Now the City of Los Angeles is bringing a suit against the financial guarantors for forcing them to buy unnecessary municipal bond insurance.  Oh, please.  Did the armies of MBIA and Ambac surround LA City Hall, threatening violence if you didn’t give in to their protection racket?  This suit almost makes the failed efforts of regulators to split the guarantors into separate municipal and non-municipal insurers seem intelligent.

First, the real value of the municipal bond insurance was not for credit enhancement.  Municipal bonds rarely default, and when they do, they often become current again.  It was liquidity insurance.  Now, for a city like Los Angeles, maybe that’s not needed, but most municipalities are small issuers, and there is not enough manpower at bond managers to analyze them all.  The rating agencies fill part of the gap with their ratings.  For most municpalities, they are the only analytical coverage at all.

Now, the municipalities had the choice of issuing insured or uninsured bonds.  Insured bonds could be sold at AAA rates, and bond managers would buy them more easily because they were more liquid.  The question to an issuer boiled down to which is cheaper?  Pay AAA rates plus the guarantee fees and have an easy sale, or, pay at the rates that managers demand for lower-rated municipal bond?  For many munipalities they chose an insured sale because it was cheaper, or not much more expensive.

Any yield premium paid could possibly be attributed to their investment bankers, who did not want the extra work of having to actually sell the bonds.  With the AAA, they would fly out the door with no questions.  A lower-rated bond would cause some bond managers to sit on their hands; even though they could look at the rating from the agencies, they would not trust the rating without further analysis, and that takes time and effort.  (I know from my time as a bond manager, you can’t push your credit staff too hard, or they start making mistakes, because they can’t do quality work.)

The municipalities had another choice as well.  They could have borrowed less money, and raised more taxes, bringning their credit profiles up to AAA.  I know, the rating agencies should have rated municipalities higher, but that’s not who they are suing.  (That said, credit ratings are only moderately related to the yield spreads paid.)

A suit like this would have a better chance if it alleged implicit collusion between the rating agencies and the financial guarantors, and sued them both.  I still don’t think the City of Los Angeles would win such a suit, but the real flaw was not the insurers, but the ratings, including the ratings the financial guarantors themselves, which in my opinion, were always somewhat liberal.  (Hint: with financials, don’t just look at the rating, but look at the implied rating from the spreads on their debt.  The rating agencies holding company debt always traded at wider yields than their stated ratings would imply.)

Now, with the added fun in the space since Moody’s moved Assured Guaranty and FSA to negative watch, something I did not expect, this leaves Berky as the last man standing in the space.  But one seller does not a market make.  What this means, if Moody’s follows through, and S&P follows suit, is that muni bond insurance is likely dead for some time.  Who loses?  Small municipalities primarily.  They will face higher debt issuance costs.  Even large issuers have found the new issue market less than inviting recently.

In closing, could this come at a worse time for municipalities?  Revenue bases are eroding even as demands for services rise.  (Housing price will be a drag here for a few more years.)  They can’t print money or issue debt at whim to solve the problem, so they have to make painful cuts.  I will add this, even more painful cuts will come over the next 10-20 years as the pensions/ retiree healthcare crisis descends on the municipalities.  Not a fun time for anyone… and I’m sure there will be more lawsuits over the whole shebang, most of them bogus.

		David Merkel
		When Is a Trade Crowded?
		8/9/2006 9:35 AM EDT

At the end of every day, every asset is owned by somebody. If you want to count in the shenanigans that occur as a result of shorting (naked or legal), those are a series of side bets that do not change the total number of shares/bonds outstanding. (I.e., if legally, shares get borrowed. Naked shorting creates a liability at the brokerage for the shares that should have been borrowed.)

So how can a trade be crowded? It comes down to the character of investors in the given stock or bond. A trade will be crowded if those owning the asset have a short time horizon that they are looking to make money over.

My example of the day is the run-up in financial stocks while waiting for the Federal Open Market Committee to pause. Financial stocks ordinarily don’t do well when the FOMC tightens, but from the time of the first tightening until now, they have returned 10%-11% annualized. There still are a lot of people betting that things will get a lot bettr for depositary institutions now that the FOMC is (in the eyes of some) done tightening.

