Search Results for “Education of an investment risk manager” – Page 2

Ten Years of Investment Writing

Posted on 12 November 2013 by David Merkel

I’m late on this.? My first foray into public writing on investing was when I started writing at RealMoney on October 17th, 2003.? But how did I get there?

Sadly, almost all of the works of RealMoney prior to 2008 are not accessible.? My first effort was writing Jim Cramer the day after General American Life Insurance failed on August 10, 1999.? He wrote a short piece asking why no one was paying attention to the failure of a major life insurer.? He wanted to know what happened.? I had heard about the failure, and so I searched for more data on it, and I saw Cramer’s article, only one hour old, so I sent him an e-mail as “your friendly neighborhood investment actuary.”

I explained the situation to him in about three hundred words, and lo and behold, my e-mail was featured in a post by Cramer that very day saying how amazing it was that he could get such a cogent explanation that was not available elsewhere on the web.

Not wanting to wear out my welcome with Cramer, I e-mailed him maybe eighty times over the next four years, with occasional e-mails to Herb Greenberg and Howard Simons.? I e-mailed mostly bond market and insurance information.? But in the period from 2000-2003, information on the bond market from an active institutional participant was interesting.? At least, I thought so, and Cramer usually returned my e-mails, as did Herb Greenberg.

In August 2003, after I had taken a job as an insurance equity analyst at a financial services only hedge fund, Cramer e-mailed me, asking me to write for RealMoney.? I don’t have the actual e-mail, but he said something to the effect of “You write better than most of our contributors.? Please come write for us.”

I went to my boss to ask permission, and he refused.? After some pleading on my part, he eventually relented.? That said, when Cramer wanted me to appear on “Mad Money,” he refused, and did not give in.? He did not want the name of his firm associated with Cramer.? I was disappointed, but I understood.

At RealMoney, I wrote about a wide variety of topics as I do at Aleph Blog.? My editor one day called me and after we chatted for a while she said to me, “Did you know that you are our most profitable columnist after Cramer?”? I expressed surprise, and asked how it could be.? She said that I wrote more comments in the columnist conversation than most, and my comments were substantial.? Also, readers would read and re-read my posts, which was rare at RealMoney.

My objective was to teach investors how to think.? I did not want to get into the “buy this, sell that” game.? My most unpleasant memories revolve around bad calls that I made on a few stocks.? I think it was fewer than five stocks, but when you get it badly wrong, passions are heightened.

Cramer and I often disagreed with each other at RealMoney.? I felt I had friends with Cody Willard and Howard Simons, and a few others like Aaron Task, Roger Nussbaum, Peter Eavis, etc.? If I didn’t mention you, please don’t take that as a slight, I just can’t remember everything now.? I thought highly of most of the cast at RealMoney, including the news staff, who would occasionally call me for advice on bonds, insurance, or investing theory issues.

I resisted the idea of starting a blog.? I said to my editors at RealMoney, “The Columnist Conversation is my blog.”? But in early 2007, while trolling the comment streams on Jim Cramer’s blog, and making comments defending him, a number of readers told me that I was one of the best writers on the site, so why didn’t I emerge from Cramer’s shadow?

I thought about this hard for about a month, and then I did it, after doing my research.? I created Aleph Blog, with the first post coming on 2/17/2007, and the first real post on 2/20/2007.? That first real post was prescient, and laid out a lot of what would happen in the bust.

But as I started, the Shanghai Market crashed, and Seeking Alpha pushed one of my posts to the top of their front page.? Cody Willard pushed another post of mine to his media contacts.

I was off and running without doing that much to advertise my blog.? I appreciated that because I think the best way of advertising my blog is to write good content.? I don’t generally like to quote large amounts of the writing of others, and add a few comments from me.? To me, that seems lazy.? I would far rather spend some time, and give you my thoughts.? I’m not always right, but I am always trying to give you my best.

After ten months of blogging, I stopped contributing to RealMoney because I liked the editorial freedom that bloggng offered.? I was never writing for RealMoney in order to get paid, so not getting paid at Aleph Blog was not a problem.

At Aleph Blog, I write about what resonates within me.? That usually produces the best results, though because I write about a wide variety of topics, some people don’t know what to expect of me, and aren’t interested in what I write.? I understand that, and I am not unhappy with a smaller audience.

What I did not expect when I started blogging was that I would do:

Book Reviews
The Education of a Corporate Bond Manager
The Education of a Mortgage Bond Manager
The Education of an Investment Risk Manager
The Rules

and other series at my blog.? I did not consider that I might be a conference blogger for notable institutions like Bloomberg and the Cato Institute.

I also did not realize that I would take aggressive stances against a wide number of semi-fraudulent financial practices like penny stocks, structured notes, private REITs, and a wide variety of other bad investments.

It’s been a lot of fun, and I did it to give something back.? With great power comes great responsibility, and that is why I blog.? Nothing more, nothing less.

May the Lord Jesus Christ bless you.

Thanks for reading me.

David

The Education of a Mortgage Bond Manager, Part IX

Posted on 13 February 2013 by David Merkel

The Negative Convexity Project

Me: We can’t buy the majority of Residential Mortgage Backed Securities [RMBS] anymore.

Boss: What! That is a staple asset class of ours.? There’s nothing illegal about life companies owning RMBS.

Me: nothing illegal, yes, but because of new cash flow testing rules which our client is subject to, the negative convexity of RMBS will force our client to put up more risk-based capital than they would otherwise have to.? Most RMBS will require so much additional capital that the additional yield is uneconomic, and that assumes we get the yield when we want it, ignoring prepayment and extension risks.

Boss: I can’t believe that we can’t buy any RMBS… are there any exceptions?

Me: There are a few.? You know about the odd RMBS classes that have positive convexity, but little yield?

Boss: Yes, Yes… but why would we want to buy that?? Our client needs yield!

