The Aleph Blog – Page 282 – Helping Institutions and Ordinary People Invest Better by Focusing on Risk Control

Looking Beyond the Three Percent Horizon

Posted on 5 January 20085 January 2008 by David Merkel

Give the Fed some credit. Not literally, of course. Isn’t it their job to give us credit?

I haven’t talked a lot about Fed policy in a while, so I thought it was time to do an update. Five months have passed since my 3% sometime in 2008 call was made, and now it is becoming the received orthodoxy. That’s why I have to ask what is wrong with it, or better, what is the next phase beyond it?

Truly, I don’t know for sure, but I will offer out my thinking process. We are seeing rising unemployment and inflation at the same time. The bond market is rallying, anticipating falling Fed funds rates, but not forecasting rising inflation rates. (Buy TIPs!) In the spirit of watch what they do not what they say, let’s review the relevant Fed data.

Effective fed funds have averaged 4.01% since the last Fed meeting. Sloppy on the low side. I believe intentionally so.
Still no permanent injection of liquidity since 5/3/07. This Fed likes unorthodox measures.
The Fed has increased the size of the TAF auctions by 50%, to $30 Billion on 1/14, and 1/28.
Since 8/8/07, my M3 proxy has run 8.4% not annualized, followed by MZM at 6.2%. M2 and the monetary base are anemic at 2.6% increases.
Ergo, the Fed is relying on the willingness of the banks to extend credit for their loosening of the money supply, not their expansion of the monetary base.
The forward curve has a sub-3% fed funds rate in 2008.
Finally, Fed funds futures and options favor a 50 bp cut in late January.

We are in a period of asset deflation and consumer price inflation, so this is a difficult period to negotiate through. You can listen to facile comments from PIMCO; everyone is focused on economic weakness, and few are focused on rising inflation.

I think we get to a 3% Fed funds rate, but we don’t get much below it, because by that time, a 3% Fed funds rate will imply a negative real interest rate on the short end. Congress will have an implied inflationary bias, because the complaints will come more from asset deflation. They will ~~kick~~ nudge the Fed that way to the extent that they can.

The TED spread is not as wide as it once was, but it is still in a historically high range. Anything above 60 basis points implies stress. To reduce this the Fed has set up an auction facility, called the TAF. The TAF has been expanded, which allows for a greater variety of securities to be lent against. That’s the real novelty of the TAF. Not new liquidity but new collateral. That said, even the discount window is getting greater use. As a result, the Commercial Paper market is showing some life, even for asset backed commercial paper.

So, liquidity is increasing on the short end, to the point where a 1/4% cut in Fed funds has for practical purposes already happened. A formal 1/4% cut at the next FOMC meeting would do little except ratify what has already been done. Now there is weakness in the job market, and the PMI is signaling some weakness as well. The yield curve has moved down, particularly on the short end, to reflect expectations of more cuts from the Fed.

But TIPS yields are quiet, at least for now, and viewing the Fed as quasi-politicians, whose main goal in life is to avoid political pain, the path of least resistance is to loosen policy further. Fed funds futures and options are indicating the most likely outcome in on January 30th is a 50 basis point loosening. Ordinarily, because of the “gradualist” culture that has built up inside the Fed, I am reluctant to argue for loosenings other than 25 basis points. I think at this point, I have to argue for 50 basis points, but with the usual squishy language that pays heed to all potential threats, effectively saying, “But no more after this! Conditions are balanced!” We know better, though. The only real question is when rising consumer price inflation or a deteriorating Dollar (think of 1986) will be a sufficient counterweight to economic weakness.

The US Dollar is weak here, and that reflects the judgment of many actors as to the value of what they get paid back will be. My guess is that foreign investors sense that inflation is higher in the US than is stated in the Government’s statistics. Too many dollar claims (internal and external) chasing too few goods that they want to buy. What will dollar-denominated bonds be worth at maturity? (Judging by current yields, quite valuable for now.) And will the US Government allow significant US companies to be owned by the Chinese, or by Arabs? How free market is the US really? Will foreign governments stop policies that disfavor the purchase of US goods? Perhaps once they import enough inflation, they will.

With gold, crude oil, and a host of agricultural prices high, and with structural reasons for them to remain high, the FOMC won’t feel too happy as they cut rates. But cut they will, and then we get to see where the excess liquidity flows. Some will bail out banks, which will invest in safe instruments in areas of the economy not under threat. Loans in or near default will not be affected. Well, more on that later. Tonight’s post will be on credit issues.

