There’s kind of a rule of thumb in Asset-Liability management, that you match liquidity over the next 12 months, and match interest rate sensitivity overall.  I would do more than that, creating my own randomized interest rate models, as well as a new way of creating structured randomness in simulation models.  For a brief period of time, I had one of the best multivariate randomness programs out there, eliminating the problem of correlations in higher dimensions common with Hammersly points.  (My work was not theoretical, but intuitive… once I saw how the randomness was created, I figured out how to de-correlate the higher dimensions (since it was based on prime numbers, create more number than you need, and use a higher prime number to select observations.)

Anyway, when I brought my full-interest rate curve scenarios to the investment department in 1994, they said to me, “These are the first realistic interest rate scenarios we have ever seen.  Did you constrain them?”  I told them “No, just weak mean reversion.  Noise dominates in the short run, mean reversion dominates in the long run.”

As a result, for the lines of business over which I had oversight, we measured our interest rate mismatch in terms of days, weeks, and months, but never years.  Please ignore this incident where things drifted, but worked out exceptionally well (really, that should be a part of this series).  We published a document to show everyone how well we managed interest rate risk in Provident Mutual’s pension division.  We used scenarios far beyond what was required to show how well we did our work.  The regulators never complained.

At that point in time, the ability to integrate residential mortgage-backed securities into cash flow analyses was rudimentary at best.  But I found ways to make it work, most of the time.  That said, I remember joking with the MBS manager in late 1993, and saying there was a new term for a well-protected PAC bond.  He asked, “What is it?”  I replied, “Cash.”  He sarcastically said, “Oh, you are so funny.”   That said, I pointed out to the investment department that some of their bonds that they thought would last another four years would disappear in 2-3 months.

Then there was the floating rate guaranteed investment contract project that I eventually killed because it was impossible.  You can’t argue with expectations that are unrealistic.  Even better, I beat the Goldman Sachs representative.

In running the GIC desk at Provident Mutual, I had to review a lot of strategies because making money on short-term bonds/loans was difficult, and difficult the degree that I doubted as to whether we were in a good business.  On the bright side, I protected the firm until the day that we  could not write any more  GICs, because our credit quality was too low.  That was the fault of the less entrepreneurial part of the company, so I couldn’t so much about it, except close my operations down.  I asked the senior management team to provide a guarantee to my GICs, but they refused.

As such, I shut the line of business down.  With clients that were unreasonable over credit quality, and management unwilling to extend credit protection to GICs, the battle over GICs was ended, and I sent the line into runoff.

Five years later, as we were now part of the same firm I stood at the estate of John Dwight, with a young woman that I had sold the last GIC of Provident Mutual to, I said, “The end of the GIC business of Provident Mutual.”  We talked, she smiled, but it was part of the end of an era, because GICs were a minority of the assets in Stable Value funds.

If nothing else, this helps to highlight the impermanence of all that is done in financial firms.  I know this in my own life, but I am sure that it is true for most people in finance.

When I worked for Pacific Standard, which had the dubious distinction of being the largest life insurance insolvency of the 1980s, I had few investment-related tasks.  Investments were handled by the overly aggressive parent company Southmark, which gave little attention to risk.

But I knew things weren’t going well, and so I interviewed widely, finally landing two job offers with Midland National and AIG.   I chose the spot with AIG, because they led me to believe I would work on the international side.  When I arrived, lo, I had a job on the domestic side.  As far as the job went, had I known I would be placed on the domestic side, I would have rather gone to Midland National.  They thought I had real leadership potential — whether true or not, that’s what I was told, and I would not have minded living in South Dakota, or nearby.  As it was, there were many good things that happen to me as a result of living in-between Wilmington, Delaware, and Philadelphia, living on the PA side of the line for reasons of adoption and homeschooling.

When I got to AIG, there was one main thing that involved my risk management skills.  AIG parent wanted growth in GAAP earnings.  They wanted to see a 15% ROE, which few in the life industry were attaining.  In order to do that, they entered into reinsurance treaties (before I arrived).  These would lever up the balance sheets of the subsidiary companies, without incurring debt.  Most of them passed risk to the reinsurers, one did not.

So, when I was called into an examination by the Delaware State Insurance Department auditor over the one treaty that did not pass risk, he said to me, “You know this treaty does not pass risk.”  I replied, “Under ordinary circumstances, I would agree, but the reinsurer has taken a significant loss from this treaty.”  He said, “What do you mean?”  I replied that when Congress passed the DAC tax, the reinsurer suffered the loss — they paid up front, and we pay over time, with zero interest.

He looked at me and said that reinsurance treaties did not exist to cover tax policy, and that the treaty was a sham.  I just shrugged.  I was not the creator of the treaty, and would not have done it if I had been at AIG two years earlier.

But the there were the two larger treaties that passed risk with a vengeance to a large reinsurer [LR] who is no longer a reinsurer (if anyone wrote treaties like these, he might not be a reinsurer anymore either).  In one sense, the treaties were structured like the trading requirements in CDOs.  If you must trade:

  • Get more income
  • Don’t give up rating
  • Don’t extend maturity
  • And a few more smaller things.

I was not there when the treaties were created.  Had I been there, I would have paid a lot more attention to them, and instructed the investment department to set up segregated portfolios, which was not done.  As it was, bonds that underlay the treaty were casually sold as if free to do so.

Now I arrive on the scene.  After reading the treaties, and looking at the data, I conclude that the treaties have been abused on our side.  I suggested to LR that I go through the history, and reallocate bonds that would have fulfilled the treaties strictures, an re-work the accounting so that the terms of the treaty would be fulfilled.  Initially LR agreed to this.

