Search Results for: Unstable

The War Against Savers

The War Against Savers

Posted on by David Merkel

Today, Charles Rotblut, CFA who is the AAII Journal Editor wrote:

Federal Reserve Chairman Ben Bernanke continues to be the enemy of savers. Yesterday, the Boston Red Sox fan reiterated his belief that interest rates should be kept at rock-bottom levels for an extended period of time. He views this as necessary in order to keep the economy growing.

When you run an investment group that is largely composed of retirees and near-retirees, it is reasonable to call Bernanke the enemy of savers, because he is the enemy of savers.? When one can’t earn anything over one year without risk, something is wrong.? Better that the economy grow more slowly, than that savers not get their due for not consuming.

Saving deserves a return.? Let the Fed raise the Fed funds rate by 1%, and they will see that there is no harm to the banks, and little harm to the economy.? Once you have 1% slope between twos and tens you have more than enough oomph to make the economy move.? What, does the AARP have to bring a age discrimination lawsuit against the Federal Reserve to make this happen?? The Fed is discriminating against the elderly.

But now consider another issue — money market funds.? I consider them to be superior to banks because their asset-liability mismatch is so small, and they have generated small losses relative to banks and other depositary institutions.

Prime money market funds in the US have been investing 50% of their assets in the Commercial Paper [CP] of Core Eurozone Banks.? Well guess what?? If the Greeks and other fringe members of the Eurozone default, and the core governments don’t bail the situation out, those holding? CP of core Eurozone banks may take a loss.? And this is at a time where French and German Banks are facing liquidity issues.? Take time to review your money market funds.

The problems of the US and China are significant, but the problems of the Eurozone are pressing.?? The endgame there will arrive more rapidly because the underlying structure is unstable.? One currency can’t serve multiple cultures.? Also, there should have been an Eurozone exit plan designed in from the beginning.? It was hubris to think it would never need that level of adjustment.

It seems like the ECB is becoming a repository of euro-fringe debt, and perhaps the IMF as well.? After all, it doesn’t cost the ECB anything to absorb those debts, but it indirectly spreads the risk to the euro-core nations if there is ever a default or unfavorable restructuring.? A central bank can’t go broke, but it can impose problems on those that use the currency if defending the central bank exacerbates other problems in the economy.? (E.g., printing money to cover over bad debts absorbed by the bank, while inflation rolls on.)

On a slightly different level, I’m not sure that the banking regulators in the US or Europe really got the main lesson from the crisis.? Risk management is liquidity management.? I still think that banks rely too much on short liabilities to finance illiquid, longer assets.? One advantage of mark-to-market accounting is that it can reveal those mismatches to investors, or perhaps, to regulators.?? Extra capital can help, but it is usually not enough when there is a run on short-term liquidity, particularly because capital is the excess of assets over liabilities.? If there are not enough liquid assets to meet the redemption of liquid liabilities, the result is insolvency.

“But that’s a liquidity problem, not a solvency problem — just give it time and the market will normalize, the assets are worth more than the liabilities anyway.”? But at such a time, no one wants to buy the longer, less liquid, lower quality assets.? If the bank could raise liquidity, it would.? It can’t, so it is not only illiquid, but insolvent.? It’s always cheaper to issue liquid liabilities, because those are attractive to savers and investors, but they a poison in a crisis.

My fear here is that there may be another call on liquidity that forces the Fed or the ECB to backstop banks.? Not sure what would cause it; it’s always hard to pick which straw will break the camel’s back.

Thus I say be cautious at present; have some safe assets available in case we have a panic that emanates out of Europe, and has second-order effects on the US.

The Best of the Aleph Blog, Part 4

The Best of the Aleph Blog, Part 4

Posted on by David Merkel

The period from November 2007 through January 2008 was challenging, but I did say a lot of good things.? Here’s a sample of the best:

Contemplating Life Without the Guarantors

Markets always beat governments, unless governments get so determined as to subvert markets.? Guarantors provide “thought insurance” so you don’t have to analyze the bond that they guarantee.? But what if the solvency of the guarantor is questioned?

The US Dollar and the Five Stages of Grieving

An important article that explains why currency interventions almost never work.? Required reading for Treasury Departments and Central Banks.

Why Did I Name This Site ?The Aleph Blog??

Cogent explanation for the odd name.? But I have gotten the question a few times as to whether I named my site after Jorge Luis Borges short story, “The Aleph.”? The answer is no, but after reading “The Aleph,” I would say that it folds into reason number four for why this is called The Aleph Blog.? Aleph is big.? Very, very big.

On the Value of Secondary and Primary Markets

They are valuable for different reasons, but they are related.

In Defense of the Ratings Agencies

The original piece, pointing out how the regulators have abandoned their responsibility, having outsourced it to the rating agencies.

Personal Finance, Part 6 ? The First Question

How much are you willing to learn, and how much work do you want to do? For people who ask my advice, that is usually the first question that I ask.

Booyah for Brainy Buybacks! (But not Brain-dead Buybacks.)

There is no simple answer to whether a buyback is the right strategy or not.? It depends on the price of the stock versus its value.

Options as an Asset Class

You can own/short options, but you can’t own/short volatility per se, at least not back in 2007.

Municipal Tensions

We are experiencing the front end of the woes now.? This won’t be over for 20 years.

How to Read the Whole Bible, and Survive the Experience

A simple way to read the whole of the Bible, and avoid getting bored, as so many do who try to read it straight through, and give up when 10-50% done.

In Defense of the Rating Agencies ? II

Anyone can criticize, but who can offer a system that is better than the present one on a comprehensive basis?

The Beauty of Broken Moats

Berky had an opportunity with almost all of the financial guarantors kicked to the curb.? It never worked out because Berky would not take modest risks.? In foresight today, those modest risks don’t seem so modest, so salute Mr. Buffett, who has forgotten more than most of us will ever know.

