In general, people don’t do well with amounts of money significantly larger than they are used to handling.  The most obvious example of that is people who win lotteries.  The money typically gets wasted — bad purchases, bad investments.

Thus I would encourage you to be very careful with any large distributions of money that you might receive.  Examples include:

  • Life insurance settlements
  • Disability insurance settlements
  • Structured settlements arising from winning a court case over a tort against you.
  • Lotteries
  • Pension lump sums
  • Inheritances
  • Big paydays, if you are one of the rare ones in a high-paying short career like entertainment or sports

There are three problems with lump sums — receiving them, investing them, and rate of their use for consumption.  Let me take these topics in the order that they should occur.

Receiving a Lump Sum

Let’s start with the cases where you have a stream of payments coming where a third party comes to you and says that you can get all of the money now.  I am speaking of structured settlements and inheritances where trusts have been structured to dole out the money slowly.  There is one simple bit of advice here: don’t do it.  Take the payments over time.  None of the third parties offering to give you cash now are giving you a good deal, so avoid them.

Then there are the cases where an insurance company is making the payments from a disability claim, a structured settlement, a lottery, a pension buyout, or an annuity that someone bought for you on your life.  The insurance company will be more fair than any third party, because they aren’t usually looking to make an obscene gain, just a big one, because it reduces their risk, and cleans up their balance sheet, so they can do more business.  One simple bit of advice here: still don’t do it.  You can do better by taking payments, and building up money for larger purchases.  Be patient.

People do best when they receive money little by little.  When they get money materially faster than the speed at which they have previously earned money, they tend to waste it.  It is almost always better not to take a lump sum if you have the option to do otherwise.

The last set of situations is when the party that owes the set of payments offers you a lump sum.  It could be a life insurance company, a defined-benefit pension plan, a lottery, or some option uncommonly granted by another payor.  I would still tell you not to do it, but the issue of getting cheated is reduced here for a variety of reasons.

The defined benefit plan has rates set by law at which it can cash you out, so they can’t hurt you badly.  That said, you will likely not earn enough off of your investments with safety to equal the stream you are giving up.  The lottery is often similarly constrained, but do your homework, and see what you are giving up.

One place to take the lump sum is with life insurance companies off of a death benefit.  The rates at which they offer to pay an annuity to you are frequently not competitive, so take the lump sum and invest it wisely.

Economically, the key question to ask on a lump sum versus a stream of payments is what you would have to earn to replicate the stream of payments.  Most of the time, the stream is worth more than the lump sum, so don’t take the lump sum.

The second question is more important.  Can you be disciplined and not waste the lump sum?  Ask those close to you what your money habits are like, if you don’t know for sure.  Ask them to be brutally honest.

Investing the Lump Sum

Again, one nice thing about taking payments, is that you don’t have to invest the lump sum.  If you do take the lump sum:

  • First, pay off high interest rate debts.
  • Second, avoid buying big things and calling them investments.  Don’t buy a big house when you don’t need a big one.
  • Third, don’t invest in any of your relatives’ or friends’ business ventures.  Tell them you try to keep personal affection and money separate.  It avoids hurt feelings.
  • Fourth, look at the time horizon of your real needs.  Plan for retirement, college, etc.  Invest accordingly — get a trustworthy adviser who will help you.  Trustworthiness is the most important factor here, with competence a close second.
  • Fifth, don’t so it yourself, unless you have developed the skill to do it previously.  If you want to do it yourself, you will have to gauge whether the various markets are rich or cheap in order to decide where to invest.  For some general, non-tailored advice, you can look at articles in my asset allocation category.  As an aside, don’t invest in anything unusual unless you are an expert.

Receiving Spending Money from Your Investment Fund

The first thing is to decide on a spending rule: many use a rule that says you can take 4% of the assets from the fund.  My rule is a little more complex, but will keep you safer, and adapt to changing conditions: as a percentage of assets, take 1% more than the yield on the 10-year Treasury Note, or 7% if less.  At present, that percentage would be 2.21% + 1% = 3.21%.

Whatever rule you use, be disciplined about your spending.  Don’t bend your spending rule for any trivial reasons.  Size your budget to reflect your income from your investment fund and all of your other income sources.


Remember that most people who get a lump sum end up wasting a lot of it.  The only thing that can keep you from a similar fate would be discipline.  If you don’t have discipline, don’t take a lump sum.  Take the payments over time.  That will give you the maximum benefit from what is a very valuable asset.

Photo Credit: Insider Monkey || Carl never looked so good.

Picture Credit: Insider Monkey || Carl never looked so good.

I’ve written about this topic twice before:


Those were back in 2008, before the financial crisis.  I made similar comments at RealMoney earlier than that, but those are lost and gone forever, and I am dreadful sorry.

I’ve written a lot about AIG over the years, including my article that was cited by the Special Inspector General of the TARP in his report on AIG.  I’ve also written a lot about insurance investing.  I’d like to quote from the final part of my 7-part series summarizing the topic:

1) The first thing to realize is that diversification across insurance subindustries usually does not work.

Do not mix:

  • Life & P&C
  • Financial & Anything
  • Health & Anything

Maybe you can mix P&C, Mortgage & Title, after all Old Republic survived.  The main point is this.  Insurance is not uniform.  Coverages are sold and underwritten differently.  Generally, higher valuations will be obtained on “pure play” companies  Diversification is swamped by management inability.  These are reasons for AIG and Allstate to spin off their life operations.

