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:

NAHC_current_loss

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.

Photo Credit: Ian || Watching Capital Implode is a Marvel to Behold!

Photo Credit: Ian || Watching Capital Implode is a Marvel to Behold!

This is one of the many times that I wish RealMoney.com had not changed its file structure, losing virtually all content prior to 2008.  (It is also a reason that I am glad I started blogging.  It’s more difficult to lose this content.)  When I was a stock analyst at Hovde Capital Advisors, I made 2 humongous blunders.  I wrote about them fairly extensively at RealMoney as the situation unfolded, so if I had those posts, it would make the following article better.  As it is, I am going to have to go from memory, because both companies are no longer in business.  Here we go:

Scottish Re

Sustainable competitive advantage is difficult to find in insurance.  Proprietary methods are as good as the employees creating and using them, and they can leave when they would like to.  This applies to underwriting, investing, and expense management.  What else is there in an insurance company?  There are back end processes of valuation and cash flow management, but those financial reporting processes serve to inform the front end of how an insurer operates.

One area that had and continues to have sustainable competitive advantage is life reinsurance.  An global oligopoly of companies grew organically and through acquisitions to become dominant in life reinsurance.  Their knowledge and mortality databases make them far more knowledgeable the life insurers that seek to pass some of the risk of the death of their policyholders to them.  They can be very profitable and stable.  I already owned shares of RGA for Hovde, and in 2005 wanted to expand the position by buying some of the cheaper and more junior company Scottish Re.

Scottish Re had only been in business since 1998, versus RGA since 1973.  These were the only pure play life reinsurers in the world.  Scottish Re had grown organically and through acquisition to become the #5 member of the oligopoly.  The top 5 life reinsurers controlled 80% of the global market.  I made the case to the team at Hovde, and we took a medium-sized position.

The first thing I should have noticed was the high level of complexity of the holding company structure.  Unlike RGA, they operated to a high degree in a wide number of offshore tax and insurance haven domiciles — notably Bermuda, Ireland, Cayman Islands, and others.  Second, their ownership diagrams rivaled AIG for complexity, and their market capitalization was less than 2% of AIG’s at the time.  [Note: balance sheet complexity did not bode well for AIG either — down 98% since then, but it beats Scottish Re going out at zero.]

The second thing I should have noticed was the high degree of underwriting leverage.  Relative to RGA, it reinsured much more life risk relative to the size of its balance sheet.

The third thing I should have noticed was the cleverness of some of the financing methods of Scottish Re — securitization was uncommon in life reinsurance, and they were doing it successfully.

The final thing that I should have noticed was that earnings quality was poor.  They usually made their earnings, but often because their tax rate was so low… and the deferred tax assets were a large part of book value.  (Note: deferred tax assets only have value if you are going to have pretax income in the future.  That was soon not to be.)

In 2005, Scottish Re won the auction for buying up another member of the oligopoly, ING Life Re.  I asked the CFO of RGA why they didn’t buy it, and his comment was that he didn’t think anyone would pay more than they bid.  That should have led me to sell, but I didn’t.  The price of Scottish Re drifted down, until August 3, 2006, when they announced second quarter earnings, reporting a huge loss, writing off a large portion of their deferred tax assets, and the stock price dropped 75% in one day.  I eventually wrote about that at RealMoney, noting it was the single worst day in the hedge funds history, and it was due to my errors.  You can also read my questions/comments from the conference call here (pages 50-53).

If you look at the RealMoney article, you might note that we tripled our position at around $6.90 after the disaster.  That took a lot of guts, and we didn’t know it then, but it was the wrong thing to do.  The stock rallied all the way up to $10 or so.  If it hit $11, we were going to sell out.   That was not to be.

I spent hours and hours going through obscure insurance filings.  I analyzed every document that I could get my hands on including the rating agency analyses, because they had access to inside data in aggregate that no one else had outside of the company.  The one consistent thing that I learned was that insolvency was unlikely — which would later prove wrong.

