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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.

The Balance: Considering Event-Driven Investing

The Balance: Considering Event-Driven Investing

Posted on by David Merkel

Photo credit: miltarymark2007

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I published another article at The Balance:?Considering Event-Driven Investing.? This is one place where writing in the third person leaves a lot out.? I’ve done a lot with some types of event-driven investing.

  • Speculating on hurricanes — I did that successfully at the hedge fund 2004, 2005 and 2006.? 2006 because I thought the risk of another strong hurricane year was overplayed.? 2004 and 2005 because I had a good idea of who was underreporting claims after disasters.? That was the only time in my life that I went from long a company to short without stopping, and I covered on the day the CEO resigned, and caught the bottom tick.
  • Bond deal arbitrage — well, sort of.? I would buy target company bonds and sell the bonds of the parent.? I had to be certain that the deal would go through, but it was a tremendous yield enhancement is the right situations.
  • From the prior article, speculating on Lula’s non-impact on Brazil qualifies as event-driven.
  • Stock arbitrage — did a lot with it when I was younger.? Didn’t do so well.
  • Index arbitrage — did a neutral trade where we shorted one company out of the Russell 2000, and bought another one in.? Made no money on the trade.? We had a good fundamental justification for the trade, but it just goes to show you that this isn’t as easy as it looks.
  • I buy a decent number of spinoffs.? Most succeeded as investments for me.

Now, all that said, most areas where there are simple arbitrages typically boil down to a simple credit risk: will the deal get completed? Will the company not take an action that changes its capital structure in a way that hurts me?

Since these are relatively simple trades, the returns are relatively low like that on a short-term junk bond — at present, like the yield on T-bills plus 2-3%.? It’s not very compelling given the risks involved.? Most of the mutual funds that do that type of arbitrage have not done so well.

Thus, aside from spinoffs, at present, I don’t do that much with event-driven investing.? Many of the forms of it are too crowded, and I prefer simplicity in investing.

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.

You Can Get Too Pessimistic

You Can Get Too Pessimistic

Posted on by David Merkel

Photo Credit: Kathryn
Photo Credit: Kathryn || Truly, I sympathize. ?I try to be strong for others when internally I am broken.

Entire societies and nations have been wiped out in the past. ?Sometimes this has been in spite of the best efforts of leading citizens to avoid it, and sometimes it has been because of their efforts. ?In human terms, this is as bad as it gets on Earth. ?In virtually all of these cases, the optimal strategy was to run, and hope that wherever you ended up would be kind to foreigners. ?Also, most common methods of preserving value don’t work in the worst situations… flight capital stashed early in the place of refuge?and?gold might work, if you can get there.

There. ?That’s the worst survivable scenario I can think of. ?What does it take to get there?

  • Total government and?market breakdown, or
  • A lost war on your home soil, with the victors considerably less kind than the USA and its allies

The odds of these are very low in most of the developed world. ?In the developing world, most of the wealthy have “flight capital” stashed away in the USA or someplace equally reliable.

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Most nations, societies and economies are more durable than most people would expect. ?There is a cynical reason for this: the wealthy and the powerful have a distinct interest in not letting things break. ?As Solomon observed a little less than 3000 years ago:

If you see the oppression of the poor, and the violent perversion of justice and righteousness in a province, do not marvel at the matter; for high official watches over high official, and higher officials are over them. Moreover the profit of the land is for all; even the king is served from the field. — Ecclesiastes 5:8-9 [NKJV]

In general, I think there is?no value in preparing for the “total disaster” scenario if you live in the developed world. ?No one wants to poison their own prosperity, and so the?rich and powerful?hold back from being too rapacious.

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If you don’t have a copy, it would?be a good idea to get a copy of?Triumph of the Optimists. ?[TOTO] ?As I commented in my review of TOTO:

TOTO points out a number of things that should bias investors toward risk-bearing in the equity markets:

  1. Over the period 1900-2000, equities beat bonds, which beat cash in returns. (Note: time weighted returns. If the study had been done with dollar-weighted returns, the order would be the same, but the differences would not be so big.)

  2. This was true regardless of what presently developed nation you looked at. (Note: survivor bias? what of all the developing markets that looked bigger in 1900, like Russia and India, that amounted to little?)

