I went to a Chief Investment Officer’s conference for insurance investors in October 2001.  What I remember most is that we were the only company being so aggressive.  In a closed0-door meeting, the representative from Conseco told me I was irresponsible.  To hear that from a company near bankruptcy rang the bell.  I was convinced we were on the right track.

By mid-November, we had almost completed our purchases of yieldy assets, when I received a phone call from the chief actuary of our client expressing concern over the credit risks we were taking; the rating agencies were threatening a downgrade.

Well, what do you know?!  The company that did not understand the meaning of the word risk finally gets it , and happily, at the right time.  We were done with our trade.

We looked like doofuses for three months before the market began to turn, and I began a humongous “up in credit” trade as we began to make a lot of money.  By the time I was done in early June, I had upgraded the whole portfolio three full notches.  A great trade?  You bet, and more.  What’s worse, it was what the client wanted, but not what it should have wanted.

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What should my client have wanted?  Interest spread enhancement with loss mitigation.  That is the optimal strategy for life insurers.  We were ready to do that, but at a meeting in late September 2001, the client said, “The management of assets for this company has been lazy; there is not enough trading.  We want to see the highest returns possible; give us total returns!”

I tried to explain why that was not the best way to manage insurance assets.  After all, I had been doing this for ten-plus years, and knew the difference between current GAAP accounting and long term sustainable GAAP accounting.

The CEO told me that I knew nothing at all, and that portfolio management needed to be active.  Activity meant more profits.  I told him that he was wrong, and was rudely cut off.  I did not go back to that argument.

After we had a few inconsequential defaults, the client complained loudly.  This was an ignorant client that did not recognize reality.  Defaults are a fact of life; if you run with your capital base so thin that you can’t take a few modest defaults, you are running your insurance company wrong.

As it was, the emphasis on trading did generate capital gains initially, the portfolio began with unrealized capital gains.  But the company took the capital gains to be “free money,” used them as new capital, and began writing more underpriced aggressive insurance/annuity policies.

But then, as capital got tight, the chief actuary came to me saying that they needed to do a financial reinsurance treaty to raise capital for the firm.  I replied that we did not have many bonds with an above market yield.  We had the Prudential
“C” bonds that I mentioned earlier, and a few more, but not a lot more.  I scraped together what I could, culling the best bonds from the portfolio, realizing that the remainder would be decidedly subpar.  You could say that they hocked the “family silver.”

They did the reinsurance deal over my objections, which technically did not meet the stipulations of the state regulations, and gained more capital to write business against.  There was a cost, though.  We could not sell any of our best bonds, and the regulatory profits of the firm would now be flat to negative.

I did my best to aid their business goals, finding weaknesses in the risk-based capital formulas, and managing the interest rate posture of the company to near-perfection, all of which reduced capital needs.  But when you are running a company that is addicted to making sales, even if the sales are only marginally profitable, and not covering the cost of capital, that is the path that matters will take.

Would that they had listened to me, but they were arrogant.  What price did they pay for their arrogance?

• The company CEO was encouraged to retire.
• The CFO and Chief Actuary had to leave.
• The parent company CEO was forced to resign for all of the money he had plowed into that loser of a subsidiary in the US.
• The company was put up for sale, but given the dubious operating history, bidders were few and reluctant to spend much.

Any successful insurance enterprise needs bright managers on both sides of the balance sheet.  Bright managers of the assets, and issuers of policies that don’t give away the store.

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PS — I had one bond that was a high interest second-lien loan on one of the most valuable buildings in Baltimore.  At the time, the equity owner of the building called me, and made me a lowball estimate to pay off the loan, a few months before it would spring to first lien status.  I politely told him “No way,” and named a considerably higher price at which I would consider a buyout.  He told me that I was ridiculous, and I said “Fine, but I have read the agreements, and know our rights.”

He then called the client, and made the same offer.  They pestered me to deal with him, and I explained how he was wrong, and that the price should be much higher.  They agreed with me, and that was put to rest… until I left the firm, and the equity own got the deal done, paying up a little more, but by no means what he should have.

As I said many times regarding my client, “You can’t teach a Sneech.”  Sad but true for many who don’t understand investing.

For those who haven’t read the articles, tail risk is when even safe investments get hit hard.  Those market outcomes are rare but severe, so some people look for insurance to clip their risks when everything is getting whacked.

Possibly a reasonable goal, and the best time to aim for it is when things are pretty good, because it is best to buy insurance when it is cheap to do so.

But what form should the insurance take?  I can think of three broad categories:

• Assets that come into existence during the disaster.
• Ready liquid assets — short-term and high quality.
• Liabilities that disappear with the disaster.

The first category is the one most people think about.  What can I buy that will do well when the disaster comes?  There are two branches to that question:

• Do I want my downside clipped on this trade (for a price)?
• Do I want to make the bet without paying much, and I could win or lose?

In the first category are puts and buying protection via CDS, which will protect for a time, but cost money to put on the trade.  Worse, you could be right on the event, but wrong on the timing, and they end up expiring worthless.

Note: be wary of products Wall Street would like to sell you here.  Most often, they sell something mispriced to you, though it looks attractive.

But even if you are right, your counterparty/exchange  has to remain solvent in order for the trade to work.  Few factor in the cost of insolvency there.  Think of those who though they were clever laying off risk to AIG, a trade which only worked due to government intervention.

In the second category, there are assets like precious metals and long Treasury zero coupon bonds, each of which will do well in a specific crisis, but not just any crisis.  But there is also the shorting of equities and high-yield bonds, which could potentially deliver big gains, or big losses if the rally continues.

I would offer this test to anyone offering a hedge against tail risk: is it any better than puts or buying protection through CDS, or shorting equities or high yield bonds?  I would suspect in most cases the answer is no.

