Recently, a company for which I once managed bond money announced a bond offering.? An odd bond offering that I would not buy regardless of pricing.You might say, “No such thing as bad assets, only bad prices.”? Mostly I believe that, but not here.? There are some assets you should not want to take the chance on.? This is one of them.
Here is the biggest weakness: you are lending to an intermediate holding company.? When I was a bond manager, I would lend to the uppermost holding company, knowing that the stockholders did not want to hand their profitable company over to me.? I would also lend to subsidiaries that I knew a parent company would not want to lose.? But I would not lend to intermediate holding companies — owned by the parent, and owning a subsidiary not directly responsible for the debt.
I inherited such a debt in the portfolio, and it took me months to sell it at a halfway decent level.
Here is the second weakness: they will take two-thirds of the proceeds, and give it to the life insurance subsidiary in exchange for a surplus note, with similar terms compared to the note sold.? Surplus notes are weak, because state insurance departments can forbid payment of interest and principal.? The ability to repay the bond is weak.? The subsidiary borrowing does not have any significant cash flow to repay, aside from dividends from its insurance subsidiary.
Third, I do not appreciate the affiliated reinsurance.? That is just a scam, with no economic difference to the enterprise as a whole.
Fourth, I do not appreciate reinsurance recoverables larger than common equity.? There is some credit risk there… how much do you rely on your reinsurers to pay claims in full?? The operating insurance subsidiaries look like they are adequately capitalized, but with that level of reinsurance, you really can’t tell for sure.
Also, some of the reinsurance agreements are specifically targeted to eliminate pesky reserves that make Statutory (regulatory) accounting more conservative than GAAP.? That’s not all that unusual with financial reinsurance, but it does lessen future statutory cash flow, which is what is needed to service the debt.
Fifth, 25% of the offering will be paid as a dividend to the parent company, which further weakens ability to repay.
Sixth, there are related party transactions within the Harbinger Group.? Harbinger Group has been through tough times and liquidity is tight.? You only do moves like this when things are desperate. Reminds me of Southmark.? The operating insurance subsidiaries have made loans to EXCO Resources, a Harbinger subsidiary, buys asset-backed securities that other Harbinger subsidaries originate, and has a large reinsurance agreement with a Harbinger subsidiary in the Cayman Islands.? I respect most reinsurers in Bermuda.? Other foreign domiciles like Ireland, Cayman Islands, etc., are more questionable.? Regulation is more lax.
Seventh, Here are some of the points from the risk factors:
Our Reinsurers, Including Wilton Re, Could Fail To Meet Assumed Obligations, Increase Rates, Or Be Subject To Adverse Developments That Could Materially Adversely Affect Our Business, Financial Condition And Results Of Operations.
Our insurance subsidiaries cede material amounts of insurance and transfer related assets and certain liabilities to other insurance companies through reinsurance. For example, a material amount of liabilities were transferred to Wilton Re pursuant to the Wilton Transaction in 2011. See ?Business?The Fidelity & Guaranty Acquisition?Wilton Transaction? below. However, notwithstanding the transfer of related assets and certain liabilities, we remain liable with respect to ceded insurance should any reinsurer fail to meet the obligations assumed. Accordingly, we bear credit risk with respect to our reinsurers, including our reinsurance arrangements with Wilton Re. The failure, insolvency, inability or unwillingness of Wilton Re or other reinsurers to pay under the terms of reinsurance agreements with us could materially adversely affect our business, financial condition and results of operations.
As noted above, reinsurance is a source of credit risk, and is a type of leverage.? Companies that use a lot of it are less strong than they seem.
Our Insurance Subsidiaries? Ability To Grow Depends In Large Part Upon The Continued Availability Of Capital.
Our insurance subsidiaries? long-term strategic capital requirements will depend on many factors, including their accumulated statutory earnings and the relationship between their statutory capital and surplus and various elements of required capital. To support their long-term capital requirements, we and our insurance subsidiaries may need to increase or maintain their statutory capital and surplus through financings, which could include debt, equity, financing arrangements or other surplus relief transactions. Adverse market conditions have affected and continue to affect the availability and cost of capital from external sources. We and HGI are not obligated, and may choose or be unable, to provide financing or make any capital contribution to our insurance subsidiaries. Consequently, financings, if available at all, may be available only on terms that are not favorable to us or our insurance subsidiaries. If our insurance subsidiaries cannot maintain adequate capital, they may be required to limit growth in sales of new policies, and such action could materially adversely affect our business, operations and financial condition.
There is kind of a pathology to insurance companies that rely on reinsurance for capital.? It fronts expected statutory profits from the future, reducing future statutory income, but increases capital.? It’s kind of an addiction.
We Operate In A Highly Competitive Industry, Which Could Limit Our Ability To Gain Or Maintain Our Position In The Industry And Could Materially Adversely Affect Our Business, Financial Condition And Results Of Operations.
