I read every email sent to me, and every comment  written at my blog.  But much as I would like to, I can’t answer them all.  One comment to my last piece on this topic questioned the validity of accrual entries in insurance accounting.  I would like to say that the standards for GAAP reserve accounting are pretty good.  They need some tweaks here and there, but they do the job fairly well.

One of the things you learn as a fundamental investor is that the quality of accounting derived from accrual entries is always lower than that for cash entries.  There is an implicit assumption behind every accrual entry that someone will make good in the future to pay cash, whether the amount is fixed or estimated.

Accruals vary in quality.  Accounts Receivable are more reliable than inventories.  Who knows what fixed assets, property, plant and equipment are worth?  Pension obligations are squishy, the assumptions can be manipulated within reason.  Deferred tax assets rely on the ability to earn more money, but most companies with the deferred tax assets have lost significant money in the past.  Will the company bounce back?

And there are intangibles.  Goodwill is only worth something if a company earns cash from operations in excess of net income over the long run.  Capitalized R&D, software costs, must produce cash flows that justify capitalizing the expenses, otherwise capitalizing is merely deferring losses.

So there are tests such as normalized operating accruals that for industrial companies and utilities can flag many companies that look cheap, but may not be, because too much of their income comes from accrual entries.

With financial companies, the problem is worse, because financial companies are a bag of accruals.  What are the loans worth?  What are those weird structured securities worth?  And with insurance it gets tougher.  What level of claims do you expect to pay out and when?  Will you recover the amounts that you invested in acquiring the policies that have been written?

Tough questions, but they are what accounting rules have been designed to try to answer.  Because there is complexity, unscrupulous management teams can take advantage of the flexibility.  That does not mean the rules are wrong, though.  No human system can be both consistent and comprehensive.  There are tradeoffs between modeling the details of a company’s financials accurately, and doing the accounting consistently across corporations.  To what degree do you make accounting “cookie cutter” versus tailored?  That is the tough question that vexes those that set the accounting standards.

I would add that insurance accrual quality is subject to three factors:

  • Length of the accrual — longer is worse.
  • Uncertainty of the contingency in question — uncertainty of amount and timing?
  • Does the law of large numbers apply?  What is uncertain in specific, may be more predictable in aggregate.

I received another comment, and initially I said, “I can’t get that done.  Yes that would be good but….”  Here is the comment:

Doug Says:

May 24th, 20109:10 am at Edit

It would be interesting to normalize the reserve charges two ways:

1) Adverse reserve development as a % of beginning reserves.
2) The ratio in #1 above compared with the industry.

While these reserve charges were bad, long-tailed P&C insurers were taking similar reserve charges – even the more “responsible” ones.

Look at the results of one of AIG’s smaller competitors – W.R. Berkley. Similar business mix and a charismatic CEO to boot. Same string of reserve charges, but the CEO is still there, and investors got a nice 20% annual rate of return from 2000. The difference? AIG was trading at 4x book value in 1999, while Berkley was trading below book.

So I went and did it, choosing eleven peer companies that were large, having long tailed liabilities.  This was the peer group:

  • ACE — ACE Limited
  • BRK — Berkshire Hathaway
  • CB — Chubb
  • CINF — Cincinnati Financial
  • CNA — CNA Financial
  • MKL — Markel
  • PRE — PartnerRe
  • TRV — Travelers
  • WRB — W. R. Berkley
  • WTM — White Mountains Insurance
  • XL — XL Capital Limited

I could have chosen more, but I thought these were representative of stockholder-owned insurers and reinsurers that write long-tailed P&C business.


So what did I find?  I found that AIG was among the worst of major P&C insurance companies in terms of having to strengthen reserves from 1993 to the present.  AIG had to strengthen its reserves 2.1%/yr versus my peer group average of 0.6%/year.  CNA did worse, and White Mountains (a company that talks a lot about conservative accounting) was slightly behind.

Note that the four companies that did not stretch all the way back to 1993 in terms of reported numbers likely would have looked better, because they missed some favorable underwriting years.

Here is the graph of the twelve companies, and the average:


And here is the graph of the companies that were not as good as the average:


The clear conclusion is that AIG was among a group of P&C insurers that were less conservative in reserving than most of their large competitors. CNA and White Mountains were much smaller companies — AIG was dropping a boulder into the pond.

Among all the other difficulties that AIG had, from a yield-seeking derivatives subsidiary, to life and mortgage insurance subsidiaries in trouble, this was just another facet of a company that played it fast and loose.  They under-reserved their P&C divisions, and there can be no reasonable defense on that topic.

PS — I like investing in P&C insurers and reinsurers that regularly release reserves for the business of prior years.  Conservative companies have high earnings quality, and are reasonable investments, despite all of the uncertainty.