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

Odds are, Buffett knew a lot more than he confessed to know.? Buffett is a maven on insurance issues.

On Benchmarking

Benchmarking enforces conformity on managers, and the shorter-term the horizon, the more it makes them closet indexers.

Pandora and the Fair Value Accounting Rules

There are really tough issues here.? Everyone wants to be accurate, but over what time horizon, and how to adjust over time?? Bright investors will build in provisions for adverse deviation, and be conservative.

Unstable Value Funds?

This didn’t prove to be an issue, in this credit cycle, though form what I heard from insiders, it got close.? If the Fed hadn’t done 0% and QE, my dire predictions might have come true.? They still might in the future.? Be wary.

Meet Some of my Friends

Though the videos have disappeared, the story of how President George W. Bush, Jr. came to visit the factory of a friend of mine (of which I own 1.4%) is an interesting tale.? I was proud of my friend, who is a humble, but a great guy.

A Bonus from MoneySense Magazine

A free version of what Canadian magazine buyers had to pay for. How to earn more while taking less risk.

Personal Finance, Part 11 ? Your Personal Required Investment Earnings Rate

The intuitive explanation of what you need to earn in order to achieve all of your life goals.? It’s probably higher than you think.

With 401(k)s and Other Defined Contribution Plans, Watch Your Wallet

An important article — from the article:

If you are paying more than 1% of assets per year, then something is wrong, unless the asset classes are esoteric, which should not be the case for DC plans.? Remember, you have to be your own guardian with defined contribution plans.? No one will do it for you.? And, if a few of your colleagues complain at the same time, you will be amazed at how quickly it will be taken seriously, because the administrative staff of the plan sponsor usually doesn?t get that much feedback.

In general, high costs are closely correlated with low performance.? Keep a close hand on your wallet, and leave those who are charging you more than 1%, unless they are doing something special for you.

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

I think I gave good advice in that era.? As the bubble deflated, investors needed to be more careful, and I highlighted that.? Not that I will always get it right…

Creating a Stable Financial System, Part I

Creating a Stable Financial System, Part I

Posted on by David Merkel

I’ve been thinking a lot about bank reform lately.? Here’s the core of the problem: deposits are sticky in ordinary times, particularly once you have a guarantor of deposits like the FDIC.? But for some banks, they look to other short term funding, whether it is short CDs or repo funding.

Now to me a lot of the issue is asset-liability mismatch.? Banks borrow short and lend long.? That leads to banking panics.? Financing illiquid assets with liquid liabilities is unstable, and begs for bankruptcy at the first significant loss of confidence.

But there is a greater mismatch present, which I want to explore.? Every asset is financed with some liability or equity.? And, every liability is someone else’s asset, but not vice-versa, because assets owned free and clear are equity-financed.

Assets financed by debt are frequently mismatched short.? Long mismatches are rare because of the cost of financing being too high.? Now, if short mismatches are small, that’s not a problem.? There is enough flexibility in financial balance sheets to accept small mismatches.? Real disasters happen when long assets are financed in such a way that there is a risk that the financing will fail prior to the assets being paid off.

The fundamental mismatch in debts that finance assets is that the ultimate assets being financed are longer-dated than the financing.? We fund land, houses, buildings, plant & equipment, and do it off of deposits, savings accounts and CDs.? Some financial companies finance off of short-dated repo funding.? The reason that this mismatch is hard to avoid is that average individuals who save want short-dated assets that can be used for transactions.? That doesn’t fit well against the need to fund long-term assets.

The same problem exists in the municipal bond market.? Much more money wants to invest short, while municipalities want to borrow long.? This leads to a steep muni yield curve.? Commercial insurers writing long tail business, and wealthy people that can tolerate interest rate volatility end up buying the long end, and lower taxes in the process.

If banks were required to approximately match cash flows for assets not financed by equity, yield curves would steepen for other areas of the fixed income markets.? Areas of the financial market where there are long/strong balance sheets, such as Life Insurers, Commerical Insurers, Defined Benefit Pensions and Endowments would get higher yields for longer commitments.? Banks would become a lower ROE business, and that would be good, as there would be many fewer failures, and there would be fewer banks; we are over-banked.? Time to re-educate bankers for more productive activities.

Long dated floating-rate loans could be a solution for banks funding loans? off of short-dated lending, or, using interest rate swaps to achieve the same result.? The risk is that a bank locks in what proves to be a low spread on the asset, while funding costs are volatile.

A few final notes: 1) the standard of broadly matching asset and liability cash flows should be applied to all regulated financial institutions, including investment banks.? Only surplus assets not needed to match liabilities can be used for investments with equity-like risk. 2) There must be an unpacking of complex vehicles with embedded leverage to do the Asset-Liability management.? As examples:

  • Securitizations
  • Repo Funding
  • Private Equity
  • Hedge Funds
  • Margin loans
  • SIVs and the like

would need to be reflected as looking through to the items ultimately financed.? As an example, the AAA portion of a senior-sub securitization is long the loans, and short the certificates sold to the rest of the deal.

Repo funding has its own issues.? In a crisis, haircuts rise as asset values fall.? Institutions relying on that funding often fail at those times, and leaves losses to the repo lender.? There would need to be something reflected for the risk of repo market failure, though the grand majority of the losses go to the borrower, and not the lender.

3) Even short lending to those getting loans that do not fully amortize should be reflected as loans that are longer-dated, because of the risk of rates being higher, and refinancing is not possible.

I have more to say, but I’m going to hit the publish now.? Comments are welcome.

