US Economics

• For all the debt, there’s a shortage of bonds stks.co/cUj1 There isn’t a shortage of bonds, but of yield w/reasonable safety $$
• FED Very Low Inflation Panic Button: Soon DEFCON 2 stks.co/sDIg Argues that Fed will give up confident talk &continue easing $$
• Wake up! Neither political party cares about the rest of us. #deadlyduopoly
• Fiscal Policy. Oy! stks.co/dUhl Dick Fisher gives us nuanced view of economic policy; if u aren’t confused u aren’t thinking $$
• US Budget Deficit Shrinks Far Faster Than Expected stks.co/sD6D Still high, and now the Fed is absorbing almost all of deficit $$
• The Question the Fed Should Be Askingstks.co/eUhV The Fed is trapped in the imagination that they can resist debt deflation $$
• Wrong:Easy Money: Too Much of a Good Thing? stks.co/pD3E No matter how slowly they remove policy accommodation it will backfire $$
• Washington & Wall Street: Ben Bernanke’s Global Inflation Strategystks.co/fVol Japan imitates US: inflationary race 2 the bottom
• Fed Maps Exit From Stimulusstks.co/rChx Much wishful thinking on Bernanke’s part, will b really tough 2 remove accommodation $$
• Beware Volatile Bond-Market Moodstks.co/tCj8 Bond market will b very sensitive to every nuance of comments by Fed Governors $$
• Red Jahncke: The Federal Revenue Surge Won’t Last stks.co/fVZ7 People took gains taking advantage of low rates, easy huh? $$
• Daily Treasury Real Yield Curve Ratesstks.co/qCVk Interested in getting the real yield rates on TIPS? U can that & more here $$
• US High-Yield Bond Conundrum: First Warning from Bernanke? stks.co/aUGJCorporations can borrow, buy back stock, improve EPS $$
• Are US Lumber Prices Giving us a Warning? stks.co/aUGE Falling pretty rapidly; is this a sign of an economic slowdown coming? $$
• Bernanke: Big Banks May Face Higher Capital Requirements stks.co/hVVNModestly optimistic: Fed to reform margining 4 repos $$
• Wrong: Fed Maps Exit From Stimulusstks.co/eU99 At present, this is formless & void, w/the doves controlling monetary policy $$

US Politics

• Greg Lukianoff: Feds to Students: You Can’t Say That stks.co/iWK2 The first amendment should deal w/this $$
• Puerto Rico’s New Governor: We’re ‘Back on Track’ stks.co/iWK1 We’ve heard this before; ask how big unfunded accruals are $$
• White House Releases Benghazi Emailsstks.co/fW4S How many scandals can the Obama Administration bear at once? $$
• CBO Sees Deficit Narrowing to $642 Billion stks.co/fVoK Good as far as it goes, but nowhere near balanced, keep cutting please $$
• Republicans Risk Razing Arizona Edge by Losing Hispanics stks.co/eUHi US political landscape shifting; Red party lost West US $$
• Crop insurance expands, costs grow in latest US farm bills stks.co/cU8h Ag subsidies decline, but crop insurance costs rise $$
• Rating Firms Steer Clear of an Overhaulstks.co/eUHL There’s no other choice; this has worked out as I predicted $$
• In La-La Land, America’s Silliest Electionstks.co/iVOz In the dictionary, next to the word “hopeless” in a picture of LA $$
• How Many More ‘Red Lines’ Must Syria Cross? stks.co/sCKR Not so fast: how have results turned out in Iraq, Afghanistan & Libya? $$

Financial Markets

• Regulators Target Exchanges As They Ready Record Fine stks.co/iWJu Another type of trading on material nonpublic information $$
• “Give the Market the Benefit of the Doubt” and Invest in Stocks: @ritholtzstks.co/gWEh When do we reduce exposure then? $$
• Wrong: Kovacevich Says Only About 20 Institutions Caused Credit Crisisstks.co/dUfn Overlending on Resid RE caused the crisis $$
• The market isn’t merely crawling a wall of worry but we’re rapidly approaching the crown molding of disbelief.
• Rise of the Zombies: Fannie, Freddie preferred shares hit post-bailout highs yesterday on.wsj.com/12tcX6r Fool me once…
• Wrong: Warren pushes SEC, regulators on ‘too-big-for-trial’ banks stks.co/hW7fSounds good in concept; very hard to execute $$
• S&P Cuts Rating on Berkshire Hathawaystks.co/dUW6 | FD: + $BRK.B Maybe Buffett should own some McGraw Hill for protection $$
• Investors Flood Into Loan Fundsstks.co/jVtV People imagine that they can earn high yield off of levered junk w/little risk $$
• “The lower the gold price, the more nervous investors holding these positions will become.” stks.co/gW22Kinda perverse market $$
• Rethink your bond strategy for retirementstks.co/cU8r What if interest rates don’t rise, amid economic weakness? What then? $$
• Brokers Go Gray as Youth Unsustainable Without Cold Calls stks.co/pCogHappened w/life agents 2, eventually sorts itself out $$
• Stock Buybacks: We Separate Smart from Dumb stks.co/iVXm Check free cash flow & relative valuation; check soundness of buybacks $$
• Mortgages are investment du jour for hedge funds stks.co/bUB7 Hedge funds r weak holders & r buying in the eighth inning $$
• Farmland: The market ‘bubble’ you’ve never heard of stks.co/gVSL Watch debt financing levels; high levels would indicate bubble $$
• Fitch:US Corporate Cash Part I: Growth at an Inflection Point? stks.co/jVJkCorporations hoard cash b/c cost of doing so is low $$
• Does the Sohn Conference Make Hedge-Fund Geniuses Stupid? stks.co/jVBvMany investment “geniuses” were one-trick ponies $$

Europe

• EC ready to hit Chinese companies with sanctions over illegal subsidiesstks.co/rCo3 Currency wars may give way 2 trade wars $$
• Europeans must face up to prospect of massive debt restructuring stks.co/iVrN If Euro survives there will b bail-ins >Cyprus $$
• Greek Bonds Soar After Fitch Upgradestks.co/sCoB Fear gives way to greed as austerity solutions begin to ebb & recovery starts $$

China

• China’s outstanding corporate debt to surpass US stks.co/tD62 When China govt steps away, corporate defaults will surpass US 2 $$
• Grade A office rents under pressure after years of rises stks.co/rChi W/all of the overbuilding, what should you expect? $$
• @AlephBlog That last tweet was about office space in China.

Japan

• Japan Posts Surge in Economic Growthstks.co/bUaO Too soon; we need to see the effect on inflation, which will lag $$
• World’s Worst Bonds Brace for Losses on Abe Growth stks.co/pCtF Japanese bonds deliver significant losses in USD term 2 holders $$
• Yen at Four-Year Low Prompts Fujitsu to Raise PC Prices stks.co/fVjU Could it be that policy is finally creating reflation? $$

Rest of the World

• Euro-Style Bail-In Plan Means Bondholder Wipe-Out stks.co/hW7gCorrect; wipe common, preferred, bonds, deposits protected2limit $$
• Canadian Housing Bubble Review: Overpriced and Overbuilt stks.co/pCuPBubbles never deflate slowly; incentives lead to panic $$
• Commented on StockTwits: Yes, the US has shifted more to temporary workers & it will get worse under Obamacare, bu…stks.co/cUG9
• Canada’s shift to a nation of temporary workers stks.co/tCjD Puts pressure on lower-skilled workers to move among a few jobs $$
• @agnestcrane Feels like the Brazilian Govt is driving $PBR into the ground. Income is anemic, debt is rising, would b reluctant 2buy