The treaty passed all investment risk to the reinsurer, so defaults would hit them.  What was worse, the liabilities underlying the treaty were structured settlements.  (Structured settlements result from a court case where someone is injured.  The defendant offers to buy from a reputable life insurer an annuity that will make the requisite payments.  Low bid wins, and if the plaintiff is badly injured, the cost goes down for payments that terminate at death.  That’s where most of the bad estimates com in.)  In those days, structured settlements were a “winner’s curse.”  If you won, it was because you mis-bid.  AIG Domestic Life Companies regularly overbid for their business (as did most of the industry).  LR did not do enough due diligence to see the underwriting errors.

I did a mortality study to estimate how badly we needed to increase reserves, and lo, it was more than $100 million, all of which would flow to LR.  LR decided to sue.  After I had gone on to Provident Mutual, AIG settled with LR.  Our missteps with the assets made the case tough, and the reinsurance treaty was rescinded.  That should have been enough to jolt AIG’s earnings for a quarter, but it did not.  Funny that, and it always left me a little suspicious of AIG.  (And LR.)

Before I left AIG, I had clipped the wings of the underwriters of the structured settlements so that they could not write on cases for the most severely disabled.  I also shut down a tiny line of variable annuities that was losing money left and right to an outsourcer who had a sweet contract from a prior management team, but upon leaving AIG I did not feel that great, because I had not built anything — most of my time had been spent trying to limit losses from prior bad underwriting and planning.  It wasn’t fun, and I loved my next company more because I got to build.

PS – a prior note on AIG.

Cyprus & The Eurozone


  • Betray Your Bank Before Your Bank Betrays You Deposits over insured limit r a sitting target 2b taken in a crisis $$ Mar 29, 2013
  • Demolishing some myths about the single currency A euro in Nicosia isn’t worth the same as a euro in Berlin $$ #ulose Mar 29, 2013
  • Neatest thing about the Eurozone interactive graphic: crisis comes in fits & spurts; u think it is over,& it’s not $$ Mar 29, 2013
  • Eurozone crisis: three-and-a-half years of pain Cool graphic that allows u2 explore the Euro-crisis blow-by-blow $$ Mar 29, 2013
  • Lines Form as Cyprus Banks Reopen How 2 destroy your banking system & bungle rescue, courtesy of the EZ & #Cyprus $$ Mar 28, 2013
  • MANDATORY CREDIT: BLOOMBERG SURVEILLANCE Marc Faber talks2 Tom Keene & Alix Steel on stocks, Europe, Cyprus & gold $$ Mar 28, 2013
  • Italy’s failure to form a government doesn’t bode well for the euro EZone a political creature w/lousy economics $$ Mar 27, 2013
  • Money fled Cyprus as president fumbled bailout Give the Russians credit (figuratively) 4 squeezing $$ out of Cyprus Mar 27, 2013
  • Euro zone overrates ability to curb contagion: Moody’s Taxing insured deposits has opened up a can of worms $$ #dumb Mar 27, 2013
  • As a kid, we had a rule, “You can’t beat up my little brother. Only I get to beat up my little brother.” Cyprus: deposit insurance & levy $$ Mar 27, 2013
  • Cyprus banks remain closed to avert run on deposits Won’t help; trust broken. Better 2 take money home, buy gold $$ Mar 26, 2013
  • Cyprus: It’s not over yet There will be a lot of pushback from Russia & wealthy Cypriots. Taxing Insured deposits? $$ Mar 26, 2013
  • Spain’s Swelling Debt Seen Impeding Rajoy Deficit Battle Unsure how Spain can escape. After that comes France $$ #woe Mar 25, 2013
  • Cyprus: crossing the green line If I had $$ in a Greek, Italian, French or Spanish bank, I would withdraw some #theft Mar 25, 2013
  • Cyprus: The Operation Was a Success. Shame the Patient Died. Misery of Cyprus is a feature, not a bug $$ #norelief Mar 25, 2013
  • Cyprus weighs big bank levy; bailout goes down 2wire Small depositors lose 4%, big 20%. Policymakers gain new tool $$ Mar 25, 2013


Financial Sector


  • Why Bad Directors Aren’t Thrown Out Large Institutional Shareholders go along 2get along. Y irritate powerful ppl? $$ Mar 29, 2013
  • Surging Student-Loan Debt Is Crushing the System Avoid student debt if u can; most onerous form of debt in US now $$ Mar 29, 2013
  • Wells Fargo Beats Rivals to Oil-Boom Deposits, Study Says FD: + $WFC | WFC bot little banks, grew them organically $$ Mar 29, 2013
  • Swiss Re settles dispute w/Berkshire Hathaway Hasn’t developed same expertise U/W life policies as P&C $$ FD:+ $BRK/B Mar 29, 2013
  • 5 Financial Advisor Red Flags There r2 many fake “credentials” in investing; the person matters more than letters $$ Mar 28, 2013
  • 5th Anniversary of Credit Crisis: Should u Buy CLOs? All loan participation funds@ prem2NAV $$ Mar 28, 2013
  • We’ve Already Built the Next Banking Disaster At minimum, we need to break up biggest 4 banks $C $JPM $BAC $WFC $$ Mar 28, 2013
  • Citigroup looks to cut cash holdings to boost earnings Every bank hates 2 keep slack liquid assets. Lowers ROE $$ $C Mar 27, 2013
  • The Best Way to Save Banking Is to Kill It @Matthew_C_Klein Separating deposit-taking from credit creation $$ #yes Mar 27, 2013
  • A successful failure by @researchpuzzler Amazing what @pimco can do when it has less money to invest $BOND $$ Mar 27, 2013
  • US Cracks Down on ‘Forced’ Insurance Restrictions on banks profits on force placed insurance won’t harm insurers $$ Mar 27, 2013
  • Warren Buffett and Goldman Sachs: Explaining the Math Buffett receives $GS shares equal 2 his profits on the trade $$ Mar 27, 2013
  • 44% of Americans think they’re covered 4 weather-related floods. Only 15% have bought a supplemental flood policy. $$ Mar 25, 2013
  • Falcone Follows Michael Jackson Path Taking Fortress Loan $HRG Falcone tapping every loan source he can $$ #desperate Mar 25, 2013
  • Dealer inventory slump threatens market stability Intermediation brings stability 2 mkts if intermediaries solvent $$ Mar 25, 2013
  • Mortgage Securitizers Didn’t Know Housing Was Going Bust Many drank the same poison Kool-aid they served to others $$ Mar 25, 2013


