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Tuesday, October 13th, 2009
With apologies to Marx and Engels, this may also sound like the clarion call for those responsible for regulating financial institutions.
We have already seen developed countries discuss how regulations on banking, derivatives, etc, can better be coordinated…all the better to keep the financial players from picking the best domicile for their activity.
And, now, we have the US Government looking to create a national office of insurance. Although the initial and ultimate authority of such a new department is still open for debate…even the insurance industry does not agree on what that should be…the trend is clear. Many regulators believe they must unite to throw off the yolk of the oppressive insurers who look for optimal domiciles or otherwise ‘game the system’. And, in some instances, insurers (some of who support an ‘optional federal charter’) are supportive of this view of the world.
Of course, in the insurance industry, the granddaddy of this approach is the National Association of Insurance Commissioners (NAIC), that trade association or regulatory body (I’m not sure even the NAIC agrees on which it is). The NAIC developed a unification tool called ‘accreditation’ to keep all its ‘members’ on the same page on key ‘model law’ issues. Yet, one of the most prestigious members, New York, takes the approach of a different Marx (Groucho), who said “I don’t care to belong to a club that accepts people like me as members.” New York remains ‘unaccredited’, preferring to buck the system, while still having a large hand in how it operates.
However, this misses something that we all should remember. Whether in banking or insurance, the regulators are ‘captured’ by the largest of those they regulate. In other words, the regulators must bend to the wishes of the largest firms they regulate, especially in difficult times.
If you don’t believe this happens in insurance, we have only to look at the topic of ‘permitted practices’, those actions that are OK for certain companies, but probably not for yours.
For example, the Insurance Underwriter recently reported that the number of life insurers using permitted practices increased from 25 companies in 2007 to 80 in 2008, and that the combined effect on surplus for those companies went from a reduction in surplus of $313 million in 2007 to an increase in surplus of $8 billion in 2008.
Capital out of thin air.
But, wait, there’s more.
The life industry is advocating relaxing capital requirements for many residential mortgage backed securities because using rating agency ratings are inaccurate. Their alternative would revolve around using third party modeling. But, isn’t the incorrect use of models one of the problems encountered by investors (and the rating agencies) in the recent financial crisis? Based upon continuing discussions, this proposal or something like it, may pass.
Regulators of the World Unite!
Indeed.
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Tuesday, October 13th, 2009
Although you probably won’t hear this from the economic analysis or similar palaver at your quarterly investment manager meetings, the crucial issue facing the US economy today is not the letter of the recovery. In fact, you may feel like your friendly economist is telling you that the economy is brought to you by a letter, V, U, W, much like an old Sesame Street episode.
But, the sad truth is that the US economy is facing a series of races between desirable and undersirable outcomes.
Submitted for your approval, here are a few inconvenient, yet likely truths .
1 - We are saddled with large zombie banks focused on drinking the blood of risk free net interest margin (between US Treasury purchases and zero cost reserves provided by the Fed) at no additional cost of required capital. This blood is important for the ongoing existence of most of the zombies (who try not to act like banks by earning net interest margin on the difference between loan and deposit rates). These zombie banks realize they will slowly be losing body parts in the form of credit losses. Those losses are hidden from sight due to loosened accounting rules, but they will eventually surface. And when the do, look out. In fact, at year end, the FASB may require many SIVs and the like be put back on the balance sheet of sponsoring banks. Ouch!
So, the question here is which zombie banks will get enough blood to offset credit losses and at what rate. Thus, ‘more blood’ is the refrain from these zombies and the US Government is obliging.
The race is on.
2 - In response to the ‘Greatest Deleveraging in the History of the World’, the US Government has responded with the ‘Greatest Releveraging in the History of the World’. Add the increase in fiscal debt with the increase in monetary debt (Federal Reserve) to increased indirect and direct guarantees (FNMA, FHLMC, GNMA, FDIC) and there is little wonder why the economy is recovering. The Government can not only ‘print money’ (mainly in the form of bank reserves right now), but they can ‘encourage’ bank purchases of US Treasuries to bridge the divide of a record fiscal deficit by providing zero percent (reserve) financing at the Federal Reserve.