Other

• The New Science Behind Philanthropystks.co/qDJX This isn’t science, but gambling; putting $$ on longshots w/big payoffs
• Dodging companies before disaster strikes stks.co/rDGz The simple aspects of ethical investing r doable; don’t make it complex $$
• Secret Rocks and Gem Huntersstks.co/dUVz The $10B jewels industry is shrouded in beauty—and mystery. Is change about to come? $$
• In U.S., Apostrophes in Place Names Are Practically Against the Law stks.co/tD6VJust another sign of cultural stupidity $$
• @The_Analyst It varies a great deal, but mostly I go to bed late; today I am up early.
• Harvard-for-Free Meets Resistance as US Professors See Threat stks.co/fVoQOvercapacity in colleges coming 2a crisis state $$ #bye
• Why More Young Kids Cheat at Schoolstks.co/fVoP We r basically evil, not good, we should b surprised when children don’t cheat $$
• North Jersey Data Center Industry Blurs Utility-Real Estate Boundariesstks.co/aUKZ Data centers r about energy costs & space $$
• Martin, CEO of ING U.S. on Growth Outlook $VOYA stks.co/sCXN CEO seems flustered, did not answer the questions he was asked.
• Bloomberg Isn’t The Only Company Able To Spy On Users stks.co/eUHm Wise 2 ask 3rd party vendors 4 how they keep ur data private $$

FWIW

• My week on twitter: 32 retweets received, 25 new followers, 37 mentions. Via:20ft.net/p

I have a saying that when there is no news, the market reveals its true direction.  That applies to individual securities as well as the market as a whole.  Why?

Think of institutional traders, who drive much of the market.  They are so big that they have to spread out their orders over time, or they would move the market against their positions.  On days when there is no news, volume tends to be light, displaying the actions of the big traders.

Valero recently spun off CST Brands, which was their retailing arm, selling gasoline, and things you find at convenience stores.  Seems cheap to me.  Over the last few days it has been rising on no news.  To me that means some institutional investors are buying.

I’ve seen the same thing happen when a stock falls on no news.  That’s usually a bad sign if you are long, because it means someone is selling for a reason you are not aware of.  Now, if you have done your homework, and know more than the seller, a lower price is to you advantage if you want to buy more.  The trouble is, you don’t know how much the seller has to unload.  To use CST Brands as an example again, I received some shares as a result of holding Valero for clients (and me, I get what my clients get), but I estimated how much index related selling had to happen as a result.  I bought a full stake for my clients at the point where the total volume from the prior “when issued” trading, plus actual trading on the first day hit my estimates.  It was close to the low for the day, though someone more enterprising could have picked up shares cheaper during the “when issued” trading, if he was clever.

But sometimes when there is news, you need to try to gauge whether something is an over- or under-reaction.  My favorite example here is RGA, the prominent well-run life reinsurer.  Once every eight quarters or so, they report a lousy quarter.  Why?  Because of the law of small numbers.  The large claims inside a life reinsurer are few, but make a considerable difference to the earnings when a bunch of large policy deaths happen at the same time.  The general public does not get this, so when RGA has a bad quarter, it is usually a good time to be a buyer.

The same applies to P&C reinsurers during crises.  I added to my reinsurance holdings post-Sandy, because I knew that the reinsurers would take relatively few claims because they don’t cover flood for residential, though they might have commercial-related claims.  As it was, none of my insurance holdings had any significant claims from Sandy, and the portfolio did well.

Toss out another example, but Endurance Specialty is one of the leading underwriters of crop insurance.  Crop insurance was a horrible place to be last year, and that put pressure on ENH as a stock.  But that neglected all of the other lines of business of Endurance that were performing well, as well as the risk controls that Endurance placed on its crop insurance business.

Perhaps the broad message here is to know your stocks well, so well that you can gauge whether a  market reaction to news is overdone, underdone, or meh, normal.

Analyzing the reaction to news (or no news) bonds and other assets as well.  When I was an institutional bond manager, I would watch the results of trading on the slow days, because it would give a clue to what the “big guys” were doing.  Also, when an event that has been anticipated occurs, like a ratings downgrade on the bonds of a troubled company, the market reaction says a lot, because often there are many who were waiting to buy once the downgrade happened, so price rises a lot at the downgrade.  (Think of the USA downgrade by S&P.)  The reverse is true for downgrades that are more of a surprise.

In summary, all news is not equal.  The reactions to news, and the lack thereof, can tell us a lot about the intentions of large market actors.  Do your homework well, and prosper off of the knowledge that it gives you regarding reactions, over-reactions, and under-reactions.

Full disclosure: long VLO CST RGA ENH

I wrote this piece once, and lost it, 1000 words.  Going to try again.

1) The first thing to realize is that diversification across insurance subindustries usually does not work.

Do not mix:

• Life & P&C
• Financial & Anything
• Health & Anything

Maybe you can mix P&C, Mortgage & Title, after all Old Republic survived.  The main point is this.  Insurance is not uniform.  Coverages are sold and underwritten differently.  Generally, higher valuations will be obtained on “pure play” companies  Diversification is swamped by management inability.  These are reasons for AIG and Allstate to spin off their life operations.

2) Middle-sized companies tend to do best from a valuation standpoint: the large have nowhere to grow, and the small are always questionable on their viability.  With a few exceptions, I like sticking with focused mid-cap companies with my insurance names.

3) Be aware of total subindustry capital relative to need.  After a big disaster, those that underwrote well will have capital to deploy into a stronger underwriting environment, where capital is scarce.  But don’t make too much of it because capital has become very fluid in insurance; the barriers to entry and exit are low.  Still, it is best to be an investor after a disaster, when everyone is running scared.  When total capital is high, and companies are fat, dumb, and happy, it is time to leave.

4) It’s good to look through the Statutory statements [regulatory statements filed with state insurance regulators] of their operating insurance subsidiaries to look for odd entries.  Occasionally, you will run into problems that do not have to be reported under GAAP accounting.  (Note: they should be reported under the spirit of GAAP, but not the letter of GAAP.  I have a saying, “It is okay to violate GAAP to be more honest, but not to be less honest.”)

Here’s an example: I ran across a life company that had to post an extra statutory reserve because they would lose money if interest rates rose.  That’s a significant admission, and the company was invested far more aggressively than almost all the other life companies we were tracking.  We shorted it, and got ripped as the credit markets surged 2003-2005.  We got out with a small gain when their earnings proved inadequate as interest rates rose, and credit losses rose.  But it took a long time.

At this point, I would be looking for special reserves established for secondary guarantees established for Term and Universal Life, and Variable Life & Annuity policies.  There is no specific requirement to hold those reserves on a GAAP basis, even though there may be general principles that would encourage additional reserves or disclosures.

5) There are ways of multiplying capital across subsidiaries — Subsidiary A reinsures liabilities of subsidiary B, while Subsidiary B reinsures liabilities of subsidiary A.  This is a way to create hidden leverage, so be aware of what is being done at the subsidiary level.  Doing these sorts of things is dumb, though legal.

Reviewing leverage is a good idea as well, where it is located, and what conditions it has.  The practice of insurance subsidiaries issuing surplus notes to parent companies has become all too common, which allows subsidiaries to write more business at the risk that when a subsidiary becomes impaired, the domiciliary state takes it over, and the parent company gets little to nothing.  (Payments on surplus notes can only be made with the approval of the insurance commissioner. In insolvency surplus notes typically receive nothing.)

The thing is, it is a lot harder to produce return on assets than return on equity. Though part 6 focused on ROE, in the short run, insurance companies can improve their ROE through substituting debt for equity.  The same applies to insurance companies that write GIC Medium Term Notes.  It’s just a cheap way of making a little extra income arbitraging your subsidiary’s high claims paying ability rating.  It fascinates me that regulators have allowed the insurance industry such latitude with deposit contracts that are called annuities, but have never once been annuitized.

Another hidden source of leverage are financial reinsurance agreements.  Down in the insurance subsidiaries, companies trade away a portion of future profits for surplus today.  These are usually bad deals to enter into, but because some insurance companies have a sales culture that requires continual growth, even if the sales that don’t justify the cost of capital required to back the policies.