Full disclosure: long PRE, CB

One quick note for readers before I begin: I passed my Series 86 exam with an 88% score.  I did better than I expected.  Now I am studying for the 87 — my how interesting it is to study law… BTW, the next book I am reviewing is Confidence Game.

The Great Reflation

I wish I had written this book.  Of course, Tony Boeckh has resources that I don’t, given his prior connections to the Bank Credit Analyst.  When I subscribed to the Bank Credit Analyst, I always prized their insights.

The Great Reflation follows many themes that I discuss regularly:

  • Are we facing inflation or deflation?  Inflation of the currency or goods prices, and deflation of assets?
  • In the bull phase, liquidity is a synonym for willingness to borrow.  In the bust phase, illiquidity is a synonym for inability to sell assets to pay off debts.
  • Public borrowing has been substituted for private borrowing, with an attendant increase in sovereign risk.
  • Whether there are central banks or not, economies go through credit cycles.  Because the Fed facilitated this cycle, the debt bubble is bigger, and the cleanup will be huge.
  • Deleveraging is needed to restore prosperity, but there will be years of pain before that starts, assuming that the politicians are willing to see it through.
  • In the short run, the US has avoided a deeper crisis because of their ability to borrow.  This sets the stage for a larger crisis later.
  • Acting to reflate assets after a bust sets the stage for a new bubble.
  • Asset allocation is tough when interest rates are low, and there is no obvious desirable safe asset class.  Be nimble, and react to changes in valuations driven by emotions.
  • Even in crisis times, stocks can be valuable investments; one merely has to get the fundamentals and timing right.
  • Bonds are easy — think about interest rate risk, credit risk, and inflation risk.
  • He is bearish on the Dollar over the long term, but it could be the best of a bunch of bad developed market currencies for a long time.
  • Gold might be a bubble, or it might go considerably higher.  He favors the bubble argument.  Same for commodities.
  • Real estate prices won’t do anything amazing, good or bad.
  • America is in decline.  Can it recover?  (It has a lot of advantages, but unless the average American citizen is willing to sacrifice and clean up his own life, the answer is no.)
  • This will lead to a decrease in American influence abroad.  That will lead to a less stable world.

In his chapter on stocks, and his chapter on bonds, and chapters on other asset classes, the author hands out a wealth of knowledge on how to analyze fundamentals, sentiment, and technicals of asset classes.

He also comes to the conclusion that I do, that there are no easy asset allocation decisions here, and that one should diversify widely in order to preserve assets.  Also, he concludes that there is no easy endgame for heavily indebted nations, and that there will be a reckoning, though whether that means inflation or deflation is impossible to tell in advance.

I enjoyed the book and would recommend it highly.  My only misgiving is that there wasn’t much new for me in the book, but it was very well presented.

If you want to buy the book, you can buy it here:  The Great Reflation: How Investors Can Profit From the New World of Money

Who would benefit from this book

Most average investors could benefit from the book.  It would give them a deep feel for the difficulties that we are now in.  It would tell them that there are no easy solutions, and that broad diversification is warranted, together with nimbleness to profit from volatility.

Full disclosure: The publisher e-mailed me, and I requested a copy.

If you enter Amazon through my site, and you buy anything, I get a small commission.  This is my main source of blog revenue.  I prefer this to a “tip jar” because I want you to get something you want, rather than merely giving me a tip.  Book reviews take time, particularly with the reading, which most book reviewers don’t do in full, and I typically do. (When I don’t, I mention that I scanned the book.  Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website.  Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites.  Whether you buy at Amazon directly or enter via my site, your prices don’t change.

In theory I agree that Central Banks should be free from political influence.  In practice, I don’t.  Why?  Central Banks regularly cave into political influence.  They are quick to loosen, and slow to tighten.  They are happy to let asset bubbles develop, because that is not what they are employed to handle.

The truth is, the arguments of Ben Bernanke are a joke (here too).  When Central Banks felt no pressure, they happily went along with what the politicians wanted.  No one wanted a strict central bank.  Thus for all of the Greenspan/Bernanke era, asking to be free from political control is just a show.  They want to agree with the politicians, who want easy credit.  They don’t want rules that would lead to a better economy in the long run, where their political friends get harmed.

Here’s a simple rule, that if put into place, would reduce volatility considerably: if the 3-month T-bill yield is more than 2% lower than the 10-year T-note yield, tighten.  If the 3-month T-bill yield is more than 1% higher than the 10-year T-note yield, loosen.  When in doubt, set Fed funds rate such that the gap between the 10-year and 3-month T-bill to 0.5%.  It’s that simple.  We don’t need grotesque yield curve shapes to guide the economy; we do need to limit  the amount of excess liquidity in loosening, lest we get asset bubbles.

