Evaluating Regulated Financials

Dear readers, I repost here an edited version of what I shared with a Linked-in group:


I took Benefit-Cost Analysis from Dr. Hanke of Johns Hopkins in 1980, and so I never gained the benefit of his current proprietary tweaks to the Discounted Cash Flows model for stock valuation.  That said, application of DCF to any regulated financial company is difficult, because not all of the capital is free to be deployed into investment in new business, stock buybacks, or dividends.

The level of required capital at a regulated financial varies with the risks of the blocks of business (liabilities) that it underwrites, the assets they buy with the proceeds from the liabilities, and the cash flow, currency and other mismatches between the assets and the liabilities.

The marginal amount of capital for new business and investments may be significantly different than what is required for old business.  So here is my question to the group, especially the students, to think about: how would you apply your DCF model to a situation like this?

Notes, Mostly on Financials

Three final notes: 1) If you want to experiment with this, here are five very different insurers that are my current favorites: RGA (life reinsurance), ENH (P&C insurance & reinsurance), AIZ (Life, P&C, Warranties, Pensions & Individual Health), SFG (disability), & NWLI (Life insurance and annuities sold to foreigners for flight capital).  Try applying the model to one, and see what you get.

2) Most real risk in large financials does not come from inadequacy of capital, but from borrowing short and investing/lending long.  The key measure is whether an institution has enough high-quality short-term assets to meet a run on the institution, where those that supply funds to the institution demand them back at the same time.

With life insurance companies, failures occasionally happen from a run on the company (General American and ARM financial in 1999), but more often, because regulators think the capital base has shrunk too much because of bad credit risks, and take the company into conservation. (Pacific Standard, Confederation, Kentucky Central, near-miss w/The Equitable, etc.)

With P&C insurers and reinsurers, failure happens because bad underwriting leads to a shrinkage of capital, and the regulators take them into conservation. (Think of Reliance and Saul Steinberg, though a lot of reinsurers were de facto bankrupt in the mid-1980s, but the regulators didn’t catch them.)

With small banks and thrifts, it’s credit problems versus capital.  Liquidity does not usually play a role because of deposit guarantees.

With large banks, it is illiquid and longer assets versus short financing.  In the recent crisis, much of that came from financing mortgage inventories in the repurchase market, where financing had to be renewed daily, and margin requirements in derivative financing that had to be adjusted daily.  In the latter case, a credit downgrade would trigger a need for more capital to be put up as margin, just at the time when liquidity was scarce.  In the former case, deteriorating prices for the assets financed in the repurchase market led to an increase in the capital haircut, requiring more liquidity out of the borrowers at the time they could least afford it. (AIG, Wachovia, Countrywide, etc.)

Finally, remember that the financial markets are talkative.  No one wants to hold unsecured credit from a bank they think will go broke, so if there is a reasonable doubt on failure, liquidity dries up because other banks stop dealing with you (Bear Stearns, Lehman Brothers, Merrill Lynch, etc.)

As an example in my own life, back when I managed and traded corporate bonds back in 2002, when the market was feeling a lot of stress, I joked with my broker, “Hey, is XYZ Corp trading flat yet?”  (With most corporate bonds, when you settle a trade, the pro-rata portion of the next interest payment is added to the price.  A bond like XYZ Corp, when its solvency is doubtful, the dealers start settling bond trades assuming it will not make another payment.)  He told me that it was not trading flat.  The high yield manager, Ed, sitting next to me, after the call ended said, “Just a matter of time.”

Half an hour later, my broker that talked with before called me back, and in an edgy voice said “XYZ Corp is now trading flat!” and quickly ended the call.  Ed looked at me and said, “Dave, don’t do that again.”

Liquidity is plenteous when you don’t need it, and scarce when really needed.  Remember that when investing in financials.

3) The Baltimore CFA Society gives significant discounts for students that want to attend our meetings.  $10 gets you a $30 meal and an interesting speaker or two, so consider yourselves invited.  Next meeting on January 11th is one of our bigger ones.  You even get to meet the aforementioned “Ed.”