Book Review: All the Devils are Here

Book Review: All the Devils are Here

Posted on by David Merkel

Have you ever seen a complex array of dominoes standing, waiting for the first domino to be knocked over, starting a chain reaction where amazing tricks will happen?? I remember seeing things like that several times on “The Tonight Show with Johnny Carson” back when I was a kid.

When the first domino is knocked over, the entire event doesn’t take long to complete — maybe a few minutes at most.? But what does it take to set up the dominoes?? It takes hours of time, maybe even a whole day or more.? Often those setting up the dominoes leave out a few here and there, so that an accident will spoil only a limited portion of what is being set up.

Those standing dominoes are an unstable equilibrium.? That is particularly true at the end, when the dominoes are added to remove the safety from having an accident.

Most books on the economic crisis focus on the dominoes falling — it is amazing and despairing to watch the disaster unfold, as the leverage in the system is finally revealed to be unsustainable.

This book is different, in that it focuses on how the dominoes were set up.? How did the leverage build up?? How was safety ignored by so many?

The beauty of this book is that it takes you behind the scenes, and describes how the conditions were created that led to a huge creation of bad debts.? I was a small and clumsy kid.? My friends would say to me during sports, “There are mistakes, but your error was so great that it required skill.”

The same was true of the present crisis.? There were a lot of skillful people pursuing their own private advantage, using new financial instruments which were harmless enough on their own, but deadly as a group.? So what were the great financial innovations that enabled the crisis?

  • Creation of Fannie and Freddie, which led to an over-issuance of mortgages.
  • Securitization, particularly of mortgages.? This led to a separation between originators and certificateholders. (And servicers, though the book does not go into servicers much.)
  • Having parties that guarantee debt, whether GSEs, Guaranty Insurers, the Government, or credit default swaps [CDS]
  • Loosening regulations on commercial banks, investment banks and S&Ls.
  • Regulatory arbitrage for depository institutions.
  • Loose monetary policy from the Federal Reserve, together with a disdain for regulating credit.? They saw Mexico and LTCM as successes, and thought that there was no crisis that could not be solved by additional liquidity.
  • Bad rating agency models, and competition among rating agencies to get business.
  • Regulators that required the use of rating agencies for capital modeling.
  • The broad, misinformed assumption that real estate prices only go up.
  • The creation of Value-at-risk, a risk management concept that has limited usefulness to true crisis management.
  • The creation of CDOs that did not care for much more than yield.
  • The development of synthetic CDOs, which allowed securitization to apply to corporate bonds, MBS, and ABS not owned by the trusts.
  • The creation of subprime loan structures, where are that was cared for was yield.
  • The creation of piggyback loans, so that people could put no money down for a home.

There are no heroes in this book, aside from tragic heroes who warned and were kicked aside in the hubris of the era.? Goldman Sachs comes out better than most, because they saw the crisis coming, and protected themselves more than mot investment banks.

I learned a lot reading this book, and I have read a dozen or so crisis books.? I didn’t learn much from the other books.? In this book, the authors interviewed hundreds of people who were integral to the crisis, and read a wide variety of sources that wrote about the crisis previously.

I found the book to be a riveting read, and I read it cover to cover.? I could not change into scan mode; it was that well-written.

This is the best book on the crisis in my opinion, because it takes you behind the scenes.? You will learn more from this book than any other on the crisis.

Quibbles

They don’t get the difficulties of being a rating agency.? There is the pressure to get things right over the cycle, and get it right on a timely basis.? These two goals are contrary to each other, and highlighting that conflict would have enhanced the book.

Who would benefit from this book:

Anyone willing to read a longish book could benefit from this book.? It is the best book on the crisis so far.

If you want to, you can buy it here: All the Devils Are Here: The Hidden History of the Financial Crisis.

Full disclosure: This book was sent to me, because I asked for it.

If you enter Amazon through my site, and you buy anything, I get a small commission.? This is my main source of blog revenue.? I prefer this to a ?tip jar? because I want you to get something you want, rather than merely giving me a tip.? Book reviews take time, particularly with the reading, which most book reviewers don?t do in full, and I typically do. (When I don?t, I mention that I scanned the book.? Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website.? Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites.? Whether you buy at Amazon directly or enter via my site, your prices don?t change.

Nonidentical Twins: Solvency and Liquidity (III)

Nonidentical Twins: Solvency and Liquidity (III)

Posted on by David Merkel

This is the third part of an irregular series on solvency and liquidity.? This time, though, I am not focusing on corporations, or accounting rules, but on countries and municipalities.

With the crisis in the Eurozone, there are times of calm, and then times of panic, with seemingly little warning for transitions.? Let me try to explain why this happens, even though it won’t explain why it happens on a particular day.

A country with a profligate fiscal policy builds up debt beyond its ability to repay if bad times were to come, but times are good, the country is growing rapidly, and most think that there will be more than adequate ability to repay given the growth of GDP.

Or, the financial sector grows of a nation far more rapidly than GDP, abut again, in boom times, the profits of the banks are roaring ahead, and only cowards or bears would question the prosperity of a boom.

But the truth is, during a credit-driven boom (whether governmental, financial, or other), much of the supposed prosperity is a mirage.? The additional leverage pushes up asset prices until the cost of financing the assets exceeds the yield the assets throw off by a small margin.? Economic agents have to rely on capital gains to make money, and that is where bubbles pop, and go into reverse, with a vengeance.

With nations, an overleveraged situation is revealed during a bear market.? Asset prices shrink.? Incomes shrink.? Demand for welfare payments rise.? Governments that relied on expanding asset prices are revealed to be the spendthrifts that they are.

Now, when a government is overleveraged, but interest rates are low, the situation is potentially unstable.? A rise in rates could tip the scales.? Market actors would conclude that they can’t survive at rates high than a certain threshold, so sell the debt now, in case rates would get so high.? That action forces rates higher, leading to a self-reinforcing panic.

