Ten Odds & Ends

I’ve wanted to post on a bunch of little things for a while, and while it won’t make for organized reading, maybe we can have some fun with it?  Here goes.

1) If Prudential drops much further, I am buying some.  With an estimated 2009 PE below 8, it would be hard to go wrong on such a high quality company.  I am also hoping that Assurant drops below $53, where I will buy more.   The industry fundamentals are generally favorable.  Honestly, I could get juiced about Stancorp below $50, Principal, Protective, Lincoln National, Delphi Financial, Metlife…  There are quality companies going on sale, and my only limit is how much I am willing to overweight the industry.  Going into the energy wave in 2002, I was quadruple-weight energy.  Insurance stocks are 16% of my portfolio now, which is quadruple-weight or so.  This is a defensive group, with reasonable upside.  I’ll keep you apprised as I make moves here.

2) Reader Steve brought this to my attention: Mark Gilbert at Bloomberg brought attention to a monetary policy game at the San Francisco Fed’s website.  So did the estimable Marketbeat blog at the WSJ.  The game used to be found at this link.  Alas, no more.  Maybe all of the attention crashed the site, after all, the SF Fed can’t afford a heavy-duty website like mine.  Okay, sorry, they get 10x the traffic that I do, more like The Kirk Report.

Perhaps the game was removed over the embarrassment from Gilbert playing the game and applying the current Fed strategy to the game, and finding inflation going through the roof.  Now, for those that want to play a monetary policy game, my current favorite is this one from the Bank of Finland.  In a true American version of the game, we would replace the manic announcer with clips of who else, Jim Cramer.  Nobody does it better.  Oh and for true junkies looking for monetary policy games, here is a list of some of them.

3) Dig the falling long bond.  Worst day since 2004.  Echoing what I said yesterday, there’s a lot of fear in that part of the market, and a lot of foreign interest.  Well, at the 30-year auction, foreign interest was light at the lowest yield since regular auctions began in 1977.  A few strong economic numbers can make fear temporarily dissipate.

4) Here’s what I posted at RealMoney today:

David Merkel
Moody’s Downgrades XL Capital Assurance
2/7/2008 3:34 PM EST

When the main rating agencies begin downgrading the lesser guarantors, the big guarantors are likely not far behind. Moody’s just downgraded XL Capital Assurance from Aaa to A3, and Security Capital Assurance From Aa3 to Baa3 (barely investment grade). Psychologically, the major rating agencies, Moody’s and S&P, have been taking baby steps toward downgrading Ambac, MBIA and FGIC. But first they have to do the lesser guarantors that are in trouble. As I have pointed out before, the major rating agencies are co-dependent with the major guarantors, and that will only throw the guarantors over the edge if hurts them more to leave the guarantors at AAA. That will cost them future revenues to cut the ratings of the major guarantors, but it might save their larger franchises. (Fitch, on the other hand, has less to lose and can downgrade with impunity.)

Now, the effects on the broader insured bond market are probably overestimated. There will be new entrants to take the place of the legacy companies that may have to go into runoff. The holding companies for the major guarantors could die, but a rescue of the operating insurance companies in runoff mode is more likely. Those who own equity in the holding companies or debt claims to the holding companies will not be happy with the results, though.

Watch for downgrades of the major guarantors. Unless a lot of new capital gets pumped into their operating insurance companies, the downgrades are coming, maybe within a month.

Please note that due to factors including low market capitalization and/or insufficient public float, we consider Security Capital Assurance to be a small-cap stock. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.

Position: none

Now after the close, MBIA offered stock at a 14% haircut to the closing price.   Let’s see where the price closes tomorrow… it almost boils down to the number of buyers saying, “At a 14% haircut, there’s no way that it will close below that level.  We can buy and flip for an easy profit.”  In this case, though, there are 60%+ more shares after this issuance.  That’s some level of dilution.  MBIA may keep its AAA, but that says little for the value of holding company common stock.

5) One reader wrote me, “mr. merkel — would you care at all to expound on point 2? it’s been the assertion of some that what makes the monoline threat a non-issue is specifically that there IS a harmony of interests in seeing ambac, mbia et al at least get to a point where they can run off their obligations. however, i must admit, i’ve not seen the case made with specificity — that is, what are the interests of the interested parties, and how do they conflict or coincide?”