Me: I know that.? Would that they could do something other than need yield to sell yield.? There is one type of RMBS that still fits, and it is the NAS bond [Non-accelerating security], last cash flow structure.? Also, some of the credit-sensitive RMBS bonds rated less than AAA don’t affect the convexity issue, but we might not want to buy them, because the additional yield per unit risk is not compelling.

Boss: So what do we do?

Me: Buy NAS bonds when they are attractive, and buy CMBS that is attractive, after that look to corporates that our analysts like.

Boss: You are right, but I hate to lose a staple asset class.

=–=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-==–=-=-=-==-=-=–=-=-=-=-=-=-=

What I wrote there took longer than a single conversation, and involved contact with the client as well.? The client was very conservative with capital, because they levered up more than most life insurers.? The results of detailed cash flow testing would affect large annuity writers like my client, and negative convexity would make them put up more capital, constraining the amount of business they could write.

Wait: negative convexity simply means your bond portfolio hates interest rate volatility — it does better when things are calm.? That is certainly true with residential mortgages, where people refinance easily when rates fall, and in that era, no one faced falling property prices.

It took some effort, but I made my case to the client and my boss, and we stopped buying most RMBS.? As an aside, it made asset-liability management tighter.

Alternative Investments

I was not totally hidebound with respect to derivatives.? I bought our first asset-swapped convertibles, and synthetic corporates.? If the risks associated with getting additional yield were small, I would take those risks.? In both cases, they converted other asset into straight corporate debt (plus counterparty risk).

But I wouldn’t do anything.? I grew to hate CDOs, as I saw how perverse the structure was. I remember one weird CMBS deal structure that added a note that combined the AAA, BBB & BB CMBS of the deal.? What a nice yield, but the riskiness was greater than my models would allow for the incremental yield.

Finally, for this piece, the “piece of work” broker that I have previously described pitched me a private placement debt deal for a power producer affiliated with his firm.? After hearing the initial spiel, I said, “Okay, soft-circle me for $25 million, subject to due diligence; send me all of the hard data via email and paper.”

My request should not have obligated me to buy the deal.? Indeed, when I got the hard data, and began estimating the counterparty risks, I thought the deal was a loser, so I contacted the “piece of work,” and said, “Sorry, but we are dropping out of the deal — it just doesn’t offer enough value for the yield.”? After some arguing, he eventually said, “Look, stay in the deal, and I promise you that I will get you out at par at minimum on deal day.? Okay?”

Sigh, even though he was number eight with us, he served an important firm that could potentially do a lot for us, so I agreed.? The day of the deal came, and indeed, he got us out at a teensy premium (I would have accepted par, maybe even a slight scrape).? The deal did horribly, at least initially, though I have no idea of what the eventual credit result was.

As my boss who taught me bonds would say, “On Wall Street, if you want a friend, get a dog.”? There are some honorable people on Wall Street, but the economics of Wall Street often leads to suboptimal results for clients, and indeed, the salesmen may be sweet enough, but they live to distribute paper; they don’t live to be your friend in any true sense.? Professional duty to company trumps friendship.

The Education of a Mortgage Bond Manager, Part VIII

Posted on 12 February 2013 by David Merkel

I sat down this evening, thinking that I would finish the series this evening, and realized that I had left out some significant things.? As such, I expect this series to have two more parts after this one.

Traveling to Annapolis

When you are an actuary, and a good one, you have elements of being a jack-of-all-trades.? Knowing the math is not enough, you have to understand the business processes that the math summarizes.? That also requires some knowledge of the law.? From early in my career, I realized that the insurance company lawyers would not help me with reserving, investing, contract provisions, and other legal questions, so I had to go to the law library and answer the questions myself.? Not fun, but I ended up learning a lot.

While working on another project one day, I made a copy of the Maryland life insurance investment code.? I took it back with me, saying to myself: “It’s only eight pages, written in 1955.? Don’t you think you should know the details of what your local regulator allows?”

Dangerous question, and it led to the following: under a strict interpretation of the law, we were in violation of the law.? Here is the key question: are asset-backed securities bonds?? They trade like bonds, but by the old Maryland statute, they are not bonds — they don’t fit any categories of permitted investments, and as such could only be held if we had sufficient surplus, which we did not, and probably most life insurers in Maryland did not.

Thus the problem.? I discussed it with my boss, and we had a conference call with the legal department, who confirmed my view of things.? A few days later we had a chat with the Maryland regulators.? That was a tough call, because at minimum we wanted them to accept asset-backed securities as bonds, which the the law did not admit.? We suggested, “Why don’t we adopt the NAIC [National Association of Insurance Commissioners] Model Investment law?”? The response was curt, “Oh, you mean the Illinois Investment Law?”

True, Illinois was the only state that adopted it verbatim, but several other major states had adopted >90% of it.? I said, “Tell me what you’d like to take out of the Model Investment Law.”? The main thing the Maryland department wanted was to avoid speculation through derivatives.? So I happily cut that out of my proposed law; I thought that was a good idea.? There were a few other minor things that they wanted, and I trimmed/added those as well.

After a lot of work between the lawyers and me, we sent the proposed bill to the Department of Insurance.? Then the conference call — would they go for it?? As it was they went for it.? They found it reasonable, and it codified what insurers were doing, and provided structure, such that present practices were approved, but bad extensions beyond that were forbidden.

But then we asked, “Are you not opposing us, or are you supporting us?”? They replied, “We are supporting you.? We know we need to modernize, but this statute meets our needs and yours.? Well done.”

(Note: all quotes here are summaries of what was said.? Most of it was not exactly the way I wrote it here.)

So, we hired an expert attorney who was skilled in getting bills through Annapolis.? He told us what we would need to do to get the bill passed.

So, a few weeks later, we were there in Annapolis, before the Assembly Finance Committee.? I can’t remember why, but I was not at the table before the Assembly Committee.? I sat a few feet behind my boss, our internal lawyer and our expert attorney.

The Assembly Finance Committee had a hard time with the bill.? Part of it was that there was no one to oppose the bill.? Opposition sharpens the minds of legislators.? As a result, the Committee remanded the bill to a study session, so that they could better understand the implications of the bill.