The stock price fell and fell all the way down to $3, with rumors of insolvency swirling, when Mass Mutual and Cerberus rode to the rescue on November 27, 2006, buying 69% of the company for a paltry $600 million in convertible preferred stock.  At that point, I finally got it right.  All of my prior research had some value, because when I read through the documents that day and saw the liquidity raised relative to the amount of ownership handed over.  Given the data that they now handed out, I concluded that Scottish Re was worth $1/share, and possibly zero.

But there was a relief rally that day, and we sold into it.  We ended up selling about 4% of the total market cap of Scottish Re that day at a price of $6.25.

The bright side of the whole matter was that we could have lost a lot more.  Scottish Re was eventually worth zero, and Mass Mutual and Cerberus took significant losses, as did the remaining shareholders.

As it was, the fault was all mine — my colleagues at Hovde deserved none of the blame.

The Lesson Learned

One year later, I wrote a note to the late Greg Newton who wrote the notable blog, Naked Shorts, when he was critical of Cerberus (they had a lot of failures in that era).  This was the summary that I gave him on Scottish Re:

Cerberus got into SCT @ $3; it’s now around $2.  For me, on the bright side, when their deal with SCT was announced, I quickly went through the data, and recommended selling.  We got out @ $6.25.  That limited our losses, but it was still my biggest failure when I was at Hovde.  The mixture of leverage, alien domiciled subsidiaries, reinsurance underwriting leverage, plus complex and novel securitization structures was pure poison.  I was mesmerized by the seemingly cheap valuation and actuarial studies that indicated that mortality experience was a little better than expected.  I violated my leverage and simplicity rules on that one.

He gave me a very kind response, better than I deserved.  As it was Scottish Re went dark, delisting in May 2008, and trading for about a nickel per share at the last 10K in July of 2008.  It eventually went to zero.

The biggest lesson is to do the research better on illiquid and opaque financial companies, or, avoid them entirely.  Complexity and leverage there are typically not rewarded.  I’d like to say that I fully learned my lesson there, but I got whacked again by the same lesson on a personal investment later in 2008.  That’s a subject for a later article.

I have one more bad equity investment from my hedge fund days, and I will write about that sometime soon, to end this part of the series.

Full disclosure: still long RGA for my clients and me

This will be the post where I cover the biggest mistakes that I made as an institutional bond and stock investor. In general, in my career, my results were very good for those who employed me as a manager or analyst of investments, but I had three significant blunders over a fifteen-year period that cost my employers and their clients a lot of money.  Put on your peril-sensitive sunglasses, and let’s take a learning expedition through my failures.

Manufactured Housing Asset Back Securities — Mezzanine and Subordinated Certificates

In 2001, I lost my boss.  In the midst of a merger, he figured his opportunities in the merged firm were poor, and so he jumped to another firm.  In the process, I temporarily became the Chief Investment Officer, and felt that we could take some chances that the boss would not take that in my opinion were safe propositions.  All of them worked out well, except for one: The — Mezzanine and Subordinated Certificates of Manufactured Housing Asset Back Securities [MHABS].  What were those beasts?

Many people in the lower middle class live in prefabricated housing in predominantly in trailer parks around the US.  You get a type of inexpensive independent living that is lower density than an apartment building, and the rent you have to pay is lower than renting an apartment.  What costs some money is paying for the loan to buy the prefabricated housing.

Those loans would get gathered into bunches, put into a securitization trust, and certificates would get sold allocating cash flows with different probabilities of default.  Essentially there were four levels (in order of increasing riskiness) — Senior, Mezzanine, Subordinated, and Residual.  I focused on the middle two classes because they seemed to offer a very favorable risk/reward trade-off if you selected carefully.

In 2001, it was obvious that there was too much competition for lending to borrowers in Manufactured Housing [MH] — too many manufacturers were trying to sell their product to a saturated market, and underwriting suffered.  But, if you looked at older deals, lending standards were a lot higher, but the yields on those bonds were similar to those on the badly underwritten newer deals.  That was the key insight.

