Category: Accounting

A Conversation with Dr. X — Why the Tax Code is a Mess

A Conversation with Dr. X — Why the Tax Code is a Mess

I have a friend who I will call Dr. X, or DX for short.? He is a friend of mine who is involved in some but not all things that I am involved in.? We talked recently about taxes, and this is my stylized version of the discussion, because I did not tape it.

Me: So, DX, how did you make out this tax season?

DX: What do you think my federal tax rate was?

Me: Uh, 25%.? You’re a successful guy.

DX: Try again. Lower.

Me: 15%?

DX: Lower.

Me: 10%?

DX: I said LOWER.

Me: Uh, yeah… 3%?

DX: It’s lower.

Me: 1%?

DX: I’m sorry, LO-wer.

Me: O%, you paid nothing?

DX: I’m SORRY, lower.

Me: Wait, the government paid you?

DX: That’s one way to put it.

Me: Then I am clueless.? I have no idea what to do with someone like you who earns a lot, but pays no taxes.

DX: Negative 3%.

Me: How does that happen?? Why aren’t you caught by the AMT?

DX: Many deductions, and many children, with some in college, like you my friend.? Aside from that there is the swiss-cheese post-AMT that wipes out taxes.

Me: Wow.? Why would the government allow this to happen?

DX: Beats me, but I am happy to be wealthy and pay no federal taxes.? That’s been largely true for the prior two years as well.? It genuinely helps if most of your income is coming from sources of investments, and businesses that benefit from certain tax credits.

Me: This is ridiculous.? Why should you get off paying no taxes when our government is running huge deficits?

DX: That’s the fault of the government favoring certain actions.? As long as the tax code is a policy tool, there will be some that take advantage of it.? As for me, I made few active actions to take advantage of it, but also, the way that I do things paid off because I have a certain configuration of income that is presently favored, and a family structure and deductions that are favored.? It may not always be that way — look at the code from the Depression through the 70s; it would be the opposite for me.

Something in-between the two would probably be optimal, including taxing all income at the same rate, and limiting deductions severely.? Stop the games, and fairness becomes a? possibility.? Otherwise, you will have some well-off that pay virtually nothing, like me for the past three years.

Me: Indeed, DX.? You are the man, and have triumphed over the federal government. But what are the common men supposed to do?

DX: Do what I do, or, pay taxes.

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Dr. X is a bit of a “piece of work,” but he’s no Leona Helmsley.? (“We don’t pay taxes. Only the little people pay taxes.”)? Much of the reason for his low taxes stems from charitable giving, including donating appreciated stock.

But this helps to point out my point for what I call “true tax reform,” which I don’t think either side in DC would favor today.? Here’s the simple version of it:

  • Flatten out the tax rates, and apply the rates uniformly to all income.
  • Eliminate all tax preferences, and eliminate the estate tax.? Get people focused on growing the economy rather than employing clever people to eliminate taxation.
  • Tax all income, including capital gains/losses, whether realized or not.? For illiquid investments, where there are no prices, assume a 12% return on equity for taxation purposes, and true it up when the investment is sold.? In other words, tax everyone as if they were traders, and develop fair market value accounting to do this.
  • Tax corporations on GAAP income, which solves the problem on overseas subsidiaries.? If they act like private equity firms, then disallow the deduction for interest, or assume a 12% return on equity for taxation purposes.
  • Eliminate all ability to defer taxation.? No more IRAs, or anything like them.? Tax the pension earnings inside corporations, etc.

My main point here is that the discussion on taxation should shift from rates to the definition of income.? You can tax wealthy people as much as you like, but if the definition of income is loose, you can bet that the wealthy will take advantage of it in ways that those less well-off can’t.

My proposal will make the clever wealthy pay.? It will make the poor pay.? We all will pay.? And that is fair.? Even Dr. X would agree with that.? And it will lead to a growing economy, because we will release many clever people who spent time trying to reduce taxes into trying to be productive.

Q&A with Roddy Boyd

Q&A with Roddy Boyd

I don’t often do a Q&A with book authors, but I appreciated my dealings with Roddy Boyd, the author of Fatal Risk.? It’s official publication date is tomorrow, but it is now available at Amazon.? If you want to buy it, you can find it here: Fatal Risk: A Cautionary Tale of AIG’s Corporate Suicide.

Full disclosure: This book was sent to me by the author, unsolicited.

If you enter Amazon through my site, and you buy anything, I get a small commission.? This is my main source of blog revenue.? I prefer this to a ?tip jar? because I want you to get something you want, rather than merely giving me a tip.? Book reviews take time, particularly with the reading, which most book reviewers don?t do in full, and I typically do. (When I don?t, I mention that I scanned the book.? Also, I never use the data that the PR flacks send out.)

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

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1) What impressed you most about your interview(s) with M. R. Greenberg?

