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Tuesday, February 1st, 2011
We begin this year with a list of ‘one hundred year flood’ type events: Possible regime change in Egypt and, Major snow and ice events in the US.
With all this excitement, it is easy to lose track of some rather interesting items that can impact insurer investing.
First up is the nascent call to ‘Break up the Auditors’.
It is a movement starting in Europe, but still bears watching: The European Commission’s Internal Markets Commissioner, Michel Barnier, is floating the idea of imposing a break-up on KPMG, Ernst & Young, PwC and Deloitte, which between them mop up two-thirds of all listed company audits in the UK including all but one of the FTSE-100. This was followed by a similar call from public companies, including insurers Standard Life and Aviva. (a hat tip to Michael Smith at IFRS4Consulting for noting this).
Second is a more immediate focus for US insurers.
AM Best is scheduled to release its 2010 SRQ filled with challenging ERM related questions. For example: Do you have a Chief Risk Officer (or senior equivalent) who is responsible for coordinating ERM? How about a formal ERM committee?
Or, how about: If your company uses an EC (Economic Capital) model to quantify aggregate risk…do you use the EC model to make strategic business decisions? And, if your company does not use an EC model…describe how you determine capital adequacy and allocation of capital to business units, lines or risk categories? (Something tells me that saying you use the BCAR model for capital allocation will not be a good answer…)
Concerned about this and what it might mean for your company’s ratings today and in the future?
Undoubtedly, this will be one of the many items discussed at our Insurer Investment Forum XI in San Diego, March 30-31. Early bird registration for insurers ends February 11. Here is a link to the agenda and the conference ‘home page’ for more details.
Finally, there are many future paths that the global economy and financial markets may take. One rather nasty, though plausible, possibility comes from Oliver Wyman in their latest tome: “The Financial Crisis of 2015: An Avoidable History”.
Welcome to a world where the risk being forced out of the Western banking sector due to tougher regulation flows into a shadow banking sector (relatively unregulated institutions and pools of money). From there, investments are made in commodities and related sectors that increase in value like topsy before crashing. This would trigger sovereign debt restructuring. In other words, instead of sub prime mortgages unleashed on investors, it will be a commodities led bubble due to increased real demand (from growing developing economies) and increased investment demand (from institutional and other investors looking for ‘non-correlated’ inflation hedges).
OW unveiled this scare document at the recent annual meeting of the World Economic Forum in Davos. So, of course, it is getting some amount of notice in the press.
Just one question from this ‘peanut gallery’: If we all think a bubble will occur in a given sector and try to avoid it, how can it happen? I guess OW believes in the inevitability of some things.
Instead, I give us frail humans a bit more credit than that.
As far as inevitability, I will side with Ben Franklin who said, “Our Constitution is in actual operation; everything appears to promise that it will last; but in this world nothing is certain but death and taxes.”
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Monday, December 6th, 2010
Sunday night, as part of his ongoing efforts to add to communication efforts at the Federal Reserve, Chairman Ben Bernanke told viewers of the venerable 60 Minutes that the Fed would not hesitate to increase the size and scope of it asset purchases (i.e. more “quantitative easing”).
We continue to be mystified by the logic used by the Fed to justify QE (i.e. how will the ‘wealth effect’ get overleveraged consumers to buy, buy, buy?…how will the ‘wealth effect’ get ever cautious large businesses to invest, invest, invest when their customers are cautious?…how will the ‘wealth effect’ get banks with more hidden losses to lend, lend, lend to consumers, let alone, non-publicly held businesses?…and how can buying US Treasuries both lower rates AND increase inflation expectations?).
But, let’s assume that QE will do more than simply push up securities prices and continue to help the ongoing repair of the balance sheets of large banks to whom the Federal Reserve most definitely defers, if not serves and protects (like the slogan of the Los Angeles Police Department).
Let’s return to what started this economic crisis and dislocation, The Greatest Deleveraging in the History of the World. The Fed (and the US Treasury through government fiscal policy) has met this major cause with The Greatest Releveraging in the History of the World. While all the media churns over the size of the deficit and debt (fiscal policy leverage), let’s take a look at leverage at the Fed.
