With the good guys (?) at financial firms being pummeled by write downs due to marking securities down to values that are, themselves, pummeled by a market low in liquidity and high in fear, the writers of the non-fiction franchise SEC have come up with their own ‘cloaking device’:  www.sec.gov/divisions/corpfin/guidance/fairvalueltr0308.htm

It grants all publicly listed companies the ability to use unobservable inputs for pricing securities (Level 3 under FAS 157) when those securities are being observably priced in a ‘forced liquidation or distressed sale’.  It does not appear to define what is meant by such distress, but does require significantly more disclosure about how securities found their way into Level 3 and how they were priced using those unobservable inputs. 

This appears to be the SEC’s attempt to temporarily derail their inexorable march to mark to market, while allowing the markets to return to ‘normalcy’ (more normal liquidity and less fear).  The theory here may be that time heals all wounds.

However, as all Star Trek fans know, the ‘cloaking device’ does have unintended consequences. 

How will investors be able to fully trust the earnings reported at companies holding many Level 3 securities?  And, how will that impact the very markets the SEC is attempting to calm?  And, will those firms using this ‘cloaking device’ be able to more as adroitly as those that do not?

This starts to appear very similar to what happened under ‘regulatory accounting’ at thrifts in the early 1980s.  That accounting treatment kept many thrifts in business despite a ‘mark to market’ problem.  The government reacted by loosening many regulations on thrifts.  Developers/promoters stepped in and took advantage of those regulations and many of those thrifts were later taken over or merged by the Resolution Trust Corp in the late 1980s and early 1990s.  The ultimate cost being borne by the US taxpayer.

One would think that policymakers would have learned about the perils of using the ‘cloaking device’ to hide or delay the resolution of problems.  But, perhaps that only happens in science fiction.

The first idea is that we are witnessing the Greatest Deleveraging in the History of the World.

When you think about it, that is not as forceful a statement as it seems on the surface, since we have just witnessed over the last few years (until about August, 2007), the Greatest Leveraging in the History of the World.  The largest single country economy ever used expanding leverage to grow in excess of the rate it would if it did not so use as much leverage.  As we all know, leverage is a two sided sword:  great when things are going well, and dangerous when they are not.  We are now in the dangerous stage.

Perhaps the Fed, by working with JP Morgan and salvaging Bear Stearns,will control the impacts of this deleveraging today.  And, perhaps there will be other large institutions (’too big to fail’) for which the Fed or other government agency will have to do the same.

And that brings me to the second idea from our conference.  Mr. Sloan was quite entertaining and witty, as he is within his column in Fortune.  However, he said that this was only the second time he can remember that a break down in the financial system is impacting the ‘real economy’ towards what looks like a recession.  (Usually, it is the ‘real economy’ that has problems that cause a recession that then impacts the financial system to some degree.)  The other time Mr. Sloan could remember that the financial system caused problems for the ‘real economy’ and not vice versa:  the great depression.

If credit continues to contract and if market liquidity continues to be under assault, the problem in the U.S. will be falling, not rising prices.  And, therein lies a truly problemmatical scenario.  In that case, when would those helicopters aluded to by Chairman Bernanke start dropping suitcases full of cash?

In May, 2007, Chairman Bernanke said he did not expect ’significant spillovers’ from the subprime market to the rest of the economy or financial system.  The Fed’s latest moves, including significant rate cuts, opening up the discount window, setting auction market lending facilities and now working on a Bear of a problem proves that not only does he ‘get it’, but he is quite concerned about the Greatest Deleveraging in the History of the World. 

There are still many other monetary and fiscal policy solutions that can and probably will be used to tackle this deleveraging.  Unlike during the depression, we have those tools at our disposal.  In addition, the occassionally maligned Mr. Bernanke could be the most educated person on this topic.

Our conference was really quite positive in many ways, but those two rather interesting and troubling ideas were my personal ‘take aways’.

We’ll have more on what this means for insurer investment strategies in future blog entries and in client communications.  

And, as always, you can comment by signing onto the Insurer Investment Forum Online.

Despite the press’ consistent harping about stock market volatility, the SP500 was only a fraction as volatile (measured by the high minus low for the month divided by the beginning value) as the 3 month T-Bill and the spread between LIBOR and the Bill.  Yes, we can thank the Fed for this, but more likely this was an indication of money moving to the sidelines (cash like instruments) awaiting the right time to reenter…putting further pressure on the Fed.

And, as all fixed income managers know, January was exceedingly volatile in terms of spreads to Treasuries, as the yield curve continued its move toward a more ‘normal’ shape.

