Strategic Asset Alliance

“Obscure Deleveraging” and Your Company’s Portfolio

iocreative — Wed, 02 Jun 2010 23:01:56 +0000

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.

Economic slowdowns in the U.S. have usually been accompanied with rather specific trends in equities, credit spreads, etc.

Meanwhile, one of the best overviews of what is happening in Europe, can be found on a recent Yves Smith’s article. The picture isn’t pretty with Spain a large potential problem – if not the Euro banks due to their sovereign holdings.

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?

Our final speaker of the day, Professor Patrick Chovanec spoke to us live from Beijing, and outlined the problems facing the soon to be second largest economy in the world. A real estate bubble similar to the US bubble but mostly accomplished without large amounts of debt; and an overheating economy that received a 1/3 increase in money supply to offset the Great Recession outside its borders are just the start.

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.

We also should not forget the deleveraging being forced upon state and municipal governments in the US – we now tax bottled water, candy and gum in WA. Nor should we be surprised by increasing civil protests and violence related to cuts in government services. Financial populism will undoubtedly rear its head in short order, as we noted over a year ago.

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."

The Restructuring Dance - How Long Will This Be Going On?

iocreative — Fri, 23 Apr 2010 23:24:56 +0000

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.

Greece is merely the first of several Euro-using states that will be facing the music of debts coming due. The salve of a European/IMF solution is only a temporary solution. And, despite assurances to the contrary by its Finance Minister, the only feasible way out the problem for Greece is debt restructuring.

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.

And, before we leave the rating agencies,they have recently initiated a restructuring of their municipal bond ratings. The result - several states now have better ratings - despite the difficulties in municipal finance generally sweeping through the U.S.

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.

Meanwhile, as the Administration attempts to push residential mortgage restructuring, lenders to large commercial real estate projects are forced to restructure else they recognize large unrealized losses - or so they think. Using the old good bank/bad bank approach and applying it to troubled commercial mortgages is one way to ‘solve’ the problem, while not solving the problem at all.

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.

Goldman Sachs: Caveat Emptor, Indeed

iocreative — Sun, 18 Apr 2010 23:43:48 +0000

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?

Ban Iran is Not the Solution

iocreative — Mon, 05 Apr 2010 16:20:58 +0000

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.

What are your thoughts about the investment gyrations of the California Insurance Commissioner/Candidate? This will undoubtedly be one of the many topics discussed at the upcoming Insurer Investment Forum X, May 19-20, only coincidentally being held in San Diego, CA.

NAIC Model Investment Law Survey Says: Change, Change, Change

iocreative — Wed, 03 Mar 2010 01:52:43 +0000

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.

Muni Bonds and Chapter 9: Last Year, We Warned with Help from Mr. Buffett

iocreative — Thu, 18 Feb 2010 16:15:42 +0000

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.

It Will Take Time…

iocreative — Mon, 08 Feb 2010 03:28:06 +0000

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.

Dubai the Current Concern, but Not the Most Important

iocreative — Sun, 29 Nov 2009 23:47:41 +0000

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.

But, we must once again raise the issue of credit default swaps and counter party risk. Worldwide, zombie banks, propped up by their local governments and tending to survival instead of lending, are showing good profits from trading. And that trading is tied to the ‘risk trade’ – both on and off- balance sheet manuevers using derivatives, including credit default swaps.

As in the days of Lehman and Bear Stearns, investors do not have a good clue as to the exposure in these instruments (direct and indirect) at these largest of institutions. Yet, we insurers dutifully list every single investment and credit derivative exposure on our annual statements. Well, I guess transparency is only good for certain regulated institutions…

Meanwhile, certainly the current Dubai incident may be prompting a call to your investment manager, or at least a glance at the latest portfolio holdings. But, as we continue to state, the key to solid investment results is a solid investment process. And, that includes understanding, in advance, how your company’s investment process is designed to deal with shocks (large and small) to financial markets.

This fact is so important that I’ve written a book about it, called Uncertain Times: A Chief Investment Officer’s Journey.

In reality, many insurers may be focusing on the investment manager at the expense of the investment process. David Holmes’ excellent Asset Outsourcing Exchange registered a strong 64% increase in number of manager searches by insurers, this year to date versus last year.

But, to the extent these searches are replacements of investment managers, one must wonder. To what end result?

Insurance companies rightfully provide a benchmark for the manager and the manager typically refuses to stray far from that benchmark. (You’ve probably heard the overused, ‘we try to hit singles, not home runs’ from managers.) With that approach in mind, can the manager truly add large amounts of value? The answer is an unequivocal, no.

The key to adding lasting, significant value is improving the investment process.