One day, I was able to confirm that insight by talking with my rep at Lehman Brothers.  I talked to him about the idea, and he said, “Did you know we have a database on the loss stats of all of the Green Tree (the earliest lender on MH) deals since inception?”  After the conversation was over, I had that database, and after one day of analysis — the analysis was clear: underwriting standards had slipped dramatically in 1998, and much further in 1999 and following.

That said, the losses by deal and duration since issuance followed a very predictable pattern: a slow ramp-up of losses over 30 months, and then losses tailing off gradually after about 60 months.  The loss statistics of all other MH lenders aside from Vanderbilt (now owned by Berkshire Hathaway) was worse than Green Tree losses.  The investment idea was as follows:

Buy AA-rated mezzanine and BBB-rated subordinated MHABS originated by Green Tree in 1997 and before that.  The yield spreads over Treasuries are compelling for the rating, and the loss rates would have to jump and stick by a factor of three to impair the subordinated bonds, and by a factor of six to impair the mezzanine bonds.  These bonds have at least four years of seasoning, so the loss rates are very predictable, and are very unlikely to spike by that much.

That was the thesis, and I began quietly acquiring $200 million of these bonds in the last half of 2001.  I did it for several reasons:

  • The yields were compelling.
  • The company that I was investing for was growing way too rapidly, and we needed places to put money.
  • The cash flow profile of these securities matched very well the annuities that the company was selling.
  • The amount of capital needed to carry the position was small.

By the end of 2001, two things happened.  The opportunity dried up, because I had acquired enough of the bonds on the secondary market to make a difference, and prices rose.  Second, I was made the corporate bond manager, and another member of our team took over the trade.  He didn’t much like the trade, and I told my boss that it was his portfolio now, he can do what he wanted.

He kept the positions on, but did not add to them.  I was told he looked at the bonds, noticed that they were all trading at gains, and stuck with the positions.

Can You Make It Through the Valley of the Shadow of Death?

I left the firm about 14 months later, and around that time, the prices for MHABS fell apart.  Increasing defaults on MH loans, and failures of companies that made MH, made many people exceptionally bearish and led rating agencies to downgrade almost all MHABS bonds.

The effects of the losses were similar to that of the Housing Bubble in 2007-9.  As people defaulted, the value of existing prefabricated houses fell, because of the glut of unsold houses, both new and used.  This had an effect, even on older deals, and temporarily, loss rates spiked above the levels that would impair the bonds that I bought if the levels stayed that high.

With the ratings lowered, more capital had to be put up against the positions, which the insurance company did not want to do, because they always levered themselves up more highly than most companies — they never had capital to spare, so any loss on bonds was a disaster to them.

They feared the worst, and sold the bonds at a considerable loss, and blamed me.

[sigh]

Easy to demonize the one that is gone, and forget the good that he did, and that others had charge of it during the critical period.  So what happened to the MHABS bonds that I bought?

Every single one of those bonds paid off in full.  Held to maturity, not one of them lost a dime.

What was my error?

Part of being a good investor is knowing your client.  In my case, the client was an impossible one, demanding high yields, low capital employed, and no losses.  I should have realized that at some later date, under a horrific scenario, that the client would not be capable of holding onto the securities.  For that reason, I should have never bought them in the first place.  Then again, I should have never bought anything with any risk for them under those conditions, because in a large enough portfolio, you will have some areas where the risk will surprise you.  This was less than 2% of the consolidated assets of the firm, and they can’t hold onto securities that would likely be money good amid a panic?!

Sadly, no.  As their corporate bond manager, before I left, I sold down positions like that that my replacement might not understand, but I did not control the MHABS portfolio then, and so I could not do that.

Maybe $50 million went down the drain here.  On the bright side, it helped teach me what would happen in the housing bubble, and my next employer benefited from those insights.

Thus the lesson is: only choose investments that your client will be capable of holding even during horrible times, because the worst losses come from panic selling.

Next time, my two worst stock losses from my hedge fund days.