  3. Relative importance of industries shifts, but the aggregate market tended to do well regardless. (Note: some industries are manias when they are new)

  4. Returns were higher globally in the last quarter of the 20th century.

  5. Downdrafts can be severe. Consider the US 1929-1932, UK 1973-74, Germany 1945-48, or Japan 1944-47. Amazing what losing a war on your home soil can do, or, even a severe recession.

  6. Real cash returns tend to be positive but small.

  7. Long bonds returned more than short bonds, but with a lot more risk. High grade corporate bonds returned more on average, but again, with some severe downdrafts.

  8. Purchasing power parity seems to work for currencies in the long run. (Note: estimates of forward interest rates work in the short run, but they are noisy.)

  9. International diversification may give risk reduction. During times of global stress, such as wartime, it may not diversify much. Global markets are more correlated now than before, reducing diversification benefits.

  10. Small caps may or may not outperform large caps on average.

  11. Value tends to beat growth over the long run.

  12. Higher dividends tend to beat lower dividends.

  13. Forward-looking equity risk premia are lower than most estimates stemming from historical results. (Note: I agree, and the low returns of the 2000s so far in the US are a partial demonstration of that. My estimates are a little lower, even?)

  14. Stocks will beat bonds over the long run, but in the short run, having some bonds makes sense.

  15. Returns in the latter part of the 20th century were artificially high.

Capitalist republics/democracies tend to be very resilient. ?This should make us willing to be long term bullish.

Now, many people look at their societies and shake their heads, wondering if things won’t keep getting worse. ?This typically falls into three?non-exclusive buckets:

  • The rich are getting richer, and the middle class is getting destroyed ?(toss in comments about robotics, immigrants, unfair trade, education problems with children, etc. ?Most such comments are bogus.)
  • The dependency class is getting larger and larger versus the productive elements of society. ?(Add in comments related to demographics… those comments are not bogus, but there is a deal that could be driven here. ?A painful deal…)
  • Looking at moral decay, and wondering at it.

You can add to the list. ?I don’t discount that there are challenges/troubles. ?Even modestly healthy society can deal with these without falling apart.

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If you give into fears like these, you can become prey to a variety of investment “experts” who counsel radical strategies that will only succeed with very low probability. ?Examples:

  • Strategies that neglect investing in risk assets at all, or pursue shorting them. ?(Even with hedge funds you have to be careful, we passed the limits to arbitrage back in the late ’90s, and since then aggregate returns have been poor. ?A few niche hedge funds make sense, but they limit their size.)
  • Gold, odd commodities — trend following CTAs can sometimes make sense as a diversifier, but finding one with skill is tough.
  • Anything that smacks of being part of a “secret club.” ?There are no secrets in investing. ?THERE ARE NO SECRETS IN INVESTING!!! ?If you think that con men in investing is not a problem, read?On Avoiding Con Men. ?I spend lots of time trying to take apart investment pitches that are bogus, and yet I feel that I am barely scraping the surface.

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Things are rarely as bad as they seem. ?Be willing to be a modest bull most of the time. ?I’m not saying don’t be cautious — of course be cautious! ?Just don’t let that keep you from taking some risk. ?Size your risks to your time horizon for needing cash back, and your ability to sleep at night. ?The biggest risk may not be taking no risk, but that might be the most common risk economically for those who have some assets.

To close, here is a personal comment that might help: I am natively a pessimist, and would easily give into disaster scenarios. ?I had to train myself to realize that even in the worst situations there was some reason for optimism. ?That served me well as I invested spare assets at the bottoms in 2002-3 and 2008-9. ?The sun will rise tomorrow, Lord helping us… so?diversify and take moderate risks most of time.

Don’t Worry About Public Bond Market Illiquidity

Don’t Worry About Public Bond Market Illiquidity

Posted on by David Merkel

Photo Credit: Mike Beauregard || Frozen solid, right?
Photo Credit: Mike Beauregard || Frozen solid, right?

The talk regarding an illiquid public corporate bond market goes on, and if you’ve read me over the past year on this topic, you know that I don’t think it is a serious issue. ?One of the reasons why it is not a big issue is that the public bond market is designed to be low liquidity.