What if you were running a financial institution with 56 million in capital supporting 2.3 billion in assets? Would the regulators close you down? With a capital ratio, just a little better than 2%, it would only be a matter of time, probably measured by the hands of the clock.
But, what if that same institution decided to grow to 3 billion in assets. Make that capital ratio less than 2% and you can just picture that ‘cease and desist’ order from the regulators.
Now multiple those numbers by 1,000 and you get a look at what the Federal Reserve System’s balance sheet looks like before and after the announced round of Treasury purchases. And that doesn’t take into account the accounting basis (fair value, cost, etc) for those assets and liabilities.
When will the markets (and the public) think that this leverage is too much? Of course, the Fed could easily ask Congress for a capital contribution, but at what point will the markets (and the public) realize that this is all a continuance of moving money from the ‘left pocket to the right pocket’…and not a true economic transaction?
Of course, we may not appreciate Professor Bernanke’s monetary experiment, but we all are subjects within it. And, that means that we must carefully look at its impacts.
That starts with performing a sensitivity analysis of how low and lower interest rates will impact your company’s investment income over the next few years. Do not be surprised that, especially for long tail lines of business, lower rates will severely hurt income as the impact of compounding interest at lower rates, takes its toll at an increasing rate as durations lengthen.
Of course, the flip side of this is that QE2 ignites higher rates., with the prospect for higher investment income. But, if this is due to inflation, it may negatively impact reserve calculations for many lines of business.
Financial markets will eventually catch up with the reality of the Fed’s overlevered situation and require changes in their modus operandi.
When that happens (as the markets have pushed some Euro economies), change will be swift. Rates and spreads may rise to unjustified levels temporarily, and, perhaps the US may not be seen as the ‘safe haven’ of the world’s reserve currency any longer. Thinking ‘outside the box’ and understanding how these macro dvelopments may impact your company’s investment philosophy are vital at this stage in the battle between private deleveraging and public releveraging.
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Sunday, September 26th, 2010
As the “Greatest Deleveraging in the History of the World,” continues along a bumpy road, with the bumps created by well-meaning political leaders, one must sit back and ask what we can learn from the past in order to better understand the present.
I would relate current US fiscal and monetary policy to a form of Asian (con)Fusion, which is leading to what I would call bi-modal financial markets.
Many of us have eaten at a Chinese, Japanese or even Thai or Vietnamese restaurant before, but once in a while you may have stumbled upon an Asian Fusion restaurant. The Fusion refers to either the offering of multiple types of Asian cuisine or the melding of those Asian cuisines into a single dish….much as we find in US policy today.
Let’s start with what the US told Japan when its banks faced massive credit problems from declining asset values in the 1990s. Quite correctly, the Americans told their democratic counterparts in the Far East to let the sick banks fail and make room for a repricing of risk – in essence, a clearing of the market so it could function efficiently again. The Japanese politely said “no thank you” and considered the socio-political costs of a major bank crisis to outweigh the quicker resolution of economic problems.
Facing a similar dilemma in 2008-2009, the US Government looked back at what it told Japan in the early 1990s and just as quickly went for the same ‘zombie bank’ solution instituted by Japan against the urging of the US Government. What goes around comes around, and the US now faces a similar bout of low, slow growth for an extended period of time, while all players in the economy (except the US Government) do their best to deleverage in their own way.
Want to see banks lend money for business, real estate purchases, etc? Sorry, with hidden losses of unknown ultimate size on their balance sheets, large banks are not about to ease the lending spigot. And, smaller banks, paying for their rush to yield (higher risk, RE development loans in many cases), have neither the current capacity, nor any real hope of raising capital to offset losses.
Oh, but if we kept interest rates close to zero, surely banks will lend and the economy will be kick started? At least that is what the Federal Reserve thought. Of course, the reality goes back to the type of lending being discussed.