Then there is my preferred solution: hold cash.  Cash is unique; it can be used for anything; it can be used for almost every contingency.  Cash may offer little to nothing; it may even yield negatively, but that is the cost of security and flexibility.

Then there is the third option: offering catastrophe [cat] bonds.  Why should the guys following hurricane, quake, typhoons, and European windstorms have all of the fun?  There are more and bigger disasters than those in the financial markets.

In simple terms, here’s how a cat bond works: after a disaster that meets the terms of the cat bonds occurs, the principal of the bond diminishes by the size of the covered loss, if it is in excess of certain thresholds.  The advantage of an arrangement like this is that an insurer or reinsurer can get reinsurance against a disaster, by issuing a high-yielding cat bond.

The high-yield investors are happy to buy it because typically cat bonds are highly rated, and offer a good return that is uncorrelated with the returns on other high yield bonds.  Physical disasters seem to happen independently from financial market disasters.

The bond issuer gets reinsurance capacity, which is sometimes scarce, at a price that reinsurers would not match.  Cat bonds can never replace reinsurers, though, because the reinsurers offer more tailored coverages, while cat bonds tend to be more broad-brush.  They are usually cross-hedges for the issuer, covering something that is likely to be highly correlated with their loss exposure in a disaster.

What Might be a New Idea

What if we applied the concept of a cat bond to hedging risky security portfolios?  Think of it as an odd sort of margin account.  A hedge fund borrows money via a special purpose vehicle [SPV], which holds high quality collateral.  The hedge fund pays the SPV for insurance coverage; the SPV pays interest to the cat bond investors.  If a loss event happens, say a large decline in the S&P 500 index below a stated level, the principal of the cat bond is written down, and the SPV pays the amount of the writedown to the hedge fund.

Compared to a cat bond based on a physical event, there is one advantage and one disadvantage.  The disadvantage is that the loss trigger on a financial cat bond is highly correlated with bad high yield bond market performance, eliminating a lot of the diversification advantage.  This would mean that a financial cat bond would have to pay a higher premium than a physical cat bond.

There is an advantage, though: it can be hard to set up a large hedge without disrupting the market, and it is difficult to gain protection over long periods of time.  Most hedging instruments are short dated, and limited in the amount of capacity available for laying off risk.

Would this be attractive to a large hedge fund?  I’m not sure.  This sort of protection has the same sort of drip, drip, drip of cash out that most managers hate to see, whether for writing puts or buying protection via CDS.  It would come down to a question of cost versus a locked-in solution that could last for ten years, with little to no counterparty risk.

Conclusion

But personally, my best solution is lower your leverage and hold some cash.  Nothing beats the flexibility and simplicity of cash in a disaster.  Cash is also an index of humility; we are willing to leave something to the side in case we are wrong.  Being wrong is a normal state of affairs in investing, so take time to prepare for the next time you will be wrong.

The staff and I got together, and the credit analysts told me that I should lead the organization during the merger.  When I asked why, they said they trusted me, appreciated my growing bond skills, that I was the only one who understood the client, and said that I had a better call on credit than the boss had.  I was surprised by that last comment, but upon meeting with the management of our parent company that was selling us, along with the life insurance company that we managed, they told me that yes, I should lead the unit until the merger closed, but rely on the high yield manager in our group to advise me for the duration, which was going to be three months.

The first thing that I did was a bond swap, trading away an older bond of a company for a new issue.  There was some hurry in the matter, so I entered into the swap before I could consult the high yield manager.  After I could talk with him, he pointed out that I had offered terms more favorable than I should have.  On a $5M swap, I ended up losing $20K.  We worked through the swap a number of different ways, which solidified my knowledge of corporate bond pricing.  I did not make that error again.

In the corporate bond market, new deals come frequently.  My former boss would do almost all of his bond buying on new deals, and almost never in the secondary market, because he knew that new deals almost always came cheap.  There is a price to be paid by corporations to gain liquidity.  The life company that I managed money for was growing like a weed (their products were perpetually underpriced), so I had a lot of money to put to work.

But, I already had a large portfolio of corporate names.  I was familiar with many of them to some degree because of my stock investing.  How could I go through the whole portfolio to look for bombs that might be lurking? Ask the credit analysts to give me a review on every name?  I did not want to kill them, or me for that matter.

I took the idea home , and thought about it, and then it struck me.  Thinking of bonds as having sold a put option to the equity, why not look at the amount that the stocks of the companies issuing the bonds had fallen in price since issuance of the bonds?  I set a threshold of 50%, and that gave me a list of about 30 names to hand to the analysts.  Manageble.  Cool.  (Oh, and tell me briefly about these 20 private bonds where there is no stock price.)

The analysts came back with their opinions, and surprisingly they advised selling half of the bonds and keeping the other half.  That was more than I expected.  But I started selling away, and began to learn the art of price discovery.  When you want to sell a bond, you first have to look at what investment banks ran the books of the deal.  There is an unwritten rule that if they play that large role in origination, they have to make a market in the bonds thereafter.  So, I consulted the various investment banks and inquired about levels, and then said something to the effect of, “If there is a reasonable bid (naming the spread over Treasuries) we would be interest in losing a few million bonds.  If there is an aggressive bid, we could be induced into selling a few more.  We might even be willing to sell the whole wad if they make us the offer that we can’t refuse.”

If there were multiple banks that traded the bond, I would set the above up with just one bank.  You never wanted to make it look like there were two sellers out there, or bids would vanish.  Beyond that, it was bad etiquette to employ two banks without telling them that they were in competition with each other.  If not. you could end up with two orders to buy your bonds, and you would have a moral obligation to meet both orders, even if that was against your interests.

