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.

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!"

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.

The children’s rhyme about ‘rain’ can now be applied to Other Than Temporary Impairment (OTTI).  Under specific direction from Congress, FASB has modified both GAAP accounting’s approach to measuring fair value as well as OTTI.  As always, the devil is in the details and these are still proposals, subject to finalization.  But the trend is clear on two basic fronts:

1 – You can separate declines in value due to the credit of an issuer or bond from all other impacts.   And, only write down through income the amount subject to credit specific to the issuer or bond.

2 – Fair value is not the last quoted price, if the market isn’t operating in a ‘usual and customary’ manner and there are not multiple bidders.  In those situations, you’ve got a distressed value and you can use more analytic approaches to valuation.

If passed as is — and we would fully expect this – you can probably expect the following:

1 – Lots of bonds will be shown to have a drop in price due to reasons not having to do with the credit of the bond, but simply due to the overall market sell off.  We suspected that many insurers and other financial institutions were facing rather large OTTI hits in Q1, as bonds would be trading below 80% of book for six months.  This will NOT be the case now, and we should start seeing much healthier earnings coming from most financials.

2 – More securities will be moving to the analytic pricing method instead of the, now typically used, ‘last quoted price’ of similar securities.  The result should be less mark to market problems, generally, on the portfolio — e.g. less unrealized losses and material improvements, in some cases, in GAAP equity.

Although the economy did not much change in one day, financial statements of financials did…and that should be reflected in bond and stock prices of many financial institutions, including insurers.

In summary, Congress threatened to ‘cloud up and rain all over’ FASB unless changes were made…and FASB decided to sing ‘rain, rain, go away’.  Some may think this to be ‘all wet’, that changing accounting in this manner does not change economic fundamentals.  How true, but in financial markets, many times appearances will overcome or mask reality.

However, just in case this does not mark a key point in the saga of the financial crisis, I will get my umbrella ready.

Currently we have an approach to solving "The Greatest Delveraging in the History of the World" that reminds one of a dysfunctional doctor’s office. 

The doctors are financial experts ‘behind the scenes,’ trying to work on solving the problem, while the receptionist is much like the politicians.  The receptionist has an idea about different procedures, but doesn’t fully understand the problem.  Yet, it is the receptionist (and his or her other receptionist friends) who must actually decide what procedures will be done.  Meanwhile, in the waiting room, stories about how someone else did (e.g. Sweden) on their procedure (e.g. bank nationalization) are bandied about, with the result that fears and concerns are either temporarily allayed or grow even further.  And, yes, the folks in the waiting room sure sound like the talking heads and scribes of the press.

Which brings up the idea of mark to market (MTM) accounting rules.  Congress and the SEC, in their finest receptionist outfits, hear testimony from numerous experts with just as numerous ideas about what to do with regards to MTM.  Meanwhile, the press babble on about the good, bad and ugly of it all.  And, when a producer or user of the financials that include MTM appears, the press typically does not have the depth of knowledge to ask questions that would better frame the issue.

So, we have a MTM stalemate of a sort, with the experts (auditors and companies) spouting different ideas that neither the Congress, SEC, nor much of the press can fully grasp in all of its implications.

I have said many times that accounting is basically a branch of sociology (the science of society, social institutions and social relationships), but when it comes to MTM, accounting has become both a branch of sociology and political science.  The solution for MTM is really quite simple, though those two branches of knowledge might keep this result from occuring:

 "These guys’ companies were on a Sherman’s March through their companies, financed by our 401ks, and all the incentives of their companies were for short term profit. And they burned the f–ing house down with our money and walked away rich as hell, and you guys knew that that was going on." - John Stewart, The Daily Show, 3/12/09

Most of the media covering the media lashing provided in the recent Stewart v Cramer interview thought it was all about them.  Mr. Stewart lambasting CNBC and its ilk for covering investing as a game instead of a serioius part of our long term economic well being.  However, like the egotists noted by Stewart, the media has once again largely missed the underlying point:  The public is generally upset with what has occurred in the markets and blames ‘those in the know’ — and that will soon include the architects of the numerous attempts at bailing out the financial sector.

