Archive for March, 2009
Monday, March 23rd, 2009
The Federales’ latest announcements – $1 trillion in financing from the Fed and the latest Treasury plans to use public-private entities to buy ‘toxic’ assets – have one thing in common: Leverage used to finance assets that are valued at a questionable amount.
Subprime borrowers also used leverage to finance homes whose prices looked to ‘never’ go down.
What is the major difference between the subprime borrowers and ‘we the people’ (UST and Fed)? Most subprime borrowers used financing that was recourse in nature, while much of this latest batch of federal financing is non-recourse. So, arguably, with these brave new initiatives, the Federales are in a worse financial position than the lenders that originally made those subprime loans.
That’s all well and good, you might say, but will these new programs work? Most likely, yes…and there will probably be more to come.
What other entity used similar public-private arrangements and bidding processes to clear ‘toxic assets’? In the 1980s and 1990s, Resolution Trust Corp (RTC) issued long term bonds to fund their activities…bonds that were repaid within 2-3 years of issuance in many instances. Today’s RTC is merely occuring without required additional Congressional approval, making it easier to execute, but perhaps, subject to lesser scrutiny.
Those with strong memories of the RTC will also remember the unusually good investment opportunities that were generated in many cases. And, as these programs become even clearer, it may be worthwhile to have discussions with your investment manager about similar opportunities.
We may all be ‘sub prime’ lenders now, but it seems like the currently announced programs have an excellent probability of working to begin a ‘great releveraging’ of the financial system. Whether that is the best course of action for both the short and long term time horizons remains to be seen.
Tuesday, March 17th, 2009
The children’s rhyme about ‘rain’ can now be applied to Other Than Temporary Impairment (OTTI). Under specific direction from Congress, FASB has modified both GAAP accounting’s approach to measuring fair value as well as OTTI. As always, the devil is in the details and these are still proposals, subject to finalization. But the trend is clear on two basic fronts:
1 – You can separate declines in value due to the credit of an issuer or bond from all other impacts. And, only write down through income the amount subject to credit specific to the issuer or bond.
2 – Fair value is not the last quoted price, if the market isn’t operating in a ‘usual and customary’ manner and there are not multiple bidders. In those situations, you’ve got a distressed value and you can use more analytic approaches to valuation.
If passed as is — and we would fully expect this – you can probably expect the following:
1 – Lots of bonds will be shown to have a drop in price due to reasons not having to do with the credit of the bond, but simply due to the overall market sell off. We suspected that many insurers and other financial institutions were facing rather large OTTI hits in Q1, as bonds would be trading below 80% of book for six months. This will NOT be the case now, and we should start seeing much healthier earnings coming from most financials.
2 – More securities will be moving to the analytic pricing method instead of the, now typically used, ‘last quoted price’ of similar securities. The result should be less mark to market problems, generally, on the portfolio — e.g. less unrealized losses and material improvements, in some cases, in GAAP equity.
Although the economy did not much change in one day, financial statements of financials did…and that should be reflected in bond and stock prices of many financial institutions, including insurers.
In summary, Congress threatened to ‘cloud up and rain all over’ FASB unless changes were made…and FASB decided to sing ‘rain, rain, go away’. Some may think this to be ‘all wet’, that changing accounting in this manner does not change economic fundamentals. How true, but in financial markets, many times appearances will overcome or mask reality.
However, just in case this does not mark a key point in the saga of the financial crisis, I will get my umbrella ready.
Saturday, March 14th, 2009
Currently we have an approach to solving "The Greatest Delveraging in the History of the World" that reminds one of a dysfunctional doctor’s office.
The doctors are financial experts ‘behind the scenes,’ trying to work on solving the problem, while the receptionist is much like the politicians. The receptionist has an idea about different procedures, but doesn’t fully understand the problem. Yet, it is the receptionist (and his or her other receptionist friends) who must actually decide what procedures will be done. Meanwhile, in the waiting room, stories about how someone else did (e.g. Sweden) on their procedure (e.g. bank nationalization) are bandied about, with the result that fears and concerns are either temporarily allayed or grow even further. And, yes, the folks in the waiting room sure sound like the talking heads and scribes of the press.
Which brings up the idea of mark to market (MTM) accounting rules. Congress and the SEC, in their finest receptionist outfits, hear testimony from numerous experts with just as numerous ideas about what to do with regards to MTM. Meanwhile, the press babble on about the good, bad and ugly of it all. And, when a producer or user of the financials that include MTM appears, the press typically does not have the depth of knowledge to ask questions that would better frame the issue.
So, we have a MTM stalemate of a sort, with the experts (auditors and companies) spouting different ideas that neither the Congress, SEC, nor much of the press can fully grasp in all of its implications.