This would all be easier to handle if the Fed had been clean during the boom.  They were anything but clean, loosening too soon, tightening too late, and being lax in regulating underwriting.  (Note: what miscreants has the Fed fired due to incompetence?  If they fired no one, then the incompetence goes to the top, and the entire Board of Governors should be cashiered.  And if they are not cashiered, let us move on to the politicians who hide behind the Fed and eliminate them.  Perhaps we should adopt a rule of our own: if incumbent, then vote him down.)

The Federal Reserve has not shown that it is worthy of retaining the freedom that it thinks it has.  Please let them show me instances where they did something bold, and received political criticism.  No, they have not done so.  They are slaves to the existing system, and will not speak truth to power.  They cravenly demand freedom, while they love their bondage to the political establishment.

My view is this: scrap the Fed.  Since we are not ready for a commodity standard as a nation, put into place a new Fed.  Fire all of the economists.  Let the new Fed adopt my neo-Wicksellian rules, which are a lot more flexible than Friedman’s baseless dogma, and more market-based.  Here are the rules again:

  • If the 3-month T-bill yield is more than 2% lower than the 10-year T-note yield, tighten Fed funds.
  • If the 3-month T-bill yield is more than 1% higher than the 10-year T-note yield, loosen Fed funds.
  • When in doubt, set Fed funds rate such that the gap between the 10-year and 3-month T-bill to 0.5%.

The Fed does not need a big staff to pull all of this off.  They could get by with a core staff of a few hundred, and however many are needed to do bank underwriting supervision.  Also, the Fed should disclaim responsibility for the economy, and simply focus on price stability.  No more bailouts.  If a bailout should be done, let Congress pass it, that they might be praised or judged for their wisdom once every two years.

The Fed led us into this mess.  That they ask to lead us out is a rude joke.  Please, let us get a totally new cast of characters at the Fed, or eliminate it and replace it with a commodity standard or a currency board.  This Keynesian stuff is killing us slowly, and leading to an eventual US sovereign crisis, which will lead most of the world into a deep recession, if not a depression.

Why do we have credit ratings?  What are the main reasons they exist?

  • To provide profits to those that rate credit.
  • To provide credit standards for regulators and creditors (shame on you, do your homework) that can’t judge credit risk.
  • To allow debtors to easily issue debt; simplifying the pricing decisions of creditors.
  • Providing quantitative and qualitative analyses of  new and existing debt issues, particularly small ones where it could not be economic for an asset manager to do his own analysis.

But credit ratings don’t exist for perfection.  Rating agencies are encouraged to rate new structures and new collateral types, whether they have good data or not.  Regulators need a rating for any asset they allow, and new asset classes should be viewed skeptically by analysts.

Applied to the Present

The standards proposed in the current finance reform bill don’t go far enough.  The existing bill allows for ratings shopping.  A better way to do it would be to allow the Credit Rating Agency Board to veto ratings of those that are too aggressive.  The CRAB could set real standards for structured lending, and perhaps, push back against the continued downgrade in ratings standards.  There would be competition to meet the standards of the CRAB, and of the originator at the same time.

Now this could eliminate securitization, and that is not all bad.  Accounting rules should not affect economic actions.  If accounting rules do affect economic  actions, it means there was something wrong with either or both of the starting and ending accounting rules.  And better that lenders keep the results of their lending decisions.  In a levered economy, it is best for lenders to eat heir own cooking; it keeps things sane.

Securitization should only exist to the degree that parties that are more willing to take on illiquidity and credit risk do so, with fair compensation for the risk that they bear.  There is no free lunch; just because there is a rating, it means you should believe it?

Caveat Emptor! should be on the wall of every house and business.  Let the Buyer Beware! Regardless of how many government agencies or politicians pretend to protect you, you are your own best and most reliable defender.

Do your homework, and don’t buy complex instruments that you don’t understand.  Don’t buy simple instruments of simple comanies that you don’t understand.

When rates are low, we struggle to find income.  Be conservative if you can be.  You are your own best defender.


The above graph is lovingly culled from AIG’s 10-Ks for the past 23 years.  It tells an amazing story, in my opinion, and you will get my view of AIG’s reserving.  I am somewhat biased because I worked for AIG from 1989-1992, and some of that bias is expressed in the paper I wrote on AIG’s operating insurance subsidiaries, in the first three pages.

A key figure in reviewing reserving is how much a company increases or reduces reserves due to claims from business written in prior years.  Good companies set initial reserves conservatively, and slowly adjust reserves downward as  time progresses, and claims emerge below estimates.

What’s that, you say? Doesn’t GAAP require reserves to be best estimates?  Well, yes, technically it does.  But no one, not even the actuaries internal to P&C insurers or reinsurers can be truly certain about what the best estimate is.  Thus, investors in insurance companies have to be confident that the management teams are being conservative, or at least neutral in their judgment on reserves.

