I have never been on live television before; the only other times that I have been on any sort of television was when I taped two segments for TheStreet.com last October. We only did one take of each segment, so I guess that’s as good as live, though there was the possibility of re-taping.
What was I going to talk about? Well, that was uncertain until 2PM today. Cody wanted to talk stocks, but he also wanted to talk macroeconomics as well. I offered him seven stocks, four foreign, and three US insurers. He took the insurers. I offered him four macro topics, and he took the most topical one, Buffett’s offer to reinsure the muni business of the major financial guarantors.
As of 3PM, I had a problem, though. I hadn’t been able to connect to the internet all day long, and though I had talked with many people about Buffett’s proposal, I really did not have any in-depth knowledge of the proposal. The Waldorf Astoria’s free Wi-fi was not working for me, so I retreated to the business center for 20 minutes of catching up. That’s all it took to get the details hammered down, so I headed down to the Bull and Bear for the show.
I got there about four, and a perceptive staff member said, “Are you one of the guests? You have that look about you.” He then seated me at a nearby table and I pulled out my laptop, and wrote out my notes for what I would say. They read like this:
Guarantors:
Company that?s in trouble: sell your good business or bad business?
Buffett wants to buy the good business at what is a bargain price to him, leaving the bad business behind and less wherewithal to pay the claims, because the profit stream from the good muni business will be gone.NPV of the muni business is more than Buffett is offering.A company would only take up Buffett?s offer if they were desperate, or forced to by the regulators.
Now effect on Munis is limited, just because you might lose your guarantee doesn?t mean that the municipality can?t make payments.
Insurers:
?Dragged down by financials
?Dragged down by AIG
?Assets are relatively clean (got religion 2001-2003)
?Favorable demographics.
?Growth in the markets will raise AUM.
?Inexpensive on earnings and book.
?High quality balance sheets.
HIG
?Very diversified– P&C, Life, Group Benefits ? domestic and international
?1.2x book, 6.8x 2009 earnings
?Quality company
?Variable products sensitive to market movements
LNC
?Still room for cost savings from the JP merger
?Well positioned in life, annuity, and group benefits
?1.2x book, 8x 2009 earnings
?Variable products sensitive to market movements
AIZ
?The next AFLAC
?Focused on specialty businesses that can obtain an above average ROE.
?Warranties, Force-placed Homeowners, Individual Health, Small Group Benefits, Funeral (pre-need)
?Deep management team ? they invest in their people
?Good capital allocators
?1.8x book, 8.8x 2009 earnings
By the time I had written that, David Newbert, of ThePanelist.com showed up, and we began to talk. Nice guy with some heavy duty Wall Street experience. Then the Fanelli twins showed up; bright ladies.
By this point it was close to 5PM. A little powder for my face and balding pate, I am going second at about 5:13. I ask the staff for advice, and they simply tell me to be opinionated and energetic. I try to be self-effacing, but I steel myself up for the task.
The first guy completes and they go to break. I’m up! They tell me to look at Cody and Rebecca, and sooner than I can expect it, we’re off. I had committed my notes to memory, but as in war, as Cody and Rebecca interact with me, I have to deviate from what I jotted out. We talk about Buffett and the Financial Guarantors, then move to stocks. I talk about Hartford, and a little about Assurant, and then, we’re out of time! That was fast! I get to name Lincoln National at the end as an afterthought. (At one point, Cody lavishes praise on me, and I get a little embarrassed. So it goes.)
The rest of the show goes on in the crowded space of the Bull and Bear, and before you know it, it’s over. The staff efficiently shuts down, and in 10 minutes, there’s no trace of what went on before. Cody and I meet for dinner later. It’s good to re-sync in our friendship.
I hope to get a copy of the video clip to post at my blog. If so, you will see it here. I had a lot of fun, and they invited me back. Should I get back to NYC, I will be back on Happy Hour.
1) I might not be able to post much for the next two days. I have business trips to go on. One is to New York City tomorrow. If everything goes right, I will be on Happy Hour with my friend Cody Willard on Tuesday.
Sometimes I think there are too many investors trading baskets of stocks, and too few doing real investing work. I have rarely been bullish on AIG? I think the last time I owned it was slightly before they added it to the DJIA, and I sold it on the day it was added.Why bearish on AIG? Isn?t it cheap? It might be; who can tell? There?s a lot buried on AIG?s balance sheet. Who can truly tell whether AIG Financial Products has its values set right? International Lease Finance? American General Finance? The long-tail casualty reserves? The value of its mortgage insurer? I?m not saying anything is wrong here, but it is a complex company, and complexity always deserves a discount.
You can read my articles from 2-3 years ago where I went through this exercise when the accounting went bad the last time, and Greenberg was shown the door. (And, judging from the scuttlebutt I hear, it has been a good thing for him. But not for AIG.)
AIG deserves to be broken up into simpler component parts that can be more easily understood and valued. Perhaps Greenberg could manage the behemoth (though I have my doubts), no one man can. There are too many disparate moving parts.
So, what would I do off of the news? Buy other insurers that have gotten hit due to senseless collateral damage (no pun intended). As I recently wrote at my blog:
If Prudential drops much further, I am buying some. With an estimated 2009 PE below 8, it would be hard to go wrong on such a high quality company. I am also hoping that Assurant drops below $53, where I will buy more. The industry fundamentals are generally favorable. Honestly, I could get juiced about Stancorp below $50, Principal, Protective, Lincoln National, Delphi Financial, Metlife? There are quality companies going on sale, and my only limit is how much I am willing to overweight the industry. Going into the energy wave in 2002, I was quadruple-weight energy. Insurance stocks are 16% of my portfolio now, which is quadruple-weight or so. This is a defensive group, with reasonable upside. I?ll keep you apprised as I make moves here.