Even if the FOMC is done tightening, as Bill Gross thinks (Who cares that he has been wrong since tightening number 5?), the yield curve needs to steepen by about 75 basis points from twos to tens before the lending margins of banks are no longer under pressure from the shape of the yield curve.

Maybe once we get our first loosening, I’ll be more constructive on lending institutions, but as for now, I am steering clear. There are too many parties that believe that the FOMC is done and too many trying to profit from the rebound that “has to happen” in lending-based financials when the FOMC is “done.”

Position: None.

		David Merkel
		Make the Money Sweat, Man! We Got Retirements to Fund, and Little Time to do it!
		3/28/2006 10:23 AM EST

What prompts this post was a bit of research from the estimable Richard Bernstein of Merrill Lynch, where he showed how correlations of returns in risky asset classes have risen over the past six years. (Get your hands on this one if you can.) Commodities, International Stocks, Hedge Funds, and Small Cap Stocks have become more correlated with US Large Cap Stocks over the past five years. With the exception of commodities, the 5-year correlations are over 90%. I would add in other asset classes as well: credit default, emerging markets, junk bonds, low-quality stocks, the toxic waste of Asset- and Mortgage-backed securities, and private equity. Also, all sectors inside the S&P 500 have become more correlated to the S&P 500, with the exception of consumer staples.

In my opinion, this is due to the flood of liquidity seeking high stable returns, which is in turn driven partially by the need to fund the retirements of the baby boomers, and by modern portfolio theory with its mistaken view of risk as variability, rather than probability of loss, and the likely severity thereof. Also, the asset allocators use “brain dead” models that for the most part view the past as prologue, and for the most part project future returns as “the present, but not so much.” Works fine in the middle of a liquidity wave, but lousy at the turning points.

Taking risk to get stable returns is a crowded trade. Asset-specific risk may be lower today in a Modern Portfolio Theory sense. Return variability is low; implied volatilities are for the most part low. But in my opinion, the lack of volatility is hiding an increase in systemic risk. When risky assets have a bad time, they may behave badly as a group.

The only uncorrelated classes at present are cash and bonds (the higher quality the better). If you want diversification in this market, remember fixed income and cash. Oh, and as an aside, think of Municipal bonds, because they are the only fixed income asset class that the flood of foreign liquidity hasn’t touched.

Don’t make aggressive moves rapidly, but my advice is to position your portfolios more conservatively within your risk tolerance.

Position: none

The concept of a crowded trade is simple.  Trades are crowded when those that hold the assets in question have short time horizons.  This can happen for a variety of reasons:

• The trade could have negative carry, i.e. you have to pay to keep the trade going (e.g., shorting a high-dividend stock).
• The investors holding the assets are predominantly momentum-driven.
• The investors bought the assets using borrowed money. (or, sold short…)
• There is an event expected to take place that will provide liquidity (e.g., a buyout); woe betide if it doesn’t happen.

Now, some will look at crude oil and other hydrocarbons and say that the trade is crowded.  Though I am now finally underweight the energy sector for the first time in seven years, I’m not sure it is a crowded trade.  The financing of the sector is pretty strong, and valuations are reasonable, discounting an oil price of around $80 or so.

What I do think is a crowded trade is residential housing, and commercial property as well.  A little over three years ago I wrote a piece called, Real Estate’s Top Looms. It had all the marks of a crowded trade:

• Lots of leverage, with much of it short-dated (Option ARMs, 2/28, etc.)
• Momentum buyers (and the get rich quick books)
• Negative carry for investors (capital gains must happen in order for the purchase to work)
• Much reliance on the “greater fool” that would buy the property from the new owner.
• A high proportion of investors to owner-occupiers

It is still a crowded trade today.  There are excess homes.  Investors still face negative carry.  Buying power of prospective buyers is reduced because of higher lending standards.  Then, there’s dark supply.

