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Archive for April, 2009

Book Review: Trend Following (5)

Thursday, April 30th, 2009

There are many places where I agree with Michael Covel.  Here are two:

  • Trend following, or, price momentum, is a good strategy.
  • Most investment advisors charge a lot, and on average deliver suboptimal performance.
  • The weak form of the efficient markets hypothesis doesn’t work.

Most of the Wall Street establishment, and those trained by universities and the CFA program believe that the weak form of the efficient markets hypothesis works.  I.e., You can’t make money from past price and volume information. This is why most of them don’t use price momentum.  They would get laughed at.  The weak form of the EMH is holy stuff.

Beyond that, the fund manager consultants try to cram every manager into a simplistic risk control model, leaving managers little room to hold cash, or invest in promising places that don’t fit the narrow pigeonhole that the fund manager consultants use to simplify their work.  Someone who rotates styles, sectors, domestic versus international, or who simply raises cash when opportunities don’t seem so good are anathema to the fund management consultants, no matter how good their performance is.

But as time has gone on, the behavioral finance folks have shown that valuation, price momentum, normalized operating accruals, and other factors have significant predictive potential on future returns.  Hedge fund managers, who have less of a tendency to listen to the fund management consultants, and a greater tendency to do what works, do use trend following, or price momentum in their investing.

What if Everyone Followed Trends?

Suppose everyone except Warren Buffett decided to follow trends.  The market would become very volatile, as was suggested in Investing by the Numbers.  (By his model, anytime momentum investors are more than 20% of the market, things go nuts.)  Buffett would make money hand over fist as he would sell holdings as they soared over fair value, and buy as they crashed well below fair value.  The valid strategy that is less employed makes more money.

There would be another effect.  There is a limitation on the ability to short on the market as a whole, if the borrow is enforced.  The whole world is 100% net long every night.  Shorts and leveraged longs are side-bets in the game of investing.  The more trend followers there are, the more that shorting capacity would prove to be a constraint, because once things start going down, the available shares to borrow would disappear.  The profitability of trend following in a bear market relies on a small enough number of parties selling short.  Everyone can’t sell short at the ame time.  Everyone can’t go to cash at the same time.  The assets must be owned by someone at the end of each day.

There’s only one strategy that could be followed by everyone — Indexing (and not fundamental indexing).  Returns to any strategy decrease as more pursue it.

On Audited Track Records

Bill Miller had a great audited track record, and it imploded in two years, largely because he did not understand the financial stocks that he owned.  While working at Provident Mutual, I interviewed a growth manager who used price momentum heavily, and had a tremendous track record.  I pointed out 10% of his portfolio that had poor earnings quality, and he gave me a “you don’t know the right things to look for” answer.  In the next week, a number of those companies preannounced earnings shortfalls.  The marketing guys came over to me and said, “You called that one.”

In truth, I didn’t.  Rarely do things happen that fast.  But that manager did disappear within a few years, despite his great past track record.

There’s a reason why we say, “Past performance does not indicate future results.”  Because it doesn’t.

I am not saying that I manage money better than Michael Covel, or anyone else.  He has done better than me, even though I have done better than 90% of all long only equity managers over the last nine years.

I do not have an audited track record, but only because I don’t want to pay for something that I don’t have use for.  I am not broadly advertising my services.  If an institutional investor would want to use me, I would get my returns audited.

I write my blog because I enjoy teaching, nothing more.  It fills a hole in my life, a part of a need to give back.

In closing, I can endorse “Trend Following” because its basic premise is true.  Follow price momentum and you will beat the equity market 80% of the time.  I just did not enjoy the lack of logic from Mr. Covel.  Correlation is not causation.  Making money in the past is not proof.  Picking and choosing trend followers does not constitute proof.  Take a more humble attitude, and you have a good book.

To What Degree Were AIG’s Operating Insurance Subsidiaries Sound? (Epilogue)

Wednesday, April 29th, 2009

Whew, I’m glad that one is done.  Thanks to the nice ladies at AIG who sent me the Statutory books.  My apologies for any difficulties with the HTML formatting.  For those that would like to read it in PDF form, here it is.  For those that would like to play around with the data that I extracted into Excel, here that is.

Comments are welcome.

I’m planning on resuming a more normal writing schedule.  The AIG work took a lot out of me.  Future projects include finishing off the Trend Following book review, the John Davidson series, and one article where I ask my readers for a bit of help.  Till then, stay well.