Rest of the World


  • US Writes Its Worries About Buying IT Gear From China Into Law Just imagine the backdoors that could be installed $$ Mar 29, 2013
  • Grooms at $18 Fuel IPO Ambitions for Indian Matchmaker India needs 2 have dowry go reverse way; husband pays $$ Mar 28, 2013
  • How Asia and Robotland have dramatically changed the US labor market Biggest thing killing off low-end jobs: tech $$ Mar 28, 2013
  • Mr Yen cautions on Japan’s ‘unsafe’ debt trajectory Takehiko Nakao warns of consequences from 2 much govt debt $$ Mar 27, 2013
  • John Mauldin:”Might I suggest that a good trade would be to be long German government debt, short French debt? ” $$ neg carry, long disaster Mar 27, 2013
  • North Korea’s Economic Outlook: Cloudy with a Chance of Statistics by @steve_hanke Communism often cre8s inflation $$ Mar 27, 2013
  • Japanese Investors Start to Cut the Cord Mrs Watanabe starts to buy stocks, even foreign & many other investments $$ Mar 27, 2013
  • Chinese housing bubble fears grow China grew its economy by forced investing, & the central planning is failing $$ Mar 27, 2013
  • Abe’s Inflation Exceeds Merkel’s After 14-Year Lag All a race to the bottom; sound $$ will produce greater growth. Mar 27, 2013
  • US shale no panacea for Japan’s crippling energy bills Infrastructure doesn’t exist 4 getting lotsa LNG 2 Japan $$ Mar 27, 2013
  • Brazil Soy Boom Bottlenecked as China Left Waiting Need 2invest transport infrastructure; tax importers/exporters? $$ Mar 26, 2013




  • REITs Trigger Fed Warning as Kain Tops $100 Billion Shadow banking returns amid unconventional Fed policies $$ #panic Mar 28, 2013
  • M&A Stumbles Amid March Deal Drought “Can u say overvaluation, boys & girls? I thought u could; you’re special.” $$ Mar 28, 2013
  • Here’s Why Marissa Mayer Is About To Spend ~$200 Million On A YouTube Wannabe Buy small $ grow organically, smart $$ Mar 27, 2013
  • Is the $DELL Stub the Right Investment for You? Gun to the head, I would say “no.” 2 much leverage & excess supply $$ Mar 27, 2013
  • Summaries of What’s Wrong w/ $YHOO ‘s Summly Buy & & $$ Mar 27, 2013
  • How the Maker of TurboTax Fought Free, Simple Tax Filing Intuit benefits from complexity in the tax code $$ #simplify Mar 27, 2013
  • Fredriksen Bets $2.6B New Ships Will Beat Glut: Freight A bold bet that may fail 4 lack of sufficient capital $$ $FRO Mar 27, 2013
  • The Scariest Stock Chart in Town @ReformedBroker Good example of analyzing balance sheet strength of stockholders. $$ Mar 27, 2013
  • Cisco Is Keeping Its Promise Not To Buy Companies In The US Makes sense given US Tax laws | FD: + $CSCO $$ Mar 27, 2013
  • T-Mobile Becomes First Major Carrier to Drop Subsidies Probably a good strategy; differentiates & unbundles $$ Mar 27, 2013
  • Customers Flee Wal-Mart Empty Shelves for Target, Costco I see it also $$ Mar 26, 2013
  • Dell Says Blackstone, Icahn Offers May Be Superior Not sure I would want 2 win $DELL game; fixing ops very hard $$ Mar 25, 2013
  • Blackstone’s $DELL Bid Sets Stage for Rare Buyout Bidding War Michael Dell may lose control of company he built $$ Mar 25, 2013
  • Heinz Sells $3.1B of New Bonds Deal upsized, rated B1/BB-/BB-, lowest financing cost ever 4a LBO@ 4.25% 7.5yrs $$ #no Mar 25, 2013