What can I say? I like the industry?s fundamentals. These companies do not have the balance sheet issues that AIG does. I will be a buyer of some of these names on weakness.
Position: long LNC HIG AIZ
3) More on AIG. As Cramer said yesterday: One last thought on the AIG issue: if President and CEO Martin Sullivan were to step down, the company might be more of a buy than a sale!
Maybe. Sullivan is a competent insurance executive with the biggest insurance job in the world. Breaking up the company, and letting the parts regain focus makes more sense. As an aside, M. R. Greenberg was known to be adamant about his ROE goal (15% after-tax on average equity), but he also liked the company to have bulk (high assets ? he liked asset-sensitive lines), which is why the ROA slid in the latter part of his tenure.
4) Some praise for Cramer on the same topic. As he said yesterday: AIG let me have it after I said last year that I couldn?t value the stock. They told me that there was a 92-page disclosure document and they wanted to know if I even looked at it. I shot back that not only did I look at it, but I had people comb it, including the forensic accountant I have on staff. The issue was always that despite the disclosure that they had CDO exposure, we couldn?t figure out what the real exposure was and we questioned whether THEY could.
Nothing gets a management more angry than being told that they don?t know what they are doing, but I was marveling at the certainty that they expressed. I told them they had tons of disclosure, but their estimation of possible losses seemed chimerical. I couldn?t figure out how THEY could value the stuff when no one else could with any certainty until it was off their books or written down. OF course, insurance companies aren?t held to the same standards of mark-to-market that banks are. They used mark-to-model, and the model, we learned today ? the Binomial Expansion Technique ? was totally wrong and dramatically understated the losses. All of this cuts to the incredible level of arrogance and stupidity on the Street, making judgments that were anti-empirical on data that could not be modeled but had to be experienced and examined nationally. In short, they were scientific and certain about something that couldn?t be quantified by science and certainly couldn?t be certain about.
Aside from the quibble that insurers for GAAP purposes are subject to the same rules as banks, Cramer got it right here. It is a major reason why I have been skeptical about AIG. Complexity in financial companies, especially financial companies that grow fast, is warranted. It is an unforgiving business where moderate conservatism works best.
5) Brief NAHC note: the CEO purchased more shares in the last few days. At least, it looks like it. Could he be acquiring shares to combat Hovde Capital? Honestly, I?m not sure, but this is looking more interesting by the day.
6) A new favorite blog of mine is Going Private. This post on insurance issues in Florida was unusual for that blog, but I thought it was perceptive. I wrote similar things at RealMoney:
Interesting note in the National Underwriter on a Towers Perrin Study (also try here) describing how much Floridians will have to pay if a 1-in-250 hurricane hits Florida. Cost per household: $14,000, or $467 per year for 30 years. On a 1-in-50 storm, the figures would be $5,640, or $188 per year. There would also be a higher initial assessment as well. Note that the odds are actually higher than stated odds would admit. The stated odds of the large losses from the 2004 and 2005 storms happening in consecutive years would have been considered astronomical, but it happened anyway.
The Florida legislature can determine how the pain is shared, but they can?t legislate that the pain go away. No free lunch.
P.S. As an aside, the state of Florida is subsidizing reinsurance rates through its catastrophe fund. Ostensibly, Florida homeowners get a cut in rates, but the insurers give that cut only because their reinsurance costs are lower. Who?s the loser? The citizens of Florida will have to reach into their pockets to recapitalize the Hurricane Catastrophe Fund if big losses hit, and at the very time that they won?t want to do it. (Note to S&P: why do you give this state a AAA GO bond rating?)
I don?t want to go on a rant here, but I do feel strongly about this. It ill-befits a state government to behave like a bunch of thugs, even if it pleases the electorate. For over two decades, the worst state to do business in as an insurer was Massachusetts. New Jersey was competitive for a while, and California was pretty bad on Worker?s Comp, but now we have a new state on the top of the heap: Florida.
The failure of the Florida property insurance market was due to the lack of willingness to allow rates to rise sufficiently to attract capital into the market. The partial socialization of risk drove away that capital. So what does the governor and legislature of Florida do to meet the crisis? Increase the level of socialization of risk, and constrain companies to a binary decision: accept profits that don?t fairly reflect the risks underwritten, or leave the state. (And, they might try to forbid insurers from leaving.)
In my opinion, if they bar the door to insurers leaving, or not being allowed to non-renew policies, it is an unconstitutional ?taking? by the state of Florida. No one should be forced to do business that they don?t want to do. Fine to set up the regulatory rules (maybe), but it?s another thing to compel parties to transact.
Okay, here?s a possible future for Florida:
1) By the end of 2007, many insurers leave Florida; the state chartered insurer now has 33% of all of the primary property risk.
2) Large windstorm damages in 2008-2009, $100 billion in total, after a surprisingly light 2006-2007.
3) Florida finds that the capital markets don?t want to absorb more bonds in late 2009, after the ratings agencies downgrade them from their present AAA to something south of single-A.
4) The lack of ability to raise money to pay storm damages leads to higher taxes, plus the high surcharges on all insurance classes to pay off the new debt, makes Florida a bad place to live and do business. The state goes into a recession rivaling that of oil patch in the mid-1980s. Smart people and businesses leave, making the crisis worse.
Farfetched? No, it?s possible, even if I give a scenario of that severity only 10% odds. What is more likely is a watered-down version of this scenario. And, yes, it?s possible that storm damages will remain light, and Florida prospers as a result of the foolishness of their politicians. But I wouldn?t bet that way.
Position: long one microcap insurer that will remain nameless
While I don?t pretend to be the insurance maven that you are, I don?t believe it?s quite as black and white as you portray.