To What Degree Were AIG’s Operating Insurance Subsidiaries Sound? (8)

Wednesday, April 29th, 2009

Continuing profitability / Is this strictly an investment problem?

2007 Net Income2008 Net Income2007 Net Operating  Income2008 Net Operating  IncomeSurplus Increase net of Capital Contributions and divsYellow Column less Realized Capital Gains
Total P&C

5,563

733

7,210

654

(353)

Total Life

3,404

(23,218)

7,206

2,819

(29,539)

(1,840)

Total

8,967

(22,485)

14,416

3,473

(29,892)

Net Underwriting Gain 2007Net Underwriting Gain 2008Net Investment Gain 2007Net Investment Gain 2008
Total P&C

2,189

(1,939)

3,783

2,485

Take a look at the above two tables.  For the P&C OISs, investment results were worse in 2008, but the really big swing was in underwriting, where profits were around $4 billion lower than 2007.  My summary figure for core P&C statutory earnings in 2008 is the -$353 million highlighted in green.  That is the surplus increase net of capital contributions and dividends.  I.e., how much did the value of the companies fall as a result of the year operations — $353 million.

For the life companies, I did the same calculation, but netted out realized capital losses, which should not recur, for a core statutory loss of $1.84 billion.  I can’t split that entirely into underwriting and investments, as with P&C, but taking out the realized capital gains approximates it.

My main point here is that 2008 was a bad year for AIG’s OISs even without the investment losses.  Not enough to take any of the main OISs into insolvency by itself, but bad still.

Articles and other issues

More holding company liquidity out of thin air: receiving a $800 million loan from American General Finance, a wholly owned subsidiary, in exchange for giving the subsidiary $600 million in capital to satisfy a debt covenant.  Wonderful, American General Finance is somewhat less creditworthy to bondholders of the firm, and the AIG holding company gets cash.

AIG attempts to raise cash and reduce leverage through the sale of subsidiaries that are in relatively good shape:

The price talk doesn’t look that great.  Counting in Hartford Steam Boiler, premium prices are certainly not being realized.

In general, the simplest units to sell are the simplest ones to value.  They have the easiest models for analyzing likely future free cash flows, or distributable earnings.  I have said before that when a company is in a crisis, and has to sell off assets, that it makes a great deal of difference what kinds of assets they sell off.  If they reach for the dirtier assets, and wish to keep the clean ones, it is usually a sign of confidence in the future.  If they sell the good assets, because that is all they can do, they are just stalling for time, and hoping that a better day arrives.  Hope is not a strategy, but that is what seems to be going on here.

Now, as for Maurice Raymond Greenberg’s claim that he had nothing to do with the wreck of AIG, let me simply say that he should shoulder a lot of the blame.  Most of the increase in leverage occurred under his watch.  AIG was a decidedly more risky investment when he left than in the late 80s, when the balance sheet had virtually no debt.  He encouraged a fear-based culture that was very bottom-line oriented for the quarterly earnings estimate, even to the point of buying finite reinsurance to manipulate the results.  He pushed for an aggressive culture at AIG Financial products, and he got one.  He may not have been there for the worst of it, but he certainly sowed the seeds of future trouble.

Summary

To what degree were AIG’s operating subsidiaries sound? Answer: aside from the mortgage insurers, the P&C subsidiaries were basically sound, though with some issues such as capital stacking, affiliated assets, etc., as mentioned above.  The non-mortgage P&C subsidiaries didn’t have a great 2008, but they would have survived as standalone entities.

The life and mortgage subsidiaries are another matter.  Without the help of the US Government, many of them would have failed.  Even now, given the levels of affiliated assets, capital stacking, deferred tax assets, etc., they are not in great shape now should there be another surprise.  Profitability is likely to be lower in the future than in the banner years of the middle of the 2000s decade.

The US government acted for multiple reasons on AIG.  Among them was to protect the other life insurers of the US from getting surcharged in order to pay for the costs going to the guarantee funds, along with systemic risk issues at AIG Financial Products (which was much bigger).

If AIG did not have AIGFP, and no bailout from the US Government, the company as a whole would have come under severe stress, and some of the life and mortgage subsidiaries would have gone into insolvency, but the company as a whole would probably have survived.

Investment implications

My view of AIG is this: the common stock will go out worthless, or nearly so.  Preferred stakes will be compromised at best.  Beyond that, I am less certain.  I look at two types of debt securities and wonder, though.  I am planning on doing a review of the funding agreement-backed notes, and perhaps a closer look at American General Finance notes after the first quarter is reported.