A week or so later, we appeared before the Senate Finance Committee, and I was on the panel this time.? Instead of the disorganized questions of the assembly, they asked three “simple” questions:

How will this law prevent Procter & Gamble?
How will this law prevent Orange County?
How will this law prevent Long Term Capital Management?

This was the reverse of the Assembly, because I answered all of the questions, and my partners were silent.? I could not have expected that.

As it was, I explained that P&G could not happen because the statute forbids using derivatives for speculation.? With Orange County, I explained that existing law required cash flow testing, so that we can’t invest in volatile mortgage derivatives or else we will fail our asset-liability management tests.

As for LTCM, I explained that the risk-based capital regulations would never allow us to take on that degree of leverage, and that the forbade speculation through derivatives.

And then, after a mercifully brief session, they let us go.? (Note: I had to sit through a couple sessions where we might be called, but weren’t.? Dull, but I brought work to do.? Also, I learned that Johns Hopkins, my Alma Mater, owns the state of Maryland.? Anything they ask for, they get.)

That left one more hurdle.? So on one early morning we met with the Assembly Finance Committee.? It was just my boss and I, because they were trying to understand what the bill meant.? (Technical subjects are tough for many state legislators.)? We met with them for two hours, and finally we convinced the Chairman of the committee that this was a good and honest deal.? (We both did good work here,? and the absence of the lawyers was a plus.)

That left the final voting, which was unanimous in both chambers.? And then, two months later, the signing ceremony with the governor, dressed like a Mafia Don, with a dark suit, and black shirt with thin white stripes.

So what did I accomplish here?? I reshaped Maryland’s Life insurance investment laws to be among the best in the nation.? I did it while working with many parties that had different goals.? I calmed and instructed many legislators that it was a good bill.? Finally, I set the company that I served on firm legal ground.? What could be better?

The Education of a Mortgage Bond Manager, Part VII

Posted on 10 February 2013 by David Merkel

1) One place where being an actuary and being a financial analyst melded well was with Affordable Housing and Historic Tax Credits.? In all of these investments, it made a great difference as to what the Statutory, Tax, and GAAP accounting bases.? When I described my methods of working through the free cash flows, AHIC [The Affordable Housing Investors Council] wanted me to speak to the whole regarding my methods.

I never gave the talk because we were full on tax credits, and I was too busy managing the portfolio of Fidelity & Guaranty Life.?? The moral is: watch free cash flow.

2) Probably the ugliest incident in managing money for Fidelity & Guaranty was when the management of F&G decided to try to buy the structured settlement liabilities of Confederation Life.? Big block, five potential buyers.?? St. Paul had a rule: we don’t outsource asset management.? Sadly, the chief actuary, against our admonitions allowed for reinsurance treaties that outsourced asset management.

During the conference call to legitimate the offer that we would make, several things happened:

a) F&G management accused St. Paul management of being bureaucrats, not businessmen.

b) St. Paul management told F&G management that they were ignoring the rules.

c) I informed both sides that we were all gentlemen here, and that the tone of discussion was not worthy of real businessmen.

d) The CEO of F&G eventually broke off the call, calling the St. Paul folks bureaucrats, rather than businessmen, and saying that they killed a good deal.

Personally, I think he said this to save face with his employees.? Also, the deal was marginal at best.? We would have had to take a lot of risk to make the deal work.? But F&G would not listen to us.

3) I liked buying seasoned bonds, because they were more predictable.? Problem: you could not buy them in size.? Buying bonds in the aftermarket is typically picking at scraps.? Face it — most bond buyer want to hold their bonds for a while.? Aside from the few that sell for a quick profit, most bond investors hold on for a long time.? But I would pick up scraps.? Enough scraps, and you have some decent positions.

If you do find a seasoned bond selling at a reasonable price, buy it in, subject to the advice of your credit analyst.

4) Regarding mortgage bonds, remember that default and prepayment are dual.? Debtors divide up into three groups: a) Very solvent, they will easily pay off their debts, and if there is an opportunity to refinance their debt, they will take it.? b) Solvent. They don’t have a lot of margin, but they can pay their debts if nothing serious goes wrong. c) We did not deserve the loan.? We will fail with high probability in the next year.

Ideally, if you want the best yield out of a bunch of consumer lending assets, you want a lot of the middle group.? Not the highest credit quality, but likely to pay off, and not so likely to prepay.? There is a hierarchy:

Best: pay,
Next best: prepay,
worst: don’t pay.

5) So as I learned about CMBS, I wondered about the interest only strip that many of the deals held — from my own testing, it had the credit properties of a BBB tranche at best, and a Single-B tranche at worst.? Sadly, because they had no principal to pay they were nominally rated AAA, and so the firm I worked for (not my area) crammed them into Stable value plans.? Because I had done the credit stress testing, I knew this, and resisted their use in my own portfolios.

But this is another example where accounting rules have led us afoul.? Nominal principal should be implied to “interest only” obligations.? “Principal only” obligations should have implied interest.

That’s all for now.? I will finish up in the last segment, probably on Monday.

The Education of a Mortgage Bond Manager, Part VI

Posted on 9 February 2013 by David Merkel

1) One thing that impressed me about working in a life insurance investment department is how many ideas we kicked around and abandoned.? I did not experience that to the same degree working at a hedge fund.? I think that is true for two reasons: 1) we have a significant balance sheet, and can take on illiquidity. 2) we are conservative, and aren’t going to take on marginal risks.

2) Another thing that impressed me was how well the money was managed, and how poorly the liability writers thought it was managed.? I did a big study to analyze what we had earned for F&G Life over the prior seven years.? We beat single-A bond yields by more than 0.7%/year.? That’s huge.? That said, they kept asking for more.? I shake my head and wish that we were running a mutual fund; we would have gotten a lot of respect.

