This was a book that I did not ask for.? Wiley has been sending some books unsolicited.? I’m not glad on all of them, but I am glad they sent this one.
Much as I admire Jack Bogle, I am not a Boglehead.? Low fees?? Yeah.? Diversification without overdiversification?? Sure.? Asset allocation?? Top priority.? Passive investing?? Best for most of us, but not me.? Quantitative methods don’t work?? Sorry, they do, if done right.? And aside from all that, I think (unlike Jack) that unhedged foreign bonds are a core part of asset allocation, especially if used tactically.? (Buy them when little looks good in domestic fixed income, like now.)
But in skimming/reading this book, I came away impressed with the acumen of those that call themselves “Bogleheads.”? They are not just dittoheads, but people who have thought hard about the retirement planning process for average individuals.
There is a decent amount of advice on tax planning.? What sorts of vehicles will make sense for most people?? How much can be contributed?
There is a decent amount of data on the usefulness of insurance, and it tends to follow my understanding of matters:
Avoid combination products unless you have a specialized tax planning need.? Keep savings separate from protection.
Don’t forget disability and health insurance.
Immediate annuities can be a useful replacement for some of the bonds in a retiree’s portfolio.
A small amount of the book deals with investing proper, but what is there is good, if simple.? It posits fund investing and passive investing, which again, is best for most people.
Another part of the book deals with the neglected liquidation phase.? How to do it?? What to tap first?? When should one file for Social Security, and what games can be played there?
Finally, the book considers what can go wrong in life (divorce and other disasters), and how to bounce back; also, how to find a good professional to help you with your specific needs, which “one size fits all” does not cover.
Quibbles
The book really does not deal with the troubles that will come in Social Security, Medicare and federal/state/corporate pension plans.? Also, by its nature, tax law is ephemeral in the US — in an era of rising structural deficits due to entitlement programs, who can tell what the tax situation will be 20 years out?? 23 years ago, after the passage of the Tax Reform Act of ’86, who would have thought that we would create something materially worse in complexity terms than what TRA ’86 replaced?? Rates are lower, though, but I don’t see it staying that way for long.? We can look at Roths, but will the government preserve the tax-free treatment if things really get tight?
That said, I found it to be a useful guide for average people that might not be up on the nuances of strategy for retirement that an average person might use.? Wealthy people should retain specialized advisors, because they will be aware of strategies that would not make sense for average people.
This was a book that I skimmed half and read half, because I’m familiar with the material and would just check aspects of sections that I was familiar with to see if they got it right.? If you want to buy it, you can find it here: The Bogleheads’ Guide to Retirement Planning.
Full disclosure: If you enter Amazon through my site and buy anything, I get a small commission.? Your costs remain the same.
I have a bunch of pieces “ganged up” to go on real estate, international economics, government policies, market risks, and a book review on “Think Twice,” but tonight the topic is pensions, with a side order of Bill Miller.? Hopefully I will get to the other topics next week.
Defined benefit [DB] pension plans have run into the perfect storm: lousy equity returns and low high-grade bond yields.? It makes the last great pension crisis in the late ’70s look good — at least they had higher yields back then.? Thus this article from the Washington Post.? Many pension plans face almost impossible odds of catching up, raising the odds significantly of more plan terminations, where the two main losers are healthy defined benefit plans, who will have to pay higher amounts for PBGC coverage, and pensioners with high benefits, because those benefits will be cut.
That places pension plan sponsors in a bind.? What to do?? Take more risk, contribute more assets to bridge the funding gap, terminate the plan, or declare bankruptcy?? It is worse for US states, who can’t declare bankruptcy.? And municipalities don’t have the PBGC behind them; the pension liabilities are difficult to shake.
Why are there these problems?? Three reasons:
Actuarial funding methods were too optimistic for sponsors, and led them to underfund.
Investment assumptions were too generous, which also led to underfunding.
We have a cultural problem where we hide deficits/profit shortfalls through adjusting pension assumptions, or trading lower salary increases for pension benefit increases, which don’t hit the bottom line immediately, but increase funding needs for years to come.
With life insurance reserving, we use assumptions that are conservative for reserves and capital.? Pension reserving is best estimate.? If a life insurance reserve is inadequate, it must be raised to adequacy.? Pensions have a lot more flexibility, even with the recent legal changes.? It should not have been that way — pension reserving should have required pre-funding and conservative reserving.
We had boom years in the ’90s, and most DB pension plans were overfunded for a while, but the boom gave the illusion that returns would be stupendous for a long time, and companies stopped contributing as much or at all to their DB plans.? Some of that was IRS policy; the IRS did not want companies hiding income by contributing to the employees’ DB plans.? Thus the IRS capped the degree of overfunding at the time when overfunding was needed.
The states have their own issues in that it was always easier to defer making payments to the DB plans, because no one wanted to raise taxes, or defer spending plans.? Now the true costs have come home to roost because of the financial crisis.? Not only are interest rates and asset values lower, but tax revenues are down significantly, and unlike the US government, the states can’t print their way out of it; there are no foreign buyers that think they have to buy the states’ debts.
I have said before that it is foolish to take more risk in order to try to get ahead of the pension promises.? Periods of debt deflation are not kind to those taking risks.
That applies to defined contribution [DC] plans as well.? This article in Time suggests that 401(k) plans be scrapped, which are a type of DC plan.? A few notes:
401(k) plans were an accident that got shoved into a piece of legislation for providing supplemental savings benefits.? It was probably design for a special interest, but was discovered by an then-obscure Ted Benna, who started a practice around it.
Whoulda thunk that it would get bigger than DB plans?? Few thought it possible until the early ’90s.