You can already here it in the lambasting of the Billions given to companies like AIG, Citicorp, et. al. on other comedy shows.  And, remember, it is the palace ‘fool’ who can safely say things that the palace ‘advisors’ would never say in public. 

There is little doubt that the financial sector will continue to require more ‘bailouts’ as the ‘Greatest Deleveraging in the History of the World’ continues.  And, as before, some will applaud and some will complain about those efforts.  However, the next set of measures MUST take into account the significant public outrage and, some may call it, class warfare, caused by what has occurred and the results of the previous bailout actions.

Thus, we will, once again, bring up the idea of the Federales setting up an agency to become the biggest landlord in the world and buy all foreclosures, fix them up, cut the grass and rent them out…and, importantly, keep them OUT of the supply of homes for sale.  Eventually, perhaps a decade or so later, we can always begin the process of selling them…slowly… into the market.  This supply reduction would put a floor and, dare I say, put some mild upward pressure on home prices in some regions.  And, if home prices stop declining, we can begin to get fair pricing on risk assets like MBS, ABS, etc.

We also think that growing financial populism makes it very difficult for the Federales to inject more and more billions into the zombie infected institutions like AIG, Citicorp, etc.  A fairer, and perhaps more transparent solution?  Break them up now.  Distribute stock in the operating subsidiaries to the existing shareholders (that includes ‘we the people’) and have the Federales start a new agency that takes on the risks that cannot be sold (for AIG, that would be risks like the CDS positions, etc.).  Who would manage these positions?  There are a lot of out of work folks on Wall Street who would welcome a government salary versus zero income.  And, finally, because ‘we the people’ have no business being in some of these risks, like CDS, perhaps we could make illegal all CDS contracts after a certain date in the US and work with other developed nations to outlaw these derivatives.

The key in both of these future baiout ideas is that no dollars go to prop up zombie infected instittuions…and they can produce solutions that fit within the growing financial populism and related class warfare that appears to be growing as unemployment rates rise, providing the population with time on their hands.

The 16th annual AM Best Review/Preview conference just wrapped up.  As usual, a ‘must see’ event for AM Best rated companies and a beautiful location (Westin Kierland, Scotttsdale, AZ).  Unfortunately, that beauty contrasted with the ugliness in the investment arena discussed there.

I was unable to go to all of the sessions.  However, the general themes seemed to be: (1) enterprise risk management (ERM) is important, and (2) we are very concerned about investments.

Some interesting highlights:

ERM is not a ‘one size fits all’ requirements, but Best sure would like to see companies making some progress in this arena, depending upon size, type of business, etc.   

One of the ‘keynote’ speakers was Raj Singh, Chief Risk Officer, Swiss Re.  Raj, a very intelligent gentlemen, outlined their ERM process in quite a bit of detail and kept telling us that he took over these responsibilities in early 2008.   Yet, has not Swiss Re incurred mammoth investment losses that required a ‘Buffett bailout’ at something like 12% interest?  The company calls itself, "Your expert in capital and risk management".  Experience must be the best teacher of all. 

The other ‘keynote’ speaker was Rob Henrickson, Chairman, President and CEO of Met Life.  In a more rousing speech, Chairman H. noted that he felt ‘fine’ with the current status of Met Life and how they have managed through this financial crisis.  They’ve got an unusually large amount of cash – a rather defensive position – and although they could have probably qualified for TARP money, to my knowledge, they have not applied.  This sounds a lot like the first class passengers on the US Air flight that was heroically piloted to a safe landing on the Hudson.  It was the folks in coach who saw the waters rise, while those in first probably were finishing their drinks.

Although much of what Best stated about the importance of ERM and a focus on investments was said before, I found it interesting that they will be spending more on the economics of the investment portfolio, beyond the accounting treatment.  An example of this:  For P/C BCAR, there is a cap on how much the unrealized loss can reduce capital.  However, Best noted they will go beyond this if the cap is ‘maxed out’, and ask questions about the impact of not using the cap in their analysis of BCAR.  Let us all remember about the power of ‘analyst adjustments’ in the BCAR model…for both Life/Health and Property/Casualty insurers.

Importantly, Best expects more OTTI and other realized losses during 2009, starting as earlly as Q1.