Dark supply are the homes that will come onto the market if it looks like prices have stabilized.  There are owners who want to sell, but they don’t want to take a large loss, or, they can’t afford to, because they would go bankrupt.  So, they feed the mortgage for now, and wait for the day when the market will have life again.

I experienced things like this in the corporate bond market in 2001-2003.  Whenever a bond would fall sharply and not die, the recovery would be fitful, because there would be market players who were burned, wanted out, but could only justify a certain level of loss.  Dealers would tell me when I expressed interest in some of the damaged names that there would be supply a short bit above the price where I could buy today, so, I should be careful.  I had a longer time horizon, so I would often buy, and watch the struggle as fundamentals improved, but prices went up more slowly due to selling pressure.

Oh, here’s another area of dark supply:  Real estate owned by the GSEs.  They can probably be a bit more patient than commercial banks, but as prices begin to firm, they will start to unload properties.

I have been reading estimates of the size and duration of further declines in residential housing prices.  My view is that we have another 10% down, and that in two years, we should be at the bottom.  How long it takes to burn through the dark supply is another matter, and one that I don’t have a good guess for.

When investors can make a good return off of buying and renting (but there aren’t many of them), and many people have reconciled themselves to the losses they have incurred, then the trade will no longer be crowded, and we will have a normal residential real estate market once again.

For those that want to read some of my older articles on market structure, have a look at these five articles at RealMoney:

The Fundamentals of Market Tops
Managing Liability Affects Stocks, Pt. 1
Separating Weak Holders From the Strong
Get to Know the Holders’ Hands, Part 1
Get to Know the Holders’ Hands, Part 2

The latter four were a series, but not labelled as such.

Oh, one more thing.  Today was my best relative performance day in a long time.  I’m back in the plus column (barely) year-to-date, and ahead of the S&P 500 for the month, after having been behind by more than 5% earlier this month.  What a manic, nutty month!  And now, watch it all shift because of Cemex’s earnings miss.  Can’t win them all.

Full disclosure: long CX

2) What, one standard for revenue recognition?  Impossible! Great!  Revenue recognition is probably the most important issue in accounting, and whatever comes out of this will be important to investors.  (If the standard is bad, value investors that watch the quality of earnings will gain additional advantages.)

3) America is too big to fail?  You bet, at least to our larger creditors.  As it stands now, our economy is partly propped up by foreign creditors.  Remember, the mercantilists lost more than they gained.  The same will happen here.

4) Tom Graff is a bright guy, and I respect him.  He disagrees with my view on buying agency mortgage backed securities.  He is worth a read.

5) Dark supply.  There are many people who want to sell homes who have them off the market now waiting for better prices.  There are investors buying properties hoping to flip them.  These are reasons I don’t expect housing prices to come back quickly.

6) When I read this piece on Countrywide, I was not surprised by the existence of special deals, but only by their extent.

7) HEL and HELOC experience will continue to decline.  Face it, on most home equity loans in trouble, the losses will be 100%.  This will only burn out one year after the bottom in housing prices.

Fannie and Freddie have their concerns:

• Their books are being reviewed again.
• They are too big to fail, but they are in trouble.
• The Government is pressing them to lend more, but their capital bases say the opposite.

9)  Loser rallies rarely persist, but that is what we have had recently.

10) Along with Barry, I do not believe that banks have bottomed yet.  There are more credit losses to be taken, particularly as housing prices fall another 10%.

This is a nice niche business, and a quality competitor in the space — well-respected by all.  And, you can buy it for less than book value.  Well, at least you could prior to the close on Monday.

Here are the financial stocks in my portfolio at present:

• Safety Insurance  (Massachusetts personal lines)
• Lincoln National (Life, Annuities, Investments)
• Assurant (Niche lines — best run insurer in the US)
• Hartford (Life, Annuities, Investments, Personal lines, Commercial Lines, Specialty Lines)
• RGA (Life reinsurance)
• Universal American Holdings (Senior Health Insurance — HMO, Medicare, etc.)
• MetLife (Life, Annuities, Investments, Personal lines)
• National Atlantic (waiting for the deal to close)

Now, I do have my worries here:

• Even though asset portfolios are relatively high quality, they still take a decent amount of investment-grade credit risk, and even squeaky-clean portfolios like the one Safety has are exposed to Fannie and Freddie, unlikely as they are to default on senior obligations.
• Those that are in the variable annuity and variable life businesses might have to take some writedowns if the market falls another 10% or so.  For those in investment businesses, fees from assets under management will decline.
• Pricing is weak in most P&C lines.