First, let me preface my comments by saying that I believe in free markets and don?t agree with the Governor?s plan, although I stand to benefit. Secondly, my insurance rates, while higher than I?d like are not too bad compared to others in the state.
That being said, I think something had to be done. In one scenario that you lay out, you describe smart people leaving due to higher taxes. That was already happening due to high insurance rates. Some people with affordable mortgages suddenly found their insurance rates skyrocketing from $2,000 to over $6,000. Lots of seniors on fixed incomes also saw their rates jump.
One factor in the housing slump is that buyers are having a hard time finding insurance on a house they are ready to close on. I know that three years ago, we were scrambling at the last minute to find an insurer who would write a policy ? and that was before all of the storms.
I?m not sure what the answer is. I fear that in an entirely free market, there will be very few insurers willing to do business here if there?s another bad storm.
Maybe that?s an argument that we shouldn?t be building major population centers right on the coast, but that?s another story.
I understand the pain that many people in Florida are in. I know how much rates have risen. What I am saying is that the new law won?t work and will leave the people of Florida on the whole worse off. Florida is a risky place to write property coverage, and the increase in rates reflects a lack of interest of insurers and reinsurers to underwrite the risk at present rates and terms.
We don?t have a right to demand that others subsidize our lifestyle. But Florida is slowly setting up its own political crisis as they subsidize those in windstorm-prone areas, at the expense of those not so exposed. Commercial risks must subsidize coastal homeowners. Further, there is the idea lurking that the Feds would bail out Florida after a real emergency. That?s why many Florida legislators are calling for a national catastrophe fund.
They might get that fund too, given the present Congress and President, but Florida would have to pay in proportionately to their risks, not their population. Other proposed bills would subsidize Florida and other high risk areas. Why people in New York, Pennsylvania, Ohio should pay to subsidize Florida and California is beyond me.
The new law also affects commercial coverages; the new bill basically precludes an insurer from writing any business in Florida, if they write homeowners elsewhere, but not in Florida. If you want to chase out as many private insurers as possible, I?m not sure a better bill could have been designed. The law will get challenged in the courts; much of it will get thrown out as unconstitutional. But it will still drive away private insurance capacity.
I?m not writing this out of any possible gain for myself. I just think the state of Florida would be better served, and at lower rates, with a free market solution. Speaking as an insurance investor, I know of half a dozen or so new companies that were contemplating entering Florida prior to the new law. All of those ideas are now dead.
I hope that no hurricanes hit Florida, and that this bet works out. If there is political furor now in Florida, imagine what it would be like if my worst-case scenario plays out.
Position: long a small amount of one microcap insurer with significant business in Florida
Florida had now dodged the bullet for two straight years. Hey, what might happen if we have a bad hurricane year during an election year? Hot and cold running promises; I can see it now!
7) One of the best common-sense writers out there is Jonathan Clements of the WSJ. He had a good piece recently on why houses are not primarily investments. Would that more understood this. There are eras where speculation works, but those eras end badly. You can be a landlord, with all of the challenges, if you like that business. You can own a large home, but you are speculating that demand for the land it is on will keep growing. That is not a given.
8 ) My favorite data-miner Eddy, at Crossing Wall Street comes up with an interesting way to demonstrate momentum effects. Large moves up and down tend to continue on the next day, and the entire increase in the market can be attributed to the days after the market moves up 64 basis points.
9) This is not an anti-Cramer day. I like the guy a lot. I just want to take issue with this article: ?Trading in CDOs Slows to a Trickle.?? The basic premise is that CDOs are going away because trading in CDOs is declining.? Well, the same is true of houses, or any debt-financed instrument.? Volumes always slow as prices begin to fall, because momentum buyers stop buying.
Short of outlawing CDOs, which I don’t think can be done, though the regulators should consider what financial institutions should be allowed to own them.? That would shrink the market, but not destroy it.? Securitization when used in a moderate way is a good thing, and will not completely disappear.? Buyers will also become smarter (read risk-averse) at least for a little while.? This isn’t our first CDO blowup.? The cash CDO vintages 1997-1999 had horrible performance.? Now we have horrible performance.? Can we schedule the next crisis for the mid-teens?
10) On Chavez, he is a dictator and not an oil executive.? Maybe someone could send him to school for a little while so that he could learn a little bit about the industry that he is de facto running?? As MarketBeat points out, take him with with a grain of salt.? Venezuelan crude oil needs special processing, much of which is done in the US.? If he diverts the crude elsewhere, who will refine it for sale?
11) I am really ambivalent about Bill Gross.? He’s a bright guy, and has built a great firm.? Some of the things he writes for the media make my head spin.? Take this comment in the FT:
That the monolines could shoulder this modern-day burden like a classical Greek Atlas was dubious from the start. How could Ambac, through the magic of its triple-A rating, with equity capital of less than $5bn, insure the debt of the state of California, the world?s sixth-largest economy? How could an investor in California?s municipal bonds be comforted by a company that during a potential liquidity crisis might find the capital markets closed to it, versus the nation?s largest state with its obvious ongoing taxing authority? Apply the same logic to the gargantuan size of the asset-backed market it has insured in recent years ? subprimes and CDOs in the trillions of dollars ? and you must come to the same logical conclusion: this is absurd. It is as if Barney Fife, television?s Sheriff of Mayberry in The Andy Griffith Show, promised to bring law and order to the entire country.
Most municipal defaults are short term in nature, even those of states, of which there have been precious few.? Ambac, or any other guarantor, typically only has to make interest payments for a short while on any default.? It is a logical business for them to be in… they provide short term liquidity in a crisis, while the situation gets cleaned up.? In exchange for guarantee fees the municipalities get lower yields to pay.
