Search Results for: Education of a corporate bond manager

The Education of a Mortgage Bond Manager, Part IV

The Education of a Mortgage Bond Manager, Part IV

Posted on by David Merkel

I sat down this evening with my trading notebooks.? It was a reminiscence of 11-14 years in the past.? I may produce another chapter of “education of a corporate bond manager” from the books.? But it gave me a flavor of what I learned (rapidly) as a mortgage bond manager 1998-2001.? So let me share a few more bits of what I learned.

1) Avoid esoteric asset classes.? I am truly amazed at how many people believed that securitization created a lot of value, when it was more incremental.? There were many who proclaimed “Buy every new ABS structure,” because it had worked well in the past.

Sadly, that is a bull market argument, and many would lose a lot of money following that advice.? In 2008, it all came crashing down for unique structures.

2) Avoid volatile asset classes.? Collateralized Debt Obligations are volatile, and not worthy of being investment grade.? That said, when I was younger, I erred with CDOs and we lost money.? Never invest with those whose incentives are different from yours.

3) There was also a period where CDO managers would buy each others BBB tranches — it was a way of lowering capital costs, at least on a GAAP basis.? We did that with NY Life, but never got the benefit, because we never did our CDO.

4) The are many asset sub-classes that have ?only been through a bull market cycle.?? That is the nature of new ideas that are introduced to applause.? But those are bull market babies.? Avoid sub-asset classes that have never seen failure.

5) There was the desire that we could originate our own commercial mortgages, with me doing the work of a full mortgage department.? I conveyed to my boss that this was impossible even if I dedicated 100% of my time to the process, and then he would not have me for the reasons he hired me.? This came up many times, and took a long time to die.

6) But at a later date, something better came up, doing credit tenant leases.? They are illiquid, but they have good protection.? The credit tenant guarantees the mortgage.? If there is non-payment, the property is yours.? I can get into securitized lending.? This was a great deal, but my colleagues in the firm overruled me, and foolishly.? Why give up protection, when you can’t get a safe yield at an equivalent spread.

7) I also learned that in the merger in 2001 that little things mattered.? So when they came to meet us in Baltimore in mid-2001, we took them to an Italian Deli that we liked.? They loved it, saying that there was nothing like it in Burlington.

I will continue this in the next part/episode.

The Education of a Mortgage Bond Manager, Part I

The Education of a Mortgage Bond Manager, Part I

Posted on by David Merkel

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

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

Liquidity for a Moment

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

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

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

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

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

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

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

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

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

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

 

Everything Old is New Again in Bonds

Everything Old is New Again in Bonds

Posted on by David Merkel

Unconstrained strategies for bonds are hot now with yields so low.? But wait. Let’s take a step back.? What do we mean by a constrained strategy?

A constrained strategy is one that limits the investments one can engage in either through:

  • Specifying an index that the manager is charged with beating
  • Specifying percentage limits for investments, split by categories such as credit quality, interest rate sensitivity, asset subclasses (ABS, RMBS, CMBS, Corporates, Agencies, etc.), and other variables
  • Barring investment in more funky fixed income instruments such as preferred stock, trust preferreds, junior debts, CDOs, ABS, RMBS, CMBS, etc.
  • Or some combination of the above.

There have been unconstrained strategies in fixed income before — they just weren’t called that.? Many value investors in the old days didn’t care what the legal form of the investment was — they only looked for an adequate margin of safety.? Their portfolios were a hodgepodge of debt and equity instruments.? Specialization in only doing debt instruments wasn’t common.

Most debt-only investments were constrained, particularly those from bank trust departments.? Of course, this was an era where investing in junk debt was not respectable for all but the most intrepid of investors.

With the advent of the 1980s we had two innovations: junk bonds and bond index funds.? The first took the world by storm with the demand for yield; I experienced that at the first insurance company that I worked for — they overloaded on junk bonds.? This was before the regulators began regulating bond credit quality more strictly.

The second took a longer time to germinate.? The first bond index fund came into existence in 1986 at Vanguard.? They couldn’t call it a bond index fund, because they could not exactly replicate the index.? There were too many bonds that were illiquid, and they could not buy them at any reasonable price.? Instead, they took an approach that we would call “enhanced indexing” today.? Match the interest rate sensitivity of the index, and the credit quality, but choose bonds that had more potential than the bonds in the index.

In that sense, though the SEC allows bond funds to be called index funds today, all bond index funds are enhanced index funds because there is no way to source all of the bonds.? And from my own days as a corporate bond manager, I learned that bonds in major indexes always trade rich.? From my piece, The Education of a Corporate Bond Manager, Part IX:

There was another example where I crossed bonds where it was legitimate ? if it was done to help a broker in distress.? One day, someone offered me a rare type of Capital One bonds at a normal level, and I asked whether the bonds in question were the ones that were in a major bond index, without saying that per se.? After figuring that out, I bought them at the level, and called a broker that was likely to be short the bonds to see if he wanted them.? He certainly did, and offered them at a three basis point concession to where I bought them, as opposed to ripping the eyeballs out (as the technical term went).

