Start with my disclaimer: I don’t know for sure. Buffett says that he didn’t know about the details, and certainly didn’t approve of the deal. From the Dow Jones Newswires:

Buffett said in a 2005 statement that he “was not briefed on how the transactions were to be structured or on any improper use or purpose of the transactions.”

Buffett’s attorney, Ronald Olson, said in a recent statement that Buffett “denies that he passed judgment in any way on the challenged AIG/Gen Re transaction in November 2000 or at any other time.”

Personally, I find this amazing for a few reasons. 1) In any dealings with AIG, a smart insurance executive would want to know what was going on. AIG has had a history of getting the better end of the deal in working with reinsurers. Buffett is not dumb, and there had been a decent amount of rivalry between the two companies over the years. 2) Buffett was not “hands off” on the insurance side of the house when it came to large insurance contracts. From his 2001 Shareholder Letter (page 8 ):

I have known the details of almost every policy that Ajit has written since he came with us in 1986, and
never on even a single occasion have I seen him break any of our three underwriting rules. His extraordinary
discipline, of course, does not eliminate losses; it does, however, prevent foolish losses. And that’s the key: Just as
is the case in investing, insurers produce outstanding long-term results primarily by avoiding dumb decisions, rather
than by making brilliant ones.

Now, maybe Buffett was overstating the case of how much he knew about what Ajit did. It is clear that he spent more time with Ajit than the managers at Gen Re, but I find it difficult to believe he didn’t review a major contract of a client who was also a major competitor known to be tough reinsurance negotiator.

3) He understands finite insurance very well. From this article of mine at RealMoney about the 2004 Shareholder letter, my last point:

12) Finally, what was not there: a discussion of Berkshire’s activities in the retroactive (or retrocessional or finite or financial) reinsurance business. This is notable for two reasons: first, in 2003, he split out the retroactive reinsurance in order to give a clearer presentation of the insurance groups operating results. This year the data is only presented in summary form. Second, Buffett made a big positive out of the retroactive reinsurance results, going so far as to explain the business in both the 2000 (page 8 ) and 2002 (page 9) shareholder letters.

Now, to varying degrees, Buffett made effort over the prior four years to explain the profitability of Berky’s retroactive reinsurance business, because it skewed the loss ratios of Berky upward. In the 2004 Shareholder letter, it was too much of a hot potato to give similar coverage to, even eliminating the entries that would have allowed one to see the accounting effect. In 2000 and 2002, he gave mini-tutorials on the business. In 2000 (page 8 ):

There are two factors affecting our cost of float that are very rare at other insurers but that now loom large at Berkshire. First, a few insurers that are currently experiencing large losses have offloaded a significant portion of these on us in a manner that penalizes our current earnings but gives us float we can use for many years to come. After the loss that we incur in the first year of the policy, there are no further costs attached to this business.

When these policies are properly priced, we welcome the pain-today, gain-tomorrow effects they have. In 1999, $400 million of our underwriting loss (about 27.8% of the total) came from business of this kind and in 2000 the figure was $482 million (34.4% of our loss). We have no way of predicting how much similar business we will write in the future, but what we do get will typically be in large chunks. Because these transactions can materially distort our figures, we will tell you about them as they occur.

Other reinsurers have little taste for this insurance. They simply can’t stomach what huge underwriting losses do to their reported results, even though these losses are produced by policies whose overall economics are certain to be favorable. You should be careful, therefore, in comparing our underwriting results with those of other insurers.

An even more significant item in our numbers — which, again, you won’t find much of elsewhere — arises from transactions in which we assume past losses of a company that wants to put its troubles behind it. To illustrate, the XYZ insurance company might have last year bought a policy obligating us to pay the first $1 billion of losses and loss adjustment expenses from events that happened in, say, 1995 and earlier years. These contracts can be very large, though we always require a cap on our exposure. We entered into a number of such transactions in 2000 and expect to close several more in 2001.

Under GAAP accounting, this “retroactive” insurance neither benefits nor penalizes our current earnings. Instead, we set up an asset called “deferred charges applicable to assumed reinsurance,” in an amount reflecting the difference between the premium we receive and the (higher) losses we expect to pay (for which reserves are immediately established). We then amortize this asset by making annual charges to earnings that create equivalent underwriting losses. You will find the amount of the loss that we incur from these transactions in both our quarterly and annual management discussion. By their nature, these losses will continue for many years, often stretching into decades. As an offset, though, we have the use of float — lots of it.

Clearly, float carrying an annual cost of this kind is not as desirable as float we generate from policies that are expected to produce an underwriting profit (of which we have plenty). Nevertheless, this retroactive insurance should be decent business for us.

The net of all this is that a) I expect our cost of float to be very attractive in the future but b) rarely to return to a “no-cost” mode because of the annual charge that retroactive reinsurance will lay on us. Also — obviously — the ultimate benefits that we derive from float will depend not only on its cost but, fully as important, how effectively we deploy it.

Our retroactive business is almost single-handedly the work of Ajit Jain, whose praises I sing annually. It is impossible to overstate how valuable Ajit is to Berkshire. Don’t worry about my health; worry about his. Last year, Ajit brought home a $2.4 billion reinsurance premium, perhaps the largest in history, from a policy that retroactively covers a major U.K. company. Subsequently, he wrote a large policy protecting the Texas Rangers from the possibility that Alex Rodriguez will become permanently disabled. As sports fans know, “A-Rod” was signed for $252 million, a record, and we think that our policy probably also set a record for disability insurance. We cover many other sports figures as well.

