Still More Odds & Ends (Twelve this Time)

1) I might not be able to post much for the next two days. I have business trips to go on. One is to New York City tomorrow. If everything goes right, I will be on Happy Hour with my friend Cody Willard on Tuesday.

2) As I wrote at RealMoney this morning:

David Merkel
Buy Other Insurers off of the Bad AIG News
2/12/2008 2:54 AM EST

Sometimes I think there are too many investors trading baskets of stocks, and too few doing real investing work. I have rarely been bullish on AIG… I think the last time I owned it was slightly before they added it to the DJIA, and I sold it on the day it was added.Why bearish on AIG? Isn’t it cheap? It might be; who can tell? There’s a lot buried on AIG’s balance sheet. Who can truly tell whether AIG Financial Products has its values set right? International Lease Finance? American General Finance? The long-tail casualty reserves? The value of its mortgage insurer? I’m not saying anything is wrong here, but it is a complex company, and complexity always deserves a discount.

You can read my articles from 2-3 years ago where I went through this exercise when the accounting went bad the last time, and Greenberg was shown the door. (And, judging from the scuttlebutt I hear, it has been a good thing for him. But not for AIG.)

AIG deserves to be broken up into simpler component parts that can be more easily understood and valued. Perhaps Greenberg could manage the behemoth (though I have my doubts), no one man can. There are too many disparate moving parts.

So, what would I do off of the news? Buy other insurers that have gotten hit due to senseless collateral damage (no pun intended). As I recently wrote at my blog:

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.

What can I say? I like the industry’s fundamentals. These companies do not have the balance sheet issues that AIG does. I will be a buyer of some of these names on weakness.

Position: long LNC HIG AIZ

3) More on AIG. As Cramer said yesterday: One last thought on the AIG issue: if President and CEO Martin Sullivan were to step down, the company might be more of a buy than a sale!

Maybe. Sullivan is a competent insurance executive with the biggest insurance job in the world. Breaking up the company, and letting the parts regain focus makes more sense. As an aside, M. R. Greenberg was known to be adamant about his ROE goal (15% after-tax on average equity), but he also liked the company to have bulk (high assets — he liked asset-sensitive lines), which is why the ROA slid in the latter part of his tenure.

4) Some praise for Cramer on the same topic. As he said yesterday: AIG let me have it after I said last year that I couldn’t value the stock. They told me that there was a 92-page disclosure document and they wanted to know if I even looked at it. I shot back that not only did I look at it, but I had people comb it, including the forensic accountant I have on staff. The issue was always that despite the disclosure that they had CDO exposure, we couldn’t figure out what the real exposure was and we questioned whether THEY could.

Nothing gets a management more angry than being told that they don’t know what they are doing, but I was marveling at the certainty that they expressed. I told them they had tons of disclosure, but their estimation of possible losses seemed chimerical. I couldn’t figure out how THEY could value the stuff when no one else could with any certainty until it was off their books or written down. OF course, insurance companies aren’t held to the same standards of mark-to-market that banks are. They used mark-to-model, and the model, we learned today — the Binomial Expansion Technique — was totally wrong and dramatically understated the losses. All of this cuts to the incredible level of arrogance and stupidity on the Street, making judgments that were anti-empirical on data that could not be modeled but had to be experienced and examined nationally. In short, they were scientific and certain about something that couldn’t be quantified by science and certainly couldn’t be certain about.

Aside from the quibble that insurers for GAAP purposes are subject to the same rules as banks, Cramer got it right here. It is a major reason why I have been skeptical about AIG. Complexity in financial companies, especially financial companies that grow fast, is warranted. It is an unforgiving business where moderate conservatism works best.

5) Brief NAHC note: the CEO purchased more shares in the last few days. At least, it looks like it. Could he be acquiring shares to combat Hovde Capital? Honestly, I’m not sure, but this is looking more interesting by the day.

6) A new favorite blog of mine is Going Private. This post on insurance issues in Florida was unusual for that blog, but I thought it was perceptive. I wrote similar things at RealMoney:

David Merkel
Move to Florida, Become a Reinsurer
3/27/2007 3:30 PM EDT

Interesting note in the National Underwriter on a Towers Perrin Study (also try here) describing how much Floridians will have to pay if a 1-in-250 hurricane hits Florida. Cost per household: $14,000, or $467 per year for 30 years. On a 1-in-50 storm, the figures would be $5,640, or $188 per year. There would also be a higher initial assessment as well. Note that the odds are actually higher than stated odds would admit. The stated odds of the large losses from the 2004 and 2005 storms happening in consecutive years would have been considered astronomical, but it happened anyway.