The tough part is we don’t know what the government will do.  If their main goal was stabilizing AIGFP, and that job is nearly complete, then if the value of AIG as subsidiaries get sold appears to not support the preferred stock, the government might walk, and not throw good money after bad.  At that point, bonds of the holding company would suffer further, because the insurance commissioners will carefully watch any dividending up to the AIG holding company.  They got bailed out once.  They will be watching more closely from now on, because lightning doesn’t often strike twice in the same place.

My basic view is take a conservative posture on AIG securities.  There are many competing interests, some political, some economic, fighting over the corpse of this once great company.  Be wary of investing in the capital structure of AIG.

To What Degree Were AIG’s Operating Insurance Subsidiaries Sound? (7)

Wednesday, April 29th, 2009

Deferred Tax Assets

Here is a table of deferred tax assets by OIS, for those having more than 10% of surplus in DTAs. Deferred tax assets are only valuable to the degree that you can earn income adequate to use them. The column “DTA payback” indicates the number of years of 2007 earnings (a relatively good year) that it would take to fully use the DTAs.

Now, it may no longer matter whether AIG ever pays taxes or not. It is largely “in one pocket, out of the other” with the government. But it does have some solvency and profit implications for the subsidiaries.

Subsidiary

DTAs/ Surplus

2008YE Surplus

DTA payback

American General L&A IC

152%

488

6.24

Am Int LIC of NY

133%

371

13.22

AIG LIC

131%

360

11.91

AIG Annuity IC

117%

3,045

15.53

First SunAmerica LIC

85%

544

17.37

The Variable Annuity LIC

70%

2,841

7.08

UG Residential IC of NC

61%

200

NA

American General LIC

50%

5,185

6.66

American Life IC

43%

3,900

2.93

AIG Premier IC

37%

144

151.43

SunAmerica LIC

35%

4,653

4.94

Hartford Steam Boiler IAIC

29%

443

1.65

AIG Centennial IC

24%

305

NA

AIG Hawaii IC

23%

64

NA

AIG SunAmerica LAC

20%

1,271

4.26

United Guaranty IC

19%

52

2.60

American Home Assurance Co

19%

5,702

1.81

AIU IC

18%

726

3.66

AIG National IC

12%

17

NA

Merit LIC

12%

406

2.00

DTAs as assets earn no income, and there is nothing that can be tapped for cash in a crisis. In insolvency, they are not very useful, because acquirers can only use them in very limited ways. Therefore, having a long DTA payback period, or a high amount of DTAs as a fraction of surplus is a negative for profitability and solvency.

This will prove to be more of a difficulty if prior profitability levels are not regained, which could be particularly difficult for the equity-sensitive OISs, where fees from variable products will likely be down for a while. Also, consider that the OISs as a whole may find that 2007 was an exceptionally good year for investments and underwriting, and may not be achievable any time soon.

To What Degree Were AIG’s Operating Insurance Subsidiaries Sound? (6)

Wednesday, April 29th, 2009

Realized Capital Losses, Excluding Securities Lending at the Life Companies

Subsidiary

Sum of 2007YE Surplus

Other Realized Capital Losses / Surplus

First SunAmerica LIC

501

-81%

The Variable Annuity LIC

2,838

-61%

AIG Annuity IC

3,729

-49%

Am Int LIC of NY

553

-41%

AIG LIC

440

-39%

American General L&A IC

471

-28%

SunAmerica LIC

4,716

-17%

American General LIC

5,704

-16%

American Life IC

6,718

-11%

Merit LIC

705

-4%

Pacific Union Assurance Co

67

-1%

If the securities lending losses weren’t enough, the life companies ran asset portfolios where many risks did not pan out.

Much of that came from corporate bonds (including junk bonds), CMBS, and non-conforming RMBS.  The domestic life companies pruned areas of their portfolios in order to prevent greater losses later.

To What Degree Were AIG’s Operating Insurance Subsidiaries Sound? (5)

Wednesday, April 29th, 2009

Reinsurance

Before I start this section, a small word of warning.  I am a life actuary, not a P&C actuary, so I may not get all of the nuances on reserve credits for P&C companies.  I have worked on life reinsurance issues at all of the life companies that I have worked with, or consulted for, but it is not my specialty.