But here is the reserving story on AIG: up until 2000 AIG generally released reserves for the business written in prior years.  Toward the end, they probably released more than they should have.

AIG was one of the consummate growth companies in the financial space in the 1990s.  It grew faster than most financials, and did not lose luster during the dot-com era.  Indeed, its price only peaked in early 2001, shortly after reporting their annual earnings.  After that, AIG went from being a growth stock to being a non-growth stock, and its P/E multiple fell.

Now, perhaps AIG goosed its earnings by setting reserves too low in the late 90s.  That is possible, and it may have led to the need to restate reserves higher in 2001-2002.  By 2002, all of the reserve releases of the past 15 years were wiped out.

In the investment community 2002 was a “big bath,” where AIG took significant one-time losses to reset its balance sheet and continue its growth.  But it was not enough. 2003 and 2004 had continued strengthening of reserves for past business written.

In 2005, Greenberg was shown the door, and Martin Sullivan took over.  The 2005 restatement of reserves for business written prior to 2005 was huge.  I suspect Martin Sullivan was trying to clean things up.  Maybe it worked; in 2006 and 2007, they released excess reserves.

In 2008, there was a small degree of reserve strengthening, but nothing compared to the other problems at AIG.  In 2009, strengthening was significant, possibly reflecting new efforts to clean up, or perhaps like my comment in the paper I referenced above:

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.

One final note on the table: 2004 and after, AIG adjusted their prior year incurred figures for foreign exchange fluctuations, and interest that needed to be accrued, because they discounted their reserves.  Those factors should not make a ton of difference to the 2003 and prior years.  Magnitudes might change but the overall story will not change.

Summary of AIG’s Behavior

There came a point in the life of AIG, in the late 90s, where management pushed reserves to be less conservative.  By 2003, the ruse was obvious, and though AIG was added to the Dow Jones Industrial Average, the stock never attained to its 2001 highs.

Possible Policy Advice

The process of P&C reserving, after reviewing the results of AIG almost begs to have a valuation actuary statute for P&C companies the way companies do, but for a different reason.  Life companies do stress tests on cash flow mismatch, credit sensitivity and more.  It’s a confidential document that the regulators can look at, but the public can’t.

For P&C companies, the actuaries would have to spell out their valuation methods down to all of the major parameters and methods by line of business, and then roll them forward from the last year in order to show the effects of parameter changes, method changes, and adverse or favorable development.

I can hear the squealing from P&C companies now.  That said, my peers in Casualty Actuarial Society would send me a box of chocolates for the new “Actuarial full employment act.” ;)  File a GAAP version confidentially at the SEC; then have the SEC hire a staff of Casualty Actuaries to review the filings in detail, and offer suggestions for dealing with egregious violators.

That’s what it would take to get reserving for P&C companies straightened away.  I could suggest it to the SEC/NAIC, but they aren’t that concerned about reserving at present because most companies seem to play fair.  AIG did not, and perhaps still does not play fair in this area in my opinion, but they were an outlier in the industry that got special treatment because of their size, complexity, and seeming success.

Final Summary

AIG was an outlier, but that does not mean it can’t teach us a few things.  First, don’t trust P&C reserving, particularly of big companies.  Second, look to see if management teams reserve conservatively — do they release reserves consistently year after year?  (Which means they set reserve high for the current year’s business.  Tough to do, because setting reserves low on the current year’s business is the easiest way to show good profits in the short run.

Third, someone paying attention to reserve strengthening would have exited AIG in 2003 or 2004, after two or three large reserve strengthenings. This brings up a subsidiary point.  M. R. Greenberg is responsible for the trouble that occurred at AIG, not Sullivan, or anyone that followed.  The huge reserve adjustments occurred under M. R. Greenberg’s watch, not anyone else.  He encouraged the growing derivatives book because it aided AIG in making its earnings numbers through seemingly free yield from writing protection.

So, no, prior to 2000, AIG was probably not underreserved.  After that, it most definitely was underreserved.  Today?  Who can tell?  Ask me in a few years.

fed's balance sheet

fed's balance sheet

The image above is borrowed from this blog post at The Wall Street Journal.  Here’s my main point: the Fed is not succeeding in reducing the size of their balance sheet.  They are happily letting it grow, buying more mortgage backed securities, more than are paying off or defaulting.   The Fed’s balance sheet is now at a record size.

I have argued in the past that the Fed is not likely to remove stimulus prematurely.  We have the bad providence that Ben Bernanke is Fed Chairman, and has the wrong view of the Great Depression, and also the wrong view of monetary policy.  He will leave rates low for too long, and buy long duration assets for the Fed, and be reluctant to sell them.

In absence of a commodity standard (which would be a very good thing), monetary policy should act to preempt high growth in debt.  If debt across the economy is growing at more than twice GDP growth rates that is a time to raise rates, and make it hard to borrow.  I realize at a time like now, this makes no sense, but had we adopted it in the 70s or 80s we would not have the present crisis.

