David Merkel – Page 276 – The Aleph Blog

In Some Ways, The Municipal Bond Market Was Asking For It

Posted on 16 February 200817 February 2008 by David Merkel

What do municipalities want from their bond market? Low long-term financing rates. In and of itself, that’s not a bad goal to pursue. The question is how you do it.

What prompted this post was an article from The Bond Buyer (via Google cache). The need for short-dated tax-free muni bonds drives hedge funds (typically) to buy long munis and sell short term debt to finance the bonds, which tax-free money market funds buy. For more on Variable Rate Demand Structures, look here. (Thanks, Accrued Interest. The article was prescient to the current troubles.) The Wall Street Journal also anticipated the current troubles in this article. The hedge funds could only take the pain for so long. As perceived risks rose with the sagging prospects of the financial guarantors, fewer market players wanted to buy the short term debt, because the collateral underlying the short term debt no long had high enough ratings. That led to the hedge funds having to collapse their balance sheets, selling the long munis, and repaying the short term debts, taking losses in the process.

Now, many of the same difficulties apply to auction rate bonds (another article from Accrued Interest), no matter who the obligor (entity that must pay on the bond) is. As I commented recently:

Part of the difficulty here is that auction rate structures are unstable. They can handle 30 mph winds, but not 60 mph winds. Auction rate structures deliver low rates when things are calm, but can be toxic when short term liquidity dries up. A sophisticated borrower like the NY Port Authority should have known that going in. Small borrowers are another matter, their investment banks should have explained the risks.

Yes, the explanations are all there in the documents, but a good advisor explains things in layman?s terms. That said, it is usually the shortsightedness of local governments wanting low rates and long term funding at the same time that really causes this. You can have one or the other, but not both with certainty.

Or, as I commented at RealMoney:

		David Merkel
		Failed Muni Auctions are not the End of the World
		2/14/2008 2:50 PM EST

Most of the municipalities with the failed auctions are creditworthy entities that don’t need bond insurance. Bond insurance is “thought insurance.” The bond manager doesn’t have to think about the credit if he knows the guarantor is good. If the guarantor is not good, then the bond manager has to get an analyst to look at the underlying creditor. That takes work and thought, and both of those hurt. Daniel Dicker is on the right track when he says the municipalities are racing refinance. Well, good. Auction rate structures are stable under most conditions, but under moderate stress, like the lack of confidence in the guarantor, they break. I would like to add, though that auction rate structures are kind of a cheat. Why?

1) The municipality gets to finance short, which usually reduces interest costs, but loses the guarantee of fixed-rate finance. 2) This is driven by investors who want tax-free money market funds. Most municipalities don’t want to issue the equivalent of commercial paper. They want long term financing. 3) The auction rate structure seems to give the best of both worlds: long term financing at short rates, without having to formally issue a floater. 4) For minor hiccups, an interested investment bank might take down bonds, but in a crisis, they run faster than the other parties from a failed auction.

The municipalities could have issued fixed or floating-rate debt over the same term, but they didn’t because it was more expensive. Well, now they will have to bear that expense, and yes, as Daniel points out, that will make the muni yield curve steepen.

Pain to municipalities, which will mean higher taxes for debt service. Fewer auction rate securities to tax free money market funds. It’s a crisis, but not a big crisis.

Position: none
Let me put it another way. No one complained when hedge funds levered up the long end of the muni market, allowing municipalities to finance more cheaply than they should have been able to. But now that the leverage is collapsing, and municipalities that did not prudently lock in their rates, but speculated on short rates are getting hurt, should it be a major crisis? I think not. Personally, I think the wave of auction failures will give way to refinancing long, and a new group of speculators buying auction rate securities at higher yields than the prior short-term equilibrium yield.

Pushing on a String? Credit Marches to its Own Drummer.

Posted on 16 February 200817 February 2008 by David Merkel

Thanks to Naked Capitalism for pointing out this post by Paul Krugman. Here was my response:

Mr. Krugman, do your homework. Extend the graph out to five years, and you will see that yields on Baa bonds fluctuated between 7.1% and 5.7% over that time period. The correlation between Fed funds and Moody’s Baa series was pretty small during that time period, whether the fed funds rate was rising or falling. I just calculated the R-squared on the regression — 0.1%, for a 3.2% correlation.

