In the previous blog entry, we discussed financial repression and the biggest investment challenge for insurers in the last thirty years – low nominal, and, in many cases, low real interest rates. For more on financial repression, we refer you to an article in the IMF’s Finance & Development magazine, Financial Repression Redux.

As noted last time, in the US we are at halftime, watching the FED marching band, as presciently sung by Don McLean in “American Pie”:

“The marching band refused to yield.
Do you recall what was revealed,
The day the music died?”

And what is being revealed to insurers is the impact of lower rates on their core fixed income portfolios.  Even if rates remain unchanged, portfolio yields will undoubtedly be re-priced lower.

As we have been discussing for some time in various conferences and with our clients, there are basically four possible investment related responses (or some combination thereof) to financial repression:

1 – Change Risk Profile (credit, duration, liquidity, etc.)
2 – Use non-Core Fixed Income as a source of additional income
3 -  Decrease Risk – waiting for more attractive yields
4 – Do Nothing substantially different

A Few Choices

Some of the different mostly non-Core Fixed Income assets that are being discussed among managers and insurers alike (as well as some very initial related thoughts):

1- Private placements (covenant protection and some yield premium due to illiquidity, and several of these bonds are investment grade)
2- Commercial mortgages (a ‘beaten down’ asset class, but be careful about underwriting, sourcing, collateral type, etc.)
3- Emerging market debt (usually sovereign debt, these assets are typically similar to high yield in quality and historical returns, with less than comparable historical volatility)
4- Bank loans (an asset class that has also seen better days, and requires superior underwriting, sourcing, etc., and we would recommend that the originating bank participates…although credit default swaps – never disclosed – could be hedging the banks’ exposure)
5- Non-agency RMBS (as housing markets recover, oh so slowly, the ability to separate the wheat from the chaff and top quality modeling and monitoring is a key…see the latest sales from the Fed)
6- High yielding dividend equities (US and foreign; but there are many reasons why an equity has a high dividend yield, and not all of them are indicative of a healthy company)

Each of these asset classes have their advantages and disadvantages and they are all designed to provide some additional income beyond the usual mix of equities that one finds in most insurer ‘risky buckets’.  And there are others, but we wanted to highlight a few of the most common ‘alternatives’ being discussed.

But, should your company consider one or more of these?

The answer lies in two basic dimensions:  Risk appetite and the Strategic versus Tactical Decision.

Risk Appetite

A solid understanding of risk appetite means first, a risk management culture at your company, and second, the ability to successfully review actionable analytics, that help define risk for your company.

Begin by asking if senior management and the Board are primarily focused on yield/return or on risk, to what extent and why.  Then start defining risk for your company – we can almost guarantee that it is not standard deviation, but probably has something that starts with ‘don’t lose any money’ and is tied, to some degree, to the accounting model.  Next, develop the analytics to quantify risk along the lines you have already defined.  Consider the alternative investment strategies and show how risk quantification changes.

All of those activities are quite a tall order, but then the really hard part begins:  a frank discussion amongst senior management and the Board on quantifying and qualifying their risk appetite.

There are many analytical tools for performing these tasks, but the most complicated and important tool is how to conduct and nurture the requisite human interactions in order to help define, quantify and determine risk appetite.

Strategic v Tactical Decision

Once you have mastered the risk appetite discussion as it applies to investment strategies, it is time to discuss another difficult question:  Are we making a strategic or tactical decision?

In most cases, the decision made with regards to lower portfolio book yields is based upon long-term historical relationships.  In other words, it is a decision based upon careful consideration of the potential risks and rewards, risk appetite, etc. over a long time frame (typically three to five years).

Quite frankly, the bright side of financial repression is that it causes all of us to rethink investment strategy.  That new desirable investment class may fit within our risk /reward parameters and risk appetite, but may not have been considered had it not been for financial repression.

However, although this may at first appear to be a strategic decision, you must answer this question:

“Would we make this portfolio change if we were not facing lower portfolio book yields?”

If the answer to that question is “no,” then you are probably really making a tactical decision.  If “yes,” you are indeed making a longer-term strategic decision.

And, it is very important to consider how you will be implementing your new investment strategy.

If a strategic allocation, you can carefully make a good decision along the lines of passive versus active management, after tax and fee comparisons, expected manager service levels, etc.

However, if a tactical allocation, those decisions made for a strategic allocation are further complicated by other important ones, such as: How do you know when you should reverse or change your tactical decision?  By how much should the change be made?  Who has the responsibility to make those decisions (many times awaiting Board action can be slow and counterproductive in tactical situations)?