To begin, his utter and consuming passion for AIG. He does not distinguish between AIG and himself, at least in any appreciable sense. What happened to AIG thus happened to him and vice versa. He will never forget anything and he will never forgive anything. Nor, for that matter, will he concede very much. The other issue is that per David Schiff?s observation, Greenberg never stops, he is ?Always running.? Since his obsession is work, then everything else in his life can be elegantly understood: The foreign policy stuff, bringing his sons into the business, the travel schedule of a foreign diplomat, the boards and foundations. Since AIG was everywhere and doing everything so was Greenberg.

2) If you could have gotten others to talk with you, who would they be, and what questions would you want them to answer?

It?s a tie between Win Neuger and Martin Sullivan. I?d want to ask Sullivan if he really saw events per his Congressional testimony on the fall of 2008, where he laid much blame for the collapse at the feet of mark-to-market accounting. This is akin to Morgan Stanley?s John Mack complaining about short-sellers at the same time–a complete abdication of all intellectual responsibility. I?m guessing Sullivan has a lot more to say than just stuff about accounting. Regardless, no one at AIG had much to say about mark-to-market accounting in 2005-2007, when they had billions of dollars in unrealized gains from their sundry portfolios.

With Neuger, I would want to start at the very beginning of the expansion of the securities lending portfolio, which tracks to around the very minute of Greenberg?s departure. It?s easy to take shots after a crash but I wouldn?t do that; I?d want to know how he thought AIG was going to have a different end than the number of other securities lending portfolios that extended duration during low rate cycles and modest volatility. I?d also want to know when HE realized there was trouble, that you can?t always unload $150 million worth of mortgage-credit paper on the bid side. That conversation might get interesting.

3) AIG Financial Products had three eras, with three different managements, strategies, and interactions with AIG parent company.? Why wasn?t AIG able to manage AIGFP to keep it sound?

In a word: competition. In 1987 the only limits to what FP could do was what they could dream up. They dominated the landscape with a virtual monopoly. Come 1996, every I-bank and commercial bank was in rate swaps in a big way and, in the case of Gen Re and Credit Suisse, had their own Financial Product units seeking to do ?bespoke? transactions. By 1999, Goldman was actively leveraging its corporate finance relationships to do custom transactions. Hedge funds, by the early parts of last decade, are competing with them on the asset finance side and on every sort of complex short-term trade FP entered, they were competing against the prop desks of Goldman, Merrill, J.P.Morgan and the like.

There is also the intellectual drift common to every enterprise. A founder comes in and designs a business in a certain fashion; By the second or third generation of management, it?s highly unusual to have the same rigid adherence to the founder?s goals. For an (extreme) example, look at the Ford Foundation and its role within the Liberal firmament and then look at who Henry Ford was. The divergence of mission usually occurs obliquely. For instance, Joe Cassano would have looked askance at a speculative bet directly on the mortgage market via Freddie or Fannie passthroughs. Instead, FP wound up long the mortgage market via writing insurance coverage they were told would never be impaired.

4) Are there any areas/subsidiaries inside AIG that you would want to look more closely at after writing Fatal Risk?

Not really.

5) What do you think the last moment was that AIG still had control of its own destiny was?

Maybe late 2006 or early 2007. Assuming some visionary philosopher King rode in with a mandate to hedge all risk, with total operational control and the budget to see it through, they would have had the ability to go out and buy a fair amount of coverage in the ABX indices for FP (and maybe structure some custom swap with a large bank) and begin an immediate ?run-off? at the Securities Lending portfolio. It would have cost them billions of dollars and they still would have taken some bitter losses in the autumn of 2008. Still, I can see a $10 billion ?investment? across FP and Securities Lending going a long way to preserving autonomy. It should be noted that I asked this question at every interview and no one said anything like it was even considered. FP executives say they never considered buying CDS on the CDS they were writing since it would have completely eliminated the ?profits? from premiums. Go figure.

6) What would it have taken for AIG to be properly managed after Greenberg?s departure?

There was a massive gap in the knowledge base of the men who stepped in after the departure of Greenberg, Ed Matthews and Howie Smith; Martin Sullivan and (CFO) Steve Bensinger knew enough to run AIG in a bull-market. Their greatest weakness was in not having a suitable understanding of the downstream, or long tail, risk of derivatives, particularly in the reference securities. They were almost childlike in their trust in systems and processes: If PWC or a big law firm looked at something, that was good enough. The problem was that it isn?t. This isn?t to indict them: A guy like Steve Bensinger was a solid Treasurer but the CFO job at AIG required the ability to be an accounting whiz plus having equals parts risk guru and legal eagle–I?m thinking of a David Viniar sort–and he wasn?t any of those things.

Part of this problem has to do with the fact Greenberg/Matthews/Smith had seemingly been there forever and so a bright, truly talented next generation CFO or COO never bloomed. How could it have? Any ambitious 40 something would conclude that the AIG executive suites were permanently closed. So there was no backbench to hand and as I explain in the book, a post-Greenberg transition plan was not something Hank thought much of as a concept. Practically speaking, Sullivan was never remotely suited for the role since he had zero financial management experience. Moreover, his trusting, amiable disposition insured that when his former peers like Joe Cassano ran into hot water, he didn?t have a skeptical or questioning bone in his body. That?s a big risk to run when you have a Financial Services unit embedded in your company that is larger than Lehman Brothers and many times as complex. Greenberg, on the other hand, had little fear of conflict and had a track record of asserting himself over his trading desks.