6) Free cash flow is difficult to determine for financials, this applies to insurers as well.  Each regulator has rules on how much can be paid in dividends to their holding company.  Typically, subsidiaries can dividend away surplus so long as they are still strongly capitalized after the dividend.  (If it is large, they may have to petition their regulator for approval)  So if you want to approximate free cash flow for an insurer, try the following:  (Income or loss outside your insurance companies for the current period) + (Distributable Income from insurance companies for the current period).  The latter figure is statutory income +/- any decrease/(increase) in capital required to maintain the remaining business with adequate financial strength, calculated separately for each subsidiary.

7) Last note: on DAC/VOBA [deferred acquisition costs, value of business acquired; they  are similar, so I will just talk about DAC].  Once I had to convince a boss that though it is an intangible, like goodwill, it is not like goodwill in that it is more rigorously tested for recoverability.  If DAC gets written down (as opposed to amortized) that means that the future sum of profits on some of the insurance business is expected to be less than the acquisition costs deferred for the business.

Now, DAC can be done conservatively, by product and class year.  The more disaggregated it is, the more conservative, generally.  A few cells getting written down is no big thing.  But DAC can be as liberal as having one cell, which means if DAC is written down, the total value of future profits from existing business has been reduced — the company is worth a lot less.  The change in value is even more than the reduction in the DAC, because in the writedown process, the discount rate on the DAC went from a positive number to zero.  All other things equal, a DAC asset is worth more the higher its discount rate.

S0 pay attention: if DAC amortization is high relative to net income before tax, it means there isn’t that much margin for adverse deviation in the DAC.  Also, all other things equal, lower levels of DAC as a fraction of net worth are better.

Close with a story: before Mony Group was bought by AXA, it was doing DAC for the company as a whole.  A value investor, seeing the discount to book value, and sensing opportunity bought a lot of Mony.  Profitability was so bad, they had to write down DAC.  Book value declined & price to book value declined as well.  The value investor agitated for a sale, and AXA stepped in, buying it for moderate premium to where it was trading.  The group I was with went long for an arbitrage trade on a cash deal.

But the value investor thought the premium wasn’t high enough and agitated for more.  Because the takeout price was 70% of book, the idea seemed plausible.  But when you factored in the DAC earning 0% and a few other items, it looked generous enough to me.  So when the price got several percent above the deal terms we sold our stake and went short as much as we could find without having to pay much interest on the borrow.  Bit-by-bit the stock price moved down until a few days before the deal would close, when the price collapsed below the deal price, and we covered.  We even arbed a little more on the long side, but the trade was over.

And the point is this: it may look cheap, but test your assumptions on the values of assets and liabilities before committing a lot of capital to a any insurance stock.  GAAP, Tax and adjusted Statutory income validate book value, so a cheap stock with a low return on equity or assets is often not cheap.

From a reader who I appreciate:

David, I am curious if you have thoughts about insurance companies (especially P&C) hedging political risk … the answer to this question obviously will carry over to healthcare quickly.

Recently, my state (Corrupticut) was hit by hurricane Sandy. Many municipalities (but not all) still had extensive flood control, hurricane gates, levies, etc from the 1970s — the last time we had really active hurricanes.

In an effort to bump up property tax revenue, several municipalities allowed developers to build McMansions right on top of, or in place of, sand dunes that had existed for centuries. The dunes blocked the view or some such nonsense. Quite predictably, these municipalities had much higher damage than those who maintained dunes and other protection.

Our idiot governor decided to keep his heel on the throats of insurance companies to make them pay — and the insurance companies called his bluff. “Fine Mr Malloy, we will stop selling home owners insurance in your state — good luck getting a mortgage without any insurance. Gee whiz, the lack of mortgages probably will devastate home prices. You should have thought of that before you chased us out.”

All up and down the coast line, insurance companies are telling state and local governments that sand dunes, levies and sea walls must be restored and maintained — or insurance will not cover anything.

States along the gulf of Mexico (ie hurricane Katrina et al) enacted laws prohibiting developers from taking down mangrove fields.

I heard rumors (not sure if they are true) that re-insurance companies have told underwriters that they will not accept pools that contain policies in states that allow destruction of natural flood barriers.

Perhaps most recently, New Jersey’s governor told his MTV “J Wow” constituents that they were going to restore sand dunes regardless of whether it looked good.

I seriously doubt that corrupt populist politicians (like the governor of my state) will stop promising to seize private property to buy votes … but it also seems they have pushed the P&C insurance industry too far. Hard to imagine that anyone will knowingly operate at a loss.

And Hugo Chavez not withstanding, most national governments won’t jeopardize their own regime to subsidize a practice that also threatens their regime.

The US government doesn’t have the trillions needed to allow FEMA to insure McMansions built where sand dunes once stood.

Whether the US ends up with “universal healthcare” or not — the federal government does not have the money to keep the current healthcare system growing 8-10% per year while the economy grows less than half as fast.

The end result is obvious — stupid government policies will fail long term. Maybe common sense will prevail again. Maybe the government will bankrupt itself and become irrelevant. Hard to guess which.

But in the short term — how can the insurance companies hedge political risk?

One of the reasons for high storm damages over the past ten years has been the pressure from developers to develop land that is beautiful, but subject to flooding risk  from storms.  In the present time, that has led insurers to raise prices on such developments, and/or refuse to insure, allowing state-sponsored captive insurers to absorb the risk on behalf of the taxpayers.

Insurers have gotten smarter, in my opinion, and most have learned to resist the actions of the states, sacrificing business volume for profitability.  They understand that there is a “Knot at the Bottom of the Rope,” below which you can’t go any lower.  So if a state is making certain classes of business unprofitable, stop underwriting those classes of business.

Contract law favors the insurers.  They can’t be compelled to take losses against their will, except by contract.

Eventually politicians have to face reality, lest they go the way of Argentina, or worse, Zimbabwe.  Insurers, though they may not be loved, reflect a fair estimation of risk.  Politicians in the short-run may try to bend the view of risk to voters, but if contract law is observed, no change will happen.

Look, we would all like Santa Claus behind us bailing out our every mistake and trouble, but in the real world, where resources are limited, claim payments flow according to contract.

Yes, the reinsurers push on the insurers, and that leads to reductions in coverage.  They have economic incentives as well, and they are all the more sharp, because they really get hit when things get bad.

Finally, you are correct that the US can’t maintain its current approach to healthcare.  If we were smart, we would eliminate the corporate tax deduction for healthcare, and return the system to the free market.  If you want health insurance, let it be done outside of the tax code.  That could help balance the budget.  As I listen to many screaming, I would add, “And let’s eliminate the interest deduction on mortgages, and the charitable donation deductions.”

We have to clean up the tax code such that most tax preferences disappear, so that the budget can balance.  Balanced budgets promote growth, because people do not fear higher future taxes.

This piece is the sixth out of seven in a series that I have been writing at Aleph Blog.  Here are links to the first five pieces:

• On Insurance Investing, Part 1 (reducing share count)
• On Insurance Investing, Part 2 (growing fully convertible book value per share)
• On Insurance Investing, Part 3 (price momentum and mean reversion)
• On Insurance Investing, Part 4 (Management & reserving conservatism)
• On Insurance Investing, Part 5 (Management quality & product quality)

Recently I decided to spend some time analyzing the insurance industry.  It’s a different place today than when I became a buy-side analyst ten years ago.  Why?

First, for practical purposes, all of the insurers of credit are gone.  Yes, we have Assured Guaranty, and MBIA is limping along. Old Republic still exists. Radian and MGIC exist in reduced states.  The rest have disappeared.  In one sense, this should not have been a surprise, because the mortgage and credit guaranty businesses never had a scientific model for reserving.  I’m not even sure it is possible to have that.

Second, the title insurers are diminished.  Some, like LandAmerica are gone. Fidelity National seems to be diversifying itself out of insurance, buying up a restaurant chain last year.

