Search Results for: Education of a mortgage bond manager

Advice to Two Readers

Advice to Two Readers

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

Sorted Weekly Tweets

Sorted Weekly Tweets

Europe

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  • Risk of Bank Failures Rising in Europe, E.C.B. Warns?stks.co/iXnFdgzCpNK1ctKk7ijN/w&pagewanted=all&pagewanted=print Bad scene $$
  • New BoE chief Carney will devalue sterling, Pimco warns?stks.co/sEin?It’s useless but everyone has 2try2 “beggar thy neighbor” $$
  • The French Economic Maginot Line: A Very Weak Strongpoint?stks.co/cVlX French economy weakening; 2 big 4 Germany 2 rescue $$
  • Greek Economy Optimism Seen in Yield-Curve Switch?stks.co/aVsv?Perhaps they r doing better, but what of France & Germany? $$
  • Hungary Cuts Policy Rate to Record Lowstks.co/sENf?Another nation sucked into the march to global ZIRP; what will break first? $$

?

Asia

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  • Asia’s Huge Debt Growth Problem: Remember 1997??stks.co/sEsy?Graph on this page is worth a look; could b another Asia crisis $$
  • Aging Chinese Face a Bleak Picturestks.co/cWG6?This should b no surprise; it is the logical outcome of the 1 child policy $$
  • China Failure to Grow With $1T Is Warning to Li: Economy?stks.co/jXddNegative Marginal productivity of capital in China $$?#FTL
  • China’s Xi Comes Calling on Americasstks.co/rEua?Interesting to see the Chinese need 4 products in the Western Hemisphere $$
  • China Failure to Grow With $1T Is Warning 2 Li: Economy?stks.co/dVzl?10 years from now, they’ll wonder y we worried about China $$
  • China-Based Cyber Attacks Rise at Meteoric Pace?stks.co/sEco?This is not news. Practice safe computing, & you will be safe. $$
  • Japanese Housewives Cooling on Aussie Uridashi?stks.co/sEcn?The strong yen is gone,& small investors realize there is no gain $$
  • Tokyo Shares Down Sharplystks.co/bW4G?Japanese stocks get hit, why should anyone be surprised? BOJ engaged in voodoo economics $$
  • Japan?s Bond Market Wants BOJ to Purchase More Short-Term?stks.co/gXRpTraders off-balance as BOJ stops giving them easy profit $$
  • China’s Shuanghui to Buy Smithfield Foods?stks.co/pEdZ?A wise addition to the strategic pork reserve; let the pigs flow west! $$
  • Japan plays down concerns bond price spike could hurt recovery?stks.co/fXGZKuroda thinks 3% higher interest rates won’t hurt?! $$
  • Fears over US stimulus highlight Japan?s fragility?stks.co/aVlz?Japan is reaching the limits of what monetary policy can do $$

 

Rest of the World

  • Sudan Threatens to Close Pipelinestks.co/cVvE?Two corrupt regimes arguing over oil – a lose/lose situation $$
  • Bank of Israel Lowers Rate Again After Surprise Mid-May Cut?stks.co/eVoS?Many fringe economies import low rates 2 aid exporters $$
  • Despite Detractors, Don’t Buy Talk of Dollar’s Demise?stks.co/cVeU?The US is in good shape compared to Japan, Eurozone & China $$
  • Fringe economies are forced to absorb loose monetary policy, or let exports suffer while hot money tries to get yield in their countries $$

 

Central Banking

?

  • Simon Johnson: Choosing the Next Head of the Federal Reservestks.co/bWEQ?No doubt that Dick Fisher would b a lot better $$
  • Is the Fed Right to Calibrate Asset Purchases to Economic Data?stks.co/fXYR?Coarse data doesn’t allow 4 fine policy precision $$
  • US Banks Looking Solid As Bernanke Keeps The Juice Flowing, But Perils Of Financial Crisis Loom?stks.co/pEdg?Low rates will end $$
  • Fed?s 100-Year Roots Grew From Virginia Congressman?stks.co/sEWJ?Puff piece of secular hagiography fawning over Carter Glass $$
  • Kuroda Struggles W/Communication as Japan Rates Rise?stks.co/eVkQ?Most central bankers don’t know forces w/which they r toying $$
  • Also, strong communication skills at central banks r a weakness, not a strength; better 2 move back to the pre-87 era, operate in shadows $$
  • The more communication a central bank puts out, the more markets become “tightly coupled” w/the CB, thus limiting the effects of policy $$
  • Stephen Poloz: Top 10 headaches BoC chief faces right off the bat?stks.co/qEKO2 much debt amid a mortgage bubble germinates $$

 

Market Impact

 

  • NYC Pension Chief Seeks $500,000 Managers to Cut Out Wall Street stks.co/eWPZ?Insourcing looks easy; u need bright mgmt 2do it $$
  • Contrarian Investing in Quality Franchises?stks.co/dWEz?It is not enough 2b contrarian, u have 2b right $$?$STUDY
  • James DeMasi on Overcoming Adversity to Start and Grow a Value Investment Management Firm?stks.co/eWPVIntelligent stuff $$?$STUDY
  • Pension-Fund Swings Make Case for Cutting Risk?stks.co/tEuZ?Much as I like ALM, probably the wrong time 2 trade stocks 4 bonds $$
  • Junk Bonds Having A Bad Week (Down 0.96%) Amid Broader Pullbackstks.co/bWEV?Yet this is small & we need it 2 persist 4 weeks $$
  • Evaluating 3 Bullish Argumentsstks.co/dW9s?PR better than logic, but he is right that the market is overvalued $$
  • Sallie Krawcheck: Big Banks Still Don?t Have Enough Capital?stks.co/rEou?No 1 knows how large the ultimate catastrophe could b $$
  • Morgan Stanley to Downsize Fixed Income?stks.co/dVzj?I think this is a mistake. Wall Street exists 2 sell debt$MS?$$
  • Record Cash Sent to Balanced Fundsstks.co/eVv4?Hail the humble balanced fund, which has the virtue of keeping panic away 4most $$
  • SEC Refocuses on Accounting Fraud stks.co/gXI1?With Crisis-Related Enforcement Ebbing, SEC Is Turning Back to Main Street $$
  • A hedge fund for u & me? Best move is 2 pass?stks.co/eVoW?Sage advice from @ritholtz?| survivor & reporting bias & fees 2 high $$
  • Goldman Sachs Buyback Orders Reach Highest Level of Year?stks.co/bVkE?Are buybacks part of the voting or weighing machine *now* $$
  • Margin Debt Hits a Record, Showing Confidence?stks.co/fX96?Confidence or froth, amid a market influenced by aggressive $$ policy?
  • Beware of ‘Bargain’ Stocks?stks.co/hXKKI disagree for now; look4 strong companies in industries under stress that will survive $$
  • Defaulted Manhattan Complex Rewards Patient $$?stks.co/iXCC?Sadly, equity & mezzanine were wiped out, patience pays only4 snr debt

 

Insurance

 

  • MetLife cuts 2,500 advisers seen lacking chance of success?stks.co/dWF0?Retail chief says productivity ‘way up;’ costs way down $$
  • Regarding the prior tweet, I have wondered 4 ~25 years when something like that would happen; has long been needed @ most life insurers $$
  • $PRU?Takes On?$AFL?in Benefits After Health Law?stks.co/fXpO?Much easier2 “enter” a market than create a sales force $$ FD: +?$AFL
  • $ENH?CEO steps down, replacement named?stks.co/iXML?Sudden. Former CEO of?$AXS?picked, owns ~1.5%, will own ~4% as comp; FD: +$ENH
  • The former CEO of?$AXS?was pushed out by his board; he built Axis, but was a bit of a prima donna. What will he do to $ENH?? | FD: +?$ENH?$$
  • One more note: the competent former CFO of?$PRE?is now CEO of?$AXS?, having been passed over for the CEO job @?$PRE?$$?#musicalchairs

 