During the boom years, few questioned the abilities of plan participants to direct their own investing.? The bust years have made that inadequacy plain.? Average people don’t know how to allocate assets.? They are either too conservative or aggressive.? Few choose the middle ground of a Ben Graham 50/50, or a DB plan 60/40 (stocks/bonds).
Participants are also not well equipped for receiving and managing a lump sum of assets at retirement.? Few will buy an immediate annuity for part of their funding needs, smart as that is.? They also will not limit themselves to withdrawing only 4% of assets per year at most.
As for the Time article, I take issue with this phrase: “This isn’t how retirement was supposed to be.”
Oh please, retirement is a modern innovation that only the developed world achieved, and only because they had more than enough children (with technological development) to fund the economic growth of the entire system.? Now that developed countries are down to replacement rate or less, the only way these systems hold together is through tax subsidies or optimistic assumptions.
The world is not so bountiful that everyone can have an easy time after age 62, without taxing others to make it happen.
Now, the 401(k) was not a bad idea, but there were limitations:
People did not contribute enough.? They should have contributed to the max, but many only did it to the degree of the match, and and some did little to nothing.
They were too aggressive or too conservative, which led to greed, panic, and underperformance.? A middling allocation would have served most well, and could have been maintained through good times and bad.
Perhaps it would have been better to have had trustee-directed plans, where participants could have chosen the amount to save, but trustees would have invested for them.? One can’t easily tell when bad markets will come, thus it pays to have dispassionate advisors do he investoing for those that will give in to fear and panic.
People were poor at choosing how to distribute their 401(k) assets — few chose immediate annuities, for two reasons: it means the forfeiture of assets for a stream of cash for life, and insurance agents don’t want the money locked up; they want to earn multiple commissions.
Some of the large insurance companies are offering deferred income benefits, i.e., pay so much today, and we will give you an income of such and so at age 65, if you are still alive then.? They are not yet common, and will say that it is a tough benefit for insurers to fund.? Not many fixed income assets are not long enough to fund such a risk.
Regarding the termination of DB plans, and their replacement with DC plans, I predicted that 15+ years ago.? Why?? As the Baby Boomers got older, there would be no way that a corporation could afford the huge benefits, because the pension funding methods were back-end loaded, as I said before.? Corporations had to pony up a lot more to fund the retirement of a 60-year old than a 25-year old.? Corporations that did not terminate their DB plans would lose investors to those that did terminate, becausetheir profits would be a lot lower.
And, If the IRS had not made it tough to overfund DB plans, perhaps we would have more of them today.? Alas, it is not so.
So, what can I say?? Don’t blame 401(k) plans for broader societal trends.? Corporations would have had to terminate their DB plans simply due to demographics.? Also, understand that the economy is limited, and stocks are not magic.? Stock don’t guarantee a good return or even a positive return.? Also, don’t blame 401(k)s and other DC plans for people not investing enough.
Okay, time for the side dish.? So Bill Miller has had a comeback over the year to date.? Big whoop.? He is still behind the S&P 500 over the last 10 years, though over the last 19 years, he is still ahead by 1-2%/year.? This is not as impressive as John Neff, by any means.
What has fueled the returns of Mr. Miller?? Low quality companies bouncing back from a crisis that the Government/Fed bailed them out of.? What Bill Miller does not do is value investing.? Value investing is not “buying them cheap,” but buying with a margin of safety.? Financials have not had a margin of safety for a long while.
Given that I think that companies with a lot of debt will underperform in the future, so do I think the Bill Miller will underperform as well.? That is an area where he he been sloppy in the past; given the weakness in the current economy, it will bite him again.
I am a risk manager first, and a profit maker second.? I tend not to trust solutions that are “magic bullets” unless there is some barrier to entry — why can you do it, and few others can?? Knowledge travels.
So, regarding the “endowment model” of investing, I have been partly a believer, and partly a skeptic.? A believer, because endowments do have the ability to invest for the long-term, and not everyone else does.? A skeptic, because many endowments were taking on too much illiquidity.
Liquidity is an underrated factor for investors who have charge over portfolios that have a long-term stable funding base.? I had that advantage once, as the main investment manager for an insurer the had a large portfolio of structured settlements.? In insurance liabilities, nothing is longer than a portfolio of structured settlements.
Buy long-dated debt?? Illiquid debt?? If the pricing is right, sure; you should have to pay to rent the strength of a strong balance sheet, where the funding is intact.? WHen managing that company’s portfolio I didn’t have to worry about a run on the portfolio, because I kept more than enough liquid assets to satisfy the demands of policyholders should they decide to surrender.
Pushing it Past the Illiquidity Limit
I decided to write about the endowment model after reading this article, of which I will quote the first paragraph:
There has been much written in the popular press lately about the failures and even the “death” of the endowment model. The discourse regarding this matter has been surprisingly simplistic, naive and exceedingly short sighted. As was the case with Mark Twain, reports on the death of the endowment model have been greatly exaggerated. Let’s start with the facts. The “endowment model” practiced by most of the big university endowments and many big foundations (but also by some astute smaller endowments and foundations) has overwhelmingly outperformed virtually all other models over any reasonable time period, and has done so for a very long time now. There is no single model, mode or manner of investing that outperforms in every environment and over every time period, and the endowment model of investing was never predicated on being the exception to this obvious reality. In fact, endowments’ time horizons are as long as any investor’s horizon, and hence are strictly focused on the long term. This is a huge advantage because there is clearly a significant liquidity premium to be captured by investing long term, not to mention the ability to better avoid the chaotic noise and behavioral finance mistakes that arise with a short term environment and outlook – especially in volatile markets.