In closing, a return to the problem that I posed at the beginning: So what’s wrong with the 3% Fed funds forecast, or better, what is the next phase beyond it? It could go several ways:

Rising price inflation and a deteriorating dollar lead to an end to the cycle, and the Fed funds rate either stops falling, or has to rise to squeeze out inflation.
Continuing asset deflation, and declining but still positive economic growth (as the government measures it) leads the Fed to continue to loosen, or stand pat in the face of rising consumer price inflation.
Liquidity difficulties in the banking system morph into solvency difficulties, leading pseudo-M3 and credit to contract (after all the banks are doing the heavy lifting here, not the Fed) and the Fed starts to loosen aggressively.
We get a “bolt for the blue” leading to something not currently predictable, but which leaves policymakers in a bind.
We muddle along, get to something near a 3% Fed funds rate, and continue to muddle (think of 1992-1993).

Personally, I favor scenario 2. And, for those that like to invest, TIPS are reasonably priced. Insurance against scenario 2 is inexpensive, and relatively high quality. But be wary, because particularly in a Presidential election year, there could be significant surprises (part of scenario 4).

Long VIPSX

On Benchmarking

Posted on 4 January 2008 by David Merkel

Sorry for not posting yesterday, there were a number of personal and business issues that I had to deal with.

Sometimes I write a post like my recent one on Warren Buffett, and when I click the “publish” button, I wonder whether it will come back to bite me. Other times, I click the publish button, and I think, “No one will think that much about that one.” That’s kind of what I felt about, “If This Is Failure, I Like It.” So it attracts a lot of comments, and what I thought was a more controversial post on Buffett attracts zero.

As a retailer might say, “The customer is always right.”? Ergo, the commenters are always right, at least in terms of what they want to read about.? So, tonight I write about benchmarking.? (Note this timely article on the topic from Abnormal Returns.)

I’m not a big fan of benchmarking.? The idea behind a benchmark is one of three things:

A description of the non-controllable aspects of what a manager does.? It reflects the universe of securities that a manager might choose from, and the manager’s job is to choose the best securities in that universe.
A description of the non-controllable aspects of what an investor wants for a single asset class or style.? It reflects the universe of securities that describe expected performance if bought as an index, and the manager’s job is to choose the best securities that can beat that index.
A description of what an investor wants, in a total asset allocation framework.? It reflects the risk-return tradeoff of the investor.? The manager must find the best way to meet that need, using asset allocation and security selection.

When I was at Provident Mutual, we chose managers for our multiple manager products, and we would evaluate them against the benchmarks that we mutually felt comfortable with.? The trouble was when a manager would see a security that he found attractive that did not correlate well with the benchmark index.? Should he buy it?? Often they would not, for fear of “mistracking” versus the index.

Though many managers will say that the benchmark reflects their circle of competence, and they do well within those bounds, my view is that it is better to loosen the constraints on managers with good investment processes, and simply tell them that you are looking for good returns over a full cycle.? Good returns would be what the market as a whole delivers, plus a margin, over a longer period of time; that might be as much as 5-7 years.? (Pity Bill Miller, whose 5-year track record is now behind the S&P 500.? Watch the assets leave Legg Mason.)

My approach to choosing a manager relies more on analyzing qualitative processes, and then looking at returns to see that the reasons that they cited would lead to good performance actually did so in practice.

Benchmarking is kind of like Heisenberg’s Uncertainty Principle, in that the act of measurement changes the behavior of what is measured.? The greater the frequency of measurement, the more index-like performance becomes.? The less tolerance for underperformance, the more index-like performance becomes.

To the extent that a manager has genuine skill, you don’t want to constrain them.? Who would want to constrain Warren Buffett, Kenneth Heebner, Marty Whitman, Michael Price, John Templeton, John Neff, or Ron Muhlenkamp? I wouldn’t.? Give them the money, and check back in five years.? (The list is illustrative, I can think of more…)

What does that mean for me, though?? The first thing is that I am not for everybody.? I will underperform the broad market, whether measured by the S&P 500 or the Wilshire 5000, in many periods.? Over a long period of time, I believe that I will beat those benchmarks.? Since they are common benchmarks, and a lot of money is run against them, that is a good place to be if one is a manager.? I think I will beat those broad benchmarks for several reasons:

Value tends to win in the long haul.
By not limiting picks to a given size range, there is a better likelihood of finding cheap stocks.
By not limiting picks to the US, I can find chedaper stocks that might outperform.
By rebalancing, I pick up incremental returns.
Industry analysis aids in finding companies that can outperform.
Avoiding companies with accounting issues allows for fewer big losses.
Disciplined buying and selling enhances the economic value of the portfolio, which will be realized over time.
I think I can pick good companies as well.

