
Fecheimer
Kirby
Nebraska Furniture Mart
Borsheim’s
Scott Fetzer
World Book (no one is perfect)
Buffalo News (who could have predicted the Internet?)

This changed his view of what he was up to, and made him willing to run an abnormal conglomerate, one that would operate on a disaggregated basis.? Buffett would take the free cash flow from controlled companies, and the dividends from partially owned companies an reinvest them in the areas he thought had the most promise.

Scale rules out Arbitrage / Distressed Debt / Small Cap Equities / not Derivatives

Over time, Buffett invested in many ways, doing deal arbitrage, buying distressed debt, and buying small cap companies.? As time went on he had to abandon these for two reasons: he had too much capital to put to work, and competition increased, driving returns down.

Derivatives were different, Buffett was willing to take bets during times of economic stress so long as he did not have to post margin.? He took bullish bets on US Credit and Global Equities.? Much as he criticized derivatives as gambling, he was willing to take an intelligent bet where his downside was limited.

Buying companies with no auction / Tuck-in acquisitions

Buffett became the home for men who wanted to sell their companies, but preserve the culture.? Buffett didn’t pay the highest price, but he did not interfere with the new subsidiaries.

His subsidiary companies would do little tuck-in acquisitions that would further the vitality of BRK, without spending a lot.

Increasing Insurance Scale

And over time, bought all of GEICO, Gen Re, and many other smaller insurers.? Supposedly, at one point, Hank Greenberg said to Buffett, “Call me when you have a real insurance company!”? The two were frenemies for some time.? But today, the show is on the other foot — the largest insurer in the US in BRK.

The increased scale of insurance provided all the more capital to finance Buffett’s asset buys.? The underwriting discipline provided additional profits.

Opportunistic Provider of Capital

During the crisis in 2008-9, Buffett provided capital to well-regarded companies like GE and Goldman Sachs.? He was ready for odd opportunities like Burlington Northern, Lubrizol, and Heinz.

He was also willing to change his view on buying back shares, setting a line in the sand where he would but back shares, rather than doing a dividend.

Conglomerate Manager

Buffett never intended to run a conglomerate, but that is what he did, and did it very well, much like Henry Singleton, who was another compounder.

That’s what he does now.? There it is, in less than 1000 words.