Despite the large and seemingly meaty title, this will be a short piece.  I class these types of investors together because most of them have long investment horizons.  From an asset-liability management standpoint, that would mean they should invest similarly.  That may be have been true for Defined Benefit [DB] pension plans and Endowments, but that has shifted over time, and is increasingly not true.  In some ways, the DB plans are becoming more like life insurers in the way they invest, though not totally so.  So, why do they invest differently?  Two reasons: internal risk management goals, and the desires of insurance regulators to preserve industry solvency.

Let’s start with life insurers.  Regulators don’t want insolvent companies, so they constrain companies into safe assets using risk-based capital charges.  The riskier the investment, the more capital the insurer has to put up against it.  After that, there is cash-flow testing which tends to push life insurers to match assets and liabilities, or at least, not have a large mismatch.  Also, accounting rules may lead insurers to buy assets where the income will show up on their financial statements regularly.

The result of this is that life insurers don’t invest much in risk assets — maybe they invest in stocks, junk bonds, etc. up to the amount of their surplus, but not much more than that.

DB plans don’t have regulators that care about investment risks.  They do have plan sponsors that do care about investment risk, and that level of care has increased over the past 15 years.  Back in the late ’90s it was in vogue for DB plans to allocate more and more to risk assets, just in time for the market to correct.  (Note to retail investors: professionals may deride your abilities, but the abilities of many professionals are questionable also.)

Over that time, the rate used to discount DB plan liabilities became standardized and attached to long high quality bonds.  Together with a desire to minimize plan funding risks, and thus corporate risks for the plan sponsor, that led to more investments in bonds, and less in equities and other risk assets.  Some plans try to cash flow match expected future plan payments out to a horizon.

Finally, endowments have no regulator, and don’t have a plan sponsor that has to make future payments.  They are free to invest as they like, and probably have the highest degree of variation in their assets as a group.  There is some level of constraint from the spending rules employed by the endowments, particularly since 2008-9, when a number of famous endowments came to realize that there was a liability structure behind them when they ran low on liquidity amid the crisis. [Note: long article.]  You might think it would be smart to have the present value of 3-5 years of expenditures on hand in bonds, but that is not always the case.  In some ways, the quick recovery taught some endowment investors the wrong lesson — that they could wait out any crisis.

That’s my quick summary.  If you have thoughts on the matter, you can share them in the comments.

 

Photo Credit: Alcino || What is the sound of negative one hand clapping?

Photo Credit: Alcino || What is the sound of negative one hand clapping?

As with many of my articles, this one starts with a personal story from my insurance business career (skip down four paragraphs to the end of the story if you want):

25 years ago, when it was still uncommon, I wanted to go to an executive course at the Wharton School for actuaries that wanted to better understand investment math and markets.  I went to my boss at AIG (a notably tight-fisted firm on expenses) and asked if the company would pay for me to go… it was an exclusive course, and very expensive compared to any other conference that I would ever go to again in my life.  I tried not to get my hopes up.

Lo, and behold!  AIG went for it!

A month later, I was with a bunch of bright actuaries at the Wharton School.  The first thing I noticed was aside from the compound interest math, and maybe some bond knowledge, the actuaries were rather light on investment knowledge, and I would bet that all of them had passed the Society of Actuaries investment course.  The second thing I noticed were some of the odd investments described in the syllabus: it was probably my first taste of derivative instruments.  At the ripe old age of 29, I was learning a lot, and possibly more than the rest of my classmates, because I had spent a lot of time studying investments already, both on an academic and practical basis.

I had already studied the pricing of stock options in school, so I was familiar with Black-Scholes.  (Trivia note: an actuary developed the same formula for valuing optionally terminable reinsurance treaties six years ahead of Black, Scholes and Merton.  That doesn’t even take into account Bachelier, who derived it 73 years earlier, but no one knew about it, because it was written in French.)  At this point, the professor left, and a grad student came in to teach us about the pricing of bond options.  At the end of his lesson, it was time for the class to have a break.  I went down to make a comment, and it went like this:

Me: You said that we have to adjust for the fact that interest rates can’t go negative.

Grad student: Of course.

Me: But interest rates could go negative.

GS: That’s ridiculous!  Why would you ever lend money and accept back less than you gave them, and lose the time value of money?!