And 2002:

Ajit Jain’s reinsurance division was the major reason our float cost us so little last year. If we ever put a photo in a Berkshire annual report, it will be of Ajit. In color!

Ajit’s operation has amassed $13.4 billion of float, more than all but a handful of insurers have ever built up. He accomplished this from a standing start in 1986, and even now has a workforce numbering only 20. And, most important, he has produced underwriting profits.

His profits are particularly remarkable if you factor in some accounting arcana that I am about to lay on you. So prepare to eat your spinach (or, alternatively, if debits and credits aren’t your thing, skip the next two paragraphs).

Ajit’s 2002 underwriting profit of $534 million came after his operation recognized a charge of $428 million attributable to “retroactive” insurance he has written over the years. In this line of business, we assume from another insurer the obligation to pay up to a specified amount for losses they have already incurred – often for events that took place decades earlier – but that are yet to be paid (for example, because a worker hurt in 1980 will receive monthly payments for life). In these arrangements, an insurer pays us a large upfront premium, but one that is less than the losses we expect to pay. We willingly accept this differential because a) our payments are capped, and b) we get to use the money until loss payments are actually made, with these often stretching out over a decade or more. About 80% of the $6.6 billion in asbestos and environmental loss reserves that we carry arises from capped contracts, whose costs consequently can’t skyrocket.

When we write a retroactive policy, we immediately record both the premium and a reserve for the expected losses. The difference between the two is entered as an asset entitled “deferred charges – reinsurance assumed.” This is no small item: at yearend, for all retroactive policies, it was $3.4 billion. We then amortize this asset downward by charges to income over the expected life of each policy. These charges – $440 million in 2002, including charges at Gen Re – create an underwriting loss, but one that is intentional and desirable. And even after this drag on reported results, Ajit achieved a large underwriting gain last year.

What I am trying to point out here is that Buffett had significant knowledge of the retroactive (finite) deals at Berkshire Hathaway. He was even somewhat proud of them, though perhaps that is a matter of interpretation. He liked the almost riskless profits that they provided.

Before I move onto my last point, I’d like to digress, and simply say that not all finite reinsurance is a matter of accounting chicanery. The key is risk transfer. Without risk transfer, regardless of what the technical accounting regulations might say, there should be no reserve relief granted, regardless of the amount of money given to the cedant by the reinsurer; that money should be treated as a loan, because it will have to be paid back with interest. With full risk transfer, the company ceding the risk should not have to hold any reserves for the business. In between, the amount of reserve credit is proportional to the amount of risk shed; excess money given to the cedant by the reinsurer should be treated as a loan. Economically, that’s what it should be, even though that is not what always happens in the accounting. (Side note: yes, I know that it is difficult to determine the amount of risk shed, and different actuaries might come to different conclusions, but can’t we at least agree on the underlying theory?)

What has happened is that in many cases, little risk is shed, and a full credit for risk reduction is taken. Sometimes FAS 113 would be followed, with its 10% chance of a 10% loss as a miserably low tripwire for risk transfer. Sometimes FAS 113 would get bent, and other times, badly bent. That brings me to point 4.

4) Berky had a lot of experience with many different types of finite insurance. I remember a notable asbestos contract they took on for White Mountains where they would bear a large amount of risk. (On that one, I think White Mountains got the better end of the deal.) There were others, like the finite contract with Australian insurer FAI, which made them look solvent while experience was deteriorating. HIH bought FAI, and later went bankrupt, partly due to the acquisition. There were other finite reinsurance deals, like Reciprocal of America, where it made a company that was insolvent look solvent.

I can argue that in many cases, Berky’s underwriters did not know the accounting treatment that the cedant would use, and could not be responsible for the troubles that followed. In many cases, Berky bore significant, if limited, risk. That’s fine too. The greater question is if they were a large writer of finite coverages, which they were, they would have to have some knowledge of the cedant’s goals if they were to underwrite properly. Also remember that Buffett watches the “float” that his insurance businesses generate like a hawk. If there was a large amount of float that would come from a new contract, he likely would have known about it.

The AIG contract was big. AIG is a tough reinsurance negotiator. AIG and Berky have been rivals (Greenberg insulted Buffett on at least one occasion). Buffett watches underwriting carefully, even that of his trusted lieutenant Ajit Jain (a nice guy, really). That makes it really hard for me to believe that Buffett did not have any significant knowledge of the AIG finite reinsurance contract. In the end, I really don’t know; I’m only guessing. My guess is this: Buffett had general, but not detailed knowledge of the deal with AIG. In my estimation, he probably checked to see that there were adequate risk controls to make sure that AIG was not getting too good of a deal.

I admire Buffett. I have learned a lot from him. In general, compared to most businessmen, he is an honest and open guy who speaks his mind. If he said that he never had any significant knowledge of the contract with AIG, we should give him the benefit of the doubt, maybe. But from my angle, it is inconsistent with the way he has done business generally.

Tickers mentioned: AIG, BRK/A, BRK/B, WTM

PS — If you ask me how I feel about writing this, I will tell you that I am not crazy about what I have written. I’m not after publicity for criticizing a man that I admire greatly. I think that Buffett should be more forthcoming on the topic, and be willing to be a witness in the trial. Five people are facing ruined lives, and if Buffett really knew about it, and is saying nothing now because he is powerful enough to get away with it, well, shame on him. If he didn’t know anything about it, well, his testimony would clear the air, because it is a distraction at the trial.