However, US Government actions are subject to public scrutiny and therein lies the rub.
The Federal Reserve was designed to be independent of the US Government (including the US Treasury) and acted as such for decades. However, the actions noted above call this into question. I recently read an article about China’s ‘bubble economy’ and how a key for future Chinese economic growth will be the development of an independent monetary authority. Undoubtedly, the same could be said for the US.
And, one wonders how a possible next stimulus bill (it may not be called that from a political perspective), or added funding for the FDIC, or a bailout of the FHA/VA, etc, will be received by a wary public. It should be noted that the on again, off again economic recovery during Japan’s lost decade was occasionally thwarted by those who felt the prior stimulus was ‘working’, so why vote for another one. It should also be noted that during the Great Depression, FDR’s calls for more aid for the unemployed was met with cries of concern about people just deciding to go ‘on the dole’. So, there is history on the side of those who think the releveraging of the US Government cannot continue unabated.
Of course, a growing economy can make the size of the deficit, national debt and even the Fed’s bloated balance sheet seem a lot more reasonable.
Thus, the race is on between economic growth (and it is on the way in a big way, per the reliable Economic Cycle Research Institute) and the limits to growth of the ‘greatest releveraging’ of the US Government.
3 - Most sentient economists believe that ‘sustainable growth’ of the US economy will not come from releveraging, but from remixing the components of GDP. Decreased participation from consumers would be offset by increased participation from net exports (now a negative contributor to GDP). However, changing the US from a net consumer of foreign goods and services to net producer of such is no easy task. Thus, step one is the slow downward glide of the US dollar, including increased pressure on countries with currencies tied to the USD (aka China). However, declining currency valuations can also mean eventual inflationary pressures.
So, the race is on between a declining dollar, fewer net exports and incipient inflation.
The discussion of whether this economy is brought to you by the letter U, V and W is truly not the point. The key point is how these races are won and lost, and how they will impact each other as well as many other segments of the economy. A careful consideration of each will assist all investors in determining how best to position their portfolios.
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Wednesday, September 9th, 2009
It has begun in earnest. A reconsideration of the NAIC Model Investment Law. And, in the current regulatory and financial environment, it is easy to expect over done and/or misguided results ahead.
Here’s the background:
In the mid-1990s, over the course of four to five years, I had the pleasure of being part of the insurance industry’s ‘interested parties’ group that provided input to the NAIC about what should be in a "Model Investment Law." Eventually, in 2001, both a defined limits (specific percentage limits by asset class, security, etc.) and a defined standards (basically a ‘prudent person’ approach) version of the law was adopted by the NAIC.
Originally, the Model Investment Law was supposed to become an "accreditation standard", one of a host of model laws that were required to be passed by a state’s legislature, else the state would not have an NAIC accredited insurance department. Today, all states and the District of Columbia are accredited, except for New York….but that is a long story. However, since the Model Investment Law is not an accreditation standard, less than half of the states have adopted the law, while some have adopted only portions of it.
Today, we truly live in a different world than the one that existed in the 1990s, so the NAIC has formed a Working Group to consider material revisions to the Model Investment Law. By the end of this month, the Group will survey all states on potential changes - some are small and some are rather large. Of course, the NAIC being the NAIC, this Group is only designed to determine if changes should be considered. Should the group report that there is support for changes, the NAIC Executive Committee must then decide to form a different Working Group (probably with the same/similar state membership) to actually recommend changes.
Importantly, the existing Working Group is open to meeting (physically or virtually) with industry interested persons in this process. However, the path is clear. We can expect material changes in the Model Investment Law…eventually. And, if some changes are discussed, you can be assured others, currently not under consideration, may be discussed as well. It will take time, but the regulatory landscape for insurer investments will undergo material change.
If you would like to receive a copy of the upcoming survey questions to be provided to the insurance departments, please click here.
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Saturday, August 8th, 2009
With the latest slight improvement in that most political economic lagging indicator called the US unemployment rate, economic pundits are forced to take one or both sides of the argument.
Resolved, the US recession is over.
Though you may never see a formal debate format as indicated by such resolution, the issue here is real.