Me: Almost of the time, you wouldn’t.  But imagine a scenario where the demand for loanable funds leaves interest rates near zero, but the times are insecure and violent, leaving you uncertain that if you stored your cash privately, you would run too large of a risk of having it stolen.  You need your cash in the future for a given project.  In this case, you would pay the bank to store your money.

GS: That’s an absurd scenario!  That could never happen!

Me: It’s unlikely, I admit, but I wouldn’t say that you can never have negative interest rates.

GS: I will say it again: You can NEVER have negative interest rates.

Me: Thanks, I guess.

Well, so much for the distant past.  Here is why I am writing this: yesterday, a friend of mine wrote me the following note:

Good evening.  I trust you had a blessed Lord’s Day in the new building. 

Talking bonds today with my Econ class.  Here’s our question. Other than playing a currency angle why would anyone buy European debt with a negative yield?  The Swiss and at least one other county sold 10 year notes with a negative yield.  Can you explain that?  No interest and less principle [sic] at the end.

Now, I didn’t quite get it perfectly right with the grad student at Wharton, but most of it comes down to:

  • Low demand for loanable funds, with low measured inflation, and
  • Security and illiquidity of the funds invested

The first one everyone gets — inflation is low, and few want to borrow, so interest rates are very low.  But that doesn’t explain how it can go negative.

Things are different for middle class individuals and large financial institutions.  Someone in the middle class facing negative interest rates from a checking or savings account could say: “Forget it.  I’m taking most of my money out of the bank, and storing it at home.”  Leaving aside the inconvenience of currency transaction reports if the amount is over $10,000, and worries over theft, he could take his money home and store it.  Note that he does have to run a risk of theft, though, so bringing the money home is not costless.

The bank has the same problem, but far larger.  If you don’t invest the money, where would you store it?  Could you even get enough currency delivered to do it?  if you had a vault large enough to store it, could you trust the guards?  Why make yourself a target?  If you don’t have a vault large enough to store it, you’re in the same set of problems that exist for those that warehouse precious metals, but with a far more liquid commodity.

Thus in a weak economic environment like this, with low inflation, banks and other financial institutions that want certainty of payment in the future are willing to pay interest to get their money back later.

Part of the problem here is that the fiat currencies of the world exist only to be units of account, and not stores of value.  Thus in this unusual environment, they behave like any other commodity, where the prices for futures are often higher than the current spot price, which is known as backwardation.  (Corrected from initial posting — i.e. it costs more to receive a given cash flow in the future than today, thus backwardation, not contango.)  The rates can’t get too negative, though, or some institutions will bite the bullet and store as much cash as they can, just as other commodities get stored.

To use another analogy, a while ago, some market observers couldn’t get why anyone would accept a negative yield on Treasury Inflation Protected Securities [TIPS].  They did so because they had few other choices for transferring money to the future while still having inflation protection.  Some people argued that they were locking in a loss.  My comment at the time was, “They’re trying to avoid a larger loss.”

Thus the difficulty of managing cash outside of the bond/loan markets in a depressed economy leads to negative interest rates.  The financial institutions may lose money in the process, but they are losing less money than if they tried to store and protect the money, if that could even be done.

Photo Credit: Fortune Live Media

Photo Credit: Fortune Live Media

As I mentioned yesterday, there wasn’t anything that amazing and new in the annual letter of Berkshire Hathaway.  Lots of people found things to comment on, and there is always something true to be reminded of by Buffett, but there was little that was new.  Tonight, I want to focus on a few new things, most of which was buried in the insurance section of the annual report.

Before I get to that, I do want to point out that Buffett historically has favored businesses that don’t require a lot of capital investment.  That way the earnings are free to be reinvested as he see fit.  He also appreciates having moats, because of the added pricing power it avails his businesses.  Most of his older moats depend on intellectual property, few competitors, established brand, etc.  Burlington Northern definitely has little direct competition, but it does face national regulation, and dissatisfaction of clients if services can’t be provided in a timely and safe manner.