The Florida legislature can determine how the pain is shared, but they can’t legislate that the pain go away. No free lunch.

P.S. As an aside, the state of Florida is subsidizing reinsurance rates through its catastrophe fund. Ostensibly, Florida homeowners get a cut in rates, but the insurers give that cut only because their reinsurance costs are lower. Who’s the loser? The citizens of Florida will have to reach into their pockets to recapitalize the Hurricane Catastrophe Fund if big losses hit, and at the very time that they won’t want to do it. (Note to S&P: why do you give this state a AAA GO bond rating?)

Position: none mentioned

David Merkel
The Worst Insurance State In The USA
2/2/2007 3:52 PM EST

I don’t want to go on a rant here, but I do feel strongly about this. It ill-befits a state government to behave like a bunch of thugs, even if it pleases the electorate. For over two decades, the worst state to do business in as an insurer was Massachusetts. New Jersey was competitive for a while, and California was pretty bad on Worker’s Comp, but now we have a new state on the top of the heap: Florida.

The failure of the Florida property insurance market was due to the lack of willingness to allow rates to rise sufficiently to attract capital into the market. The partial socialization of risk drove away that capital. So what does the governor and legislature of Florida do to meet the crisis? Increase the level of socialization of risk, and constrain companies to a binary decision: accept profits that don’t fairly reflect the risks underwritten, or leave the state. (And, they might try to forbid insurers from leaving.)

In my opinion, if they bar the door to insurers leaving, or not being allowed to non-renew policies, it is an unconstitutional “taking” by the state of Florida. No one should be forced to do business that they don’t want to do. Fine to set up the regulatory rules (maybe), but it’s another thing to compel parties to transact.

Okay, here’s a possible future for Florida:

1) By the end of 2007, many insurers leave Florida; the state chartered insurer now has 33% of all of the primary property risk.
2) Large windstorm damages in 2008-2009, $100 billion in total, after a surprisingly light 2006-2007.
3) Florida finds that the capital markets don’t want to absorb more bonds in late 2009, after the ratings agencies downgrade them from their present AAA to something south of single-A.
4) The lack of ability to raise money to pay storm damages leads to higher taxes, plus the high surcharges on all insurance classes to pay off the new debt, makes Florida a bad place to live and do business. The state goes into a recession rivaling that of oil patch in the mid-1980s. Smart people and businesses leave, making the crisis worse.

Farfetched? No, it’s possible, even if I give a scenario of that severity only 10% odds. What is more likely is a watered-down version of this scenario. And, yes, it’s possible that storm damages will remain light, and Florida prospers as a result of the foolishness of their politicians. But I wouldn’t bet that way.

Position: long one microcap insurer that will remain nameless

Marc Lichtenfeld
Florida Insurance
2/2/2007 4:17 PM EST


While I don’t pretend to be the insurance maven that you are, I don’t believe it’s quite as black and white as you portray.

First, let me preface my comments by saying that I believe in free markets and don’t agree with the Governor’s plan, although I stand to benefit. Secondly, my insurance rates, while higher than I’d like are not too bad compared to others in the state.

That being said, I think something had to be done. In one scenario that you lay out, you describe smart people leaving due to higher taxes. That was already happening due to high insurance rates. Some people with affordable mortgages suddenly found their insurance rates skyrocketing from $2,000 to over $6,000. Lots of seniors on fixed incomes also saw their rates jump.

One factor in the housing slump is that buyers are having a hard time finding insurance on a house they are ready to close on. I know that three years ago, we were scrambling at the last minute to find an insurer who would write a policy — and that was before all of the storms.

I’m not sure what the answer is. I fear that in an entirely free market, there will be very few insurers willing to do business here if there’s another bad storm.

Maybe that’s an argument that we shouldn’t be building major population centers right on the coast, but that’s another story.

Position: None

David Merkel
My Sympathies to the People of Florida
2/2/2007 4:45 PM EST


I understand the pain that many people in Florida are in. I know how much rates have risen. What I am saying is that the new law won’t work and will leave the people of Florida on the whole worse off. Florida is a risky place to write property coverage, and the increase in rates reflects a lack of interest of insurers and reinsurers to underwrite the risk at present rates and terms.

We don’t have a right to demand that others subsidize our lifestyle. But Florida is slowly setting up its own political crisis as they subsidize those in windstorm-prone areas, at the expense of those not so exposed. Commercial risks must subsidize coastal homeowners. Further, there is the idea lurking that the Feds would bail out Florida after a real emergency. That’s why many Florida legislators are calling for a national catastrophe fund.