The idea here is that you will obtain better returns if you can focus out to an almost infinite horizon — after all, endowments will last forever.? There is an edge to having a long investment horizon, but there are still reasons to be cautious, and not aim a majority of investments in such a manner that means that they cannot be touched for a long time.
Here is my example: Harvard.? At the end of fiscal 2008, those that managed Harvard Management Company were heroes.? The largest university endowment, stupendous returns, etc.? Who could ask for more?
The risk manager could ask for more.? With an endowment of nearly $37 billion in June of 2008, only $16 billion was liquid assets.? Of that $16 billion, $11 billion was spoken for because of commitments to fund limited partnerships.? Harvard also had $4 billion in debt, not all of which was directly attributable to the endowment, but still would be a drag on the total Harvard entity.?? If this is representative of the endowment model, let me then say that the endowment model accepts illiquidity risk more than most strategies do.? Even after their great investment successes, Harvard did not have enough liquidity.
Then Came Fiscal 2009 — We’re out of liquid assets!
My guess is that sometime in the fourth quarter of calendar 2008, the powers that be at Harvard concluded that they were in a liquidity bind — negative net liquid assets, and there is a need for liquidity at Harvard, to pay for ordinary operations, as well as expansion.? Thus they moved to sell illiquid investments, and take a haircut on them.? They reduced their forward commitments by $3 billion.? They also raised $1.5 billion in new debt, $500 million worth of 5-, 10-, and 30-year debt each.
This is clear evidence of a panic, and an indication that the portfolio was too illiquid.? What else might indicate that?? Well, Harvard had to scale back capital projects, and had a round of layoffs of ancillary personnel.
The idea of an endowment is that you can run your institution without fear of the future.? But that also implies that those endowed will not make abnormal demands on the endowment.? That applies to the amount disbursed and the liquidity of the underlying investments.
Now at the inception of fiscal 2010, Harvard is much in the same place as it was in 2009.? Net of debt and commitments, Harvard’s endowment does not have liquid assets on net.? (My estimates: $12.5 billion of liquid endowment funds, $8 billion of funding commitments, and $5.5 billion of debt.)? Granted, it was wise to move the endowment’s cash policy target from -5% to -3% to +2% over the past two fiscal years.? Even if cash doesn’t return anything, it is still valuable.? You can’t pay professors with shares of a venture capital partnership.
The Horizon Isn’t Infinite
This brings me to my penultimate point, which is that the investment horizon for endowments is different for other investors in degree, but not in kind.? The horizon for an endowment is infinite only under conditions of permanent prosperity.? Well, anyone can invest forever under conditions of permanent prosperity.? The forever-growing investments can be borrowed against.
The investment horizon must take into account the possibility of a depression, or at least a severe recession or war, if you want to have an endowment that will truly last forever.? There has to be cash and high quality liquid debt adequate to provide a buffer of a few years of expenses.? That will give the institution more than adequate time to adjust to the new economic conditions.
Most college endowments that have not gone overboard on illiquid investments and don’t have a boatload of debt probably don’t have to worry here.? But for those that bought into the alternative investments craze, the idea of invest for forever must at least be tempered into something like 20% of our investments exist to buffer the next 5 years, and the other 80% can be invested to the infinite horizon (maybe).? That’s a more realistic approach to endowment investing, akin to a speculator paying off his mortgage and having a year of savings in the bank before beginning a trading career with capital beyond that.
Alternative Investments are not Alternative Anymore
There is another reason, though, to be cautious about illiquid investments.? With any new alternative investment class, the best deals get done first, and wow, don’t they provide a thundering return!? Trouble is, knowledge travels, and success breeds imitators.? The imitators typically bring deals that will have lower returns or higher risks than the original deals.? But the pressure of additional money into the alternative illiquid investments force progressively more marginal ideas to get done as deals.? Also, mark-to-market returns of earlier investments get marked up, giving them an even more impressive return, which attracts more capital to the investment class.
Eventually deals get done that make no sense, but the momentum of demand carries the asset class until returns of newer deals prove to be negative.? That? gets the mark-to-market process moving in reverse, and demand for the “no longer new” investment class declines.? In some cases, investors will try to get out of funding commitments, and even try to sell their interests to a third party, usually at a significant concession to the hard-to-define fair market value.
Eventually enough capital exits the class, inferior deals get written down, and the once new investment class might still be labeled “alternative,” but has entered the mainstream, because it has been around long enough to go through a failure cycle.? The now mainstream but still illiquid investment class is near a normal size versus the investment universe, and should possess forward-looking returns that embed a risk premium to reflect the disadvantages of illiquidity.? Also, the now mainstream investment becomes more correlated with risk assets generally, because the actions of institutional investors chasing past returns is common to much of what qualifies for asset allocation.
Summary
Liquidity is valuable, and should not be surrendered without proper compensation.
Alternative investment classes eventually go through a mania phase, and then go through a failure cycle.
After failure, they tend to be more correlated with other risk assets.
Endowments can indeed invest for a long horizon, but should keep sufficient liquid assets on hand to deal with significant market corrections.
Harvard’s endowment would be vulnerable if we had a repeat in the near term of what happened in fiscal 2009 because of its low net liquidity.
Investing is a business where the smarter you are, the more it pays to be humble and recognize risk limits.? Major universities and colleges (and defined benefit plans) should review their asset allocations and stress-test them on scenarios where liquidity is in short supply.? Better safe than sorry.
Every 100 posts or so, I stop to talk to my readers more personally, thank them for reading me, reflect on where we have been, and where we might be headed.