In other words, a tactical decision requires another tactical decision, or an overriding strategic decision to follow.  This is unlike a strategic decision, which merely requires another (typically annual) strategic decision.

Process Orientation

As many of you know, our firm has a very disciplined approach to the Investment Process Value Chain, finding areas where ‘best practices’ can lead to improved financial results.  And, this entire subject of financial repression and how insurers should react is one that must be customized to each insurer and its own unique goals, objectives, circumstances and constraints.

Some insurers we speak to have already made changes to their risky bucket to take advantage of higher income alternatives (For example, SAA has noted the importance of high dividend strategies for some time).  Others have asked themselves the question of “Would we make this portfolio change if we were not facing lower portfolio book yields?” and have answered with an unequivocal “no,” deciding to maintain their present course.

Different decisions are most appropriate for different insurers, facing the same threat of financial repression.

In fact, several of our speakers at the upcoming Insurer Investment Forum will be discussing this issue (we have less than a handful of seats left).

But, whether you can attend or not, it is vitally important that you begin the process of developing a successful investment strategy in the world of financial repression.

We started the previous blog with a reference to the Chrysler Super Bowl ad, featuring Clint Eastwood. But, now we find ourselves quoting one of Mr. Eastwood’s characters, “Dirty Harry” Callahan, who, pointing a gun at the bad guy’s head, said, “you’ve got to ask yourself one question: ‘Do I feel lucky?’”

The Fed, in essence, has pointed a gun at investors in general, and insurers specifically.  It is time for all insurers to meet this, their most difficult investment challenge in thirty years, by asking the tough questions.

Like a finely tuned, yet incessantly blaring marching band, the Federal Reserve continues its financial repression march.  If your insurer is like most, the preferred scenario for rates is typically ‘slow, up’, meaning rates moving higher, consistently but slowly over time.  However, this is unlikely in the present regime.

As Chrysler’s latest controversial ad says, it is halftime in America.  Meanwhile, the marching band called ‘the Fed’ has entered the stadium and will continue to play, loud and long, a medley of tunes from the Financial Repression songbook.  (It almost makes one pine for Madonna’s halftime show.)  Until they finish their “prelude to an inflationary day” finale, do not expect to see a change from  continued low rates for longer, in all its less than melodic variations.

What this all adds up to for insurers is plainly the largest investment challenge over the last thirty years.  It is one thing when equity markets slump (most well managed firms realize that equities can easily sell of 20-30% in a given year, as we have occasionally seen in that period).  However, it is another when fixed income market interest rates fall so low that they not only threaten product profitability but product viability.

With negative real US Treasury rates leading the way, insurers have few places to achieve adequate yields in the core fixed income universe.  So, step 1 for successfully dealing with financial repression is to perform a few projections. First, project your company’s portfolio yield over several years, assuming no change in current market yields.  Then, start ‘shocking’ the results, by assuming a 50, 100 or 150 basis point drop in market yields.  The shorter the duration of your portfolio, the greater will be the drag of current yields on the portfolio’s yield.

We are reminded of the insurer who wanted to be conservative, so, over the years their long time investment manager had kept duration in the 1-3 year range, despite their predominantly long tail line of business.  This is obviously a huge mismatch in interest rate risk, meaning what looked like a ‘conservative’ portfolio on a standalone basis was far from it when considering the entire enterprise.  Now, faced with meager short term investment yields, and their (and their manager’s) lack of realizing the true riskiness of their so-called ‘conservative’ investment policy, they have an even more difficult decision to make:  Do the right strategic thing (move the portfolio duration closer to the duration of reserves), or consider the decision in light of tactical considerations and their mark to market of assets (how low can rates go?).  More on strategic versus tactical approaches later.

As we have been discussing for some time in various conferences and with our clients, there are basically four possible investment related responses (or some combination thereof) to financial repression:

1 – Change Risk Profile (credit, duration, liquidity, etc.)
2 – Use non-Core Fixed Income as a source of additional income
3 -  Decrease Risk – waiting for more attractive yields
4 – Do Nothing substantially different

Even the ‘do nothing substantially different’ is a decision which should be carefully weighed.  All of these options will be discussed in various levels of detail at our upcoming Insurer Investment Forum XII (I have been told rooms are going quickly.)  However, let’s touch on a few of the responses to Financial Repression we’ve seen from that creative bunch known as investment managers.

We are starting to see managers propose different core fixed income asset classes (such as private placements or commercial mortgage loans) as well as various non-core fixed income classes.  In the latter category, we’ve seen emerging market debt, high yield, bank loans, and non-agency residential mortgage backed securities (you know, the ones that some of us had to work to sell).  And this is just a subset of what the managers are starting to talk to their clients about.  (You can hear from at least two top tier managers about this subject – as well as your peers – in much more detail at the conference.)