They might get that fund too, given the present Congress and President, but Florida would have to pay in proportionately to their risks, not their population. Other proposed bills would subsidize Florida and other high risk areas. Why people in New York, Pennsylvania, Ohio should pay to subsidize Florida and California is beyond me.

The new law also affects commercial coverages; the new bill basically precludes an insurer from writing any business in Florida, if they write homeowners elsewhere, but not in Florida. If you want to chase out as many private insurers as possible, I’m not sure a better bill could have been designed. The law will get challenged in the courts; much of it will get thrown out as unconstitutional. But it will still drive away private insurance capacity.

I’m not writing this out of any possible gain for myself. I just think the state of Florida would be better served, and at lower rates, with a free market solution. Speaking as an insurance investor, I know of half a dozen or so new companies that were contemplating entering Florida prior to the new law. All of those ideas are now dead.

I hope that no hurricanes hit Florida, and that this bet works out. If there is political furor now in Florida, imagine what it would be like if my worst-case scenario plays out.

Position: long a small amount of one microcap insurer with significant business in Florida

Florida had now dodged the bullet for two straight years. Hey, what might happen if we have a bad hurricane year during an election year? Hot and cold running promises; I can see it now!

7) One of the best common-sense writers out there is Jonathan Clements of the WSJ. He had a good piece recently on why houses are not primarily investments. Would that more understood this. There are eras where speculation works, but those eras end badly. You can be a landlord, with all of the challenges, if you like that business. You can own a large home, but you are speculating that demand for the land it is on will keep growing. That is not a given.

8 ) My favorite data-miner Eddy, at Crossing Wall Street comes up with an interesting way to demonstrate momentum effects. Large moves up and down tend to continue on the next day, and the entire increase in the market can be attributed to the days after the market moves up 64 basis points.

9) This is not an anti-Cramer day. I like the guy a lot. I just want to take issue with this article: “Trading in CDOs Slows to a Trickle.”  The basic premise is that CDOs are going away because trading in CDOs is declining.  Well, the same is true of houses, or any debt-financed instrument.  Volumes always slow as prices begin to fall, because momentum buyers stop buying.

Short of outlawing CDOs, which I don’t think can be done, though the regulators should consider what financial institutions should be allowed to own them.  That would shrink the market, but not destroy it.  Securitization when used in a moderate way is a good thing, and will not completely disappear.  Buyers will also become smarter (read risk-averse) at least for a little while.  This isn’t our first CDO blowup.  The cash CDO vintages 1997-1999 had horrible performance.  Now we have horrible performance.  Can we schedule the next crisis for the mid-teens?

10) On Chavez, he is a dictator and not an oil executive.  Maybe someone could send him to school for a little while so that he could learn a little bit about the industry that he is de facto running?  As MarketBeat points out, take him with with a grain of salt.  Venezuelan crude oil needs special processing, much of which is done in the US.  If he diverts the crude elsewhere, who will refine it for sale?

11) I am really ambivalent about Bill Gross.  He’s a bright guy, and has built a great firm.  Some of the things he writes for the media make my head spin.  Take this comment in the FT:

That the monolines could shoulder this modern-day burden like a classical Greek Atlas was dubious from the start. How could Ambac, through the magic of its triple-A rating, with equity capital of less than $5bn, insure the debt of the state of California, the world’s sixth-largest economy? How could an investor in California’s municipal bonds be comforted by a company that during a potential liquidity crisis might find the capital markets closed to it, versus the nation’s largest state with its obvious ongoing taxing authority? Apply the same logic to the gargantuan size of the asset-backed market it has insured in recent years – subprimes and CDOs in the trillions of dollars – and you must come to the same logical conclusion: this is absurd. It is as if Barney Fife, television’s Sheriff of Mayberry in The Andy Griffith Show, promised to bring law and order to the entire country.

Most municipal defaults are short term in nature, even those of states, of which there have been precious few.  Ambac, or any other guarantor, typically only has to make interest payments for a short while on any default.  It is a logical business for them to be in… they provide short term liquidity in a crisis, while the situation gets cleaned up.  In exchange for guarantee fees the municipalities get lower yields to pay.

The muni business isn’t the issue here… the guarantors should not have gotten into the CDO business.  That’s the issue.

12) I try to be open-minded, though I often fail.  (The problem of a permanently open mind is that it doesn’t draw conclusions when needed.  Good judgment triumphs over openness.)  I have an article coming soon on the concept of the PEG ratio.  This is one where my analytical work overturned my presuppositions, and then came to a greater conclusion than I would have anticipated.  The math is done, but the article remains to be written.  I am really jazzed by the results, because it answers the question of whether the PEG ratio is a valid concept or not.  (At least, it will be a good first stab.)

Full disclosure: long AIZ HIG LNC NAHC