From my heart, I thank you for reading me.? You have many things to do with your time, and you deign to read me.? Thanks.? In some ways, my blog is an acquired taste.? I cover many areas thinly, because I have a broad range of interests in finance, business and economics.? I’m sure that the average reader has to endure (or ignore) 50% of what I write, and that’s fine.
Where have we been
I am reminded of Psalm 66, verse 12 in the era we have been through: Thou hast caused men to ride over our heads; we went through fire and through water: but thou broughtest us out into a wealthy place. [KJV]? The wealthy place is not yet here.? This has been a chaotic time.? We have seen markets destroyed, and come back to life in more limited ways.? There has been a bounce-back from panic, but options are reduced compared to where we were when I started writing this blog.? Areas of over-leverage have been revealed, even in seemingly safe areas.? There is nothing certain in such an environment.? All of the old certainties get questioned, even if they survive.
Where we are now
Though I am a value investor, and a quantitative investor, I don’t write much about my stock picks, mainly because you don’t get much praise for it, and you get a lot of complaints when you are wrong.? I wrote a piece at RealMoney that reflected my frustration in writing there about my investments.? It was called: Investing Is About the Whole Portfolio.? Too many people are looking for stock picks, when they should be looking to learn thought processes.? With a stock pick, you don’t know what to do as markets change.? Learning the thought processes is more complex, but it prepares you in how to understand the market as it changes, albeit imperfectly.
I spend a lot of time on macroeconomic and fixed income issues.? Why?? The bond market is bigger than the stock market, and has a big effect on the stock market.? I keep toying with an idea that would replace Modern Portfolio Theory, with something that would use contingent claims theory to develop a consistent cost of capital model for enterprises.? Essentially, it says that in ordinary circumstances, the more risk one takes in the capital structure of a company, the higher the return required to invest.? Estimate the implied volatility of the assets, and then apply that to the liabilities and equity.
Another way of saying it is that we can learn more from the shape of the yield curve and credit spreads than by looking at backward-looking estimates of asset class returns.? I continue to be amazed at those that use historical averages for asset allocation.? Start with the yield curve.? That will give you a good estimate on bond returns.? When credit spreads are high, typically it is better to be in corporate bonds rather than stocks, but it does imply that stocks might be cheap relative to Treasury bonds.
Most of the time the markets as a group tell the same story.? It gets interesting where one is out of line from the others.? My current example is banks exposed to commercial real estate versus REIT stocks and bonds, and CMBS.? The banks are not reflecting the future losses, but the REITs and CMBS are reflecting the losses.? Chalk it up to accounting rules for the banks.
Where are we going?
Demographics is destiny, to some degree.? Countries that shrink, or have large pension/healthcare promises will have a hard time of it.
Defaults are rising in both the corporate and consumer sectors.? Anyone who thinks the financials are out of the woods is wrong.? Even as new housing sales rise, there are many defaulting on their mortgages because they can’t afford their mortgages, or think that they are stuck with too much payment for too little house.? Add onto that continuing problems with commercial mortgage defaults and corporate defaults.
The Dollar is a problem in search of a solution.? None of the solutions are any good, so changes get delayed until the pain can’t be stood anymore.? This could be decades or years — but the Dollar is in decline.
The world has more laborers, the same amount of capital, and declining resources.? Relatively, the price of labor should go down, and the price of resources up.? The value of capital will fluctuate in-between.
Where is this blog headed?
We are going in my own idiosyncratic direction.? That means when crises hit, I will be there.? Aside from that, I will talk about the issues that affect the markets more generally.? There will be book reviews.? The next two are from Justin Fox, and James Grant.
I have more models that I will trot out.? For example, I have a short-term investment model that I am developing, and I hope it will come out in the next six months.? I might also roll out my alternative to Modern Portfolio Theory, if I work it out (I am dubious that I will get there).? I also have a review of the people on the FOMC coming out.? There’s more… I always have a list of articles that I want to get to, but time is short.
Time is short.? My apologies to all who have written to me, but I have not responded to.? I can’t answer all of my e-mails.? I do read all of them, and I appreciate that you write to me.? I don’t read comments on other sites that repulish my works, so I urge you to write to me here if you want to bring something to my attention.
One last bit of thanks
I could have stayed behind the pay wall at RealMoney, but I wanted to interact with a broader audience.? Amid some criticism, the investment blogosphere is a very intelligent place, and more attuned to the real situation than most of the mainstream news media.? Give the New York Times, the Wall Street Journal, Bloomberg, and Reuters their due, but the world needs investment bloggers — we point out truths that are missed by many.? I am not speaking for me, but for the many that I respect in blogging.
