The credit cycle is kind of like a Monty Python skit where the humor has reached a point of diminishing marginal returns. At that point, they might blow something up, and move onto the next skit. Credit cycles end with a bang, not a whimper. Take a spin down the last few cycles:

  • 2000 — Nasdaq, dot-coms
  • 1997-98 — Asia/Russia/LTCM
  • 1994 — Mortgages/Mexico
  • 1989 — Banks/Commercial Real Estate
  • 1987 — Stock Market
  • 1984 — Continental Illinois
  • Early ’80s — LDC debt crisis

In each case, we had assets that were weakly financed.  When liquidity began to become scarce, the entities that were weakly financed faced sharply rising borrowing costs, and many defaulted.  The purpose of this piece is to muse about what entities in our world today are reliant on the presence of favorable financing, and would suffer if that financing ceased to exist.  Here’s my initial list.  Can you give me some more ideas?

  1. Too obvious: CCC-rated bond issuers.  We’ve had a lot of them issue debt over over the past three years.  Those that have not shored up their balance sheets and paid down debt will suffer if they need additional financing.
  2. Yield-seeking hedge funds.  When the credit cycle turns, yield becomes poison.  Those holding the equity of Collateralized Debt Obligations, and other levered forms of credit will have a rough time, particularly if their investors ask for their money back.
  3. Dodgy mortgages.  We’ve already seen the beginning with subprime mortgages, but there are more loans that will hit resets over the next twelve months.  The troubles with Alt-A lending will be more spread out, but it really hurts to have your financing rate jacked up at a time that the asset financed is experiencing weakness in price.
  4. Private equity over-borrowing.  Much of private equity relies on the idea that they can have an easy liquidity event five years from now.  What if interest rate are three percent higher then?  P/E and EV/EBITDA multiples will be lower, not higher, and then what do you do with all of the debt used to finance the purchase?
  5. Overly indebted cyclicals, and mergers that increase leverage.  Companies that presumed too much about the future get killed when the cycle turns.  The mergers and recapitalizations that looked so promising are horrid when the willingness to take risk drops.
  6. Mis-hedged investment banks.  This is a little more speculative, but in a credit crisis, investment banks without adequate liquidity are in the soup.  Lehman Brothers barely survived 1998; in a more severe crisis, who would get harmed?
  7. Sovereign nations with large current account deficits.  This is the most controversial category.  I am not talking about the main emerging markets here; I am talking about developed countries that lack discipline, like Iceland, New Zealand, and the United States.  The large emerging markets are in better shape than the derelict nations that they fund.  If the debt is in their own currency, the nation has more options than merely defaulting.  They can inflate, or create a two-tier currency system to give foreigners the short end of the stick.  (Think of Argentina, or South Africa back in the 80s.)


These are the weak entities that I can think of.  There are more, I am sure, particularly as the demographic crises emerge over the next decade, but for now, if liquidity becomes scarce, these are the entities that will suffer.

As Paul mentioned in the comments on the last post, I answered a question at Stockpickr.com today. James Altucher, the bright guy who founded the site, asked me if I would answer the question, and so I did. Here is a reformatted version of my answer, complete with links that work:


Q: Any thoughts on how to value an insurance business? What are the best metrics to use? In particular I’m looking at small cap insurers (P&C) as potential acquisition targets. Does that change the methodology?


A: That’s not an easy question, partly because there are many different types of insurance companies, and each type (or subsector) gets valued differently due to the degree of growth and/or pricing power for the subsector as a whole.

Now, typically what I do as a first pass is graph Price/Book versus return on equity for the subsector as a whole, and fit a regression line through the points. Cheap companies trade below the line, or, are in the southeast corner of the graph.

But then I have to make subjective adjustments for reserve adequacy, excess/noncore assets, management quality, pricing power on the specific lines of business that write as compared to their peers, and any other factors that make the company different than its peers. When the industry is in a slump, I would have to analyze leverage and ability of the company to upstream cash from its operating subsidiaries up to the parent company.

Insurance is tough because we don’t know the cost of goods sold at the time of sale, which requires a host of arcane accounting rules. That’s what makes valuation so tough, because the actuarial assumptions are often not comparable even across two similar companies, and there is no simple way to adjust them to be comparable, unless one has nonpublic data.

My “simple” P/B-ROE method above works pretty well, but the ad hoc adjustments take a while to learn. One key point, focus on management quality. Do they deliver a lot of negative surprises? Avoid them, even if they are cheap. Do they deliver constant small earnings surprises? Avoid them too… insurance earnings should not be that predictable. If they become that predictable, someone is tinkering with the reserves.

Good insurance managements teams shoot straight, have occasional misses, and over time deliver high ROEs. Here are three links to help you. One is a summary article on how I view insurance companies. The second is my insurance portfolio at Stockpickr. The last is my major article list from RealMoney. Look at the section entitled, “Insurance & Financial Companies.”

Now, as for the small P&C company, it doesn’t change the answer much. The smaller the insurance firm, the more it is subject to the “Law of Small Numbers,” i.e., a tiny number of claims can make a big difference to the bottom line result. Analysis of management, and reserving (to the extent that you can get your arms around it) are crucial.

As for takeover targets, because insurers are regulated entities, they are difficult to LBO. Insurance brokers, nonstandard auto writers, and ancillary individual health coverage writers have been taken private, but not many other insurance entities. State insurance commissioners would block the takeover of a company if it felt that the lesser solvency of the holding company threatened the stability of the regulated operating companies. The regulators like strong parent companies; it lets them sleep at night.

