1)  A modest proposal: The government announces that they will refinance all debtors.  Not only that, but they will buy out existing debt at par, and allow people and firms to finance all obligations at the same rate that the government does for whatever term is necessary to assure profitability or the ability to make all payments.  The US Treasury/Fed will become “The Bank.”  No need for the lesser institutions, The Bank will eat them up and dissolve their losses, taking over and refinancing their obligations.  Hey, if we want a single-payer plan in healthcare, why not in finance?  Being healthy is no good if you can’t make your payments. 😉

This scenario extends the US Government’s behavior to its logical absurd.  The US Government would never be large enough to achieve this, but what they can’t do on the whole, they do in part for political favorites.  They should never have bailed out anyone, because of the favoritism/unfairness of it.  Better to have a crash and rebuild on firmer ground, than to muddle through in a Japan-style malaise.  That is where we are heading at present.  (That’s the optimistic scenario.)

2)  I have exited junk bonds, and even low investment-grade corporates.  Consider what Loomis Sayles is doing with junk.  Yield = Poison, to me right now, which echoes a very early post in this blog.  There are times when every avenue in bonds is overpriced — that is not quite now, because of senior CMBS, carefully chosen.  All the same, it makes me bearish on the US Dollar, and bullish on foreign bonds.  This is a time for capital preservation.

3) High real yields are driving the sales of US Government debt.  Is that a positive or a negative?  I can’t tell, but there is always a tradeoff for indebted governments, because they can usually reduce interest expense by financing short.  When their average debt maturity gets too short, they have a crisis rolling over the debt.  We are not there yet, but we are proceeding on that road.

4)  I have a bias in favor of buyside analysts, after all I was one.  But this research makes me question my bias.  Perhaps sellside analysts are less constrained than buyside analysts?

5) Debtor-in-possession lending is diminishing, reflecting the likelihood of loss.  In some cases that may mean more insolvencies go into liquidation.  Interesting to be seeing this in the midst of a junk bond rally.

6)  Short-selling isn’t dead yet.  Would that they would take my view that a “hard locate” is needed; one can’t short unless there is a hard commitment of shares to borrow.

7) Should we let managers compete free of the constraints imposed by manager consultants?  You bet, it would demonstrate the ability to add value clearly.  I face that  problem myself, in that I limit myself to anything traded on US equity exchanges.  As such, I have beaten most US equity managers (and the indexes) over the last nine years, but no one wants to consider me because I don’t fit the paradigms of most manager consultants.

8 )  Is there a fallacy in the “fallacy of composition?”  I think so.  Yes, if everyone does the same thing same time, the system will be unstable.  But if society adopts a new baseline for saving/spending, the system will adjust after a number of years, and there will be a new normal to work from.  That new normal might be higher savings and investment, in this case, leading to a better place eventually than the old normal.

9)  Anyway, as I have said before, stability of a capitalist system is not normal.  Instability is normal, and is one of the beauties of a capitalist system, because it adjusts to conditions better than anything else.

10)  Corporate treasurers are increasingly engaged in a negative arbitrage where they borrow long and hold cash so that the company will be secure.  How will this work out?  Will this turn into buybacks when things are safe?  Or will it just be a drag on earnings, waiting for an eventual debt buyback?

11)  Does debt doom the recovery?  Maybe.  I depends on where the debt is held, and how is affects consumption spending.  Personally, I think that consumers and small businesses are under a lot of stress now, and it won’t lift easily.

12)  So things are looking better with junk bond defaults.  Perhaps it was an overestimate, or that it would not all come in 2009.  We will see.

13)  Junk bonds do well; junk stocks do better.  In a junk rally, everything flies.  All the more to hope that this isn’t a bear market rally; if so, the correction will be vicious.

14)  Eddy, pal.  Guys who criticize data-mining are near and dear to me.  Now the paper in question has a funny definition of exact.  I don’t know how to describe it, except that it seems to mean progressively more accurate.  I didn’t think the paper was serious at first, but given the relaxed meaning of “exact,” it data-mines for demographic influences on the stock market.  Hint: if you have lots of friends when you are nine, ask for stock as a birthday present.

15)  I’m increaisngly skeptical about China, and this doesn’t help.  I sense that the global recession is intesifying, amid the current positive signs in the US.