US Monetary & Fiscal Policy


  • How the Fed Can Create a Market-Friendly Exit Strategy: Jeremy Siegel’s Proposal Listen 2 bank shareholders scream $$ Mar 29, 2013
  • Pentagon to Cut $41B After Getting More Funding We could a lot of dead wood @ the Pentagon, expensive non-soldiers $$ Mar 29, 2013
  • Big Business Spars Over Rewriting Tax Code Importer, Exporter, Services, REIT, MLP, PE: no common corptax position $$ Mar 29, 2013
  • The Exhausted US Consumer Spent-up, not pent-up $$ Looks at Disposable Personal Income, which recently dropped Mar 28, 2013
  • Restaurant Chains Cut Estimates for Health-Law Costs Test Q: List all the ways that the PPACA fails $$ #needmorepaper Mar 28, 2013
  • Best Predictor of Financial Crisis: Huge Inflows of Foreign Money Long assets financed w/short liabilities is why $$ Mar 28, 2013
  • Stockton Deficits May Total $100 Million, Forecast Shows That’s the cash pmt curve of generous employee benefits $$ Mar 27, 2013
  • Stockton Bankruptcy Decision to Come Monday, Judge Says $BEN $AGO & $MBI argue city didn’t negotiate in good faith $$ Mar 27, 2013
  • US Retail Sales: Very Soft Indeed! Unusual in that seasonal adjustments typically go away on YOY figures $$ Mar 27, 2013
  • Brenner and Fridson: Bernanke’s World War II Monetary Regime Sad but true. Bernanke robs savers to fund US Govt $$ Mar 26, 2013
  • States Build Cash Reserves, Raising Rainy-Day Debate State budgets should balance on an accrual basis. None do $$ Mar 25, 2013




  • Wrong: Gold Declines in Worst Run Since 2001 as Economic Concerns Ease Gold is falling because of debt deflation $$ Mar 28, 2013
  • Wrong: Proving Greenspan Wrong Shows Why Rey Became Worthy to Bernanke Proving Greenspan wrong is trivial $$ #tiny Mar 28, 2013
  • Wrong:Key US senator blames speculators for high ethanol RIN price Note Senator is from Iowa, which benefits most $$ Mar 27, 2013
  • Wrong: Why the Rich Don’t Give to Charity The missing variable here is Christian faith; media is blind to that $$ Mar 27, 2013


Market Dynamics


  • Everybody is Furiously Looking for Bubbles Bubbles are financing phenomena; look 4 short finance of long assets $$ Mar 29, 2013
  • Morningstar: Stocks Are Close to Fair Value “US stock market is some 50 percent above its historic mean value” $$ Mar 28, 2013
  • Crises exist 2 eliminate things that don’t need 2b done; governments interfere w/ this process b/c they r in league w/those who skim society $$ Mar 28, 2013
  • When will the Bond Bubble Finally Burst? Fund flows, Fed, other CBs, Banks, & measured inflation supportive 4 now $$ Mar 27, 2013
  • Investors face a shrinking stock supply Maybe we can get rid of Sarbanes Oxley b4 it kills the equity mkt entirely $$ Mar 27, 2013
  • Investing in a High Debt Environment Concentrate on inflation, study interest rates & focus on business fundamentals Mar 27, 2013
  • Low Volume = Good Investment? Analysis of David’s “Neglected Stocks R Typically in Strong Hands” Thesis Good Stuff $$ Mar 27, 2013
  • Use free cash 4 buybacks when price < 90% of franchise value [FV], issue dividends above that. FV is where u rather issue stock than debt $$ Mar 26, 2013
  • Not Everyone Loves Dividends: Guy’s Argument is Worth Hearing Buybacks vs Divs: depends on undervaluation of stock $$ Mar 26, 2013
  • Warren Buffett and John Hussman On The Stock Market The Market Cap/GDP ratio indicates significant overvaluation $$ Mar 26, 2013
  • Investors Pile Into Housing as Landlords Anytime investors become a large part of residential RE-> trouble $$ #bubble Mar 25, 2013
  • Buttonwood: Credit watch New book argues that investors should focus on the credit cycle, not economic growth $$ #duh Mar 25, 2013
  • How to Unlock That Stashed Foreign Cash If there are attractive foreign companies 2 buy, would b best use of $$ Mar 25, 2013




  • Corn Supply Slumps Most Since ’75 on Ethanol Profit Corn supplies may tighten by summer, tough if another bad crop $$ Mar 29, 2013
  • Business Insider Just Told College Students Their Secrets of Success Sprinter & marathoner, act dumb, ask Qs, etc. $$ Mar 28, 2013
  • Leaked Photos of Johansson Expose Cloud’s Vulnerabilities to Social Engineering Take security seriously $$ Mar 28, 2013
  • Methadone Deaths Tied to For-Profit Clinics Prompt Bills They get paid per visit; few incentives 2 act ethically $$ Mar 28, 2013
  • 6 Reasons You Should Have Cyber Liability Insurance U can make your computer invisible 2 the internet in 15 mins $$ Mar 28, 2013
  • Arms Race to Grow World’s Hottest Pepper Goes Nuclear I don’t get this; I eat spicy food for taste, not 2b macho $$ Mar 27, 2013
  • The New US Industrial Renaissance A bit overstated but cheap energy & rising wages in China aid US competitiveness $$ Mar 27, 2013
  • Falling US Gasoline Demand: A Weaker US Economy? Gasoline is fairly core 2 consumption, when it goes down, trouble $$ Mar 27, 2013
  • Case-Shiller: Home Prices Post Biggest Rise Since 2006 But after the huge drop, it’s really just a dead cat bounce $$ Mar 27, 2013
  • Wringing Out Laundered Cash Always easier 2 press a civil suit than a criminal suit; look at the bankers 4 proof $$ Mar 27, 2013
  • 3D-Printed Polymer Skull Implant Used For First Time in US Offers high degree of customization 4 surgical repairs $$ Mar 26, 2013