We operate in a highly competitive industry. We encounter significant competition in all of our product lines from other insurance companies, many of which have greater financial resources and higher financial strength ratings than us and which may have a greater market share, offer a broader range of products, services or features, assume a greater level of risk, have lower operating or financing costs, or have different profitability expectations than us. Competition could result in, among other things, lower sales or higher lapses of existing products.
They are up against much stronger competition with better balance sheets.? In a crisis, they would have less flexibility, and have a harder time raising capital than most competitors.
The Issuer Is A Holding Company And Its Only Material Assets Are Its Equity Interests In FGLIC. As A Consequence, Its Ability To Satisfy Its Obligations Under The Senior Notes Will Depend On The Ability Of FGLIC To Pay Dividends To The Issuer, Which Is Restricted By Law.
The issuer is a holding company with limited business operations of its own. Its primary subsidiaries are insurance subsidiaries that own substantially all of its assets and conduct substantially all of its operations. Accordingly, the repayment of interest and principal on the senior notes by the issuer is dependent, to a significant extent, on the generation of cash flow by its subsidiaries and their ability to make such cash available to the issuer, by dividend or otherwise. The issuer?s subsidiaries may not be able to, or may not be permitted to, make distributions to enable it to make payments in respect of the senior notes. Each subsidiary is a distinct legal entity and legal and contractual restrictions may limit the issuer?s ability to obtain cash from its subsidiaries. While the indenture governing the senior notes will limit the ability of the issuer?s subsidiaries to incur consensual restrictions on their ability to pay dividends or make other intercompany payments to the issuer, these limitations are subject to certain qualifications and exceptions. If sources of funds or cash from the issuer?s subsidiaries are not adequate, we may be unable to satisfy our obligations with respect to the senior notes without financial support from the issuer?s parent, which is under no obligation to provide such support.
(snip)
The issuer intends to use $195.0 million of the proceeds from the senior notes to purchase a surplus note from FGLIC. The interest rate and tenor of the surplus note will be substantially similar to those of the senior notes.
As pointed out above, owners of this bond would be lending to an empty shell from which it will be difficult to extract value if there is financial stress.
We And Our Subsidiaries May Be Able To Incur Substantially More Debt And Other Obligations.
We May Not Be Able To Generate Sufficient Cash To Service All Of Our Obligations, Including The Senior Notes, And May Be Forced To Take Other Actions To Satisfy Our Obligations, Which May Not Be Successful.
The Senior Notes Will Not Be Secured And Will Be Effectively Subordinated To Future Secured Debt To The Extent Of The Value Of The Assets Securing Such Debt.
The Issuer May Not Be Able To Repurchase The Senior Notes Upon A Change Of Control, And Holders Of The Senior Notes May Not Be Able To Determine When A Change Of Control Giving Rise To Their Right To Have The Senior Notes Repurchased Has Occurred Following A Sale Of ?Substantially All? Of Our Assets.
Our Principal Shareholder?s Interests May Conflict With Yours.
Lest this post go from “too long” to “way too long,” I am summarizing off of the headings of five more risk factors.? The first three show the weakness of the position of the holders of the notes, in that you can be diluted or subordinated.?? The fourth shows how the notes themselves would complicate a sale of insurance subsidiary assets.
The fifth tells you that Phil Falcone has different interests than you.? If things go well, he may do very well, while you get repaid early because of call provisions, and must reinvest.? If things go badly, recoveries on a bond like this could be very low.? When surplus notes stop paying interest and principal, they trade near zero if it looks permanent.? Remember, the Maryland Insurance Administration has every reason to be conservative about making surplus note payments if the operating insurance subsidiary is under financial stress.
Eighth, if it’s not obvious get, I eschew complexity in debt agreements.? I’m not crazy about:
- Reserving on indexed and variable products
- Complexity of financial operations
- Liabilities that can run easily — I don’t have the data for that, so I don’t know how big that is, I would have to look at the Statutory books to know for sure.
- Deferred tax assets as a part of Statutory Capital — again, I would have to look at the Statutory books to know for sure.
Ninth and Last, the covenants protecting the notes are weak, and exceptionally verbose.? I have a rule that the longer and more detailed covenants are, the less protection they usually give note owners.? It’s kind of like Proverbs 10:19, “In the multitude of words sin is not lacking, But he who restrains his lips is wise.”
For a corporate bond prospectus, this one is really long, ~320 pages, longer than some securitizations that I used to buy as a mortgage bond manager.? I assume that most of the investor interest here would be institutional, but if you give your broker some discretion over an account in which he purchases individual bonds, you might ask him to avoid this deal.? It will be a tempting bond to buy, because it will come with a fat yield in this yield-starved environment, if the deal gets completed.
As one friend of mine once said to me, “This bond deal is horrid, but it has one sweet YTNJ.”
