Now, don’t take me too seriously here, but there is an easy way to solve the housing crisis.  We have too many homes for people with the means to buy them to occupy them.  We also have too much debt to foreigners that they don’t know what to do with.  Well, let’s kill two birds with one stone:  Make a one-time offer of green cards to any foreigner who is willing to buy a house in the US worth $250,000 or more, free and clear.

There are many advantages to this proposal:

• The foreigners that come will be wealthy, and will contribute even more to the US economy.
• They will appreciate the stability and freedom of the US, and will send back positive signal to their powerful friends back in the “old country.”
• Many will want a home in the US for vacations.  Others for a place to flee if politics turns against them in the “old country.”  Either way, we get more of their money.
• If we want foreigners as citizens, we will be skimming the cream, rather than Emma Lazarus’ comments on the Statue of Liberty.  (Now, if you want to know my heart, I like immigrants, especially poor ones… they work hard to make America great.)
• It solves problems in mortgage lending and the current account deficit in one fell swoop.

Now, this comes close to selling citizenship.  I don’t want that; they would still have to take the citizenship test, and  have the residency requirement.  Personally, I would like all new citizens to know English as well as  the 25th percentile in the US does now.  (low bar)

This is only partially serious; there are cultural aspects to immigration that are unpopular today.  I would only say to those that don’t like an idea like this, is that your great-grandparents (or so) were openly welcomed here a century ago.  Should we not welcome political, economic, and other migrants looking for a better life, even as our great-grandparents did?  Or are we more stingy than a generation that welcomed our great-grandparents, even if they had stronger negative views against those of different ethnic groups?

One of the troubles with the way that academic research in the social (and biological) sciences is set up, is that there is a bias toward publishing research that is statistically significant. Here are some of the problems:

1. If honestly done, there is value in publishing research that says there doesn’t seem to be any relationship between variable being studied and the cofactors. If nothing else, it would tell future researchers that that avenue has been checked already. Try another idea.
2. It encourages quiet specification searches, where the researcher tries out a number of different variables or functional forms, until he gets one with significant t-coefficients. Try enough models, one will eventually hit the 95% significance threshold.
3. What is statistically significant is sometimes not really significant. The result might be statistically significantly different than the null hypothesis, but be so small that it lacks real significance. I.e., learning that a compound increases cancer risk by one billionth should not be significant enough to merit attention.
4. Researchers are people just like you and me, and all of the foibles of behavioral finance apply to them. They want tenure, promotions, don’t want to be let go, respect from colleagues and students, etc. They have biases in the selection of research and the framing of hypotheses. For example, we can’t assume that stock price movements have infinite variance, because then Black-Scholes, and many other option formulas don’t work. The Normal distribution and its close cousins become a crutch that allows for papers to get published.
5. Once an idea becomes a researcher’s “baby”, they tend to nurture it until a lot of contrary evidence comes in. (I’ve seen it.)
6. Famous researchers tend to get more slack than those that are not well-known. I would trot out as my example here returns-based style analysis, which was proposed by William Sharpe. When I ran into it, one of the first things I noticed was that there were no error bounds on the calculations, and that the cofactors were all highly correlated with each other. The paper didn’t get much traction in the academic world, but was an instant hit in the manager selection consultant community. A FAJ paper in 1998 (I think) came up with approximate error bounds, and proved it useless, but it is still used by some consultants today. (I have many stories on that one; it is that only time that I wrote a pseudo-academic paper in my career to keep some overly slick consultants from bamboozling my bosses.)
7. Data sets are usually smaller than one would like, and the collection of raw data is expensive. Sample sizes can get so small that relying on the results of subsamples for various cofactors can be unreliable. This is a particular problem in the media when they publish the summary results on drug trials, but don’t catch how small the samples were. People get excited over results that may very well get overturned in the next study.
8. Often companies fund research, and they have an interest in the results. That can bias things two ways: a) A drug company wants their proposed drug approved by the FDA. A researcher finding borderline results could be incented to look a little harder in order to get the result his patron is looking for. b) A finance professor could stumble across a new profitable anomaly to trade on. That paper ends up not getting published, and he goes to work for a major hedge fund.
9. The same can be true of government-funded research. Subtle pressure can be brought on researchers to adjust their views. Politically motivated economists can ignore a lot of relevant data while serving their masters, and this is true on the right and the left.

