Wednesday, January 7, 2009

Look at the Cockroaches scamper/SAY, AIG & BERNIE/ Managing Risk: Examples from these Posts

The cockroaches do seem to multiply during economic downturns.  It is just as well that Satyam Computer Services (SAY), one of India's largest information technology companies, was just a name barely known to me.   The announcement today that Satyam  had overstated its cash balance by at least a billion dollars, overstated profits and understated expenses for years is just another of a very long line of sobering revelations.  Some may ask how an auditor could miss a billion dollars.  Cash in a bank is easily verified by an accounting firm.   Given our experiences with audited results and assorted other scams, lies, and falsehoods, a jaundiced, skeptical and critical eye, never assuming credibility, needs to used on virtually every aspect of of our financial lives, peering into every hole that a cockroach may be hiding.    It is mildly humurous that the name Satyam means "truth" in Sanskrit.  The auditor was not some Indian clone of Bernie's accountant, but Price Waterhouse

I was thinking some more about that Gerry Pasciucco who was hired to clean up and shut down the AIG Financial Products Unit. His initial impression was that the whiz kids were "very, very smart" and had just overlooked what might have happened to their elaborate and beautiful models in the event of an AIG debt downgrade.   I would want to ask him a few questions about that characterization since it seems more like "very, very dumb" would be a more apt description to me.  It would be very helpful to have an insightful analysis of all of the failures which had to go way beyond the single one identified by Pasciucco.  You could probably start with their credit models and ask questions like did the model consider this variable or these events, as they were occurring in real time, such as the unprecedented rise in subprime loans, funky mortgage products, no doc loans layered on top a rise in home prices that went way, way beyond the rise in incomes.   You could ask many questions along those lines, mostly just tied to reading the newspaper, and just being aware of what was actually going on outside the ivory towers in the real world, and were any of those reasonable and obvious questions asked or answered at this Financial Product unit-ever?   

Since I have been forced by my left brain to become a bond investor, I am still making up my rules as I go along.  For those who read all of these posts, you are already aware that I prefer searching for bond alternatives that give me two ways to earn a return, from a narrowing of the discount to par value and the current coupon yield.  This raises the question of what do I do when I purchase a bond at a discount and it quickly moves to trading over par value.  My first inclination was to sell the security that made that movement this morning.  I then paused and thought of a few more considerations.  Unlike some of the speculative buys that I have made in the 4th quarter of last year, this one was one of the more secure and relatively safe issues, and a security blanket is a good thing not to be thrown away lightly.  Second, there is something to be said about receiving a good return on capital, year after year, for say 20+ years, with the only concern being a massive blow up in the credit which was at best a very remote possibility in this example.  The third consideration was the short term nature of the gain.  So, weighting all of those issues, I decided to stay with it, but I will look for an opportunity to sell it and to place the proceeds into a higher yielding security that is functionally equivalent.  

One way that I manage risk is simply trade a security many times until I accomplish one or more of  several objectives. One objective is simply to reduce my cost basis and thereby increase my yield. Another objective would be to reach the point where I am playing with the house's money.   Some of this activity has been illustrated with real time trades posted in this blog about TCs that have the same underlying junior debenture issued by AON, with slightly different terms on the coupon and KTN having a one time yield enhancement feature.  Another has been mentioned dealing with one of the REIT cumulative preferred stocks.  Another way to do manage risk actually requires the investor to take on more risk initially, by buying more shares than you really intend to keep, keeping in mind the risk and potential loss, and then trade one-half of the position at a profit,  and hold onto the other shares.  This is generally known of course and there is nothing new by me describing it.   I am not doing following this procedure with a security like DKR but in retrospect it would have been a trade that would have worked.  This would have required a 200 share purchase when I made my last purchase.  The security thereafter doubled in price in a few days, which would trigger a sale of 1/2 of the position probably before that peak was reached,  and that kind of risk management would have then placed me a better position than I am in now to ride out the considerable risk in DKR.  Instead, I am lowering my stop loss just by the interest received as I receive it.   I do manage risk for many securities by buying more than I initially want to keep, trading the position, but chose not to follow it with DKR due to my perception of its heightened risk profile which meant for me at least that I was not willing to risk at any one time double my current actual exposure.

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