Sometimes this happens in advance of a debt refinancing, leading some politicians and bureaucrats to say the forever bogus phrase, “This is not a solvency crisis, this is a liquidity crisis.”? Sorry, if you play near the cliff, don’t complain if you happen to fall off.

Liquidity crises do not happen to governments with low debt levels.? Liquidity crises are solvency crises during the panic phase, before they are revealed to be solvency crises alone.

It is difficult to change government behavior, because the politics of reducing spending, or raising taxes is tough.? Once a crisis hits, there are protests.? People point at shadowy interests that are denying them the illusionary prosperity of the boom; conspiracy theories thrive.

With the Eurozone, there are contagion effects; panics in one nation prompt investors to look at other nations, and leave weak situations.? Crises separate good and bad credits.? That may push bad credits over the edge.? Again, never play near the cliff; always ask, “Could we survive easily in bad times?”

The difficulty for the strong nations of the Eurozone is that their banks lent a lot to the fringe nations that are failing.? Thus the strong are likely to bail out the fringe, though a more prudent course would be to bail out their own banks after a promise limiting lending abroad.? The real political question is what is the price that Germany will charge to bail out the Euro?? What sovereignty will the fringe have to give up?? And what will the German and Fringe electorates tolerate?? Perhaps the intersection set is null.? No agreement.? At that point the Eurozone shrinks or ends.

The proper solution for the Eurozone fringe, and other deadbeats in this crisis, is to negotiate writedowns of debt, and cut them off from borrowing at the rate they were accustomed to receive.? Recognize losses, and wean them off credit.? If not, let them fail, and bail out your own banks, which is cheaper than bailing out the fringe.

Pressures are building.? If the Eurozone survives in its present form, it will be because Germany bailed it out, at some political price that they will specify.? Investors should look at cash financing schedules and balance sheets to evaluate the future solvency of Eurozone nations.

And, lest the US smirk, the same exercise will come here, reserve currency or not.

What if We Replaced the US Postal Service Two Years from Now?

What if We Replaced the US Postal Service Two Years from Now?

Posted on by David Merkel

Two notes before I begin: I will be in New York City next Wednesday, and maybe Tuesday or Thursday.? I will be meeting with potential investors.? If you would like to hear what I am up to, e-mail me, and maybe we can get together.

Also, if you have a moment, have a look at my friend Cody’s website that deals with applications for mobile devices.? He seems to have found an interesting new niche.

=–==-=-=–==-=–==-=-=-=-=-=-=-=-

When I was a kid, I remember reading a story about a business that started a letter delivery service in a major American city, I think it was Philadelphia.? They undercut the US Postal Service by about 20% or so, and they began to attract a decent amount of volume, such that government came and shut them down, because USPS has a monopoly on delivering non-urgent mail.

Unfortunately for USPS, it has a much larger lower cost competitor: the Internet, which is eating into its high margin businesses, forcing prices up as it tries to maintain its subsidy to activities that lose money.

The Internet improves and destroys.? The economics of newspapers has been destroyed by the internet.? Should we be surprised that the economics of a similar business, the Post Office, is suffering similar troubles?? Delivering paper mailings to addresses seems to be populated by junk mailers and a variety of businesses that could deliver via e-mail.? I get few personal letters for my family, and many of those could go via e-mail.

This is a system that is looking for a kick to get it to move from an unstable equilibrium, perpetually asking for price increases, and service decreases, to a stable equilibrium where people receive almost all mail traffic over the internet.? So, what if we replaced the postal service two years from now?

If there were two years of lead time, older folks would be forced to adapt to e-mail, and advertisers would find new means contacting clients.? Some clever businesses would buy up post office sites, perhaps UPS and Fedex, and augment their businesses.

It would be likely that the cost of purely local mail delivery would go down in densely populated areas, but that delivery outside of major urban areas would be considerably more expensive, and would depend on the location of both the sender and the receiver.

The price differences would become similar to the price of a person traveling from one place to another.? Is it hard and costly for you to go from point A to point B?? It would be the same for mail.? Sending a piece of mail from one low density area to another would be expensive.

Now, I don’t think the postal service will go away in two years.? But ten years down the road the answer might be different.? Here are two alternative visions of the future:

Now, I think Hassett is mistaken when he says, “We need only write regulations that require firms that compete for postal business to provide universal service.”? The US is a big place, with a lot of sparsely populated areas.? The countries that have privatized are typically more compact, making it possible to have netorks that deliver everywhere at a reasonable cost.? Universal service will come with astronomical pricing for low density deliveries.

But I think the Postmaster General is mistaken when he estimates the total amount of demand over the next ten years.? I think that more and more will go online, with many businesses making people pay extra to receive paper bills, statements, etc.? Paper mail is not only costly to deliver, but costly to create.

People will also evaluate the postal service on convenience as well.? As the number of days for delivery declines to five, and local post offices and local delivery diminish in rural areas, people will begin asking for more to be delivered via e-mail.

One final note: I find it tragic/comical that USPS does with its employee benefit plans what all companies and governments should do: fully fund them.? But now they are looking to raid the funds to support current services, and push back on the? Federal government to absorb more of certain shared costs.? I think it is amazing to call funding 30% of retiree healthcare and 80% of pensions to be “fully funded,” because those are the average levels of many corporations.? Raiding the funds may help today, but ten years out, as postal workers age and retire, this will place even more expense pressure on postage rates.

Eventually the economics of a situation prevails.? The proposed move with the employee benefit plan is desperate.? Eventually a significant change will have to be made to the US Postal Service.? It would probably be better to think about an integrated plan today, than let ten years elapse, and face a larger crisis.

Given the nature of the US, and the short-termism that plagues us today, I suspect that we get the crisis.