The reason that I write this is not to denigrate academic research; I use it in my investing, but I try to be careful about what I accept.

Now, recently, I took a little heat for making a comment that I thought that the unadjusted CPI or median CPI was a better predictor of the unadjusted CPI than the “core” CPI. So, I went over to the database at FRED (St. Louis Fed), and downloaded the three series. I regressed six month lagged unadjusted, median, and core CPI data on unadjusted CPI data for the next six months. I made sure that the data periods were non-overlapping, and long enough that data corrections would induce little bias. I constrained the weights on my three independent variables to sum to one, since that I am trying to figure out which one gets the most weight. My data set had 80 non-overlapping six-month observations stretching back to 1967. Well, here are the results:

• Intercept: -0.0002 (good, it should be close to zero)
• Unadjusted CPI: 0.1720 (prob-value 12.3%)
• “Core” CPI: -0.1665 (prob-value 11.2%)
• Median CPI: 0.9945 (no prob-value because of the constraint imposed)
• Prob-value on the F-test: 24.3% (ouch)
• Adjusted R-squared: 1.10%. (double ouch)

What does this tell me? Not much. The regression as a whole is not significant at a 95% level. Does the median CPI (from the Cleveland Fed) better predict the unadjusted CPI than the “core” or unadjusted CPI? Maybe, but with these results, who can tell? It is fair to say that core CPI does not possess any special ability to forecast unadjusted CPI over a six-month horizon.

From basic statistics, we already know that the median is a more robust estimator of central tendency than the mean, when the underlying distribution is not known. We also know that tossing out data (”core”) arbitrarily because they are more volatile (and higher) than the other components will not necessarily estimate central tendency better. Instead, it may bias the estimate.

So, be wary of the received opinion of economists that are in the public view. Our ability to use past inflation measures to predict future inflation measures is poor at best, and “core” measures don’t help in the explanation.

So FGIC requests to be broken in two.  Personally, I expect that it stemmed from giving into strong-arming from the New York Department of Insurance and perhaps the Governor as well, but if I were FGIC, I would want to do this.  Who wouldn’t want the option of splitting his business in two during a crisis, putting the good business into subsidiary A, which will stay solvent (and protect some of your net worth) and putting the bad business into subsidiary B, which will go insolvent, and pay little to creditors?

In many other situations this would be called fraudulent conveyance, but when you have a state government behind you, I guess it gets called public policy.  The NY Insurance Department tries to sidestep a big insolvency by creating favored classes of insureds.

Those with concentrated interested in non-municipal guarantees should band together to protect their rights, and sue FGIC and NY State (seeking punitive damages) to block the breakup.  The question is, who will be willing to bear the political heat that will arise from this, and oppose an illegal “taking?”

I’ve been involved in financial reporting for a large amount of my career, so even though I’ve never had an accounting course in my life, I’ve had to work with some of the most arcane accounting rules out there as an actuary, and later as an investor.  Over the years, the direction that the FASB and IASB have gone is in the direction of presenting the statement of financial position (balance sheet) on more and more of a fair market value basis.  (Please ignore the treatment of goodwill, advertising,  R&D, you get the idea though…)  To soften the blow on the income statement, changes in the value of many balance sheet items don’t get run through net income, but through accumulated other comprehensive income, so that income can reflect sustainable earnings power, in theory.  Now, I agree with Marty Whitman’s critique on these accounting issues.  We may be getting more accurate on individual companies (if the accounting is done by angels, for humans we are granting too much freedom), but we are losing comparability across companies.  What an item means on the balance sheet of one company may be considerably different than the value at another company.
The hot topic today is SFAS 157 and 159.  I would point you to Dr. Jeff’s article this evening on the topic.  I would like to give my perspective on this, becaue I have had to work with these accounting rules, and ones like them.