It starts with how bonds are originally issued. ?New bonds and new stocks are issued in similar ways, but with a few differences:

  • IPOs of stocks have a higher retail component. ?Bonds, aside from muni bonds, are typically almost entirely institutional
  • IPOs are typically priced cheap, but with bonds the cheapness is smaller and more frequent.
  • Bond IPOs usually happen with companies that have issued other bonds before
  • Bond IPOs happen more frequently, except in a bear market
  • Bond IPOs typically happen more rapidly, minutes to a few days, except in a bear market

IPOs on Wall Street get allocated if they are oversubscribed. ?When they are oversubscribed, the deal is typically good, and everyone wants more, so they put in huge orders. ?The dealer desks on Wall Street solves this problem by allocating proportionate?to the size that they have come to understand the managers in question typically buy and sell at,?with some adjustment for account profitability.

Those that flip cheap bonds for a quick profit typically get penalized, and their allocations get reduced. ?Those that buy bonds in the open market when the deal breaks and becomes “free to trade” can become eligible for larger allocations. ?The dealer desks work in this way because they want the buyers to be long-term holders, and not seekers of easy profits from flipping. ?That doesn’t mean you can never trade a bond you have bought — just not in the first month, subject to a few exceptions like a small allocation, your credit analyst rejected it, etc. ?(Oh, and if one of those exceptions exists, the primary dealers want to do the secondary trade. ?If the exceptions don’t exist, they don’t want to know about it.)

If flippers ever get big, despite the efforts of the dealer desks, they will price a deal very tight, and let the flippers take a big loss, with no one wanting to buy the excess bonds unless they are much, much cheaper.

The main effect of this is that once a deal is allocated, it is typically “well-placed,” with few secondary trades after the IPO. ?This is even more pronounced with mortgage bonds, which aside from the AAA tranches, have very small tranche sizes, making them very illiquid.

In this environment, where yields have fallen over the past few years, it is difficult for financial companies that have bought bonds to replace the income if they sell the bond. ?Thus, few bonds will be sold unless they are in the hands of?buyers that don’t have a formal balance sheet, or, when credit quality is deteriorating badly.

Add in one more factor, and you can see why the market is so illiquid — the buy side of the market is more concentrated than in prior years, with big buyers like PIMCO, Blackrock, Metlife, Prudential, etc. being a larger portion of the market. ?Concentrated markets with few holders tend to be less liquid.

All Good/Bad Things Must Come to an End

Some of these factors can be reversed, and others can be mitigated.

  • There’s no reason why the buy side has to stay concentrated. ?Big institutions eventually break up because diseconomies of scale kick in. ?Management teams typically do worse as companies get more complex.
  • Eventually interest rates will rise. ?Once bonds are in a nearly neutral to negative capital gains positions, parties with balance sheets will trade bonds again.
  • Even mutual funds that own a lot of yieldy bonds can have a strategy for dealing with the illiquidity. ?Yieldy bonds have excess yield relative to bonds of similar duration and credit quality, and are often less liquid because there is something odd about them that makes some portion of the market skeptical, which reduces liquidity. ?A mutual fund holding a lot of less liquid bonds, can deal with illiquidity by selling opportunistically, selling more liquid bonds in the short-run, while discreetly inquiring on a few less liquid issues to see where real bids might be. ?Remember, the amount of underperformance is likely to be limited, if any, so a run on a mutual fund is not likely, but in the unlikely case of a run, this can mitigate the effects. ?Personally, I would not be concerned, so long as you keep your pricing marks conservative if cash outflows become a rule in the short-run.

In closing, don’t worry about illiquidity in the bond markets. ?If there is a need for liquidity, the problem will solve itself as sellers lose a little bit in order to gain cash to make payments. ?It’s that simple.

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.

A Few Investment Notes

A Few Investment Notes

Posted on by David Merkel

Just a few notes for this evening:

1) I’ve been a bull on the long end of the Treasury curve for a while. ?It’s been a winning bet, and the drumbeat of “interest rates have nowhere to go but up” continues. ?Here’s an argument from Jeffrey Gundlach on why long rates should remain low, and maybe go lower:

Gundlach, however, was one of the very few people?who believed rates would stay low, especially with the Federal Reserve committed to keeping rates low with its loose monetary policy.