And as for readers, I thank the following selection of institutions where I have readers:
Alexander & Alexander
AllianceBernstein L.P. (US)
AMAZON.COM (US)
American International Group
Bank of America (GB)
Banque Paribas (US)
Barclays Capital (GB)
Bharti Broadband (IN)
BLOOMBERG, LLP (US)
Bridgewater Associates
Cambridge MAN Customers (GB)
Charles Schwab & Co. (US)
CIBC World Markets (CA)
Citadel Investment Group
Citicorp Global Information
Credit Suisse Group
DBS VICKERS SECURITIES
Dean Witter Financial Services
DEUTSCHE BANK (US)
Dow Jones-Telerate (US)
Dresdner Kleinwort Wasserstein
Federal Home Loan Mortgage
Federal Reserve Board (US)
Fidelity Investments (US)
GOLDMAN SACHS COMPANY (US)
Google (US)
H&R Block (US)
Harvard University (US)
Hewlett-Packard Company (US)
HSBC Bank plc, UK (GB)
Intel Corporation (US)
INTERNAL REVENUE SERVICE (US)
Jefferies & Company (US)
Johns Hopkins University
JPMorgan Chase & Co. (US)
Knight Capital Group (US)
KOCH INDUSTRIES (US)
KPMG LLP (US)
LEHMAN BROTHERS (US)
MAN Financial (US)
Merrill Lynch and Company (US)
Michigan State Government (US)
Microsoft Corp (US)
MILLENIUM PARTNERS, L.P. (US)
Moody’s Investors Service (US)
Morgan Stanley Group (US)
Morningstar (US)
Mutual of Omaha Insurance
Nat West Bank Group (GB)
Nesbitt Burns (CA)
Nomura International plc
Northern Trust Company (US)
RBC CAPITAL MARKETS
Repubblica e Cantone Ticino
Royal Bank of Canada (CA)
Salomon (US)
Societe Generale (FR)
Speakeasy (US)
Stanford University (US)
STARBUCKS COFFEE COMPANY (US)
The St. Paul Travelers Companies
The Vanguard Group (US)
Thomson Financial Services (US)
UBS AG (US)
Union Bank of California (US)
United States Senate (US)
University of Chicago (US)
University of Virginia (US)
US Department of the Treasury
Watson Wyatt
WELLS FARGO BANK (US)
Yale University (US)
What a group.? I am honored.? Again, thanks for reading me, whoever you are, and whoever you work for.
Final note
I am still looking for a lead institutional investor for my equity fund, which is available in both a long only, and market-neutral form.? (I’ve beaten the S&P 500 8 out of the last 9 years.)? If any of my readers have a lead on any institutional investor who might want to invest $1 million or more in my fund, please e-mail me, and I will send you my pitchbook.? Whoever gets me my first institutional investor gets my undying gratitude.? Help me if you can.
1) I may as well start out the evening with some predictions. I’m not an expert on this, but Chapter 9 of the bankruptcy code applies to municipalities, but not states. Given the problems with state & municipal pensions, we will probably see chapter 9 modified over the next two decades to allows states to default. There will also be some modification to retirement funding laws as applied to municipalities, states, and maybe the US Government, to allow for retroactive negotiation of pensions and healthcare benefits for an insolvent government.
2) California will lead the parade of states in trouble.? They want the US to guarantee their municipal debt.? Schwartzenegger did all he could to try to pass the referenda that might partially close the budget gap, but from what I see now, it looks like most of the important ones have failed.? Having been a California resident for seven years, I went though my share of referenda; the referendum process makes the politicians of California lazy… they pass the tough stuff off to the electorate, who then get to decide off of voters’ guides and soundbites.
3) California is an exaggerated version of the troubles that other states are having.? Social program spending rises, while taxes on wages, corporate profits, real estate, real estate transfers, etc., all fall.? If you can’t print your own money, and must balance your budget, life is tough, kind of like it is for most Americans.
4) Another municipal issue — can financial guarantors split in two?? I have argued “no,” but who cares what I think?? We do care about those that use the courts, and banks are suing to prevent the MBIA split.? It is a simple issue of fraudulent conveyance.
5) One last municipal issue: pension placement agents.? This is very similar to what I experienced in Pennsylvania regarding municipal pensions there.? Pension consultants would gain business through campaign contributions, and the Democratic and Republican consultants would collaborate and share to control the profits jointly.? Insurance companies providing pension services would pay? compensation to the consultants in exchange for business.? It’s a dirty business, and when I raised ethical objections to it, I was told that I was naive.? Perhaps I have more company now.
Anytime you have opaqueness of compensation, politics, and uncertainty of results (investing), there is always room for corruption.
6) Asset allocation.? The belief in a large equity premium led many to overweight stocks.? I have argued against that.? Now there are many who are finding the they have to start over, after bad equity returns.? There is no magic in any asset class.? Yes, equities do better than bonds in the long run, but only by 1-2%/yr, not 5-7%.
As for the arguments of Ayres and Nalebuff, only the most emotionally dead investors can live with levering up 1.9 times perpetually.? Most people panic.? They can barely deal with the volatility of the S&P 500, much less double that.
7) Mmmm… is it time to take on Bill Miller again?? Yeh.? Overweighting financial stocks?? That is quite a bet, and probably irresponsible again.? Here is my free advice — analyze your estimates of intrinsic value with commercial real estate prices 30% lower than today.? Aside from short-tail insurers, I don’t think you want to be overweight financials.
8 ) On the same note, many small and intermediate-sized banks face troubles under stress, particularly from commercial real estate lending.
9) I think we are in the second inning for declines in prices for commercial real estate, but perhaps the seventh inning for residential real estate.? So long as residential properties sell for less than their mortgages there is downward pressure on prices, because negative events lead to foreclosures, not sales.
11) Will the US Government likely get full value back on TARP buyouts? No, because they lack expertise at analyzing these situations.? They don’t know what a warrant is worth.
12) Will low-rate mortgages rescue the economy?? No, but many middle class people with equity will breathe easier after they refinance.? Also, some will buy homes, but who will have the downpayment necessary to qualify now that underwriting has tightened?? Not many.
After the plunge, and the run, I scaled out of Hartford three times, and then sold because of the high odds that they will take the TARP money.? Taking TARP money has led to underperformance in the past, and though it looks like cheap capital, it can be a very expensive set of handcuffs to cut off.
If Allstate takes the TARP money, I will sell them as well, and buy a certain P&C reinsurer.? I suspect that they won’t take it — only the desperate take TARP money.