In order to provide this subject sufficient attention, this blog entry is divided into two parts.  In the second part, we will discuss more issues surrounding financial repression and successfully dealing with low for longer rates, including:

- Strategic v Tactical approach – When does it makes sense to change your portfolio risk profile and how can you determine if it might be worth the risk?

- Why your company’s risk appetite is oh so important and how to include this key attribute into your decisions about financial repression.

If you are on our Blog Blast list, you will automatically be notified of Part II.  If you are not, we invite you to subscribe at no charge.

While the Fed blares on, let’s start making decisions about Financial Repression.  See you at Part II.

In a recent article in McKinsey Quarterly called “Working Out of Debt,” the venerable consulting firm tracks past deleveraging processes and compares them to the current process in the US, UK and Spain.

In a nutshell for the US, households appear to be about a year and a half away from reducing debt as a percentage of disposable income, to a rising trend line that would be at about 100% at mid-2013.  If, for example, the US was to follow a similar deleveraging path as Sweden, we can expect such deleveraging to continue to go below that trend line and bottom out in about four years.

Interestingly, due to declining debt levels and lower interest rates, the US household debt service ratio has declined from its peak of 14% in the third quarter of 2007 to 11.5%, lower than it was in 2000.

Household debt outstanding has fallen by 4 percent from the end of 2008 (near the Lehman blow-up) to the second quarter of 2011, says the article.  However, defaults have contributed 70-80% of the decline in mortgage and consumer credit.  Of the mortgage defaults, it is estimated that up to 35% were due to ‘jingle mail’, as homeowners walked away from their ‘underwater’ homes and mailed the keys to the lenders.

Of course, just because household deleveraging may come to a halt in a few years, it does not mean that re-leveraging will kick into high gear.  One wonders where any strong uptick in the borrowing power of consumers may come from, given the steep drop in home values and the relative lack of home equity borrowing availability.

We named this period of our economy as the “Greatest Deleveraging in the History of the World,” and discussed it at our Insurer Investment Forum in March, 2008.  But, little did we know that it would be as virulent or spread to other countries, as it is in the process of doing in Europe.

And, we did not expect the unprecedented borrowing spree from the federal government, which amounted to the “Greatest Re-Leveraging”.  However, if history of similar deleveraging incidents at other countries is a guide, we can expect the federal government to begin to show much lesser budget deficits as consumer deleveraging subsides and the economy begins a slow improvement.  After all, consumers drive over two-thirds of US GDP.

As noted in several earlier blogs and confirmed by this latest research from McKinsey, this Deleveraging will take time (and now may even be impacted by a severe Deleveraging in Europe).  But, at least it does appear we can see some light at the end of the tunnel.

Finally, over four years after the start of the Great Recession, the Fed, in a letter to Congress has started pushing some aggressive solutions to the housing crisis that may not sit well with investors and banks.

Read the letter here: http://www.federalreserve.gov/publications/other-reports/files/housing-white-paper-20120104.pdf

Bill Dudley, NY Fed President, Chairman of the Federal Open Market Committee, successor to Treasury Secretary Geithner…and Goldman Sachs alumus, of course…outlined a list of possible changes to housing finance mentioned in that letter.  Here are a few:

- refinancing made broadly available on streamlined terms and with moderate fees to all prime conforming borrowers who are current on their payments

(Looks like the FED is starting to realize that buying mortgages and maintaining the stifling ZIRP policy at least through the middle of next year is not good enough.  If you can buy an ice cream cone for only 10 cents, but don’t have a dime, the low price of the delicious desert serves as an unrequited temptation.  The same is true with low refi rates when it is nigh impossible to qualify for the refi, for a host of possible reasons.)

- an “earned” principal reduction for borrowers who are underwater but kept on making their mortgage payments

(More bad news for investors and banks, but it does have a bit of a moral tinge to it:  “If you’ve decided against ‘strategic default’, we will lower what you owe us.”  Although this may improve the probability of repayment and ultimately reduce downward pressure on housing prices, it is against the Santelli inspired rant that resonates with so many and is given some credit for igniting the Tea Party.  (http://youtu.be/zp-Jw-5Kx8k))

- Dudley also called for getting banks to accept more risk, have looser underwriting and smaller risk-based premiums, and getting appraisers to have less of a “downward” bias – just the opposite of urgings from bank regulators today.

