The Rules – Page 2 – The Aleph Blog

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?

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 Rules, Part LV

Posted on 14 October 2013 by David Merkel

Financial intermediation reduces volatility.? In bull markets, demand for financial intermediaries drops.

Ordinary people do well if they have a budget and stay within it.? They do even better if they save and invest, but really, they don’t know what to do.? Market returns are like magic to them.? They don’t know why they occur, positively or negatively.? Life would be best for them if a mutual financial company gave them smooth returns 0n a regular basis, and absorbed all of the market volatility over a market cycle.? That would be hard for the mutual financial company to do, because they don’t know what the ultimate returns will be, so how would they know what smooth returns to credit?

There is a reason why banks, mutual funds, money market funds, life insurers, and defined benefit pension plans exist.? People need vehicles in which to park excess cash that are more predictable than direct investing.? Set an average person free to make his own investment decisions with individual bonds an stocks, and he will make incredibly aggressive or scared moves.? Fear and greed will seize him, making him sell low, and buy high.

That’s why entities that reduce volatility, whether absolutely or relatively, whether short-run or long-run, exist.? But there is seasonality to this: average people seek intermediaries during and after bear markets, when they have been burnt.? After losses, they seek guarantees.? That is often the wrong time to seek guarantees, because often the market turns when average people are running.

During bull markets, the opposite happens.? When easy money is being made by amateurs, the temptation comes to imitate.

If my stupid brother-in-law can make money flipping houses, so can I.
If my stupid cousins can make money buying dot-com stocks, so can I.
If my stupid neighbor can make money buying gold, so can I.

First lesson: don’t be envious.? Aside from being a sin, it almost always induces bad investment and consumption decisions.

Second lesson: build up your investment expertise, piece-by-piece.? Don’t follow the crowd.? Develop the mindset of? a businessman who calmly analyzes opportunity, asks what could go wrong, and estimates likely returns dispassionately.? Pretend you are a Vulcan; if they actually existed, they would be some of the best investors, and not the Ferengi.

Third lesson: an experienced advisor can be of value even if he does not beat the market, by avoiding selling out at the bottom, and avoiding taking more risk near the top.

Fourth lesson: remember that market returns tend to be lumpy.? The economy may be volatile, but markets are more volatile, and not in phase with the economy, because markets anticipate.

Fifth lesson: if you can do it in a disciplined way, invest more during bad times, after momentum has slowed, and things cease getting worse.? Also, if you can do it in a disciplined way, invest less during good times, after momentum has slowed, and things cease getting better.

The main idea here is to be forward looking, and avoid the frenzies that take place near turning points.

The Rules, Part LIV

Posted on 12 September 2013 by David Merkel

When do employee and corporate incentives line up?? Ideally, incentive schemes should reward people with a fraction of the additional profitability that resulted from the additional work that they did.? Difficulties: measurement impossible in many cases, people could receive a bonus when the firm is not profitable, neglects synergies (both positive and negative).

Though I wrote that in 2002, I formulated the idea in the late 1980s.? The concept of how bonus/incentive systems should work intrigued me.? Part of it also stemmed from Warren Buffett’s observation that he would never hand out stock options, because employees can’t control P/E expansion or shrinkage, but employees have some impact on profits, if fairly measured.? So Buffett would offer profit incentives, rewarding employees with a share of the profits over a given threshold.

The first time I mentioned the idea publicly was at the Fellowship Admission Course for the Society of Actuaries in 1991.? The first case study was on a misuse of employee incentives, and I commented something close to “rule” that I mentioned above.? After I said that, a female consulting actuary based in Australia said that it was one of the stupidest comments she had ever heard.? But beyond that, she didn’t explain.? The discussion moved on.? I didn’t make too much of what she said, because she offered no reasons for her opinion.

In 1994, my best boss came to me, and said, “Well, you drew the short straw.? You get to try to redesign our compensation system for our representatives.”? He described to me the current system, and what the overall goals were.? I assented, and he left.? Shortly after that, the division’s Radar O’Reilly, “Roy” came to me and said, “You got the compensation project?”

I told him that I had been given the project, and he told me not to put too much time into it early, or it would suck up gobs of time, and besides, no compensation scheme over the past five years had lasted longer than a year.? I thanked Roy, he was a loyal friend, and never told less than the truth.

But then I had to think.? Surely there had to be a way that would work here, and maybe putting in some development time in on the front end could pay off, maybe?