The whole set of two transactions took 15 minutes, and made $15,000 for my client.? What was funnier, was that my whole family came to visit me that day, my wife and at that time, seven kids.? They heard the two transactions, though I had to explain it to them later. To the second broker, I had each of the kids say ?Hi,? ending with the then three-year old girl who squeaked ?Hi.?? He said something to the effect of, ?I knew you had a large family, but it only really struck me now.?

That three-year old is now a beauty at twelve, and bright as anything, but I digress.? (They grow so fast… the nine-year old girl is cute as a button too.)

Bond management was once unconstrained by those who looked for total returns in the old days, and constrained in the old days by those who looked for yield.? (Many managers would not buy bonds that traded at a premium.)? Then the bond indexes became popular as a management tool.? In one sense, it freed bond management, because rather than hard constraints, they matched credit and interest rate sensitivities of the index.

But what that constrains is credit policy and interest rate policy.? One managing to beat a benchmark index has limited options.? What if you want to position for:

  • Widening credit spreads
  • Narrowing credit spreads
  • Rising interest rates
  • Falling interest rates
  • Yield curve steepening
  • Yield curve flattening
  • Outperformance/underperfomance of a given sector

Any sort of directional bet could go wrong, and more often than bonds that fit the idea of replicating the index parameters, but are special in ways that the index does not appreciate.? So rather than going “whole hog” with the bet, you merely lean toward it, such that if you are wrong, you won’t destroy the outperformance versus the index.

But in this modern world where derivatives are widely accepted as fixed income instruments, a la Pimco, fixed income managers can do a lot more.? There is more freedom to make or lose a lot of money.

The unconstrained strategy can be thought of? in two ways: always trying to earn a positive return with high probability (T-bills are the benchmark, if any), or being willing to accept equity-like volatility while the bond manager sources obscure bonds, or takes large interest rate or credit risks.

I prefer the first idea, because it is more conservative, and fixed income management should aim for safety on average.? As I have said before, I only believe in taking risks that are well-compensated.

But here’s a hard one.? With the yield curve so wide, shouldn’t a bond manager with an unconstrained mandate put a little into long bonds or long zeroes?? I would think so, but I wouldn’t put a lot there unless the momentum started to favor it.

I like the concept of the unconstrained strategy; indeed, it is what I am doing for clients, but it is of the first variety, try to make money for clients in all markets, and not just be a wild man in search of yield or total return.

I find the move to unconstrained mandates to be a return to what value managers did long ago, but in a more complex fixed income environment.? I wonder though, as to whether the future failures will invalidate the idea for most.? It is tough to manage any asset class while adjusting the risk level to reflect what should not be done in a given era, whether in equities or debt.? The danger comes from trying to maintain yield levels that are higher than what is sustainable.

Thoughts on 9/11 and its Aftermath

Posted on by David Merkel

Picture Credit: Jackie || Though the idea for the lights bringing back the twin towers is beautiful, for me, someone who travelled to the PATH station beneath them many times, I miss the twin towers.

For those that don’t know my blog well, I described what happened to me during 9/11 in two places:

There’s one small thing I left out. I was planning to go to a conference at the World Trade Center on 9/12, if things were in good enough order at my work. I had to leave it flexible, because I did not know what would come of my client meeting planned for 9/11 — the client was rarely reasonable, and I might have to jump on a bunch of projects, and not go to NYC. As it was, I never had to make that choice. The events that unfolded made it for me.

One of the things that surprised me at the time was all the people who said, “Why did they attack us? What did we ever do to them?” in the US. I remember an email that came to me saying that, and I came up with seven reasons why they would do it. Now, I don’t have that email, so I am guessing at what I said, and I may not be able to come up with all seven, but I will try to do it here.

  1. The US supports Israel.
  2. Our entertainment dominates the globe, and poisons their culture, as many in Islamic countries like the entertainment, and become lukewarm to serious Islam.
  3. We support “moderate” Islamic governments, which keeps serious Islamists out of power.
  4. We kept bases in Saudi Arabia, desecrating their Holy Land.
  5. The Saudi Monarchy talks a good game with respect to Islam, but they oppose radicalism, and the US supports them.
  6. They hate the US because it is so morally degenerate, and yet so rich, which gnaws at them because the more consistent a nation is with Islam (excluding the accident of crude oil), the poorer they tend to be.
  7. The US invaded Iraq for less than significant reasons in Gulf War I. The US & Israel make military and pseudo-military actions with impunity in the Middle East. Think of Reagan bombing Ghaddafi.