Retweets & Replies


  • The local situation in the US can’t run too far ahead of the world. Too interconnected $$ RT @boes_ America Mar 29, 2013
  • ‘ @JaredKastriner As for me, I play banker for my children. I pay 4 tuition & unavoidable costs. They pay avoidable costs& I lend 2 them $$ Mar 29, 2013
  • @JaredKastriner No, but it should make us consider whether college is needed, and maybe borrowing against the house might b better $$ Mar 29, 2013
  • ‘ @AndreCimini There r many incentives 4 politicians, regulators & businessmen 2 prolong a boom; I worked 4 a firm that foresaw it & made $$ Mar 25, 2013
  • I hold a CFA Charter, (and was an FSA — dues too expensive) but credentialing is overrated in almost all… Mar 28, 2013
  • Commented on StockTwits: Banks got bailed out after so many bad mortgage & other loans. A few hedge funds properl… Mar 28, 2013
  • @EddyElfenbein As a Christian, it embarrasses me. They misinterpret Revelation & it makes people think they can gauge when Christ will come Mar 28, 2013
  • ‘ @kyles09 My point is this: in 2007, the last time I saw something like this, it was right before loan pricing fell apart. That’s all. $$ Mar 28, 2013
  • ‘ @Nonrelatedsense I’m wrong, cancel that comment on the $PSX midstream assets. Thanks 4 the correction $$ Mar 28, 2013
  • Bitcoin $$ RT @groditi: OK, spill it, who’s gonna be the Big Short for BitCoin?. that parabola looks like it’s about to break any second now Mar 27, 2013
  • RT @SoberLook: Chart: Bitcoin’s unprecedented rally. Another way for Cyprus citizens to take funds out of the country – … Mar 27, 2013
  • I like it, thanks $$ RT @adamjbonesjones: @AlephBlog Short Frenchies vs EFSF bonds (over-collateralised, positive carry)…. Mar 27, 2013
  • Monster, yes. Greatest? No $$ RT @MattZeitlin: Whoever decided that tables and figures go at the end of papers is history’s greatest monster Mar 27, 2013
  • @Matthew_C_Klein Sometimes they hand out the Nobel Peace Prize 4 what they wish the world could b, hence Obama (drones), EZ (fantasyland) $$ Mar 27, 2013
  • RT @Matthew_C_Klein: For this they won the Nobel Peace Prize MT @SonyKapoor: EZ has made every country feel that they’ve been hard done by Mar 27, 2013
  • Patient is dying. More morphine. $$ RT @TheStalwart: RT @CNBC: Fed’s Kocherlakota: “Monetary policy is currently not accommodative enough.” Mar 27, 2013
  • Controlling system changes it RT @MatthewPhillips @CardiffGarcia:Fantastic NYFed paper financial risk monitoring $$ Mar 27, 2013
  • Extra points 4 USSR & Japan parallels RT @prchovanec: Apply these last three quotes (from “This Time is Different”) to China … discuss. Mar 26, 2013
  • [cute dog warning] I guess you did have to. RT @moorehn: Sorry. I had to. Mar 26, 2013
  • ‘ @kyles09 Good point, the rule mostly deals with excess cash over and above a low regular dividend $$ Mar 26, 2013
  • @ToddSullivan I could live with the word “moderate” 🙂 Mar 26, 2013
  • “Thing about low vol investing is that it is a moderate risk strategy, b/c it invests in stocks…” — David_Merkel $$ Mar 25, 2013




  • My week on twitter: 57 retweets received, 2 new listings, 60 new followers, 57 mentions. Via: Mar 28, 2013


This is likely to be the last series describing how I learned my skills that I still apply today.  I hope you enjoy it.


It was mid-1988, and I had just earned my Associate in the Society of Actuaries [ASA] credential.  After my boss congratulated me, he told me I was now invited to the monthly management meetings.

In insurance terms, this era was the “bad old days.”  Risk-based capital regulations had not yet been developed, and aggressive companies like First Executive and Pacific Standard Life [my company] invested almost entirely in junk bonds.  These were some of the pigs Michael Milken was feeding junk bonds to.

What initially impressed me was that monthly income was so variable, and that most of the variation came from asset performance.  Now, as an actuary, I had more asset knowledge than most, but seeing the variation made me say to myself that if actuaries are risk managers in life insurers, the syllabus for teaching actuaries is wrong, because it focuses on liabilities, not assets.

Pardon this excursus — the Society of Actuaries in the US needs to be more like The Institute and Faculty of Actuaries in the UK.  Investing should be a core skill, not a peripheral skill.  Actuaries have the capability of exceeding the skill of CFA charterholders by a wide margin.  Assets vary far more than liabilities in an insurance company, most of the time.  Focus on what varies, and improve management skills there.

I was low enough in the hierarchy that there was nothing I could do to prevent Pacific Standard from failing in 1989.  That said, I accelerated my job search so that I left two months before Pacific Standard was taken into conservation by the California Department of Insurance.  But for me, that was out of the frying pan, and into the fire, because I went to work for AIG.

PS — I learned a few more things as well:

  • Highly levered companies are dangerous.  Southmark, which owned Pacific Standard, needed everything to go right because of the high degree of leverage.
  • When ever you hear of a management team that is highly litigious, stay away.  Phillips & Friedman surrounded themselves with a phalanx of lawyers, and got away with everything short of murder.  They will get it on Judgment Day, but not likely before.
  • When you interlace the capital of subsidiaries, it is a sign of desperation, indicating likely failure.  If you have subsidiary A buy the preferred stock of subsidiary B, and subsidiary B buy the preferred stock of subsidiary A, in the same amount, they both look a lot healthier, but nothing has happened, aside from an accounting ploy.  Pacific Standard died when the California Department of Insurance refused to accept some preferred stock as an admitted asset.
  • My first project was to set the GAAP reserve factors for Universal Life.   In hindsight, my boss manipulated me into creating the best profit stream in hindsight, which produced lousy future profits.  He stripped profitability out of the future for then present management bonuses.