I view the structural parts of my deviation versus the broad market as being factors that will help me over the long haul.? In the short-term, I live with underperformance.? Tactically, stock picking should help me do better in all environments.

That’s why I measure myself versus broad market benchmarks, even though I invest more like a midcap value manager.? Midcap value should beat the market over time, and clients that use me should be prepared for periods of adverse deviation, en route to better returns over the long haul.

Tickers mentioned: LM

If This Is Failure, I Like It

Posted on 2 January 2008 by David Merkel

I thought I did worse this quarter, but I ended up trailing the S&P 500 by less than 50 basis points. That meant that I trailed the S&P 500 for the first year in eight by somewhat less than 1%. So goes the streak.

On the bright side, it happened in a period where growth was trouncing value, and large capitalization stocks were trouncing the small.? My investing style is value-oriented, and all-cap, so I will always be smaller than the S&P.? I did better than value indexes, and better than small caps.? Is this examination of factors an excuse?? I don’t know.? The wind was at my back for the last seven years, and it is in my face now.? What I do know is that I’ve had my share of bad decisions, and I will try to rectify them in 2008.? The next reshaping is coming up soon, and I am gathering my tickers and industries.

But winning big and failing small should be good for anyone. With that, I wish you a Happy New Year.? Let’s make some serious money in 2008, DV.

What Did Buffett Know about the Gen Re Finite Reinsurance Deal with AIG?

Posted on 2 January 20082 January 2008 by David Merkel

Start with my disclaimer: I don’t know for sure. Buffett says that he didn’t know about the details, and certainly didn’t approve of the deal. From the Dow Jones Newswires:

Buffett said in a 2005 statement that he “was not briefed on how the transactions were to be structured or on any improper use or purpose of the transactions.”

Buffett’s attorney, Ronald Olson, said in a recent statement that Buffett “denies that he passed judgment in any way on the challenged AIG/Gen Re transaction in November 2000 or at any other time.”

Personally, I find this amazing for a few reasons. 1) In any dealings with AIG, a smart insurance executive would want to know what was going on. AIG has had a history of getting the better end of the deal in working with reinsurers. Buffett is not dumb, and there had been a decent amount of rivalry between the two companies over the years. 2) Buffett was not “hands off” on the insurance side of the house when it came to large insurance contracts. From his 2001 Shareholder Letter (page 8 ):

I have known the details of almost every policy that Ajit has written since he came with us in 1986, and
never on even a single occasion have I seen him break any of our three underwriting rules. His extraordinary
discipline, of course, does not eliminate losses; it does, however, prevent foolish losses. And that?s the key: Just as
is the case in investing, insurers produce outstanding long-term results primarily by avoiding dumb decisions, rather
than by making brilliant ones.

Now, maybe Buffett was overstating the case of how much he knew about what Ajit did. It is clear that he spent more time with Ajit than the managers at Gen Re, but I find it difficult to believe he didn’t review a major contract of a client who was also a major competitor known to be tough reinsurance negotiator.

3) He understands finite insurance very well. From this article of mine at RealMoney about the 2004 Shareholder letter, my last point:

12) Finally, what was not there: a discussion of Berkshire’s activities in the retroactive (or retrocessional or finite or financial) reinsurance business. This is notable for two reasons: first, in 2003, he split out the retroactive reinsurance in order to give a clearer presentation of the insurance groups operating results. This year the data is only presented in summary form. Second, Buffett made a big positive out of the retroactive reinsurance results, going so far as to explain the business in both the 2000 (page 8 ) and 2002 (page 9) shareholder letters.

Now, to varying degrees, Buffett made effort over the prior four years to explain the profitability of Berky’s retroactive reinsurance business, because it skewed the loss ratios of Berky upward. In the 2004 Shareholder letter, it was too much of a hot potato to give similar coverage to, even eliminating the entries that would have allowed one to see the accounting effect. In 2000 and 2002, he gave mini-tutorials on the business. In 2000 (page 8 ):

There are two factors affecting our cost of float that are very rare at other insurers but that now loom large at Berkshire. First, a few insurers that are currently experiencing large losses have offloaded a significant portion of these on us in a manner that penalizes our current earnings but gives us float we can use for many years to come. After the loss that we incur in the first year of the policy, there are no further costs attached to this business.

When these policies are properly priced, we welcome the pain-today, gain-tomorrow effects they have. In 1999, $400 million of our underwriting loss (about 27.8% of the total) came from business of this kind and in 2000 the figure was $482 million (34.4% of our loss). We have no way of predicting how much similar business we will write in the future, but what we do get will typically be in large chunks. Because these transactions can materially distort our figures, we will tell you about them as they occur.