At one company that I managed money for, I originated a bunch of long duration high quality assets that did not trade.  At year end, our incentive payment was based on the total return that we generated.  Interest rates had fallen through the year, and so my high quality illiquid assets had yields well in excess of where new money could be deployed.  What were those assets worth?  Historic cost?  The cash flow streams were fixed.  As a conservative measure, though spreads over Treasury yields had fallen for those instruments, we kept the spreads from the issue, and accounted for the price change due to the move in Treasury yields.  (If spreads had risen, I would have argued that we move the spreads up as a conservative gesture.)  Now this was prior to SFAS 157, but it illustrates the point.  How do you calculate the value of illiquid instruments?  Worse, under SFAS 157, you can’t be conservative; you have to try to be realistic.

Now, that was a simple example.  Almost every moderate-to-large life insurance company has a variety of illiquid privately placed bonds for which there is no market.  What is the fair value?  Who can tell you?  Well, the broker(s) that brought the deal are supposed to provide continuing “color” on the bonds, and what few trades might transpire.  Typically, they don’t move the prices much as the interest rate and spread environments change, and third party pricing services are loath to opine on anything too illiquid.  Though the rating agencies night give a rating at issue, they might not update it for some time.  What’s the fair value?  The life insurer has a hard time determining that for that small minority of assets.

Now let’s take it to a yet more difficult level.  If we are talking about many asset-backed securities, they are generic enough that pricing models can determine a spread to Treasury or Swap yields for tranches with a given vintage, maturity, originator, and rating.  Yes, there will be many assets that “trade special,” but those are deviations from the model that the traders feel out.

With CDOs, things get more difficult, because aside from indexed CDOs, there is no generic structure.  The various tranches are bought and held.  They rarely trade.  Projecting the cash flows is a difficult talk, because there are many different bonds in the trust, with many different scenarios for how many will default, and what recoveries will be obtained.  The best a good simulation model can do is to illustrate what a wide variety of possibilities could be, and look at the average of those possibilities.  Even then, the modeler has an expected cash flow stream.  What’s the right discount rate to use?

There is no good answer here.  One can try to infer a rate from what few trades have happened in the market with similar instruments, but that can be unreliable as well.  During a bear market, the sellers will be more incented than the buyers, particularly if they are trying to realize tax losses.  One can try to look at the scenarios across the tranches, and see which tranches have cash flows that behave like bonds, equities, and warrants, and apply appropriate discount rates like 6%, 20%, and 40% respectively.  Some explanation:

• Bonds: pays interest regularly, and principal within a narrow window.  Few deferrals of interest.
• Equities: high variability of payoffs.  Pays something in almost all scenarios, but the amounts vary a lot.  Timing and existence of principal repayment varies considerably.  Interest deferrals are common, but rarely last long.
• Warrants: many scenarios have very low or zero payoffs.  Some scenarios have significant payoffs.  Interest deferrals last a long time, many never end.  Principal payments are rare.

Estimating fair value in a case like this is tough, if not impossible.  But a fair value must be estimated anyway.  Management teams may try to make the third party estimator come to a certain value that fits their accounting goals.  Given the squishiness of what the discount rate ought to be, management teams could say that once the market normalizes a low discount rate will prevail, and our models should reflect normalized, not panic conditions.

Well, good, maybe.  The thing is, once we open Pandora’s box, and allow for flexibility in valuation methods, subject to auditor sign-off (now, who is paying them?), our ability as third party investors to evaluate the value of illiquid assets and liabilities declines considerably.  There’s a great argument here for avoiding companies that own/buy complex assets in an era where fair value accounting reigns.  There is too much room for error, and human nature tells us that the errors are not likely to yield positive earnings surprises for investors.

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.