3) When I came, the client held no CMBS, after three years 25% of the assets were CMBS.? It made so much sense given the 10-year duration of the EIAs that were growing so rapidly.? Given my models, and the lack of yield from corporates, this was a big improvement.

CMBS, because it is noncallable, makes a lot more sense for longer-dated liabilities.? Hey, I was not only the mortgage bond manager, I was the interest rate risk manager.? I would not knowingly take bad risks.

4) When the merger happened, the boss decided to jump to another firm.? Unintentionally, I may have encouraged that, because when he asked me, ‘What would I do in this new organization?”? I said, “Let me draw it out for you,” showing that he would be CIO of insurance asset management.? He was crestfallen, and sought other avenues of employment.? When he announced his new job, there was a big change.

First, the St. Paul talked with me and the High Yield manager, and gave me authority to manage things, so long as the high yield manager agreed.? Basically, they trusted me, but knew I was inexperienced, so they wanted the high yield manager, who was far more experienced than me, to guide me.? There was an economic incentive here: the better we did, the less cash the St. Paul had to transfer to Old Mutual at the closing.

But after that, the analysts came to me and said “you be our leader.”? The high yield manager agreed.? When I asked why, they said, “We trust you. You have always had a better call on credit than the prior boss, and you understand our client better than anyone else!”

That led to something hard.? I called a meeting of the analysts and managers, but told the old boss, who was still with us, that he was not invited.? I almost cried.? He was our leader for so long, and a good one, but I had to take control.

Once I did so, I asked the analysts for reports on all companies where the stock price had fallen by more than 50% since bond purchase.? We began selling those bonds where it made sense.? Those sells were almost always good sells, and I wish I had not been countermanded by my new bosses on Enron (the greatest company in the world.)

I have more to say but that will have to wait for the next part.

The Education of a Mortgage Bond Manager, Part II

Posted on 20 July 2012 by David Merkel

In much of my life, I have been thrust into situations for which I was not ready, and ended up rebuilding the wheel, or came up with an unorthodox approach that worked.? But a lot of the problem came down to the question of time horizon.? How long can you buy and hold, even if temporary market conditions make you squeamish?

I remember the first CMBS bond that I bought in 1998: it was the longest AAA tranche of a Nomura deal, which was out of favor at the time.? I did a lot of work analyzing the deal, and concluded that the bond was a lot safer than many competing bonds and offered more yield.? In early 1999, when I described this purchase to the investment committee of a charitable board the I was on, one said, “Only 7%, and you are locked in for 14 years?”? I said that stock valuations were high, and that 7% was a great return.? It was a great return, and far better than the stock market over the same time period, though I could not have known that at the time.

I became an advocate for CMBS in my firm as I realized that the hot product being offered would have the majority of its cash flows come at the 10-year maturity, but there would still be some level of withdrawals.? After some modeling, I realized that the best strategy was investing 80-85% of the money 10 years out, while leaving 15-20% of the money as pseudo-cash: 2 years out or shorter.? Of all of the mortgage bond categories, only CMBS offered assets with a ten-years or more duration, with minimal credit risk.

I used Charter/Conquest as my software.? It enabled me to set a consistent set of macroeconomic principles to evaluate a large number of properties in different economic areas.? The software would project the cash flows? of each property, given the assumptions that you fed it.

I spent time analyzing geography and property types.? I had a decent idea as to what areas of the country were doing badly, and with what property types.

I created what I called the black bucket.? Property types and geographic areas that I did not like were assigned to the black bucket, and if the? black bucket got big enough, we did not play in the deal.? It was a good method, and one CMBS expert at a bulge-bracket bank said to me that it was the most rigorous means of testing CMBS that he had run into.? Most buyers were far more trusting, and tended to buy quality issuers that were taking advantage of their reputation.

By having an independent standard of value where I worked, I did better than competitors.? I did not follow fads; I followed value to the greatest extent that I knew.

Brokers would be puzzled on why I turned down deals from good dealers, or why I bought deals from originators that were subpar.? My lesson was dig into the details, and ignore names.? Analyze the data, avoid the marketing.

Doing your own analysis is a lot of investing.? Ignore the puzzled expressions of your brokers, and buy what you have determined is valuable.? More in part 3.

The Education of a Mortgage Bond Manager, Part I

Posted on 14 July 2012 by David Merkel

You might remember my “Education of a Corporate Bond Manager” 12-part series.? That was fun to write, and a labor of love, but before I was a corporate bond manager, I was a Mortgage Bond Manager.? There is one main similarity between the two series — I started out as a novice, with people willing to thrust a promising novice into the big time.? It was scary, fun, and allowed me to innovate, because in each case, I had to rebuild the wheel.? I did not have a mentor training me; I had to figure it out, and fast.? Also, in this era of my career, I had many other projects, because I was the investment risk manager for a rapidly growing life insurer.? (Should I do a series, “The Education of a Financial Risk Manager?”)

One thing my boss did that I imitated was keep notebooks of everything that I did; if this series grows, I will go down to the basement, find the notebooks, and mine them for ideas.? When you are thrust into a situation like this, it is like getting a sip from a firehose.? Anyway, I hope to do justice to my time as a mortgage bond manager; I have been a little more reluctant to write this, because things may have changed more since I was a manager.? With that, here we go!

Liquidity for a Moment

In any vanilla corporate bond deal, when it comes to market for its public offering, there is a period of information dissemination, followed by taking orders, followed by cutoff, followed by allocation, then the grey market, then the bonds are free to trade, then a flurry of trading, after which little trading occurs in the bonds.