Maybe it’s just a bad time period, so I ran it back to 1971, which was as far as my Bloomberg terminal would let me go. (Maybe I’ll go to FRED and download longer series, and use Excel, but I don’t think the result will be much different — the R-squared was 6.5%, for a correlation coefficient of 25.5%. Not a close relationship in my book for two time series relationships that are both interest rates.

Practical economists like me are aware that credit-sensitive investments often have little practical relationship to Fed funds. We work in the trenches of the bond market, not the isolation of academic economics, where you don’t contaminate your theories with data.

The Fed may or may not be pushing on a string, but you have certainly not proven your case.

-=-=-=-=-

Here’s the graph for the Fed funds rate and Moody’s Baa yield series since 1971. (When I ran my calculations, I used monthly, but could only get the graph back to 1971 if I went to quarterly.

(graph: Bloomberg)

As I said, not much of a correlation, but why so low?? This is related to a topic on which Bill Rempel has asked me for an article.? (To do that article, I have to drag a lot of yield data off of Bloomberg for analysis; I will be getting my full subscription soon, and once that happens, I can start.)

As an investment actuary, I’ve had to develop models of the full? maturity/credit yield curve — maturities from 3 months to 30 years (usually about 10 points) and credit from Treasuries, Agencies and Swaps to Corporates, AAA to Single-B.? A Treasury yield curve at any point in time can be fairly expressed by a four factor model, and the R-squared is usually around 99%.? (I learned this in 1991, and there is a funny story around how I learned this, involving a younger David and a Bear Stearns managing director.)

The short end of the Treasury yield curve is usually far more volatile than the long end in yield terms (but not in price terms!).? All short high-quality rates are tightly correlated, and that includes Fed funds, Agency discount notes, T-bills, LIBOR (well, usually), A-1/P-1 commercial paper, etc.? As one goes further down the yield curve in maturity, the correlations weaken, but still remain pretty tight among bonds rated single-A or better.? (As a further note, Fed funds and 30-year Treasury yields also don’t correlate well.)

Credit is its own factor, which varies with expectations of the economy’s future prospects.? A single-B, or CCC borrower can only repay with ease if the economy does well.? If prospects are looking worse, no matter what the Fed does to short high-quality rates, junk grade securities will tend to rise in yield.? Marginal investment grade securities (BBB/Baa) will tread water, and short high-quality bond yields will correlate well with Fed funds.

When I say “credit is its own factor,” what I am saying is that outside of Treasury securities, every credit instrument participates to varying degrees in exposure to the future prospects of the economy.? (Credit in its purest form behaves like equity returns.)? For conservatively capitalized enterprises with high quality balance sheets, their credit spreads don’t change much as prospects change for the economy.? For entities with low quality balance sheets, their spreads change a lot as prospects change for the economy.

So, for two reasons, Mr. Krugman should not have expected the Fed funds target rate and the Moody’s Baa yield to correlate well:

Fed funds is a short rate, and Moody’s Baa is relatively long (bonds go over the full maturity spectrum).
Fed funds correlates well with the highest quality yields, and Baa is only marginally investment grade.? Recessions should hurt Baa spreads, leaving yields relatively constant.

Let the Lawsuits Begin — II

Posted on 16 February 2008 by David Merkel

Consider this article from the WSJ, Bond Insurer Seeks to Split Itself, Roiling Some Banks.? The banks will fight this.? Here are some quotes:

The move may help regulators protect investors who have municipal bonds insured by the firm. But it could also force banks who are large holders of the other securities to take significant losses. Some banks that have been talking with FGIC in recent weeks to bolster the firm were taken aback by the announcement and could yet try to block it, say Wall Street executives.

and —

The banks learned of the split-up plan Friday by seeing it reported on CNBC, this person said, calling it a “bizarre situation.”