I have said many times that accounting is basically a branch of sociology (the science of society, social institutions and social relationships), but when it comes to MTM, accounting has become both a branch of sociology and political science. The solution for MTM is really quite simple, though those two branches of knowledge might keep this result from occuring:
Require both sides of the balance sheet to be MTM – in a footnote – with excrutiating detail about holdings, assumptions, etc, such that anyone can take those assumptions and other detail and reconstruct the exact numbers. Then, what the auditors want to put on the balance sheet and income statement should be overshadowed by this transparency and detail. In other words, the existing manufacturing based accounting model has little use for financial institutions, where transparency can be the cure for reducing the mistrust found between financial counterparties, as well as within the overall financial markets.
Saturday, March 14th, 2009
"These guys’ companies were on a Sherman’s March through their companies, financed by our 401ks, and all the incentives of their companies were for short term profit. And they burned the f–ing house down with our money and walked away rich as hell, and you guys knew that that was going on." - John Stewart, The Daily Show, 3/12/09
Most of the media covering the media lashing provided in the recent Stewart v Cramer interview thought it was all about them. Mr. Stewart lambasting CNBC and its ilk for covering investing as a game instead of a serioius part of our long term economic well being. However, like the egotists noted by Stewart, the media has once again largely missed the underlying point: The public is generally upset with what has occurred in the markets and blames ‘those in the know’ — and that will soon include the architects of the numerous attempts at bailing out the financial sector.
You can already here it in the lambasting of the Billions given to companies like AIG, Citicorp, et. al. on other comedy shows. And, remember, it is the palace ‘fool’ who can safely say things that the palace ‘advisors’ would never say in public.
There is little doubt that the financial sector will continue to require more ‘bailouts’ as the ‘Greatest Deleveraging in the History of the World’ continues. And, as before, some will applaud and some will complain about those efforts. However, the next set of measures MUST take into account the significant public outrage and, some may call it, class warfare, caused by what has occurred and the results of the previous bailout actions.
Thus, we will, once again, bring up the idea of the Federales setting up an agency to become the biggest landlord in the world and buy all foreclosures, fix them up, cut the grass and rent them out…and, importantly, keep them OUT of the supply of homes for sale. Eventually, perhaps a decade or so later, we can always begin the process of selling them…slowly… into the market. This supply reduction would put a floor and, dare I say, put some mild upward pressure on home prices in some regions. And, if home prices stop declining, we can begin to get fair pricing on risk assets like MBS, ABS, etc.
We also think that growing financial populism makes it very difficult for the Federales to inject more and more billions into the zombie infected institutions like AIG, Citicorp, etc. A fairer, and perhaps more transparent solution? Break them up now. Distribute stock in the operating subsidiaries to the existing shareholders (that includes ‘we the people’) and have the Federales start a new agency that takes on the risks that cannot be sold (for AIG, that would be risks like the CDS positions, etc.). Who would manage these positions? There are a lot of out of work folks on Wall Street who would welcome a government salary versus zero income. And, finally, because ‘we the people’ have no business being in some of these risks, like CDS, perhaps we could make illegal all CDS contracts after a certain date in the US and work with other developed nations to outlaw these derivatives.
The key in both of these future baiout ideas is that no dollars go to prop up zombie infected instittuions…and they can produce solutions that fit within the growing financial populism and related class warfare that appears to be growing as unemployment rates rise, providing the population with time on their hands.
Wednesday, March 4th, 2009
The 16th annual AM Best Review/Preview conference just wrapped up. As usual, a ‘must see’ event for AM Best rated companies and a beautiful location (Westin Kierland, Scotttsdale, AZ). Unfortunately, that beauty contrasted with the ugliness in the investment arena discussed there.
I was unable to go to all of the sessions. However, the general themes seemed to be: (1) enterprise risk management (ERM) is important, and (2) we are very concerned about investments.
Some interesting highlights:
ERM is not a ‘one size fits all’ requirements, but Best sure would like to see companies making some progress in this arena, depending upon size, type of business, etc.
One of the ‘keynote’ speakers was Raj Singh, Chief Risk Officer, Swiss Re. Raj, a very intelligent gentlemen, outlined their ERM process in quite a bit of detail and kept telling us that he took over these responsibilities in early 2008. Yet, has not Swiss Re incurred mammoth investment losses that required a ‘Buffett bailout’ at something like 12% interest? The company calls itself, "Your expert in capital and risk management". Experience must be the best teacher of all.
The other ‘keynote’ speaker was Rob Henrickson, Chairman, President and CEO of Met Life. In a more rousing speech, Chairman H. noted that he felt ‘fine’ with the current status of Met Life and how they have managed through this financial crisis. They’ve got an unusually large amount of cash – a rather defensive position – and although they could have probably qualified for TARP money, to my knowledge, they have not applied. This sounds a lot like the first class passengers on the US Air flight that was heroically piloted to a safe landing on the Hudson. It was the folks in coach who saw the waters rise, while those in first probably were finishing their drinks.