The muni business isn’t the issue here… the guarantors should not have gotten into the CDO business.? That’s the issue.
12) I try to be open-minded, though I often fail.? (The problem of a permanently open mind is that it doesn’t draw conclusions when needed.? Good judgment triumphs over openness.)? I have an article coming soon on the concept of the PEG ratio.? This is one where my analytical work overturned my presuppositions, and then came to a greater conclusion than I would have anticipated.? The math is done, but the article remains to be written.? I am really jazzed by the results, because it answers the question of whether the PEG ratio is a valid concept or not.? (At least, it will be a good first stab.)
I’m just trying to clean up old topics, so bear with me:
1) This blog is not ending because of my new job. Finacorp wants me to keep it going, and they may use the posts in PDF form for clients. Also, unlike my prior employer, Finacorp wants me to have a high degree of exposure, because it aids them. You may see me in more venues, which could include TV and radio.
2) In one sense, I had an unusually productive Saturday. I built two models — one for a critique of the PEG ratio, and one for a model of the Treasury yield curve. You will see articles on both of these, and I am really jazzed on both of them. It is not often that I get one impressive result in a day. Today I got two. I’ll give you one practical upshot for now, if you are an institutional bond investor: go long 10-year Treasuries and short 7-year. We are very near the historical wides. If you are like me, and can live with negative carry, dollar duration-weight the trade, so that you are immune to parallel yield curve shifts.
3) I didn’t read Barron’s, Forbes, or The Economist today, but I did read the Financial Analysts Journal. In it there were three articles that are worth a comment. There was an interesting article on fundamental indexation that comes close to my view on the topic. Fundamental indexation, when properly done, is nothing more than enhanced indexing with a value tilt. Will it make you more money than an ordinary index fund? Yes, it will, over a long enough period of time. Will it work every year? No. Is there one optimal way to fundamentally index? No. There is no one cofactor, or set of cofactors that optimally define value, if for no other reason than the accounting rules keep changing.
4) The second article went over the value of immediate annuities as risk reducers to retirees, something I commented on recently. The tweak here is buying annuities that start paying later in retirement, for example at 80 or 85, with the risk that if you die before then, you get nothing. Longevity insurance; a very good concept, but the execution is tough.
5) The third article was on Risk Management for Event-Driven Funds. Here’s my take: risk arb is like being a high yield bond manager. Anytime a deal is announced, you have to do a credit risk analysis:
How likely is it that this deal will go through?
How badly could I be hurt if it does not go through?
Am I getting paid more than a junk bond with equivalent risk?
But the portfolio manager must ask some more questions:
Are there any common factors in my risk arb book that could bite me? Sectors? Need for debt finance?
What if deal financing terms go awry all at the same time? How will that affect the worst risks in my book?
Am I getting paid more than a junk bond with equivalent risk? (Okay, it’s a repeat, but it deserves it.)
Risk arbs have been burned lately, with all of the deals that have been busted because financing is not available on easy terms. It’s tough but this happens. Most easy arbs tend to get overplayed before blowups happen. The lure of easy money brings out the worst in people, even institutional investors.
I took some criticism at RealMoney.com for writing things like this about GM, though the author here was a much better writer.
The thing is, there are enough levers here that GM can keep the debt ball in the air for some time, as can many of the financial guarantors, so long as they can make their interest payments.
The “Big 3” lose vitality vs. Toyota and Honda each year — in the long run GM and Ford don’t make it. Perhaps after they go through bankruptcy, and shed liabilities to the PBGC, and issue new equity to the current unsecured bondholders, they can exist as smaller companies that have focus. Maybe Ford could be a division of Magna, and GM a division of Johnson Controls. At least then there would be competent management.
7) Barry Ritholtz had a good post called, 5 Historical Economic Crises and the U.S. The paper he cited went into five recent crises in the developed world, and how the current US situation stacks up against that.? Here was my comment on one of the areas where the US situation did not seem so dire, that of the run-up in government debt:
On the last point about the increase in the debt, what is missed is that a lot of the government debt increase is hidden by the non-marketable Treasury bonds held by the entitlement programs. Add that in, and consider the unfunded promises made at the Federal, State, and municipal levels, and the debt increase on an accrual basis is staggering.
We do face real risks here.? The rest of the world will not finance us in our own currency forever.? Oh, one critical difference between the US and the 5 crises — we are the worlds reserve currency, for now.
8 )? I like Egan-Jones on corporate debt.? They have quantitative models that follow contingent claims theory, and use market based factors to estimate likelihood and severity of default.? They are now trying to do models for asset backed securities.? Very different from what they are currently doing, and their corporate models will be no help.? They will also find difficulties in getting the data, and few market-based signals that inform their corporate models.? I wish them well, but they are entering a new line of business for which they have no existing tools to help them.
9) This article from Naked Capitalism pokes at the rating agencies, and the proposed reforms from the SEC.? My view is this: the financial regulators need a model on credit risk.? They need a common platform for all credit risks.? They need one set of ratings that allow them to set capital levels for the institutions that they regulate, or they need to bar investments that cannot be rated adequately.? The problem is not the rating agencies but the regulators.? How do they properly set capital levels.? They either have to use the rating agencies, or build internal ratings themselves.? Given my experiences with the NAIC SVO, it is much better to use the rating agencies.? They are more competent.
I have to be careful as I write this post, because I have agreements with my former employer. I will stick with what is publicly understood, and avoid internal knowledge of what my former employer thought when I last worked with them.