All of the banks have hired legal counsel and are prepared to go to court. The person familiar with the situation said FGIC’s move could result in “instant litigation.” FGIC didn’t respond to queries about the banks’ reaction to Friday’s announcement.

?now, it could lead to:

One plan the parties are discussing involves commuting, or effectively tearing up, the insurance contracts the banks entered into with FGIC, according to another person familiar with the matter. In exchange, FGIC would pay the banks some amount to offset the drop in value of those securities, or give them equity stakes in the new municipal-bond insurance company.

and —

However, if a breakup is endorsed by the New York Department of insurance, that could limit the legal liability.

One other wild card: If FGIC splits into two, it could throw into turmoil potentially billions of dollars of bets that banks, hedge funds and other investors have made on whether FGIC would default on its own debt. If FGIC is split, it isn’t clear how those “credit default swaps” would be valued, since one half of the new company would have a higher risk of default than the other.

?To the extent that the NY Department of Insurance limits the legal liability of PMI, they raise their own liability.? If I were one of the banks, I would sue the State of New York, and quickly, because NY is moving more quickly than they ought to.? There is no NY crisis here, and the politicians and bureaucrats of New York should behave as gentlemen, and not thugs.

Now, one thing I would agree with the NY Department of Insurance on is this: no dividends to the holding companies.? Until things stabilize, retain assets at the operating companies in order to make sure that claims can be paid.? If MBIA and PMI go broke, that is no great loss, except to those that hold equities, or holding company debt.? But if the operating subsidiaries go broke, that is significant to those who will make claims against the companies.

Let the Lawsuits Begin

Posted on 15 February 2008 by David Merkel

So FGIC requests to be broken in two.? Personally, I expect that it stemmed from giving into strong-arming from the New York Department of Insurance and perhaps the Governor as well, but if I were FGIC, I would want to do this.? Who wouldn’t want the option of splitting his business in two during a crisis, putting the good business into subsidiary A, which will stay solvent (and protect some of your net worth) and putting the bad business into subsidiary B, which will go insolvent, and pay little to creditors?

In many other situations this would be called fraudulent conveyance, but when you have a state government behind you, I guess it gets called public policy.? The NY Insurance Department tries to sidestep a big insolvency by creating favored classes of insureds.

Those with concentrated interested in non-municipal guarantees should band together to protect their rights, and sue FGIC and NY State (seeking punitive damages) to block the breakup.? The question is, who will be willing to bear the political heat that will arise from this, and oppose an illegal “taking?”

Split the Financial Guarantors in Two? You Can’t Do That.

Posted on 15 February 200815 February 2008 by David Merkel

This will be a brief note because it is late, but the state insurance commissioners lack authority to favor one class of claimants over another to the degree of setting up a “good bank/bad bank” remedy, where municipalities get preferential treatment ovr other potential claimants.? The regulators allowed the nonstandard business to be written for years, with no objection.? The insureds that would be forced into the “bad bank” would likely not have agreed to the contract had they known that the claims-paying ability of the guarantor would be impaired.

There is nothing in contract law that should favor municipalities over other claimants.? Now, if they want to modify the law prospectively, that’s another thing.? Create a separate class of muni insurers, distinct from financial guarantors that can guarantee anything for a fee.? Different reserving and capital rules for each class.

Now this doesn’t mean that New York won’t try to split the guarantors in two; I think they will lose on Ambac because it is Wisconsin-domiciled.? With MBIA, they will lose after a longer fight, because they don’t have the authority to affect the creditworthiness of contracts retroactively.

What Might the Shape of the Treasury Yield Curve Tell Us?

Posted on 15 February 200815 February 2008 by David Merkel

There are many things that are unusual about the current Treasury yield curve. I’ve built a moderately-sized model to analyze the shape of the curve, and what it might tell us about the state of the economy, and perhaps, future movements of the yield curve. My model uses the smoothed data from the Federal Reserve H15 series, which dates as far back as 1962, though some series, like the 30-year, date back to 1977, and have an interruption from 2002-2005, after the 30-year ceased to be issued for a time.

So, what’s unusual about the current yield curve?