US Politics

 

  • Pelosi: ?We have to pass the bill so you can find out what is in it.? The more we find out, the less sense it makes.stks.co/pF0S
  • GOP senators want IG probe of Sebelius’ ‘Obamacare’ fundraising?stks.co/dWA5Obama administration is more corrupt than Nixon $$
  • Bible Class in Texas Schools Faulted as Unconstitutional?stks.co/iXnP?Look in the comments 4 bigoted ideas that aren’t American $$
  • Obamacare Competition Has Roots in Economist?s Passion?stks.co/dW9n?If you believe in neoclassical economics u r deluded $$?#loser
  • Regulators Want Better Financial Datastks.co/gXjV?Well, duh, but there are costs involved & the government does not bear those $$
  • When Chinese Walls Come Crumbling Down?stks.co/rEot?There r still conflicts of interest on Wall Street. Be aware & defensive $$
  • Deposits Guaranteed Up to $250,000?Maybe?stks.co/pEdo?Congress transfers insured deposit risks to the taxpayers & depositors $$
  • Liberty Reserve Joe Bogus Account Said to Reflect Evasion?stks.co/jXKv?Money laundering goes high-tech; Feds take action $$
  • Obama Accepting Sequestration as Deficit Shrinks?stks.co/gXIj?Whaddaya know? A policy no one liked actually isn’t that bad $$
  • Health Law Critics Seek to Gut It by Attacking Exchanges?stks.co/rEO6 Exchanges will only attract sick, will b high costs4all $$
  • The US Federal Government Spending: a Huge Fiscal Drag http;//stks.co/iXMS Cutting less useful spending it may help, not harm $$
  • Hollywood Loses Blockbusters as ?Iron Man? Finds Subsidy?stks.co/gXIX?Like building stadiums, except u have to keep doing it $$
  • Obama Nominates 2 Senate Aides for S.E.C. Posts?stks.co/fX8w?A team 2 assure continued incompetence & weak enforcement $$
  • Banks’ Lobbyists Help in Drafting Financial Bills?stks.co/pEJH?Basic goals: min capital reqs, max flexibility, weaken regs $$

 

Other

 

  • Cord Cutters Lop Off Internet Service More Than TV?stks.co/hXwv?You can cut your costs, but what does that do to your life? $$
  • Online Course Providers Reach Out2 Wary Professors?stks.co/jXde?Better to ask the question, “Where is new revenue coming from?” $$
  • Victor Davis Hanson: Why Some Wars Are So Savage?stks.co/bW4K?Evenly matched wars that take a long time lead to barbarism $$
  • Mary Meeker is Back With Her 2013 Internet Trends Report Slidesstks.co/pEfP?A lot of interesting information $$ Things change
  • European Sunscreen Roadblock on U.S. Beaches?stks.co/tENx?If you sunburn like me, maybe European sunscreens will help u $$
  • Dear Grads, Don’t ‘Do What You Love’ stks.co/hXVe?The solution is 2love what u do; working 4 $$ helps other priorities in life
  • Death Jolts Texas Investorsstks.co/aVsN?Since his body was found 2 weeks ago, investors say they lent him millions of $$?#badodor
  • Common Core Education Is Uncommonly Inadequate?stks.co/sENHNational curriculum standards tend 2b dumbed-down; local better $$
  • Science Can?t Pin Powerful Tornadoes on Global Climate Change?stks.co/eVoUA rare fair article on climate @ Bloomberg. Who knew $$
  • Noahpinion: Bets do not (necessarily) reveal beliefs?stks.co/dVdu?In which Noah Smith arbs Brad Delong & Patrick Chovanec $$?#FTW
  • Immunology Gets Turned On Its Headstks.co/jX4P?Discovery may aid vaccine design&begins2explain y gene therapy runs in2 trouble $$
  • Is This Google X’s Plan to Wire the World??stks.co/hXKJ?Solar powered balloons dot the skies, could last 5 years & upgrade $$

 

Companies

 

  • Buffett’s Safe Bet on Vegas?stks.co/gXjUThe Maestro does it again, takes a marginally profitable company, & refinances it $$
  • Goldman Upgrades Defense Contractors?stks.co/gXjT?My but how contrarian; won’t there b less cash flowing to defense companies? $$
  • Berkshire Hathaway Unit to Buy NV Energy for $5.6B?stks.co/dVzk?Another wise move by Buffett; utility earnings make $$ vs funding
  • Alcoa Cut to Junk by Moody?s as Aluminum Price Declines?stks.co/pEkEAnother sign of economic weakness, but Alcoa will survive $$
  • Payday Lenders Evading Rules Pivot to Installment Loans?stks.co/eW4q?I like people to have choice, but not 1 that leads2a trap $$
  • Empire State Building IPO Plan Is Approved?stks.co/fXUM?”The second-largest IPO for a U.S. real-estate investment trust” ever $$
  • BHP Halts Coal Expansion?stks.co/dVthDownturn in the global economy & thus steel makes demand fall for metallurgical coal $$?$BHP
  • Newsweek for Sale: IAC Seeks Buyersstks.co/jXKo?The internet changes everything; say goodbye to a dinosaur $$
  • Utilities Weigh Entering Rooftop-Solar Business?stks.co/sEWA?Sounds dumb; it’s a very different biz in almost every way $$?#FTL
  • Samsung, Sony Court Indians as Subsidies Fund Factories?stks.co/gXIgIndia gives 25% subsidy4capital costs2setup tech plants. $$

 

Energy

 

  • As US Oil Booms, an Unlikely Word Rises: Depletion?stks.co/dVl5?Wells created by fracking have shorter production profiles $$
  • U.S. Oil Boom Divides OPECstks.co/pEUQ?Those most dependent on oil revenues want others in OPEC 2 cut, so that they can cheat $$

 

Replies, Retweets & Comments

  • I just left a comment in “Energy stocks down, look to end week higher – Energy Stocks – MarketWatch”on.mktw.net/18DiBrm
  • “I have read both. Buffett made mistakes that cost him, but never such that he could not bounce back?” ? D_Merkeldisq.us/8da393?$$
  • Commented on StockTwits: Old tweet deleted, new tweet out?stks.co/iXMe
  • “Don’t forget his purchase of 83% of CVR Energy. Equally good. FD: +$CVI ” ? David_Merkel?disq.us/8d9jmi?cc:@refomedbroker?$$
  • @AlephBlog?Growth and the Market. Useful piece to help people make sense of seemingly over-valued equity market:wp.me/p3nd6r-4s
  • Sets up future losses $$ RT@tomkeene: ?Cov-lite? loans soar in dash for yield -?FT.com?on.ft.com/12daxfK
  • @kurtgodeldabomb?I like your name. Yes, that’s y I said it; I think its the voting machine 4 most companies, & weighing machine 4 a few
  • “Until the strategy fails, and he asks you to leave.” ? David_Merkeldisq.us/8d97f5?$$
  • @pope_stephen?Sadly, monetary policy was much better run under Volcker & Martin, & they were not going out of their way 2 explain the Fed $$

 

FWIW

  • My week on twitter: 42 retweets received, 2 new listings, 60 new followers, 37 mentions. Via:?20ft.net/p

 

The Rules, Part XLII

The Rules, Part XLII

During a panic, it is useful to reflect on the degree to which the real economy has been driven by the financial economy.? In the Great Depression, the degree was heavy; in the seventies, it was light.? Today, my guess is that it is in-between, which makes it difficult to figure out the right strategy.

Again, this was written in 2002 or so.? As I posted last night, the banks were in relatively good shape then.? I made a lot of money for my clients buying bank floating rate trust preferred securities at ~$80.? There was no security that we did not clear at least $10 on, and most cleared $20 within a year.? One even went from $68 to $100, plus a healthy coupon.? In bond terms those were a series of home runs.? As an aside, as a bond investor, I focused more on net capital gains than most, and that helped us in a rocky era.? I often gave up current income to gain the potential for capital gains, which was the opposite of most of my competitors.