Reinsurance involves a transfer of risk to another insurance carrier.  To the degree that risk is transferred, a reserve credit can be set up to reflect the discounted expected value of future claim payments.

Reinsurance does carry a risk, though, if the reinsurer can’t or won’t pay.  AIG’s rather sharp handling of reinsurers in the past carries with it the risk that reinsurers will be less than sympathetic to their problems.  Because of AIG’s difficulties, reinsurers will be more likely to try to deny claims while AIG is weak.  And like the parable of the unjust steward, some AIG employees might be inclined to compromise at levels fairer to the reinsurer.  After all, opportunities at AIG are ebbing, but having friends in the industry is always an aid when looking for work.

Here’s a table listing the size of the net reinsurance reserve credits by subsidiary relative to the size of the surplus.

Subsidiary2008YE Surplus

Reinsurance Reserve Credit / Surplus

AIG National IC

17

1300%

Am Int IC

374

1006%

Am Int Specialty Lines IC

726

742%

AIU IC

726

407%

Am Int IC of Delaware

48

319%

UG Mortgage Indemnity Co of NC

128

260%

AIG Excess Liability Co.

1,438

179%

Lexington IC

4,263

162%

AIG Hawaii IC

64

144%

Landmark IC

155

143%

American General LIC

5,185

101%

New Hampshire Indemnity Co

140

100%

United Guaranty Residential IC

1,106

97%

21st Century IC

747

96%

American Life IC “Alico”

3,900

93%

AIG Premier IC

144

92%

AIG Centennial IC

305

83%

AIG LIC

360

70%

Audubon IC

39

69%

UG Residential IC of NC

200

45%

Hartford Steam Boiler IAIC

443

41%

F book

23,314

22%

American General L&A IC

488

18%

Delaware American LIC

25

16%

SunAmerica LIC

4,653

13%

Am Int LIC of NY

371

12%

First SunAmerica LIC

544

6%

AIG SunAmerica LAC

1,271

5%

AIG Auto IC of NJ

21

2%

A few notes: 1) The higher the reinsurance reserve credit is relative to surplus, the greater the risk if the reinsurers can’t or won’t pay.  2) AIG reinsures many of their risks internally through intercompany P&C pools, but the reinsurance credits from those agreements should net out of the net reinsurance credit figure. The reinsurance pools spread out risk within AIG, but do not reduce the risk within AIG.  Plus, say an insurance commissioner trying to keep an OIS afloat in his state might take actions that keep that OIS safer, but that would push risks to other OISs in other states.  3) There is one odd entry called “F book.” Five OISs share one statutory book for all of their reinsurance – National Union Fire IC, American Home Assurance Co, Commerce and Industry IC, New Hampshire IC, and AIG Casualty Co.  Those OISs are 5 of the 6 largest, ranked by 2008 year-end surplus.   Though large, there is not much reinsurance credit exposure there.

Whether internally or externally reinsured, the size of reinsurance credits relative to surplus raise solvency risk issues if reinsurers can’t or won’t pay.

To What Degree Were AIG’s Operating Insurance Subsidiaries Sound? (4)

Wednesday, April 29th, 2009

Unrealized Capital Losses

SubsidiaryC UR CG / Surplus2008YE Surplus
Pacific Union Assurance Co

-385%

20

AGC LIC

-360%

5887

American Life IC “Alico”

-118%

3900

American General LIC

-89%

5185

SunAmerica LIC

-74%

4653

AIG Casualty Co

-46%

1457

AIG Annuity IC

-29%

3045

American Home Assurance Co

-21%

5702

The Variable Annuity LIC

-20%

2841

Hartford Steam Boiler IAIC

-16%

443

Commerce and Industry IC

-16%

2678

Audubon IC

-15%

39

AIG LIC

-15%

360

Lexington IC

-10%

4263

Am Int Specialty Lines IC

11%

726

AIU IC

32%

726

UG Residential IC of NC

34%

200

AIG SunAmerica LAC

50%

1271

The table to the left indicates current unrealized capital gains as a fraction of surplus.  When I first looked at this, I though most of these must have been from unrealized losses on bonds, but to my surprise, they are mostly losses from affiliated company stocks, which must be valued at market price or net worth.

But as I began to dig into the losses, I found something unusual at Alico. At the end of 2007, almost the entirety of their surplus assets were composed of AIG common stock.