A few readers asked me if I would review some books dealing with accounting issues. I’m happy to do that. I am not an accounting expert, and certainly not a forensic accountant, but my investing has benefited from being willing to look at the weaknesses in financial statements, and avoid companies where the economic results are likely worse than the accounting statements.

Howard Schilit, in his book, Financial Shenanigans, highlights seven areas where accounting can be fuddled:

1. Recording revenue too soon.
2. Recording bogus revenues.
3. Boosting income with one-time gains.
4. Shifting current expenses to a later period.
5. Failing to record or disclose all liabilities.
6. Shifting current income to a later period.
7. Shifting future expenses to the current period.

There are several common factors at play here.

• Beware of companies where earnings exceed operating cash flows by a wide margin. (1-4)
• Watch revenue recognition policies closely. It is the largest area of financial misstatement.  (1-2)
• Look for assets and liabilities that aren’t on the balance sheet, and avoid companies with hidden liabilities. (5)
• When companies do well, they often hide some of the profitability, and build up a reserve for bad times. This will show up in an excess of cash flows over earnings, so look for companies with strong cash flow.  (6,7)

The book liberally furnishes historical examples of each of the seven main categories for accounting machinations, showing how the troubles could have been seen from documents filed with the SEC in advance of  the accounting troubles that occurred.  Now, aside from point 5, the other six points boil down to a simple rule: watch operating cash flow versus earnings.  I wouldn’t say that the cash flow statement never lies, but investors pay more attention to the income statement and balance sheet.  Aside from outright fraud, ordinary deceivers can manipulate one statement, and clever deceivers can manipulate two.  To do three, it takes fraud.

Now, suppose you have found a company where the operating cash flows are weak relative to reported earnings.  That is where this book can help, because it will give you ways to analyze whether the difference is accounting distortion or not.  For those of us who use quantitative methods to aid our investing, this is particularly important, because many companies are seemingly cheap on GAAP book and earnings, but a review of the cash flow statement will often highlight the troubles.

The book is an easy read, and does not require detailed knowledge of accounting in order to get value out of it.  For fundamental investors, I recommend this book, with the proviso that it only works with non-financial companies.  Financial companies are more complex (they are all accruals — the cash flow statement is not very useful), and can’t easily be analyzed for earnings quality from looking at the financial statements alone.

Full disclosure: I get a pittance from each book sold through the link listed above.

I am a fan of value investing in all of its different variations, and so when I run across a book on the topic, particularly from a skilled practitioner, I buy it. I’ll do more book reviews on value investing, but one of the first that I wanted to do was Value Investing, by Marty Whitman.

So, I start looking around for my copy, and I can’t find it. Arrrgh, I can guess what happened. I lent it out, I can’t remember who I lent it to, but the borrower never gave it back to me. Annoyed at myself, I do notice a book that was just as good, The Aggressive Conservative Investor, by Marty Whitman and Martin Shubik. Even better, it is back in print, after being out of print for 20+ years.

So, what’s so great about the book? (Most of this applies to both books.) Marty Whitman has a strong “What can go wrong” approach. He realizes that he, and most other investors, will be outside passive minority investors. We only ride on the bus. The inside active control investors drive the bus, and if we are going to make money with reasonable safety, we have to understand the motives of those that control the companies. They benefit somewhat disproportionately from control. They receive wages and benefits that other shareholders do not receive, can gain cheap outside financing, and limit tax exposures, in addition to other benefits.

Like me, Whitman doesn’t care much for modern portfolio theory. More notable for a value investor, he has a few criticisms for the traditional “Graham-and-Dodd” type of value investing.

• Typically, it works best for “going concern” situations, and not situations where activism could be necessary to unlock value. (Though, Graham did do things like that in his career; he just didn’t try to teach amateurs about it.)
• He doesn’t always stick to high quality companies, if enough information can be obtained about the target. Information allows for more risk to be taken.

There are four things that he insists on in equity investments:

1. Strong financial position
2. Honest management that is creditor-aware and shareholder-oriented
3. Adequate disclosure of information relevant to the success of the company
4. The stock can be bought for less than the net asset value (adjusted book value) of the firm.

If you have these items in place, you won’t lose much, and if the management team makes value enhancing decisions, one can make a lot of money on the stock.

Whitman places a lot of stress on reading through the documents filed with the SEC. They may not be perfect, but managements know that they need to provide adequate disclosure of material information, or they could be sued. A lot gets revealed in SEC filings, and not every investor sees that.

He also places great stress on understanding the limitations of the accounting, whether under GAAP, Tax, or any other basis. Comparing the various accounting bases can sometimes illuminate the true financial well-being of a company. (Note: this is what killed me on Scottish Re. I should have questioned the GAAP profitability, when they never paid taxes.) He lists the underlying assumptions behind GAAP accounting, and explains how they can distort the estimation of economic value. Honestly, it is worse today in some ways than when he wrote the First Edition in 1979. GAAP accounting is more flexible, and less comparable across companies today.

Marty Whitman looks for situations where resources in a company can be used in a better manner, creating value in the process.

• Is the company too conservatively financed? Perhaps borrowing money to buy back stock, or issuing a special dividend could unlock value.
• Are there divisions that are undermanaged, or would fit better in another company?
• Are management incentives properly aligned with shareholders?
• Would the company be better off going private?
• Is government regulation a help or a hindrance? (Barriers to entry)
• Analyzing corporate structures for where the value is.

