The Rules – Page 6 – The Aleph Blog

The Rules, Part XVI

Posted on 13 July 2010 by David Merkel

Governments are smaller than markets; markets are smaller than cultures.

This rule has always had a special place in my heart.? It is an attempt to explain what drives human action in our world.? Though I think economic reasons for action are important, they are not the dominant reason for human action.? Human actions are dominated by the religious and philosophical views of each culture.? That is what men will sacrifice for.? Economics is how they fund those ideals.

Homo Oeconomicus does not exist.? Few live to merely maximize their personal enjoyment of life, narrowly described.? Yes, if one broadens the paradigm to say that enjoyment of life means achieving the unique goals that one might have for influencing society, that might make the two similar, but there is no way for that to be true for all men at the same time, because views differ there.

Cultures are not Neutral with Respect to Economics

Let’s take a step back.? The embedded beliefs of cultures affect what can be done by its inhabitants economically.? Does the culture permit/encourage:

Borrowing and lending with interest? (In non-stilted ways)
Taking risks?? Having a bankruptcy code that is not too punitive?
Avoiding big risks, that might harm parties two or three links removed?
Education of children, such that they are motivated to learn.? (Note: only parents can do this effectively.? Teachers will try, but school cultures depend on parenting cultures.? Lazy parents –> lazy kids.? This applies to children in public, private and home schools.)
Education, so long as we don’t get too many people in any area where there is not enough demand.? (I am thinking of the science and math deficit here.)
Labor flexibility; will a significant subset of people retrain when their area of the economy is no longer in so much demand?
Basic honesty in business dealings?? Business is based on trust.
A strong view of the value of time?? Time is money, and cultures that say “tomorrow” will not prosper as much.
Allowing freedom to business within the basic boundaries of ethics?
Government officials don’t commonly take bribes, or political action committee contributions?
People to have an interest in building something through their lives, and free to pass on the benefits as they wish?
Charity, not welfare, to those who have had a rough go of it.
Fair courts that will adjudicate rights and claims impartially.
Legislatures that will be restrained?
Executive officers and bureaucrats that will balance the varying needs of society in accordance with the laws, and not become pseudo-dictators?
Honest money, where a stable unit of account is maintained, rather than trying to trick people into doing more or less through monetary policy.
And more, I hope you get the idea.

Cultures set the backdrop for what men will value and do.? More than laws and regulations, cultures have the soft power such that it is difficult for a man to imagine other ways to do things rather than the accepted norms of the culture.

Cultures are not contiguous with nations; it is more of a tribal thing.? Some cultures exist inside a single nation, some exist across nations.? I think it boils down to a similar view of life that gets propagated through families sharing a similar world view.

Each nation has a meta-culture that is a weighted average of the influences of the cultures inside it.? The weightings depend on size, and willingness to exert effort.

Over the long haul, I think that culture has a bigger impact on the growth of GDP/person than natural resources of an area.? Hong Kong and Singapore are small examples of successful meta-cultures.? Russia and Venzuela would be examples of a resource-rich places that did not capitalize on its opportunities because of the lack of honesty in government.

Governments Have Limits Relative to their Economies

The present time helps show the limits of governments.? Yes, governments have taken bold actions to prevent a banking crisis.? And, it may have worked, but who can tell two years out?? But the governments took on a lot of debt to do so.? Debt-based systems are inherently less flexible than equity-based systems.? As such, the governments of our world are less capable of meeting a significant crisis than they were ten years ago.

Governments that try to do too much run the risk of growing beyond their meta-culture’s willingness to fund them.? It makes sense for governments to focus on the few things that they should do well: internal security, defense, public health, justice, etc.? Beyond that, the effectiveness of governments breaks down.? Governments that try to favor/disfavor a wide variety of actions through tax and stimulus policies don’t typically achieve what they wish for.? Instead, they get populaces that get a minority of clever people who milk the legal code to their advantage, and pay lobbyists to continue the practice, while the average person is frozen out through barriers to entry.

There is something similar to the Laffer Curve that applies to governments, though the shape is unknown to me.? At some point, increasing tax rates stops leading to an increase in revenues, and at some point beyond that increasing tax rates leads to a decrease in revenues.? Those break points will vary, but the clever rich forever reduce their taxes through loopholes.? For the second break point to be hit, taxes have to rise such that the middle class starts to seek shelter from taxes.

Conclusion

Governments can’t dominate economies or meta-cultures.? If they do, they will enforce relative poverty on their countries.? They have to reflect the basic ethics of their meta-cultures, or they won’t survive for long.? Economies will only grow to the degree that their meta-cultures allow them to do so.? Willingness to take and fund risk are culture-driven.