Point 2 was the idea that a bailout would be tough to achieve, because of differing interests on the part of those being sought to bail out the guarantors.   Here’s my rationale: different investment banks have differing levels and types of exposure to the credit risks covered by the guarantors.  Coming up with an equitable allocation of concessions would be tough, but not impossible.  Beyond that, you have all of the ways that the guarantors reinsured each other, which further tangles the web of promises.  A bailout could be done, given enough time, and enough angelic third-party experts to divide the pie perfectly.  Time is short here, and I suspect the rating agencies will lose patience, given their need to protect their franchises.

6) At present, the yield curve indicates a 2% Fed funds rate by mid-to-late 2008.  Uh, that’s not what I would do, but it seems pretty likely for now.  What kind of price inflation would get the attention of the Fed here?  Beats me; the slope of the yield curve today is adequate to allow banks to make money; if the Fed waits at these levels, the economy should recover over the next two years.

7) I liked the idea of this post at the American Prospect, but for a different reason.  Since I called the housing bubble very clearly over at RealMoney, and even subprime too, does that mean that I can criticize the Fed with impunity?  Constructively, of course.

8) From another reader, Bamboo: I have not seen much discussion of the statutory capital requirements of the financial guaranty insurers.  It seems that Article 69 of the New York Insurance Law is the critical statute.

Although the rating agencies do not consider mark to market losses in their evaulations of capital adequacy, do they affect statutory capital?

Is there a possibility that the financial guarantors will have to take a premium deficiency reserve for their structured finance business?

I would like to get a copy of article 69, but I can’t find one.  In general statutory regulations are less market-oriented than rating agencies and GAAP.  The problems usually show up faster on GAAP than Stat, leaving aside high growth situations.

9) Another reader, Bill Luby of VIX and More, writes: Hi David,

Once again, kudos for keeping up a consistently high quality of posting here.  Your thinking often sets my brain in motion — in a very good way.

If you don’t mind, I’d be interested to get your take on the current status of the bond insurer problem and how you think it might play out.  In addition to what happens to MBI and ABK, I am also interested in whether you think others with a stronger financial position (AGO?) might make significant gains in this space.



Yes, AGO, Dexia (FSA), and Berky all do well from the turmoil.  Strong balance sheets benefit from increased volatility, even as weak balance sheets are harmed.

10) Finally, from Reader Scott, regarding Medicare and entitlements, “David, wondering your thoughts on how the situation gets addressed.  There is no question at all that the equation doesn’t solve, presently.  My current thoughts are that (1) taxes go higher – not even up for serious discussion; and (2) so do trade barriers.  we trade some protectionism, a la Europe, and reduced overall welfare, for a feel-good “leveling” of some of society’s current inequties.  our nation’s most influential demographic, old folks, who vote, are appeased. add to that, perhaps, some guest worker immigration policies.  second class citizens earning second-tier wages.  on balance, we begin looking a lot more like Europe, reversing the cherished myth of American exceptionalism, and staving off acceptance of the twenty-first being the China Century.  Care to comment?

Americans are exceptional, and that is not always a good thing.  We have fewer presuppositions than most of the world, and that leads to innovative solutions, a certain amount of unnecessary chaos, and occasional hubris.  We are probably heading for an era of leveling, but that is not certain.  Historically, it is likely.  Trade may be another matter; we may be getting close to a point where the rest of the world sees the value of freer trade, even if the US goes the other way.  Organized efforts against free trade are weak compared to protectionist eras.

As for old folks that vote, yes, that’s what makes this problem tough.  I’m not into doom and gloom, but I can see a negative self-reinforcing cycle coming.  If Bush, Jr., got smacked over his all-too-cautious attempt at Social Security reform (it would have done almost nothing, but listen to the squeals), can you imagine what true reform of a much bigger problem might entail?  We would need a full blown panic in the debt markets to get focus there, and as for now, foreigners are still very willing to roll over US debt denominated in US dollars.

Full disclosure: long AIZ, LNC