Let’s take another look at The Great Re-Leveraging AKA US Government bailouts, which tend to generally take one of three forms (or some combination):

(1) Government guarantee (as seen with money market funds, some bank loans, increased FDIC deposit coverage and, of course, a special guarantee for Citi’s ‘bad bank’ assets)

(2) Direct loans or preferred/quasi-common stocks investments (as seen with AIG, and the innumerable amount of banks that got the first half of TARP money).

(3) Liquidity sources (as seen with many of the Federal Reserve programs, designed to take assets - with ‘haircuts’ so questionable they make ‘comb overs’ look good.)

Add these up and what do you get?  Well, according to Bloomberg, we’re at $7.7 trillion and counting (http://bloomberg.com/apps/news?pid=20601109&sid=arEE1iClqDrk&refer=home) and that was as of last week.  That’s about 1/2 of U.S. annual G.D.P.

Want another view of things?  Just take a look at the Federal Reserve and the FR Bank’s balance sheets (http://www.federalreserve.gov/releases/h41/Current/) — all very complicated, but they boil down to one plain fact:  Where the Fed once backed those green Federal Reserve Notes in our wallets with US Treasuries, we now have a Fed that has now ballooned its balance sheet by a factor of nearly 3 times versus a year ago due to bailout related activities.

One can argue all day about the importance of, the amount and the type of bailouts that have occured thus far, but one issue is clear:  The US Government is re-leveraging to combat the ‘Greatest Deleveraging in the History of the World’.  One hopes that this will all end up well and the US Government and economy can eventually get back to normal.  However, two major questions linger:

1 - How many more bailouts, of how much, what type and for how long, and….

2 - How (and when) might things ‘get back to normal’?

An answer to question one will require a coherent strategy - something not yet divulged to ‘we the people’.  I would seriously recommend the new Administration propose such a strategy for all to view and understand.

An answer to question two will allow investment managers to develop tactical strategies (to go with strategic asset allocation decisions) that take into account when the force of ‘mean reversion’ might return to the fore.  Remember that nearly all investment manager decisions are based upon long term relationships reasserting themselves.  However, in the current liquidity and credit challenged markets, long term relationships have been virtually thrown out the window.  Thus, how and when things ‘get back to normal’ is perhaps the most challenging question facing investment managers today….and worthy of detailed discussions with your manager as it relates to your company’s portfolio. 

As for the USA, a larger unknown that could be solved by the answer to question two is the probability that, at some point, investors and other countries might rachet up their assessment of US Government currency and/or credit risk.  The result might be a much lower dollar and a higher yield demanded on those ‘risk less’ Treasuries.

Yes, Virginia, there may be a Santa Claus, and sometimes the US Government tries to act like St. Nick when it comes to bailouts.  However, bailouts don’t come down our collective chimney without a cost.  Perhaps by answering the two questions noted here, we might get a better idea of what we are truly receiving.

 …You wake up Monday morning and realize that loans are defaulting at faster rates than expected. You just increase loss reserves and go back to work, but…

Four months left for the Administration and the Goldman Sachs-US Treasury department.  The Greatest Deleveraging in the History of the World has destabilized financial markets and threatens to drag one developed economy after another into a recession.

In the latest move to have this occur, the US Treasury has basically taken over the largest single sources of mortgage finance in the world: FNMA and FHLMC.  In our prior post, we said:

"However, it (the mortgage market) will eventually recover, although with significant changes.  FNMA, FHLMC and GNMA (and the US Government) will continue, in some form or other, to be the cornerstone of the market.  And, where there is money to be made, Wall Street will find a way to securitize mortgages - more transparency, more risk sharing, improved ratings methodologies, etc - but I believe it will happen.  Meanwhile, we should all follow the guidance from the Hitchhiker’s Guide to the Galaxy: Don’t Panic"

As expected, the result of that "some other form" has been conservatorship…a nice legal word for bankruptcy.

Every day it seems like the US economy is starting to look more like (take your pick) the US in the 1930s or Japan in the late 1980s/early 1990s.  We prefer the later, since the former brings about results we know that the Fed can successfully deter.  As the economy slowly moves into this Godzilla-like stage of slow growth/recession coupled with asset deflation due primarily to the credit excesses of the past, we must carefully view government responses to determine if we bordering the eastern Pacific have learned anything from our friends bordering the western Pacific.