This should be short.  Let me start with some facts.

  1. Buybacks are preferred on a taxation basis to dividends.
  2. But buybacks are especially good when the stock is trading below its franchise value, and especially bad the further above franchise value the stock is trading.
  3. Using slack capital to improve operations, or do little tuck-in acquisitions is probably best of all.  Organic growth is usually the best growth, and small acquisitions can facilitate that.  Small acquisitions are usually not expensive.  Be wary of acquisitions to increase scale, they don’t work so well.
  4. Paying a dividend makes management teams more cognizant of the cost of equity capital, which makes them more effective.
  5. In the reinsurance business in Bermuda, companies with slack capital tend to buy back shares below 1.3x book value, and issue special dividends if they are above that level.

Franchise value is management’s best estimate of the value per share of the company’s equity.  If a management team does not have a firm handle on the value of the company, it has no business buying back stock.  Stock should never be bought back over franchise value.  If you want to reward shareholders then, issue a special dividend.

I am reminded of how in 2000 the CFO of The St. Paul cleverly bought back shares in the 20s, wisely bought back shares in the 30s, stupidly bought back shares in the 40s, and foolishly bought back shares in the 50s.  He was a Johnny One Note, except that he impaired the balance sheet so badly that he became the one of the main causes of why The St. Paul sold out to The Travelers.  Price matters with buybacks.

The reinsurance industry is a good example, because well-run reinsurers are simple companies.  The book of business is worth book value.  The reserves are conservative, which is worth ~0.1x book value or so.  Future underwriting profits are worth ~0.2x book value of so.

So the reinsurers have their standard — the companies are worth around 1.3x book value.  That gives them a discipline for capital — buying back at under 1.3x book, and issuing special dividends above that.

It is my opinion that most buybacks are a waste, even with the tax advantages, given that the buybacks occur at prices over franchise value, sometimes significantly over.  It’s also my opinion that a 2% dividend makes management teams think harder about their shareholders, which is a good thing.

If you get to talk to a management team doing buybacks, ask them if they have a model for what their stock should be worth.  If they don’t have one, tell them they should not be doing buybacks, unless they are buying back the stock cheaply.  Above franchise value, buybacks are a value destroyer.

This post is at the behest of my friend Tom Brakke of The Research Puzzle.  It is meant to briefly describe how Warren Buffett’s investing changed over the years.

Compounding Capital

The basic idea of Warren Buffett’s investing is simple.  Try to compound your capital at the fastest rate consistent with a margin of safety.  That margin of safety might be a strong balance sheet, or it might be a product with high gross margins that faces little competition.  But compound capital over the long haul.  Do it, whether it is public or private investing.  Do it, regardless of the form of the asset.  Do it, if you have to change in midstream from being an asset manager, to being the manager of an investment-oriented conglomerate.

Those are themes I will explore in this essay, but who can explain Buffett well in less than 1000 words?

Buying Cigar Butts

Ben Graham had a huge influence on Buffett, but Buffett was his own man.  He had made money in many ways prior to working for Graham/Newman — he was a very driven, determined man.  But buying dud companies where the price was far lower than what the net assets were worth was a simple strategy that few followed.  It had great returns from the mid-30s to mid-60s or so.

Why? The Great Depression left the stock market in disarray, and convinced a generation not to touch stocks; they were not able to be analyzed.  So a few enterprising men analyzed and made a lot of money.

After Graham-Newman folded in 1956, Buffett started his own investing partnerships, which he eventually consolidated into one partnership in

But there were limits to this exercise.  Companies were sold for a profit, and the number of companies selling at bargain basement prices shrank dramatically.  Ben Graham folded; Warren Buffett adapted.

End of Buffett Partnership

Buffett ended his investment partnership as opportunities declined, and distributed out the shares to holders around 1969.  After a little delay, he consolidated his holdings under Berkshire Hathaway.  This was a significant move because now Buffett was running a business as an investor.  He had permanent capital, and could use it were he thought best.  Berkshire Hathaway itself was a failing textile producer.  In hindsight Buffett was too kind, and gave it too many chances, it would have been better to shut down the textile company earlier.

Textile Company to Insurance/Conglomerate Holding Company

Buffett discovered insurance early, through GEICO in 1952, and then through Berkshire Hathaway bought insurance companies which became the bedrock of the company, including buying 50% GEICO in 1974 to rescue it.  This would provide the capacity to finance/leverage investment insights.

Influence of Charlie Munger (Growth/Moat)

His friendship with Charlie Munger began in 1959, and he affected the way Buffett thought about investing.  Companies that had protected boundaries, or, sustainable competitive advantages deserved a premium valuation.  That insight began to free Buffett from the Cigar Butts, i. e., dud companies that have no growth potential, only sellout potential.  Such businesses could be bought in whole or in part, but they had to possess a durable advantage.  This would play a role as Buffett wold buy Coke, Capital Cities, American Express, Wells Fargo, and many other high quality businesses.

Willing to work Public or Private, and increasingly Private

Though Buffett was known in the 70s and 80s as a public equity manager inside a public company, he increasingly bought private companies like:

  • See’s Candies
  • Fecheimer
  • Kirby
  • Nebraska Furniture Mart
  • Borsheim’s
  • Scott Fetzer
  • World Book (no one is perfect)
  • Buffalo News (who could have predicted the Internet?)