When you consider international investing, examine the culture that you are investing in and ask whether it will be fair to foreign shareholders.? Ask whether they will have standards of governance as good or better than in your home country.? Ask whether they will be motivated to do their best for themselves and their owners.

Don’t underestimate cultural effects in economies.? Men are not the same everywhere; their cultures lead them to think differently.

The Rules, Part XV

Posted on 19 May 201020 June 2017 by David Merkel

What if securitization allows the economy to expand more rapidly than it would at a price of volatility, when intermediaries would prove useful?

Sometimes securitization and tranching creates securities for which there is no native home.

As the life insurance industry shrinks, it will be hard to find buyers for subordinated structured product.

Securitization is an interesting phenomenon.? Take a group of simple securities, like commercial or residential mortgages, and carve the cashflows up in ways that will appeal to groups of investors.? Do investors want ultrasafe investments?? Easy, carve off a portion of the investments representing the largest loss imaginable by most investors.? The remainder should be rated AAA (Aaa if you speak Moody’s).? Then find risk taking parties to buy the portion that could suffer loss, at ever higher yields for those that are willing to take realized losses earlier.

What’s that, you say?? What if you can’t find buyers willing to buy the risky parts of the deal at prices that will make the securitization work?? Easy, he will take the loans and sell them as a block to a bank that will want them on its balance sheet.

That said, securitized assets are typically most liquid near the issuance of the deal, with the short, simple and AAA portions of the deal retaining their liquidity best.? Suppose you hold a security that is not AAA, or complex, or long duration, and you want to sell it.? Well, guess what?? Now you have to engage in an education campaign to get some bond manager to buy it, or, take a significant haircut on the price in order to move the bond.

It helps to have a strong balance sheet.? If the credit is good, even if obscure, a strong balance sheet can buy off the beaten path bonds, and hold them to maturity if need be.? And yet, there is hidden optionality to having a strong balance sheet — you can buy and hold quality obscure bonds, but if thing go really well, you can sell the bonds to anxious bidders scrambling for yield, while you hold more higher quality bonds during a yield mania.

Endowments, defined benefit pension plans, and life insurance companies have those strong balance sheets.? They do not have to worry that money will run away from them.? The promises that these entities make are long duration in nature.? They have the ability to invest for the long-run, and ignore short-term market fluctuations, even more than Buffett does, if they are so inclined.

If there was a decrease in the buying power of institutions with long liability structures, we would see less long term investing in fixed income and equity investments.? Investments requiring a lockup, like private equity and hedge funds, would shrink, and offer higher prospective yields to get deals done.

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But what of my first point?? There are securitization trusts, and there are financial companies.? During a boom phase, the securitization trusts can finance assets cheaply.?? During a bust phase, the securitization trusts have a lot of complicated rules for how to deal with problem assets.? Financial companies, if they have adequate capital, are capable of more flexible and tailored arrangements with troubled creditors.? Having a real balance sheet with slack capital has value during a financial crisis.? Securitization trusts follow rules, and have no slack capital.? Losses are delivered to the juniormost security.

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Sometime around 2004, a light went on in the life insurance industry regarding non-AAA securitized investments.? In 2005, with a few exceptions, the life insurance industry stopped buying them.? AIG was a major exception.? The consensus was that the extra interest spread was not worth it.? Fortunately for the investment banks there were a lot of hedge funds willing to take such risks.

There should be some sort of early warning system that clangs when the life insurance industry stops buying, and those that buy in their absence have weaker balance sheets.? When risky assets are held by those with weak balance sheets, it is a recipe for disaster.

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During the boom phase, securitization trusts provide capital, cheaper capital than can be funded through banks.? That allows the economy to grow faster for a time, but there is no free lunch.? Eventually economic growth will revert to mean, when securitizations show bad credit results, and the economy has to slow down to absorb losses.

In addition, when losses come, loss severities will tend to be higher than that for corporates.? Usually a tranche offering credit support will tend to lose all of its principal, or none.? (Leaving aside early amortization and the last tranche standing in the deal.)? For years, the rating agencies and investment banks argued that losses on securitized products were a lot lower than that for corporates, because incidence of loss was so low on ABS, CMBS and non-conforming RMBS.? But the low incidence was driven by how easy it was to find financing, as lending standards deteriorated.

Thus, securitization allowed more lending to be done.? First, originators weren’t retaining much of the risk, so they could be more aggressive.? Second, the originators didn’t have to put up as much capital as they would if they had to hold the loans on a balance sheet.? Third, there were a lot of buyers for higher-rated yieldy paper, and ABS, CMBS and non-conforming RMBS typically offered better yields, and seemingly lower losses (looking through the rear-view mirror).? What was not to like?

What was not to like was the increased leverage that it allowed the whole system to run at.? Debt levels increased, and made the system less flexible.?? Investors were fooled into thinking that assets were worth a lot more than they are worth today because of the temporary added buying power from applying additional debt financing to the assets.