Corporate bond markets are their healthiest since the Lehman closure of 2008, as these large companies provide public information and have a greater, more diversified economic footprint than smaller companies. Bank lending to those smaller companies continues to shrink, despite zero short term rates. So, I guess Chairman Ben gets a 50% on his report card – still an ‘F’ according to typical grading scales. And more quantitative easing – buying US Treasuries to help out his fiscal “compadres” – would produce the same result, while easing the way for cheaper Treasury issuance (nothing beats the terms you can give yourself on a loan).
But, what if the US instituted the Chinese policy of mandating loans to businesses? It seemed to help keep China out of the global recessionary soup, right? So far, so good, but we all know many of those banks are government run and many of those loans were made to government run enterprises. And, besides, it takes some time before a bank knows that it has actually made a bad loan.
Undaunted, the US Government is in the process of providing incentives for banks to lend to small businesses.
Some banks say, ‘no thank you,’ not trusting a Government that might change the rules of the game and make senior management’s lives miserable. While, other banks, thirsting for a lower burden from the TARP funds they received to keep ticking, will take the bait. How effective this program will be to kick start the economy remains to be seen (small businesses do tend to move quicker in adding to payroll than more conservative, slower moving, large companies). However, has anyone done an analysis of what unintended consequences the success of the new small business lending bill may bring? Will it be a Chinese style temporary surge in economic activity or only a blip on the radar screen of economic growth?
The lessons to be learned from the US’ Asian (Con)Fusion economic policy are this:
1 – “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. However,
2 – There exists the possibility that these and future Government efforts to accelerate economic growth may succeed in the short term and cause some rather severe disruptions in financial markets. Thus,
It is highly likely that we are facing bi-modal financial markets at this time. Put simply, markets can do quite well, or quite poorly with a greater probability than expected by all those fancy Markowitz efficient frontier models. With that in mind, it is more important than ever to stress test your company’s portfolios for ‘worst case’ scenarios (you can stress test for ‘best case’ scenarios, but ‘best case’ results are typically not a concern). There are many ways to do this, from several different perspectives such as market value changes, credit write downs, spread changes, yield curve changes, inflation/deflation impacts on both sides of the balance sheet, etc.
Finally, with the US Government’s continued policy of Asian (Con)Fusion, perhaps we all should keep in mind a few of the quotes from the great Chinese philosopher, Confucius:
"To know your faults and be able to change is the greatest virtue."
And
"Knowledge is recognizing what you know and what you don’t."
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Wednesday, June 2nd, 2010
Soon after I wrote about the ‘Restructuring Dance’ helping to maintain the climate of greed in financial markets, the cycle swiftly turned.
The ‘Dance’ ended quickly as none of the dancers requiring restructuring took to the floor.
Neither Greece, nor other highly levered sovereign credits, nor Wall Street, nor the rating agencies took the restructuring tango. With no other good solution posed and no restructuring in the offing, the markets quickly entered fear mode.
But, it was deep concern more than fear that emanated from the participants at our company’s recent Insurer Investment Forum X. Although some saw opportunity within the growing clouds in financial markets, many indicated concern for what may occur in the months ahead.
It is quickly becoming apparent that although the ‘lifeguards’ (governments) have rescued the banking sector to some degree, the major issue now is ‘who will rescue the lifeguards?’
At IIF VIII (March, 2008), I noted that we should expect, "The Greatest Deleveraging in the History of the World." Then, at IIF IX (March, 2009), I observed that the governments have followed the greatest deleveraging with the greatest re-leveraging.
Now at IIF X, I noted that we are entering ‘Obscure Deleveraging’. If you think understanding the financial statements of a large financial concern is difficult (especially those with material off balance sheet and contingent liabilities), imagine trying to understand the financials of a government (with even more off balance sheet and contingent liabilities).
Fully understanding the amount and timing of the ‘Obscure Deleveraging’ at the governmental level and its impact on their close cousin – the banking system – will be a key tool in understanding the future of the global economy. And, I do mean global economy.
