At my hedge fund’s weekly macro meeting, I noted the divergent trends in covenants. For newly issued BBB bonds, there is an increase in change of control covenants, which would allow bondholders to sell their bonds at investment grade levels (if not better) in a takeover.

But in bank loans to entities acquiring corporations, the covenants are getting weaker. I’m afraid that banks care more about present earnings than future earnings. Risk is getting transferred from the public equity space to the bank loan and private equity spaces. Personally, I think the eventual result will be ugly, though the current set of deals does not seem outlandish.

I want to give credit to Roger Nusbaum on his brief commentary on Dow Chemical. Too many people think short term about investing, and don’t consider how much a company might be worth over time, versus a buyout today.

I faced the same problem on National Atlantic Holdings. I believe it is more valuable as a going concern than as a buyout candidate at present. I was happy when the Commerce Group negotiations broke down, because Commerce wouldn’t pay up!

I don’t have to get all of my gains today. So long as I do well enough over the next 3-5 year period, I will be happy enough. I don’t have to make a killing today. Having slightly better than average performance over a moderate period of time is reward enough.

Long DOW NAHC (the firm I work for owns 17%)

I remember once being at a First Boston Insurance conference and talking to the (now former) CEO Ed Liddy afterwards. I mentioned that we were shareholders and that I thought the stock was cheap (then around $40). He looked at me intently and said that he could not figure out why the market valued Allstate so cheaply. It was an incredible free cash flow machine.

With the hurricanes of 2004 and 2005 after that, one can see that the performance since then has been superb. But now we are in a soft pricing environment; profits will not rise rapidly, if at all. But even if profits remain level, Allstate looks cheap. EV/EBITDA is near 5x.
That should attract private equity. If one can take over Texas Utilities, Allstate should be easier. Here’s why: one can sell the life arm, Allstate Financial for $5 billion to one of the major life insurers. Along with that, the private equity buyers can lever up the holding company balance sheet to a BB- rating, which would leave the operating entities at a marginal investment grade of BBB-. The private equity buyers would use the free cash flow to repay the bank debt incurred, and five years from now, would IPO Allstate at a higher valuation.

Though I am not crazy about all of the increased leverage, a scenario like this could happen. It is just another ramification of interest rates that are too low.
Long ALL (the funds I work for and me personally)

The two chemical names in my portfolio are both doing well on an otherwise tough day, supporting my broad market portfolio. Lyondell Chemical [LYO] sells its Titanium Dioxide business to the Saudi-owned National Titanium Dioxide Co. This will allow them to focus on petrochemicals and refining, and (what!) reduce debt. Looks like a good multiple on the sale and a good deal strategically.

Dow Chemical [DOW] is a buyout target?! I would have thought that it was too large. Strange times indeed, where any asset with a low EV/EBITDA not only can be bought and refinanced, but are almost required to be so. And, with less leverage and a simpler structure, might not Lyondell be a target also? It’s much smaller.

In the short run, all of this is bullish for the market. Remember, bubbles are financing phenomena. Bubbles pop when cash flow is insufficient to continue financing them. We’re not there yet, but watch for signs of difficulty in these newly levered creations. Private equity is doing these deals at lower and lower IRRs from what I’ve heard, and eventually, that is not sustainable, given the levered up risks taken.


I read with amusement this week the “Agreement Among PWG And U.S. Agency Principals On Principles And Guidelines Regarding Private Pools Of Capital.” Now, I think this is a serious issue; I’m not convinced that we are in a better position to deal with systemic risk than we were back in 1998. I think that many institutions are in better shape, but for the system as a whole, the degree of leverage, both implicit and explicit, is higher now.

Now, I can take two paths here. Path one: I like systemic risk, since I am a conservative investor. I like getting bargains that are screaming, as in the Fall of 1987, the Fall of 1998, and the Fall of 2002. What I wouldn’t like is the Fall of 1929 and its aftermath. My risk control methods would allow me to do relatively well even in that scenario, but great relative performance when you are down over 20% is not my idea of a fun time. I prefer scenarios where my neighbors aren’t getting harmed badly. That said, my best relative performance as an investor came during and immediately after panic periods like we have had in the past 20 years. (No guarantees about the future though.)