Third, health insurers face an uncertain future.  Obamacare may disappear, or Obamacare could slowly eliminate insurers.  It’s a mess.  Insurers debate to what degree they should compete in insurance exchanges.

But beyond all of that, valuations are fair-to-cheap across the insurance industry.  Part of that may stem from ETFs.  Insurers as a whole are smaller than the banks, but not as much smaller as they used to be.  Now, if you are a hedge fund, and you want to short banks, you probably have the best liquidity shorting a basket of financials, which shorts insurers as well.

That may be part of the issue.  There are other aspects, which I will try to address as I go through subindustries.

Offshore

By “Offshore” I mean P&C reinsurers and secondarily insurers that do business significantly in the US, and who list primarily on US exchanges, but are not based in the US.  Most of them are located in Bermuda.

In 2011-2012, many of them were challenged by the high levels of catastrophes globally.  But the prices of the reinsurers did not fall because pricing power returned, and investors expect higher future earnings as a result.

Before I go on, I need to explain that what I will use to give a rough analysis of value is a Price-to-Book vs Return on Equity analysis [PB-ROE].  For more details, you can read my article here.  The short explanation is that companies in the insurance business (and other financials) are constrained by the amount of equity (net worth) that they have.  The ability to earn a return as a percentage of the equity [ROE] drives the market valuation as a fraction of the equity [P/B].

Here is a scatterplot for PB-ROE for the Offshore group:

Companies above the line may be overvalued, and companies below the line may be undervalued.  ROE is what is expected by analysts for the next fiscal year, not what has been obtained in the past.

The fit is fairly tight, and indicates mostly logical valuations for this group.  The companies that are possibly overvalued are: Arch Capital [ACGL] and Renaissance Re [RNR]. Possibly undervalued: Tower Group [TWGP] and Endurance Specialty [ENH].

Now, this simple model can fail if you have an intelligent management team that has a better model.  Arch Capital and Renaissance Re may be that.  But with an expected ROE of less than 20%, it is hard to justify their valuation, when the average stock in this group needs an expected 11% ROE to be valued at book.

Why such a high ROE to get book?  Earnings quality.  Reinsurers have noisy earnings due to catastrophes.  You don’t give high valuations to companies that run hot or cold.  But the trick here is to see who is accumulating book value the fastest – they tend to be the stars over time.  Endurance and Arch have been good at that.

Life

The life insurance business would be simple, if it indeed were only life insurance.  Much of the industry is handed over to annuities, and all manner of asset gathering.  Even life insurance can be made more complex through variable and variable universal life, where assets are invested in stocks, and do not receive a rate from the company.

Part of the trouble is that variable products are not simple, but the insurers offer guarantees for a fee.  When I see those products, my reaction is usually, “How do they hedge that?!”

Thus I am concerned for insurers that are “equity-sensitive” as I reckon them.  Here is the PB-ROE scatterplot:

A tight fit.  The insurers that are seemingly undervalued are equity-sensitive ones: Phoenix Companies [PNX], Aegon [AEG], and ING [ING].  Those that are overvalued are Citizens [CIA], Eastern Insurance Holdings [EIHI], and Atlantic American [AAME].  For the undervalued companies, I am unlikely to buy because I am skeptical of the accounting.  I would look further down the list and consider buying some companies that are more reliable, like Assurant [AIZ], National Western [NWLI], and Fortegra Financial Corp [FRF].

One more note: to get book value in Life Insurance, you need a 9.8% ROE on average.  That’s high, but I expect that is so because investors are skeptical about the accounting.

Property & Casualty

This graph gives PB-ROE for the entire onshore P&C insurance industry:

It’s a good fit.  Again, the casualties of the last year weigh on the property-centric insurers, but for the most part, this is logical.

Potential underperformers include First Acceptance [FAC], Employers Holdings [EIG], and Erie Indemnity [ERIE].  Below the line: Hartford Financial Services [HIG], Hilltop Holdings [HTH] Hartford Financial [HIG], and United Insurance Holdings [USIH].

Again, these are only screening tools.  Before buying or selling, understanding management and reserving quality, and riskiness of the lines of business makes a considerable difference.  Erie Indemnity has an “asset light” model where it manages insurers, but does not bear underwriting risk.  Hartford has a significant life insurance and annuity exposure.  Models are models, and we have to understand their limitations.

Health

With Obamacare, I don’t know which end is up.  It could end up being a giant sop to the health insurers, or it could destroy the health insurers in order to create a government single-payer model, rather than the optimal model for cost reduction, where first parties pay directly, or pay insurers.  You want reductions in medical costs, get the government out of healthcare, and that includes the corporate deduction for employee health insurance.

My rationale is this: it could mess up the private market enough that the solution reached for is a single payer solution. I’ve talked with a decent number of health actuaries on this. The ability to price risk is distinctly limited. Young people pay too much, older folks too little. That’s a formula for antiselection. I think Obamacare was badly designed. I will not achieve its ends, and when the expenses start coming in, they will be far higher than anticipated. That has been the experience of the government in health care in the US. Utilization is underestimated, the further removed people from feeling its costs.

There are many models for profitability here, which makes things complex, but here is the present PB-ROE graph:

It’s an okay fit, with the idea that the following companies might be undervalued: Wellpoint [WLP] and Humana [HUM].  And the following overvalued:  Molina Healthcare [MOH].

I don’t regard myself as an expert on the health insurance sub-industry, so treat this with skepticism.  I include it for completeness, because I think the PB-ROE concept has value in insurance.  One more note, the PB-ROE model thinks of this as a safe investment subindustry, because to have a book value valuation, you have to have an ROE of 1.8%.

Financial Insurers

This group comprises the surviving mortgage, title and financial insurers, and two companies in the ghoulish business of buying life insurance policies from sick people.  Here’s the PB-ROE graph:

This graph is weird, because it slopes down, and does not have a good fit.  That’s because we’ve been through a rough period financially, and in many cases GAAP accounting does not do a good job with these companies that take a lot of credit risk.

We can still look for companies that have high price-to-book, and low ROEs – note Life Partners [LPHI] and Radian [RDN] as possible sell candidates. We can also look for companies that have low price-to-book, and high ROEs – note Assured Guaranty [AGO] and MBIA [MBI] as possible buy candidates.

This subsector is more difficult than most, because credit is not an underwritable risk.  It is feast and famine.  We are in a period of feast now, so in some ways what is bad is good.  The more risk, the more return.  But winter may come soon – who knows what the Fed may do?  In general, I avoid this subsector for longs.

Insurance-Related Companies

This is a group that is a non-group.  It comprises brokers and insurance service providers.  Here’s the PB-ROE graph:

It doesn’t look like much of a group.

As it is the potential outperformers include Brown & Brown [BRO], and Aon [AON], two leading insurance brokers.  A potential underperformer Willis Group [WSH], another leading insurance broker.

Summary

Insurance is complex, and the accounting is doubly complex, which is a major reason why many stay away from it.  But insurers as a group have had reliable and outsized returns over the rememberable past, which should encourage us to do a little kicking of the tires when a decent amount of the industry trades below its net worth and is still earning money with little debt.

In my opinion, this is a recipe for earnings in the future, and why I own a lot of insurers for myself, and for clients.

In the final part of this series, I will go over some nuances of insurance accounting – I leave it to the end because it is kind of dull, but can make a lot of difference, because some companies look cheap and aren’t really cheap.

