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.

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.

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.

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.