16)  Do firms with female board members do worse than companies with only male board members?  No, but they get lower valuations, according to this study.  I started a study on female CEOs in the US, and I got the same result, but it is imcomplete at present — perhaps new data will invalidate my earlier findings.  Why does this happen, if true?  Men seem to be better at managing single investments, while women are better at managing portfolios.

17)  Do we have more pain coming from the banks?  I think so.  Residential real estate problems have not reconciled, and Commercial real estate problems are just beginning.  If we mark loans to market, many large banks are insolvent, and this is not an issue that will easily be healed with time.

18)  As a nation, I like Japan, and would like to visit it someday.  What I don’t want is for the US to imitate its economic stagnation, but maybe that could be the best of all possible worlds for the US.

19)  I am de-risking my equity and bond portfolios at present.  I do not think that the present market levels fairly reflect the risks involved.  I am reducing risk in bonds, and looking for strong sustainable equity yields in equities.

20)  Echoing point 17, we face real problems on bank balance sheets from commercial real estate lending.  There is more pain to come.  The time to de-risk is now.

June 2009August 2009Comments
Information received since the Federal Open Market Committee met in April suggests that the pace of economic contraction is slowing. Conditions in financial markets have generally improved in recent months.Information received since the Federal Open Market Committee met in June suggests that economic activity is leveling out. Conditions in financial markets have improved further in recent weeks.They have greater confidence in a recovery in the financial markets, and that real activity is no longer falling.
Household spending has shown further signs of stabilizing but remains constrained by ongoing job losses, lower housing wealth, and tight credit.Household spending has continued to show signs of stabilizing but remains constrained by ongoing job losses, sluggish income growth, lower housing wealth, and tight credit.Regardless of other signs of improvement, household spending is problematic – even for those that have jobs, wages are constrained.
Businesses are cutting back on fixed investment and staffing but appear to be making progress in bringing inventory stocks into better alignment with sales.Businesses are still cutting back on fixed investment and staffing but are making progress in bringing inventory stocks into better alignment with sales.More certainty that the “inventory correction” has likely run its course.
Although economic activity is likely to remain weak for a time,  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.Although economic activity is likely to remain weak for a time, 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.No change.
The prices of energy and other commodities have risen of late. However, substantial resource slack is likely to dampen cost pressures, and the Committee expects that inflation will remain subdued for some time.The prices of energy and other commodities have risen of late. However, substantial resource slack is likely to dampen cost pressures, and the Committee expects that inflation will remain subdued for some time.No change.
In these circumstances, the Federal Reserve will employ all available tools to promote economic recovery and to preserve price stability.In these circumstances, the Federal Reserve will employ all available tools to promote economic recovery and to preserve price stability.No change.  Why do they even bother to say this?
The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period.The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period.No change.
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.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 change.
In addition, the Federal Reserve will buy up to $300 billion of Treasury securities by autumn.In addition, the Federal Reserve is in the process of buying $300 billion of Treasury securities. To promote a smooth transition in markets as these purchases of Treasury securities are completed, the Committee has decided to gradually slow the pace of these transactions and anticipates that the full amount will be purchased by the end of October.No big change; October is in autumn.  Quantitative easing continues, but will slow down.  Same for the above section – they just have more securities to buy there.
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.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.No change.
The Federal Reserve is monitoring the size and composition of its balance sheet and will make adjustments to its credit and liquidity programs as warranted.The Federal Reserve is monitoring the size and composition of its balance sheet and will make adjustments to its credit and liquidity programs as warranted.No change.
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.

Quick Hits:

  • The FOMC is comforted over the recovery in the debt and equity markets.
  • The FOMC sees the real economy bottoming.
  • Very few changes, and fewer substantive changes — these two statements are the most alike of two statements in the recent past.  The FOMC is likely trying to convey that policy accomodation will not be rapidly withdrawn, and thus:
  • They aren’t changing any of their policies significantly now.

I’m not sure I buy their logic, but this is par for the course with the FOMC, partly because policymakers often err on the side of increasing confidence in the economy.

1)  As I’ve said before, I don’t care whether Bernanke is reappointed or not, because who will be appointed that has a materially different theory of central banking than Bernanke?  I don’t see Ron Paul getting appointed.

But to reappoint Bernanke because a bunch of economists think it is a good idea is dumb.  The neoclassical economists were blind going into this crisis, and only a few outside the mainstream saw the debt building up, and said this would not work out well.