In a fiat money/credit world, evil as it is, monetary policy is credit policy.  The issues become clear at the bust, but the prescriptions work best before the boom starts.

The Fed always delays trouble in the modern era.  Slow to tighten, quick to loosen.  No wonder that we built up a mountain of debt, because the Fed would always ride to the rescue of crises, but never let the pain settle in that would liquidate poor investments.

We need fewer banks, fewer homebuilders, and fewer auto companies.  But guess what we bailed out?  We bailed out the very things that were the least productive in our economy, and taxed those more productive to do so.  Monstrously dumb.

So when the market corrects because there has been no effective change in economic policy that would allow for elimination of bad debts, and shrinkage of bloated industries, we should not be surprised.  Government stimulus can only do so much.  The markets incorporate the stimulus, and they move on.  Those stimulated gain, and taxpayers/moneyholders lose, but the markets move on.

In the two-dimensional Fed where they offer credit to banks, and buy long assets as well, the Fed can’t be considered to be tight when the Fed funds rate is under 1/4%, and they are still sucking in long duration paper.  The Fed is engaged in an operation to support asset prices, which may fail when goods prices begin to show some life, regardless of whether the CPI agrees or not.

Monetary policy needs an anchor like gold, and people need to stop looking to the government for prosperity; the government can do little to achieve prosperity, aside from laying down a consistent set of rules.  Prosperity is in the hands of the culture, and productive cultures that take on little debt will tend to be prosperous.

And Now For Something Slightly Different

While I’m on the topic of monetary policy, what if the money markets are beginning to run ahead of the Fed?  Look at this:

Money markets rising?

Money markets rising?

There are 3 components to the Treasury-Eurodollar [TED] spread:

  1. The orange line is the LIBOR slope: 3 month US Dollar [USD] LIBOR minus overnight USD LIBOR.  LIBOR is a rate that banks will supposedly lend to each other at unsecured for short amounts of time.  As the LIBOR slope gets higher, banks are less willing to lend to each other.
  2. The yellow line is the Overnight LIBOR gap: it is overnight USD LIBOR minus the Fed funds target.  This measures how much banks need overnight money through sources outside of Fed Funds.
  3. The green line is called the Fed spread: it is the Fed funds target minus 3 month T-bills.  It measures how tight Fed policy is versus the ability of the US government to fund itself on the short end.

Now the current move is small, so far.  Banks are showing slightly more need for funding versus Fed funds, and since the crisis in the Eurozone intensified, the costs of borrowing longer in the Eurodollar market have risen.  But there isn’t the grab for safety, when T-bills go to zero, at least, not yet.  And contrast the last year with the last five years:

money markets panic

money markets panic

Panics aren’t pretty. They also start small.  I’m not saying that this must turn into a money markets panic, but only that it is possible.  There is a budding distrust in the Eurodollar lending markets, and that could spill into the short term lending markets in the US, though the effect should be less than in the Eurozone, where distrust is building across national borders.  Many banks implicitly say, “Better to have assurance regarding getting our money back if we need it, than be at the mercy of another nation’s laws.  Who knows if this grand experiment of the EU and the Euro will really last?”

Two Experiments

The Euro is an experiment, but so is unbacked paper money.  Both are undergoing a lot of stress at present; it will be interesting to see if either survives.

What if securitization allows the economy to expand more rapidly than it would at a price of volatility, when intermediaries would prove useful?

Sometimes securitization and tranching creates securities for which there is no native home.

As the life insurance industry shrinks, it will be hard to find buyers for subordinated structured product.

Securitization is an interesting phenomenon.  Take a group of simple securities, like commercial or residential mortgages, and carve the cashflows up in ways that will appeal to groups of investors.  Do investors want ultrasafe investments?  Easy, carve off a portion of the investments representing the largest loss imaginable by most investors.  The remainder should be rated AAA (Aaa if you speak Moody’s).  Then find risk taking parties to buy the portion that could suffer loss, at ever higher yields for those that are willing to take realized losses earlier.

What’s that, you say?  What if you can’t find buyers willing to buy the risky parts of the deal at prices that will make the securitization work?  Easy, he will take the loans and sell them as a block to a bank that will want them on its balance sheet.

That said, securitized assets are typically most liquid near the issuance of the deal, with the short, simple and AAA portions of the deal retaining their liquidity best.  Suppose you hold a security that is not AAA, or complex, or long duration, and you want to sell it.  Well, guess what?  Now you have to engage in an education campaign to get some bond manager to buy it, or, take a significant haircut on the price in order to move the bond.