Away from that, though, the companies are cheap, and I have a reasonable expectation of significant book value growth at all of them.  Also, a number of the names benefit from the drop in the dollar — Assurant, MetLife, Hartford, and RGA.

One final note before I close: diversification is important.  I have Charlotte Russe in the portfolio, and it got whacked 20%+ yesterday.  Yet, my portfolio was ahead of the S&P 500 in spite of it.  If Charlotte Russe falls another 5% or so, i will buy some more.  There is no debt, earnings are unlikely to drop much (young women will likely continue to buy trendy clothes), and there are significant assets here.  I don’t expect a quick snapback, but as with all of my assets, I expect to have something better 3 years from now, at least relative to the market.

Full disclosure: long SAFT LNC AIZ HIG RGA UAM MET NAHC CHIC

Are they the best way to tilt value portfolios?  My guess is no.  There are many factors that drive the calculation of value, and dividends are one of them.  A multifactor model including dividends will probably beat a dividend yield only model.  It will definitely allow for a more diverse portfolio, rather than being just utilities, financials, LPs, etc.

Do dividend-yield tilted portfolios always do better than the indexes?  No, they don’t always do better.  Take the current period as an example.  These two notes from Bespoke are dated, but still instructive.  The total returns off of stocks with above average dividend yields has been poor recently.  Part of that is the current trouble in financials.  Part of it is the financial stress that is leading to cuts in dividends (again, mainly at financials).

Dividend paying stocks tend to lag when bond yields rise, also.  I remember an absolute yield manager who floundered in the early-to-mid ’90s when rates rose dramatically and bonds proved to be greater competition for the previously relatively high-yielding stocks.  They had a great time in the ’80s as yields fell but 1994 proved to be their undoing.

That said, dividends are an important part of total returns, probably one-third of all the money a diversified portfolio earns.  Also, on average, companies that pay dividends also tend to do better in the long run than companies that don’t pay dividends.  Why?

DIvidends have a signaling effect.  They teach management teams a number of salutary things:

• Equity capital has a cash cost.
• Be prudent risk takers, because we want to raise the dividend if possible, and avoid lowering it, except as a last resort.
• Focus on free cash flow generation.  Be wary of projects that promise amazing returns, but will require continual investment.
• Be efficient at using capital generated from free cash flow.  The dividend forces management teams to do only the most productive capital projects.  Increasing the dividend is alternative use of capital that must be considered.
• Dividends keep management team honest in ways that buybacks don’t.  Buybacks can quietly be suspended, but in the American context, a dividend is a commitment.

Now, if you are going to use dividend yields as a part of your strategy, you need to pay attention to two things:

• Payout ratios, and
• Growth of the dividend is more important than its size

Is the company earning the dividend?  Do they have enough left over to pay for capital expenditures for maintenance and growth?   Be careful with companies that have high dividends.  My belief is that companies with middling dividends tend to offer value, but the really high dividends portend trouble.  High dividends tend to be cut during periods of financial stress, as we are seeing today.  This article on newspaper stock yields does not convince me.  I have been a bear on the industry for the last ten years.  You can’t maintain high dividends in a industry with significant competition from new entrants (Internet destroying ad revenue, classified ad revenue, and sales revenue).

REITs have decent dividend yields, but the companies with the best total returns had low dividend yields, but they grew them more rapidly.  In general, growing dividend yields where payout ratios are not deteriorating are usually good stocks to own.  Think of it this way, the dividend yield plus its growth rate will approximate the total return of the stock in the long run (for dividend paying stocks).