So, let’s not take our eyes off the ball.  Significant valuation changes continue to occur in the fixed income markets and some of them are a negative result for insurers (who typically hold ’spread’ product).  If you didn’t like your manager’s performance in Q4, you may not be too happy about Jan 08 either.

Can investment grade managers truly add risk adjusted value with ‘active management’?  During Q4 and, undoubtedly in January, the jury returned a ‘no’ vote for many.

As a reminder, as punishment from the gods for his trickery, Sisyphus was compelled to roll a huge rock up a steep hill, but before he reached the top of the hill, the rock always escaped him and he had to begin again.  The maddening nature of this punishment was reserved for Sisyphus due to his hubris and belief that his cleverness surpassed that of Zeus.

Perhaps the markets are playing the role of Zeus.  Of course, as an the former Chairman and CEO of Goldman Sachs, it is hard to imagine a lack of some degree of hubris.

With Citgroup’s and other banks’ recent action to add SIVs to their balance sheet, it is increasingly looking like the US Treasury’s plan for a master conduit of SIVs to rescue that market may go by the wayside.  (Of course, SIV’s must still face the burgeoning roll over of their Medium Term Notes — an event that will start in earnest in January.)

And, now the announcement of a sub prime mortgage rescue appears to have a similar approach to the Treasury engineered SIV plan.

When originally announced two weeks ago, I could not resist the impulse to answer the Wall Street Journal’s forum question:  "Will Bush’s mortgage plan have an impact on the housing crisis?"  Here’s what I noted then, and I would echo those thoughts today:

I don’t know what this does other than give servicers the legal wiggle room to delay repricing for five years and make it possible for folks to stay in their home for now. However, the ARMs will reprice and the rate is tied to short term rates which may be higher five years from now.

Also, this ‘moving of the chairs on the Titanic’ does not seem to address repricing of more exotic loans (e.g. Option ARMs) – but I guess we’ll see. And, I wonder if the interest at the new (not repriced) rate is forgiven (unlikely) or deferred (likely). If deferred, this will just add to the balance of the loan and this negative amortization will eat into most of the potential price appreciation. If forgiven, investors will be furious and lawsuits will descend like attorney manna from heaven.

Meanwhile, investors, including the banks may get less of a mark down due to a lower probability of foreclosures…but maybe not, depending upon what the bond market thinks.

My guess is that this looks a lot like what Paulsen came up with for the SIV problem - get the big guys together, try to delay the inevitable and get others to go along. The SIV problem is NOT going away and this ‘quick and easy’ fix has not even been effectuated at this point. In other words, this mortgage plan could end up being more smoke and mirrors than substance when it’s time to implement.

If the federal government wanted to solve the problem, they would set up an RTC like entity that would buy the mortgages, do the workout, while calming the worried financial markets and pass any losses to taxpayers…which may still occur.

This is starting to look like another Sisyphean effort.   The markets (Zeus) want transparency so that it can begin the process of correcting prior excesses. 

This may mean mergers of large financial players.  It may mean further reorganizations of others.  And, it may mean other consequences which we all must face (including further declines of the value of the US Dollar).

To put the onus solely on the Fed (and their new liquidity auctions) for solving this problem is like fighting with one hand behind your back.  If you want Zeus to solve the problem, you will have to give him what he wants (transparency) and not a plan that will result in another Sisyphean result.

Just as in credit default swaps, insurers and others will be able to sell mortality protection (long mortality risk) or buy mortality protection (short mortality risk).  This mortality index (expected to be enhanced and added to over time) is a representative sample of the US senior insured population over 65 years old.  The initial index references a pool of over 46,000 de-identified lives.  Undoubtedly, if this approach is successful, we will see mortality indices based upon lives outside of the 65+ group.

There is much more detailed information at QxX-index.com.

Mortality risk is a serious issue for life insurers who have typically used a mix of life and annuity products to ‘hedge’ mortality risk.  This index may provide a more granular approach to hedging this key risk. 

In addition, there is the outside chance that other insurers, such as PC insurers, may want to diversify their insurance exposures by adding life insurance business.  Previously, this would be done via acquistion, but, perhaps this will be done via derivatives contracts in the future. 

And, there is no telling what impact this will have on the burgeoning life settlements business.  Perhaps this added transparency may accelerate both the reduction of the imbedded egregious fees and the acceptability of life settlements as an alternative investment.  Perhaps not.

In any event, this is certainly the beginning of the end of another risk that ‘could not be hedged’ effectively.  If only Goldman or another firm could come up with a hedge for liquidity risk….

Yes, default rates have hit 25 year lows at 0.74% of high yield bonds per S&P, but that measure is backward looking. 