Delaware regulators, please tell me, why would you allow this?  It is one thing to allow this for a pup subsidiary like Pacific Union, and quite another thing for a big dog like Alico.

For those less aware, holding affiliated stock of subsidiaries is capital stacking, which raises leverage, but owning holding company stock is creating capital out of thin air.  When things are going good capital rises disproportionately.  When things are bad, the opposite happens.  We are experiencing that negative part of the cycle now.

Now there were other areas of loss for AIG OISs, many are detailed in this article here.  I’m not generally a fan of insurance companies investing in anything more dangerous than investment grade bonds.  My main reason for this view is the outlier types of events, like that which we are seeing now.  Insurance companies should never want to be in a situation where they are suffer underwriting losses at  a time where they are taking losses on the investment side as well.  Most of these losses from limited partnerships (private equity and hedge funds), though unrealized, have already hit capital levels.  Some will make part of the losses back, but many will not.  In this environment, high risk investments are not being rewarded.

Fed Statements Compared

Wednesday, April 29th, 2009

March StatementApril Statement

My Comments

Information received since the Federal Open Market Committee met in January indicates that the economy continues to contract.

Information received since the Federal Open Market Committee met in March indicates that the economy has continued to contract, though the pace of contraction appears to be somewhat slower.

They are hoping that this blip in the degree of financial confidence is a sign that the real economy is deteriorating at a slower rate.

Job losses, declining equity and housing wealth, and tight credit conditions have weighed on consumer sentiment and spending.Household spending has shown signs of stabilizing but remains constrained by ongoing job losses, lower housing wealth, and tight credit.

No material change, unless they mean that consumer psychology is rational; there is reason for negative sentiment.

Weaker sales prospects and difficulties in obtaining credit have led businesses to cut back on inventories and fixed investment.Weak sales prospects and difficulties in obtaining credit have led businesses to cut back on inventories, fixed investment, and staffing.

Adds that jobs are being cut as well.

U.S. exports have slumped as a number of major trading partners have also fallen into recession.

Statement dropped. What was true in March is still true now, though.

Although the near-term economic outlook is weak,

Although the economic outlook has improved modestly since the March meeting, partly reflecting some easing of financial market conditions, economic activity is likely to remain weak for a time.

They are hoping that this blip in the degree of financial confidence is a sign that the real economy is deteriorating at a slower rate.

the Committee anticipates that policy actions to stabilize financial markets and institutions, together with fiscal and monetary stimulus, will contribute to a gradual resumption of sustainable economic growth.

Nonetheless, the Committee continues to anticipate that policy actions to stabilize financial markets and institutions, fiscal and monetary stimulus, and market forces will contribute to a gradual resumption of sustainable economic growth in a context of price stability.

They think their policies will work, and that the markets may help them. They are saying there is no problem of inflation coming from all of the liquidity injected into their panoply of credit market programs.

In light of increasing economic slack here and abroad, the Committee expects that inflation will remain subdued.  Moreover, the Committee sees some risk that inflation could persist for a time below rates that best foster economic growth and price stability in the longer term.

In light of increasing economic slack here and abroad, the Committee expects that inflation will remain subdued. Moreover, the Committee sees some risk that inflation could persist for a time below rates that best foster economic growth and price stability in the longer term.

No change.

In these circumstances, the Federal Reserve will employ all available tools to promote economic recovery and to preserve price stability.  The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and anticipates that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period.

In these circumstances, the Federal Reserve will employ all available tools to promote economic recovery and to preserve price stability. The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and anticipates that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period.

No change. The fed funds rate is irrelevant now.

To provide greater support to mortgage lending and housing markets, the Committee decided today to increase the size of the Federal Reserve’s balance sheet further by purchasing up to an additional $750 billion of agency mortgage-backed securities, bringing its total purchases of these securities to up to $1.25 trillion this year, and to increase its purchases of agency debt this year by up to $100 billion to a total of up to $200 billion.

As previously announced, to provide support to mortgage lending and housing markets and to improve overall conditions in private credit markets, the Federal Reserve will purchase a total of up to $1.25 trillion of agency mortgage-backed securities and up to $200 billion of agency debt by the end of the year.

No material change.

Moreover, to help improve conditions in private credit markets, the Committee decided to purchase up to $300 billion of longer-term Treasury securities over the next six months.

In addition, the Federal Reserve will buy up to $300 billion of Treasury securities by autumn. The Committee will continue to evaluate the timing and overall amounts of its purchases of securities in light of the evolving economic outlook and conditions in financial markets.