As the US economy has recovered from recession, its respite from recession may be limited in size due to a global slowdown. The Economic Cycle Research Institute’s latest Weekly Leading Index (WLI) tells us to expect materially slower growth towards the end of this year.
“The downturn in WLI growth evident since early 2010 has recently intensified, so it should be no surprise when U.S. economic growth slows noticeably in the months ahead,” said Lakshman Achuthan, managing director of ECRI.
In Asia, Japan grapples with its own set of problems, beset by deflationary trends, an aging demographic and growing debt (perhaps sounding like the US in the near future?).
But, what of China?
Most likely, stability is very important to the ruling Communist Party, and stability is quite difficult when trying to rein in runaway real estate prices and banks following ‘extend and pretend’ to the n-th degree.
Other speakers at the conference provided a glimpse of what to expect from the regulators, AM Best and the auditors (yes, we discussed mark to market and the move to IFRS – look out). But, we also heard about silver linings to be found in many insurer’s commercial mortgage portfolios (versus those found at banks where underwriting standards slipped materially) and in opportunities (albeit a few basis points) in short term investments.
But the issues of what to expect in the uncertain times of ‘Obscure Deleveraging’ remain.
For insurers, “Obscure Deleveraging” raises several issues, including:
What should our equity v fixed income allocation be? A slowing economy, coupled with disinflation and/or the threat of deflation, should mean downward pressure on rates (perhaps offset by rising spreads). But, such a scenario may wreak havoc on expected equity returns. If deleveraging lasts a long time, that may impinge on future expected equity returns for some time.
And, if we are concerned about ‘obscure deleveraging’, should we not try to avoid or materially reduce investments in those sectors directly facing such activities?
First in line, of course, would be deleveraging governmental entities, but next, in line, I believe, would be large financials – owners of those government bonds and obfuscators of sufficient disclosure of their financial risks.
This becomes a more important issue with the highly likely passage of ‘financial industry reform’ in the US Congress. As I understand it, the likelihood is that there will be no protection afforded investors in these financials’ debt, such as we saw in the last major bailout by the government.
That means, the financials must stand on their own…but on what ground?
It is difficult to understand their ability to stand on their own when there is way too little disclosure of the risks and way too much obfuscation of off balance sheet and contingent exposures. This new law, coupled with continued obfuscation on financial reports, will undoubtedly make investment in the financial sector’s bonds or equities an increasingly dicey proposition.
Of course, all is not ‘doom and gloom’. We’ve noted a US slowdown, not a recession, despite global issues.
However, in a world of ‘Obscure Deleveraging’, we must simultaneously plan for the most likely – low, slow growth in the US. – while considering a reasonable ’worst case’ scenario.
Our ability to do that was perhaps best challenged by F. Scott Fitzgerald. Writing in 1936, as the world struggled to exit the icy grip of the Great Recession, he correctly provided the backdrop for portfolio management today:
"The test of a first-rate intelligence is the ability to hold two opposed ideas in the mind at the same time, and still retain the ability to function."
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Friday, April 23rd, 2010
Financial markets have continued to be buffeted by some bad news, which has mostly been ignored. Meanwhile, key indicators like bond spreads and equity levels have recovered from, and in many cases improved beyond, where they were when Lehman Brothers was forced to bid adieu.
Thus, it seems like we may be entering the greed phase of the fear/greed cycle, but how far with this phase run?
Maybe longer than you think, as long as the Restructuring Dance continues.
Let’s start with sovereign debt problems and one of the cradles of civilization, Greece. The problem of getting all of the largest economies in Europe (except Great Britain) to agree on a single currency and a single source of monetary policy, but leave fiscal policy to each member state has finally arrived….thanks to the Greatest Deleveraging followed by the Greatest Releveraging in the History of theWorld.
With more sovereign credits in Europe ready to follow the Greek path, there are two unthinkable alternatives to restructuring:
Get the EU countries to agree to have a single ruling body for pan-European fiscal policy, or end the single currency experiment.