Other reinsurers have little taste for this insurance. They simply can?t stomach what huge underwriting losses do to their reported results, even though these losses are produced by policies whose overall economics are certain to be favorable. You should be careful, therefore, in comparing our underwriting results with those of other insurers.

An even more significant item in our numbers ? which, again, you won?t find much of elsewhere ? arises from transactions in which we assume past losses of a company that wants to put its troubles behind it. To illustrate, the XYZ insurance company might have last year bought a policy obligating us to pay the first $1 billion of losses and loss adjustment expenses from events that happened in, say, 1995 and earlier years. These contracts can be very large, though we always require a cap on our exposure. We entered into a number of such transactions in 2000 and expect to close several more in 2001.

Under GAAP accounting, this ?retroactive? insurance neither benefits nor penalizes our current earnings. Instead, we set up an asset called ?deferred charges applicable to assumed reinsurance,? in an amount reflecting the difference between the premium we receive and the (higher) losses we expect to pay (for which reserves are immediately established). We then amortize this asset by making annual charges to earnings that create equivalent underwriting losses. You will find the amount of the loss that we incur from these transactions in both our quarterly and annual management discussion. By their nature, these losses will continue for many years, often stretching into decades. As an offset, though, we have the use of float — lots of it.

Clearly, float carrying an annual cost of this kind is not as desirable as float we generate from policies that are expected to produce an underwriting profit (of which we have plenty). Nevertheless, this retroactive insurance should be decent business for us.

The net of all this is that a) I expect our cost of float to be very attractive in the future but b) rarely to return to a ?no-cost? mode because of the annual charge that retroactive reinsurance will lay on us. Also ? obviously — the ultimate benefits that we derive from float will depend not only on its cost but, fully as important, how effectively we deploy it.

Our retroactive business is almost single-handedly the work of Ajit Jain, whose praises I sing annually. It is impossible to overstate how valuable Ajit is to Berkshire. Don?t worry about my health; worry about his. Last year, Ajit brought home a $2.4 billion reinsurance premium, perhaps the largest in history, from a policy that retroactively covers a major U.K. company. Subsequently, he wrote a large policy protecting the Texas Rangers from the possibility that Alex Rodriguez will become permanently disabled. As sports fans know, ?A-Rod? was signed for $252 million, a record, and we think that our policy probably also set a record for disability insurance. We cover many other sports figures as well.

And 2002:

Ajit Jain?s reinsurance division was the major reason our float cost us so little last year. If we ever put a photo in a Berkshire annual report, it will be of Ajit. In color!

Ajit?s operation has amassed $13.4 billion of float, more than all but a handful of insurers have ever built up. He accomplished this from a standing start in 1986, and even now has a workforce numbering only 20. And, most important, he has produced underwriting profits.

His profits are particularly remarkable if you factor in some accounting arcana that I am about to lay on you. So prepare to eat your spinach (or, alternatively, if debits and credits aren?t your thing, skip the next two paragraphs).

Ajit?s 2002 underwriting profit of $534 million came after his operation recognized a charge of $428 million attributable to ?retroactive? insurance he has written over the years. In this line of business, we assume from another insurer the obligation to pay up to a specified amount for losses they have already incurred ? often for events that took place decades earlier ? but that are yet to be paid (for example, because a worker hurt in 1980 will receive monthly payments for life). In these arrangements, an insurer pays us a large upfront premium, but one that is less than the losses we expect to pay. We willingly accept this differential because a) our payments are capped, and b) we get to use the money until loss payments are actually made, with these often stretching out over a decade or more. About 80% of the $6.6 billion in asbestos and environmental loss reserves that we carry arises from capped contracts, whose costs consequently can?t skyrocket.

When we write a retroactive policy, we immediately record both the premium and a reserve for the expected losses. The difference between the two is entered as an asset entitled ?deferred charges ? reinsurance assumed.? This is no small item: at yearend, for all retroactive policies, it was $3.4 billion. We then amortize this asset downward by charges to income over the expected life of each policy. These charges ? $440 million in 2002, including charges at Gen Re ? create an underwriting loss, but one that is intentional and desirable. And even after this drag on reported results, Ajit achieved a large underwriting gain last year.

What I am trying to point out here is that Buffett had significant knowledge of the retroactive (finite) deals at Berkshire Hathaway. He was even somewhat proud of them, though perhaps that is a matter of interpretation. He liked the almost riskless profits that they provided.