Usually the broker would ask for the total size of the wad available for sale.  The idea was to get the buyers to think economically.  Yes, they could get a small amount of bonds if they met the spread, but was it worth it to bid for more?  Also, if they bought the wad, they would know that there were likely no more bonds on offer, the selling pressure would be gone, and the bonds would likely trade up from there.

I sold away a decent amount of the bonds that the analysts wanted gone, and then 9/11 hit.  What a day.  Since we worked inside the insurance company that we manager money for, and we had two TVs on the corners of our trading floor, all of a sudden our area was flooded with people staring at the spectacle.  I almost felt like Crocodile Dundee as I had to maneuver my way around and over them.

I gathered my staff and told them to look at their portfolios, and e-mail me threat reports so that I could inform our client.  After that, take the rest of the day off, as there is nothing to do here; many of them wanted to mourn friends that might be dead (I lost two acquaintances).  I summarized the threat reports, and submitted them to the client by 4PM.  We repeated that process for the next eight business days, until the crisis was past.

I had worries over One Liberty Plaza, next to the former World Trade Center, which seemed to be leaning, and might fall.  We owned the AAA portion of the CMBS that contained the loan for that building.  As I scoured the web, I concluded there was no danger, the building only looked like it was leaning; the dark coloration was deceptive.

Eventually trading resumed.  If you remember Metcalfe’s Law, the value of a telecommunications network is proportional to the square of the number of connected users of the system.  Well, after 3 days, 2 of 12 major brokers were running, which meant that there was no trading.  After 4 days, 6 brokers were up, so I made an offer on some AA Manufactured Housing ABS, deeply below where there market was prior to the crisis.  I got hit, and I owned the bonds.  Some said to me, “Why not wait?  Why offer liquidity now?  I said that some had to make some bids to restart the market; my client had ample liquidity, and I was offering liquidity at a price; if someone was that desperate for liquidity, they could have it at my price.

After 5 days 8 of the 12 were up, and after 6, 10 of 12.  The last two took a while to re-emerge, but were back after 10 days.  Even so, things seemed sluggish.

I began to do the same with corporate bonds, doing a large auction offering liquidity, specifying bonds that I wanted at certain levels, and the amounts.  I ended up buying half of my list, and still my client had ample liquidity.  What a high quality problem to have.  More in my next segment.

Anyway, here are three responses that I gave to my bosses over a four month period on deals that were brought to them.  Names have been obscured where possible.

Project 1

This was a deal that attempted to securitize life settlements, i.e. life insurance policies where the owner has sold off his interests to a third party.  The biggest problem was all of the money sucked out of the deal that would not be invested to earn a return.  Here is what I wrote:

Dear Boss,

Notes on the deal

I have read the Overview and the Private Placement Memorandum [PPM], and have scanned everything else.  Here are the main points:

1. The key page of the entire document is page 18 of the PPM.  In it we learn: the zeros get a 4.07% return, but the collateral has to earn 11.72% net of fees in order to make this deal pay off.  Also, 65.52% of the proceeds go to other than investment purposes.  Why so large?  (As an aside, this yield is at a discount to Treasuries.  An equivalent length treasury zero yields 4.55%, AAA Aid to Israel – ~5%.)
2. The continuing fees are hefty – Servicing 1%/year of Face?  Origination – 1%/month of the Matured Policy Increase Amount [MPIA - essentially a measure of cash flow profitability]?  Administrative expenses as well to third parties.  I can’t tell how big those are, or how much the collateral would have to earn to make the bond pay off.
3. The residual value guarantor, AAACO, is not in good shape.  The central bank of CN has taken over the assets and liabilities for now, but it does not seem that they have guaranteed the liabilities permanently. They are rated “B” by AM Best – not a sound rating.  On taking over the group that owned AAACO, S&P said that it was a big enough rescue that they might have to downgrade CN from its A rating.  They have since reaffirmed the rating as stable, but Moody’s now rates CN as Baa1.
4. The residual value policy doesn’t do much if there is a modest deviation from perfect performance by the originator or servicer, the policy won’t pay.
5. We don’t have all of the documents, such as the Blocked Account Control Agreement.  But beyond documents, we don’t have any sort of cash flow analysis.  How are they going to earn so much on so little invested capital?
6. We don’t have any data on the life policies, insurers, etc.  Some insurers fight life settlements.
7. The Overview dramatically oversells the virtues of the deal.  Many of the things it lists as protections are weak.  Points 3 and 5 are the same points, but it makes them sound different.  Further, CN do not own AAACO, they have it in a form of semi-receivership.  If they did own it, AM Best would give it a better rating.
8. BBB is the actuary, but she owns the originator and the servicer. [Origco & Servco]  She is not bound to continue with the deal till maturity if it gets originated (she will be 75 herself then).
9. Servco and Origco have defaulted on prior deals, and they weren’t able to get enough interest on the first deal to make it work.
10. Origco is basically broke.  They have assets of $500K, and liabilities of $2 million.  The assets are receivables from Servco.  Servco owes $16 million that it can’t pay off either.
11. Origco and Servco do not use accrual accounting.  They could not pass a GAAP audit.  Even with accrual accounting, they would not be a going concern.
12. Origco and Servco have existing default judgments against them, and no way to pay them.
13. If Servco or Origco default, the residual value policy does not pay.
14. Servco and Origco have no significant staff.  If this gets originated, there will be a significant risk as they staff up.   They also don’t have licenses.  This is not a bond, it is seed stage venture capital.
15. They have had run-ins with the SEC, Texas Securities Commission, and Securities Division of North Carolina.
16. The notes are deemed equity for tax purposes, which seems aggressive to me.