2) Middle-sized companies tend to do best from a valuation standpoint: the large have nowhere to grow, and the small are always questionable on their viability.  With a few exceptions, I like sticking with focused mid-cap companies with my insurance names.

Both of these concepts augur in favor of a breakup of AIG — even without the additional capital needed for being a SIFI (which no insurance firm should be, they don’t collapse together, like banks do), large firms get a valuation discount, because they can’t grow quickly.

Synergies and diversification benefits between differing types of insurance tend to be limited as well.  Focus is worth a lot more in insurance than diversity, because managements are typically not good at multiple types of insurance.  They have different profit models, distribution systems, capital needs, and mindsets.  Think of it this way: if you can’t get personal lines agents to sell life insurance and annuities, why do you ever think there might be synergies?  They are very different businesses.

Now Carl Icahn is arguing the same thingsize and diversification are harming value at AIG, as well as a high cost structure.  I think his first argument is right, and a breakup should be pursued, but let me mention four complicating factors that he ought to consider:

1) Costs aren’t overly high at AIG, and there may not be a lot to cut.  Greenberg ran a tight ship, and I suspect those who followed tried to imitate that.  I would try to double-check cost levels.

2) ROEs are low at AIG likely because many life insurers have low embedded margins and those can’t be changed rapidly because of the long duration nature of the contracts.  The accounting for DAC [deferred acquisition cost] assets can be liberal at times — writedowns are not required until you are deferring losses.  I would analyze all intangible assets, and try to estimate what they returning.  I would also try to look at the valuation of life insurers comparable to those at AIG, which are high complexity beasties.  You might find that a breakup won’t release as much value as you think, at least initially.

3) Pure play mortgage insurers are fodder for the next financial crisis.  If one of those gets spun off, it won’t come at a high valuation, particularly if you give it enough capital to maintain its credit ratings.

4) There are a variety of cross-guarantees across AIG’s subsidiaries.  I’m assuming Icahn read about those when he looked through the statutory books of AIG.  That is, if he did do that.  They are mentioned in the 10K, but not in as much detail.  Those would probably be the most difficult part of a breakup of AIG, because you would have to replace guarantees with additional capital, which reduces the benefit of breaking the companies up.


Breaking up AIG would be difficult, but I believe that focused insurance companies with specialist management teams would eventually outperform AIG as it is currently configured.  Just don’t expect a quick or massive initial benefit from breaking AIG up.

One final note: it would pay Carl Icahn and all of the others who would be interested in breaking up AIG to hire some insurance expertise.  Insurance is a set of complex businesses, and few understand most of them, much less all of them.  It would be easy to naively overestimate the ability to improve profitability at AIG if you don’t know the business,  the accounting, and how free cash flow emerges, if it ever does.

They might also want to have a frank talk with Standard and Poors as to how they would structure a breakup if the operating subsidiaries were to maintain all of their current ratings.  Icahn and his friends might be surprised at how little value could initially be released, if any.


Full disclosure: long ALL


Before I start on this tonight, let me say that I never begrudge any salesman a fair commission.  When I was a bond manager, I made a point of never letting my brokers “cross bonds” to me, i.e., at no commission.  I would raise my purchase price a little to compensate them.  Had my client known that I did that, he might have objected, but it was in his best interests that I did it.  As a result of that and other things that I did, my brokers were very loyal to me, and worked to give my client excellent executions whether buying or selling.  They were also more frank with me about bonds they thought I should sell.  Fairness begets fairness under most conditions, and suspicion and tightness also have their way of breeding as well.  Consider that in all of your dealings.

My main reason for writing tonight is to remind investors to think about how the parties you transact with are compensated.

  • If they are compensated on transactions, expect to see a lot of buying and selling.
  • If they are compensated on asset-based fees, expect them to try to get business, and then retain it.
  • If they are compensated on profits, they will try to get profits.  Be wary of how much control they might have over the accounting, they will be incented to be liberal if they have any control.  They will also be incented toward volatility, because volatile assets offer the best possibility of a big score, even if the probability is moderate at best.

The greater the potential compensation, the greater the tendency to act along the incentives offered.  As a result, if a life insurance salesman has a product offering a high commission, and one offering a low commission, he may act in the following way:

  • Figure out if you are price-sensitive or not.
  • Figure out if you are willing to accept a product that has a long surrender charge.  Long surrender charges lock in business, and allow for high commissions to be paid.
  • Also analyze how much complexity you are willing to accept — more complex permanent policies and especially ancillary riders are far more profitable because even external actuaries would have a tough time analyzing them.
  • If you are price-sensitive, bring out the low commission policy that is more competitive.
  • If you are price-insensitive, bring out the high commission policy that is less competitive.

(Note: there are state laws in every state that constrain this behavior for life insurance agents, but it can never be eliminated in entire.)

Now, many agents will act in your interests in spite of their own interests, but some won’t, so be aware.  Always ask a question like, “This seems expensive.  Don’t you have another policy that is less expensive that accomplishes only the main goal that I am shooting for?”