And, if I were in Bernanke’s shoes, I would not want endorsements from economists.  Oh wait, he is one.  Alas, I am one too, though rogue. Outside of economists, are politicians the only ones who trust economists?  Yet, the politicians use the economists as a useful shield.  “We only did what the economists suggested would bring prosperity.  We cannot be blamed if the experts are dunces.”

I think Bernanke will be reappointed.  I only hope he is there long enough to see him either struggle with stagflation, or with a Japan-style malaise, or both.  As I have said since 2004 at RealMoney, “This will not work out well.”

2)  Barack Obama is a bright guy.  He may be the brightest president since… um, I’m not sure, he might be the brightest of them all.  That does not mean that I agree with his ideas, because a bright man starting from bad postulates ends up in a bad place quicker.  That said, there seems to be some restraint on his part, as noted in this WSJ article:

In early July, the president ordered a briefing on derivatives — financial contracts that track the return on stocks, bonds, currencies or other benchmarks. Critics had been raising questions about administration proposals to regulate certain derivatives, such as credit-default swaps, which many blame in part for the financial crisis. With advisers gathered round on the Oval Office’s twin sofas, Mr. Obama said he was concerned that the administration hadn’t struck the right balance.

Its proposal called for standard derivatives to be traded on an exchange, bringing them into the open. Critics were calling the proposal too timid because it also would allow “customized” derivatives to continue trading privately. “What is to assure that this won’t drive all derivatives off the exchange?” the president asked, according to Mr. Emanuel.

He says Mr. Obama was frustrated his team wasn’t offering up a full range of views on how to approach derivatives regulation. “Get me some other people’s opinions on this,” Mr. Emanuel recalls the president as saying. “I want more than what’s in this room.”

In the end, the administration tweaked its position on derivatives. In legislative language drafted this week, it is seeking to require financial firms that offer customized derivatives to maintain higher capital cushions.

And so goes the proposed legislation.  It only tweaks at the edges the existing derivative setup, and does not question the troubles that the financial markets wreak on the cash markets when they are allowed to become gambling markets, where speculators trade with speculators, and the tail begins to wag the dog.  Synthetic markets must be smaller than the real markets, if we want to have longer-term stability.  Hedgers must lead the markets, not speculators.


That’s all for now.  I don’t have much hope in the legislation on derivatives, or who leads the Fed.  Given where the terms of debate are, the debate excludes my views.

I’m not a healthcare actuary; I am a life & investment actuary.  I did pass my health exam on the actuarial syllabus with a high score, but that was almost 20 years ago.  So, take what I say not as expert opinion, but as reasonably well-informed opinion (I hope).

I general, I believe the US needs to move away from insurance with respect to healthcare.  Let people pay directly for healthcare services, and if they must have insurance, let it be with a high deductible, like $5000/year.  If the government then wants to help the poor, let them pay on the deductible.

Wait.  That’s a non-starter.  First-dollar coverage is the holy grail.  Expensive as anything, but that is the perverted goal.

Rationing takes place in any economic/political system, it is merely a question of how the goods and services get rationed.  Price?  Time?  Need (however defined)?

So, the politicians look to cover everyone, and yet control costs in the medical system.  Covering everyone is very expensive, because for the most part, the worst risks aren’t insured.  Those that would pay the highest premiums on a actuarially fair basis don’t buy/get insurance.

Controlling costs means reducing access, limiting doctor freedom, limiting choices, delaying treatment, etc.  Preventive care is a nice concept, but the gains are negligible.

I say let people be free, and get the government out of the picture.  No corporate deduction for healthcare costs.  No HSAs or other tax-preferred benefits (I have one of those).  Scale back Medicare; it is way too expensive relative to the GDP of the US.  Finally, inculcate a culture that recognizes that we are all going to die, and that certain care for the elderly will not be available unless they can pay for it privately.  We don’t want to prolong an expensive death at taxpayer expense.

An Idea

But with all that, let me propose one idea that might help.  I once proposed a program to improve the banking system of the US through the creation of mutual banks.  I thought, why not try the same idea with health insurers?

So, I started reading the news on the healthcare proposals, and I was surprised to find the idea of co-ops being discussed (also).  Some co-ops have been successful in managing costs and access, others not, as many co-ops have failed.

