David Merkel
Ugh. After the purchase of EOP, I felt that equity REITs had reached valuation levels that not only discounted the lifetime of my children, but eternity as well. With the purchases of Archstone Smith and the Pennsylvania REIT, we are at valuation levels near those at the EOP purchase. My metric is equity REIT dividend yields versus the 10-year treasury yield. When one has to give up 1.2% in yield to move from safe Treasuries to risky REIT equity, there is something amiss. The valuation levels embed significant assumptions for growth in rents, which is particularly dangerous when the bull cycle in commercial real estate is so extended.
As a side note, before the purchases were announced, REITs looked the worst from a technical standpoint in the financial space. Now they are the best. So much for the utility of technical analysis.
Wednesday, June 6, 2007
Alt-A Loan Performance Statistics Getting Worse
David Merkel
Look at this press release from Fitch. Though it is only dealing with one set of securitizations, Residential Accredit Loan, Inc., or RALI, it is interesting to see how many 2005 and 2006 deals are experiencing poor performance, and as a result, the lowest classes in those deals are being downgraded.
Just a reminder that the stress in lending is not limited to only subprime lending. All non-prime lending is affected. This is just a straw blowing in the wind… but I would lighten up on financial stocks with significant commitments to Alt-A lending relative to their overall book of business.
Look at this press release from Fitch. Though it is only dealing with one set of securitizations, Residential Accredit Loan, Inc., or RALI, it is interesting to see how many 2005 and 2006 deals are experiencing poor performance, and as a result, the lowest classes in those deals are being downgraded.
Just a reminder that the stress in lending is not limited to only subprime lending. All non-prime lending is affected. This is just a straw blowing in the wind… but I would lighten up on financial stocks with significant commitments to Alt-A lending relative to their overall book of business.
When Will the Goat Reach the End of the Snake?
David Merkel
Speculation. Rampant speculation. This run in the market has to end soon, right? Right?!
Look, I’m not so sure. I have a lot to write on this topic, but not so much time. Market trends have a nasty tendency to persist longer than fundamentally-based market observers would expect. Let me give you the four things that could derail the markets, and tomorrow I can detail what I have seen in the markets concerning the four potential trouble spots (and more).
1. The recycling of US dollar claims from the trade deficit ends because the US dollar falls enough to make imports dear and US exports cheap. US interest rates rise as a result, stopping the substitution of debt for equity, and in some cases, leading to the raising of new equity capital. We have seen upward adjustments in many foreign currencies so far, but not enough to change the basic terms of trade.
2. Defaults in the bond and loan markets lead to a closing of the synthetic CDO market, which in turn leads to underperformance of many hedge fund-of-funds. Bond spread widen as risk returns to lending, and the substitution of debt for equity slows to a halt.
3. New supply comes to the equity market, overwhelming cash available. This could come from private equity seeking to liquefy marginal asses at favorable prices. Alternatively, this could come from private equity investments that are unable to pay their debt coupons. It is less well known outside of fixed income investing that most insolvencies occur because companies can’t make a coupon payment, not that they can’t refinance a principal payment.
4. Rising inflation in countries providing capital to the US forces them to revalue their currencies higher, and not keep sucking in US dollar claims, which don’t provide any goods to their people who want to buy goods to support their lives.
Interest rates need to be around 1.5% higher to shut off the speculation with near-certainty (did not work in 1987… rates got much higher.). Until then, the party can go on. I have an article being developed on this topic, but I fear it is a “next week” item.
Speculation. Rampant speculation. This run in the market has to end soon, right? Right?!
Look, I’m not so sure. I have a lot to write on this topic, but not so much time. Market trends have a nasty tendency to persist longer than fundamentally-based market observers would expect. Let me give you the four things that could derail the markets, and tomorrow I can detail what I have seen in the markets concerning the four potential trouble spots (and more).
1. The recycling of US dollar claims from the trade deficit ends because the US dollar falls enough to make imports dear and US exports cheap. US interest rates rise as a result, stopping the substitution of debt for equity, and in some cases, leading to the raising of new equity capital. We have seen upward adjustments in many foreign currencies so far, but not enough to change the basic terms of trade.