You could always ask them what commission is that they will earn.  Most won’t answer that.  First, it’s kind of offensive, and second, they will argue that it is not material to your decision.

But it is material to your decision.  Here’s why:

  • The size of the commission directly affects the size of the premium that you pay.
  • It also directly affects the length and size of the surrender charge that you would pay if you terminate the policy early.
  • After all, the actuaries or other mathematical businessmen are trying to avoid the risk of paying a commission that they can’t recover under ALL circumstances.  They will get their fees from you to recoup the commission cost.  They will either get it from you coming or going, but they WILL get it from you, at least on average.

If the salesmen disagree with you after mentioning this (or showing them this), you can say to them that every actuary knows this is true, don’t argue with the actuaries, they know the math.  (And its why we tend to buy term and other simple policies.  Shhh.)

I’ve seen more than my share of ugly products in my time.  I’m happy I never designed any.  I did kill a few of them.  That said, one of the most unpleasant duties I ever had as a life actuary was about 18 years ago when I inherited a department to clean up, and I got the responsibility of talking to the clients that were the most irate, demanding to talk to the man in charge.  I never created those products, but I was nominally in charge of the division as I cleaned up the pricing, reinsurance, reserving, accounting, and asset-liability management.

I’ll tell you, it is no fun talking to people who conclude that they have been had.  It is even less fun to be the one who has been had.  Thus I would tell you to view all salesmen of financial with skepticism.  It is hard to assure a good result with intangible products that are hard to compare.  Thus aim for simplicity and lower surrender charge and commission products.

Now, I used life insurance as my example here because I know it best, and it excels in complexity.  But this applies to all financial products, especially illiquid ones.  Be wary of:

  • Brokers who make money off of commissions
  • Those who sell private REITs and structured notes
  • Any product where you have a limited ability to liquidate or sell it.
  • Any product that you can’t understand how the company and salesman are making money off it.
  • Any product where you can’t understand what the legal form of the investment is (Stock, bond, mutual fund, partnership, derivative, insurance, etc.)

Here are some final bits of advice:

  • Look for advisers who are fiduciaries, and are responsible to look out for your interests (but still be wary)
  • Look at the fee structures, and look for lower cost alternatives.
  • Seek competing products, salesmen and companies.
  • Negotiate lower compensation where possible.
  • Remember that higher yields are almost never free… what yields more typically has more risk.  Yield is the oldest scam in the books.

Remember, regardless of what laws exist, you are your own best defender when it comes to your own economic interests.  Be aware of the economic incentives of those who seek your business with financial products, and be reasonably skeptical.

Photo Credit: Mike Beauregard || Frozen solid, right?

Photo Credit: Mike Beauregard || Frozen solid, right?

The talk regarding an illiquid public corporate bond market goes on, and if you’ve read me over the past year on this topic, you know that I don’t think it is a serious issue.  One of the reasons why it is not a big issue is that the public bond market is designed to be low liquidity.

It starts with how bonds are originally issued.  New bonds and new stocks are issued in similar ways, but with a few differences:

  • IPOs of stocks have a higher retail component.  Bonds, aside from muni bonds, are typically almost entirely institutional
  • IPOs are typically priced cheap, but with bonds the cheapness is smaller and more frequent.
  • Bond IPOs usually happen with companies that have issued other bonds before
  • Bond IPOs happen more frequently, except in a bear market
  • Bond IPOs typically happen more rapidly, minutes to a few days, except in a bear market

IPOs on Wall Street get allocated if they are oversubscribed.  When they are oversubscribed, the deal is typically good, and everyone wants more, so they put in huge orders.  The dealer desks on Wall Street solves this problem by allocating proportionate to the size that they have come to understand the managers in question typically buy and sell at, with some adjustment for account profitability.

Those that flip cheap bonds for a quick profit typically get penalized, and their allocations get reduced.  Those that buy bonds in the open market when the deal breaks and becomes “free to trade” can become eligible for larger allocations.  The dealer desks work in this way because they want the buyers to be long-term holders, and not seekers of easy profits from flipping.  That doesn’t mean you can never trade a bond you have bought — just not in the first month, subject to a few exceptions like a small allocation, your credit analyst rejected it, etc.  (Oh, and if one of those exceptions exists, the primary dealers want to do the secondary trade.  If the exceptions don’t exist, they don’t want to know about it.)

If flippers ever get big, despite the efforts of the dealer desks, they will price a deal very tight, and let the flippers take a big loss, with no one wanting to buy the excess bonds unless they are much, much cheaper.

The main effect of this is that once a deal is allocated, it is typically “well-placed,” with few secondary trades after the IPO.  This is even more pronounced with mortgage bonds, which aside from the AAA tranches, have very small tranche sizes, making them very illiquid.

In this environment, where yields have fallen over the past few years, it is difficult for financial companies that have bought bonds to replace the income if they sell the bond.  Thus, few bonds will be sold unless they are in the hands of buyers that don’t have a formal balance sheet, or, when credit quality is deteriorating badly.

Add in one more factor, and you can see why the market is so illiquid — the buy side of the market is more concentrated than in prior years, with big buyers like PIMCO, Blackrock, Metlife, Prudential, etc. being a larger portion of the market.  Concentrated markets with few holders tend to be less liquid.