Oh, there is actually one more unthinkable, yet possible alternative: Let each troubled country go bankrupt and then restructure its debt. Sounds like restructuring on the front end would be much better.
Restructuring must also occur on Wall Street.
Although Goldman Sachs is now in the SEC’s sights, do not think that the rest of the Street has clean hands. As noted in last week’s From the Northwest Quadrant, the issue here is one of imbedded conflicts which must be met with a strong dose of caveat emptor. Irrespective of what is being jawed about in D.C., the Street must come to the realization that some kind of restructuring in the way business is done must occur. Whether this means the Volcker solution, the trading of all derivatives on an exchange, and/or something else is unknown.
Expect sounds of restructuring to come from Wall Street once they realize the obvious this time: All of the protection money they want to throw at Congress won’t stop our commissioned salespeople in D.C. from being more concerned with getting re-elected (amidst a sea of anti-Wall Street angst) than getting cash payments.
Next up on the restructuring list are the rating agencies, lackies to the Street’s desires to churn out more complex and opaque securities. The conflicts imbedded in the rated paying the raters are obvious and ripe for Congressional bloviating.
Perhaps the rating agencies will also come forth with a restructuring proposal of their own; though, it will take more than bloviating for this to occur. Rating agencies are rather nebulous creatures for the average voter. Large banks have large buildings which make them much easier for the voter to despise.
If you are trying to level the playing field, should you really be lowering the bar at the same time? Yes, say the agencies, pointing to consistency across their global platform. Proving that consistency may be the hobgoblin of rating agency minds.
It certainly is starting to feel like we are entering the greed phase of the markets; and the creativity behind restructuring will undoubtedly allow it to roll along for some time.
But, as during the subprime craze, we must ask, “How long will this be going on?”
Or, as the 70s rock group Ace once prophetically sang:
How long has this been goin’ on?
Well, your friends with their fancy persuasions
Won’t admit that it’s part of a scheme,
But I can’t help but have my suspicions
‘Cause I ain’t quite as dumb as I seem.
And you said you were never intendin’
To break up our scene in this way,
But there ain’t any use in pretendin’,
It could happen to us any day.
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Sunday, April 18th, 2010
By now, you’ve undoubtedly read about the SEC action against Goldman Sachs related to its structuring and sales of a certain subprime CDO.
But, what you’ve probably not read about yet is much more interesting.
Let’s harken back to the ‘sub prime crisis’, which quickly evolved into the Great Recession. And, which SAA warned about in this blog providing even the most recalcitrant investment managers sufficient time to sell all of these securities (though few did).
If you want to ‘win’ at the sub prime crisis, why not have inside information?
Know about both sides of the trade at all times. And that goes beyond the alleged information shared between hedge fund maven Paulson and Goldman, while the Abacus CDO was being used to calculate profits.
Why not own the servicers and/or originators of subprime mortgages?
Then, you would know more about the underlying mortgages, their initial state and their ongoing performance, before anyone else on Wall Street. As we have read, this was the case for some investment banks.
Why not shield this inside information from potential investors by providing ‘average’ statistics as a guide?
“We’ve done an analysis,” the investment banker would say, “and the average FICO score of the pool is 720.” Of course, they don’t tell you if the range of scores is 710-730, or if you’ve got one quarter of the pool with very low FICO scores offset by the remainder with very high FICO scores. Or, they don’t bother to tell you how the FICO scores, themselves, can be gamed.
Or, how about, “our analysis shows an average Loan to Value at origination of 77%”. Could that really mean that a quarter of the pool are LTV’s of 100% and three quarters are at LTV’s of 70%?….before the heart stopping dives in real estate values we’ve seen?
Some investors, looking beyond the ‘average’ statistics and doing their own detailed, independent research saw trouble coming in subprime years before it actually occurred. They wanted to ‘short’ subprime, but, at first, there was no investment product or derivative available to them to do so.
That’s where some of the large investment banks come in, developing tools like derivatives, CDOs and the like, at break neck speed and finding investors still ready and willing to take the ‘long end’ of the subprime bet…including themselves.