I had been playing around with reduced discrepancy point sets with my free time.? Like Assurant, my boss gave me eight free hours per week to come up with new ideas, and temporarily, I created the best method of creating structured randomness — how best to have “r” points represent an n-dimensional unit hypercube.? The practical upshot was that I could create scenario analyses that were far more accurate than any others around.? (Note: better methods emerged within 10 years, and I never published my work, because my insights were intuitive rather than provable… but it enabled me to do some amazing things for the next ten years.)

I set up my profit model, and chose my criterion: Try to pay commissions equal to 1.25% of the Present Value of the Gross Value Added.? My model had four components.? I can’t remember all of them now, but the last one was the most significant, an item called the “revenue bonus.”? Over a certain threshold offices (with multiple representatives) would receive extra compensation for exceeding targets.

It leveled out the amount paid versus the Present Value of the Gross Value Added.? Success, except that my best boss ever had one of our two fights over it — he thought it was a horrible idea — we could be paying out too much money in a bad year, or too little in a good year.? I argued? that it was better than what we currently had, and that we could tweak it in future years.? We will learn from the errors of the method.? He told me that it was fine for me to present it to the chief marketing officer and the CEO of the division, but he would not be behind me.

Much as I respected him, I had done my work, so I presented it two days later to the CMO and CEO.? They went gaga for the idea, and in the meeting my boss said “I see it now.”? Later, he came to me and apologized, and as is usual with me, I accepted it, saying it was no big thing.

So what happened?? Not only did the compensation scheme work for a year, it stayed in place for four years without modification, while sales and profitability grew dramatically, and the division grew to be the star of the company.

That said, after the CEO retired, the CMO became the new CEO, and I got transferred to a different division to clean up operations and financials there.? After four years, the representatives complained that the scheme was too tough, and they needed some low hanging fruit to motivate them.? And so my scheme was abandoned, and sales did not improve, but they were worse.

Profit-based incentives work if they are structured right.? You want representative to write good business, and should incent them to do so.? Offering them a percentage of the expected improvement of the value of the company is a smart thing.

The Rules, Part LIII

Posted on 9 September 201320 June 2017 by David Merkel

The tech market washes out about every eight years or so.? The broad market, which is a more robust beast, washes out far less frequently.? My question: are these variants of the same phenomenon?

I wrote this back in early 2003.? I can now answer my own question: No.

I’ve looked at this question many times, and debated the answer, but there are a few things that have made me decide “No.”

Sectors often move independently of the market as a whole, particularly growthy sectors that lose their growth.
The big moves of the market as a whole have usually been correlated with credit crises, which are part of the financial sector, not the tech sector.
The tech sector grows more slowly as a whole now, and hasn’t washed out for a while.
The financial sector fails because of financial leverage, the firms are too levered, and take too much credit risk.? The tech sector fails because market players bid up the prices of stock assuming permanently high rates of growth.? These are fundamentally different reasons for over-valuation, because most tech stocks have little debt.

Credit crises lead to big overall declines in market values, particularly with financial stocks, but affecting all other stocks, because when credit conditions are tight, things slow for all firms.

When tech stocks are overbid, it is more of a local mania where market players overestimate the degree of growth the sector can achieve.? There is little collateral damage to the market.? A seeming exception to this is 2000-2002, where the market went down with tech, but financials were less affected. In that drawdown, tight Fed policy drew everything down, and tech more than everything else.? Remember the NASDAQ over 5000?? Still hasn’t returned there, while the Dow, S&P 500, and Russell 2000 have hit new highs.

Here’s the summary: financial stress tends to be pervasive, affecting everything.? Stress from growth expectations that disappoint tend to be sector-specific, and don’t drag down the market as a whole.

And so the answer to my question that I asked 10+ years ago is “no.”

The Rules, Part LII

Posted on 7 September 2013 by David Merkel

g_e + E/P > i_{longest bond}

Let me explain.? The first term is the growth rate of earnings for a company.? The second term is the earnings yield of a company.? The last term is the yield on the longest, most subordinated bond or preferred stock a company has issued.

The idea here, is that the more risk you take with a company, the more return you should invest for.? Bank debt should yield less than senior unsecured debt, which should yield less than preferred stock, which should yield less than the expected total return from the common stock.