All Good/Bad Things Must Come to an End

Some of these factors can be reversed, and others can be mitigated.

  • There’s no reason why the buy side has to stay concentrated.  Big institutions eventually break up because diseconomies of scale kick in.  Management teams typically do worse as companies get more complex.
  • Eventually interest rates will rise.  Once bonds are in a nearly neutral to negative capital gains positions, parties with balance sheets will trade bonds again.
  • Even mutual funds that own a lot of yieldy bonds can have a strategy for dealing with the illiquidity.  Yieldy bonds have excess yield relative to bonds of similar duration and credit quality, and are often less liquid because there is something odd about them that makes some portion of the market skeptical, which reduces liquidity.  A mutual fund holding a lot of less liquid bonds, can deal with illiquidity by selling opportunistically, selling more liquid bonds in the short-run, while discreetly inquiring on a few less liquid issues to see where real bids might be.  Remember, the amount of underperformance is likely to be limited, if any, so a run on a mutual fund is not likely, but in the unlikely case of a run, this can mitigate the effects.  Personally, I would not be concerned, so long as you keep your pricing marks conservative if cash outflows become a rule in the short-run.

In closing, don’t worry about illiquidity in the bond markets.  If there is a need for liquidity, the problem will solve itself as sellers lose a little bit in order to gain cash to make payments.  It’s that simple.

Photo Credit: Dana || They charge more for "Arrest me red" too!

Photo Credit: Dana || They charge more for “Arrest me red” too!

This should be a relatively quick note on personal lines insurance. I’m writing this after reading the piece in this month’s Consumer Reports on Auto Insurance.  I agree with most of it.  For those that are short on time, my basic advice is this: bid out your auto, home, umbrella and other personal lines property & casualty insurance policies once every three years, or after every significant event that changes your premium significantly.

Here are a few simple facts to consider:

  • Personal lines insurance — auto, home, umbrella, rental, etc. is a very competitive business, and the companies that offer it all want an underwriting formula that would give them the best estimate of expected losses from each person insured.
  • After that, they want to know how much “wiggle room” that they would have to build in some profit.  Where might the second place bid be?  How likely are consumers to shop around?
  • Most insurers use a mix of credit scores and claim history to calculate rates.  Together, they are effective at forecasting loss costs — more effective than either one separately.
  • Read my piece On Credit Scores.  They are very important, because they measure moral tendency.  People with low scores tend to have more claims than those with high scores on average.  People with high scores tend to be more careful in life.  This is a forward-looking aspect of a person’s underwriting profile.
  • It’s fair to use “credit scores” because they are positively and significantly correlated with loss costs.  The actuaries have tested this.  Note that it is legal in almost all states to use credit scores, or something like them, but not all of them.
  • As the Consumer Reports article points out, many insurance companies take advantage of insureds that stick with them year by year, because they don’t shop around.  Easy cure: bid out your policy every three years at minimum.  If enough people do this, the insurance companies that overcharge loyal customers will stop doing it.  (Note: when I was a buy side analyst analyzing insurance stocks, one company implicitly admitted to doing this, and I was insured by them.  Guess what I did next?  It was not to sell the stock, though eventually I did when I saw that their premium increases were no longer increasing profits.)
  • Also be willing to unbundle your home and auto policies — there may be a discount, or there may not as the Consumer Reports article states.  I’ve worked it both ways, and am unbundled at present.
  • If they have that much money for amusing advertising, it implies that the market isn’t that rational.  Bid it out.
  • But — it is important to realize that insurers don’t all have the same formulas for underwriting, and those formulas are not static over time.  Bidding out your insurance makes sure you benefit from changes that positively affect you.
  • Insurers tend to get more competitive as the surplus they have to deploy gets bigger, and vice-versa when it shrinks after a large disaster.  If your premium goes up after a disaster, bid the policies out.  If it drifts up slowly when there have been no significant disasters, or claims on your part, they are taking advantage of you.  Bid it out.

Bid it out.  Bid it out.  Bid it out.  What do you have to lose?  If loyalty means something to the insurer, they will likely win the bid.  If it doesn’t, they will likely lose.  Either way you will win.  If you have an agent, they will note that you are price-sensitive.  The agent will become more of an ally, even if it doesn’t seem that way.

I went through this several times.  Most people who have read me for a while know that I have a large family — I am going to start teaching number seven to drive now.  I bid it out when kids came onto my policy.  It produced a change.  When two of my kids had accidents in short succession, my premiums rose a lot.  They would not underwrite one kid.  I got most of it back when I bid it out.  Since that time, the two have been claim-free for 2.5 years.  Guess what I am going to do next March, when I am close to the renewal where premiums would shift?  You got it; I will bid it out.

There is one more reason to bid it out: it forces you to review your insurance needs.  You may need more or less coverage than you currently have. You might realize that you need an umbrella policy for additional protection.  You may decide to self-insure more by raising your deductibles.  The exercise is a good one.

You don’t need transparency, or more regulation.  You don’t get transparency in the pricing of many items.  You do need to bid out your business every now and then.  You are your own best defender in matters like this.  Take your opportunity and bid out your policies.