Before I move onto my last point, I’d like to digress, and simply say that not all finite reinsurance is a matter of accounting chicanery. The key is risk transfer. Without risk transfer, regardless of what the technical accounting regulations might say, there should be no reserve relief granted, regardless of the amount of money given to the cedant by the reinsurer; that money should be treated as a loan, because it will have to be paid back with interest. With full risk transfer, the company ceding the risk should not have to hold any reserves for the business. In between, the amount of reserve credit is proportional to the amount of risk shed; excess money given to the cedant by the reinsurer should be treated as a loan. Economically, that’s what it should be, even though that is not what always happens in the accounting. (Side note: yes, I know that it is difficult to determine the amount of risk shed, and different actuaries might come to different conclusions, but can’t we at least agree on the underlying theory?)

What has happened is that in many cases, little risk is shed, and a full credit for risk reduction is taken. Sometimes FAS 113 would be followed, with its 10% chance of a 10% loss as a miserably low tripwire for risk transfer. Sometimes FAS 113 would get bent, and other times, badly bent. That brings me to point 4.

4) Berky had a lot of experience with many different types of finite insurance. I remember a notable asbestos contract they took on for White Mountains where they would bear a large amount of risk. (On that one, I think White Mountains got the better end of the deal.) There were others, like the finite contract with Australian insurer FAI, which made them look solvent while experience was deteriorating. HIH bought FAI, and later went bankrupt, partly due to the acquisition. There were other finite reinsurance deals, like Reciprocal of America, where it made a company that was insolvent look solvent.

I can argue that in many cases, Berky’s underwriters did not know the accounting treatment that the cedant would use, and could not be responsible for the troubles that followed. In many cases, Berky bore significant, if limited, risk. That’s fine too. The greater question is if they were a large writer of finite coverages, which they were, they would have to have some knowledge of the cedant’s goals if they were to underwrite properly. Also remember that Buffett watches the “float” that his insurance businesses generate like a hawk. If there was a large amount of float that would come from a new contract, he likely would have known about it.

The AIG contract was big. AIG is a tough reinsurance negotiator. AIG and Berky have been rivals (Greenberg insulted Buffett on at least one occasion). Buffett watches underwriting carefully, even that of his trusted lieutenant Ajit Jain (a nice guy, really). That makes it really hard for me to believe that Buffett did not have any significant knowledge of the AIG finite reinsurance contract. In the end, I really don’t know; I’m only guessing. My guess is this: Buffett had general, but not detailed knowledge of the deal with AIG. In my estimation, he probably checked to see that there were adequate risk controls to make sure that AIG was not getting too good of a deal.

I admire Buffett. I have learned a lot from him. In general, compared to most businessmen, he is an honest and open guy who speaks his mind. If he said that he never had any significant knowledge of the contract with AIG, we should give him the benefit of the doubt, maybe. But from my angle, it is inconsistent with the way he has done business generally.

Tickers mentioned: AIG, BRK/A, BRK/B, WTM

PS — If you ask me how I feel about writing this, I will tell you that I am not crazy about what I have written. I’m not after publicity for criticizing a man that I admire greatly. I think that Buffett should be more forthcoming on the topic, and be willing to be a witness in the trial. Five people are facing ruined lives, and if Buffett really knew about it, and is saying nothing now because he is powerful enough to get away with it, well, shame on him. If he didn’t know anything about it, well, his testimony would clear the air, because it is a distraction at the trial.

Two Final Notes in 2007

Posted on 31 December 200731 December 2007 by David Merkel

When I was seven years old, my parents gave me a colorful wind-up alarm clock. I thought it was beautiful. They taught me how to wind it up each evening so that I would wake up to go off to first grade. Being a boy, after a while, I wondered how tight I could wind it, but there seemed to be a limit to that. One night, I found I could wind it one “click” tighter than usual. A week or so later, another “click” tighter. After some time, I wound it one click to many, and I heard a snap, after which the clock rapidly moved in reverse for about 30 seconds, and then moved no more. I was heartbroken, because I really liked the clock. Perhaps its “death” was not in vain, because it is a great analogy for a full swing of the credit cycle. The spread tightening in the bull phase of the cycle is initially relatively rapid, and gives way to smaller bits of incremental tightening, until it is too much, or an exogenous force acts on it. Eventually, when cash flow proves insufficient for debt service, the credit cycle turns, and the move to spread widening is rapid. Once spreads get really wide, the cycle can resume when those with strong balance sheets can tuck bonds away and realize a modest return in the worst scenario, if they just buy-and-hold. Though it did not happen for me, it would be the equivalent of buying the little kid a new clock. Then the cycle begins again.
Economically, Japan has had a lost decade. It is beginning to verge on two decades. During this time, interest rates have been low, and growth has not been forthcoming. The main reason why low rates did little to stimulate the economy is that the banks were impaired, and could not lend. The secondary reason was demographic; equity markets tend to do well when there are more savers versus spenders. For Japan, that peaked in the early 90s. For the US, that will peak in the early teens. Now, it is possible that the more market-oriented culture of the US has reacted to this factor faster than Japan would, thus the relatively stagnant equity market in the 2000s in the US. This is also a cautionary note to those that thing that lower short-term rates will benefit the US markets; after all, what good have they done for Japan?