Today, after the close, Hovde Capital filed a 13D, seeking to own more than 17% of National Atlantic, and asking for seats on the board of directors. Now, what I want to say to my readers might agree with what Hovde Capital might want. Don’t make too much out of this. First, the New Jersey Department of Banking and Insurance might turn Hovde down. Second, realize that any party acquiring 10% or more of any publicly traded company has to file two days after making any trade. That is the signal that I would be looking for.
National Atlantic is my largest holding, and I am aware of other parties considering buying National Atlantic, but they fail the urgency test for me. There’s lots of talk but no action. Don’t take any action off of Hovde’s SEC filing. There are too many uncertainties here, and wise investors will wait for favorable levels for investing.
IRVINE, Calif., Feb. 8 /PRNewswire/ — In an ongoing campaign to provide targeted, value add services to its institutional client base,Finacorp Securities has hired David Merkel, formerly a Portfolio Manager for Dwight Asset Management, and an Equity Analyst for Hovde Capital Advisers. David is both a Chartered Financial Analyst, and a Fellow in theSociety of Actuaries.
Finacorp Securities today announced that David Merkel has joined as its Chief Economist and Director of Research. David has been a long time leading contributor to RealMoney.com, after being invited by Jim Cramer to write there. In addition to this he has acted as a Portfolio Manager to equity, corporate bond and structured product funds. He is also author and
owner of the popular finance weblog Alephblog.com. David’s focus has been equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues and corporate governance. As Chief Economist and Director of Research at Finacorp Securities, David’s chief responsibility will be to develop economic analysis with equity and
fixed income strategies and provide advice to the firm’s sales & trading staff and its client base.
“With the current credit crisis and ensuing market volatility we think it is imperative to offer additional support and insight to our client base. David is a proven professional that has analyzed, and created opportunities in many markets and will help do the same for our client base in this market and those in the future. David’s ability to analyze many of the complex and impaired assets in today’s marketplace including CDOs, SIVs, and Insurance Guarantors will create an immediate value add to our institutional clients. This is very much in line with our philosophy of bringing together the finest personnel in a collaborative environment,” said Ed Prado, President and CEO of Finacorp Securities.
This hiring comes after tremendous expansion by the company of personnel and infrastructure as it established a presence in: Seattle, Portland and Chicago.
About Finacorp Securities
Finacorp Securities is a full service broker/dealer focusing on servicing its institutional clients within the U.S. and select
international markets. The firm operates as a certified Minority-OwnedHispanic Broker/Dealer headquartered in California. Through a combination of its own proprietary systems and third-party partnerships, it provides seamless execution, settlement and custody to institutional fixed income and equity market participants. Finacorp has been built on a tradition of highly personalized brokerage services delivered by professionals harnessing the power of technology and strategic partnership to deliver value-driven securities execution, detailed portfolio analytics, and seamless settlement. Finacorp’s high-touch, high-tech business model represents a comprehensive set of fixed income and equity solutions for
today’s value driven, risk adverse investment professional.
As WordPress counts, this is post 500, though it is only really the 409th post. (A glitch in the software yesterday ate up ten numbers… weird. I had planned on post 500 being near my first blogoversary on 2/20, but it was not to be.) I use the hundred milestones to take a moment to reflect on blogging, and update readers on what is going on in my life, my plans for the blog, and to ask for advice.
For the most part, I just blog now, and I don’t pay too much attention to the statistics on readership and links. I have a decent feel for where I fit into the financial blogosphere, and I know I won’t be the top writer here. I’m not for everyone.
As I have commented before, one of the good points and bad points of my blog is that blog readers really can’t tell what I will be serving up next. My interests are broad, and I like writing about a wide number of topics. I think it strengthens my understanding of the markets, rather than weakening it.
I have also said that this blog is not a business, but it is an option on a business. Well, the option came into the money regarding my new position with Finacorp. Today, an announcement will go out over PR Newswire over my new job there. To any of my readers in the regular media: if you read it, and you have a place for it in your publications, it will be much appreciated here.
So where am I going from here in blogging? I will continue to cover current issues, and long term ideas of interest, but I also have a list of articles that I would like to do:
Traffic
Academic Finance Lies
Rescuing Capitalism from Capitalists
Flexibility vs Fixed Commitments
Fundamentals of Market Bottoms
Revisiting DFR
Commercial Paper less Two-year Treasury Yields
Predicting Inflation
Unemployment Risk
Risk Management vs VAR vs ERM
Central Banks can lose money?
The Problem of Taxation
Before I close here, I want to thank my readers, and thank those that refer readers to me. I don’t take anyone for granted here. Your time is limited, and I appreciate that you read/refer to me. Special thanks to Abnormal Returns, Seeking Alpha, Marketbeat, The Big Picture, Random Roger, VIX and More, and more.
If you have suggestions for me, please send them my way. I write about what interests me, but I listen to readers in order to gauge the broader interest in what I write about.
I’ve wanted to post on a bunch of little things for a while, and while it won’t make for organized reading, maybe we can have some fun with it?? Here goes.
1) If Prudential drops much further, I am buying some.? With an estimated 2009 PE below 8, it would be hard to go wrong on such a high quality company.? I am also hoping that Assurant drops below $53, where I will buy more. ? The industry fundamentals are generally favorable.? Honestly, I could get juiced about Stancorp below $50, Principal, Protective, Lincoln National, Delphi Financial, Metlife…? There are quality companies going on sale, and my only limit is how much I am willing to overweight the industry.? Going into the energy wave in 2002, I was quadruple-weight energy.? Insurance stocks are 16% of my portfolio now, which is quadruple-weight or so.? This is a defensive group, with reasonable upside.? I’ll keep you apprised as I make moves here.