- And he pushed for a $15 billion-a-year bridge loan program to those who are laid off so that they can keep paying their mortgage while finding a new job.

“Negative price expectations and flawed financing and administrative mechanisms, if left unaddressed, can contribute to ongoing weakness in housing demand and make it harder to generate a robust economic recovery,” Dudley said.  He also downplayed moral hazard concerns from offering homeowners relief and further said they would be in the interest of taxpayers.

The FED letter also emphasizes the importance of turning REO (real estate owned) or near REO homes into rentals, in order to stabilize the housing market.  In fact, a variant of this was proposed in our ‘From the Northwest Quadrant’ blog of November, 2008  (http://www.saai.com/index.php/lets-say-you-run-a-banka-modest-proposal/

…and was actually successfully accomplished by the FDR administration during the Great Depression.

The fact that these ideas are being mentioned by the FED at this late stage in the game…and publicized by a Goldman alum…shows just how serious the FED regards the housing crisis.   Alas, it also reminds me of John McEnroe’s retort to a tennis judge as shown in this video:  “You can’t be serious.” (http://youtu.be/ekQ_Ja02gTY)

Perhaps this time the FED just might be serious?  And if it is, one must think carefully about the potential impacts of government policy on your company’s investment in both non-agency and agency RMBS.

Chairman Bernanke once saw no problem in the subprime crisis.  But, perhaps the FED is now finally ready to actively and seriously discuss and promulgate viable alternative solutions to the housing crisis…instead of following a passive aggressive policy of keeping rates low, while leveraging its own balance sheet and hoping for the best.

At this time of year, it seems that everyone has their own special wishes as we approach the end of one year and the beginning of another.  I thought I would share a few of mine with you.  I wish…

…the US pols would wake up and serve their country honorably instead of themselves dishonorably.  They could start by leveling with the populace and saying that this is not a normal economic condition, but one of deleveraging.  And that it will take time and determination to reduce debt levels by repayment or forgiveness.  As forgiveness appears ‘off the table’ for many Americans, it will take time to get debt levels down to a reasonable level, upon which a true economic expansion can begin.

…the US pols would realize that the our representative democracy is not very representative. In my opinion, that is the message underlying all the histrionics behind both Tea Party and Occupy movements.  “Job one” for the US pols should not be to come up with laws that will create jobs (that is what private industry does a lot better and more efficiently).  “Job one” for the pols should be to work on making our representative democracy a lot more representative.  Moving in that direction would improve discussion and decision-making. It might even make the pols sound intelligent.

…the Federal Reserve would stop using smokescreens and legal defenses to keep the public from knowing how much they have subsidized and are subsidizing the operations of US and foreign banks. Bloomberg, LP had to go to court to get one Fed program’s bank borrowers’ names and amounts ($trillions) exposed to sunlight. Chairman Bernanke seems like an intelligent, kind man, trying his best to keep the economy moving, without much help from fiscal policy, during a balance sheet recession.  But, I also think that he does essentially report to the large money center banks…and that keeps transparency from rising to the occasion.  Thus, we see another example of a not very representative democracy.

…the Federal Reserve and US Treasury would once again act independently (the Fed is supposed to be a central bank, independent of the Administration’s urgings).  And, that includes letting the public know of the basic strategy being used to deal with the ever growing pile of US government and agency debt: Financial Repression – low, negative real interest rates (see earlier blog post).

…the Eurocrats would not attempt to follow in the footsteps of the US and Japan. Let’s face it, whether it is Japan in the 1990s, or the US at 2008/9, the goal was to save the large money center (zombie) banks, despite the fact that their poor management was a large reason for the excesses that caused a balance sheet recession.  Both the Japanese and Americans kept those zombies going primarily because they are the oligarchs and, perish the thought, bank shrinkage and/or reorganization and/or recapitalization would cause deep economic scars, from which there would be no recovery.  Right.  What this does cause is a slowing of economic growth, as the zombies suck on the blood of government subsidies (direct and indirect). Today, when you hear that (fill in the blank country) must be saved, you might want to consider that what is being saved are the banks mismanaged enough to overleverage with high yielding Euro sovereign debt that required no risk capital.   The overall expected result…a lot slower growth in 2012 than the so-called experts are crossing their fingers about.