Why is it this way?? Let me take each point:

period of information dissemination — depending on how hot the market is, and deal complexity, this can vary from a several weeks to seven minutes.
taking orders — you place your orders, and the syndicate desks scale back your orders on hot deals to reflect what you ordinarily buy and even then reduce it further when deals are massively oversubscribed.? When deals are barely subscribed, odd dynamics take place — you get your full order, and then you wonder, “Why am I the lucky one?”? After that, you panic.
cutoff — it is exceedingly difficult to get an order in after the cutoff.? You have to have a really good reason, and a sterling reputation, and even that is likely not enough.
allocation — I’ve gone through this mostly in point 2.
grey market — you have received your allocation but formal trading has not begun with the manager running the books.? Other brokers may approach you with offers to buy.? Usually good to avoid this, because if they want to buy, it is probably a good deal.
bonds are free to trade — the manager running the books announces his initial yield spreads for buying and selling the bonds.? If you really like the deal at those spreads and buy more, you can become a favorite of the syndicate, because it indicates real demand.? They might allocate more to you in the future.
flurry of trading — many brokers will post bids and offers, and buying and selling will be active that day, and there might be some trades the next day, but…
after which little trading occurs in the bonds — yeh, after that, few trades occur.? Why?

Corporate bonds are not like stocks; they tend to get salted away by institutions wanting income in order to pay off liabilities; they mature or default, but they are not often traded.

By this point, you are wondering, if the title is about mortgage bonds, why is he writing about corporate bonds?? The answer is: for contrast.

period of information dissemination — depending on how hot the market is, and deal complexity, this can vary from a several weeks to a few days.? Sometimes the rating agencies provide “pre-sale” reports.? Collateral inside ABS, MBS & CMBS vary considerably, so aside from very vanilla deals, there is time for analysis.
taking orders — you place your orders, and the syndicate desks scale back your orders on hot deals to reflect what you ordinarily buy and even then reduce it further when deals are massively oversubscribed.? When deals are barely subscribed, odd dynamics take place — you get your full order, and then you wonder, “Why am I the lucky one?”? After that, you panic.
cutoff — it is exceedingly difficult to get an order in after the cutoff.? You have to have a really good reason, and a sterling reputation, and even that is likely not enough.
allocation — I’ve gone through this mostly in point 2.
grey market — there is almost no grey market.? There is a lot of work that goes into issuing a mortgage bond, so there will not be competing dealers looking to trade.
bonds are free to trade — the manager running the books announces his initial yield spreads for buying and selling the bonds.? If you really like the deal at those spreads and buy more, you can become a favorite of the syndicate, because it indicates real demand.? They might allocate more to you in the future.
no flurry of trading — aside from the large AAA/Aaa tranches very little will trade.? Those buying mezzanine and subordinated bonds are buy-and-hold investors.? Same for the junk tranches, should they be sold.? These are thin slices of the deal, and few will do the research necessary to try to pry bonds out of their hands at a later date.
after which little trading occurs in the AAA bonds — yeh, after that, few trades occur.? Same reason as above as for why.? Institutions buy them to fund promises they have made.

Like corporate bonds, but more so, mortgage bonds do not trade much after their initial offering.? The deal is done, and there is liquidity for a moment, and little liquidity thereafter.

Again, if you’ve known me for a while, you know that I believe that liquidity can’t be created through securitization and derivatives.? Imagine yourself as an insurance company holding a bunch of commercial mortgage loans.? You could sell them into a trust and securitize them.? Well, guess what?? Only the AAA/Aaa tranches will trade rarely, and the rest will trade even more rarely.? The mortgages are illiquid because they are unique, with a lot of data.? You would have a hard time selling them individually.

Selling them as a group, you have a better chance.? But as you do so, investors ramp up their efforts, because the whole thing will be sold, and it justifies the analysts spending the time to do so.? But after it is sold, and months go by, few institutions have a concentrated interest to re-analyze deals on their own.

And so, with mortgage bond deals, even more than corporate bond deals, liquidity is but for a moment, and that affects everything that a mortgage bond manager does.? More in part 2.

Against Risk Parity, Redux

Posted on 7 February 2012 by David Merkel

Here are two articles to read on risk parity:

Pro: Pick Your Poison

Con: The Hidden Risks of Risk Parity Portfolios

I’m on the “con” side of this argument, because I am a risk manager, and have traded a large portfolio of complex bonds.? For additional support consider my article Risks, Not Risk.? Or read the second half of my article, “The Education of a Corporate Bond Manager, Part X.” There is no generic risk in the markets.? There are many risks.? Interest rate risk and credit risk are different topics.?? There are bonds that have interest rate risk but not credit risk — long Treasuries.? There are bonds that have credit risk but not interest rate risk — corporate floating rate notes, my favorite example being floating rate bank trust preferred securities.

It is not raw price volatility that drives investment results as much as the underlying drivers of the volatility.? For fixed income, I described those in the two articles linked in the last paragraph.? During non-credit-stressed times, a bank’s 30-year floating rate trust preferred security is roughly as volatile as a five-year noncallable bond that it issues.? But during times of credit stress, the first security becomes volatile, whereas the second one doesn’t.? The first moves in line with 30-year swap yields, LIBOR, and long junior bank spreads.? The second moves in line with 5-year Treasury yields, and short senior bank spreads.? The underlying drivers have little in common, and when things are calm, their volatilities are similar, because the drivers aren’t moving.? But when the drivers move, which in this case is one correlated driver, credit stress (30-year swap & junior bank spreads go a lot higher), the volatilities are very different, the first one being high and the second one low.

Thus equating volatilities across a bunch of asset subclasses, investing less in the volatile, and levering up the non-volatile, is hard to do.? History embeds all the curiosities of the study period, and calls them normal, and that past is prologue.

From the Pick Your Poison article above, what I think is the (lose) money quote:

Gundlach insists most money managers misunderstand junk bonds, comparing them to 5-year Treasurys to determine how rich their yields are, when the correct comparison should be to 30-year Treasurys.

How can Gundlach compare junk bonds, which do better when the economy heats up, with long-term Treasurys, which get killed when the economy revs up and the Fed raises interest rates?