It helps to have a strong balance sheet.  If the credit is good, even if obscure, a strong balance sheet can buy off the beaten path bonds, and hold them to maturity if need be.  And yet, there is hidden optionality to having a strong balance sheet — you can buy and hold quality obscure bonds, but if thing go really well, you can sell the bonds to anxious bidders scrambling for yield, while you hold more higher quality bonds during a yield mania.

Endowments, defined benefit pension plans, and life insurance companies have those strong balance sheets.  They do not have to worry that money will run away from them.  The promises that these entities make are long duration in nature.  They have the ability to invest for the long-run, and ignore short-term market fluctuations, even more than Buffett does, if they are so inclined.

If there was a decrease in the buying power of institutions with long liability structures, we would see less long term investing in fixed income and equity investments.  Investments requiring a lockup, like private equity and hedge funds, would shrink, and offer higher prospective yields to get deals done.


But what of my first point?  There are securitization trusts, and there are financial companies.  During a boom phase, the securitization trusts can finance assets cheaply.   During a bust phase, the securitization trusts have a lot of complicated rules for how to deal with problem assets.  Financial companies, if they have adequate capital, are capable of more flexible and tailored arrangements with troubled creditors.  Having a real balance sheet with slack capital has value during a financial crisis.  Securitization trusts follow rules, and have no slack capital.  Losses are delivered to the juniormost security.


Sometime around 2004, a light went on in the life insurance industry regarding non-AAA securitized investments.  In 2005, with a few exceptions, the life insurance industry stopped buying them.  AIG was a major exception.  The consensus was that the extra interest spread was not worth it.  Fortunately for the investment banks there were a lot of hedge funds willing to take such risks.

There should be some sort of early warning system that clangs when the life insurance industry stops buying, and those that buy in their absence have weaker balance sheets.  When risky assets are held by those with weak balance sheets, it is a recipe for disaster.


During the boom phase, securitization trusts provide capital, cheaper capital than can be funded through banks.  That allows the economy to grow faster for a time, but there is no free lunch.  Eventually economic growth will revert to mean, when securitizations show bad credit results, and the economy has to slow down to absorb losses.

In addition, when losses come, loss severities will tend to be higher than that for corporates.  Usually a tranche offering credit support will tend to lose all of its principal, or none.  (Leaving aside early amortization and the last tranche standing in the deal.)  For years, the rating agencies and investment banks argued that losses on securitized products were a lot lower than that for corporates, because incidence of loss was so low on ABS, CMBS and non-conforming RMBS.  But the low incidence was driven by how easy it was to find financing, as lending standards deteriorated.

Thus, securitization allowed more lending to be done.  First, originators weren’t retaining much of the risk, so they could be more aggressive.  Second, the originators didn’t have to put up as much capital as they would if they had to hold the loans on a balance sheet.  Third, there were a lot of buyers for higher-rated yieldy paper, and ABS, CMBS and non-conforming RMBS typically offered better yields, and seemingly lower losses (looking through the rear-view mirror).  What was not to like?

What was not to like was the increased leverage that it allowed the whole system to run at.  Debt levels increased, and made the system less flexible.   Investors were fooled into thinking that assets were worth a lot more than they are worth today because of the temporary added buying power from applying additional debt financing to the assets.


Securitization has been a mixed blessing to investors.  It is brilliant during the boom phase, and exacerbates trouble during the bust phase.  And so it is.  As you evaluate financial companies, have a bias against clipping yield.

Regulators, as you evaluate risk-based capital charges, do it in such a way that securitized products get penalized versus equivalently-rated corporates.  Just add enough RBC such that it takes away any yield advantage versus holding it on balance sheet, or versus the excess yield on equivalently rated average corporates.  It’s not a hard calculation to run.


Off-topic end to this post.  I added Petrobras to my portfolio today.  Bought a little Ensco as well.  I haven’t been posting as much lately since I was busy with two things: studying for my Series 86 exam, which I take tomorrow, and I gave a presentation on AIG to staff members on the Congressional Oversight Panel the oversees the TARP yesterday.  Good people; they seemed to appreciate what I wrote on AIG’s domestic operating subsidiaries last year.

Full disclosure: Long PBR ESV

Prepayment and default are dual to each other.  The less likely is default, the more likely is prepayment, and vice-versa.

In a pool of loans, the critical distinction is the likelihood of loans to prepay or default.  Just because prepayment has been high, does not mean the remainder won’t default under stress.

I don’t have clear answers to Maiden Lane LLC, the bailout of Bear Stearns yet.  The complexity of Maiden Lane LLC, as compared to Maiden Lane 2 or 3, is enormous.  I have a more work to do.  But, at least, I have scrubbed the data, and figured our what the Fed released to us.

In the Bear Stearns bailout, the Fed received a wide variety of securities, including:

Comm RE WLs
CRE Notes
Agency pools
Agency MBS
Res Re WLs
CDS Corporate
CDS CRE Securities
CDS Municipal
Interest Swaps

Maiden Lane 2 & 3 were simple compared to this, and this had over 10x the securities of both combined. Plus, this had CDS transactions which would profit from failure of a wide variety of assets.