It’s important to note that U.S. Treasuries don’t have the lowest yields in the world. French and?German government bonds have yields?that are about 100 basis points lower than those of Treasuries. In other words, those European bonds actually make U.S. bonds look cheap, meaning that yields have room to go lower.

This will trend toward lower rates will eventually have to end, but neither GDP growth, inflation, or business lending justifies it at present.

2) From Josh Brown, he notes that correlations went up considerably with all risk assets in the last bitty panic. ?Worth a read. ?My two cents on the matter comes from my recent article, On the Recent Anxiety in High Yield Bonds, where I noted how much yieldy stocks got hit — much more than expected. ?I suspect that some asset allocators with short-dated or small stop-loss trading rules began selling into the bitty panic, but that is just a guess.

3) That would help to explain the loss of liquidity in the bond market during the bitty panic. ?This article from Tracy Alloway at the FT explores that topic. ?One commenter asked:

Isn’t it a bit odd to say lots of people sold quickly *and* that there isn’t enough liquidity??

Liquidity means a number of things. ?In this situation, spreads widened enough that parties that wanted to sell had to give up price to do so, allowing the brokers more room to sell them to skittish buyers willing to commit funds. ?Sellers were able to get trades done at unfavorable levels, but they were determined to get the trades done, and so they were done, and a lot of them. ?Buyers probably had some spread target that they could easily achieve during the bitty panic, and so were willing to take on the bonds. ?Having a balance sheet with slack is a great thing when others need liquidity now.

One other thing to note from the article is that it mentioned that retail investors now own 37%?of credit, versus?29% in 2007, according to RBS. Also that?investment funds has been able to buy?all?of the new corporate debt sold since 2008.

There’s more good stuff in the article including how “matrix pricing” may have influenced the selloff. ?When spreads were so tight, it may not have taken a very large initial sale to make the estimated prices of other bonds trade down, particularly if the sales were of lower-rated, less-traded bonds. ?Again, worth a read.

4) Regarding credit scores, three articles:

From the WSJ article:

Fair Isaac?Corp.?said Thursday that it will stop including in its FICO credit-score calculations any record of a consumer failing to pay a bill if the bill has been paid or settled with a collection agency. The San Jose, Calif., company also will give less weight to unpaid medical bills that are with a collection agency.

I think there is less here than meets the eye. ?This only affects those borrowing from lenders using the particular FICO scores that were modified. ?Not all lenders use that particular score, and many use FICO data disaggregated to create their own score, or ask FICO to give them a custom score that they use. ?Again, from the WSJ article:

Fair Isaac releases new scoring models every few years, and it is up to lenders to choose which ones to use. The new score will likely be adopted by credit-card and auto lenders first, says John Ulzheimer, president of consumer education at CreditSesame.com and a former Fair Isaac manager.

Mortgages are likely to lag, since the FICO scores used by most mortgage lenders are two versions old.

The?impact of the changes on borrowers is likely to be significant. Accounts that are sent to collections, including credit-card debts and utility bills, can stay on borrowers’ credit reports for as long as seven years, even when their balance drops to zero, and can lower their scores by up to 100 points, said Mr. Ulzheimer.

The lower weight given to unpaid medical debt could increase some affected borrowers’ FICO scores by 25 points, said Mr. Sprauve.

But lowering the FICO score by itself doesn’t do anything. ?Some lenders don’t adjust their hurdles to reflect the scores, if they think the score is a better measure of credit for their time-horizon, and they want more loan volume. ?Others adjust their hurdles up, because they want only a certain volume of loans to be made, and they want better quality loans at existing pricing.

Megan McArdle at Bloomberg View asks a different question as to whether it is good to extend more credit to marginal borrowers? ?Didn’t things go wrong doing that before? ?Her conclusion:

That in itself [DM: pushing for more loans to marginal borrowers as a matter of policy] is an interesting development. Ten years ago, politicians were pressing hard for banks to extend the precious boon of homeownership to every man, woman and shell corporation in America. Five years ago, when people were pushing for something like the CFPB, the focus of the public debate had dramatically shifted toward protecting people from credit. Oh, there were complaints about the cost of subprime loans, but ultimately, on most of those loans, the problem?wasn?t the interest rate but the principal: Too many people had taken out loans that they could not realistically afford to pay, especially if anything at all went wrong in their lives, from a job loss to a divorce to an unexpected illness. And so you heard a lot of complaints about predatory lenders who gave people more credit than they could handle.