The Education of a Corporate Bond Manager, Part V

The Education of a Corporate Bond Manager, Part V

Posted on by David Merkel

There has been a lot of talk lately about systemic risk, a concept that is not well-understood.? Let me simplify it for you.? Anytime debt grows in an area of the economy at a rapid pace, there is an unstable situation to be avoided.? If you are a portfolio manager at such a time, you must take the tough decision and underweight the area of the bond market that is growing the fastest.? That is not easy to do, particularly because that is where most of the new issues are coming from.

I wrote a piece called Fruits and Vegetables Versus Assets in Demand, where I said:

There is a way in which fruits and vegetables and financial products are opposites: when quantities are high for fruits and vegetables, quality is high, and prices are low. With financial products, when issuance is high, quality is low, and pricing is expensive, leading to poor future returns from lower yields, and higher future defaults. I offer this for what it is worth, but is there something more to it, than the seeming oppositeness?? Why are they opposites?

I had a follow-up piece here that answered the questions.? It takes time and effort to farm, but financial products can be whipped up easily in any season.

In the present environment, this would mean avoiding government debt.? If you believe in inflation coming you can buy the short end, and if deflation, the long end, but aside from that, the ability of the US Government to repay is not growing as rapidly as their debts are.

When I came on the scene in 2001 as a corporate bond manager, there were several areas of the bond market that had a lot of issuance: autos and telecommunications.? I began selling the weaker bonds in those areas; I sold all of my auto bonds (including GMAC and FMCC) except for $10 million of an illiquid issue of a Dutch Ford subsidiary, and limited my holdings in Telecom bonds to the Baby Bells.

That took effort.? Debt-based industry expansions rarely work out well.? If the idea was that promising, it could be funded with higher cost equity, rather than debt.

Now, what would this rule have meant 2004-2007?? Avoid financials, especially banks, S&Ls and mortgage companies.? Though financials are always a large part of issuance, they were even larger then.

I can hear some manager saying, “But I can’t vary that much against the index!? That’s an impossible strategy for big fixed income managers to follow.”? I understand, there are tradeoffs in investing.? If I am underweight, someone else must be overweight versus the index.? Someone has to absorb all of the paper of the hot sector; don’t let that be you.

=-=-=-=-=-=–==-=-=-=-=-=-=-=-=–==-=-

Credit analysts understand the creditworthiness of bonds.? What are portfolio managers good for?? Portfolio managers should grasp three things at least:

  1. Portfolio composition versus the needs of the client.
  2. The trading dynamics of the marketplace, and whether a bond might be temporarily mispriced.
  3. The dirty details of a bond.? What are the covenants, terms, etc.

I will handle #1 at a later point in time.? As for #2, a good portfolio manager attempts to explain to his credit analyst why he is ignoring his opinion for a time, because the market for a given bond seems promising in the short run.? There is momentum in bond pricing, and it is better to sell a little late rather than early.

As for point #3, it is the responsibility of the portfolio manager to understand all the special features of a given bond, and why there are pricing differences across the bonds of a given main obligor (borrower), taking advantage of those differences when they get out of whack.

Having been a mortgage bond manger, where document review was a bigger part of what we did, in the minority of corporate bonds that need that review, there is a lot of value to be added.? Often I would review a complex prospectus to find out a big negative: amid all of the legalese, the bonds were as secure, or more so than the senior unsecured of the main obligor.

In a time of panic, those insights are golden, because other managers toss out illiquid bonds that they don’t fully understand.

Even understanding what a put bond is worth is valuable; after deducting yield because of the illiquidity of the smaller put bond issue.? The same is true of trust preferreds, preferred stock, premium bonds versus discount bonds, call features, etc.

The portfolio manager has to balance all of those factors off, along with client factors, in order to manage the assets properly.

I’ll talk more about client factors in a later post; those are always fun, or at least controversial.

The Lack of Cultural Agreement Roars, the Eurozone Mews

The Lack of Cultural Agreement Roars, the Eurozone Mews

Posted on by David Merkel

Economic systems are the result of cultures.? Where there is little cultural agreement, the economic system will be unstable, as will be governmental action.

No, this is not another “Rules” post.? But this is a post about the Eurozone and Japan today.? Japan faces trouble, but there is cultural agreement on what should be done, so there is no great crisis today, though the demographics may force issues eventually.

The Eurozone does not publicly recognize that there are large disagreements over what economic policy should be.? In the countries that are in economic trouble, there are many that push their governments to spend more on them, forcing the governments to borrow more.? This is particularly true of the unions.

My view of unions is that they slowly kill whomever they serve.? Industries with high unionization die eventually.? Countries that support unions die slowly as well.

Unions introduce inflexibility into the economic process which has a huge cost, eventually.? Greece is controlled by its unions.? They are willing to seek their own prosperity even if it leads to the destruction of the nation.? They don’t think the nation will be destroyed, but think that there are parties in power that hold back value from them, and they must be opposed, deluded fools that the unions are.

But there is a bigger problem for the Eurozone.? What do they do about Portugal, Ireland, Spain, and maybe Italy?? Yeah, the Eurozone could rescue Greece, but could it rescue Spain?? The answer is simple, NO.? But rescuing Greece discourages Spain from taking hard actions.

There is a lot of moral hazard involved in rescuing countries in the Eurozone.? Far better for nations to rescue banks that have lent to Greece, Portugal, Ireland, Spain, Italy, etc.? From what I have read, Europeans don’t exist.? Nations exist around a common culture and language.? Nations in Europe exist, and many act against the concept of a Eurozone.

Both positively and negatively, one can say that the Eurozone can’t make everyone into Germans.? The Germans exercised discipline that other nations would not.? Because of the size of Germany, and those allied with them in the Eurozone, the Euro is a hard currency, harder than many cultures/nations with lower labor productivity would like.