I replaced Hartford with National Western Life.? Little company, and illiquid.? If you follow me here, limit orders only.? It is a basic life an annuity company.? No debt.? Trades for half of book value.? Currently profitable, but future profits are uncertain.? One controlling investor, R. L. Moody, and the rest of the shareholder’s list reads like a “Who’s Who” of small cap value investing.? I have not reviewed the accounting in detail, but when I reviewed it in detail six years ago, I thought the accounting was more conservative than most insurance companies.
With all of the cash building up from rebalancing sales, I needed to add another name with a strong balance sheet.? I chose Canadian National.? Unlike US railroads, they go coast-to-coast — less need for loading and unloading.? Second, the valuation is not much higher than peers.? Third, the balance sheet is stronger than all peers.? Not that I think that any of the major North American railroads is at risk of failure, but it is unlikely that Canadian National will come under significant stress.
That’s all for now.? So far, it’s been a good year for me.? I’m running with cash at my upper 20% limit, so I am looking for safe and cheap ideas that would not get hit that badly in another pullback.
Full disclosure: long NWLI CNI DIIB.PK? AIZ ALL SBS GD GPC IBA EWZ NE SAFT SCVL VSH
I’m leaving for two days.? I might be able to post while I’m gone, but connectivity is never guaranteed, particularly in southwestern Pennsylvania.? (Sometimes I call it “the land that time forgot.”) Apologies to those that live there — Pittsburgh is the capital city of Appalachia.
Here are a few thoughts of mine:
1) Many have been critical of Buffett after a poor showing in 2008.? Much as I have criticized Buffett in the past, I do not do so here. The mistake that many make in analyzing Berky is forgetting that it is first an insurance company, second an industrial conglomerate, and last an investment vehicle for Warren Buffett for stocks, bonds, derivatives, etc. With most of his investments, he owns the whole company, so you can’t tell how Buffett’s investing is doing through looking at the prices of the public holdings, but by reading Berky’s financial statements. By that standard, 2008 was not a banner year for Berky — book value went down — but it was hardly a disaster. Buffett remains an intelligent businessman who deserves the praise that he receives.
From The Investor’s Consigliere, he agrees with me.? Berky is more like a special private equity shop than like a mutual fund.
2) I’m past my limit for cash for my broad market portfolio.? I have sold bit-by-bit as the market has risen.? I’m planning on buying more of my losers, or finding a few new names to throw in.? Will the current “bull market” evaporate?? There are some sentiment measures that say so.? Also, when cyclicals lead, I get skeptical.
3) As correlations rise, so does equity market risk.? Are we facing crash-like risks now?? I don’t think so, but I can’t rule it out.? My opinion would change if I knew that major foreign investors were willing to “bite the bullet” and recognize the losses that they will experience from investing in Treasuries.
4) My initial opinion of Ben Bernanke, which I repudiated, may be correct.? My initial opinion was that he would be a disaster.? Now that the transcripts of the 2003 Fed meetings are out, he was among the most aggressive in loosening policy, which was the key blunder leading into our current crisis.? It also explains the novel policies adopted by the Fed over the last 18 months.
5) Investors are geting too excited about a recovery in residential housing.? Such a recovery is not possible while 20%+ of all residential properties are under water.? Foreclosures happen because of properties under water where a random glitch hits (death, disaster, disability, divorce, debt spike (recast or reset), and disemployment).
6) I have long had GM and Ford as “zero shorts.”? Sell them short, and you won’t have to pay anything back.? Though Ford is prospering for now, GM is declining rapidly.? In bankruptcy the common is a zonk.? With dilution, the common will almost be a zonk.
7) I worry over our government’s involvement in the markets.? First, I am concerned over contract law.? The bankruptcy code in the US strikes a very good balance between the needs of creditors and debtors.? I worry when the government tampers with that.? I fear that the Obama administration does not grasp that if they attempt to change certain regulations, it will have a disproportionate effect on the economy.
12) He who pays the piper calls the tune.? To the degree that the government gets involved in business, it will intrude into lesser details that should only be the province of shareholders.? What this says to management teams is “don’t let the government in in the first place,” which should be pretty obvious.? Major shareholders with secondary interests are often painful.? With the government, that secondary interest is regulation, which makes them a painful shareholder.
With that, I bid all of you adieu for a time.? May the Lord watch over you.
The chatty, folksy annual report of Berkshire Hathaway is out.? I have occasionally been a critic of Buffett, but this year, I see little to criticize.? In a bad year, he told it straight.? He lost more book value in 2008 than any other year in percentage and dollar terms.? Worse yet, the market capitalization fell much more.
But guess what?? Berky is the biggest financial company in the US, bar none, by a wide margin.? Financials have done horribly, Berky less so.? Comparing the book value performance of Berky versus the market value of the S&P 500, this was one of Berky’s best years.
Looking at his divisions, insurance, utilities, and other businesses did well, and his investing did horribly, like most of the rest of us.? Sure, his timing was bad with some of his preferred stock purchases, and his willingness to write index put options.? But if those that Berky invested in survive the crisis, Buffett will come back smiling broadly.
Here’s another pillar of strength.? A lot of capital has been destroyed in the insurance industry in the capital markets, reducing surplus.? Those that have surplus will benefit.? Who is the most ready to write more business?? Berky.? After that, maybe PartnerRe.? Insurance should do well for Berky in the intermediate term.
Though I don’t own it, I find Berky to be intriguing.? Who knows, I might finally join the Buffett cult and buy some under $75,000.
PS — Give Buffett credit?? I would argue that Berky is cheap relative to other insurance credits.? Complexity creates the discount, but the firm is well-managed.