7) Did AIG management err in moving so aggressively into areas that exposed them to the credit cycle and equity markets?? Do you think Greenberg could have been happy running a smaller insurance enterprise that would have a hard time growing profitably with moderate risk?

Part one: That?s the core challenge of AIG?s entrance into ?The Kingdom of Money? as I put it. As conceived, its financial units were never supposed to have this risk; that was what the asset management units were for. Per question #3 however, FP inevitably had its advantages competed away and was forced to seek profits in areas that had long been frowned upon, like getting long fixed income risk.

Part two: No. Handsome and steady profits were attractive to Greenberg but growing them were what he was all about.

8 ) What were the shortcomings from Greenberg being an autocrat at AIG, even if he was one of the most talented CEOs ever?

In AIG under Greenberg the single-minded focus on profits, new opportunities and growth that he instilled obviously facilitated a period of expansion and wealth creation that has a bare handful of rivals in history. However, given time and the law of averages, profit opportunities began to fade (the returns on assets tell this story) so they had to go farther out on the risk curve to sustain income growth. There is the same end to this story every time. Secondly, autocratic organizations tend to have weak leadership benches. At the unit level, AIG was shot through with talented people from top to bottom. The person who could run the company post-Greenberg, however, arguably didn?t exist at the company. For a talented executive, in retrospect, AIG was a company that you either came to understand that you were never going to go any farther than where Greenberg saw you going or you left. A lot of people chose the latter but over time, many of them ?went along,? and didn?t speak up at key junctures. For instance, in the securities lending debacle, the global investment unit?s senior leadership seemed fine with things but it was a pair of rank-and-file portfolio managers, Mike Rieger and another guy, who spoke up. They were roundly ignored.

9) What aspects of AIG?s culture overall helped lead to the eventual failure?

A problematic trust in process over actual insight and investigation. Time after time, ?A law firm signed off on it? was considered actual risk management; it?s not. There was also just abysmal risk management, not only in the obvious things like writing $73 billion of super-senior CDO tranche protection and the Securities Lending debacle, but in the minutiae. It appears no one even looked at the credit support annexes, which were standard in all swaps. Moreover, FPs valuation systems were completely inadequate in getting real market prices for the underlying CDOs. There is an element of the ?The Wizard of Oz? to AIG–?So that?s what is behind the curtain??

10) Do you think AIG got sloppy in the early 2000s as business got more complex, and the need to meet earnings estimates grew more difficult?? (Gen Re, PNC, Brightpoint, etc.)

Yes. They were all very different transactions but yes. Gen Re should have been caught by a mid-level risk analyst or lawyer in the general counsel?s office around the second week it was under construction. Brightpoint and PNC were separate but had at their core the manipulation of earnings. The odd thing is that the PNC transactions had been done several times in Japan with the same ill intent and were thoroughly blessed by regulators there, who were apparently happy to do anything to suggest that the nightmarish balance sheets of Japanese banks were improving. They had not a concern in the world that the deals were totally abusive to the investor.

11) At the end, AIG had subprime risk in their life insurers (through securities lending), mortgage insurers, at American General Finance, and at AIGFP.? Was it a mere coincidence that they had it everywhere?

No. AIG was a corporation whose ethos was a ceaseless hunt for earnings. When you are a AAA, or AA+ and fund at Fannie/Freddie levels, the carry trade is a very obvious place to capture some seemingly risk free spread. Given that AIG?s risk management was highly passive–relying on what others said about risk (as opposed to doing their own work)–trusting the rating agencies to get it right came easy. What was interesting is that Securities Lending and the mortgage insurance company continued to add exposure months after the market started to turn but American General Finance and FP examined the market in-depth, had a heart attack and immediately ceased those lines of business. The best thing? No one said a word to each other. AIG, in this sense, resembles a large and dysfunctional family, where no one shared anything with anyone, even Mom and Dad. Under Greenberg, big decisions like that invariably resulted in long, detailed phone calls where the decision was hashed out with Greenberg and Matthews. They would abide the decision but would want to know every reason why it was made.

12) Did it ever dawn on anyone at AIGFP that they were the big patsies insuring subprime securitizations prior to them stopping the practice in entire in 2005?? Or that the Street were patsies for relying on one insurer? (Forget that the US bailed them out in the bailout of AIG.)

Not as laid out in your question, no. An FP executive named Gene Park has become a minor celebrity because of media accounts that have him as a ?Voice in the Wilderness,? decrying abusively structured mortgage credit. Park certainly hated the sector and let it be known but his effect was limited in that Cassano disliked him with varying degrees of intensity. A guy named Andrew Forster, who ran the asset-finance group out of London and had ultimate authority over the swaps, was much more methodical and cautious. Park certainly communicated his dislike to him but Forster took months to flesh out his concerns. It doesn?t appear that the concerns over the swaps were ever put in terms of systemic risk but rather as just something that had higher than expected likelihood of default. It is difficult to overemphasize how incurious many at FP were.