2. Defaults in the bond and loan markets lead to a closing of the synthetic CDO market, which in turn leads to underperformance of many hedge fund-of-funds. Bond spread widen as risk returns to lending, and the substitution of debt for equity slows to a halt.
3. New supply comes to the equity market, overwhelming cash available. This could come from private equity seeking to liquefy marginal asses at favorable prices. Alternatively, this could come from private equity investments that are unable to pay their debt coupons. It is less well known outside of fixed income investing that most insolvencies occur because companies can’t make a coupon payment, not that they can’t refinance a principal payment.
4. Rising inflation in countries providing capital to the US forces them to revalue their currencies higher, and not keep sucking in US dollar claims, which don’t provide any goods to their people who want to buy goods to support their lives.
Interest rates need to be around 1.5% higher to shut off the speculation with near-certainty (did not work in 1987… rates got much higher.). Until then, the party can go on. I have an article being developed on this topic, but I fear it is a “next week” item.
Bottom Left Hand Drawer Issues
David Merkel
Back in the saddle. I have a lot to write about, but not so much time. The insights developed over vacation will be spread out over the next week or so.
Just a quick one to get started. In general, I think insurance companies with more than $100 million in assets should have their own investment departments, and not outsource the management of assets. (Note: to any insurance CEOs reading this — would you like a chief investment officer with experience in all major fixed income classes, equity, and derivatives, and a knowledge of the actuarial side of investing as well? E-mail me, and we can talk.)
I only know one insurance asset outsourcing larger than this, but Safeco has outsourced their asset management to Blackrock. I think that it is a mistake. Why?
1. Insurance companies excel at creating tailored liabilities, taking individual risks away, and pooling them. The same should be done with assets. Anyone can hire Blackrock (a very good firm), but an intelligent management will take the time and effort to develop in-house expertise, which is usually cheaper than most third party solutions. It gives up what should be a profit center for the enterprise as a whole.
2. Third-party arrangements miss what I call “The Bottom Left Hand Drawer” issues. I worked in insurance for 17 years, and I grew to love the competent but uncelebrated people in the company that did excellent work, but management thought were expendable. Third-party relationships lack the freedom for customization that in-house management allows for. Often because accounting systems don’t get it quite right, human intervention is needed. Someone makes an adjustment off of a schedule that they keep in their bottom left hand drawer once a year, and that keeps the system running right. In a third party solution, those issues can get lost; I have personally seen it fail.
3. Penny wise, pound foolish. The explicit expense savings are easy to see, but the implicit losses from not having someone managing the investments that is totally on your side is hard to measure. Though I can’t prove it, the soft costs are large.
If I served an insurance company again as an asset manager, I would want to serve that company only, and not run a third-party asset management shop. The work of an insurance company is important enough that it deserves the undivided attention of professionals on staff.
Back in the saddle. I have a lot to write about, but not so much time. The insights developed over vacation will be spread out over the next week or so.
Just a quick one to get started. In general, I think insurance companies with more than $100 million in assets should have their own investment departments, and not outsource the management of assets. (Note: to any insurance CEOs reading this — would you like a chief investment officer with experience in all major fixed income classes, equity, and derivatives, and a knowledge of the actuarial side of investing as well? E-mail me, and we can talk.)
I only know one insurance asset outsourcing larger than this, but Safeco has outsourced their asset management to Blackrock. I think that it is a mistake. Why?
1. Insurance companies excel at creating tailored liabilities, taking individual risks away, and pooling them. The same should be done with assets. Anyone can hire Blackrock (a very good firm), but an intelligent management will take the time and effort to develop in-house expertise, which is usually cheaper than most third party solutions. It gives up what should be a profit center for the enterprise as a whole.
2. Third-party arrangements miss what I call “The Bottom Left Hand Drawer” issues. I worked in insurance for 17 years, and I grew to love the competent but uncelebrated people in the company that did excellent work, but management thought were expendable. Third-party relationships lack the freedom for customization that in-house management allows for. Often because accounting systems don’t get it quite right, human intervention is needed. Someone makes an adjustment off of a schedule that they keep in their bottom left hand drawer once a year, and that keeps the system running right. In a third party solution, those issues can get lost; I have personally seen it fail.