My thought was this: mutual banks could work versus the big  banks, because scale is not much of an advantage in banking.  Big banks have expense advantages, but they take dumb risks.  With healthcare there is a real advantage to size.  Small co-ops can’t compete against major health insurers.  But maybe a big mutual entity could do so.

Instead of a bunch of medical co-ops, better to sponsor/seed one mutual health insurance company that can cover the whole USA, and challenge the big private insurers.  The new entity would be charged with the tasks of reducing the uninsured, and lowering healthcare costs.  Much better than the co-ops idea.

But, nothing is perfect; we haven’t reached Solla Sollew yet.  If the mutual insurer is supposed to subsidize care, how should they do it?  Many of those that are uninsured are bad risks.  Others who might want to use the mutual company might look for policyholder dividends, particularly if they did not use the healthcare system much.

In the life insurance industry, the best mutuals imitate stock insurers, but adopt a longer-term view of their business.  I would assume that it would be true of a mutual health insurer as well.  So, what benefit would come from a large mutual health insurer?

  • Competition against the large managed care providers, lowering prices, kind of like what Southwest Airlines does…
  • Skimming the cream of those who are basically healthy, but can’t easily find insurance.
  • Congress would gain insight into how difficult it is to lower medical expenses, and how difficult it is to cover the uninsured.

The main reason that Congress is having large problems with this issue is that they are trying to do too much.  They are aiming for costless solutions to a costly problem.  They are looking to restrain access to healthcare to a culture that wants its problems solved now.

This is all a fool’s bargain to me, so let Congress charter National Healthcare Mutual, and see how much good it can do, before it returns to them hat in hand.

This has been an interesting earnings season.  Many companies have been beating earnings estimates once certain one-time items are excluded.  This has led to criticism by market commentators alleging that earnings estimates and/or adjusted earnings are not a reliable guide for individual stocks or the market as a whole.  There’s some truth there, but let me try to give a more nuanced view.

What are we really trying to estimate?

Earnings estimates do not primarily exist for the purpose of estimating the next few quarters’ or years’ earnings.  They exist for estimating the future path of free cash flows.  Wait, what is free cash flow?  Free cash flow is the amount of money that you can take away from a business at the end of an accounting period and leave the company as well off as it was at the beginning of the accounting period.  How does that compare to earnings?  Typically, non-cash charges like depreciation and amortization get added back to earnings, and maintenance capital expenditures get deducted — what remains is free cash flow, which can be used for dividends, buybacks, and investments to build the business.  Free cash flow is similar to what I will call “run rate” earnings, though there are some differences.

In that sense, analysts are trying to estimate “run rate” earnings when they adjust for “one time” events.  Absent these abnormal occurrences which won’t happen next quarter, what would the earnings have been?  Surprises above and below the consensus estimates of the analysts provide information to investors.  Positive surprises indicate that the future run rate for earnings might be higher, and vice-versa for negative surprises.

I say “might be,” rather than “will be,” because of randomness in profitability, or, an inability to truly figure out all of the abnormalities and timing differences in a given quarter.  Typically, several positive earnings surprises must take place before estimates of the run rate begin to rise.  One is normal randomness, two is happenstance, three is a pattern, four is a change in trend.

Guiding up, guiding down

Of course, corporate management can make life easier by giving earnings guidance to analysts, and then guiding the estimates up or down as they see best.  They can also break out their estimates of operating or adjusted earnings in order that analysts can decide for themselves which adjustments are “one time,” and which aren’t.  (In my opinion, Allstate does a particularly good job with this, as does Assurant.)

But changing guidance is powerful, particularly for companies with a reputation for UPOD (underpromise, overdeliver), as opposed to companies with a reputation for OPUD (overpromise, underdeliver).  When analyzing guidance changes, one must adjust for prior earnings surprises to figure out whether th raise in guidance reflects only past successes, or forecasts greater successes in the future.

That’s a lot of “one time” events!  Why do so many of them raise operating earnings?  Shouldn’t the difference net to zero over a long enough timespan?

Alas, once we start adjusting earnings to create operating earnings, we enter a new world with a new accounting basis that superficially resembles “run rate earnings” but with a fault.  Almost every quarter has its parade of “one time” events.  On average, the adjustments raise operating earnings over ordinary GAAP earnings.  Managements are more incented to find the positive adjustments to earnings in the short run.  Obvious negative adjustments get accounted for, but non-obvious ones don’t get searched for.