13) What area in the AIG parent failed to note that AIGFP could call upon resources inside AIG upon downgrades, forcing a posting of collateral?? Treasury? CFO?? That had to be signed off on by someone at the AIG parent, no?

Every area. No one really looked at the absolute risk levels of the insurance FP was writing, no one looked at the CSAs, there were no autonomous risk procedures for determining valuations, no one modeled corporate cash flows in the event these swaps became a problem and it goes on. In July of 2007, when there was the first collateral demand from Goldman, much of the senior management of AIG was unaware this product line existed. That?s a problem.

14) Tim Geithner was supposed to be the Fed?s point man on derivatives.? How could he miss something this large? How do you think derivatives should be regulated?

Let me combine these two questions. Geithner missed it because he didn?t know enough to look for it, but I interviewed a number of senior Fed officials who had not missed AIG?s rapid balance sheet expansion, the leverage of the banks and brokers to each other and, ultimately, everyone to structured products. Their response was that the Fed (in New York) only analyzed bank holding companies, or the entities that owned the big banks. They fully acknowledged the financial filth going on but said it was at the operating units, where they had no ability to do anything. That was the purview of the Office of the Comptroller of the Currency, another federal regulator with minimal funding and difficulty retraining an experienced analyst corps. I?ll bet you can figure out how it went from there.

The only regulation that really, truly, deeply matters in pondering the credit crisis is the repeal of Glass-Steagall. Once banks were able to throw themselves and their funding capacities into market-making and underwriting full bore, nightmares could only result. To that end, the only regulation that matters in reframing a regulatory apparatus is the reimposition of Glass-Steagall in some form or shape. Commercial banks, all joking aside, have usually been pretty good at making loan decisions; conversely, when investment banks dominated the marketplace, risk was a function of how much capital a firm was willing to lose at one time. For all the mania?s and fads that come and go in the markets, from the mid 1930s onward, Wall Street did a decent job of keeping its insanities form effecting the economy too much.

It would be optimal if we got back to that.

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Many thanks to Roddy Boyd for the answers.? He want above and beyond again.

Book Review: Boombustology

Book Review: Boombustology

For those that have read me for years at The Aleph Blog, this book will impart little that is new.? But, you get a set of powerful arguments in one integrated slim package.

I really liked this book.? The author took a broad view of bubbles, and developed five lenses through which to analyze them:

  • Microeconomics
  • Macroeconomics
  • Psychology
  • Politics
  • Biological (contagion) analogies

This picks up the growth in debt, the misaligned short-term versus long-term incentives, crowd behavior, imitation, political agreement with booms, finger-pointing during busts, etc.

This book integrates the ideas of Keynes, Minsky, the Austrian economists, Soros (reflexivity), and others.? The author was very willing to interact with the view of those that might not fully agree with him, and yet bring out the areas where they do agree.

And the author tests the five lenses on five bubbles:

  • The tulip bubble
  • The Great Depression
  • Japan in the late 80s
  • The Asian crisis in 1997
  • The US Housing Crisis 2006-?

Not surprisingly the crises chosen support the theory.? It would be interesting to see what the author would say on other bubbles, like the South Sea Bubble, the Tech Bubble, etc.

And so the author summarizes his case, and I think he does it well. But then he takes it a step further, and effectively says, “Well, is there an obvious bubble to point out now?”? And so he points out China.? The debts, the manipulation, malinvestment, bad incentives, etc.? You can read it for yourself and draw your own conclusions.

My main verdict on this book is that it provides a firm basis for evaluating bubbles.? I place it behind “Manias, Panics, and Crashes,” and “Devil Take the Hindmost,” but not by much.? To the author: Great job.

Quibbles

I disagree with the idea that booms and busts are a capitalist phenomenon.? Command-and-control economies do have booms and busts — the Great Leap Forward was a boom followed by a tremendous bust.? The effort to plant cotton in the Soviet Union was short-lived, leading to declining yields and destruction of the ecology of the Aral Sea.? There are more examples than this; at least in capitalism, the boom yields some decent rewards.

Who would benefit from this book:

Anyone who wants a better understanding of the boom-bust cycle will benefit from this book.? The author has nailed it in my opinion.? This book will help you to properly skeptical in the next unsustainable boom, and minimize your exposure to the bust.

If you want to, you can buy it here: Boombustology: Spotting Financial Bubbles Before They Burst.

Full disclosure: I asked the publisher for the book, and they sent it to me.

If you enter Amazon through my site, and you buy anything, I get a small commission.? This is my main source of blog revenue.? I prefer this to a ?tip jar? because I want you to get something you want, rather than merely giving me a tip.? Book reviews take time, particularly with the reading, which most book reviewers don?t do in full, and I typically do. (When I don?t, I mention that I scanned the book.? Also, I never use the data that the PR flacks send out.)

