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.

For those wanting a road map of where I am likely to post over the next few days, tonight is mortgages and real estate, tomorrow is speculation, and Friday should involve longer dated topics. For those that commented on the blog redesign, I want to say that I appreciated your comments, particularly the critical ones. In the next two months, I’ll be doing a minor redesign to fix some of the flaws that I introduced in the process. I’m not perfectly happy with the result, and it can be improved. Trivia: I co-edited the best high school yearbook in the nation back in 1979, so I do have some eye for design. It’s more of a question of the computer implementation.

Onto real estate:

1) After a bubble bursts, it’s amazing the details that come out on the ethical lapses that transpired. With Countrywide, people were steered into loans that were worse than what they might have qualified for there or elsewhere. Now, they should have shopped around; I always do that on mortgage loans. That Countrywide is still facing problems after the Bank of America infusion might not be too surprising; companies that cut corners with their customers are more likely to be aggressive in their accounting practices. After the post-bailout bounce, the convertible preferred that Countrywide got is now under the $18 strike price.

2) Can the mortgage crisis swallow a town?  Yes.  I know this personally, as some friends of mine on the Eastern Shore of Maryland are finding out right now.  They are not in one of the best areas, and demand has dropped off a cliff.  Entire neighborhoods near them are in bad shape, making everything else less salable.  They need to sell their home for medical reasons, and they can’t do it without taking a loss, which would impoverish them.

3) The internals of the housing market are now such that no one is arguing over the troubles faced.  Consider:

• Housing prices are expected to drop in the US for the next few years by some analysts, including Goldman Sachs.
• Home resales continue to fall.
• The National Association of Realtors has slashed its forecasts for home sales and construction.  (The last to admit it, kinda sad, but telling.)
• Investors in residential real estate are a disproportionate number of the defaults.
• 33% of mortgage loans did not close in August.  A more normal number is 4%.
• A record number of homes entered foreclosure in the second quarter of 2007.
• Mortgage trouble?  It’s not just a subprime issue.  The ability to finance or refinance a non-conforming loan has been greatly reduced, even for borrowers with good credit.  Higher rates reduce demand, and reduce sale prices.
• When I became a corporate bond manager, one of the rules of the firm was “no homebuilder bonds.”  The wounds of the early 90s were still memorable.  If you want to see why that was possibly a good rule, look here, because these bonds have gotten whacked recently.

4) But won’t the President and Congress bail out strapped homeowners?  Tough task.  Current proposals are just dust on the scales, and doing anything big would be a budget-buster.  I agree with Accrued Interest; a bailout is bad policy.  I suspect one will happen anyway.  Washington, DC specializes in bad policy, if it wins votes.

5)  After a bubble bursts the second order effects can be quite significant.  Consider:

• “Rising defaults on subprime home loans are boosting the inventory of unsold homes and driving sale prices lower. That’s cutting into housing-related revenues from building-permit fees, taxes on contracting and recording property transfers, and even sales taxes.”   Housing is a big source of revenue for the states; no surprise that they are suffering as prices and transaction volumes decline.
• The ranks of Realtors get thinned.  Good thing, too.  Too many thought there was easy money there.
• Title insurers get whacked by fraud claims.  (Note investable idea: wait for a little while, because the fraud claims will eventually pass.  An entry point on the title insurers will come slightly after housing inventories begin to decline.)
• Credit card defaults are probably the next significant credit issue to surface.
• In the case of American Home Mortgage, many borrowers face foreclosure because tax and insurance payments are not getting to to the local governments and insurance companies.
• What new homes are getting built are smaller, which is quite a change in the over-housed US.
• Shutting the barn door after the cow has escaped to the pasture; so much for tighter lending requirements now.  It would have been better to have had moderately tighter standards over the past five years, than to have the whipsaw.
• Then there are the higher-order financial effects, whether it is reneging on merger terms, or the effects on foreign investors from buying subprime mortgage risk inside their CDOs.  You mean they didn’t look?
• And, anytime a bubble bursts, it is a business opportunity for the lawyers.  I never thought of it this way before, but the legal profession benefits from societal volatility.

6) Now, I wonder if Merrill Lynch will have any significant hits from subprime.  I would expect it, but who can tell for sure?

7)  Was it such a good idea for the US government to promote home ownership so vigorously?  I have generally said no, and Caroline Baum questions the wisdom of the policy as well.

Finally, we keep them in a bubble to make sure that their theories on how the economy works do not get contaminated by data.  I’m partly kidding here, but the Fed is very optimistic that any spillover from residential real estate to the general economy will be light.  I think the effect will be moderate; it will definitely hurt, but not destroy the US economy.