Some investment banks were caught relatively unaware about how bad things would get and were slow to realize that the ‘short end’ of the subprime bet would prevail. For Lehman and Bear Stearns, that approach contributed to their demise. For Goldman, coming to this realization allowed them to profit from the ‘short end’.
Back to the SEC charges:
Did Goldman commit fraud by not revealing the way in which Abacus was structured? Although determining ‘fraud’ will be left to the courts and Goldman has always stated that it always operates ‘within the law’, it is likely we will discover that Goldman acted unethically.
Did other investment banks act in a similar fashion – effectively using inside information – to shape their opinion and investment philosophies about subprime? Of course, they did. It is pretty hard not to use what you hear from each side of a trade in making a case for your firm’s risk/reward position.
However, was there other inside information – beyond trading facilitated by investment banks – that was illegally used to fashion the firm’s investment stance? For that, we will rely upon the courts. However, the obvious ethical problems remain.
Investment managers owned by investment banks or broker/dealers always tell us there is a legal ‘firewall’ between the bank and the manager and, this is undoubtedly true. However, the issue here is not legality but how ethically the firm acts. Do you want to deal with a firm (either as an investment manager or as a firm that your manager trades with) that acts unethically? And, where do you draw the line?
Hopefully, the SEC case against Goldman will not solely be discussed from a legal standpoint.
“Caveat emptor” is what comes to mind when dealing with investment managers, broker/dealers and others in the investment space. And, as we have been saying for some time, you must spend time understanding the motivation of the group on the ‘other side of the trade’ as well as their business model for generating revenues.
With the SEC action against Goldman, things may seem to have gotten a whole lot more complicated in the financial markets. But, it really has been like this for a very long time.
The question remains: How will you now practice ‘caveat emptor’? And will that practice prove up to the task?
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Monday, April 5th, 2010
California gubernatorial candidate, Steve Poizner badly trails in the polls to his competition in the upcoming Republican primary, 63-14%, according to a recent Field Poll. So, when you’re so far behind that the leader can barely see you in the rear view mirror, what do you do? Either continue to say you are for ‘mom and apple pie’ or find an evil to denigrate.
And, California Insurance Commissioner Steve Poizner has indeed found an evil in the current Iranian regime. The Candidate has instituted a one Commissioner jihad against insurers who invest in securities with links to Iran. Publishing an arbitrary list of these ‘bad’ investments, he has requested that any insurer doing business in the Golden State sell these investments and pledge by April 2 to never invest in them again. Candidate Poizner has threatened to publish a list of insurers who do not comply.
Last we checked, no state insurance commissioner has the authority to conduct foreign policy on behalf of the United States. Thus, it is not surprising to see today’s news that five insurance trade groups have taken legal action to stop implementation of such regulations. The groups set forth the usual reasons for their case, including the ‘where will it stop?’ defense, as well as a reference to existing and pending Federal law concerning doing business with Iranian related entities. However, the Candidate’s actions are not that unusual. Commissioners who are current or potential candidates tend to use their current position as a platform for their own agenda. And, this will mean, from time to time, that investments will come under fire. It has occurred in the past and will undoubtedly occur in the future.
But, in his current vilification of a very narrow type of investment, the Commissioner is misrepresenting his mandate to protect policyholders.
If he wants to protect policyholders from poor investment practices, then promulgate regulations that foster improved investment processes across various types of insurers. Of course, this would require the Insurance Department to have sufficient expertise to judge such practices, but shouldn’t competence be required of our state and federal agencies, or am I asking too much?
And, such a focus on the investment process would require a more measured and nuanced approach than is found in the ‘cookie cutter’ approach to regulation now primarily utilized. Importantly, it would be very difficult to grab headlines, but it could be worthwhile for both insurers and policyholders.
We are in no way suggesting that state and/or federal authorities should regulate investments any more than they do now, just that they could be taking an improved, more productive approach: one that would be focused on competence not on politics.