So in 2002 it was reasonable to buy banks as the willingness to supply of credit grew.? But there are limits to how much credit you can have in an economy without things getting screwy.? An economy with too many promises to pay becomes inflexible; far better to finance more of the economy with equity, but that requires a Fed that works properly, like it was under Eccles, Martin and Volcker.? Under men of less courage, like Bernanke, Greenspan, Burns, Miller, Crissinger, and Young, it simply paves the way for asset bubbles and price inflation.

In 1929 and 2008, though, it was relatively easy to know that the financial economy had grown too large for the real economy.? Total debt to GDP levels were at records.

Or think of it from this angle: in 2004, I was recruited by another financial hedge fund to be their insurance analyst.? I talked with them, but ultimately I refused, because I felt the boss was probably less competent than my current boss.? A major part of his presentation was how amazing the outperformance of financial stocks had been over the prior 10 years, implying that it would be the same over the next 10.? That outperformance was not repeatable because the capital of the banking and shadow banking industries had gotten so large that there was no longer any way that they could extract a high return out of the rest of the economy.? As it was, the effort to do so made them take on asset risks that killed many companies, and should have killed many, many more, had economic policy been handled properly.

This is one reason why my long only portfolio was so light on financials, excluding insurers, going into 2008.? I sold the last of my banks in 2007, realizing Europe would be no safe haven.? I retained one mortgage REIT that cratered as repo fell apart, teaching me a valuable lesson that I had bought something cheap, but not safe.? That was my only significant loss during the crisis starting in 2007-2008.? Repo funding is not a safe funding source during crises, and this is something that is not fixed from the last crisis, along with portfolio margining, and a few other weak liability structures.

With respect to the eras starting in 1929 and 2008, the key concept is debt deflation?? When there are too many debts, there will be too many bad debts.? That is the time to only only companies with strong balance sheets that will not need to refinance under any conditions.? That eliminates all banks and shadow banks.

I can’t guarantee that we are past the crisis, because we haven’t seen what will happen to the economy when the Fed starts to lessen policy accommodation, much less tighten.? As it is, for the most part, I not only own companies that are cheap, but primarily companies that are safe.? Value investing is “safe and cheap,” not just cheap.? This applies to financials as well, but many value investors lost a lot of money on financials because they ignored credit quality near the end of a credit boom.? Many credit-sensitive companies looked cheap near the end of the 2007, but they were cheap for a reason — they were about to get pelted by a ton of losses.

As an aside, do you know how hard it is to get a value manager to short something trading at 50% of book value?

I know how tough that is.? I’ve been through it.? He would not bite.

The company had asset risks as well as liability risks.? I extrapolated the liability cash flows to realize the long-term care? policies the company had written would likely bankrupt them.? But when the boss came to me pitching it as a long because one his buddies thought it was dirt-cheap, I uttered, “Gun to the head boss, I would tell you to short it.”? Reply: “But it’s trading at half of book value.” Me: “Book value is misstates true economic value.? Can’t say for certain, but I think this one goes out at zero.”

As it was, we did nothing, and the stock, Penn Treaty, did go out at zero. (There was one small positive out of this, I did convince the private equity arm not to fund a competitor in long-term care.)

Back to the main point.? Have a sense as to the financial economy.? This will probably only happen once in your life, but that time is crucial.? If there is a financial mania going on, move to safety, and reduce exposure to credit-sensitive financials.? It’s that simple, but to most value investors who invest in seemingly cheap financials that is a hard move.? Remember, safe comes before cheap in value investing, and that means questioning asset accrual items.? Financial companies have that in spades.

The Rules, Part XXXVII

The Rules, Part XXXVII

The foolish do the best in a strong market

“The trend is your friend, until the bend at the end.”? So the saying goes for those that blindly follow momentum.? The same is true for some amateur investors that run concentrated portfolios, and happen to get it right for a while, until the cycle plays out and they didn’t have a second idea to jump to.

In a strong bull market, if you knew it was a strong bull market, you would want to take as much risk as you can, assuming you can escape the next bear market which is usually faster and more vicious.? (That post deserves updating.)

Here are four examples, two each from stocks and bonds:

  1. In 1998-2000, tech and internet stocks were the only place to be.? Even my cousins invested in them and lost their shirts.? People looked at me as an idiot as I criticized the mania.? Buffett looked like a dope as well because he could not see how the enterprises could generate free cash reliably at any intermediate time span.
  2. In 2003-2007, there were 3 places to be — owning homebuilders, owning depositary financials or shadow banks, and buying residential real estate directly.? This was not, “Buy what you know,” but “Buy what you assume.”
  3. In 1994 many took Mexican credit risk through Cetes, Mexican short-term government debt.? A number of other clever investors thought they had “cracked the code” regarding residential mortgage prepayment, and using their models, invested in some of the most volatile mortgage securities, thinking that they had eliminated all risk, but gained a high yield.? Both trades went badly.? Mexico devalued the peso, and mortgage prepayments did not behave as expected, slowing down far more than anticipated, leading the most levered players to? blow up, and the least levered to suffer considerable losses.
  4. 2008 was not the only year that CDOs [Collateralized Debt Obligations] blew up.? There were earlier shocks around 2002, and the late ’90s.? Those buying them in 2008 and crying foul neglected the lessons of history.? The underlying collateral possessed no significant diversification.? Put a bunch of junk debt in a trust, and guess what?? When the credit cycle turns, most of those bonds will be under stress, and an above average amount will default, because the originators tend to pick the worst bonds with a rating class to maximize the yield, which allows the originator to make more.? Yes, they had a nice yield in a bull market, when every yield hog was scrambling, but in the bear market, alas, no downside protection.

I could go on about:

  • The go-go years of the ’60s or the ’20s
  • The various times the REIT market has crashed
  • The various times that technology stocks have wiped out
  • And more, like railroads in the late 1800s, or the money lost on aviation stocks, if you leave out Southwest, but you get the point, I hope.

People get beguiled by hot sectors in the stock market, and seemingly safe high yields that aren’t truly safe.? But recently, there has been some discussion of a possible “safety bubble.”? The typical idea is that investors are paying up too much for:

  • Dividend-paying stocks
  • Low-volatility stocks
  • Stable sectors as opposed to cyclical sectors.

A “safety bubble” sound like an oxymoron.? It is possible to have one?? Yes.? Is it likely?? No.? Are we in one now?? Gotta do more research; this would be a lot easier if I were back to being an institutional bond manager, and had a better sense of the bond market pulse.? But I’ll try to explain:

After 9/11/2001, institutional bond investors did a purge of many risky sectors of the bond market; there was a sense that the world had changed dramatically.? At my shop, we didn’t think there would be much change, and we had a monster of a life insurer sending us money, so we started the biggest down-in-credit trade that we ever did.? Within six months, yield starved investors were begging for bonds that we had picked up during the crisis.? They had overpaid for safety — they sold when yield spreads were wide, and bought when they were narrow.

But does this sort of thing translate to stocks?? Tenuously, but yes.? Almost any equity strategy can be overplayed, even the largest and most robust strategies like momentum, value, quality, and low volatility.? In August of 2007, we saw the wipeout of hedge funds playing with quantitative momentum and value strategies, particularly those that were levered.

Those with some knowledge of market? history may remember in the ’60s and ’70s, there was an affinity for dividends, with many companies borrowing to pay the dividend, and others neglecting necessary capital expenditure to pay the dividend.? When some of those companies ran out of tricks, they would cut or eliminate the dividend, and the stock would fall.? Now, earnings coverage of dividends and buybacks seems pretty good today, but watch out if one of the companies you own has a particularly high dividend.? You might even want to look at some of their revenue recognition and other accounting policies to see if the earnings are perhaps somewhat liberal.? You also compare the dividend to what the cash flow from operations is, less cash needed for maintenance capital expenditure.