1) It’s nice to see someone else recommend my proposal for partially solving housing woes.? Immigration made America great.? Kudos to my Great-great-grandparents.
I neither like nor dislike buybacks, special dividends, and other bits of financial engineering that extract limited value at a cost of increasing leverage. In one sense, these measures are a type of LBO-lite at best, merely covering the tracks of the dilution from options issuance mainly, or preparing to send the company to bankruptcy at worst.
A lot depends on what spot in an industry’s pricing cycle a given company is. It’s fine to increase leverage when the bad part of the cycle has played out and pricing power is finally returning. Unfortunately, unless they are careful, companies tend to have more excess cash toward the end of the good part of the cycle, at which point increasing leverage is ill-advised, but often happens because of pressure from activist investors and sell-side analysts.
My first article on RealMoney dealt with the concept of financial slack, and why it is particularly valuable for cyclical companies not to take on as much leverage as possible. One of the dirty secrets of investing is that highly-levered companies typically do not do well in the long run; they sometimes do exceptionally well in the short run, though, so if it is your cup of tea to speculate on highly-levered companies, just remember, don’t overstay your welcome at the party.
One final note: If a management team is talented, they should retain a “war chest” for the opportunities presented by volatility. Lightly-levered companies benefit from volatility, because they can buy distressed assets on the cheap. Highly-levered companies need volatility to stay low, because adverse conditions could lead to insolvency.
Leverage policy is just another tool in the bag of corporate management; it is neither good nor bad, but in the wrong hands, it can be poisonous to the health of a company. For most investors, sticking with strong balance sheets pays off in the longer-term.
Position: None
4) Financial accounting rules can work one of two ways: best estimate (fair value), or book value with adjustments for impairment.? Either system can work but they have to be applied fairly, estimating the value/amount of future cash flows.? Management discretion should play a small role.
5) Regarding Barry’s post on Bank Nationalization: I don’t like the term “nationalization.”? It’s too broad, as others have pointed out.? I am in favor of triage, which is what insurance departments (and banking regulators are supposed to) do every year.? Separate the living from the wounded from the dead.
The dead are seized and sold off, with the guaranty fund taking a hit, as well as any investors in the operating company getting wiped out.? The wounded file plans for recovery, and the domiciliary states monitor them.? The living buy up the pieces of the dead that are attractive, and kick money into the guaranty fund.? No money from the public is used.
We have made so many errors in our “nationalization” (bailout) that it isn’t funny.? We give money to them, rather than taking them through insolvency.? Worse, we give money to the holding companies, which does nothing for the solvency of operating banks.? We don’t require plans for recovery to be filed.? Further, we let non-experts interfere in the process (the politicians).? Better that the regulators get fired for not having done their jobs, and a new set put in by the politicians, than that the politicians add to the confusion through their pushing of unrelated goals like increasing lending, and management compensation.
The concept of the “stress test” is crucial here.? It could be set really low (almost all banks pass) or really high (almost all banks fail — akin to forcible nationalization).? Clearly, something in-between is warranted, but the rumors are that the test will be set low, ensuring that few banks get reconciled, and the crisis continues for a while more.
I’m in favor of the bank regulators doing their jobs, and the FDIC guiding the rationalization of bad banks, with an RTC 2 to aid them.? Beyond that, there isn’t that much to do, and there shouldn’t be that much money thrown at the situation.? We have wasted enough money already with too little in results.
One final comment — for years, many claimed that the banks were better regulated than the insurers.? Who will claim that now?
6) Equity Private rides again at Finem Respice (“look to the end”).? A good first post on how this all will not end well.
7) Whatever one thinks about mortgage cramdowns (I can see both sides), they will have a negative effect on bank solvency, and the solvency of those who hold non-Fannie and Freddie mortgage backed-securities.
9)? Will the new housing plan work?? I’m not sure, but I would imagine that it would cost a great deal to support a large asset class above its theoretical equilibrium value.? There are also the issues of favoritism, and rewarding those less prudent.? We will see whether it doesn’t work (like Bush’s proposals), or works too well (my, but we burned through that money fast).? (Other thoughts: Mean Street, Barry, simple explanation from the NYT.)? As it is, many people will not be eligible for the help.
10) How do you eat an elephant?? One bite at a time. How well did Japan do in working through its leverage problem in the 90s and 2000s?? Reasonably well, though it took a while.? Deleveraging takes time when many balance sheets are constrained, and asset values are falling back to psuedo-equilibrium levels.? One person’s liability is another person’s asset; when a large fraction of parties are significantly levered, the reconciliation of bad debts can cascade, like a child playing with dominoes.
So, Japan took its time with a messy process rather than have a “big bang,” with less certain results in their eyes.? In America, we want to get this over with quickly, but not do a “big bang” either.? That’s where a lot of the cost comes in, because in order to reconcile private debts rapidly, the government must subsidize the process.? All that said, in the end we will have a lot of debt issued by the US Government, just in time to deal with the pensions/entitlement crisis from a position of weakness. And, that’s where Japan is today, facing a shrinking population with a lot of government debt, and rising demands for entitlement spending.? Japan may be a laboratory for the US, Canada, and Europe as we look at the same problems 5-20 years out.
11) If you want to search for prices and other data on bonds, look here.
12) Marc Faber makes many of the point that I have made about the crisis in this editorial.
13) Swiss bankruptcy?? I would never have thought of that possibility, but considering that it is a smaller country with a relatively large banking system, and those banks have made a decent amount of loans to weaker creditors in Eastern Europe.? Add Switzerland to the list with Austria on Eastern European lending troubles.
