All or Nothing at All
I had some “down time” today (taking my third child to junior college), when I could sit and think about some of the issues in the markets, when all of a sudden, a weird correlation hit me. Similarities between:
- The near bankruptcy of the Equitable back in the early 90s.
- Neomercantilism
- The relationship of Moody’s and S&P to MBIA and Ambac.
Now, I write as I think, so at the end of this, I hope to have a theory that links all of these. For now, let me tell a story.
When I was younger, I worked for AIG in their domestic life companies. While I was there 1989-92, the life insurance industry was undergoing a lot of troubles from overinvestment in mortgages and real estate. Many companies were under stress. A few went bankrupt. One big one was probably insolvent, and teetered in the balance — the Equitable. I was the juniormost member of AIG’s team. I have a lot of stories about what happened, and why AIG lost and AXA won. If readers want to read about that, I’ll write about it. For now though let me mention what I did:
- Produced an estimate of value of the annuity lines in four days.
- Estimated the “hole” in reserving for the Guaranteed Investment Contract line of business (accurate within 10%, according to the writedown they took later)
- Wrote an analysis of AXA that indicated that we should take them seriously (probably ignored).
- Analyzed the Statutory statement, the Cash Flow testing, and Guaranteed Separate Account filing (Reg 128), and came to the conclusion that the latter two were in error. (Those filings, I later learned, forced the NY department to
tell Equitable that it had to find a buyer, because they could not believe the rosy scenarios.) - Analyzed the investment strategies that the Equitable employed in the late 80s. (They doubled down.)
Two years after that, I was at the Society of Actuaries annual meeting, where I met a well-known actuary who had worked inside the corporate actuarial area of the Equitable during the critical years. I.e., he watched and analyzed the assets and the liabilities as they arose. The conversation went something like this:
David: What was it like working inside the Equitable during that period of fast growth?
Corporate Actuary: It was amazing. It took everything we could do to stay on top of it, and still we fell behind.
D: Didn’t you think that perhaps you were offering guaranteed rates that were too attractive?
C: We wondered about it, but with money coming in, everyone felt great about the growth. We simply had to find ways to productively deploy all of the cash flow.
D: But wait. Didn’t the investment department have a difficult time investing all of the proceeds? With that much money coming in, the likelihood of making severe errors would be high.
C: Were you a bug on the wall at our meetings? Yes, that is exactly what happened. The money came in faster than we could invest it prudently.
D: Wow. I thought that was what happened, but it amazes me to hear it confirmed.
They offered free options, and surprise, investors took them up on them. They couldn’t make enough to fund the promises, and undertook a risky strategy in the late 80s that I called “double or nothing.” The strategy failed, and they almost went broke, except that AXA bought them, pumped in a little capital, and then the real estate market turned.
What’s my point here? Twofold: one, rapid growth in financial institutions is rarely a good thing; it usually means that an error has been made. Two, there is a barrier in many financial decisions, where responsible parties are loath to cry foul until it is way past obvious, because the cost of being wrong is high.
So what of my other two cases? With the neomercantilists, which I have written about more at RealMoney, they entered into the following trade: sell goods to the US and primarily take back bonds. This suppressed inflation in the US, and lowered interest rates, because their bond buying reduced the excess supply of bonds. In one sense, through export promotion, the neomercantilistic countries sold their goods too cheaply, and then had little current use for the US Dollars, since they did not want their people buying US goods. So, they took the money and bought US bonds, probably too dearly. Certainly so, after taking the falling US Dollar into account.
With the major rating agencies and the major financial guarantors, they are locked in a co-dependent relationship, one that I highlighted in a RealMoney article three years ago. The financial guarantors are next to a cliff, and the rating agencies have a choice:
- The guarantors are clearly in trouble, but how bad is it? Do we push them over the edge to save our franchise, at a cost of a lot of forgone revenue in the short run?
- Or do we sit, wait, and hope that things are not as bad as the equity markets are telling us? This could preserve our ability to make money, and the government is giving us pressure to go this way, for systemic risk reasons. Besides, someone could bail them out, right?
Ugh, I went through this back in 2001-2002, when the rating agencies changed their methodology to become more short-term in nature. Funny how they always do that in bear markets for credit.
So, what’s the common element here? Each situation has a major financial entity at the core. Underpriced goods or promises were made in an effort to attract revenue. When the revenues came too quickly, errors were made in deploying the revenues, whether into goods or bonds. The faster and the larger the acquisition of the revenues, the larger the problem in deployment.
In each of these situations, then, there is a cliff:
- Do the rating agencies push the guarantors over?
- Does the NY department of insurance force Equitable to find a buyer?
- Do neomercantilistic nations keep sucking down dollar claims in exchange for goods, importing inflation, or do they finally give up, and purchase US goods, and slow down their own economies, and the inflation thereof?
This is what makes practical economics tough. Cycles that are self-reinforcing eventually break, and when they break the results can be ugly. Why else are credit cycles long and benign in the bull phase, and short and sharp in the bear phase?
February 5th, 20086:55 pm at
David, thanks for sharing this – it’s a fascinating illustration of how large the scale of irrational behavior can be in financial markets….