Tickers mentioned: BAC CFC GS MER

When the market gets wonky, I write more about current events.  I prefer to write about longer-dated topics, because the posts will have validity for a longer time, and I think there is more money to be made off of the longer trends.  Before I go there tonight, I would like to say that at present the Fed says that it is ready to act, but it hasn’t done much yet.  As for the Bush Administration, and Congress, they have done nothing so far, and the few credible promises are small in nature.  My counsel: don’t be surprised if the markets stay rough for a while.

Onto longer-dated topics:

1. Perhaps this should go into my “too many vultures” file, but conservative players like Annaly can take advantage of bargains produced by the crisis.  My suspicion is that they will succeed in their usual modest conservative way.
2. Falling rates?  Falling equity prices?  Pension funding declines.  This issue has not gone away in the UK, and here in the US, the PBGC is still struggling.  As it is, FASB is facing the issue head on (finally), and the result will likely be a diminution of shareholders’ equity for most companies with defined benefit plans.
3. China is a capitalist country?  Eminent domain can be quite aggressive there.  At least now they are promising compensation, but who knows whether the government really follows through.
4. Any strategy, like quant funds, can become overcrowded.  As a strategy goes from little known to crowded, total returns rise and then flatten.  Prospective returns only fall as more and more compete for scarce excess returns.  As the blowout occurs, total returns go negative, and more so for the most leveraged.  Prospective returns rise as capital exits the trade.  Smart quants measure prospective return, and begin liquidating as prospective returns get too low.  Not many do that for institutional imperative reasons (investor: what do you mean cash is building up?  What am I paying you for?), but it is the right strategy regardless.
5. This is a useful graph of sector weights in the S&P 500.  If nothing else, it is worth knowing what one is underweighting and overweighting.  I am overweight Energy, Basic Materials, Staples, Utilities, and (urk) Financials, and underweight the rest.  My portfolio, right or wrong, never looks like the market.
6. I’ve written about SFAS 159 before.  Well, we may have a new poster child for why I don’t like it, Wells Fargo.  Mark-to-model is impossible to escape in fixed income, but I would treat gains resulting from changes in model assumptions as very low quality.  Watch SFAS 159 disclosures closely with complex financial companies.  If we wanted to repeat the late 90s headache from gain on sale accounting, we may have created the conditions to repeat the experience in a related way.
7. How dishonest is the P&C insurance industry?  It varies, as in most industries.  Insurance is a bag of complex promises, which leaves it more open to abuse.  This article goes into some of that abuse, and teaches us to evaluate a company’s claims paying record.  You may have to pay more to get Chubb or Stancorp, but they almost always pay.
8. China’s financial system is maturing slowly; one example of that is reduced reliance on bank finance, and issuing bonds directly.
9. I don’t care what regulations get put into place, capitalist economies are unstable, and that’s a good thing.  There are always information asymmetries, and always crowd behavior, such that risk preferences change precipitously.  That’s the nature of the system.  The only true protection is to be aware of this reality, and adjust your behavior before things get crazy.
10. A firm I was with had an early opportunity to invest in LSV and we didn’t do it.  The two members of our committee that read academic research thought we ought to (I was one), but the practical men of the committee objected to investing with unproven academics.  Oh, well, win some, lose some.
11. Speaking of academic research, here’s a non-mathematical piece on cognitive biases.  Economists believe that man is economically rational not because of evidence, but because it simplifies the models enough to allow calculations to be made.  They would rather be precisely wrong than approximately right.
12. Bit by bit, the efficient markets hypothesis get chipped away.  Here we have a piece indicating persistence of excess returns of the best individual investors.  For those of us that have done well, and continue to plug away in the markets, this is an encouragement.  It’s not luck.

I have enough for two more pieces on longer dated data.  It will have to come later.

Tickers Mentioned: NLY WFC CB SFG

Here are some posts that have caught my attention over the last month, but I never commented on because of the increase in volatility placed more of a premium on covering current events.