If the recession is over (defined as positive real GDP growth in Q3), hold onto your hats. Most of the previously approved stimulus funds will be spent in the months ahead and that will serve to further improve GDP growth. And that may cause much stronger GDP growth than the consensus of economic pundits expect. The most likely results – a continuing flight from quality, which means improving equity prices, continued tightening of credit spreads and upward pressure on commodity prices. Eventually, we would even start hearing more about when and how the Fed should ‘unwind’ its programs and even start raising rates.
But, if the recession is really in a Pythonesque ‘not dead yet’ mode, the upcoming stimulus spending will have some heavy lifting to do. Remember that the average consumer will continue to deleverage (and I have yet to find the average US consumer, though I see the parodied version nearly everywhere I look) . That means continued increases in savings, paying down debt, and holding back on spending. And, when 80+% of GDP is being held back, how can GDP grow very much, if at all?
The most likely case, though, is probably something that most economists are not contemplating – primarily because the consensus, from which they seldom depart very far, has not been discussing it.
As low inventories are getting replaced, the economy will undoubtedly find its way out of recession either this quarter or Q4. However, how long can GDP growth last if the aforementioned average consumer is holding back spending? Will inventory replacement require job gains at some point, which will make consumers more sanguine?
And, therein lays the rub. GDP growth is undoubtedly on the way, but its level of sustainability is questionable. And, for investors, this means things may continue to get better in the short run, as the flight from quality continues. However, there are mighty big mountains to climb, as the ‘Greatest Deleveraging in the History of the World’ will continue.
Helping the economy climb those mountains will continue to be bailouts in several guises. As stated in our blog posting of November 30, 2008 (“Two Key Questions about the Great Re-Leveraging AKA Bailouts”), the US government (that would be ‘we the people’) is attempting to offset this great deleveraging. And, as we all have seen, success in doing so has produced uneven and politically controversial results. Alas, we can expect more political posturing to impact future bailout moves using existing or previously unannounced activities. The bottom line for investors: It is likely that the flight from quality will continue (subject to an unknown geo-political event temporarily reversing that flight), but whether it will continue past the next few quarters remains a huge question.
Thus, the question of what happens AFTER we see positive GDP growth is a discussion insurers should be having with their investment managers today.
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Thursday, July 9th, 2009
In one of Charles Dickens’ greatest works, Great Expectations, the protagonist, Pip begins life as an orphan, slowly rising in social standing towards what many consider a successful end.
In one of the Adminstration’s most ballyhooed efforts to cure the current financial and economic crisis, it established its own PPIP (Public Private Investment Partnership) program.
PPIP was designed to basically act as a sort of ‘off balance sheet RTC’ that would get toxic assets (loans and securities) off of banks’ books. As you may remember, the RTC was designed in the 1980s to do the same and it worked quite well, although the costs were large and did indeed seep onto the Federales’ books. And, therein lies the reason we have PPIP instead of an RTC II. PPIP’s creation did not require Congress to act.
Someday someone will be able to explain to me why the government of the world’s largest economy requires decisions made by people with little or no economic or financial background, unless you count Congress’ ability to count their campaign commissions (I mean, contributions).
Be that as it may, PPIP’s Great Expectations were really split in two: A ‘legacy loan’ program and a ‘legacy securities’ program. However, as Dicken’s Pip had to learn the ways of the world, so did the Fed and US Treasury.
You see, no bank in its right mind would sell loans held at near book value at a sufficient discount to make the PPIP ‘legacy loan’ program work. It would crush their capital levels, which were already being supported by the Federales’ TARP program. Even though some banks have paid back their TARP money, the last thing bankers need are more capital hits….especially if it would cause them to return to the TARP window. Thus, the ‘legacy loan’ program will undoubtedly soon be used as a dumping ground for banks that have no choice but to participate: those taken over by the FDIC.
Now, PPIP’s Great Expectations have been tempered by that reality and the size of the program has been toned down, but still with plenty of leverage supplied by one of our most overlevered institutions, the Federal Reserve (take a look at their latest balance sheet and you’ll see assets only about 2% greater than liabilities…physician, heal thyself).
