November 2007 – Page 3 – The Aleph Blog

Holding My Nose, Still

Posted on 8 November 20078 November 2007 by David Merkel

Three companies of mine reported after the bell, Flagstone, Deerfield, and National Atlantic. I’ll take them in that order.

Flagstone beat handily, as I would have expected a property-centric reinsurer to do in this environment. Let’s see what optimism tomorrow brings. At 96-97% of book value, it seems cheap, but I can’t imagine property reinsurance rates will be that robust next year.

Deerfield is a little more tricky. They took a loss due to mark-to-market events in their portfolio. REIT taxable income is reasonable at 50 cents/share, and much of the writedown is a GAAP anomaly that shaves $1.20 off of the current book value. Economic book value is $11.84, which provides some support to the stock. The dividend of 42 cents is still intact. There is reasonable excess liquidity, even after the increase in repo margins during the third quarter. Let’s see what the market thinks.

Now for the problem child, National Atlantic, which takes an 83 cent loss. Here’s the main offending paragraph from the press release:

“For the three months and nine months ended September 30, 2007, reserves have increased by $17.6 million and $9.4 million, respectively, principally as a result of the strengthening of the reserves for bodily injury claims. During the third quarter it was determined that the Company’s policy related to claims handling procedures and reserving practices were not applied consistently, primarily within the bodily injury claims unit. As part of the resolution of this matter, the Company retained an independent claims consulting firm.”

For a company the size of National Atlantic, these are huge reserve changes, particularly for a short-tail line like auto. What I am about to write here is only a guess, but this likely was building up since sometime in 2006. One of the reasons I am willing to be a little more bullish on short-tail insurers is that it is a lot harder to get the reserve wrong. Looks like I am getting one of the rare events that teaches greater caution. (That said, my average cost is $8.85, so I’m not that badly hurt.) Given the large reserve change this period, ordinarily, the decks are cleared for future periods, but who can tell for sure? Also, this places the combined ratio since 2002 at 103.7%. It makes me think that the company will do well to eke out any underwriting profit.

I’ll be listening to the call tomorrow. What’s the endgame here? Given the marginal ability to earn underwriting profits, perhaps the company would best be reconciled by merging with another firm. That wasn’t my opinion over the past three years, but it is my opinion now. There are many firms that could have an interest at the right price, which probably approximates the book value of $13.28. That said, many of them may have kicked the tires already and passed, some probably thinking that a bid at book value would not be honored. All I can say is, give it a shot. Rumor is that Commerce wasn’t offering more than book, so if you want a greater presence in NJ personal lines, it may be available at a reasonable price.

Full disclosure: long FSR DFR NAHC

Circuit Breakers, but no Curbs

Posted on 8 November 2007 by David Merkel

Posted today at RealMoney:

		David Merkel
		Bye-bye to Trading Curbs
		11/7/2007 2:37 PM EST

When the NY Composite fell 2% today, no trading curbs kicked in. Program trading went on unfettered by a need for upticks. Around 1:20, when the curbs would have kicked in, the market fell a little, stabilized, and began to rally. So much for the curbs. Now all that remains are the circuit breakers, which kick in when the DJIA is down 10% and 20%. The circuit breakers only came into existence in 1987, and to the best of my knowledge, have never been triggered. (Anyone else know for sure? I don’t have intraday data.)

Using closing data since 1900 (again, I don’t have intraday), the circuit breakers would have been triggered 5 and 2 times each. That’s once every 21 and 54 years, respectively. To me, that’s not frequent enough to have a rule in place, even if intraday data would double the frequency.

Position: none

As it was, the market finished down nearly 3% today.? I suspect that curbs wouldn’t have helped much, but who can tell.? The market is a lot more game-friendly than it used to be; far fewer rules to observe (or flout).

On an unrelated note, here are my two REIT charts from yesterday, in thumbnail form, for those who had a hard time with them yesterday.

Mortgage REITs

Equity REITs

Personal Finance, Part 4 — Health and Disability Insurance

Posted on 7 November 2007 by David Merkel

With health insurance, the main idea is that you should be covered in the event of a catastrophe.? First dollar coverage is nice if your employer is a sugar daddy (be sure and thank him, but not too effusively, lest he realize how much he is paying…), but insurance is not really effective at claims management; it is far more effective at risk-bearing.