But clever investors eventually adjust for this.  Here’s a way to do it.  Analyze a long period of time, say five years, or the CEO tenure, whichever is shorter.  Look at the growth in book value, and add back dividends.  Compare that to cumulative diluted earnings over the same time period.  If cumulative diluted earnings are higher, then earnings are inflated.  Here’s another way: if you have a long enough data series, add up operating and diluted earnings over a long period of time, say five years, or the CEO tenure, whichever is shorter.  If operating earnings are significantly larger, there is a company that is using operating earnings to make itself look more profitable than it actually is.

If nothing else, over a long enough period of time, this is a means of measuring the honesty of management teams where it comes to financial reporting.  In my book, honest/conservative management teams deserve higher multiples than less scrupulous management teams.  These measures document the games that management teams play in order to make their results look better than they should appear.

How are we doing versus the expectations of the market?

The investment game is one where profitability performance versus expectations determines price performance.  Prices don’t ordinarily react to backward-looking data, unless there is a big one-time charge that adds a lot to book value, or takes a lot away, perhaps impairing the future prospects of the firm.  Prices do react to the signals given through earnings relative to expectations, as it leads investors to update their views of potential future run rate earnings, or, free cash flow.

Can we make a lot of money off of this effect?

Not so much any more.  There are many investors following earnings momentum, earnings surprises, analyst estimate revisions, and price momentum, that the average investor can’t make a lot of money off of this effect.  But ordinarily it does help an investor understand what is going on when stock prices move after earnings are released.  Expectations of the future change, and that drives current stock prices.

Full disclosure: long ALL AIZ

1)  Great minds think alike.  Fools seldom differ.  Remember my post on AIG’s subsidiaries?  Well, now in the New York Times, much of the same.

2)  Fed Independence! (spit, spit)  Come on, Bernanke, you argue against the Fed being audited because it might compromise Fed independence, and yet you regularly have lunch with leaders of the Executive branch.  You compromise the independence of the Fed more than any audit could by acting cooperatively with the Treasury.  If you were really independent, you would do what is best for your explicit mandate — fighting inflation and unemployment, rather than tinkering with non-bank credit markets, and rescuing companies.

3) Manus manum lavat. One hand washes the other.  Banks that have been bailed out are buying more Treasuries.  Some of that is lower spreads — lack of lending opportunities.  The rest is implicitly paying back the government.

4) The government may be increasing its sales of TIPS.   I’ve been less bullish on TIPS of late, and this does not encourage me to change.  Further, farmland values may be falling.  Given growth in demand for food in the world, that should not be so, but maybe that is wrong.  Maybe depressionary conditions are that strong.  I also offer up the piece from UBS, via FT Alphaville, that suggests that deflation is more likely to minimize the total cost of debt to the US government.

All of this depends on the current length of US government debt.  If all of it were nominal (not inflation-indexed) 30-year debt, the US Government would gladly inflate.  Their financing is locked in.  But if it were all short-dated, the US government would have to manage the powder keg.  After all that was Mexico in 1994 — the government was financed in the short-term interest rate markets.

Thus, governments that have not been prudent, and have financed short-term can face a run on the currency.  The US government finances to an average of 4-5 years, so it is not apparent whether they could face a run or not.

The more TIPS that are issued as a fraction of the total debt, the less valuable the inflation guarantee becomes.  If China, or any other creditor thinks that TIPS are the solution to loss of value on US debt claims, let them realize this:

  • Yes, if the US inflates its currency, there will be protection.
  • No, if the US defaults on its obligations, you won’t be materially better off.
  • If the US decided to selectively default on foreigners, paying them back in a different US dollar than the domestic one, TIPS won’t help you much.

5)  Bye, bye, Fannie and Freddie?  Sending them into runoff was my proposed solution when the crisis hit.  Now that the reality of the humongous losses from mortgage lending and guarantees has become apparent, the government faces reality, and may wind them down.  As it is now, we know that F&F are unlikely to pay back their aid from the government in full.  In my opinion, better that the government would have let the companies go into Chapter 11 without interference. Instead, the taxpayers bail out much of the capital structure that did not deserve a bailout.

6)  Should Ben Bernanke be reappointed as Fed Chairman?  It doesn’t matter.  There is no significant variation in ideas among likely candidates that would make a significant difference in how the Fed behaves.  I don’t think Ben should be reappointed, but I don’t see any worthy replacements.  Ron Paul is out of the question, sadly.