If you want, read page 18, and scan the risk factors section of the PPM (pages 19-57).  It is my belief that this is something that we don’t want to get mixed up with, at any price.  I can understand why no underwriter wants to take this on, and why they are looking to smaller broker-dealers.  But if you want to look into this further, have them forward to me their cash flow analyses.  I can’t imagine how they get this to work.

I have this phrase that I use sometimes, “Holding my nose as I hit the delete key.”  That is when something smells so bad, the odor can even travel over the Internet.  This feels like the attempt of some desperate people who are deeply in debt, and need one “grand slam” to bail themselves out of debt
and have a happy retirement.

Postscript: this deal not only did not get done, but the boss apologized for bringing it to me.

Project 2

This was a case where someone was willing to offer us $5 million in capital if we gave them $1 million.  What an altruist!  Not.  Yes, the value of shares if you could sell them all at the “last trade” was worth $5 million, but the company was basically a warrant on the success of a technology, and the balance sheet was horrendous.  This is what I wrote:

Dear Boss,

This doesn’t smell good.  Here’s my commentary, together with excerpts from their recent 10-K and 10-Q:

$6250 Stock Trading Volume per day

Negative earnings, cash flow, and net worth.  Little to no liquidity – huge negative net working capital.

1-100 reverse split

Auditors comment for 2008 10K: The accompanying consolidated financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 11 to the consolidated financial statements, the Company has a significant working capital deficit, has recognized significant operating losses in each of the years in the three year period ended December 31, 2008, and will need significant amounts of investment funds to fully develop its oil and gas leases. Management’s plans in regard to these matters are described in Note 11. The financial statements do not include any adjustments that might result from the outcome of this uncertainty.

The Company currently has three full-time employees.

Risk factor: The Company has incurred net operating losses since 1997. However, the Company currently has operations that provide working capital. The Company is also seeking further project based financing to develop its existing projects. There is no assurance that the Company will be able to secure adequate financing to fund those operations.

High compensation to management for not much of a company.  $5 million in 2008.

The Company failed to timely file a current report on Form 8-K upon the occurrence of the Default Notice and Acceleration Notice under the Credit Agreement with CCC, and the July 22, 2008 Limited Forbearance Agreement pursuant to which Gas Rock agreed to refrain from pursuing remedies for a limited time.

NOTE 7 – Note Payable – CCC CAPITAL LLC

The Company entered into an advancing term credit agreement for $30,000,000 on April 13, 2006 through its subsidiary DDDa, LLC with CCC Capital, LLC to fund the purchase of the EEE Field in GGG Oklahoma. This agreement was increased to $50,000,000 on April 2, 2007. The balance at December 31, 2008 was $13,423,221, net of debt discount of $41,077, and the Company paid interest of $1,957,294 for the year ended December 31, 2008. The note is secured by all of DDDa’s assets and certain personal assets owned by EEE, CEO of the Company. DDDa’s assets are cross-collateralized on a $3,469,000 loan made by CCC Capital, LLC to FFF, a related party. This loan is currently in default, with interest only payments being made.

On April 9, 2008, CCC delivered to the Company a Notice of Events of Default and Unmatured Events of Default (“Default Notice”) under the Credit Agreement. Due to these claimed Events of Default, interest under the Credit Agreement began accruing at the Default Rate of 15% and 100% of DDD’s Net Revenues were applied to Debt Service and other Obligations as of April 9, 2008. On April 16, 2008, CCC delivered to the Company a Notice of Acceleration (“Acceleration Notice”) under the Notes due to the continuing claimed Events of Default under the Credit Agreement. The Acceleration Notice declared the amounts due under the Note to be accelerated and due and owing in full as of April 16, 2008.

On July 22, 2008, CCC, DDDa and FFF (“FFF”, and together with DDDa, the “Borrowers”), entered into that certain Limited Forbearance Agreement, pursuant to which CCC agreed, subject to the terms thereof, to forbear from pursuing remedies under the Credit Agreement and Notes in respect of the Events of Default claimed as of that same date until the earlier of (i) November 15, 2008 and (ii) the date that CCC gives DDDa notice of any additional payment default under the Credit Agreement. FFF is controlled by the Company’s CEO and is a guarantor of the DDDa Obligations under the Credit Agreement. CCC is also a lender to FFF under an Advancing Term Credit Agreement (the “FFF Credit Agreement”, and together with the Credit Agreement, the “Credit Agreements”.

The Forbearance is subject to the following conditions to be fulfilled:

1) On or before November 15, 2008, (i) the Borrowers must repay all Obligations (as defined in the Credit Agreements) or (ii) DDD must have entered an agreement for the full or partial sale of the EEE Field, the proceeds of which would fully repay the Obligations owing under the Credit Agreements, and such sale shall close and repayment of the Obligations shall be made by December 31, 2008;

2) If the Obligations are not repaid by November 15, 2008, DDD must assign a 5.0% net profits interest in the EEE Field to CCC, effective as of November 1, 2008. The form of this assignment and the potential assignments discussed in paragraph 3, below, will be substantially in the form of the Conveyance of Net Profits Overriding Royalty Interests, attached as Exhibit A to the Forbearance Agreement;

3) If the Obligations are not repaid by December 15, 2008, DDD must assign an additional 1.0% net profits interest in the EEE Field to CCC, effective as of December 1, 2008, and will assign to CCC an additional 1.0% net profits interest each subsequent month if the Obligations are not repaid by the 15th of such month;

4) DDD shall escrow one 5% net profits interest conveyance and five 1% net profits interest conveyances to ensure it’s delivery of any potential obligations under paragraphs 2 and 3, above;

5) Any and all Net Proceeds (as defined in the Forbearance Agreement) from any equity issuance, refinancing, or asset sale will be applied first to outstanding fees and expenses of CCC, second to the accrued and unpaid interest on the Notes, and third to the outstanding principal balances on the Notes; and

6) The Borrowers must ensure that its hydrocarbon purchasers make payments relating to any of CCC’s overriding royalty interests in the EEE Field directly to CCC.