To that end, high deductible plans can be effective for those that have to buy insurance privately.? Just make sure that you fund the deductible. Health Savings Accounts are triple tax free, and can be a particularly sweet deal.

Though this also applies to health insurance, with disability insurance, consider the claims-paying record of the insurer.? This is not a coverage where lowest premium payment wins.? Good companies do their underwriting on the front end, and pay legitimate claims.? Bad companies don’t do their underwriting on the front end, and deny legitimate claims.? This usually shows up in the complaint statistics at you state insurance department, so review those before buying disability insurance.

Also, with disability insurance, note the distinctions between “own occupation” and “any occupation” coverage.? With “own occ,” a surgeon who loses his steady hand could make a claim, but could not under “any occ.”? He could go flip burgers.? Also, note total and partial disability terms.? Under what conditions will they pay, and how much?

If you do become disabled, the insurance company may attempt to buy out your claim with a lump sum.? Don’t take the lump sum; they typically lowball the offers; claimants would receive a lot more over time if they were patient and took the payments gradually.

Now, not everyone needs disability insurance.? If you’re in a low-risk occupation, like me, odds are that you won’t be disabled to where you can’t earn money.? Analyze your own willingness to take risk in this area if you decide not to buy disability insurance.? Some risks are best self-insured.

Buying Cheap and Holding My Nose

Posted on 7 November 20077 November 2007 by David Merkel

How comfortable would you be buying National Atlantic Holdings?

Or Deerfield Triarc?

Or YRC Worldwide?

I could go on, after all, recently I bought some Redwood Trust, and a number of smaller cap value names that don’t seem to be getting much respect right now. Value as a strategy is lagging now, and I am feeling that in my performance. Financials that deal with mortgages are out of favor also.
So why mortgage REITs now? Take a look at this chart of the 10-year Treasury yield less that on mortgage REITs:

Yields are pretty high relative to “safe” Treasuries, comparable with 1990 and mid-2002 spreads. Only the bad old days of 1974 surpass the yield spreads of this era by a significant amount. As I recall, REITs had a really bad name in the late 1970s after the mid-decade shellacking. I remember technical terms like “fraud,” but then, I was an impressionable teenager with an active imagination. 🙂

Now consider this chart of the 10-year Treasury yield less that on equity REITs:

The result is closer to fair value. I certainly would not call equity REITs as a group cheap; future returns rely on property price appreciation, which doesn’t seem likely to me at present.
Now, I’m not endorsing all mortgage REITs. Review funding structures and excess liquidity; you want excess cash flow and conservatism at this point. Heroics offer more downside than upside here.

As for YRC Worldwide, trucking is needed in our economy, and even with some slowdown, YRC should still make money, just not as much. On National Atlantic, I would only say that it seems that there is a forced seller in the name now, and when he is exhausted, the stock will lift. It is difficult to destroy a personal lines insurer with a conservative balance sheet. At 60% of a conservative book value, I can live with adverse outcomes.

Remember, do you own due diligence here. Just because it looks cheap does not mean it can’t get cheaper.

Full disclosure: long RWT NAHC DFR YRCW

Personal Finance, Part 3 — Buy The Life Insurance You Need

Posted on 6 November 2007 by David Merkel

Sorry that my posts have become more terse and less frequent.? A large part of that was recent computer troubles, which have largely been rectified.? I highly recommend the program and advice on this webpage if your computer is running slow.? Beyond that, I have had internet outages (thank you Verizon), and my efforts at obtaining long-term investors for my strategies have eaten up a lot of time.

Tonight’s post deals with life insurance.? My main advice: buy what you need, not what someone wants to sell you.? What most people need is protection for their loved ones from untimely death, which can be satisfied by term insurance.? Now, some wealthy people with complex estate planning needs can benefit more from other forms of life insurance, but that’s not common.? Also, people who aren’t so healthy can benefit from permanent insurance through an agent, because that may be the only way that they can obtain coverage on a reasonable basis.

Why do I favor term insurance?? It’s cheap.? It’s cheap because it is easy to compare the features of various policies against each other to find the best price.? But what if some company that is lower quality offers the best price?? The state guaranty funds stand behind the insurance companies, and no one has failed to receive a death benefit on a timely basis as a result.? (Note: agents are not allowed to tell you this, because the states don’t want lower quality companies to gain a marketing advantage by mentioning the guaranty funds.)