…the Eurocrats would stop calling it a ‘bailout’ of a country, when it really is just a change or increase in credit availability for that country.  The ‘bailout’ is an implicit one for the banks holding the sovereign paper. As an ex-commercial lender, I know that you can do one of two things with a bad loan: send it to the collection department or restructure.  As the first option essentially means default, the second option remains.  And restructuring can mean changing terms, loaning additional funds so that the borrower can effectively rebalance the timing of its cash flows, and/or obtain collateral.  What the Eurocrats are missing is a comprehensive formula for restructuring on a country-by-country basis (not the current band aid approach), including obtaining collateral in the form of state owned enterprises.  As the Chairman of my former bank employer used to say, “collateral makes a good loan better.”  A more honest and complete restructuring will also keep sovereign debt values from falling more than they would have and make the shrinkage/reorganization/recapitalization of the banking sector cheaper.  But the Eurocrats want to keep the oligarchs in place (see above), including themselves, and the result may not be very pretty.

…economic and financial forecasters would stop making forecasts so heavily biased towards what just happened. At the end of every year, we hear one forecast after another basically saying the same thing, “what is happening now will probably just keep happening…with minor variations.”  Making decisions based upon an assumption that tomorrow will be like today, is one of the major problems in making good decisions.  How many forecasters predicted equities would be flat in 2011?  Or, that we would see a US 10 Year Treasury around 1.9%?  With most forecasters telling us that US GDP will be about 2.5% next year and that the stock market will muddle along, I think we can be fairly certain that those forecasts will be either very low or very high.  I wish I could tell you with certainty which of those last two alternatives would occur.  Thus, we highly recommend that insurers focus on the impacts of the ‘tails’ of the distribution when reviewing investment strategies.

…you would please consider joining our discussion group on LinkedIn.  Insurer Investment Forum Online can be found there and, with a free LinkedIn account, you can participate…even adding your own wishes…or letting me know how much you might disagree with my ‘wishes.’

Those are just a few of my wishes as we approach the end of 2011.

But, most importantly, I wish you and your family the happiest of Holiday Seasons and the healthiest of New Years.

Today, the Federal Reserve announced that it will start “Operation Twist,” selling shorter term securities and buying longer term securities.

This is another in the continuing move towards ‘financial repression’ as recently discussed in a recent International Monetary Fund paper from Carmen Reinhart and Belen Sprancia .  Basically, financial repression is a conscious policy by the US Government to make repayment of its massive debt load (both existing and expected) easier.  This is a topic that has been discussed by PIMCO and other leading investment managers.

To summarize, financial repression consists of the following key elements:

1. Explicit or indirect capping or control over interest rates, such as on government debt and deposit rates.  See today’s and prior months’ Fed actions….keep rates low for an extended period, make it easier for the government to borrow at those low rates with longer maturities, etc.

2. Government ownership or control of domestic banks and financial institutions while placing barriers to entry before other institutions seeking to enter the market.  We saw this with TARP and still see this in other instances – AIG is still majority owned by the US Government and, contrary to popular opinion, not all TARP funds have been repaid.

3. Creation or maintenance of a captive domestic market for government debt achieved by requiring domestic banks to hold government debt via reserve requirements, or by prohibiting or disincentivising alternative options that institutions might otherwise prefer.  For example, banks can buy USTreasuries with borrowed money from the Fed and lock in a handsome spread, while holding zero (that’s right, zero) capital against it.  In fact, the Fed encourages this behavior.  Talk about a high return on regulatory capital!

4. Government restrictions on the transfer of assets abroad through the imposition of capital controls.  We have not seen this yet, but it is not beyond one’s imagination that we may see some of this.  In fact, some may argue that the IRS’ strong moves towards requiring that US citizens report foreign holdings is a step in that direction.  And certainly the conversation about requiring repatriation of cash at foreign subsidiaries of US companies could have more than corporate income tax implications.

Add in a small dose of inflation, say the authors of this study, and you have a form of taxation, designed to ease repayment of government debt. In fact, it is a form of taxation that can be done without passing one bit of tax legislation.  And, it can easily lead to implicit currency devaluation.

Of course, this will help the overall economy in its  long, deleveraging process.  And, a devalued currency can also help the economy (something the politicos will never, ever say).  However, for insurers the situation will be different.

Why is financial repression important to insurers? Primarily because It begins to throw the usual investment and reserve relationships on their respective heads.

For example, life insurers who see most of their growth through interest sensitive products will find it difficult to maintain adequate spreads between investment yields and crediting rates.  Property/casualty insurers will  get ‘repressed’ from both sides of the balance sheet – investments will be hard pressed to produce positive real yields, while that expected dose of inflation can wreak havoc on reserve adequacy, especially in areas such as medical inflation.

Right now, what can insurers do to prepare for continued financial repression?

One thing that should be considered…It is time to reconsider the role of the ‘risky bucket’ (investments that are not investment grade bonds) in providing income as well as the traditional less correlated, total return. (The ‘risky bucket’ is discussed in Chapter 3, Uncertain Times: A Chief Investment Officer’s Journey).