Thanks to all my readers, and especially my commenters. You make the blog worthwhile to me. I hope to better for all of you in 2008. Happy New Year to all of my readers, whether here, or at other sites that use my posts. May God bless you richly in 2008.

What the Treasury Yield Curve is Telling Us About Corporate Bond Yields

Posted on 31 December 2007 by David Merkel

I learned from a dear friend of mine who manages high yield at Dwight Asset Management (one of the largest fixed income management shops that you never heard of), that with high yield bonds, spreads over Treasuries aren’t the most relevant measure for riskiness of the bonds.? Because they are more equity-like, high yield bonds have intrinsic risk that is independent of the level of yields in high quality bonds, the leading example of which are Treasury bonds.

In general, Treasury bonds can be thought of as a default-free debt claim (not perfectly true, but people think so), while other bonds must carry a margin for default losses.? As one moves down the credit spectrum, the riskiest corporate bonds act like equities, largely because as a company nears default, the equity of the firm is worthless, and true control of the firm is found in some part of the debt structure.
Spread curves of high yield bonds tend to invert when the Treasury yield curve is steeply sloped. ? The slope of the Treasury curve for that effect to be active now, particularly since high yield spreads have widened out from earlier in 2007.? The effect can be seen though, in higher quality investment grade bonds.? Given the lower spreads over Treasury yields on investment grade debt, the relative uncertainty in the present economic environment, and the lack of liquidity in the short end of the yield curve, it’s no surprise to find the spread curve inverted on Agencies, and flattish, but still positively sloped for single-A and BBB corporates.

What this means is that there are intrinsic levels of risk affecting the yields on high quality corporate debt, lessening the positive slope of their spread curves, or with agencies inverting the spread curves.? As the Treasury curve gets wider in 2008, those corporate? spread curves should flatten, and then invert, unless more macroeconomic volatility leads to still wider credit spreads, or a rise in short term inflation expectations causes the yield curve to stop widening.

Another way to say it is that if the short end of the Treasury yield curve falls dramatically, don’t expect the yields corporate debt to follow suit to anywhere near the same degree.

The Beauty of Broken Moats

Posted on 28 December 200728 December 2007 by David Merkel

When I wrote this post on Berkshire Hathaway, the main point I was going for was that the price of Berky was not unreasonable if one attributed value to what Berky could do in a crisis. When I trotted out the Ambac scenario, the idea was to illustrate how Buffett could if he wanted to, take advantage of a situation where values are depressed because the moats of competitors have been broken. (Think of what he did in manufactured housing finance after all the competitors were nearly destroyed. He bought the one healthy remaining company inexpensively.)

Now, had I been more thorough, I also would have pointed to pieces referencing Buffett and his experience with Gen Re Financial Products. The thing is, Buffett doesn’t like to be an external money manager or lender (for the most part), and
does not like structured finance exposure (even in its infancy, a la Salomon Brothers), he does recognize where there can be a clean, core business with defensible boundaries (a moat), where he can earn above average returns over time — insuring municipal bonds.

One key decision that any businessman must come to when entering a new field is build versus buy. Buy can be more attractive when there might be synergies between the acquirer and the target, or if the purchase price is sufficiently low. Build can be more attractive when the necessity of having something new that is unaffiliated with the old order is more attractive (no legacy liabilities), and where your competitors are viewed as being compromised, whether in balance sheet terms, or ethically. For the latter, think of the revenue lost by major insurance brokers after the Spitzer investigations. New players ate into the business models by avoiding conflicts of interest.

So, the announcement of Berkshire Hathaway Assurance Corp [BHAC] is no surprise here. Warren sees an opportunity, and he will pursue it.