Thus the newer challenge of BRK: having to fund significant capital projects that don’t add a new subsidiary, may increase capacity a little, but are really just the price you have to pay to stay in the game.  From page 4 of the Annual Letter (page 6 of the Annual Report PDF):

Our bad news from 2014 comes from our group of five as well and is unrelated to earnings. During the year, BNSF disappointed many of its customers. These shippers depend on us, and service failures can badly hurt their businesses.

BNSF is, by far, Berkshire’s most important non-insurance subsidiary and, to improve its performance, we will spend $6 billion on plant and equipment in 2015. That sum is nearly 50% more than any other railroad has spent in a single year and is a truly extraordinary amount, whether compared to revenues, earnings or depreciation charges.

There’s more said about it on pages 94-95 of the annual report, but it is reflective of BRK becoming a more asset-heavy company that requires significant maintenance capital investment.  Not that Buffett is short of cash by any means, but less will be available for the “elephant gun.”

Insurance Notes

Now for more arcane stuff.  There are lots of people who write about Buffett and BRK, but I think I am one of the few that goes after the insurance issues.  I asked Alice Schroeder (no slouch on insurance) once if she thought there was a book to be written on Buffett the insurance CEO.  Her comment to me was “Maybe one good long-form article, but not a book.”  She’s probably right, though I think I have at least 10,000 words on the topic so far.

Here are two articles of mine for background on some of the issues involved here:

Here’s the main upshot: reserving is probably getting less conservative at BRK.  Incurred losses recorded during the year from prior accident years is rising.  Over the last three years it would be -$2.1B, -$1.8B, and now for 2014 -$1.4B.  (See page 69 of the annual report.)  Over the last three years, the amount of reserves from prior years deemed to be in excess of what was needed has fallen, even as gross reserves have risen.  In 2012, the amount of prior year reserves released as a proportion of gross reserves was greater than 3%.  In 2014, it was less than 2%.

In addition to that, in general, the reserves that were released were mostly shorter-tailed reserves, while longer-tailed reserves like asbestos were strengthened.  In general, when longer-tailed lines of business are strengthened in one year, there is a tendency for them to be strengthened in future years.  It is very difficult to get ahead of the curve.  Buffett and BRK could surprise me here, but delays in informing about shifts in claim exposure are a part of longer-tailed lines of insurance, and difficult to estimate.  As I have said before, reserving for these lines of business is a “dark art.”

From page 91 of the annual report:

In 2014, we increased estimated ultimate liabilities for contracts written in prior years by approximately $825 million, substantially all of which was recorded in the fourth quarter. In the fourth quarter of 2014, we increased ultimate liability estimates on remaining asbestos claims and re-estimated the timing of future payments of such liabilities as a result of actuarial analysis. The increase in ultimate liabilities, net of related deferred charge adjustments, produced incremental pre-tax underwriting losses in the fourth quarter of approximately $500 million.

This was the only significant area of reserve strengthening for BRK.  Other lines released prior year reserves, though many released less than last year.

There were a few comments on insurance profitability.  In addition to asbestos, workers’ compensation lost money.  Property-catastrophe made a lot of money because there were no significant catastrophes in 2014, but rates are presently inadequate there, and BRK is likely to write less of it in 2015.

My concern for BRK is that they are slowly running out of profitable places to write insurance, which reduces BRK’s profitability, and reduces the float that can be used to finance other businesses.

Maybe BRK can find other squishy liabilities to use to create float cheaply.  They certainly have a lot of deferred tax liabilities (page 71).  Maybe Buffett could find a clever way to fund pensions or structured settlements inexpensively.  Time to have Ajit Jain put on his thinking cap, and think outside the box.

Or maybe not.  Buffett is not quite to the end of his “low cost of informal borrowing” gambit yet, but he is getting close.  Maybe it is time to borrow at the holding company while long-term rates are low.  Oh wait, he already does that for the finance subsidiary.

Final Notes

From an earnings growth standpoint, there was nothing that amazing about the earnings in 2014.  A few new subsidiaries like NV Energy added earnings, but existing subsidiaries’ earnings were flattish.  Comprehensive income was considerably lower because of the lesser degree of unrealized appreciation on portfolio holdings.