I don’t know whether we are in a “safety bubble” now for stocks.? I do think there is a “yield craze” in bonds, and I think it will end badly when the credit cycle turns.? But with stocks, I would simply say look forward.? Analyze:

  • Margin of safety
  • Valuation, absolute & relative
  • Return on equity
  • Likely and worst case earnings growth

And then balance margin of safety versus where you have the best opportunities for compounding capital.? If relative valuations have tipped favorably to less common areas for stock investing that considers safety, then you might have to consider investing in industries that are not typically on the “safe list.”? Just don’t? compromise margin of safety in the process.

Sorted Weekly Tweets

Sorted Weekly Tweets

 

Politics

 

  • California Democrats seize super majorities in both houses of Legislature http://t.co/Wp2cVYTF CA businesses plan exit strategies $$ Nov 08, 2012
  • Harsher energy regulations coming in Obama’s second term http://t.co/JHDKAhok Fracking, chemical emissions, & more $$ -losing green energy Nov 08, 2012
  • US crop insurance a post-election target, farm bill elusive http://t.co/9OdbRVjy W/Ag doing so well over last 5 yrs, this should b ez, not Nov 08, 2012
  • Ethanol Going Ugly Turns Bush Plan Into Obama Test http://t.co/Pe6ixxc1 Should b a no-brainer, but Congress ag state politics r ugly $$ Nov 08, 2012
  • Could This Be End of Evil Filibuster? http://t.co/t72aR3OR Limit filibusters to actual votes & require physical presence on the floor $$ Nov 08, 2012
  • Obama Win Means Health Overhaul to Move Ahead in States http://t.co/ybXggsLt Destroy health care 2 replace it w/single-payer system $$ Nov 08, 2012
  • Yep, There Have Been Problems With Email Voting in New Jersey http://t.co/lZjzVNrG In general, probability of fraud in voting is rising $$ Nov 07, 2012
  • Defense Fund Rockets to Four-Year High: Romney Rally? http://t.co/3fzUDRTH Discounting Obama’s change of heart after election $$ 😉 Nov 06, 2012
  • Romney Threatens Pimco?s Gross With Bernanke-Dumping Plan http://t.co/xO6Tm0aF 2 many links in the chain of reasoning; low prob correct $$ Nov 06, 2012
  • Southfield Twp. voter appears to die, then asks ‘Did I vote?’ http://t.co/2ZwRgotp I found his words to his wife 2b touching in many ways $$ Nov 06, 2012
  • Tuesday Is Election Night, Be Careful What You Tweet http://t.co/UdPPMYiJ Measure twice, cut once, tweeps. & bring a dose of skepticism $$ Nov 05, 2012
  • Three Men Make a Tiger http://t.co/eX1PziJK John Mauldin predicts Romney as victor; piece is mostly about eliminating confirmation bias $$ Nov 05, 2012

 

China

 

  • China: Worse Than You Ever Imagined http://t.co/Kp69IC1n 40MM+ people were killed during the “Great Leap Forward.” Mao deserves derision $$ Nov 08, 2012
  • China’s leadership challenge in new era: douse “inequality volcano” http://t.co/pJiAksUl Widespread poverty in China scares Communist Party Nov 08, 2012
  • A Cheerleader for Mao’s Cultural Revolution http://t.co/d3RhdV95 Lied about Cultural Revolution & The Great Leap Forward. Millions died. Nov 08, 2012
  • The Chinese Credit Bubble – Full Frontal http://t.co/MDZn1jCs As I have argued for some time, total debt in China is quite high $$ #danger Nov 07, 2012

 

Companies

 

  • Peltz Takes Stake in Danone http://t.co/P1AdRe9G Danone $DANOY is a French firm, will be difficult to encourage change $$ Nov 08, 2012
  • Prudential Records $618 Million Loss on Derivatives http://t.co/6ZQK1Uk5 I worry about life industry; the acctg 4 secondary gtees: yuck $$ Nov 08, 2012
  • Nucor Galvanizes Gas Hopes http://t.co/NmfZ9fmJ $NUE provides capital 4 development of gas resources of $ECA -Gets 50% stake in wells $$ Nov 08, 2012
  • Office Depot-OfficeMax Deal Seen Rescuing Value http://t.co/bNsFKuJU The failure of office retailers as the non-profit $AMZN undercuts $$ Nov 07, 2012
  • SapuraKencana Agrees 2 Buy Seadrill Tender Rigs http://t.co/XXrAsjFj Interesting deal, clever investor; expands Malaysia exposure $SDRL $$ Nov 05, 2012
  • Sharp blunted, and it?s not alone http://t.co/5jTHzKuN Argues that Japanese electronics mfg & exports r getting killed by strong yen $$ Nov 04, 2012

 

Federal Reserve

 

  • Inflation, QE and forcing the banks to lend http://t.co/XuPgRPJm I’ve subscribed 2 The Economist for 25 years; they r getting dumber $$ Nov 04, 2012
  • Casting Dual Roles, at Treasury & the Fed http://t.co/kIwpAzZ3 Bernanke’s Last Supper & The Return Of Larry Summershttp://bit.ly/Sp9PBZ $$ Nov 04, 2012
  • Off of the last tweet, it would be nice 2c Bernanke retire; he really may b tired of the abuse. His prob was he thought he knew what 2 do $$ Nov 04, 2012
  • & as a result, could not c that Neoclassical macro does not work with an overindebted economy. We need fewer economists at the Fed & Tsy $$ Nov 04, 2012
  • Wrong: Seth Klarman Goes Nuts On The Fed In His Latest Investor Letter http://t.co/G6gAkMfU Y I think value investors should run the Fed $$ Nov 04, 2012
  • Seth Klarman, like most value investors, is farsighted & not just thinking about how to goose GDP for the next year. Klarman 4 Fed chair $$ Nov 04, 2012

 

Eurozone

 

  • Convergence between the core and the periphery economies in the Eurozone http://t.co/2oD2exeV Drowning PIIGS pull Germany & France under $$ Nov 08, 2012
  • ECB & Fed: Worlds Apart http://t.co/zZuaFiXU Axel Merk praises the ECB & disses the Fed. Argues that ECB has not gone fiscal as the Fed has Nov 08, 2012
  • Unsteady Greek Coalition Faces More Strikes http://t.co/dxQJYzmw Suspect they make it through; Greeks don’t want 2 leave Eurozone yet $$ Nov 05, 2012
  • The peripheral threat to France http://t.co/0atOAKZq Many of the PIIGS r getting more competitive relative 2 France. No E-zone w/o France Nov 04, 2012

 

Rest of the World

 

  • Old People Versus Babies, In One Graph http://t.co/Erk2Mu8z Global demographic crisis in one very easy to manipulate graphic $$ Nov 08, 2012
  • Iceland Sees Mortgage Bubble Threat From Foreign Cash http://t.co/djtYZDxw The problems of capital controls start to bite $$ #nofreelunch Nov 06, 2012
  • Turning Trash Into Tidy Profit http://t.co/FvM32C3a Optimistic story on turning trash into durable building materials in Senegal $$ Nov 05, 2012

 

Sandy and Disaster

 

  • Frederick County teen wins regional science competition http://t.co/F72thGx3 The software can read a picture & tell where it is. $$ Nov 08, 2012
  • Sandy’s Aftermath: Samuel Pritt Develops Geolocation Software http://t.co/InnwZaGe Young friend won Siemens US Science Competition $$ Nov 08, 2012
  • Insurance divides haves from have-nots after Sandy http://t.co/NngZdchm Insurance is for catastrophes; scrimp on frequency, not severity $$ Nov 04, 2012
  • Reserved Buoyancy, Down-Flooding, and Living Off the Grid http://t.co/TXxn9f6e The value of slack in physical systems, especially boats $$ Nov 03, 2012

 

Market Dynamics

 