NOTE 11 – Going Concern

The Company has reported operating losses aggregating $9,877,016 for the two (2) year period ended December 31, 2008. At December 31, 2008, the consolidated balance sheet reported a working capital deficit of $23,887,172. The Company must raise significant amounts of cash to pay its current liabilities and to provide investment funds to continue development of its oil and gas leases. There can be no assurance the Company’s management will be able to secure funding.

David here: There is little assurance that an immature development stage company like this will ever be worth anything.  I am no expert on hydrocarbons but this company is overindebted, and it is likely that debtholders will own the assets within a year or two, and equityholders get nothing.

DDD shares would not, not, not be an asset to our firm.

Postscript: 6 months later, the stock worth $5 million is worth $300,000.  And will be worth zero soon.

Project 3

Another life settlements securitization.  The originator seems to be honest, but is using the securitization to get a cheap commercial mortgage loan.  What I wrote:

Dear Boss,

I’ve read through the whole document.  Here are my thoughts:

Summary Notes

The officers of the company have no experience at all with life settlements.  They do have some experience with multifamily housing.  They are using a life settlements securitization to facilitate loans for their multifaqmily housing expansion plans.  To me, that is pretty convoluted.  Why not simply go out and borrow the money?

I realize the offering memorandum is preliminary, but there are several things that need to be clarified:

• Need to see the financials of the GGG enterprises
• Correct address for their website.
• Who is HHH Capital Management?  Can’t find them – the portfolio managers.
• Need fees, policy data, and expected cash flows
• What are they doing to source portfolio 2?
• Need actuarial projections
• Exactly what are the trusts receiving as collateral for the loans?  I need pro-forma financials on the property(ies) to be developed…
• Where are the related party transactions?
• If this deal is 3x overcollateralized, where does the excess money come from?  Who is the equity, and what are their motives?

That’s all for now.  Looking forward to more data.

After the response, I wrote:

Dear Boss,

I realize the offering memorandum is preliminary, but there are several things that need to be clarified:

I have three tentative conclusions (with questions):

1.      The largest asset is a 9 year fully amortizing 2.7% loan on the $40,000,000 to the sponsoring company.  It is a hidden source of profit to them, but the full amortization makes the loan more secure, it they can make the first few payments.  That said, they would need 12% cash flow on the loan to make the payment, and where will they get that?

2.      The deal would need a 6.1% return on the Life policies to get a Treasury yield on the certificates.  8.0% return to get T+100.  15.75% to get T+500.  What would it take to sell these notes?

3.      There is a low probability of full payment of principal.  A margin of $25 million on a $250 million principal payment is skimpy, and in my opinion, decidedly not investment grade.  I assume these aren’t going to be rated, right?

And I have additional data needs:

4.      Who is HHH Capital Management?  It looks like a new firm – do they have the ability to do their part?

5.      I need fees, policy data, and more detailed expected cash flows. Where is Appendix B?

6.      How were the life expectancies calculated?  That’s hard to do right.  Second opinions?

7.      I need actuarial projections, with considerable detail. That would mean a copy of the JJJ review.

8.      Exactly what are the trusts receiving as collateral for the $40 million loan?  Pro-forma financials on the property(ies) to be developed… And, I would need to see the financials of the GGG enterprises.

I think this deal will prove hard to complete.

Postscript: we went further with this group than the other two, but when faced with my data requests, the originator gave up.

After this happened to me, I talked with an investment banker who is local, and has many contacts like mine.  He commented on how small broker dealers get hit up with slick pitches, any one of which if accepted, could destroy the broker-dealer.  The trafficking of blocks of life settlements is endemic, and is a search for what lemming has the lowest discount rate — has mis-estimated the risks.

He also mentioned how these groups toss around big names as those that will buy the senior certificates.  I experienced that myself.  Kuwaiti Investment Authority, indeed.

So, in four months time, I kept my firm from making dumb decisions three times, any one of which might have severely damaged or destroyed the firm.  What did I get get for my efforts?  The best thing of all: gratitude from my bosses, and knowing that I did my best for those that hired me, protecting the interests of all stakeholders of the firm.

Skepticism is a necessary aspect of investing, particularly as the complexity level rises.  Aim for simplicity, and put safety first in your investing.  It is easier to protect value than to try to earn back losses from mistakes.

To phrase it another way — in order to work through these deals, I had to read through over 1000 pages of data.  Don’t let the multiplicity of words dull you to the risks that exist.  Even for small investors I would say avoid complexity.   Where there is complexity, there is a much higher risk of loss, almost always.  Stick to simple investments, and let the complex stuff be bought by experts, who will turn away most of the charlatans.

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Onto tonight’s topic: asset allocation.  So, we had a bad quarter for equities.  Not that I can predict things, but I pulled in my horns progressively over the last nine months, culminating in buying a bunch of utilities at the last portfolio reshaping.  I own mostly energy, insurance, utilities, and consumer nondurables stocks, with a little tech thrown in for fun.  At present, median P/E is around 9, and P/B around 90%, with strong balance sheets, and around 17% of the portfolio in cash.  I missed roughly half of the carnage of the last quarter, and this week, I put some money to work, cash falling by 1%.

So, when are equities cheap?  Next question: cheap relative to what?  It’s difficult to say when equities are absolutely cheap, but here are some ideas on cheapness:

• Stocks are absolutely cheap when they trade in aggregate at less than book value, or less than 8x trailing earnings.  Think of Buffett getting excited back in 1974.
• Stocks are relatively cheap to Baa bonds when the earnings yield of stocks plus 3.9% is above the yield on Baa bonds.  But this at present depends on very high profit margins continuing, and sales not shrinking, neither of which are guaranteed.
• When there is significant debt deflation going on, determining cheapness is tough.  Better to ignore the market as a whole, and focus on survivability/cheapness.  Aim at companies in necessary industries with relatively little debt, strong accounting practices, and cheap to earnings/book/sales.
• I don’t have a good metric for when equities are cheap/dear to commodities.  Ideas welcome.