Term insurance offers another advantage: re-underwriting.? If after ten years, you are still in good shape, and you still need insurance, apply for a new policy at a lower rate over the same remaining term as your old one.? If you can get one, buy it and cancel the old policy.? If your health is not so good, keep paying premiums on the old policy.

Where do you buy the insurance, then?? Google the phrase “term insurance,” and a variety of comparison services will pop up.? Try a few of them, and buy from the cheapest.? The younger you are, the longer the term you should buy for, because the far-out years are cheaper.? The older you are, stick to ten years at most.

A few final points: don’t buy policy riders; they are an expensive way to obtain insurance.? Also, don’t buy convenience insurance policies that offer token amounts of insurance; they are expensive also.? Last, don’t scrimp on the amount of coverage.? Few people are overinsured when it comes to life insurance; 5-10x your salary is pretty standard, but analyze how much your loved ones will need in your absence, and buy that much coverage.

Personal Finance, Part 2 — Risks

Posted on 3 November 20076 November 2007 by David Merkel

I view personal finance through the prism of risk management. What can go wrong? Here are many of the threats that the average person faces:

Die too soon
Bad health
Disability
Inflation/Deflation
Unemployment
Property & Liability losses
Live too long
Not earn enough on investments

This list is not exhaustive; perhaps you can think of more. Each one reflects an aspect of life that we don’t fully control. ? Some of them can be fully or partially hedged through insurance (1, 2, 3, 6, 7), some can be fully or partially hedged through investment policy (4, 8 ), and some can’t be hedged at all (5).? My next few articles in the series will deal with the hedgeable risks, and what reasonable strategies can be for dealing with each one.

Personal Finance, Part 1

Posted on 2 November 2007 by David Merkel

This is the first in an irregular series of articles on personal finance issues.? I have only worked in two industries in my life — life insurance and asset management.? I have distinct opinions here, and ones that may prove to be controversial, because they will step on the toes of those who disproportionately benefit from how the system works at present.? All of that said, don’t take my word as gospel on these issues for your own personal situation.? Get personal, tailored advice from someone who knows your intimate financial details.

Tonight’s topic is on work.? Who drives your financial plan?? Either you can drive it, or, you can hire someone to drive it, or, you can let multiple parties take a “piece of the action” and end up with a crazy quilt.? The first option means that you have to work and learn.? The second option means that you have to learn enough to choose a good advisor.? The last option means that there is no organizing principle, but you end up with whoever successfully convinces you to part with money for a part of a financial plan on any given day.

I encourage the first two options.? They are cheaper, integrated, and you get better results.? When friends come to me for advice, my first question is “how much work do you want to do?”? It’s good to learn about financial topics.? Aside from the personal benefits, there are positive spillover effects into the rest of life.? It makes you more productive to those you serve, if you understand the basic economics behind the tasks that you do.

I understand enough about automobiles to be able to know whether my mechanic is likely lying to me.? The same is needed to be an intelligent user of financial professionals.? To not learn the modest amount needed to evaluate financial professionals is to invite financial salesmen to come and sell you on their product of the day, which may not be the best thing for you.

Twenty years ago, I? began spending an hour a day on average improving my knowledge of financial matters.? You don’t need to do that much, but you do need to learn about personal finance issues.? Future articles in this series will give my view of personal finance topics; I hope you can benefit from them.

The Problems of Ruin, Near-Ruin, and Decay

Posted on 1 November 2007 by David Merkel

Many investors, both institutional and individual, take too much risk. Taking too much risk can take a number of forms:

Buying companies with weak balance sheets.
Buying companies with high valuations.
Inadequate diversification, whether by number of companies, number of industries, or some risk factor like buying only high-yielding stocks.
And more…

There are three ways that problems can manifest themselves.? The first way is ruin.? An investor is so certain of himself that he uses a large amount of leverage to express his position.? When the bet goes wrong, he loses it all; he is ruined.? The second manifestation is near-ruin.? As ruin is threatening, the investor sells everything to preserve some of his assets, often near the local bottom for that set of assets.