14) What is Buffett thinking in his recent sale of stocks?? Some criticize him for being inconsistent with his philosophy of long holding periods, but Buffett is a very rational guy.? He is getting some good opportunities in this market, and is selling opportunities that seem less good to him.? Could he be wrong?? Yes, but over the year, he has been pretty good at estimating the relative values of assets.? He’s made his share of mistakes recently, but 95% of investors have been in that same boat.? At least he has the insurance franchise to carry things along, and given the reduction in surplus across the industry from the fall in equitiues and other risky assets, pricing power should begin improving soon.? Berky is interesting here.
15) Mirroring the bubble, Anglo-Irish Bank rode the global liquidity wave up, then down.? Ireland was the hot place in the EU, and now the bigger boom, fueled by easy credit, has given way to a bigger bust.
With options, we often talk about them being in, out or at the money. When options are in the money, there is a high probability of receiving a payoff.? When options are out of the money, there is a low probability of receiving a payoff.? When options are at the money, it could go either way.
The same is true of banks.? There are some banks that were cautious during the boom era, and their underwriting stayed conservative.? There are others that were so aggressive that once the results of their sloppy underwriting/investing begin to be realized, it will be obvious that they are deeply insolvent.? Then there are those banks that hang in the balance.? Which way will they fall?? Will they survive or not?
I’m not in favor of blanket nationalization of banks.? My best example is the stupid move by Hank Paulson where he forced bailout money on a bunch of big banks, with no attention to whether they needed the money or not.
Who could use the capital?? The banks that have big holes in their balance sheets can’t use the capital, because it will just plug holes, and maybe it will not be enough.? Those that are healthy don’t need the money, and there is a public policy reason why the government should not forcibly buy stakes in solvent companies.? But those that are on the brink could really benefit from a capital injection.? Anything to remove the uncertainty, and the high cost of incremental capital due to uncertainty over survival.
My point is that our dear Government, should it decide to intervene in the banks at all, should aim its capital injections toward banks that are on the cusp of creditworthiness.? (On the cusp assuming that assets and liabilities are fairly valued).? Those that will likely eventually be dead should be declared dead, the assets absorbed by RTC 2 (in concert with the FDIC), and the liabilities absorbed by other local banks.? Those banks that are healthy should continue on.? Giving them more capital in order to lend more is a cute idea, but really, why should the government get involved if there is no crisis?? Many solvent banks are looking for quality borrowers now, and finding few of them.
An aside: Why are we giving money to bank holding companies? If there is trouble in the regulated subsidiaries there might be a reason to help there directly, after cutting off the subsidiaries’ ability to dividend back to the holding company (and watching transfer payments — a good transfer pricing accountant is worth his weight in gold.)? Let the unregulated subsidiaries die, and the holding companies too.? If there are excess assets of these entities let them be distributed through chapters 11 or 7 of the bankruptcy code.? I understand exceptions for systemic risk reasons, but if the operating regulated banks are firewalled, that shouldn’t be as big of a problem.
I’ve been a critic of the industry that I grew up in for a long time, but the state insurance regulators have a better handle on their companies than the banking regulators do from a solvency standpoint.? The insurance risk models work better, even though the companies are more complex.? Imperfect as the insurance risk-based capital models are, they captured much of the action.? The banking regulators did not get as much data, and did not see the damages that could occur in a real credit bust, because many were obscured by securitization and derivatives.
There is no need to nationalize the banking system.? Set up RTC 2.? Let the regulators look at the banks on an asset-by-asset basis, and analyze what the hard-to-value assets are worth.? Compare values across companies to make fair comparisons.? Do triage then.? Send the insolvent to RTC 2.? Pump some money into the operating banks that are marginal, after cutting off dividends to the holding companies.? Let the healthy banks look for opportunities on their own.
Our existing legal framework can deal with operating bank solvency problems.? We did not need something as big as TARP 1 to solve issues at the operating banks… but if we are profligate in handing out money to bank holding companies, then even TARP 2 might not be enough to deal with all of the mess.
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One more note: there have been times in insurance regulation where the regulators looked the other way and said to themselves, “Meh, the company is insolvent if we marked it to market today, but if I just give them a few years, operating profits will bail them out.? We didn’t pay close enough attention to the issues involved in the new assets they bought or new liabilities they issued, so I will be embarrassed in front of the Governor, legislators and media if this company goes down.? I will forbear for now.”
And, about half of the time, that strategy worked.? Half of the time it didn’t, leading to a deeper hole and deeper embarrassment.? In more than a few cases where it worked in the short run, in the long run, the management culture of a firm that survived did not learn the lessons of undue risk taking, and blew it up again.? Part of fixing the system is weeding out bad management teams.
So, when I see arguments that say, “Let the banks in trouble borrow at low rates.? The positive carry will bail out their balance sheets over a period of years,” I say, “Been there.? Done that.? Got the T-shirt, and a Polaroid of them drinking the Kool-aid.”
Why provide a subsidy in such a haphazard way?? Manay banks have spent a great deal of time and effort developing low-cost deposit bases, and rotten managements should now receive a low funding cost?? If banks know that the regulators will forbear, and even subsidize their incompetence, why shouldn’t they take the free option, and continue to speculate?? Let the RTC 2 deal with the problem, and let them borrow at Treasury rates.
Part of the need to collapse bad banks is a need to eliminate bad management teams.? Without that, the system will not reset properly as bad debts get cleared.? They will get cleared eventually, but what will the nation look like when it is done?? Will we still have the same level of property rights and the rule of law?? Will we have a currency that is worth anything?? If the last century changed the value of a dollar from a dollar to a few cents, what will happen with this century?