A more concurrent indicator would be the number of US corporate bond issuers being downgraded versus those being upgraded.  According to Moody’s, this ratio is now at 4.5 downgrades to upgrades, more than double the rate for October and the highest since the bad old credit days of late 2002.  As we all know, market signals are also flashing red, as there are amazingly over 150 issues trading at 1000 bps over US Treasuries.

And now, Moody’s late on Friday, placed the Aaa ratings of FGIC and XL Capital Assurance ynder review for possible downgrade. It affirmed the Aaa insurance ratings of MBIA CIFG, though it said the outlooks were “negative.'’  A downgrade for any of these bond insurers would have negative impacts for insured bonds, especially those supposedly ’safe’ municipal bonds.

‘What’s the next shoe to fall in the credit risk arena?’ may not be the correct question.  Perhaps ‘What and how many shoes?’ is a better question.

Although life insurers do allocate surplus in the form of asset valuation reserves for credit risk, PC insurers do not have such a valuation reserve.  We highly recommend that all insurers review the potential for credit losses and Other Than Temporary Impairment write downs over the next year (both expected values and probabilistic distribution of those values) in order to get a better idea of future portfolio performance.  

There are many different ways to perform such an analysis.  However, using credit rating transition matrices, long term credit default performance as well as stress testing that performance is a good start.  It is much better to be prepared now than be surprised later.

1 - Most forecasters work for firms at financial institutions which are designed to SELL something…and I don’t mean good economic advice.  The economist is considered someone who can explain what at times is the unexplainable…and who can help legitimize the recommendations of his or her firm.

2 - There is very little advantage to being an outlier, unless you want to gamble on getting it right when all others are wrong.  The latter is a risky strategy (one can look like a fool in many cases), so most economists, like most investment managers, stick close to their benchmark — and the benchmark for the economist is what his peers are predicting.

However, every once in a while, an independent economic group is able to add significant value.  We have found that in the case of the Economic Cycle Research Institute for recession/inflation predictions, and we recently found it in a paper from the Levy Economics Institute of Bard College.  Take a peek at their publicly available research, "The U.S. Economy: Is There a Way Out of the Woods?" 

Like any good academic paper, it starts with multiple equations — that took me back to my old economics courses.  But, please take a look at the last two graphs for what they are predicting for US GDP over the next five years in a ’soft landing’ and a ‘credit crunch’ scenario.  Yes, there are lots of assumptions here, but the conclusions are fascinating:  In a ‘credit crunch’ scenario, expect no to -1% growth in GDP by the end of 2008, before things start picking up.  And, in a ’soft landing’ scenario, GDP falls as low as a bit under 1% toward the end of 2008, before picking up.

This is significantly different from the expected 2.5% growth in GDP forecast by the heard of economists in the recent WSJ survey.  More importantly, its carefully reasoned approach provides solid insight during this interesting time in the financial markets.

And that is the kind of solid insight we all need, as we take time to reflect on the most important part of our lives: family and friends.  I hope you and your family have a very Happy Thanksgiving!

In the update, below, it is fairly obvious that this unwind of the carry trade has been rather consistent over the last nine months and certainly has picked up in two of the last three months.  We’ve seen similar analyses, where the New Zealand dollar is substituted for the SP 500, as NZ has relative higher rates…and the results point to a similar conclusion.

Until we see this correlation decouple, the unwinding of the carry trade will continue to be a drag on global financial markets.

However, first the bond market and now the equity market have shifted gears to the state of fear.  The US economy is slowing and may move into recession by the end of next year.  The equity markets await the salve of Fed easing, but Mr. Bernanke must be careful not to tip his hand, lest the dollar will fall swifter than few of us can imagine.  Any corner of the financial or real economy subject to the use of credit has been and will continue to be impacted by what we called over a year ago "Deleveraging".  (Those that simply refer to this as a credit crunch are missing the fact that financial institutions will probably be forced to delever to some degree to meet their capital requirements; while we have already seen this occuring in other areas like hedge funds.)

What can be done to alleviate the grip of fear?  Let’s start by getting at the truth.  It may not set us free, but it sure would give us all a better idea of how pervasive subprime and other credit related problems are.

What if, instead of, slowly leaking out credit related write downs, banks and brokerages actually had to list the securities subject to write down? 

Transparency in our time. 

Shocking?