  • FIRE IN THE DISCO! http://t.co/YComOnGA @reformedbroker warns us that a recession is coming, & talks about a decline in corporate profits $$ Nov 08, 2012
  • Even 6.75% is too high. Looking at the Q-ratio, CAPE10, & long high quality bond yields would make 4% more realistic http://t.co/vjP0X7y1 $$ Nov 06, 2012
  • Lightening the Pension Load http://t.co/bi2j6cdJ Never thought I’d c terminal funding return; can b bad 4 annuitants if insurer fails $$ Nov 06, 2012
  • Fitting Factors Into the Formula http://t.co/35speWwR Bob Arnott& Cliff Asness discuss quantitative investing; long article worth reading $$ Nov 06, 2012
  • TAGP expiration will put downward pressure on short-term yields http://t.co/YgwmR2bu Once guarantee goes, much S-T $$ will look 4a home $$ Nov 06, 2012
  • Cash as Trash, Cash as King, and Cash as a Weapon http://t.co/fWS1TOTl In different environments & hands, cash has different properties $$ Nov 06, 2012
  • Wrong: Is Your Manager Skillful?or Just Lucky? http://t.co/vJu2tTrd Bill Miller neglected “margin of safety” & reaped bad results $$ Nov 05, 2012
  • http://t.co/VRj1k4Vg They didn’t read paper closely. Performance of anomalies diminished, not destroyed, by publishing academic research $$ Nov 05, 2012
  • For John Maynard Keynes, Economic Theory Was a Sideline http://t.co/IVdB6Gyc He was a better investor than he was an economist $$ Nov 05, 2012
  • It?s the Earnings, Stupid: ?Atrocious? Q3 Turns Josh Brown Cautious http://t.co/a2ChJKTL Time 2b cautious says @reformedbroker. Calendar? Nov 05, 2012
  • “All I know: The next bankruptcy cycle, whether in 2 or 3 or 4 years, is going to be one for the ages. Count on it.” http://t.co/xtHy7lqj $$ Nov 03, 2012

 

Policy

 

  • A New Idea of How to Fix the Ratings Agencies http://t.co/fTEECPUP by @carney | My response: http://t.co/3dWFo2Pv $$ Nov 06, 2012
  • Investors won?t read the fine print http://t.co/t2W8Nrk9 Even many institutional investors become overworked, lazy, etc. & don’t read $$ Nov 06, 2012
  • Hero of the day, CPDO edition http://t.co/wIxyPo2T I remember 2006 when @alea_ @interfluidity & I (@ Realmoney) were criticizing CPDOs $$ Nov 05, 2012
  • Health-Care Law Spurs Shift to Part-Time Workers http://t.co/0ui2LGvm Law of unintended consequences: How 29-hr workweek got created $$ Nov 05, 2012
  • 10 things walk-in clinics won?t tell you http://t.co/qKPj3D3R Major factor is the loss of continuity u have w/doctor who knows u $$ Nov 05, 2012
  • After Bailout, Giants Allowed to Dominate the Mortgage Business http://t.co/K9HZZWDu “Is this what we saved [the financial system] for?” $$ Nov 04, 2012

 

Retweets

  • Can say that again RT @bespokeinvest: Wow, big selloff in the last couple minutes of trading. Dow down 430 points since Tuesday’s close. $$ Nov 08, 2012
  • Some gift RT @pdacosta: Gift that keeps on taking: France, Belgium agree to pump 5.5B euros into bailed-out Dexia http://t.co/qgq8PI6R Nov 08, 2012
  • RT @ReformedBroker: This Greek austerity bill is the equivalent of slapping a Kick Me sign on the Troika’s back. Gives us one day’s peac … Nov 07, 2012
  • Rupert goes back to sleep $$ RT @felixsalmon: RT @dansabbagh: Pearson says FT is not for sale. “This particular Bloomberg story is wrong. ” Nov 06, 2012
  • RT @SimoneFoxman: you’ve got to be kidding me. — Southfield Twp. voter appears to die, then asks ?Did I vote?? http://t.co/2ZwRgotp Nov 06, 2012
  • First of many 2 come RT @FrancesDenmark: Indiana is the first state to drop its pension return expectations below 7.0% http://t.co/ir8anqN4 Nov 06, 2012
  • Murdoch would b interested $$ RT @ReformedBroker: The Financial Slides RT @TheStalwart: Who will buy the FT? Maybe BI in a reverse merger? Nov 06, 2012
  • Bite your tongue 🙂 Janet Yellen has exceeded the Peter Principle $$ RT @fundmyfund: precious metals say = janet yellen here we come Nov 06, 2012
  • Easy 2 talk tough, hard 2 not repay $$ RT @munilass: So much for cities standing up to Calpers http://t.co/xWIciI4C Nov 06, 2012
  • marriage changes u $$ RT @moorehn Surprising: single & married women are further apart politically than men & women r http://t.co/b4adY1pc Nov 06, 2012
  • Probably priced in $$ RT @kyles09: isn’t the exp of TAG a negative for the big bank stocks or do you think it is already priced in? Nov 06, 2012
  • I was just looking forward to the end of the political season, sigh RT @jfahmy: Hillary Clinton listed as current 2016 favorite (6:1 odds). Nov 05, 2012
  • Dog bites man RT @TheStalwart: National Review endorses Mitt Romney http://t.co/ZBAptg8Q Nov 05, 2012
  • Wow $$ RT @businessinsider: New York Magazine’s Breathtaking Cover Shows Manhattan From Up In The Sky by @KimBhasin http://t.co/FaTgCqA1 Nov 03, 2012

 

Replies

  • @valuewalk Thanks. $DANOY might do what they can to improve margins, but might play badly in France. Has mgmt been s/h-friendly in past? $$ Nov 08, 2012
  • @Frank_McG Very cool. We homeschool — only 4 left, 1 senior, 2 freshmen & a 5th grader. My wife is having a blast. $$ Nov 08, 2012
  • @TheOneDave You’re welcome — you do some great stuff Nov 07, 2012
  • @TheOneDave Hey, Dave, don’t see where we can get the Chart… Nov 07, 2012
  • @amacker Floating NAV, hehe Nov 07, 2012
  • @TheStalwart My friend and former boss Eric Hovde would have beaten Baldwin, and handily… Nov 07, 2012
  • @kyles09 My actuarial conservatism, and knowing that God can do whatever he wants with me Nov 07, 2012
  • @carney I hear you: I’m going to write a piece where I take my “eliminate the rating agencies model” and clarify it http://t.co/x4WsWaj3 $$ Nov 06, 2012
  • @PragCapitalist Thanks, Cullen. I applied that idea to corporate board elections when writing 4 Realmoney, Shame it didn’t get traction $$ Nov 06, 2012
  • @michaelroston Yes, but there is a lot of $$ on both sides, and the phones ring. WV & PA gambling firms & Christians vs MD gambling firms Nov 06, 2012
  • @michaelroston However, if you live in MD all u hear about is 7, the ballot measure expanding gambling. Other measures: <crickets> $$ Nov 06, 2012
  • @BradErvin1 That’s what I am saying — they r taking consensus risks $$ Nov 05, 2012
  • @BradErvin1 But my point about the balanced funds is this: in the selection he could invest in, they r all taking the same broad risks Nov 05, 2012
  • @BradErvin1 57, Married, one kid at home, significant assets good job, wife w/good health, 52, he not so healthy, has saved aggressively Nov 05, 2012
  • @FriedrichHayek I knew that Keynes got bailed out once (or was it twice?), but he learned from his losses, & was far better at the end $$ Nov 05, 2012
  • @MarketIntegrity @CFAInstitute @CFAcareers @CFAevents You might want to get different logos; it makes you look like u r RT-ing yourself $$ Nov 05, 2012
  • @japhychron Bingo. You got it. Nov 04, 2012
  • @TeamHeadwaters Forgot about that.. those are some of the best limestone deposits in the world, in an area ideal 4 potato farming, right? Nov 04, 2012
  • @nelson3748 That seems correct, but doesn’t S. Korea have the same issues w/the Chaebol, & they r functioning ok, seemingly… Nov 04, 2012
  • @munilass Thanks. I put it on my wish list. We discussed mishedging in the finance markets, Soros, &c. Nice of him 2 spend time w/little me. Nov 03, 2012
  • @munilass What’s the title of the book? I spent about ten minutes talking with him in early 2000 at a Complexity Theory conf @ Columbia U Nov 03, 2012