Okay, I got to seven, and I suspect at least six of these were in my original email. My statement to those I ran across in 2001 was that the attack was not irrational. They had genuine reasons to hate the US government.

I think we didn’t learn anything from 9/11. Or, we didn’t care that we offended them. We essentially doubled down.

  1. We fought Gulf War II.
  2. We invaded Afghanistan, a nation that is not a nation, and tried to change it, blowing a lot of money on a hopeless cause. Cultural change is almost impossible to achieve, and certainly will not happen when pushed by outsiders.
  3. The O-bomber used drone strikes with impunity to eliminate enemies, and occasionally innocent people by mistake. Now Biden follows in his footsteps.
  4. Seal team six eliminated Osama Bin Laden in Pakistan. (Do we really want a world where those who are technologically powerful can assassinate with impunity? How should we feel about Salvador Allende of Chile?)

I believe that war is legitimate if there are legitimate reasons. I believe in Just War Theory. Aside from that, I tend to be a pacifist. One of the few things I liked about Trump was that he was probably the least hawkish President that we had in a long time. I don’t think the US has had a legitimate war over the last 70 years. It is our job to defend our nation, not the world as a whole.

I think we have created more problems in the Middle East over the last 20 years, and to the degree we feel we have to continue to interfere there, those problems will increase still more. If you think of George Washington warning about “entangling alliances,” I think we have fallen into the dangers that he described. And if you think of Eisenhower warning us about the “military-industrial complex,” that has come to dominate us as well.

We may have beaten back serious Islam for a time, but it will come back. We have offended them too much. The US has to understand that the hatred that exists in the Middle East can’t be solved. Let them fight, and let us stay out of it. Protect our nation? Yes. Protect the world? No. Offensive wars are almost never just.

Part of being a strong nation is controlling that strength, and only using it in the most severe situations that affect us directly. If you waste that strength on lesser matters, you weaken you own nation, and your reputation abroad.

So no, I don’t think we did the right things as a nation post-9/11, and I haven’t even touched on the loss of freedom here. The US needs to be more humble, and not impose its will on the rest of the world.

SImilarities of the Coronavirus to 9-11

Posted on by David Merkel

Photo Credit: Gene Han || This picture was taken four years after the attack.

I am going to reprint here the beginning of the article The Education of a Corporate Bond Manager, Part VI. I am doing this because it describes how our investment department dealt with 9-11. Here it is:

After 9/11, and and before the merger was complete on 9/30/2001, our investment team got together and came to an unusual conclusion ? 9/11 would have little independent impact on the credit markets, so be willing to take credit risk where it is not well-understood by the market.? We bought bonds in hotels, airplane EETCs (A-tranches), anything having to do with confidence in the system at that time.? I consciously downgraded our portfolio two full notches from September to November.

I went to a Chief Investment Officers’ conference for insurance investors in October 2001.? What I remember most is that we were the only company being so aggressive.? In a closed-door meeting, the representative from Conseco told me I was irresponsible.? To hear that from a company near bankruptcy rang the bell.? I was convinced we were on the right track.

By mid-November, we had almost completed our purchases of yieldy assets, when I received a phone call from the chief actuary of our client expressing concern over the credit risks we were taking; the rating agencies were threatening a downgrade.

Well, what do you know?!? The company that did not understand the meaning of the word risk finally gets it , and happily, at the right time.? We were done with our trade.

We looked like doofuses for three months before the market began to turn, and I began a humongous ?up in credit? trade as we began to make a lot of money.? By the time I was done in early June, I had upgraded the whole portfolio three full notches.? A great trade?? You bet, and more.? What?s worse, it was what the client wanted, but not what it should have wanted.

The Education of a Corporate Bond Manager, Part VI

9-11 was a shock to the system, but one where our investment team concluded that everything would return to normal, and relatively soon. We thought that the terrorists had gotten lucky, and that there was no persistent threat. Thus, prosperity would return, well, as long as the economy would hold up, which was in question at that time. The second-order effects of the deflation of the dot-com bubble were more severe than 9-11 would ever be.

From October 2001 through October 2002, our department bravely soldiered on, and during that time I played the speculation cycle relatively well, as noted in other episodes of “Education of a Corporate Bond Manager.”

The main challenge was trying to separate the transitory from the medium-term from the permanent. 9-11 was transitory. Deflation of the dot-com bubble was medium-term, and general prosperity was the long term — and definitely so at the valuations experienced in October 2002.

The same is true today. The coronavirus, no matter how ugly it will be, is transitory, as are the effects on the supply chain, travel, etc. But if you can believe it, valuations are still absolutely high (5.5%/year over the next 10 years), though not high relative compared to bonds and cash.