Ugliness and beauty, we had both sides of the same coin in Scottsdale this week.

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 devasating 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 Calfornia.  And, by all means, feel free to ignore the value of the bond insurance in your analysis.

We’re now hearing from politicos of all stripes about the potential to ‘nationalize’ some large US banks.  Eventually, this may not be called ‘nationalization’ and instead may be called ‘rehabiliation’ or ‘restructuring’ or something similar…in advance of breaking those banks into smaller pieces and re-selling them in the public markets.

In such a scenario, we fully expect depositors to continue to be protected by the Feds, while today’s equity holders’ interests will likely disappear.  However, for insurers, nearly all with significant investments in unsecured debt issued by those banks, the major question is ‘What will happen to the bond holders?’ 

If this means the government will sell off assets at ‘fire sale’ prices to deleverage ‘nationalized’ banks, what will that mean for the values of bonds, generally, in insurer portfolios?

That’s where the man most slighted this year by the Academy of Motion Picture Arts and Sciences comes in (he and his excellent film, Gran Torino, got zero nominations).

"You’ve got to ask yourself one question:  ‘Do I feel lucky’?"

More and more, fundamental portfolio decisions, like these, are primarily subject to the whims of the political process.  One things is certain, however.  All that palaver from investment managers about how the Federales had ‘picked winners and losers’ via the TARP, and that you ‘would not lose’ investing along side the Federales will prove to be nonsensical in light of future US Government moves.

"If you want a guarantee, buy a toaster."

Nothing could be more prescient in this market than that.  It’s time to rethink what the banking system – worldwide- will look like in a few years with your invesment manager and then decide what portfolio decisions should be made today in light of that expected landscape.

"My old drama coach used to say, ‘Don’t just do something.  Stand there.’"

And, while you’re standing there, you might be thinking of the next moves the US Government will make that will impact our business..  Federal regulation of insurance?  Reorganiztion of state guaranty funds?  Unique opportunities to invest in ABS backed by low-cost financing at the Fed?  

"Go ahead, make my day."

There is little doubt that when it comes to some of these Federal actions, most insurers would agree most with Mr. Eastwood’s sentiments in Gran Torino:

"Get off my lawn!"

With the Obama Administration rightly proposing a major fiscal stimulus – and probably not enough – analysts are expecting well over a $1 trillion deficit in this fiscal year…and probably higher in the succeeding year.  The government can print money to fund these deficits, but it would much rather borrow (primarily from Japan and China). 

But, can we keep borrowing from the Chinese if they need to keep their savings at home to support their own troublesome economy.  How troublesome?  Below is a forecast from the OECD (not exactly a very incendiary group) and it is not pretty:

 If you’re in the leadership class in China, this graph is quite scary, as economic growth below something like 7-8% probably means insufficient jobs for the hordes coming from the country to the city looking for jobs. And, history tells us that angry hordes can pose severe problems for social, economic and governmental stability.  Thus, one can make a reasonable case for China being very careful in its purchases of securities offshore. 

In fact, this has probably already happened in some fashion, as noted in the Treasury’s January 15 press release detailing November data (December data won’t be available until mid-February):  "Net foreign purchases of long-term U.S. securities were negative $56.0 billion. Of this, net purchases by private foreign investors were negative $18.9 billion, and net purchases by foreign official institutions were negative $37.1 billion."

With apologies to economists much smarter than me, the math is really quite simple:

Large deficits = borrow or print money. 

Borrowings = Domestic Savings + International Savings (i.e. Purchases of Treasuries)

If domestic savings is something we don’t want to encourage in order to recover from a recession, we must borrow from abroad.  However, if one of our largest creditors faces a large economic downturn, it will not have the desire to extend credit at current rates.  The results: (1) higher US Treasury rates in the U.S. and/or (2) dollar devaluation (express or implied) and/or (3) inflation.   Should China have the problems noted in the OECD study, we could expect some combination of one or more there.

Of course, if foreign interest in Treasuries wanes, the Fed could always buy the securities.  But isn’t that just borrowing from one pocket to pay the other?  And, to do so would most likely result in more dollars injected into the economic system (inflation).  Perhaps inflation is not so bad in an economy suffering a slight bout of deflation…but at what long term cost?