Make sure that you:

  • Choose a range of insurers — Large companies, smaller local companies, stock/mutual, and any that favor a group you belong to, if the group is known to be filled with good risks.
  • Give them a standardized request for insurance, giving all of the parameters for your coverage, and data on those insured.
  • Tell them they get one shot, so submit their best bid now… there will be no second looks.
  • Some companies argue more about paying claims.  (AIG once had a reputation that way.)  Limit your bidders to those with a reputation for fairness.  State insurance departments often keep lists of complaints for companies.  Take a look in your home state.  Talk with friends.  Google the company name with a few choice words (cheated, claim denied, etc.) to see complaints, realizing that complainers aren’t always right.
  • Limit yourself to the incumbent carrier and 4-6 others.  Seven is more than enough, given the work involved.

So, what are you waiting for?  Bid out your personal insurance business.

Full disclosure: long AIZ, ALL, BRK/B, TRV for myself and clients (I know the industry well)

Everyone reading should know that I am an actuary, as well as a quant and a financial analyst.  Math is my friend.

Math is not the friend of many of my readers, so I usually don’t bother them with the math.  Tonight’s post will be no different.  It stems from my time of creating investment strategies for what was at that time a leading indexed annuity seller.

What is the return that you get from an indexed annuity?  It is the return from index options, subject to a certain minimum return over a 7-15 year period. Now, on average, what is the return you get from buying any fairly priced option?  You get the return on T-bills plus zero to a slight negative percentage.  So, if the option premiums paid are cumulatively greater than the guaranteed minimum return, the product should return more than the minimum on average — but likely not much more on average.

Why is that?  Options are a zero sum game, and usually there is no inherent advantage to the buyer or seller.  There are some exceptions to this rule, but it favors at-the money option sellers, never buyers. Buying options is what happens with indexed annuity products.

Now, over any short amount of time, like 5-10 years, you can get very different results than the likely average.  That doesn’t affect my point.  With games of chance, some get get good outcomes, and other get bad outcomes.

Now, the indexed product sellers will tell potential buyers that they will never lose money if the market goes down.  True enough.   What they don’t tell you is that over the long haul, you will most likely earn more investing in one of Vanguard’s S&P 500 funds or even their Balanced Index Fund.  You may even earn more investing in their high yield fund, or even their bond market index fund.

In exchange for eliminating all negative volatility, you end up getting very modest interest credits, while still being exposed to the credit risk of the insurance company.  In an insolvency, your policy will be affected.  The state guaranty funds will likely protect you if your policy is underneath the coverage limits, but still it is a bother.

Add to that the illiquidity of the product.  Yes, you can cash it in at any time, do 1035 exchanges, etc., but before the end of the surrender charge period you will pay a fee that compensates the insurance company for the amortized value of the large commission that they paid the agent that sold you the policy.  For most people, the surrender charge psychologically locks them in.

Thus I say it is better to be disciplined, and buy and hold a volatile investment with low fees over time, rather than own an indexed annuity that will tend to lock you in, and deliver lower returns on average.  That’s all, aside from the postscript.



How does an insurance company make a profit on an indexed annuity?  They take the proceeds of the sale, pay the agent, and use the rest to invest.  About 90% of the money will be invested in a bond that will cover the minimum guarantee.  The remainder will buy option premiums — the amount of money that gets applied to that is close to the credit spread on the bonds less the insurance company’s fees to pay the costs of the company and a charge for profit. Not a lot is typically left in a low yield environment like this.  The company tries to buy the most attractive options that they can on a limited budget.  Inexpensive options typically imply that most will finish out of the money, and/or when they do finish in-the-money, the rewards won’t be that large.

Photo Credit: Bowen Chin || What's more Illiquid than Frozen Tundra?

Photo Credit: Bowen Chin || What’s more Illiquid than Frozen Tundra?

My last piece on this topic, On Bond Market Illiquidity (and more), drew a few good comments.  I would like to feature them and answer them.  Here’s the first one:

Hello David,

One issue you don’t address in your post, which is excellent as usual, is the impact of what I’ll call “vaulted” high quality bonds. The explosion and manufacturing of fixed income derivatives has continued to explode while the menu of collateral has been steady or declining. A lot of paper is locked down for collateral reasons.

That’s a good point.  When I was a bond manager, I often had to deal with bonds that were salted away in the vaults of insurance companies, which tend to be long-term holders of long-term bonds, as they should be.  They need them in order to properly fund the promises that they make, while minimizing cash flow risk.

Also, as you mention, some bonds can’t be sold for collateral reasons.  That can happen due to reinsurance treaties, collateralized debt obligations, accounting reasons (marked “held to maturity”), and some other reasons.

But if the bonds are technically available for sale, it takes a certain talent to get an insurance company to sell some of those bonds without offering a steamy price.  You can’t sound anxious, rushed, etc. My approach was, “I’d be interested in buying a million or two of XYZ (mention coupon rate and maturity) bonds in the right price context.  No hurry, just get back to me with any interest.”  I would entrust this to one mid-tier broker familiar with the deal, who had previously had some skill in prying bonds out of the accounts of long-term holders before.  I might have two or three brokers doing this at a time, but all working on separate issues.  No overlap allowed, or it looks like there is a lot of demand for what is likely a sleepy security.  No sense in driving up the price.