So, if you have courage, buy the damaged industries. People will still travel, and not a lot of people will die. Buy the strongest companies that you know will survive.

My main point to you is this: the coronavirus is transitory. Act as if it is so, and think about what the economy will be like 3-5 years from now. Do that, and you will likely prosper, unless the effects of too much debt finally comes to bear on the market. We can’t tell when the day of reckoning will come on that topic.

Getting a Job in Insurance

Getting a Job in Insurance

Posted on by David Merkel

Photo Credit: Boston Public Library

Well, I never thought I would get this question, but here it is:

Thank you for your dedication to your blog.

I was wondering if you have any skill development advice for recent graduates to gain a job in insurance – is technical or programming skills the most important or perhaps making business cases, or showing that you can make sound and reasonable conclusions?

Thank you for your time.

Kind regards,

There are many things to do in insurance.? Some are technical, like being an actuary, accountant, investment analyst/manager/trader, underwriter, lawyer or computer programmer.? Some take a great deal of interpersonal skills, like being an administrator, marketer or agent.? Then there are the drones in customer service and claims.? Ancillary jobs can include secretaries, janitors, human resources, and a variety of other helpers to the main positions.

Before I begin, I want to say a few things.? FIrst, if you work in insurance, be kind to the drones and helpers.? It is the right thing to do, but beyond that, they don’t have to go beyond their job description — they know their opportunities are limited — it is only a job.? Treat them with respect and kindness, and they will go above and beyond for you.? I learned this positively first-hand, and a few of them 20-30 years older explained it to me when I noticed they weren’t helping others who were full of themselves.

Second, the insurance industry does a lot to train drones, helpers, agents, marketers, underwriters, and younger people generally, if they are willing to work at it.? There are self-study courses and exams that vary based on what part of the industry you are in.? Take the courses and exams, and your value goes up — it is not obvious how that will work, but it often pays off.

Third, it is not a growing industry, but lots of Baby Boomers are retiring, and leave openings for others.? Also, drone and helper positions often don’t pay so well at the entry level, and turnover is somewhat high.? The same is true of agents — more on that later.

Fourth, watch “The Billion Dollar Bubble,” and episodes of Banacek if you want.? The actual practices of how they did things in the ’60s and ’70s don’t matter so much, but it gets the characterization of the various occupations in insurance right.

FIfth, insurance is a little like the “Six Blind Men and the Elephant.”? Actuaries, Accountants, Administrators, Marketers, Underwriters, and Investment Managers (and Lawyers and Programmers) each have a few bits of the puzzle — the challenge is to work together effectively.? It is easier said than done.? You can read my articles on my work life to get a good idea of how that was.? I’ve written over 30 articles on the topic.? Here are most of the links:

DId I leave out the one on insurance company lawyers?? Guess not.

Sixth, it is easier to teach those with technical skills how the business works than to teach drones and helpers technical skills.? It’s kind of like how you can’t easily teach math and science to humanities and social science majors, but you can do the reverse (with higher probability).? It is worth explaining the business to computer programmers.? It is worth explaining marketing and sales to actuaries.? Accountants get better when they understand what is going on behind the line items, and maybe a touch of what the actuaries are doing (and vice-versa).

Seventh, only a few of the areas are close to global — the administrators, the underwriters, the actuaries, and the marketers — and that’s where the fights can occur, or, the most profitable collaborations can occur.

Eighth, insurance companies vary in terms of how aggressive they are, and the dynamism of positions and ethical conundrums vary in direct proportion.

So, back to your question, and I will go by job category:

  1. Drones and helpers typically don’t need a college education, but if they show initiative, they can grow into a limited number of greater positions.
  2. Computer programmers probably need a college degree, but if you are clever, and work at another insurance job first, you might be able to wedge your way in.? While I was an actuary, I turned down a programming job, despite no formal training in programming.
  3. Lawyers go through the standard academic legal training, pass the bar exams, nothing that unusual about that, but finding one that truly understands insurance law well is tough.
  4. Accountants are similar.? Academic training, pass the accounting exams, work for a major accounting firm and become a CPA — but then you have to learn the idiosyncrasies of insurance accounting, which blends uncertainty and discounting with interest.? The actuaries take care of a lot of it, but capturing and categorizing the right data is a challenge.
  5. Actuaries have to be good with math to a high degree, a college degree is almost required, and have to understand in a broad way all of the other disciplines.? The credentialing is tough, and may take 5-10 years, with many exams, but you often get study time at work.
  6. Agents — can you sell?? Can you do a high quality sale that actually meets the needs of the client?? That may not require college, but it does require significant intelligence in understanding people, and understanding your product.? Many agents can fob some bad policies off on some simpletons, but it comes back to bite, because the business does not last, and the marketing department either revokes your commissions, or puts you on a trouble list.? “Market conduct” is a big thing in insuring individuals.? The agents that win are the ones that serve needs, are honest, and make many sales.? Many people are looking for someone they can trust with reasonable returns, rather than the highest possible return.? One more note: there are many exams and certifications available.
  7. Marketers — This is the province of agents that were mediocre, and wanted more reliable hours and income.? It’s like the old saw, “Those who cannot do, teach. Those who cannot teach, administrate.”? It is possible to get into the marketing area by starting at a low level helper, but it is difficult to manage agents if you don’t have their experience of rejection.? Again, there are certifications available, but nothing will train you like trying to sell insurance policies.
  8. Underwriters — as with most of these credentials, a college degree helps, but there is a path for those without such a degree if you start at a low level as a helper, show initiative, and learn, learn, learn. Underwriters make a greater difference in coverages that are less common.? Where the law of large numbers applies, underwriters recede.? The key to being an underwriter is developing specialized expertise that allows for better risk selection.? There are certifications and exams for this, pursue them particularly if you don’t have a college degree.? Pursue them anyway — as an actuary, I received some training in underwriting.? It is intensely interesting, especially if you have a mind for analyzing the why and how of insured events.
  9. Investment personnel — this is a separate issue and is covered in my articles in how one can get a job in finance.? That said, insurance can be an easier road into investing, if you get a helper position, and display competence.? (After all, how did I get here?)? You have to be ready to deal with fixed income, which? means your math skills have to be good.? As a bonus, you might have to deal with directly originated assets like mortgages, credit tenant leases, private placements, odd asset-backed securities, and more.? It is far more dynamic than most imagine, if you are working for an adventurous firm.? (I have only worked for adventurous firms, or at least adventurous divisions of firms.)? Getting the CFA credential is quite useful.
  10. Administrators — the best administrators have a bit of all the skills.? They have to if they are managing the company aright.? Most of them are marketers, and? a few are actuaries, accountants,or lawyers.? Marketing has an advantage, because it is the main constraint that insurance companies face.? It is a competitive market, and those who make good sales prosper.? VIrtually all administrators are college educated, and most have done additional credentialing.? Good administrators can do project, people and data management.? it is not easy, and personally, few of the administrators I have known were truly competent.? If you have the skills, who knows?? You could be a real success.

Please understand that I have my biases, and talk to others in the field before you pursue this in depth.? Informational interviewing is wise in any job search, and helps you understand what you are really getting into, including corporate culture, which can make or break your career.? Some people thrive in ugly environments, and some die.??Some people get bored to death in squeaky-clean environments, and some thrive.

So be wise, do your research, and if you think insurance would be an interesting career, pursue it assiduously.? Then, remember me when you are at the top, and you need my clever advice. 😉

 

On Finding a Job in Finance

On Finding a Job in Finance

Posted on by David Merkel

Photo Credit: Chris-H?vard Berge

I was approached by a younger friend for advice.? This is my response to his questions below:

Thank you for agreeing to do this for me. I would love to have an actual conversation with you but unfortunately, I think that between all of the classes, exams, and group project meetings I have this week it would prove to be too much of a hassle for both of us to try to set up a time.

1. What professional and soft skills do you need to be successful in this career and why?
2. What advice would you give to someone considering working in this field?
3. What are some values/ethics that have been important to you throughout your career?
4. I understand that you currently run a solo operation, but are there any leadership skills you have needed previously in your career? Any examples?
5. What made you decide to make the switch to running your own business?

Thanks again,

ZZZ

What professional and soft skills do you need to be successful in this career and why?

I’ve written at least two articles on this:

How Do I Find a Job in Finance?

How Do I Find a Job in Finance? (Part 2)

Let me answer the question more directly.? You need to understand the basics of how businesses operate.? How do they make money?? How do they control risk?

Now, the academics will show you their models, and you should know those models.? What is more important is understanding the weaknesses of those models because they may weakly explain how stocks in aggregate are priced, but they are little good at understanding how corporations operate.? The real world is not as ideal as the academic economists posit.

It is useful to read broadly.? It is useful to dig into a variety of financial reports from smaller firms.? Why smaller firms?? They are simpler to understand, and there is more variation in how they do.? ?Learn to read through the main financial statements well.? Understand how the income statement, balance sheet, and cash flow statement interact.? Look at the footnotes and try to understand what they mean.? Pick an industry and compare all of the companies.? I did that with trucking in 1994 and learned a boatload.? This aids in picking up practical accounting knowledge, which is more powerful when you can compare across industries.

As for soft skills, the ability to deal with people on a firm and fair basis is huge.? Keeping your word is big as well.? When I was a bond trader, I ate losses when I made promises on trades that went wrong.? In the present era, I have compensated clients for losses from mistaken trades.