That?s irrelevant, he responds. The thing to look at is volatility, because that tells you the odds you will have to sell at a loss when you need to raise cash in an emergency. On that basis, junk bonds that were trading at a seemingly reasonable spread of 5 percentage points, or 500 basis points, to 5-year Treasurys in mid-2011 were actually trading at an intolerably low 250-basis-point spread to the proper bond. (By then DoubleLine had cut its junk bond allocation from 10% to 1%.) Sure enough, junk fell 12% as the year went on, and the spread to 30-year Treasurys has doubled since mid-2011.

?It?s called risk parity,? Gundlach says. ?There?s only two investors who seem to understand it?me and Ray Dalio,? the highly successful manager of $122 billion (assets) Bridgewater Associates.

Personally, I don’t think Gundlach makes his money that way for his funds, but in case he does, how should a good bond manager view junk bonds?

First, ignore Treasuries — they aren’t relevant to the price performance of junk bonds.? I’ve run the regression of Treasuries vs junk bond index yields many times.? It’s barely significant for BBs, and insignificant thereafter.? Second, look at stock market indexes of industries that lever up and issue junk debt.? Junk corporate debt is a milder version of junk stocks, i.e., the stocks that issue junk debt.

Third, a corollary of my first reason, realize that risks with junk aren’t driven by spreads, but yields.? With highly levered, or very junior debt, it does not trade on a spread basis, but on a price basis.? Anyone looking at spreads will see too much volatility versus yields and prices.

But mere volatility won’t tell you the riskiness.? Indeed, when economic times are good, junk will do well, and long Treasuries do poorly.? Now, maybe that makes for a very noisy hedge, but I wouldn’t rely on it.

And, volatility is a symmetric measure, which as bond yields get closer to zero, the symmetry disappears.? Most asset classes display negative skew and fat tails, which also makes volatility problematic as a risk measure.

Going back to my first piece on the topic, if I were applying risk parity to a bond portfolio, it would mean that I would have to buy considerably more of shorter and higher quality instruments, and lever them up to my target volatility level, somehow with spreads large enough that they overcome my financing costs.? Now, maybe I could do that with mispriced mortgage securities, but with the problem that those aren’t the most liquid beasties, particularly not in a crisis if real estate is weak.

I guess my main misgiving is that levered portfolios are path-dependent, as pointed out in the GMO piece above.? You can’t be certain that you will be able to ride through the storm.? The ability to finance short-term disappears at the time it is most needed.

Now, if you can get leverage after the bust, and invest in beaten-up asset classes, you can be a hero.? But that’s a time when only the most solvent can get leverage, so plan ahead, if that’s the strategy.? If an investor could consistently time the liquidity/credit cycle, he could make a lot of money.

As the GMO piece concludes, the only benchmark that everyone could hold would be a proportionate slice of all of the assets in the world, which implicitly, would strip out all of the leverage, because one would own both the shares of the company, and the debt it owes, and in the right proportion.

So I don’t see risk parity as a silver bullet for asset allocation.? I think it will become more problematic, as all strategies do, as more people show up and use it, which is happening now.?? First in the hands of the master, last in the hands of a sorcerer’s apprentice.? Be careful.

PS — I have respect for the skills of Gundlach and Dalio.? I’m just skeptical about what happens to risk parity when too many use it, and use it without understanding its limitations.? And, here is a nice little piece about Bridgewater and its strategies.

The Education of a Corporate Bond Manager, Part XII (The End)

Posted on 7 August 20108 August 2010 by David Merkel

Tonight I pick up on the odds and ends.? Going along with last night’s theme of making mistakes, we had a saying in our office, “Great minds think alike.? Fools seldom differ.”? It helped us stay humble about our culture.? If we agreed, it might be because we were all bright, or all dumb.

As an aside, one of the brighter associates at the main office pulled me aside to ask about the foolish behavior of the client.? Having worked for a much larger and more professional firm, he was shocked.? I simply said (regarding the client), “It may be a rusty tub, but its OUR rusty tub.”? He gave me the grim smile of understanding.

Timing Purchases and Sales

I developed my own view of technical analysis while trading corporates.? I wrote about it in this post, A Fundamental Approach to Technical Analysis.? Here is the most relevant excerpt:

But not every fundamental investor agrees on what the proper prices are for buying and selling. As the old saying goes, ?It takes two to make a market.? Sometimes, I will make it into the office and my trader will tell me that someone is aggressively selling a company that we own. I might ask him if our brokers have any feel for the size of the seller, and how desperate he is. The answer is usually ?no,? but if we do get an answer, that can help dictate our trading strategy. We would want to buy more as the big seller is closer to being done. In fact, we want to buy his last block of shares from him, if possible. Sometimes that can be arranged by talking to our broker; other times not.

As another aside, this is simpler to do in the bond market than the stock market. The large brokers generally know who is doing what. Be nice to your sales coverages, and you?d be amazed what they will tell you?. Here?s a stylized example.

Broker: ?You sure you want to buy that Washington Mutual bond??

Me: ?Yes, why??

Broker: ?Uh, there?s someone with size selling the name.?

Me: ?How much size??

Broker: ?Best indications are eight times your order size.?

Me: ?I can?t take that much down. Keep me in mind, and when he gets down to about double the size of my order, call me, and I?ll take the tail [everything that?s left].?

Broker: ?You got it.?

There were other rules that helped me. Keeping the VIX on my screen helped me accelerate or slow down purchases and sales in a given day. Yield spreads lag behind option volatility even though the two should be closely related. Momentum of spreads also helped — falling and rising spreads tended to persist, so be more aggressive when the market was hot, and not when it is not. Beyond that, there were credit default swap [CDS] spreads, which were just becoming a factor then. I came to the conclusion that credit spreads moved a lot slower than CDS, so I developed a rule that said, “Don’t buy if CDS is above the credit spread. Wait for the CDS to fall below, then buy.” Worked well, and kept me out of deteriorating situations.

These rules also left me more calm and capable when the market was falling apart.? I also tended to build up a cash buffer when things were going awry, waiting for the eventual turn in the market.