As one insurer CIO once told me, ‘you can’t eat total return’.  But, you can indeed ‘eat’ the dividend or interest income portion of that return, adjusted for risk.  That means considering asset classes with competitive or better yields to core fixed income alternatives, such as dividend paying equities, high yield bonds, emerging market bonds, etc. We are not advocating increasing the size of the ‘risky bucket’ to take advantage of added income, as we still believe the size of the ‘risky bucket’ must be carefully analyzed and kept within the risk appetite of the Board and senior management.  We are, however, advocating taking another, systematic look at alternatives with the ‘risky bucket’.

By the way, this process will be discussed in some detail at our two upcoming conferences:  Nov 1 at the NAMIC Investment Workshop and Nov 14-15 at the Investment Seminar for Government Risk Pools.

If your firm is either a NAMIC member or a government risk pool, you may want to consider these focused events.

We think you will be hearing the term ‘financial repression’ enter the discussion about investments more and more, in the months and years ahead.  It is better that we all understand what that means today and what it means for our portfolios.

As always, I look forward to your comments and questions.

While experts ponder what might happen to the financial markets and the real economy should the US default – even for a day – on its US Treasury payments, a larger issue is being missed by some:  The practical impacts of US Treasury downgrade to AA+.

Default is, of course, more worrisome because it would materially shake a basic assumption upon which markets and, to an extent, modern finance is based.  That is, US Treasury debt is ‘credit risk free’.  However, whether the US defaults is within US control.  Of course, the levers of that control are based upon a democracy in severe conflict, across several dimensions.  That kind of analysis is beyond our expertise so we will leave it to the political scientists and other pundits.

However, a credit downgrade is NOT within US control.  This will be a call of the oft-maligned rating agencies.  But, even if they do not downgrade, the market may…especially since it is the market that typically acts prior to the rating agencies.

So far, the market (primarily via the credit default swap arena) is telling us that the US is still a slightly better credit risk than the strong German economy.  But, that may be more a case of Germany’s commitment to the much expanded pan-European, EFSF, bailout fund (so far a backstop primarily for Greece, with more candidates on the horizon) than a comment on any stability in US finances.

But, the more salient point for insurers is how would a US downgrade specifically impact your portfolio?

Of course, we are unable to answer that for every insurer, but we can discuss how a generic insurer’s policy and portfolio might be impacted, even if the downgrade is simply to AA+.  Here is a start to the discussion:

1 – Say goodbye to 100% limits on US Treasury investments or those with the ‘full faith and credit’ of the US government.  Most policies view UST’s as ‘credit risk free’, so why not allow what is in essence ‘no limit’?  When they stop being such, we would expect insurers will want to place similar limits as those placed on other AA+ credits and/or other sovereign exposure.  For most insurers, we would expect that this will cause little or no change in current UST exposure, since they already are a very low percentage of the portfolio (there are not many reasons to hold low yielding securities).

However, many insurers hold significant amounts of mortgage related securities that are guaranteed by GNMA, a ‘full faith and credit’ issuer.  And, a UST downgrade will most certainly cause a downgrade in GNMA debt. We would expect that policies would be revised to reconsider GNMA securities and be subject to tighter per pool or diversification limits.

And, we would also expect that FNMA/FHLMC securities would suffer a similar downgrade, causing a parallel reappraisal of policy limits.

2 – Should the US be downgraded by the rating agencies, next up on the hit list (after US agencies) will be financials. Please remember that the rating agencies are generally dubious about the Dodd-Frank ‘reforms’ when it comes to ‘too big to fail’.  They suspect that should a large bank get in financial trouble, the US government will be forced to ‘save’ them ‘for the sake of the US and global economies.’  In other words, implicit in large bank ratings is some kind of implicit backing of the US government.  Thus, a downgraded US government will mean downward rating pressures for the large banks.  Perhaps atleast the ‘weakest’ of the group may be downgraded, which could cause problems for contracts that require a minimum credit rating level.  Thus, forward looking insurers will want to reassess their financial sector exposure both from a policy and portfolio holdings perspective.

3 – Other corporate bonds will undoubtedly receive scrutiny as well, since it is difficult for a corporate to be rated higher than its sovereign rating. I think we only have one or two AAA corporate issuers remaining in the US.  But, will Microsoft still be standing at AAA if Uncle Sam takes a hit?  We shall see.  More importantly, the rating agencies may very well consider the distance between a given corporate today and the supposed ‘risk free’ UST, and then reconsider the corporate rating to maintain that distance from a downgraded UST.