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Securitization has been a mixed blessing to investors.? It is brilliant during the boom phase, and exacerbates trouble during the bust phase.? And so it is.? As you evaluate financial companies, have a bias against clipping yield.

Regulators, as you evaluate risk-based capital charges, do it in such a way that securitized products get penalized versus equivalently-rated corporates.? Just add enough RBC such that it takes away any yield advantage versus holding it on balance sheet, or versus the excess yield on equivalently rated average corporates.? It’s not a hard calculation to run.

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Off-topic end to this post.? I added Petrobras to my portfolio today.? Bought a little Ensco as well.? I haven’t been posting as much lately since I was busy with two things: studying for my Series 86 exam, which I take tomorrow, and I gave a presentation on AIG to staff members on the Congressional Oversight Panel the oversees the TARP yesterday.? Good people; they seemed to appreciate what I wrote on AIG’s domestic operating subsidiaries last year.

Full disclosure: Long PBR ESV

The Rules, Part XIV & Thoughts on Maiden Lane LLC, Part 1

Posted on 18 May 201020 June 2017 by David Merkel

Prepayment and default are dual to each other.? The less likely is default, the more likely is prepayment, and vice-versa.

In a pool of loans, the critical distinction is the likelihood of loans to prepay or default.? Just because prepayment has been high, does not mean the remainder won?t default under stress.

I don’t have clear answers to Maiden Lane LLC, the bailout of Bear Stearns yet.? The complexity of Maiden Lane LLC, as compared to Maiden Lane 2 or 3, is enormous.? I have a more work to do.? But, at least, I have scrubbed the data, and figured our what the Fed released to us.

In the Bear Stearns bailout, the Fed received a wide variety of securities, including:

Cash

CDOs

Comm RE WLs

CRE Notes

Agency pools

Agency MBS

WL MBS

ABS

Res Re WLs

Treasuries

CDS CDOs

CMBX

CDS Corporate

CDS CRE Securities

CDS Municipal

CDS WL MBS

CDS ABS

Interest Swaps

Maiden Lane 2 & 3 were simple compared to this, and this had over 10x the securities of both combined. Plus, this had CDS transactions which would profit from failure of a wide variety of assets.

Additional difficulties included a lot of coding difficulties on the CDS.? The Fed did not try to make things clear.? I spent many hours trying to clarify the tranches in question.? A few of them are guesses, but 99% are reliable.

The Fed’s principal figures were original principal figures not those for current principal.? That was another area of ambiguity.

After all that, here is my breakdown of?the assets by original principal:

And, here is my breakdown of the assets by current principal:

–

The current value of what is owed to the Fed is over $28 billion.? There is almost $49 billion in current principal, so why worry?

Worry because of all of the interest only securities.? The principal for them is notional; principal payments will never be made.? With CMBS, I know that IO securities are typically worth no more than 5% of the notional principal balance.? Because most CMBS protect against prepayment, the prices of interest only securities reflect? the likelihood of default.? Though they are rated AAA, their creditworthiness is more like BB.

With Residential mortgages, the question is harder.? How big is the interest margin, and when might it cut off due to default or prepayment?? Interest only securities are typically worth a lot less then the? notional principal.? Same for principal only securities.? Their value is the likelihood of payment discounted by the length of time until payment.

Beyond that, there are the residential and commercial loans made, with almost $10 billion of principal, for which we have no idea of the creditworthiness.? Are there any statistics on the currency of the collateral?? The Fed had not deigned to tell us.? I place the creditworthiness at BB, but who knows for sure?

I can tell you now that the securities involved were mostly originated 2005-2007, during the worst of the underwriting cycle.? Is it any surprise?? Few can escape the credit cycle.? Within a given credit cycle, the credit quality of securities originated declines all of the way till slightly past the peak of the credit cycle.

I am going to do more analysis of the RMBS, so that I can get a better feel for the value there.? It is not clear to me whether Maiden Lane LLC is adequately funded or not.? The high degree of junk, whole loans, and interest only securities gives me doubt.

The Rules, Part XIII, subpart C

Posted on 4 May 201020 June 2017 by David Merkel

The need for income naturally biases a portfolio long.? It is difficult to earn income without beneficial ownership of an asset ? positive carry trades will almost always be net long, absent major distress or dislocation in the markets.? Those who need income to survive must then hope for a bull market.? They cannot live well without one, absent an interest rate spike like the late 70s/early 80s.? But in order to benefit in that scenario, they had to stay short.

More with Less.? Almost all of us want to do more with less.? Save and invest less today, and make up for it by investing more aggressively.? We have been lured by the wrongheaded siren song that those who take more risk earn more on average.? Rather, it is true 1/3rd of the time, and in spectacular ways.? Manias are quite profitable for investors until they pop.