2) Reader Steve brought this to my attention: Mark Gilbert at Bloomberg brought attention to a monetary policy game at the San Francisco Fed’s website.? So did the estimable Marketbeat blog at the WSJ.? The game used to be found at this link.? Alas, no more.? Maybe all of the attention crashed the site, after all, the SF Fed can’t afford a heavy-duty website like mine.? Okay, sorry, they get 10x the traffic that I do, more like The Kirk Report.
Perhaps the game was removed over the embarrassment from Gilbert playing the game and applying the current Fed strategy to the game, and finding inflation going through the roof.? Now, for those that want to play a monetary policy game, my current favorite is this one from the Bank of Finland.? In a true American version of the game, we would replace the manic announcer with clips of who else, Jim Cramer.? Nobody does it better.? Oh and for true junkies looking for monetary policy games, here is a list of some of them.
3) Dig the falling long bond.? Worst day since 2004.? Echoing what I said yesterday, there’s a lot of fear in that part of the market, and a lot of foreign interest.? Well, at the 30-year auction, foreign interest was light at the lowest yield since regular auctions began in 1977.? A few strong economic numbers can make fear temporarily dissipate.
When the main rating agencies begin downgrading the lesser guarantors, the big guarantors are likely not far behind. Moody’s just downgraded XL Capital Assurance from Aaa to A3, and Security Capital Assurance From Aa3 to Baa3 (barely investment grade). Psychologically, the major rating agencies, Moody’s and S&P, have been taking baby steps toward downgrading Ambac, MBIA and FGIC. But first they have to do the lesser guarantors that are in trouble. As I have pointed out before, the major rating agencies are co-dependent with the major guarantors, and that will only throw the guarantors over the edge if hurts them more to leave the guarantors at AAA. That will cost them future revenues to cut the ratings of the major guarantors, but it might save their larger franchises. (Fitch, on the other hand, has less to lose and can downgrade with impunity.)
Now, the effects on the broader insured bond market are probably overestimated. There will be new entrants to take the place of the legacy companies that may have to go into runoff. The holding companies for the major guarantors could die, but a rescue of the operating insurance companies in runoff mode is more likely. Those who own equity in the holding companies or debt claims to the holding companies will not be happy with the results, though.
Watch for downgrades of the major guarantors. Unless a lot of new capital gets pumped into their operating insurance companies, the downgrades are coming, maybe within a month.
Please note that due to factors including low market capitalization and/or insufficient public float, we consider Security Capital Assurance to be a small-cap stock. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.
Position: none
Now after the close, MBIA offered stock at a 14% haircut to the closing price. ? Let’s see where the price closes tomorrow… it almost boils down to the number of buyers saying, “At a 14% haircut, there’s no way that it will close below that level.? We can buy and flip for an easy profit.”? In this case, though, there are 60%+ more shares after this issuance.? That’s some level of dilution.? MBIA may keep its AAA, but that says little for the value of holding company common stock.
5) One reader wrote me, “mr. merkel — would you care at all to expound on point 2? it’s been the assertion of some that what makes the monoline threat a non-issue is specifically that there IS a harmony of interests in seeing ambac, mbia et al at least get to a point where they can run off their obligations. however, i must admit, i’ve not seen the case made with specificity — that is, what are the interests of the interested parties, and how do they conflict or coincide?”
Point 2 was the idea that a bailout would be tough to achieve, because of differing interests on the part of those being sought to bail out the guarantors. ? Here’s my rationale: different investment banks have differing levels and types of exposure to the credit risks covered by the guarantors.? Coming up with an equitable allocation of concessions would be tough, but not impossible.? Beyond that, you have all of the ways that the guarantors reinsured each other, which further tangles the web of promises.? A bailout could be done, given enough time, and enough angelic third-party experts to divide the pie perfectly.? Time is short here, and I suspect the rating agencies will lose patience, given their need to protect their franchises.
6) At present, the yield curve indicates a 2% Fed funds rate by mid-to-late 2008.? Uh, that’s not what I would do, but it seems pretty likely for now.? What kind of price inflation would get the attention of the Fed here?? Beats me; the slope of the yield curve today is adequate to allow banks to make money; if the Fed waits at these levels, the economy should recover over the next two years.
8) From another reader, Bamboo: I have not seen much discussion of the statutory capital requirements of the financial guaranty insurers.? It seems that Article 69 of the New York Insurance Law is the critical statute.
Although the rating agencies do not consider mark to market losses in their evaulations of capital adequacy, do they affect statutory capital?
Is there a possibility that the financial guarantors will have to take a premium deficiency reserve for their structured finance business?
I would like to get a copy of article 69, but I can’t find one.? In general statutory regulations are less market-oriented than rating agencies and GAAP.? The problems usually show up faster on GAAP than Stat, leaving aside high growth situations.
9) Another reader, Bill Luby of VIX and More, writes: Hi David,
Once again, kudos for keeping up a consistently high quality of posting here.? Your thinking often sets my brain in motion — in a very good way.
If you don’t mind, I’d be interested to get your take on the current status of the bond insurer problem and how you think it might play out.? In addition to what happens to MBI and ABK, I am also interested in whether you think others with a stronger financial position (AGO?) might make significant gains in this space.
Cheers,
-Bill
Yes, AGO, Dexia (FSA), and Berky all do well from the turmoil.? Strong balance sheets benefit from increased volatility, even as weak balance sheets are harmed.
10) Finally, from Reader Scott, regarding Medicare and entitlements, “David, wondering your thoughts on how the situation gets addressed.? There is no question at all that the equation doesn’t solve, presently.? My current thoughts are that (1) taxes go higher – not even up for serious discussion; and (2) so do trade barriers.? we trade some protectionism, a la Europe, and reduced overall welfare, for a feel-good “leveling” of some of society’s current inequties.? our nation’s most influential demographic, old folks, who vote, are appeased. add to that, perhaps, some guest worker immigration policies.? second class citizens earning second-tier wages.? on balance, we begin looking a lot more like Europe, reversing the cherished myth of American exceptionalism, and staving off acceptance of the twenty-first being the China Century.? Care to comment?”