1. Will we ditch GAAP accounting for IFRS?  Personally, I don’t want to learn a new set of rules, but if it improves our ability to invest in a more global era, then maybe it will be a good thing.
2. Do we care if we have auditors or not?  BDO Seidman recently got hit for damages of $521 million.  If this damage amount stands, it will bankrupt them, and possibly eliminate the #5 auditor in the US.  My argument here is not over guilt, but merely the size of the award.  That said, if the damage amount stands my solution would be to award 30% of the ownership of BDO Seidman to the plaintiffs.  Let them earn it through shared profits.
3. Peter Bernstein takes my side in the understating inflation debate.  As I have said before, if you want to smooth inflation, use the median or the trimmed mean, which is more statistically robust than excluding food and energy.
4. Jeff Matthews comments on how many companies that paid large special dividends, or bought back too much stock are regretting it in this environment.  What should they say to shareholders, but won’t?  I’ve said that for years at RealMoney, but during a boom phase, who listens?
5. I found it fascinating that private issuances of equity via 144A are exceeding IPOs at present.  Only the big institutions get to invest, and they can only trade it to each other.  I experienced that as a bond manager, but for equities, this is new, and a growing thing.  Question: most trading will then be negotiated block trades as in the bond market.  If a mutual or hedge fund buys one of these 144A issues, how do they price it?  With bonds, it doesn’t usually matter as much, because things usually move slowly, but with equities?
6. Can we time the value premium?  (I.e., when do we invest in growth versus value?)  The answer seems to be no.  Value strategies work about two-thirds of the time, which makes them dominant, but not so much so as to overcome the more sexy growth investing.  This allows the anomaly to continue.  The end of the article concludes: The bottom line for investors is that the prudent strategy is to ignore the calls to action you hear from Wall Street and the media and adhere to your investment plan. The only actions you should be taking are to rebalance your portfolio and to harvest losses when that can be done in a tax-efficient manner.  I like it.
7. I’ll say it again.  Be careful with ETNs.  They may have tax advantages versus ETFs, but the hidden risk is that the sponsor of the ETN goes bankrupt, in which case you are a general creditor.  With an ETF, bankruptcy of the sponsor should pose little risk.
8. Hit me again, please.  If financials didn’t hurt me recently, then it was cyclicals.  Ouch.  Both are at risk, but for different reasons.  Financials, because of a fear of systemic risk.  Cyclicals, because of a fear of a slowdown stemming from an impaired financial system being unwilling/unable to lend.

I’ll try to post on the other half of this on Monday.  Have a great Sunday.

Assurant, which is still my favorite insurance company and stock, is down 10% as I write. The CEO, CFO, and EVP, Chief Actuary, and VP-Risk Management for Solutions/Specialty Property, have all received Wells notices, and are now on administrative leave.So what are the issues? Prior to its IPO, when it was a part of Fortis, Assurant entered into a treaty that provided a limited amount of reinsurance to Assurant’s property lines. From the 8/16/2005 NT 10-Q:

As disclosed in the Risk Factors section of Assurant, Inc.’s (the “Company”) Annual Report on Form 10-K for the year ended December 31, 2004, one of the Company’s reinsurers thinks the Company should have been accounting for premiums ceded to them as a loan instead of as an expense. Based on the Company’s investigation to date into this matter, the Company has concluded that there was a verbal side agreement with respect to one of the Company’s reinsurers under its catastrophic reinsurance program, which has accounting implications that may impact previously reported financial statements. While management believes that the difference resulting from any alternative accounting treatment would be immaterial to the Company’s financial position or results of operations, regulators may reach a different conclusion. In 2004, 2003 and 2002, premiums ceded to this reinsurer were $2.6 million, $1.5 million and $0.5 million, respectively, and losses ceded were $10 million, $0, and $0, respectively. This contract expired in December of 2004 and was not renewed.

From my reading, when the original reinsurance deal was done, the current CEO was CFO, and the current CFO was head of Solutions. So, all five were involved with the unit in question, so the Wells notices to the CEO and CFO do not necessarily mean that Assurant as a whole is implicated, just the Solutions unit, and not the Solutions unit’s current operations either. If earnings have to be restated, the net result should be near zero, and it would be only for 2002-2004.

It is possible that the finite reinsurance treaty in question may have smoothed earnings during the IPO and the first year, but from my angle, it seems to be going the wrong way. That said, in 2005, the audit committee found the side letter, which is the incriminating bit of data, which turned a reinsurance treaty into an accounting ploy that should have been treated as a loan.

There are only two risks here. Assurant loses five great employees, who get replaced from their exceptionally deep bench. No other insurer in the industry invests as much in their people as Assurant does. They have the people to fill the shoes, if need be. The second possibility is some sort of legal settlement, and in this day and age, who can tell how large that will be? For Ren Re on a more serious lapse on finite Re, the size of the fine was $15 million.