With respect to bonds, credit spreads are not wide enough to make me yell buy, as I did in November 2008 and March 2009.  Beyond that, the spread on GSE debt and guaranteed mortgages is thin.  TIPS look attractive, as few care about inflation.  The US dollar has been strong lately, largely due to weakness in the Euro.  I would be light on non-dollar bonds for now.

What we have been experiencing is creeping illiquidity, where the prior stimulus from the Fed and US Government has been declining.  There isn’t enough private demand growth to drive the economy, because we need to pay off or compromise on debts.  Also, the private sector looks at the growing debts of the government, and gets concerned.  How will the government deal with it?  Higher taxes, inflation, default?  No good scenarios there.

When an economy is overleveraged, there are no good solutions.  If sales fall, then corporations will fire more people, and idle more capacity in order to maintain profits near prior levels.  High quality bonds do well, but stocks do poorly, until enough debts are paid of or compromised, and the economy can work without the fear of mass insolvency again.

I have written before on a new approach to asset allocation.  Broadly, I am looking at a system that:

• Considers the credit cycle first.  Great returns typically happen after credit spreads are wide, and are lousy after they are tight.
• Considers the slopes of the Treasury nominal and TIPS curves.
• Looks at the cash flow yield of all asset classes relative to history, relative to other asset class yields, etc.
• Factors in safety provisions for each asset class.  Stocks need the most, then junk bonds, then investment grade.
• Looks at the short-run and the long-haul returns of each asset class, attempting to analyze when the short run is way above or far below long-haul trends.

At present, I am still happy playing conservative, because I am less confident about debt deflation than most investors are now.  There will come a time to be much more bullish, but it will come after earnings decline, and firms have delevered still further.

I’m working on my quarterly reshaping — where I choose new companies to enter my portfolio.  The first part of this is industry analysis.

My main industry model is illustrated in the graphic.  Green industries are cold.  Red industries are hot.  If you like to play momentum, look at the red zone, and ask the question, “Where are trends under-discounted?”  Price momentum tends to persist, but look for areas where it might be even better in the near term.

If you are a value player, look at the green zone, and ask where trends are over-discounted.  Yes, things are bad, but are they all that bad?  Perhaps the is room for mean reversion.

My candidates from both categories are in the column labeled “Dig through.”

If you use any of this, choose what you use off of your own trading style.  If you trade frequently, stay in the red zone.  Trading infrequently, play in the green zone — don’t look for momentum, look for mean reversion.

Whatever you do, be consistent in your methods regarding momentum/mean-reversion, and only change methods if your current method is working well.

Huh?  Why change if things are working well?  I’m not saying to change if things are working well.  I’m saying don’t change if things are working badly.  Price momentum and mean-reversion are cyclical, and we tend to make changes at the worst possible moments, just before the pattern changes.  Maximum pain drives changes for most people, which is why average investors don’t make much money.

Maximum pleasure when things are going right leaves investors fat, dumb, and happy — no one thinks of changing then.  This is why a disciplined approach that forces changes on a portfolio is useful, as I do 3-4 times a year.  It forces me to be bloodless and sell stocks with less potential for those wth more potential over the next 1-5 years.

I still like energy names here, utilities, and reinsurers, particularly those that are strongly capitalized.  I’m not concerned about hurricanes for the strongly capitalized; they will be around to benefit from the increase in pricing power after any set of hurricanes.

I’m looking for undervalued and stable industries.  Human resources — sure, more part time workers.  Healthcare information?  A growing field, even with the new “health bill.”  Same for Biotech.

Even in a double dip, toiletries will still be purchased.  Phone calls will still be made, and the internet will still be accessed.  Perhaps life insurers are worth a look here; after all, the Bush tax cuts are expiring, and there will be more demand for tax avoidance.

I’m not saying that there is always a bull market out there, and I will find it for you.  But there are places that are relatively better, and I have done relatively well in finding them.

At present, I am trying to be defensive.  I don’t have a lot of faith in the market as a whole, so I am biased toward the green zone, looking for mean-reversion, rather than momentum persisting.  The red zone is more highly cyclical than I have seen in quite a while.  I will be very happy hanging out in dull stocks for a while.

This book review is special to me.  I don’t often get quoted in books, but in this book I get quoted on page 98.  Here is the quotation:

When I asked an insurance analyst whether he thought the credit rating companies would ever rethink MBIA’s top rating, he was skeptical.  “For Moody’s [or Standard and Poor's] to put a bond insurer on negative watch (indicating a rating cut was being considered) could have extremely negative ramifications” for the entire bond insurance business, said David Merkel with Hovde Capital Advisors in Washington, DC.  “It’s a bit of a confidence game.”

Confidence Game indeed.  I did not see the phrase elsewhere in the book, but I may have missed it. If I inadvertently titled the book, I am honored.

I do not remember talking to the author, Christine Richard, but what she quoted was broadly representative of half of my view on the financial guarantee insurers.  I believed that it would be very difficult for the rating agencies to downgrade the financial guarantors, because they were such a large part of their AAA ratings, and because they would lose money in the short run from doing so.  Though it was written a year later, this article at RealMoney reflected my views.

In the short run, I viewed the rating agencies and financial guarantors as co-dependent.  The rating agencies  would protect the guarantors for as long as they could, and after that, the bottom would fall out, and it would become a “free fire” zone.