And, related to this are portfolio ‘average credit rating’ minimums found in policies.  How will this recalculation, assuming the UST and its agencies are downgraded, impact portfolio compliance?  Will it mean a sale of bonds at the lower end of the investment grade spectrum just to maintain that ‘average credit rating?

4 – Many municipal debt issuances are either defeased with US Treasury debt or have some link to support of the US government.  Those issuances would also be subject to downward rating pressure and would have to be reconsidered in limit of both policy limits and portfolio holdlings.

5 – Some structured securities also use US Treasuries as a way to guarantee ultimate payment of some long dated tranches.  Downgrading of those tranches will undoubtedly occur, but this type of asset is usually quite a small part of insurer portfolios, if at all.

Quite frankly, these are just some initial thoughts about how a downgraded UST market would impact policies of insurers.  I am certain that the portfolio impacts (changing valuations, spreads, etc) will be much more important and are much more interconnected than noted here.

What are your thoughts on what might happen should the US be downgraded?  If you have not started thinking about this, now would be a good time to think about it atleast as a possibility.

With that in mind, we are hosting a discussion of this topic on our new Insurer Investment Forum Online discussion group on LinkedIn.  If you have a LinkedIn account (it is free), please click here to join the discussion. If not, you can always join LinkedIn, or add your comment on the link below.

Thank you and I look forward to your thoughts on this burgeoning issue.

OK, now that I have successfully shocked you.  I will attempt to make the case for the benefits of Greece, the cradle of democracy, defaulting.  You see, I think the players in this Greek drama will be forced to don their masks and agree with that proposition sooner or later.

First, the downside of a Greek default and we’ve heard plenty of them.   Might it be another Lehman moment?  Not exactly, as this is a country defaulting not a financial.  But, it would cause losses in European banks, with downgrades a plenty, banks perhaps being liquidated by their regulators and counter party issues causing the credit derivative markets to hiccup, money market fund holdings of Euro banks would be hit, and it might begin a domino of defaults with Ireland, Portugal, Spain and Italy next.  Reuters recently did a good summary of these terrible possible events.

However, this really reminds me of someone being told of all the horrible things that will happen if they drive their car off a cliff.  So, the likely reaction is not to drive off a cliff…or atleast build an exit ramp before you get to it.  And that exit ramp is what may be in the offing.

While the ECB, France and Germany remind Greece to pass austerity measures, Greece reminds those three powerful players that they and their banks own the most exposure to Greek debt.  This dance macabre reminds one of a variation on an old saying, “if you owe the bank $100, they own you; but if you owe the bank $1 trillion, you own the bank.”  The Euro players say “do this” and we will keep you from defaulting, while the Greeks say keep us from defaulting and we might do “some of that.”  It is a fascinating game to watch, but one that, I think, all the players will grow tired of.

More likely, the Euro players are meeting with the largest holders of Greek debt (including the ECB) and deciding: (1) how to recapitalize the ECB after the Greek default and (2) how to prop up and then recapitalize certain Euro banks after the Greek default.  Think “sub prime mortgage problem” as the firestarter behind the fall of key players, resulting in a bailout of key financials, and instead replace “sub prime mortgages” with “Greek debt”, and you get the picture.

So, this game of chicken will go on until the Euro players have had enough AND have a plan of their own for dealing with default.  At that point, the Greeks can default, markets can go crazy and economies will suffer.  Only this time, the leaders will be better prepared to cushion the problems…although there will be problems.  And, Greece may even be forced to reject the Euro as its currency….it all depends upon what the exit ramp before the cliff looks like.

Once Greece defaults “the sun will come up tomorrow” over a slightly changed world economic landscape.  Markets will clear and eventually find new levels.  There will be some rather severe changes for some countries – how can that not be in Greece and other countries who are unable to service their debt?  But, much will be learned and the next country default will be even better handled by all involved.

And, perhaps, just perhaps, the beacon of democracy called the United States will learn something from the experience of the cradle of democracy.  Unless you’ve got a really good exit ramp (plan) in place, don’t even think of a “restricted default” by not coming to some agreement on a revised debt limit.

Reaction to Dr. Bernanke’s latest press conference (June 22) has been rather more biting than his first conference last April.

A blog on Forbes.com put it less than mildly:  Bernanke Admits He’s Clueless on Soft Patch

On Bloomberg.com: Bernanke Public Approval Declilnes to Lowest with Too-Slow Economy in Poll, as if Dr. B is actually subject to an election.