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

Creating a Stable Financial System, Part I

Creating a Stable Financial System, Part I

I’ve been thinking a lot about bank reform lately.? Here’s the core of the problem: deposits are sticky in ordinary times, particularly once you have a guarantor of deposits like the FDIC.? But for some banks, they look to other short term funding, whether it is short CDs or repo funding.

Now to me a lot of the issue is asset-liability mismatch.? Banks borrow short and lend long.? That leads to banking panics.? Financing illiquid assets with liquid liabilities is unstable, and begs for bankruptcy at the first significant loss of confidence.

But there is a greater mismatch present, which I want to explore.? Every asset is financed with some liability or equity.? And, every liability is someone else’s asset, but not vice-versa, because assets owned free and clear are equity-financed.

Assets financed by debt are frequently mismatched short.? Long mismatches are rare because of the cost of financing being too high.? Now, if short mismatches are small, that’s not a problem.? There is enough flexibility in financial balance sheets to accept small mismatches.? Real disasters happen when long assets are financed in such a way that there is a risk that the financing will fail prior to the assets being paid off.

The fundamental mismatch in debts that finance assets is that the ultimate assets being financed are longer-dated than the financing.? We fund land, houses, buildings, plant & equipment, and do it off of deposits, savings accounts and CDs.? Some financial companies finance off of short-dated repo funding.? The reason that this mismatch is hard to avoid is that average individuals who save want short-dated assets that can be used for transactions.? That doesn’t fit well against the need to fund long-term assets.

The same problem exists in the municipal bond market.? Much more money wants to invest short, while municipalities want to borrow long.? This leads to a steep muni yield curve.? Commercial insurers writing long tail business, and wealthy people that can tolerate interest rate volatility end up buying the long end, and lower taxes in the process.

If banks were required to approximately match cash flows for assets not financed by equity, yield curves would steepen for other areas of the fixed income markets.? Areas of the financial market where there are long/strong balance sheets, such as Life Insurers, Commerical Insurers, Defined Benefit Pensions and Endowments would get higher yields for longer commitments.? Banks would become a lower ROE business, and that would be good, as there would be many fewer failures, and there would be fewer banks; we are over-banked.? Time to re-educate bankers for more productive activities.

Long dated floating-rate loans could be a solution for banks funding loans? off of short-dated lending, or, using interest rate swaps to achieve the same result.? The risk is that a bank locks in what proves to be a low spread on the asset, while funding costs are volatile.

A few final notes: 1) the standard of broadly matching asset and liability cash flows should be applied to all regulated financial institutions, including investment banks.? Only surplus assets not needed to match liabilities can be used for investments with equity-like risk. 2) There must be an unpacking of complex vehicles with embedded leverage to do the Asset-Liability management.? As examples:

  • Securitizations
  • Repo Funding
  • Private Equity
  • Hedge Funds
  • Margin loans
  • SIVs and the like

would need to be reflected as looking through to the items ultimately financed.? As an example, the AAA portion of a senior-sub securitization is long the loans, and short the certificates sold to the rest of the deal.

Repo funding has its own issues.? In a crisis, haircuts rise as asset values fall.? Institutions relying on that funding often fail at those times, and leaves losses to the repo lender.? There would need to be something reflected for the risk of repo market failure, though the grand majority of the losses go to the borrower, and not the lender.

3) Even short lending to those getting loans that do not fully amortize should be reflected as loans that are longer-dated, because of the risk of rates being higher, and refinancing is not possible.

I have more to say, but I’m going to hit the publish now.? Comments are welcome.

Book Review: All the Devils are Here

Book Review: All the Devils are Here

Have you ever seen a complex array of dominoes standing, waiting for the first domino to be knocked over, starting a chain reaction where amazing tricks will happen?? I remember seeing things like that several times on “The Tonight Show with Johnny Carson” back when I was a kid.

When the first domino is knocked over, the entire event doesn’t take long to complete — maybe a few minutes at most.? But what does it take to set up the dominoes?? It takes hours of time, maybe even a whole day or more.? Often those setting up the dominoes leave out a few here and there, so that an accident will spoil only a limited portion of what is being set up.

Those standing dominoes are an unstable equilibrium.? That is particularly true at the end, when the dominoes are added to remove the safety from having an accident.

Most books on the economic crisis focus on the dominoes falling — it is amazing and despairing to watch the disaster unfold, as the leverage in the system is finally revealed to be unsustainable.

This book is different, in that it focuses on how the dominoes were set up.? How did the leverage build up?? How was safety ignored by so many?

The beauty of this book is that it takes you behind the scenes, and describes how the conditions were created that led to a huge creation of bad debts.? I was a small and clumsy kid.? My friends would say to me during sports, “There are mistakes, but your error was so great that it required skill.”

The same was true of the present crisis.? There were a lot of skillful people pursuing their own private advantage, using new financial instruments which were harmless enough on their own, but deadly as a group.? So what were the great financial innovations that enabled the crisis?