These articles argue that Ben Bernanke should not be reappointed, and they make some good arguments:

All that said, what is the option?  Is there someone stunningly good standing in the wings, with a materially different view of monetary policy from Bernanke, who would be acceptable to the activist Obama administration?  I don’t see one available, so perhaps the devil you know is better than the devil you don’t.

7)  The corporate bond market has been on fire of late, with higher prices, tightening spreads and greater issuance.  We had several episodes like that in 2002, before facing reversals.  The first time is not the charm, and I would expect more of a backup in prices because corporate loss rates have not peaked yet.

8)  Let me just point out that “cash for clunkers” is another version of the “broken window fallacy.”

9)  As for AIG, I don’t expect the government to be paid back in full.  Sales of AIG subsidiaries have gone at cheap prices, and only the simple subsidiaries have been able to be sold.  Investment banks will make money on the deal, though.

10)  Even if GDP shrinkage is slowing due to government spending, that still means that the private sector is weak.  GDP ex-government growth will be a statistic to watch in the future.

I’ve written a number of pieces where I have discussed limits on derivatives.  These have seemingly been among my least popular pieces, partly because I seem to argue against the free market.  I’m not arguing against the free market, per se, but arguing that there are some types of contracts that should not be valid on a public policy basis.  This piece is meant to integrate my thoughts on:

  • Having a hard locate with shorting — (shares that have not been previously lent are located and confirmed to be borrowed).
  • Insurable interest with respect to credit default swaps [CDS].  Only hedgers can initiate transactions, and if the hedger sells, he must first collapse the CDS transaction.
  • Insurable interest should apply across all derivative markets, and should become a regular part of insuring systemic stability.  Regulators of the various exchanges would require hedgers to divulge the assets or liabilities in question that they are hedging.  The hedgers would then be allowed to buy and sell contracts up the hedging need, and no more.  Speculators would bid for the right to trade with the hedgers, but could not trade with other speculators.  Every transaction must have a hedger.

One of my core reasons for this is to shrink derivative activity so that it is smaller than the underlying markets.  This will keep “the tail from wagging the dog.”  After all, if you need to do a transaction, why not buy/sell the underlying, on a forward basis if necessary?  Also, let the regulators understand their clients more closely, so that they can better prevent insolvencies.

My second core reason is that speculators dealing with speculators is gambling, and should be regulated that way, because there is no transactional tie to the real economy.  Now, some will say,”Doesn’t all investment involve gambling?”  My answer is no.  All investment involves risk-taking, but there is a difference between risk-taking and gambling.

Every business/businessman takes risks.  Many of those risks get externalized in public security markets because the equity and debt of the company trade on secondary markets.  The prices of the shares and bonds reflect marginal perceived risk of the business.  That risk is necessary risk.  Unnecessary risk is two unrelated parties with no economic interest betting on whether the company can survive or not; such a bet should be regulated as gambling.

Most people buying/shorting a stock have some reason why they think they will make money.  Even if they are wrong, they don’t think their actions are as uncertain as a coin flip.  Few pick tickers randomly, and decide positions (buy/short) randomly.

My third core reason is to reduce regulatory and taxation arbitrage.  Many derivative transactions are done to escape regulations and taxation existing in the underlying markets.  Let these parties abide by the rules of their regulators, and let them pay the taxes that they owe.

There are legitimate reasons for wanting to lay off short-term risk, without selling a long term asset.  But on the whole, speculative markets should not exceed the demand for hedging.  Similarly, markets for shorting should not exceed the amount of underlying available to be borrowed.

That’s my position.  Separate investment and gambling through a requirement of hedging in synthetic transactions.  If some want to gamble on companies, let them go to Vegas; the margin requirments will be tighter.

I know this article won’t be popular, but I do want financial markets to have real legitimacy over the long term.  Gambling, even if legal,  never has moral legitimacy.  Better to have smaller markets that are viewed by most to be legitimate, than to have large markets that have the legitimacy of a casino.

I was driving home from some event with the youngest five of my children — it was a long and tiring event, so my kids were quiet, and a thought came to me… what of the companies that I have worked for in the past?

