17 March 2008 – The Aleph Blog

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Last Thoughts on the FOMC Meeting

Last Thoughts on the FOMC Meeting

Posted on 17 March 200817 March 2008 by David Merkel

FOMC cycles usually have some sort of underlying consistency to them. In this cycle, the underlying consistency has been:

Unorthodox measures, attempting to use the asset side of the Fed’s balance sheet to solve lending problems among banks and broker-dealers.
They have effectively “sterilized” their unorthodox measures by withdrawing other liquidity from the system, leading to…
Lack of growth of the monetary base, which has only risen 2% in the last year, and the last permanent injection of liquidity was 5/7/07. (After reviewing the Annual Reports of the Open Markets desk of the NY Fed 1996-2007, I think that’s a record… it is certainly a record for a loosening cycle. How can you have a loosening cycle without growing the monetary base significantly? Unless they are planning on reversing their policy easing rapidly once the financial crisis is past.)
They have never cut rates less than expected.

So, that leaves me at a 1% cut in Fed funds tomorrow, with a parallel cut in the now-meaningful discount rate. Now that primary dealers can borrow there, that will be an active window. That said, the Fed will probably try to sterilize any borrowings there, withdrawing liquidity elsewhere.

Come to think of it, that was one of the problems with the Bank of Japan as they slid into their crisis in the 1990s. They always sterilized their monetary policy so that it had little effect, thus restraining inflation, but not doing much for their overleverage situation.

In this case, that’s a mistake. We can live with price inflation. Dealing with the collapse of leverage is a lot tougher. The Fed can use unorthodox measures until their supply of lendable/saleable Treasuries runs out. Then they will have no choice but to begin monetizing the debts of the US Government or its agencies, if they want to attempt further stimulus. Then we will get price inflation. As for me, I would own TIPS here. CPI inflation will likely rise if the bailouts needed exceed the size of the Fed’s balance sheet. I also like agency residential mortgage bonds here. Implied volatilities can’t get that much higher, so we should get some sort of rally.

Let see what happens tomorrow.

Update

So what happens after I hit the publish button, but I receive a great article from Calculated Risk talking about the same issues.

National Atlantic Notes

National Atlantic Notes

Posted on 17 March 2008 by David Merkel

Given the furor of the day, I thought I might have to abandon the National Atlantic Teleconference call.? I didn’t miss the call.? The transcript is here (thanks, Seeking Alpha).? Let me quote my portion of the call.

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Operator

Thank you, sir. Today?s question-and-answer session will be conducted electronically. (Operator Instructions). We?ll go first to David Merkel of Finacorp Securities.

David Merkel – Finacorp Securities

Hi, Hello.

James V. Gorman

Good morning, David.

David Merkel – Finacorp Securities

Very good. I wanted to ask a little bit about the, you had a number of parties go over your reserves, three and all I believe and how, I would assume at this point you are rather certain that you have been able to clean up most of reserving problems particularly given what was happening in your claim department prior to, I guess September 2007? Can you walk us through that one more time?

James V. Gorman

Yes, we have taken a very hard look at the claim review process, within the claim department. We have modified the procedures, we have updated our diaries. And when you go through a change like this, your historical information and your typical loss development patterns are no longer appropriate to use.

David Merkel – Finacorp Securities

Right.

James V. Gorman

In estimating alternates. So, we had to rely heavily on projecting the open, ultimate number of claims that will be paid and the severity associated with those clients. And I think our review that was done as well as that done by our external auditors have focused on looking at average claim cost as opposed to looking at normal loss development methods.

We continue to look very closely, as part of our quality control process to make sure that the adjusters are in fact keeping claims up to date that we are managing them affectively and that we are in fact putting in place an aggressive settlement policy to move these claims off of our balance sheet. So, we are cautiously optimistic that we have our arms around, our ultimate liabilities. But, obviously there is no guarantee but we have scrubbed this thing it from many different angles.

David Merkel – Finacorp Securities

Great, well that?s good. The re-insurance recoverable change, it was $3.1 million or something like that? What was that about?

James V. Gorman

While we project our direct loses, we also project how much is going to commend in ceded loses and you know based upon our current retention as a company we?ve retained the first 500,000 of loss the emergence of ceded losses is very slow to develop.

David Merkel – Finacorp Securities

Right.

James V. Gorman

And we have looked more carefully at our projected reinsurance recoverables and determined that we are not going to be in a position to collect as much as we had previously thought. This is not connected at all to any reinsurance recoverable on paid clients.

David Merkel – Finacorp Securities

Yes got it.

James V. Gorman

This is based on projected losses.

David Merkel – Finacorp Securities

Okay. Last question, do you have side of your balance sheet, you know, there is a decent amount of turmoil out there now, with respect to various types of AAA structured product and I know you didn?t do that much with subprime or anything like that. But, what are you experiencing if anything on the asset side of your portfolio at present, I assume that it?s just ordinary payments of cash flows from your mortgage bonds and other assets, because you have a fairly high quality portfolio we use the way the rating agencies rate them. Are you experiencing any difficulties there at all?

James V. Gorman

Well, I?ll start that answering your question David and then I?ll turn it to Frank, but from the investments, I would like to just further assure our investors that we have absolutely no subprime exposure. In addition, any bond that we have is A or better on its own merits without the effective any MBIA or AM backed insurance less to the rating, further we have no equities in our portfolio. So, on the investment side, I think that we are pretty planned and pretty solid and we had a great yield in ?07 given all of the decrease in interest, average interest rates. Frank can you add anything to that on the balance sheet.

Frank Prudente

I think you well covered it I may I think we felt for a long time, we have a conservative portfolio and with a disruption we?ve seen in the market it?s evident it?s conservatism by us not having any issues.

David Merkel – Finacorp Securities

Well, thank you gentlemen. I appreciate it and I will be looking forward to any releases that describe the logic for the $6.25 purchase price. So, I thank you both.

James V. Gorman

Thank you, David.

David Merkel – Finacorp Securities

Take care.

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Okay, why did I ask those questions?? Why not bluster about the huge discount to book that they are selling the company at?

Rather than do it that way, I asked about the two least certain items on their balance sheet — their loss reserves, and the value of their assets.? If they express confidence in those two numbers, then it will be hard to back away from an adjusted book value north of $10.? Why does this have value?? Well, there are many other investors bigger than me in the company, and this gives them a reason to vote down the deal.? NAHC has no debt; there is no solvency crisis here, so a large discount to book is not warranted.? With a short-tail P&C company you could hire a specialist to inexpensively run the book off, and after a year or so, sell of the tail of the company.? We would definitely realize a price north of $6.25.

But what if the deal goes through?? In that case, I might not tender my shares, but file for appraisal rights.? I would show the judge the management’s answers to my questions, demonstrating the confidence that they had in the asset values and reserving, immediately after the deal announcement.? It is rare that the judges allow deals to go out at less than tangible book value, particularly on short-tailed P&C companies with little insolvency risk.

So, that’s why I asked those questions.? Now to see what happens.

Full disclosure: long NAHC

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