One error that the academics say Japan made was to prop up banks and other credit sources too long and not let the capitalist system wash away the bad apples and start afresh as soon as possible.  With the UST’s four point plan, it appears that some of these errors may indeed occur unless the federal government can successfully think like an entrepreneur.  Although no one doubts Mr. Paulson’s entrepreneurial capabilities (a minimum requirement for a "master of the financial universe"), one must severaly doubt if the next administration and Treasury secretary will have a similar bent.  And those doubts can easily be placed at the feet of both Presidential candidates, too busy to talk about mindless topics than the core of our financial system, which indirectly and directly supports all potential voters.

The four point plan will undoubtedly be viewed with glee by troubled financial markets: (1) an unlimited commitment to buy convertible preferred stock, (2) a 60+% reduction in their mortgage holdings over time, (3) a senior lending credit facility to provide virtually unlimited liquidity, (4) UST commitment to buy an unspecified amount of GSE mortgages.

However, such glee should also be tempered.  Note the message it is sending. "We are the government and we are here to run the mortgage business for an indefinite period of time."  Although this plan may solve short term problems, it does not give comfort that the government will eventually let the capitalist system wash away the bad apples and start afresh as soon as possible.  And therein lies the troubling comparison with Japan in the late 1980s/early 1990s.

Four months to go, and the Administration and Goldman Sachs-UST has delivered us into a Godzilla like moment.  They think they have tamed the beast.  But, until there is assurance that the private sector will be allowed to devise new ways to securitize and sell securities without stifling competition from the federales, there is the risk that we may follow in the footsteps of our friends in Japan.

Don’t Panic is a phrase used in the book The Hitchhiker’s Guide to the Galaxy by Douglas Adams. It comes from the fictional intergalactic travel guide The Hitchhiker’s Guide To the Galaxy, that theoretically served to show planet-hoppers how to see the Universe on less than thirty Altairian dollars a day.

Now to FNMA and FHLMC - both insolvent from a mark to market perspective, and both deeply strugglling (depending upon your definition of capital) with the problems in the mortgage markets.   The Bush administration just opened a new chapter in their figurative Hitchhiker’s Guide by announcing a plan to save these GSE’s by extending a $300 billion line of credit. Since this will require an act of Congress, it is expected that the Fed will provide the financing in the interim.

But wait, the Fed already has about 1/2 of its assets (about $400 out of $878 billion) tied up in non-US Treasuries and their existing ’short term’ credit facilities for banks and brokers.  The Fed reports its balance sheet weekly.  Click here for the most recent numbers.  No wonder the old saying is "If you owe the bank $1 million and can’t pay, you’re in trouble, but if you owe the bank $1 billion and can’t pay, the bank’s in trouble."  Just add a few zeros (in the contingent liability column) in this case.

It has always been my impression that FNMA and FHLMC underwriting standards were superior and tighter as compared to other lenders, especially many of those in the private label securitization game.  Thus, we will probably learn that the market’s latest concerns are overblown.  In fact, this may get back to the value of the mortgages held by the GSE’s.

With Friday’s FDIC takeover of the very aggressive lender - IndyMac Bank - there should be no worries for depositors with less than $100,000 at the bank.  However, the real worry will be what the FDIC will be able to receive when it goes to liquidate IndyMac’s assets in an already tight mortgage market. 

Thankfully, one would assume that:

(1) Most mortgages held by these GSE’s are better underwritten than those held by IndyMac, or Countrywide, or Washington Mutual, or…

(2) The U.S. government will continue to make good on any of these GSE’s problems, since debt and MBS issued by them are held not just by domestic investors, but foreign investors consider them to be as good as US government debt.  And, those investors hold trillions of dollars of US securities.

(3) FNMA and FHLMC now make up a large majority of mortgages being originated today.  Thus, they must continue in business in order for the mortgage market to begin to recover and, with it, the valuation of residential properites.  An interesting article in Barron’s this week has Chip Case, of Case/Shiller Index fame, making a case for the residential market turning around.  And, I would add that ARM repricings (the fire starter of the subprime mess) are projected to peak next month.