The third manifestation is decay.? In this case the investor says, I will never take losses greater than x% of my position.? Nice intention, but it raises the spectre of the death by a thousand cuts.? Many assets fall before a significant rise; why get stopped out?? Instead, use falls in price to re-evaluate positions, and consider adding if the original thesis is still valid.

To be a little more controversial here, I don’t trust the bold claims of most technicians who place stops on their positions, and claim to have good performance.? Once one places stop orders, the probability rises for multiple small losses that exceed the few larger gains in the portfolio.? Call me a skeptic, but I would rather re-evaluate my positions than automatically sell, which seems to me to be a recipe for decay.

Looking Backwards at the FOMC Meeting

Posted on 1 November 2007 by David Merkel

I posted three times on the Fed today over at RealMoney.com.? Here are two of the more important posts:

		David Merkel
		Since the Last FOMC Meeting
		10/31/2007 12:28 PM EDT

Canadian dollar up 7%

Euro up 5%

Swiss franc up 3%

Yen flat

Long U.S. Treasury bond up a few ticks in price ~0.1%

3-5 year Treasuries up half a buck in price ~0.5

Yields on the short end fall 0.25%

U.S. dollar LIBOR falls 70 basis points, and the TED spread falls 47 points to 104 basis points.

The volatility index falls 25%, but all of that occurred on the first day

Five-year forward five-year inflation as implied by TIPS, has fallen 20 basis points

The S&P 500 returns 4.5%

Here’s the summary: Systemic risk has declined but is still an issue. The U.S. dollar is weak, because projections of future FOMC policy point to lower short rates, when the rest of the world isn’t going that way. Note the declines against the non-carry-trade currencies. Market stability has brought the carry trade back.

The FOMC will likely cut 25 basis points today and leave a “growth risk” assessment in place. That’s what the market is expecting; anything different from that will drive any market surprise. At 50 basis points, the dollar tanks, implied inflation rises, the yield curve steepens and the stock market rallies, at least temporarily. With no cut, the dollar rises, implied inflation falls, the yield curve flattens and the stock market falls, at least temporarily.

Well, let’s watch the furor at 2:15. If we get 25 bp, there should be noise, but not much movement to the close.

Position: none — happy Reformation Day!

		David Merkel
		Correction
		10/31/2007 3:34 PM EDT

The FOMC vote was not unanimous. Governor Hoenig felt no change was needed. So what has happened so far?

Yield curve steepens

Equity market rallies

Volatility index falls

Dollar falls

Expectations of future Fed funds moves declines — fewer cuts anticipated

Long bonds fall in price, rise in yield

TIPS fall a little less, show a touch more in inflation expectations

Gold and many commodities rise; oil stays flattish.

All in all, a market that fears inflation to a degree, but is not worried that much about growth.

Position: none

Okay, I got the growth risk assessment wrong, but largely, my analysis of FOMC action has been on target.? As for my post yesterday that got a bit of play over the web, I would just like to clarify a few things.? First, my view does not imply permanent easing of Fed policy.? Quite the contrary, I am an advocate of a flattish yield curve under ordinary circumstances, because it restrains speculation, and tends to preserve a sound currency.? That said, if one has to deviate from my baseline policy, don’t waste time getting to your policy goal, because slow adjustments merely put off the time when the cumulative adjustment is enough to matter.

As for the inability of anyone to call turning points: true enough, unless you’re ECRI — maybe we can outsource monetary policy to them.? But the idea of having a central bank presumes their ability to spot turning points, and take action.? If they can’t do that, let’s simplify the system, and move back to a currency board or a gold standard.? Let’s take monetary policy out of the hands of politicians, and those whom they appoint, and put it back in the hands of the free market, if they can’t pick turning points.

As for the Federal Reserve being affected by politicians, perhaps Volcker was an exception, but during the Carter and Nixon years, the White House successfully attempted to influence policy.? Greenspan admits to being influenced on policy decisions by the White House as well.? If we need more proof, look at the prior loosening cycle, where the rates went far lower, and stayed abnormally low far longer than a policymaker following the Taylor Rule would have done.

PS — I am a fan of Dr. Jeff Miller, though we likely disagree on issues like this.? His addition to the commentary over at RealMoney.com is a real plus for the site.