Here’s another “soft” skill worth considering.? Many employers are aghast at the lousy writing skills of young people coming out of college, and rightly so.? Make sure that your ability to communicate in a written form is at a strong level.

Oral communication is also important.? If you have difficulty speaking to groups, you might try something like Toastmasters.

Many of these things come only with practice on the job, so don’t think that you have to have everything together in order to do well — the important thing is to improve over time.? Young people are not expected to be as polished as their older colleagues.

What advice would you give to someone considering working in this field?

It’s a little crowded in finance.? That is partially because it attracts a lot of people who think it will be easy money.? If you are really good, the crowding shouldn’t be much of a hurdle.? But if you don’t think that you are in the top quartile, there are some alternatives to help you grow and develop.

  • Consider developing your skills at a small bank or insurer.? You will be forced to be a generalist, which sets you up well for future jobs.? It also forces you to confront how difficult the economics of smaller firms are, and how costly/difficult it is to change strategy.? For a clever person, it offers a lot of running room if you work for a firm that is more entrepreneurial
  • Or, consider working in the finance area of an industrial firm.? Finance is not only about selling financial products — it is about the buyers as well.
  • Work for a government or quasi-governmental entity in their finance area.? If you can show some competence there, it would be notable.? The inefficiencies might give you good ideas for what could be a good business.

What are some values/ethics that have been important to you throughout your career?

Here are some:

  • Be honest
  • Follow laws and regulations
  • Work hard for your employer
  • Keep building your skills; at 57, I am still building my skills.
  • Don’t let work rob you of other facets of life — family, friends, etc.? Many become well-paid slaves of their organization, but never get to benefit personally outside of work.
  • Avoid being envious; just focus on promoting the good of the entity that you work for.
  • Try to analyze the culture of a firm before you join it.? Culture is the most important aspect that will affect how happy you are working there.

I understand that you currently run a solo operation, but are there any leadership skills you have needed previously in your career? Any examples?

This is a cute story:?Learning Leadership.? I have also written three series of articles on how I grew in the firms that I worked for:

There’s a lot in these articles.? They are some of my best stories, and they help to illustrate corporate life.? Here’s one more:?My 9/11 Experience.? What do you do under pressure?? What I did on 9/11 was a good example of that.

I know I have a lot more articles on the topic on this, but those are the easiest to find.

What made you decide to make the switch to running your own business?

I did very well in my own investing from 2000-2010, and wanted to try out my investing theories as a business.? That said, from 2011-2017, it worked out less well than I would have liked as value investing underperformed the market as a whole.

That said, I proceed from principle, and continue to follow my investment discipline.? It follows from good business management principles, and so I continue, waiting for the turn in the market cycle, and improving my ability to analyze corporations.

Nonetheless, my business does well, just not as well as I would like.

I hope you do well in your career.? Let me know how you do as you progress, and feel free to ask more questions.

Simple Stuff: On Bid-Ask Spreads

Simple Stuff: On Bid-Ask Spreads

Posted on by David Merkel

Photo Credit: Eddy Van 3000
Photo Credit: Eddy Van 3000

This piece is an experiment. ?A few readers have asked me to do explanations of simple things in the markets, and this piece is an attempt to do so. ?Comments are appreciated. ?This comes from a letter from a friend of mine:

I hope I don?t bother you with my questions.? I thought I understood bid/ask but now I?m not sure.

For example FCAU has a spread of 2 cents.? That I understand – 15.48 (bid) ? that?s the offer to buy and 15.50 (ask) ? that?s the offer to sell.

Here?s where I?m confused.? How is it possible that those numbers could more than $1 apart? EGAS 9.95 and 11.13.? I don?t understand.? Is the volume just so low? ?And last price is 10.10 which is neither the ask nor bid price.? Can you please explain?

You have the basic idea of the bid and ask right. ?There is almost always a spread between the bid and the ask. ?There can be occasional exceptions where a special order is placed, such as an “all or none” order, where the other side of the trade would not want to transact the full amount, even though the bid and ask price are the same. ?The prices might match, but the conditions/quantities don’t match.

You ask why bid/ask spreads can be wide. ?I assume that when you say wide, you mean in percentage terms. ?Here the main?reason:?many of the shares are held by investors with a long time horizon, who have little inclination to trade. ?Here is a secondary reason: the value of the investment is more uncertain than many alternative investments. ?I believe these reasons sum up why bid/ask spreads are wide or narrow. ?Let me describe each one.

1) Few shares or bonds are available to trade

Many stocks have a group of dominant investors that own the stock for the longish haul. ?The fewer the shares/bonds that are available to trade, the more uncertainty exists in where the assets should trade, because of the illiquidity.