Why is the Euro weak?? Because the present crisis has relegated it to the status of an experiment.? Wondering over how Eurozone obligations will be repaid is an issue outside the Eurozone.? There are solutions, but they are painful — 1) let Greece become a state of Germany.? Not happening. 2) Let the Eurozone pour money into Greece; I’m sure they will reward you by adopting austerity measures, not. 3) Let Greece default, and then, let the Eurozone attempt to ameliorate it.? It will be difficult, and I doubt that debts to Greece will be settled at over 40% per Euro.

The major trouble is that banks in countries with relatively orthodox finances have lent to countries with liberal finances.? Well, who else could have done it, but the banks making the loans are in a fix because their health is subject to the creditworthiness of those that they lent to, which should be no surprise, but we forget.

Thus the big crisis in Europe is really over the soundness of the banking sector.? Rather than bailing out nations in trouble, far better to bailout your own banks that made bad loans, and let the profligate nations fail.? Remember, the Eurozone was not a promise to support profligate nations, but an effort for responsible nations to share a common currency.? If nations are not responsible, it is not the responsibility of the other Eurozone nations to subsidize them.

Do you want to save the Eurozone?? Save it by protecting your own banks, and letting profligate nations fail.? You will end up with a “hard” Eurozone of nations that are not profligate, and can live up to the demands of a strong currency.? The Eurozone exists without the UK.? It can exist without Greece, Portugal, Spain, Italy, and Ireland.

Subsidies don’t work, and that is what the loans to Greece are.? The Greeks will just suck them in, and continue their unruly fracas over who gets what.? Far better to let Greece fail, and scare marginal nations to clean up their acts.

-=-==–==-=-=-=-=–==-=-=-=-

I don’t write this because I want the US Dollar to prosper because of a failure of the Euro.? Hey, I want credible alternatives to the Dollar, because it is at best the best of a bunch of sorry currencies, and I am not ready to sign on to the cult of Gold.? I like gold as a currency, but am not crazy about it as an investment.

My view is that the Euro can exist even after the failure of nations that leave the Euro, and that Euro obligations could still be enforced on defaulting nations because of the large amount of commerce inside Europe.

My advice to European statesmen, including those that share my surname, is to focus on your national interests.? The Eurozone is too vague to matter to those who elect you.? Focus on protecting your banks, rather than those the banks have lent to, which would waste money.

In Defense of the Rating Agencies ? V (summary, and hopefully final)

In Defense of the Rating Agencies ? V (summary, and hopefully final)

Posted on by David Merkel

I write this because I was invited to be on CNBC on the topic, but I suggested that my opinion would not make for good television.? That said, I have taken my four prior posts on the topic, and assembled them into one comprehensive post.? I do not intend on posting on this again.? With that, here is my post:

The ratings agencies have come under a lot of flak recently for rating instruments that are new, where their models might not be do good, and for the conflicts of interest that they face.? Both criticisms sound good initially, and I have written about the second of them at RealMoney, but in truth both don?t hold much water, because there is no other way to do it.? Let those who criticize put forth real alternatives that show systematic thinking.? So far, I haven?t seen one.

Most of the current problems exist in exotic parts of the bond market; average retail investors don?t have much exposure to the problems there, but only less-experienced institutional investors.

Here are my five realities:

  • Somewhere in the financial system there has to be room for parties that offer opinions who don?t have to worry about being sued if their opinions are wrong.
  • Regulators need the ratings agencies, or they would need to create an internal ratings agency themselves, or something similar.? The NAIC SVO is an example of the latter, and proves why the regulators need the ratings agencies.? The NAIC SVO was never very good, and almost anyone that worked with them learned that very quickly.
  • New securities are always being created, and someone has to try to put them on a level playing field for creditworthiness purposes.
  • There is no way to get investors to pay full freight for the sum total of what the ratings agencies do.
  • Ratings can be short-term, or long-term, but not both.? The worst of all worlds is when the ratings agencies shift time horizons.

Ratings are Opinions

The fixed-income community has learned that the ratings agencies offer an opinion, and they might pay for some additional analysis through subscriptions, but if they were forced to pay the fees that issuers pay, they would balk; they have in-house analysts already.? The ratings agencies aren?t perfect, and good buy-side shops use them, but don?t rely on them.? Only rubes rely on ratings, and sophisticated investors did not trust the rating agencies on subprime.? My proof?? Look how little exposure the Life and P&C insurance industries had to subprime mortgages outside of AIG.? Teensy at best.

Please understand that institutions own most of the bonds out there.? We had a saying in a firm that I managed bonds in, ?Read the write-up, but ignore the rating.?? The credit analysts at the rating agencies often knew their stuff, giving considerable insight into the bonds, but may have been hemmed in by rules inside the rating agency regarding the rating. It?s like analysts at Value Line.? They can have a strong opinion on a company, but their view can only budge the largely quantitative analysis a little.

Let?s get one thing straight here.? The rating agencies will make mistakes.? They will likely make mistakes on a correlated basis, because they compete against one another, and buyers won?t pay enough to support the ratings.

So there are systematic differences and weaknesses in bond ratings, but the investors who own most of the bonds understand those foibles.? They know that ratings are just opinions, except to the extent that they affect investment policies (?We can?t invest in junk bonds.?) or capital levels for regulated clients.

On investment policies, whether prescribed by regulators or consultants, ratings were a shorthand that allow for simplicity in monitoring (see Surowiecki?s argument).? Now, sophisticated investors knew that AAA did not always mean AAA.? How did they know this?? Because the various AAA bonds traded at decidedly different interest rates.? The more dodgy the collateral, the higher the yield, even if it had a AAA rating.? My mistake: I, for one, bought some AAA securitized franchise loan paper that went into default long before the current crisis hit.? Many who bought post-2000 AAA securitized manufactured housing loan paper are experiencing the same.? Early in the 2000s, sophisticated investors got burned, and learned.? That is why few insurers have gotten burned badly in the current crisis.? Few insurers bought any subprime residential securitizations after 2004.? But, unsophisticated investors and regulators trust the ratings and buy.