 

Comments

  • I suspect that Obama ends up winning the popular vote as well, and maybe surpasses 50%, fwiw, which isn’t much… $$ Nov 07, 2012
  • Best thing about elections: they’re over. Second best: gridlock continues. Worst: Four more years of Bush-clone Obama. $$ Nov 07, 2012
  • “Stocks aren’t GDP futures, so its not a lock that they immediately fall during the recession?” ? David_Merkel http://t.co/CdH1CNuP Nov 08, 2012
  • Last pres election, took oldest child 2 vote. This time, took child #5 2 vote. If I live, next time will be kids 6 & 7. Time after, kid 8 $$ Nov 06, 2012
  • “Josh, the article is worth a read, but the Chronicle of Higher Education misreported on it. The?” ? David_Merkel http://t.co/BFGqCw04 $$ Nov 06, 2012
  • “People easily forget that the stocks of commodity producers are very different than buying the?” ? David_Merkel http://t.co/dDlMNxIY $$ Nov 05, 2012
  • Helping a client w/his 401(k). Common balanced fund risk factors chosen: Low Duration, Medium credit quality, Large Cap Blend Equities $$ Nov 05, 2012
  • The benchmark changes added jobs that were created at an unknown earlier point in time. If they were… http://t.co/TmRLG1vg Nov 03, 2012

 

Yield is the Last Refuge of Scoundrels

Yield is the Last Refuge of Scoundrels

Governments involved in financial repression (keeping savings rates below the inflation rate) encourage their citizens to do stupid things by reaching for yield.? Remember, most people think of yield as a magic chicken that lays eggs on schedule, and never gets sick or dies.? Those who truly understand markets know that yield is an allocation of free cash flow, and that many businesses can’t control their free cash flow, so dividends are less than fully certain.

And so, I’m skeptical of the focus on income investing.? With bonds, I am not as skeptical, because there is a promised, though not guaranteed return of principal.? That doesn’t mean there aren’t problems there.? We are having a record year for issuance of corporate bonds.? Abbott Labs is offering a huge deal.? My experience with huge deals is to avoid them, unless there is some special reason to play, kind of like the last bond deal from Household International in 2002, where I bought and then traded them away for the 3o-year non-deal protected bonds bigtime.

That said, I get concerned over:

China has low interest rates for savers, so many Chinese turn to Wealth Management Products in order to earn something decent on their money.? Many of them may be little different than a Ponzi scheme.? When governments do not allow savers to earn rates exceeding inflation, savers turn to all manner of products that could harm them, both legitimate and illegitimate.

The same thing goes on in Malaysia with their Gold Plans, and suchlike.? But let’s keep things simple: let’s invest in the best corporate bond investment out there: long Baa bonds.

What’s that I see?? We’re at a 50-year low for yields on low investment-grade-rated bonds.? Surely the economy should be booming.

What, like the Great Depression, we are in a liquidity trap?? Seems that way.? Additional capital finds rare incremental productive uses, and often the best use is shrinking the company by buying back stock.

Part of that stems from the folly of the Federal Reserve using its balance sheet to buy up all manner of high quality debts by expanding its balance sheet — its cost of finance is 0% (maybe, wait till the losses come, they came to Fannie and Freddie).? By doing so, they distort pricing in the debt markets, favoring issuers over lenders, favoring the government over the private sector.

It leads to nothing good, because increasingly marginal projects get financed.? As in Japan, the marginal efficiency of capital fell dramatically, and has not risen for two decades plus.? Though it would have been painful it would have been better to have more failures and longer recessions 1986-2007.? The Fed should have kept rates higher for longer.? We would have normal markets today if they had.

As I have said before, investors don’t do well when they don’t have a place to park excess money for a small real return.? I’m not looking for the ’80s, when the return was often huge, but something above inflation, fairly estimated.? Until then, the misguided plans of the Fed will continue to do little, as businesses look at the low marginal efficiency of capital, and shrink their operations.? Remember, when businessmen see economic policies that can’t persist, they don’t take advantage of the situation — they pull in their horns and become defensive.? Thus the budget deficits, QE, and the ZIRP lead to a slower economy in the intermediate-term.

On Floating Rates

On Floating Rates

I have to admit I don’t have much sympathy for those who lent or borrowed at floating rates like LIBOR.? Personally, I have always preferred fixed-rate deals where everything is locked in from the beginning.? It means the terms are fixed, and either you can meet them or you can’t.

There are two problems with floating rate deals.? The first is that you can’t control your funding costs.? This stems from two things: short rates are volatile, and the index is typically not controlled, though it often acts like it is.? Here is an example: there were mortgages that floated off of the one-year Treasury Note rate.? Then the Treasury cancelled the one-year Treasury Note auction, and investment banks scrambled to come up with a substitute.? As I recall, they used the interpolated rate on six month bills, and two year notes.

When I was a corporate bond manager, aside from rare occasions, I never bought floating rate debt.? Why?? I needed more certainty for the client.? Fixed rate bonds and loans are more certain.? When you float, you are subject to the vicissitudes of the index, whether a borrower or a lender.

Whatever else is true, you do not control a floating rate index.? If a related party has some influence on it, that is a negative surprise, but there may be nothing illegal about their influence, particularly if it is moderate as is likely with LIBOR.

As I say to so many others in related situations: don’t give others options against you; don’t play in their casino by their rules.? Average people should not let financial institutions have variability of terms; terms should be fixed to the greatest extent possible.

And, why do borrowers go for floating rates, if they can be harmed by them?? Because they are cheaper on average.? Yield lust works on the downside as well, and many borrow shorter than is prudent for them, in order to save a little.? Works most of the time, but not all of the time, and when it doesn’t work, it can be ugly.

Thus I encourage fixed rate finance, as always, and encourage lenders and borrowers to fix their financing in advance.

Sorted Weekly Tweets

Sorted Weekly Tweets

Eurozone

 

  • Danske Bank?s Patience With Moody?s Evaporates http://t.co/eGbf3kV5 Questions over willingness of Denmark to provide support in a crisis. May 11, 2012
  • CIC Stops Buying Europe Government Debt on Crisis Concern http://t.co/dljk9Tau Overblown; China will return to funding the Eurozone $$ May 10, 2012
  • Greeks May Hold $510 Billion Trump Card in Renegotiation http://t.co/P7U4LSpG Depends on how well Core EZone banks have divested Greece $$ May 10, 2012
  • Spanish Banks Erode Creditors With ECB Loans http://t.co/HaEx3bgT Better collateral highly encumbered; Unsec debts implicitly subord 2 ECB May 10, 2012
  • Greece Euro-Exit Debate Goes Public http://t.co/0xOgsa7G Core Eurozone wrestles w/how to kick Greece out, even though they can’t. $$ May 10, 2012
  • How a Radical Greek Rescue Plan Fell Short http://t.co/Ds0589IG Greece is failing as a culture due2 corruption; no rescue would work $$ May 10, 2012
  • Denmark?s Banks Endure Writedown Shock Delaying Recovery http://t.co/A2Vdpymn Good sign on Denmark; take pain early -> in good shape $$ May 10, 2012
  • Greek Election Surprise Rejects ?Barbarism? of Bailout Austerity http://t.co/oX0nt5SF Growth is magic, magic I tell u! Just invoke it! $$ May 08, 2012
  • Merkozy End Means Franco-German Gulf; Greek Voters Rebel http://t.co/iCd0Cs6l Loss of Sarkozy may not b bad, but Greek paralysis will b $$ May 08, 2012
  • Francois Hollande has ten weeks to avert a French bond crisis http://t.co/3SEAWJB5 When few adults r in the room the children run wild $$ May 08, 2012
  • Challenge to Austerity, And Germany, Is Sharpened http://t.co/BWbgQJ85 The odds have risen that Germany will leave the Eurozone $$ May 08, 2012
  • Obvious but it needs 2b said $$ RT @Hawk100Clemens: Mauldin tells #CFA12 every monetary union in history has failed. May 07, 2012
  • France faces 40pc house price slump http://t.co/nPuMaVnJ If French banks have trouble now, just wait until the bad mortgage debt hits $$ May 06, 2012