I really enjoyed being an investment grade corporate bond manager.  I enjoyed interacting with credit analysts and sales coverages, and the hurly-burly of price discovery in markets that were thinner than optimal.  My credit analysts were professionals, and I never went against them; at most, I would explain to them why market technicals favored a delay in the action they proposed.  But I would never permanently disagree.  What they wanted to buy I would buy, and sell I would sell, eventually.  The level of communication evoked greater effort from them.  Machiavelli was wrong.  It is better to be loved than feared, at least in the long run.  I have gotten more out of associates and brokers by being altruistic than through transactional constraint.  People will give far more to someone that cares for them, than someone that threatens them, in the long run.  (The short run is another matter…)

Now, this is not my character.  I tend to be shy, and constant interaction pushes me out of my comfort zone.  But when others are depending on me, I push myself harder, and do what needs to be done for the good of others.  I can’t let down those who rely on me.

Yesterday I had lunch with three friends and a new friend.  Two were sales coverage, and two from the firm that I used to work for.  It was fascinating to hear the tales of woe in the structured securities markets (worse than I expected, and I am cynical).  It was also fascinating to consider why investors for a life insurance company, which has a liability structure that would allow them to buy and hold temporarily distressed assets, does not do so.   A lot depends on how short-term the investment orientation of the client is, and this client is definitely short-term oriented.

I talked about my new CDO model, and about what I write about for all of you who read this blog.  The summary of our discussions is that it is a tough environment out there, and one that is particularly not kind to complex securities.  After the lunch, which the sales coverages generously paid for (at present, I don’t know what I can do for them), I went back to the office of my old friends, and reacquainted myself with one of the best consumer/retailing credit analysts period, who is a very nice woman.  I also talked with my former secretary, who is sweet, and was always a real help to me and all of the staff.

Friends.  I am richer for them.  I am richer for being one.  Beyond that, it is excellent business to live life in such a way that your business dealings leave people happy for having dealt with you.  I am truly blessed for all the business friends that I have gained.

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’m about to add advertising to my blog, and I’d like to ask a small favor from my readers.  If you happen to see an advertisement that is morally objectionable, please send me an e-mail.  Include the URL of the ad.  Examples would include:

• Payday lenders
• Gambling
• Tarot Reading
• Known Investment Scams

There are likely more, but that’s a start.  Google on ads is not “don’t be evil,” but rather, is amoral in their ad filtering, not allowing even for rudimentary category blocking.  One has to block ads URL by URL.  Klunky, if you ask me.

Again, thanks to all my readers for their help in making this a better site.

Early on Monday, Cramer put up a piece called, “KKR: Cut the Hubris, Start the Healing.” Good piece generally, but it got me thinking. One reason I was an effective corporate bond manager was the way that I treated my brokers. I had a few rules:

• My brokers must always be paid. Doing me favors is nice, but I want your long term loyalty, and confidentiality.
• If a broker makes a mistake in your favor, give him back a portion of the error if he asks (20%-30% of the price difference).
• Hold good on my commitments, even if it hurts.
• If the broker is way out of the market context, tell him. It earns loyalty.
• Use brokers to their highest ability levels. Know who is sharp in a given market, and use them there. Don’t waste their time on names they don’t know.
• If their risk control desk is forcing them to kick out a position, try to help them. This is an Androcles and the Lion situation, so be a good Androcles. They will often offer you some good deals for helping them, beyond that, that will help you when you need it.
• Don’t take advantage of them in obvious ways. If you must flip newly issued bonds, do it through the syndicate (with a polite explanation that your analyst doesn’t like the deal, or that your risk controls are forcing you), or through a quiet third party.
• Be as transparent as possible without giving away the real secrets of what you are doing. You can get better execution if they know you are not acting on private information that they don’t possess.
• Be sharp. Show them that they can’t take advantage of you, but don’t be arrogant about it. Let your performance speak for itself.

That was a long digression, but here’s the point: focus on the long term value of the business relationship. Most bond managers and traders are very short term in their orientation, and it keeps the Street wary of them. The Street holds them at arm’s length, and the handshake is not friendship, but a check for weapons up the sleeve, as in the old days.