Two more notes before I end.  FIrst, special dividends usually not a good idea; they signal reduced prospects for the company to deploy capital productively; better to do a dutch tender and buy back shares.  When Microsoft did their special dividend four years ago, I made the following comment at RealMoney:

		David Merkel
		Note From Fed Chairman: Don’t Worry, Be Happy
		7/21/04 12:46 PM ET
Alan Greenspan completed his testimony slightly after noon today. The Q&A went quicker than usual. No real news from the affair; Dr. Greenspan tells us that inflation is not a problem, growth is not a problem, there is no systemic risk, the carry trade is reduced, a measured pace of tightening won’t hurt anyone, etc.Very optimistic; I just don’t go for the Panglossian thesis that everything can be fine after holding the fed funds target so low for so long. Bubbles develop when credit is too easy.And as an aside, I’d like to toss out a dissenting question on Microsoft (MSFT:Nasdaq). I know that the software business is not capital intensive, but if Microsoft disgorges a large amount of its cash, doesn’t it imply that they don’t see a lot of profitable opportunities to invest in it? Buying back $30 billion of Microsoft stock is a statement that they see no better opportunities (that the government will allow them to do), than to concentrate on current organic opportunities. It implies that additional organic growth opportunities are limited, no? No positions in stocks mentioned

TSCM quoted me in two articles at the time of the special dividend.  I was ambivalent about the buyback, and Microsoft stock has done nothing since then.

I also wrote this article to talk about the value of excess cash flow to management teams.  My view continues to be that excellent management teams should be given free rein to add value, while poor management teams should pay out excess cash to shareholders.

Also, there is a rule in the reinsurance business: buy back shares when the price-to-book ratio is under 1.3; issue special dividends when the price-to-book is higher, and you have slack capital.  But be careful.  Slack capital can be valuable.  I remember Montpelier’s special dividend before the 2005 hurricanes.  Ill-advised in hindsight.  The stock was a disaster, and is the only time in my career that I have flipped from long to short on a stock, post-Katrina.

Finally, I don’t look for dividends.  It is a factor in my models, but not a big one.  That said, 20 of 36 of the stocks in my portfolio pay dividends, and I receive a 2% yield or so on the portfolio as a whole.  I would rather focus on free cash flow, but dividends follow along behind free cash flow.

Bringing this back to the present, be wary.  High dividend yields, particularly on financial stocks, may be cut.  Analyze the payout ratios on stocks you own.  In general, dividends are good, but analyze the situation to determine the sustainability of the dividend.

The above graph shows the difference in yields between a current coupon 30-year FNMA pass-through security, and a 10-year on-the-run FNMA senior note.  It is a good proxy for how much value is available in agency mortgages versus the debt that they issue.  Now, in mid-March, spreads were particularly high, because mortgage REITs and other leveraged holders of agency mortgages were forced to sell because of rising haircuts on repo financing.  Today, the furor is over the solvency of the agencies themselves.

I would not be worried about the creditworthiness of agency mortgages.  The US Government is not going to let the senior liabilities of the agencies be questioned as to creditworthiness.  To do so would incite panic among investors in many financial institutions that own agency debt and agency guaranteed mortgages.

Here is a graph of the Lehman Brothers Swaption Volatility index:

Now, in March, there was panic in the mortgage market, leading to high implied volatilities.  Today, it is more quiet.

I don’t agree with everything El-Erian of PIMCO says, but I think he is right when he believes that the senior portions of capital structures at the agencies will not be harmed.  It sounds high to me, but according to the article, 61% of PIMCO’s Total Return Fund is in mortgage bonds.  I can support an overweight position in agency mortgage bonds, the yields seem attractive at current levels of volatility.

Now, I have a number of disciplines that help me on average and over time as I manage equity money.  That doesn’t eliminate the “pit in the stomach” when nothing seems to be working.  It does give me something to do about it, though.  Evaluate poor performers (”what, down so much on no news!”), do some rebalancing trades (”ugh, cash is shrinking… will I have to move into concentration mode as I did in 2002?), and search for errors in my macro views (”why do I have so much cyclicality in the portfolio?”).