Full disclosure: long AIZ, ENH, NWLI for clients and myself

China

• Pettis: I would argue that until Beijing has cleaned up its debt problems and its very unstable balance sheets, it cannot move quickly. $$
• Pettis: Reducing the [interest] subsidy by raising rates would cause them all to bleed money. (DM: thus fin’l liberalization difficult) $$
• Pettis: Far more than 100% of total SOE profits come from the interest rate subsidy (not to mention other subsidies…) $$
• Target loopholes in pension system firststks.co/fVB7 China pensions exceeds the stupidity of US but not Greece: ret ages 2 low $$
• Chinese steel association seeks to tackle ‘vicious competition’ stks.co/pBzz A lot of words trying to explain away 2 much steel $$
• China Slowing Reserves – A reverse QE?stks.co/hUjH Hu Jintao ate sour grapes & Xi Jinping’s teeth r set on edge $$#dealtabadhand
• Policy battle rages in China as slowdown feeds ‘sense of crisis’ stks.co/qBXa Hard to overcome bureaucracy stifling the economy $$

Europe

• Germans Splurge on Italian Homes Locals Can’t Afford stks.co/iUpP Pushes $$ into Italian economy, don’t kvetch
• German euro founder calls for ‘catastrophic’ currency 2b broken upstks.co/tBWC The political experiment should end; harm>good $$
• Eurozone crisis deepens as German ‘sado-monetarists’ refuse to back QEstks.co/gUXD Either centralize or dissolve the Eurozone $$
• Southern Europeans Flock to Germanystks.co/cTEw Cheaper labor emigrates to Germany to benefit from their capital invested $$
• Sweden a Crisis Casualty No More Shows How to Get Haven Glowstks.co/bTBH Which inflates asset values in their economy, great $$

Rest of the World

• Egypt’s Wheat Farmers Hobbled by Fuel Shortages as Silos Run Lowstks.co/pCGK Who would have the courage 2free Egypt’s economy? $$
• Dollar Buying Continues Apace After ¥100 Break stks.co/iVEm & stks.co/jV1m& stks.co/fVAg Three on #Japan $$
• Iran Cracks Down Ahead of Electionstks.co/gV0Q The Ghanoon newspaper says. “Only in Iran: Election comes and Internet goes.” $$
• SAT Scandal Shines Harsh Light on South Korean Academics stks.co/qC0LSAT exams cancelled in S. Korea, a first for any country $$
• Egypt Investment Collapsing as Citizens Turn Into Vigilantes stks.co/eTds It was smart 2 topple Hosni Mubarak & Saddam Hussein $$
• In India, a Quixotic Fight Against Car Honks stks.co/sBQj Makes me want 2 create a bumper sticker, “Honk if you love India!” $$

Companies & Industries

• Blackstone Targets Bulging Corporate Coffers Via New Unit stks.co/sC9w W/ MMFs under threat, alternative S-T income funds arise $$
• Temporary Workers Near US Record Makes Kelly a Winner stks.co/rC9qStaffing firms benefit from need 4 fewer full-time workers $$
• And, as an aside, once PPACA [Obamacare] really kicks in, part-time work may become even bigger; very ill-thought out law, unforced error $$
• Delta Capital-Return Plan Puts Focus on Cash Flow stks.co/cThy Airlines r2 capital intensive 2b run 4 free cash flow; dubious $$
• Scor lead bidder for Generali USA in $800m deal stks.co/qC1o Not surprising 2c Scor overpay; $RGA is conservative $$ | FD: + $RGA
• Some Insurers Turn Away Variable-Annuity Money stks.co/eTaG When a life company does this, fund it, & don’t surrender; you won $$
• Merged Bonds May Spur Fannie, Freddie Revamp stks.co/dT4a Offer the equity interests a kiss goodbye & merge them into GNMA $$
• Cheapest Way to Rob Bank Seen in Cyber Attack Like Hustle stks.co/tBQ6Start Denial of Service attack, raid $$ during distraction
• New technology propels ‘old energy’ boom stks.co/rBPp Alternative energy will make sense when conventional energy gets scarce $$
• Amazon’s growing threat 2 H-P, Dell and Oracle stks.co/qBQR It’s amazing how you can beat your competitors w/no profit FD: + $ORCL
• Some Verizon Investors OK With Paying Premium 4 Vodafone Stake stks.co/bTAjSome large $VZ shareholders ok paying $130B FD: + $VOD

US Politics & Economics

• Deficit Reduction Is Seen by Economists as Impeding Recovery stks.co/eTyxEconomists have not been right, y listen 2 them? $$
•  “Big banks get a great deal when they borrow from the Fed,” Warren said on the Senate floor. “In effect, the American taxpayer… (1/2)
• …is investing in those banks. We should make the same kind of investment in our young people who are trying to get an education.” (2/2) $$
• Private Student Debt Refinancing Could Help Economy, CFPB Says stks.co/fV03Elizabeth Warren is a dangerous loony in this case $$
• @AllenSammey When a politician lobbies to use the borrowing power of the Fed for narrow political ends, that is dangerous, no?
• @AllenSammey Also, read the two prior tweets. They were meant as a group. I like a lot about Warren, but there is a lot 2 worry about also
• @AllenSammey That’s y I lend to my own children @ 0% in place of student loans; that they r not dischargeable in BK is another neg feature
• Blacks Surpass Whites in Voter Turnout, Census Data Show stks.co/hVAA Helps explain the last election’s results $$
• Colleges Soak Poor US Students While Funneling Aid to Rich stks.co/bTURColleges r funded by donations. Poor people can’t donate.
• What was Gallagher thinking?stks.co/dTHw Difficult 2harm muni bonds w/strong economic purpose/pledges behind them $$ by @munilass
• Time for Americans to Rethink Retirement? stks.co/rBX4 If u have not concluded that u won’t retire, u r not paying attention $$
• Federal Reserve Blows More Bubblesstks.co/eTLo Ron Paul minces no words about the foolishness of current Fed policy $$
• If this was a pill, you’d do anything to get it stks.co/jUPk Simple: have a nurse check on sick elderly at home once a week $$
• Gore Is Romney-Rich With $200 Million After Bush Defeat stks.co/pBWE An utter hypocrite, pursuing his politics 4 financial gain $$
• US Non-Farm Payrolls – The Hidden Weaknesses – not +165k but -376k?stks.co/rBPu A pessimistic alternative view of jobs report $$
• Too Much Asset Inflation stks.co/eTGDTakes on Paul Krugman’s blather about there not being enough inflation, given asset bubble $$
• Everything You Think You Know About the Fed’s Exit Plan May Be Wrongstks.co/rBOX Fed may try 2 tighten &hold down long yields $$
• Reverse Revolving Door: How Corporate Insiders r Rewarded, Leaving Firms For Congress stks.co/gUMN Y the Purple Party rules DC $$

Market Dynamics

• Seth Klarman Warns of False Calm in the US stks.co/jUu8 It is far easier 2b lax in $$ policy than it is to remove laxity#klarman
• Investor Demand Propels Cheap Corporate Debt stks.co/dTcm Note that borrowing is not going on to fund organic growth, generally $$
• Yields on Junk Bonds Reach New Lowonline.wsj.com/article/SB1000… When the average yield on junk bonds drops below 5%, we should run away $$
• Listening to Harry Markowitz drone on about MPT, while I have 2 questions pending. stks.co/aTco Webinar:Arizona CFA socieities $$
• As Sohn gears up, is it open season on Paulson and other hedge funds?stks.co/qBls Hedge funds have a weak liability structure $$
• This graph is 1 of many reasons y I follow the credit cycle: stks.co/iUiM Not perfect, but credit is the heartbeat of commerce $$
• “Putting Dow 15,000 in Perspective” by@ReformedBroker stks.co/qBe9 Round numbers fascinate us; processes behind them r unclear $$
• Spinning single-family home investments into mortgage-backed securities stks.co/iUe9 Better idea than securitizing rents $$
• Current Account: Cheap Junk Leads to Expensive Mistakes stks.co/aTNl A lower coupon on a junk bond means more refinancing risk $$
• Wall Street’s trading businesses turn to survival of the least dead stks.co/gUR6You want 2b the last man standing: monopoly $$
• Rush for gold coins, jewels peters outstks.co/hUcf Looks like the drive to own physical precious metals has finished 4 now $$
• Speedy Robots Still a Wall Street Perilstks.co/gUQe Anytime a strategy gets too large, the non-linearities kick in, w/crisis $$
• Chart of the Day: NYSE Margin Debt Raises Eyebrows stks.co/hUcAAsset/Liability mismatch invites trouble; margin debt goes up $$