Because it is difficult to get the actual cash bonds, it is tempting for some managers to buy synthetic versions of those bonds, or synthetic collateralized debt obligations of them instead.  Aside from counterparty risk, the derivatives exist as “side bets” in the credit of the underlying securities, and don’t provide any additional liquidity to the market.

My point here would be that these conditions have existed before, and I think what we have here is a repeat of bull market conditions in bond credit.  This isn’t that unusual, and it will eventually change when the bull market ends.

Here’s the next comment:

Hi David,

I hope you’re doing well.  I’ve been reading your blog for about a year now and really appreciate your perspective and original content.  Just wanted to ask a quick question regarding your most recent post on bond market liquidity. 

Our investment committee often talk about the idea of bond liquidity (and discusses it with every bond manager who walks in our doors), and specifically how there are systematic issues now which limit liquidity and considerably push the burden onto money managers to make markets vs. the past, when banks themselves were free to make more of a market with their own balance sheets.

My (limited) understanding is that legislation since 2008 has changed the way that investment banks are permitted to trade on their own books, and this is a big part of the significantly decreased liquidity which has thus far been a relative non-issue but which could rear its head quickly in the face of a sharp correction in bonds.

Do you have any thoughts about this newer paradigm of limited market-making at the big banks?  You didn’t seem to mention it at all in your article and I’m wondering if my thoughts here are either inaccurate or not impactful to the bottom line of the liquidity conversation.

I’m sure you’re a busy guy so I won’t presume upon a direct response but it may be worthwhile to post an update if you think these questions are pertinent.

Another very good comment.  I thought about adding this to the first piece, but in my experience, the large investment banks only kept some of the highest liquidity corporates in inventory, and the dregs of mortgage- and asset-backed bonds that they could not otherwise sell.  The smaller investment banks would keep little-to-no-inventory.  Many salesmen might have liked the flexibility of their bank to hold positions overnight, or buying bonds to “reposition” them, but the experiences of their risk control desks put the kibosh on that.

As a result, I think that the willingness of investment banks to make a market rely on:

  • The natural liquidity of the securities (which comes from the size of the issue, market knowledge of the issue, and composition of the ownership base), and
  • How much capital the investment bank has to put against the position.

The second is a much smaller factor.  Insurance companies have to deal with variations in capital charges in the bonds that they hold, and that is not a decisive factor in whether they hold a bond or not.  It is a factor in who will hold a bond and what yield spread the bond will trade at.  Bonds tend to gravitate to the holders that:

  • Like the issuer
  • Like the cash flow profile
  • Have low costs for holding the bonds

Yes, the changed laws and regulations have raised the costs for investment banks to hold bonds in inventory.  They are not a preferred habitat for most bonds.  Therefore, if an investment bank buys a bond in order to sell it (or vice-versa) in the present environment, the bid-ask spread must be wider to compensate for the incremental costs, thus reducing liquidity.

To close this evening, one more letter on bonds from a reader:

First off, thank you for taking the time to share your knowledge via your blog.  It is much appreciated.

Now for a bond question from someone learning the fixed income ropes…

What is the advantage/reasoning behind a company co-issuing notes with a finance subsidiary?  Even with reading the prospectus/indenture I can’t understand why a finance sub (essentially just set up to be a co-issuer of debt) would be necessary especially since the company is an issuer anyway and they also may have other subs guarantee the debt also.  I’m probably missing something obvious.

The answer here can vary.  Some companies guarantee their finance subsidiaries, and some don’t.  Those that don’t are willing to pay more to borrow, while bondholders live with the risk that in a crisis, the company might step away from its lending subsidiary.  They would never let the subsidiary fail, right?

Well, that depends on how easy it is to get financing alternatives, and how easy it might be for the parent company to borrow, post-subsidiary default.

If things go well, perhaps the subsidiary could be spun off as a separate company, or sold to another finance company for a gain.  After all, it has had separate accounting done for a number of years.

Beyond that, it can be useful to manage lending separately from sales.  They are different businesses, and require different skills.  Granted, it could be done as two divisions in the same company, but doing it in separate companies would force separate accountability if done right.

There may be other reasons, but they aren’t coming to my mind right now.  If you think of one, please note it in the comments.

I was riding home with child number seven after a basketball practice about four months ago — this is the child that if any of mine has the capability of taking over for me someday, this is the one. She said to me, “Dad, I always knew we were better off than most, but it finally sank home to me how much better off we are than most of the people we know.”

Me: “What do you mean?”

7: “I’ve been talking with my friends after basketball practice, after church, and other times, and I hear about what happens when their parents have a $500 surprise bill for a repair, and things like that.  They have to scrape for months to deal with the added expense, and they can’t do a lot of things that they do normally while they rebuild their finances.”

Me: “Okay, so what makes us different?”

7: “We just had three disasters hit us at the same time, and you just dealt with them for the long term without making a lot of noise about it.  Had that happened to any of my friends’ families, they would not know what to do, it would be impossible for them to do it without help.”

Me: “Actually there are a few of your friends whose families would likely survive what hit us easily, but yes, you’ve hit on something that I think is the most significant initial lesson on finance for the 75% of the population on the low end of incomes.  People need to start saving early, and build a buffer against disasters, etc.  If I were going to give a talk at most churches on personal finance, I would talk only about that, and almost nothing more.  Earn, budget, save, and be generous.  After that, we can talk about investing, but it is only relevant to a minority of the population with enough discipline to save early and often, initially aiming for 3-6 months of expenses.”