My performance versus the market as a whole tends to streak.  There are several reasons for that:

1. The portfolio has a value tilt.
2. Market capitalizations are smaller than the S&P 500.
3. I concentrate the industries that I invest in.
4. I turn over my portfolio more slowly than most investors.

But, as of Wednesday, as the market bounced back, my portfolio did even better.  I’m behind the S&P 500 by less than a percent now.  But this is what puzzles me here: ordinarily, I expect to outperform more in bear markets than in bull markets, but it seems to be flipped here.

I am overweighted in financials — though all of them are insurers, and none in the financial guarantee business.  Given all of the basket and ETF trading that goes on today, maybe my insurance names are getting dragged along with the banks.  In the short run, that can persist, but eventually industry performance emerges in stock prices.  That’s my best explanation for now.

Away from that, I did a rebalancing sale on YRC Worldwide today.  First rebalancing sale in a while.  Trucking is a volatile industry.  Then again, in cyclical industries, it is always a question of value over the cycle.  The stocks move more than the industry prospects do, so if you resist trends with companies strong enough to survive the cycle, you will make money in the long run.

Full disclosure: long YRCW, and many insurers  (full portfolio available at Stockpickr.com)

This is my monetary aggregates graph over the last year.  Growth of the monetary base is anemic, but that is intentional.  Rather than let the monetary base grow through the purchase of Treasuries, the Fed is using its balance sheet to add liquidity to certain money markets.  When was the last time the Fed did a purchase of Treasuries?  5/3/07.  I think this is the longest period in the Fed’s history without a purchase of Treasuries, and I have written the Fed to ask, but alas, no answer.  For comparison purposes, there is a tool at the NY Fed website that allow you to look at permanent open market operations after August 25, 2005.  How many purchases of Treasuries during the tightening/flat period from 8/25/05 to 5/3/07?  Fifty-nine.  Fifty-nine during a predominantly tightening period, and not one during a loosening period?

I point this out because the Fed is behaving very differently under Bernanke than any Fed Chair since the Great Depression.  Part of it is the situation in the capital markets.  Leverage got too high among a number of big capital markets players, and the SEC didn’t do diddly.

But under this new arrangement, liquidity goes out to the capital markets through the Fed’s new programs, but not out (at least not directly) to the commercial banking system and the general economy.  The balance sheets of some financial entities get relief, but not much stimulus makes it into the general economy.  What liquidity that is created gets extinguished by the Fed, because they sell/lend Treasuries to fund their lending programs.

Taking a quick spin around the globe, inflation is viewed as a major threat, enough so that the ECB raised its policy rate to 4.25%.   There may not be a lot more rises, but the likely direction of ECB policy is up not down.

China is having inflows of hot money, and much as the central bank keeps raising deposit requirements, it does little good.  Inflation keeps rising.

It’s an inflationary world, and one of the reasons that the US is not feeling it as bad is that we are the world’s reserve currency.  So long as China and OPEC keep buying US debts, the game can go on, but woe betide us if the music stops.

At present, Fed funds futures indicate a Fed that is frozen.  No more moves in 2008.  Using my “pain model” for the Fed (the Fed acts to minimize its political pain), I would concur.  When you don’t know what will work, doing nothing seems like a great plan.

A great plan for now, that is.  My guess is that the Fed can’t be out of step with the rest of the world for too long, and in 2009, they will begin tightening, even if the economy and the banks are weak.

One reader has asked my opinion on stop loss orders, and I must admit, I have never used one.  I use the “economic sell rule,” which tries to look forward at the value of companies, rather than analyzing past price movements.  I sell when companies no longer offer me a good return on my money versus other investments.  I sell a little in rebalancing trades, because there is value in redeploying fundsafter quick moves up.

Do I take some losses from not having an automatic sell rule when prices fall?  Yes, but it is more than made up for from the gains on companies that I would have sold , but didn’t.

Don’t blindly adopt a sell rule, but use your head, and estimate the future value of the company, rather than agonizing over the paper loss.

Full disclosure: long LNC GEHL CHIC GPI APC