All in all, over the next five years I wrote over 30 times about the financial guarantors.  Here is a sample of that (in rough chronological order):

• Miscellaneous Notes, Redux
• A Tale of Two Insurance Companies
• Insurance Asset Quality, Part 3
• Contemplating Life Without the Guarantors
• Not Dissing Warren the Wonderful
• The Beauty of Broken Moats
• What Would Happen to Structured Products if the Guarantors were Insolvent?
• Thirteen Notes on the Nexus of Woe: Financials and Real Estate
• The Dike Has Sprung a Leak
• All or Nothing at All
• Five Thoughts on the Financial Guarantors
• Moody’s Downgrades XL Capital Assurance
• Bill Ackman Talks His Own Book
• Shelter Fallout
• The rating agencies have been dragged. When will the kicking and screaming stop?
• Now, That Was Fast!
• Downgrades Come Easy, Upgrades Come Hard, Upgrades to AAA? — Forget It.
• The Rules, Part XI

Again, my view was that the financial guarantors would eventually be downgraded, but that the rating agencies would delay it for as long as they possibly could.  That is what happened.

Now, as for Bill Ackman, he was prescient; he saw the problems early — way too early.  As I said about Markopolous and Madoff, it is usually a mistake to obsess over something that is manifestly wrong, but that you can’t affect.  Ackman spun his wheels for years over MBIA, and he was right eventually.  Many other men would have given up, but not Ackman.  And part of that is the nature of shorting; it is normally supposed to be a tactical discipline rather than a strategic one.  There are few companies that one can short into the ground, and Ackman almost went that way with MBIA.

But when you are right, you are right, so long as your funding base sticks with you.  Ackman had loyal investors, because the gains took years to manifest.

As for the author, she has carefully balanced the words of Ackman versus the words of others in the situation.  She has done an admirable job of being neutral while still portraying the victor fairly; would that the heads of MBIA talked to her more.  Sadly, they come off as a bunch of hacks who don’t understand that their models relied on a highly liquid economy, with rising housing prices.

I recommend this book highly.  If you want to buy the book, you can buy it here:  Confidence Game: How a Hedge Fund Manager Called Wall Street’s Bluff.

Who would benefit from this book

Most average investors could benefit from the book.  It would tell them that economic systems that rely on third-party appraisals are inherently fragile.  They can be gamed by those with a concentrated interest for a time, until reality catches up with them.

Full disclosure: Janet Tavakoli told me I was quoted in the book, so I asked the publisher for a copy to review.

If you enter Amazon through my site, and you buy anything, I get a small commission.  This is my main source of blog revenue.  I prefer this to a “tip jar” because I want you to get something you want, rather than merely giving me a tip.  Book reviews take time, particularly with the reading, which most book reviewers don’t do in full, and I typically do. (When I don’t, I mention that I scanned the book.  Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website.  Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites.  Whether you buy at Amazon directly or enter via my site, your prices don’t change.

Hey, thanks for mentioning me. Here’s a bonus for those with access to RealMoney:

• Time to Get Personal With Insurers
• Parsing the Financials of the Financials
• Buyers Beware: Financials are Different
• Don’t Bet Your Life on the Insurance Sector
• Playing the Cycles in the Insurance Sector

And away from RealMoney:

• How Wall Street Looks at Insurance Companies
• An Amazing Ten Years for Insurance Stocks
• Investing in Financial Stocks is Tough
• Don’t Overpay, for Insurance M&A
• Assurant and Intelligent Acquistions
• Quantitative Analysis is not Trivial — The Case of PB-ROE
• How Do You Value an Insurance Business?
• Why Financial Stocks Are Harder to Analyze

I hope you enjoy these. They are the bulk of my thoughts on insurance stocks, aside from issue-specific commentary.

David

Disclosure: long ALL NWLI SAFT RGA AIZ PRE CB

I went back through all of my blog posts in insurance to analyze what were the best things I had written on insurance investing.  I also added one more blog post idea to my list.  A long time ago, I wrote a 16-page paper summarizing the whole insurance industry for a former employer.  It was urgent, so I pulled an all-nighter at the ripe old age of 43.  He was deeply grateful for the piece, and then it never got published.  It was supposed to span three issues of his newsletter, but it never appeared in one.  I have no idea why it never ran, but it bugged me that it never did.  So, with a little updating, I hope to release it in serial form sometime in the next few months.  I have lost the original file, so I will have to scan it in and edit it.

But enough of that — the articles listed above are a reasonable summary of how I analyze insurance and other financial stocks.  For those that invest in stocks, I hope you enjoy these posts.

Postscript — Apologies to PlanMaestro, Manual of Ideas republished his work, and I appreciate the two mentions from him at his blog, Variant Perceptions.  He expands his thoughts on my most recent piece on AIG’s under-reserving.  Keep it up PlanMaestro, and remember, PartnerRe does not discount its reserves.

Thoughts:

• Real Estate servicers and finance companies lead.  GSEs and guarantors trail.  Light corporate news day.
• AIG Bankers Said to Value Asia Unit at Up to $36 Billion in Stock Offering – dream, baby.  You can’t get as much as Pru plc was willing to overpay.
• Citi U.S. Consumer Unit to Show Profit by Shifting Loans, Closing Branches – Wisdom.  Shrink operations and focus on what makes money.  Universal banking does not work, because managements lack focus.
• Covered Bond Sales Surge, Transocean Falls, GE Buys CMBS – the panic in Europe takes a breather, but RIG has some worried about its survival.  For a primer on covered bonds look here: Covering Covered Bonds.
• Buffett Forced to Testify Backs Moody’s in Hearing Without `Candid’ Voice — well, what do expect when he is compelled to testify by a subpoena?  I would be careful about what I said as well.
• Buffett Expects ‘Terrible Problem’ for Municipal Debt – Buffett sounds the same themes as my “New Normal,” where municipalities will have a hard time for a long while.
• AIG’s Benmosche May Survive AIA Deal Failure – Who else has the chutzpah to take on the job?
• The short-term performance model for financial stocks recommends Real Estate Services, Real Estate Development, Residential REITs, Consumer Finance, Hotels, Office REITs, Diversified REITs, Multiline Insurance, Regional Banks, and Retail REITs.
• Whether insurers or banks, avoid equity-sensitive names here – aim at companies that don’t have a high degree of sensitivity to stock market performance.