They are saying they won’t let the liquidity injections get out of hand and create inflation. Also, if things get worse, the Fed will expand its balance sheet further.

The Federal Reserve has launched the Term Asset-Backed Securities Loan Facility to facilitate the extension of credit to households and small businesses and anticipates that the range of eligible collateral for this facility is likely to be expanded to include other financial assets.

The Federal Reserve is facilitating the extension of credit to households and businesses and supporting the functioning of financial markets through a range of liquidity programs.

The TALF has not taken off so well, so they move from specifics to a more general statement of their “credit easing” programs.

The Committee will continue to carefully monitor the size and composition of the Federal Reserve’s balance sheet in light of evolving financial and economic developments.The Committee will continue to carefully monitor the size and composition of the Federal Reserve’s balance sheet in light of financial and economic developments.

Conditions are no longer evolving. ;)

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; Elizabeth A. Duke; Charles L. Evans; Donald L. Kohn; Jeffrey M. Lacker; Dennis P. Lockhart; Daniel K. Tarullo; Kevin M. Warsh; and Janet L. Yellen.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; Elizabeth A. Duke; Charles L. Evans; Donald L. Kohn; Jeffrey M. Lacker; Dennis P. Lockhart; Daniel K. Tarullo; Kevin M. Warsh; and Janet L. Yellen.

No change.

The Upshot:

  • They think things are going their way.
  • They aren’t worried about inflation.
  • Job losses are beginning to build up.

To What Degree Were AIG’s Operating Insurance Subsidiaries Sound? (3)

Wednesday, April 29th, 2009

Capital Stacking, Cross-guarantees, and Surplus Notes

After the difficulties with securities lending, the next issue reminded me a lot of the first company I worked for: Southmark.  A two-time loser in chapter 11, in their second trip of insolvency, they interlaced the capital of their subsidiaries, forcing them to do business on a thin capital base.  Subsidiary A would own stock of subsidiary B, and B would own stock of A.   They would both look more solvent, but would not be any more solvent.  Neither “asset” could be tapped for liquidity purposes.  In AIG’s case, most of the capital stacking was not so crude.  Most of it was operating subsidiaries owning shares in other subsidiaries, without another transaction going the other way.

Capital stacking increases leverage in a hidden way.  Say Subsidiary A owns Subsidiary B.  The surplus of B not only supports B’s business, but also A’s business.  A downturn in the business of B affects not only the affairs of B, but also A, particularly so if the surplus of B is a large fraction of A’s surplus.

With AIG, many of the operating insurance subsidiaries [OISs] held stakes (usually common stock) in other OISs.  Here’s a table of those subsidiaries with the exposure to the issue:

Subsidiary2008YE SurplusAffiliated Assets / Surplus
Am Gen Property IC

18

628%

AGC LIC

5,887

171%

UG Residential IC of NC

200

138%

SunAmerica LIC

4,653

107%

National Union Fire IC

11,825

90%

American Life IC “Alico”

3,900

79%

Audubon IC

39

77%

American General LIC

5,185

74%

New Hampshire IC

1,652

72%

AIG Centennial IC

305

63%

Hartford Steam Boiler IAIC

443

47%

AIG Casualty Co

1,457

35%

AIU IC

726

34%

AIG Hawaii IC

64

27%

AIG Excess Liability Co.

1,438

24%

American Home Assurance Co

5,702

23%

AIG Annuity IC

3,045

22%

American General L&A IC

488

22%

Commerce and Industry IC

2,678

20%

The Variable Annuity LIC

2,841

20%

Am Int IC

374

19%

Am Int LIC of NY

371

19%

AIG Premier IC

144

18%

United Guaranty Residential IC

1,106

16%

New Hampshire Indemnity Co

140

13%

Hartford Steam Boiler IAIC of CT

46

11%

Lexington IC

4,263

11%

Pacific Union Assurance Co

20

10%

AIG LIC

360

9%

AIG SunAmerica LAC

1,271

8%

Some of AIG’s larger OISs have significant exposures to other subsidiaries.  One minor subsidiary, Pacific Union, invested directly in AIG’s common stock.  That subsidiary doesn’t have much business in it, and is in little danger of insolvency, but is the most egregious example of creating capital out of thin air.  (I feel the same way when companies contribute common stock to Defined Benefit plans.)