Beyond that, he explains how to calculate net asset values, as distinct from book values. He describes the problems with earnings as a value metric. He explains the value of dividends and other distributions. He also explains when it can make sense to own companies that are losing money. (Underlying values are growing in a way that the tax accounting basis does not catch.)

It’s a good book. Together with Value Investing, it gives you a full picture of how Marty Whitman thinks about value investing. He is one of the leading value investors of our time, but he has spent more time than most on the underlying theory. For those who want to think more deeply about value investing, Marty Whitman is a highly recommended read. For those wanting still more, read his shareholder letters here.

Full disclosure: if you use the links on this page to buyread books, I receive a small amount of money.

PS — Twelve years ago, I wrote Marty Whitman, begging to be one of his analysts. Though I didn’t get a response, I still admire him and his staff greatly.

1. Superstition is alive and well.  Google at $666?  Personally, I think it is all hooey.  There has always been a morbid fascination about the Antichrist in Western Culture.  Would that they had more concern about Christ.
2. Longtime readers know I am no fan of FAS 157 or FAS 159.  From the Accounting Onion, here is a good demonstration of what could go wrong as FAS 157 is implemented.  In my opinion, the concept of fair market value allows managements too much flexibility.  For assets that have a liquid market bigger than the holdings of the company in question, fair market value is not a problem.  It is a misleading concept otherwise, because the ability to realize that asset value in a sale is questionable.
3. This is an “uh-oh” moment on two levels.  Level one is defined benefit pension plans exiting US equities.  They are big holders, and a reallocation could hurt US stock prices.  Level two is that foreign markets have outperformed the US by a great deal over the last few years.  Perhaps the DB pension plans are late to the party?
4. There are no “almosts” in investing.  I have owned Genlyte twice in my life.  Great company.  I had it on my candidate list in my last reshaping.  I didn’t buy it then.  Now it is being bought out by Philips Electronics.  Good move for Philips; the only way they could make it better would be to take the management team of Genlyte, and have it run Philips.  That won’t happen; it is more likely that Philips will ruin Genlyte.
5. Activist hedge funds don’t always know best.  Smart managements and boards don’t get scared.  They calculate.  What’s the best thing for shareholders in the long run?  Do the hedge funds really have the willingness to fight?  Personally, I think it is usually best for managements to “call their bluff” and make the hedge funds work for control, rather than wave the white flag early.
6. Higher US dollar oil prices are only partly a dollar phenomenon.  Oil prices are rising in almost every currency; there is a relative shortage of crude oil globally.
7. Want an antidote to pessimism?  Read this post from VOX.  Personally, I think the lending issues are bigger than they think, but it is true that corporate balance sheets are in good shape.  Would that we could say the same for the consumer or the government.
8. Appreciation of the Chinese Yuan versus the Dollar may be accelerating.  Alongside that, many of the Gulf States are re-evaluating their peg to the US Dollar.  Given the inflation, who can blame them?
9. $300 Billion in losses from US residential mortgages?  That’s a believable figure to me.  Underwriting got progressively worse from 2003 to the first quarter of 2007.  Needless to say, that would kill a lot of non-bank mortgage lenders, and a few banks as well.
10. Could Japan be the great countercyclical asset in this market phase?  There is more speculative fervor in Japan at present, and many Japanese investors are buying stocks and selling bonds, partly due to relative yield measures.

That’s all for now.  More to come.

Back after a hiatus of sorts.  I should have a piece on my portfolio reshaping coming on Monday or so.  Tentatively, what I find fascinating, is that I have so many shoe and retail names near the top of my list.  Oh, and a few mortgage REITs, if they make sense…

But on with this morning’s topic, which deals with global macroeconomic pressures.  A few of the articles are a month dated, most are current, but this is meant to illustrate the pressures that the economy is under.