Group Price Movements for this Morning

I look at these companies for big news events that have occurred since the last close.  Often there isn’t any, but big changes here can be an indication that someone knows something, or there is trading noise.  After that, it is up to the analyst to dig.  Often, the dog that does not bark is the clue, as stocks move up or down on no news, as well as unexplained large spikes in volume, CDS spreads, and implied volatility of options.

Note: If I use the phrase “better seller,” it does not mean “sell.”  If I use the phrase “better buyer,” it does not mean “buy.”  “Better seller” and “better buyer” are bond portfolio manager terms that simply mean that if I were forced to take action on a security, what would I do as a trader in the short run, given the current news.

Disclosure: long ALL NWLI SAFT RGA AIZ PRE CB

One of the things you learn as a fundamental investor is that the quality of accounting derived from accrual entries is always lower than that for cash entries.  There is an implicit assumption behind every accrual entry that someone will make good in the future to pay cash, whether the amount is fixed or estimated.

Accruals vary in quality.  Accounts Receivable are more reliable than inventories.  Who knows what fixed assets, property, plant and equipment are worth?  Pension obligations are squishy, the assumptions can be manipulated within reason.  Deferred tax assets rely on the ability to earn more money, but most companies with the deferred tax assets have lost significant money in the past.  Will the company bounce back?

And there are intangibles.  Goodwill is only worth something if a company earns cash from operations in excess of net income over the long run.  Capitalized R&D, software costs, must produce cash flows that justify capitalizing the expenses, otherwise capitalizing is merely deferring losses.

So there are tests such as normalized operating accruals that for industrial companies and utilities can flag many companies that look cheap, but may not be, because too much of their income comes from accrual entries.

With financial companies, the problem is worse, because financial companies are a bag of accruals.  What are the loans worth?  What are those weird structured securities worth?  And with insurance it gets tougher.  What level of claims do you expect to pay out and when?  Will you recover the amounts that you invested in acquiring the policies that have been written?

Tough questions, but they are what accounting rules have been designed to try to answer.  Because there is complexity, unscrupulous management teams can take advantage of the flexibility.  That does not mean the rules are wrong, though.  No human system can be both consistent and comprehensive.  There are tradeoffs between modeling the details of a company’s financials accurately, and doing the accounting consistently across corporations.  To what degree do you make accounting “cookie cutter” versus tailored?  That is the tough question that vexes those that set the accounting standards.

I would add that insurance accrual quality is subject to three factors:

• Length of the accrual — longer is worse.
• Uncertainty of the contingency in question — uncertainty of amount and timing?
• Does the law of large numbers apply?  What is uncertain in specific, may be more predictable in aggregate.

I received another comment, and initially I said, “I can’t get that done.  Yes that would be good but….”  Here is the comment:

Doug Says:

May 24th, 20109:10 am at Edit

It would be interesting to normalize the reserve charges two ways:

1) Adverse reserve development as a % of beginning reserves.
2) The ratio in #1 above compared with the industry.

While these reserve charges were bad, long-tailed P&C insurers were taking similar reserve charges – even the more “responsible” ones.

Look at the results of one of AIG’s smaller competitors – W.R. Berkley. Similar business mix and a charismatic CEO to boot. Same string of reserve charges, but the CEO is still there, and investors got a nice 20% annual rate of return from 2000. The difference? AIG was trading at 4x book value in 1999, while Berkley was trading below book.

So I went and did it, choosing eleven peer companies that were large, having long tailed liabilities.  This was the peer group:

• ACE — ACE Limited
• BRK — Berkshire Hathaway
• CB — Chubb
• CINF — Cincinnati Financial
• CNA — CNA Financial
• MKL — Markel
• PRE — PartnerRe
• TRV — Travelers
• WRB — W. R. Berkley
• WTM — White Mountains Insurance
• XL — XL Capital Limited

I could have chosen more, but I thought these were representative of stockholder-owned insurers and reinsurers that write long-tailed P&C business.

So what did I find?  I found that AIG was among the worst of major P&C insurance companies in terms of having to strengthen reserves from 1993 to the present.  AIG had to strengthen its reserves 2.1%/yr versus my peer group average of 0.6%/year.  CNA did worse, and White Mountains (a company that talks a lot about conservative accounting) was slightly behind.

Note that the four companies that did not stretch all the way back to 1993 in terms of reported numbers likely would have looked better, because they missed some favorable underwriting years.

Here is the graph of the twelve companies, and the average:

And here is the graph of the companies that were not as good as the average:

The clear conclusion is that AIG was among a group of P&C insurers that were less conservative in reserving than most of their large competitors. CNA and White Mountains were much smaller companies — AIG was dropping a boulder into the pond.

Among all the other difficulties that AIG had, from a yield-seeking derivatives subsidiary, to life and mortgage insurance subsidiaries in trouble, this was just another facet of a company that played it fast and loose.  They under-reserved their P&C divisions, and there can be no reasonable defense on that topic.

PS — I like investing in P&C insurers and reinsurers that regularly release reserves for the business of prior years.  Conservative companies have high earnings quality, and are reasonable investments, despite all of the uncertainty.

Full disclosure: long PRE, CB