As I have said many times before, the lure of free money brings out the worst in people.? Few people are disposed to say, “On a current earnings yield basis, these investments yield little.? I should invest elsewhere,”? when the price momentum of the investment is high.

I will put it this way: in the intermediate-term, investing is about buying assets that will have good earnings three or so years out relative to the current price.? Whether one is looking at trend following, or buying industries that are currently depressed, that is still the goal.? What good investments will persist?? What seemingly bad investments will snap back?

That might sound odd and nonlinear, but that is how I think about investments.? Look for momentum, and analyze low momentum sectors for evidence of a possible turnaround.? Ignore the middle.

Less with More.? Doesn’t sound so appealing.? I agree.? As a bond manager, I avoided complexity where it was not rewarded.? I was more than willing to read complex prospectuses, but only when conditions offered value.? Away from that, I aimed at simple situations that my team could adequately analyze with little time spent.

That is one reason why I am not sympathetic to those who lost money on CDOs.? We had two prior cycles of losses in CDOs — a small one in the late ’90s, and a moderate one around 2001-2003.? CDOs are inherently weak structures.? That is why they offer considerably more yield relative to similarly rated structured assets.

So, for those buying CDOs backed by real estate assets mid-decade in the 2000s, I say they deserved to lose money.? Not only were they relying on continued growth in real estate prices, but they were reaching for yield in a low yield environment.? Goldman and other investment banks may have facilitated that greed, but the institutional investors happily took down the extra yield.? No one held guns to their heads.? The only question that I would raise is whether they disclosed all material risk factors in their prospectuses.? (Not that most institutional investors read those — they call it “boilerplate.”)

Reaching for yield always has risks, but the penalties are most intense at the top of the cycle, when credit spreads are tight, and the Fed’s loosening cycle is nearing its end.? It is at that point that a good bond manager tosses as much risk as he can overboard without bringing yield so low that his client screams.

Perhaps the client can be educated to accept less yield for a time.? I suspect that is a losing battle most of the time, because budgets are fixed in the short-run, and many clients have long term goals that they are trying to achieve — actuarial funding targets, mortgage payments, college tuition, cost of living in retirement, endowment spending rule goals, implied cost of funds, etc.

That’s why capital preservation is hard to achieve, particularly for those that have fixed commitments that they have to meet.? It is impossible to serve two masters, even if the goals are preserving capital and meeting fixed commitments.? Toss in the idea of beating inflation, and you are pretty much tied in knots — it goes back to my “Forever Fund” problem.

This third subpart ends my comments on this rule.? You’ve no doubt heard the Wall Street maxim, “Bulls make money; Bears make money; Hogs get slaughtered.”? Yield greed is one of the clearest examples of hogs getting slaughtered.? So, when yield spreads are tight (they are tight relative to risk now, but could get tighter), and the Fed nears the end of its loosening cycle (absent a crisis, they are probably not moving until unemployment budges, more’s the pity), be wary for risk.? Preserve capital.

The peak of the cycle may not be for one to three years, or an unimaginable crisis could come next month.? Plan now for what you will do so that you don’t mindlessly react when the next bear market in credit starts.? It will be ugly, with sovereigns likely offering risk as well.? At this point, I wish I could give simple answers for here is what to do.? What I will do is focus on things that are very hard for people to do without, and things that offer inflation protection.? What I will avoid is credit risk.

The Rules, Part XIII, subpart B

Posted on 1 May 201020 June 2017 by David Merkel

To short bonds with success, you have to identify a tipping point.? The one shorting a bond borrows it and then sells it.? After that, he has to pay the interest on the bond, and maybe a little more, if the bond is hard to borrow, while he waits for the bond’s price to collapse.? If the capital losses to a holder of the bond are not greater than the interest paid, the short loses money.? (Yes, he makes some money off of interest on the proceeds from the sale, but let’s ignore that for now.) Bonds mostly have finite maturities; time can work against the short seller as the bond gets closer to maturity, because the bond will mature at par, and he will have to pay the par value.

The same applies to credit default swaps [CDS].? The party buying protection must pay for the protection. He looks for a disaster to happen, but as time elapses, and gets closer to the swap termination date, the odds of making money off of a failure declines.

Thus being short any sort of fixed income, whether through shorting or CDS involves paying money out regularly to support the position, with the possibility of incredible payoffs if default happens within the lifetime of the bond or CDS.

This mindset is the opposite of the way bond managers think.? A common way they view things is to maximize expected yield over the expected lifetime of their liabilities.? That is a simple way for bond managers at banks, insurance companies, pension funds and endowments to manage their bond assets.? It is not so easy for total return mutual fund managers, because they can’t tell with accuracy how patient/jumpy their mutual fundholders will be.? Typically, they pick an index of bonds, and mirror the most critical aspects of it — duration, convexity, credit quality, etc.? Retail investors don’t care about that but they look at the return series, and analyze whether the volatility is too great or too small for them, and if they have beaten many of their peers.