On net, it was a subpar year for Berkshire Hathaway.  The annual letter provided a lot of flash and dazzle, but 2014 was not a lot to write home about, and limits to the BRK business model with respect to float are becoming more visible.

Full disclosure: long BRK/B for myself and clients, for now

Photo Credit: Chuck Coker

Photo Credit: Chuck Coker || Another Dynamic Duo and their secret Batcave

This piece has kind of a long personal introduction to illustrate my point.  If you don’t want to be bored with my personal history, just skip down to the next division marker after this one.

=–=-=-=-=-==–==-=–=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=

There will always be a soft spot in my heart for people who toil in lower level areas of insurance companies, doing their work faithfully in the unsexy areas of the business.  I’ve been there, and I worked with many competent people who will forever be obscure.

One day at Provident Mutual’s Pension Division [PMPD], my friend Roy came to me and said, “You know what the big secret is of the Pension Division?”  I shook my head to say no.  He said, ” The big secret is — there is no secret,” and then he smiled and nodded his head.  I nodded my head too.

The thing was, we were ultra-profitable, growing fast, and our financials and strategies were simple.  Other areas of the company were less profitable, growing more slowly, and had accrual items that were rather complex and subject to differing interpretations.  But since the 30 of us (out of a company of 800) were located in a corner of the building, away from everyone else, we felt misunderstood.

So one day, I was invited by an industry group of actuaries leading pension lines of business to give a presentation to the group.  I decided to present on the business model of the PMPD, and give away most of our secrets.  After preparing the presentation, I went home and told my wife that I would be away in Portland, Oregon for two days, when she informed me we had an important schedule conflict.

I was stuck.  I tried to cancel, but the leader of the group was so angry at me for trying to cancel late, when I hung up the phone, I just put my head on my desk in sorrow.

Then it hit me.  What if I videotaped my presentation and sent that in my place?  I called the leader of the group back, and he loooved the idea.  I was off and running.

One afternoon of taping and $600 later, I had the taped presentation.  It detailed marketing, sales, product design, risk control, computer systems design, and more.  If you wanted to duplicate what we did, you would have had a road map.

But the presentation ended with a hook of sorts, where I explained why I was so free with what we were doing.  We were the smallest player in the sub-industry, though the fastest growing, and with one of the highest profit margins.  I said, “The reason I can share all of this with you is that if you wanted to copy us, you would have to change an incredible amount of what you do, and kill off areas where you have invested a lot already.  I know you can’t do that.  But maybe you can imitate a few of our ideas and improve your current business model.”

So my colleague took the tape to the meeting, and when he returned, he handed me a baseball cap that had the word “Portland” on it.  He said, “You did it, Dave.  You won the best presentation of the conference award.  Everyone sent their thanks.”

Sadly, that was one of the last things I did in the Pension Division, as corporate management chose me to clean up another division of the company.  That is another story, but one I got few thanks for.

Today I call that hat “the $600 hat,” and I wear it to my kids baseball and softball games as I keep score.

=–=-=-=-=-==–==-=–=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=

The secret of Berkshire Hathaway is the same as my story above.  There is no secret. Buffett’s methods have been written about by legions; his methods are well known.  The same applies to Charlie Munger.  That’s why in my opinion, there were no significant surprises in their 50th anniversary annual letter. (There were some small surprises in the annual report, but they’re kinda obscure, and I’ll write about those tomorrow.)  All of the significant building blocks have been written about by too many people to name.

Originally, this evening, I was going to write about the annual report, but then I bumped across this piece of Jim Cramer’s on Buffett.  Let me quote the most significant part:

…Cramer couldn’t help but wonder if things in the business world could be different if we approached other CEOs the way that Buffett is approached.

Perhaps, if the good CEOs were allowed to stay on longer like Buffett has or if people treated them as if they were their companies the way that Buffett is treated in relation to Berkshire, things could be different?

“Clearly something’s gone awry in the business world if we can praise this one man for everything he does, and yet every other chief executive feels shackled into being nothing like him,” Cramer said.