3. Penny wise, pound foolish. The explicit expense savings are easy to see, but the implicit losses from not having someone managing the investments that is totally on your side is hard to measure. Though I can’t prove it, the soft costs are large.
If I served an insurance company again as an asset manager, I would want to serve that company only, and not run a third-party asset management shop. The work of an insurance company is important enough that it deserves the undivided attention of professionals on staff.
Away for the Next Week
David Merkel
2007 is the transition year at the Merkel household. Our two oldest children go off to college in the fall, and our youngest starts home schooling at the same time. As such, this is the last time that we can rely on that we will be able to take all of our children on a trip. In the late summer of 2006, we went to visit my wife’s parents in San Diego; next week, we visit my parents in Milwaukee.
Now, I have no idea what internet access I might have while there. If I have good access, I will post in the late evenings. If not, well, you’ll hear from me next on the 29th. With that, I sign off. I have a lot of other things to write about, but little time to do so. Traveling with eight children is quite a feat, and it will take a lot of my energy to accomplish that.
2007 is the transition year at the Merkel household. Our two oldest children go off to college in the fall, and our youngest starts home schooling at the same time. As such, this is the last time that we can rely on that we will be able to take all of our children on a trip. In the late summer of 2006, we went to visit my wife’s parents in San Diego; next week, we visit my parents in Milwaukee.
Now, I have no idea what internet access I might have while there. If I have good access, I will post in the late evenings. If not, well, you’ll hear from me next on the 29th. With that, I sign off. I have a lot of other things to write about, but little time to do so. Traveling with eight children is quite a feat, and it will take a lot of my energy to accomplish that.
On Inflation
David Merkel
Inflation is a vague concept, because the term stretches to do duty in multiple areas: wage inflation, consumer price inflation, asset inflation, and monetary inflation, to name a few. I agree with what Milton Friedman said that inflation is always and everywhere a monetary phenomenon, but where I differ is that monetary inflation may express itself in terms of inflation in the prices of goods and services, or in asset inflation. Where inflation chooses to manifest itself depends on the balance of savers vs. spenders in a country. Monetary inflation plus saving equals asset price inflation. Monetary inflation plus spending equals goods and services price inflation.
As for the last week, I have a few articles to bring to your attention on inflation:
1. Baby Boomers need to think about purchasing power risk in their old age. This doesn’t mean overdosing on stocks, but it does mean considering investment classes that are correlated with inflation, like TIPS, floating rate bonds, selected commodities, and stocks of companies that produce them.
2. I’m on record that I don’t like the way that the US government calculates goods price inflation. From the way that they deal with owners equivalent rent, to the substitution effect, to hedonics (correct in principle, but they don’t do it right), to plain mismeasurement of the proper basket of goods, and the concept of core inflation, they mess things up.
3. Barry Ritholtz and I agree on many things. Inflation is one of them. These two articles express much of what I think about what is wrong with the measurement of inflation. Far better to use a median (Cleveland Fed) or trimmed mean (Dallas Fed) to eliminate volatility than to exclude food and energy. Food and energy are crucial to our lives, and they have been running at higher rates of inflation.
Inflation is growing in many areas of the world, including those that finance our current account deficit. Buying our bonds rather than letting their currencies rise, encourages inflation in their countries, while suppressing it in the US. There will come a day when they float their currencies, and then inflation will return to the US with a vengeance. When that happens, call Chuck Schumer to thank him for his vigilance on the Chinese exchange rate, not.
Inflation is a vague concept, because the term stretches to do duty in multiple areas: wage inflation, consumer price inflation, asset inflation, and monetary inflation, to name a few. I agree with what Milton Friedman said that inflation is always and everywhere a monetary phenomenon, but where I differ is that monetary inflation may express itself in terms of inflation in the prices of goods and services, or in asset inflation. Where inflation chooses to manifest itself depends on the balance of savers vs. spenders in a country. Monetary inflation plus saving equals asset price inflation. Monetary inflation plus spending equals goods and services price inflation.
As for the last week, I have a few articles to bring to your attention on inflation:
1. Baby Boomers need to think about purchasing power risk in their old age. This doesn’t mean overdosing on stocks, but it does mean considering investment classes that are correlated with inflation, like TIPS, floating rate bonds, selected commodities, and stocks of companies that produce them.