Other OISs of note: 1) AGC LIC seems to be an intermediate level holding company, with little business of its own.  2) National Union is the biggest P&C company.  3) Alico is the intermediate holding company for most of the International Life business.  4) SunAmerica and American General are holding companies for the companies when they were acquired by AIG.  They have significant business in themselves as well.

There are guarantees as well.  Some of the larger subsidiaries, like National Union, together with AIG, guarantee a number of other domestic and international OISs.

Finally, there are surplus notes, concentrated in the mortgage guarantee subsidiaries.  This is another way of creating capital out of this air.  Surplus notes are considered as surplus, not debt, to the issuer, because any payment of principal or interest must be approved by the state Insurance Commissioner.  Subsidiary A offers surplus notes to Subsidiary B, which sends cash back to subsidiary A.  Subsidiary B gets to admit the surplus note as an asset.  New surplus created, with no transfer of risk to an external party.  Three of the four mortgage guarantee subsidiaries issued surplus notes to other AIG mortgage insurance-related subsidiaries totaling a little less than $900 million.

Now, given all of the complexity and leverage from all of these arrangements, it is all the more stunning that the normally intelligent New York Insurance Department allowed for the OISs of AIG to contemplate lending $20 billion to AIG.  At the time, I thought the idea was dubious.  This article from Enforce (pages 17-20) gives the definitive treatment of the issue, though I disagree with one of their main conclusions.  I don’t think the Federal Government would do a better job regulating insurance than the states currently do.  They have certainly not distinguished themselves in their regulation of depositary institutions.

To What Degree Were AIG’s Operating Insurance Subsidiaries Sound? (2)

Wednesday, April 29th, 2009

The Securities Lending Fiasco

Most, if not all life insurance companies engage in securities lending to some degree.  AIG did it in a big way, involving almost all of their life subsidiaries.  When a life insurer lends out its bonds, they receive back safe liquid collateral equal to 100-102% of the par value of what they lent out.  Most companies leave well enough alone at that point.  After all, you still receive the income on the bonds you lent out, plus securities lending fees.  The borrower receives the income on his collateral, less securities lending fees.  The borrower sells the bonds he borrowed, hoping to buy them back cheaper.

So far, so good, but AIG added a wrinkle to the game.  The safe liquid collateral was a slack asset to them.  Why not replace it with equally safe and liquid assets that offered considerably more yield, like bonds backed by AAA-rated subprime or Alt-A mortgage collateral?  After all, AIG was already writing financial reinsurance through default swaps on such mortgages, why not add to a winning bet?

They did so in a big way:

Subsidiary

Realized sec lending losses

2007YE Surplus

RSLL / 2007YE Surplus

American General L&A IC

(977)

471

-207%

AIG LIC

(871)

440

-198%

AIG Annuity IC

(7,110)

3,729

-191%

Am Int LIC of NY

(771)

553

-139%

First SunAmerica LIC

(653)

501

-130%

The Variable Annuity LIC

(3,562)

2,838

-126%

American General LIC

(3,790)

5,704

-66%

SunAmerica LIC

(2,281)

4,716

-48%

AIG SunAmerica LAC

(424)

1,151

-37%

Merit LIC

(50)

705

-7%

American Life IC (Alico)

(470)

6,718

-7%

Delaware American LIC

(1)

24

-4%

Life Companies Total

(20,960)

27,550

-76%

It took an amazing amount of skill to lose 76% of the surplus of the affected life companies.  One company, American General L&A IC, lost more than double its surplus.  Wow.  Why did this turn out so wrong?  The assets were mismatched to the liabilities in two ways:  1) The mortgages had longer lives than the securities lending transactions.  Even if there were no credit issues, there was no way to assure that the mortgage bonds would be worth the same at the beginning and end of the transaction.

2) Though AAA-rated, they were not credit risk-free.  Non-prime mortgages were made to borrowers of lower quality.  Of their own, they wouldn’t be investment grade, much less AAA, without credit support.  That credit support came through subordination.  Other investors would take the first X% of losses before the AAA bondholders would take any losses.  That X-factor was set too low.  In order to maintain a AAA rating, the X-factor not only has to be high enough that losses don’t harm the AAA investors, it has to be high enough that other investors would think that it would be almost impossible for losses to harm the AAA investors.