The second path is more interesting though. What if the government gathered all of data from every major investor? Say, for every firm managing more than $100 million, measured by assets, rather than equity, they asked for inventories of both the assets and the funding sources. For nonpublic assets, they would also need the counterparty data. The purpose of this would be to ascertain who owes cash to whom, and under what circumstances payment would need to be made. Ideally, with this data, one could identify where market players with weak balance sheets are overexposed to risks.
Now, this will never be done, but just imagine for a moment. What would the government do if it had data like this? At present, nothing, like the report that they put out. They wouldn’t know what to do with it. They don’t have the analytical meanpower to deal with the complexity of one derivative swap book, much less all of them, the hedge funds, the securitizations, the CDOs, etcAt best, they could contract it out, asking the investment banks as a consortium to set up a separate company to do the analysis for the New York Fed, and the Department of the Treasury. It takes a thief to catch a thief, but would the government be willing to shell out enough to get effective data and analysis? I would suspect not.

The same problem exists in the auditing of swap books at investment banks. Anytime an investment bank runs into an auditor smart enough to audit their books, they hire him and pay him ten times the salary. So, even if the government makes noises that they want to control systemic risk, I view it as kind of a joke. They don’t have the data or intellectual resources to even begin the project.

Let me put it another way: if the government wants to reduce systemic risk, let them create risk-based capital regulations for investment banks, and let them increase the capital requirements on loans to hedge funds and investment banks. Or, let the Fed change the margin requirements on stocks. These are simple things that are within their power to do now. In my opinion, they won’t do them; they are friends with too many people who benefit from the current setup. If they won’t use their existing powers, why would they ask for new ones?

We will have to wait for the next blowup for the Federal Government to get serious about systemic risk. They might not do it even then. Upshot: be aware of the companies that you own, and their exposure to systemic risk. You are your own best defender against systemic risk.

The broad market fund was up 85 basis points this week, against a disappointing 25 bp loss for the S&P. My balanced mandates were up 40 basis points, also good. In general, my cyclical and foreign names outperformed.

On the insurance side, Conseco reported that it would be taking some middling charges — the reaction in the stock market was muted. My own estimate of reserve insufficiencies is higher than what they took, so if this cleans it all up, this is a net plus. I’m still waiting to hear back from Conseco IR, so I can’t really tell what is going on yet. From my recent conversation with James Prieur, the CEO, I think the company is on the right track; the only real question is how bad the old long term care [LTC] block is.

Lincoln National increased its buyback today. I appreciate the shareholder-friendly actions of many insurers. Rather than being hyper-competitive, many companies are returning capital in the soft part of the pricing cycle, and that is the right thing to do.


Insurance stocks are tricky for several reasons. There are probably more unique accounting rules for insurance, then any other industry. Why? The cost of goods sold is not known at the issuance of a policy. Every dollar into an insurance company is equal, but every promise made is not equal. Over time, estimates of cost become more accurate, but with long-tailed lines the progress is often fitful at best.

Life reserving is a science (please ignore the new funky investment derivatives inside some policies). Short-tailed P&C reserving is close to a science. Long-tailed P&C reserving is an art, and a dark art. I’m not sure that even the internal actuaries reserving the long-tailed lines can be that comfortable with the accuracy of the reserves.

This is why it pays to stick with conservative and competent managements that have shown that they can manage the soft part of the cycle. I may miss some speculative gains managing this way, but for the most part, I will miss out on the losses. To give you further insight into my philosophy, here’s a presentation that I gave to the Southeastern Actuaries Club. (I am available for other speaking engagements if I can show my employer a business purpose.)

  1. The Broad Market Portfolio made 30 basis points yesterday, amid a rally in some cyclicals. Names that worked for me included Tsakos Energy Navigation [TNP], Royal Bank of Scotland [RBSPF], and Lafarge SA [LR]. Industrias Bachoco SA lagged, but after yesterday’s great performance, who can complain? Energy names did okay, but less well than the commodity; this may be part of a correction for the recent energy equity outperformance.

  2. I think Cramer has it wrong on railroad mergers. The great demand in rail is for traffic to go East-West, not North-South. If the antitrust authorities allowed it, it would make sense for Union Pacific and Norfolk Southern to merge, as well as Burlington Northern and CSX. That would offer far more value than what he proposes.


1. Hartford increases its buyback authorization by a billion dollars. Well good. Like Allstate, they are oozing free cash flow in this environment, and don’t have as many reinvestment opportunities; they ought to be returning cash to shareholders, but cautiously, buying only on dips.

2. How do you lower personal lines insurance premiums, if you are a state regulator? Oddly, the answer is to not panic and create mandates for insurers in the state, but to allow free entry and exit for the insurers. Premium rate filings should either not be required, or be “file and use.” If a regulator does that, the insurers will trust the regulator, and there will be no lack of insurance companies seeking business in the state. Premium rates will fall.

Immature regulators place demands on insurance companies (leaving aside fraud issues). Mature regulators focus on fraud, and let the market do its work.