Because few shares are available to trade, price moves can be violent, because it only takes a small order to move the price. ?Woe betide the person who foolishly places a large market order, looking to buy or sell at the best price possible. ?I did that once on a microcap stock (the stock of a very small company), and ended up doubling the price of the stock as my order was fully filled, only to see the price fall right back to where it was. ?Painful lesson!

As a result, those that make markets, or ?buy and sell stocks tend to be more cautious in setting prices to buy and sell illiquid securities because of the difficulty of trading, and the problem of moving the market away from you with a large order.

I’ve had that problem as well, both with small cap stocks, and institutionally trading illiquid bonds. ?You can’t go in boldly, demanding more liquidity than the market typically offers. ?If you are buying, you will scare the sellers, and the ask will rise. ?If you are selling, you will scare the buyers, and the bid?will fall. ?There is a logical reason for this: why would someone come into a market like a madman trying to fit 10 pounds into a 5-pound bag? ?Perhaps they know something that everyone else does not. ?And thus the market runs away, whether they really do know something or not.

In some ways, my rookie errors with small cap stocks helped me become a very good illiquid bond trader. ?For most bonds, there is no bid or ask. ?Some bonds trade once a week, month, or year… indicative levels are given, maybe, but you navigate in a fog, and so you begin sounding out the likely market to get some concept of where a trade might be done. ?Then negotiation starts… and you can read about more this in my “Education of a Corporate Bond Manager” series… I know most here want to read about stocks, so…

2) Uncertainty of the value of an asset

Imagine a stock that may go into default, or it may not. ?Or, think of a promoted penny stock, because most of them are in danger of default or a dilutive stock offering. ?Someone looking to buy or sell has little to guide them from a fundamental standpoint — it is only a betting game, with volatile prices in the short run. ?Market makers, if any, and buyers and sellers will be cautious, because they have little idea of what may be coming around the corner, whether it is a big news event, or a crazy trader driving the stock price a lot higher or lower.

For ordinary stocks, large enough, with legitimate earnings and somewhat predictable prospects, the size of the bid-ask spread reflects the short-run volatility of price. ?In general, lower volatility stocks have low bid-ask spreads. ?Even with market makers, they set their bid-ask spreads to a level that facilitates trade, but not so tight that if the stock gets moving, they start taking significant losses. ?And, as I experienced as a bond trader, if news hits in the middle of a trade, the trade is dead. ?You will have to negotiate afresh when the news is digested.

As for the “Last Price”

The last price reflects the last trade, and in this era where so much trading occurs off of the exchanges, the bid and ask that you may see may not reflect the true state of the market. ?Even if it does reflect the true state of the market, there are some order types that are flexible with respect to price (discretionary orders) or quantity (reserve orders). ?Trades should not occur outside of the bid-ask spread, but many trades happen without a market order hitting the posted bid or lifting the posted ask.

And though this is supposed to be simple, the simple truth is that much trading is far more complex today than when I started in this business. ?I disguise my trades to avoid alarming buyers or sellers, and most institutional investors do the same, breaking big trades into many small ones, and hiding the true size of what they are doing.

Thus, I encourage all to be careful in trading. ?Until you know how much capacity for trading a given asset has, start small, and adjust.

All for now, until the next time when I do more “simple stuff” at Aleph Blog.

Ten Years of Investment Writing

Ten Years of Investment Writing

Posted on by David Merkel

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

May the Lord Jesus Christ bless you.

Thanks for reading me.

David

Advice to Two Readers

Advice to Two Readers

Posted on by David Merkel

I get a lot of requests for advice.? Here are two of them.

David,

?I really appreciate you discussing your trading/haggling strategies in the Education of a Corporate Bond Manager. ?It’s definitely given me new ideas and helped me get better pricing in my purchases the last couple of years. ?I still refer to them every few months or so.

I have a question about changing jobs in the fixed income industry – I work in a treasury division, managing my company’s cash and short-term investments. ?I’ve done well, but we use yield-based benchmarks, as part of the portfolio is used to immunize short term liabilities. ?When I interview with asset management shops, they want previous total return portfolio management experience. ? ?

Do you know any particular types of firms or sub-industries that use yield-based benchmarks? ?Does managing to a yield benchmark stunt my learning growth compared to a total return mandate?

 

Yield-based benchmarks exist when:

  • The liability structure being invested against is short (We could need this cash at any moment for business use!)
  • The liability structure is long, but well-defined, such as a bank or insurer that wants predictable income versus their liabilities, and so the game becomes maximize spread net of default costs, subject to matching asset and liability durations (and maybe partial durations if the liability stream is long).

You are doing the first of these.? Truth, what you are doing could be measured on a total return basis, but it wouldn?t make a lot of difference.