So what does this have to do with private equity and the banks? The private equity firms that have financing guaranteed by the banks have the banks over a barrel. At the same time, their deals are delayed, because the banks are dragging their feet. The solution isn’t hard, but it means that the private equity firms must give up a little in the short run to get the long run. Give up 20-30% of the loss that the banks are taking in order to soften the blow. Do it in a way that allows the banks to spread the loss, if you are clever enough, by agreeing to covenants, or other non-interest-rate means of improving the position of the banks.
The banks will groan, but they know that this is the best that they will get, and will take the deal. The log jams will begin to break, and the market will return to “normal,” though with more covenants and fewer guarantees on future deals. That is, until the next craze hits.

Therefore, I wasn’t surprised when KKR agreed to a minimum EBITDA covenant (earnings available to pay the creditors). That’s what is needed to allow the banks to “save face,” and do the deal. There are a lot of pending commitments in the loan market, perhaps as high as $540 billion. If you are a major private equity firm, and you have multiple deals being held up, these small compromises will grease the skids for not only today’s deal, but all of the deals in the pipeline. For those few that don’t compromise, yes, the deal will get done eventually, but you will sour relationships on the Street.

Now, the banks may get some help as they seek financing for the deals. This is one place where the vultures are lining up. Private equity, hedge funds, hedge fund-of-funds, and banks are setting up funds to take advantage of the dislocation. This “crisis” will likely resolve more easily than the troubles over in mortgage finance.
In closing, five more random bits on private equity:

1. When I look at the stock chart of Blackstone, it makes me want to find a black stone and toss it in to a pond to watch it sink. Quite an untimely stock offering.
2. The rise in financing rates will cost private equity on future deals, and as they try to harvest their existing deals when they come to maturity.
3. Now, private equity funds with uncommitted capital can benefit by purchasing deals cheaply from firms that are exiting.
4. Here is an excellent article from Going Private on the concept of liquidity within private equity financing. It’s long but good, and my commentary can’t improve on it, so enjoy it.
5. Finally, private equity is concerned about financing, but should be concerned the possibility of recession as well. After all, junk bonds and bank debt are very sensitive to slowdowns in economic activity.

As I said to a friend of mine once, it often pays to give up a little to get long term advantages. Private equity needs to show a little mercy here in order to do well in the long run. Investment banks are powerful friends to have, and they remember who has helped them, and who has hurt them.