This is a simple idea, but it can occasionally yield good buy or sell ideas when the equation seemingly does not work.? If it does not work, consider buying the bonds and/or selling the stock.? On the other hand, when the equation works, and the gap is wide, consider buying the stock and/or selling the bonds.

The idea is to look for the best risk-adjusted returns, and not be wedded to one particular type of asset.

Another way to think about it is when a company would buy back its shares.? Would it buy them back when it costs more to borrow on safe terms than the company is earning, including likely increases? in earnings?? No, that’s not likely, they might even issue more shares in such a situation.? Buying the shares back requires that the debt or excess cash is less valuable than the stock being bought.

The main point of this rule is to think through the capital structure of a corporation, and look at the relative valuations.? Deviations of expected returns from likely risk deserve attention.

Here’s an example: my boss called me one day and told me he sold short two stocks that afterward doubled on him.? What should he do?? I looked at the bonds of the stocks and saw that they were trading above par.? He thought they were going bankrupt, but the bond market did not agree.? I told him to cover.? He objected, but I said, do you want to cover at a higher level?? Eventually he covered.

Pay attention to all of the securities in the capital structure of companies that you own (or short).? They may give you valuable data that the stock market does not know.

The Rules, Part LI

Posted on 2 September 201320 June 2017 by David Merkel

65% of the time, the rules work.? 30% of the time, the rules don’t work. 5% of the time, the opposite of the rules works.

When I wrote that to Cramer in 2003, his comment was that he loved it.? To me, this meta-rule about market rules in general expresses how markets work.? Re-expressing the three periods:

1) There are rules, and they work most of the time.? Value and Momentum strategies work on average.? So do many other strategies that work off accounting quality, distress, neglect, company quality, low volatility, etc.

2) But they don’t work all of the time.? Sometimes it seems that there is no discernible reward to a strategy, and performance is market-like.

3) But even valid strategies occasionally attract too many followers.? Too many foxes versus rabbits, means that foxes will die.? During those times, you think that the world is coming to an end, but these times are usually mercifully short.

In early 2000, a lot of great value investors got fired.? They had just suffered the worst period of relative performance in a decade, and investors were fed up.? Those firings were a sign that things were about to improve for value investing.? Near market troughs, qualitative signals occur to show that people are giving up because the rules have been reversed.

What does this mean for us regarding portfolio management?? The first and easiest solution is to stick to your discipline no matter what, and ride out the hard times.? After all, the rules work most of the time; you will get rewarded following them.

It is like what Max Heine said to Michael Price during Price’s younger days (extreme paraphrase from memory): If you follow this method, you will earn 15% per year on average.? One year out of ten, you will look like a genius.? One year out of ten, you will look like a loser.? Be mentally prepared for that.

And perhaps, that is the main message here.? Be prepared, like a good Boy Scout.? Be prepared for the days when your strategies, so strong in the past, go dead, or even become corrosive.? That is not a reason to abandon strategies that have a strong argument behind them, like momentum, value, etc.? It is a time to show courage, and buy the best stocks you can find.? Crises test investors, and the best stick to their guns and concentrate on the best opportunities.

The irregularity of the markets exists to shake out market players that cannot handle losses.? Those that cannot handle losses had unrealistic expectations.? Markets are perverse, and they suck in amateurs near peaks, and the amateurs leave near troughs.? They help provide the excess performance of the best.

The second message is to realize there are no strategies that work year-after-year, and that you have to accept years where your normally valid strategies? don’t work, or worse, become toxic. Don’t lose heart.

The third message is after a strategy has had a long run of success, don’t be afraid to lighten up.?? Eventually the evil days come, when the results of investing at high prices relative to value are punished.

Follow the rules, then, and be ready to absorb losses during the fleeting bad times.

The Rules, Part L

Posted on 30 August 2013 by David Merkel

Countries are firms that produce claims on assets and goods

If I were rewriting this today, it might read, “Countries are firms that produce claims on assets, goods, and income, and anything else they can dream of, in order to retain their privileged position.”

Countries exist for defense and internal justice.? That’s the bare minimum; think of it this way: can there be rivals for defense and internal justice without a civil war?? With many other issues, countries may be willing to share the load — charities that deal with the poor, in addition to welfare programs.

Countries have unique taxation rights, and though big businesses and other interest groups may bend countries to their will, the countries still have their rights.? In a crisis, that could be significant.