7: “When did you and Mom finally have that much saved?”

Me: “Going into our marriage back in 1986.  I had been a graduate student, and your mom a high school teacher in one of the poorest school districts in California, but we still both lived low on the hog, and saved money.  That gave us enough money that we were able to buy a small house at an opportunistic time six months after we married.  Within a year, we had rebuilt the buffer, and we haven’t been without it since.”


In personal finance, you have to develop good habits early, and learn that life isn’t about how much you spend.  I try to teach my kids that — Seven understands it, as does three or four of her siblings.  The other three or four don’t understand, despite my best efforts — some of it seems to be personality-driven, but I have seen one or two of them change and get better at money management.  We’ll see… they are still developing.

In finance, you have to focus on what you can control.  You have reasonable control over ordinary spending.  You have less control over what you earn, and almost no control over accidents and investment returns.  Thus the first bit of advice is to live below your means and save.  The second bit is to plan against catastrophes on a reasonable level.  Insurance can be useful to protect against some of the worst outcomes.  Just remember, insurance is an expense and not an investment.

Along with the above article cited, note these four basic articles and one book review on personal finance:

The last one is useful for learning to live less expensively, while still having most reasonable comforts that others have.

Now, what I have written about above has been noted in the financial media lately regarding a study done by JP Morgan on how many people don’t keep a buffer around, no matter how much they earn.  Here are two articles that talk about that study (one, two — good articles both, read them if you can).  Personally, I’m not surprised having worked with people who earned a lot and spent to the limit.  They lived far more opulent lives than I do, but decided they would save later.

If you want to save, start now.  Most good habits have to be started now, or they won’t get started.  Most good intentions don’t die from a frontal assault, but from the idea that you have plenty of time to change.  As a result — you don’t change.  And that is not just you, it is me in my life also.  Change must start now, or it does not start.

Two more articles worth a read:

These largely follow my point of view on personal finances.  Save, protect against bad risks, and take moderate risks to earn money both in work and in investing.  You can do it too, but remember, it is not a question of knowledge, it is a question of whether you have the will to do it or not.  I wish you the best in your efforts.

Now if you haven’t done it yet, go build the buffer.

I can’t help but think after the financial crisis that we have drawn some wrong conclusions about systemic risk. Systemic risk is when the financial system as a whole threatens to fail, such that short-term obligations can’t be paid out in full.  It is not a situation where only big entities fail — the critical factor is whether it creates a run on liquidity across the system as a whole.

Why does a bank fail?  It can’t pay in full when there was a demand for liquidity in the short run.  Typically, there is an asset-liability mismatch, with a lot of payments payable now, and assets that cannot be easily liquidated for what their stated value reported to the regulators.

Imagine the largest bank failing, and no one else.  Yes, it would be a mess for the FDIC to clean up, but it could be done.   Stockholders and preferred stockholders get wiped out. Bondholders, junior bondholders, and large depositors take a haircut.  Future deposit insurance premiums might have to rise, but there would be enough time to do that, with banks adjusting their prices so that they could afford it.

But banks don’t fail one at a time, except perhaps in good times with a really incompetently managed bank.  Why do some banks tend to fail at the same time?

  • They own many of the same debt securities, or same types of loans where the underlying asset values are falling.
  • They own securities of other banks, or other deposit-taking institutions.
  • Generalized panic.

What can stop a bank from failing?  Adequate short-term cash flow from assets.  Why don’t banks make sure that they always have more cash coming in than going out?  That would be a lower profitability way of running a bank.  It is almost always more profitable to borrow short and lend long, and make money on the natural term spread that exists — but that creates the very conditions that makes some banks run out of liquidity in a panic.

You will hear the banks say, “We are solvent, we just aren’t liquid.” That statement is always hogwash.  That means that the bank did not adequately plan to have enough liquidity under all circumstances.

Thus, planning to avoid systemic risk across an economy as a whole should focus on looking for the entities that make a lot of promises where payment can be demanded in the short run with no adjustments for market conditions versus assets available to make payments.  Typically, that means banks and things like banks that take deposits, including money market funds.  What does it not include?

  • Life insurers, unless they write a lot of unusual annuities that can get called for immediate payment, as happened to General American and ARM Financial in 1999.  The liability structure of life insurance companies is so long that there can never be a run on the bank.  That doesn’t mean they can’t go insolvent, but it does mean they won’t be part of a systemic panic.
  • Property & Casualty and Health insurers do not have liabilities that can run from them.  They can write bad business and lose money in the short-run, but that doesn’t lead to systemic panic.
  • Investment companies do not have liabilities that can run from them, aside from money-market funds.  Since the liabilities are denominated in the same terms as the assets managed, there can’t be a “run on the bank.”  Even if assets are illiquid, the rules for valuing illiquid assets for liquidation are flexible enough that an investment firm can lower the net asset value of the payouts, while liquidating other assets in the short run.
  • Even any large corporation that has financed itself with too much short-term debt is not a threat to systemic panic.  The failure would be unique when it could not roll over its debts.  Further, it would take some effort to actually do that, because the rating agencies and lenders would have to allow a non-financial firm to take obvious risks that non-financial firms don’t take.