Financial institutions and regulators have to be ?big boys.? If you were stupid enough to rely on the rating without further analysis, well, that was your fault.? If the ratings agencies can be sued for their opinions (out of a misguided notion of fiduciary interest), then they need to be paid a lot more so that they can fund the jury awards.? Their opinions are just that, opinions.? As I said before, smart institutional investors ignore the rating, and read the commentary.? The nuances of opinion come out there, and often tell smart investors to stay away, in spite of the rating.

How Can Regulators Model Credit Risk?

It started with this piece from FT Alphaville, which made the point that I have made, markets may not need the ratings, but regulators do.? (That said, small investors are often, but not always, better off with the summary advice that bond ratings give.)? The piece suggests that CDS spreads are better and more rapid indicators of change in credit quality than bond ratings.? Another opinion piece at the FT suggests that regulators should not use ratings from rating agencies, but does not suggest a replacement idea, aside from some weak market-based concepts.

Market based measures of creditworthiness are more rapid, no doubt.? Markets are faster than any qualitative analysis process.? But regulators need methods to control the amount of risk that regulated financial entities take.? They can do it in four ways:

  1. Let the companies tell you how much risk they think they are taking.
  2. Let market movements tell you how much risk they are taking.
  3. Let the rating agencies tell you how much risk they are taking.
  4. Create your own internal rating agency to determine how much risk they are taking.

The first option is ridiculous.? There is too much self-interest on the part of financial companies to under-report the amount of risk they are taking.? The fourth option underestimates what it costs to rate credit risk.? The NAIC SVO tried to be a rating agency, and failed because the job was too big for how it was funded.

Option two sounds plausible, but it is unstable, and subject to gaming.? Any risk-based capital system that uses short-term price, yield, or yield spread movements, will make the management of portfolios less stable.? As prices rise, capital requirements will fall, and perhaps companies will then buy more, exacerbating the rise.? As prices fall, capital requirements will rise, and perhaps companies will then sell more, exacerbating the fall.

Market-based systems are not fit for use by regulators, because ratings are supposed to be like fundamental investors, and think through the intermediate-term.? Ratings should not be like stock prices ? up-down-down-up.? A market based approach to ratings is akin to having momentum investors dictating regulatory policy.

Also, their models that I am most familiar with only apply to publicly-traded corporate credit.? Could they have prevented the difficulties in structured credit that are the main problem now?

What to do with New Classes of Securities?

Financial institutions will want to buy new securities, and someone has to rate them so that proper capital levels can be held (hopefully).? But what are rating agencies to do when presented with novel financial instruments that have no significant historical loss statistics?? Many of the likely buyers are regulated, and others have investment restrictions that depend on ratings, so aside from their own profits, there is a lot of pressure to rate the novel financial instrument.? A smart rating agency would punt, saying there is no way to estimate the risk, and that their reputation is more important than profits.? Instead, they do some qualitative comparisons to similar?but established financial instruments, and give a rating.

Due to competitive pressures, that rating is likely to be liberal, but during the bull phase of the credit markets, that will be hidden.? Because the error does not show up (often) so long as leverage is expanding, rating agencies are emboldened to continue the technique.? As it is, when liquidity declines and leverage follows, all manner of errors gets revealed.? Gaussian copula?? Using default rates for loans on balance sheet for those that are sold to third parties?? Ugh.

Some will say that rating agencies must say ?no? to Wall Street when asked to rate exotic types of debt instruments that lack historically relevant performance data.? That?s a noble thought, but were GICs [Guaranteed Investment Contracts] exotic back in 1989-1992?? No.? Did the rating agencies get it wrong?? Yes.? History would have said that GICs almost never default.? As I have stated before, a market must fail before it matures.? After failure, a market takes account of differences previously unnoticed, and begins to prospectively price for risk.

But think of something even more pervasive.? For almost 20 years there were almost no losses on non-GSE mortgage debt.? How would you rate the situation?? Before the losses became obvious the ratings were high.? Historical statistics vetted that out.? No wonder the levels of subordination were so small, and why AAA tranches from late vintages took losses.

When prosperity has been so great for so long, it should be no surprise that if there is a shift, many parties will be embarrassed.? In this case both raters and investors have had their heads handed to them.

Now there are alternatives.? The regulators can ban asset classes until they are seasoned.? That would be smart, but there will be complaints.? I experienced in one state the unwillingness of the regulators to update their permitted asset list, which had not been touched since 1955.? In 2000, I wrote the bill that modernized the investment code for life companies; perhaps my grandson (not born yet), will write the next one.

Regulators are slow, and they genuinely don?t understand investments.? The ratings agencies aren?t regulators, and they should not be put into that role, because they are profit-seeking companies. Don?t blame the rating agencies for the failure of the regulators, because they ceded their statutory role to the rating agencies.? But if the regulators ban asset classes, expect those regulated to complain, because they can?t earn the money that they want to, while other institutions take advantage of the market inefficiencies.

Compensation and Conflicts

Some say that rating agencies must be encouraged to make their money from investor subscriptions rather than fees from issuers, to ensure more impartial ratings.? If this were realistic, it would have happened already.? The rating agencies would like nothing more than to receive fees from only buyers, but that would not provide enough to take care of the rating agencies, and provide for a profit.? They don?t want the conflicts of interest either, but if it is conflicts of interest versus death, you know what they will choose.