 

JP Morgan

 

  • What Beached the London Whale? Credit Indices http://t.co/JKFxfaMb Crosshedging long credit risk by buying protection on an index? $$ May 11, 2012
  • J.P. Morgan Trades In Its Crown http://t.co/QUJ6hmoA That goes for firms and CEOs as well: $JPM and Jamie Dimon will not get free passes May 11, 2012
  • Drew Built 30-Yr JPMorgan Career Embracing Risk http://t.co/uocyyVC1 Lifetime 2build reputation; few years 2destroy it; revealed: 1 day $$ May 11, 2012
  • And the best way to reduce risk is to lower leverage & raise cash $$ RT @marydchilds: “The best way to hedge something is to get rid of it.” May 11, 2012

 

Facebook

 

  • Facebook Co-Founder Saverin Gives Up U.S. Citizenship Before IPO http://t.co/kL1VQYXU Cuts down on the tax bill; discount prior 2 IPO $$ May 11, 2012
  • Facebook IPO Said to Get Weaker-Than-Forecast Demand http://t.co/ktK5Bgun $FB faces slowing revenue growth, order books 4 IPO go slack $$ May 11, 2012

 

Miscellaneous

 

  • Google?s Brin Makes Strides in Hunt for Parkinson?s Cure http://t.co/YvL4LUNA He may get it one day; his Mother already has Parkinson’s $$ May 11, 2012
  • And also for those who call vegetables “veggies?” RT @jasonWSJ: Can we impose a $40 fine on dudes who refer to sandwiches as “sammies”? May 10, 2012
  • Firefox browser group irked with Microsoft, Windows 8 http://t.co/tBZ9GFuw Only Internet Explorer runs on Windows 8; expect some lawsuits $$ May 10, 2012
  • Aluminum Buyers in Japan to Pay Record Fee on Supply Drop http://t.co/7AVU1knI Smelting capacity reduced, China buys more, Japan pays up May 10, 2012
  • @RobTheStreet A lot depends on the definition of marriage, Would you allow people to marry inanimate objects, animals, or multiple parties? May 09, 2012
  • Brookstone to sell Lilliputian portable power chargers, this year http://t.co/FnSvdfOw Impressive technology if it works. $$ May 08, 2012
  • Economy Reshapes Wisconsin Recall Vote http://t.co/G0OetHhV My wife and father were forced in2 unions by collectivist brutes. Go Walker! May 08, 2012
  • Father?s Shadow as Transit Leader Hard to Evade for Shuster http://t.co/0FAZUqd4 Bud Shuster is a jerk, forcing us through Breezewood $$ May 08, 2012
  • Kellogg?s Kashi Targeted as Web Food Fighting Escalates http://t.co/BNhf5294 We need 2 send a lot of people back 4 science reeducation May 08, 2012

 

Rest of the World

 

  • Sony, Panasonic Fall to 30-Year Lows as TV Losses Mount http://t.co/Euo37RLQ Sold Panasonic after reviewing uneconomic “green” agenda $$ May 11, 2012
  • Kim Jong Un Bashes ?Pathetic? North Korea Fun Park http://t.co/gb4S9HBc He should know; he lived outside NK, where there is real fun $$ May 10, 2012
  • Sukhoi SuperJet Disappears During Indonesia Demo Flight http://t.co/0JrxAkAw Another sign of degraded Russian abilities in aerospace $$ May 10, 2012
  • Bad H/L: Shooting to Kill Pirates Risks Blackwater Moment http://t.co/laW55VEo Correct H/L: Hiring Armed Guards protects cargoes &crews $$ May 10, 2012
  • Drug-Defying Germs From India Speed Post-Antibiotic Era http://t.co/XGeno5mf Long. Scariest article of the day; wash your hands w/soap $$ May 08, 2012
  • Israel Pyramid Rules Turn Insurers Into Buyout Targets http://t.co/4tXBqehx Interesting:

Israel is limiting holding company levels to 3 $$ May 10, 2012

  • UK Pay Protests Oust Aviva Chief http://t.co/WKVdmQGM I remember when they overpaid for Amerus Life in the US; sign of bad management $$ May 10, 2012

 

 

Energy

 

  • RT @merrillmatter: @AlephBlog Methinks we’ll need to see some epic blowouts in natgas space (ha ha) before supply/demand can come back i … May 10, 2012
  • Chesapeake Deals Carry $1.4 Billion in Undisclosed Liability http://t.co/UFohsseZ $CHK May b worth a look when things stop getting worse May 10, 2012
  • When the Exxon way stops working http://t.co/BgN2zLO6 $XOM learns 2b more cooperative w/foreign countries where it wants 2 explore 4 oil $$ May 08, 2012
  • Argentina Taps Ex-Schlumberger Executive Galuccio to Run YPF http://t.co/j5P1oyoS Possibly a good choice to run the purloined company $$ May 08, 2012

 

Fixed Income

 

  • Still time to make money in Treasury bonds http://t.co/ABl43gzM The depressionary bull case 4 long T-bonds; D. Rosenberg & Lacy Hunt $$ May 10, 2012
  • Why Emerging Market Corporate Bond ETFs are Hot http://t.co/tWvz0sif High USD yield, but be wary. Laws governing creditor rights vary $$ May 10, 2012
  • In other words, the 30-year Tsy sold well today b/c some seek Depression insurance & others hedge convexity or immunize long liabilities $$ May 10, 2012
  • Treasuries Pare Losses as Europe Concern Aids Sale http://t.co/C7jytF08 Investors make sure they get income 4 30-yrs & $$ back when old May 10, 2012
  • S&P Warns Of $46T Perfect Credit Storm http://t.co/jZTbvy42 If companies have adequate cash flows from operations, this is not an issue. May 10, 2012

 

Canada

 

  • In Canada, Alternate Currency Keeps Traction With Fans http://t.co/ePyXRH1f Paper Money, Issued by Canadian Tire, Is Popular Way 2Pay $$ May 11, 2012
  • Revisit after their housing bubble pops RT @vgmac: There is a lot of love for Canada’s banking system here at the Chicago Fed conferences $$ May 10, 2012
  • @vgmac Then again, at the first Treasury/blogger summit I told them they should imitate the Canadian regulators and central bankers. #canada May 10, 2012
  • Canada Housing Bubble Concern Shown in Insurer Query http://t.co/kGHcqgDE Should the Canadian govt try2exit the mortgage insurance biz? $$ May 10, 2012
  • CMHC Says Capital Levels “Double” OSFI Requirements http://t.co/R4p5TuBO F&F also had capital far higher than their disaster level $$ May 08, 2012

 

Cisco Systems

 

  • Cisco shares drop on tech spending worries http://t.co/06maBaX4 Global economic weakness feeds into tech firms that sell much abroad $$ May 10, 2012
  • @ampressman Cramer said something like, “It’s not a growth company if they have to talk about the economy, weather, industry factors, etc.” May 10, 2012
  • @ampressman $AAPL is a growth company, at least for now, $CSCO was a growth company somewhere in the last 15 years… May 10, 2012

 

Delta Air Lines

 