What might it include?

  • Money market funds are different because of the potential to “break the buck.”
  • Any financial institution that relies on a repurchase [repo] market for financing is subject to systemic risk because of the borrow short to finance a long-dated asset mismatch inherent in the market.
  • Watch any entity that has to be able to post additional margin in order maintain leveraged asset finance.

How then to Avoid Systemic Risk?

  • Regulate banks, money market funds and other depositary financials tightly.
  • Don’t let them invest in one another.
  • Make sure that they have more than enough liquid assets to meet any conceivable liquidity withdrawal scenario.
  • Regulate repurchase markets tightly.
  • Raise the amount of money that has to be deposited for margin agreements, until those are no longer a threat.
  • Perhaps break up banks by ending interstate branching.  State regulation is good regulation.

But aside from that, there is nothing to do.  There are no systemic risks from investment companies or those that manage them, because there can’t be a self-reinforcing “run on the bank.”  Insurance companies are similar, and their solvency is regulated far better than any bank.

Thus, there shouldn’t be any lists of systematically important financial institutions that contain investment managers or insurance companies.  Bigness is not enough to create a systemic threat.  Even GE Capital could have failed, and it would not have had significant effects on the solvency of other financials.

I think it is incumbent on those that would call such enterprises systemically important to show one historical example of where such enterprises ever played a significant role in a financial crisis like the ones that happened in the 1870s, 1900s, 1930s, or 2000s.  They won’t be able to do it, and it should tell them that they are wasting effort, and should focus on the short-tailed liabilities of financial companies.

This will be the last of my institutional error pieces. It is not that I have not made any other errors, but these were the big ones.

National Atlantic Holdings [NAHC]

I was wrong yesterday.  I actually do have a lot available that I have written on this failure, since I wrote about it here at Aleph Blog.  More than you can shake a stick at.

Let me start at the beginning.  NAHC was an insurer with a niche presence in New Jersey.  They competed only in personal lines, which usually is easy to analyze.  New Jersey was a tough but not impossible state to operate in, and NAHC was a medium-sized fish for the size of the pond that they were in.

Chubb was not in NewJersey at that point in time, and so they wanted to insure autos, homes, and personal property, particularly that of wealthy people.

I thought it was an interesting company, trading slightly below tangible book, with a single-digit multiple on earnings, good protective boundaries, and a motivated management team.  The CEO owned over 10% of the firm, which seemed to be enough to motivate, but not enough to ignore shareholders.

In 2005, we bought a 5%+ stake in the company, which in 2006 became 10%+, and eventually topped out at 17%.  We might have bought more with the approval of the NewJersey Department of Insurance, which was easy at lower levels, and harder at higher levels, which was an interesting anti-takeover defense.

The company showed promise in many ways, but always seemed to have performance issues — little to medium surprises every few quarters.  The stock price didn’t do that much bad or good.  When I left Hovde at the end of July 2007, the position was at a modest gain.  Hovde had a hard time finding long names in that era, so the performance up to that point wasn’t that bad.

If you want to see my original logic for buying the stock after I left Hovde, you can read it here.

Here was the stock price graph from May 2007 to May 2008:


My old employer Hovde owned 17%.  I eventually owned 0.15%, at the prices you see there, at an average cost of $6.67 for me.  I eventually sold out at an average price of around $6.10.  (In the above graph, “Exit” was not a sale, but where I cut off the calculation.)  This wasn’t my worst loss by any means, but it cost my former employer badly, and it was my fault, not theirs.

What Went Wrong?

  • Their competitive position deteriorated as companies that previously avoided New Jersey entered the state.
  • They announced that they had reserving errors, and reported moderate losses as a result.
  • They announced a sale to Palisades Insurance, a private New Jersey insurer for $6.25/sh, valuing the company at less than 60% of tangible book value.  The fairness opinion was a bad joke.  The company would have been worth more in run-off.
  • Really, the management team was weak.

The first problem would be a tough one to solve.  On the second problem, I never got a good answer to how the loss reserves got so cockeyed, and somehow no one was to blame for it.  This is personal lines insurance — the reserves validate themselves every year.

But the third problem made me think the management was somewhat dishonest.  A larger company could have paid a higher price for NAHC, but that probably would have meant that management would lose their jobs.  They gave shareholders the short end of the stick for the good of management, and perhaps employees.

My biggest error was giving too much credit, and too much patience to the management team.  I met far better management teams in my time as a buy-side analyst, and they were on the low end of the competence scale.  I let cheapness and a strong balance sheet blind me to the eroding competitiveness, and weak ability to deal with the problem.

Ultimately, Hovde found itself in a weak position because it could not file for appraisal rights, a fraud case would have been weak, and the NJ Department of Insurance would not let them acquire enough to block the deal.  Besides, once arbs got a hold of over 40% of the shares, the deal was almost impossible to block.

As I often say, risk control is best done on the front end.  On the back end, solutions are expensive, if they are available at all.

The front end for you can be learning from my errors.  Wise men learn from the mistakes of others.  Average men learn from their own mistakes.  Dumb men never learn.

In closing, be conservative in investing, and be wise.  I thought I was being both, so seek the counsel of others to check your logic.