Cramer is very close to the following insight: the reason why more companies don’t imitate Berkshire Hathaway is that they would have to destroy too much of their existing corporations to make it worth their while.  As such, the “secrets” of Berkshire Hathaway can be hidden in plain view of all, because the only way to create something like it would be to start from scratch.  Yes, you can imitate pieces of it, but it’s not the same thing.

Creating a very profitable diversified industrial conglomerate financed by insurance liabilities is a very unique strategy, and one that few would have the capability of replicating.  It required intelligent investing, conservative underwriting, shrewd analysis of management teams so that they would act independently and ethically, and more.

Indeed, an amazing plan in hindsight.  Kudos to Buffett and Munger for their clever business sense.  It will be difficult for anyone to pursue the same strategy as well as they did.

But in my next piece, I will explain why one element of the strategy may be weakening.  Until then.

Full disclosure: long BRK/B for myself and clients

Photo Credit: Snowshoe Photography

Photo Credit: Snowshoe Photography

This should be a short post. Weather forecasters deserve to be double-checked, as there has been a tendency among weather broadcasters to sacrifice accuracy for ratings, which can be goosed in the short run by offering a good scare.

I offer the most recent snowstorm as a partial exhibit. There is a real cost to misforecasting, as this article from USA Today points out:

The lost wages and tax revenue from stores and others businesses that shut down early Monday and kept employees home Tuesday, in anticipation of something far more … dramatic.

The vacations, business trips and job interviews disrupted by the pre-emptive cancellation of thousands of airline flights across the Northeast. The extra aggravation caused Monday by those two words that every working parent of school-age children dreads: early dismissal.

All the overkill adds up, in ways that may be impossible to tease out precisely.

Now, many actions are due to a need for caution, but caution needs to be kept in bounds, lest the costs of businesses and government grow without any value gained.  Maybe my bias comes from growing up in Wisconsin, because we were always ready for bad weather, and at least in that era, rarely canceled anything in the winter.

My second observation stems from hurricane forecasting.  Both the overall estimates of the number and severity of storms for the season and the individual estimates of likely severity seem to be biased high.  Again, I blame the need for high ratings.

Yes, we get occasional monster years with hurricanes, like 2004 and 2005.  We also get freak storms like Katrina and Sandy that cause a lot of damage from the degree of flooding that accompanies some severe storms.

As an analyst of insurance companies that insure against many of the losses that come from these storms, it has taken an iron constitution to keep from trading out of loss-exposed insurers when I think the forecast is overly pessimistic.

On a personal level, it is good to be prepared for the kinds of catastrophes common to the area in which you live, regardless of the current predictions.  But where weather affects your business or your investing, I would encourage you to double-check severe weather forecasts to see if they make sense before taking actions as a result.  There are costs to being wrong on each side, so be careful.

1. Recently I appeared on RT Boom/Bust again.  The interview lasts 6+ minutes.  Erin Ade and I discussed:

  • Who benefits from lower energy prices.
  • The No-Lose Line for owning bonds,
  • Whether you are compensated for inflation risks in long bonds
  • How much an average person should invest in stocks with any assets that they have after buying their own house.
  • The value of economics, or lack thereof, to investors today.

2. Also, I did an “expert interview” for Mint.com.  I answered the following questions:

  • What is your most basic advice on investing?
  • What can you tell young people to help them stay financially secure in their futures?
  • How can a potential investor go about finding the best investment professional to work with for his or her individual needs?
  • Please explain how being a good investor and a good businessman go hand in hand.
  • What is your favorite part of your job?
  • You clearly do a lot of reading, as seen from your book reviews. What other genres of books do you enjoy?

3. Finally, Aleph Blog was featured in a list of the Top 100 Insurance Blogs at number 29.  I find it interesting because my blog has maybe 18% of posts on insurance topics.  That said, I have a distinctive voice on insurance, because I will talk about consumer issues, and what are companies that might be worth owning.

Enjoy the overly long infographic.

Top 100 Insurance BlogsAn infographic by the team at Rebates zone

.