This changed his view of what he was up to, and made him willing to run an abnormal conglomerate, one that would operate on a disaggregated basis.  Buffett would take the free cash flow from controlled companies, and the dividends from partially owned companies an reinvest them in the areas he thought had the most promise.

Scale rules out Arbitrage / Distressed Debt / Small Cap Equities / not Derivatives

Over time, Buffett invested in many ways, doing deal arbitrage, buying distressed debt, and buying small cap companies.  As time went on he had to abandon these for two reasons: he had too much capital to put to work, and competition increased, driving returns down.

Derivatives were different, Buffett was willing to take bets during times of economic stress so long as he did not have to post margin.  He took bullish bets on US Credit and Global Equities.  Much as he criticized derivatives as gambling, he was willing to take an intelligent bet where his downside was limited.

Buying companies with no auction / Tuck-in acquisitions

Buffett became the home for men who wanted to sell their companies, but preserve the culture.  Buffett didn’t pay the highest price, but he did not interfere with the new subsidiaries.

His subsidiary companies would do little tuck-in acquisitions that would further the vitality of BRK, without spending a lot.

Increasing Insurance Scale

And over time, bought all of GEICO, Gen Re, and many other smaller insurers.  Supposedly, at one point, Hank Greenberg said to Buffett, “Call me when you have a real insurance company!”  The two were frenemies for some time.  But today, the show is on the other foot — the largest insurer in the US in BRK.

The increased scale of insurance provided all the more capital to finance Buffett’s asset buys.  The underwriting discipline provided additional profits.

Opportunistic Provider of Capital

During the crisis in 2008-9, Buffett provided capital to well-regarded companies like GE and Goldman Sachs.  He was ready for odd opportunities like Burlington Northern, Lubrizol, and Heinz.

He was also willing to change his view on buying back shares, setting a line in the sand where he would but back shares, rather than doing a dividend.

Conglomerate Manager

Buffett never intended to run a conglomerate, but that is what he did, and did it very well, much like Henry Singleton, who was another compounder.

That’s what he does now.  There it is, in less than 1000 words.

In valuing companies or indexes, one must look at the earnings or cash flow statements, and the balance sheet.  The former are flow measures, measuring performance over a period, versus the balance sheet which attempts to measure the value of the company on an amortized cost basis (with varying accuracy).

There are advantages to each method.  My view of it is over the short-run, flow measures are the most meaningful.  Over the long-run stock measures are the most meaningful, because over the long run the returns from assets or net worth are more regular than those versus other flow measures.

That is why I focus on longer term valuation measures among short-term valuation measures that are neutral at best at present,  Mean-reversion eventually takes hold.



1 March 2013

Dear Mr. Buffett,

Four years ago, I contacted the IR department at AIG to ask for copies of all the 2008 statutory books for all the insurance subsidiaries.  To my surprise, they sent them, 60 pounds worth, and I wrote a report explaining how almost all of the domestic life subsidiaries had to be bailed out because of a funky securities lending agreement that allowed AAA subprime RMBS to used as collateral in place of T-bills.  The report was cited by SIGTARP in their review of the AIG bailout.

I am writing to you asking for copies of the 2012 statutory books for Berkshire Hathaway.  My purposes are different than with AIG.  You’ve done something unique with Berkshire Hathaway.  No one else has created such a multifaceted conglomerate, much less one with well-run insurance companies at the core, providing funding.

I have the capability of understanding the documents and doing a good job with them.  I am an actuary as well as a value investor, and have been a buy-side analyst in a hedge fund where I focused on the insurance industry.  (Todd Combs and I interacted a little when I was a buy-side analyst.  You chose well.)

My clients and I own “B” shares of Berkshire Hathaway, so I am a small part of the Berkshire family.  If you are willing, please send me of the 2012 statutory books for Berkshire Hathaway.


David J. Merkel, CFA

Principal, Aleph Investments

Writer at the Aleph Blog

And the deservedly terse handwritten response:

David, Sorry we get a lot of requests & it would be burdensome for a small staff to respond to these.


My Thoughts

Buffett is right, and I should have thought harder.  Everything BRK does is disaggregated, even filing Statutory Statements.  I am mentally stuck in the world of when I was an actuary engaged in financial reporting, where we would have a room where we would gather all the data to go to the states, rating agencies, etc.  I had to do that many times.

But Berkshire acts like a bunch of unaffiliated companies, and files their data separately.  To the best of my knowledge, that means I would have to ask 37 different entities for their Statutory Statements.  Here they are:

Company NameState of DomicileNAIC Number










































































How do you get the data in this case?

1) I suppose I could write each one and ask, but there is no guarantee that many would listen or act.

2) I could buy it from the NAIC, but it would run to around $700, and I am not doing that for a mere blog post.  Most insurers give you the statutory statements if you ask (in PDF form).  I never pay for Stat statements; I believe that they should be available in electronic form for free, or a nominal fee.

Maybe someone would want to pay it in exchange for credit on the series of articles that would flow from it?  Maybe SNL would pay for an article from me?  Or Bloomberg?  Or a competitor?  Or the sell-side wanting a guest piece? Or…

3) I could ask my readers for ideas.

Why would anyone care about this?

1) Alice Schroeder wrote the first sell-side analysis of Berkshire Hathaway.  In it she stated that the company had a waiver from the Risk-Based Capital rules from the states.  If true, that is quite a regulatory advantage, and I would want to verify that.  Current regulators might care.