The slope of six months to three months (19 bp) is very inverted — a first percentile phenomenon.
The slope of two years to three months (38 bp) is very inverted — a third percentile phenomenon.
The slope of seven years to ten years is steep (57 bp – 5 bp away from the record wide) — a 100th percentile phenomenon.
The slope of five years to thirty years is steep (186 bp – 30 bp away from the record wide) — a 100th percentile phenomenon.
The slope of two years to thirty years is steep (274 bp – 97 bp away from the record wide) — a 97th percentile phenomenon.
The slope of ten years to thirty years is steep (82 bp – 29 bp away from the record wide) — a 98th percentile phenomenon.
The butterfly of three months to two years to thirty years is at the record wide (312 bp). (Sum of #5 and #2. Buy 3 months and 30-years, and double sell 2-years? Lots of positive carry, but the 30-year yield could steepen further versus the rest of the curve, and its price volatility is much higher than the shorter bonds.)

What prior yield curves is the current yield curve shaped like?

9/7/1993 — after the end of the 1990-1992 easing cycle to rescue the banks from their commercial real estate loans.
2/15/1996 — after the end of a minor easing cycle, recovering from the 1994 “annus horribilis” for bonds.
9/14/2001 — 60% through the massive easing cycle where Greenspan overshot Fed policy in an effort to reliquefy the economy, particularly industrial companies that were in trouble. Also days after 9/11, when the Fed promised whatever liquidity the market might need to stave off the crisis.

Okay, I’ve set the stage. What conclusions might we draw from the current shape of the yield curve?

The curve is forecasting a 2% Fed funds rate in 2008.
Fed policy is adequate at present to reliquefy the economy; the Fed doesn’t need to ease more, but it will anyway. Political pressure will make that inevitable. (If we really want an independent central bank, let’s eliminate the ~~pressure~~ oversight that Congress has over the Fed. Better, let’s go back to a gold standard; a truly private monetary policy. Oh, wait. I’m behind the times. We don’t want an independent central bank. Dos that mean we can now blame Congress for monetary policy errors?)
We could see a record slope for the yield curve (in the post Bretton Woods era) if the Fed persists in its easing policies.
One can sell sevens and buy tens, dollar-duration-weighted and have positive carry. Assuming one can hold onto the position, it would be hard to lose at these levels, if the last thirty years of history is an adequate guide to the full range of possibilities.
The Fed is planting the seeds of its next tightening cycle now. Every cut from here will make the tightening cycle that much more intense.
The curve can get steeper from here, but it is getting close to the boundaries where strange things begin to happen. The Fed is not omnipotent, and the steepening curve is evidence of that.
As I have said before, recently, the US Dollar is no longer a “sell” for now. The anticipation of Fed funds cuts is already factored in, and even if we get down to 2%, I suspect that we can’t go much lower because of negative real interest rates and rising inflation.

That’s where I stand for now. The Fed is trying to rescue the economy from asset deflation, much like 1990-1992, but will run into the buzzsaw of price inflation, and tighten a la 1994. Conditions in the real economy are not as weak today as they were in 2001, but the banks are in worse shape. That will drive further loosening by the Fed, until inflation is intolerable. Continue reading “What Might the Shape of the Treasury Yield Curve Tell Us?”

Eight Thought on Our Fragile Debt Markets

Posted on 14 February 2008 by David Merkel

It’s early morning now, after two days on the road.? It is good to be home, and it will be good to get back to “regular work” once the workday begins.? A few thoughts:

1) Here are two Fortune articles where Colin Barr quotes me regarding Buffett’s offer to reinsure the muni liabilities of the financial guarantors.? He correctly quotes my ambivalent view.? I am not willing to take Ackman’s side here, nor that of the guarantors and rating agencies.? This is one of those situations where I don’t think anyone truly knows the whole picture.? My thoughts are limited to Buffett’s offer.? He’ a bright guy, and he is hoping that one of the guarantors is desperate enough to take him up on his offer.