Full disclosure: long RGA, AIZ, NWLI, ENH, SFG


  • Greg says:

    Stamford (Connecticut) CFA Society tried the same deal with students — offering them better deals than actual dues paying members. As this ultimately backfired … there was some finger pointing that Charlottesville (CFA Institute headquarters) had actually “ordered” local societies to favor students over dues paying members.

    Whomever’s idea it was: the end result was a drop in attendance. I am sure there were other mitigating factors, but its a serious insult when you tell members that they have to pay more.

    Being CFA’s, dues paying members can quickly figure out the real reason for favoring students: CFA Institute wants to attract more people to take (and fail) the exams, which are huge money makers for CFAI. And if possible, get the suckers — err, um, students — to pay for exam prep classes.

    CFA Institute has lost its focus and has (at least) twice stuck their middle finger up at NYSSA and Boston societies.

    Like many bureaucracies, the Charlottesville staff see themselves as more important than the membership they are supposed to serve.

    That is why Baltimore (and many societies) are having membership involvement troubles. Who wants to pay money to hear how “we” (excluding Charlottesville) have ethics problems, while they (Charlottesville) operate a pyramid scheme and bad-mouth members?

    Fix that, and local societies won’t have to pay students to come to meetings. Students will actually *want* to attend

    • Dear Greg,

      It has worked differently for Baltimore CFA. We get students, and they enliven some of our meetings. We’ve been growing in our membership as well, up significantly over the last year.

      This is my opinion — though I am on the board of the Baltimore CFA society, this does not speak for them: Baltimore CFA Society has usually been a little skeptical with respect to the CFA Institute. The level has varied over time; we were one of the few large-ish societies to oppose mandatory CE.

      We are doing well in Baltimore. We find our strength in facilitating local entities that are growing, And we ally w/the other Eastern US societies against centralizing tendencies.

  • Greg says:

    David, I do not mean to discredit students or minimize their potential contributions to local CFA societies or the profession.

    The issue is whether a bunch of ethically compromised bureaucrats in Charlottesville (or Washington DC) should decide what is best for THEMSELVES and then force their decision on the people they supposedly work for.

    I am not sure I follow your definition of “large-ish societies”. The two largest CFA societies in the world, by an enormous margin, are the NYSAA and the Boston CFA Society. Those two represent something like 45% of total CFAI membership. The percentage was a bit over 50% when CFAI bureaucrats wanted to force documented mandatory CE on members.

    Both NYSSA and Boston told then CFAI president Tom Bowman that mandatory CE was a terrible idea and they would not even pretend to support it. Mr Bowman was an employee, not a monarch. He was absolutely out of line to force his opinions on a membership that did not agree. You may recall that CFAI bureaucrats did not publicize the voting results (they were available if you looked for them).

    Membership overwhelmingly rejected extra paperwork intended to create bureaucrat jobs in Charlottesville .. because that is what mandatory CE is all about.

    CFA members already spend many hours staying up to date with financial models — far more than what CFA bureaucrats were proposing. Mandatory CE would not increase education or knowledge.

    It would create a lot of extra paperwork — and monitoring “jobs” in Charlottesville. Since the crooks in Charlottesville would decide what CE was acceptable, it would give them the power to mandate attendance at overpriced CFAI conferences — or else members would lose the designation they worked so hard to get.

    In short, mandatory CE was an extortion plot by central bureaucrats. A super majority of CFAI membership saw it as such and rejected it.

    Several local societies that had (past tense) active membership, now are lucky to have a few social mixers each year — and I would blame the alienation of members 100% on the folks in Charlottesville.

    Instead of admitting that CFA Institute was on the wrong track under Tom Bowman, the current crop of CFAInst bureaucrats have shifted their efforts to encouraging Asian regulators to make CFA membership a requirement. Millions of Asians paying membership dues to support an ever growing mass of bureaucrats in Charlottesville. Isn’t that wonderful for THEM?

    It doesn’t benefit members. It certainly doesn’t benefit our clients. All this focus on extra lawyers and compliance staff the past decade has resulted in *** LESS CLIENT TRUST IN MARKETS ***. More lawyers, more compliance bureaucrats, more costs … but less public confidence.

    More “ethics training”, whether voluntary or mandated, has not improved public confidence. If anything, the public feels the markets are even more rigged against them.