1. Let’s start with the good news, ECRI still doesn’t see a recession on the horizon.  They’re pretty accurate, so I give them room, and mute my own views.
2. That doesn’t mean there aren’t significant pockets of weakness.  Mortgage equity withdrawal is a spent factor, so to speak, and it ripples through current consumption and housing price weakness.  The less equity available, the less to pad consumption, and the less buying power for homes.  Credit card default rates are worsening, which can’t be good for buying power either.  On the low end of the income spectrum, many Hispanic workers are finding it hard, and that affects Wal-Mart, among other retailers on the low end.  That said, I have read that the Hispanic immigrants are much less likely to default on their mortgage loans than non-immigrants with similar credit characteristics.
3. CLSA predicts a record gold run, and so far, gold is cooperating.  That said, it will take a lot more to get gold to $3400/ounce.  We would need a real dollar collapse, and not this slow grinding selloff.  That said, the grinding selloffs tend to persist; more on that later in this post.
4. Of course, we could look at the price of wheat, or even just the price of stuff.  If it deals with food or energy, two items that are core to almost everyone’s budget, prices are rising.  John Wasik repeats a number of my arguments for why core CPI does not represent the diminution of the average person’s buying power.  I’m honestly surprised that no one has made a campaign issue out of honesty in inflation statistics so far.  It helped Reagan versus Carter in 1980.
5. That said, maybe we should be grateful that fuel grade ethanol is in surplus, at least temporarily, because we can’t distribute it to the end consumers efficiently.  Maybe not.  It’s no good for price to go down, if it only indicates lack of effective end-demand.
6. Oil at $90/barrel?  It’s partly a US dollar phenomenon (new trade-weighted low today), but not just a US dollar phenomenon.  In Euros, as I measure it, it’s a new high there as well, just not by much.   Now, when a critical commodity becomes scarce, it tends to attract wars, kidnapping, sabotage, etc., because bargaining power goes up as the price of the commodity goes up.  (Think of “blood diamonds” for another example…)  So we see pipeline sabotage, graspy politicians wanting a bigger cut of the royalties (no, not Chavez this time), and tensions between the Turks and the Kurds.  This leaves aside issues in Nigeria, and other aspects of supply disruption.
7. Now if that’s not enough, Western oil companies, which are often shut out of places where goverment monopoly oil companies tread, are finding less oil, and find that they have to buy back stock because of a limited number of places to invest in new fields.  Now, perhaps OPEC has the same problem, but it manifests differently.  They’re making a lot of money also, and don’t want to plow it into too many new projects, for fear of killing the price.  So what do they do with the free cash flow?  Their governments buy US Treasuries and other US debt claims, closing the money loop and financing the US current account deficit.
8. Well, maybe not entirely, though.  We had a glitch in capital flows in August, and foreigners sold more US securities than they bought by a significant margin.  Can’t help but think that it led to more pressure on the US dollar.  That said, the books have to balance: foreign capital inflows must balance the current account deficit over the intermediate term.  That doesn’t mean that they have to balance at the same price, though, just that the nominal values must balance at some implied exchange rate.  On the other hand, some nations are adjusting their currency baskets, like Vietnam and Qatar to reflect the lower value of the US dollar.  Quite a statement about their relative faith in their own currencies versus the US dollar.
9. The US has not had a strong dollar policy for some time, despite protests to the contrary.  We are happier to see export industries prosper, US tourism prosper, and consumer buying power from abroad suffer.  My question is when we will see foreign governments notably uncomfortable.  We’re not there yet, which makes me think that the path for the US dollar is lower still.
10. One final factor that doesn’t help: the size of the US budget deficit on an accrual basis.  Much larger than the stated deficit because of extra inflows to social security, and debt that doesn’t get counted because other government programs buy it to fund future liabilities.  Add onto that the wars which largely off-budget, and you have a significant present and future cash flow hole to cover.  Here’s to our children and grandchildren, who will have to pay it one way or another.

I’m still flooded by my workload, so just one comment this evening.  The Wall Street Journal posts an article on overly favorable (and smoothed) returns at hedge funds through securities that are mismarked favorably.  It was no surprise to naked capitalism, and no surprise to me either (point 26).  I’ve been writing about this issue off and on for three years now, because economic processes are messy, and tend to generate messy returns, not smooth returns, particularly once the easy arbitrages are glutted with yield-seeking investors.  Also, I know what the temptation is to mismark illiquid bond positions when incentive payments may be riding on the result (which is why we took the marking out of our hands at a prior firm).

Having been an actuary in financial reporting for twelve years, I know what the pressure is when someone above you in the hierarchy asks if your reserve is wrong.  It is rarely asked when the reserves are too low.  Few managements are so farsighted.  It is always asked when income is too low, and adjusting reserves downward is so convenient.  And who will notice?  Few, I’m afraid, but most actuaries I know are highly ethical, and resist these pressures.

My target here not insurance companies, though, but the investment banks.  Actuaries have detailed rules for setting reserves.  We have societies and ethics codes.  Those who work at the investment banks are not typically CFAs, which is more of a buy-side thing, so there is no industrywide ethics code there.  Also, the value setting rules for many investment banking assets and liabilities are far more squishy than for insurance liabilities.  Finally, investment banks frequently hold the same instruments as the hedge funds, and get their pricing marks from the same sets of sources.  I suspect that the positions are similarly mismarked, and they are big enough to hide it, because derivative books are never unwound.

Well, almost never.  Buffett phrased it well in his 2005 Annual Report: (pp. 9-10)

Long ago, Mark Twain said: “A man who tries to carry a cat home by its tail will learn a lesson that can be learned in no other way.” If Twain were around now, he might try winding up a derivatives business. After a few days, he would opt for cats.

We lost $104 million pre-tax last year in our continuing attempt to exit Gen Re’s derivative operation. Our aggregate losses since we began this endeavor total $404 million.

Originally we had 23,218 contracts outstanding. By the start of 2005 we were down to 2,890. You might expect that our losses would have been stemmed by this point, but the blood has kept flowing. Reducing our inventory to 741 contracts last year cost us the $104 million mentioned above.

Remember that the rationale for establishing this unit in 1990 was Gen Re’s wish to meet the needs of insurance clients. Yet one of the contracts we liquidated in 2005 had a term of 100 years! It’s difficult to imagine what “need” such a contract could fulfill except, perhaps, the need of a compensation conscious trader to have a long-dated contract on his books. Long contracts, or alternatively those with multiple variables, are the most difficult to mark to market (the standard procedure used in accounting for derivatives) and provide the most opportunity for “imagination” when traders are estimating their value. Small wonder that traders promote them.

A business in which huge amounts of compensation flow from assumed numbers is obviously fraught with danger. When two traders execute a transaction that has several, sometimes esoteric, variables and a far-off settlement date, their respective firms must subsequently value these contracts whenever they calculate their earnings. A given contract may be valued at one price by Firm A and at another by Firm B.

You can bet that the valuation differences – and I’m personally familiar with several that were huge – tend to be tilted in a direction favoring higher earnings at each firm. It’s a strange world in which two parties can carry out a paper transaction that each can promptly report as profitable.