Now here are three weaknesses of doing it this way. Buffett is not going to be the low cost provider, in a business where basis points matter as to who gets the business, and who does not. This strategy implies that he suspects that the major bond insurers have problems more severe than have been discounted by the equity and debt markets, and that their AAA bond ratings will remain under threat for some time. Second, it assumes that the managements of his competitors won’t take some action that significantly dilutes their equity in order to retain the solvency of their franchises, benefitting their own bondholders, those guaranteed by their firms, and management themselves (assuming they aren’t ousted). So far, the infusions to the financial guarantors have been significant, but not significant enough to remove doubt. The purpose of a AAA rating is that it is beyond doubt.

Third, a new startup will have higher fixed costs to amortize over the new business written. Mr. Buffett wants to charge more. Well, he will need to charge more, though perhaps that disadvantage is minimized because his competition faces higher costs in a different way from financial stress:

Distraction of management over structured finance exposure
Distraction with the rating agencies
Distraction over shoring up the capital structure
A much higher cost of capital than was previously available
Shareholder lawsuits (coming)

But, if I were in the seat of the competitors, I would tell my municipal divisions to ignore the problems of the company as a whole, and keep writing good business at pricing levels below that of BHAC. That will contribute to the value of the firm, and, the ratings agencies know that the marginal amount of capital needed to write that business against a mature block is almost zero. So keep writing, and protect the franchise.

Finally, it looks like this subsidiary is separately capitalized, and not guaranteed by Berky. It likely gets a AAA on its own, with only implicit support from the holding company. This gives Buffett the option to write a lot of business by providing more capital as needed, preserving flexibility at the holding company, while limiting downside if that subsidiary should ever run into trouble (very unlikely, given their business plan).Tickers mentioned: BRK/A, BRK/B, ABK

The Financing of Last Resort

Posted on 27 December 2007 by David Merkel

In 2002, we used to comment at the office that unless a company was dead, it could always get financing through a convertible bond offering.? The more volatile the situation (up to a point), the more the conversion option is worth, which can significantly reduce the effect of higher credit spreads, at a cost of possible dilution.

So, with the difficulties in getting financing at present, is it any surprise that we are having record issuance of convertible bonds?? I expect to see more of it, particularly for areas involved with housing, commerical real estate, mortgage finance, financial guarantee, and the investment banks.? High volatility and a need for financing begets convertible bond issuance.? That’s where we are now.

Current Industry Ranks

Posted on 26 December 200729 December 2007 by David Merkel

Just a short post this evening because I’m tired, and not feeling that well. Here is an Excel file containing my industry ranks for year end 2007:

Year End 2007 Industry Ranks

Remember, this can be used two ways. In the short run, the “hot industries,” the ones in the red zone, can be bought if one follows a fast turnover momentum-type strategy. For those of us with lower turnover value-type strategies, we buy industries in the green zone, but insist on quality, and attempt to analyze how transient the industry troubles are likely to be. Note that I’m not looking at all industries in the green zone — areas affected by the housing and finance sectors, for example.

One more brief note, since a couple of readers e-mailed me on this. It looks like the forced sellers of National Atlantic are done. Also, the compensation decisions for the three senior executives give them some compensation if a deal goes through. I’m not smiling on this one yet, and things could still go badly wrong. Use caution here.

Full disclosure: Long NAHC

Depression, Stagflation, and Confusion

Posted on 26 December 2007 by David Merkel

I’m not sure what to title this piece as I begin writing, because my views are a little fuzzy, and by writing about them, I hope to sharpen them.? That’s not true of me most of the time, but it is true of me now.

Let’s start with a good article from Dr. Jeff.? It’s a good article because it is well-thought out, and pokes at an insipid phrase “behind the curve.”? In one sense, I don’t have an opinion on whether the FOMC is behind the curve or not.? My opinions have been:

The Fed should not try to reflate dud assets, and the loans behind them, because it won’t work.
The Fed will lower Fed funds rates by more than they want to because they are committed to reflating dud assets, and the loans behind them.
The Fed is letting the banks do the heavy lifting on the extension of credit, because they view their credit extension actions as temporary, and thus they don’t do any permanent injections of liquidity.? (There are some hints that the banks may be beginning to pull back, but the recent reduction in the TED spread augurs against that.)
Instead, they try novel solutions such as the TAF.? They will provide an amount of temporary liquidity indefinitely for a larger array of collateral types, such as would be acceptable at the discount window.
We will get additional consumer price inflation from this.
We will continue to see additional asset deflation because of the overhang of vacant homes; the market has not cleared yet.? Commercial real estate is next.? Consider this fine post from the excellent blog Calculated Risk.
The Fed will eventually have to choose whether it is going to reflate assets, or control price inflation.? Given Dr. Bernanke’s previous statements on the matter, wrongly ascribing to him the name “Helicopter Ben,” he is determined not to have another Depression occur on his watch.? I think that is his most strongly held belief, and if he feels there is a modest risk of a Depression, he will keep policy loose.
None of this means that you should exit the equity markets; stick to a normal asset allocation policy.? Go light on financials, and keep your bonds short.? Underweight the US dollar.
I have not argued for a recession yet, at least if one accepts the measurement of inflation that the government uses.