Not really.  Here in the world of US insurance companies, annual statement filings must list all investment holdings along with significant data, including cusip, book value, market value, yield, credit rating, etc.  Quarterly, insurers file statements that include their investment transactions.  And the NAIC (National Association of Insurance Commissioners) is even considering going further with a proposal to add an annual statement disclosure outlining all subprime exposure (direct and indirect), including MBS, CDO’s, other structured securities, debt and equity securities of companies with ’signficant subprime exposure’, and the always perplexing ‘other assets’.

Of course, banks and brokerages would complain mightily about this proposal.  However, I am only suggesting detail on securities subject to write down.  Why shouldn’t we know how problemmatical these holdings are and how they are being valued? 

Would it be a violation of trade secrets or trading strategies?  No, because such disclosure would only apply to a portion of the overall investment portfolio.  And, I’m not sure what partial disclosure of a portfolio really tells us about overall strategy.

Would it let others know what they might be trying to ‘unload’ in the future?  Possibly, but once the securities are written down, the rush to unload may not be so great as the ‘pain’ should already be felt.

Or, would it allow banks and brokerages to hide the extent of the ‘damage’ from bad investment decisions, hoping markets would reverse before they have to revise their write downs at a later date?  Such banks are acting like the two year old boy who doesn’t want to tell his parents he unloaded in his pants…until he positively had to do so.

We’ve read talk of a ’super’ regulator being established with authority to require such disclosures.  However, I believe that existing regulators have the ability to do so (and the last thing we need is another regulatory bureaucracy).  In the US, the SEC, promoters of the ‘disclose but caveat emptor’ approach to regulation, should require this transparency.

The accountants are indeed trying sometimes, but they are trying to be quasi-regulator (tough to do when the institutions ‘quasi-regulated’ pay your audit fees) by forcing public companies to show how they obtain valuations on securities and allowing them to choose mark to market.

Please, no new regulator, just a requirement for transparency.  Once we know how bad these credit related problems, the market will swiftly adjust.  And, like members of Alcoholics Anonymous, the banks and brokerage firms, after admitting they have a problem and how large it is, can begin taking steps to improve.

Transparency is the lubricant that can loosen the grip of fear in the markets.  The tools are there.  We only have to use them.

Let’s listen in on a few earnings announcements for banks that discuss risk management’s role in their recent problems:

Citigroup just announced a 57% drop in earnings and noted on its conference call: "We are examining our risk management organization to enhance particular areas such as convergence risk management and the management of aggregate exposures by asset class."

Merrill Lynch announced an expected loss for the quarter: According to Chairman and CEO Stan O’Neal: "We can do a better job in managing this risk…"

More earnings announcements are coming, and we should brace ourselves for ‘risk management’ to be a watchword for casting blame.  But, how fair is that?

Don’t these banks’ shareholders want to see increasing earnings?  Don’t these banks’ senior management and board members want to see the same, in order to continue to reap the rewards of options and other incentive compensation programs?  When you’re all about earnings, many other metrics fall by the wayside, especially many that use risk in their calculation.

Of course, all of these commercial and investment banks have spent large sums to develop risk management systems, but what good is the best risk management system when they are not part of the ‘game’ of rising earnings?  We all know that these systems are sensitive to model assumptions and structure.  However, they are also subject to the bias of ‘tell me what I want to hear’.

The problem is developing a fine line between using risk management systems to make good decisions, while maintaining their independence.  The problem is similar to that in the accounting area.  We need solid accounting information to make good decisions, but the accounting function must be periodically audited by both internal and external independent auditors.

Although many large financial institutions have a ‘risk management’ or ‘asset/liability committee’, this group is usually charged with measuring and monitoring risk while relying upon experts.  But, those experts’ models, assumptions, etc, are not subject to the same degree of scrutiny as they would be if overseen by a separate audit function.  In other words, there is typically no board committee primarily charged directly with evaluation of the risk management function WITHOUT participation of senior management; as we see within the duties of the audit committee of the Board when it comes to accounting issues.  And, financial institutions are in the business of risk management, not accounting.

Thus, if senior management chooses to ignore the potential for ‘eight standard deviation results’, (or, more likely, they are relying upon models that assume normality with little skewness or kurtosis and/or inadequate correlation assumptions) they can do so without serious challenge.   It’s earnings, earnings, earnings for management and they’ve got the models to prove their point.

And, why not?  Those ‘eight standard deviation’ models are quite rare and may not even occur on their watch.

The issue here is one of corporate governance and accountability.  As terrific as our risk management professionals and systems are, they are playing in a game that is rigged against them.  Until independent oversight of risk management occurs, ‘tell me what I want to hear’ becomes more and more likely.

I was once told that when someone points a finger at you, there are three others pointing at them.  As these earnings come out and we hear about risk management problems, watch the other fingers.