The Rules: Asset-Backed Securities

If an asset-backed security can produce a book return less than zero for reasons other than default, that asset-backed security should not be permitted as a reserve investment.

The Rules: Asset-Backed Securities

Compared to most of my rules, this one is a little more esoteric, so let me explain.  Reserve investments are investments used to back the promises made by a financial institution to its clients.  As such, they should be very certain to pay off.  In my opinion, that means they should have a fixed claim on principal repayment, with risk-based capital factors high enough to take away the incentive invest too much in non-investment grade fixed income claims.

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Other assets are called surplus assets.  There is freedom to invest in anything there, but only up to the limits of a company’s surplus.  After all, surplus assets are the company’s share of the assets, right?

If I were rewriting regulation, I would change it to read that only “free surplus” is available to be invested in assets that do not guarantee principal repayment.  Free surplus is the surplus not needed to provide a risk buffer against default on the reserve assets.

But back to the rule.  I think the reason I wrote it out 10+ years ago was my objection to interest only securities that received high ratings, despite the possibility of a negative book yield if prepayments accelerated, and they were rated AAA, and could be used as reserve assets with minimal capital charges.  Buying an asset that can lose money on a book basis for a non-default reason is inadequate to support reserves.  (This leaves aside the ratings’ arbitrage of interest only securities, where defaults hit the yield.  Many have negative yields at levels that would impair related junk rated securities)

This can be applied to other assets as well.  Reverse convertibles that under certain circumstances can be forcibly converted to a weak preferred stock or common stock should only be allowed as surplus assets.  Risk based capital formulas should consider the greater possible risk and adjust required capital up.

Now, maybe this is a rule for another era.  Maybe there aren’t as many games being played with assets today, but games will be played again — having some sort of rule that stress-tests securities to see that they will at least repay principal (leaving aside default), would prevent a certain amount of mischief the next time Wall Street gets creative, putting other financial companies at risk in the process.

By David Merkel, CFA of alephblog

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David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.