Now, there continue to be bad portents in many short-term lending markets.? Take for example, this article on the BlackRock Cash Strategies Fund.? In a situation where some money market funds and short-term income funds are under stress, the FOMC is unlikely to stop loosening over the intermediate term.

Clearly there are bad debts to be worked through, and the only way that they get worked out is through equity injections.? Think of the bailing out of money market funds and SIVs (not the Super-SIV, which I said was unlikely to work), or the Sovereign Wealth Fund investments in some of the investment banks.

Now, one of my readers asked me to opine on this article by Peter Schiff, and this response from Michael Shedlock.? Look, I’m not calling for a depression, or stagflation, at least not yet.? At RealMoney, my favored term was “stagflation-lite.”? Some modest rise in inflation while the economy grows slowly in real terms (as the government measures it).?? A few comments on the two articles:

?First, international capital flows from recycling the current account deficit provide more stimulus to the US economy than the FOMC at present.? Will they stop one day?? Only when the US dollar is considerably lower than now, and they buy more US goods and services than we buy from them.
Second, the Federal Reserve can gain more powers than it currently has.? If this situation gets worse, I would expect Congress to modify their charter to allow them to buy assets that it previously could not buy, to end the asset deflation directly, at a cost of more price inflation, and spreading the lending losses to all who hold longer-term dollar-denominated assets.? If not Congress, there are executive orders in the Federal Register already for these actions.
Third, in a crisis, the FOMC would happily run with a wide yield curve — they will put depositary institution solvency ahead of purchasing power.
Fourth, the Fed can force credit into the economy, but not at prices they would like, or on terms that are attractive.? In a crisis, though, anything could happen.
Fifth, I don’t see a crisis happening.? It is in the interests of foreign creditors to stabilize the US, until they come to view the US as a “lost cause.”? Not impossible, but unlikely.? The flexible nature of the US economy, with its relatively high levels of freedom, make the US a destination for capital and trade.? The world needs the flexible US, less than it used to, but it still needs the US.

One final note off of the excellent blog Naked Capitalism.? They note, as I have, that the FOMC hasn’t been increasing the monetary base.? From RealMoney:

		David Merkel
		The Fed Has Shifted the Way it Conducts Monetary Policy
		12/21/2007 11:56 AM EST

Good post over at Barry’s blog on monetary policy. Understanding monetary policy isn’t hard, but you have to look at the full picture, including the presently missing M3. I have a proxy for M3 — it’s total bank liabilities from the H8 report –> ALNLTLLB Index for those with a BB terminal. It’s a very good proxy, though not perfect. Over the last years, it has run at an annualized 9.4%. MZM has grown around 12.8%. The monetary base has grown around 3%, and oddly, has not been spiking up the way it usually does in December to facilitate year-end retail.

The Fed is getting weird. At least, weird compared to the Greenspan era. They seem to be using regulatory policy to allow the banks to extend more credit, while leaving the monetary base almost unchanged. This is not a stable policy idea, particularly in an environment where banks are getting more skittish about lending to each other, and to consumers/homebuyers.

This has the odor of trying to be too clever, by not making permanent changes, trying to manage the credit troubles through temporary moves, and not permanently shifting policy through adding to the monetary base, which would encourage more price inflation. But more credit through the banks will encourage price inflation as well, and looking at the TED spread, it seems the markets have given only modest credit to the Fed’s temporary credit injections.

I am dubious that this will work, but I give the Fed credit for original thinking. Greenspan would have flooded us with liquidity by now. We haven’t had a permanent injection of liquidity in seven months, and that is a long time in historical terms. Even in tightening cycles we tend to get permanent injections more frequently than that.

Anyway, this is just another facet of how I view the Fed. Watch what they do, not what they say.

Position: noneThe Naked Capitalism piece extensively quotes John Hussman.? I think John’s observations are correct here, but I would not be so bearish on the stock market.

After all of this disjointed writing, where does that leave me? Puzzled, and mostly neutral on my equity allocations.? My observations could be wrong here.? I’m skeptical of the efficacy of Fed actions, and of the willingness of foreigners to extend credit indefinitely, but they are trying hard? to reflate dud assets (and the loans behind them) now.? That excess liquidity will find its way to healthy assets, and I think I own some of those.