Other

• Better Than Buffett, This Investor Made Me Rich for Life stks.co/bTj3@davidweidner ’s tribute to his late mother $$ Love > Money
• If Spending Is the Goal, Try Use-It-Or-Lose-It Gift Cards stks.co/iUpXSeiniorage should b distributed to the people per capita $$
• The Internet Kills More Jobs Than It Creates stks.co/fUm6 It is shrinking the cash/taxable economy, but not the economy. $$
• Today’s CEOs Are Too Timid for the Times stks.co/aTbG The marginal productivity of capital is falling b/c of debt deflation. $$
• David Ferrucci: Life After Watsonstks.co/dTER Creator of IBM’s Watson goes 2Bridgewater 2apply Big Data & AI 2forecasting econ $$

Berkshire Hathaway

• $BRK.A CEOs Spend Quietly, Match Buffett on Heinz Deal stks.co/dTmE FD: +$BRK.B | Clever subsidiary CEOs grow BRK organically $$
• New book teaches children ABCs of Buffett’s Company stks.co/iUpW There would b a Hebrew version, but the Gecko isn’t kosher $$
• I think reinsuring Long Term Care is stupid almost always. Insureds know more than insurer, who know more than reinsurer cc @retheauditors
• BRK knew *far* less than SwissRe about the policies they were reinsuring. On life re, meh, but 2 reinsure LTC takes real knowledge $$ + $BRK
• Buffett’s Ribbing About Swiss Re Dispute Is Fibbing stks.co/bTGH SwissRe took BRK 2 the cleaners FD: + $BRK/B cc@retheauditors $$
• Warren Buffett worries about Fed’s ‘huge experiment’ stks.co/eTFv Reliable: removing accommodation is harder than providing it $$
• Munger: It’s time to break up the banksstks.co/hUcC Munger knows that you should mix deposit insurance w/investment banking $$
• A Lesson From Warren Buffett: Doubt Yourself stks.co/sBPW Many great investment teams encourage disagreement 2 test theses hard $$
• “We Want to Win”:Berkshire Hathaway Ann’l Meeting, 2013 Edition stks.co/gUPpBuffett could help $VZ buy VZ Wireless FD: +$BRK $VOD

Wrong

• @creditplumber My article is about insurance companies; u r taking my words out of context
• Wrong: Fed in 2008 Showed Panic of 1907 Was Excessive stks.co/jV1r If/when the tightening cycle ends & things r fine, then crow $$
• Wrong: Earnings Seen Lifting S&P 500 to Real Record stks.co/bTjd Profit margins would have 2 rise from record highs 2 do this $$
• Wrong: Y I Have Never Said 2Invest With Warren Buffett stks.co/qC02 U don’t tug on Superman’s cape, u don’t spit in the wind… $$
• Unsure: Chanos sees downturn in hard disk drive industry stks.co/iV3L Will b hard to fight all of the free cash flow $$
• Wrong: Larry Fink’s radical retirement recommendation stks.co/fUaf Please do *not* constrain people 2save; failure is an option $$
• @AllenSammey I mean that people should be free 2 take care of current needs rather than being forced to save, even if it means poor when old
• Wrong: House Democrats Seeking Control Eye 17 Split-Ticket Seatsstks.co/gURH This article asserts, it does not prove $$
• Wrong: Bond Buyers See No 1994 Rout Helped by Bernanke Clarity stks.co/qBQsNo one saw 1994 coming either; we r flying blind $$
• Wrong: Crises Before and After the Creation of the Fed (2013-13, 5/6/2013)stks.co/gULU Very premature 2 run a victory lap $$

Replies, Retweets & Comments

• @SarcasticBull I agree.
• That is funny & weird. Very, very weird $$ RT @izakaminska: Meme time:Hitler finds out about negative interest ratesstks.co/fUfN
• @munilass The danger 4 those that seek notable media coverage: media likes bold predictions, b/c they are “newsy.” Kind of a trap $$
• @ScrollnKey 6x prior premium? Thanks. Post-Cyprus I think many people are analyzing how they can preserve their wealth.
• Building a bigger, badder, bubble RT@kmac: RBA statement herebit.ly/12cL7Kk
• @ScrollnKey How is it compared to six months ago?
• +1 Houses r expenses RT@cullenroche: Rarely do I disagree with Rick Ferri, but I do here.rickferri.com/blog/investmen…
• @OffRoadFinance I will accept the premise of the paper once we get through the ultimate tightening cycle, which may not b 4 decades
• Van Hoisington, Lacy Hunt & Gary Shilling would agree RT @carney: …a lot of people making bets on rates rising could get burned badly …
• @ReformedBroker thanks
• @The_Analyst @ReformedBroker There are levels of trust; this one ain’t so high, but it’s a straw blowing in the wind
• @ReformedBroker What was the forward PE on the cyclicals?
• @gmacd18 Too early to say. Japan has been given a temporary free pass from the G20. When more nations try2 weaken their currencies, we’ll c
• RT @volatilitysmile: “The tax deductibility of interest played its part in creating this mess, both in the corporate and mortgage markets.”

FYI

• My week on twitter: 51 retweets received, 1 new listings, 87 new followers, 61 mentions. Via: 20ft.net/p

My view is that there is no such thing as a free lunch, not even for governments or central banks.  Any action taken may have benefits, but also imposes costs, even if those costs are imposed upon others.  So it is for the Fed.  At the beginning of 2008, they had a small, clean, low duration (less than three years) balance sheet on assets.  Today the asset side of their balance sheet is much larger, long duration (over 6 years), negatively convex, and modestly dirty as a result.  Let me give you a few graphs created from the H.4.1 data, obtained via the poorly designed and touchy Data Download Program at the Fed’s H.4.1 portion of their website.

The first graph gives the liabilities of the Fed over the last 5+ years.  The data is taken from table 1 in the H.4.1 release.  You can see the massive expansion of the liabilities, and the way the crisis unfolded.  Currency, and “Other Liabilities & Capital” build “slowly,” i.e. 6.9%/yr and 10.2%/yr, respectively.  The US Treasury steps in with the Supplementary Financing Account at a few points where the Fed could use money deposited there for further expansion of quantitative easing, and leaves when they are no longer needed.

But the real growth comes in the “Everything else” which grew at 37%/yr, and reserve balances with Federal Reserve Banks, which you can calculate an annualized rate of growth for (112%/yr), but a rate doesn’t do justice to the process, because it grew due to the three events — QE1, QE2, and QE3.  The Fed bought assets from various parties, who now deposit at banks inside the Federal Reserve System.

The next two graphs come from Table 2 of the H.4.1 report.  These describe the assets that have a maturity, which comprise over 80% of the Fed’s assets over the time of the graph, and over 90% at present.  First, you can see the growth of the assets bought through QE, Treasuries, Agencies, and MBS.  Second, you see the crisis responses: 1) the loan programs in the US, which explode and trail away and 2) the Central Bank Liquidity Swaps, which explode, trail away, and have come back in a muted form in late 2011 to early 2012.

Perhaps the bigger change is that the Fed’s balance sheet has a lot more long-maturity assets than it used to.  This stems from the quantitative easing they have done, as well as their efforts to play God flatten the Treasury yield curve.

Now, almost all of the assets underlying everything 10 years and shorter pay out their principal all at the end, with no right of prepayment.  For 10 years and longer, at present 70% are Mortgage Backed Securities [MBS].  Those have average lives (weighted average time for payment of principal) considerably shorter than a bond that pays all of its principal at the end for three reasons:

• Principal gets paid down slowly due to normal amortization.
• Prepayments get made when it is advantageous to the borrower, which not only pays off principal today, but shortens the term of the loan, which accelerates the normal repayment of principal.
• The final maturity of the longest loan in the pool is the final maturity of the pool.