Credit has tightened considerably since then, and now, it appears, we?re unhappy with that. We want cheaper, easier credit for everyone, and particularly for the kind of financially struggling people who have seen their credit scores pummeled over the last decade. And so we see the CFPB pressing FICO to go easier on people with satisfied collections.

That?s not to say that the CFPB is wrong; I don?t know what the ideal amount of credit is in a society, or whether we are undershooting the mark. What I do think is that the U.S. political system — and, for that matter, the U.S. financial system — seems to have a pretty heavy bias toward credit expansion. Which explains a lot about the last 10 years.

Personally, I look at this, and I think we don’t learn. ?Credit pulls demand into the present, which is fine if it doesn’t push losses and heartache into the future. ?We are better off with a slower, less indebted economy for a time, and in the end, the economy as a whole will be better off, with people saving to buy in the future, rather than running the risk of defaults, and a very punk economy while we work through the financial losses.

On Bond Risks in the Short-Run

On Bond Risks in the Short-Run

Posted on by David Merkel

From a letter from a reader:

Hi David,

I’ve been following your blog for the last few months and the articles are extremely insightful.

I’ve been working with fixed income credit trading the last few years but I feel that I have not been measuring risk well. I only look at cash bonds

Right now I’m only looking at DV01 and CR01, but my gut tells me that there’s a lot more to risk monitoring that can be done on a basic cash bond portfolio.

From your experience as a bond portfolio manager, what other risk metrics have you found useful?

I’d really appreciate if there were a few pointers you could give or just a trail that you could show me and I’ll follow it.

First, some definitions:

Basis Point [bp]: 0.01% — one one-hundredth of a percent. ?If you have $10,000 in a money-market fund, and they pay one basis point of interest per year, at the end of the year you will have $10,001. ?In this environment, that’s not uncommon.

DV01:?A?bond valuation?calculation?showing the?dollar?value?of a one?basis point?increase or?decrease?in?interest rates. It shows the?change?in a?bond’s?price?compared to a decrease in the bond’s?yield.

CR01: Credit Sensitivity ? Credit Default Swap [CDS] price change for 1bp shift in Credit par spread — same as DV01, but applied to CDS instead of a bond.

Now, onto the advice: when you manage bonds, the first thing you have to do is understand your time horizon. ?Is it days, weeks, months, or years? ?When I managed bonds for a life insurer 1998-2003, the answer was years. ?Many years, because the liabilities were long. ?That gave me a lot of room to maneuver. ?You sound like you are on a short leash. ?Maybe you have a month as your time horizon.

When the time horizon is short, the possibilities for easy profits are few, and here are a few ideas:

1) Momentum: yes, it works in the bond market also. ?Own bonds that are rising, and sell those that are falling. ?Be sensitive to turning points, and review the relative strength index.

2) Stick with sectors that are outperforming. ?Neglect those that underperform.

3) If you have significant research that has a differential insight on a bond, pursue it with a small amount of money if it may take a while. ?If the change might happen soon, increase the position.

4) Try to understand when CDS is rich or cheap vs cash bonds by issuer. ?Look at the price history, and commit capital when pricing is significantly in your favor.

5) Set spread?targets for your investing. ?Decide on levels where you would commit minimum, normal, and maximum funds. ?Be generous with the maximum level, because markets are more volatile than most imagine.

6) Look at the criteria for my one-minute drill:?http://alephblog.com/2010/07/17/the-education-of-a-corporate-bond-manager-part-ii/

(and look at the end of the piece, but the whole piece/series has value.)

7) Analyze common factors in your portfolio, and ask whether those are risks you want to take:

  • Industry risks
  • Duration risks
  • Counterparty risks

8 ) Look at the stock. ?If it is behaving well, the bonds will follow.

Maybe your best bet is to trade CDS versus cash bonds, if the spread is thick enough to do so. ?If not, I would encourage you to talk with more senior ?traders to ask them how they survive. ?Trading is a tough game, and I do not envy being a trader.

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