Why would US Treasury Secretary Henry Paulson appear to be like the legendary Sisyphus?

As a reminder, as punishment from the gods for his trickery, Sisyphus was compelled to roll a huge rock up a steep hill, but before he reached the top of the hill, the rock always escaped him and he had to begin again.  The maddening nature of this punishment was reserved for Sisyphus due to his hubris and belief that his cleverness surpassed that of Zeus.

Perhaps the markets are playing the role of Zeus.  Of course, as an the former Chairman and CEO of Goldman Sachs, it is hard to imagine a lack of some degree of hubris.

With Citgroup’s and other banks’ recent action to add SIVs to their balance sheet, it is increasingly looking like the US Treasury’s plan for a master conduit of SIVs to rescue that market may go by the wayside.  (Of course, SIV’s must still face the burgeoning roll over of their Medium Term Notes — an event that will start in earnest in January.)

And, now the announcement of a sub prime mortgage rescue appears to have a similar approach to the Treasury engineered SIV plan.

When originally announced two weeks ago, I could not resist the impulse to answer the Wall Street Journal’s forum question:  "Will Bush’s mortgage plan have an impact on the housing crisis?"  Here’s what I noted then, and I would echo those thoughts today:

I don’t know what this does other than give servicers the legal wiggle room to delay repricing for five years and make it possible for folks to stay in their home for now. However, the ARMs will reprice and the rate is tied to short term rates which may be higher five years from now.

Also, this ‘moving of the chairs on the Titanic’ does not seem to address repricing of more exotic loans (e.g. Option ARMs) – but I guess we’ll see. And, I wonder if the interest at the new (not repriced) rate is forgiven (unlikely) or deferred (likely). If deferred, this will just add to the balance of the loan and this negative amortization will eat into most of the potential price appreciation. If forgiven, investors will be furious and lawsuits will descend like attorney manna from heaven.

Meanwhile, investors, including the banks may get less of a mark down due to a lower probability of foreclosures…but maybe not, depending upon what the bond market thinks.

My guess is that this looks a lot like what Paulsen came up with for the SIV problem - get the big guys together, try to delay the inevitable and get others to go along. The SIV problem is NOT going away and this ‘quick and easy’ fix has not even been effectuated at this point. In other words, this mortgage plan could end up being more smoke and mirrors than substance when it’s time to implement.

If the federal government wanted to solve the problem, they would set up an RTC like entity that would buy the mortgages, do the workout, while calming the worried financial markets and pass any losses to taxpayers…which may still occur.

This is starting to look like another Sisyphean effort.   The markets (Zeus) want transparency so that it can begin the process of correcting prior excesses. 

This may mean mergers of large financial players.  It may mean further reorganizations of others.  And, it may mean other consequences which we all must face (including further declines of the value of the US Dollar).

To put the onus solely on the Fed (and their new liquidity auctions) for solving this problem is like fighting with one hand behind your back.  If you want Zeus to solve the problem, you will have to give him what he wants (transparency) and not a plan that will result in another Sisyphean result.

The only major investment banker to laregly escape from the current sub prime woes unscathed, has announced the first of a series of indices that will allow insurers and others to hedge mortality risk.  Goldman Sachs is behind the new QxX index that allows investors to be long or short mortality risk, using real time pricing information and execution (no pun intended).  Atleast that is the plan, as this is truly in its infancy. 

Just as in credit default swaps, insurers and others will be able to sell mortality protection (long mortality risk) or buy mortality protection (short mortality risk).  This mortality index (expected to be enhanced and added to over time) is a representative sample of the US senior insured population over 65 years old.  The initial index references a pool of over 46,000 de-identified lives.  Undoubtedly, if this approach is successful, we will see mortality indices based upon lives outside of the 65+ group.

There is much more detailed information at QxX-index.com.

Mortality risk is a serious issue for life insurers who have typically used a mix of life and annuity products to ‘hedge’ mortality risk.  This index may provide a more granular approach to hedging this key risk. 

In addition, there is the outside chance that other insurers, such as PC insurers, may want to diversify their insurance exposures by adding life insurance business.  Previously, this would be done via acquistion, but, perhaps this will be done via derivatives contracts in the future. 

And, there is no telling what impact this will have on the burgeoning life settlements business.  Perhaps this added transparency may accelerate both the reduction of the imbedded egregious fees and the acceptability of life settlements as an alternative investment.  Perhaps not.

In any event, this is certainly the beginning of the end of another risk that ‘could not be hedged’ effectively.  If only Goldman or another firm could come up with a hedge for liquidity risk….

While the press concentrates on the ’sub prime crisis’, because it is so easy to put a face on it, insurers should be focusing heavily on good old fashioned credit risk.

Yes, default rates have hit 25 year lows at 0.74% of high yield bonds per S&P, but that measure is backward looking. 

A more concurrent indicator would be the number of US corporate bond issuers being downgraded versus those being upgraded.  According to Moody’s, this ratio is now at 4.5 downgrades to upgrades, more than double the rate for October and the highest since the bad old credit days of late 2002.  As we all know, market signals are also flashing red, as there are amazingly over 150 issues trading at 1000 bps over US Treasuries.

And now, Moody’s late on Friday, placed the Aaa ratings of FGIC and XL Capital Assurance ynder review for possible downgrade. It affirmed the Aaa insurance ratings of MBIA CIFG, though it said the outlooks were “negative.'’  A downgrade for any of these bond insurers would have negative impacts for insured bonds, especially those supposedly ’safe’ municipal bonds.

‘What’s the next shoe to fall in the credit risk arena?’ may not be the correct question.  Perhaps ‘What and how many shoes?’ is a better question.

Although life insurers do allocate surplus in the form of asset valuation reserves for credit risk, PC insurers do not have such a valuation reserve.  We highly recommend that all insurers review the potential for credit losses and Other Than Temporary Impairment write downs over the next year (both expected values and probabilistic distribution of those values) in order to get a better idea of future portfolio performance.  

There are many different ways to perform such an analysis.  However, using credit rating transition matrices, long term credit default performance as well as stress testing that performance is a good start.  It is much better to be prepared now than be surprised later.