Americans are exceptional, and that is not always a good thing.? We have fewer presuppositions than most of the world, and that leads to innovative solutions, a certain amount of unnecessary chaos, and occasional hubris.? We are probably heading for an era of leveling, but that is not certain.? Historically, it is likely.? Trade may be another matter; we may be getting close to a point where the rest of the world sees the value of freer trade, even if the US goes the other way.? Organized efforts against free trade are weak compared to protectionist eras.
As for old folks that vote, yes, that’s what makes this problem tough.? I’m not into doom and gloom, but I can see a negative self-reinforcing cycle coming.? If Bush, Jr., got smacked over his all-too-cautious attempt at Social Security reform (it would have done almost nothing, but listen to the squeals), can you imagine what true reform of a much bigger problem might entail?? We would need a full blown panic in the debt markets to get focus there, and as for now, foreigners are still very willing to roll over US debt denominated in US dollars.
Every now and then, valuation metrics in a market will get changed by the entrance of an aggressive new buyer or seller with a different agenda than existing buyers or sellers in the marketplace.? Or conversely, the exit of an aggressive buyer or seller.
Think of the residential mortgage marketplace over the last several years.? With an “originate and securitize” model where no one enforced credit standards at all, credit spreads got really aggressive, and volumes ballooned. Many marginal mortgage lenders entered the market, because it was strictly a volume business.? Now with falling housing prices, there are high levels of delinquency and default, and mortgage volumes have shrunk, leading to the failures/closures of many of those marginal lenders.? Underwriting standards rise, as capacity drops out.? Even prime borrowers face tougher standards.? In two short years, fire has given way to ice.
If you’ll indulge another story of mine, I worked for an insurer who had a well-run commercial mortgage arm.? Very conservative.? They did small-ish loans on what I would call “economically necessary real estate.”? See that ugly strip mall with the grocery anchor?? Everyone in the area shops there; that’s a good property.
Well, in 1992, the head of the Commercial Mortgage area had a problem.? The company had only three lines of business, and two lines representing 60% and 20% of the assets of the firm were full up on mortgages.? What was worse, was they didn’t want to even replace maturing loans, because the ratings agencies had told the company that commercial mortgage loans were a negative rating factor.? Never mind the fact that the default loss rate was 40% of the industry average.
He stared down the possibility that he would have to close down his division.? He had one last chance.? He called the actuary that ran the division that I was in (my boss), and pitched him on doing some commercial mortgages.? The conversation went something like this:
Mortgage Guy: I know you haven’t liked commercial mortgages in the past, but my back is against the wall, and if you don’t take my originations, I’ll have to shut down.? You’ve heard that the other two divisions won’t take any more mortgages at all.?
Boss: Yeah, I heard.? But the reason we never took commercial mortgages was that we didn’t like the credit spread compared to the risks involved.? 150 basis points over Treasuries just doesn’t make it for us.
M: Well, because many companies have reduced originations, the spreads are 300 basis points now.
B: 300?! But what about the quality of the loans?
M: Only the best quality loans are getting done now.? I can insist on additional equity, in some cases recourse, and faster amortization.? My loan-to-values are the lowest I’ve seen in years.? Coverage ratios are similarly good.
B: Well, well.? Perhaps I’ve been right in the past, but I’m not pigheaded.? Look, we could take our percentage of assets in mortgages from 0% to 20%, but no more.? At your current origination rate, that would allow you to survive for two years.? We will take them all, subject to you keeping high credit quality standards.? Okay?
M: Thank you.? We’ll do our best for you.
And they did.? For the next two years, our line of business and the mortgage division had a symbiotic relationship, after which, spreads tightened significantly as confidence came back to the market.? We had 20% of our assets in mortgages, and the other two lines of business now felt comfortable enough with commercial mortgages to begin taking them again — at much lower spreads (and quality) than we received.
It’s important to try to look through the windshield, and not the rear-view mirror in investing.? Analyze the motives of current participants, new entrants, and their likely staying power to understand the competitive dynamics.? I’ll give one more example: the life insurance industry was a lousy place to invest for years.? Why?? A bunch of fat, dumb, and happy mutual companies were willing to write life insurance business earning a minimal return on capital.? As another boss of mine once said, “It doesn’t take mere incompetence to kill a mutual life insurer; it takes malice.”? Well, malice, or at least its cousin, killed a number of insurers, and crippled others in the late 80s to mid 90s.? Investment policies that relied on a rising commercial real estate market failed.
But that was the point to begin investing in life insurers.? They began pricing capital economically, and the industry began insisting on higher returns as a group.? Many mutuals demutualized, and the remaining large mutuals behaved indistinguishably from their stock company cousins.? The default cycle of 2001-2003 reinforced that; it is one of the reasons that the life insurance industry has had only modest exposure to the current difficulties afflicting most financials.? After years of being outperformed by the banks, the life insurers look pretty good in comparison today.
I could go on, and talk about the CDO and CLO markets, and how they changed the high yield bond and loan markets, or how credit default swaps have changed fixed income.? Instead, I want to close with an observation about a very different market.? Who likes Treasury bonds at these low yields?
Well, I don’t.? At these yield levels the odds are pretty good that you will lose purchasing power over a 2-3 year period.? Then again, I’m a bit of a fuddy-duddy.? So who does like Treasury yields at these levels?
Players who are scared.
Players who have no choice.