So, I started down the list.  Pacific Standard Life — biggest life insurance insolvency of the 1980s.  (That you have never heard of it tells you the ’80s were kind to life insurers.)  I was a great place for me to start.  More than doubled its size every year for the 3.5 years that I was there.  My responsibilities grew as rapidly.  It was like taking a drink from a firehose.  I became indispensable, and then as I realized that the probability of company failure was growing, I looked elsewhere.  I ended up with two offers — Midland National, and AIG.

Pacific Standard was eventually sold to the Hartford, and exists no more today.

I took AIG, and am not sad that I did, even though the Midland National offer was better in hindsight, and AIG cheated me by placing me on the domestic side rather than the international side.  The church that I went to while working for AIG more than made up for the difference.

That said, my life at AIG was miserable.  What a political, unprofitable place — that is, the domestic life companies, prior to the purchase of SunAmerica.  I really hated myself as I got more recognition for closing down unprofitable lines, than building profitable lines.  That said, I learned a lot there — you had to do everything — price products, value results, risk control, and even poke around at the investments.

But I knew I was a short-termer there; my conscience bothered me regularly.  Why so much effort on an unprofitable division, where every day was a battle?  I interviewed many places, eventually Conning made made me an offer (and then withdrew it).  Provident Mutual was more honorable, and so I became their investment actuary in the Pension Division.

Wait, what of AIG today?  It is being chopped up and sold off.  I suspect the name will disappear in entire before 2020.

As part of a six member group of officers over a 30+ staff in Provident Mutual’s Pension Division, I made and helped make significant changes that improved profitability and lowered risk. By the time I was done, projects that I executed accounted for 5% of Provident Mutual’s net present value of profits.  The Pension Division went from being a backwater to the star division of the company.

Mid-way through my time at Provident Mutual, senior management asked me to be the line actuary for the Annuity Division.  I did that, changing the investment and crediting strategies.  I still remember telling the investment department to invest 25% of their assets in 30-year bonds.  Doesn’t sound right when the crediting rate reprices each year, but when you have floor crediting rate guarantees, it makes a lot of sense.  That call has paid off.

But, all humanly good things come to an end.  Senior management at Provident Mutual took a dislike to actuaries who were too competent.  They fired my boss, and gave me less and less to do.  I could read the writing on the wall, so I looked elsewhere.

Where is Provident Mutual today?  It is a part of Nationwide Mutual.  Management sold the company for a piddling amount of compensation to the management team, and reasonable compensation to the dividend-receiving policyholders.  As I have said to my children, “That is stupid-greedy.  When you sell the company and receive only three times your annual salary as a bonus, you are trading away something more valuable, for something less valuable.”  But the real loser was Nationwide, who had to write off a large portion of the purchase price stemming from the adjustments made to the earnings statements from Provident Mutual management.

I took a job at USF&G as it was being acquired by The St. Paul.  The St. Paul wanted an actuary that understood how to invest life insurance assets, because they hadn’t had a life insurance subsidiary in over 25 years.  I explained the theory to them — maximize interest spreads over the life of the business.  Very different from the P&C version — premium reserves get invested in cash, claim reserves in bond of the proper duration for payout.  Surplus assets get invested in risk assets, like equities.

USF&G is gone, but so is The St. Paul, which is now subsumed in The Travelers.  I could go on over how the CFO of The St. Paul ruined the balance sheet by buying back too much stock, or how The St. Paul increased its leading market share in Medical Malpractice by buying crummy medium sized competitors in the wrong point of the pricing cycle.  But I won’t; they are gone now.

Now the operating life company that I used to manage money for is still alive, if not kicking.  Old Mutual plc owns them, and the underperformance of the life subsidiary led to the dismissal of the CEO of Old Mutual.  I would not be surprised if that subsidiary were sold off.

The investment management subsidiaries that I worked for survived better, but where operating management is marginal, the pressure comes to replace investment management.  It is easy to blame the operating management, but much harder to eject the investment management.

Two more takeaways for me: first, the insurance insustry, for all its complexity, has done very well with taking over complex liabilities and corporatations, leaving policyholders relatively unaffected.  Second, my own career has been marked by working for companies that tried to grow too quickly.  Using  my fictional story as a template, I worked most of my insurance career for the aggressive guy.  As an asset manager, I’ve spent most of my time investing in conservative management teams.  I guess I learned what works by working for what doesn’t work, again and again.

I’m not disappointed; I learned a lot, and it made me better with both risk control and investing.  May we all make lemonade if we get a lot of lemons.