Think of it this way. The manager is like the mechanic who can fine tune your car and keep it running well. And the investment process is like the car. But, if you’ve got a VW Beetle, you really don’t have much of a chance of winning the Indy 500, do you? And, if your investment process seems to be running okay to you, perhaps you are simply settling for satisfactory Beetle-like performance?

We can tell you stories of companies that realize this and have seen rather impressive, documented improvements in investment results directly tied to improvements in their investment process.

But, the more interesting stories, quite frankly, are those companies that only get concerned when their manager ‘under performs’ or they have to deal with ‘impairments’.

The ‘risk trade’, where any security carrying credit or other risk has done quite well since March of this year, has buoyed the performance of many an investment manager. And, where Boards may have been very concerned about investments in Q4, 2008 and Q1, 2009, those concerns have somewhat ebbed due to the ‘risk trade’. Alas, that is truly a short sighted view.

The question all Boards should be asking now must include, “how will our investment process deal with the next ‘shock’ to the system?” And this is a small part of a larger look at the overall investment process.

What should your company be focusing on now? How the (mechanic) manager performs or how well your (automobile) investment process is built?

As Dubai’s friends in the Middle East might say, "Happy Motoring!"

Happy Thanksgiving - from your friends at the NAIC and PIMCO

iocreative — Wed, 25 Nov 2009 16:39:41 +0000

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:

Scenario	Probability	Peak to Trough HPA
Most Aggressive	2.5%	-33%
Aggressive	22.5%	-35%
Base Case	50.0%	-38%
Conservative	22.5%	-41%
Most Conservative	2.5%	-61%

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.

Will your voice be heard in the deliberations on this? Probably not, unless your company is a large life insurer. However, there is a public meeting and open conference call scheduled for next Monday (so soon) at 11am ET. If you would like to participate, please contact Chorus Call (866-332-4905), the NAIC conference call coordinator, in advance and ask for the Evangel Call (there is a fee for participation). And if you cannot participate via telephone, it has been requested that your comments be made in written to Bob Carcano (RCarcano@naic.org).

NAIC’s New RMBS Rating Model: Be Careful What You Wish For

iocreative — Fri, 06 Nov 2009 22:24:53 +0000

“Be careful what you wish for” could be the most appropriate saying for the insurance industry, when reviewing the NAIC’s latest attempt to diminish increasing risk based capital charges (RBC) at mostly large, capital starved insurers.

One only has to visit the NAIC’s website and note how proud they are of the latest change to RBC rules for residential mortgage backed securities (RMBS). The reasoning is simple enough and goes something like this.

1 – The rating agencies did a poor job of rating these non-agency RMBS in the past and their current model is too punitive on the most conservative tranches of these securities. Ergo…

2 – The NAIC can do a better job of assessing RBC charges by partnering with a so-called ‘independent’ firm to re-analyze and provide a ‘revised’ rating for purposes of the Securities Valuation Office (SVO) of the NAIC.

This is all well and good, once you get over the fact that no firm we know of can possibly be completely independent in their modeling.

But, putting that "small" fact aside, we move towards valuation and how this jives with impairment rules. Here is how one might expect the NAIC to compare expected losses to NAIC SVO ratings (remember below investment grade is 3 through 6):

NAIC SVO Rating	Expected Loss
1	< 0.5%
2	0.5-1%
3	1-6%
4	6-15%
5	15-27%
6	>27%

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.

On the valuation front, please remember that most insurers use some kind of arbitrary dividing line to determine if a bond needs to be reviewed for potential write down. We typically see that level at about 20% below book value. Most of this decline in book value is unsurprisingly due to expected losses.

Now imagine an insurer dutifully analyzing a non-agency RMBS and determining that due to expected losses, the bond is worth about 85. No write down is needed since it has not pierced 20% below book. Now, let’s say the ‘independent’ firm employed by the NAIC to model bonds agrees with that assessment. So, it’s time to slap an SVO 5 on the bond, even though using the old model of relying upon the rating agencies may not produce a rating as low as SVO 5 (a CCC rated bond).

Or how about a non-agency RMBS modeled at 98, with a 2% expected loss? No write down necessary under impairment rules, but it would be an SVO 3 under the new rubric, subject to immediate write down for P/C insurers.

Insurance regulation is a very difficult task. It is made more difficult by a few companies who did a less than stellar job in their investment process and who are now are asking for regulatory relief. These companies have undoubtedly run all the numbers and believe they have ‘won’ in this latest NAIC ruling. However, the impact on each individual company in the industry has undoubtedly not been completely assessed….certainly not by the NAIC, captured by the largest insurers in this latest regulatory bailout.