Back to the Hitchhiker’s Guide: The words ‘Don’t Panic’ are printed on the cover of the Guide (always capitalized) "in large friendly letters".  The novel explains that this was partly because the device "looked insanely complicated" to operate, and partly to keep intergalactic travelers from, well, panicking.

The mortgage market today does look a bit ‘insanely complicated’ to operate…probably even from the standpont of an intergalactic traveler.

However, it will eventually recover, although with significant changes.  FNMA, FHLMC and GNMA (and the US Government) will continue, in some form or other, to be the cornerstone of the market.  And, where there is money to be made, Wall Street will find a way to securitize mortgages - more transparency, more risk sharing, improved ratings methodologies, etc - but I believe it will happen.

Meanwhile, we should all follow the guidance from the Hitchhiker’s Guide to the Galaxy: Don’t Panic

We would, however, recommend discussions with your investment manager about the FNMA and FHLMC securities your company owns.

 The SEC has just release for comment (within an aggressive 30 day period), their proposal for improving the process at credit rating agencies (NRSROs). 

One suggested change is:

Require credit rating agencies to publish performance statistics for 1, 3 and 10 years within each rating category, in a way that faciliates comparison with their competitors in the industry.

Shockingly, this adds a hint of competition to an industry that is an oligopoly.  It is a slow move towards the word most hated and feared by Moody’s, S&P and Fitch - COMPETITION.   In a capitalist economy, lack of competition can lead to inefficient and ineffective markets….something that is still endemic in the NRSRO industry today.

We firmly believe this disclosure is a step in the right direction.  It might even get investors to realize how truly imperfect credit ratings are, and how important independent credit research is.  It should also be a stark reminder to investors that ALL portfolios with credit risk are subject to losses which can indeed be anticipated and analyzed in advance. 

Unsurprisingly, we are called upon to provide such quantitative analyses for our client portfolios.  Each portfolio exhibits a different expected loss distribution, but all portfolios’ credit loss distributions tend not to be ‘normal’ and are subject to severe negative spikes in losses in certain ‘unusual’ cases. 

Given the current and expected state of the economy, perhaps it is time for analysis of expected loss distributions in your company’s portfolio?

Last December, in a blog entry entitled, "Credit Risk: Prepare for What Will Come Next" we warned of focusing on the ‘headlines’ of sub prime problems without considering "good old fashhioned credit risk".  We noted:

‘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.

Now, Moody’s has confirmed our thoughts with a recent report, as noted by Reuters:

A record $772 billion of U.S. corporate debt may be put on review for downgrade this quarter as financial firms stumble and rising commodity prices take a toll on industrial companies, according to Moody’s Investors Service.

The previous record for downgrade reviews was $543 billion in the third quarter of 2001, a year of massive bankruptcies as accounting scandals and recession toppled corporate giants. Downgrade reviews for this quarter are on pace to top the $593 billion reported for all of last year, according to a report released late on Wednesday.

We’ve been in recent meetings with some investment managers who see value in the investment grade corporate market because spreads are predicting defaults in excess of those seen back in 2001.  Alas, these managers may be too sanguine if Moody’s predictions, which are pointing to worse credit conditions than 2001, come to pass.

The report goes on to say: 

"Three clear trends have stood out among U.S. issuers subject to recent downgrade reviews: financial firms hurt by holdings of toxic structured financial products, industrial firms squeezed by rising commodity prices, and firms with direct exposure to the discretionary spending of the U.S. consumer," according  to Moody’s statistical economist Benjamin Garber.

In the case of financial firms, the reliance on leverage is endemic; and for firms with direct exposure to discretionary consumer spending, leverage has been a strong contributing reason for revenue gains. 

The rising tide of credit risk will make your investment managers’ tasks more difficult.  However, it is incumbent upon insurers to carefully question, understand and monitor the process or credit risk management at those investment management firms.

And, as noted in our earlier blog:

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, credit default swap spreads, 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 surprised later.

That’s not our quote, but it was Bob Herz, FASB head who noted this at the recent CFA Institute Annual Conference in  Vancouver, B.C, as he laid out a plan for convergence of FASB and IFRS (international accounting) standards.  There are several areas that need to be addressed before this occurs, and mark to market (now required by IFRS) is one of these areas.