There is a “fear factor” in Treasury yields now.? Beyond that, there is the recycling of the current account deficit, which is still large relative to the issuance of Treasuries.? The current account deficit is large, but shrinking, since the US dollar at these low levels is boosting net exports.? As the current account deficit shrinks, Treasury yields should rise, because foreign demand has been a large part of the buyers of Treasuries.? The Fed can hold the short end of the curve where it wants to, but the long end will rise as the current account deficit shrinks.
I think the current account deficit does shrink from here, because the cost of buying US debts, and not buying US goods is getting prohibitive.? Also, fewer retail buyers will take negative real yields.
That’s my thought for the evening.? Analyze the motives of other players in your markets, and don’t assume that the current state of the market is an equilibrium.? Equilibria in economics are phantoms.? They exist in theory, but not reality.? Better to ask where new entrants or exits will come from.
The Financial Guarantors are receiving a lot of attention these days, and for good reason.? I want to offer a few observations to give my own take on the problem:
1) With structured finance, the initial choice is “Do we ask a financial guarantor to bring the credit up to AAA, or do we do it through a senior-subordinate structure?”? A senior-subordinate structure has classes of lenders with differing rights to payment.? The AAA, or, senior lenders only take losses after the subordinate lenders (who are receiving higher yields) have lost all of their money.? In the present environment, S&P and Moody’s have been downgrading subordinates, and even some senior bonds in senior-sub structures.
This should lead to downgrades of MBIA and Ambac, eventually.? The rating agencies can’t keep downgrading bonds that are similar to those guaranteed by MBIA and Ambac, without downgrading them as well.? Remember, MBIA and Ambac were late to the party; their bonds are disproportionately weak because later lending standards were weaker.
2) The main difficulty with a bailout of the guarantors is that most interested parties have different interests.? That said, the beauty of a bailout is that the guarantor can sit back and pay timely principal and interest, while waiting for better times to come.
3) Did the rating agencies force the guarantors into the CDO business?? I’ve heard rumors to this effect, but it would be pretty easy to prove or disprove.? Look at when MBIA and Ambac entered the business, and look at the commentary from the rating agencies around it; if they are trumpeting diversification, then it is likely that they pitched it to the guarantors.? If not, then the guarantors did it on their own.
4) Even in a bailout of financial guarantors, current shareholders may find themselves diluted beyond measure.? Given current political pressures, those risks are elevated; remember that management teams want to keep their jobs, and that regulators have some say in that.
Tim, I like your stuff, since I am a value investor. Be careful with XL Capital. The challenge is estimating what sort of guarantees they face from Security Capital Assurance. When I looked at them last, the potential payments could be huge — potentially larger than XL’s net worth, but hey, that’s the financial guarantee business. I looked at XL during my last portfolio reshaping — Finish Line also, and could not get past the potential risks. I had easier plays to go for, with less uncertainty, if also lower upside. I don’t try to hit home runs, so it makes it easier for me to not buy the stocks that are optically stupid cheap, but might have balance sheet issues. Cheap means that a company will have the capability to carry their positions through a downturn; it’s part of the “margin of safety” that we require.
Anyway, keep it up, and let’s see if we can’t make some money on our value investing.
Please note that due to factors including low market capitalization and/or insufficient public float, we consider Security Capital Assurance and Finish Line to be small-cap stocks. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.
Summary: there is still downside risk here.? Avoid the financial guarantors, and economic areas affected by the overleveraging of our credit markets. ? Stick with companies that have strong balance sheets.
I started my business career as an actuary.? For an actuary, though, I had an unusual background — I wasn’t a math or a statistics major, I was an economics major, though admittedly, one with a lot of math.? You can’t get through the Ph.D. courses in econometrics without a lot of math.? In my business career, I’ve put my economics background to use, and added to it through studying finance.? Now, I studied much of the finance and economics of risk literature back in grad school, and developed a healthy dislike for MPT, the CAPM, and suchlike.
I grew up in a home where my self-taught mother used her head and picked stocks.? She did it quite well, too, and continues to do so today.? I figured that I could do it too, and over the past fifteen years, have done so.? Perhaps my major theme would be “hunt for value, and don’t be afraid to have a portfolio that looks weird.”? My studies of finance in my post-academic days were practical in nature, analyzing ways of beating the market, or reducing risk, realizing that any strategy can become overused, and useless.
After leaving my former employer, I’ve done a bunch of things — writing, consulting, etc.? Now it is time to focus.? I have taken a job as Chief Economist and Director of Research for Finacorp Securities, based in Irvine, California.? Their main focus is serving the investment needs of municipalities.? I have three main tasks:
Publish research that encourages clients to trade with us.
Provide research for internal staff and clients, enabling staff to serve clients better.
Build an asset management franchise for our clients around my value investing, and bond investing.
Beyond that, aid in the management of the firm where possible.? Now, I’m not changing locations; I am still based near Baltimore.? What I do can be done from anywhere, so long as I can connect to the Internet.
I have already produced a draft version of a newsletter for our institutional clients.? I am making preparations to?offer equity asset management services to clients.? What form that will take is still open.
That said, it is interesting at this point in my life to finally have the word “Economist” in my job title, as well as “Chief.”? In one sense, this dovetails well into my interests, as those who read my blog will know.? I write about the intersection of macroeconomics and investing.? That’s what I do.? It allows me to keep my interests broad, while solving a wide array of practical problems.? I have sometimes said that I am an investment omnivore.? That’s not quite true, but I like to wander across the investment wilderness, and gather disparate data, gaining good conclusions about the total investment landscape.
Anyway, that is what I am up to now.? To the extent that our newsletter or investment services might be open to individuals, I will let you all know.? I thank you all deeply for your support of me.
PS — I may be on FOX Business Wednesday between 12 and 2PM Eastern.? This is uncertain at present.? We will see.