Tickers mentioned: BX

1. August wasn’t all that bad of a month… so why were investors squealing? The volatility, I guess… since people hurt three times as much from losses as they feel good from gains, I suppose market-neutral high volatility will always leave people with perceived pain.
2. Need a reason for optimism? Look at the insiders. They see more value at current levels.
3. Need another good investor to follow? Consider Jean-Marie Eveillard. I’ve only met him once, and I can tell you that if you get the chance to hear him speak, jump at it. He is practically wise at a high level. It is a pity that Bill Miller wasn’t there that day; he could have learned a few things. Value investing involves a margin of safety; ignoring that is a recipe for underperformance.
4. Call me a skeptic on 10-year P/E ratios. I think it’s more effective to look at a weighted average of past earnings, giving more weight to current earnings, and declining weights as one goes further into the past. It only makes sense; older data deserves lower weights, because business is constantly changing, and older data is less informative about future profitability, usually.
5. I found these two posts on the VIX uncompelling. Simple comparisons of the VIX versus the market often lead to cloudy conclusions. I prefer what I wrote on the topic last month. When the S&P 500 is below the trendline, and the VIX is relatively high, it is usually a good time to buy stocks.
6. What does a pension manager want? He wwants returns that allow him to beat the actuarial funding target over the lifetime of the pension liabilities. If long-term high quality bonds allowed him to do that, then he would buy them. Unfortunately, the yield is too low, so the concept of absolute return strategies becomes attractive. Well, after the upset of the past six weeks, that ardor is diminished. As I have said before, to the extent that hedge funds seek stable, above average returns, they engage in yield-seeking behavior which prospers as credit spreads and implied volatilities fall, and fail when they rise. Eventually pension managers will realize that hedge fund returns cannot provide returns over the full length of the pension liability, in the same way that you can’t invest more than a certain amount of the pension assets in junk bonds.
7. Is productivity growth slowing? Probably. What may deserve more notice, is that we have larger cohorts entering the workforce for maybe the next ten years, and larger cohorts exiting as well, which will decrease overall productivity. Younger workers are less productive, middle-aged most productive, and older-aged in-between. With the Baby Boomers graying, productivity should fall in aggregate.
8. This is just a good post on sector data from VIX and More. It’s worth looking at the websites listed.
9. Economic weakness in the US doesn’t make oil prices fall? Perhaps it is because the US is important to the global economy, but not as important as it used to be. It’s not hard to see why: China and India are growing. Trade is growing outside of the US at a rapid pace. The US consumer is no longer the global consumer of last resort. Now we get to find out where the real resource shortages are, if the whole world is capitalist in one form or another.
10. Calendar anomalies might be due to greater macroeconomic news flow? Neat idea, and it seems to fit with when we get the most negative data.
11. Is investing a form of gambling? I get asked that question a lot, and my answer is in aggregate no, because the economy is a positive-sum game, but some investors do gamble as they invest, while others treat it like a business. Much depends on the attitude of the investor in question, including the time horizon and return goals that they have.
12. Massachusetts vs. the laws of economics. Beyond the difficulty of what to do with expensive cohorts in a public insurance system, I’ve heard that they are having difficulties that will make the system untenable in the long run… most of which boil down to antiselection, and inability to fight the force of aging Baby Boomers.
13. Rationality is one of those shibboleths that economists can’t abandon, or their mathematical models can’t be calculated. Bubbles are irrational, therefore they can’t happen. Welcome to the real world, gentlemen. People are limitedly rational, and often base their view of what is a good idea, off of what their neighbor thinks is a good idea, because it is a lot of work to think independently. Because it is a lot of work, people conserve on hard thinking, since it is a negative good. They maximize utility where utility includes not thinking too hard. Any surprise why we end up with bubbles? Groupthink is a lot easier than thinking for yourself, particularly when the crowd seems to be right.
14. Is China like the US with 120 years of delay? No, China has access to better technology. No, China does not have the same sense of liberty and degree of tolerance of difference. Its culture is far more uniform from an ethnic point of view. It also does not have the same degree of unused resources as the US did in the 1880s. Their government is in principle totalitarian, and allows little true freedom of religious expression, which is critical to a healthy economy, because people work for more than money/goods, but to express themselves and their ideals.
15. As I have stated before, prices are rising in China, and that is a big threat to global stability. China can’t continue to keep selling goods without receive goods back that their workers can buy.
16. The US needs more skilled immigrants. Firms will keep looking for clever ways to get them into the US, if the functions can’t be outsourced abroad.
17. It’s my view that dictators like Chavez possess less power than commonly imagined. They spend excess resources on their pet projects, while denying aid to the people whom they claim to rule for their benefit. With inflation running hard, hard currencies like the dollar in high demand, and the corruption of his cronies, I can’t imagine that Chavez will be around ten years from now.
18. Makes me want to buy Plum Creek, Potlach, or Rayonier. The pine beetle is eating its fill of Canadian pines, and then some, with difficult intermediate-term implications. More wood will come onto the market in the short run, depressing prices, but in the intermediate term, less wood will come to market. Watch the prices, and buy when the price of lumber is cheap, and prices of timber REITs depressed.
19. Pax Romana. Pax Americana. One went decadent and broke, the other is well on its way. I love my country, but our policies are not good for us, or the world as a whole. We intrude in areas of the world that are not our own, and neglect the proper fiscal and moral management of our own country.
20. Finally, it makes sense for economic commentators to make bold predictions, because there’s no such thing as bad publicity. Sad, but true, particularly when the audience has a short attention span. So where does that leave me? Puzzled, because I enjoy writing, but hate leading people the wrong way. I want to stay “low hype” even if it means fewer people read me. At least those who read me will be better informed, even if it means that the correct view of the world is ambiguous.

Tickers mentioned: PCH PCL RYN