Subsidiary

Net capital contributed / 2007 Surplus

(neg = divs)

2007YE Surplus

Net capital contributed

(neg  =  divs)

American General LIC

123%

5,704

7,004

AIG Annuity IC

167%

3,729

6,223

The Variable Annuity LIC

113%

2,838

3,213

SunAmerica LIC

57%

4,716

2,696

AGC LIC

12%

7,729

895

American General L&A IC

185%

471

872

First SunAmerica LIC

153%

501

768

AIG LIC

167%

440

736

Am Int LIC of NY

101%

553

557

AIG SunAmerica LAC

25%

1,151

284

New Hampshire IC

19%

1,369

265

American Life IC

3%

6,718

211

Commerce and Industry IC

7%

2,688

180

UG Mortgage Indemnity Co of NC

55%

55

30

21st Century IC

0%

663

2

AIG Auto IC of NJ

0%

18

-

AIG Centennial IC

0%

335

-

AIG Excess Liability Co.

0%

1,248

-

AIG Hawaii IC

0%

65

-

AIG National IC

0%

18

-

AIG Premier IC

0%

162

-

Am Gen Property IC

0%

18

-

Am Int IC

0%

367

-

Am Int IC of Delaware

0%

45

-

Am Int Specialty Lines IC

0%

638

-

Audubon IC

0%

42

-

Delaware American LIC

0%

24

-

F book

0%

-

-

Landmark IC

0%

146

-

New Hampshire Indemnity Co

0%

102

-

Pacific Union Assurance Co

0%

67

-

UG Residential IC of NC

0%

194

-

United Guaranty IC

0%

24

-

United Guaranty Residential IC

-2%

496

(10)

Hartford Steam Boiler IAIC of CT

-26%

43

(11)

AIG Casualty Co

-5%

1,884

(103)

Hartford Steam Boiler IAIC

-22%

720

(158)

Lexington IC

-5%

4,551

(250)

Merit LIC

-38%

705

(270)

AIU IC

-33%

1,398

(463)

American Home Assurance Co

-8%

7,297

(571)

National Union Fire IC

-6%

12,157

(787)

Totals

30%

72,089

21,313

As a result of the securities lending losses, and the troubles at AIGFP, the Fed and Treasury began the bailout of AIG.  (Look at the above table to see the amount pumped in and taken out of each subsidiary on net.)  Why did they indirectly bail out life insurance companies that they do not regulate including one that mainly serves foreigners (Alico), by bailing out the AIG holding company?

I can’t be totally certain here, but I suggest that all major state insurance regulators should send Ben Bernanke, Tim Geithner, and Hank Paulson some really nice gifts, because had AIG’s life companies failed, the state guaranty funds would have been hard pressed to come up with something north of $10 billion by surcharging the other insurance companies doing business in each state.  At a time like this, where many life insurers, particularly ones facing credit risks, and those having variable policies, where profitability has declined along with the stock market, the surcharges could have kicked additional life insurers over the edge, and who knows how big the cascade would have been.

(Note to corporate bond managers managing insurance money: this is why you don’t own insurance bonds in your neck of the industry.  The company you manage money for already has contingent credit exposure to all of their peers through the guaranty funds.)

AIGFP was the bigger issue, but the domestic life companies of AIG posed a separate, distinct issue that the US Government addressed, right or wrong.

Disclaimer


David Merkel is an investment professional, and like every investment professional, he makes mistakes. David encourages you to do your own independent "due diligence" on any idea that he talks about, because he could be wrong. Nothing written here, at RealMoney, Wall Street All-Stars, or anywhere else David may write is an invitation to buy or sell any particular security; at most, David is handing out educated guesses as to what the markets may do. David is fond of saying, "The markets always find a new way to make a fool out of you," and so he encourages caution in investing. Risk control wins the game in the long run, not bold moves. Even the best strategies of the past fail, sometimes spectacularly, when you least expect it. David is not immune to that, so please understand that any past success of his will be probably be followed by failures.


Also, though David runs Aleph Investments, LLC, this blog is not a part of that business. This blog exists to educate investors, and give something back. It is not intended as advertisement for Aleph Investments; David is not soliciting business through it. When David, or a client of David's has an interest in a security mentioned, full disclosure will be given, as has been past practice for all that David does on the web. Disclosure is the breakfast of champions.


Additionally, David may occasionally write about accounting, actuarial, insurance, and tax topics, but nothing written here, at RealMoney, or anywhere else is meant to be formal "advice" in those areas. Consult a reputable professional in those areas to get personal, tailored advice that meets the specialized needs that David can have no knowledge of.

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