Me: “YTNJ? Haven’t heard that one.”
Friend: “Yield to next job.”
Be like Will Rogers, the return of the money is more important than the return on the money.? Be wise, stay safe.
David,
The first problem you have – for clarification, is that like with Sears Holdings, holding the debt of Sears Roebuck Acceptance; where you are a debt holder of the “lesser” holding company? Maybe my understanding of Sears Holding and Sears Roebuck Acceptance isn’t correct but I’m trying to identify other situations where that is the case. Thanks. Really enjoy the blog.
Ari
Here’s an example: when I was a bond manager, I owned bonds of Verizon. During 2002, my telecoms analyst began to get worried about VZ, as did much of the market.
There were two main flavors of bonds I could own: Parent company senior unsecured, which meant in most cases my interests would be protected because the stockholders would have to go broke first, before I was harmed. Second class of bonds were those of the operating telephone companies covering a given region or state — they had names like “New Jersey Bell,” etc. Even if VZ went broke, I had the cash flows of the operating telephone company, and their assets to back them up.
But then I had a funny bond issued by a subsidiary of the parent company, an intermediate level holding company, that had the operating telephone companies as subsidiaries. Very few covenants to protect my client. (I had not bought the bond for the client, I inherited it.) That bond had neither the protections of the parent company, nor the direct connection to the assets of the operating telephone companies.
During a sharp bull market, I managed to sell the bond at a smaller yield concession to prices of the parent company bonds than the concession when we were worried, and reinvested in bonds of the operating telephone companies.
David — just curious if you think selling a bond like this is an “ethics violation” (bad ethics, not a legal violation) or is this an example of greater fool theory?
The issuer is fully and “honestly” disclosing that the buyer faces enormous risks, including loss of principal — yet there is very limited upside. You might get the coupon / interest if and only if everything works out; but the issuers interests *do* sharply differ from the lenders (I know the wording says “may differ”, but they obviously differ a lot).
Seems to me this issuance says as much if not more about the buy side than the sell side.
Anything as “simple” as a bond issuance that requires such a lengthy and complicated disclaimer … I think I would dismiss the bond as too complex to work (and not bother reading the prospectus as carefully as you did).
If buyers simply looked out for themselves, issues like this would never come to market. No investment bank wants to get stuck with something they can’t sell.
What are your thoughts on the ethics angle of this?
Yes, it says a lot about the buy side too. For every sharp practice, there is often a yield hog buying. The CDO bid 2004-2007 was complicit with the monster.
We missed a lot of problems because I eschew complexity, and I read prospectuses in good times and in crises (sometimes what looks like trash isn’t).
As for reading this one carefully, it was two speed. Run, stop, something significant, boilerplate, run, repeat as needed…
Who I feel sorry for are retail investors who could get clipped by this. After that, the Maryland Insurance Administration for reasons that I don’t want to put in print.
I was kind of mixed on the ethics of this bond.
Suppose a criminal mugger tells you that he is going to rob you if you walk down this isolated, poorly lit alley.
Then you walk down said alley and you get mugged. Can you really act surprised? Yes, the mugger clearly committed an ethics violation (legal one too).
But if you deliberately put yourself in a dangerous situation, you aren’t exactly a “victim”.
This does not exonerate the mugger in any way; send him to prison (in securities industry, the sheriff has been a bit weak in this area).
But if one walks down an isolated, poorly lit alley with an ATM receipt and hundred dollar bills sticking out of your pockets … I think a lot of people would say you are a fool. People living in a major city would openly laugh at you. I think the NYPD generally does a good job, but they would be smirking and have trouble keeping a straight face when you reported the mugging.
Doesn’t mean the mugger hates you. He is a mugger, and doing what muggers do. Still unethical and illegal, but he is a mugger.
Seems to me a lot of retail (and buy side institutional) investors would never walk down a dark alley with an ATM receipt sticking out of their pocket … they would feel stupid for doing so.
Yet, they wouldn’t hesitate to buy a bond like you describe. Why the difference?
My main ethical objection is to “jamming retail.” Brokers often buy poor quality to generate income.
A secondary issue is the principal/agent problem, which manifests itself in the YTNJ issue. If institutional investors are forced by clients to achieve a certain yield, rather than the best total return, the investors may do the the best they can to hit that yield while staying as safe as possible, which might not be safe enough.
What about the customer is always right?
If your client gives specific instructions to generate x% yield, and you run off and buy an perfectly suitable asset to get a capital gain instead (eg target total return that matches the x% yield) … that is in most cases a legal violation in addition to an ethics violation. You ignored the clients wishes and executed a discretionary trade without authorization… forget about YTNJ — your next job is in a federal penitentiary.
I agree with you that existing business models do not support (and often work against) efforts to educate a client about risk/return trade offs. The problem goes way just yield chasing.
Its why I don’t work for Mega Bank Corp anymore