Mr. California Commissioner, if you want to protect your policyholder constituents from bad investments at their insurers, focus on the process.
Is there another AIG festering under your nose? How would you know, if you’re primarily focused on their investment in 50 arbitrary bond issuers?
But, if you want to try to win an election, find an arbitrary enemy, attack it and get ready to write off your own poor investment of time and money. Your constituents deserve better.
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Tuesday, March 2nd, 2010
The results of the NAIC’s survey of insurance departments across the US is in, and the answer is the Model Investment Law, which only took over five years to write, needs a serious overhaul. Without going into the answer to every detailed question, about 90% or more of the states wanted to see changes in the following:
- Special designations/asset class treatment for structured securities
- Current maximum of 45% of assets for first mortgage loans and income producing property
- Diversification rules where the investments are insured by mono-line insurers.
- Securities lending limits
- Specific limits for hybrid securities
- Include credit risk from Credit Default Swaps in credit risk limits
- Pledged asset limitations
The states were also asked for suggestions of other areas for change and they did not hold back on this, as they included:
- Investment pools, BA assets, FHLB pledged assets, basket clause, auction rate securities, foreign sweep accounts, internal controls, prudence evaluation criteria, standards found in the ‘prudent person’ version of the Model Investment Law.
Tellingly, the states noted additional areas where they needed guidance on defining certain asset classes, including:
- securities lending, hybrids, pledged assets, CDS, mutual fund treatment, bank sweep accounts
If there is some good news here, it is that only about half the states wanted to make the Model Investment Law the law of their state and an accreditation standard. That’s about where we are today with Model Investment Law adoption, so the ‘good news’ is really ‘no news’.
My guess is that the NAIC will eventually begin the process of ameding the Model Investment Law – with more changes than are even noted in this survey. We’ve talked about it before in this blog, but we’re looking at a long slog to adoption. During that time, we expect insurers will keep one eye on their portfolio and the other on what the NAIC is mulling over doing to that portfolio.
Recently, with changes to statutory accounting rules and capital relief via their joint venture with PIMCO on structured securities, the NAIC has acted like ‘captured’ regulators. However, as the economic recovery continues, they may start to seem less ‘captured’ and more ‘capricious’ in their approach to investments.
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Thursday, February 18th, 2010
From the Northwest Quadrant attempts to be an ‘early warning’ blog on issues important to insurance investment professionals.
As Harrisburg contemplates bankruptcy under Chapter 9 and a few other municipalities either have declared or are contemplating per the Wall Street Journal, let’s take a look at the Northwest Quadrant blog (still applicable) from March 1, 2009:
So what if Warren Buffett’s annual letter to shareholders says the economy will remain in a shambles through 2009 and probably beyond? We didn’t need the Oracle of Omaha to tell us things in the economy look ugly.
However, when reading any good narrative, it is important to view the entire tome before drawing conclusions and here is where the popular press has once again missed the boat.. And investors in insured municipal bonds will not like what they see.
Buffett’s Berkshire Hathaway Acceptance Corp is a new entrant in bond insurance, so his group has done more than a passing analysis of the market for insured munis and Mr. B’s basic thesis is centered around poor analytics that sound eerily similar to the simplistic approach utilized for residential mortgages.
"The rationale for very low premium rates for insuring tax-exempts has been that defaults have historically been few. But that record largely refelcts the experience of entities that issued uninsured bonds. Insurance of tax-exempt bonds didn’t exist before 1971, and even after that most bonds remained uninsured."
So, because we’ve never had big problems with munis, there is little or no chance of that occuring in the future. Just like home prices, right?
"Local governments are going to face far tougher fiscal problems in the future than they have to date." (He cites pension problems as a large contributing factor…in addition to the recession, of course)"
Warren seemingly pines for the days when New York City declared bankruptcy, but the confluence of interests of uninsured bondholders (many wealthy New Yorkers and institutions with material NYC interests) caused a financial reorganization plan without the use of insurance. Remember the old Municipal Acceptance Corp? Mr. B. then applies this lesson to potential future scenarios.