  • Creation of Fannie and Freddie, which led to an over-issuance of mortgages.
  • Securitization, particularly of mortgages.? This led to a separation between originators and certificateholders. (And servicers, though the book does not go into servicers much.)
  • Having parties that guarantee debt, whether GSEs, Guaranty Insurers, the Government, or credit default swaps [CDS]
  • Loosening regulations on commercial banks, investment banks and S&Ls.
  • Regulatory arbitrage for depository institutions.
  • Loose monetary policy from the Federal Reserve, together with a disdain for regulating credit.? They saw Mexico and LTCM as successes, and thought that there was no crisis that could not be solved by additional liquidity.
  • Bad rating agency models, and competition among rating agencies to get business.
  • Regulators that required the use of rating agencies for capital modeling.
  • The broad, misinformed assumption that real estate prices only go up.
  • The creation of Value-at-risk, a risk management concept that has limited usefulness to true crisis management.
  • The creation of CDOs that did not care for much more than yield.
  • The development of synthetic CDOs, which allowed securitization to apply to corporate bonds, MBS, and ABS not owned by the trusts.
  • The creation of subprime loan structures, where are that was cared for was yield.
  • The creation of piggyback loans, so that people could put no money down for a home.

There are no heroes in this book, aside from tragic heroes who warned and were kicked aside in the hubris of the era.? Goldman Sachs comes out better than most, because they saw the crisis coming, and protected themselves more than mot investment banks.

I learned a lot reading this book, and I have read a dozen or so crisis books.? I didn’t learn much from the other books.? In this book, the authors interviewed hundreds of people who were integral to the crisis, and read a wide variety of sources that wrote about the crisis previously.

I found the book to be a riveting read, and I read it cover to cover.? I could not change into scan mode; it was that well-written.

This is the best book on the crisis in my opinion, because it takes you behind the scenes.? You will learn more from this book than any other on the crisis.

Quibbles

They don’t get the difficulties of being a rating agency.? There is the pressure to get things right over the cycle, and get it right on a timely basis.? These two goals are contrary to each other, and highlighting that conflict would have enhanced the book.

Who would benefit from this book:

Anyone willing to read a longish book could benefit from this book.? It is the best book on the crisis so far.

If you want to, you can buy it here: All the Devils Are Here: The Hidden History of the Financial Crisis.

Full disclosure: This book was sent to me, because I asked for it.

If you enter Amazon through my site, and you buy anything, I get a small commission.? This is my main source of blog revenue.? I prefer this to a ?tip jar? because I want you to get something you want, rather than merely giving me a tip.? Book reviews take time, particularly with the reading, which most book reviewers don?t do in full, and I typically do. (When I don?t, I mention that I scanned the book.? Also, I never use the data that the PR flacks send out.)

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

The Value of Fair Accounting

The Value of Fair Accounting

I was a reluctant convert to fair value accounting, because I like standardization in accounting that allows for comparisons across corporations.? Also, unlike the complaints that emanate from financial companies that argue that fair value is procyclical, my experience has been that financial companies mismark their assets high, no matter what.

But when I read this article in the New York Times, it hit me.? The reason that the banks complain about fair value accounting being procyclical, is that they are mismatching assets and liabilities.

Think about it.? The argument that the banks make is that they are solvent.? Unfavorable temporary asset price changes should not be reflected in the accounting.? But if liabilities are marked to market at the same time, the difference should be minimal if the cash flows of the assets and liabilities are matched, unless there is a credit problem with the assets.

The thing is, with most banks, they have a large amount of their financing through deposits, savings accounts, CDs, and repo funding, all of which is short-dated, relative to the length of their assets.? (For floaters, look at the maturity, not the reset period.)

Thus, it should be no surprise when a bank is mismatched short versus its assets that it would squawk during times of crisis, and complain about fair value accounting.? But the problem isn’t the fair value accounting; it is the cash flow mismatch.? Banks try to make extra money off of that mismatch in good times, only for it to become a deadly risk in times of bad credit and liquidity.

Let the banks do what the insurers do, and come close to matching assets and liabilities.? If they do that, the financial system will become a lot more stable, and financial crises will be much less common.

And at that point, it won’t matter what accounting system is used, so long as those using book value impair assets fairly.? Still, I would prefer fair value.? Investors deserve the best information, even if it complicates life for corporate managements.

Flavors of Insurance, Part II (Life)

Flavors of Insurance, Part II (Life)

Life insurance probably has the most complex accounting of any of the sub-industries. Part of this comes from the complexity of the contingencies underwritten, and most of the rest from producer compensation and the length of the contracts underwritten.

Life insurance and annuities are sold, not bought. In general, people have a mental bias toward thinking that they aren’t going to die in the immediate future. Annuities are often sold to people who won’t otherwise plan for their retirement. To overcome those biases, life insurance companies pay agents handsomely to originate policies. The commission is large enough that if the company expensed it, it would lose money on a GAAP basis every time it issued a policy. That’s why policy acquisition costs are deferred, set up as an asset, and amortized in proportion to the gross profitability of the business over the life of the business.