It begins with the Treasury choosing nine investment managers to be involved in managing PPIP assets. The nine then become cheerleaders for PPIP (much like Pip’s supporters in the book), raising funds to invest in ‘legacy securities’. Such securities were at one time AAA rated (but just don’t look at their rating today) or are currently AAA rated. They are to be non-agency residential and commercial mortgage backed securities.
These securities would come from any institution ready to unload them…at market prices. But, what are market prices? In reality, the most troubled of these securities are undoubtedly being ‘marked to model’, a standard now embraced for ‘illiquid’ markets by both GAAP and STAT accounting. And, most institutions’ models may be quite a bit sunnier than the models used to determine the price that the nine cheerleading managers will pay for them. This pricing crevasse may or may not be bridged by all that cheap Federal loan money, but this has yet to be proved.
Alas, as Dickens’ Pip would undoubtedly realize, timing is everything. Until the accounting poobah’s were forced to change from ‘mark to market’ to ‘mark to model’ by Congressional pressure (i.e. bank and other financial institution lobbyists), PPIP’s ‘legacy securities’ program had a much better chance of being successful. Thus, PPIP’s Great Expectations may be further tempered by the reality of accounting rules that have made it easier to hold these securities instead of sell through PPIP.
You will hear the cheerleading nine telling us that the revised PPIP will provide pricing support to nearly all similarly rated non-agency RMBS and CMBS in the short term. And, this may very well be true. However, it is obvious that PPIP must have many other changes in its future in order to be successful, just ask Mr. Dicken’s Pip.
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Thursday, June 25th, 2009
According to Barnert Reports it appears that the NAIC has adopted the "Application of the Fair Value Definition" (INT 09-04 T, if you are keeping score). Although it may be further changed by work done at the Statutory Accounting working group, this new accounting pronouncement for statutory financials opens up a new world for many insurers.
Securities where ‘fair value’ is difficult to ascertain due to illiquidity or related reasons could now be priced based upon a ‘modeled’ value instead of the incredibly low, low price provided by independent third party pricing services. This will be especially useful for insurers holding structured securities showing values that make no sense at all when reviewed on an economic, ‘worst’ case basis.
Although insurers generally hold bonds at amortized cost (book value), those ugly Other Than Temporary Impairment (OTTI) rules rear their ugly heads when ‘fair value’ is materially below book value for a period of time. But, under INT 09-04 T, fair value could be modeled value — albeit based upon a discounted present value under another new rule, SSAP 98, for structured securities.
This raises lots of interesting issues like:
1 - Comparability of statutory financials - my valuation of the same bond may be different from yours, and that can directly impact my bottom line…and yours. Why does this have the possibility of becoming a ‘race to the bottom’ in modeling quality?
2 - What role will the SVO have in all of this? Doesn’t the SVO post pricing that must be followed by all insurers? Now, your company can act as its own SVO when it comes to fair value.
3 - Since all of this ultimately impacts measures like BCAR, regulatory capital, etc, will companies on the financially weak end of the spectrum be able to look better with a few changes to a spreadsheet?
4 - Until we see the pronouncement in final form, we are uncertain as to implementation date, but if might be ASAP. Given the last minute nature of this change, are all insurers aware of this?
Just as in the recently issued GAAP pronouncements on fair value that allowed banks to pump up their results and capital, this STAT change may have some very interesting side effects. Everyone wanted a better way to value securities fairly, but sometimes we should be careful what we wish for…we just might get it.
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Thursday, April 23rd, 2009
Towards the end of last year, Bank of America, apparently seeing a depressed valuation for Merrill Lynch and lusting after their considerable retail distribution network, agreed to purchase the firm. According to BofA’s CEO Ken Lewis, though, there was more to the story, as he now tells the NY Attorney General that he was pressured into the deal by then Treasury Secretary Paulson and current Fed Chair Bernanke.
This may seem completely plausible - remember that the Federales got the big banks together at a low point in the current crisis and told them they were all going to hang together instead of separately - and take various amounts of TARP money. However, CEO Lewis’ defense sounds peculiarly like someone trying to find an excuse for a bad transaction and an attempt to keep his job.