To a good bond manager, he aims to add risk when he is well compensated for it, and reduce risk when it is not well compensated.? That said, many bond managers have dumb clients.? They want more yield, because they think that yield is free.

I remember the Chief Actuary of a client insurance firm saying to me, “Why can’t you earn the returns of ARM Financial, General American, Jefferson Pilot, and Conseco?? (This was around early 1999.)? My response was: “You want to take absurd risks?? Not only do these firms take asset risks, they are taking more risks than any large firm that I can find.? They take asset risks everywhere.? Worse, their liability structures are weak, and their leverage is high.? A lot of their liabilities can run at will.”

It was not long before General American and ARM Financial failed.? Conseco took a few more years; the acquisition of Green Tree helped kill them.? Jefferson Pilot wasn’t as bad as the others, but they sold out to Lincoln National while they could.

It is foolish to be a yield hog.? Yet, many institutional investors were yield hogs prior to the crisis.? Someone had to buy the CCC junk bonds.? Someone had to sell protection in order to receive yield.? The investment banks could not manufacture gains for those shorting the mortgage market on their own.? There had to be yield hogs that wanted to receive yield in exchange for guaranteeing debts.? Given the low interest rate environment that they faced, many parties felt they needed to earn more.? AIG in particular offered protection on many bonds in order to suck in extra income so that earnings estimates might be achieved.? They were the ultimate yield hog, and like most hogs, they got slaughtered.

As for the one offering protection, he must be sure that there is no tipping point over the life of the swap.? Then the extra yield would be safe.

I have more to say on this, but let me summarize for now.? The need to earn income biases many bond investors to take too much risk.? Repeat after me: “Yield is not free.” It exists because of perceived risks; the great question is whether the perceived risks are underplayed, overplayed, or accurate.? The good bond manager looks at the risks versus the incremental yields, and spreads his investments among? a mix of good risks.

The Rules, Part XIII, subpart A

Posted on 1 May 201020 June 2017 by David Merkel

My paternal Grandfather invested in CDs through the interest rate? spike of the late 70s and early 80s.? He looked pretty smart for a time, but he never shifted to take risk when there was a reward to do so.? Contrast my Mom, who had her 50/50 mix of utility stocks and growth stocks (a clever strategy, which as far as I know, she thought up herself).? As she once said to me, “My utilities are my bonds.”? Though my Mom’s strategy underperformed my Grandfather’s in the short run, in the intermediate term it soundly beat his strategy.? Long term?? No contest.

There is something about yield.? Almost everyone wants to have it, and have more than what would be average.? My own equity portfolio throws off more yield than the S&P 500, even with 19% earning nothing in cash.? There is something tangible about yield: cash in hand, vs. uncertain capital gains, even if the dividend leads the stock price to drop.

There is a sense that yield is free, like harvesting eggs from your chicken coop in the morning.? Mentally, that is the way that many view it.? They may adjust the yield for risk of nonpayment, but there is a tendency to assume that the yield will come in.

Here’s an example: in 1999-2000, Morgan Stanley did a piece on some corporate bonds that they called, “The Dirty Thirty.”? They were the worst of BBB-rated bonds, but they argued off of a limited period of past returns, that the widening in yield spreads over Treasuries was not justified, so but them because they survive and outperform.? Very bad timing, I must say.? Many of the companies defaulted 2000-2002, and enough came under severe stress, that those with weak balance sheets kicked them out at the wrong time, for fear of their possible insolvency.

This was a prime example of a brokerage providing advice that was technically correct off of history, but deadly wrong with respect to the situation at hand.? Now, was Morgan Stanley trying to lighten its inventory of Dirty Thirty bonds?? I don’t know, but I suspect not.? Most corporate bonds of large corporations are liquid enough that they can be bought and sold easily.

Truth is, if you are a bond manager, you get lots of sell side research telling you how to get a higher yield.? To clients who report on a book value basis, like banks or insurers, that is manna, or pennies from Heaven.? Yield goes straight to the bottom line.? Capital gains or losses can be deferred, at least until default or maturity, and even if they are realized, analysts exclude them from operating earnings.

Thus the tendency for many regulated financial institutions to be yield hogs, unless the management team has religion regarding risk control.? As for me, I held the unique position of being risk manager and leading corporate bond manager at one job.? There was a conflict of interest there, but for me, it enabled me to be more cautious, and more risk-taking at appropriate times.? Gaining real market experience is something most risk managers never get, but it imparts knowledge of likely ways in which asset management can go astray.