"When faced with large revenue shortfalls, communities that have all of their bonds insured will be more prone to develop ’solutions’ less favorable to bondholders than those communities that have uninsured bonds held by local banks and residents. Losses in the tax-exempt arena, when they come, are also likely to be highly correlated among issuers. If a few communities stiff their creditors and get away with it, the change that others will follow in their footsteps will grow. What mayor or city council is going to choose pain to local citizens in the form of major tax increases over pain to a far-away bond insurer?"
"Insuring tax-exempts, therefore, has the look today of a dangerous business – one with similarities, in fact, to the insuring of natural catastrophes. In both cases, a string of loss free years can be followed by a devastating experience that more than wipes out all earlier profits."
You might say this is all hogwash and posturing on the part of an owner of the only AAA rated bond insurer. However, the logical progression of the argument cannot easily be dismissed. With that in mind, if you or your company own municipals, please don’t think they are safe because they are "insured", or because after the recent MBIA bifurcation, the insurance is backed by the ‘good insurer’, etc.
Once more, we cannot stress enough that your investment manager review with you the underlying credit of every municipal bond in the portfolio – even GO’s – hello California. And, by all means, feel free to ignore the value of the bond insurance in your analysis.
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Sunday, February 7th, 2010
Just ask the Super Bowl winning New Orleans Saints.
In 1980, they did not win their first game until the next to last game of the season finishing with a franchise worst record of 1-15. During the season Saints fans would show up at the Superdome wearing paper bags over the heads, while carrying signs suggesting the team should be called the "Aints".
Although we don’t expect critics of current economic policy will don paper bags, we do expect that it will take time for the US economy to recover from the Great Recession. Headwinds created by the Greatest Deleveraging in the History of the World will continue to challenge the Greatest Releveraging being engineered by government stimuli the world over.
But, government efforts do have limits. Starting with small overlevered economies (Dubai, UAE), moving to medium sized and larger overlevered economies (Greece, Portugal, Spain) and even, probably, eventually impacting large overlevered economies (UK, Japan, US).
Of course, when you’re printing the world’s reserve currency, you’ve got a big advantage. But, the US was just put on notice by an entity it regulates (Moody’s) which noted that reduced deficits or solid economic growth will be a requirement to maintain a AAA rating. But, the most likely case remains historically high deficits coupled with slow, normative growth numbers.
Undoubtedly, now is neither the time to panic nor don those paper bags. We can expect the EU and/or the IMF and/or a group of world finance ministers to work through the issues posed by sovereign credit. The adjustments won’t be pretty, but there will be adjustments across world economies. And the results will not only challenge governments, but the very social fabric of some countries.
Importantly, it will be increasingly difficult for the world’s top rated countries to maintain that AAA rating. The fallout for insurer portfolios would be greater from a mindset change than from an actual credit risk standpoint. Historically, there is really very little difference in credit rating between AA and AAA. However, insurance investment laws and insurer policies were constructed with the idea that US government guaranteed (direct or implied) securities are the safest of investments. In a deleveraging world economy, credit risk must be constantly monitored and reconsidered.
What to do now?
Take a good hard look at what your company’s investment policy and portfolio is allowing in terms of credit risk.
For years, Strategic Asset Alliance has provided clients the opportunity to review credit risk in terms of both price degradation (due to ratings migration) as well as loss given default. Our Portfolio Credit Review uses a contingent claims approach that highlights that expected net income from credit instruments is practically never a ‘normal’ distribution. And consider all of this in light of policy limitations, as well.
It will take time for the full impact of the Greatest Deleveraging in the History of the World to be felt in all of its aspects. And it will take time for world economies to fully recover since, ultimately, deleveraging requires debt repayment ; which is most easily accomplished over time if it cannot be done all at once.
It took thirty years for the Saints to recover from the depths to the summit of their sport. World economies should take much less time than that to recover…but it will take time.
Meanwhile, just to be sure, on my next supermarket trip, I will request paper instead of plastic.
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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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