And, some economists and former Fed officials thank Dr. B should rethink the central bank’s wait-and-see policy as growth slows.

Undoubtedly, we can expect a slower economy for a couple of quarters. (just ask the Economic Research Institute).  So, why is Dr. B not scrambling around for another round of monetary stimulus?

Well, it has happened time and again in the history of the Fed, and is happening again.  Facing some rather potentially severe known unknowns, he is undoubtedly keeping the Fed’s “powder dry” (if they have any substantial supplies left), awaiting very real future problems, such as: (1) Greek default and the potential for contagion, and (2) US failure to increase the debt limit and become a ‘restricted default’, in rating agency language.  And, I believe he is hoping the ultimate fate of these issues will become clearer before the US economy approaches the feared zero growth number.

We business people sometimes see academics as those who live ‘in a perfect world’ or have their ‘heads in the clouds.’  However, we should not underestimate Dr. B and his survival instinct.  Don’t forget that he has his bosses at the large banks and the nation’s CEO to report and meet their needs first.  And, Dr. B may be a lot more practical than many think he is.  Meanwhile, one can speculate as to what form that dry powder may take…because it will likely come…eventually.

Today, we revisit From the Northwest Quadrant’s blog entry of September, 2010. Just nine months ago, we noted the following:

“The Greatest Deleveraging in the History of the World” continues, only slightly impeded by governmental efforts to borrow against future economic growth (that’s what a loan/bond really is) or coerce/convince others to do so as well. In other words, this is a trend that will take time to play out and will eventually reassert itself after the effectiveness of government roadblocks decline.”

Today, it looks like the effectiveness of those government roadblocks are indeed declining.

In the US, a recalcitrant congress concerned about record $ (but not % of GDP) deficits, is not about to think about fiscal stimulus…at least not until we get closer to the election next year when it will be time to strategically ‘buy’ votes.

Meanwhile, an increasingly politicized Fed is stunted from looking towards another version of monetary stimulus.

Perhaps a continued focus on a declining dollar will be the manner in which a ‘stealth’ monetary stimulus is accomplished – it worked after the Great Depression. (Of course, the ongoing subsidy to the large banks, in the form of virtually zero interest on borrowings from the Fed, is another form of ‘stealth’ monetary stimulus…for the banks!)

Meanwhile, ratings agencies have begun to circle around the politicians who are discussing a needed borrowing limit increase for the US Treasury.

More importantly, the agencies have already stated that fiscal problems in a country’s government can spill over into the creditworthiness of its banks. Certainly that is a major fear in the Eurozone, and it probably should be a fear in the US.

But, what is likely to happen next?

For that we go back to what we have noted previously. In fact, it has been noted by others. For example, who said this back in February, 2009 (Answer at the end of this blog entry)?

“As a consequence they (Japan) suffered what was called the ‘lost decade,’ where essentially for the entire ’90s, they did not see any significant economic growth. So what I’m trying to underscore is…that this is not your ordinary, run-of-the-mill recession.”

Less well known, but much brighter on these matters, than our mystery speaker above, Richard Koo of the Nomura Institute maintains that the US does not have to make the same mistakes as Japan…even though it certainly looks like we are doing so. He has even noted similarities between US and Japanese housing prices over similar periods.

And, Koo is not alone. Steve Roach, non-executive chair of Morgan Stanley Asia, recently called US consumers ‘zombies’ who threaten the global economy…but with good reason.

Gavyn Davies, another highly regarded economist, wonders if the US economy may be approaching ‘stall speed’, at which an inevitable movement to recession occurs. Despite this, his analysis provides recession to be a 30% probability at this time.

And, crunching the numbers at the reliably accurate Economic Cycle Research Institute, Lakshman Achuthan expects much slower growth over the next couple of quarters.

At what point will Congress and/or the Fed act (even as inflation seems to be seeping into the system — but not for all the usual reasons, like output constraints)?

You see, that is now the operative question for US investors.

The ‘balance sheet recession’ noted by Koo (or, as we have called it, ‘The Greatest Deleveraging in the History of the World’) will go on unabated, and it will only be temporarily sidetracked by macro actions by governments.

We have already seen what QE2 has done to risk assets. But, when the great experiment called QE2 pulls into port, we need only play the movie backwards to guess what will happen to those same risk assets….unless we see another giant ship on the horizon.

Choose the ship you may desire, but the economic seas will remain what they are for the US until the economy is sufficiently deleveraged.

(By the way, the speaker who, in February 2009 compared the US recession to Japan was President Barack H. Obama.  Please feel free to draw your own conclusions.  And, as always, you may post your comments using the link below.  Thank you.)