Short vs. Long-Term Opinions

Ratings agency opinions are long-term by nature, rating over a full credit cycle.? During panics people complain that they should be more short-term.?? Hindsight is 20/20.? Given the multiple uses of credit ratings, having one time horizon is best, whether short- or long-term.? Given the whipsaw that I experienced in 2002 when the ratings agencies went from long- to short-term, I can tell you it did not add value, and that most bond manager that I knew wanted stability.

Non-solutions

Some say rating agencies no longer should have exclusive access to nonpublic information, to even out the playing field.? That sounds good, but the regulators want the rating agencies to have the nonpublic information.? They don?t want a level playing field.? As regulators, if they are ceding their territory to the rating agencies, then they want the rating agencies to be able to demand what they could demand.? Regulators by nature have access to nonpublic information.

Some ask for greater disclosure of default rates, but that is a non-issue.? They also look to punish rating agencies that make mistakes, by pulling their registration. ?Disclosing default rates is already done, and sophisticated investors know this.? Yanking the registration is killing a fly with a sledgehammer.? It would hurt the regulators more than anyone else.?The rating agencies are like the market.? The market as a whole gets it wrong every now and then.? Think of tech stocks in early 2000, or housing stocks in early 2006.? To insist on perfection of rating agencies is to say that there will be no rating agencies.? It takes two to make a market, and agencies will often be wrong.

Solutions

As for solutions, I would say the following are useful:

  • Competition. ?I?m in favor of a free-ish market here, allowing the regulators to choose those raters that are adequate for setting capital levels, and those that are not.? For other purposes, though, the more raters, the better.? I don?t think rating fees would drop, though.? Remember, ratings are needed for regulatory purposes.? Will Basel II, NAIC, and other regulators sign off on new credit raters?? I think that process will be slow.? Diversity of opinion is tough, unless a ratings agency is willing to be paid only by buyers, and that model is untested at best.
  • Compensate with residuals and bonuses (give the raters some skin in the game)
  • Deregulation (we can live without rating agencies, but regulators will have to do a lot more work)
  • Greater disclosure (sure, let them disclose their data and formulas (perhaps with a delay).
  • Have regulators bar unseasoned asset classes.

Summary

Let those who criticize the ratings agencies bring forth a new paradigm that the market can embrace, and live with in the long term.? Until then, the current system will persist, because there is no other realistic way to get business done.? There are conflicts of interest, but those are unavoidable in multiparty arrangements.? The intelligent investor has to be aware of them, and compensate for the inherent bias.

Unless buyers would be willing to pay for a new system, it is all wishful thinking.? Watch the behavior of the users of credit ratings.? If they are unwilling to pay up, the current system will persist, regardless of what naysayers might argue.

The Rules, Part X

The Rules, Part X

Posted on by David Merkel

The more entities manage for total return, the more unstable the financial system becomes.

The shorter the performance horizon, the more volatile the market becomes, and the more index-like managers become.? This is not a contradiction, because volatile markets initially force out those would bring stability, until things are dramatically out of whack.

I was at a conference on Stable Value Funds, I think around 1995.? The meeting hadn’t started? but a few attendees? had arrived.? We were talking about the need to find yield in the market when one said (with an arrogant attitude), “Yield?? Why not total return?”

A tough question, and one none of us were ready for at the time.? My thoughts a few days later were on the order of, “If only it were that simple.? Right, you can generate positive returns over every time horizon worth measuring.? Okay, Houdini, do it.”

Total return investors don’t have long time horizons.? Investors with short time horizons either aim for momentum plays, or aim for yield.? Momentum persists in the short run, so play it if you must, remembering that the market gets more volatile when many play momentum.

Yield is less volatile than momentum, at least most of the time.? But yield is a promise, and frequently disappoints during times of stress.? Look at all of the dividend cuts over the past two years.

But consider this from a different angle.? Imagine your boss comes to you and says, “I want you to deliver the best returns to me every day versus the S&P 500.”? Okay, beat the S&P 500 every day.? That means the portfolio has to be a lot like the S&P 500, with some tweak that will beat it.? Anything too different from the S&P 500 will miss too frequently.

Now, I would say loosen up, why constrain daily performance?? Aim for great returns over the long haul, and don’t sweat years, much less days.? Great asset management requires a willingness to be wrong over significant periods, with a strong sense of what will work in the long run.

Those with short horizons will tend to index relative to their funding need, whether it is cash, short bonds, or indexed equities.? Note that most managers should have long horizons, but clients evaluate the returns of the past quarter or month, and the manager feels as if he is on a short leash, which makes him look to the next month or quarter, and makes him invest more like an index.

-=-==–=-=-=-=-=-=-=-=-=-

If you have a good manager, set him free — lengthen the performance horizon; give him room to do things that are unorthodox.? Ignore the consultants with their foolhardy models that constrain manager behavior.? Let me tell you that you are brighter than the consultants, and can better manage managers than they do.? Their models encourage managers who hug the indexes to avoid doing too much worse than them, and so you get index-like performance.

-=-==–==-=-=–==–==-=-=

At turning points, a different breed of investor shows up.? At busts, investors show up who will buy and hold, bringing stability to the market.? They look at fundamental metrics and conclude that their odds of losing money are small.? At the booms, a different investor leaves.? They will sell and sit on cash.? Similarly, they think the odds of losing money, or, not making as much, is large.

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

Good money managers think long term, but all of the short-term measurements fight against that.? They force managers to think short term, or else their assets will leave them.? That is a horrible place to be.? Better that clients should ignore the consultants, and aim for the long-term themselves.? You will do much better choosing managers for yourselves and ditching the consultants who (it should be known) merely chase performance.? With help like that, you may as well invest in the hottest stocks with a portion of your portfolio — you might do better than you are doing now.

Theme: Overlay by Kaira.