The second one applies to banks and insurers, and can be done on either basis as well.? The difficulty comes with trying to calculate the total return of the liabilities. ??If that it too hard to do, they create a bond benchmark that they think represents when they think the liabilities may pay out.? If the liabilities possess some degree of optionality, like that of residential mortgage prepayment, the benchmark could include bond options (long or short).

The yield on the bond benchmark is easy to calculate, as is the total return.?? Thus relative performance can be calculated either way.? I had to do this for an insurance client once who insisted that our performance was poor when we had returned more than 0.70% year more than single-A corporate, which was quite good.

Thus, one place you could try working is for is an insurer, bank, or other financial intermediary.? But what of those that manage funds for retail.? What then?

Aside from unconstrained funds, even a mutual fund has a liability to invest against ? the expectations of the client.? In that sense, most mutual fund managers aren?t doing full total return either ? they have to stay within a certain range for interest rate sensitivity. They also could be evaluated on the basis of yield realized versus that of a generic portfolio meeting their interest rate sensitivity targets.? More commonly, they would be ranked against their competitors on a total return basis.

In closing, it you don?t want to manage money for a bank or insurer, you?ll have to try to wedge your way into work in a total return environment ? taking a junior level position, and showing competence.? Believe me, most firms would love to promote from inside, if possible.

Sincerely,

David

Dear Mr. David Merkel,

I really appreciate your hard work you are putting in your site and I am an avid reader of it. I would like to seek your advice regarding a decision I am facing. My goal is become a value investor and establish my own asset management firm to manage my own money and other people’s money. Right now, I have the opportunity to pursue partnership in my family business and be able to run it along with my father. I am 23 years old, and I am a freshman student at the _+_+_+_+_.? If I am to be a partner in my family business, I have to drop out from the university and travel to +_+_+_+_+_+_+_, where the business is. I am still a freshman student because when I was 19 years old, I dropped out to establish my own business in the same industry as my family in +_+_+_+_+_. I had an experience running a business and I had the opportunity to sell my business after two years of operation to my cousins, and, thankfully, it was a profitable venture.

My family business is somehow facing sales shrinkage and cash flow problem due to low capital (my family made terrible mistakes in managing it) and economic downturn. They are specialty contractors and manufacturers of fenestration products (windows, doors, kitchens, curtain walls, and rolling shutters). If I am to work with them, I can be able to help them in reorganizing the company. It might be risky for me, but if everything worked out well enough, I will have earnings that I believe is better than being an employee.

I am facing a decision that I need to make. You might not be able to advice me, but whatever advice you give me, I appreciate it. If my goal is to manage my own money and other people’s money by establishing my own asset management firm, is it helpful to have a university degree or the experience of having ran a business? Shall I drop out and pursue my family business opportunity? If I am to continue studying, I will incur student loan debt which I won’t prefer. But, alas, I will do it if it need be to accomplish my goal. Thank you a lot.

You have my sympathies on two fronts:

1) Choosing between family obligations and personal goals is never easy.? I have had to face that in deciding what jobs I could take while raising my family.? I was recruited for a managing director position in an investment bank in the mid-90s, but passed it up because I could not peel away that much time from my family and church.? It took a lot of time for me to become an institutional investor as a result.? I became an investment actuary at the age of 31, started working in an investment department at age 37, started work at a hedge fund at age 42, and started my own firm at age 49.? By 49, I had more than enough assets to care for my family if my business failed, at least to put the kids through college.?? After that, I could be stretched.

2) Good operational businessmen can be very good investors.? There are synergies between the ability to operate a business, and the ability to make good investment decisions.? Don?t think that building another business is a waste of your time.? It will sharpen you in ways that most institutional investors never grasp.? I benefited a great deal from building profitable business within insurance companies, and it sharpened my knowledge on how to invest.

Now, all that said, if you take time out to rebuild your family?s business, don?t neglect your education.? Read good books on value investing, and study those who have been great.? I?m not saying that college is useless, but I am saying that much of the knowledge that academics teach on economics is deficient.? In some ways, it is better to be a clever businessman than an academically trained man.? The latter will not gain much insight into how to invest.? The businessman has a better chance.

Perhaps a good compromise would be to study for the CFA credential in your spare time.? I did that.? Along with that, invest some of your money in ideas that you think are worthy.? I did that from 1992-2003, before I began investing in stocks professionally, and I did very well.

You need to find out whether you have significant insights versus the rest of the markets.? Academic learning will not help that.? Operational business experience *might* help that.

Don?t give up your goal of managing your own value investing firm, but realize that there are many paths to getting there, and the most important thing is trying to develop insight into the markets that others don?t have.? Typically, academic study does not develop that.

I hope things work out for you.? Let me know how you do.

Sincerely,

David

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