I dwell on our experience in derivatives each year for two reasons. One is personal and unpleasant. The hard fact is that I have cost you a lot of money by not moving immediately to close down Gen Re’s trading operation. Both Charlie and I knew at the time of the Gen Re purchase that it was a problem and told its management that we wanted to exit the business. It was my responsibility to make sure that happened. Rather than address the situation head on, however, I wasted several years while we attempted to sell the operation. That was a doomed endeavor because no realistic solution could have extricated us from the maze of liabilities that was going to exist for decades. Our obligations were
particularly worrisome because their potential to explode could not be measured. Moreover, if severe trouble occurred, we knew it was likely to correlate with problems elsewhere in financial markets.

So I failed in my attempt to exit painlessly, and in the meantime more trades were put on the books. Fault me for dithering. (Charlie calls it thumb-sucking.) When a problem exists, whether in personnel or in business operations, the time to act is now.

The second reason I regularly describe our problems in this area lies in the hope that our experiences may prove instructive for managers, auditors and regulators. In a sense, we are a canary in this business coal mine and should sing a song of warning as we expire. The number and value of derivative contracts outstanding in the world continues to mushroom and is now a multiple of what existed in 1998, the last time that financial chaos erupted.

Our experience should be particularly sobering because we were a better-than-average candidate to exit gracefully. Gen Re was a relatively minor operator in the derivatives field. It has had the good fortune to unwind its supposedly liquid positions in a benign market, all the while free of financial or other pressures that might have forced it to conduct the liquidation in a less-than-efficient manner. Our accounting in the past was conventional and actually thought to be conservative. Additionally, we know of no bad behavior by anyone involved.

It could be a different story for others in the future. Imagine, if you will, one or more firms (troubles often spread) with positions that are many multiples of ours attempting to liquidate in chaotic markets and under extreme, and well-publicized, pressures. This is a scenario to which much attention should be given now rather than after the fact. The time to have considered – and improved – the reliability of New Orleans’ levees was before Katrina.

When we finally wind up Gen Re Securities, my feelings about its departure will be akin to those expressed in a country song, “My wife ran away with my best friend, and I sure miss him a lot.”

I could go on about this, but it’s late.  There are other weaknesses in the system as well.  A good rule of thumb is that whenever there is a lack of natural counterparties, there will be pricing difficulties.

Closing comment: When I was at a Stable Value conference in 1994, I ran into some investment bankers and talked to them about this topic.  I asked them how they hedged their synthetic wrap exposures.  They said they didn’t hedge because it was riskless “free money.” I pointed out the scenario under which they could lose money, and asked how their auditor could sign off on the lack of the hedge.  Their comment went like this: “When we find an auditor capable of auditing our derivative books, we hire him and pay him ten times the salary.”

In a world like that, who knows what problems may lurk in the derivative books, because the auditors stand a better chance of figuring out the truth than the ratings agencies and regulators.

Tickers mentioned: BRK/A, BRK/B

I know why Sarbanes-Oxley [SOX] came into existence: to give one of America’s least productive Senators a fitting legacy.  I think the legislation was perhaps well-intended, but on the whole, it has perhaps imposed more costs than produced benefits.  Today I am faced with one of the costs: Lafarge SA has delisted, and now trades on the pink sheets.  Now, big institutional investors will buy and sell shares of this fine firm on the Paris bourse, but I’m not big, so I end up with an illiquid nonsponsored ADR.  This is the third time this has happened to me since the passage of SOX, because my investing travels the world in a cheap way, through ADRs.

It has been said in many ways, but I will summarize it in this way: there is price, quantity, and quality.  You can at most regulate two out of three, and usually, it’s not wise for a government to regulate more than one variable at a time.  Often, it is wisest not to regulate, unless there are material problems in quality that ordinary people cannot verify, and yet ordinary people have a common need for (think of food safety, and our government does well at that, but could do better).

Large companies are complex, and the accounting is more so.  The personal burdens placed on the CEO and CFO are misplaced, in my opinion, and the degree of auditing/testing prior to SOX was adequate to catch most abusive situations.  Are financial statements higher quality now?  Yes, but at a cost: Higher accounting costs, particularly for smaller firms, more firms going private, and fewer foreign firms listed in the US.  (Note to those pushing for unification of GAAP and IFRS.  If you’re trying to get more listings in the US, it would be better to aim for reform of SOX.  If GAAP and IFRS are the same, and I were a medium-sized US firm, maybe I would list in London.)

There is a logical balancing point to regulation, and SOX tipped the balance, imposing more costs than the value of improvements in quality.

Full disclosure: long LFRGY (not LR )

Earlier today at RealMoney, I responded to a question in the Columnist Conversation. It was a longish post that tried to be complete, so I reprint it here:

		David Merkel
		Mark-to-Management Assumptions
		9/18/2007 1:50 PM EDT

Bob, Joe is essentially correct, but I’d like to add a little. From the Office of Thrift Supervision Examination Handbook (pages 137 & 138):

Observable Inputs - market participant assumptions developed based on market data obtained from sources independent of the reporting entity

Level 1 Inputs - Unadjusted quoted prices in active markets for the identical assets and liabilities that the reporting entity has the ability to access at the measurement date. Examples: Treasury bonds and exchange traded securities.