One more note: insurance acquisitions get talked about more than done, because acquiring companies don’t always trust the reserves of target companies. Merger integration with insurance companies has a long history of integration failures, so many executives are wary of being too aggressive with purchases. That said, occasionally takeover waves hit the insurance industry, which often sets up the next round of underperformance, particularly of the acquirers.

Three months ago, the global financial markets were at their short-term nadir, but few knew it at the time.  Long term bond yields bottomed then as well, which should be no surprise in hindsight.  Since that time, the average 10-year swap rate (what a AA-rated bank can borrow at) for the 10 nations that I track (USA, Germany, Japan, Britain, Switzerland, Canada, Australia, New Zealand, Norway, and Sweden) have risen 53 basis points (0.53%).  Equity markets have rallied, and implied volatilities and corporate bond spreads have fallen.

The correlated change in the global bond markets is significant, and if it runs another one percent or so, could derail the equity markets.  Bond yields would then be fair relative to equity yields, assuming that the current high operating profitability continues, which is not guaranteed, though I think it will persist long enough to embarrass those who say it must mean-revert imminently.

There is a change going on here, and as for my balanced mandates, I think it means that I toss out my long bonds [TLT] for a small loss, and keep my duration short.  As for my equities, no action for now, aside from ordinary rebalancing activity.  Don’t panic, but be vigilant, and use your ordinary risk control methods.

Full disclosure: long TLT, but not much

In securitizations, a series of assets, typically ones with well defined payoffs, such as fixed income (bonds and loans) and derivatives of fixed income get placed in a trust, and then the trust gets divided up into participations of varying riskiness. The risks can be ones of cash flow timing (convexity) and/or credit. Regardless of what the main risk is, the challenge for those issuing the securitization is who will buy the riskiest participations.

When the market is hot, and there are many players gunning for high income, regardless of the risk level, selling the risky pieces is easy, and that is what conditions are like today, with the exception of securitizations containing subprime loans.  When the market is cold, though, selling the risky pieces is hard, to say the least.  If market conditions have gotten cold since the deal began to be assembled, it is quite possible that the will not get done, or at least, get done at a much smaller profit, or even a significant loss.

In that situation, hard choices have to be made.  Here are some options:

  1. If there is balance sheet capacity, keep the risky parts of the deal, and sell the safer portions.  Then if the market turns around later, sell off the risky pieces.
  2. If there is a lot of balance sheet capacity, hold all of the loans/bonds and wait for the day when the market turns around to do your securitization.
  3. Sell all of the loans/bonds off to an entity with a stronger balance sheet, and realize a loss on the deal.
  4. Reprice the risky parts of the deal to make the sale, and realize a loss.


The proper choice will depend on the degree of balance sheet capacity that the securitizer has.  Balance sheet flexibility, far from being a waste, is a benefit during a crisis.  As an example, in 1994, when the residential mortgage bond market blew up, Marty Whitman, The St. Paul, and other conservative investors bought up the toxic waste when no one else would touch it.  Their balance sheets allowed them to buy and hold.  They knew that at minimum, they would earn 6%/year over the long haul, but as it was, they earned their full returns over three years, not thirty — a home run investment.  The same thing happened when LTCM blew up.  Stronger hands reaped the gains that the overly levered LTCM could not.

In this era of substituting debt for equity, maintaining balance sheet flexibility is a quaint luxury to most.  There will come a time in the next five years where it goes from being a luxury to a necessity.  Companies that must securitize will have a hard time then.  Those that can self-finance the assets they originate will come through fine, to prosper on the other side of the risk cycle.  Be aware of this factor in the financial companies that you own, and be conservative; it will pay off, eventually.

Cody has an point that everyone should listen to in his post, Cody on Your World with Neil Cavuto.  I still regard myself as a moderate bull here, but it is altogether wise to take something off the table here.  My methods have me forever leaning against the wind.  As an example, near the close yesterday I trimmed some Anadarko Petroleum as a rebalancing trade.  I still like Anadarko, but at a higher valuation, it pays to take something off the table.  Why?  Because we don’t know the future, and something could happen out of the blue that transforms the risk profile of the market in an instant.


So, what does this mean for me?  I’m up to 12% cash in my broad market portfolio, which is higher than the 5-10% that I like it to be, but not up to the 20% (or down to zero) where I have to take action.  My balanced mandates are taking on cash to a lesser extent.  A 5.25% yield is pretty nice.


Now, here’s where I am different (not better, but different) than Cody.  Cody advocated taking 20% off the table (in his Fox interview), whereas I am forever taking little bits off the table as the market runs.  My robotic incrementalism takes the emotion out of the selling and buying processes.  That said, I may leave something on the table versus someone making bigger macro adjustments.


Whatever you do, it has to be comfortable for you in order to be effective.  The market may go up further from here; on average, I expect it will do so, but I can imagine scenarios where it will not do so.  That’s why I take a little off the table each time my stocks hit upper rebalance points; my baseline scenario may not happen, and rebalancing to target weights protects against what is unexpected.  It is a modest strategy that guards against overconfidence, and will always allow you to stay in the game, no matter how bad the market gets.


I don’t have to be a raving bull or raving bear.  I just have to control my risks, and over the long run, I will do pretty well.  Cody will do well too; he just does it differently.

Full Disclosure: long APC