We do firmly believe that the current lack of independence between the Fed and the Treasury is troubling and should (probably will) be addressed by Congress at a later date. However, blaming them at this stage for a seriously poor investment decision is much like comedian Flip Wilson’s lament as the irrepressible Geraldine, "The devil made me do it."
The ’story behind the story’ on this could very well go back to the soon to be unveiled and, probably misnamed, stress tests of major US banks. Undoubtedly CEO Lewis knows how the venerable BofA will look and he realizes that the upshot may be that he will have to fall on his sword, as well as see any legacy trashed, in order to avoid complete loss of shareholder value.
Perhaps Mr. Lewis could take heart in another of Mr. Wilson’s sayings, "You can’t expect to hit the jackpot if you don’t put a few nickels in the machine." Alas, Mr. Lewis played more than BofA could reasonably afford to lose.
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Thursday, April 23rd, 2009
Put this one in the ‘Ripley’s Believe it Or Not’ file.
Apparently at the March NAIC meeting the SVO Initiatives Working Group was charged with examining how the Securities Valuation Office could be expanded into a nonprofit ratings agency. OK, stop reading and go back and read that last sentence again.
Could the SVO become a true rating agency? Can you teach fish to swim?
Everyone knows that simply using the credit ratings published by the existing NRSROs for bonds, etc, has been a huge problem….and that the NRSRO economic model MUST change either by market forces or fiat. That’s why we are constantly asking investment managers for their independent assessment of credit.
However, the SVO as a guide for credit ratings? Virtually everyone on the investment side of the insurance industry knows the SVO is ill-staffed and too poorly organized to consider performing such a function, and that its main function is largely to serve as a security blanket for regulators.
Is this just another way for the NAIC to find job justification as the heavy hand of federal regulation descends upon the insurance industry in some form? Probably, and we have already seen it elsewhere, as the NAIC starts to reconsider the Model Investment Law.
Meanwhile, the Rating Agency Working Group was charged with examining the reliance on ratings from Nationally Recognized Statistical Rating Organizations (NRSRO) by the NAIC and insurers. This has the potential to move insurers from being able to use the provisionally exempt (PE) designation for ratings, and go back to the "kaching-kaching" of paying the SVO for merely referencing a translation table.
As tennis great John McEnroe yelled at many a regulator (umpire), "You Can’t Be Serious!" Alas, in this case, the NAIC, worried like crazy over Federal involvement, is undoubtedly very serious. Mr. Ripley may have to open a new wing at the museum.
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Tuesday, April 7th, 2009
That seems to be the message from the respected Economic Cycle Research Institute, whose weekly index of leading indicators has started turning up and seems to be staying above cycle lows during Q4. Economic activity in the US does seem to be contracting at a lesser rate and this is telling us that light at the end of the tunnel may not be an oncoming train.
As the Federales continue their quest to become the largest hedge fund in the world, leading the greatest Re-Leveraging in the History of the World, recovery will get here eventually. However, there remain questions about the medium and longer term impact of this Re-Leveraging, including the eventual rise of inflation and over-regulation…
On the accounting front, expect the theme of less worse to continue as new FASB pronouncements will allow banks to create capital (via retained earnings) out of what some may call ‘thin air’. Combine positions on OTTI and FMV with the ability to restate historical ‘non-credit related’ OTTI losses from retained earnings to accumulated Other Comprehensive Income and regulatory capital rises (while total shareholders’ equity stays unchanged). When the FASB caves in, it does so big time…and one would expect international accounting standards - where they have not done so - to follow suit. More fuel for ‘less worse’.
And as we all see and hear, at this ‘less worse’ period, there are always fascinating commentaries going around. Perhaps one of the most interesting was a former bank regulator who called the Federales’ bank stress tests a sham, designed to fool the American people. This could very well be true, but stress test impacts might easily be offset by accounting and related machinations.
It reminds me of the punchline to the old joke about the guy trying to find a new accountant.
"How much is 2+2?," asks the client.
"What do you want it to be?" replies the accountant.
"You’re hired!"
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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.
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Welcome…
Friday, March 2nd, 2007
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. |
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