So, I have been buying Assurant today. Hasn’t been this cheap on earnings since 2004. You get a top quartile ROE insurer at a below market multiple.

Full disclosure: long AIZ

I have a friend who works for the Williams Inference Service.  Those who work for WIS spend their time looking for deep trends in our world that are underappreciated.  I dedicate a little of my time to that as well, and try to draw investable conclusions from odd bits of data that come across my radar.  But even without explicit conclusions, it richens my knowledge of our world, and perhaps with other data, will yield some return for me.  If nothing else, I love reading and writing, so join with me on this tour of articles around the web.

1. I’m not sure if pollution problems in China are any worse than the problems faced by the US or the UK at similar points in their development.  That said, one major constraint on their ability to grow is pollution.  These articles from the Wall Street Journal are an excellent example of that: heavy metals in the food supply, and lead in jewelry that they sell domestically and export, with the lead coming from US scrap metal.  These practices may allow businesses to survive in the short run, but soon enough, jewelry will get tested in the US, and importers sued for liability.  In China, there will be increasing pressure for change, perhaps even violent change.  In Chinese history, there is a tendency for change not happen, or to happen rapidly when troubles for average people become too great.
2. Demographics is a favorite topic of mine, particularly as the world slowly heads into a shrinking population.  For the most part, national economies don’t work so well when population levels shrink, which leads to pressure to import low skilled laborers from nations with surplus workers.  One nation that is at the front of the problem is Japan, where the population is shrinking pretty rapidly today.  Japan is now seeing that its pension system will be hard to sustain because of the lack of children being born.  Europe will face this problem as well.  The US less so, because of the higher birth and immigration rates; for us, the foreign debt will be our problem.
3. Is war with Iran a done deal in a few years?  I hope not.  Given the mismanagement of the Iranian economy in the hands of the cronyist mullahs that run the joint, and the genuine difficulty of producing effective nuclear weapons without a strong academic/technical/manufacturing base, my guess is that there will be another revolution there before a significant bomb gets made.  (We’re still waiting on North Korea; what a joke.)  Economically, Iran is a basket case.  As I have mentioned before, they have mismanaged their oil resources.  What is less noticed is their coming demographic troubles.  Not all Muslims are fanatics, and many are having small families, which will generate it’s own old age crisis thirty years out.  That said, if Iran is provoked, it’s leaders will not give in; they iwill fight, as the second article i cited points out.  Better to quietly hem the current Iranian leadership in by supporting their enemies, than to risk another war that the US does not have the resources to fight.  Iran is weaker and more divided than it looks; its government will fall soon enough.
4. Memo to all quantitative investors: are you ready for IFRS?  IFRS, the European accounting standard, particularly for financials will change enough things that older formulas of calculating value and safety may need to be severely modified.  The larger the importance of accrual items to an industry, the worse the adjustment will be.  All I say is, watch this.  If it changes, it will affect the way that we numerically analyze investments.  We are definitely losing foreign economies on our exchanges, mainly due to Sarbox, not accounting rules, but I think we are rushing through a compromise with IFRS to protect the interests of our exchanges, and I think that is a mistake.
5. Then again, maybe we don’t need the Europeans to mess up our accounting rules; we can do just fine ourselves.  Our accounting standards are a hodgepodge between amortized cost and fair value standards… we keep moving more and more toward fair value, but will the auditors be able to keep up?  Auditing amortized cost is one thing; there are different skills required when fungible but not liquid assets can be written up on a balance sheet. (Think about real estate or mortgage derivatives.)  Accounting will become less reliable in my opinion.
6. I wish we had a harder currency; why else do I buy foreign bonds?  Anyway, I appreciated this short partial monetary history of the US, from the Civil War onward, from Elaine Meinel Supkis.
7. When you can’t deliver the underlying, typically futures markets don’t work well.  It is no surprise then that a derivatives market on economic indicators closed.  Futures markets exist to allow commercial interests to hedge.  Where there is nothing to hedge, it is akin to mere betting, and without the extra thrill of a sports contest, that rarely attracts enough interest to be economic.  That said, aren’t the VIX futures and options contracts catching on?
8. Not sure what the second order effects will be here, but a rule is finally coming that will require the trade execution occur at the best price.  It will be extra work for the exchanges, but it will probably centralize exchanges in the intermediate term.  If you have to share data, why not merge?
9. One reason that Buffett was/is that best was his ability to learn from mistakes.  He kept his mistakes small and eventually found ways out of many of them.  US Air?  Salomon Brothers?  He eventually gets cashed out.  General Re?  The earnings from investing float bails him out. The “Shoe Group” and World Book?  Small, and you can’t win them all.
10. What do you do when the market has passed you by?  You got burned 2000-2002, and moved to a more conservative posture, only to find that the market ran like wild while you weren’t there.  What do you do now?  My advice: do half of what you would do if the market hadn’t run.  If you are at 20% equities, and you know that in normal times you should be at 60% equities, raise your investment level to 40% equities.  If the market rallies, you have more on, if it falls, you will have the chance to reinvest another 20% into equities at more attractive prices.
11. I usually agree with Eddy Elfenbein; he’s very common sense.  But here I do not.  Get me right here, Eddy is correct in all that he says.  I frame the problem differently.  You have someone sitting on cash, and the market has appreciated to where valuations are high-ish.  You can  1) invest it all now, 2) dollar cost average, or 3) do nothing.  Eddy doesn’t consider that many will choose 3.  On average, 1 beats 2 by a small margin, but 2 beats 3 by a wide margin.  Dollar cost averaging is a way to get psychologically unprepared people into the market who would never risk putting it all in at once.  We use DCA to get inexperienced investors from a bad place to a “pretty good” place, because the best place is unimaginable to them.
12. Desalination is the wave of the future, even in the US.  Potable water is scarce globally (think of India and China), and the cost of potable water justifies the energy and other costs associated with desalination.  The article that I cited does not capture the environmental costs of desalination, in my opinion, but it gives a good taste of what the future will hold.