Level 2 Inputs - Other than quoted prices included in Level 1 that are observable for the asset or liability, either directly or indirectly. Level 2 inputs include quoted prices for similar assets or liabilities in active markets and quoted prices for identical or similar assets or liabilities in markets that are not active. Examples: loans traded within the secondary market and plain vanilla interest rate swaps.

Unobservable Inputs

Level 3 Inputs - Entity specific inputs to the extent that observable inputs are unavailable. Because there is little to no market activity, these inputs reflect the entity’s supposition about the assumptions of market participants based on the best information available in the circumstances. In those situations, the reporting entity need not undertake all possible efforts to obtain information about market participant assumptions. However, the reporting entity must not ignore information about market participant assumptions that is reasonably available without undue cost and effort. Examples: credit enhancing I/O strips and private equity securities.

Another way to phrase it is this:

Now, I’m not a fan of SFASs 157 & 159, or any of the current statements dealing with intangibles. Even level 1 is subject to problems when markets are less liquid. I’ve known of situations where a bond manager found himself holding a disproportionate share of the market of a publicly tradable bond, where it almost never trades because he owns so much of the issue. Where do you mark that? That’s just level one!

Aside from AAA securities, most asset backed bonds never trade. Level 2 comes into play here, because the dealers estimate a pricing grid from what few transactions take place. with “fair value” accounting, there is no way to avoid mark-to-model, but there are significant possibilities for error.

The classic case of level 3 is how one estimates the changing value of private equity investments over time. Discounted cash flow anyone?

As a result of the changes, we have to be a lot more careful in how we interpret the financial statements of financial companies. The game just got a lot more complex given the new fair value accounting rules.

Position: none

After I wrote that, a friend of mine e-mailed me saying that Private Equity accounting was for the most part conservative at present, but that there was some pressure to use fair value accounting to smooth results. He also thought the use of these methods wouldn’t make private equity correlate more closely with public equities. I think he is onto something there, and that could affect that amount allocated by pensions and endowments to private equity. On the flip side, if the returns are smoothed through these accounting methods, the standard deviation of returns would drop, which is a bigger effect than the correlation effect. So allocations might go up, and some Private Equity managers, believing the smoother returns, might be tempted to lever up more.

One other note: I expect that companies with high percentages of level 3 assets will trade at discounts to relative to their peers. Accounting complexity and opaqueness always have valuation discounts. I see it in insurance for financial insurers, reinsurers, and long-tailed commercial lines. Uncertain assets and liabilities should always get lower valuations. Thus, aggressive users of fair value will wonder why their P/Es and P/Bs are so low. It’s because of the lack of ability of investors to verify the asset and liability figures used.

In my continuing series where I try to look beyond the current furor of the markets, here are a number of interesting items I have run into on the web:

1) Asset Allocation

• Many people who want to stress the importance of their asset allocation services will tell you that asset allocation is responsible for 90% of all returns, so ignore other issues.  An article on the web reminded me of this debate.  The correct answer to the question, as pointed out by this paper, is that asset allocation explains 90% of the variability of the returns of a given fund across time, but only explains only 40% of the variability of a fund versus other funds.  Security selection matters.
• Two interesting papers on asset class correlation.  Main upshots: historical correlations are not fully reliable, because risky assets tend to trade similarly in a crisis.  Value tends to march to its own drummer more than other equity styles in a crisis.  The effects on correlation in crises vary by crisis; no two are alike.  Natural resources and globa bonds tend to be good diversifiers.
• In bull markets, risky asset classes all tend to do well.  Vice-versa in the bear markets.  My reason for this correlation is that you have institutional asset buyers all focusing on asset classes that were previously under-recognized, and are now investing in them, which raises the correlation level, not because the economics have changed, but becuase the buyers have very similar objectives.
• There are a few good states, but by and large, public pensions are a morass.  Most are underfunded, and rely on future taxation increases to support them.  When a public system realizes that it is behind, the temptation is to take more investment risk by purchasing alternative asset classes that might give higher returns.  This will end badly, as I have commented before… I suspect that some state pension plans are the dumping grounds for a lot of overpriced risk that Wall Street could not offload elsewhere.

2) Insurance

• When the premiums get too high, people tend to stop buying insurance, or reduce coverage severely. That’s happening for Southeast windstorm coverage now, particularly in Florida.  That might be a good bet this year, but I wouldn’t press my bet in 2008 even if 2007 ends loss free.
• Similarly, when reinsurance premiums are high, insurers buy less reinsurance, and more when prices fall.  Though Swiss Re is saying that 2007 will be worse from a loss standpoint than 2006, that’s not saying much.  Swiss Re can try to avoid premium decreases, but they will lose business in the process.

3) Investment Abuse of the Elderly

It’s all too common, I’m afraid.  Senior citizens get convinced to buy inappropriate investments.  Even the SEC is looking into it.  This applies to annuities as well, mainly deferred annuities, which I generally do not recommend, particularly for seniors.  The comment that a CEO doesn’t fully understand his own annuity products is telling.

Now fixed immediate annuities are another thing, and I recommend them highly as a bond substitute for those in retirement, particularly for seniors who are healthy.

The only real cure for these deceptive practices is to watch out for the seniors that you care for, and tell them to be skeptics, and to run all major investment decisions by you, or another trusted soul for a second opinion.