Reserving for term policies isn’t very complex, but reserves for cash value policies are set as the expected present value of future benefits less future premiums. Small changes in interest, mortality, and lapse rates can make large changes to reserve values. Other contingencies can affect different classes of policies as well; variable and indexed contracts rely on returns of the stock and bond markets. Higher assets under management mean higher fees.

There is a second business that most life insurance companies engage in. Since the companies would not be profitable if they invested in Treasury securities, they typically invest in corporate bonds, mortgage-backed securities, and other risky forms of debt. Some also invest in commercial mortgages and real estate. When there is stress in the credit and mortgage markets, life insurance companies do poorly.

In reviewing the performance of life companies as group from March 1994 through March 2004, one can see the effect of the major drivers of profitability. Underwriting was typically profitable for companies throughout the entire decade, so that was not a differentiating factor. Most of the shifts in profitability came from investment results. The credit cycle was generally positive to the beginning of 1999, negative 1999-2002, and positive after that. The equity market supported variable life and annuity writers until the bull market peak in March 2000, punished them until March 2003, and has rewarded them since then. The only period that deviated from this description was after the bubble popped in March 2000; life companies temporarily did better as equity investors fled technology stocks for the safety of stodgy sectors like life insurance.

The outlook for life insurance is no different than the past; it is tied to the outlook for the asset markets. If the credit and equity markets do well, so will life companies.

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Bringing it to the Present

Many of the things that I wrote back in 2004 regarding life insurers have proved prescient.? Life insurers have prospered as the asset markets have prospered, and suffered during the bear markets. On average, life insurers have done better than other financials, and better than the market as a whole since 2004.

One advantage the life insurers had 1999-2003 was that they got burned on CDOs and did not get caught in the bubble.? Even with other types of structured lending, life? insurers got more conservative 2003-2005, unlike most of the rest of the financial sector.? Life insurers noticed the poor underwriting, and stayed away.

It should be noted that there are life insurers that do a lot of variable business, and those that don’t.? Those that write a lot of variable life and annuities will be more sensitive to the stock market than those that don’t write a lot of variable business.

One final squishy spot: secondary guarantees.? With Universal Life and Variable Annuities, there are secondary guarantees where the reserving is questionable.? Also true of long-dated term policies… be aware that there might be some bombs lurking there, that will manifest in severe economic scenarios.

At present, I don’t own any pure life insurers.

Flavors of Insurance, Part I

Flavors of Insurance, Part I

I view the insurance industry as a loosely related group of sub-industries, where knowing something about one sub-industry tells little about any other sub-industry. Even within each sub-industry, companies can be very different from each other. This article will attempt to go through the vast wasteland that is the insurance industry, and attempt to point out some of the more interesting aspects of it.

There are three major risk factors with insurers: the underwriting cycle, investment returns, and expense control.

The Underwriting Cycle

The property/casualty insurance industry, like all mature industries, is a cyclical business. Cyclical businesses revolve around pricing, which involves the relative degree of capacity available in the industry.

The P/C industry derives its capacity to write business from the amount of surplus available to support business. This creates a four-phase cycle for the industry.

1.????? When surplus is abundant, rate-cutting is prevalent, and generally poorer-quality business gets written in an effort to retain market share. Terms and conditions for insurance are loose. During this period, the prices of P/C companies fall relatively hard, as prospective estimates of profitability fall.

2.????? After enough poor quality business gets written, and premium rates decrease meaningfully, high quality companies exit lines of business, or buy reinsurance, and low quality companies begin to look impaired. At these times, the stock prices of high quality firms fall a little, and low quality firms fall more.

3.????? As the results of bad business become evident, reserves get raised, sometimes drastically, and surplus declines. When surplus is deficient, premium rates rise, and the stocks of companies that have survived the cycle rise dramatically. The best business from both a profit and risk control standpoint, gets written in this phase of the cycle Terms and conditions for insurance are tight.

4.????? When surplus becomes adequate, premium growth rate slows, and stock prices rise slowly, at roughly the rate of retained earnings. This continues until surplus is abundant.

Catastrophes, when they happen, temporarily reduce surplus, and improve pricing. The companies least affected by the cat rally, and those most affected, tend to fall, or rise little. Major catastrophes can cause the cycle to bottom, or extend the positive side of the cycle, because surplus is diminished.

The rating agencies tend to cut ratings near phase 2, and raise them near phase 4. Diminished ratings decrease the amount of business that an insurer can write, and further limit the willingness of prospective purchasers of insurance, particularly long-tailed coverages, who want to be sure that the company that they buy insurance from will be around to pay claims.

Investment Returns

Strong investment returns increase surplus. In a bull market, some companies become more aggressive about writing business so that they can earn money from investments. This is particularly true of companies that sell coverages that result in long-tailed liabilities. Strong investment returns prolong phases 1 and 4 of the cycle. Investment returns were so strong throughout the 1990s that insurers often compromised underwriting standards, leading to much of the troubles that occurred in the industry from late 2000 to early 2003. Not only were investment returns low or negative, but the results of prior poor underwriting were realized through reserve adjustments that diminished surplus.