Although much of what Best stated about the importance of ERM and a focus on investments was said before, I found it interesting that they will be spending more on the economics of the investment portfolio, beyond the accounting treatment. An example of this: For P/C BCAR, there is a cap on how much the unrealized loss can reduce capital. However, Best noted they will go beyond this if the cap is ‘maxed out’, and ask questions about the impact of not using the cap in their analysis of BCAR. Let us all remember about the power of ‘analyst adjustments’ in the BCAR model…for both Life/Health and Property/Casualty insurers.
Importantly, Best expects more OTTI and other realized losses during 2009, starting as earlly as Q1.
Ugliness and beauty, we had both sides of the same coin in Scottsdale this week.
Sunday, March 1st, 2009
So what if Warren Buffett’s annual letter to shareholders says the economy will remain in a shambles through 2009 and probably beyond? We didn’t need the Oracle of Omaha to tell us things in the economy look ugly.
However, when reading any good narrative, it is important to view the entire tome before drawing conclusions and here is where the popular press has once again missed the boat.. And investors in insured municipal bonds will not like what they see.
Buffett’s Berkshire Hathaway Acceptance Corp is a new entrant in bond insurance, so his group has done more than a passing analysis of the market for insured munis and Mr. B’s basic thesis is centered around poor analytics that sound eerily similar to the simplistic approach utilized for residential mortgages.
"The rationale for very low premium rates for insuring tax-exempts has been that defaults have historically been few. But that record largely refelcts the experience of entities that issued uninsured bonds. Insurance of tax-exempt bonds didn’t exist before 1971, and even after that most bonds remained uninsured."
So, because we’ve never had big problems with munis, there is little or no chance of that occuring in the future. Just like home prices, right?
"Local governments are going to face far tougher fiscal problems in the future than they have to date." (He cites pension problems as a large contributing factor…in addition to the recession, of course)"
Warren seemingly pines for the days when New York City declared bankruptcy, but the confluence of interests of uninsured bondholders (many wealthy New Yorkers and institutions with material NYC interests) caused a financial reorganization plan without the use of insurance. Remember the old Municipal Acceptance Corp? Mr. B. then applies this lesson to potential future scenarios.
"When faced with large revenue shortfalls, communities that have all of their bonds insured will be more prone to develop ‘solutions’ less favorable to bondholders than those communities that have uninsured bonds held by local banks and residents. Losses in the tax-exempt arena, when they come, are also likely to be highly correlated among issuers. If a few communities stiff their creditors and get away with it, the change that others will follow in their footsteps will grow. What mayor or city council is going to choose pain to local citizens in the form of major tax increases over pain to a far-away bond insurer?"
"Insuring tax-exempts, therefore, has the look today of a dangerous business – one with similarities, in fact, to the insuring of natural catastrophes. In both cases, a string of loss free years can be followed by a devasating experience that more than wipes out all earlier profits."
You might say this is all hogwash and posturing on the part of an owner of the only AAA rated bond insurer. However, the logical progression of the argument cannot easily be dismissed. With that in mind, if you or your company own municipals, please don’t think they are safe because they are "insured", or because after the recent MBIA bifurcation, the insurance is backed by the ‘good insurer’, etc.
Once more, we cannot stress enough that your investment manager review with you the underlying credit of every municipal bond in the portfolio – even GO’s – hello Calfornia. And, by all means, feel free to ignore the value of the bond insurance in your analysis.
From the Northwest Quadrant. We chose that name for this blog for its multiple meanings and to highlight a new beginning. Investment professionals are all familiar with the preference for building portfolios that are in the Northwest Quadrant of the risk/reward graph — improved return with lower risk. And, those of you who know Strategic Asset Alliance (SAA) know that our headquarters are located in the Northwest Quadrant of the lower 48 United States - Bellingham, WA. Of course, those of you who know SAA also know that our approach to improving the investment process, and with it the financial results, of our insurer clients goes well beyond the typical efficient frontier risk/reward graphing so familiar to pensions, endowments, foundations and others. And, that is the main purpose of this blog. To provide an ongoing commentary on how INSURERS can go beyond the business as usual approach to investments and improve their financial results, with the Northwest Quadrant as a point of departure. Your comments are most welcome on any entry in this blog. And, simultaneously with the introduction of this blog, SAA is introducing the Insurer Investment Forum Online - an opportunity to enjoy an ongoing Q&A with your peers and other experts on the investment process for insurers. Like Lewis and Clark, we stand in the Northwest Quadrant together ready to forge a new approach, but this time to improve the insurance invesment process for insurers. I hope you will join me on this adventure.