And, with that, that completes my tour of the periphery.  Next week, I hope to provide more color for you on our changing risk environment.

As Paul mentioned in the comments on the last post, I answered a question at Stockpickr.com today. James Altucher, the bright guy who founded the site, asked me if I would answer the question, and so I did. Here is a reformatted version of my answer, complete with links that work:

Q: Any thoughts on how to value an insurance business? What are the best metrics to use? In particular I’m looking at small cap insurers (P&C) as potential acquisition targets. Does that change the methodology?

A: That’s not an easy question, partly because there are many different types of insurance companies, and each type (or subsector) gets valued differently due to the degree of growth and/or pricing power for the subsector as a whole.

Now, typically what I do as a first pass is graph Price/Book versus return on equity for the subsector as a whole, and fit a regression line through the points. Cheap companies trade below the line, or, are in the southeast corner of the graph.

But then I have to make subjective adjustments for reserve adequacy, excess/noncore assets, management quality, pricing power on the specific lines of business that write as compared to their peers, and any other factors that make the company different than its peers. When the industry is in a slump, I would have to analyze leverage and ability of the company to upstream cash from its operating subsidiaries up to the parent company.

Insurance is tough because we don’t know the cost of goods sold at the time of sale, which requires a host of arcane accounting rules. That’s what makes valuation so tough, because the actuarial assumptions are often not comparable even across two similar companies, and there is no simple way to adjust them to be comparable, unless one has nonpublic data.

My “simple” P/B-ROE method above works pretty well, but the ad hoc adjustments take a while to learn. One key point, focus on management quality. Do they deliver a lot of negative surprises? Avoid them, even if they are cheap. Do they deliver constant small earnings surprises? Avoid them too… insurance earnings should not be that predictable. If they become that predictable, someone is tinkering with the reserves.

Good insurance managements teams shoot straight, have occasional misses, and over time deliver high ROEs. Here are three links to help you. One is a summary article on how I view insurance companies. The second is my insurance portfolio at Stockpickr. The last is my major article list from RealMoney. Look at the section entitled, “Insurance & Financial Companies.”

Now, as for the small P&C company, it doesn’t change the answer much. The smaller the insurance firm, the more it is subject to the “Law of Small Numbers,” i.e., a tiny number of claims can make a big difference to the bottom line result. Analysis of management, and reserving (to the extent that you can get your arms around it) are crucial.

As for takeover targets, because insurers are regulated entities, they are difficult to LBO. Insurance brokers, nonstandard auto writers, and ancillary individual health coverage writers have been taken private, but not many other insurance entities. State insurance commissioners would block the takeover of a company if it felt that the lesser solvency of the holding company threatened the stability of the regulated operating companies. The regulators like strong parent companies; it lets them sleep at night.

One more note: insurance acquisitions get talked about more than done, because acquiring companies don’t always trust the reserves of target companies. Merger integration with insurance companies has a long history of integration failures, so many executives are wary of being too aggressive with purchases. That said, occasionally takeover waves hit the insurance industry, which often sets up the next round of underperformance, particularly of the acquirers.