Additional difficulties included a lot of coding difficulties on the CDS.  The Fed did not try to make things clear.  I spent many hours trying to clarify the tranches in question.  A few of them are guesses, but 99% are reliable.

The Fed’s principal figures were original principal figures not those for current principal.  That was another area of ambiguity.

After all that, here is my breakdown of the assets by original principal:

original principal

And, here is my breakdown of the assets by current principal:


The current value of what is owed to the Fed is over $28 billion.  There is almost $49 billion in current principal, so why worry?

Worry because of all of the interest only securities.  The principal for them is notional; principal payments will never be made.  With CMBS, I know that IO securities are typically worth no more than 5% of the notional principal balance.  Because most CMBS protect against prepayment, the prices of interest only securities reflect  the likelihood of default.  Though they are rated AAA, their creditworthiness is more like BB.

With Residential mortgages, the question is harder.  How big is the interest margin, and when might it cut off due to default or prepayment?  Interest only securities are typically worth a lot less then the  notional principal.  Same for principal only securities.  Their value is the likelihood of payment discounted by the length of time until payment.

Beyond that, there are the residential and commercial loans made, with almost $10 billion of principal, for which we have no idea of the creditworthiness.  Are there any statistics on the currency of the collateral?  The Fed had not deigned to tell us.  I place the creditworthiness at BB, but who knows for sure?

I can tell you now that the securities involved were mostly originated 2005-2007, during the worst of the underwriting cycle.  Is it any surprise?  Few can escape the credit cycle.  Within a given credit cycle, the credit quality of securities originated declines all of the way till slightly past the peak of the credit cycle.

I am going to do more analysis of the RMBS, so that I can get a better feel for the value there.  It is not clear to me whether Maiden Lane LLC is adequately funded or not.  The high degree of junk, whole loans, and interest only securities gives me doubt.

One thing that I do differently than most investors is the concept of rebalancing.  I buy and sell positions to maintain their weights in the portfolio, within a 20% band around the intended weight.  As I wrote about it at RealMoney:

The two smaller purchases were done for a different reason than the other trades. I already owned Petrobras (PBR:NYSE) and Dycom (DY:NYSE) , but both had been performing badly. Their weight had shrunk to be the smallest in my portfolio. After a review of their fundamentals, I did what I call a rebalancing trade.

When I interviewed fund managers, I would often ask how they would rebalance positions in response to market movements. Many of them would do nothing; others had no fixed strategy. However, three of them had really worked on refining their strategies, and to my surprise, their outcomes were similar — even though other aspects of their styles were different. One was value, one was growth, one was core, but they each had evidence that their approach improved their returns by a few percent per year. That caught my attention.

One cost of trading comes from whether a trade demands or supplies liquidity to the market. When a trader posts a limit order, he or she offers other market participants an option to exchange shares for liquidity at a known price. In offering liquidity, the trader hopes to get an execution at a favorable price.

The approach that the three managers use — and that I employ in my personal account — is as follows:

  • Define a series of fixed weights for the stocks in the portfolio.
  • Do a rebalancing trade when any position gets more than 20% away from its target weight. The 20% figure is arbitrary, but I think it strikes a balance between excessive trading and capturing reasonable trading profits by providing shares and liquidity to the market when it wants them.
  • Use this time as an opportunity to re-evaluate the thesis on the stock. If the thesis is no longer valid, exit the position and buy something that you like better.
  • If the rebalancing trade generates cash, invest the cash in the stocks that are the most below their target weights, to bring them up to target weight.
  • If the rebalancing trade requires cash, generate the cash from selling stocks that are the most above their target weights, to bring them down to target weight.

This discipline forces you to buy low and sell high and to re-evaluate your holdings after significant relative market movement. This method works best with companies that possess low total leverage relative to others in their industries. This helps avoid the problem of averaging down to a huge loss.

It also works best for diversified portfolios with 20 to 50 stocks, with reasonably even weights. In my portfolio, the weights range from 3% to 7%, with 33 companies altogether.

The incremental profits add up as companies and industries fall in and out of favor, and the rebalancing system buys low and sells high.