2) Personally, I found this note from the WSJ economics blog worrisome.? Ben Bernanke is probably a lot smarter than me, but I can’t see amelioration in the residential real estate markets in 2008.? We still have increases in delinquency and defaults at present.? Vacancy is increasing. Inventory is increasing.? The market is not close to clearing yet.

3) I like the “quants.”? Are they a big force in the stock market?? Yes.? But they are an aspect of Ben Graham’s dictum that in the short run the stock market is a voting machine, but in the long run it is a weighing machine.? “Dark pools” sound worrisome, but to long-term investors they are a modest worry at best.? Traders should be concerned, but that is part of the perpetual war between traders and market makers/specialists.

4) There are two aspects to the concept of the rise in housing prices.? One is the scarcity of desirable land near where people want to live.? The second is that financing terms got too loose.? Marginal Revolution says there is/was no housing bubble.? They are focusing on the first issue, and downplaying the second issue.? My view is that there are legitimate reasons for housing prices to rise, but we built more homes than were needed, and offered financing terms to buyers that were way too generous.? To me, that is a bubble, and we are still working through it.

5) Auction-rate securities have always seemed to me to be micro-stable, but subject to macro-instability.? What do I mean?? Small fluctuations get absorbed by the investment banks, but large ones don’t.? As an old boss of mine used to say, “liquidity is a ‘fraidy cat.”? It’s around for minor jolts, but disappears in a crisis.

6) Muni bond insurance is thought insurance.? Most municipal bonds are small.? What credit analyst wants waste time analyzing a small municipality?? With a AAA guaranty, the bonds get bought in a flash, and they are liquid (so long as the guarantor continues to be viewed positively).? So, I still view municipal guarantees as having value.? Not everyone else does.

7)? Intuitively, I can feel the dispute regarding the recycling of the current account deficit.? The two sides boil down to:

When are they going to stop buying depreciating assets?
What choice do they have?? They have to do something with all the dollars that they hold.

It’s a struggle.? In the short run, supporting the US Dollar makes a lot of sense, but the build-up of continual imbalances is tough.? Why should we buy into a depreciating currency in order to support our exporters?

8 ) Privatize your gains, socialize your losses.? It’s a dishonest way to live, but many press their advantage in such an area. Personally, I think that losses need to be realized by aggressive institutions.? They took the risk, let them realize the (negative) reward.

That’s all for the morning.? Trade well, and be wary of things that work in the short run, but are long run unstable.

Happy Hour with Cody and Rebecca

Posted on 13 February 200813 February 2008 by David Merkel

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.

So, it was interesting for me to be on Happy Hour yesterday.

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.

Full disclosure: long AIZ HIG LNC

Still More Odds & Ends (Twelve this Time)

Posted on 12 February 2008 by David Merkel

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.

2) As I wrote at RealMoney this morning:

		David Merkel
		Buy Other Insurers off of the Bad AIG News
		2/12/2008 2:54 AM EST

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:

		David Merkel
		Move to Florida, Become a Reinsurer
		3/27/2007 3:30 PM EDT

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?)

Position: none mentioned

		David Merkel
		The Worst Insurance State In The USA
		2/2/2007 3:52 PM EST

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

		Marc Lichtenfeld
		Florida Insurance
		2/2/2007 4:17 PM EST

David,

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.

Position: None

		David Merkel
		My Sympathies to the People of Florida
		2/2/2007 4:45 PM EST

Marc,

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.)

Full disclosure: long AIZ HIG LNC NAHC

Ten More Odds & Ends

Posted on 9 February 200810 February 2008 by David Merkel

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.

6) Naked Capitalism had an interesting post on GM. I made the following comment:

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.

10)? Finally, on Friday, a UBS report stirred the pot regarding non-borrowed reserves.? You can see the H.3 report here. Both Caroline Baum of Bloomberg and Real Time Economics debunked the UBS piece.? But it was simpler than that.? The Fed published its own explanation at the time they put out the H.3 report.? UBS did not include the effect of the new TAF.? Whoops.? Oh well, I make mistakes also.? It’s just better to make mistakes when one doesn’t sound so certain.
Full disclosure: long MGA, HMC