We’re all for mark to market of assets AND liabilities…when it makes good sense.  

Please remember that accounting is basically sociology…what we group of humans think is the best way to report financial results of enterprises, etc…and these are always subject to change.

And, as we tell all of our clients, when it comes to their investment process, everything starts with what you are trying to accomplish (your company’s key goals and objectives, key performance indicators, etc.).  And, the same holds for accounting…it still comes down to what you are trying to accomplish. 

If the goal is to provide a snapshot of balance sheet market values without regard to why those assets and liabilities are on the balance sheet, it’s full speed ahead on MTM — and any problems are indeed implementation problems, per the esteemed Mr. Herz.  However, if the goal is to accurately convey the financial condition of a firm within its unique goals and objectives, MTM only applies where those assets and liabilities are subject to conversion at those values.

For example, insurers typically purchase equities for long term capital appreciation.  When preparing a balance sheet as of a certain date, there is good reason to mark these assets to market, because we all want to know how far along that capital appreciation path those investments are hopefully on. 

However, if an insurer puchases a bond to hold for a long period of time (whether for maturity or not) in order to provide investment income (assuming no credit risk), it makes little sense to mark the bond to market, since the bond is being held to support the business/income statement of the company and not to produce outsized total returns.  Conversely, if an insurer actively trades those same bonds, with a philosophy of looking for total return advantages through relative value decisions, etc., than the insurer should indeed mark those bonds to market, because they are less interested in providing income to support the business and more interested in that long term capital appreciation, similar to the investment in equities noted earlier.  It all comes down to something similar to the ‘cash flow statement’ required of companies — trying to determine what the sources and uses of cash flows are.

Of course, market illiquidity has caused getting good market values to be problemmatical, but if one is actively trading, one should know those values or else how could one trade effectively…and if one could not trade effectively, it brings up much more serious issues than what is shown on a financial statement.

Meanwhile, our friends at the CFA Institute, without considering all of their consituencies such as insurance company investment professionals, continue down the path of blindly supporting MTM:

“Putting the blame on fair value for current market conditions is misguided,” said Georgene Palacky, director of the CFA Institute Centre’s financial reporting group. “Fair value is the most transparent method of measuring financial instruments, such as derivatives, and is widely favored by investors. Recent finger pointing seems merely an attempt to shift the focus from the real causes of the financial crises involving sub-prime lending practices and lack of market discipline. Indeed, fair value accounting and disclosures, which provide investors with information about market conditions as well as forward-looking analyses, does not create losses but rather reflects a firm’s present condition.”

Market value disclosures are always a good idea…the more transparency the better is a generally good rule to follow.  However, forcing MTM on investors that use investment grade bonds as a source of income, not total return, is completely missing why those investments are being held.  Alas, MTM is not just an ‘implementation problem’ when you look at insurers. 

The writers of the sci-fi franchise Star Trek long ago realized the importance of plot devices to keep the viewer interested and make problems more intractable.  Thus, they had the bad guys use a technology that the good guys did not have: a ‘cloaking device’ that would hide the existence of their starships despite being in proximity of the good guys’ Enterprise.

With the good guys (?) at financial firms being pummeled by write downs due to marking securities down to values that are, themselves, pummeled by a market low in liquidity and high in fear, the writers of the non-fiction franchise SEC have come up with their own ‘cloaking device’:  www.sec.gov/divisions/corpfin/guidance/fairvalueltr0308.htm

It grants all publicly listed companies the ability to use unobservable inputs for pricing securities (Level 3 under FAS 157) when those securities are being observably priced in a ‘forced liquidation or distressed sale’.  It does not appear to define what is meant by such distress, but does require significantly more disclosure about how securities found their way into Level 3 and how they were priced using those unobservable inputs. 

This appears to be the SEC’s attempt to temporarily derail their inexorable march to mark to market, while allowing the markets to return to ‘normalcy’ (more normal liquidity and less fear).  The theory here may be that time heals all wounds.

However, as all Star Trek fans know, the ‘cloaking device’ does have unintended consequences. 

How will investors be able to fully trust the earnings reported at companies holding many Level 3 securities?  And, how will that impact the very markets the SEC is attempting to calm?  And, will those firms using this ‘cloaking device’ be able to more as adroitly as those that do not?