Expense Control

Every time a premium gets calculated, there is an estimate embedded in the premium for expense. Expenses typically take three forms: policy acquisition, claims adjustment, and operational. There is a tendency for expenses to drift higher when investment returns are strong, and when the market is softening due to greater competition.

Now I will discuss each sub-industry separately. Included in each discussion is a description of products, risks, and industry performance over the last ten years. The graphs show the performance of each sub-industry over the last ten years, derived from my own proprietary indexes. At the end, I give my outlook for each sub-industry.

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Bringing it to the Present

This series was written seven years ago in an all-nighter for my new boss.? The piece never saw the light of day, which annoyed me, though I liked my boss, and I never complained about it.

As I publish the ten-or-so pieces of it, because it was long, at the end of each installment, I will try to update the insurance subindustries to the present.? But it would be useful for anyone reading this to look at my presentation to the Southeastern Actuaries Conference on the Amazing Decade for Insurance Stocks.? Aside from that, I have lost the graphs of the original presentation.? My apologies.

Insurance is an amazing business.? Insurers make promises.? Many of the promises are uncertain with respect to amount and/or timing.? That makes the accounting complex.? This is one of the reasons why examining the qualitative aspects of an insurance company to understand how a management team makes decisions is so valuable.

Anyway, more to come here, and I hope you all enjoy this series.

The Portfolio Rules Work Together

The Portfolio Rules Work Together

Here are the eight rules with links to my recent pieces:

  1. Industries are under-analyzed, relative to the market on the whole, and relative to individual companies. Spend time trying to find good companies with strong balance sheets in industries with lousy pricing power, and cheap companies in good industries, where the trends are not fully discounted.
  2. Purchase equities that are cheap relative to other names in the industry. Depending on the industry, this can mean low P/E, low P/B, low P/S, low P/CFO, low P/FCF, or low EV/EBITDA.
  3. Stick with higher quality companies for a given industry.
  4. Purchase companies appropriately sized to serve their market niches.
  5. Analyze financial statements to avoid companies that misuse generally accepted accounting principles and overstate earnings.
  6. Analyze the use of cash flow by management, to avoid companies that invest or buy back their stock when it dilutes value, and purchase those that enhance value through intelligent buybacks and investment.
  7. Rebalance the portfolio whenever a stock gets more than 20% away from its target weight. Run a largely equal-weighted portfolio because it is genuinely difficult to tell what idea is the best. Keep about 30-40 names for diversification purposes.
  8. Make changes to the portfolio 3-4 times per year. Evaluate the replacement candidates as a group against the current portfolio. New additions must be better than the median idea currently in the portfolio. Companies leaving the portfolio must be below the median idea currently in the portfolio.

For the most part these are rules that would only serve a value investor.? They focus on the first principle of value investing, which is “margin of safety (rule 3),” and after that on the less important principle of buying them cheap (rule 2).

I would add the concept “sell them relatively dear,” which? rules 7 and 8 spell out.? The sell discipline gets short shrift in much of value investing, and I think I have a very good sell discipline.

But value traps do in many value investors.? Value traps are companies that are cheap, but cheap for a reason.? How do you avoid value traps?

  • Try to have industry factors working for you (Rule 1)
  • Look for companies that still have some room to grow (Rule 4)
  • Avoid companies that are aggressive in their reporting of income (Rule 5)
  • Look for managements that use their free cash flow wisely (Rule 6)

I have my failures, but I don’t trip into many value traps, relative to the average value investor.

That is how my rules work together.? They are meant to cover the basic areas of value investing, while attempting to avoid the traps that harm value investing.

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This is the end of the “Portfolio Rules” series.? From these articles, I hope you get a good idea of how I invest, whether you invest like me, or invest with me.

If You Must Tax Corporations…

If You Must Tax Corporations…

I general, I think our tax code is nuts, allowing deductions for interest, and not dividends.? That creates a pro-debt bias in the tax code, which we are suffering from now.? I would reverse it, and allow deductions for dividends, and not interest, which would create a pro-equity tax code.

Leaving that aside, though I think corporations should not be taxed, and individuals should be taxed more heavily, if you must tax corporations, do not create a separate tax accounting basis.? There should be no social engineering through the tax code.? Instead, tax corporations on their GAAP income.? If there is some other figure that they highlight to investors, such as operating earnings, tax them on that.

A taxation method like this gets rid of two sets of games:

  1. The game of lowering taxable income below GAAP income.
  2. The game of boosting reported income above GAAP income.

It is far better for the nation as a whole to have one set of strict rules on taxation that are almost impossible to avoid that the Swiss cheese tax code that we have gotten post-Reagan.? Discretion in the tax code allows the wealthy to avoid paying their fair share, regardless of what the tax rates are.? Why do you think wealthy Democrats support increases in tax rates and estate taxes?? Because they have clever ways of avoiding those taxes.

Again, I support true tax reform.? But who else would support such a fair system, when politicians support unfairness to aid them in getting re-elected?

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