2) Buffett is clever, and has the holding company and well-run insurers owning industrial, utility and service businesses.  If this is done well, and it is quite an accomplishment, because the alphas of prudent underwriting and ownership of well-run businesses get added together on one capital base.  Others might like to duplicate it.  I know that I have gotten pitches from consultants touting such ideas.


Well, it was worth a try.  Marc Hamburg did not return my phone calls, but I understand.  BRK is different from other companies — even the insurance is done subsidiary by subsidiary.  If any of you have ideas, I am all ears.

On the bright side, I do have a short note from the guy I have learned so much from.  I may frame it… 😉

Full disclosure: long BRK/B

Hubris:  “We can do it better than [the target company].  With additional scale, we will be able to gain operating efficiencies and marketing opportunities. We will be a big company in our industry, and we will control our own destiny.”

So some CEOs think.  It is easy to propose a large merger, wave your hands at the details, and the deal takes on a life of its own.  But large deals:

  • Attract competition.  If a large piece of market share is up for grabs, many will try to grab it.  Premiums to get a large deal are often uneconomic, akin to the guy who shows of a jar of nickels  in a crowded room, and invites people to bid for it.  He never clears less than a 20% profit on the jar.
  • Have to meld two different cultures.  This is not trivial.
  • Have to meld two different information technology departments.  Also not trivial.
  • Have synergies and cost savings that are often overestimated.
  • Face greater scrutiny from the government, which slows things down, and results in greater restrictions on the combined enterprise.
  • Have a CEO that will be severed, and he will require handsome compensation to go. Sadly, the remaining CEO will get a pay boost, after all, he is running a bigger company.
  • Run into the problem of Too Big To Manage.  This may not apply to large energy companies, because they are relatively simple, but with most other companies with market caps over $100 billion, performance deteriorates.  It is difficult to keep incentives sharp for employees and managers.
  • Have a buyer who may not appreciate some strengths of the target company.  In two insurance acquisitions, I saw the acquirer throw away valuable divisions that they could not understand, firing people more talented than the acquirer was.  At least they should have sold the division to someone else.
  • Generates goodwill, which makes the company harder to analyze, an lowering its valuation versus book.

That’s why I don’t buy companies that do scale acquisitions.  They tend to flounder and lose money.

But I do buy companies that do tuck-in acquisitions.  Tuck-in acquisitions are buying a little company that adds:

  • A new technology
  • A new marketing channel
  • A new product or service

Which is complementary to their existing business, and they will grow it organically.  With a tuck-in, the competition is less, integration issues are less, almost every difficulty versus large acquisitions are less.  Prices are low.

One use of free cash flow is acquisitions.  Companies that focus on small acquisitions and organic growth use free cash flow wisely.  Large acquisitions overpay to buy a trophy asset that the acquirer may unintentionally destroy.  Avoid such acquisitive companies.  The company  may grow, but the stock price likely will not.

A friend of mine told me the price talk for the Fidelity & Guaranty Life Holdings, Inc. bonds was 6.5%, but yield lust must have prevailed, because the coupon was 6.375% when the deal closed.  Almost all corporate bonds are priced at a slight discount, so the actual deal yield may have been higher.

So much for my warning.  Anyway, here is the press release:

Harbinger Group Inc. Announces Pricing of Fidelity & Guaranty Life Holdings, Inc.’s $300 Million Senior Notes

NEW YORK–(BUSINESS WIRE)– Harbinger Group Inc. (“HGI”; NYSE: HRG), announced today that its wholly-owned subsidiary, Fidelity & Guaranty Life Holdings, Inc. (“FGL”), priced an offering of $300.0 million aggregate principal amount of its 6.375% senior notes due 2021. The notes were priced at par with a coupon of 6.375%. The notes will mature on April 1, 2021. The offering is expected to close on or about March 27, 2013. FGL expects to use the net proceeds from the issuance of the notes for general corporate purposes, to support the growth of its subsidiary life insurance company and to pay a dividend to HGI.

The notes were offered to qualified institutional buyers pursuant to Rule 144A under the Securities Act of 1933, as amended (the “Securities Act”) and to persons outside the United States under Regulation S of the Securities Act.

I got one thing wrong in my initial piece, domestic retail investors could not buy it — it was a 144A deal.  That said, if it has registration rights, it could be resold to retail in the future.

If anyone buying the bonds is reading me, let me suggest a swap for you, while the market is still liquid.  Sell this bond and swap it for the recently issued subordinated bonds of The Hanover Insurance Group.

The Hanover Insurance Group, Inc. (THG) announced that it has priced a registered offering of $175 million of subordinated debentures due March 30, 2053 with a coupon of 6.35%, and redeemable in whole or in part after March 30, 2018 at a redemption price equal to their principal amount.  The debentures are also redeemable in whole, and not in part, before March 30, 2018 in case of specified changes in the tax or rating agency treatment of the debentures. The Hanover plans to use the net proceeds from this offering for general corporate and working capital purposes, which may include repurchases of its common stock.

The yields are almost the same but the risks are far lower on The Hanover Insurance Group’s subordinated debt.  There is no complexity here.  The structure is simple.  It’s a short duration P&C company that has not lost money for the last seven years.  FGLHI may be improved from the past, but it had a really bad past.  Improvement might not be enough for FGLHI.

Risk Summary: Sell complexity, buy simplicity.  Pick up rating. Add duration, drop convexity. Take on the risks of a smaller deal.

I would do this trade in a heartbeat.  It’s not perfect, but I prefer simpler bonds to more complex bonds, unless I am one of the few that understands the complexity.

Full disclosure: I am long the common stock of THG