So, in terms of actual interest rate sensitivity, the over 10 years bucket is probably only a little more sensitive to change in rates than the 5-10 year bucket.

In normal times, central banks buy only government debt, and keeps the assets relatively short, at longest attempting to mimic the existing supply of government debt.  Think of it this way, purchases/sales of longer debt injects/removes liquidity for longer periods of time.  Staying short maintains flexibility.

Yes, the Fed does not mark its securities or gold to market.  Under most scenarios, it is impossible for a central bank which can issue its own currency to go broke.  Rare exceptions — home soil wars that fail, or political repudiation of the bank, where the government might create a new monetary standard, or closes the bank because of inflation.  (Hey, the central bank has been eliminated twice before.  It could happen again.)

The only real effect is on how much seigniorage the Fed remits to the Treasury, or, if things go bad, how much the Treasury would have to lend/send to the central bank in order to avoid the bad optics of negative capital, perhaps via the Supplemental Financing Account.  This isn’t trivial; when people hear the central bank is “broke,” they will do weird things.  To avoid that, the Fed’s gold will be revalued to market at minimum; hey maybe the Fed at that time will be the vanguard of market value accounting, and revalue everything.  Can you imagine what the replacement cost of the NY Fed building is?  The temple in DC?

Or, maybe the bank would be recapitalized by its member banks, if they are capable of doing so, with the reward being the preferred dividend they receive.

Back to the main point.  What effect will this abnormal monetary policy have in the future?

Scenarios

1) Growth strengthens and inflation remains low.  In this unusual combo, it will be easy for the Fed to collapse its balance sheet, and raise rates.  This is the dream scenario; and I don’t think it is likely.  Look at the global economy; there is a lot of slack capacity.

2) Growth strengthens and inflation rises.  The Fed will likely raise the interest on reserves rate, but not sell bonds.  If they do sell bonds, the market will back up, and their losses will be horrible.  If don’t take the losses, seigniorage could be considerably reduced, or even vanish, as the Fed funds rate rises, but because of the long duration asset portfolio, asset income rises slowly.  This is where the asset-liability mismatch bites.

If the Fed doesn’t raise the interest on reserves rate, I suspect banks would be willing to lend more, leaving fewer excess reserves at the Fed, which could stimulate more inflation. Now, there are some aspects of inflation that remain a mystery — because sometimes inflationary conditions affect assets, rather than goods, I think depending on demographics.

3) Growth weakens and inflation remains low.  This would be the main scenario for QE4, QE5, etc.  We don’t care much about the Fed’s balance sheet until the Fed wants to raise rates, which is mainly a problem in Scenario 2.

4) Growth weakens and inflation rises, i.e. stagflation.  There’s no good set of policy options here. The Fed could engage in further financial repression, keeping short rates low, and let inflation reduce the nominal value of debts.  If it doesn’t run wild, it could play a role in reducing the indebtedness of the whole economy, though again, it will favor debtors over savers.  (As I’ve said before, in a situation like this, or like the Eurozone, all creditors want to be paid back at par on the bad loans that they have made, and it can’t be done.  The pains of bad debt have to go somewhere, where it goes is the argument.)

I’ve kept this deliberately simple, partially because with all of the flows going back and forth, and trying to think of the whole system, rather than effects on just one part, I know that I have glossed over a lot.  I accept that, and I could be dead wrong, as I sometimes am.  Comment as you like, with grace and dignity, and let us grow together in our knowledge.  I’ve been spending some time reading documents at the Fed, trying to understand their mechanisms, but I could always learn more.

Summary

During older times, the end of a Fed loosening cycle would end with the Fed funds rate rising.  In this cycle, it will end with interest of reserves rising, and/or, the sale of bonds, which I find less likely (they will probably be held to maturity, absent some crisis that we can’t imagine, or non-inflationary growth).  But when the tightening cycle comes, the Fed will find that its actions will be far harder to take than when they made the “policy accommodation.”  That has always been true, which is why the Fed during its better times limited the amount of stimulus that it would deliver, and would tighten sooner than it needed to.

Far better to be like McChesney Martin or Volcker, and be tough, letting recessions do their necessary work of eliminating bad debt.  Under Greenspan, and Bernanke to a lesser extent (though he persists in pushing the canard that the Fed was not too loose 2003-2004, ask John Taylor for more), there were many missed opportunities to stop the buildup of bad debts, but the promise of the “Great Moderation” beguiled so many.

Removing policy accommodation is always tougher than imagined, and carries new risks, particularly when new tools have been used.  Bernanke can go to his carefully chosen venues and speak to his carefully chosen audiences, and try to exonerate the Fed from well-deserved blame for their looseness in the late 80s, 90s, and 2000s.  Please, Mr. Bernanke, take some blame there on behalf of the Fed — the credit boom could never have happened without the Fed.  Painting the Fed as blameless is wrong; the “Greenspan put” landed us in an overleveraged bust.

I’m not primarily blaming the Fed for its current conduct; we are still in the aftermath of a lending bust — too much bad mortgage debt, with a government whose budget is out of balance.  (In the bust, there are no good solutions.)  I am blaming the Fed for loose policies 1984-2007, monetary policy should have been a lot tighter on average.  But now we live with the results of prior bad policy, and may the current Fed not compound it.

Postscript

The main difference between this time and the last time I wrote on this is QE3.  What has been the practical impact since then?  The Fed owns more MBS and long maturity Treasuries, financed by more reserve balances at the Fed.

Banks use this cheap funding to finance other assets.  But if they want to make money, the banks have to take credit risk (something the Fed is trying to stimulate), and/or interest rate rate risk (borrow short, lend long, negative convexity, etc).  The longer low rates go on through interest on reserves, the greater the tendency to build up imbalances in the banking system through credit and interest rate risks. 1992-1993 where Fed funds rates were held at 3%, was followed by the residential mortgage backed security market melting down in 1994, not to mention Mexico.  Sub-2% Fed funds rates from 2002 through mid-2004 led to massive overinvestment in residential housing, leading to the present crisis.

Fed tightening cycles often start with a small explosion where short-dated financing for thinly capitalized speculators evaporates, because of the anticipation of higher financing rates.  Fed tightening cycles often end with a large explosion, where a large levered asset class that was better financed, was not financed well-enough.  Think of commercial property in 1989, the stock market in 2000 (particularly the NASDAQ), or housing/banks in 2008.  And yet, that is part of what Fed policy is supposed to do: reveal parts of the economy that are running too hot, so that capital can flow from misallocated areas to areas that are more sound.  At present, my suspicion is that we still have more trouble to come in banking sector.  Here’s why:

We’ve just been through 4.5 years of Fed funds / Interest on reserves being below 0.5% — this is a far greater period of loose policy than that of 1992-1993 and 2002 to mid-2004 together, and there is no apparent end in sight.  This is why I believe that any removal of policy accommodation will prove very difficult.  The greater the amount of policy accommodation, the greater the difficulties of removal.  Watch the fireworks, if/when they try to remove it.  And while you have the opportunity now, take some risk off the table.

These articles appeared between February 2012 and April 2012:

We Eat Dollar Weighted Returns — III

What did a buy-and-hold investor get owning SPY?  7%/year.  What did the average holder get? 0%.  A warning against over-trading.

Against Risk Parity

Against Risk Parity, Redux

Expressing skepticism over a strategy using leverage to extract returns out of lower-yielding asset classes.  Why not but subordinated asset-backed securities instead, and how did they do in the crisis?

Individual Investing Can Be Tough

Individual Investing Can Be Tough, Redux

The investment game is competitive, and I give a few tips on how to avoid the risks.

Musings on the “400% Man”

Understanding small asset managers, and why you might want to invest with them.

Thinking about the Insurance Industry

I take a tour through the insurance industry after the carnage of the credit crisis.