Now, one aspect of this that I did not write about at RealMoney is that it saves on taxes.  In a very volatile market, like we have had over the last three years, and that we had 2000-2004, there were a lot of opportunities to buy low.  Now for someone like me, who runs with 30+ positions, a sharp move down and up feels like this:

  • At the start of the move down, I have realized and unrealized capital gains.
  • As the move down proceeds, I have realized gains but no unrealized capital gains.  I have redeployed  money into defensive industries, or, at least stocks that are undervalued.
  • Further into the move down, I have no realized gains and and I have unrealized capital losses.  I am still redeploying money into defensive and cheap investments.
  • Still further into the move down, I have realized losses and and I have large unrealized capital losses.  At this point I should be moving into economically sensitive names, and add cyclicality.
  • I may have to do that twice, or even three times, but eventually a bottom comes.
  • As the move up begins, I have realized losses and unrealized capital losses.  As I sell stocks to reinvest in better companies, I sell stable names to buy cyclical ones.  As stocks hit my upper rebalancing points, I sell high tax cost lots, and hold onto the low tax cost lots.  My realized losses grow.
  • As the move up continues, I have realized losses and no unrealized capital losses.  I continue to sell high tax cost lots of companies that have hit my rebalancing points.
  • Further into the move up, I have no realized losses, and unrealized capital gains.  My rebalancing and other sales are now creating small gains.
  • Still further into the move up, I have realized gains and large unrealized capital gains.  I then look for my largest unrealized long-term capital gains in stocks that I would like to sell, and donate them to charity.  Fidelity Investments makes that very easy.  After the year end, I repeat that process.  The advantage is that I don’t get taxed on the capital gain, and I get a full tax deduction on the market value of stock donated.

I do almost all of my charitable giving via appreciated stock.  It works well.  Given the volatility of the markets, for those that have a diversified portfolio, and a dedicated reason to give to charity, it is a free lunch.  I marvel each  year at the ways that I eliminate capital gains, while still managing to make good money in stocks over the long haul.

This is a book about Harry Markopolos, who is the author of this book.  He talks about how he attempted  for years to expose the fraud that was Bernie Madoff.

The book takes the following form (from my view of how the author sees it):

  • How he came to a quick conclusion that Bernie Madoff was a fraud.
  • How he tried to convince others of that view, especially those that were feeding more money to Madoff.
  • Two journalists took his side and wrote about Madoff in 2001 or so, but to no avail.
  • Trying to come up with a similar strategy that would work, though it would return much less than Madoff’s supposed returns, and finding few would invest in it.
  • Fruitless wranglings with the clueless SEC.
  • Finally, in 2009, Madoff blows up.
  • Vindicated, he talks to the media, Congress, and anyone who will listen.
  • He excoriates the toothless SEC, and proposes better ways to root out financial fraud.

That’s the book in a nutshell.  But stylistically, the book harps on how no one would listen.  Well, duh.  No one did listen, or the book would have been over sooner.

People are not Vulcans.  They aren’t logical.  Most don’t think; instead, they mimic.  “If it works for him, it will work for me also.”

That was the case with Madoff.  He maneuvered many sheep into position to be fleeced, and worse, they begged for the privilege to be his clients.

There were many red flags flying:

  • No independent custodian
  • No independent Trustee
  • Small Auditor, incapable of auditing such an enterprise.
  • Returns were too smooth for being so high.
  • The asset size was to large for the markets supposedly employed.
  • Even front-running profits would not be enough, were Madoff to do that.
  • No profit motive.  Other managers with lesser track records charged more.
  • Marketing was by invitation.
  • Investors were sworn to secrecy.
  • And more, read the book.

Markopolos saw all of this, and ten years before it all blew.  All that said, I came away less than fully impressed with Harry Markopolos.  When I counsel people in trouble, I often tell them, “Don’t let the one who troubles you define your life.  You should be living for more than to see the one who troubles you punished.”  Markopolos triumphed here; good for him.  But many people in similar situations become fixated on seeing the enemy punished, and ruin their lives, focusing on punishing another, rather than doing good themselves.  There is a proper humility that should come to many of us when we can’t prove something beyond a shadow of a doubt, where we must give up.

My view is that Markopolos should have given up earlier, even though he succeeded in the end.  I have known too many people who have destroyed their lives on similar quests.  Good for Harry that he succeeded, but it was more likely that he would have ended up destroying his life.

And do I need more proof than that he had a plan to kill Madoff if Madoff threatened to kill him?  Throughout the book, there is no indication that Madoff would try to kill his enemies.

This was a book that needed a strong editor.  Much as I liked it because I appreciated the tale of the rise and fall of Madoff, someone needed to grab control of the narrative, and make it less personal for Mr. Markopolos.

Then again, if that had happened, the book would have been better written, but less colorful.  Hearing the off-color remarks of Mr. Markopolos is entertaining, if off-key.

With all that I have said here, I strongly recommend the book.  The best part of the book, though the least graphic, is the last chapter, where he recommends solutions, all of which I think make eminent sense.

If you want to buy the book, you can buy it here:  No One Would Listen: A True Financial Thriller

Who would benefit from this book

Most average investors could benefit from the book.  What it would point out to them is that if something seems to good to be true, it usually is, and that they should do their own due diligence.

Full disclosure: The publisher e-mailed me, and I requested a copy, if they had an extra one.

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