It can easily go astray.? As Warren Buffett says, “If you’ve been playing poker for half an hour and you still don’t know who the patsy is, you’re the patsy.”? Goes double for trading with the main desks on Wall Street.? They look for weaknesses, and the leading weakness is being a yield hog.? They will more than happily dig up yieldy securities that are more risky than normal for such a client, because the client wants it, and it is easy to find those securities.

The investment banker may think the client is dumb, but he is under no obligation to tell him so.? And besides, in investments, who knows?? The client may know things that the investment bank does not.

To illustrate, I got cheated on my first corporate bond trade with CSFB.? It looked like a good trade to me.? It would gain incremental yield on a seemingly similar security.? My boss was gone, so I, the new assistant, made the trade.? On a $5M trade, I lost $20K instantly.? My boss was leaving for another job in a week, but he chewed me out anyway, and told me at some firms I would have been fired for what I had done.

I took it to heart, and hyperanalyzed the trade to understand all of my errors.? I did not make those errors again, and I was very diligent to be a skeptic regarding the trades that I did with the big firms.? That did not mean that I did not trade, but that I drove the trades that I did, rather than accepting the trades that the Street suggested.

Instead, I relied on our in-house analysts to do our digging, and I became persistent at pursuing what we wanted, and enlisted second-tier brokers that could help us.

I would often do swap trades that gave up yield, if I saw a greater improvement in the risk profile.? That is rare among bond traders.? Even among professionals, there is a bias toward more yield.? I ended up preserving capital for our main client, allowing me to reinvest at favorable yields as the crisis was cresting.

The bias for yield among individual investors is worse, and Wall Street readily takes advantage of individual investors in order to hedge expensive options by offering seemingly high yields through structured products.? The credit and interest rate risks take away what the yield offers, and more.? That’s the business, and smart investors stay away.? Don’t be the patsy at the investment poker game.

The Rules, Part XII

Posted on 30 April 201020 June 2017 by David Merkel

Growth in total factor outputs must equal the growth in payment to inputs.? The equity market cannot forever outgrow the real economy.

This is the “real economy rule,” and was listed first in my document, but i have not gotten to it until now.? It is very important to remember, because men are tempted to forget that financial markets depend on the real economy.? If the global economy grows at a 3% rate, well guess what?? In the long run, payments to the factors — wages, interest, rents, and profits will also grow at a 3% rate.? Maybe some of the factor payments will grow faster, slower, or even shrink, but you can’t get more out of the system than the system produces year by year.

The value of equity is the capitalized value of the profit stream.
The value of debt is the capitalized value of the interest stream.
The value of property, plant and equipment is the capitalized value of the rent stream.
The value of a slave/employee is the capitalized value of the wage stream.

Hmm, that last one doesn’t sound right.? We no longer capitalize people, as if one could legally own a person today.? Contracts for labor are short-term, and employees typically can leave at will.

But, there can be bubbles in property, debt and equity markets.? We just happen to be the beneficiaries of a situation where we have simultaneously had bubbles in all three.? Think of late 2006 — high values for residential and commercial real estate, low credit spreads, and high P/Es (relative to future profits).? Market participants expected far more growth than the overindebted economy could deliver.

Important here are the discount rates.? By asset class, relatively low discount rates relative to swap or Treasury yields indicate complacency.? It is one thing if stocks move up because profits are rising rapidly, and another if the discount rate is declining.? Similarly, it is one thing if stocks are rising because GDP is growing rapidly, and thus revenues are rising, and another thing if it is due to profit margins rising, and profit margins are near record levels, as they are today.

Extreme profit margins invite competition.? Extreme profit margins tend not to last.

In many asset classes, investors were fooled.? Home buyers bought thinking the prices could only go up.? They ignored the high ratio of property value relative to what they would currently pay.? Commercial real estate investors bought at lower and lower debt service coverage ratios.? Collateralized debt investors accepted lower and lower interest spreads at higher and higher degrees of leverage.? With equity, investor assumed that growth in asset values in excess of growth in GDP would continue.? The stock market does grow faster than GDP, but the advantage is less than double GDP growth.

Thus after the long rally, with no appreciable growth in the economy, I would be careful about equities, and corporate debt as well.? Some yields are high relative to long run averages, but the risk is higher as well.

The main point is to remember that the real businesses behind the financial markets drive performance in the long haul, even if adjustments to the discount rate do it in the short run.? To be an excellent manager, focus on both factors — likely payments, and rate at which to discount.? But who can be so wise?

The Rules, Part XI

Posted on 20 April 201020 June 2017 by David Merkel

Could an investment bank go to junk status?

Some of my “rules” were phrased as questions.? I wrote that one prior to 2002, possibly musing about downgrades in the credit ratings of investment banks.? But today we know the answer: NO.