  • Buy Delta Air Lines: Trainer Refinery Purchase & Improving Financials Will Lift The Stock http://t.co/W7YeEmgb Poorly reasoned thesis $$ May 08, 2012
  • Remember when $DD bot Conoco? There would b synergies in petrochemicals. $DD bot it at the peak, spit it out at the bottom $$ #limitscope May 08, 2012
  • $DAL substitutes risk in jet fuel pricing 4 risks in crude oil, gasoline, heating oil prices, & operational risk in a biz it doesn’t know $$ May 08, 2012
  • @The_Analyst Agreed, though enough capacity has come out of the industry through mergers that they might finally c some pricing power $$ May 08, 2012

 

US Housing

 

  • 5 Pitfalls of Home Refinancing http://t.co/ZxGUF3HM Longer maturity, Closing costs, Contract terms, Hidden fees, Appraisals $$ May 10, 2012
  • Look Who?s Pushing Homeowners Off the Foreclosure Cliff http://t.co/T6CBkUAt Mtge docs exist to protect the lender’s property interest $$ May 08, 2012
  • RE: @bloombergview Read any mortgage contract; it exists to protect the rights of lenders, including protecting the m? http://t.co/ob9eIcBt May 08, 2012
  • No Repeating Slowdown Seen by U.S. With Banks to Housing http://t.co/A0LNwrjh While hi % of mtges r underwater, finl stress will remain $$ May 08, 2012
  • Pimco Housing Bear Kiesel Says It?s Time to Start Buying http://t.co/f3zaBNZA He assumes dark supply will hang on for higher prices. $$ May 06, 2012

 

US Regulation

 

  • Maybe to be perfectly fair, the government releases the data on a website at midnight ET, long before the US markets ? http://t.co/9Zqniljs May 10, 2012
  • A Jury of Peers for Broker Disputes http://t.co/5Ly14oKJ The playing field may be more even now; odds r still stacked against investors May 10, 2012
  • Congress Seeks Postal Overhaul While Making It Impossible http://t.co/lvcEBxmw The real danger is after reduction, PS is less relevant $$ May 10, 2012
  • US Millionaires Told Go Away as Tax Evasion Rule Looms http://t.co/Tx6lr1Bl Fewer foreign banks will accept accts w/US citizens/firms $$ May 10, 2012

 

Berkshire Hathaway

?

  • Biggest Buffett Targets Seen Spanning Deere to Henkel http://t.co/dLbp9pic Muses about what Buffett would buy 2 eclipse BNSF $$ May 08, 2012
  • +1 RT @Kevin_Holloway: Good read on possibilities of recent $BRK.B purchases among some other gd thoughts by @AlephBlog http://t.co/xkN8SlXu May 08, 2012
  • Deep in the Insurance Weeds at Berkshire Hathaway http://t.co/GkH9oWBo This helps explain the life reinsurance losses at $BRKB. LTC $$ May 08, 2012
  • Buffett understands tech. But he searches for revenue streams that can’t easily be obsoleted. $AAPL & $GOOG could be ? http://t.co/VyOnKUTy May 07, 2012

?

Market Dynamics

 

  • World?s Simplest Stock Valuation Measure http://t.co/OvmQTmHs Growth Rate/2 + 8 = PE Ratio; @eddyelfenbein & his conservative PE formula $$ May 10, 2012
  • Dole Food Breakup Seen Bearing Fruit With 58% Return http://t.co/C4SvaNvw Can $DOLE become a high margin biz, & pay down debt? $$ May 10, 2012

 

Financial Sector

 

  • What about front-running? $$ RT @abnormalreturns: @MebFaber: Nail in the Mutual Fund Coffin (NAV Based ETF Trading) http://t.co/SZ3CbIY3 May 08, 2012
  • BTW, for those holding dividend funds, back in 1994, stock managers following a yield strategy got crushed. $$ #annushorribilisforbonds May 08, 2012
  • The Dangers of Dividend Funds http://t.co/5WSdEFwN Dividend funds may b safer than other stock funds, r still stock funds w/real risk $$ May 08, 2012
  • True 4 many $$ RT @ReformedBroker: ?Daddy, what do you do at your job?? http://t.co/mxrcVyhm May 08, 2012
  • BofA?s New Black-Belt Data Chief Targets Blinding Gaps http://t.co/P60yhtAk Merger integration didn’t happen in $BAC ‘s IT areas $$ #mess May 08, 2012
  • Billion-Dollar Traders Quit Wall Street for Hedge Funds http://t.co/2yFJ2JXr Volcker Rule reducing dealer-driven market liquidity $$ May 08, 2012
  • Flash-Crash Story Looks More Like a Fairy Tale http://t.co/0mBQDGKZ Still a mystery; but4any self-feeding panic, players leaning wrong way May 08, 2012
  • Almost Half of Finance Graduates Seek New Jobs, PwC Says http://t.co/YUuH9KJl The bubble in financial jobs has popped, decamp 2 other inds May 08, 2012
  • ?Where is Everybody?? http://t.co/7YPOcMUb Little retail participation is bullish; it means that only the relatively smart $$ is playing May 08, 2012
  • 50 Ways to Restore Trust in the Investment Industry http://t.co/VHhllKyp The CFA Institute gathers opinions from members on cleaning up $$ May 08, 2012
  • RE: @bloombergview Equity is more expensive than other types of bank capital; raising the cost of capital means fewer? http://t.co/qPvVygll May 07, 2012
  • Heat’s on Triparty Repos http://t.co/7Jk7DrTS Fed Is Pressing Big Players to Reduce Exposures to $1.7 Trillion Market $$ May 06, 2012

 

Company Specific

 

  • How Hewlett-Packard lost its way http://t.co/pA683e3H Very long & ugly article about board & mgmt dysfunction @ $HPQ. FD: +$HPQ 4 me&clients May 08, 2012
  • A Real Concern For Apple?s Stock: Telecom Carriers Threaten to Kill Subsidies on Phones http://t.co/JlQwSDAq Interesting thesis $$ May 08, 2012
  • AMR Said to Seek More Overseas Flights as Suitor Circles http://t.co/eUHdHju4 $LCC wins more backing, could allow filing another plan $$ May 08, 2012

 

Politics

  • Exodus From Tiburon to Texarkana Is Exaggerated http://t.co/nsyd3QjF Truth is, people & firms r sticky, until they finally get fed up! $$ May 10, 2012
  • If we do not discipline ourselves, the bond market will discipline us $$ RT @carney: Why the left will keeping winning. http://t.co/kJcfgEt4 May 08, 2012
  • Too bad, we need a better opponent to Obama $$ RT @BloombergNews: Breaking: Santorum Endorses Former Rival Romney as Republican Nominee May 08, 2012
  • Don’t Worry (About GDP), Be Happy http://t.co/BaSDMbTM GDP approximates economic growth; more subjective progress measures r ridiculous May 08, 2012
  • @justinwolfers Last thing we need on the Fed is another neoclassical Ph. D. economist. Let’s try some brainy generalists, value investors $$ May 07, 2012
  • @GaelicTorus @justinwolfers All I am saying is value investors understand how the economy works better than neoclassical economists do $$ May 07, 2012
  • Disabled Americans Shrink Size of U.S. Labor Force http://t.co/NX6ZzCjK I still resent former neighbor on SSD, putting Xmas lights on roof May 06, 2012
  • But are they ending with an accrual basis surplus, not just a cash surplus? That’s the question. http://t.co/uGa7WX14 May 06, 2012
Against Risk Parity, Redux

Against Risk Parity, Redux

Here are two articles to read on risk parity:

Pro: Pick Your Poison

Con: The Hidden Risks of Risk Parity Portfolios

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The Rules, Part XV

The Rules, Part XV

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

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

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

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

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

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

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

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

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

-==–==-=-=-=-=–=-=-=-==-=-=–=

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

=-=-=-=-=-=-=-=-=-=-=-==-=-=-=-=-=-

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

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

-=-=-=-=-=-=-=-=-=-=-=-=-===-=-=-=-=-

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

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

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

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

=–=-=-=-=-=-==–=-=–==-=-==–==-==-=-=

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

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

=-=–==-=-

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

Full disclosure: Long PBR ESV

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