Time Horizons

If I had to summarize it, it boils down to managing three time horizons:

Daily — watch daily momentum and deal flow.
Weekly-Monthly — how is the momentum going?? Gauge the speculative nature of the market.
Credit cycle — where is the credit cycle in heading to the next peak or through?? How long till we get there, and what will it feel like as we near the peak or trough?

Thinking of it this way aids daily trading, and allows for clever trading in bear market rallies, and bull market pullbacks, while still watching the overall macroeconomic credit cycle.? You can’t get all three horizons in full; they fight each other at times.? Doing this means you can more intelligently weigh the costs of action and inaction, because the client needs income, and it helps you determine how long can you delay in providing income in order to avoid capital losses.

The client was growing like a weed.? That made my job easier and harder.? Easier because I could snap up every mispriced bond that was money good.? Harder, because during sharp rallies, I could not let cash build up too much.? I took the opportunity to buy AAA & AA bonds rather than A & BBB bonds, which gave up yield, but it was better than cash.

Scaling

One concept that aided me in trading was realizing that I did not have to be a big trader.? Moving in and out of positions slowly, as market conditions warranted was useful.? If the liquidity was available, and you were facilitating someone else’s bold move, that is another thing.? But the cardinal rule was, “Never demand liquidity unless it is an emergency, and you meet the strenuous test that you know something everyone else does not.? But, make others pay up for liquidity where possible.? You are doing them a service.”

Those ideas affect me today in my equity investing.? Most of the time I do small trades around core positions, and adjust my companies at a slow pace.? I make money while I wait.

Income Replacement

I was the risk manager as well as a corporate bond manager.? I understood that the policies written by the client had implied hurdle rates attached to them.? Selling a bond that was a good buy two years ago would realize a great capital gain, but would lead to a reduction in income most likely upon reinvestment of the proceeds.

The question was, and always will be, how to maximize the long-term well-being of the client.? Short-term gains matter little.? How can you build up a sustainable interest margin is the key.? Thus in my trading I looked at income replacement, adjusted for quality, maturity, liquidity, optionality, premium/discount, and a wide number of lesser variables.? Given that the client foolishly wanted me to trade aggressively, I did so, but matched off interest-rate related gains and losses, while building interest margins.

The End

No good deed goes unpunished.? The neophyte corporate bond manager that excelled was eventually told by his boss in early 2003 that they were losing manager searches because he was not in the home office (far away), and that fund management consultants told them that multi-city firms did not work.? (Those who can’t do, consult.)

I was offered a move to the main office, or be severed.? Hearing this, I went and called my wife, using my cell phone in an out-of-the-way place.? Little did I know that there was a betting line in the main office favoring that I would come by 3-1.? My gift to those who knew me in the main office was that little win, because in early 2003, investment jobs were hard to find, and would I just give my job up?

Well, yes.? I had enough confidence in my abilities (under God/Jesus), that I looked to the needs of my family first.? We had friends that we did not want to give up in our congregation for the first time, and I gave my family the benefit of the doubt, saying that I would try other possibilities in the area for a year or so.

Informally, I let my colleagues in my office know in advance; they were friends.? So on the last day for my decision, I announced that I would take severance.? Then something weird happened.? They left me with trading authority for the next two weeks.? Ordinarily that is cancelled, because the unscrupulous use that to reward friends at the expense of the client.? Rather than do that, I used the opportunity to sell down positions that I was comfortable with, but were too large forthose that would inherit the portfolio I built.? I managed to get all positions but one down to a reasonable level, leaving a clean portfolio for my successor.

Parties

My colleagues in my office took me out for lunch; they gave me a great time.? The analysts came and thanked me because I genuinely listened to them, and never blamed them.? They even told me that I was the only portfolio manager they knew who could be a credit analyst.

A few days before that, Legg Mason took me out to dinner with a few of my colleagues.? I was mystified as to why.? Yes, I had traded with them a lot, but they had given me good value on my trading.? In the middle of the dinner, I said, “This is really nice, guys, but why so much for me?”? They looked at my sales coverage and said, “Didn’t you tell him?”? They picked up and said, “What you don’t know is that your willingness to trade with us allowed us to build up our corporates coverage; without you we would not have a business today.? Also, you were honest with us and kept us from mistakes when we were out of the market context.”

I was floored.? Really?? I did that much for you?? They said, “Whatever we can do for you, just ask.”? I asked for an interview with Bill Miller.? That probably exceeded their notional credit line, because that never happened.

As it was, I landed a job with a wonderful hedge fund, Hovde Capital, in two months, and was very grateful to them for hiring me.

Postscript

There is one story that I left out from the beginning, which still needs to be told.? When our little money management firm was being acquired by an arm of Old Mutual, the CEO of that firm balked at paying our credit analysts the salaries they were receiving, and was really annoyed at the bonus structure.? He said to me and the high yield manager, “Look, the only people I need are the two of you, and we can hire other analysts.”? The two of us knew that our analysts/friends were golden — analysts that would be hard to replace.

The prospective buyer of our little firm called the two of us to a phone conference.? Somehow it leaked to the analysts what was being proposed and when.? As we headed off to the meeting, one analyst who was Jewish, called out to me, “David, don’t forget you are a Christian!”? Surprised, I turned and said, “I won’t.”? What determination I had doubled.

The high yield manager and I went into the teleconference and held our ground.? Then the counterproposal came, “If you want to protect your analysts, are you willing to put your bonuses on the line?”? We looked at each other.? I nodded; he nodded.? I said, “If we don’t meet your expectations as a group, you hit our bonuses first.”

As it was, we did well, and we all got our bonuses.? But it was never lost on the analysts that we put them first, both as colleagues and friends.? It was one big reason why we continued to do great business together.

Though I was only a corporate bond manager for two very special years, where I did well against a tough market, the way I did business helped us to do well, by being ethical above all else.? In a bad environment, that can really help.? Even Wall Street differentiates between who keeps their word and who does not.

I would have loved to continue in that business.? It was a lot of fun, but jobs like that are not handed out willy-nilly.? All that said, I went out knowing that I had done my best, and was ready to do more for my next employer.