There are functions in the credit markets that only belong to strongly capitalized entities.? Anything involving a large degree of credit risk requires an exceptionally strong balance sheet.? Though my original question was about investment banks, think of mortgage and financial insurers.? Where are they today?

Looking at my list of financial/mortgage insurers from three years ago, this is what I find:

Ambac Financial Group [ABK] — Aaa/AAA to C/CC (default in all but name)
ACA Holdings — A to default
Assured Guaranty — Aa3/A+ to A3/A+
MBIA Inc — Aa2/AA to Ba3/BB-
MGIC — A1/A to Caa1/CCC
PMI — A1/A to Caa2/CCC+
Primus Guaranty — Baa1/BBB+ to B2/CCC
RAM Re — Aaa/AAA — Ba3/NR
Radian — A2/A to Caa1/CCC
Syncora — Aaa/AAA to default
Triad Guaranty — A- to default.

Let me make a modest suggestion: financial and mortgage insurance does not work in times of extreme financial stress.? Aside from Assured Guaranty every insurer offering coverage from financial/mortgage risks got smashed.? Aside from AGO, all are at junk credit levels.

What this says to me is that the method of regulating financial and mortgage insurers is wrong.? Financial risks are more severe than other risks, and a greater amount of capital must be held for solvency. When financial risks go bad, many risks go bad.

But wait, you say, at the greater level of capital, no one will buy the insurance.? That might be true in the short run, but in the long run pricing levels will adjust.? Insurance for mortgages will be bought, if the credit is secure.

Back to investment banks.? They must be fundamentally sound institutions, given the high degree of leverage employed.? Once they have a junk rating, fewer will do business with them, much like the financial insurers.

As a result my answer is no, no credit-sensitive institution can be junk-rated.? Even a low-investment-grade rating is a stretch. During the boom phase, any investment grade rating can work; in the bust phase only the best market practices maintain a credit rating. and few credit sensitive entities maintain an investment grade rating.

The Rules, Part X

Posted on 18 April 201020 June 2017 by David Merkel

The more entities manage for total return, the more unstable the financial system becomes.

The shorter the performance horizon, the more volatile the market becomes, and the more index-like managers become.? This is not a contradiction, because volatile markets initially force out those would bring stability, until things are dramatically out of whack.

I was at a conference on Stable Value Funds, I think around 1995.? The meeting hadn’t started? but a few attendees? had arrived.? We were talking about the need to find yield in the market when one said (with an arrogant attitude), “Yield?? Why not total return?”

A tough question, and one none of us were ready for at the time.? My thoughts a few days later were on the order of, “If only it were that simple.? Right, you can generate positive returns over every time horizon worth measuring.? Okay, Houdini, do it.”

Total return investors don’t have long time horizons.? Investors with short time horizons either aim for momentum plays, or aim for yield.? Momentum persists in the short run, so play it if you must, remembering that the market gets more volatile when many play momentum.

Yield is less volatile than momentum, at least most of the time.? But yield is a promise, and frequently disappoints during times of stress.? Look at all of the dividend cuts over the past two years.

But consider this from a different angle.? Imagine your boss comes to you and says, “I want you to deliver the best returns to me every day versus the S&P 500.”? Okay, beat the S&P 500 every day.? That means the portfolio has to be a lot like the S&P 500, with some tweak that will beat it.? Anything too different from the S&P 500 will miss too frequently.

Now, I would say loosen up, why constrain daily performance?? Aim for great returns over the long haul, and don’t sweat years, much less days.? Great asset management requires a willingness to be wrong over significant periods, with a strong sense of what will work in the long run.

Those with short horizons will tend to index relative to their funding need, whether it is cash, short bonds, or indexed equities.? Note that most managers should have long horizons, but clients evaluate the returns of the past quarter or month, and the manager feels as if he is on a short leash, which makes him look to the next month or quarter, and makes him invest more like an index.

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If you have a good manager, set him free — lengthen the performance horizon; give him room to do things that are unorthodox.? Ignore the consultants with their foolhardy models that constrain manager behavior.? Let me tell you that you are brighter than the consultants, and can better manage managers than they do.? Their models encourage managers who hug the indexes to avoid doing too much worse than them, and so you get index-like performance.

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At turning points, a different breed of investor shows up.? At busts, investors show up who will buy and hold, bringing stability to the market.? They look at fundamental metrics and conclude that their odds of losing money are small.? At the booms, a different investor leaves.? They will sell and sit on cash.? Similarly, they think the odds of losing money, or, not making as much, is large.