    That is a failure. A total failure. And yet, the folks in Washington and Charlottesville (all bureaucrats who don’t care about their constituencies) want to mandate even more stupidity.

    Its like hiring extra TSA agents to grope your grandma on her way to and from Florida is going to somehow fight terrorism? Come on guys… CFA members are supposed to be smart enough to see through this fraud. Not long ago, even high school drop-outs could see through it.

    That is how Madoff conned so many people. It wasn’t mandatory CE. It was thousands of otherwise good people willing to look the other way when they knew a crime was being committed.

    As long as CFA members look the other way while Charlottesville bureaucrats screw us over … why should our clients trust us?

    • It may interest you to know that I was one of the members of the “Gang of 12″ back in 2002-3 that led the charge against mandatory CE, and the only one to be on the board of any local CFA society. I got the Baltimore Society to oppose mandatory CE.

      Your 45% figure for NYSSA & Boston is high, I think. If NYSSA & Boston opposed mandatory CE, I did not hear about it at the time. Good that they did, but the board in Baltimore was unaware of it. When I call Baltimore large-ish, I mean this: we are in the top 20, but we don’t think of ourselves as large — we are at the low side of large. We know our limits, but we also know that we have good working relationships with NYSSA, Boston, Philadelphia, and DC, especially DC & NYSSA.

      Also, I was the Baltimore representative to the Eastern US Regional Meeting (filling in for our President) in 2003, where we threw a plan into motion to eliminate corruption at AIMR, and it succeeded, firing the then current president Bowman.

      Not to boast, but my perception is that at the local society level there is more resistance then you might think. Even on the board of the CFA Institute, I have received friendly correspondence on some of the criticisms that I have politely rendered. Also, I have been invited to blog at their most exclusive blog — but I can’t figure where to get the time to do that.

      There is still ability to work from within at the CFA Institute — the local societies in the Eastern US are mostly skeptical, and if NYSSA & Boston decided to break away and start something new, I think you would see half of the membership of the US societies join them.

  • Greg says:

    The current 45% number for NYSSA and Boston might be a little high, but not by much. I am less involved now, so I have to hedge on that. However, I am positive that the two largest societies in 2003 were NYSSA and Boston, and together they were more than half of AIMR’s membership.

    The board of NYSSA sent out an e-mail to all their members opposing mandatory CE. That was the official stance of the board (though not unanimous), and the opposition was supported by opinion polls of membership. That opinion poll was confirmed by overwhelming opposition in the official AIMR/CFAI vote.

    I am not on Boston Society’s e-mail list, but I heard through two of their board members at the time that Boston opposed mandatory CE — and that they told Charlottesville in advance that they would officially oppose the idea.

    Since I am not in Boston Society, I can’t speak first hand — but two board members gave me the same story on separate occasions.

    I do not mean to minimize your involvement or the “gang of 12″, but I believe the opposition to mandatory paperwork was a lot more widespread than Bowman let on … and he knew most members opposed it in advance. But it typified a very dysfunctional bureaucracy in Charlottesville.

    I too was involved in society leadership, although the only CFA leadership thing I attended was the “leadership conference” in Chicago one year. AIMR staff literally bumped members out of the hotel (to another hotel 10 minutes away). The public thinks investment bankers are arrogant (not without reason), but I can’t imagine investment banking staff bumping clients to a far away hotel.

    I can’t help but mention the “curse” of CFA Institute involvement — Brian Singer, Cliff Agness, Chuck Hill to give a few famous names (lots of others less famous).

    Based on membership alienation / lack of involvement at the two “large-ish” societies I occasionally visit / attend programs … I would argue that the damage done to member involvement in 2003 has not been repaired. NYSSA is still very active, but they have operated almost independently of Charlottesville all along. They operate their own blog, host their own webcasts, run their own conferences, attract their own speakers, and have their own office staff. Easier for them to do in a place like New York City (and with such a huge membership)… but the point is they have very little in Charlottesville to break away from.

    Anyway, thanks for all your efforts on this blog.

    • All I know, is that the next main time that we need to oppose the CFA Institute, we can make a really big stink, and I am ready to lead the charge. I have a good reputation, and my board is behind me, so why not do it? It worked once, and we had less power behind us — why should it not work again?