The Education of a Corporate Bond Manager, Part XI

Posted on 7 August 2010 by David Merkel

I appreciate my readers.? That doesn’t mean that I am the fastest to respond to e-mails, but I appreciate what they write, even when I don’t agree.? But here is an e-mail very relevant to tonight’s piece:

Great series, David.

If you have more posts planned, it would be interesting to know what the biggest mistake you’ve made that you learned from the most.

In my short tenure as a corporate bond manager, I had a very good run in the midst of a bad environment.? Sometimes I think my lack of formal training was a plus for analyzing a situation where little was going well.

But I did make my mistakes. One was Enron — don’t get me wrong, I urged the sale of Enron bonds, but was countermanded.? Could I have argued the cause better?

Fast-growing company in a slow-growing industry.
Management that could not take criticism.
Growing profits, shrinking cash flow.
We had a peek inside the veil, because we had financed some of their private deals.? The complexity was astounding.
Opaque balance sheet.

I made all of those points and still lost; my new bosses were not deep when it came to corporate credit; they were skilled in other areas of the bond market.? I eventually ended up selling the Enron bonds at an unfavorable price.? Would that I had sold on the date of the default, rather than a month later.

Then there was the Teleglobe situation, where I erred in many ways.? BCE, Incorporated had a unregulated subsidiary called Teleglobe.? Think of Global Crossing, and other marginal telecom ideas.? BCE was a sound company, and they offered verbal support for their subsidiary, but would not put it into writing, and formally guarantee their debt.

I did not know the company well, and I had no stock price to give me aid.? Stock prices are more sensitive than bond prices, and can give warnings before bond prices move dramatically.? My analyst went off to a telecom/technology conference, where the S&P analyst disclosed over dinner that she was likely to downgrade Teleglobe because of the lack of explicit support from the parent company.

Now given the broader picture, this should have been obvious.? There were too many situations where implicit support did not translate into real support, and Teleglobe, most than most, needed support.

My analyst called me after the comment from the S&P analyst, and I asked, “Should I sell?”? He said I should wait; he wanted to gather a little more data.? We had our opportunity to sell at $90, and waiting missed that.? By the time he returned, the S&P analyst indicated that a downgrade was likely, and the pseudo-price fell to $70.? But, we were now determined to sell.

So I called my favorite broker, who was at the only firm making a market in Teleglobe bonds.

DM: “What’s the market in Teleglobe bonds?”

FB: “$68/$72.”

DM: “Very good.? I sell you $XX Milllion of Teleglobe bonds at $68.”

FB: “I’m sorry, that’s not a real market, that is an indicative market.”

DM: “So where is the real market?”

FB: “We’ll take an order from you.”

DM: “You mean there is no real market?? You brought this deal to market, you have to maintain a market.”

FB: “We’ll take an order from you.”

DM: (Pause) You have an order for $XX million Teleglobe bonds at $65.

FB: “We will do our best for you.”

To this day, I have no doubt that she was serious with me.? Teleglobe bonds after that point traded in the $50s, but never at the main broker.? As I learned later, they had 10+ times more Teleglobe bonds than I did, and were trying to minimize their own exposure.? They lost a lot more than I did.

When BCE sent Teleglobe into bankruptcy several weeks later, we sold the bonds at $20.? The eventually went out as a zonk.? No value.

Lesson learned: bonds are asymmetric.? You are paid to be cautious regarding failure.? When in doubt, sell.? Also, don’t take your broker at face value always.

The fallout from the Teleglobe failure was twofold.? 1) the client accused us of incompetence, because we had missed on Enron, KMart, and Teleglobe. 2) My boss asked me how I could have missed it, and I said, “I was following it and did the best I could.? But I am following over 500 credits.”

Sadly, he made the wrong decision, and hired another corporate bond manager, and we split the portfolio.? It led to poorer portfolio management.

Another error: I am not politics-sensitive.? I am more interested in doing what is right for clients, than what looks best.? So when the client proposed value destroying ideas that would benefit them directly, I argued against them.? The asset manager took me out of direct client contact, aside from actuarial risk management, but asked me to tell them what was up, because the client asked for weird things.? The same applied inside the asset manager, where my willingness to take or avoid risk was in sync with opportunity, but out of sync with the firm.

I had learned to avoid undue pessimism from the high yield manager who sat next to me, and that often made me more optimistic amid gloom than others in the firm.? I was not a pea in the pod, and perhaps that made those that had acquired my firm wonder about me.? I never did anything more than make my opinions known, but that is enough for some to take umbrage.

Maybe the point is this: you can be right in the long run, but wrong in the short run.? What eventually happened to the client?? Well, I mentioned all of the dismissals before, but as God would have it, the client was sold yesterday to hedge-fund manager Phil Falcone.? The new CEO of Old Mutual said:

But just to remind you of the background of the transaction, we bought US Life in 2001 with the aim of building a Life business in the United States. This has proved to be a poor acquisition for the Group, and we acknowledge it, largely due to taking excessive credit risk, the impacts of which came to a head in the 2008 global financial crisis. So we said in March we intended to explore the sale of the business.

Old Mutual pumped in hundreds of millions in capital, in addition to what they paid for it.? They lost badly.? But they did not list the real reason why they lost, which gives me little confidence that they will do better in the future.? They lost because their US life division sold policies at levels that did not cover the cost of capital.? In order to avoid the inevitable losses from selling policies too cheaply, they pushed those who invested for them to try to make it up by taking much more risk.? The risk didn’t come first; what came first was a bad management culture that pushed sales growth at the expense of everything else.

Hopefully, Mr. Falcone will see that and realize that sales aren’t everything, and dial back investment risk.? But who can tell?

My main errors came from mis-estimating people.? I was not strong enough to change the culture, and I should have realized that, and tried to be more incremental.? As it was, I was right, but frozen out from being able to effect change.

Final episode tomorrow, most likely…