Far be it from me to improve upon the excellent, though government shielded, coverage of the credit default originating in Dubai. Apparently rooted in a hangover from a major commercial building boom, this default does have some parallels in Western economies. 

They say if you want to get out ‘bad’ news, the best time is on a Friday evening.  Even better is on the day before a major holiday, like Thanksgiving.   Well, Happy Thanksgiving!

It seems our friends at the NAIC have been reading the public relations playbook and just released an outline of the new non-agency RMBS modelling performed by PIMCO.

I have been assured that this will be used for determining risk based capital (RBC) factors only.   And that issues such as impairment, will not be addressed by this methodology.  However, let’s put that in perspective.

You have valued a bond at 85 – no review for impairment necessary per policy as it does not impinge on the typical ‘below 80% for more than six months’ standard.  PIMCO, in the infinite wisdom of their arbitrary model (see below for more on this), decides that valuation is 70. 

The reasonable news on this:  If you want to carry it at 85, you will have to allocate more RBC than a company holding the same bond and valuing it at 70. 

The problemmatic news:  Your auditor sees the valuation and says, ‘This should probably be impaired since that’s what the NAIC (PIMCO) says.  In fact our audit firm audits both your company and the one holdling the bond at 70, so take the write down…but atleast you won’t have to maintain as much RBC.’

As noted in my prior post, if you are a large, leveraged life insurer, RBC is more important than the earnings hit.  Adequate RBC is tied to survival, while earnings is more transitory.  However, across the entire insurance industry, the earnings hit and subsequent disclosure is much worse than holding more RBC, since capital is usually not as large an issue as earnings.  As noted previously, score one for the large life insurers.  Those hefty dues to the American Council of Life Insurance sure look like a good deal for them.

But, what of PIMCO’s model?  It looks like a relatively common approach to modeling non-agency RMBS.  And many of the details ‘under the hood’ still appear hidden in the latest memorandum from the NAIC.  However, one item not hidden is a very key assumption,  Expected home price depreciation or, peak to trough HPA, as shown below:

This deserves a few comments:

1- This assumes geography has zero to do with HPA declines.  More sophisticated models tend to use this very significant factor when using HPA as a driver in determining incidence and severity of loss.

2 - Recent readings of Case-Shiller indices show a slowing in HPA declines to a leveling in some areas.  Is it reasonable to assume further declines?  I do not know the answer to this, but it is a very difficult and important point tied to the ‘most likely’ case of slow economic growth versus a double dip recession in the future.

Besides my nagging feeling about ‘conflicts of interest’ when an investment manager of assets, including RMBS, is called upon to value such assets for regulatory purposes, I remain concerned about the use of these arbitrary valuations.

Will they produce ‘more accurate’ RBC than the ratings? Perhaps, perhaps not.  Remember, we all got into this mess relying upon inadequate models.  Who is to say that PIMCO’s modeling for the NAIC will not prove just as inadequate?

Will they produce problems when auditors notice your company’s valuation, based upon perhaps more strenuous modeling than PIMCO’s, has a higher value than PIMCO’s valuation, prompting concerns about impairment?  I don’t see how they won’t.

This chart seems reasonable, prima facie, since the relationship between expected loss and SVO rating are similar to that imbedded in the NAIC risk based capital models.