FDR confiscated gold during a crisis.? Cyprus swiped bank deposits in a crisis.? Argentina meddles with pension monies.? What could governments do as entitlement (welfare) payments rise more rapidly than taxes?? I don’t know for sure, but you can bet there will be some desperate moves made, tapping many sources of income, transactions, and assets, as well as limit benefits via benefits taxation and other methods.

You could even see widespread purging of the SS Disability Insurance [SSDI] rolls in a real crisis.? I think of an former neighbor, on SSDI because of a bad back who was regularly on his roof putting up and taking down Christmas lights.? He always seemed hale & hearty to me, but there he was on the government dole.

To the extent that they can, countries establish the rules of the economic game. reserving the right to change the rules.?? It has to be this way, because aside from God, there is no greater power that can make countries change their ways by fiat.? Yes, there are wars and civil wars, but those have no determinate outcome.? No one orders a country around directly.? Indirectly, things are different, as diplomacy may bring pressure that makes another country compromise.

The model where countries rule over others to get “a piece of the action” is a fair approximation economically of how countries act.? Consider it as you invest, especially with foreign investing.

The Rules, Part XLIX

Posted on 20 August 201320 June 2017 by David Merkel

In institutional portfolio management, the two hardest things to do are to buy higher than your last buy, and sell lower than your last sale.

I’ll tell you about two former bosses that I had.? They are both good men, and I respect them both.? The first one taught me about bond management.? He had a difficulty though.? Typically, he did not like to trade.? When I stepped into his role, but with far less experience, I traded a lot more than he did.? Because I traded more, and liquidity in the bond market is sporadic, I came up with the rule listed above.

The boss had an interesting insight, though: he suggested when you get to large sizes, stocks and bonds are equally illiquid.? I tend to agree.? In my days, I have traded stocks and bonds where I was a disproportionate holder of them, more so with bonds than with stocks.? If you want to learn the microstructure of markets, there is no better training ground than with illiquid securities.? And if you hold a lot of any security, the position is illiquid.

Once you are big, it is hard to trade in and out of positions rapidly.? You have to scale in and scale out, and do it in such a way that you don’t tip your hand to the market, which would then move against you.? Now, it would be easy if you had a fixed estimate of value for the securities, so that you knew whether a proposed buy or sell made sense, but corporate bonds and stocks improve and deteriorate.

Imagine for a moment that you hold five percent of a company’s bonds, and to your surprise, the situation is deteriorating.? Bid prices are falling.? What do you do?? First question: are the bonds money good?? Will they pay off, with high likelihood?? If so, bide your time, and maybe add some more if you have room.? If not, the second question: so what are the bonds worth?? If less than the current price, start selling, but avoid the appearance that you are desperate.? You have a lot of bonds to sell.? For the market to absorb them all will be a challenge.? I would say to brokers, that I was willing to sell small amounts of bonds at the current market, but if someone wanted to buy my full position, I might be willing to compromise a little.? Then you can have negotiations.

More often, in a deteriorating situation, you sell in dribs and drabs as the price of the asset falls.? There is psychological pain as you sell lower, but a good manager dismisses it, forgetting the past and focusing on the future.

Then there was the other boss.? At the interview he asked me, “What is one of the hardest lessons you have learned?”? I said, “In institutional portfolio management, the two hardest things to do are to buy higher than your last buy, and sell lower than your last sale.”

He appreciated the answer, though he had a hard time applying it personally.? He had a tendency to look to the past more than me.? Over the years I have learned to be forward-looking and try to analyze what securities will do the best, regardless of my cost basis.

I got the largest allocation of the Prudential “C” bonds when the deal was done. but I bought an equal amount 10% higher in price terms when it was a great deal in relative terms.? It was tough to buy more at a higher price, but it was still a great yield on a misunderstood bond.

Regret is native to mankind, but you can’t change the past.? You can try to estimate the future.? Don’t think about your cost bases.? Rather, think about what an asset is truly worth, and its trajectory, and manage your buys and sells relative to that.

Forward-looking management wins.? Look forward, and avoid regret.

PS — On Scottish Re (spit, spit) we went through this process.? We bought and bought more as it went down.? I erred in my judgment.? Had I looked at the taxable income, I would have realized that a lot of the profits weren’t real.

Before the company announced its reorganization plan, we doubled our position at a very low price, but then sold the whole thing into an astounding rally when the company announced its plans.? That cut our losses considerably, and we didn’t buy it back.? Eventually, it was worth nothing.? Focus on the future; ignore the past.

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.