4) Accounting

• I am against the elimination of the IFRS to GAAP reconciliation for foreign firms.  What is FASB’s main goal in life — to destroy comparability of financial statements?  We may lose more foreign firms listed in the US, which I won’t like, but a consistent accounting basis is critical for smaller investors.
• Congress moves from one ditch to the other.  This time it’s sale of subprime loans.  Too many modifications, and sale treatment is at risk, so Congress tries to soften the blow for the housing market.  Let auditors be auditors, and if you want the accounting rules changed, then let Congress do the job of the FASB, so that they can be blamed for their incompetence at a complex task.
• As I’ve said before, I don’t like SFAS 159.  It will lead to more distortions in financial statements, because managements will tend to err in favor of higher asset and lower liability values, where they have the freedom to set assumptions.

5) Volatility

• Earn 40%/year from naked put selling?  Possible, but with a lot of tail risk.  I remember how a lot of naked put sellers got smashed back in October 1987.  That said, it looks like you can make up the loss with persistence, that is, until too many people do it.
• Here’s an interesting graph of the various VIX phases over the past 20 years.  Interesting how the phases are multiyear in nature.  Makes me think higher implied volatility is coming.
• I don’t think a VIX replicating ETF would be a good idea; I’m not sure it would work.  If we want to have a volatility ETF, maybe it would be better to use variance swaps or a fund that buys long delta-neutral straddles, and rebalances when the absolute value of delta gets too high.

That’s all for now.  More coming in the next part of this series.

1)  Start with the pessimists:

• It’s often thought that foreigners are the ultimate dumb money, entering near the end of a bull wave, because they are the last to notice, and chase performance.  Well, they are big investors now.
• Normal forward-looking assumptions about asset class returns don’t look that bullish either.  This is similar to my argument in this RealMoney article.

2)  Move to the optimists:

• When stocks trade like a herd, the past short-term price movements have been up on average.
• With the Dow Industrials, the dividend yield may be cheap relative to high quality bonds.  Hidden assumption: average future dividend growth or better.
• Insiders are buying.  Really, insiders are buying.
• P/Es are low in the eyes of some.  (Of course, profit margins are high…)
• The guy who said “Sell Sell Sell,” now says “Buy Buy Buy.”  (Of course, this is Europe, but equity markets are pretty correlated.)

3) Hedge funds are getting outflows at present (and here), and August performance was pretty bad (and here — look at  “Splutter”).  I began toting up a list of notable losers, but it got too big.  One positive note, many of the large quant funds bounced back from their mid-August stress.

4)  When muni bonds get interesting, you know it’s a weird environment.  It starts with the fundamental mismatch of muni bonds.  Muni issuers want to lock in long term financing, but most investors want to invest shorter.  Along come some trusts that buy long bonds and sell short-dated participations against them, and hedge the curve risk with Treasuries.  When credit stress got high, long munis were sold because they could be, and long Treasuries rallied, which was the opposite of what was needed for a hedge.  (Note: hedging with Treasuries can work in normal markets, but fails utterly in panics, as happened in 1998.)  When the selling was done, in many cases high quality muni yields were high than Treasuries even before adjusting for taxes.  That didn’t last long, but munis are still a good deal here.

5) Large caps are outperforming small caps.  Foreign exposure that large caps have here is a plus.

6) Not all emerging markets are created equal.  Some are more likely to have trouble because they are reliant on foreign financing. (Latvia, Iceland, Bulgaria, Turkey, Romania)  Others are more likely to have trouble if the US economy slows down, because they export to us. (Mexico, Israel, Jordan, Thailand, Taiwan, Peru)  I would be more concerned about the first group.

7) Are global banks cheap?  Yes on an earnings basis, probably not on a book basis.  We need to see some writedowns here before the group gets interesting.

I’ve talked about SFAS 159 before, and you know I think it is a bad accounting rule.  This article from my friend Peter Eavis helps to point out some of the ways that it allows too much freedom to managements to revalue assets up.  What I would watch in financial companies is any significant increase in their need for financing, which could point out real illiquidity, even though the balance sheet might look strong; this one is tough because financials are opaque, and the cash flow statement is not so useful.  Poring over the SFAS 159 disclosures will be required as well.

9) As I have suggested, pension plans will probably end up with a decent amount of the hit from subprime lending, through their hedge fund-of-funds.

10) Hedge funds do better if the managers went to schools that had high average SAT scores?  I would not have guessed that.  Many of the best investors I have known were clever people who went to average schools.

11) My but bond trading has changed.  When I was a corporates manager, hedge funds weren’t a factor in trading.  Now they are 30% of the market.  Wow.  Surprises me that volatility isn’t higher.

12) Rich Bernstein of Merrill (bright guy) is getting his day in the sun.  His call for outperformance of quality assets seems to be happening.  Now the question is whether the cost of capital is going up globally or not.  If so, he says to avoid: “1) China, 2) emerging market infrastructure, 3) small stocks, 4) indebted U.S. consumers, 5) financial companies, 6) commodities and energy companies.“  Personally, I think the cost of capital is rising for companies rated BBB and below, which brings it back to the quality trade.

13) Econocator asks if markets have priced in a recession, and he says no. My problem with the analysis is that we would need 10-year Treasury yields in the 2.5% area to fully price it in by his measure, and that makes no sense, outside of a depression, and then, nothing is priced in.

14) Morningstar moves into options research.  Could be interesting, though Value line has had a similar publication, and I’m not sure that the market for publications like this is big enough.  They make a good point that most people use options wrong, and get the short end of the stick.

15) Oil is amazing, but wheat is through the roof.  I’ve seen articles about bread prices rising.  Fortunately, the cost of grain is a small part of the cost of foods that rely on grain.

With that, I bid you good night.