2. I’m on record that I don’t like the way that the US government calculates goods price inflation. From the way that they deal with owners equivalent rent, to the substitution effect, to hedonics (correct in principle, but they don’t do it right), to plain mismeasurement of the proper basket of goods, and the concept of core inflation, they mess things up.
3. Barry Ritholtz and I agree on many things. Inflation is one of them. These two articles express much of what I think about what is wrong with the measurement of inflation. Far better to use a median (Cleveland Fed) or trimmed mean (Dallas Fed) to eliminate volatility than to exclude food and energy. Food and energy are crucial to our lives, and they have been running at higher rates of inflation.
Inflation is growing in many areas of the world, including those that finance our current account deficit. Buying our bonds rather than letting their currencies rise, encourages inflation in their countries, while suppressing it in the US. There will come a day when they float their currencies, and then inflation will return to the US with a vengeance. When that happens, call Chuck Schumer to thank him for his vigilance on the Chinese exchange rate, not.
Insurance Earnings So Far 1Q07 — XII (Final)
David Merkel
Only three more companies to mention since my last post, here goes:
Primary Commercial
Employers Holdings beats estimates, but on falling premium volume. North Pointe misses earnings on falling premium volume, a higher loss ratio, and expansion expenses that can’t be deferred. Their acquisition looks interesting though; should be accretive to earnings.
Personal Lines
Affirmative Holdings misses estimates badly. More premiums, but higher loss and expense ratios.
Quarter End Summary
Here are the themes of the quarter. I would expect them to persist into the next quarter, which is what normally happens, but when themes don’t persist, the adjustment to prices can be severe.
1. Though the sell side has gotten into greater agreement with the idea that the top line doesn’t matter much (an idea that I support), the buy side did not agree this quarter. In general, companies that grew their premiums were rewarded, and vice-versa for those who shrank or stood still.
2. What worked: Primary Commercial, The Bermudans, Financial Guarantors and Life Companies. With Life companies, in general, the larger companies, and the ones with greater exposure to asset management did better. With Primary Commercial insurers and the Bermudans, in general the less conservative did better.
3. What sort of worked: Personal lines and Conglomerates.
4. Indeterminate: Title Insurers.
5. What didn’t work: Brokers, Mortgage Insurers and Specialty Credit players. Credit trends were poor in the first quarter, and brokers faced shrinking revenue from shrinking premium rates.
That was the quarter as I saw it. Did you find this series valuable? If so, e-mail me at the address listed at the Aleph Blog. I have a few ideas on how to make it better, but perhaps this is too superficial to be of use. If so, tell me, and I’ll focus on other things.
Only three more companies to mention since my last post, here goes:
Primary Commercial
Employers Holdings beats estimates, but on falling premium volume. North Pointe misses earnings on falling premium volume, a higher loss ratio, and expansion expenses that can’t be deferred. Their acquisition looks interesting though; should be accretive to earnings.
Personal Lines
Affirmative Holdings misses estimates badly. More premiums, but higher loss and expense ratios.
Quarter End Summary
Here are the themes of the quarter. I would expect them to persist into the next quarter, which is what normally happens, but when themes don’t persist, the adjustment to prices can be severe.
1. Though the sell side has gotten into greater agreement with the idea that the top line doesn’t matter much (an idea that I support), the buy side did not agree this quarter. In general, companies that grew their premiums were rewarded, and vice-versa for those who shrank or stood still.
2. What worked: Primary Commercial, The Bermudans, Financial Guarantors and Life Companies. With Life companies, in general, the larger companies, and the ones with greater exposure to asset management did better. With Primary Commercial insurers and the Bermudans, in general the less conservative did better.
3. What sort of worked: Personal lines and Conglomerates.
4. Indeterminate: Title Insurers.
5. What didn’t work: Brokers, Mortgage Insurers and Specialty Credit players. Credit trends were poor in the first quarter, and brokers faced shrinking revenue from shrinking premium rates.
That was the quarter as I saw it. Did you find this series valuable? If so, e-mail me at the address listed at the Aleph Blog. I have a few ideas on how to make it better, but perhaps this is too superficial to be of use. If so, tell me, and I’ll focus on other things.
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