Notes on the 2011 Berkshire Hathaway Annual Report, Part 3 (On Acquisitions)

Lists all of the notable acquisitions of Berkshire Hathaway from 1977 to 2011.  Analyzes Buffett’s strategy, which has been remarkably consistent over 40 years.

Notes on the 2011 Berkshire Hathaway Annual Report, Part 4 (10K Issues)

Goes through the main risks of Berkshire Hathaway.

Replacing Defined Contributions

I propose a hybrid plan that would replace 401(k)s, and other participant-directed DC plans.

The Rules, Part XXXI

The offering of liquidity through limit orders is a real service to the market, and on average gets rewarded in lower overall execution costs.  In choppy markets, it can really add value.

Buy-and-Hold Can’t Die

Buy-and-Hold Can’t Die, Redux

Explains how every investor (even speculators) has the option of holding on  for a long time, and why that can be valuable.

The Anti-Consultancy Consultancy

Call me, and I will tell you to fire the consultant, and listen to your middle managers.

Easy in, Hard out

It is always easier to loosen monetary policy than to tighten it.  The next tightening cycle will be particularly rough, should the Fed ever choose to do it.

Gold does Nothing

This post got a lot of play over the internet.  I was really surprised at how much response it received.  Gold has few industrial uses, but is pretty; that’s why it is so interesting.

Misunderstanding the Tax Debate

Misunderstanding the Tax Debate (II)

The debate should be about what income is, and not about what the rates should be.  Wealthy people have clever advisers that minimize “income.”  Doesn’t matter what the tax rate is.  The debate should focus on income.

Simple Retirement Calculator

Gives a simple way of analyzing whether you have saved enough or not.  Quick answer: you haven’t saved enough, particularly for the wretched investment environment that we are in now.

These articles appeared between November 2011 and January 2012:

The Foul Deed of the SEC in 2004

Why the SEC is to blame, and not to blame, regarding the net capital rule.  They changed little in 2004, but should have been more aggressive than that.

Bubbles are Easy to Spot, well almost…

How to spot bubbles, and why our world is so messed up from an unwillingness to takes losses on bad debts.

At the Cato Institute’s 29th Annual Monetary Conference (Epilogue)

My thoughts on monetary policy versus the many odd people who come to the conference.

A Large Middle Class Isn’t Necessarily Normal

After all, across human history, middle classes have been abnormal.  Why should they be regarded as normal now?  Has something fundamentally changed?  Lotsa flame-mail on this one. Hot!

Valuing Behemoths

Valuing Behemoths, Redux

On the issues regarding cheaply valued companies where the equity is worth more then $100B.

Improve the Position

We are no good at choosing the best assets, but we are better at choosing assets that are better than what we currently hold.

The Gold Medal Gold Model

I take Eddy Elfenbein’s model and apply regression to it.  The results explain what affects the price of gold — the real cost of carry.

Peak Credit

What I write here will not be rigorous.  We’ve heard about “peak oil.”  We’ve heard about other resources, and how production will decline over time.

But what of credit? It isn’t that hard to create, but it is hard to create well, particularly when debt levels are high, as in this environment.

The Rules, Part XXVIII

Rebalancing of any sort in investing presumes an underlying stability to the economic system, and thus, market returns.  Rebalancing will not protect against socialism, war, or an overleveraged position.

The Rules, Part XXIX

Risk premiums should never be capitalized, they should only be taken into income as earned.

The Rules, Part XXX (30)

In the recent run-up, there was talk of the infallibility of equities.  This led to a higher level of variable compensation in the economy through option and share issuance and low pressure to raise fixed wages.  This was yet another form of hidden leverage, which hid the unprofitability of enterprises through share dilution.

Stock Prices versus Implied Inflation

Stocks, at least in this environment do better when inflation implied by TIPS rises.

Permanent Asset Allocation

An attempt to explain why Harry Browne’s asset allocation idea works, at least until many realize it, and send gold shooting through the roof.

Too Many Par Claims versus Sub-Par Assets

This sums up the problems of our world today.  Everyone wants to be paid back in full, but many are “bust” and cannot repay.

On Predicting the Future

I reverse-engineered ECRI, and the response is minuscule.  This took a lot of work, and was controversial.

Against Simple Valuation Metrics

On the value of dividends, buybacks, acquisitions, and organic growth.

On Opaque Transparency

After a certain point, the more data you reveal, the harder it gets to evaluate what is going on.  Far better to reveal to the public the core data that explains policy than to make them slog through big data releases.

And in those cases, what is not revealed is the most important data.

These articles appeared between August and October 2011:

Take Prudent Risk

One of the great secrets of investing is taking moderate risk.  High risk fails on average, because those swinging for homers make a lot of strikeouts.  Low risk fails because there is little reward.

De Minimus Laws, Redux

I catalog all of the de minimus laws for Registered Investment Advisers.  Only Texas and Arkansas require registration on the first client.  The rest require it on the sixth client.

How Would You Run a Rating Agency?

Points out the incompatible standards that rating agencies are encouraged to achieve.  It is a no-win situation.

Stagflation-Plus

There is no escape.  There will be a crisis.  Do you want a smaller crisis sooner, or a bigger crisis later?  The actions of our government say, “A bigger crisis later, much bigger and later if possible.”

The Rules, Part XXIV

Every excess eventually unwinds.  When an excess unwinds, the fall gets exacerbated by trend-followers blowing out of mutual and other pooled funds with lousy relative performance.

Leverage Isn’t Free

A critique of risk parity.  This is implicitly the same idea behind securitization, but it does not get the same criticism.

The Predictions of Michael Pettis

Few global macroeconomists are as perceptive as Michael Pettis.  I have learned a lot from him over the years.

The Folly of Large Acquisitions

I explain what most tends to improve the value of companies with respect to the use of free cash flow.

The Rules, Part XXVI (Efficiency vs Stability)

T+1 will raise volatility.  Often increases in the technical efficiency of information or trading systems increase volatility, because people can act precipitously on information, all at the same time.

Missed Opportunities

The Federal Reserve was the primary architect of the debt bubble that we are now wrestling with.  It is the main reason that we need to eliminate the incompetent, overstaffed Fed.  (Lay off anyone that has a Ph. D.  there.  Dangerous idealists who have little contact with reality.)

On High Correlations

I explain why high asset correlations have to be bearish indicators.

How Do I Find a Job in Finance?

How Do I Find a Job in Finance? (Part 2)

I have helped many people get jobs in finance.  Most of my useful advice is in these two articles.

On Multiparty Transactions

My simple rule to average people when involved in complex transactions is this: be cynical.  No one is interested in your well-being, and most of the transactional terms are skewed against you.  To the extent that you can borrow less, and eliminate some of the parties that would be a part of the transaction, it is to your good that you do so.  The best situation is that you buy for cash, if you have it.

Debt Relief

The main thing holding back our world from recovery, is no one wants to take losses from bad debt, and so central banks extend a lot of credit, as if those pointy-headed intellectuals have any idea about how the economy really works.

Build the Buffer

There are advantage to having surplus cash around.  You can get discounts and minimize risks.

Financial Complexity, Part 1

Alas, there is no part two to this piece.  But this piece explains why financial markets are often not efficient.

The Retirement Bubble

We know we should save for retirement, but we don’t.  That applies to governments, corporations, and individuals.

We Eat Dollar-Weighted Returns

Explains how the average person did poorly investing with Bill Miller, while the few buy-and-hold investors did pretty well.

On Social Media, and How I Built my Blog, Part 1

On Social Media, and How I Built my Blog, Part 2

I divulge almost all of my tricks for building a good blog.

Improving Publishing in the Social Sciences

I adapt the concept of double-blind studies to the social sciences.  It would definitely improve the quality of the research.

Occupy Your Time Productively

I got a lot of hate mail over this, but my main point was that protesters should organize, and form a political party or something like it (think of a leftist version of the Tea Party).  The Occupy movement was lazy, and the results of their actions were minimal.