The Education of a Corporate Bond Manager, Part VI

After 9/11, and and before the merger was complete on 9/30/2001, our investment team got together and came to an unusual conclusion — 9/11 would have little independent impact on the credit markets, so be willing to take credit risk where it is not well-understood by the market.  We bought bonds in hotels, airplane EETCs (A-tranches), anything having to do with confidence in the system at that time.  I consciously downgraded our portfolio two full notches from September to November.

I went to a Chief Investment Officer’s conference for insurance investors in October 2001.  What I remember most is that we were the only company being so aggressive.  In a closed0-door meeting, the representative from Conseco told me I was irresponsible.  To hear that from a company near bankruptcy rang the bell.  I was convinced we were on the right track.

By mid-November, we had almost completed our purchases of yieldy assets, when I received a phone call from the chief actuary of our client expressing concern over the credit risks we were taking; the rating agencies were threatening a downgrade.

Well, what do you know?!  The company that did not understand the meaning of the word risk finally gets it , and happily, at the right time.  We were done with our trade.

We looked like doofuses for three months before the market began to turn, and I began a humongous “up in credit” trade as we began to make a lot of money.  By the time I was done in early June, I had upgraded the whole portfolio three full notches.  A great trade?  You bet, and more.  What’s worse, it was what the client wanted, but not what it should have wanted.


What should my client have wanted?  Interest spread enhancement with loss mitigation.  That is the optimal strategy for life insurers.  We were ready to do that, but at a meeting in late September 2001, the client said, “The management of assets for this company has been lazy; there is not enough trading.  We want to see the highest returns possible; give us total returns!”

I tried to explain why that was not the best way to manage insurance assets.  After all, I had been doing this for ten-plus years, and knew the difference between current GAAP accounting and long term sustainable GAAP accounting.

The CEO told me that I knew nothing at all, and that portfolio management needed to be active.  Activity meant more profits.  I told him that he was wrong, and was rudely cut off.  I did not go back to that argument.

After we had a few inconsequential defaults, the client complained loudly.  This was an ignorant client that did not recognize reality.  Defaults are a fact of life; if you run with your capital base so thin that you can’t take a few modest defaults, you are running your insurance company wrong.

As it was, the emphasis on trading did generate capital gains initially, the portfolio began with unrealized capital gains.  But the company took the capital gains to be “free money,” used them as new capital, and began writing more underpriced aggressive insurance/annuity policies.

But then, as capital got tight, the chief actuary came to me saying that they needed to do a financial reinsurance treaty to raise capital for the firm.  I replied that we did not have many bonds with an above market yield.  We had the Prudential
“C” bonds that I mentioned earlier
, and a few more, but not a lot more.  I scraped together what I could, culling the best bonds from the portfolio, realizing that the remainder would be decidedly subpar.  You could say that they hocked the “family silver.”

They did the reinsurance deal over my objections, which technically did not meet the stipulations of the state regulations, and gained more capital to write business against.  There was a cost, though.  We could not sell any of our best bonds, and the regulatory profits of the firm would now be flat to negative.

I did my best to aid their business goals, finding weaknesses in the risk-based capital formulas, and managing the interest rate posture of the company to near-perfection, all of which reduced capital needs.  But when you are running a company that is addicted to making sales, even if the sales are only marginally profitable, and not covering the cost of capital, that is the path that matters will take.

Would that they had listened to me, but they were arrogant.  What price did they pay for their arrogance?

  • The company CEO was encouraged to retire.
  • The CFO and Chief Actuary had to leave.
  • The parent company CEO was forced to resign for all of the money he had plowed into that loser of a subsidiary in the US.
  • The company was put up for sale, but given the dubious operating history, bidders were few and reluctant to spend much.

Any successful insurance enterprise needs bright managers on both sides of the balance sheet.  Bright managers of the assets, and issuers of policies that don’t give away the store.


PS — I had one bond that was a high interest second-lien loan on one of the most valuable buildings in Baltimore.  At the time, the equity owner of the building called me, and made me a lowball estimate to pay off the loan, a few months before it would spring to first lien status.  I politely told him “No way,” and named a considerably higher price at which I would consider a buyout.  He told me that I was ridiculous, and I said “Fine, but I have read the agreements, and know our rights.”

He then called the client, and made the same offer.  They pestered me to deal with him, and I explained how he was wrong, and that the price should be much higher.  They agreed with me, and that was put to rest… until I left the firm, and the equity own got the deal done, paying up a little more, but by no means what he should have.

As I said many times regarding my client, “You can’t teach a Sneech.”  Sad but true for many who don’t understand investing.