This starts to appear very similar to what happened under ‘regulatory accounting’ at thrifts in the early 1980s.  That accounting treatment kept many thrifts in business despite a ‘mark to market’ problem.  The government reacted by loosening many regulations on thrifts.  Developers/promoters stepped in and took advantage of those regulations and many of those thrifts were later taken over or merged by the Resolution Trust Corp in the late 1980s and early 1990s.  The ultimate cost being borne by the US taxpayer.

One would think that policymakers would have learned about the perils of using the ‘cloaking device’ to hide or delay the resolution of problems.  But, perhaps that only happens in science fiction.

At our recent Insurer Investment Forum VIII, each attendee probably had a few key ideas that they gleaned from the conference.  In my case, one idea came when I was preparing my brief opening remarks, and the other came from listening to Allan Sloan, Fortune Magazine, address us at lunch.

The first idea is that we are witnessing the Greatest Deleveraging in the History of the World.

When you think about it, that is not as forceful a statement as it seems on the surface, since we have just witnessed over the last few years (until about August, 2007), the Greatest Leveraging in the History of the World.  The largest single country economy ever used expanding leverage to grow in excess of the rate it would if it did not so use as much leverage.  As we all know, leverage is a two sided sword:  great when things are going well, and dangerous when they are not.  We are now in the dangerous stage.

Perhaps the Fed, by working with JP Morgan and salvaging Bear Stearns,will control the impacts of this deleveraging today.  And, perhaps there will be other large institutions (’too big to fail’) for which the Fed or other government agency will have to do the same.

And that brings me to the second idea from our conference.  Mr. Sloan was quite entertaining and witty, as he is within his column in Fortune.  However, he said that this was only the second time he can remember that a break down in the financial system is impacting the ‘real economy’ towards what looks like a recession.  (Usually, it is the ‘real economy’ that has problems that cause a recession that then impacts the financial system to some degree.)  The other time Mr. Sloan could remember that the financial system caused problems for the ‘real economy’ and not vice versa:  the great depression.

If credit continues to contract and if market liquidity continues to be under assault, the problem in the U.S. will be falling, not rising prices.  And, therein lies a truly problemmatical scenario.  In that case, when would those helicopters aluded to by Chairman Bernanke start dropping suitcases full of cash?

In May, 2007, Chairman Bernanke said he did not expect ’significant spillovers’ from the subprime market to the rest of the economy or financial system.  The Fed’s latest moves, including significant rate cuts, opening up the discount window, setting auction market lending facilities and now working on a Bear of a problem proves that not only does he ‘get it’, but he is quite concerned about the Greatest Deleveraging in the History of the World. 

There are still many other monetary and fiscal policy solutions that can and probably will be used to tackle this deleveraging.  Unlike during the depression, we have those tools at our disposal.  In addition, the occassionally maligned Mr. Bernanke could be the most educated person on this topic.

Our conference was really quite positive in many ways, but those two rather interesting and troubling ideas were my personal ‘take aways’.

We’ll have more on what this means for insurer investment strategies in future blog entries and in client communications.  

And, as always, you can comment by signing onto the Insurer Investment Forum Online.

 According to the old saw, "As January goes, so goes the year."  Let’s hope that is only partially true this year, as shown in the below statistics.

Despite the press’ consistent harping about stock market volatility, the SP500 was only a fraction as volatile (measured by the high minus low for the month divided by the beginning value) as the 3 month T-Bill and the spread between LIBOR and the Bill.  Yes, we can thank the Fed for this, but more likely this was an indication of money moving to the sidelines (cash like instruments) awaiting the right time to reenter…putting further pressure on the Fed.

And, as all fixed income managers know, January was exceedingly volatile in terms of spreads to Treasuries, as the yield curve continued its move toward a more ‘normal’ shape.

So, let’s not take our eyes off the ball.  Significant valuation changes continue to occur in the fixed income markets and some of them are a negative result for insurers (who typically hold ’spread’ product).  If you didn’t like your manager’s performance in Q4, you may not be too happy about Jan 08 either.

Can investment grade managers truly add risk adjusted value with ‘active management’?  During Q4 and, undoubtedly in January, the jury returned a ‘no’ vote for many.