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Good money managers think long term, but all of the short-term measurements fight against that.? They force managers to think short term, or else their assets will leave them.? That is a horrible place to be.? Better that clients should ignore the consultants, and aim for the long-term themselves.? You will do much better choosing managers for yourselves and ditching the consultants who (it should be known) merely chase performance.? With help like that, you may as well invest in the hottest stocks with a portion of your portfolio — you might do better than you are doing now.

The Rules, Part IX

Posted on 13 April 201020 June 2017 by David Merkel

A few readers have asked me where they can find a list of my “Rules” posts.? You can find such a list here.? One further note on the “Rules” posts — I’m not exactly sure how many there will be, but if I write all of them, there will be around 50 of them.? Should I live so long, and readers still enjoy the series, maybe I would write the last one in 2011.

Here’s tonight’s rule: Attempting to control a system changes it.

Maybe tonight’s rule deserves the “Duh!” award, but it reminds me of reading THE ART OF WAR, by Sun Tzu.? Most of what Sun Tzu writes about is really basic, but it is amazing how many times generals neglect his easy advice, and bullheadedly persist in unwise courses of action.

Well, it is that way in politics and economics as well, and we don’t seem to learn from history.? Go back to the 1960s, when economists discovered there was seemingly a tradeoff between unemployment and inflation.? All they had to do to minimize unemployment was raise inflation.? So, easy; print more money, and there will be less unemployment.

It didn’t work that way.? People got used to the inflation and assumed that inflation would occur at that higher level indefinitely, and unemployment didn’t drop.? Instead, we got stagflation in the 1970s.

I would point out the same thing to those who run the Eurozone if they would listen to me.? I feel privileged to have 29% of my readership coming from outside of the US.? Most of that is in Europe, with significant amounts in Canada, Israel and the financial centers of Asia.

The Euro was never supposed to be an area where the nations would be joint-and-severally liable for each other’s debts.? Indeed, nations were supposed to restrain their borrowing so as to avoid such and occurrence.? Bailouts change behavior.? Those that are bailed out see less need to change radically.? Those that are near being bailed out do not see a reason to stop borrowing.? Those that are in no imminent trouble, but would like more latitude in borrowing see a green light to borrow more.? Upshot: bailing out Greece leads to many perverse consequences.? It lowers the probability of individual nations defaulting in the short run, while raising the risk of total system failure in the intermediate-term.? The Eurozone is not a nation; there is little sympathy across national borders such that they would send tax dollars to bail another nation out of their debt crisis.

Or, consider US Monetary policy (or, most developed nation monetary policies, they have been pretty similar): the continual effort to promote prosperity via monetary policy, contra William McChesney Martin, Jr.? Monetary policy can’t create prosperity.? It can restrain inflation.? Attempting to use monetary policy to create prosperity was the Greenspan and Bernanke era.? They lowered interest rates, and raised asset values.? That is no prosperity, though, because the assets throw off the same cash flows.? Only the discount rate has changed.? Any asset has a higher Net Present Value when the discount rate declines.? That is all that Greenspan and Bernanke ever did, to a first approximation, is lower the discount rate.? The wealth effect stimulated consumption and additional indebtedness.

Or consider US housing policy.? We have spent bundles of money trying to entice marginal buyers to buy homes.? It is as if those that don’t own homes are inferior — a threat to society.? But have all of the efforts to increase the home ownership rate worked?? The jury is out; maybe in two years we will know for sure, but to me it seems that encouraging home ownership has been a disastrous social experiment.? I’m not an environmentalist, but isn’t it greener to have dense cities with apartment dwellers?? Face it, many people can’t maintain the discipline of a mortgage payment, regardless of what incentives are offered on the front end.

Or, consider US medical policy.? There was a time when medicine was relatively inexpensive, and people avoided using the medical system.? That was prior to offering a tax deduction for employer paid medical care, and Medicare.? Once people get separated from paying the immediate cost, they are far more willing to seek expensive care.? The insurance industry itself lost money for 20 years, because it failed to see the change in behavior the would happen once people were insured.? That is why my main recommendation for healthcare is to remove the tax deduction for all.? (Maybe leave the deduction on HSAs, and things like them.? Those are first party payer systems, and people won’t spend aggressively with them.

This is a major reason why I am a skeptic about the recent health bill.? You can’t get something for nothing.? A bill that cuts costs should result in less services, unless greater freedoms are allowed, and this bill does the opposite of that.? Single-party payer systems work because they restrict access to care, something that Americans will have a hard time adjusting to.

Or, look at the Japanese economy over the last two decades.? Keynes triumphs.? Low interest rates, and a lot? of government spending on marginal projects.? Huge increase in government debt.? Is the nation better off?? Hard to tell; wait to see if they survive to 2020 without a debt crisis.

Summary

In economics, one of my firmest beliefs is that you can’t get something for nothing.? A government increasing regulation may change the behavior of an area of the economy, but will not increase overall economic well-being.

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